Passive Activities and Other Oxymorons

Discount case

2011-07-05T20:46:00.000-04:00

Estate of Ellen D. Foster, et al. v. Commissioner, TC Memo 2011-95 , Code Sec(s) 2001; 2031; 2051; 2053; 7491.

ESTATE OF ELLEN D. FOSTER, DECEASED, ASHLEY BRADLEY AND TARA SHAPIRO, CO-EXECUTORS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information: Code Sec(s): 2001; 2031; 2051; 2053; 7491

Docket: Docket No. 16839-08.

Date Issued: 04/28/2011

Judge: Opinion by COHEN

HEADNOTE

XX.

Reference(s): Code Sec. 2001 ; Code Sec. 2031 ; Code Sec. 2051 ; Code Sec. 2053 ; Code Sec. 7491

Syllabus

Official Tax Court Syllabus

Counsel

D. Douglas Metcalf, George L. Paul, and Hope E. Leibsohn, for petitioners.

Christopher J. Sheldon and Shad M. Brown, for respondent.

Opinion by COHEN

MEMORANDUM FINDINGS OF FACT AND OPINION

Respondent determined a deficiency in the Federal estate tax of the Estate of Ellen D. Foster (the estate) of $4,749,722. By amended answer, respondent asserts an increased deficiency of $14,637,722.

After concessions, the issues for decision are: (1) Whether the estate is entitled to discount the value of certain assets in the gross estate; (2) the value of claims held by the estate; and (3) whether the estate is entitled to deduct its actual litigation expenses for those claims.

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the date of decedent's death, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. Ellen Foster (decedent) resided in Arizona at the time of her death. Ashley Bradley and Tara Shapiro (coexecutors) were appointed coexecutors of the estate, and they also resided in Arizona at the time the petition was filed.

Decedent's husband, Thomas S. Foster (Mr. Foster), founded Foster & Gallagher, Inc. (F&G), in 1951. F&G was in the mail- order horticulture business and relied heavily on a sweepstakes program as part of its direct mail advertising.

In 1991, Mr. Foster and F&G entered into a stock restriction agreement (SRA) which required F&G, upon the deaths of decedent and Mr. Foster, to purchase all of the F&G stock held by Mr. Foster's family group (family group). To ensure that F&G had the money to do so, the SRA required F&G to maintain life insurance on the joint lives of decedent and Mr. Foster, payable after both had died. F&G accordingly purchased and maintained $50 million of paid-up life insurance (the life insurance). The SRA prohibited F&G from borrowing against the cash surrender value of or otherwise encumbering the life insurance and gave decedent or Mr. Foster the right to purchase the life insurance if the family group disposed of its F&G stock. Kavanagh, Scully, Sudow, White & Frederick, P.C. (Kavanagh), represented both Mr. Foster and F&G in the negotiation and drafting of the SRA.

In 1995, Mr. Foster and several other shareholders of F&G decided to sell the majority of their stock to F&G's employee stock ownership plan (ESOP). In order to finance the ESOP's purchase of that stock (ESOP transaction), F&G borrowed approximately $70 million on an unsecured basis (the ESOP loans) from four institutional lenders (ESOP transaction lenders) and lent the proceeds to the ESOP. In connection with the ESOP transaction, F&G hired U.S. Trust Company, N.A. (U.S. Trust), as the ESOP's new trustee, and Mr. Foster agreed to indemnify U.S. Trust against any loss arising from any misrepresentation or breach of duty committed by Mr. Foster. On December 20, 1995, the ESOP purchased 3,589,743 shares of F&G common stock at $19.50 per share. Mr. Foster received $33,120,789 for the 1,698,502 F&G shares that he sold. Mr. Foster transferred the stock sale proceeds along with his remaining F&G stock to the Thomas S. Foster Revocable Trust (Foster Trust).

Mr. Foster died on July 11, 1996. Upon his death, the Foster Trust was divided into three trusts: Marital Trusts #1, #2, and #3 (collectively, the Marital Trusts). Decedent was the sole income beneficiary of the Marital Trusts during her life and could withdraw any part of the principal of Marital Trust #3 at any time. The trust instrument appointed Northern Trust Company (Northern Trust) and decedent cotrustees of the Marital Trusts and gave them the discretion to invade the principal for decedent's benefit.

In 1998, F&G began experiencing financial trouble on account of negative publicity surrounding sweepstakes advertising strategies such as the one F&G employed. F&G's revenues and earnings steadily declined, causing F&G to be in violation of the financial covenants of the ESOP loans. Because the ESOP loans were unsecured, the ESOP transaction lenders (which included Northern Trust) sought to restructure the loans to gain a security interest in F&G's assets.

In February 1999, Northern Trust, as co-trustee of the Marital Trusts, waived the SRA's restrictions and allowed F&G to borrow against the cash surrender value of the life insurance. In September 1999, Northern Trust again waived the SRA prohibition against encumbrance and assigned itself the life insurance as collateral for the ESOP loans. F&G also demanded that decedent lend F&G approximately $6.8 million (the Founder's Loan). In order to make the Founder's Loan, decedent borrowed $6.8 million from Northern Trust, securing the loan with over $12 million worth of assets that she withdrew from Marital Trust #3. Kavanagh represented and advised both decedent and F&G in connection with all three of these transactions (the 1999 transactions).

As a result of F&G's borrowing on the cash surrender value of the life insurance, the life insurance ceased to be self- funding. F&G filed for bankruptcy on July 2, 2001, and the life insurance ultimately lapsed when F&G failed to pay the premiums.

On April 6, 2001, just before F&G's bankruptcy filing, beneficiaries of the ESOP (the ESOP plaintiffs) filed suit (the Keach lawsuit) in the U.S. District Court for the Central District of Illinois alleging breaches of fiduciary duty committed by U.S. Trust and Mr. Foster (with decedent named as a defendant as executrix of Mr. Foster's estate) in connection with the ESOP transaction. The ESOP plaintiffs also sought restitution against decedent and Northern Trust as cotrustees of the Marital Trusts and requested the imposition of a constructive trust over the assets held by decedent as executrix of Mr. Foster's estate and co-trustee of the Marital Trusts. Kavanagh represented decedent in the Keach lawsuit as well.

To avoid potential liability to the ESOP plaintiffs for distributions from the Marital Trusts, Northern Trust unilaterally froze decedent's right to withdraw the principal of Marital Trust #3. However, despite the freeze, some of the assets of Marital Trust #3 were sold at undiscounted prices.

On March 5, 2003, the District Court granted summary judgment to decedent as executrix of Mr. Foster's estate because his estate was closed and therefore no judgment could be enforced against her in that capacity. The District Court did leave open the possibility that the ESOP plaintiffs could proceed with their restitution claim against decedent as co-trustee of the Foster Trust if the ESOP plaintiffs could establish that Mr. Foster had committed a breach of fiduciary duty. However, on February 12, 2004, the District Court entered an order finding, among other things, that Mr. Foster and U.S. Trust had committed no such breach. The District Court entered a judgment on March 8, 2004, and an amended judgment on April 23, 2004, in favor of all of the defendants.

On April 9, 2004, the ESOP plaintiffs appealed to the Court of Appeals for the Seventh Circuit. Decedent died on May 15, 2004, while that appeal was pending. On September 27, 2004, coexecutors, as successor cotrustees of the Marital Trusts, entered into a settlement agreement whereby the ESOP plaintiffs released their claims against the estate. On August 17, 2005, the Court of Appeals affirmed the District Court's judgment.

Shortly after decedent's death, coexecutors met with Kavanagh and Northern Trust on May 27, 2004, to discuss the administration of the estate. Coexecutors were not informed of the existence and lapse of the life insurance.

On June 4, 2004, upon being appointed coexecutors of decedent's estate, coexecutors hired the law firm Lewis and Roca, LLP (L&R), to handle the probate of the estate. During the course of administering the estate, coexecutors came to believe that the work Kavanagh had done in planning decedent's estate and in representing decedent in the Keach lawsuit had been deficient. By September 22, 2004, L&R had identified and begun investigating potential claims against Kavanagh. By October 2004, coexecutors had stopped paying Kavanagh's legal fees. On November 12, 2004, L&R discovered that the life insurance had lapsed during F&G's bankruptcy.

On June 13, 2005, Kavanagh filed a claim against the estate for unpaid legal fees in the Superior Court of Arizona, Maricopa County.

In July 2005, L&R began investigating the circumstances surrounding the lapse of the life insurance, including Northern Trust's involvement. However, L&R quickly determined that a claim against Northern Trust would not be viable when on August 4, 2005, the attorney for the trustee of F&G's bankruptcy estate informed George Paul (Paul), an L&R attorney and coexecutors' counsel in this case, that Northern Trust had decided against reinstating or transferring the life insurance because the tax consequences of doing so would be “detrimental and uneconomical”. On the basis of that information, L&R concluded that a claim against Northern Trust would be unsuccessful because Northern Trust had a justifiable reason for allowing the life insurance to lapse.

On August 12, 2005, a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, was filed on behalf of the estate. On Schedule F, Other Miscellaneous Property Not Reportable Under Any Other Schedule, of the return, the estate reported: THE DECEDENT WAS PREDECEASED BY HER SPOUSE, THOMAS S. FOSTER. UPON MR. FOSTER'S DEATH ON JULY 11, 1996, THREE MARITAL TRUSTS WERE FORMED UNDER THE THOMAS S. FOSTER REVOCABLE TRUST DATED APRIL 15, 1994 * * *.

UNDER INTERNAL REVENUE CODE SECTION *** [2056(b)(7)],

THE ASSETS OF ALL THREE MARITAL TRUSTS ARE INCLUDIBLE IN THE ESTATE OF THE DECEDENT. * * *

The estate reported the following as assets of Marital Trust #1 at the values set forth below:

Cash $12,862

Publicly traded securities 972,722

Accrued dividend on securities 969

The estate reported the following as assets of Marital Trust #2 at the values set forth below:

Cash $362,418

Publicly traded bonds 33,891,338

Accrued interest on bonds 515,367

Federal home loan bond 1,000,000

Shares of Foster & Gallagher, Inc. -0-

The estate reported the following as assets of Marital Trust

#3 at the values set forth below:

Cash $781,814

Publicly traded bonds 5,122,019

Accrued interest on bonds 73,645

Publicly traded securities 6,784,708

Accrued dividend on securities 6,190

Partnership interests in real estate funds 1,086,000

Shares of Foster & Gallagher, Inc. -0-

The estate also listed on Schedule F a “LIABILITY RELATED TO LITIGATION AGAINST THOMAS S. FOSTER MARITAL TRUST” for each of the Marital Trusts. The estate reported the value of these “liabilities” as negative $286,100 for Marital Trust #1, negative $10,373,046 for Marital Trust #2 and negative $4,017,769 for Marital Trust #3 (collectively, the Marital Trust discount) based on an appraisal performed by Lynton Kotzin (Kotzin), vice president of Ringel Kotzin Valuation Services, on July 22, 2005. Kotzin's appraisal report (which was attached to the return) determined a 29-percent Marital Trust discount attributable solely to the hazards of litigation presented by the Keach lawsuit. The estate did not report any potential claims against Kavanagh or Northern Trust as assets of the estate.

By August 30, 2005, the only claim against Northern Trust being investigated by L&R was for negligently managing the Marital Trusts. Paul, however, believed this claim to be “weak and speculative.” He concluded that “Unless something jumps out at us, it does not appear to be as economical an investment as the *** [claims] against Kavanagh.”

On September 6, 2005, coexecutors, individually and as coexecutors of the estate, filed a counterclaim against Kavanagh alleging that it had committed legal malpractice while drafting decedent's will and breach of fiduciary duty while representing decedent in the Keach lawsuit. Coexecutors obtained a subpoena for Northern Trust's records of its administration of the Marital Trusts and its loans to F&G and to decedent.

In October 2005, Robert McKirgan (McKirgan) joined the L&R team investigating the estate's claims against Kavanagh and Northern Trust. McKirgan reexamined the encumbrance of the life insurance but believed the estate did not have a viable claim against Northern Trust because: (1) There were not enough facts about what Northern Trust had or had not done; (2) decedent apparently knew about and gave her informed consent to the encumbrance of the life insurance; and (3) Mr. Foster had waived Northern Trust's conflict of interest by allowing Northern Trust to remain successor co-trustee of the Marital Trusts after it had become a creditor of F&G.

L&R was finally able to assemble the estate's claims against Northern Trust when on November 16, 2005, Northern Trust produced a memorandum (the memorandum) which L&R believed suggested that Northern Trust had been concerned only with justifying the encumbrance of the life insurance and had ignored its duty to investigate the merits of the transaction and advise decedent as to what rights she was surrendering. The memorandum also helped L&R identify which of the documents that were already in the estate's possession were essential to proving the estate's claims.

On July 28, 2006, coexecutors met with Kavanagh and Northern Trust to present the estate's claims against them regarding the 1999 transactions. At this point, the claims were based on the theory that Northern Trust and Kavanagh failed to advise decedent to obtain independent legal and financial advice for the 1999 transactions. On August 23, 2006, coexecutors offered to settle the estate's claims against Northern Trust and Kavanagh concerning the 1999 transactions for $19 million. On September 28, 2006, Northern Trust rejected coexecutors' offer and claimed it would be entitled to attorney's fees because the estate's claims were “completely without merit”.

On October 27, 2006, coexecutors filed an amended counterclaim which sought joinder of Northern Trust as an additional defendant. In the amended counterclaim, coexecutors alleged, among other things, that Northern Trust had breached its fiduciary duty as trustee of the Marital Trusts when it (1) engaged in self-dealing by allowing decedent to give up her rights to the life insurance in order to improve its position from unsecured to secured creditor of F&G (the Life Insurance Claim) and (2) facilitated decedent's withdrawal of assets from Marital Trust #3 to overcollateralize the loan it made to decedent in connection with the Founder's Loan (the Founder's Loan Claim). The estate sought compensatory damages, punitive damages, emotional distress damages, disgorgement of Northern Trust's and Kavanagh's fees, prejudgment interest, reimbursement of costs, and reasonable legal fees.

In 2007, coexecutors, Kavanagh, and Northern Trust engaged in court-ordered mediation. Northern Trust offered to settle the case for $250,000, but coexecutors rejected that offer.

On or about January 29, 2007, the estate's tax return was selected for examination. On May 24, 2007, coexecutors informed the Internal Revenue Service (IRS) of a potential additional asset of the estate. The asset, consisting of the claims held by the estate against Kavanagh and Northern Trust, was appraised on September 25, 2007, by Philip M. Schwab (Schwab), senior vice president of FMV Valuation & Financial Advisory Services. L&R provided the IRS with Schwab's appraisal report on September 27, 2007.

On March 28, 2008, coexecutors settled the estate's claims against Kavanagh for approximately $850,000 (Kavanagh's $1 million insurance limit minus litigation costs of approximately $150,000).

On April 24, 2008, the IRS sent the estate a notice of deficiency determining a deficiency of $4,749,722. The notice stated:

The *** [Marital Trust discount has] been disallowed as the amounts are not “sums certain” and “legally enforceable” at death. Estate of Van Horne v. Commissioner, 83-2 USTC (CCH) 13,548, [720] F.2d 1114, 1116 (9th Cir. 1983) and Propstra v. United States, 680 F.2d 1248, 1254 [50 AFTR 2d 82-6153] (9th Cir. 1982). Alternatively, the *** [Marital Trust discount has] been disallowed as vague and uncertain estimates that are not ascertainable with reasonable certainty. IRC § 2053(a)(3) and Treas. Reg. § 20.2053-1(b)(3). The notice did not determine a deficiency with respect to the estate's claims against Kavanagh and Northern Trust or disallow attorney's fees claimed to date as deductions with respect to administering the estate. On July 8, 2008, a timely petition was filed.

In April 2008, coexecutors filed a motion to compel in the State court action which led to the production of hundreds of documents that Northern Trust had claimed were privileged. L&R believed these documents suggested that Northern Trust's legal department had concealed from its own trust department the fact that Northern Trust's lending department had deliberately disregarded Northern Trust's conflict of interest arising from its roles as co-trustee of the Marital Trusts and creditor of F&G and decedent.

The trial of the estate's claims against Northern Trust began on October 22, 2008. On October 24, 2008, coexecutors settled the estate's claims against Northern Trust for $17 million plus the return of previously withheld trust funds.

On July 21, 2009, respondent filed an amended answer asserting an increased deficiency of $14,637,722 attributable to the estate's claims against Kavanagh and Northern Trust, which respondent valued in the amended answer at $20.6 million. No adjustments were requested regarding attorney's fees claimed as deductions.

OPINION

The valuation issues in this case, as discussed below, are to be decided as of the date of decedent's death, May 15, 2004. Differences between the parties focus in large part on the reasonableness of the valuation positions of the parties in appraising likely resolutions of litigation after the date of death. Before discussing the applicable legal principles, it is useful, therefore, to repeat the chronology of events relevant to the valuation issues. The important dates are:

Regarding Keach Lawsuit

Mar. 5, 2003 Summary judgment in favor of decedent as

executrix of Mr. Foster's estate

Feb. 12, 2004 District Court finding in favor of defendants

Mar. 8, 2004 Judgment in favor of defendants

Apr. 9, 2004 Appeal filed

Sept. 27, 2004 Release of claims against the estate

Aug. 17, 2005 District Court judgment affirmed

Regarding Claims Held by the Estate Sept. 22, 2004 Decedent's counsel investigated and identified potential claims against Kavanagh June 13, 2005 Kavanaugh suit for unpaid legal fees filed Aug. 12, 2005 Estate tax return filed without mention of claim against Kavanagh or Northern Trust Sept. 6, 2005 Counterclaim for malpractice and breach of fiduciary duty against Kavanagh Oct. 27, 2006 Amended counterclaim sought joinder of Northern Trust as a defendant Mar. 28, 2008 Kavanagh agreed to pay approximately $850,000 in settlement of estate's claims Oct. 24, 2008 Northern Trust agreed to pay $17 million in settlement of estate's claim and to return withheld trust funds

As a general rule, the Internal Revenue Code imposes a Federal tax “on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States.” Sec. 2001(a). The taxable estate, in turn, is defined as “the value of the gross estate”, less applicable deductions. Sec. 2051. Section 2031(a) specifies that the gross estate comprises “all property, real or personal, tangible or intangible, wherever situated”, to the extent provided in sections 2033 through 2045.

Property is included in the gross estate at its fair market value, which is “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.” Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990) (quoting sec. 20.2031-1(b), Estate Tax Regs.). The determination of fair market value is a question of fact. Id.

I. Value of Marital Trusts As a preliminary matter, the parties disagree as to whether the burden of proof has been shifted to respondent under section 7491(a). The burden of proof is relevant only when there is equal evidence on both sides: “In a case where the standard of proof is preponderance of the evidence and the preponderance of the evidence favors one party, we may decide the case on the weight of the evidence and not on an allocation of the burden of proof.” Knudsen v. Commissioner, 131 T.C. 185, 185-189 (2008).

The parties agree on the unencumbered values of the assets of the Marital Trusts. The parties disagree as to whether the estate is entitled to a Marital Trust discount consisting of (1) a discount for the hazards of litigation and (2) discounts for lack of marketability and lack of control attributable to the freeze imposed by Northern Trust. For purposes of trial, coexecutors hired David M. Eckstein (Eckstein), managing director of FMV Valuation & Financial Advisory Services, to reappraise the Marital Trust discount. Eckstein determined the impaired value of the Marital Trusts to be $34,200,000 based on (1) a 12.9- to 17.2-percent discount for the hazards of litigation presented by the Keach lawsuit followed by (2) discounts of 4 percent for lack of control and 15 to 20 percent for lack of marketability attributable to the freeze imposed by Northern Trust. Thus, coexecutors now claim a Marital Trust discount of approximately 32.4 percent.

A. Hazards of Litigation

The estate contends that it is entitled to discount the values of the assets of the Marital Trusts because the ESOP plaintiffs sought to impose a constructive trust over those assets. The estate cites cases which it argues held that litigation (or the threat of litigation) concerning an asset in the gross estate justified discounting the value of the asset for estate tax purposes: Am. Natl. Bank & Trust Co. v. United States, 594 F.2d 1141 [43 AFTR 2d 79-1297] (7th Cir. 1979), Estate of Newhouse v. Commissioner, supra at 218, Estate of Curry v. Commissioner, 74 T.C. 540 (1980), Estate of Sharp v. Commissioner, T.C. Memo. 1994-636 [1994 RIA TC Memo ¶94,636], Estate of Lennon v. Commissioner, T.C. Memo. 1991-360 [1991 TC Memo ¶91,360], Estate of Henderson v. Commissioner, T.C. Memo. 1989-79 [¶89,079 PH Memo TC], Estate of Crossmore v. Commissioner, T.C. Memo. 1988-494 [¶88,494 PH Memo TC], and Estate of Cobb v. Commissioner, T.C. Memo. 1982-571 [¶82,571 PH Memo TC].

