The Tax Court in Brief May 31 – June 4, 2021
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Tax Litigation: The Week of May 31 – June 4, 2021
- ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
- Michael Torres v. Commissioner, T.C. Memo. 2021-66
- New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67
ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
Tax Dispute Short Summary:
In the relevant tax year, Petitioner, a partnership for U.S. tax purposes, became part of a labyrinth of entity ownership. The initial structure saw a single individual owning 100% interest in an incorporated entity. The incorporated entity owned all the shares for all the classes of stock in a limited liability company (“LLC1”). LLC1 owned all the shares for all the classes of stock in another LLC (LLC2). All entities were considered disregarded entities.
Petitioner exercised a call option granted by the incorporated entity to acquire all of a particular class of stock in an entity wholly owned by the incorporated entity granting the option. Under the call option, petitioner agreed to provide services to the incorporated entity, in exchange for the option to pay $100,000 to the incorporated entity for the class of stock in LLC1. Specifically, the services included providing strategic advice for the purpose of enhancing the performance of the incorporated entity’s business and assemble an investor group that would purchase forty percent of the incorporated entity’s business for a substantial amount of money. At the end of the assignment, the petitioner owned interest in LLC1, along with the incorporated entity.
IRS issued a final partnership administrative adjustment (FPAA) for the relevant tax year. The FPAA increased petitioner’s income and issues section 6662 accuracy-related penalties to the petitioner’s members.
Tax Litigation Key Issue:
- Whether petitioner is liable for the increase in tax?
- The Tax Court held that petitioner received interest in LLC1, a disregarded entity, in exchange for cash and performance of future services. Therefore, petitioner is liable for tax increases provided in the FPAA.
Key Points of Law:
- A party may move for summary judgment regarding all or any part of the legal issues in controversy. See Rule 121(a); Wachter v. Comm’r, 142 T.C. 140, 145 (2014). A court may grant summary judgment if the pleadings, stipulations and exhibits, and any other acceptable materials show that there is no genuine dispute as to any material fact and that a decision may be rendered as a matter of law. See Rule 121(a) and (b); see also CGG Americas, Inc. v. Comm’r, 147 T.C. 78, 82 (2016). A court construes the facts and draws all inferences in the light most favorable to the nonmoving party to decide whether summary judgment is appropriate. Sundstrand Corp. v. Comm’r, 98 T.C. 518, 520 (1992). The moving party has the burden of proving that there is no genuine issue of material fact. Naftel v. Comm’r, 85 T.C. 527, 529 (1985). However, the nonmoving party may not rest upon the mere allegations or denials in its pleadings but instead must set forth specific facts showing that there is a genuine dispute for trial. Rule 121(d).
- Section 6226 provides for judicial review of FPAAs. In general, section 6226(f) gives the Tax Court jurisdiction to determine all partnership items of the partnership for the partnership’s taxable year to which the FPAA relates. However, the Tax Court’s jurisdiction does not extend to determining the partnership items of lower tier partnerships. See Sente Inv. Club P’ship of Utah v. Comm’r, 95 T.C. 243, 247-248 (1990). Therefore, the court may determine only the partnership items of the partnership to which the FPAA relates. If the partnership items of a lower tier partnership are included in the FPAA of the partnership before the court, it is without jurisdiction to determine those lower tier partnership items. See Rawls Trading, L.P. v. Comm’r, 138 T.C. 271, 288-289 (2012).
- Generally, the Commissioner’s determinations in an FPAA are presumed correct, and the party challenging the FPAA bears the burden of proving those determinations are erroneous. See Rule 142(a)(1); Crescent Holdings, LLC v. Comm’r, 141 T.C. 477, 485 (2013). However, the party alleging our jurisdiction to determine partnership items bears the burden of proving the facts establishing our jurisdiction. Jimastowlo Oil, LLC v. Comm’r, T.C. Memo. 2013-195 (2013).
- Section 6231(a)(3) defines a partnership item as any item required to be taken into account for the partnership’s taxable year under any provision of subtitle A to the extent regulations prescribed by the Secretary provide that, for purposes of this subtitle, such item is more appropriately determined at the partnership level than at the partner level.
