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:
- The purpose of summary judgment is to expedite litigation and avoid costly, unnecessary, and time-consuming trials. See FPL Grp., Inc. & Subs. v. Comm’r, 116 T.C. 73, 74 (2001). The Tax Court may grant summary judgment regarding an issue as to which there is no genuine dispute of material fact and a decision may be rendered as a matter of law. Rule 121(b); Arts, Inc. & Subs. v. Comm’r, 118 T.C. 226, 238 (2002).
- In 2003, the Treasury Department issued final regulations addressing the taxation of split-dollar life insurance arrangements. Split-dollar life insurance arrangements of the sort involved in this case fall into one of two categories—“compensatory arrangements” or “shareholder arrangements.” Reg. § 1.61-22(b)(2)(ii), (iii). In both types, the “owner” of the life insurance contract pays the premiums, and the “non-owner” has a current interest in the policy.
- In a “compensatory arrangement,” the arrangement “is entered into in connection with the performance of services” by a service provider for a service recipient. Reg. § 1.61-22(b)(2)(ii)(A). In a “shareholder arrangement”, the arrangement “is entered into between a corporation and another person in that person’s capacity as a shareholder in the corporation.” Treas. Reg. § 1.61-22(b)(2)(iii)(A).
- In the case of any split-dollar arrangement, “economic benefits are treated as being provided to the non-owner of the life insurance contract,” and the non-owner “must take into account the full value of all economic benefits,” less any consideration paid therefor. Reg. § 1.61-22(d)(1). “Depending on the relationship between the owner and non-owner, the economic benefits may constitute a payment of compensation, a distribution under section 301,” or a transfer having some other tax character. Id. This means that economic benefits under a “compensatory arrangement” will generally constitute the payment of compensation to the service provider, and economic benefits under a “shareholder arrangement” will generally constitute a distribution to the shareholder. Our Country Home Enters., Inc. v. Comm’r, 145 T.C. 1, 51 (2015).
- Section 301 governs distributions of property by a corporation to its shareholders. Not all payments from a corporation to a shareholder, however, constitute “distributions” within the ambit of section 301. Rather, section 301(a) requires that the transfer be made “by a corporation to a shareholder with respect to its stock.” The phrase “with respect to its stock” means that the distributee must receive the payment in his capacity as a shareholder.” “Section 301 is not applicable to an amount paid by a corporation to a shareholder unless the amount is paid to the shareholder in his capacity as such.” Reg. § 1.301-1(c).
- Accordingly, a payment is not a “distribution” if the shareholder receives it in his capacity as a creditor of the corporation. Loftin & Woodard, Inc. v. U.S., 577 F.2d 1206, 1242 (5th 1978). Nor is a payment of a “distribution” if the shareholder receives it in his capacity as an employee of the corporation. Haber v. Comm’r, 52 T.C. 255, 268 (1969), aff’d per curiam, 422 F.2d 198 (5th Cir. 1970). “These transfers are not made with respect to stock because, if not for the obvious reason that the shareholder’s standing as a shareholder is incidental, the corporation receives equal value in return . . .”
- “The provision by a corporation to its shareholder pursuant to a split-dollar life insurance arrangement . . . of economic benefits . . . is treated as a distribution of property.” Reg. § 1.301-1(q)(1)(i).
- The split-dollar regulations govern the taxation of such arrangements, not only for income and gift tax purposes, but also for employment taxes purposes. Reg. § 1.61-22(a)(1). And it is well established that an S corporation “cannot avoid federal employment taxes by characterizing compensation . . . as distributions of the corporation’s net income.” Veterinary Surgical Consultants, P.C. v. Comm’r, 117 T.C. 141, 145-46 (2001).
- Subchapter S governs the tax treatment of S corporations and their shareholders. Section 1372 provides that “for purposes of applying the provisions of this subtitle . . . which relate to employee fringe benefits—(1) the S corporation shall be treated as a partnership, and (2) any 2-percent shareholder of the S corporation shall be treated as a partner of such partnership.” A “2-percent shareholder” is defined to include “any person who owns . . . more than 2 percent of the outstanding stock of such corporation.” 1372(b).
- The term “fringe benefit” is commonly understood to mean “any form of employee compensation provided in addition to wages or base salary, as a pension, insurance coverage, vacation time, etc.” Webster’s New World Collegiate Dictionary 568 (4th 2010). Although the term “fringe benefit” is not defined in the Code, all available evidence suggests that Congress intended to adopt the common understanding of the term, i.e., that a “fringe benefit” includes any employer-provided benefit that supplements an employee’s salary, specifically including life insurance benefits.