The cited cases are distinguishable, however, because they involved litigation that could have affected the rights of a purchaser of the asset that was the subject of the litigation. A willing buyer in such a situation would have refused to pay full fair market value in light of the possibility that the buyer's rights in the asset could have subsequently been impaired.

In contrast, a willing buyer would not have insisted on a discount on the assets of the Marital Trusts because the Keach lawsuit could not have affected a buyer's rights. See Estate of Kahn v. Commissioner, 125 T.C. 227, 241 (2005). Moreover, the District Court entered its amended judgment in decedent's favor on April 23, 2004. “Upon a final judgment or decree, a party must seek a stay of judgment pending appeal to protect its interest in the underlying property.” Duncan v. Farm Credit Bank of St. Louis, 940 F.2d 1099, 1102 (7th Cir. 1991). The ESOP plaintiffs did not do so. While rule 62(a) of the Federal Rules of Civil Procedure as in effect at the relevant time provides for an automatic 10-day stay of the judgment, that automatic stay expired before decedent's death. Since the ESOP plaintiffs did not thereafter seek a stay under rule 62(d) of the Federal Rules of Civil Procedure, the assets of the Marital Trusts could have been transferred at decedent's death free and clear of the ESOP plaintiffs' claim for a constructive trust.

The estate contends alternatively, that if the Keach lawsuit is not an impairment to the value of the estate under sections 2031 and 2033, then the Keach lawsuit instead constitutes a claim against the estate entitling the estate to a deduction under section 2053.

Section 2053(a) allows a deduction for claims against the estate that are allowable by the laws of the jurisdiction under which the estate is administered. Section 20.2053-1(b)(3), Estate Tax Regs., as in effect for the date of death of decedent provided:

An item may be entered on the return for deduction though its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be paid. No deduction may be taken upon the basis of a vague or uncertain estimate. *** Section 20.2053-4, Estate Tax Regs., provided:

The amounts that may be deducted as claims against a decedent's estate are such only as represent personal obligations of the decedent existing at the time of his death, whether or not then matured, and interest thereon which had accrued at the time of death. *** Only claims enforceable against the decedent's estate may be deducted. *** Our decision in this case is appealable to the Court of Appeals for the Ninth Circuit, and thus respondent relies on Propstra v. United States, 680 F.2d 1248, 1253 [50 AFTR 2d 82-6153] (9th Cir. 1982) (stating that “The law is clear that post-death events are relevant when computing the deduction to be taken for disputed or contingent claims” (citing section 20.2053-1(b)(3), Estate Tax Regs.)), and Estate of Van Horne v. Commissioner, 78 T.C. 728, 735 (1982) (in which we concluded that we consider postdeath events in cases where the decedent's creditor has only a potential, unmatured, contingent, or contested claim that requires further action before it becomes a fixed obligation of the estate, but not where a claim is valid and fully enforceable on the date of death), affd. 720 F.2d 1114 [53 AFTR 2d 84-1549] (9th Cir. 1983). See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 [27 AFTR 2d 71-1583] (10th Cir. 1971); see also Estate of Shapiro v. United States, 634 F.3d 1055 [107 AFTR 2d 2011-942] (9th Cir. 2011); Marshall Naify Revocable Trust v. United States, 106 AFTR 2d 2010-6236, 2010-2 [106 AFTR 2d 2010-6236] USTC par. 60,603 (N.D. Cal. 2010) (discussing the precedential weight of Propstra) on appeal (9th Cir., Oct. 19, 2010). Respondent describes the combined effect of those cases as holding “in the case of a contingent claim, which is not certain and enforceable at the decedent's death, post-death events (such as a subsequent settlement) should be taken into account.” The estate discounts the Propstra rationale as dicta.

In Estate of Saunders v. Commissioner, 136 T.C. ___ (2011) (slip op. at 20-23), we observed that courts appear to disagree on the extent to which events subsequent to the date of death may be considered in determining the deductibility of a claim under section 2053: the Courts of Appeals for the Eighth and Ninth Circuits have directed that postdeath events be considered whereas the Courts of Appeals for the Fifth and Tenth Circuits have directed that postdeath events should not be considered. See Estate of McMorris v. Commissioner, 243 F.3d 1254 [87 AFTR 2d 2001-1310] (10th Cir. 2001), revg. T.C. Memo. 1999-82 [1999 RIA TC Memo ¶99,082]; Estate of Smith v. Commissioner, 198 F.3d 515 [84 AFTR 2d 99-7393] (5th Cir. 1999), revg. on this issue 108 T.C. 412 (1997); Estate of Sachs v. Commissioner, 856 F.2d 1158, 1160-1163 [62 AFTR 2d 88-6000] (8th Cir. 1988), affg. in part and revg. in part 88 T.C. 769 (1987); Propstra v. United States, supra. We declined to attempt to reconcile these cases and did not consider the effect of a post-death settlement of a claim against the taxpayer-estate because we instead found that the value of the claim was not ascertainable with reasonable certainty on the valuation date. The taxpayer-estate had suggested several values for the claim, and we considered the great differences in valuations to be a prima facie indication of the lack of reasonable certainty. We noted that the estate's experts did not and could not reasonably opine that any of the suggested amounts would be paid, as required by the applicable regulation. We concluded that stating and supporting a value is not equivalent to ascertaining a value with reasonable certainty.

Here, respondent alternatively determined in the notice of deficiency that the value of the Marital Trust discount was not ascertainable with reasonable certainty, and the estate has also suggested inconsistent values that indicate a lack of reasonable certainty. Kotzin, in the appraisal report included with the return, determined a 29-percent discount for the hazards of litigation presented by the Keach lawsuit. In the appraisal report prepared for the trial of this case, however, Eckstein determined only a 12.9- to 17.2-percent discount. The estate's experts thus differed on the effect of the Keach lawsuit by up to $8.1 million. In addition, Kotzin altogether failed to evaluate the lack of marketability and lack of control purportedly created by the freeze. The sharp discrepancy in their figures evidences a lack of reasonable certainty in the values they suggested. Like the taxpayer's experts in Estate of Saunders v. Commissioner, supra, neither Kotzin nor Eckstein opined or could reasonably opine that the amounts they suggested would be paid by the estate. Indeed, at the date of death the Keach lawsuit had been decided in favor of the defendants, although an appeal was pending. The estate has therefore failed to establish the value of the Marital Trust discount with reasonable certainty, as required by the applicable regulation.

Thus, the estate is not entitled to a discount or a section 2053 deduction in connection with the Keach lawsuit.

B. Lack of Marketability and Control

The estate contends that it is entitled to lack of marketability and lack of control discounts on the assets of the Marital Trusts on account of the freeze placed on Marital Trust #3 by Northern Trust.

We agree with respondent, however, that the estate is not entitled to discounts on the assets of the Marital Trusts. There is no basis for discounts on the assets of Marital Trusts #1 and #2 because the freeze was imposed only on Marital Trust #3. Furthermore, the estate is not entitled to discounts on the assets of Marital Trust #3 because the restrictions applied only to decedent, not the underlying assets of the trust themselves. When determining the value of a trust for estate tax purposes, we determine the value of the underlying assets in a hypothetical Estate of Kahn v. Commissioner, 125 sale to a willing buyer. T.C. 227 (2005); see also Rev. Rul. 2008-35, 2008-2 C.B. 116. That the freeze may have prevented decedent from selling any of the assets of Marital Trust #3 does not affect the value of those assets; we must assume that such a sale would take place even if it could not actually occur. Shackleford v. United States, 262 F.3d 1028 [88 AFTR 2d 2001-5658] (9th Cir. 2001); Bank of Cal., N.A. v. Commissioner, 133 F.2d 428, 433 [30 AFTR 913] (9th Cir. 1943), affg. in part and revg. in part Estate of Barneson v. Commissioner, a Memorandum Opinion of the Board of Tax Appeals dated May 27, 1941. Moreover, the “freeze” was loosely enforced, and trust assets were in fact sold at undiscounted prices. Thus, no discount is appropriate because once a hypothetical buyer purchased the assets, he or she would be unaffected by the freeze and would be able to resell the assets at an undiscounted price.

Accordingly, the estate is not entitled to a discount for lack of marketability or for lack of control.

II. Claims Held by the Estate The estate held choses in action consisting of its claims against Northern Trust and Kavanagh. The estate concedes it improperly failed to report the choses in action as assets of the estate but disputes respondent's valuations.

Section 2031(a) provides that the value of a decedent's gross estate shall include “the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.” For purposes of determining the value of the gross estate, the term “property” encompasses choses in action. See generally Estate of Curry v. Commissioner, 74 T.C. at 545-546. The contingent nature of a claim bears on the question of its value, not on its includability in the value of the gross estate. Id.

During trial we received reports and testimony from expert witnesses. We evaluate the opinions of the experts based on the qualifications and reasoning of each expert and on all other credible evidence in the record. See Estate of Jones v. Commissioner, 116 T.C. 121, 131 (2001). We are not bound by the expert opinions, and we may determine a value based on our own examination of the record. It is the responsibility of the parties to instruct the experts on all the relevant facts that Estate of Hall v. Commissioner, 92 might affect the valuation. T.C. 312, 338 (1989). If the parties fail to provide the experts with complete information concerning material facts or reasonable assumptions to be made, the reliability of the experts is undermined. In the context of valuation cases, we have observed that experts may lose their usefulness and credibility when they merely become advocates for the position argued by a party. See, e.g., Laureys v. Commissioner, 92 T.C. 101, 129 (1989).

Respondent did not raise the issue of choses in action in the notice of deficiency. Respondent raised it as a new matter in the amended answer. Accordingly, respondent bears the burden of proof on this issue. See Rule 142(a).

Respondent provided evidence as to the value of the claims against Northern Trust but failed to provide any evidence of the value of the claims against Kavanagh. Respondent submitted the expert reports and testimony of Mark L. Mitchell (Mitchell) and Mark E. House (House) regarding the value of the Life Insurance Claim and the Founder's Loan Claim. Mitchell's report explicitly states that “No analysis is provided of claims against Kavanagh or others.” Respondent therefore has failed to carry his burden of proof as to any claims against Kavanagh. Respondent relies on the reports of House and Mitchell and Mitchell's conclusion that the fair market value of the Life Insurance Claim was $4,600,000 and the fair market value of the Founders Loan Claim was $500,000, for a total valuation of the claims against Northern Trust of $5,100,000 as of the date of death. These values, however, rise or fall on House's position that a hypothetical purchaser of the claims would have knowledge of all relevant facts that are reasonably known. And these facts were reasonably known. And yes, I mean I appreciate the fact that these guys put together a huge jigsaw puzzle. But all of those pieces were known even if they didn't understand the legal theories on how to put them together. In his report, he assumes that the hypothetical purchaser would have knowledge of all of the facts in Northern Trust's files, including specifically those discovered by the estate's counsel after time-consuming and contested discovery. We agree with the estate's characterization of respondent's theory: that any fact known or document possessed by any of the relevant witnesses on date of death — even if in the possession of concealing parties like Northern Trust or *** [Kavanagh] — should be imputed to hypothetical actors on date of death. In essence, they become omniscient of all relevant material. Using House's analysis, Mitchell values the claims as they ultimately were refined over 2 years after the date of death with a 50-percent probability of success. Respondent's experts, however, ignore the intervening expenditures of time and money investigating those claims in order to reach that level of knowledge and assume that it was all “knowable” on May 15, 2004, over 2 years before the claims were actually discovered by the estate's counsel.

Respondent argues that Mitchell's use of a 50-percent- likelihood-of-success assumption in his calculations is “conservative” and favors the estate because the estate's expert used a 75-percent likelihood of success in his calculations. That percentage, however, was the final number in the analysis of possible outcomes and assumed that the litigation had proceeded beyond various stages during which it might have been abandoned or concluded without any recovery to the estate.

The estate's valuation expert, Schwab, relied entirely on information provided by McKirgan and Paul. The estate's expert valued the potential claims that were reasonably known and under consideration at the date of death, specifically: (1) “The possibility of seeking damages from the misdiagnosis of *** [decedent's] medical condition”, (2) “the possibility of pursuing redress against the lack of a hedge or other financial instrument protecting the wealth of *** [decedent] and her family from failure of *** [F&G]" (Financial Hedge Claim), (3) “the possibility that the Kavanaugh [sic] law firm may have submitted excessive billings related to the Keach litigation”, and (4) “the investigation and correction of any accounting errors related to M[r]s. Foster's business partnership with Mel Regal”.

The estate's expert concluded that only the “Financial Hedge Claim” had a positive value, found to be $43,474 before a 25- percent marketability discount, leading to a final value of $33,000. If this relatively minimal value had been placed on the claims by the estate's lawyers as of the date of death, however, we do not believe that they would have pursued the claims. On the contrary, we believe that at the date of death the estate's lawyers, as evidenced by their pursuit of the claims against Kavanagh within a reasonable time after decedent's death, had reason to believe that the claims had substantial value. Therefore, we reject Schwab's conclusion as a reasonable estimate of the value at which the claims would have been relinquished by the hypothetical seller to a hypothetical buyer.

We are left with the conviction that neither side's experts in this case have provided an objective and reliable conclusion and that they have each have engaged in “an overzealous effort *** to infuse a talismanic precision into an issue which should frankly be recognized as inherently imprecise”. Messing v. Commissioner, 48 T.C. 502, 512 (1967).

Schwab's calculations assume a 99-percent probability of abandonment of the claim after a preliminary investigation and an 80-percent probability of abandonment after a comprehensive investigation. We believe that these assumptions are not reasonable and that the estate would not have proceeded past the preliminary investigation stage if the chances of a favorable outcome were less than 10 percent and would not have proceeded past the comprehensive investigation stage if the chances of a favorable outcome were less than 50 percent. By the time coexecutors filed the amended complaint on October 27, 2006, Northern Trust had refused to pay anything in relation to the estate's claims and had claimed that it would be entitled to attorney's fees if the litigation were pursued. Nonetheless, the estate decided to pursue the claim and to invest the additional resources necessary. At this point, Schwab incorporates a 75- percent probability of success in his analysis. On consideration of the methodology used by both valuation experts and adjusting Schwab's calculations to reflect (1) a 10-percent probability of a successful preliminary investigation (instead of 1 percent), (2) a 50-percent probability of a successful comprehensive investigation (instead of 20 percent), (3) a 39.5-percent lack of marketability discount (as determined by Mitchell), and (4) zero estimated litigation costs (since, as discussed below, the estate has claimed the actual costs of litigating its claims against Kavanagh and Northern Trust), we arrive at our conclusion that the fair market value of the claims against Northern Trust at the date of death was $930,000.

III. The Estate's Actual Litigation Expenses Section 2053 allows a deduction from the value of the gross estate for administration expenses. Sec. 2053(a)(2). Administration expenses include attorney's fees. Sec. 20.2053- 3(a), Estate Tax Regs.

Respondent does not dispute that the expenses actually incurred by the estate in litigating the claims against Northern Trust and Kavanagh qualify as administration expenses within the meaning of section 2053 and the regulations thereunder. Respondent argues only that the estate should not be entitled to deduct these expenses if the estimated cost of that litigation has already been factored into the valuation of the choses in action. Because we have not done so, there is no disagreement as to the estate's entitlement to deduct these administration expenses.

Accordingly, the estate is entitled to deduct its actual litigation expenses under section 2053. We have considered all of the parties' contentions, arguments, requests, and statements. To the extent not discussed herein, we conclude that they are irrelevant, moot, or without merit.

To reflect the foregoing, Decision will be entered under Rule 155.

.

Roth Scheme

2011-07-05T20:45:00.001-04:00

Michael S. Oshman, et ux. v. Commissioner, TC Memo 2011-98 , Code Sec(s) 4973; 6651.

MICHAEL S. AND PAMELA S. OHSMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information: Code Sec(s): 4973; 6651

Docket: Docket No. 23756-08.

Date Issued: 05/3/2011

Judge: Opinion by NIMS

HEADNOTE

XX.

Reference(s): Code Sec. 4973 ; Code Sec. 6651

Syllabus

Official Tax Court Syllabus

P-H's Roth IRA formed an FSC which entered into a commission agreement with P-H's wholly owned C corporation. For excise tax purposes only, R recharacterized commission payments from the C corporation to the FSC as distributions to P-H followed by P-H's contribution of the proceeds to his Roth IRA. R determined that Ps were liable for excise taxes on excess contributions to P-H's Roth IRA under sec. 4973, I.R.C., and additions to tax under sec. 6651(a)(1), I.R.C., for failing to file the appropriate information returns.

Held : The transactions must be treated consistently for sec. 4973, I.R.C., and income tax purposes.

Held , further, the commission payments from P-H's C corporation do not represent excess contributions to P-H's Roth IRA.

Held , further, Ps are not liable for excise taxes under sec. 4973, I.R.C.

Held, further, Ps are not liable for additions to tax under sec. 6651(a)(1), I.R.C. Neal J. Block, Robert S. Walton, and Brian C. Dursch, for petitioners.

Counsel

Peter N. Scharff, for respondent.

Opinion by NIMS

MEMORANDUM OPINION

This matter is before the Court on petitioners' motion for summary judgment under Rule 121 (Motion).

Respondent determined the following deficiencies and additions with respect to petitioners' Federal income tax:

Addition to Tax

Deficiency Sec. 6651(a)(1)

Year

2001 $79,293 $19,823.25

2002 85,595 21,398.75

2003 85,595 21,398.75

2004 85,595 21,398.75

2005 85,355 16,105.75

2006 85,355 21,300.75

The issues for consideration are: (1) Whether petitioners

are liable for excise taxes under section 4973 and (2) whether

petitioners are liable for additions to tax under section

6651(a)(1). Unless otherwise indicated, all section references

are to the Internal Revenue Code in effect for the years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

Background

For the purposes of deciding the Motion only, the following facts are derived from the affidavits and exhibits submitted by the parties and the parties' pleadings. Petitioners resided in Arizona when they filed their petition.

Michael S. Ohsman (petitioner) owned 100 percent of Ohsman & Sons Co., Inc. (Ohsman), a C corporation which was in the hide trading business. Petitioner established a Roth IRA which subscribed to all of the previously unissued stock of Ohsman Export, Inc. (Ohsman Export), a foreign sales corporation (FSC).

From 1999 through 2001 Ohsman made commission payments to Ohsman Export (Ohsman commission payments) of $104,896 in 1999, $3,152,714 in 2000, and $3,585,712 in 2001. Ohsman Export accordingly reported taxable income of $27,160, $192,246, and $259,305, and paid taxes of $5,469, $58,226, and $84,379, respectively.

Ohsman Export made actual distributions to petitioner's Roth IRA of $635,000 in 2000 and $789,559 in 2001.

On July 1, 2008, respondent issued petitioners a statutory notice of deficiency in which he determined that payments from Ohsman to Ohsman Export each represented: (1) A distribution from Ohsman Export to petitioner and (2) a subsequent contribution of the proceeds to petitioner's Roth IRA. Respondent determined that the amounts deemed contributed to the Roth IRA were excess contributions subject to the section 4973 excise tax. Respondent also determined that petitioners were liable for additions to tax under section 6651(a)(1) for failure to file Forms 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

On September 26, 2008, petitioners filed a petition with this Court. On April 14, 2009, petitioners filed the Motion.

Discussion

I. Summary Judgment Summary judgment may be granted when there is no genuine issue of material fact and a decision may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 [73 AFTR 2d 94-1198] (7th Cir. 1994). The moving party bears the burden of proving there is no genuine issue of material fact, and factual inferences will be read in a manner most favorable to the party opposing summary judgment. Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985); Jacklin v. Commissioner, 79 T.C. 340, 344 (1982). The adverse party must set forth specific facts showing that there is a genuine issue for trial and may not rest on mere allegations or denials in his pleadings. Rule 121(d).

Petitioners' return preparer, Mr. DeKock, described Ohsman's payment of FSC commissions to Ohsman Export and the subsequent distribution Ohsman Export made to petitioner's Roth IRA (Transaction). Respondent has not contested any part of Mr. DeKock's affidavit and claims only that he is unable to do so because he has not had a reasonable opportunity to conduct discovery. While respondent may require discovery to obtain the evidence necessary to resolve the factual issues that are in dispute, the absence of discovery should not prevent him from being able to identify what those disputed issues are.Respondent may not rely on generalized allegations that material issues of fact potentially exist.

