The Tax Court in Brief July 12 – July 17, 2020
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 Court: The Week of July 12 – July 17, 2020
- Duffy v. Comm’r, T.C. Memo. 2020-108
- Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
- Weiderman v. Comm’r, T.C. Memo. 2020-109
- Robert Elkins v. Comm’r, T.C. Memo. 2020-110
Tax Court Case:
Duffy v. Comm’r, T.C. Memo. 2020-108
Tax Case Short Summary: The taxpayers purchased property in Gearhart, Oregon for $2 million in 2006. The purchase was seller financed, but the taxpayers later borrowed $1.4 million from JPMorgan Chase and used the proceeds to pay the seller. In 2009 and 2010, the taxpayers rented the Gearhart property to family and acquaintances—prior to, they had used the property as a vacation home. They sold the Gearhart property in 2011 for $800,000 with JPMorgan Chase agreeing to accept $750,841 of the proceeds in full satisfaction of the mortgage loan that encumbered the property.
In February 2011, Mr. Duffy organized Impact Medical, LLC (Impact Medical), which was formed to design and manufacture equipment to alleviate a medical condition known as deep vein thrombosis. Later, additional investors became members of Impact Medical. Mr. Duffy ran the day-to-day operations of Impact Medical.
In 2013, Wells Fargo Bank N.A. forgave $391,532 of debt the taxpayers owed on a home equity line of credit secured by their residence in Portland, Oregon.
The taxpayers filed joint returns for 2009 through 2014. On those returns, the taxpayers reported: (1) for 2009 and 2010, a Schedule E loss related to their rental of the Gearhart property, which was treated as nondeductible passive activity losses; (2) for 2011, a loss from their sale of the Gearhart property, cancellation of debt income related to the JPMorgan Chase loan, and a net operating loss which was carried back to 2009 and 2010, (3) for 2012, Schedule E income which reported Mr. Duffy’s guaranteed payments from Impact Medical as not subject to self-employment tax, and a nonpassive loss for unreimbursed partnership expenses, (4) for 2013, a Schedule E nonpassive loss from Impact Medical, and a nonpassive loss for unreimbursed partnership expenses, and none of the Impact Medical guaranteed payment as subject to self-employment tax; and (5) for 2014, nonpassive loss for unreimbursed partnership expenses, and none of the Impact Medical guaranteed payments as subject to self-employment tax.
Key Tax Dispute Issue: Whether the taxpayers: (1) are entitled to deduct an ordinary loss from their sale in 2011 of residential property in Oregon; (2) must include in their 2011 taxable income, in connection with the sale of the Oregon property, COD income due to discharge of debt that the property secured; (3) are entitled to deduct losses they reported from their rental of the Oregon property; (4) must include in their taxable income for 2013 COD income from the discharge of a home equity line of credit secured by their property in Portland; (5) are entitled to deduct all or a portion of the losses allocated to Mr. Duffy by Impact Medical; (6) are entitled to deduct other losses reported on Schedules E for their 2012 through 2014 tax years; (7) must pay self-employment tax on Mr. Duff’s guaranteed payments he received from Impact Medical; and (8) are liable for accuracy-related penalties.
- The taxpayers are: (1) not entitled to deduct an ordinary loss from their sale of the Oregon property in 2011 because they have not established that the adjusted basis of the property at the time of the sale exceeded the amount realized on the sale; (2) required to report the amount of the JPMorgan Chase loan from which they were discharged in their amount realized from the sale of the Gearhart property; (3) not entitled to deduct losses form the Oregon property for 2009, 2010, and 2011 because the taxpayers failed to advance the argument on brief and therefore the issue is deemed conceded; (4) taxable on $117,128 of the COD income related to the Wells Fargo debt because they were insolvent, immediately before the discharge, by $274,404; (5) not entitled to deduct any ordinary loss from Impact Medical for 2012 but are entitled to deduct the loss the partnership allocated to Mr. Duffy for 2013; (6) not entitled to deduct losses for unreimbursed partnership expenses because taxpayers have provided no substantiation for the losses; (7) are subject to self-employment tax for 2012 but are not subject to self-employment tax for 2013 or 2014 because Mr. Duffy had no net earnings from self-employment for those years; and (8) are not liable for the accuracy-related penalties because the IRS failed to meet its burden of production in showing that it obtained written managerial approval of the penalties under Section 6751(b).
