The Tax Court in Brief April 26 – April 30, 2021

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The Tax Court in Brief April 26 – April 30, 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 26 – April 30, 2021

 


Tax Court Case: Plentywood Drug, Inc.

April 26, 2021 | Holmes| Dkt. No. 17753-16

Tax Dispute Short Summary:

  The Tax Court was asked to decide whether rent paid by the Taxpayer was reasonable.  The Taxpayer was owned by four related individuals (the “Shareholders”).  The Shareholders owned the building where the Taxpayer was operating.  The Taxpayer paid rent of $83,584, $192,000, and $192,000 for 2011, 2012 and 2013, respectively.

The IRS disallowed certain rent deductions by the Taxpayer to the Shareholders because the IRS stated that the rent paid by the Taxpayer was greater than what the fair market rent would have been paid at an arm’s length transaction.  The IRS recharacterized the excess rent as dividends, therefore, the Taxpayer would not be able to deduct the dividends.

The Taxpayer and the IRS introduced experts to testify regarding the fair market value of rent for the building.  This case is unique because there were no comparable properties in this small town of 1,700 people.

It should be noted the IRS does not often question the reasonableness of a rent agreed to by parties at arm’s length. When there is a close relationship between the lessor and lessee and there is no arm’s length dealing between them, the IRS will inquire into what constitutes reasonable rent.

Tax Litigation Key Issues

What is the fair market rent for the building?

Primary Holdings The Court, after considering each party’s expert witness, concluded that a proper rent would be $15.90 per square foot for the main retail space of the store and $8 per square foot for the basement storage space in the building, resulting in a total fair market value of rent each year of $171,187.50.  The Court denied the Taxpayer a deduction of approximately $20,000 for tax years 2012 and 2013.

Key Points of Law:


Tax Court Case:
Ronnie S. Baum and Teresa K. Baum v. Comm’r, T.C. Memo 2021-46

April 27, 2021Kerrigan, J. | Dkt. No. 19567-19

Short SummaryThe case discusses the substantiation of expenses, and the deductibility of theft losses under I.R.C. 165.

Mr. and Mrs. Baum (the taxpayers) were self-employed during 2015 and 2016 (years at issue). Mr. Baum was a consultant for Harrington Capital Partners, LLC, for which he was the sole owner. Mrs. Baum was a realtor. During the years at issue, the taxpayers claimed multiple deductions on their Schedule C, such as meals and entertainment expenses, offices and car and truck expenses.

In 2012, Mr. Baum acquired stock of Globe Protect, Inc. a company that manufactured filters to clean saline water. It must be noted that this opportunity was presented to Mr. Baum by a third party, a Mr. Zeilinger, and the stock was acquired from Mr. Zeilinger’s mother.

Despite the promising prospective for the Globe, Mr. Zeilinger filed for bankruptcy in 2014 and some other creditors obtained judgment in their favor. Mr. Baum did not receive a favorable judgment. However, the taxpayers claimed the loss suffered from the investment on their 2015 tax return, Schedule A, as a theft deduction. Such return and the 2016 tax return were filed until 2018.

Tax Dispute Key Issues: Whether the loss suffered by the taxpayers qualifies as a “theft loss” under Section 165.

Primary Holdings:

To be deductible as a theft loss, the loss must arise from a theft according to the laws of the jurisdiction where the loss was incurred, but also, the taxpayer must determine the amount of the loss and the year in which it was sustained. Failure to meet any of these standards translates in the rejection of the loss.

Key Points of Law:  

I.R.C. 162 allows taxpayers to deduct ordinary and necessary expenses incurred in carrying a trade or business. Some of these deductions, to be deductible, must comply with certain substantiation rules. Here, the taxpayers did not provide any proof to support the amount, time, and business purpose of the various expenses, such as the travel expenses, meals and lodging, among others. Consequently, such expenses are disallowed, sustaining the Commissioner’s determination.

I.R.C. 165 allows taxpayers to deduct three types of losses: those incurred in a trade or business, those incurred in a transaction entered into for profit or losses arising from other causes, such as theft.

Theft is defined broadly, and encompasses various criminal conducts including larceny, embezzlement and robbery. Treas Regs. Sec. 1.165-8 (d). Moreover, the taxpayer must prove that the theft occurred under the law of the jurisdiction wherein the alleged loss occurred, See Monteleone v. Commissioner, 34 T.C. 688 , 692 (1960), the amount of loss and the date that the loss was discovered.