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:
- Generally, taxpayers bear the burden of proving that the IRS’ determinations are erroneous. C. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). In an unreported income case, if the IRS introduces evidence that the taxpayer received unreported income, the taxpayer must show by a preponderance of the evidence that the deficiency determination was arbitrary and erroneous. Hardy v. Comm’r, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g, T.C. Memo. 1997-97.
- Gross income generally includes all income from whatever source derived. 61(a). Taxpayers must keep adequate books and records from which their correct tax liability can be determined. Sec. 6001. When a taxpayer fails to keep records, the IRS has discretion to reconstruct the taxpayer’s income by any reasonable method that in the IRS’ opinion clearly reflects income. Sec. 446(b); Cole v. Comm’r, 637 F.3d 767, 774-75 (7th Cir. 2011). The specific items method is a direct proof of income reconstruction the Tax Court has approved. See Dyer v. Comm’r, T.C. Memo. 2012-224.
- Once the IRS produces clear evidence of unreported gross income, the taxpayer bears the burden of proving that the IRS’ method of income reconstruction is unfair or inaccurate under the specific deposits method. See id.; Levine v. Comm’r, T.C. Memo. 1998-383. To carry this burden, the taxpayer must offer “competent and relevant evidence from which it could be found that he did not receive the income alleged in the deficiency notice.” Dyer v. Comm’r, T.C. Memo. 2012-224.
- Section 6651(a)(1) imposes an addition to tax for failure to timely file a federal income tax return. This addition to tax equals 5% of the tax required to be shown on the return for each month or fraction thereof for which there is a failure to file a return, up to 25% in the aggregate. Section 6651(f) increases those respective percentages to 15% and 75% where the failure to timely file is fraudulent. In order to ascertain whether a taxpayer’s failure to timely file was fraudulent under section 6651(f), the Tax Court considers whether the taxpayer failed because of fraudulent intent to timely file a return for the tax year where there was a tax liability required to be shown on the return. 6651(a), (b)(1), (f); Clayton v. Comm’r, 102 T.C. 632, 653 (1994); Porter v. Comm’r, T.C. Memo. 2015-122. The IRS has the burden of proving these elements by clear and convincing evidence for each year for which fraud is alleged. Sec. 7454(a); Clayton v. Comm’r, 102 T.C. at 646.
- To prove the fraud penalty under Section 6651(f), the IRS must first show that the taxpayer failed to timely file a required tax return. 6651(a)(1). The IRS may establish that a taxpayer’s income was sufficient to require filing a federal tax return through income figures supplied on a loan application. See Trescott v. Comm’r, T.C. Memo. 2012-321.
- In determining whether a taxpayer had the requisite fraudulent intent for imposition of the Section 6651(f) addition to tax, the Tax Court considers the same elements that it considers in imposing the fraud penalty under Section 6663 and former Section 6653(b)(1). Clayton v. Comm’r, 102 T.C. at 653. Fraud is established by proving that a taxpayer intended to evade tax believed to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of tax. Clayton v. Comm’r, 102 T.C. at 647; Pittman v. Comm’r, 100 F.3d at 1319. The existence of fraudulent intent is determined by looking at the entire record and the taxpayer’s conduct. See DiLeo v. Comm’r, 96 T.C. 858, 874 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). Fraud is never presumed and must be proven by independent evidence. Zell v. Comm’r, 763 F.2d 1139, 1143 (10th 1985), aff’g T.C. Memo. 1984-152. Fraud need not be established by direct evidence, which is rarely available, but it may be proved by circumstantial evidence and reasonable inferences drawn from the facts. Niedringhaus v. Comm’r, 99 T.C. 202, 210 (1992).
- In determining whether there was fraudulent intent, the Tax Court will look at a nonexclusive list of factors. See Pittman v. Comm’r, 100 F.3d at 1319; Bradford v. Comm’r, 796 F.2d 303, 307 (9th 1986). These factors include: (1) failing to file income tax returns; (2) filing false documents; (3) understating income; (4) concealing income or assets; (5) engaging in illegal activity; (6) failing to cooperate with tax authorities; and (7) asserting frivolous arguments and objections to the tax laws. Bradford v. Comm’r, 796 F.2d at 307. While no single factor is determinative for establishing fraud, the existence of several “badges of fraud” may constitute compelling circumstantial evidence of fraud. Bradford v. Comm’r, 796 F.2d at 307-08.