Key Points of the Tax Laws:
- Section 165(a) allows a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Losses of individual taxpayers, however, are deductible only if they were incurred in a trade or business or transaction entered into for profit or arising from a casualty or theft. 165(c).
- Although losses from sales of personal residences are generally nondeductible under section 165(c), Treas. Reg. § 1.165-9(b)(1) provides: “If a property purchased or constructed by the taxpayer for use as his personal residence is, prior to its sale, rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale, a loss sustained on the sale of the property shall be allowed as a deduction.” In general, the allowable loss is the excess of the property’s adjusted basis over the amount realized from the sale. Reg. § 1.165-9(b)(2). For that purpose, however, the property’s adjusted basis upon conversion cannot exceed its fair market value at that time. Id. Basis is further reduced by any depreciation allowed between the conversion of the property and its sale. Sec. 1016(a)(2); Treas. Reg. § 1.167(g)-1; Treas. Reg. § 1.1011-1.
- Section 61(a) defines gross income to mean “all income from whatever source derived.” That section includes as a specifically listed item “income from discharge of indebtedness.” 61(a)(12).
- Section 108(a)(1)(B) excludes from a taxpayer’s gross income amounts otherwise includible as a result of the discharge of indebtedness if “the discharge occurs when the taxpayer is insolvent.” In addition, section 108(e)(2) provides: “No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.”
- When a creditor forgives debt in connection with the sale or exchange of property that secures the debt, the discharge of debt can either result in the taxpayer’s amount realized from the sale, thereby increasing the taxpayer’s gain or reducing the taxpayer’s loss on the sale. The varying treatment of the debt discharge turns on whether the indebtedness was recourse or nonrecourse—that is, whether the creditor’s remedies were limited to the transferred property. Reg. § 1.1001-2(a)(1) provides a general rule that “the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor discharged as a result of the sale or disposition.” However, Treas. Reg. § 1.1001-2(a)(2) provides: “The amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be realized and recognized) income from the discharge of indebtedness under section 61(a)(12).”
- The adjusted basis of a personal residence converted to business use is stepped down to fair market value for purposes of determining a loss on a subsequent sale of the property but not for purposes of determining gain on such sale. Simonsen v. Comm’r, 150 T.C. 201, 214 (2018).
- Section 469 prohibits specified taxpayers, including individuals, from deducting losses from passive activities against other income. In general, passive activities are trade or business activities in which the investor does not materially participate. 469(c)(1). Rental activities are generally considered passive activities regardless of the extent of the investor’s participation. Sec. 469(c)(2). But an individual who actively participates in rental of real estate can deduct up to $25,000 of annual losses from the activity. Sec. 469(i)(1) and (2). This exclusion is phased out for a taxpayer whose adjusted gross income exceeds $100,000 and is eliminated entirely if the taxpayer’s adjusted gross income exceeds $150,000. Sec. 469(i)(3)(A).
- Losses disallowed under the passive activity loss rules can be carried forward and used to offset income from passive activities or when the taxpayer, in a taxable transaction, disposes of his interest in the activity that generated the loss. 469(b), (g)(1)(A).
- Under Section 172, when an individual taxpayer incurs a net loss for a year from business activities, the loss is carried back to offset income of the taxpayer for the two prior years. 172. Any NOL remaining after carryback is then carried forward to offset the taxpayer’s income in future years. Sec. 172(b)(1)(A). Section 172(b)(3) allows the taxpayer to waive the carryback and simply carry the NOL forward.
- An issue raised by the pleadings may be conceded if a party fails to advance on brief an argument regarding that issue. Bradley v. Comm’r, 100 T.C. 367, 370 (1993); Ashkouri v. Comm’r, T.C. Memo. 2019-95.