Accordingly, we find and hold that there is no genuine issue of material fact and that judgment may be rendered as a matter of law.

II. Section 4973 Excise Taxes Section 4973 imposes a 6-percent excise tax on excess contributions to IRAs. The tax applies each year until the excess contributions are eliminated from the taxpayer's IRA. See sec. 4973(b)(2).

Respondent contends that petitioner used the Transaction as vehicle to improperly shift value into his Roth IRA. Respondent contends that the Ohsman payments therefore represented, in substance, excess contributions to petitioner's Roth IRA. Respondent has amended his recharacterization of the Transaction as described in the notice of deficiency and now argues that the Transaction represents a distribution from Ohsman to petitioner followed by petitioner's contribution of the proceeds to his Roth IRA.

We previously rejected this argument in a case involving See Hellweg v. Commissioner, T.C. Memo. similar transactions. 2011-58 . In Hellweg, the Commissioner attempted to use the substance-over-form doctrine to recharacterize, for excise tax purposes only, commission payments from an S corporation to a domestic international sales corporation owned by the taxpayers' Roth IRAs as excess contributions. We held that the Commissioner could not do so without also making a corresponding income tax adjustment because (1) section 4973 was intertwined with and inseparable from the income tax regime and (2) the Commissioner's approval of the transactions for income tax purposes undermined his attempted use of the substance-over-form doctrine.

Respondent has neglected to challenge the substance of the Transaction for income tax purposes. Consequently, he cannot rely on the substance-over-form doctrine to recharacterize the Transaction for purposes of section 4973 only.

For these reasons, we hold that the Ohsman commission payments do not constitute excess contributions to petitioner's Roth IRA. Accordingly, we will grant petitioners summary judgment as to the issue of their liability for excise taxes under section 4973.

III. Section 6651(a)(1) Additions to Tax Section 6651(a)(1) imposes a 5-percent addition to tax for each month or portion thereof a required return is filed after the prescribed due date. Taxpayers are required to file a Form 5329 for each year they have excess contributions to their IRA. See Frick v. Commissioner, T.C. Memo. 1989-86 [¶89,086 PH Memo TC], affd. without published opinion 916 F.2d 715 (7th Cir. 1990). Because petitioner did not make excess contributions to his Roth IRA, petitioners were not required to file Forms 5329 and are therefore not liable for additions to tax under section 6651(a)(1).

Accordingly, we will grant petitioners summary judgment as to the section 6651(a)(1) additions to tax.

To reflect the foregoing,

An appropriate order and decision will be entered granting petitioners' motion for summary judgment.

Look back losses

2011-07-05T20:45:00.000-04:00

U.S. v. SMITH, Cite as 107 AFTR 2d 2011-XXXX, 04/29/2011

UNITED STATES OF AMERICA, Plaintiff - Appellee, v. KRIS SMITH, Defendant - Appellant.

Case Information:

Code Sec(s):

Court Name: UNITED STATES COURT OF APPEALS TENTH CIRCUIT,

Docket No.: No. 10-1117; (D.C. Nos. 1:08-CV-01721-WDM and 1:05-CR-00502-WDM-1) (D. Colorado),

Date Decided: 04/29/2011.

Prior History:

Disposition:

HEADNOTE

.

Reference(s):

OPINION

UNITED STATES COURT OF APPEALS TENTH CIRCUIT,

Before MURPHY, TYMKOVICH, and GORSUCH, Circuit Judges.

ORDER AND JUDGMENT *

Judge: Michael R. Murphy Circuit Judge

I. Introduction

Following a five-day trial, defendant-appellant Kris A. Smith was found guilty of three counts of willfully making false statements on federal income tax returns, in violation of 26 U.S.C. § 7206(1), and one count of willfully failing to file a federal income tax return, in violation of 26 U.S.C. § 7203. Smith subsequently identified a number of alleged deficiencies in the performance of her trial counsel, Gregory Mueller, and moved to vacate, set aside or correct her sentence pursuant to 28 U.S.C. § 2255. She also filed a separate motion requesting an evidentiary hearing in the event the district court found the record insufficient to support her requested relief. In a thorough order, the district court denied the § 2255 motion and, in so doing, effectively denied the hearing request sub silentio. The district court then granted Smith's subsequent application for a certificate of appealability (“COA”) on the merits of her habeas claim, but denied a COA on the issue of the evidentiary hearing. See 28 U.S.C. § 2253(c) (providing no appeal may be taken from a “final order in a proceeding under section 2255” unless the movant first obtains a COA). Smith now appeals the denial of her § 2255 motion and presents argument on the question whether she was entitled to an evidentiary hearing, which we treat as an application to this court for a COA.

Even assuming Mueller's performance at trial fell below the objective standard of reasonableness required underStrickland v. Washington , 466 U.S. 668, 687–88 (1984), the evidence adduced against Smith was so overwhelming that these alleged deficiencies caused her no prejudice. Exercising jurisdiction under 28 U.S.C. §§ 2255(d) and 2253(a), we therefore AFFIRM the district court's decision denying Smith's § 2255 motion. Furthermore, because Smith has not “made a substantial showing” that the district court's refusal to grant an evidentiary hearing resulted in “the denial of a constitutional right,” 28 U.S.C. § 2253(c)(2), the court DENIES her request for a COA.

II. Background

Smith was a Colorado business owner with over twenty years of experience as a bookkeeper and tax preparer. In the late 1990's, one of her businesses was acquired through merger, and she received a sizable amount of stock as compensation. Between 1997 and 1998, Smith sold $188,108 worth of this stock, incurring significant capital gains taxes. She liquidated the remainder of this stock in 1999, generating proceeds of $410,479.

Unhappy with the large tax burden she expected to incur from her stock sales, Smith became involved with Anderson's Ark and Associates (“AAA”), an organization that purported to offer financial planning strategies designed to reduce or eliminate its clients' tax liabilities. After being introduced to AAA and paying several thousand dollars in fees, Smith availed herself of the organization's so-called “Look Back Program.” The Look Back Program involved creating business partnership losses, which could be used to offset

current taxable income and reduce the client's tax liability in surrounding years. The Look Back losses were generated as follows: First, AAA planners prepared documents purporting to form a partnership between Smith and Macro Media Advertising LLC (“Macro Media”), a AAA-controlled entity. Smith held a 95% interest in the partnership, which was known as “Rocky Ventures.” Rocky Ventures was then made to incur a $1,000,000 payment obligation to its 5% partner, Macro Media. In exchange, Macro Media agreed to market certain tax reduction programs and a 1-900 tax advice phone number. The proceeds from Macro Media's marketing efforts would then be returned to Rocky Ventures, recouping the $1,000,000 payment and, ultimately, resulting in profit for the partnership. Pursuant to a separate agreement, Macro Media contracted to repay the bank loan itself in the event that its marketing efforts generated insufficient profits. Rocky Ventures ostensibly obtained the $1,000,000 for this payment through a loan issued by La Maquina Blanca, S.A., a AAA-controlled entity purporting to be a Costa Rican bank. The bank demanded no collateral for this loan, but AAA charged Smith an $87,000 “loan origination fee,” of which she ultimately paid $50,000.

Through this arrangement, Rocky Ventures recognized the $1,000,000 payment as a tax loss for fiscal year 1999. The tax loss then “flowed through” to Rocky Venture's owner, Smith, in proportion to her interest in the partnership (95%), and was sufficient to completely eliminate Smith's tax liability for 1999 despite the $394,830 in capital gains she recognized from the sale of stock. Smith's losses were in fact so large that her net taxable income for 1999 was reported to be negative$460,547. Pursuant to the Internal Revenue Code provisions in effect at the time, Smith's net loss for 1999 could be carried back and used to offset income for the two preceding tax years. Accordingly, Smith filed an amended return, seeking a refund for federal income taxes paid in 1997 and 1998; she later received refunds of $50,284 for 1997 and of $21,149 for 1998. Finally, Smith carried her 1999 net loss forward to 2000, completely offsetting her income for that tax year as well.

In addition to her use of the Look Back Program, Smith participated in AAA's “Loan 4” program. Under Loan 4, AAA clients could supposedly fund short-term loans to Costa Rican businesses in a “factoring” investment program. The loans promised high returns (4% growth every six weeks). Smith ultimately invested over $200,000 in the Loan 4 program.

Apparently pleased with the results of AAA's products and strategies, Smith sought to increase her involvement with the organization. After successfully completing a written examination, she became an “Information Officer” for AAA. In this capacity, Smith introduced others to AAA's programs and presented at AAA-sponsored events, receiving commissions from AAA in exchange.

The astonishingly effective tax avoidance opportunities offered by AAA were, of course, too good to be true. AAA's business strategies and investment programs were largely fraudulent and illegal, resulting in millions of dollars in losses to both the United States government and AAA clients. In the Look Back Program, for example, La Maquina Blanca never actually provided any loan proceeds to Macro Media, and Macro Media never engaged in any marketing of tax reduction products. Consequently, the partnership losses created by the Look Back Program were not cognizable for tax purposes. The 5–7% “loan origination fees” charged by AAA for these fictitious loans were, moreover, either appropriated by AAA's principals or cycled back into the scheme. Similarly, the money paid into Loan 4 by AAA clients was never invested into a “factoring” program, but was instead converted for AAA's principals' personal use or comingled with general AAA funds.

The founders and principals of AAA were charged with a variety of conspiracy, fraud and criminal tax violations (the “Anderson prosecution”). Key figures charged in the Anderson prosecution included Keith Anderson, founder of AAA; Richard Marks, AAA's lead accountant and planner; and Jim and Pamela Moran, AAA “Executive Education Officers” and Smith's primary point of contact with the organization. After trial in the United States District Court for the Western District of Washington, the Andersondefendants were found guilty of all charges. 1Smith was listed as a victim of AAA's Loan 4 scheme in theAnderson prosecution, and the Government obtained a judgment ordering Keith Anderson to pay $250,000 restitution for her losses.

Although Smith was described as a victim of the Loan 4 scheme in the Anderson prosecution, the government concluded Smith had perceived the sham nature of the deductions she claimed through the Look Back Program. Accordingly, Smith was charged with three counts of willfully making false statements on federal income tax forms in violation of 26 U.S.C. § 7206(1). The underlying bases for the charges were her tax returns for years 1999 and 2000, and her request for refunds from 1997 and 1998. A fourth count charged her with willfully failing to file a 2003 federal income tax return on behalf of Neco & Associates, a partnership founded by Smith, in violation of 26 U.S.C. § 7203.

Faced with these criminal tax charges, Smith retained Gregory Mueller, a sole practitioner from Colorado, to represent her at trial. Mueller had extensive experience in criminal matters, but had never before represented a client against federal felony or tax charges. Smith and Mueller determined their primary defense would be that Smith had a good faith belief in the legitimacy of the deductions recognized through the Look Back Program (rendering her false statements non-willful), and that her failure to file a tax return for Neco & Associates was negligent rather than willful. Following a five-day trial, Smith was found guilty on all counts.

Prior to sentencing, Smith retained new counsel and filed a motion for a new trial. Because she had been previously awarded restitution as a victim of the AAA programs in theAnderson prosecution, Smith argued, the government was estopped from subsequently claiming she had the requisite mental state to commit the charged crimes. Furthermore, because Mueller had failed to raise this estoppel argument, and because of certain other shortcomings in his trial strategy, discussed at greater length below, Smith argued Mueller's representation at trial amounted to ineffective assistance of counsel.

The trial court denied Smith's motion on the procedural ground that it was untimely, but also passed upon the merits of Smith's claim. It concluded Smith's characterization as a victim in the Loan 4 scheme did not preclude the government from asserting she was aware of the sham nature of her Look Back transactions, and that Mueller had presented himself as a “capable adversary” at trial, providing effective assistance. Smith was then sentenced to twenty-eight months' imprisonment and ordered to pay approximately $186,000 in restitution to the IRS. She appealed the denial of her motion for new trial, and this court affirmed on the procedural ground. United States v. Smith, No. 07-1044, 2008 WL 55996 [101 AFTR 2d 2008-398] (10th Cir. Jan. 4, 2008).

Smith next filed (1) a motion to vacate, set aside, or correct the sentence, pursuant to 28 U.S.C. § 2255, arguing ineffective assistance of her trial counsel had resulted in a deprivation of her Sixth Amendment rights; and (2) a motion for immediate release on bond pending resolution of the § 2255 motion. A limited evidentiary hearing was held in connection with the latter motion, and testimony was taken from Mueller regarding his trial preparation and strategy. Smith then filed a request for a full evidentiary hearing in connection with the § 2255 motion.

The district court issued a thorough order denying Smith's § 2255 motion, thereby effectively denying her hearing request as well. In its order, the district court acknowledged certain aspects of Mueller's performance at trial fell below the objective standard of reasonableness required underStrickland , 466 U.S. 687–88, but concluded those shortcomings caused Smith no prejudice in light of the government's overwhelming evidence of guilt. Smith applied for a COA on both the merits of her § 2255 motion and the denial of her request for a full evidentiary hearing. The district court granted a COA only as to the former.

III. Discussion

A. Ineffective Assistance of Counsel

1. Legal Standards

28 U.S.C. § 2255 permits a prisoner in federal custody to challenge a sentence imposed in violation of the Constitution or laws of the United States. Smith contends her conviction and sentence were imposed in violation of her Sixth Amendment right to effective assistance of counsel. Evaluation of her claim is controlled by the two-part rubric set forth inStrickland , which requires Smith to demonstrate (1) Mueller's representation fell below an objective standard of reasonableness, and (2) his deficient performance was prejudicial to Smith's defense. 466 U.S. at 687–88, 692. The district court's Strickland analysis presents a mixed question of fact and law, which we review de novo.United States v. Orange , 447 F.3d 792, 796 [97 AFTR 2d 2006-2293] (10th Cir. 2006).

Because “[t]here are countless ways to provide effective assistance in any given case,”Strickland , 466 U.S. at 689, the court starts from the presumption that counsel's performance was objectively reasonable “and that [Mueller's] challenged conductmight have been part of a sound trial strategy.”Bullock v. Carver , 297 F.3d 1036, 1046 (10th Cir. 2002). “[W]here it is shown that a particular decision was, in fact, an adequately informed strategic choice, the presumption that the attorney's decision was objectively reasonable becomes “virtually unchallengeable.”” Id. The court must also look to the totality of the evidence to determine whether Mueller's alleged shortcomings prejudiced Smith's defense.See Boyd v. Ward , 179 F.3d 904, 914 (10th Cir. 1999). The touchstone of this inquiry is whether “counsel's conduct so undermined the proper functioning of the adversarial process that the trial cannot be relied on as having produced a just result.” Strickland, 466 U.S. at 686. This court “may address the performance and prejudice components in any order, but need not address both if [Smith] fails to make a sufficient showing of one.” Boyd, 179 F.3d at 914 (quotation omitted).

2. The Presentations at Trial

Smith's § 2255 claim is premised largely on Mueller's failure to present certain evidence at trial. To properly analyze the merits of her claim, then, it is necessary to first review the evidence actually presented to the jury.

The government's case sought to demonstrate Smith was aware the tax losses created through her use of the Look Back Program were invalid. To accomplish this, the prosecution presented evidence concerning (i) the evident illegality of AAA as a whole, and (ii) the sham nature of Smith's Rocky Ventures partnership. Evidence showed Smith had worked for many years in bookkeeping and tax preparation. Smith was introduced to AAA by an acquaintance after she mentioned her desire to liquidate stock holdings without incurring tax liability. Testimony indicated that upon joining AAA, she was given the so-called “Gateway” tapes, which contained recordings from AAA founder Keith Anderson's speeches and lectures. In these tapes, Anderson explains the tax protester concept of “sovereignty,” according to which a taxpayer can supposedly stop accepting the benefits of citizenship from the federal government and thereby be relieved of the duty to pay income taxes. To achieve sovereignty, Anderson recommends taxpayers rescind their social security numbers and have their children at home, so that the children do not have birth certificates. The Gateway lectures further recommend that property be purchased in gold and silver, as opposed to Federal Reserve notes, because such property need not be “registered” with the government. An acquaintance of Smith's testified she had expressed an interest in these concepts and desired to become “sovereign.”

Another of the government's witnesses was a law enforcement officer who had, in connection with an undercover investigation, attended a AAA seminar in August 2000. He testified that sovereignty concepts were conveyed to the audience through a PowerPoint presentation, and that certain slides in these presentations depicted the IRS as a scorpion. Other slides showed the United States tax code in flames.

Samuel Baldwin, another government witness and Smith's former accountant, also attended the August 2000 AAA seminar. Baldwin was brought to the seminar by Smith, who sought to involve him in the organization. Baldwin testified that the presentation was very anti-government and included a slide depicting a plane full of IRS agents being shot down by a helicopter. He further testified that the basic Look Back Program was described at this seminar, and appeared designed to create fictitious deductions. He was particularly concerned about the legitimacy of AAA because he was unable to get additional information about their programs without first joining the organization. Baldwin expressed his skepticism to Smith, who disregarded his concerns. Further testimony revealed Smith contacted Baldwin shortly prior to her trial and sought to influence his participation.

Additional testimony and exhibits were presented demonstrating that Smith had adopted AAA's tax protester doctrines. For example, before becoming an Information Officer for AAA, Smith had to complete a written examination. One question concerned ownership of property; Smith's answer on the exam stated that, to establish sovereignty, “[o]wnership of a house inside the Land Title System should be titled to a fictitious entity.” Other evidence demonstrated Smith had, in fact, transferred title to her vacation home and other real property to a fictional entity called “Skyway Properties.” Warranty deeds recording these transfers listed “$21 in gold coin” as consideration. Furthermore, numerous tax forms and other official documents completed by Smith were shown to have the initials “TM” beside Smith's signature: a marking prescribed by sovereignty literature.

The government also presented numerous documentary exhibits indicating Smith's partnership, Rocky Ventures, was not a real business enterprise at all, but instead a shell created solely to generate tax losses. The partnership agreement by which Rocky Ventures was created, for example, is dated October 13, 1999. Rocky Venture's tax returns, however, on which the $1,000,000 tax loss was first claimed, state that the business was started on September 1, 1999, approximately six weeks prior to its creation and two weeks before Smith's participation in AAA began. Still more troubling, the contract by which Rocky Ventures incurred its obligation to pay Macro Media $1,000,000 for “marketing & consulting services” states that Macro Media's performance was to be completed by December 31, 1998, ten months before Rocky Ventures came into existence. Other evidence indicated Rocky Ventures engaged in no business activity whatsoever from 1999 through 2001, owned no assets, maintained no books of accounts, and received no capital contributions from its partners.

The jury was also presented with evidence concerning the circumstances of the $1,000,000 loan allegedly provided by La Maquina Blanca to Rocky Ventures and purportedly paid over to Macro Media. Documentary evidence showed no collateral was required to secure this loan, even though Rocky Ventures was a start-up company with no assets. The promissory note for the loan listed the due date as September 1, 2099, approximately 100 years after the disbursement of proceeds. An invoice accompanying the loan stated, “[w]hen the loan is approved, La Maquina Blanca, S.A. is hereby authorized to pay the loan proceeds directly to Mason Advertising, LLC,” a company with no apparent connection to Rocky Ventures. 2

Further evidence indicated Smith did not consider the $1,000,000 loan, for which she signed on behalf of Rocky Ventures, to be a true obligation. In 2000, for example, Smith submitted an application to refinance her home mortgage. The application required Smith to list all assets and liabilities. Although the $250,000 Smith invested into AAA's Loan 4 was listed as an asset, the application does not mention the $1,000,000 loan as a liability. Other evidence on this point included the testimony of Robert Haueisen, a AAA client for whom Smith served as Information Officer and whose version of the Look Back Program required him to sign for a $750,000 promissory note. When Haueisen expressed doubts about taking on such a large liability, Smith advised him the loan would not have to be repaid.

Smith's defense, in turn, sought to prove Smith had a good faith belief in the legitimacy of her deductions and was an unwitting victim of AAA. To that end, Mueller elicited witness testimony regarding the Anderson prosecution, the criminal judgments entered against AAA's principals, and Smith's prior adjudication as a victim of the Loan 4 scheme. Mueller emphasized that Richard Marks, AAA's lead accountant, had told AAA clients the programs were legal, and sought to demonstrate it was reasonable for Smith to rely on these representations.