The Court determined that “Theft” under California laws. Under the California Penal Code, the concept of theft consolidates various similar criminal conducts, such as larceny, theft by false pretenses and embezzlement. Cal. Penal Code sec. 484(a). Taxpayers claimed they suffered losses from “fraud in inducement”, directing the analysis to false pretenses, which includes elements on the defendant such as intent to defraud the owner of the property, making false representations and obtaining title of the owner’s property as consequence of the reliance. In this case, the Court found that the petitioners did not provided any evidence that supported that Mr. Zeilinger made false representations or with the intent to defraud. Therefore, this element was not met.

The Court also ruled that even if a theft was present, the petitioners still would not be able to claim the loss because they had failed to prove the amount of the loss and to establish the year that the loss was sustained. If the taxpayer has “reasonable prospect of recovery”, the loss is not sustained. Treas. Regs. Sec. 1.165-1 (d)(3). Here, the taxpayers did not have a reasonable prospect of recovery of their investment in 2015 because the bankruptcy proceeding for Mr. Zeilinger was still in Court.

Alternatively, the taxpayers argued that the loss was deductible as a loss incurred in a trade or business as provided by Section 165(c)(1). This argument is flawed because the involvement of the petitioners in Globe was that of an investor, and investment losses do not fall within this exception.

The second alternative argument was that the loss was deductible as a worthless security. I.R.C. 165(g). Because the taxpayers did not provide any evidence that the shares of Globe became worthless in 2015, such rule does not apply.

The penalties were sustained under I.R.C. 6651(a)(1) because the tax returns were filed after the due date, and the taxpayers failed to prove that the failure to file was due to reasonable cause.

Tax Litigation Insight: Theft losses is an area with particular circumstances. However, it is clear that the taxpayers must provide evidence to support the three-factor test mentioned by the Court in this case. More importantly, the determination of a “theft” under State jurisdiction must be given special relevance, because failure to fall within the specific concept of a “theft” in accordance with such jurisdiction, will prevent the taxpayers to move forward in the analysis of the Court.


Tax Court Case:

Mylan, Inc. & Subsidiaries v. Commissioner, 156 T.C. No. 10

April 27, 2021 | Docket No. 26976-16 | Urda, J.

Tax Dispute Short Summary:

 Mylan, Inc. & Subsidiaries (“Mylan”) is a manufacturer of brand name and generic pharmaceutical drugs. To obtain Food & Drug Administration (“FDA”) approval for generic versions of brand name drugs, Mylan was required to provide a certification regarding the status of any patents that the FDA had listed as covering the respective brand name drug.

Mylan certified that listed patents covering the respective brand name drug were invalid or Mylan’s generic version would infringe on them. This type of certification automatically counts as patent infringement and often provokes litigation under 35 U.S.C. Section 271(e)(2). Mylan was required to send notice letters to the brand name drug manufacturer and any patentees stating that Mylan made this certification.

Mylan incurred legal expenses to prepare notice letters and to defend against patent infringement suits. On its 2012, 2013, and 2014 federal income tax returns, Mylan deducted its legal expenses as ordinary and necessary business expenditures.

Tax litigation Key Issues:

Primary Holdings:

Key Points of Law:

Tax Litigation Insight: The Mylan decision demonstrates that the deductibility of a legal expense generally depends on the origin and character of the underlying claim or transaction out of which the legal expense was incurred. An expenditure, such as legal expenses, may be deductible in one setting but nevertheless required to be capitalized in another. Legal expenses directly connected with (or pertaining to) the taxpayer’s trade or business are deductible under I.R.C. Section 162 as ordinary and necessary business expenses, while expenses arising out of the acquisition, improvement, or ownership of property are capital expenditures under I.R.C. Section 263(a) and are not currently deductible.


Tax Court Case:

Aschenbrenner v. Comm’r, Bench Opinion

April 28, 2021 | Marvel, J. | Dkt. No. 2676-20S

Tax Dispute Short Summary:

As early as 2017, Petitioners purchased health insurance from Kaiser Permanente and were entitled to an Advance Premium Tax Credit (“APTC”) to subsidize their health insurance premiums. In 2018, the Petitioner-husband found employment. Petitioners could have secured less expensive health insurance through one of Petitioners’ employers, but they elected not to do so. The Petitioners continued with their insurance and continued to receive an APTC. In 2018, the Petitioners’ APTC totaled $7,842.