- Section 108(a)(1)(E) excludes from income the discharge before January 1, 2014, of “qualified principal residence indebtedness.” Indebtedness qualifies for the Section 108(a)(1)(E) exclusion only if it was incurred to acquire, construct, or improve a taxpayer’s principal residence.
- A partner can deduct his share of a partnership’s loss for a tax year only to the extent of the adjusted basis of his partnership interest at the end of the year. 704(d). Any excess of the loss allocated to the partner over his outside basis carries forward to the following year.
- When a partner acquires his interest in a partnership by contributing property to the partnership, the partner’s initial outside basis equals the amount of any money and the adjusted basis of any other property contributed. 722. The partner’s initial outside basis if adjusted over time to reflect partnership activity. In particular, his outside basis is increased by his share of partnership income and decreased by distributions made by the partnership to the partner and by the partner’s share of partnership losses and nondeductible expenditures. Secs. 705, 733. A partner’s outside basis also includes the partner’s share of partnership liabilities. Section 752 achieves that result by treating increases in the partner’s share of partnership liabilities as cash contributions and decreases as cash distributions.
- Section 6222 requires a partner to report partnership items on an individual return in a manner consistent with the partnership’s reporting. If the partner reports inconsistently and fails to notify the Commissioner of the inconsistency, Section 6222(c) authorizes the Commissioner to make a computational adjustment to conform the partner’s treatment of the relevant items to the partnership’s treatment of those items and collect any additional tax without deficiency procedures.
- When a partner pays expenses of a partnership, an issue can arise regarding the proportion of those expenses the paying partner is entitled to deduct. See Cropland Chem. Corp. v. Comm’r, 75 T.C. 288, 294-97 (1980), aff’d without published opinion, 665 F.2d 1050 (7th Cir. 1981). A partner generally cannot deduct partnership expenses as such. But a partner’s payment of partnership expenses can be treated as a contribution to the partnership, with the paying partner then entitled to deduct his allocable share of the expense. By express agreement or course of conduct, however, the entire expense can be specifically allocated to the partner who paid it.
- Section 1401(a) imposes a tax “on the self-employment income of every individual.” An individual’s “net earnings from self-employment” are included in his self-employment income unless specifically excluded. 1402(b). Subject to specified exception, Section 1402(a) provides that the term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.
- Reg. § 1.1402(a)-1(a)(2) defines “net earnings from self-employment” to include two components, the second of which is an individual’s “distributive share (whether or not distributed), as determined under section 704, of the income (or minus the loss), described in section 702(a)(* * * ) and as computed under section 703, from any trade or business carried on by any partnership of which he is a member.”
- Section 6662(a) and (b)(1) provides for an accuracy-related penalty of 20% on the portion of an underpayment of tax attributable to negligence or disregard of rules and regulations. Section 6662(a) and (b)(2) provides for the same penalty on the portion of an underpayment of tax attributable to “[a]ny substantial understatement of income tax.”
- Section 6662(d)(2)(A) generally defines the term “understatement” as the excess of the tax required to be shown on the return over the amount shown on the return as filed. In the case of an individual, an understatement is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 6662(d)(1)(A). An understatement is reduced, however, by the potion attributable to the treatment of an item for which the taxpayer had “substantial authority” or, in the case of items adequately disclosed, a “reasonable basis.” Sec. 6662(d)(2)(B). Moreover, Section 6664(c)(1) provides an exception to the imposition of the Section 6662(a) accuracy-related penalty if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.
- The burden of production that Section 7491(c) imposes on the Commissioner requires him to establish compliance with the supervisory approval requirement of Section 6751(b). Graev v. Comm’r, 149 T.C. 485, 493 (2017), supplementing and overruling in part 147 T.C. 460 (2016). Section 6751(b)(1) provides: “No penalty under this title 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 or such higher-level official as the Secretary may designate.”
