The Tax Court in Brief August 15 – August 21, 2020
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The Week of August 15 – August 21, 2020
- Emanouil v. Comm’r, T.C. Memo. 2020-120
- Nirav B. Babu, T.C. Memo. 2020-121
- Brashear v. Comm’r, T.C. Memo. 2020-122
Emanouil v. Comm’r, T.C. Memo. 2020-120
Short Summary: Mr. Emanouil is a real estate developer. In 1999, he purchased approximately 200 acres of undeveloped property in Westford, Massachusetts. Although he made several attempts to develop or sell the property over the next several years, he ultimately obtained approval for an affordable housing project on 104 acres of the property. Towards the conclusion of the project in 2008, he donated 16 acres of the property to Westford. The following year, after Westford had approved the affordable housing project, Mr. Emanouil donated an additional 71 acres of the property to Westford.
On his 2008 return, Mr. Emanouil reported a $1.5 million charitable contribution deduction with respect to the 16-acre donation. On his 2009 return, he reported a $2.5 million charitable contribution deduction with respect to the 71-acre donation. Due to limitations on claiming the charitable contribution deductions for each year, Mr. Emanouil carried forward the deductions to his 2010 through 2012 tax years.
The IRS examined Mr. Emanouil’s 2010, 2011, and 2012 returns and issued a notice of deficiency disallowing the carryover charitable contribution deductions. The notice of deficiency disallowed the carryovers because, according to the IRS, Mr. Emanouil had failed to substantiate the reported values of the properties transferred and failed to show that the properties were transferred with charitable intent. The IRS also determined accuracy-related penalties for such years.
Key Issues: (1) Whether Mr. Emanouil complied with the qualified appraisal requirements of Section 170(f)(11)(C); (2) Whether Mr. Emanouil’s contributions were part of a quid pro quo exchange rather than a charitable gift; (3) What the fair market values were of the properties that Mr. Emanouil contributed; and (4) Whether the accuracy-related penalties apply.
Primary Holdings: (1) Although the qualified appraisal did not contain the date (or expected date) of contribution to Westford and although the qualified appraisal did not contain a statement that it was prepared for income tax purposes, Mr. Emanouil substantially complied with the qualified appraisal requirements. (2) The evidence in this case shows that Mr. Emanouil did not make the charitable contributions as part of a quid pro quo exchange. (3) The fair market values of the properties that Mr. Emanouil contributed were $1.5 million and $2.5 million, or the amounts as reported on the income tax returns. (4) The accuracy-related penalties do not apply because there are no underpayments of tax.
Key Points of Law:
- Generally, the IRS’ deficiency determinations in a notice of deficiency are presumed correct, and the taxpayers bear the burden to prove otherwise and to show their entitlement to any claimed deduction. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Proving entitlement to a claimed deduction generally includes proving that the taxpayers satisfied the specific requirements for any deduction claimed. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).
- Section 7491(a) provides an exception that shifts the burden of proof to the Commissioner as to any factual issue relevant to the taxpayers’ liability if they provide credible evidence with respect to that issue and also substantiate the item, maintain records, and cooperate with the Commissioner’s reasonable requests for information. Taxpayers bear the burden of proving that they have met the Section 7491(a) requirements. Rolfs v. Comm’r, 135 T.C. 471, 483 (2010), aff’d, 668 F.3d 888 (7th Cir. 2012).
- Rule 142(a)(1) provides that the Commissioner shall bear the burden of proof “in respect of any new matter, increases in deficiency, and affirmative defenses, pleaded in the answer”. A new theory that “merely clarifies or develops the original determination is not a new matter.” Wayne Bolt & Nut Co. v. Comm’r, 93 T.C. 500, 507 (1989). But a new theory that either “alters the original deficiency or requires the presentation of different evidence” is a new matter for which the Commissioner bears the burden of proof.
- When each party has satisfied its burden of production by offering some evidence, then the party supported by the greater weight of the evidence will prevail, and thus the burden of proof has real significance only in the event of an evidentiary tie. See Knudsen v. Comm’r, 131 T.C. 185, 189 (2008), supplementing C. Memo. 2007-340.