Petitioners timely filed their 2018 income tax return. The Respondent issued a Notice of Deficiency determining a deficiency of $14,964 and a penalty under Section 6662(a) of $2,992.80. The Respondent then issued a Letter 555, reducing the deficiency to $7,482 and eliminated the penalty. Petitioners timely petitioned the Tax Court.

Tax litigation Key Issues:

Primary Holdings:

Key Points of Law:

Tax litigation Insight:

The Aschenbrenner case notes that the APTC creates a potential trap for taxpayers. For those taxpayers who qualified for a premium tax assistance credit in one year and then increase their income to more than 400% of the Federal poverty line in a following year, they may receive an APTC for which they are not entitled. Taxpayers may be caught in sympathetic situations, but they must consider their changing household income with respect to an APTC.


Tax Court Case:

Stankiewicz v. Comm’r, 2021 BL 156162 (T.C. Apr. 28, 2021) 

Kerrigan | Dkt. No. 3139-20

Tax Dispute Short Summary

By notice of deficiency dated November 20, 2019, the Internal Revenue Service (IRS or Respondent) determined a deficiency in Petitioner Jeffrey Stankiewicz’s Federal income tax for 2017 of $6,796, a penalty of $1,359 pursuant to section 6662 , and an addition to tax of $667 pursuant to section 6651(a)(2) .

Tax litigation Key Issue Whether Petitioners received unreported taxable wages and are liable for a penalty pursuant to  § 6662 and an addition to tax pursuant to § 6651(a)(2).

Primary Holdings

Key Points of Law:

Tax litigation InsightAs with every tax protester case, the Court here confirms the U.S. Government’s right to collect taxes.  The taxpayer here was no different.  While no one likes to pay taxes, courts have held time and again that the government has such authority, and fighting that basic principle is futile.


Tax Court Case:

Haghnazarzadeh v. Comm’r, T.C. Memo 2021-47

April 29, 2021 | Kerrigan, J. | Dkt. No. 27031-17 

Tax Dispute Short Summary

During 2011 and 2012 (“Years at Issue”), taxpayer-husband was in the real estate business.  The taxpayers held nine bank accounts in the name of taxpayer-husband and/or taxpayer-wife during the Years at Issue.  The IRS selected the taxpayers’ 2011 and 2012 income tax returns for examination and determined that they had unreported taxable income of $4,854,849 and $1,868,212 for 2011 and 2012, respectively, based on bank deposit analyses.  After the IRS issued a notice of deficiency for the Years at Issue, the taxpayers filed a timely petition with the Tax Court seeking a redetermination.

Tax litigation Key Issues:

Whether the taxpayers had unreported income for the Years at Issue.

Primary Holdings:   Based on the IRS’ bank deposit analyses, which was sustained, the taxpayers had unreported income for the Years at Issue.

Key Points of Law:

Tax litigation InsightThe Haghnazarzadeh case shows that once the IRS has made a prima facie case that a taxpayer received income, the taxpayer then bears the burden of showing that any deposits made into his or her account represent nontaxable income.


Tax Court Case:

Woll v. Comm’r, Bench Opinion

April 29, 2021 | Holmes, J. | Dkt. No. 7024-20

Tax Dispute Short Summary: Petitioner Molly Woll was laid off from her employer in 2017, resulting in the termination of her 401(k) savings plan that had a balance of more than $86,000. Ms. Woll and her husband spent part of the proceeds from the plan on paying back a loan, as well as paying medical expenses, student loan payments, mortgage bills, house expenses, and other bills. This resulted in a taxable distribution.

Ms. Woll prepared the couple’s 2017 tax return and reported the taxable distribution but did not add the extra 10 percent tax imposed by I.R.C. § 72(t). This triggered an IRS audit, which resulted in the assessment of the 10 percent tax, as well as a substantial understatement penalty. Mr. and Mrs. Woll timely filed their tax court petition.

Tax litigation Key Issues:

Primary Holdings:

Key Points of Law:

Tax Litigation Insight: Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis. Woll highlights the fact that a taxpayer who has an advanced degree, such as an attorney, will likely have more difficulty showing reasonable cause. Reliance on a computer program or failure to read a tax form, such as a Form 1099-R, are not sufficient alone to prove reasonable cause.

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