Tax Court Motion: Mr. and Mrs. Duffy may have lost on some major issues in Duffy, but they obtained a major win on the penalty issue. Interestingly, the IRS sought to satisfy its burden of production under Section 6751(b) via a civil penalty form and a stipulation which provided that the signer “was the manager or supervisor of one or more of the auditing agents.” On this basis, the Tax Court concluded that the stipulation alone did not establish that the signer was the immediate supervisor of the person who made the initial determination to assess the penalties in issue. Thus, the Duffy decision demonstrates that proper wording via the stipulation process in Tax Court matters considerably.
Tax Court Case:
Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
Tax Dispute Short Summary: On July 29, 2008, Rockefeller Holdings, LLC (Rockefeller), owned in part by David Hewitt, purchased 21.89 acres of property on Lewis Smith Lake in Alabama for $200,000. Rockefeller transferred the property to Smith Lake, LLC (Smith Lake). Mr. Hewitt and his wife each owned a 50% interest in Smith Lake at the time of the transfer.
On December 20, 2013, Mr. and Mrs. Hewitt each sold and assigned 49.75% of their interests in Smith Lake to Smith Lake Investment Partners, LLC (Smith Lake Investments). On December 23, 2013, Smith Lake conveyed a deed of easement for the 21.89 acres to the Pelican Coast Conservancy, LLC, by and through its sole member, Atlantic Coast Conservancy, Inc., a Georgia nonprofit corporation.
For the conservation easement, Smith Lake claimed a $6,524,000 noncash charitable contribution deduction.
Tax Litigation Key Issue: Whether the taxpayer satisfied the perpetuity requirement of Section 170(h)(5)(A), and whether Treas. Reg. § 1.170A-14(g)(6) is valid under Chevron.
- The taxpayer has failed to satisfy the perpetuity requirement of Section 170(h)(5)(A) because the deed granting the conservation easement reduces the donee’s share of the proceeds in the event of extinguishment by the value of improvements (if any) made by the donor. In addition, the proceeds regulation of Treas. Reg. § 1.170A-14(g)(6) is valid under Chevron.
Key Points of the Tax Laws:
- Section 170(a)(1) allows a deduction for any charitable contribution made within the tax year. If the taxpayer makes a charitable contribution of property other than money, the amount of the contribution is generally equal to the FMV of the property at the time the gift is made. Reg. § 1.170A-1(c)(1).
- The Code generally restricts a taxpayer’s charitable contribution deduction for the donation of “an interest in property which consists of less than the taxpayer’s entire interest in such property.” 170(f)(3)(A). However, there is an exception to this rule for a “qualified conservation contribution.” Sec. 170(f)(3)(B)(iii). This exception applies to a “qualified conservation contribution”, which is a contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. Sec. 170(h)(1).
- Section 170(h)(5)(A) provides that a contribution will not be treated as being made exclusively for conservation purposes “unless the conservation purpose is protected in perpetuity.” To meet the requirements of Treas. Reg. § 1.170A-14(g)(6)(ii), the deed must guarantee that the donee will receive “a proportionate share of extinguishment proceeds.” Carroll v. Comm’r, 146 T.C. 196, 219 (2016).
- When considering whether a regulation is arbitrary and capricious, the Tax Court generally employs the two-part inquiry established by Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). The first part is to inquire “whether Congress has directly spoken to the precise question at issue.” at 842. If the intent of Congress is clear, there is no further inquiry. Id. The next part is to consider whether the regulation “is based on a permissible construction of the statute.” Chevron, 467 U.S. at 843. If the statute is silent, the Tax Court gives deference to the interpretation embodied in the agency’s regulation unless it is “arbitrary, capricious, or manifestly contrary to the statute.” U.S. v. Mead Corp., 533 U.S. 218, 227 (2001); Chevron, 467 U.S. at 844. The Tax Court will uphold the regulation if it represents a “reasonable interpretation” of the law Congress enacted. Chevron, 467 U.S. at 844.