Mueller also presented the testimony of George Benoit, an IRS-licensed tax expert and the preparer of Smith's tax forms. Benoit testified he had looked into the legitimacy of the Rocky Venture tax losses and had satisfied himself that they appeared legal. In reaching this conclusion, Benoit testified, he had in part relied upon conversations with Richard Marks. 3 Testimony was also elicited from Alan Gavel, an accountant and tax attorney, who described his investigation of the victimization of AAA's Look Back Program clients. Mr. Gavel, however, was prevented from testifying that Smith was personally a victim of the Look Back Program, due to certain of Mueller's oversights discussed below.

Further testimony was given by Michael Skillo and Kirby Clock, two former AAA clients, who had also participated in the Look Back Program. Mr. Skillo testified to his good faith belief in the legitimacy of the partnership losses he recognized through the Look Back Program. Mr. Clock also testified that Smith had told him the partnership loans involved in the Look Back Program would have to be repaid.

Finally, Smith herself testified for the limited purpose of introducing United States Postal Service receipts for 2003 and 2005 tax returns filed by Neco & Associates. On cross-examination, however, it was elicited that these returns were signed by Smith, and that beside her signature was the phrase “under duress.” When asked to explain the significance of this notation, the following colloquy ensued:

Q. What does “Under duress” mean?

A. I had to file this tax return, is that right? I am required to file it. Am I required to file this tax return?

Q. I get to ask the questions, you get to answer.

A. “Under duress,” in my opinion, which I read for through some different publications and stuff, that I cannot file this tax return without it being under the penalty of perjury. I am concerned about the tax laws, that I'm not — they are so complex that I am not able to follow the tax laws. I don't have a problem filing my tax returns.

3. The Alleged Shortcomings

Smith argues Mueller's trial preparation and performance were objectively deficient for the following reasons: (1) inadequate preparation time, including failure to thoroughly review discovery; (2) failure to introduce evidence of a conversation in which Richard Marks allegedly states he kept the illegality of AAA programs secret from Information Officers, such as Smith (the “Marks Transcript”); (3) failure to introduce a confession signed by AAA founder, Keith Anderson, in which he states his leadership of AAA was “incompetent and destructive” (the “Anderson Confession”); (4) failure to authenticate and introduce the victim lists from the Andersonprosecution; (5) failure to introduce check receipts evidencing Smith's payment to AAA of loan commitment fees for her participation in the Look Back Program; (6) failure to establish foundation for admission of AAA's “Tax Magic” infomercial and related materials; (7) failure to comply with rules concerning the pre-trial disclosure of expert testimony; (8) failure to rebut certain aspects of the government's evidence of willfulness; and (9) failure to properly counsel Smith regarding the need for, and consequences of, her testimony at trial.

Smith contends these shortcomings prevented Mueller from effectively presenting her defense. The Marks Transcript, for example, contains a secretly tape-recorded conversation between lead AAA accountant Richard Marks and an undercover IRS agent from October 2000. In the transcript, Marks discusses future planning strategies being developed by AAA accountants, and states that “we don't tell Jim and Pam [Moran], or any of the IOs, what we're working on in detail” because “some of the stuff we say [in AAA planning conferences] shouldn't be published because it's illegal, but we still discuss the illegal and how do we make it legal.” Smith argues this evidence proves she was kept in the dark regarding the illegality of the Look Back Program, and lends credence to her claim of good faith belief in the validity of her Rocky Ventures tax losses.

Similarly, Smith argues, the victim lists from theAnderson prosecution listing her as a victim of AAA's Loan 4 scam and the check receipts indicating she had paid AAA $50,000 for her participation in the Look Back Program demonstrate she was taken advantage of by a sophisticated scam. Although Mueller referred to this evidence in his opening statement, neither the victim lists nor the check receipts were introduced at trial. Mueller's opening statement additionally promised the jury it would hear testimony from tax expert Alan Gavel, who allegedly was prepared to testify that Smith was a victim of the Look Back Program. Because Mueller had failed to provide the government a written summary of Gavel's proposed expert testimony as required by Fed. R. Crim. P. 16, and because Gavel had based his opinion upon a report he had not personally prepared, the trial court did not permit Gavel to testify about Smith. Mueller's failure to present this evidence to the jury, Smith asserts, prejudiced her defense not only by its absence, but also because Mueller announced he would be presenting it in his opening statement.

Smith also claims Mueller prejudiced her defense by failing to introduce materials, including a video, progress reports, and revenue projections relating to AAA's “Tax Magic” program. Tax Magic refers to a program of “50 highly effective tax reduction strategies” and a related 1-900 tax advice number that AAA was allegedly producing for sale to the public. The program was to be marketed through a polished infomercial narrated by an individual claiming to be a former IRS revenue agent; the narrator assures the audience his tax strategies are completely legal. Some evidence indicates the Tax Magic program was the product to be marketed by Macro Media pursuant to its agreements with Rocky Ventures, and that AAA produced a series of progress reports and revenue projections creating the impression that Tax Magic would be a viable business. 4 Smith argues these materials corroborated her good faith belief that Rocky Ventures and Macro Media would actually carry on business operations, and thereby validate her tax losses. The Tax Magic materials, however, were never presented to the jury because the defense witness intended to provide foundation ultimately could not do so.

Smith also attributes prejudicial effect to Mueller's failure to rebut certain aspects of the government's evidence that Smith was aware her partnership venture was a sham. For example, the invoice recording La Maquina Blanca's purported $1,000,000 loan to Rocky Ventures states the loan proceeds will be paid to Mason Advertising, rather than Macro Media, and the government pointed to this inconsistency as inculpatory evidence. Smith believes Mueller prejudiced her defense by failing to rebut the government's use of this invoice by explaining that Macro Media and Mason Advertising were the same entity. Similarly, Smith argues the government's use of the absence of business records and audits for Rocky Ventures as inculpatory evidence could have been rebutted by the “innocent explanation that these terms of the partnership agreement were simply inapplicable until Rocky Ventures began receiving proceeds” from Macro Media's marketing efforts. The evidence that Smith advised her AAA clients the Look Back Program loans would never have to be repaid, in turn, could have been explained as a reference to the side agreement in which Macro Media contracted to repay the bank loan itself in the event its marketing effort produced insufficient proceeds.

Finally, Smith contends Mueller was prejudicially ineffective in his counsel regarding her decision whether to testify at trial. Mueller advised Smith he thought her testimony was necessary for two reasons: (1) for the jury to “at least hear her voice and see her demeanor on the stand,” and (2) to introduce postal receipts evidencing the mailing of Neco & Associates' tax returns. Mueller was apprehensive, however, that if Smith testified to her involvement with AAA, her radical views on taxation and “sovereignty” would be elicited on cross-examination and damage her case. Accordingly, once Smith decided to take the stand, Mueller worked with her to prepare a script for her direct testimony designed to minimize the scope of cross-examination and avoid potentially damaging testimony. Despite this script, and over Mueller's objections, the government cross-examined Smith concerning the contents of the Neco & Associates tax return, ultimately eliciting Smith's explanation of her handwritten notation, “Under Duress.”

Although a criminal defendant's decision whether to testify lies squarely with the defendant, defense counsel “should inform the defendant that he has the right to testify ... [and] discuss with the defendant the strategic implications of choosing whether to testify.” Cannon v. Mullin, 383 F.3d 1152, 1171 (10th Cir. 2004). Smith argues Mueller's counsel in this area fell below an objective standard of reasonableness for several reasons. First, the postal receipts introduced by Smith's direct testimony could also have been authenticated by a postal service custodian of records, pursuant to Fed. R. Evid. 803(6), thereby eliminating one of the reasons Mueller recommended Smith testify. Second, the contents of the Neco & Associates tax returns were determined by the trial court to be an appropriate topic for the government's cross-examination, and Mueller was incorrect to conclude otherwise. Third, because Mueller incorrectly concluded that the contents of the Neco & Associates tax returns could not be discussed on cross-examination, he failed to prepare Smith for the government's cross-examination. Fourth, Mueller counseled Smith against testifying about her involvement in AAA because Smith remained convinced Keith Anderson and the other AAA principals had been wrongly convicted; he consequently feared that if the government were able to cross-examine Smith on AAA-related matters, her responses would be damaging. Had Mueller discovered the Anderson Confession, Smith argues, her opinion of Anderson might have changed, thereby opening up new areas for testimony. Together, Smith contends, these shortcomings contributed to her decision to give limited testimony at trial, led to the government's allegedly damaging cross-examination, and prejudiced her defense.

4. Analysis of Alleged Prejudice

Even assuming each of the shortcomings identified by Smith constituted performance falling below the objective standard of reasonableness required by Strickland, the district court's denial of relief must be affirmed because Smith has not demonstrated a reasonable probability that these shortcomings impacted the outcome of her trial. The second prong of theStrickland analysis requires the court to aggregate the impact of counsel's errors in assessing prejudice, but for purposes of analysis, it remains necessary to address each alleged shortcoming individually. See Cargle v. Mullin, 317 F.3d 1196, 1212 (10th Cir. 2003).

The consequence of Mueller's allegedly inadequate preparation that, at first blush, appears most serious is his failure to identify and utilize the Marks Transcript. Smith attributes great exculpatory value to the Marks Transcript, which can arguably be read as evidence that Information Officers (including Smith) were not informed of the illegality of AAA's programs by its principals. 5Upon analysis, however, it is clear the Marks Transcript would not have impacted the outcome of the trial. The crux of Smith's three false statement convictions is that she was aware her Rocky Ventures losses were invalid at the times she claimed them. Smith first claimed the invalid Rocky Ventures losses in April 2000, one month before she took the written examination to become an Information Officer. The information given to, or concealed from, Information Officers regarding the legality of the Look Back Program is consequently irrelevant to the question whether Smith made the first charged false statement knowingly. Because the jury, by finding Smith guilty of the first false statement charge, concluded Smith was aware her Rocky Ventures losses were invalid even before she became an Information Officer, and because the Marks Transcript at best indicates that Smith was not given additional inculpatory information before she made her subsequent charged false statements, no prejudice can flow from its omission at trial.

Similarly, Mueller's failure to discover and introduce the Anderson Confession cannot be said to have prejudiced Smith's defense. The Anderson Confession discusses only the Loan 4 Program and Anderson's mis-management of AAA; it says nothing about the Look Back Program or Smith's involvement in AAA. Smith suggests the discovery of the Anderson Confession might have disabused her of the notion that Anderson was a good person who would be exonerated on appeal, and thereby caused her to testify differently at trial. Whether Smith's testimony would, in fact, have changed, and whether her modified testimony would have increased her chances of acquittal, however, are matters of pure speculation, clearly insufficient to carry Smith's burden of proving prejudice. See Boyle v. McKune, 544 F.3d 1132, 1140 (10th Cir. 2008).

The same reasoning prevents us from identifying any prejudicial consequence of Mueller's inability to introduce the expert testimony of Alan Gavel. Smith has never offered any affidavit or other indication of the contents of the expert testimony expected if Mueller had secured its admission. Whether such expert testimony would have been exculpatory and persuasive to the jury is unknown.

Nor have prejudicial effects been shown to flow from Mueller's failure to offer Smith's after-the-fact rebuttals to the government's evidence of willfulness. When the government presented the La Maquina Blanca invoice indicating the Rocky Ventures loan proceeds would be transferred to Mason Advertising, Mueller certainly could have attempted to rebut the inculpatory use of the document by pointing out that Mason Advertising and Macro Media were simply different names used by AAA to refer to the same entity. For such a rebuttal to be effective, however, Mueller would also have had to demonstrate Smith was aware of this fact at the time. The record provides no indication this is so. By the same token, when Robert Haueisen testified Smith had repeatedly advised him his Look Back loan would never have to be repaid, Mueller could have asked on cross examination whether Smith might have been referring to the side agreement whereby Macro Media promised to repay the loan in the event its marketing efforts generated insufficient proceeds. The court has no way of knowing, however, what the witness's response would have been. Finally, in response to the government's reliance on the absence of business records, banking activity or annual audits for Rocky Ventures, Smith argues Mueller should have offered “the innocent explanation that these terms of the partnership agreement were simply inapplicable until Rocky Ventures began receiving proceeds” from its marketing efforts. Nothing in the partnership documents, however, so provides.

The government's cross-examination of Smith, furthermore, was nowhere near as damaging as Smith claims. Smith's response to the government's cross-examination on the “under duress” notation essentially expressed her unremarkable understanding that tax returns must be filed, and must be filed under penalty of perjury. Smith also stated she did not “have a problem filing [her] tax returns.” Precisely how this response prejudiced Smith's defense eludes the court. The only damage to Smith's defense apparent from the record is that the government's cross-examination served to bring the “under duress” notation to the jury's attention, thereby possibly confirming Smith had adopted AAA's sovereignty concepts. The government's case, however, was replete with other proof of Smith's tax protester beliefs, including evidence Smith had transferred real estate to fictional entities for gold coin, signed tax return documents with the “TM” marking, repeatedly expressed an interest in sovereignty concepts to her acquaintances, and served as an Information Officer for AAA. The jury had, in fact, been shown other tax returns filed by Smith and bearing the same “under duress” notation even before Smith took the stand. Smith has consequently failed to demonstrate how she was prejudiced by her testimony on cross-examination.

The remaining shortcomings identified by Smith can at least be said to have had some negative impact on her defense. The introduction of check receipts indicating Smith's $50,000 loan origination payment to AAA, for example, might have provided support for her alleged good faith belief in the legitimacy of the loan. Similarly, the victim lists from theAnderson prosecution, while only directly indicative of her victimization in the Loan 4 scam, at least partially corroborated Smith's argument that she was also a victim of the Look Back Program. 6 The Tax Magic infomercial and materials, too, could have provided support for Smith's claimed belief in the legitimacy of Rocky Ventures business purpose.

Nevertheless, the combined effect of these alleged shortcomings do not give rise to a reasonable probability that “but for counsel's unprofessional errors, the result of the proceeding would have been different.”Strickland , 466 U.S. at 694. In this context, demonstrating a reasonable probability “requires a “substantial,” not just “conceivable,” likelihood of a different result.” Cullen v. Pinholster, No. 09-1088, 2011 WL 1225765, at 12 (U.S. Apr. 4, 2011) (quotingHarrington v. Richter , 131 S. Ct. 770, 791 (2011)). Whether Smith has satisfied this high threshold must, moreover, be determined with reference not only to trial counsel's alleged shortcomings, but also to the strength of the prosecution's case.Boyd , 179 F.3d at 914. Here, the latter is overwhelming and largely unrebutted. Even now, no justification has been given for the eminently fraudulent, back-dated documentation purporting to form the Rocky Ventures partnership or its marketing agreement with Macro Media. No reason has been offered why Smith, a sophisticated business owner with many years experience in bookkeeping and tax preparation, was not suspicious that La Maquina Blanca would provide a $1,000,000 loan to her start-up business without requiring any collateral and without requiring any payments before the expiration of the loan's 100-year term. No explanation was given for Smith's failure to report this loan as a liability on her mortgage-refinancing application, and no attempt has been made to articulate why neither Macro Media, Rocky Ventures, nor Smith herself ever did anything to advance their purported business. In short, Smith has provided no plausible interpretation of this evidence to counter the implication that she formed Rocky Ventures solely as a tax haven and used it to generate tax losses she knew were fraudulent.

Because correction of Mueller's allegedly unprofessional errors would do little to offset the weight of the government's case, Smith has not shown there is “a reasonable probability that” the result of the trial would have been different.Strickland , 466 U.S. at 694. The district court's order denying Smith's § 2255 motion is affirmed.

B. Motion for an Evidentiary Hearing

Following a limited evidentiary hearing on Smith's motion for release on bond pending resolution of her § 2255 motion, at which Mueller's testimony was taken, Smith submitted a motion (the “Hearing Motion”) requesting, in the event habeas relief was not granted based on the record and briefings, a full evidentiary hearing be held. The Hearing Motion indicated Smith would use the evidentiary hearing to more fully examine Mueller, and to present the testimony of William Cohan, an expert witness, in support of her ineffective assistance of counsel claim. 7 By its order denying Smith's § 2255 motion, the district court effectively denied the Hearing Motion sub silentio. Smith now challenges the merits of this denial, which we treat, in connection with her notice of appeal, as an application for a COA. See Fed. R. App. P. 22(b)(2); 28 U.S.C. § 2253(c)(1)(B) (providing no appeal may be taken from a “final order in a proceeding under section 2255” unless the movant first obtains a COA).

For this court to grant a COA and proceed to the merits of Smith's appeal, she must make a “substantial showing of the denial of a constitutional right.” 28 U.S.C. § 2253(c)(2). A § 2255 petitioner, in turn, is entitled to an evidentiary hearing unless “the motion and the files and records of the case conclusively show that the prisoner is entitled to no relief.” Id. § 2255(b). For the reasons discussed above, the records of this case conclusively show Smith's defense was not prejudiced by Mueller's performance, and Smith was consequently not entitled to relief under § 2255. The district court, therefore, did not abuse its discretion in determining Smith was not entitled to an evidentiary hearing. Smith has thus failed to make a substantial showing that the denial of her Hearing Motion resulted in a denial of her constitutional rights. The application for a COA is denied.

IV. Conclusion

For the foregoing reasons, the district court's denial of habeas relief is AFFIRMED, and Smith's application for a COA is DENIED.

ENTERED FOR THE COURT

Michael R. Murphy

Circuit Judge

*

This order and judgment is not binding precedent except under the doctrines of law of the case, res judicata, and collateral estoppel. It may be cited, however, for its persuasive value consistent with Fed. R. App. P. 32.1 and 10th Cir. R. 32.1.

1

The convictions of Marks and Anderson were largely upheld on appeal.See United States v. Marks , 530 F.3d 799 [101 AFTR 2d 2008-2570] (9th Cir. 2008); United States v. Anderson, 472 F.3d 662 [98 AFTR 2d 2006-8369] (9th Cir. 2006). The convictions of Jim and Pamela Moran were reversed and remanded for new trial due to an erroneous evidentiary ruling. See United States v. Moran, 493 F.3d 1002 (9th Cir. 2007). On retrial, the Morans were acquitted.

2

Record evidence not presented at trial indicates that Macro Media and Mason Advertising were apparently different names used by AAA to describe the same entity.

3

Government cross-examination, however, revealed Benoit had suspected the partnership loans were unfunded, recognized the partnership documents were back-dated, and believed the Sixteenth Amendment (allowing Congress to levy an income tax without apportionment among the States) had never been properly ratified. See U.S. Const. amend. XVI.

4

The government, however, argues that Tax Magic had no connection to Rocky Ventures, and that Macro Media's marketing agreement called for it to market the Gateway tapes, which the district court found lack the veneer of legality that the Tax Magic materials convey.

5

An equally plausible interpretation, however, is that Marks and the other accountants did not reveal the details of prospective AAA programs until they were ready for implementation. For instance, although Marks at one point states that “we don't tell Jim and Pam, or any of the IOs, what we're working on in detail,” he later explains that “[w]hat we say in [our planning sessions] goes no further until we walk out there and tell them.”

6

The negative impact of Mueller's failure to introduce this evidence, however, is mitigated because Mueller was able, through cross-examination of a government witness, to elicit other testimony indicating Smith was a victim of the Loan 4 scam and had lost over $200,000.

7

Smith did not indicate what Cohan was expected to testify to if a hearing had been granted. His previously submitted declaration in support of Smith's § 2255 motion, however, largely repeats the arguments made in the motion itself.

Jorgensen

2011-07-05T20:44:00.000-04:00

JORGENSEN v. COMM., Cite as 107 AFTR 2d 2011-XXXX, 05/04/2011

ESTATE OF ERMA V. JORGENSEN, Deceased; JERRY LOU DAVIS, Executrix and Co-Trustee; GERALD R. JORGENSEN, Co-Trustee, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

Case Information:

Code Sec(s):

Court Name: UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT,

Docket No.: No. 09-73250,

Date Decided: 05/04/2011Argued and Submitted April 13, 2011 Pasadena, California.

Disposition:

HEADNOTE

.

Reference(s):

OPINION

UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT,

Appeal from a Decision of the United States Tax Court

Before: REINHARDT, HAWKINS, and GOULD, Circuit Judges.

MEMORANDUM *

Judge: Harry A. Haines, Tax Court Judge, Presiding

NOT FOR PUBLICATION

Tax Ct. No. 21936-06

The Estate of Erma V. Jorgensen (the “Estate”) appeals the tax court's affirmance of the Commissioner of the Internal Revenue's (“Commissioner”) assessment of an estate tax deficiency. Concluding that certain transfers decedent had made to two family limited partnerships should remain included in the estate valuation, the tax court found that decedent had retained the economic benefits and control of such property and that the transfers did not involve a bona fide sale for full consideration. See 26 U.S.C. § 2036(a). We review these determinations for clear error, Estate of Bigelow v. Comm'r, 503 F.3d 955, 964 [100 AFTR 2d 2007-6016], 970 n.6 (9th Cir. 2007), and affirm.

