The Tax Court in Brief April 11 – April 16, 2021

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The Tax Court in Brief April 11 – April 16, 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.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

Tax Litigation: The Week of April 11 – April 16, 2021

De Los Santos v. Comm’r, 156 T.C. No. 9

April 12, 2021 | Lauber, J. | Dkt. No. 5458-16 

Tax Dispute Short Summary:

Taxpayer-husband is a medical doctor.  During 2011 and 2012 (“Years at Issue”), he was the sole shareholder of Dr. Ruben De Los Santos MD, PA, an S corporation organized in Texas (“S Corp.”).  The S Corp. employed taxpayer-husband and taxpayer-wife, the latter of whom served as office manager for the medical practice.  Four other employees also worked for S Corp.

Prior to the Years at Issue, the S corp. had adopted an employee welfare benefit plan to provide its employees with life insurance and other benefits.  Under the plan, taxpayers were entitled to a $12.5 million death benefit, and the four rank-and-file employees were entitled to a $10,000 death benefit and certain flexible benefits.  To fund the promised death benefits, the S Corp. used the Legacy Employee Welfare Benefit Trust (“Trust”), which purchased a life insurance policy insuring the taxpayers’ lives.  The policy was a “flexible premium variable universal life” policy with accumulation values based on the investment experience of a separate fund.

During 2006-2010, the S Corp. paid $1,862,349 to the Trust and treated these contributions as tax-deductible expenses of the medical practice.  During 2007-2012, the Trust paid aggregate premiums of $884,534 on the policy.  Because of these premium payments and the investment gains thereon, the “accumulation value” of the policy was $640,358 at the end of year 2011 and $744,460 at the end of year 2012.

The taxpayers timely filed joint federal income tax returns for 2011 and 2012.  They did not report any income on these returns related to their participation in the plan.  On December 4, 2015, the IRS issued taxpayers a notice of deficiency, determining that the economic benefits they received under the plan were currently taxable to them as ordinary income.  The taxpayers filed a petition with the United States Tax Court challenging the determination.

After the parties filed cross motions for partial summary judgment, the Tax Court held that the plan constituted a compensatory split-dollar life insurance arrangement and that the economic benefits flowing to the taxpayers generated current taxable income.  See De Los Santos, T.C. Memo. 2018-155.  Thereafter, the taxpayers filed a second motion for summary judgment contending that the characterization of the payments should be treated as a distribution under Section 301 of the Code.

Tax Litigation Key Issues:

Whether the compensatory split-dollar life insurance arrangement resulted in ordinary income to the taxpayers or distributions under Section 301 of the Code.

Primary Holdings:  Because the compensatory split-dollar life insurance arrangement afforded benefits to taxpayer-husband in his capacity as an employee of the S corporation, such benefits may not be characterized as a distribution by a corporation to a shareholder with respect to its stock.  In addition, for purposes of taxing employee fringe benefits, taxpayer-husband is treated as a partner of a partnership and the economic benefits he realized are therefore taxable under Section 707(c) as guaranteed payments, i.e., ordinary income.

Key Points of Law:

Insight: The De Los Santos decision shows the complexity that arises when taxpayers engage in split-dollar life insurance arrangements.  Taxpayers who participate in these or other types of life insurance arrangements should consult knowledgeable tax counsel to ensure that these arrangements are reported properly on all applicable tax returns.

Flynn v. Comm’r, T.C. Memo 2021-43

April 13, 2021 | Paris, J. | Dkt. No. 15975-14

Tax Dispute Short Summary:

In or about 1998 Janet Marcusse and others organized Access Financial Group (AFG), which they operated and promoted as an investment business.  Mr. Flynn began working for AFG in 1999—specifically, from 1999 until approximately December 2001, Mr. Flynn worked to promote AG and managed a group of investors from northern Wisconsin.

Between 1998 and 2001 AFG received approximately $20.7 million from approximately 577 investors.  However, by May 2001, most of this money was no longer in the business, and AFG began to default on its monthly payments to investors.  Later, in December 2001, AFG closed its office, leaving investors with no information and no money.

In late 2001, the federal government began a criminal investigation into AFG and its participants in the Western District of Michigan.  Mr. Flynn and Ms. Marcusse were subpoenaed by the grand jury; however, they claimed that the grand jury had no jurisdiction to subpoena them, and they challenged the validity of federal income tax laws.  The federal grand jury later determined that, of the approximately $20.7 million in investors’ funds received by AFG, approximately $8.4 million was used to make monthly payments purported to be investment profits to existing investors.  Ms. Marcusse and her co-conspirators, however, were determined to have diverted approximately $4.8 million for their personal use, in addition to further dissipating approximately $7.3 million in other transfers and payments.

Mr. Flynn and his co-conspirators were indicted and after a five-week trial in the U.S. District Court for the Western District of Michigan, a jury returned a guilty verdict on all counts against Mr. Flynn.  Mr. Flynn was later sentenced by the court to 108 months’ imprisonment followed by three years of supervised release.

Mr. Flynn also operated several other businesses, including various bars.  He made various deposits into accounts associated with those businesses.  He was also a recreational gambler.

In 2013, the IRS prepared substitute-for-returns (SFRs) for Mr. Flynn’s 1999 through 2001 tax years.  To prepare the SFRs, the IRS relied upon specific checks and wire transfers deposited into his various business accounts in addition to IRS Forms W2-G.  When Mr. Flynn failed to pay any taxes due on the SFRs, the IRS issued a notice of deficiency to Mr. Flynn.

Tax Litigation Key Issues:

Whether Mr. Flynn:  (1) failed to report certain gambling income on his 1999, 2000, and 2001 returns; (2) failed to report other income on his 1999, 2000, and 2001 returns; (3) is liable for additions to tax for fraudulent failure to file penalties under Section 6651(f) for 1999, 2000, and 2001; (4) is liable for additions to tax for failure to timely pay under Section 6651(a)(2) for 1999, 2000, and 2001; and (5) is liable for additions to tax for failure to pay estimated tax under Section 6654 for 1999, 2000, and 2001.

Primary Holdings:  Mr. Flynn (1) failed to report gambling income on his 1999, 2000, and 2001 returns; (2) failed to report other income that was deposited into various bank accounts he held for the 1999, 2000, and 2001 tax years; (3) is liable for the fraud penalty under Section 6651(f) for 1999, 2000, and 2001; (4) is liable for the addition to tax under Section 6651(a)(2) for 1999, 2000, and 2001; and (5) is liable for the additions to tax for failure to pay estimated tax under Section 6654 for 1999, 2000, and 2001.

Key Points of Law:

Insight: The Flynn decision shows the uphill battle a taxpayer may face with the IRS in defending against the fraudulent failure to file penalty when the taxpayer engages in unlawful activities and attempts to conceal assets.  Although the IRS bears the burden of proof in establishing fraud, the IRS can (and oftentimes does) rely on circumstantial evidence to prove up applicability of the penalty.


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