- While the mere failure to file a return, standing alone, is not sufficient to support a finding of fraud, an extended pattern of failing to file returns is a badge of fraud and may be persuasive circumstantial evidence of the intent to evade tax. See Bradford v. Comm’r, 796 F.2d at 308; Petzoldt v. Comm’r, 92 T.C. 661, 701 (1989).
- Filing false documents with the IRS constitutes an “affirmative act” of misrepresentation sufficient to justify the fraud penalty. Zell v. Comm’r, 763 F.2d at 1146. And filing false documents with a third party supports an inference of fraud. See Isaacson v. Comm’r, T.C. Memo. 2020-17.
- A pattern of substantially underreporting income for several years is strong evidence of fraud, particularly if the understatements are not due to innocent mistake or are not otherwise satisfactorily explained. See Holland v. U.S., 348 U.S. 121, 137-39 (1954); Spies, 317 U.S. at 499.
- An intent to evade tax may be inferred from “concealment of assets or covering up sources of income”. Spies, 317 U.S. at 499. Concealing assets coupled with a failure to file tax returns is a strong indication of fraud. Freidus v. Comm’r, T.C. Memo. 1999-195. A taxpayer’s use of nominee corporations is evidence of asset concealment. See Bennett v. Comm’r, T.C. Memo. 2014-256.
- Failure to cooperate with revenue agents during an audit is a badge of fraud. Grosshandler v. Comm’r, 75 T.C. 1, 19-20 (1980).
- Frivolous, irrelevant, and meritless arguments, coupled with affirmative acts designed to evade federal income tax, support a finding of fraud. See Kotmair v. Comm’r, 86 T.C. 1253, 1259-61 (1986).
- Section 6651(a)(2) imposes an addition to tax on taxpayers for their failure to pay timely the amount of tax shown on a return. This addition to tax applies only when an amount of tax is shown on a return, unless it is shown that the failure is due to reasonable cause and not due to willful neglect. See Wheeler v. Comm’r, 127 T.C. 200, 208-09 (2006), aff’d, 521 F.3d 1289 (10th 2008). Where the taxpayer did not file a valid return, the IRS must introduce evidence that a substitute for return under Section 6020(b) was prepared to satisfy the burden of production. See Sec. 6651(g)(2). To satisfy his burden of production, the IRS must produce sufficient evidence that the taxpayer filed returns showing tax liabilities for the years at issue. See Wheeler v. Comm’r, 127 T.C. at 210. A return prepared by the IRS in accordance with Section 6020(b) is treated as the return filed by the taxpayer for the purpose of determining the amount of the addition to tax under Section 6651(a)(2). Sec. 6651(g)(2); Wheeler v. Comm’r, 127 T.C. at 208-209. Once the IRS meets his burden, the burden of proof is with the taxpayer to show that the additions to tax that the IRS determined in the notice of deficiency should not be imposed. See Higbee v. Comm’r, 116 T.C. 438, 446-47 (2001).
- Section 6654(a), (b) and (c) imposes an addition to tax on an individual taxpayer to the extent he underpays a required installment of estimated tax. The addition to tax is calculated with reference to four installment payments each equal to 25% of the required annual payment. 6654(c)(1), (d)(1)(A). The “required annual payment” is generally the lesser of (1) 90% of the tax shown on the return for the tax year; or (2) 100% of the tax shown on the taxpayer’s return for the preceding tax year. Sec. 6654(d)(1)(B) and (C).
- The IRS has the burden of production with respect to the section 6654 addition to tax. 7491(c). To satisfy that burden, the IRS, at a minimum, must produce evidence establishing that the taxpayer had a “required annual payment” as defined in Section 6654(d)(1)(B); Wheeler v. Comm’r, 127 T.C. at 211-12.
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.
Tax Court Litigation Attorneys
Need assistance litigating in the U.S. Tax Court? Freeman Law’s tax attorneys are experienced litigators with trial-tested litigation skills and in-depth substantive tax knowledge, having collectively litigated hundreds of cases before the U.S. Tax Court. Our tax controversy lawyers have extensive experience in Tax Court matters involving partnership audits and litigation under both the TEFRA and BBA regimes, international tax penalties, foreign trusts, valuation, reasonable compensation disputes, unreported income, fraud penalties, other tax penalties, any many other matters. We draw on our experience and wealth of tax knowledge to advise and guide clients through the entire tax controversy process, building the right strategy to resolve tax controversies from day one. Schedule a consultation or call (214) 984-3000 to discuss your Tax Court concerns or questions.
There is a solution to every tax problem, and we’re ready to assist you.