On appeal, the Estate does not contest the tax court's determination that § 2036(a) applies; that is, it acknowledges decedent retained some benefits in the transferred property (because she had written checks on partnership accounts to pay some personal expenses and make some family gifts), but argues that these amounts should be consideredde minimis or that the application of the section should be limited to the actual amount accessed by decedent. These arguments are made for the first time to this court and run contrary to stipulations made by the Estate below.

In any event, these arguments are also without merit. We do not find it de minimis that decedent personally wrote over $90,000 in checks on the accounts post-transfer, 1 and the partnerships paid over $200,000 of her personal estate taxes from partnership funds. See Strangi v. Comm'r, 417 F.3d 468, 477 [96 AFTR 2d 2005-5230] (5th Cir. 2005) (post-death payment of funeral expenses and debts from partnership funds indicative of implicit agreement that transferor would retain enjoyment of property); see also Bigelow, 503 F.3d at 966 (noting payment of funeral expenses by partnership as supporting reasonable inference decedent had implied agreement she could access funds as needed).

Nor did the tax court clearly err by concluding there was an implied agreement decedent could have accessed any amount of the purportedly transferred assets to the extent she desired them. The actual amount of checks written for decedent's benefit does not undermine the court's finding that shecould have accessed more, it was only used to buttress the court's conclusion that decedent had such access to the funds if needed. 2

Nor did the tax court clearly err by concluding decedent's transfer was not a bona fide sale for adequate and full consideration. Although not per se inadequate, transfers to family partnerships such as this are subject to heightened scrutiny, and, to be bona fide, must objectively demonstrate a legitimate and significant nontax reason for the transfers. Bigelow, 503 F.3d at 969. Here, the type of assets transferred (marketable securities) did not require significant or active management, there was some disregard of partnership formalities, and the nontax justifications are either weak or refuted by the record (including formation of a second family partnership to hold higher-basis assets for gift-giving purposes, purportedly for the same nontax justifications that the original partnership could have already served). See, e.g., Bigelow, 503 F.3d at 970–72;Strangi , 417 F.3d at 480–82. Thus, as the tax court found, the overriding objective purpose appeared to be a mere “recycling of value” into the partnership vehicle to permit discounted gift-giving and/or reduce the ultimate estate tax owed (by reducing the stated value of the securities due to a lack of control and marketability). See Estate of Thompson v. Comm'r, 382 F.3d 367, 378–81 [94 AFTR 2d 2004-5764] (3d Cir. 2004).

Finally, there was no error in not applying the burden-shifting provision of 26 U.S.C. § 7491. When, as here, the tax court decides the case based on the preponderance of the evidence and without regard to presumptions of correctness, § 7491's burden-shifting is simply not relevant. See Whitehouse Hotel Ltd. P'ship v. Comm'r, 615 F.3d 321, 332–33 [106 AFTR 2d 2010-5759] (5th Cir. 2010);Blodgett v. Comm'r , 394 F.3d 1030, 1039 [95 AFTR 2d 2005-448] (8th Cir. 2005).

AFFIRMED.

*

This disposition is not appropriate for publication and is not precedent except as provided by Ninth Circuit Rule 36-3.

1

We acknowledge that decedent attempted to repay some of these funds upon discovery of the errors by an accountant, although it appears they were repaid to the wrong partnership. However, it was the failure to observe partnership formalities and the fact she had access to the accounts (including her name on the checks for JMA II) despite being only a limited partner that the tax court found significant in determining there was an implicit retention of economic benefits.See Bigelow , 503 F.3d at 966 (“The Tax Court's finding that partnership formalities were not observed buttresses the conclusion that there was an implied agreement.”);Estate of Reichardt v. Comm'r , 114 T.C. 144, 155 (2000) (“[Y]earend and ... post-mortem adjusting entries made by [a CPA] were a belated attempt to undo decedent's commingling of partnership and personal accounts.”).

2

The Second Circuit's opinion inStewart v. Comm'r , 617 F.3d 148 [106 AFTR 2d 2010-5710] (2d Cir. 2010), as a real estate possession case, is factually inapposite.

.

Joint Venture

2011-07-05T20:43:00.000-04:00

RIGAS v. U.S., Cite as 107 AFTR 2d 2011-XXXX, 05/02/2011

--------------------------------------------------------------------------------

JOHN A. RIGAS, and CARRIE RIGAS, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.

Case Information:

Code Sec(s):

Court Name: UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF TEXAS HOUSTON DIVISION,

Docket No.: CIVIL ACTION NO. H-09-3770,

Date Decided: 05/02/2011.

Disposition:

HEADNOTE

.

Reference(s):

OPINION

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF TEXAS HOUSTON DIVISION,

MEMORANDUM AND ORDER

Judge: KEITH P. ELLISON UNITED STATES DISTRICT JUDGE

Pending before the Court are the cross-motions for summary judgment of Plaintiffs John A. Rigas and Carrie Rigas (collectively, the “Rigases”) and Defendant United States of America (the “Government”), and Plaintiffs' Motion to Shift the Burden of Proof. Upon considering the Motions, all responses thereto, arguments of counsel, and the applicable law, the Court finds that Plaintiffs' Motion to Shift the Burden of Proof (Doc. No. 30) must be granted, Plaintiffs' Motion for Summary Judgment (Doc. No. 38) must be denied, and Defendant's Motion for Summary Judgment (Doc. No. 32) must be granted.

I. BACKGROUND

This is a tax refund case brought by the Rigases against the Government. The Rigases claim they are entitled to a refund on their 2004 personal income tax return because income that was reported and taxed as ordinary income should have been reported and taxed as capital gains. The income that is the source of the dispute are proceeds from a business relationship between Odyssey Energy Capital I, LP (“Odyssey”) and Hydrocarbon Capital LLC (“Hydrocarbon”).

Prior to 2003, John Rigas, David Stewart, R. Kelly Plato, Harold Abels, and Robert Loving worked for Mirant Corporation (“Mirant”) and managed Mirant's oil and gas investments. (Stip. of Facts ¶ 2.) In March 2003, Hydrocarbon purchased from Mirant a portfolio of interests related to the oil and gas industry, including credit agreements, royalty interests, and stock warrants. (Id. ¶ 1.) Hydrocarbon asked the five former Mirant employees to manage the portfolio of assets due to their past management experience. (Id. ¶ 2.) The five men formed Odyssey to carry out the management functions. (Id.) Each man was a limited partner in Odyssey, while Odyssey's general partner was a limited liability corporation. (Doc. 32 Ex. 7.)

Odyssey and Hydrocarbon entered into a Loan Management and Servicing Agreement (the “Management Agreement”). (Doc. 32 Ex. 5.) Under the terms of the Management Agreement, Odyssey provided servicing, management, administration and disposition services with respect to the asset portfolio, including the hiring of necessary environmental and petroleum consultants and conducting physical inspection of the assets within the portfolio. (Id. Art. V.) Odyssey agreed to maintain an office, to employ adequate personnel, to collect payments on the assets, and to track overhead expenses. (Id.) Odyssey's overhead expenses, including salaries of the individual partners of Odyssey, were funded through a $6 million nonrecourse promissory note (the “Promissory Note”) issued by Hydrocarbon to Odyssey. (Doc. No. 32 Exs. 3, 10.) On a semiannual basis, Odyssey would submit a budget for overhead expenses to Hydrocarbon for its review and approval. Once approved, Hydrocarbon would draw down sums from the promissory note and wire the loan funds to Odyssey. (Id.)

Odyssey possessed the authority to take actions with respect to the assets that were in the best interest of Hydrocarbon. (Id. Art. VII.) However, Odyssey was subject to certain limitations on its authority, including the inability to enter into binding commitments to dispose of assets, to incur unforeseen expenses, and to enter into transactions that were not previously approved by Hydrocarbon. (Id.) Odyssey acknowledged that Hydrocarbon retained title, ownership, and exclusive control of the assets and that Odyssey would not acquire title to, any security interest in, or rights of any kind in the assets. (Id. Art. II.) Finally, Article 18.1 of the Management Agreement provided,

No Partnership Intended. Nothing in this Agreement shall be deemed or construed to create a partnership or joint venture between or among any of the parties hereto nor shall [Odyssey] be deemed to be the general partner of [Hydrocarbon]. It is specifically acknowledged and agreed that, in performing its duties and obligations hereunder, [Odyssey] is acting solely in the capacity as an independent contractor for, and an agent of, [Hydrocarbon].

Under the Management Agreement, Odyssey would be paid a performance fee (the “Performance Fee”) “[a]s full compensation for rendering services.” (Doc. No. 32 Ex. 5 at 33.) The Performance Fee would be paid after disposing of income realized on the asset portfolio in the following manner. First, Hydrocarbon would recoup all third-party out-of-pocket expenses. Second, Hydrocarbon would recoup the initial value of the asset portfolio. Third, Hydrocarbon would receive a preferred return of 10% of the profits. Fourth, Hydrocarbon would use the remaining funds to pay off any amounts outstanding on the Promissory Note. Fifth and finally, Odyssey and Hydrocarbon would split the profits whereby Odyssey would take 20% of the profits and Hydrocarbon would retain 80% of the profits. (Id. at 33–34.) Odyssey's Performance Fee was subject to a “claw-back” provision that ensured Hydrocarbon would receive the amounts provided for in steps 1–4 of this calculation. (Id. at 34.)

In 2004, the capital assets in the portfolio were sold for $288,000,000. (Stip. of Facts ¶ 4.) Hydrocarbon's gain on the sale was approximately $110,000,000. (Id.) After providing for the first four steps in the Performance Fee calculation, Odyssey received approximately $20 million as its Performance Fee. (Doc. No. 32 Ex. 1 at 1.) Odyssey later paid Hydrocarbon $31,920 under the claw-back provision of the Management Agreement. (Stip. of Facts ¶ 6.)

Odyssey filed a partnership income tax return on Form 1065 for the tax year 2004 (the “Original 2004 Odyssey Return”). (Doc. No. 32 Ex. 1.) In it, Odyssey characterized the approximately $20 million it had received from Hydrocarbon as “gross profit” income. (Id. at 1.) Odyssey issued Schedules K-1 to its limited partners, including John Rigas. (Id. at 13.) The K-1 stated that Odyssey had distributed to Rigas approximately $4 million in ordinary business income. In turn, the Rigases filed a joint individual income tax return for tax year 2004 (the “Original 2004 Rigas Return”). (Doc. No. 32 Ex. 25.) In line with the K-1, the Rigases reported the approximately $4 million they received from Odyssey as ordinary income.

In April 2007, Odyssey filed an amended partnership tax return for tax year 2004 (the “Amended 2004 Odyssey Return”). (Doc. No. 32 Ex. 2.) Odyssey used the standard Form 1065 and checked the box next to “Amended Return” to indicate that it was amending its original 2004 return. In the amended return, Odyssey changed the way it characterized the $20 million it had received from Hydrocarbon. Odyssey now characterized the $20 million as “net long-term capital gain” acquired from a sale of “Hydogen Capital.” (Id. at 3, 6.) Odyssey also attached amended Schedules K-1 for its limited partners, including John Rigas. Rigas's amended K-1 listed the $4 million distribution to Rigas as “net long-term capital gain” rather than ordinary business income. (Id. at 7.) The Amended 2004 Odyssey Return was accepted and processed by the Internal Revenue Service (“IRS”). IRS records show that activity on the return occurred in September 2007, November 2007, and January 2008, but without full examination by an IRS field office. (Doc. No. 42 Exs. 1, 2, 3; Swain Aff. ¶¶ 11–14.)

Meanwhile, the Rigases also filed an amended individual tax return for tax year 2004 (the “First Amended 2004 Rigas Return”). (Doc. No. 32 Ex. 27.) The Rigases changed the characterization of the approximately $4 million received from Odyssey in 2004 from ordinary income to capital gains. As the explanation for the changes made to the return, the Rigases stated: “Taxpayers received amended K-1S from Odyssey Energy Capital I LP and from Odyssey Energy Capital LLC after their original return was filed. This amended return reflects the amended information.” (Id. at 2.) Based on the new characterization of the income as “capital gains,” the Rigases sought a refund of approximately $800,000. (Id. at 1.)

In August 2007, the IRS sent the Rigases a request for more information, including a “completed Form 1040X to support the changes you have made” and a “completed copy of Part II, page 2, Form 1040X. We need to know what items of income, deductions, or credits you changed, the amount of each change, and the reasons for the changes. Attach supporting forms and/or schedules to the amended return.” (Doc. No. 32 Ex. 47 at 1.) Specifically, the IRS noted that the amended K-1 did not explain the tax decrease or the increase to adjusted gross income and taxable income. (Id.) The Rigases' accountant responded by mailing the IRS the Original 2004 Odyssey Return, the Amended 2004 Odyssey Return, the original and amended Forms K-1, the Original 2004 Rigas Return, and the First Amended 2004 Rigas Return. (Doc. No. 32 Ex. 48.) The accountant explained in his letter that the “long-term capital gains” changed from a loss of $3,000 to a gain of $4,448,657, and that passive income and loss had changed from income of $4,222,999 to a gain of $3,394. (Id.)

In December 2007, the IRS disallowed the Rigases' refund claim. (Doc. No. 42 Ex. 13.) However, the IRS accepted the amended individual tax returns of two of Odyssey's other limited partners, which had been filed based on the Amended 2004 Odyssey Return, and issued refunds to them in February and May 2008. (Doc. No. 42 Ex. 5 ¶¶ 14–15.)

The Rigases subsequently filed another amended individual tax return in January 2008 (the “Second Amended 2004 Rigas Return”). (Doc. No. 32 Ex. 28.) The case was assigned to an IRS examining officer named Michael Glass. (Doc. No. 42 Ex. 20; Ex. 11 at 18) Glass contacted the Rigases and spoke with the Rigases' accountant over the course of 2008 and early 2009 about the return. Glass understood the main issue to be whether the income received by Odyssey from Hydrocarbon should be considered capital gains or ordinary income, which, in turn, depended on the nature of the portfolio assets and Odyssey's relationship with Hydrocarbon. (Id. at 2.) In addition, Glass researched whether Odyssey possessed a “carried interest” in the asset portfolio. (Id.) The Rigases' accountant met with Bridges, provided Bridges with the agreements between Odyssey and Hydrocarbon, and provided Bridges with information regarding the assets in the portfolio. (Id. at 1–2.) In July 2009, Glass transferred the Rigases' case to another IRS agent named Michael Bridges. (Doc. No. 42 Ex. 11 at 15.) While the IRS considered the Rigases' refund claim, the Rigases also filed a Notice of Inconsistent Treatment or Administrative Adjustment Request (“AAR”) on Form 8082. (Doc. No. 42 Ex. 21.) The IRS eventually concluded that Odyssey's 20% profits interest was compensation for services and, therefore, the income received by Rigas should be characterized as ordinary income. (Doc. No. 42 Ex. 24 at 12–13.). The IRS disallowed the Rigases' refund claim for the second time in December 2009. (Doc. No. 42 Ex. 25.) The Form 8082 submitted by the Rigases was rejected because it had not been filed within three years after the Original 2004 Odyssey Return had been filed.

The Rigases subsequently filed suit against the Government for a tax refund pursuant to 26 U.S.C. §§ 6228(b), 7422. The Rigases have moved to shift the burden of proof to the Government and for summary judgment. The Government has moved for summary judgment. Oral argument was held on February 11, 2011. The motions have been briefed and are ripe for disposition.

II. MOTION TO SHIFT BURDEN OF PROOF

The Rigases have moved to shift the burden of proof to the Government on the basis of IRC § 7491 and the IRS's allegedly baseless and arbitrary decision to deny the Rigases' request for a tax refund. 1 Because we find that application of IRC § 7491 supports shifting the burden to the Government, we need not determine whether the IRS's notice of disallowance was arbitrary and baseless.

IRC § 7491 provides for a shifting of the burden of proof to the Government where the taxpayer provides “credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by” the Code. IRC § 7491(a). The burden will shift only if the taxpayer meets three requirements:

((A)) the taxpayer has complied with the requirements under this title to substantiate any item;

((B)) the taxpayer has maintained all records required under this title and has cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews; and

((C)) in the case of a partnership, corporation, or trust, the taxpayer is described in section 7430(c)(4)(A)(ii) [ 26 USCS § 7430(c)(4)(A)(ii)].

IRC §§ 7491(a)(1)(A)–(C). Subsection (C) does not apply here since the Rigases are not a partnership, corporation, or trust.

We first examine whether the Rigases have submitted credible evidence. “Credible evidence” is the “quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness).” Higbee v. Comm'r, 116 T.C. 438, 442 (T.C. 2001) (quoting H. Conf. Rept. 105-599, at 240–41 (1998), 1998-3 C.B. 747, 994–95). The issue presented here is whether the Rigases are entitled to claim as capital gains the distribution that Odyssey received from Hydrocarbon in 2004. This determination turns on whether Odyssey and Hydrocarbon were in a partnership, under federal tax law, or were simply in a servicing relationship. To support the claim for capital gains treatment, the Rigases submitted Odyssey's original and amended returns, the Rigases' original and amended returns, and the original and amended Forms K-1. To support the existence of a partnership between Odyssey and Hydrocarbon, the Rigases submitted the Management Agreement, the Promissory Note, and deposition testimony of several Odyssey partners. This evidence provides sufficient information about the Odyssey relationship in order to determine whether the relationship between Odyssey and Hydrocarbon was a partnership. Therefore, we find that the Rigases have provided credible evidence with respect to a factual issue—here, the existence of a partnership—that is relevant to ascertaining whether the Rigases are liable for ordinary income tax or capital gains tax.

We also find that the Rigases have complied with the substantiation requirements of the Code. They have retained the relevant tax returns for themselves and for Odyssey, the relevant Forms K-1, the relevant correspondence with the IRS, underlying documentation of the assets held by Hydrocarbon, and the relevant agreements between Hydrocarbon and Odyssey.

Finally, we find that the Rigases have cooperated with the IRS's requests for witnesses, information, documents, meetings and interviews. The Rigases' accountant, Jeffrey Wilkinson, spoke frequently with IRS agent Bridges about the Rigases' tax returns. Wilkinson met with Bridges at Bridges' request to discuss the amendment to the Rigases' tax return. Wilkinson provided Bridges with copies of the relevant agreements between Hydrocarbon and Odyssey and informed him of the Rigases' bases for characterizing their income from Hydrocarbon as capital gains. Though the Government argues that the Rigases' were less than forthcoming in response to the IRS's August 2007 letter, we find that the Rigases' provided sufficient information at that time considering the cursory nature of the IRS's request.

In sum, we find that the Rigases have met their burden under § 7491 to shift the burden of proof to the Government. As a result, the Government will be required to prove by a preponderance of the evidence that the Rigases are not entitled to a tax refund. See United States v. Janis, 428 U.S. 433, 440 [38 AFTR 2d 76-5378] (1976) (in a conventional refund action, “the taxpayer bears the burden of proving the amount he is entitled to recover.”)

III. SUMMARY JUDGMENT LEGAL STANDARD

A motion for summary judgment under Federal Rule of Civil Procedure 56 requires the Court to determine whether the moving party is entitled to judgment as a matter of law based on the evidence thus far presented. Fed. R. Civ. P. 56(c). Summary judgment is proper “if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law.” Kee v. City of Rowlett, 247 F.3d 206, 210 (5th Cir. 2001) (quotations omitted). A genuine issue of material fact exists if a reasonable jury could enter a verdict for the non-moving party. Crawford v. Formosa Plastics Corp., 234 F.3d 899, 902 (5th Cir. 2000). The Court views all evidence in the light most favorable to the non-moving party and draws all reasonable inferences in that party's favor.Id. Hearsay, conclusory allegations, unsubstantiated assertions, and unsupported speculation are not competent summary judgment evidence. F.R.C.P. 56(e)(1); See, e.g.,Eason v. Thaler , 73 F.3d 1322, 1325 (5th Cir. 1996),McIntosh v. Partridge , 540 F.3d 315, 322 (5th Cir. 2008); see also Little v. Liquid Air Corp., 37 F.3d 1069, 1975 (5th Cir. 1994) (noting that a non-movant's burden is “not satisfied with “some metaphysical doubt as to the material facts.”” (citing Matsushita Elec. Indus. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 586 (1986)).

