The Tax Court in Brief May 10 – May 14, 2021

The Tax Court in Brief May 10 – May 14, 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 May 10 – May 14, 2021

• Jenkins v. Commissioner, T.C. Memo. 2021-54
• Adler v. Commissioner, T.C. Memo. 2021-56
• Bailey v. Commissioner, T.C. Memo. 2021-55
• Battat v. Commissioner, T.C. Memo. 2021-5
• ESTATE OF MORRISSETTE, T.C. Memo. 2021-60

Tax Court Case: Jenkins v. Commissioner, T.C. Memo. 2021-54

May 10, 2021 | Holmes, J. | Dkt. Nos. 27139-11, 28712-11

• Opinion

Tax Dispute Short Summary:

Mr. Ira Gentry (Gentry) owned Universal Dynamics, a company that primarily produced a software program called Northstar. In the late-1990s, a reverse merger occurred between Universal Dynamics (a private corporation) and UniDyn Corp. (a public corporation). UniDyn acquired many of Universal Dynamics’ assets in exchange for 180,000 shares of stock. Following the merger, Gentry became president, CEO, and director of UniDyn. Universal Dynamics became the owner of more than 70% of UniDyn’s outstanding stock.

During this time, Gentry became acquainted with Mr. Randy Jenkins (Jenkins). Jenkins set up overseas entities related to UniDyn. He also helped implement an employee-leasing scheme that UniDyn used to save on employment tax.

As the controlling shareholder of a publicly traded corporation, Gentry wanted to raise money to pursue two developmental avenues. The first involved the purchase of Derritron to become a single source for quality-assurance shaker systems. This was disclosed in SEC filings. The second involved the creation of a new product, the Sterling. This product would be a revolutionary technological development.

In promoting the Sterling, Gentry wooed a variety of groups. A UPS employee, under the allure of Gentry’s pitch, helped raise $470,000 to produce the Sterling. In 1998, UniDyn stated in SEC filings that it was patenting the Sterling. It also disclosed that a large Japanese company made a commitment to buy 20 units. Later, Gentry identified the company as TechNet, Inc. and suggested that the contract totaled $3.8 million. UniDyn also disclosed that it completed stock acquisition of Avalon Manufacturing Co. to begin the manufacture. This series of announcements built significant momentum for the business. It culminated with a press release that the company secured a $250 million contract with TechNet, signed by Hiroshi Tsuriya. As a result of these efforts, the UniDyn stock price soared.

The problem addressed by the case is simple: these claims were all lies. The press release failed to disclose that Avalon was actually a subsidiary of UniDyn. IBM never tested the product. Contrary to the 1998 disclosure, Gentry had not begun the patenting process. The TechNet contracts were made up. Hiroshi Tsuriya denied signing the contract. The court notes that the Tsuriya signature may have been pasted or traced on the TechNet contract. The Board determined that Gentry never wrote the thesis that provided the basis for the Sterling, and beyond that, the Board concluded that the actual author concluded that this project was not feasible. Following the revelations, the stock of UniDyn plummeted.

In 2006, the Federal Government executed a search warrant on Mr. Gentry’s office. Gentry and Jenkins were arrested, and the Government concluded that Gentry and Jenkins conducted a “pump-and-dump scheme.”  Neither paid taxes on their gains. Both were convicted for a variety of felony counts. The court entered judgments against both men at the end of the criminal case.

Later, the Commissioner pursued a civil case against both Gentry and Jenkins. The Commissioner controlled that Gentry controlled four corporations—Marriott Investment, Universal Dynamics Prime Security, and Mearns Acceptance—that saw significant gains when they dumped their UniDyn stock in 2000. The Commissioner argued that Gentry used these entities as alter egos to avoid reporting the financial gains and is liable for the tax on the $7.8 million gains.

Tax Litigation Key Issue(s):

• Whether the Commissioner successfully proved that fraud occurred;
• What is the amount of unreported income for both Mr. Gentry and Mr. Jenkins.

Primary Holding(s):

• Although the Commissioner did not issue a notice of deficiency for Tax Year 2000 until 2011, the Commissioner is able to pursue the case because: (1) the statute of limitations did not run because neither Gentry not Jenkins filed a tax return; and (2) the three-year limit does not apply if a taxpayer files a fraudulent return.
• For the purposes of alter ego analysis, the Court held that Arizonan law applied.
• The amounts differ slightly from the amount in the notice of deficiency, so the decision is entered under Rule 155.

