The Tax Court in Brief January 18 – January 22, 2021
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
The Week of January 18 – January 22, 2021
Adams Challenge (UK) Limited v. Comm’r, 156 T.C. No. 2
Short Summary: The case discusses whether under Section 882(c)(2) of the Code, a foreign corporation is entitled to the benefits of deductions or credits after the IRS has prepared returns for such corporation. The case also discusses whether the application of Section 882(c)(2) violates provisions of the tax treaty between the U.S. and the U.K., specifically those related to business profits and nondiscrimination.
During 2009 through 2011, Adams Challenge, a UK corporation (the taxpayer) owned a multipurpose support vessel. In 2009, the taxpayer entered into a contract with a U.S. company, allowing the U.S. company to use the vessel for various oil projects within the Outer Continental Shelf in the Gulf of Mexico.
In 2013, the IRS issued a Notice of Jeopardy Assessment to the taxpayer in the amount of $23,780,625 for the 2009-2011 period. At that time, the taxpayer had not filed a U.S. income tax return.
In 2014, the IRS issued a notice of deficiency where it determined that the taxpayer had effectively connected income adding that the taxpayer was not entitled to deductions or credits because it had failed to submit a tax return. The taxpayer submitted a petition with the Court. In 2017, the taxpayer filed protective returns for 2009 and 2010.
The IRS argued that under Section 882(c)(2) the taxpayer had failed to submit a true and accurate return before the IRS issued the notice of deficiency, consequently the taxpayer was not entitled to receive the benefits of the deductions and credits allowed by the Code.
The taxpayer argued that such regulation did not provide such a requirement. Additionally, it argued that Section 882(c)(2) was overridden by the provisions of the UK-U.S. tax treaty (the Treaty) specifically those related to business profits (which allow foreign corporations to the deductions and credits related to the business of a foreign corporation) and the nondiscrimination article.
After analyzing the statutory and case law development behind Section 882(c)(2), and the applicability of the UK-US tax treaty, the Court agreed with the IRS.
Key Issues: Whether Section 882(c)(2) provides a specific terminal date for a foreign corporation to submit a tax return and be entitled to the benefits of deductions and credits under the Code. Whether Section 882(c)(2) violates the business profits article or the nondiscrimination article of the Treaty.
Primary Holdings: Based on the statutory and the applicable case law, Section 882(c)(2) establishes that a foreign corporation must file a true and accurate tax return before the IRS prepares a return on behalf of the foreign corporation. Moreover, Section 882(c)(2) does not contradict the provisions of the Treaty, specifically the business profits and nondiscrimination articles.
Key Points of Law:
- Section 882(c)(2) was introduced in 1928 (as Section 233) to prevent foreign corporations from not reporting income effectively connected with a U.S. trade or business, by allowing such corporations to receive the benefits of deductions and credits conditioned to the filing of a U.S. income tax return. Because Section 882(c)(2) is not clear in relevant aspects, caselaw has mostly defined the reach and limits of the statute.
- In Anglo-American Direct Tea Trading Co. v. Comm’r 38 BT.A. 711 (1938), the Court ruled determined that the mere fact that a tax return was not timely filed by a foreign corporation did not preclude the allowance of the deductions claimed.
- In Taylor Securities, Inc. v. Commissioner, 40 B.T.A. 696 (1939), the Court determined that under Section 233, the foreign corporation loses its right to deductions and credits if it does not file a return until after the IRS has prepared a return for it and has notified the taxpayer of the deficiency determination.
- In Ardbern Co. v. Commissioner, 41 B.T.A. 910 (1940), modified and remanded, 120 F.2d 424 (4th 1941), the Court established that if the taxpayer “attempted in good faith” to file a return before the IRS prepared returns for it, but it ultimately filed the return after the IRS has prepared the return, the taxpayer was entitled to deductions because of “elementary justice”.
- In Blenheim Co. v. Commissioner, 42 B.T.A. 1248, the Court determined that although Section 233 did not provide a “time element” to submit the tax return, the statute required the foreign corporation to file the return before a “terminal date” which, under Taylor, is defined as the date on which the IRS prepares a return for the foreign corporation.