- In Oakbrook Land Holdings, LLC v. Comm’r, 154 T.C. at ___ (slip op. at 29), the Tax Court reasoned that Treasury’s goal in prescribing the proceeds regulation was to ensure satisfaction of the statute’s “protected in perpetuity” requirement. In that case, the Tax Court also concluded that the proceeds regulation’s “proportionate value” approach is not “arbitrary, capricious, or manifestly contrary to the statute” as examined under the two-part Chevron
- The doctrine of judicial estoppel focuses on the relationship between a party and the courts, and it seeks to protect the integrity of the judicial process by preventing a party from successfully asserting one position before a court and thereafter asserting a completely contradictory position before the same or another court merely because it is now in that party’s interest to do so.” Huddleston v. Comm’r, 100 T.C. 17, 26 (1993). Although judicial estoppel requires a court’s acceptance of a party’s prior position, acceptance “does not mean that the party being estopped prevailed in the in the prior proceeding . . . but rather only that a particular position or argument asserted by the party . . . was accepted by the court.” The Court in Huddleston, 100 T.C. at 26, further stated that, in cases that settle, “an argument can be made that the court did not affirmatively accept any of the underlying positions reflected in the settlement and that judicial estoppel should not apply.”
Tax Court Motion: The IRS is on a hot streak on the conservation easement front, and the decision in Smith Lake is another notch in its belt. Taxpayers with docketed Tax Court cases who are able to settle with the IRS under the IRS’ new settlement program should carefully consider their defenses and whether to accept the settlement terms. Next moves may be extremely important.
Tax Court Case:
Weiderman v. Comm’r, T.C. Memo. 2020-109
Tax Dispute Short Summary: Mrs. Weiderman accepted an executive marketing position with K-Swiss in 2006. Under the terms of her employment offer, K-Swiss agreed to assist the Wediermans in their relocation to California, providing them with a $500,000 interest-free loan to help finance the purchase of a new residence. K-Swiss and Mrs. Weiderman later executed a promissory note, dated February 15, 2007, which discussed the terms and conditions of the loan including that the loan was due and payable in full in one lump-sum payment on the earlier of February 15, 2017, or the effective date of her termination (whether voluntary or non-voluntary). After the loan disbursement, the Weidermans used the loan proceeds to purchase a residence in California.
But on December 1, 2008, K-Swiss terminated Mrs. Weiderman’s employment. Accordingly, K-Swiss demanded full payment of the $500,000 loan. Ultimately, Mrs. Weiderman and K-Swiss agreed (through various settlement negotiations) that K-Swiss would cancel $285,000 of the loan with proceeds from the sale of the California residence satisfying the remaining loan balance.
In 2009 and 2010, Mr. and Mrs. Weiderman also claimed various business deductions on Schedules C.
Tax Litigation Key Issue: Whether the taxpayers: (1) must include in gross income COD income of $255,000 and $30,000 for 2009 and 2010, respectively; (2) are entitled to deduct certain expenses they reported on their 2009 and 2010 Schedules C, Profit or Loss From Business; and (3) are liable for accuracy-related penalties.
- The taxpayers (1) must include in gross income COD income of $255,000 and $30,000 for 2009 and 2010 because the COD income was not excludible under Section 108(e)(1)(A); (2) are not entitled to deductions on Schedule C because Mrs. Weiderman was not engaged in carrying on a separate trade or business for profit under Section 162 and, in any event, she did not provide substantiation for the expenses, and the Schedule C deductions claimed with respect to Mr. Weiderman’s business were deemed conceded during trial; and (3) are liable for the accuracy-related penalty because they did not satisfy all of the factors under Neonatology Assocs. in asserting that they relied on the professional tax advice of a tax preparer.