Key Points of Law:

• Section 6501(a) requires that the Commissioner assert any deficiency of income tax within three years of filing a return. There are two exceptions:
  • The three-year statute of limitations does not begin to run if a taxpayer fails to file a tax return. Sec. 6501(c)(3).
  • The three-year limit also doesn’t apply if a taxpayer files a fraudulent return. Sec. 6501(c)(2).
• Whether a corporation is a taxpayer’s alter ego is a question of fact.
• There is no federal general common law, but one may find federal common law in narrow area where applying state law would significantly conflict with federal legislation and frustrate its specific objectives.
  • There are few examples where federal courts supplant state corporate law. See, e.g., ERISA (a nationwide program created by federal statute to ensure that employees receive their anticipated benefits); see also, CERCLA (federal statute imposing liability for the cost of cleaning up hazardous waste on “owners” and “operators”).
• Following Bancec, the Court concluded (1) that Second Restatement of Conflict of Laws Section 307 does not apply and (2) that the limitation of the use of the law of the jurisdiction of incorporation when the rights of third parties are involved is sensible.
• When assessing alter egos, Second Restatement Section 6(2) compels courts to assess:
  • the needs of the interstate and international systems;
  • the relevant policies of the forum;
  • the relevant policies of other interested states and the relative interests of those states in the determination of the particular issue;
  • the protection of justified expectations;
  • the basic policies underlying the particular field of law;
  • certainty, predictability, and uniformity of result; and
  • ease in the determination and application of the law to be applied.
• Alter ego analysis under Arizona law assesses if “there is such a unity of interest and ownership that the separate personalities of the corporation and the owners cease to exist.” Arizona law also directs consideration of whether the owner exercises “substantially total control” over the corporation. Finally, the purpose of alter-ego doctrine is “the prevention of ‘fraud,’ ‘misuse,’ and ‘injustice’ arising from misuse of the corporate form of organization.”
• Civil liability can be tried after a criminal judgment. Criminal judgments have no res judicata effect because criminal trials can’t determine deficiencies.

Adler v. Commissioner, T.C. Memo. 2021-56 

May 10, 2021 | Kerrigan, J. | Dkt. No. 13564-19

• Opinion

Tax Dispute Short Summary:

Petitioner owned a sales and consulting business called Grupo Fortuna, LLC. In 2016, Petitioner filed a Schedule C, reporting expenses totaling $105, 227, including $16,535 for travel expenses.

In 2016, MediaNaviCo—a digital entertainment company—hired Petitioner as a consultant. This position required travel to and attendance at both conferences and trade shows. When traveling, Petitioner was initially responsible for paying the expenses and would deliver them to MediaNaviCo’s CFO for reimbursement. Later, NBCUniversal Media, LLC purchased MediaNaviCo.

Two specific instances raised issues here. First, during this time, Petitioner traveled to Blackfoot, Idaho, to look at land inherited from his father. Second, Petitioner reported $44,586 for contract labor expenses on his 2016 Schedule C. The contract labor expenses arose because, during this time, Petitioner performed construction work. Despite this work, Petitioner did not issue any W-2 Forms to employees or Forms 1099-MISC to contract laborers.

In 2017, Petitioner and his wife filed Form 1040, reporting expenses of $57,397 on his Schedule C.

On May 1, 2019, respondent issued: (1) a notice of deficiency for 2016, disallowing expense deductions for travel and contract labor; and (2) a notice of deficiency for 2017, disallowing deductions for $53,098 of the expenses.

Tax Litigation Key Issue(s):

Whether Petitioner is entitled to deduct business expenses for 2016 and 2017?

Primary Holding(s): For both 2016 and 2017, Respondent’s disallowance is sustained because the Petitioner failed to provide evidence to support the expenses.