IV. ANALYSIS

A. Jurisdiction Under TEFRA

The Government seeks summary judgment on the ground that the Rigases' individual amended tax return conflicts with the Odyssey tax return, which, according the Government, remains unadjusted. As a result, the Odyssey tax return still shows the income received from Hydrocarbon as ordinary income rather than capital gains. In the face of the partnership-level characterization of the income as ordinary, the Rigases cannot characterize the income on their partner-level return as anything other than ordinary.

The Rigases make several arguments that TEFRA forecloses differential treatment among the Odyssey individual partners and between Odyssey and themselves. The Rigases contend that the IRS adjusted the Performance Fee, changing its characterization from ordinary income to capital gains, when it processed the Amended 2004 Odyssey Return. As such, the Rigases believe that TEFRA prevents the IRS from doing anything other than issuing refunds to the individual partners. As an alternative, the Rigases believe that they have instituted proper proceedings in order to obtain an adjustment of the Performance Fee.

We note that, under TEFRA, our jurisdiction to hear refund claims is exceedingly narrow. We begin by describing the relevant provisions of TEFRA and then determine whether they operate to allow jurisdiction in this case.

1. TEFRA

For tax purposes, partnerships are considered pass-through entities that file informational returns, but do not pay federal income tax. 26 U.S.C. § 6031. Partnerships issue Schedules K-1 to individual partners, who report all income, gain, losses, deductions, taxes, and penalties corresponding to their share in the partnership on their personal income tax returns.Id. §§ 701–704.

Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), 26 U.S.C. §§ 6221–6233, to avoid duplicative litigation stemming from the tax treatment of partnerships. TEFRA creates a unified procedure for determining the treatment of partnership transactions by requiring that “the tax treatment of any partnership item shall be determined at the partnership level” rather than separately at the partner level. 26 U.S.C. § 6221; see also In re Crowell, 305 F.3d 474, 478 [90 AFTR 2d 2002-6374] (6th Cir. 2002).

A partnership item is defined 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 [Subtitle F], such item is more appropriately determined at the partnership level than at the partner level.” 26 U.S.C. § 6231(a)(3). The regulations provide that items “more appropriately determined at the partnership level” include the gains, losses, deductions, and credits of a partnership. 26 C.F.R. § 301.6231(a)(3)-1. The term “partnership item” also “includes the accounting practices and the legal and factual determines that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.” 26 C.F.R. § 301.6231(a)(3)-1(b).

TEFRA provides two ways to adjust a partnership item. First, the IRS may initiate administrative “partnership proceedings,” which result in the issuance of a Final Partnership Administrative Adjustment (“FPAA”). 26 U.S.C. §§ 6223, 6225. Second, the taxpayer may request adjustment of a partnership item by filing an administrative adjustment request (“AAR”). The AAR may be filed by either an individual partner or by a partnership. 26 U.S.C. §§ 6227(a), (c). Both an AAR filed by a partner and an AAR filed by a partnership must be submitted within three years after the partnership return for the year that is the subject of the AAR that has been filed. Id. § 6227(a)(1)(A).

If an individual partner files an AAR, the IRS may do one of the following: (1) process the AAR in the same manner as a claim for credit or refund with respect to items which are not partnership items; (2) assess any additional tax that would result from the requested adjustments; (3) mail to the partner a notice that all partnership items of the partner for such tax year shall be treated as nonpartnership items; or (4) conduct a partnership proceeding. Id. § 6227(d).

If a partnership, through its tax matters partner (“TMP”), files an AAR, the IRS may treat the AAR as a substituted return in which only clerical or mathematical errors have been corrected. Id. § 6227(c)(1). If the IRS decides not to treat the AAR as a substituted return, it may do one of the following: (1) without conducting a proceeding, allow or make to all partners the credits or refunds arising from the requested adjustments; (2) conduct a partnership proceeding; or (3) take no action. Id. § 6227(c)(2).

Section 6228 allows partnerships and partners that have filed AARs to seek further review if the IRS fails to allow part or all of the AAR. Importantly, the statute distinguishes between the type of review that may be sought. In the case of a partnership-filed AAR, the TMP may file “a petition for an adjustment” if the IRS fails to allow any part of the AAR. 26 U.S.C. § 6228(a). 2 In the case of an AAR filed by an individual partner, the partner may “begin a civil action for refund of any amount due by reason of the adjustments described” in the disallowed AAR. Id. § 6228(b)(2)(A)(i). 3 Once the partner files the civil action, the partnership items listed on the disallowed AAR “shall be treated as nonpartnership items for purposes of [TEFRA].” Id. § 6228(b)(2)(A)(ii);see also 26 U.S.C. § 6231(b)(1)(B). A partner who wishes to file a civil action under § 6228(b) must do so no sooner than 6 months after the filing of the AAR and no later than two years after the AAR's filing. 26 U.S.C. § 6228(b)(2)(B)(i).

Both parties miss the central issue here. Under TEFRA, the Performance Fee and its characterization as ordinary income or capital gains are partnership items. District courts do not have jurisdiction to hear refund claims relating to partnership items unless one of two exceptions applies. See 26 U.S.C. § 7422(h) (“No action may be brought for a refund attributable to partnership items (as defined in section 6231(a)(3)) except as provided in section 6228(b) or section 6230(c).”). Under the exception that would be applicable here, civil actions brought under 26 U.S.C. § 6228(b), partnerships items are converted into nonpartnership items. Thus, if the Rigases properly filed under § 6228(b), the Performance Fee and its tax treatment can be addressed at the partner-level without regard to how the income is treated at the partnership-level. In other words, once the Performance Fee is considered a nonpartnership item, it is no longer subject to TEFRA's requirement that the tax treatment of partnership items be determined at the partnership level. See Wall v. United States, 133 F.3d 1188 [81 AFTR 2d 98-459] (9th Cir. 1998) (once partnership items are converted into nonpartnership items, the TEFRA provisions requiring consistent treatment of partnership items no longer apply). Thus, the relevant question is whether the Rigases fall within the § 6228(b) exception. We view the arguments relating to the alleged adjustment of the Amended 2004 Odyssey Return and whether the Rigases must be treated consistently with the treatment accorded to the partnership as beside the point. It is irrelevant whether the Amended 2004 Odyssey Return triggered a partnership-level proceeding or adjusted the treatment of the Performance Fee because, once the Rigases fall within the § 6228(b) exception, they may receive different treatment, as partners, than the treatment received by Odyssey, as a partnership.

The Rigases also argue that their suit is not solely an action for a refund of a partnership item, and therefore is not subject to § 7422(h). The Rigases contend that their action is also a refund based on a claim for TEFRA consistent treatment/settlement, which is an nonpartnership item. The problem with the Rigases' argument is that the IRS never entered into a settlement agreement with any partners after the initiation of a partnership proceeding. See 26 U.S.C. §§ 6224(b), (c). In fact, the IRS never initiated partnership proceedings upon receipt of either Odyssey's Amended 2004 Return, the Rigases' First Amended 2004 Return, or the Rigases' Second Amended 2004 Return. At most, the IRS treated the Odyssey 2004 Amended Tax Return as a substituted return,see id. § 6227(c)(1), or took no action on the return. Id. § 6227(c)(2). In neither case did the IRS come to a settlement with some partners, and not others, whereby the Rigases would be able to bring an action for consistent treatment with the settling partners. See Monti v. United States, 223 F.3d 76, 77 [86 AFTR 2d 2000-5713] (2d Cir. 2000) (holding that refund action based on IRS's failure to offer consistent settlement terms to nonsettling partners of a partnership is not attributable to a “partnership item” for purposes of TEFRA). Without a TEFRA settlement in place, the Rigases cannot base their refund claim simply upon an argument for consistent treatment with the other Odyssey individual partners who received a return. The IRS is not bound to accept or allow an individual taxpayer's 1040X refund claim merely because similar refund claims by other taxpayers, or by plaintiff himself, were allowed. See Dixon v. United States, 381 U.S. 68, 73 [15 AFTR 2d 842] (1965) (“Commissioner's acquiescence in an erroneous decision ... cannot in and of itself, bar the United States from collecting a tax otherwise lawfully due.”);Knetsch v. United States , 348 F.2d 932, 940 [16 AFTR 2d 5213] (Ct. Cl. 1965) (taxpayers not entitled to rely on tax treatment (private rulings) applicable to other taxpayer(s)); Carpenter v. United States, 7 Cl. Ct. 732, 740 [55 AFTR 2d 85-1585] (Ct. Cl. 1985) (IRS not bound to give one taxpayer a treatment consistent with that of another similarly situated taxpayer).

Therefore, we find that the only way the Rigases can proceed with their claim in this Court is to fall within the § 6228(b) exception. Accordingly, we examine whether either the Rigases' Form 8082 or the Rigases' Second Amended 2004 Tax Return qualifies as an AAR.

2. The Rigases' Form 8082

Under Treasury Regulation 301.6227(d)-1(a), the IRS is authorized to designate a particular form to be used when a taxpayer files an AAR. See 26 C.F.R. § 301.6227(d)-1(a). The IRS has designated IRS Form 8802 Notice of Inconsistent Treatment or Administrative Adjustment Request.See Samueli v. Comm'r , 132 T.C. 336, 341–42 (2009). The uncontroverted facts show that the Rigases filed an AAR on Form 8082, though the form signed by the Rigases does not disclose when it was signed or when it was submitted to the IRS. The Government asserts in its brief that the Rigases' Form 8082 was filed approximately one month before the Rigases filed suit in this Court on November 20, 2009. The Government refers to Government Exhibit 30 as evidence for this assertion, but has not attached the exhibit to its filing. The Rigases, however, have not contested this assertion and have accepted its truthfulness in their own brief. (Doc. No. 42 at 26.) Section 6228(b) requires a partner to wait at least six months after filing the AAR to bring a civil action. Since the Form 8082 was filed only two months prior to the filing of suit, it is clear that the Form 8082 cannot serve as the basis for proceeding under § 6228(b). Therefore, we disregard the Rigases' Form 8082 to the extent that it serves as the jurisdictional basis for this lawsuit. 4

3. The Rigases' Second Amended 2004 Tax Return

Alternatively, the Rigases argue that their amended 2004 tax returns on Form 1040X qualify as partner AARs under the doctrine of substantial compliance. The Government contends that the substantial compliance doctrine does not apply here, and even if it did, the Rigases' amended tax returns do not substantially comply with the relevant statutory requirements.

The Fifth Circuit has recognized the doctrine of substantial compliance in certain circumstances. “Although regulatory requirements that relate to the substance or essence of a statutory provision of the Internal Revenue Code must be strictly complied with, a line of cases from the United States Tax Court has established that “substantial compliance with regulatory requirements may suffice when such requirements are procedural and when the essential statutory purposes have been fulfilled.”” Young v. Comm'r, 783 F.2d 1201, 1205 [57 AFTR 2d 86-911] (5th Cir. 1986) (quoting American Air Filter v. Comm'r, 81 T.C. 709, 719 (1983)). The Ninth Circuit and the Tax Court have held that substantial compliance doctrine can be used to allow an amended individual tax return unaccompanied by a Form 8082 to qualify as a partner AAR. See Wall v. United States, 133 F.3d 1188, 1189 [81 AFTR 2d 98-459] (9th Cir. Cal. 1998);Samueli v. Comm'r , 132 T.C. 336, 343 (T.C. 2009);but see Rothstein v. United States , 81 AFTR 2d 2132, 98-1 USTC par. 50,435 (Fed. Cl. 1998) (rejecting argument that amended tax return qualifies as partner AAR when unaccompanied by Form 8082 because language of Treasury Regulation requiring use of particular form to file AAR is one of “strict compliance”).

We also find that the doctrine of substantial compliance applies to the relevant Treasury Regulation to excuse certain deviations by a taxpayer when filing an AAR. The Treasury Regulation outlining the requirements of a valid AAR states:

(a) In general. A request for an administrative adjustment on behalf of a partner shall be filed on the form prescribed by the Internal Revenue Service for that purpose in accordance with that form's instructions. Except as otherwise provided in that form's instructions, the request shall -

((1)) Be filed in duplicate, the original copy filed with the partner's amended income tax return (on which the partner computes the amount by which the partner's tax liability should be adjusted if the request is granted) and the other copy filed with the service center where the partnership return is filed (but, if the notice described in section 6223(a)(1) (beginning of an administrative proceeding) has already been mailed to the tax matters partner, the statement should be filed with the Internal Revenue Service office that mailed such notice);

((2)) Identify the partner and the partnership by name, address, and taxpayer identification number;

((3)) Specify the partnership taxable year to which the administrative adjustment request applies;

((4)) Relate only to partnership items; and

((5)) Relate only to one partnership and one partnership taxable year.

26 C.F.R. § 301.6227(d)-1. The regulation envisions the AAR as a way to provide substantive information to the IRS regarding the requested adjustments, and provides the use of a particular form to do so as a procedural mechanism for facilitating the delivery of this information. Moreover the IRS does not treat Form 8802 as a mandatory prerequisite to initiate an AAR. See Prussner v. United States, 896 F.2d 218, 224–25 [65 AFTR 2d 90-1222] (7th Cir. 1990) (substantial compliance covers situations where “the taxpayer had a good excuse (though not a legal justification) for failing to comply with eitheran unimportant requirement or one unclearly or confusingly stated in the regulations or the statute.” (emphasis added)). In correspondence written by a TEFRA technical advisor at the IRS, he states “[i]f the partner does not attach a Form 8082 to his or her Form 1040X, but provides substantially the same information, Counsel usually has us treat it as an informal AAR.” (Doc. No. 42 Ex. 11 at 19.) Another email from a different TEFRA technical advisor refers to the Rigases' failure to file a Form 8082 with their amended return as a “procedural ground to disallow the claim.” (Id. at 14.) From these exchanges we can glean that the IRS's practical view on Form 8082 is that it a procedural, rather than a substantive, requirement.

The Government cites several cases in support of its argument that Treasury Regulation § 301.6227(d)-1's requirement of a specific form imposes a substantive requirement that cannot be waived through the doctrine of substantial compliance. However, all of the cases cited relate to administrative exhaustion under 26 U.S.C. § 7422(a), which requires a taxpayer to file a refund claim with the IRS prior to filing a refund suit in court. Moreover, in one of the cases cited, the Seventh Circuit recognizes that, “while the Treasury may not waive the congressionally mandated requirement that a claim be filed, the Treasury can waive its own formal requirements.”Kikalos v. United States , 479 F.3d 522, 525 [99 AFTR 2d 2007-1615] (7th Cir. Ind. 2007). We interpret Treasury Regulation § 301.6227(d)-1 as imposing the substantive requirement that certain information be filed with the IRS in order to initiate an AAR, but that Form 8802 is a formal requirement that can and has been waived on occasion by the IRS. We join the Ninth Circuit and the Tax Court in finding that a taxpayer's failure to file a Form 8082 along with his amended tax return can be excused under the substantial compliance doctrine.

We turn next to the question of what a taxpayer must do in order to substantially comply with the regulation. The Fifth Circuit has held that “substantial compliance is achieved where the regulatory requirement at issue is unclear and a reasonable taxpayer acting in good faith and exercising due diligence nevertheless fails to meet it.” Estate of McAlpine v. Comm'r, 968 F.2d 459, 462 [70 AFTR 2d 92-6216] (5th Cir. 1992) (citingPrussner , 896 F.2d at 224–25).

The Second Amended 2004 Rigas Return complies with the Treasury Regulation by identifying the individual partner (John Rigas), the partnership (Odyssey), their addresses, and their taxpayer identification numbers. 5 In addition, the return relates to one partnership taxable year and identifies that year as 2004. Finally, the return provides the following explanation of the changes to income, deduction, and credits being made:

Taxpayers received Amended K-1s from Odyssey Energy Capital I LP and from Odyssey Energy Capital LLC after their original return was filed. This amended return reflects the amended information. All documentation to support the calculations is enclosed. The information includes the amended K-1s and the effected forms and schedules which include Form 1040 pages 1 and 2, Forms 4797, 6251, and 8582 and Schedules D, E and SE.

(Doc. No. 32 Ex. 28 at 7.)

However, the Second Amended 2004 Rigas Return departs from the Treasury Regulation in the following ways. First, the Second Amended 2004 Rigas Return related to more than one partnership. Second, the Second Amended 2004 Rigas Return includes amendments not only to partnership items (i.e. the income received from Hydrocarbon via Odyssey), but also amendments to non-partnership items such as credits. (Doc. No. 32 Ex. 28 at 1;compare Doc. No. 32 Ex. 28 at 18, l. 54with Doc. No. 32 Ex. 25 at 2, l. 54.) Finally, the Second Amended Rigas Return was not filed in Odgen, Utah, where counsel for the parties represented that the Amended 2004 Odyssey Return had been filed.

Despite these deficiencies, we find that the Second Amended 2004 Rigas Return substantially complied with requirements of an AAR imposed by Treasury Regulation § 301.6227(d)-1. Although the Second Amended 2004 Rigas Return departed in certain ways from the regulatory requirements, it provided the key information needed by the IRS to realize that the Rigases were requesting an adjustment of a partnership item. It provided information about Odyssey, the tax year to be adjusted, and the partnership item to be adjusted. The inclusion of a request for adjustment relating to another partnership was clearly described in the document so that the IRS would understand that two different partnership K-1s were at issue. Finally, the Rigases intended to adjust a partnership item by filing the Second Amended 2004 Rigas Return, after several attempts to obtain an adjustment and filing what they believed was the necessary paperwork to do so. (Rigas Dep. 27:21–28:6; Wilkinson Dep. 56:14–18, 59:25–60:18, 60:19–23.) In sum, we find that the Second Amended 2004 Rigas Return qualifies as an AAR under the doctrine of substantial compliance. As such, the Rigases' may bring a claim for a tax refund under § 7422 because their claim falls within the § 6228(b) exception of § 7422(h).

B. Partnership Relationship Between Odyssey and Hydrocarbon

Both parties have moved for summary judgment on the partnership relationship between Odyssey and Hydrocarbon. The Rigases argue that Odyssey and Hydrocarbon were engaged in a joint venture or partnership, 6 while the Government argues that they were engaged merely in a service relationship. As an initial matter, there do not appear to be any genuine issues of material fact to be resolved. Both parties have submitted tax documents, deposition testimony, and IRS materials. Neither party has contested factual assertions made in these documents. The parties' dispute ultimately centers on whether, drawing upon the facts presented, a partnership existed between Odyssey and Hydrocarbon. Since no facts are in dispute, we can resolve this issue at the summary judgment stage.

To determine whether a partnership exists for purposes of federal tax law, courts look to federal law. See 26 U.S.C. §§ 761(a), 7701(a)(2). 7 Partners may contribute capital, services, or both to a partnership.Culbertson , 337 U.S. 733, 740 [37 AFTR 1391] (1949). To determine whether a partnership exists, a court must engage in a factual inquiry as to whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” 8Culbertson , 337 U.S. at 742; see also Spector v. Commissioner, 641 F.2d 376, 381 [47 AFTR 2d 81-1248] (5th Cir. 1981). Several courts have emphasized that the focus in the partnership inquiry is upon the intent of the parties, not upon the form of the venture. See, e.g., Estate of Smith v. Comm'r, 313 F.3d 724, 730 (8th Cir. 1963); Wheeler v. Comm'r, 37 T.C.M. (CCF) 883 (T.C. 1978) [“[T]he single most important consideration is the parties' intent to enter into a joint venture.”). In determining intent, a court looks at the following factors, none of which is conclusive:

The agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties' control over income and capital and the right of each to make withdrawals; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.

Luna v. Comm'r, 42 T.C. 1067, 1078 (T.C. 1964). We review these factors below.

1. Agreement of the Parties

Several courts have recognized that, despite the existence of an agreement that specifically disclaims a joint venture or partnership, the underlying nature of the relationship between the parties can give rise to the creation of a partnership.See Hirsch v. Comm'r , T.C. Memo 1983-371 [¶83,371 PH Memo TC], 22 (T.C. 1983); Jensen v. Comm'r, T.C. Memo 1980-335 [¶80,335 PH Memo TC], 10 (T.C. 1980). As the Fifth Circuit stated in Haley v. Comm'r, 203 F.3d 815 (5th Cir. 1953), “even though it was expressly stated that the parties did not intend to enter into a joint venture or partnership, if the agreements and the conduct of the parties thereunder plainly show the existence of such relationship, and the intent to enter into it, it will nevertheless be held to exist for tax purposes.”Id. at 818. Consistent with this principle, courts have held both that partnerships have existed despite written agreements disclaiming partnership or venture relationship,see Jensen , T.C. Memo 1983-371 [¶83,371 PH Memo TC], Hirsch , T.C. Memo 1983-371 [¶83,371 PH Memo TC], and that partnerships have not existed when the conduct of the parties was consistent with the employment relationship set forth in the written agreement. See Kessler v. Comm'r, T.C. Memo 1982-432 [¶82,432 PH Memo TC] (T.C. 1982);Luna , 42 T.C. 1067.