Key Points of the Tax Laws:
- Generally, the Commissioner’s determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving otherwise. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). In the Ninth Circuit, and with respect to unreported income cases, the Commissioner must provide some reasonable foundation connecting the taxpayer with the income-producing activity, see Weimerskirch v. Comm’r, 596 F.2d 358, 360-61 (9th 1979), rev’g 67 T.C. 672 (1977), or demonstrate that the taxpayer received unreported income, see Hardy v. Comm’r, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo. 1997-97. Once the Commissioner has done this, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary and capricious. Helvering v. Taylor, 293 U.S. 507, 515 (1935). Similarly, under section 6201(d), if a taxpayer in any court proceeding asserts a reasonable dispute with respect to any item of income reported on an information return, the Commissioner shall have the burden of producing reasonable and probative information concerning such deficiency, in addition to such information return.
- Tax deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed. Rule 142(a); INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); Segel v. Comm’r, 89 T.C. 816, 842 (1987). This burden generally requires the taxpayer to demonstrate that the claimed deductions are allowable pursuant to some statutory provision and to substantiate the expenses giving rise to the claimed deductions by maintaining and producing adequate records that enable the Commissioner to determine the taxpayer’s correct liability. 6001; Higbee v. Comm’r, 116 T.C. 438, 440 (2001).
- The Commissioner bears the burden of production with respect to accuracy-related penalties under section 6662(a), see 7491(c), but the taxpayer bears the burden of proving that the Commissioner’s determinations with respect to the accuracy-related penalties are incorrect, see Rule 142(a); Welch v. Helvering, 290 U.S. at 115; Higbee v. Comm’r, 116 T.C. at 447.
- A taxpayer’s gross income includes “all income from whatever source derived,” including COD income. 61(a)(12). “The underlying rationale for the inclusion of canceled debt as income is that the release from a debt obligation the taxpayer would otherwise have to pay frees up assets previously offset by the obligation and acts as an accession to wealth—i.e., income.” Bui v. Comm’r, T.C. Memo. 2019-54 (citing U.S. v. Kirby Lumber Co., 284 U.S. 1, 2 (1931)).
- Generally, the amount of COD income that is includible in a taxpayer’s gross income is equal to the face value of the canceled debt minus any amount paid in satisfaction of the debt. Rios v. Comm’r, T.C. Memo. 2012-128, aff’d, 586 F. App’x 268 (9th 2014). The income is recognized for the year in which the debt is canceled, Bui v. Comm’r, T.C. Memo. 2019-54, and is taxed at ordinary rates, Callahan v. Comm’r, T.C. Memo. 2013-131.
- “[C]ertain accessions to wealth that would ordinarily constitute income may be excluded by statute or other operation of law.” Comm’r v. Dunkin, 500 F.3d 1065, 1069 (9th 2007). But “given the clear Congressional intent to exert the full measure of its taxing power, exclusions from gross income are construed narrowly in favor of taxation.” Id. (quoting Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955).
- Section 108(a)(1)(E) provides that gross income does not include amounts that would be includible as COD income if “the indebtedness discharged is qualified principal residence indebtedness.” The term “qualified principal residence indebtedness” is defined as acquisition indebtedness with respect to the taxpayer’s principal residence. 108(h)(2), (5). Section 168(h)(3)(B)(i) provides that acquisition indebtedness is any indebtedness which is: (1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (2) secured by that residence. For these purposes, secured debt is any debt that is on the security of an instrument (such as a mortgage, deed of trust, or land contract) that makes the debtor’s interest in the qualified residence specific security for the payment of the debt (1) under which, in the event of default, the residence could be subjected to the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated and (2) is recorded or otherwise perfected in accordance with the applicable State law. Temp. Treas. Reg. § 1.163-10T(o)(1).
- Section 162 allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. 162(a); Treas. Reg. § 1.162-1(a). An expense is “ordinary” if it is “normal, usual, or customary” in the taxpayer’s trade or business or 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). Additionally, a taxpayer may not deduct a personal, living, or family expense unless the Code expressly provides otherwise. Sec. 262(a). 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).