Key Points of Law:

• Generally, the Commissioner’s determinations in a Notice of Deficiency are presumed correct. The taxpayer bears the burden of proving that the Commissioner’s determination is incorrect.
• Section 162(a) allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business.
• Ordinary Expenses are ones that commonly or frequently occur in a taxpayer’s business.
• Necessary Expenses are ones that are appropriate and helpful in carrying on the taxpayer’s business.
• A taxpayer may not deduct a personal, living, or family expense unless the Code expressly provides otherwise.
• Whether an expenditure is ordinary or necessary is a question of fact.
• Section 274(d) overrides the Cohan rule. So, expenses related to travel are subject to strict substantiation rules and cannot simply be estimated by the court.

Bailey v. Commissioner, T.C. Memo. 2021-55

May 10, 2021, | Pugh, J. | Dkt. No. 5477-14

• Opinion

Tax Dispute Short Summary: 

Mr. Bailey working as an unenrolled tax return preparer assisted clients (Uwe Zink and Gary Skuro) in creating a new entity, Interradiology, Inc. (Interradiology) organized under the laws of Arizona and elected to be treated as an S corporation for Federal tax purposes in 2017. Therefore, Mr. Bailey prepared and filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for Interradiology for tax years 2007 through 2012. Also, he held 10% of the shares of Interradiology during the tax year 2008 and 20% during tax years 2009 through 2012.

Mr. Bailey prepared and filed petitioners’ Forms 1040, U.S. Individual Income Tax Return, for the years in issue. He timely filed their 2008 and 2012 Forms 1040, but he untimely filed their 2009, 2010, and 2011 Forms 1040 on March 9, 2011, November 29, 2011, and February 19, 2013, respectively. The 2010 and 2011 returns both reported tax due, which the IRS assessed before the issuance of the notices of deficiency for those years.

Regarding petitioners’ Forms 1040, Mr. Bailey reported gross income by adding together any wages, Schedule C business income, capital gain, and taxable Social Security benefits, plus the distributive shares of Interradiology’s income petitioners received during each year. Mr. Bailey offset this income in part with the standard deduction in 2010 and Schedule A itemized deductions in 2008, 2009, 2011, and 2012. In respect to petitioner’s Schedules C, Mr. Bailey reported gross profits and offset those profits in part with business expense deductions, including rent he paid for the Broadway office.

The IRS audited petitioners’ Forms 1040 and Interradiology’s Forms 1120S for the years in issue, resulting in the issuance of notices of deficiency to petitioners for tax years 2008 to 2013, adjusting the petitioners’ distributive shares of Interradiology’s income upward, and reducing the Schedule C deductions. Some of the adjustments included reclassifying petitioners’ mortgage interest expense deductions as home mortgage interest expense deductions, so the respondent also adjusted the corresponding Schedule A deductions.

Petitioners timely filed petitions with the United States Tax Court challenging the proposed adjustments. The respondent sent to the petitioners a proposed stipulation of settled issues. Both parties signed the document which was filed on November 21, 2019. The proposed stipulation stated: (i) that two of the substantive issues were resolved; (ii) that the remaining issues involve primarily substantiation of business expenses and itemized deductions, additions to tax, and penalties; (iii) that petitioners had raised new issues requesting additional deductions not originally claimed; (iv) agreements regarding Interradiology’s income, deductions and the amounts of Mr. Bailey’s distributive share of Interradiology’s income; (v) that petitioners did not receive the capital gain relating to Interradiology that had been reported on their Forms 1040 for 2010 and 2012.

After the document was submitted, the respondent filed a motion for leave to file the first amendment to answer under I.R.C. §6651(a)(2). The motion requests additions to tax for failure to timely pay tax shown on petitioners’ Forms 1040 for 2010 and 2011 which continue to accrue since the issue of notices of deficiency. At trial, the parties filed their first stipulation of facts showing the parties’ agreement outlined in detail the time and manner of determination of the I.R.C. §6662 penalties for each year, and the parties’ agreement that respondent had satisfied the requirements of section 6751(b) for each penalty determined in the statutory notices.

Tax Litigation Key Issue:

• Whether Petitioners are: (1) entitled to additional mortgage interest expenses for 2010; (2) entitled to vehicle depreciation and expenses deductions for 2008, 2009, and 2010; (3) entitled to professional fees deductions for 2009 and 2010; (4) entitled to additional home office expenses for 2011 and 2012; (5) liable for an addition to tax according to section 6651(a)(1); and (6) liable for the accuracy-related penalty under section 6662.

