The Tax Court in Brief
The Tax Court in Brief
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.
Tax Litigation: The Week of August 9 – August 13, 2021
Tax Dispute: Manuelito B. Rodriguez & Paz Rodriguez v. Comm’r, No. 19122-19| August 9, 2021 | Kerrigan, J. | Dkt. No. 19122-19
Tax Case Short Summary: The case, rendered on oral findings and opinions, involved whether the taxpayers were entitled to deduct business expenses, COGS, a capital loss, and a section 6662 penalty.
Manuelito B. Rodriguez and Paz Rodriguez (the taxpayers) filed a Schedule C for an automotive repair business for the period 2014-2016. For 2014-2015, they filed a Schedule C for the ownership of a Seven-Eleven store, sold in 2015 and for which they claimed a loss of $98,217. The IRS disallowed rent expenses and COGS for the automotive repair business.
The Tax Court determined that the taxpayers did not met their burden of proving that the IRS’ determinations were incorrect and sustained the deficiencies.
It must be noted that this case has no precedential value.
Key Tax Issues: Whether the taxpayers met their burden of proof in regard to the various items subject to litigation.
Primary Holdings: The taxpayers did not meet their burden of proof concerning the IRS’ disallowance of various items, including expenses, NOLs, and capital losses.
Key Points of The Tax Law:
IRS’ determinations are presumed correct, and the taxpayer bears the burden of proving those determinations are incorrect. Rule 142(a); See Welch v. Helvering, 290 U.S. 111 , 115. COGS is not a deduction but rather an offset subtracted from gross receipts to determine gross income. See Metra Chem Corp. v. Commissioner, 88 T.C. 654 , 661 (1987). COGS must be substantiated by the taxpayer. Ordinary and necessary expenses are deductible when incurred in a trade or business under Section 162(a), and deductions are matter of legislative grace, which the taxpayer must prove his/her entitlement. SeeINDOPCO, Inc. v. Commissioner, 503 U.S. 79 , 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). In certain cases, however, the Court may estimate the amount of a deductible expense, if the taxpayer established that the expense is deductible but is unable to substantiate the precise amount, known as the “Cohan Rule”. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).
Tax Court Motion: In this case, the taxpayers did not provide any evidence to support their deductions, their unreported income and capital losses, thus failing to meet their burden of proof. Finally, as to the penalties imposed under Section 6662(a), such penalty was sustained because the taxpayers did not show.
Tax Law Insight: Although this case has no value as a precedent, it serves as a clear example that taxpayers must substantiate every expense that they claim on a tax return. Failure to do so, will unequivocally lead to a fatal result in Tax Court.
Tax Case: Christian D. Silver v. Comm’r, T.C. Memo 2021-98| August 9, 2021 | Copeland, J. | Dkt. No. 8805-18.
Tax Dispute Short Summary: The case involved the analysis of a tax protestor’s arguments to sustain the not reporting of income. More interestingly, this case discusses whether a penalty under Section 6673 should be imposed under the circumstances of the case.
During 2012, Mr. Silver (the taxpayer) worked for 11 different businesses, for which he received wages and an additional business, for which he received compensation as an independent contractor (1099-Misc). When filing his tax return, he attached 11 (one per job he had) Forms 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distribution From Pensions, Annuities, Retirement or Profit Plans, IRA’s Insurance Contracts, Etc. For the independent contractor payment, he attached a “corrected” Form 1099-Misc. On the 4852 the taxpayer claimed that he received $0.00 as income. On the “corrected” 1099-Misc the taxpayer stated that such document was to “rebut the 1099-Misc” filed by the payor. In other words, the taxpayer argued that the compensation he received for his job/services was not taxable.
Tax Court Motion: The Court determined that the taxpayer’s arguments were that of a tax protestor and plainly rejected them, and qualified them as “groundless and frivolous”. However, the Court analyzed whether a penalty under Section 6673 – penalties for positions that are frivolous or groundless – applied, and ruled that such penalty was not applicable in this case.
Key Issues: Whether wages or compensation for independent services are subject to tax income. Whether a taxpayer should be sanctioned with a penalty under Section 6673 when he has not been advised of the applicability of the penalty before trial.
Primary Holdings: Wages constitute income. A penalty under Section 6673 requires that the taxpayer knows of the applicability of the penalty before trial, in order to be imposed by the Court.