- Whether a taxpayer is engaged in a trade or business is a question of fact to be decided on the basis of all the relevant facts and circumstances. Stanton v. Comm’r, T.C. Memo. 1967-137, aff’d, 399 F.2d 326 (5th 1968). Applying this facts and circumstances test, courts have focused on the following three factors indicative of whether a trade or business exists: (1) whether the taxpayer’s primary purpose in undertaking the activity was for income or profit; (2) whether the taxpayer is regularly and actively involved in the activity; and (3) whether the taxpayer’s activity has actually commenced. Jafarpour v. Comm’r, T.C. Memo. 2012-165.
- Under the Cohan rule, if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount, the Court may estimate the amount of the deductible expense, bearing heavily against the taxpayer whose inexactitude is of his or her own making. See Cohan v. Comm’r, 39 F.2d 540, 543-44 (2d Cir. 1930). In order for the Court to estimate the amount of a deductible expense, the taxpayer must establish some basis upon which an estimate may be made. Norgaard v. Comm’r, 939 F.2d 874, 879 (9th 1991). Otherwise an allowance would amount to “unguided largesse.” Norgaard v. Comm’r, 939 F.2d at 879.
- The Cohan rule, however, is superseded—that is, estimates are not permitted—for certain expenses specified in section 274; to wit, traveling expenses (including meals and lodging while away from home), entertainment expenses, and “listed property” (including passenger automobiles, computers, and, as relevant here, 2009 phone) expenses. 274(d); Sec. 280F(d)(4)(A); Temp. Treas. Reg. § 1.274-5T(a). Instead, these types of expenses are subject to strict substantiation rules. Sanford v. Comm’r, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969). These strict substantiation rules generally require the taxpayer to substantiate with adequate records or by sufficient evidence corroborating the taxpayer’s own statement (1) the amount of the expense; (2) the time and place the expense was incurred; (3) the business purpose of the expense; and (4) in the case of entertainment expenses, the business relationship between the person entertained and the taxpayer. Balyan v. Comm’r, T.C. Memo. 2017-140.
- For “listed property” expenses, in addition to the time such expenses were incurred and their business purpose, the taxpayer must establish the amount of business use and the total use of such property. Balyan v. Comm’r, T.C. Memo. 2017-140. Generally, deductions for meals and entertainment expenses are subject to the 50% limitation imposed by section 274(n).
- Substantiation by adequate records requires the taxpayer to maintain (1) an account book, diary, log, statement of expense, trip sheets, or similar record prepared contemporaneously with the expenditure and (2) documentary evidence, such as receipts or paid bills, which together prove each element of an expenditure. Balyan v. Comm’r, T.C. Memo. 2017-140.
- Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return if, as provided by section 6662(b)(1) and (2), the underpayment is attributable to negligence or disregard of rules or regulations and/or a substantial understatement of income tax. For these purposes, negligence includes any failure to make a reasonable attempt to comply with the internal revenue laws, disregard includes any careless, reckless, or intentional disregard, and an understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return for that tax year or $5,000. 6662(c) and (d)(1)(A).
- Reasonable cause may exist where the taxpayer relies on professional advice if the taxpayer proves by a preponderance of the evidence that: (1) the adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him or her; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
Tax Court Motion: The Weiderman decision is a good illustration of the difficulties a taxpayer may face in attempting to fall within an exclusion to COD income under Section 108. Taxpayers should be aware that in many instances (as in this case), the lender will issue a Form 1099 alerting the IRS that the debt has been cancelled. In such a case, the IRS will often look to the debtor’s tax return to determine whether the COD income has been properly reported. In many cases, with proper tax planning, taxpayers can provide better arguments and documentary proof to meet an exception under Section 108.
Tax Court Case:
Robert Elkins v. Comm’r, T.C. Memo. 2020-110
Tax Dispute Short Summary: The case involved the rejection of an offer-in-compromise (OIC) based on the abuse of discretion by the Office of Appeals of the Internal Revenue Service (IRS).
Dr. Elkins (the “taxpayer”), a prominent businessman and a partner at Delta Trading Partners IV, LP, entered a joint stipulation with the IRS to settle adjustments to certain amount of income and deductions reported by the partnership during 1998 and 1999. The Tax Court entered a decision consistent with the stipulation of the settled issues. Consequently, the IRS made computational adjustments to Dr. Elkins 1998, 2000 and 2001 Federal income tax returns consistent with the Tax Court’s decision and assessed more than $10 million in income tax deficiencies, accuracy-related penalties and interest.