Primary Holdings: 

• (1) Petitioners offered no support for the increased amounts of mortgage expenses they claimed in their amended returns. The Court held that petitioners are not entitled to any additional mortgage interest expense deductions.
• (2) Petitioner’s record does not show that petitioners converted the vehicle to business use at any point. Also, there isn’t documentary evidence to support deductions for vehicle expenses in amounts greater than those previously allowed by respondent. The Court held that petitioners are not entitled to deduct any vehicle depreciation or additional vehicle expenses.
• (3) Petitioner’s legal fees reported are related to an unsuccessful malpractice suit Mr. Bailey commenced against his attorney and an expert witness. The Court held that petitioners are not entitled to deduct professional fees.
• (4) Petitioners failed to provide any supporting documents for these new and increased deductions. The Court held that petitioners are not entitled to any additional home office expenses deductions.
• (5) Petitioners did not address or dispute those additions to tax at trial and have neither contended nor shown that they had reasonable cause for filing late or not paying the tax due. The Court held that the additional tax will be sustained.
• (6) Petitioners offered no evidence of reasonable cause or of the manner in which Mr. Bailey made erroneous entries on Interradiology’s or petitioners’ returns. The Court held that I.R.C. 6662 penalties will be sustained.

Key Points of Law:  

• Originally, the burden of proof in cases before the Court is on the taxpayer. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115, 54 S. Ct. 8, 78 L. Ed. 212, 1933-2 C.B. 112 (1933).
• R.C. § 7491(a)(1) provides that the Commissioner shall have the burden of proof when the taxpayer introduces credible evidence concerning any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B. See Higbee v. Commissioner, 116 T.C. 438, 441-442 (2001).
• The Commissioner does not bear the burden of disproving deductions that a taxpayer belatedly claims. See Sham v. Commissioner, T.C. Memo. 2020-119, 38-39; Rappaport v. Commissioner, T.C. Memo. 2006-87, 2006 WL 1083434, at 4.
• Rule 91(e) states that a stipulation shall be treated, to the extent of its terms, as a conclusive admission by the parties to the stipulation, unless otherwise permitted by the Court or agreed upon by those parties.
• Stipulations of settlement are usually enforced when a request to withdraw them is made close to trial. See Dorchester Indus. Inc. v. Commissioner, 108 T.C. 320, 334-335 (1997).
• Taxpayers have the burden of proving entitlement to their claimed deductions. See New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 54 S. Ct. 788, 78 L. Ed. 1348, 1934-1 C.B. 194 (1934).
• According to I.R.C. §6001, taxpayers are required to maintain sufficient records to establish the amount and purpose of any deduction. See Higbee v. Commissioner, 116 T.C. at 440.
• The taxpayer’s failure to keep and present records counts heavily against a taxpayer’s attempted proof. See Rogers v. Commissioner, T.C. Memo. 2014-141, at 17.
• Amended returns are merely statements of petitioners’ position and not evidence of the contents. See McLaine v. Commissioner, 138 T.C. 228, 245 (2012); Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979); Roberts v. Commissioner, 62 T.C. 834, 837 (1974).
• Reg. §1.167(a)-11(1)(i) states that the depreciation of an automobile begins when the taxpayer places the asset in service and ends when it is retired from service.
• Automobiles are classified as three-year property for depreciation purposes. See Rev. Proc. 87-56, 1987-2 C.B. 674.
• R.C. §274(d) specify substantiation requirements for vehicle expenses which require a taxpayer to substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.
• The taxpayer must demonstrate when taking vehicles expenses: (i) the amount of the expense, (ii) mileage for each business use of the vehicle as well as the total mileage for all purposes during the taxable period, (iii) the time and place of the travel or use, and (iv) the business purpose of the expense. See Treas. Reg. §1.274-5 (j)(2); §1.274-5T (b)(6); Shea v. Commissioner, 112 T.C. 183, 186- 188 (1999).
• To substantiate by adequate records, a taxpayer must provide an account book, a log, or similar record and documentary evidence which together are sufficient to establish each element with respect to an expenditure. See Treas. Reg. §1.274-5T (c)(2)(i).
• The legal fees are deductible if its origin and character of the claim were related to a business. See generally United States v. Gilmore, 372 U.S. 39, 49, 83 S. Ct. 623, 9 L. Ed. 2d 570, 1963-1 C.B. 356 (1963).
• R.C. §280A(a) bars deductions for a home used by the taxpayer as a residence during the taxable year.
• R.C. §280A(c)(1)(A) and (B) establish that the taxpayer can deductions for a home when part of the taxpayer’s home was used on a regular basis as the principal place of business for their trade or business or as a place of business used by clients or customers in meeting or dealing with them in the normal course of their trade or business (and allocate the expenses to that part of their home).
• R.C. § 7491(c) states that respondent has the burden of production with respect to the liability of any individual for penalties and additions to tax.
• In any event, the respondent has the burden of proving the increased amounts claimed in the amendment to the answer if we grant the respondent’s motion. See Rule 142(a)(1).
• R.C § 6651(a)(1) and (2) imposes an addition to tax for the late filing of a return and an addition to tax for late payment of the amount shown as tax on the return.
• R.C. §6651(a)(1) requires the respondent to meet the burden of production with respect to late filing under See Wheeler v. Commissioner, 127 T.C. 200, 207-208 (2006); and Higbee v. Commissioner, 116 T.C. at 446-447.
• Respondent “bears the overall burden of proof with respect to his increases in the additions to tax”. See Rader v. Commissioner, 143 T.C. 376, 389 (2014).
• R.C. § 6662(a), (b)(1) and (2) imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on the return that is attributable to “negligence or disregard of rules or regulations” and/ or a “substantial understatement of income tax.”
• R.C. § 6662(c) states that negligence includes “any failure to make a reasonable attempt to comply with the provisions of this title”. See Allen v. Commissioner, 92 T.C. 1, 12 (1989).
• R.C. § 6664(c)(1) establishes that once the Commissioner has met the burden of production, the taxpayer must come forward with persuasive evidence that the penalty is inappropriate. See Higbee v. Commissioner, 116 T.C. at 448-449.
• Reg § 1.6664-4 (b)(1) states that the decision as to whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all of the pertinent facts and circumstances. Also, that the most important factor in determining reasonable cause and good faith is the extent of the taxpayer’s effort to assess his or her proper income tax liability.