- Section 170(a)(1) provides that a taxpayer may deduct any charitable contribution (as defined under subsection (c)) made in the taxable year. Section 170(c) defines the term “charitable contribution” as a contribution or gift to or for the use of a qualified recipient. In order for a charitable contribution to be deductible, the contribution must be verified under regulations prescribed by the Secretary, e.g., the taxpayer must comply with specified reporting requirements. Sec. 170(a). For deductions in excess of $5,000, the taxpayer must obtain a qualified appraisal of the property, attach to the tax return a fully completed appraisal summary (i.e., Form 8283), and maintain records regarding the property, the terms of the contribution, and the donee organization. See sec. 170(f)(11)(C); Treas. Reg. § 1.170A-13(c)(2).
- The regulations define the term “qualified appraisal” as an appraisal document that, among other things, “[i]ncludes the information required by paragraph (c)(3)(ii) of this section.” Reg. § 1.170A-13(c)(3)(i). Paragraph (c)(3)(ii) requires eleven items of information to be included in the appraisal, including the date (or expected date) of contribution to the donee and a statement that the appraisal was prepared for income tax purposes.
- Strict compliance will necessarily satisfy the elements of a qualified appraisal. However, the taxpayer who does not strictly comply may nevertheless satisfy the elements if he has substantially complied with the requirements. That is, the above requirements are “directory” (i.e., “helpful to respondent in the processing and auditing of returns on which charitable deductions are claimed”) rather than “mandatory” (i.e., literal compliance is required); and the “fact that a Code provision conditions the entitlement of a tax benefit upon compliance with respondent’s regulation does not mean that literal as opposed to substantial compliance is mandated.” Bond v. Comm’r, 100 T.C. 32, 41 (1993); see also Costello v. Comm’r, T.C. Memo. 2015-87; Hewitt v. Comm’r, 109 T.C. 258, 264 (1997).
- In Cave Buttes, LLC v. Comm’r, 147 T.C. 338 (2016), the Tax Court noted the legislative history of the qualified appraisal statute and observed that its purpose was to provide the Commissioner with sufficient information to “deal more effectively with the prevalent uses of overvaluations.” at 349-350. Moreover, in Alli v. Comm’r, T.C. Memo. 2014-15, the Tax Court stated that the purpose of the appraisal requirements is to “ensur[e] that the correct values of donated property are reported.” Accordingly, it follows that if the appraisal at issue does generally provide the information required in the regulations to do just that—i.e., to ensure that the correct values of donated property are reported—then the “essential requirements of the governing statute,” can be satisfied despite certain defects that may not be significant in a given case.
- In the absence of a heightened potential for abuse, it is appropriate to recall that Congress generally favors charitable giving and that the courts have honored that legislative intent by broadly construing statutes “begotten from motives of public policy” like section 170 and similar statutes “enacted to benefit . . . charitable organizations.” See Helvering v. Bliss, 293 U.S. 144, 150-151 (1934); Estate of Crafts v. Comm’r, 74 T.C. 1439, 1455 (1980) (“As a relief provision which inures to the benefit of charity, we believe that it should be construed liberally so that the intended charitable purposes are furthered.”).
- The Tax Court has held that failing to include the date of contribution in the appraisal is not significant when the return includes a Form 8283 that specifies the date of contribution. See Zarlengo v. Comm’r, T.C. Memo. 2014-161 (finding that taxpayers substantially complied by disclosing contribution date on appraisal summary); Simmons v. Comm’r, T.C. Memo. 2009-208, aff’d, 646 F.3d 6 (D.C. Cir. 2011).
- The importance of providing an income tax purpose statement is to help the appraiser and the client identify the appropriate scope of work for the appraisal and the level of detail to provide in the appraisal, e., to make sure that all the information required for relying on the appraisal—for income tax purposes—is included in the appraisal. However, a statement of purpose may not always be necessary to achieve substantial compliance, especially not when the appraisal otherwise includes the level of detail necessary to estimate the fair market value of the property in question. See Consol. Inv. Grp. v. Comm’r, T.C. Memo. 2009-290 (finding substantial compliance where “[t]he appraisal did lack a statement that it was prepared specifically for income tax purposes; however, we find this omission to be insubstantial.”).