- In the 1954 Code, Section 233 was recodified as Section 882(c)(2). Such provision was in substance, identical to its predecessor, according to the Senate Finance Committee. In a new case, Brittingham v. Commissioner, 66 T.C. 373 (1976), aff’d per curiam, 598 F.2d 1375 (5th Cir. 1979), the Court reaffirmed the previously developed caselaw to now Section 882(c)(2) coupled with the 1957 regulations. Finally, the Court analyzed that under Espinosa v. Commissioner, 107 T.C. 146 (1996), a nonresident alien forfeits his rights for deductions and credits if he fails to file a return before the IRS prepares a return for him.
- Under the previous case law and the statutory language of Section 882(c)(2), the Court reasoned that the taxpayer did not file a return before the IRS prepared a return for the taxpayer. Consequently, under Taylor, the taxpayer is not entitled to deductions or credits for the year. The Court also added that the taxpayer in this case could use the “good faith” defense established by Ardbern Co., because the taxpayer failed to offer a plausible excuse for failing to file a return until the IRS had prepared the return.
- The Court also analyzed the taxpayer under the Regulations, which were revised in 1990 and 2003. Under the Regulations, a foreign corporation has a fixed deadline to submit a return within 18 months of the due date (which for foreign corporations is within 5 ½ months after the close of the tax year). This allows foreign corporations a total period of 23 ½ months to submit a tax return before Section 882(c)(2) applies. And although such a deadline can be waived if requested, the taxpayer did not show that it requested a waiver. Considering such elements, the Court argued that under the Regulations and the relevant case law, the taxpayer was not entitled to deductions or credits for the relevant years.
- As for the applicability of the Treaty provisions, the Court determined that under the intent of the contracting States, the UK did not express any intention that the Treaty should override Section 882(c)(2). Additionally, the business profits article of the Treaty does not conflict with Section 882(c)(2), because the latter provides only administrative and procedural conditions that limit the deductibility of business expenses.
- As for the nondiscrimination argument, the Court ruled that foreign corporations are not in the same circumstances as domestic corporations with respect to the filing of tax returns. Under the view of the Treasury, to which the Court deferred, the nondiscrimination article is not violated if a foreign corporation is subject to different requirements than those applicable to a domestic corporation. Accordingly, the Court held that Section 882(c)(2) did not violate the Treaty.
Insight: This case provides great insight for foreign corporations that may be subject to ECI rules, specifically as for the filing of a tax return. Careful analysis is required to determine whether a protective tax return must be filed, to comply with Section 882(c)(2). Moreover, the case is relevant to determine the interpretation of tax treaties entered by the U.S. Multiple provisions of tax treaties are usually deemed to override he provisions of the Code, but this case clearly shows that if the provision of the Code does not directly contradict the provisions of a treaty, then the requirements of the Code may be applicable. This case clearly opens the door for the IRS to subject transactions that are “covered” by a treaty to U.S. requirements which could lead to denial of treaty benefits in a variety of cases.
Aspro, Inc. v. Comm’r, T.C. Memo. 2021-8
Short Summary: Aspro, Inc. (Aspro) paid management fees to its three shareholders: Milton Dakovich, Jackson Enterprises, Corp., and Manatt’s Enterprises, Ltd. for the tax years ending November 30, 2012, November 30, 2013, and November 30, 2014. The IRS disallowed the deductions as disguised dividends. Aspro filed a timely petition with the United States Tax Court challenging the IRS’ determinations.
Key Issues: Whether Aspro is entitled to deductions for fees it paid to Milton Dakovich, Jackson Enterprises, Corp., and Manatt’s Enterprises, Ltd.?
Primary Holdings: Aspro is not entitled to deductions for fees it paid to Milton Dakovich, Jackson Enterprises, Corp. and Manatt’s Enterprises, Ltd. because most of the evidence shows that Aspro paid the fees to its three shareholders as disguised distributions. This evidence includes: (1) Aspro made no distributions to its three shareholders during the years at issue or its entire corporate history but paid management fees each year; (2) the two large shareholders always got equal amounts and the percentages of management fees all three shareholders received roughly correspond to their respective ownership interests; (3) Aspro paid the management fees as lump sums at the end of each tax year to its shareholders; (4) Aspro had relatively little taxable income after deducting the management fees each year; and (5) Aspro’s process of setting management fees was unstructured and had little, if any, relation to the services being provided. Moreover, any payments to the three shareholders were not reasonable in amount.