Tax Litigation Insight: The Bailey decision shows that taxpayers have the burden of proof of their entitlement to deductions. Accordingly, they have to keep request books and records in order to prove their request.

Battat v. Commissioner, T.C. Memo. 2021-57 

May 11, 2021 | Colvin, J. | Dkt. No. 17784-12

• Opinion

Tax Dispute Short Summary: 

The IRS examining agent sent taxpayers a revenue agent report (RAR) attached to a Letter 4121 that (1) corrected the tax due and (2) notified of liability for penalty under section 6662.  At the time of issuance, the IRS examining agent failed to receive immediate supervisor approval in writing for the RAR, the Letter 4121, or the penalty liability.  Two weeks after the postage of the RAR with Letter 4121, the examining agent issued a Form 4549-A attached to a Letter 950, 30-day letter. Also on that day, the examining agent received written supervisory approval for the section 6662 penalty.  Tax Court considered when the penalty liability was imposed and whether such liability was properly imposed.  The Tax Court determined the “initial determination” occurred at the time of issuance of the RAR and that it failed to have the requisite approval of an immediate supervisor.

Key Issue:

• Whether the Form 4549, Income Tax Examination Changes, also known as a revenue agent report (RAR), sent with a Letter 4121, Agreed Examination Report Transmittal, was the “initial determination” by an “individual” to impose a penalty for purposes of section 6751(b).

Primary Holdings: 

• The Tax Court concluded that the Form 4549 sent with Letter 4121 was the initial determination by an individual to impose a penalty.
• The imposed penalty failed to meet the requirements of section 6751(b) because the supervisor, when issued, did not provide written approval of the tax determination or penalty liability.