Here the Management Agreement explicitly disclaimed the existence of a partnership relationship between Odyssey and Hydrocarbon. Moreover, the Management Agreement expressly characterized Odyssey as an independent contractor and the Performance Fee as compensation for services rendered. Since no one from Hydrocarbon has provided affidavits or testimony regarding Hydrocarbon's intent, we must assume that the Management Agreement is reflective of their true intent.See Kessler , T.C. Memo 1982-432 [¶82,432 PH Memo TC]. Indeed, an email from David Roberts, an Odyssey limited partner, references Hydrocarbon's desire to avoid partnership with Odyssey.

Odyssey argues that, despite the text of the Management Agreement, its intent to form a partnership is evidenced in a number of ways. First, Roberts' email describes Odyssey's willingness to invest $500,000 in the asset portfolio in order to take advantage of capital gains treatment on its 20% interest, thereby documenting Odyssey's intent to form a partnership. (Stewart Dep. 86:18–23.) Second, Odyssey executed the Promissory Note, whereby it would pay all the overhead expenses of the venture. (Stewart Dep. 94:24–95:5.) Finally, Rigas and Stewart both testified to their intent form a partnership with Hydrocarbon. Rigas stated, “I don't think we, specifically, went around discussing whether we were in a partnership with Hydrocarbon or not. We knew what our arrangement with Hydrocarbon was. So, I don't know if I recall say, “Hey, you know, this is our partnership with Hydrocarbon” ... No we understood that we were in a—you know, in a partnership with respect to how we dealt with the assets and the things that we were managing with the folks at Hydrocarbon.” (Rigas Dep. 23:5–18.) Stewart testified that Odyssey's “intent was to essentially work in a partnership” with Hydrocarbon managing the assets. (Stewart Dep. 24:4–5.) Hydrocarbon did not become a partner in Odyssey because the Hydrocarbon's asset purchase from Mirant was so rushed as to leave little time to negotiate the agreements between Hydrocarbon and Odyssey. (Stewart Dep. 26:9–24.)

The text of the Management Agreement is unambiguous with respect to the relationship that was formally created between the parties. However, since the conduct of the parties may establish that the parties were actually engaged in a partnership, we will not treat the Management Agreement's language as dispositive of the partnership relationship.

2. Contributions of the Parties to the Venture

Odyssey argues that it made contributions to the venture in the form of capital and services. With respect to capital contributions, Odyssey first contends that it contributed funds for overhead expenses through its draw downs on the Promissory Note. (Stewart Dep. 46:10–12.) Second, Odyssey purchased a working interest in an ExxonMobil lease for $130,000. (Stewart Dep. 45:1–7.) The $130,000 came from funds that Odyssey obtained from the Promissory Note. (Stewart Dep. 45:13–16.) We find that these types of transactions were contributions to capital made by Odyssey. Although both sets of transactions were initially funded by Hydrocarbon through the Promissory Note, Odyssey later bore the cost of these transactions. According to the method by which the Performance Fee was calculated, Hydrocarbon would have to receive full payment of the loans expended under the Promissory Note before Odyssey would receive a Performance Fee. In other words, Odyssey's Performance Fee was reduced by the amount needed to pay off the Promissory Note. If Odyssey had not been required to pay off the Promissory Note, its Performance Fee would have been greater. We thus characterize these reductions of Odyssey's Promissory Note as capital contributions, where the contribution is deferred until the liquidation of the partnership.

Third, Odyssey used its own funds to buy furniture and fixtures for the office. (Stewart Dep. 46:13–20.) These start-up costs were not paid for through the Promissory Note and were not reimbursed by Hydrocarbon. (Stewart Dep. 46:18–20.) Thus, they are capital contributions made by Odyssey to the venture.

With respect to contributions in the form of services, it is clear that Odyssey possessed the “know-how” or expertise needed to manage the assets. Plato testified that all of the entities interested in purchasing the asset portfolio from Mirant were interested in keeping on the Odyssey limited partners to manage the assets due to the bidders' lack of experience doing so. (Plato Dep. 12:18–21.) Stewart testified that Odyssey provided advice to Hydrocarbon in investing an additional $75 million into the asset portfolio after it was purchased from Mirant. (Stewart Dep. 27:15–25.) Because Hydrocarbon had no experience in managing oil and gas investments, Hydrocarbon relied on Odyssey's evaluation, judgment and experience to ensure that the $75 million was invested appropriately. (Id.) Such contributions of “know-how” or expertise have been characterized as contributions by a partner, as opposed to an employee. See Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] at 13; Wheeler, T.C. Memo at 1978-208 at 12.

In addition, the Odyssey partners took an approximately 50% pay cut from the industry-standard salaries and bonus packages that they would have received if they worked as employees doing investment management. (Stewart Dep. 46:20–47:4, 48:21.) We do not view these as capital contributions, but believe that they are more appropriately characterized as contributions in the form of services.

In sum, we find that Odyssey contributed both capital and services to the relationship with Hydrocarbon.

3. Interest in Profits and Losses

Another key issue is the extent to which the parties share the profits and loss of the venture. Culbertson relied in large part upon the test set forth in Commissioner v. Tower, 327 U.S. 280 [34 AFTR 799] (1946), which held that a partnership is determined by resolving “whether the partners really and truly intended to join together for the purpose of carrying on businessand sharing in the profits or losses or both .”Id. at 287 (emphasis added.) Culbertson adopted Tower's focus on the intent of the parties to join together in carrying out a business, but did not adoptTower 's additional requirement that parties share in the partnership's profits, losses, or both. However, several courts have continued to emphasize the significance of the parties' sharing of profits or losses, and the particular form that takes, within the overall factual inquiry into intent.

With respect to sharing of profits, courts are split on whether this signals a partnership or whether it is merely a way in which compensation for services is measured. InPodell v. Comm'r , 55 T.C. 429 (T.C. 1970), the court found a partnership in a real estate development venture where the parties agreed to split the profits and losses of the venture. See also Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC]. In contrast, in Kessler v. Comm'r, T.C. Memo 1982-432 [¶82,432 PH Memo TC] (T.C. 1982), the court did not find a partnership in a real estate deal where an individual agreed to be paid 15% of profits in exchange for his management services. The court believed the 15% fee to be “contingent compensation” that was similar to “typical employment or independent contractor relationships which are relatively common among lawyers and brokers. Under such circumstances, merely providing for compensation to be measured by reference to profits to be derived from the sale of property does not convert the relationship to a partnership for Federal Tax purposes.” Id. at 20. However, the court also noted that the 15% of profits that Kessler received was in lieu of any other compensation for the services rendered, suggesting that the 15% was the compensation for his services.Id. at 21; but see Revenue Ruling 54-84 (finding partnership in oil and gas investment venture where one party received no compensation except its share of profits). Here Odyssey received a 20% share of the profits generated by the asset portfolio. If the asset portfolio performed well, the 20% share would be the only compensation Odyssey received for its services, because the salaries Odyssey had previously received under the Promissory Note would have been first paid back to Hydrocarbon. However, if the asset portfolio performed poorly, the only compensation to Odyssey would have been the salaries paid out under the Promissory Note. In either case, Odyssey would receive only one form of compensation for its services. This arrangement distinguishes the case presented from the cases in which partners who contribute “know how” or “expertise” receive a stipend or salary for their services in addition to the profit interest. See Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] at 5–6; Wheeler, T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 4.

More dispositive of a partnership relationship is the presence of loss sharing among the partners. In Estate of Smith, the Eighth Circuit addressed a situation where an investment firm that contended it was partners with individual investors possessing trading accounts at the firm. The firm split the profits of trading accounts with the individual investors. However, only under unusual circumstances, would the firm be required to cover losses to the trading accounts. Rather, the individual investors would be liable to the extent of their investment to cover losses. The Eighth Circuit found that “such limited assumption of liability would not conclusively establish a partnership or negative the existence of an employment contract.” 313 F.3d at 732. Several other courts have also found that, where one party bears all of the loss in a relationship, no partnership exists. See Duley, T.C. Memo 1981-426 [¶81,426 PH Memo TC] at 32 (no partnership was formed where one individual put up all the capital and agreed to split profits with the other, but the latter did not share losses);Kessler , T.C. Memo 1982-432 [¶82,432 PH Memo TC] at 21 (property manager paid via profits interest but not required to share in losses resulting from the property); Luna, 42 T.C. at 1078 (insurance salesman's compensation was measured in relationship to profits, but he did not share losses on insurance policies).

Yet a few courts have found partnerships where losses were not shared by all the partners. In both Jensen andWheeler , one partner put up the money to purchase properties, while the other partner carried out management and development duties on the properties in exchange for a percentage of the profits realized on the properties. The courts in these cases clearly recognized that the partner with management and development duties did not bear any losses if the venture did not succeed. However, in both cases, the courts found that a partnership had been created. Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] at 12; Wheeler, T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 25–27.

Odyssey claims here that it shared losses with Hydrocarbon in two major ways. First, Odyssey argues that, if the venture did not make any profits, it would be required to pay back the salaries and overhead expenses obtained via the Promissory Note or, if Hydrocarbon cancelled the amount owing on the Promissory Note, Odyssey would bear tax liability for discharge of indebtedness income. 9 The Government argues that the Promissory Note was nonrecourse as to Odyssey and its limited partners in the event that the revenue from the assets could not cover repayment of the Promissory Note.

The Promissory Note created a nonrecourse obligation that Odyssey was not required to repay to Hydrocarbon if the asset portfolio proved unprofitable. The Promissory Note states in clear terms that repayment was limited to “the amount and right to receive the Performance Fee” and, should the amount be insufficient to pay Odyssey's obligations under the Promissory Note, Hydrocarbon waived its rights to a deficiency claim on account of such liability and would cancel the Promissory Note. In addition, the Promissory Note stated that “no recourse for payment of the obligations” of the Promissory Note would be had by Hydrocarbon against Odyssey or its individual partners. Finally, Odyssey did not put up any collateral for the Promissory Note. The Promissory Note did not confer any risks upon Odyssey if the assets that were the subject of the partnership relationship did not perform well.

The Rigases next rely on Comm'r v. Tufts, 461 U.S. 300 [51 AFTR 2d 83-1132] (1983), to contend that cancellation of nonrecourse debt would constitute discharge of indebtedness income or “skin in the game.” In Tufts, the Supreme Court held that a taxpayer who sold property encumbered by a nonrecourse mortgage exceeding the fair market value of the property must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale under 26 U.S.C. § 61(a)(3). However, “[t]here is a distinction between what constitutes income realized from the “discharge of indebtedness” under § 61(a)(12) and income realized from “gains derived from dealing in property” under § 61(a)(3).” 2925 Briarpark, Ltd. v. Comm'r, 163 F.3d 313, 317–18 [83 AFTR 2d 99-312] (5th Cir. 1999). Section 61(a)(12) provides that a debtor may realize discharge of indebtedness income where his debt is canceled, forgiven or otherwise discharged for less than the full amount. When a nonrecourse debt is forgiven, the debtor's basis in security the property is reduced by the amount of debt canceled, and realization of income is deferred until the sale of the property. United States v. Kirby Lumber Co., 284 U.S. 1 [10 AFTR 458] (1931). “This interpretation attributes income only when assets are freed, therefore, an insolvent debtor realizes income just to the extent his assets exceed his liabilities after the cancellation.”2925 Briarpark , 163 F.3d at 318 (citingTufts , 461 U.S. at 310 n.11). In contrast, § 61(a)(3) applies when a taxpayer agrees to surrender the property in exchange for the cancellation of the debt. 2925 Briarpark, 163 F.3d at 318. Here, the Promissory Note did not contemplate that Odyssey would surrender any property in the event that the Promissory Note was cancelled. Therefore, Odyssey's cancellation of indebtedness income would not have fallen under § 61(a)(3) as a gain derived from dealing in property.

Second, Odyssey argues that the “clawback provision” acted to create an obligation to share losses. The clawback provision provided that, after the distribution of the 20% and 80% of income, Hydrocarbon could ask Odyssey to repay some of its 20% income if subsequent expenses or losses on the assets came to light. Odyssey, in fact, did pay approximately $30,000 to Hydrocarbon pursuant to the clawback provision. Stewart stated that, if back-end expenses exceeded the profits distributed to Hydrocarbon and Odyssey, “everybody had to pay back part of their ownership interest to the assets.” (Stewart Dep. 62:22–23.) Stewart viewed this as a defining characteristic of the partnership—i.e., that Odyssey had to participate, good or bad, in the performance of the assets. (Stewart Dep. 62:24–63:1.) In contrast, when Stewart worked as an employee at Mirant, he was never required to pay back his bonus. (Stewart Dep. 63:2–3.) The clawback arrangement is indicative of a partnership arrangement. In Wheeler, a partner did not share in any losses if the venture was unprofitable, but was required to absorb losses if the venture succeeded. T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 26–27.

Finally, the subordination of the profits interest to Hydrocarbon's recovery of its expenses and initial investment can be indicative of a partnership relationship, though it is equally consistent with a theory that Odyssey was a service provider to be rewarded with a percentage of the profits. Compare Wheeler, T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 28 (profit sharing arrangement whereby capital investor was reimbursed for invested capital first was not adverse to finding of partnership relationship)with Kahn v. Comm'r , 499 F.2d 1186, 1190 [34 AFTR 2d 74-5278] (2d Cir. 1974) (a contingent profits interest that was subordinated to capital owner's expenses in purchasing and liquidating assets was fee for services).

4. Responsibilities of the Parties

Courts have emphasized the level of control and responsibilities that a putative partner exercises over the business venture's affairs when considering whether the individual is truly a partner. In Wheeler v. Commissioner, T.C. Memo 1978-208 [¶78,208 PH Memo TC] (T.C. 1978), the Tax Court found a partnership relationship to exist between Wheeler and another individual who engaged in a joint venture for real development. The partner provided front money for the real estate projects, while Wheeler carried them through the financing, construction and occupancy phases. As the Tax Court put it, “[t]he association between [Wheeler] and [the partner] was a marriage of capital and know-how.” Id. at 5. The Tax Court found a partnership in part due to the actual conduct of the parties. Wheeler exercised authority on a day-to-day basis by selecting subcontractors, signing subcontracts, approving payrolls, approving interim payments to subcontractors, approving payments for materials, approving change orders in construction, and negotiation commitments. Id. at 25. In addition, Wheeler could sign checks on the bank account of the venture.Id. at 26.

Other courts have also found that an individual's contribution of substantial time and day-to-day management of an investment, such as a business or real estate development, can contribute to a finding of a partnership. See Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] at 12; Cobb v. Comm'r, 185 F.2d 255, 257–59 [39 AFTR 1274] (6th Cir. 1950) (wife was partner in husband's business in part due to her management of business's operations and books in exchange for “wholly inadequate” compensation). In a revenue ruling, the IRS found a partnership to exist in an oil and gas development venture where one party contributed all the income and bore all the loss, but where the other parties were authorized to “acquire oil and gas leases, to make contracts and commitments for the drilling of wells for oil an gas, and otherwise development the property.” Revenue Ruling 54-84 (1954). What appears clear from these cases is that the putative partner possesses legal authority in significant matters that would bind the partnership, such as signing authority on bank accounts, the authority to enter into contracts, and to make business decisions affecting the capital of the venture without direct oversight from the other partner.

Odyssey possessed a great deal of autonomy in managing the day-to-day operations of the asset portfolio with Hydrocarbon. Stewart described Odyssey's duties as involving engineering analysis, title work for the assets, structuring hedging agreements, managing loan agreements, servicing collateral bank accounts, making deposits in the bank accounts, preparing end-of-month, performance, and financial reports, preparing loan disbursement requests, and negotiating the exit from transactions. (Stewart Dep. 35:19–36:19.) Regarding disbursement requests, Odyssey made recommendations to Hydrocarbon for the actual disbursement. (Stewart Dep. 36:10–11.) Stewart also testified that Odyssey carried out more tasks than those set out in the Management Agreement. Odyssey planned all of the operating expenses of the venture and invested in a capital asset. (Stewart Dep. 32:13–17.) Prior to receiving written approval from Hydrocarbon, Odyssey often represented that it had the authority to dispose of an asset. (Stewart Dep. 57:19–58:11.) Stewart described the relationship as one of “good business partners” who would make a decision together. (Stewart Dep. 52:3–4.) Plato testified that he monitored the portfolio's investments, including valuing the performance of the portfolio companies in relation to their development plans, deciding where wells should be drilled, whether to advance more capital to the companies. (Plato Dep. 13:19–14:12.) Odyssey did not need to obtain approval from Hydrocarbon in order to approve a portfolio company's decision to drill wells as long as it was within the portfolio company's budget. (Plato Dep. 14:21–15:14.) However, Odyssey needed to get Hydrocarbon's approval in order to increase the capital commitment to a portfolio company. (Plato Dep. 15:22–16:4.) Rigas describes having done more than simply the duties outlined in the Management Agreement in order to “protect the investment in these assets, both the investments that Hydrocarbon made and the investments that we were making in these assets.” (Rigas Dep. 19:17–19.) One example included Odyssey's purchase of a lease from ExxonMobile to perfect title to an asset. (Rigas Dep. 19:22–24.)

Despite the great deal of responsibility Odyssey exercised over the asset portfolio, Odyssey did not have authority to withdraw funds from Hydrocarbon's bank accounts, could not increase Hydrocarbon's capital commitment to a particular asset, could not enter into binding agreements in Hydrocarbon's name, and could not dispose of an asset without Hydrocarbon's prior written approval. Odyssey's responsibilities, while numerous, did not extend into the key areas of acquiring and disposing of assets or drawing upon Hydrocarbon's bank accounts that would indicate a partnership relationship.

5. Parties' Right to and Control over Income and Capital

Where the putative partner does not possess an ownership interest in capital, title to the assets of the partnership, or no practical ability to control the assets, a partnership is unlikely to exist. See Kahn, 499 F.2d at 1190;Kessler , T.C. Memo 1982-432 [¶82,432 PH Memo TC] at 21. InWheeler , however, the Tax Court found that the lack of the incidents of control over partnership capital did not defeat a finding of a joint venture:

To be sure, there are factors in the agreement which tend to indicate the relationship between the parties was not that of a joint venture. Title to the properties was held solely in Perrault's name. Cumulative losses of the venture were to be borne solely by Perrault. Petitioner could not borrow or lend money on behalf of the venture, execute a security instrument, release any debt or claim except upon payment in full, compromise or submit to arbitration any controversy involving the venture or to sell, assign, pledge, or mortgage his net profits interest in the venture. However, these restrictions on petitioner's authority were merely protection for Perrault's capital advances, and characteristics such as Perrault's holding title to properties or bearing all the losses have been specifically recognized as the respondent as insufficient to negate the existence of a joint venture.

Wheeler, T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 29–30 (citing Rev. Rul. 54-84, 1954-1 C.B. 284); see also Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] (partnership existed even where management partner did not own title in the real estate that constituted partnership's assets).

Here, we view Odyssey's relationship to Hydrocarbon in much the same light as the courts in Kahn andKessler . Odyssey did not own title to any of the assets in the portfolio, not even the ExxonMobil interest it purchased with $134,000 of funds taken from the Promissory Note. Apart from depositing checks, Odyssey did not share control with Hydrocarbon over the bank accounts that corresponded with the companies in the asset portfolio. Odyssey could only make recommendations to Hydrocarbon, upon which Hydrocarbon relied, to disburse funds from the accounts. (Stewart Dep. 82:5–83:3.) Odyssey's relationship to the asset portfolio, while bearing some similarities to the Wheeler and Jensen cases, did not include any control over the venture's business income like the Wheeler and Jensen partners did. Thus, we find Odyssey's right to and control over the assets and income of the venture as indicative of a service provider relationship.