Key Points of Law:
The seminal rule of income tax is that gross income includes all income from whatever source derived. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 , 429 , 75 S. Ct. 473 , 99 L. Ed. 483 , 1955-1 C.B. 207 (1955) (quoting Helvering v. Clifford, 309 U.S. 331 , 334 , 60 S. Ct. 554 , 84 L. Ed. 788 , 1940-1 C.B. 105 (1940)). A payment that is an undeniable accession to wealth constitutes taxable income. Wages are considered as an accession to wealth, thus subject to tax income.
In this case, the taxpayer did not deny receiving income but rather argued that he was not a taxpayer or that he did not received taxable compensation but rather exchanged his services for remuneration paid to him. The Tax Court determined that such arguments were groundless and frivolous. See Wnuck v. Commissioner, 136 T.C. 498 (2011). The Court did not even refute the taxpayer’s arguments because they did not have any colorable merit.
Section 6673 provides the imposition of a penalty not in excess of $25,000 when it appears that the taxpayer’s position is frivolous or groundless. Such penalty is entirely within the discretion of the Court. In this case, the Court explained that although the taxpayer had two other pending petitions in the Court, he was not warned that the penalty could be imposed on him. Relevant also, is the fact that the penalty request was not advanced before trial. Under these circumstances, the Court determined to not impose the penalty, but warned the taxpayer that advancing similar positions in future cases would carry the imposition of the penalty.
Insight: A penalty under Section 6673, for frivolous or groundless positions, is an additional weapon that the IRS can request against the taxpayer. This case shows that the Tax Court will not impose such types of penalties easily, but rather it considers that the threshold to impose them is quite high.
Tax Case: Wathen v. Comm’r, No. 4310-18, T.C. Memo 2021-100 | August 11, 2021 | Pugh | Dkt. No. 4310-18
Tax Litigation Short Summary: This case involved a combination of underreported income and unsubstantiated deductions. The Petitioner, a bankruptcy attorney, under-reported certain gross receipts for 2010 and 2011. He further failed to report partnership income. Finally, he was unable to substantiate most of his claimed expenses – including some that were subject to the heightened substantiation requirement of I.R.C. §274(d), and even some that were only subject to the general substantiation requirement. Finally, in a slightly varied fact pattern, Petitioner argued that a Chapter 13 bankruptcy case filed in 2012, and for which the Petitioner received a discharge in 2017, served as res judicata and thereby precluded the IRS from assessing the amounts at issue. The Court ultimately found that res judicata did not apply because the issues before the Tax Court in this case were not before the Bankruptcy Court.
Tax Dispute Key Issue: The Court identified seven (7) discreet issues for determination in this case:
- Whether petitioner’s prior bankruptcy proceeding precludes respondent from pursuing the above deficiencies, additions to tax, and penalties;
- Whether petitioner failed to report gross receipts of $59,726 and $15,833 for 2010 and 2011, respectively, on Schedules C, Profit or Loss From Business;
- Whether petitioner failed to report partnership income of $1,951 for 2010 on Schedule E, Supplemental Income and Loss;
- Whether Petitioner is entitled to deduct travel expenses of $8,732 and $21,980 for 2010 and 2011, respectively, on Schedules C;
- Whether Petitioner is entitled to deduct office expenses of $46,717 and $53,420 for 2010 and 2011, respectively, on Schedules C;
- Whether petitioner is liable for additions to tax under section 6651(a)(1) for failure to timely file tax returns for both years in issue; and
- Whether petitioner is liable for penalties under section 6662(a) and (b)(2) for substantial understatements of income tax for both years in issue.
- Petitioner’s prior bankruptcy case did not preclude the IRS’s deficiency assessment based on grounds of res judicata, collateral estoppel, or judicial estoppel. Citing to the Tax Court’s opinion in Breland v. Comm’r, 152 T.C. 156 (2019), the Court held that res judicata did not apply because the redetermination of a taxpayer’s total Federal tax liability for the years covered by the notice of deficiency and the resolution of the IRS’ objection in a bankruptcy plan confirmation proceeding were not the same cause of action.
- The Court further held that collateral estoppel did not apply because there was no indication that Petitioner’s total Federal tax liability was ever actually litigated or even at issue before the bankruptcy court.