- The Supreme Court in Hernandez v. Comm’r, 490 U.S. 680, 701-702 (1989), stated: “The relevant inquiry in determining whether a payment is a ‘contribution or gift’ under Section 170 is . . . whether the transaction in which the payment is involved is structured as a quid pro quo” In examining whether a transfer was made with the expectation of a quid pro quo, the Tax Court gives most weight to the external features of the transaction, avoiding imprecise inquiries into taxpayers’ subjective motivations. See id. at 690-691. If it is understood that the property will not pass to the charitable recipient unless the taxpayer receives a specific benefit, and if the taxpayer cannot garner that benefit unless he makes the required “contribution,” then the transfer does not qualify the taxpayer for a deduction under section 170. See Graham v. Comm’r, 822 F.2d 844, 849 (9th Cir. 1987), aff’g 83 T.C. 575 (1984), aff’d sub nom. Hernandez v. Comm’r, 490 U.S. 680 (1989).
- In general, the amount of a charitable contribution of property under section 170(a) is the “fair market value” of the property at the time it is contributed. See Reg. § 1.170A-1(a), (c)(1). The regulations define “fair market value” as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Id. Valuation is not a precise science, and the fair market value of property on a given date is a question of fact to be resolved on the basis of the entire record. See, e.g., Kaplan v. Comm’r, 43 T.C. 663, 665 (1965); Arbini v. Comm’r, T.C. Memo. 2001-141. In considering the evidence in the record, we take into account not only the current use of the property but also its highest and best use. See Stanley Works & Subs. v. Comm’r, 87 T.C. 389, 400 (1986); Treas. Reg. § 1.170A-14(h)(3)(i) and (ii). A property’s highest and best use is the highest and most profitable use for which it is adaptable and needed or likely to be needed in the reasonable near future. Olson v. U.S., 292 U.S. 246, 255 (1934). The highest and best use can be any realistic, objective potential use of the property. Symington v. Comm’r, 87 T.C. 892, 896 (1986).
- The Tax Court evaluates expert opinions in the light of the expert’s demonstrated qualifications and all other evidence in the record. See Parker v. Comm’r, 86 T.C. 547, 561 (1986). Where experts offer competing estimates of fair market value, the Tax Court decides how to weight those estimates by, inter alia, examining the factors they considered in reaching their conclusions. See Casey v. Comm’r, 38 T.C. 357, 381 (1962). The Tax Court is not bound by the opinion of any expert witness and may accept or reject expert testimony in the exercise of its sound judgment. Helvering v. Nat’l Grocery Co., 304 U.S. 282 (1938); Estate of Newhouse v. Comm’r, 94 T.C. 193, 217 (1990). It may also reach a decision as to the value of property that is based on its own examination of the evidence in the record. Silverman v. Comm’r, 538 F.2d 927, 933 (2d Cir. 1976), aff’g C. Memo. 1974-285.
- Section 6662(a) and (b) imposes an accuracy-related penalty if any part of an underpayment of tax required to be shown on a return is due to negligence, a substantial understatement of income tax, or a substantial valuation misstatement. The penalty is equal to 20% of the portion of the underpayment to which the section applies. Section 6662(e)(1)(A) provides that a valuation misstatement is “substantial” if the value claimed on the return is “150 percent or more of the amount determined to be the correct amount.” Section 6662(h) provides that in the case of a “gross valuation misstatement,” where the value claimed on the return is 200% or more of the amount determined to be the correct amount, the penalty is increased from 20% to 40%.
Insight: The Emanouil case is a good reminder that strict compliance with certain regulatory provisions is not always required, particularly with respect to the qualified appraisal rules. Thus, if taxpayers fail to meet one or more requirements for a qualified appraisal, they should carefully consider whether they may raise the doctrine of substantial compliance.
Nirav B. Babu, T.C. Memo. 2020-121
Short Summary: Petitioner sought a determination from the Tax Court that he was not liable for an accuracy-related penalty for an underpayment attributable to a substantial understatement of income tax by failing to report passthrough entity income on his Schedule E, Supplemental Income and Loss. He argued that he had reasonable cause for failing to report and pay the proper amount of tax. The Tax Court disagreed given that the Petitioner failed to provide credible evidence in favor of his position.
Key Issue: Whether a taxpayer’s failure to report flow-through income on Schedule E, Supplemental Income and Loss, from a pass-through entity generates an accuracy-related penalty for an underpayment attributable to a substantial understatement of income tax. Specifically, whether reasonable cause for the failure existed in this scenario.