Key Points of Law:

• Summary judgment is designed to expedite litigation and avoid unnecessary and expensive trials. Peach Corp. v. Comm’r, 90 T.C. 678, 681 (1988). Summary judgment may be granted with respect to all, or part of the legal issues presented if “there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law.” SeeSundstrand Corp. v. Comm’r, 98 T.C. 518, 520 (1992), aff’d, 17 F.3d 965 (7th Cir. 1994). Petitioners, as the party moving for partial summary judgment, bear the burden of showing that there is no genuine dispute as to any material fact, and all factual inferences will be drawn in a manner most favorable to respondent. See Id. at 520.
• 6751(b)(1) provides that no penalty shall be assessed unless the initial determination of such assessment is personally approved, in writing, by the immediate supervisor of the individual making such determination.” Petitioners are entitled to partial summary judgment if the initial determination was included in the RAR because supervisory approval was not provided before the RAR was issued.
• 6751(b)(1) requires approval for the “initial determination” of a penalty assessment. A signed, completed RAR sent with a Letter 4121 includes an “initial determination” for purposes of section 6751(b)(1). See Beland v. Comm’r, 156 T.C. (2021) U.S. Tax Ct. LEXI 8, at *5 (Mar. 1, 2021).
• The term, determination, has an established meaning in the tax context and denotes a communication with a high degree of concreteness and formality. Belair Woods, LLC v. Comm’r, 154 T.C. 1, 15 (2020). The term, further, denotes a “consequential moment” of IRS action. Chai v. Comm’r, 851 F.3d 190, 220-221 (2d Cir. 2017), aff’g in part, rev’g in part T.C. Memo. 2015-42.
• Providing the opportunity to consent to assessment of tax and penalty is a “consequential moment” to a taxpayer and the Commissioner. See Beland v. Commissioner, 156 T.C., 2021 U.S. Tax Ct. LEXI 8 at *6. A signed, completed RAR sent with a Letter 4121 provides the requisite definiteness and formality to constitute an “initial determination” for purposes of section 6751(b)(1). See Id., 156 T.C., 2021 U.S. Tax Ct. LEXI 8 at *5

Tax litigation Insight:  The Tax Court’s determination reaffirms the statutory requirement of supervisory approval, in writing, for a penalty liability assessed by an examining agent.  The employees of the IRS must follow proper procedure, or, else, risk failing to adequately impose tax and penalty liabilities.  This can be a procedural pitfall for the IRS.  It represents a small comfort to the taxpayer that everyone must play by the same rules, even the IRS.

ESTATE OF MORRISSETTE, T.C. Memo. 2021-60

May 13, 2021 | Geoke, J. | Docket No. 4415-14 

• Opinion

Tax Dispute Short Summary:

Decedent Clara M. Morrissette established a perpetual dynasty trust (the “CMM trust”) for the benefit of her three sons. On October 31, 2006, the CMM trust entered into two split-dollar agreements with each dynasty trust. Mrs. Morrissette reported the payment of the premiums as gifts to her sons for gift tax purposes to the extent required by the economic benefit regime of Treas. Reg. § 1.61-22, which treats the premiums as annual gifts equal to the annual cost of current protection. The IRS argued that IRC § 2036 and IRC § 2038 should be applied to the transfer of the premiums that the CMM trust made as part of the split-dollar agreements and argued that the values of the split-dollar rights should be included in the gross estate, at least in the amount of the transferred premiums or the cash surrender values of the underlying policies. In practice, however, the real issue of the case concerned the actual valuation of the split-dollar rights included in Mrs. Morrissette’s gross estate.

Tax Litigation Key Issues:

The primary issues presented in Estate of Morrissette are (1) whether section 2036 or 2038 applies to recapture inter vivos transfers made as part of the split-dollar agreements, and; (2) if not, how to determine the fair market values of the split-dollar rights, including whether the special valuation rule of section 2703 applies to require that the valuation disregard a provision in the split-dollar agreements that restricts the parties’ right to unilaterally terminate the agreements, and; (3) is the estate liable for a 40% penalty for a gross valuation misstatement?

Primary Holdings:

• (1) Sections 2036 and 2038, the bona-fide sales exceptions, do not apply because the sections do not require inclusion of the premiums or policies’ cash surrender values in Mrs. Morrisette’s gross estate.
• (2) The special valuation rules of section 2703(a) would not require the inclusion of the cash surrender values of the six life insurance policies in the gross estate on the basis of the terms of the split-dollar agreements and the section 2703(b) exception.
• (3) The tax court found that the brothers’ appraisal was not reasonable and did not rely on good faith in the valuation of the split-dollar rights. As such, the estate is liable for a 40% accuracy related penalty for a gross valuation misstatement.