- In general, the “partnership’s aggregate and each partner’s share of items of income, gain, loss, deduction, or credit of the partnership” are partnership items. Proced. & Admin Regs. Sec. 301.6231(a)(3)-1(a)(1)(i). Taxable income of a partnership shall be computed in the same manner as in the case of an individual. I.R.C. §703(a). The tax treatment of any partnership item generally must be determined at the partnership level. I.R.C. §6221.
- Section 721(a) provides that no gain or loss shall be recognized to a partner in the case of a contribution of property to the partnership in exchange for an interest in the partnership. For the same reason, the Commissioner has ruled that partners generally do not recognize gain or loss upon the conversion of a disregarded entity to a partnership. See Rev. Rul. 99-5.
- By contrast, where a person receives a partnership interest in exchange for a contribution of services, nonrecognition is not always guaranteed. Treas. Reg. §1.721-1 (b)(1). Under section 1.721-1(b)(1) of the Treasury Regulations, the receipt of a partnership capital interest in exchange for services is taxable to the service provider. Crescent Holdings, 141 T.C. at 488.; see Section 83(a) provides that generally dictating the recipient’s tax treatment of property received in connection with services performed. sec. 1.61-2 (d), Income Tax Regs. (stating property received as compensation must be included in income). Under Revenue Procedure 93-27, if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership. Rev. Proc. 93-27, sec. 4.01, 1993-2 C.B. at 344. Whether the receipt of a partnership interest in exchange for services provided to or for the benefit of the issuing partnership is a taxable event turns on whether the partnership interest is a capital interest or a profits interest. See Proc. 93-27, sec. 4.01.
- Section 83(h) allows a deduction under section 162 to the person for whom were performed the services in connection with which property was transferred. Property includes a partnership interest in or held by the service recipient. Treas. Regs. §§ 1.83-3(e), 1.721-1 (b). The service recipient may deduct an amount equal to the payment that the service provider included in gross income under section 83(a), (b), or (d)(2), to the extent the amount meets the requirements of section 162 and the regulations interpreting it. I.R.C. §83(h); Treas. Regs. §1.83-6 (a)(1).
- Section 162(a) allows a deduction for the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Additionally, section 162(a)(1) allows a deduction for reasonable allowance for salaries or other compensation for personal services actually rendered.
Insight: There is a fine line when providing services in exchange for an interest in a partnership or other disregarded entity. The transfer of the partnership interest resembles payment for rendered services. The IRS and the Tax Court treat such an exchange no different than a neighbor paying for lawn maintenance services with Apple stock instead of money. This pitfall is too well-established for this issue to keep repeating. Taxpayers need to pause and think before jumping into these types of partnerships or disregarded entity contributions.
Michael Torres v. Commissioner, T.C. Memo. 2021-66
Tax Dispute Short Summary:
Petitioner is the sole shareholder of a flow-through S corporation. In the relevant tax year, the petitioner suffered an illness that prevented him from reading, working or timely filing his tax return. During this period, the S corporation issued a FORM 1099-MISC, Miscellaneous Income, to a former shareholder but current manager of S corporation’s books and records. Two years later, petitioner relearned how to read and started handing the S corporation’s tax matters.
After learning of the income issued to the former shareholder, the petitioner filed a lawsuit, claiming misappropriation of funds. The lawsuit was still pending as of the time of this opinion. Additionally, petitioner and the S corporation failed to timely file their Form 1040 and Form 1120S, respectively. The following year, IRS issued a notice of deficiency. Two weeks later, the S corporation submitted an amended return claiming an additional expense for outside services, reflecting the S corporations increase in expenses. Likewise, petitioner submitted an amended tax return that reduced his flow through income to the amount claimed as embezzled. IRS neither accepted nor filed the amended tax returns.
Tax Litigation Key Issues:
- Whether petitioner is entitled to reduce the flow through income from a wholly owned S corporation for a theft-loss deduction under section 165 or a deduction for nonemployee compensation?
- Whether petitioner is liable for an addition to tax for failure to timely file a return pursuant to section 6651(a)(1)?
- The Tax Court concluded that petitioner was not entitled to reduce his flow through income for a theft-loss deduction.
- The Tax Court concluded that petitioner was not entitled to a deduction for nonemployee compensation.