The taxpayer submitted an OIC proposing to settle his tax debt for $17,500. To support his OIC premised on doubt as to collectibility, he argued that he was 71 years old, divorced, unemployed, and did not had any substantial assets and that his reasonable collection potential (RCP) was limited to $15,500 (He later increased his OIC to $33,000 and $71,500).
The IRS rejected the OIC and sustained the Notice of Federal Tax Lien (NFTL) on the ground that the offer was not in the best interest of the Government, considering public policy and tax administration concerns. The main points to sustain such rejection were: (i) that the taxpayer’s increases to his OIC did not shown good faith, (ii) that the taxpayer did not make voluntary payments during the years the OIC had been pending, and (ii) the taxpayer’s negative history with use of company funds. These elements show that the IRS did not abused its discretion in sustaining the OIC’s rejection as not in the best interest of the Government.
Tax Litigation Key Issues: Whether the IRS abused its discretion to reject an OIC because it was not in the best interest of the Government.
Primary Holdings: The IRS does not abuse its discretion when rejecting an OIC, when (i) the requirements of applicable law or administrative procedure met by the taxpayer have been properly verified, (ii) the IRS considers any relevant issues raised by the taxpayer, such as good faith and previous negative history, and (iii) the proposed collection action balances the need for efficient collection with the taxpayer’s concern that such action is no more intrusive than necessary.
Key Points of the Tax Laws:
The Court argued that to determine an abuse of discretion by the IRS when rejecting an OIC because it is not in the best interest of the Government, the following elements must be analyzed:
- The decision to accept or reject an OIC is in the Secretary’s discretion. Sec. 301.7122-1(c)(1).
- An OIC may be rejected if acceptance would not be in the best interest of the Government and the IRS takes into account public policy and tax administration concerns. Rev. Proc. 2003-71, sec. 6.03, 2003-2 C.B. at 519.
- The Internal Revenue Manual (IRM) provides that such rejection should be fully supported by the facts outlined in the rejection narrative and should not be routine.
- When reviewing for abuse of discretion, the Court uphold the IRS’ determination unless it is arbitrary, capricious or without sound bases in fact or law. Murphy v. Commissioner, 125 T.C. 301, 320 (2005), aff’d, 469 F.3d 27 (1st Cir. 2006); Taylor v. Commissioner, T.C. Memo. 2009-27, 97 T.C.M. (CCH) 1109, 1116 (2009).
- The Court has determined that to uphold a notice of determination, it requires that the basis for the determination is reasonably discerned. Bowman Transp., Inc. v. Ark.-Best Freight Sys., Inc., 419 U.S. 281, 285-286 (1974) Melasky v. Commissioner, 151 T.C. 93, 106 (2018), aff’d, 803 F. App’x 732 (5th Cir. 2020); cf. Kasper v. Commissioner, 150 T.C. 8, 24-25 (2018).
- Additionally, the Court may consider any “contemporaneous explanation of the agency decision’ contained in the record.” (quoting Tourus Records, Inc. v. Drug Enf’t Admin., 259 F.3d 731, 738 (D.C. Cir. 2001)
- Based on the above, the Court determined that the analysis made by the IRS where it considered the bad faith of the taxpayer when making his OIC, the lack of payments made by the taxpayer and the negative history of the taxpayer constituted a sound basis for the OIC rejection.
- Finally, in cases where the OIC is rejected and the taxpayer does not offer a viable collection alternative, a NFTL is the least intrusive mean of collecting an outstanding liability.
Tax Court Motion: The question presented in this case provides some elements that may be helpful to determine whether an OIC can be rejected by the Government because it is not in its best interest. Factors such as the good faith of the taxpayer, his real reasonable collection potential and background financial history are elements that can support a favorable narrative when filing an OIC.