Key Points of Law:

• Sections 2036 and 2038 both provide exceptions to the recapture of an inter vivos transfer in the gross estate if the transfer was a bona fide sale for an adequate and full consideration for money or money’s worth. The exceptions have the same meaning for both sections. Estate of Mirowski v. Comm’r, T.C. Memo. 2008- 74. The exceptions have been interpreted as two prongs: (1) a legitimate and significant nontax purpose and (2) adequate and full consideration for money or money’s worth. Estate of Powell v. Comm’r, 148 T.C. 392, 411 (2017).
• Note that neither sections 2036 and 2038 nor the accompanying regulations define the term “sale”. The regulations indicate a broad interpretation of the term “sale” to include transactions that may not otherwise be considered sales in the strictest sense. Secs. 20.2036-1(a), 20.2038-1(a)(1), Estate Tax Regs. The court as has also interpreted the term “sale” for purposes of the bona fide sale exceptions broadly to include transfers that are not necessarily sales and have defined the term “transfer” to mean any voluntary act of transferring property. Estate of Bongard v. Comm’r, 124 T.C. at 113. The court has also interpreted the term “sale” for purposes of the bona fide sale exceptions broadly to include transfers that are not necessarily sales and have defined the term “transfer” to mean any voluntary act of transferring property. Id. Moreover, the court asserts that it has not relied on the dictionary definition of “sale” and does not adopt it in Estate of Morrisette.
• In general, IRC § 2036 and IRC § 2038 apply if three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest in or a right or power over the transferred property that she did not relinquish before her death, as defined in either section.
• Section 2703(a) provides that the value of any asset includible in the gross estate shall be determined without regard to (1) any option, agreement, or other right to acquire or use the property at a price less than its fair market value or (2) any restriction on the right to sell or use such property.
• Section 2703(b) provides a three-pronged exception to Section 2703(a). The restriction must be part of a bona fide business arrangement, not a device to transfer property at less than adequate and full consideration, and for terms comparable to similar arrangements entered into at arm’s length. Sec. 2703(b); sec. 25.2703-1 (b)(4), Gift Tax Regs. Note that a bona fide business arrangement is not defined in the Code or the regulations, but the court has held that in order to be considered a bona fide arrangement, a restrictive arrangement must further some business purpose. Amlie v. Comm’r, T.C. Memo 2006-76; Sec. 2703(b)(1).
• Section 1.6664-4 (b)(1) asserts that whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis, taking into account all pertinent facts and circumstances. In general, the most important factor is the taxpayer’s efforts to ascertain its tax liability. Reliance on professional advice may provide a reasonable cause defense if, under all the circumstances, the reliance was reasonable and in good faith. When considering reliance on an appraisal as a defense to a valuation penalty, the court will consider the methodology and assumptions underlying the appraisal, the appraised value, the circumstances under which the appraisal was obtained, and the appraiser’s relationship to the taxpayer. Estate of Richmond v. Comm’r, T.C. Memo. 2014-26, at *48.
• Under Sections 6662(a), (b)(5), (g)(1), and (h) a substantial estate tax valuation understatement exists if the value of any property claimed on an estate tax return is 65% or less of the amount determined to be the correct amount of such valuation and a gross valuation misstatement exists if the value is 40% or less of the correct value.
• Section 6662 penalties do not apply if the taxpayer demonstrates it acted with reasonable cause and in good faith. Sec. 6664(c)(1). Reasonable cause and good faith are determined on a case by case basis and reliance on professional advice may provide a reasonable cause defense if the reliance was reasonable and in good faith. Sec. 1.6664-4 (b)(1), Income Tax Regs; see Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
• When considering reliance on an appraisal as a defense to a valuation penalty, the court considers the methodology and assumptions underlying the appraisal, the appraised value, the circumstances under which the appraisal was obtained, and the appraiser’s relationship to the taxpayer. Estate of Richmond v. Comm’r, T.C. Memo. 2014-26, at *48.

Insight: The Estate of Morrisette decision demonstrates the critical quality of ‘in good faith’ metrics, especially with competing valuations in play. Morrisette highlights that taxpayers are not entitled to rely upon facially unreasonable appraisals (here, a $30 million payout turned into $7.5 million for estate tax reporting purposes) and then later claim to have done so in good faith, even when dealing with the complicated valuations of split-dollar rights.

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