- The Tax Court concluded that petitioner was not liable for penalties under section 6651(a)(1) because he was able to demonstrate reasonable cause.
Key Points of Law:
- Generally, the Commissioner’s determinations in a notice of deficiency are presumed correct, and a taxpayer bears the burden of proving those determinations are incorrect. Rule 142(a).
- Section 1366(a) provides that income, losses, deductions, and credits of an S corporation are passed through pro rata to its shareholders on their individual income tax returns. The character of each item of income is determined as if it were realized directly from the source from which the corporation realized it or incurred in the same manner as it was by the corporation. I.R.C. §1366(b). A shareholder’s gross income includes his or her pro rata share of the S corporation’s gross income. I.R.C. §1366(c). Where, as here, a notice of deficiency includes adjustments for S corporation items with other items unrelated to the S corporation, we have jurisdiction to determine the correctness of all adjustments. See Winter v. Comm’r, 135 T.C. 238 (2010).
- Section 165(a) allows a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise. Generally, to substantiate a theft loss deduction, the taxpayer must prove that a theft actually occurred under the law of the relevant State and the amount of the loss. See Nichols v. Comm’r, 43 T.C. 842, 884-885 (1965). The term “theft” is broadly defined to include larceny, embezzlement, and robbery. Normally, a loss will be regarded as arising from theft only if there is a criminal element to the appropriation of the taxpayer’s property. See Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956).
- In order to claim a theft loss deduction, the taxpayer must prove (1) that a theft occurred under the law of the jurisdiction wherein the alleged loss occurred, Monteleone v. Comm’r, 34 T.C. 688, 692 (1960); (2) the amount of the loss; and (3) the date the taxpayer discovered the loss, see 165(e); Elliott v. Comm’r, 40 T.C. 304 (1963). The taxpayer bears the burden of proving by a preponderance of evidence that a theft actually occurred. Jones v. Comm’r, 24 T.C. 525, 527 (1955).
- Whether a theft has occurred is decided under each State’s applicable law.
- Section 162 allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Treas. Regs. §1.162-1(a). An expense is ordinary if it is normal, usual, or customary in the taxpayer’s trade or business or it arises from a transaction of common or frequent occurrence in the type of business involved. Deputy v. du Pont, 308 U.S. 488, 495 (1940).
- An expense is necessary if it is appropriate and helpful to the taxpayer’s business, but it need not be absolutely essential. Comm’r v. Tellier, 383 U.S. 687, 689 (1966). The determination of whether an expense satisfies the requirements of section 162 is a question of fact. Cloud v. Comm’r, 97 T.C. 613, 618 (1991).
- Section 6651(a)(1) imposes an addition to tax if the taxpayer fails to file his or her income tax return by the required due date, including any extension of time for filing. A taxpayer has the burden of proving that failure to timely file was due to reasonable cause and not willful neglect. SeeR.C. §6651(a)(1). A showing of reasonable cause requires the taxpayer to demonstrate that he exercised ordinary business care and prudence but was unable to file within the prescribed time. Proced. & Admin. Regs. § 301.6651-1(c).
- Under section 7491(c) the Commissioner bears the burden of production with respect to the liability of the taxpayer for any additions to tax. See Higbee v. Comm’r, 116 T.C. 438, 446-447 (2001).
Insight: This is one of those decisions that seems unfair to the taxpayer. Although the Tax Court followed the letter of the law, one can just feel the “sigh” that the taxpayer must feel. However, the decision plays a helpful reminder that when claiming a theft loss deduction to ensure that it is satisfied that an actual theft took place! Further, the Code rules supreme and tells the taxpayer when it is able to take a theft loss deduction. These simple checks can prevent a taxpayer future headaches.
New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67
Tax Dispute Short Summary:
Under a plan of merger, the taxpayer acquired the target company’s appreciated assets in the tax year at issue. Taxpayer subsequently sold the assets, reported a carryover basis in the assets, and reported capital gains that were offset by loss deductions. The year of the merger, the target company failed to file a tax return. Rather, the acquiring entity attached a pro forma return for the target company on its tax return. For several years, the taxpayer and the target company heard nothing.