Key Points of Law:
- The taxpayer generally bears the burden of proving that the Commissioner’s determinations in a notice of deficiency are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The taxpayer also bears the burden of proving entitlement to any deductions claimed. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The Code and the regulations, therefore, require the taxpayer to maintain records sufficient to establish the amount of any deduction claimed. See 6001; Treas. Reg. § 1.6001-1(a).
- A subchapter C corporation is subject to Federal income tax on its taxable income, which is its gross income less allowable deductions. 11(a), 61(a)(1) and (2), 63(a). A corporation may deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Sec. 162(a)(1); Treas. Reg. § 1.162-7(a).
- An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a transaction “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense is necessary if it is appropriate and helpful for the development of the business. See Comm’r v. Heininger, 320 U.S. 467, 471 (1943). Whether an expense is ordinary and necessary is generally a question of fact. at 475.
- In testing whether compensation is deductible we consider whether the payments “are in fact payments purely for services.” Reg. § 1.162-7(a). This is a question of fact to be determined from all the facts and circumstances. Am. Sav. Bank v. Comm’r, 56 T.C. 828 (1971). However, distributions to shareholders disguised as compensation are not deductible. Treas. Reg. § 1.162-7(b)(1).
- Courts closely scrutinize compensation paid by a corporation to its shareholders to ensure the payments are not disguised distributions. Charles Schneider & Co. v. Comm’r, 500 F.2d 148, 152 (8th 1974); Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d 193, 194 (8th Cir. 1952). In the Eighth Circuit, where an appeal would lie in this case, the issue of whether or to what extent compensation paid by a corporation to its shareholders represents compensation for services or constitutes a distribution of profits is a determination of “matter purely of fact.” Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d at 195.
- In determining whether the compensation paid to a corporation’s shareholders is instead a distribution of profit, the Tax Court considers all the facts and circumstances. And the Tax Court is not “compelled to accept at face value the naked, interested testimony of the corporation or the stockholder[s], merely because that testimony is without direct contradiction by other witnesses.” Id.
- In addition to being for services, the amount allowed as compensation may not exceed what is reasonable under all the circumstances. Home Interiors & Gifts, Inc. v. Comm’r, 73 T.C. 1142, 1155 (1980); Treas. Reg. § 1.162-7(b)(3). The regulations state that generally, reasonable and true compensation is only such an amount as would ordinarily be paid for like services by like enterprises under like circumstances. Reg. § 1.162-7(b)(3). The reasonableness of the amount is also a question of fact to be determined from the record in each case. Charles Schneider & Co. v. Comm’r, 500 F.2d at 152; Estate of Wallace v. Comm’r, 95 T.C. 525 (1990). Finally, the test of reasonableness is not applied to the shareholders as a group but rather to each shareholder’s compensation in the light of the individual services performed. L. Schepp Co. v. Comm’r, 25 B.T.A. 419 (1932).
- In the case of shareholder-employee compensation, courts have considered the following factors: the employee’s qualification; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; a comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the taxpayer’s salary policy for all employees; and in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years. Charles Schneider & Co. v. Comm’r, 500 F.2d at 152; Mayson Mfg. Co. v. Comm’r, 178 F.2d 115, 119 (6th 1949); Home Interiors & Gifts, Inc. v. Comm’r, 73 T.C. at 1155-1156. No single factor is dispositive of the issue; instead, the Court’s decision must be based on a careful consideration of applicable factors in the light of the relevant facts. See Mayson Mfg. Co. v. Comm’r, 178 F.2d at 119.
- Some courts have supplemented or completely replaced the multifactor approach for analyzing shareholder-employee compensation with the independent investor test. See Mulcahy, Pauritsch, Salvador & Co. v. Comm’r, 680 F.3d 867 (7th 2012). The Court of Appeals for the Eighth Circuit has not opined on this test yet. But in cases appealable to that Court of Appeals, we have applied the independent investor test as a way to view each factor. See Wagner Constr., Inc. v. Comm’r, T.C. Memo. 2001-160.
The Aspro case shows the difficulties corporate taxpayers can face in attempting to prove that compensation paid to shareholders is reasonable and, in fact, true compensation. For corporate taxpayers who pay their shareholders compensation, it may be advisable to have a tax attorney document the compensation to protect against any challenge and future IRS examination.
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