- As to unreported income, the Court held that the IRS’s use of the bank deposit method was appropriate. That approach assumes that all money deposited in a taxpayer’s bank account during a given period constitutes taxable income. Since Petitioner in this case did not keep a set of books and records, Respondent’s reconstruction of Petitioner’s income using the bank deposit method was appropriate. That analysis supported Respondent’s determination that Petitioner received unreported income. Furthermore, Petitioner failed to meet his burden of proving that the adjustments to his Schedule C gross receipts were erroneous. He not only appeared to concede that they were correct, but also did not present any evidence refuting them.
- Similarly, as it relates to unreported Schedule E Partnership Income, the taxpayer did not dispute the IRS’s contention at trial.
- As to expenses, the taxpayer was unable to satisfy the necessary burden. With respect to certain business expenses – including travel, lodging, and meal expenses – a heightened substantiation requirement exists under I.R.C. § 274(d). The Taxpayer was unable to satisfy that requirement because he kept no books and records.
- As to the general substantiation requirement, courts can apply the Cohan rule, which allows a Court to estimate the amount of an expense if the taxpayer is unable to demonstrate that he has paid or incurred a deductible expense but cannot substantiate the precise amount, as long as he produces credible evidence providing a basis for the Court to do so. Because the taxpayer kept no books or records, and was therefore unable to provide any documentation indicating for what services his bank payments were made, the Court found that he couldn’t even satisfy the general substantiation requirement and therefore refused to apply the Cohan rule for most of his general expenses. The Court made an exception for a small number of expenses – including bankruptcy filing fees, PACER charges, and LexisNexis expenses, which were fairly clear from the documentation.
- The Court had no trouble in finding that the failure to timely file penalty under § 6651(a)(1) was properly applied. The IRS satisfied its burden to show that the taxpayer failed to timely file his returns, and the taxpayer failed to provide any evidence that his failure to timely file was due to reasonable cause and no willful neglct.
- Similarly, the Court found that accuracy-related penalties were appropriately assessed under §6662(a) because the IRS had satisfied its burden showing that the underpayment occurred and that it satisfied the requirement to have the penalty approved by management. Further, the taxpayer once again failed to show he had acted with reasonable cause and in good faith with respect to any portion of the underpayment.
Key Points of Tax Law:
- Res judicata does not attach to a bankruptcy confirmation plan because confirmation of a bankruptcy plan and resolution of an IRS tax deficiency are not the same cause of action. Breland v. Commissioner, 152 T.C. 156, 161-62 (2019).
- Collateral estoppel does not apply where a taxpayer’s federal tax liability was never actually litigated or even at issue in a bankruptcy court Breland v. Commissioner, 152 T.C. 156, 171-72 (2019).
- Taxpayers’ bear the burden of proving that the IRS’s determinations in a notice of deficiency are erroneous. Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
- If a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of a taxpayer for any tax, the IRS has the burden of proof with respect to such issue. 26 U.S.C. § 7491(a)(1)
- In cases involving unreported income, the IRS must present some predicate evidence supporting the determination that the taxpayer received unreported income for the presumption of correctness to attach to the notice of deficiency. Portillo v. Commissioner, 932 F.2d 1128, 1133-34 (5th 1991).
- Gross income includes “all income from whatever source derived.” 26 U.S.C. § 61(a).
- A taxpayer is responsible for maintaining adequate books and records sufficient to establish his income. 26 U.S.C. § 6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
- For taxpayers who fail to keep adequate books and records, section 446(b) confers broad powers on the Secretary and his delegate, i.e., the Commissioner, to compute taxable income. Reg. 1.446-1(b)(1).
- One method of computing taxable income is the bank deposit method. It assumes that all money deposited in a taxpayer’s bank account during a given period constitutes taxable income. Price v. United States, 335 F.2d 671, 677 (5th 1964).
- Taxpayers bear the burden of proving that they are entitled to any deductions claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Therefore, they are required to substantiate expenses underlying each claimed deduction by maintaining records sufficient to establish the amount of the deduction and to enable the Commissioner to determine the correct tax liability. 26 U.S.C. § 6001
- Under the Cohan rule, the Court may estimate the amount of the expense if the taxpayer is able to demonstrate that he has paid or incurred a deductible expense but cannot substantiate the precise amount, as long as he produces credible evidence providing a basis for the Court to do so. Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir. 1930).