Subsequently, the IRS began an audit for the taxpayer’s tax year at issue. Taxpayer refused to cooperate during the audit. The audit failed to consider the structure of the taxpayer’s merger in the tax year at issue. Further, the IRS employees assigned to the audit failed to question the taxpayer about the merger or the target company. Accordingly, the IRS issued a notice of deficiency to the taxpayer for the tax year at issue.
After the discovery period for the taxpayer’s case ended, the IRS opened an audit into the target company. The IRS determined that the target company failed to file a tax return ending on the merger date and that the merger did not qualify as an F reorganization. The IRS then prepared a substitute for return for the target company and issued a notice of deficiency. The taxpayer, as successor in interest to the target company, filed a Tax Court petition. The Tax Court held that the notice of deficiency was untimely, and that the statute of limitations barred the assessment for the tax year at issue.
The taxpayer, in return, amended its tax return to claim it did not realize capital gain from the sale of assets. Rather, taxpayer alleged that, because the merger failed to qualify as an F reorganization, the target company realized capital gains and the taxpayer took a basis in the target’s securities equal to the fair market value. Taxpayer changed course in categorizing the merger, agreeing with the IRS’ position. As a consequence of this amended return, IRS issued a notice of deficiency for the taxpayer’s tax year at issue. In response, the taxpayer filed a Tax Court petition.
- Whether the taxpayer should be estopped from changing its reporting of an asset sale after impacted tax year has been closed to the detriment of the Commissioner?
- Whether the taxpayer realized capital gains on the sale of a target company’s assets in the amount it reported on its income?
- The Tax Court concluded that the taxpayer was estopped from changing its reporting of its bases in a target company’s assets because the statute of limitations bars assessment of the tax against the target company.
- Taxpayer realized the amount of capital gain from the sale of the target company’s assets as it reported on the tax return.
Key Points of Law:
- Section 1001 requires taxpayers to recognize any gain or loss realized on the sale or exchange of property unless an exception exists. One such exception is an F reorganization under section 368(a)(1)(F). An F reorganization is defined as a mere change in identity, form, or place of organization of one corporation, however effected. I.R.C. §368(a)(1)(F).
- An F reorganization encompasses only the simplest and least significant of corporate changes and presumes that the surviving corporation is the same corporation as the predecessor in every aspect for minor or technical differences it typically has been understood to comprehend only such insignificant modifications as the reincorporation of the same corporate business with the same assets and the same stockholders. Berghash v. Comm’r, 43 T.C. 743, 752 (1965)
- To qualify, the reorganization must occur pursuant to a plan of reorganization, have a valid business purpose, and have continuity of business enterprise and continuity of interest. Treas. Regs. § 1.368-1(c), (d), and (e). Continuity of business enterprise generally requires the surviving corporation to continue at least one line of the target’s historic business or use a significant portion of the target’s historic business assets in a business after the reorganization, and continuity of interest generally requires a substantial portion of the target’s shareholders to have a continuing ownership interest in the successor corporation after the reorganization. Treas. Regs. § 1.368-1(d)(1), (e).
- In an F reorganization the target’s tax year does not terminate on the reorganization and the surviving corporation must file a full-year return on the basis of a single tax year that includes the operations of the target before the reorganization and the surviving corporation for the remainder of the year. Treas. Regs. § 1.381 (b)-1(a)(2). The transfer of the target’s assets to the successor corporation in an F reorganization is not a taxable disposition. When a transaction does not qualify as an F reorganization, the target must recognize gain on its assets as if it had sold the assets to the surviving corporation for their fair market values. Rev. Rul. 69-6, 1969-1 C.B. 104.
- The Supreme Court has long recognized that the doctrine of equitable estoppel applies in tax cases. See R.H. Stearns Co. of Bos., Mass. v. U.S., 291 U.S. 54 (1934). In holding the taxpayer estopped from obtaining a refund, the Supreme Court provided that no one shall be permitted to find any claim upon his own inequity or take advantage of his own wrong. at 61-62. The Court of Appeals for the Second Circuit has stated that equity plays a very limited role in tax cases. Callaway v. Comm’r, 231 F.3d 106, 134 (2d Cir. 2000). However, the Second Circuit has applied the doctrine of equitable estoppel to tax issues. See, e.g., U.S. v. Wynshaw, 697 F.2d 85, 87 (2d Cir. 1983). The duty of consistency, also referred to as quasi-estoppel, originates in similar principles of equity but is seen as having broader application than equitable estoppel. See, e.g., Estate of Ashman v. Comm’r, 231 F.3d 541 , 543 (9th Cir. 2000). Both doctrines are affirmative defenses. S. Pac. Transp. Co. v. Comm’r, 75 T.C. 497, 838 (1980). The party asserting them bears the burden of proof. Rule 142(a).