- The taxpayer did not establish through credible evidence that he had reasonable cause for failing to report and pay such amount. Specifically, the Tax Court found that the evidence weighing in favor of granting reasonable cause lacked credibility.
Key Points of Law:
- Section 7491(c) generally provides that “the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty.” This burden requires the Com- missioner to come forward with sufficient evidence indicating that imposition of the penalty is appropriate. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
- Once the Commissioner meets this burden, the burden of proof is on the taxpayer to “come forward with evidence sufficient to persuade a Court that the Commissioner’s [penalty] determination is incorrect.” at 447.
- Generally, the Internal Revenue Code imposes a 20% penalty upon the portion of any underpayment of tax that is attributable to (among other things) “[a]ny substantial understatement of income tax.” Sec. 6662(a), (b)(2).
- An understatement of income tax is “substantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. Sec. 6662(d)(1)(A).
- The Commissioner’s burden of production under section 7491(c) also includes establishing compliance with section 6751(b), which requires timely supervisory approval of penalties. See Chai v. Commissioner, 851 F.3d 190, 217, 221- 222 (2d Cir. 2017), aff’g in part, rev’g in part T.C. Memo. 2015-42; Graev v. Commissioner, 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016).
- But a section 6662 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to * * * [it].” Sec. 6664(c)(1).
- The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.”
- Indeed, reasonable cause can be shown by good-faith reliance on the advice of a qualified tax professional. Sec. 1.6664-4(b)(1), (c), Income Tax Regs. But to establish this defense the taxpayer must prove that: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer fully disclosed all relevant facts to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
- The professional must also be free of conflicts of interest, if the taxpayer bases his actions on the professional’s advice, in order to establish reasonable cause on this basis. See 106 Ltd. v. Commissioner, 136 T.C. 67, 79 (2011) (“[A]dvice must generally be from a competent and independent advisor unburdened with a conflict of inter- est[.]”).
Insight: The Babu case illustrates the importance of presenting credible evidence to establish a “reasonable cause defense” to penalties asserted by the IRS. Specifically, the case demonstrates that establishing reasonable cause requires credible evidence—particularly in a case where the taxpayer purportedly relied on the advice of a tax professional. The Tax Court is free to determine if evidence is credible, and may decline to hold that reasonable cause exists if the evidence does not seem credible to the Court. In other words, providing evidence alone is not enough to establish reasonable cause. The evidence must also be credible to the fact-finder.
Brashear v. Comm’r, T.C. Memo. 2020-122
Short Summary: Petitioners sought review of the IRS’s determination that: (1) many of the claimed deductions for Petitioners’ 2009, 2010, and 2011 Federal income tax returns should be disallowed; (2) Petitioners had additional income in 2010; (3) Petitioners are not entitled to a net operating loss carryover from 2008 to 2009; (4) Petitioners are liable for IRC § 6651 additional tax; and (5) Petitioners’ are liable for IRC § 6662(a) accuracy-related penalties. The Tax Court found in favor of the IRS.
Key Issue: Does a taxpayer have the burden of proof for the deductions that he has claimed on his Federal income tax return?
- A taxpayer has the burden to substantiate deductions that he claims through the production of adequate records and must demonstrate the deduction is allowable pursuant to a statutory provision.
Key Points of Law:
- The IRS’ determination of a taxpayer’s Federal income tax liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is erroneous. See 26 USC App Rule 142(a); See alsoWelch v. Helvering, 290 U.S. 111, 115 (1933).
- Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any claimed deduction. See 26 USC App Rule 142(a); See also INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
- This burden requires the taxpayer to substantiate expenses underlying deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability. See IRC § 6001; See alsoHradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965). A taxpayer claiming a deduction on a Federal income tax return must demonstrate that the deduction is allowable pursuant to some statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. See IRC § 6001; See also Hradesky v. Commissioner, 65 T.C. at 89-90; 26 CFR § 6001-1(a). Income Tax Regs.