- Certain business expenses (including travel, lodging, and meal expenses) are subject to the heightened substantiation requirements of section 274(d). Section 274(d) supersedes the Cohan rule with respect to such expenses.
- To meet the requirements of section 274(d), a taxpayer must substantiate the following by adequate records or by sufficient evidence corroborating the taxpayer’s own statement: (1) the amount of the expense, (2) the time and place of the travel or use, and (3) the business purpose of the expense.
- To substantiate by adequate records, the taxpayer must provide: (1) an account book, log, or similar record and (2) documentary evidence, which together are sufficient to establish each element with respect to an expenditure. Sec. 1.274-5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985).
- The IRS bears the burden of producing evidence with respect to the liability of any individual for any addition to tax. Sec. 7491(c). The taxpayer bears the burden of proving that failure to timely file was due to reasonable cause and not willful neglect. See sec. 6651(a)(1).
- The Commissioner bears the burden of producing evidence with respect to the liability of any individual for any penalty. Sec. 7491(c). This includes showing compliance with section 6751(b)(1), which requires that certain penalties be personally approved in writing by the immediate supervisor of the individual making the determination. The taxpayer bears the burden of proving that the Commissioner’s determination is incorrect or that he or she has an affirmative defense, such as reasonable cause and good faith under section 6664(c). See Rule 142(a).
Tax Litigation Insight:
This case provides yet another example of the benefits of good record keeping. It seems likely that many of this taxpayer’s expenses were legitimate, but it is incumbent on a taxpayer to be able to prove the legitimacy of those expenditures.
Tax Case: Kidz University, Inc. v. Comm’r, T.C. Memo. 2021-101 | August 12, 2021 | Urda, J. | Dkt. No. 23866-18L
Tax Dispute Short Summary: Petitioner Kidz University, an Arkansas childcare company, belatedly filed certain Forms 941 for tax years 2012 and 2013 between June 2014 and October 2015. In response, the IRS assessed taxes, as well as interest and penalties under Sections 6651(a)(1); 6651(a)(2); and 6656(a). The IRS issued a Notice of Intent to Levy to Kidz University, and the Petitioner timely filed a Request for Collection Due Process Hearing.
Tax Court Motion
Over several months, the representative for Kidz University and the IRS Appeals Officer communicated via phone and fax. IRS Appeals requested, on more than one occasion, verification of current tax filing and payment compliance. Moreover, IRS Appeals requested completed Forms 433-A and 433-B. After the representative was silent and non-responsive to attempted communications by IRS Appeals in August, September, and October 2018, IRS Appeals issued a notice of determination, stating Kidz University did not qualify for a collection alternative. Kidz University filed its petition with the Tax Court, and Respondent filed a motion for summary judgment.
Tax Litigation Key Issues:
- (1) Whether IRS Appeals’ denial of Petitioner’s request for a collection alternative was an abuse of discretion.
- (1) Based on the administrative record, IRS Appeals’ denial of Petitioner’s request for a collection alternative was not an abuse of discretion.
Key Points of Tax Law:
- Where the validity of the underlying tax liability is not properly at issue, the Tax Court will review the Commissioner’s administrative determination for abuse of discretion. See Goza v. Comm’r, 114 T.C. 176, 182 (2000).
- In reviewing for abuse of discretion, the Court must uphold the administrative determination unless it is arbitrary, capricious, or without sound basis in fact or law. See, e.g., Murphy v. Comm’r, 125 T.C. 301, 320 (2005), aff’d, 469 F.3d 27 (1st Cir. 2006).
- The Tax Court reviews the record to determine whether the settlement officer: (1) properly verified that the requirements of applicable law or administrative procedure have been met; (2) considered any relevant issues the taxpayer raised; and (3) considered whether “any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary.” See I.R.C. § 6330(c)(3); Ludlam v. Comm’r, T.C. Memo. 2019-21, at *9-*10.
- A taxpayer must be “in compliance with current filing and estimated tax payment requirements to be eligible for collection alternatives.” Coastal Luxury Mgmt. Inc. v. Comm’r, T.C. Memo. 2019-43, at *9.
Tax Litigation Insight:
As noted in other recent Tax Court decisions, tax filing and payment compliance should be viewed by taxpayers as a minimum threshold to pursue collection alternatives. Further, a taxpayer should be selective in choosing a representative before the Internal Revenue Service. Lack of communication is hardly a recipe for success in dealing with the IRS.