- The Court of Appeals for the Second Circuit has identified four requirements for applying equitable estoppel against a taxpayer: (1) the taxpayer made a false representation or engaged in a wrongful misleading silence, (2) the error originated in a statement of fact and was not a mistake of law, (3) the Commissioner did not know the correct facts, and (4) the Commissioner is adversely affected by the taxpayer’s acts or statements. Lignos v. U.S., 439 F.2d 1365, 1368 (2d Cir. 1971). Equitable estoppel can apply to bind a taxpayer to a representation made by another taxpayer where the two taxpayers are in privity (i.e., where there is sufficient identity of interests between them). Milton H. Greene Archives, Inc. v. Marilyn Monroe LLC, 692 F.3d 983, 996 (9th Cir. 2012).
- Applying duty of consistency requires that the Commissioner acquiesced in or relied on the representation made for the closed year but does not examine whether the misrepresentation was innocently or intentionally made. Beltzer v. U.S., 495 F.2d 211, 212 (8th Cir. 1974). Courts have recognized their respective applicability to an innocent mistake as the primary difference between the two doctrines. Equitable estoppel would not apply to an innocent mistake. LeFever v. Comm’r, 100 F.3d 778, 786 (10th Cir. 1996). In LeFever, the court stated that equitable estoppel requires a showing that the taxpayer made an intentional misrepresentation.
- The Court of Appeals for the Second Circuit recognizes the doctrine of equitable estoppel where the taxpayer, by his conduct, which includes language, acts or silence, knowingly makes a representation or conceals material facts which he intends or expects will be acted upon by taxing officials in determining his tax. Wynshaw, 697 F.2d at 87. In Wynshaw, the Court of Appeals applied equitable estoppel against a taxpayer in a collection action to preclude her from claiming the signature on her joint return was not hers where she had previously represented in a separate court proceeding that it was her signature. The Court of Appeals has previously declined to estop a taxpayer who made an innocent mistake of fact from correcting the mistake in a subsequent year. Bennet v. Helvering, 137 F.2d 537, 538 (2nd Cir. 1943).
- A taxpayer’s treatment of an item on a return can be a representation that facts exist which are consistent with how the taxpayer reports the item on the return. Estate of Letts v. Comm’r, 109 T.C. at 299-300. Likewise, the failure to report an item of income may be treated as a representation of the underlying facts of that item’s tax effect. Estate of Letts, 109 T.C. at 300. Failure to report income from a transaction is a representation that the transaction is nontaxable. Crane v. Comm’r, 68 F.2d 640, 641 (1st Cir. 1934). A taxpayer’s reporting of the loss leg of a straddle is a factual representation that the straddle had economic substance. Herrington v. Comm’r, 854 F.2d at 758.
- Equitable estoppel does not apply to a mistake of law. Helvering, 137 F.2d at 539.
- Courts have stated that a mistake of law occurs when both parties have knowledge of all relevant facts before the period of limitations expired. See Crosley Corp., 229 F.2d at 381; Garavaglia v. Comm’r, T.C. Memo. 2011-228. However, the Court of Appeals for the Second Circuit considers the Commissioner’s knowledge a separate requirement under the doctrine of equitable estoppel.
nsight: When the Tax Court gives you a win, please hesitate before trying to take a second bite of the apple. The statute of limitations has the primary purpose of shielding against liability. In the tax regime, taxpayers should avoid utilizing the statute of limitations as an income-reducing tool because it likely means opening oneself up to the type of scrutiny this Court displayed. The Duty of Consistency, or estoppel in this case, exists for the sole purpose to prevent the taxpayer from continuously altering to the most favorable position at the most opportune time.
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