- Taxpayers may deduct ordinary and necessary expenses paid in connection with operating a trade or business. See IRC § 162(a); See also Boyd v. Commissioner, 122 T.C. 305, 313 (2004). To be ordinary the expense must be of a common or frequent occurrence in the type of business involved. See Deputy v. du Pont, 308 U.S. 488, 495 (1940). To be necessary an expense must be appropriate and helpful to the taxpayer’s business. See also Welch v. Helvering, 290 U.S. 111, 113 (1933).
- Whether an expenditure satisfies the requirements for deductibility under section 162 is a question of fact. See Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
- Generally, a net operating loss (“NOL”) is the excess of allowable deductions over gross income for a given tax year. See IRC § 172(c). An NOL generally must first be carried back 2 years and then carried forward 20 years. See IRC §172(b)(1)(A). A taxpayer who makes an election can waive the carryback requirement and carry forward the NOL directly. See IRC § 172(b)(3). An election to waive the carryback must be made on a timely filed tax return for the year of the NOL for which the election is to be in effect. See Id.; See also Moretti v. Commissioner, 77 F.3d 637, 647 (2d Cir. 1996).
- A federal income tax alone cannot substantiate a NOL. See Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979) (explaining that a tax return is merely a statement of claim and does not establish truth of matters stated therein).
- IRC § Section 6201(d) provides that the IRS in certain circumstances cannot rely on information returns alone to establish unreported income but “shall have the burden of producing reasonable and probative information” in addition thereto. This provision applies only where the taxpayer “asserts a reasonable dispute with respect to any item of income reported on an information return” and only if “the taxpayer has fully cooperated with the Secretary.” Id.
- IRC § 6651(a)(1) authorizes the imposition of an addition to tax for failure to file a timely return unless the taxpayer proves that such failure is due to reasonable cause and is not due to willful neglect. See United States v. Boyle, 469 U.S. 241, 245 (1985); See also Harris v. Commissioner, T.C. Memo. 1998-332.
- IRC § 6651(a)(1) imposes an addition to tax of 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, not to exceed 25% in the aggregate.
- To avoid liability for the additions to tax, taxpayers must show that each failure to timely file (1) did not result from willful neglect and (2) was due to reasonable cause. See United States v. Boyle, 469 U.S. 241, 245-246 (1985); See alsoCrocker v. Commissioner, 92 T.C. 899, 912-913 (1989); 26 CFR § 6651-1(c)(1). Willful neglect has been defined as a “conscious, intentional failure or reckless indifference.” Boyle, 469 U.S. at 245. Reasonable cause exists where the taxpayer exercised ordinary business care and prudence but was nevertheless unable to file the return by the date prescribed by law. Id. at 246. The existence of reasonable cause or willful neglect is a question of fact. Id. at 249 n.8.
- IRC § 6662(a) imposes a penalty of 20% of the portion of an underpayment of tax attributable to the taxpayer’s: (1) negligence or disregard of rules or regulations or (2) substantial understatement of income tax. “Negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code, including any failure to keep adequate books and records or to substantiate items properly. See IRC § 6662(c); 26 CFR § 6662-3(b)(1). A “substantial understatement of income tax” is any understatement of income tax that exceeds the greater of 10% of the tax required to be shown on the return or $5,000. See IRC § 6662(d)(1)(A); 26 CFR § 1.6662-4(b).
- IRC § 6751(b)(1) provides that, subject to certain exceptions in section 6751(b)(2), no penalty shall be assessed unless the initial determination of the assessment is personally approved in writing by the immediate supervisor of the individual making the determination or such higher level official as the Secretary may designate. Written approval of the initial penalty determination under IRC § 6751(b)(1) must be obtained before the date when the taxpayer is first sent written notification of the penalties proposed. See Clay v. Commissioner, 152 T.C. 223, 249 (2019); See also Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev’g in partC. Memo. 2015-42. Compliance with IRC § 6751(b)(1) is part of the IRS’s burden of production in any deficiency case in which a penalty subject to section 6751(b)(1) is asserted. See Chai v. Commissioner, 851 F.3d at 221.
Insight: The Brashear case highlights the importance of producing adequate records and documentation that substantiate any deductions taken on a Federal tax return. Further, it illustrates the pitfalls that pro sese petitioners can fall into who are unfamiliar with the Federal Tax Code or the Tax Court’s Rules of Practice and Procedure when appearing before the Tax Court. This case shows that it is advisable to consult with a tax attorney when dealing with the Tax Court.
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