6. Representation to IRS and Third-Parties, Separate Books, Parties' Agency Relationship, and Business conducted in the Joint Name of the Partnership

Courts also focus on the way that the parties represent themselves to third-parties and governmental authorities. InKessler , the court did not find a partnership in part because neither of the putative partners filed partnership returns for the relevant taxable years. T.C. Memo 1982-432 [¶82,432 PH Memo TC] at 20–21. The case of Wheeler involved a partner who owned the real estate and Wheeler, who conducted management and development of the properties. When the properties were sold, and profits were shared between the partner and Wheeler, the partner did not deduct Wheeler's profit share on his tax return as compensation paid to a service provider. T.C. Memo 1978-208 [¶78,208 PH Memo TC] at 8, 27. Rather, the profit reported on the partner's tax return was the gain on the sale of the real estate reduced by Wheeler's profit share. Id.; see also Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] (monthly allowance given to management partner were capitalized as a cost of acquiring and developing property rather than expenses). It may also be important whether the company providing the profit share reports that income on a Form W-2 or Form 1099-MISC, withholds taxes, or provides benefits as it would to employees. See Holdner, T.C. Memo 2010-175 [TC Memo 2010-175] at 30; Jensen, T.C. Memo 1980-335 [¶80,335 PH Memo TC] at 15.

Here Odyssey and Hydrocarbon did not file joint tax returns or joint financial reports with governmental authorities. (Plato Dep. 9:23–25; 10:1–3.) We also have no evidence as to the type of tax return filed by Hydrocarbon in relevant tax years nor how Hydrocarbon reported the 20% profit share paid to Odyssey. Odyssey did not receive Forms K-1 from Hydrocarbon. (Wilkinson Dep. 33:21–23.) On the other hand, it appears that Odyssey did not receive Forms W-2 or 1099-MISC from Hydrocarbon.

As for how Odyssey represented itself to third-parties, Rigas testified that he never told anyone that Odyssey owned the assets in the portfolio. (Rigas Dep. 18:11–15.) On the other hand, Rigas told the portfolio companies that he could dispose of assets and did not disclose the limitation on his authority contained in the Management Agreement. (Rigas Dep. 21:7–25.) Stewart testified that neither he nor any of the other Odyssey partners represented to third-parties that they owned the asset portfolio. (Stewart Dep. 43:22–44:4.) In addition, Odyssey and Hydrocarbon had separate checking accounts.

These factors do not establish a partnership relationship existed between Odyssey and Hydrocarbon. Rather, these factors indicate that Odyssey and Hydrocarbon maintained separate accounting and financial arrangements. Odyssey was mindful of the distinction between itself and Hydrocarbon in its representations to third-parties. These facts tilt towards a finding that Odyssey was a service provider rather than a partner with Hydrocarbon.

After considering all of the factors indicative of the entities' intent to form a partnership, we must hold that the Government has established by a preponderance of the evidence that a partnership relationship did not exist between Odyssey and Hydrocarbon. On one hand, there are some indications that a partnership relationship existed, including the marriage of capital and “know how,” Odyssey's contributions to overhead expenses, and Odyssey's payment under the “clawback” provision of the Management Agreement. On the other hand, many more aspects of the relationship indicate that it was one of services provided in exchange for a fee based on a percentage of profits, rather than a partnership involving a profits interest. The Performance Fee was to be the only compensation Odyssey received for its services, unlike the “know how” partners in Wheeler and Jensen. Odyssey did not bear any losses of the venture—if the asset portfolio performed poorly, Odyssey did not have to pay back sums obtained under the Promissory Note. The reduction in pay that the Odyssey individual partners assumed while working on the venture is not unlike a contingency fee arrangement. Odyssey's day-to-day responsibilities and its right to and control over the assets shows that Odyssey could not dispose or acquire assets, could not make significant business decisions, and could not withdraw funds from Hydrocarbon's account without Hydrocarbon's approval. Finally, the Management Agreement explicitly stated that the parties had not entered into a joint venture or partnership. These facts establish that no partnership relationship existed between Hydrocarbon and Odyssey. As such, we must deny the Rigases' motion for summary judgment and grant the Government's motion for summary judgment on this ground.

V. CONCLUSION

Plaintiffs' Motion to Shift the Burden of Proof (Doc. No. 30) is GRANTED. Plaintiffs' Motion for Summary Judgment (Doc. No. 38) is DENIED. Defendant's Motion for Summary Judgment (Doc. No. 32) is GRANTED.

IT IS SO ORDERED.

SIGNED in Houston, Texas this the 2nd day of May, 2011.

KEITH P. ELLISON

UNITED STATES DISTRICT JUDGE

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1

Previously, the Rigases also sought to shift the burden of proof on the grounds of spoliation of evidence. The Government subsequently provided the Rigases with the documentation they sought and so the Rigases withdrew their spoliation argument.

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2

The Rigases appear to argue that the 2004 Amended Odyssey Return qualifies as a partnership-filed AAR and that the IRS failed to take appropriate action with respect to the AAR. However, even if this particular return were to qualify as an AAR, the Rigases' remedy would be limited to a petition for an adjustment. The Rigases have not filed such an action in this Court. Therefore, we are precluded from determining whether the IRS properly allowed or disallowed the adjustments requested on the 2004 Amended Odyssey Return.

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3

We do not interpret § 6228(b) as requiring a taxpayer to receive an IRS denial or notice of disallowance prior to filing a refund action. Rather, once the taxpayer has filed the AAR and the IRS has failed to allow it, the taxpayer may file suit even if the taxpayer has not yet received a formal notice of denial or disallowance. This interpretation is consistent with the language of the Code, which allows a taxpayer to file a civil action “[i]f the Secretary fails to allow any part of an administrative adjustment request.” 26 U.S.C. § 6228(b)(2)(A); see also Consumer Product Safety Comm'n v. GTE Sylvania, Inc., 447 U.S. 102 (1980) (when interpreting a statute or regulation, the court must look first to the plain language of words in the statute, which must be regarded as conclusive absent a clearly expressed legislative intent to the contrary). Moreover, this reading of the Code prevents a taxpayer from running afoul of the time limits prescribed on a refund action. The Code requires a taxpayer to file a refund action no sooner than six months after filing an AAR and no later than two years after filing an AAR. 26 U.S.C. § 6228(b)(2)(B)(i). In some circumstances, such as the one presented here, the IRS may engage in lengthy review of the AAR easily lasting over two years. If the taxpayer were to be required to wait until after receiving a formal notice of denial or disallowance from the IRS before filing a refund action, the taxpayer would be time-barred by the Code from filing such a suit.

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4

The Government argues that the Rigases' Form 8082 was not timely filed within three years after the 2004 Original Odyssey Return was filed. We need not address this argument. Regardless of whether the Rigases' Form 8082 was timely filed with respect to the Original 2004 Odyssey Return, it cannot serve as the basis for this refund claim under § 6228(b) because it was filed only two months before the civil action in this Court was filed. See 26 U.S.C. § 6228(b)(2)(B)(i).

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5

We need not examine whether the First Amended 2004 Rigas Return, which was filed in April 2007, can be considered a partner AAR. Even if the First Amended 2004 Rigas Return qualifies as a partner AAR, the Rigases would be barred from proceeding under § 6228(b) because they filed suit in this Court over two years after it was filed.

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6

The Rigases use the terms “partnership” and “joint venture” interchangeably. “Whether or not a joint venture exists for tax purposes is determined by applying the same tests used in determining the existence of a partnership.” See Wheeler v. Comm'r, T.C. Memo 1978-208 [¶78,208 PH Memo TC], 22 (T.C. 1978);see also Allison v. Comm'r , T.C. Memo 1976-248 [¶76,248 PH Memo TC], 27 (T.C. 1976). Thus, we treat the relevant inquiry as one into partnership between Odyssey and Hydrocarbon.

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7

A partnership, as defined by the Internal Revenue Code (the “Code”), “includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term “partner” includes a member in such a syndicate, group, pool, joint venture, or organization.” 26 U.S.C. § 7701(a)(2).

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8

Culbertson identified the following facts as potentially relevant to this inquiry: “the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent.” 337 U.S. at 742.

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9

The Rigases also argue that they shared risk of loss by agreeing to accept a much-reduced salary as compensation during the period before the asset portfolio was sold. Courts have not looked favorably on the concept of construing absence of compensation as a loss. InKessler , the individual who was to be paid 15% of profits in the event of a profitable deal would not receive any compensation if the property was not sold for a profit or was sold for a loss. T.C. Memo 1982-432 [¶82,432 PH Memo TC] at 19. The court did not view this arrangement as true loss sharing. Id. at 21. However, receiving “wholly inadequate” compensation for services can be seen as evidence of a partnership relationship.See Cobb , 185 F.2d at 257.

EY Spinoff

2011-07-05T20:42:00.001-04:00

U.S. v. FORT, Cite as 107 AFTR 2d 2011-XXXX, 04/19/2011

UNITED STATES OF AMERICA, Plaintiff-Appellee, v. DANNY C. FORT, SHERRI E. FORT, Defendants-Appellants.

Case Information:

Code Sec(s):

Court Name: IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT,

Docket No.: No. 10-13053; D.C. Docket No. 1:08-cv-03885-TWT,

Date Decided: 04/19/2011.

Prior History:

Disposition:

HEADNOTE

.

Reference(s):

OPINION

IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT,

Appeal from the United States District Court for the Northern District of Georgia

Before MARCUS and ANDERSON, Circuit Judges, and ALBRITTON, * District Judge.

Judge: ALBRITTON, District Judge:

[PUBLISH]

This case presents an appeal by Danny C. Fort (“Fort”) 1 of a grant of summary judgment in favor of the United States. The government brought this action against Fort to recover a tax refund of over $300,000 that it contends was erroneously refunded. For the reasons set forth below, we affirm the district court's entry of summary judgment in favor of the government.

I. BACKGROUND

A. Ernst & Young Sells its Consulting Business to Cap Gemini

In early 2000, Ernst & Young (“E&Y”) prepared to spin off and sell its information-technology consulting business to Cap Gemini, S.A. (“Cap Gemini”), a French corporation. At this time, Fort was a partner in that consulting business. On February 28, 2000, E&Y and Cap Gemini executed a Master Agreement that detailed the terms of the transaction.

Under the Master Agreement, the proceeds of the sale were divided among E&Y's partners. For consulting partners who qualified as accredited investors under SEC rules, such as Fort, the consulting partner agreed to terminate his or her interest in E&Y, and in exchange, received a distribution of Cap Gemini shares. Additionally, these partners would begin working at a new entity, Cap Gemini Ernst & Young (“CGE&Y”), under employment agreements containing noncompete clauses.

Cap Gemini shares would not be distributed outright to each partner. Rather, 25% of each partner's shares would be sold immediately to cover that partner's income taxes incurred as a result of this transaction, and the other 75% of the shares (the “Restricted Shares”) were placed into an individual account in the partner's name at Merrill Lynch.

The Restricted Shares could not be withdrawn from the partner's account at Merrill Lynch immediately, and therefore, the Merrill Lynch accounts were like escrow accounts. For four years and 300 days following the closing, partners could only sell portions of the Restricted Shares at scheduled times. After the four-year, 300-day period, the partners could withdraw all remaining Restricted Shares from the Merrill Lynch account. Arthur Gordon (“Gordon”), the former tax director of E&Y's consulting practice, who helped structure this transaction, stated that the reason for these restrictions was to prevent all of the partners from selling too many Cap Gemini shares at once, thereby diminishing the value of the shares.

The Restricted Shares were also subject to forfeiture as “liquidated damages” if a partner (1) breached his employment agreement; (2) voluntarily left his employment; or (3) was terminated. The amount of forfeitable shares decreased with each anniversary of the closing date that the partner remained at CGE&Y, so, generally, the longer a partner worked for CGE&Y, the fewer shares he or she would forfeit if the forfeiture provision were triggered.

Additionally, the termination forfeiture requirement applied to only two types of termination, and the number of Restricted Shares forfeited upon termination depended on under which type a partner was terminated. If a partner was terminated “for cause,” the partner forfeited the full amount of the forfeitable Restricted Shares. However, if a partner was terminated for “poor performance,” the partner forfeited at least 50% of the forfeitable Restricted Shares, but could keep a percentage of the remaining 50%, as determined by a review committee.

Partners also would have dividend and voting rights in the Restricted Shares. The dividends paid on the Restricted Shares were not subject to forfeiture, and partners could withdraw these dividends shortly after they were declared. As for voting, Merrill Lynch's French affiliate would vote a partner's shares “as instructed by [the partner] as beneficial owner.”

Because of the restrictions placed upon the Restricted Shares, the Master Agreement stated that, for tax purposes, the Restricted Shares would be valued at 95% of the closing price of Cap Gemini stock on the closing date.

B. The Partners Vote to Approve the Transaction

To help the partners determine how to vote on the sale, E&Y prepared a Partner Information Document (“PID”), which summarized the proposed transaction and discussed its tax implications. The PID stated that the sale “is a taxable capital gains transaction,” and that it “has been agreed that Ernst & Young, its partners, and Cap Gemini will treat valuation and related issues consistently for US federal income tax purposes.” The PID further included hypothetical tax calculations that showed the gain from receiving the Restricted Shares was reportable in full in 2000. It was generally expected that the stock would appreciate in value, and this structure was designed to assure capital gains treatment, with all tax on the then-value of all of the stock being paid in 2000.

At the conclusion of a meeting of partners in Atlanta on March 7 and 8, 2008, 95% of the consulting partners, including Fort, voted in favor of the transaction.

Fort subsequently signed the Partner Agreement, making him a party to the Master Agreement.

C. Fort's 2000 Tax Return

The transaction closed on May 23, 2000. Twenty-five percent of Fort's shares were sold at closing and the proceeds turned over to Fort, to cover taxes due based on receipt of the full value of all the stock in 2000. The remaining 75%, the Restricted Shares, were deposited into Fort's Merrill Lynch account.

Fort reported gross proceeds of $1,759,097 from this transaction on his 2000 income tax return. At this time, the Cap Gemini stock was worth approximately $156 per share.

In September 2003, Fort was terminated as part of a downsizing. At this time, the value of the Cap Gemini shares had declined substantially. Cap Gemini did not require Fort to forfeit any of his Restricted Shares. Shortly after his termination, Fort learned that several former E&Y consulting partners had filed amended year 2000 tax returns, claiming that they did not realize income from the Restricted Shares in that year. Fort followed suit, filing his own year 2000 amended return, asserting that he did not realize income in 2000 from the then-value of the Restricted Shares.

The IRS initially accepted Fort's amended return and granted him a refund for his 2000 tax return. Subsequently, however, the IRS determined that the refund to Fort was in error, and the government filed this suit to recover the refund.

D. The District Court Grants the Government's Motion for Summary Judgment

The district court granted the government's motion for summary judgment and awarded it the disputed amount. United States v. Fort, No. 1:08-CV-3885-TWT, 2010 WL 2104671 [105 AFTR 2d 2010-2559], at 3 (N.D. Ga. May 20, 2010). The court stated that taxable income during a given taxable year includes all income from whatever source derived that is “actually” or “constructively” received during that year. Id. at 1 (citing 26 U.S.C. § 61(a)(3); 26 C.F.R. § 1.61-2(a)). While the court assumed that Fort did not actually receive the Restricted Shares, it concluded that he constructively received them, because:

He alone stood to gain or lose money based on the stock's performance. He received the benefit of the dividends paid on the shares, and he had the right to direct how the shares would be voted. Moreover, he knowingly agreed to the sale restriction and the forfeiture provision. He also agreed to the amount of the discount.

Id. at 2.

The district court also rejected Fort's argument that the forfeiture provision prevented him from constructively receiving the Restricted Shares in 2000. The court explained that “the fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place.”Id.

Subsequently, Fort filed a timely appeal to this court.

II. STANDARD OF REVIEW

This court reviews a district court's grant of summary judgment de novo, applying the same legal standards used by the district court. Galvez v. Bruce, 552 F.3d 1238, 1241 (11th Cir. 2008). Summary judgment is appropriate where, viewing the movant's evidence and all factual inferences arising from it in the light most favorable to the nonmoving party, there is no genuine issue of any material fact, and the moving party is entitled to judgment as a matter of law.Id.

This court may affirm a decision of the district court on any ground supported by the record. Bircoll v. Miami-Dade Cnty., 480 F.3d 1072, 1088 n.21 (11th Cir. 2007).

III. DISCUSSION

Fort has appealed the grant of summary judgment in the government's favor, arguing that he did not “receive” the escrowed shares of stock in the year 2000 for tax purposes, and, therefore, was not taxable for their value in that year.

A. The Danielson Rule

The first issue is the application of the “Danielson Rule” to this case. See Comm'r v. Danielson, 378 F.2d 771 [19 AFTR 2d 1356] (3d Cir. 1967). The government argues, citing to Danielson, that Fort's ability to challenge his 2000 tax return is limited, because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income received in 2000. Fort responds that the Danielson rule is inapplicable to this case.

The government's argument is misplaced. Danielsonand its progeny recognize that parties may agree to a certain form of a transaction, and that if they do, they face a difficult burden in convincing the court that they did not actually engage in the form that they contracted to engage in. See id. at 774–75; Bradley v. United States, 730 F.2d 718, 720 [53 AFTR 2d 84-1208] (11th Cir. 1984) (noting that theDanielson rule applies if a taxpayer “challenge[s] the form of a transaction”) (emphasis added).

Agreeing to a certain form of transaction is significant, because different transaction forms can yield different tax liability consequences. Yet agreeing to form(e.g., agreeing to sell A for B on October 18, 1985) is different from agreeing to a certain type of taxliability (e.g., agreeing that the result of the transaction will yield no tax liability in 1985). In this case, Fort does not argue that the form of this transaction differed from what was written in the CGE&Y agreement. Rather, he argues that the agreed-upon form had particular tax consequences. Such an argument is outside the scope of the Danielson rule. See, e.g., United States v. Fletcher, 562 F.3d 839, 842–43 [103 AFTR 2d 2009-1674] (7th Cir. 2009) (in a case dealing with this same transaction and materially identical facts as the one at bar, the Seventh Circuit rejected reliance on the Danielson rule, writing that “because [the former E&Y partner] does not try to recharacterize the transaction, doctrines that limit or foreclose taxpayers' ability to take such a step are beside the point”); United States v. Nackel, 686 F. Supp. 2d 1008, 1019 [105 AFTR 2d 2010-474] (C.D. Cal. 2009) (in another case involving this same transaction, the District Court for the Central District of California wrote: “The government impermissibly conflates case law concerning a party's effort to look through and re-characterize the form of a transaction with that which addresses what the parties intended would be the tax consequences of a transaction. The former is subject to the heightened scrutiny sought now by the government, the latter is not.”).

As the Fletcher court expressed it: “Income was constructively received in that year not because the contract said that everyone would report it so to the IRS, but because the parties were right to think that this transaction's actual provisions made the income attributable to 2000.”Fletcher , 562 F.3d at 845.

Because the Danielson rule is inapplicable to this case, we now turn to evaluate the tax consequences of the form of this transaction.

B. Constructive Receipt

A taxpayer who uses the cash basis method of accounting, such as Fort, must pay tax on income in “the taxable year in which [it is] actually or constructively received.” Treas. Reg. § 1.446-1(c)(1)(I) (emphasis added). The district court found that, in 2000, Fort did notactually receive income from the Restricted Shares, but constructively received it. The government does not dispute this framing of the issue. Accordingly, the issue in this case is whether Fort constructively received income in the amount of the agreed value of the Restricted Shares in 2000.

The Treasury Regulations state that a taxpayer constructively receives income when “it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.” Treas. Reg. § 1.451-2(a). On the other hand, “income is not constructively received if the taxpayer's control of its receipt is subject tosubstantial limitations or restrictions .”Id. (emphasis added). In other words, the more control a taxpayer has over the receipt of income, the more likely the taxpayer has constructively received the income.See, e.g., Fletcher , 562 F.3d at 843.

The doctrine of constructive receipt is implicated when a taxpayer receives an asset, but that asset is placed in an escrow account, only to be released to the taxpayer upon the occurrence of some contingency. The fact that an asset is placed in such an account is relevant, but not dispositive, as to the question of whether the taxpayer has constructively received income. As the IRS has stated in a General Counsel Memorandum:

Generally, when assets are placed in escrow as security or otherwise and the taxpayer receivesno right to control or otherwise enjoy those assets, the courts and the Service have held that income is not realized until such time as the contingency is satisfied and the funds are paid over to the taxpayer....

However, in those cases in which the facts are such that the taxpayer exercises a considerable degree of domination and control over the assets in escrow, the courts and the Service have generally held ... that income is presently realized notwithstanding that the taxpayer lacks an absolute right to possess the escrowed assets.

I.R.S. G.C.M. 37073 (Mar. 31, 1977) (emphasis added) (citingChaplin v. Comm'r , 136 F.2d 298 [31 AFTR 124] (9th Cir. 1943);Bonham v. Comm'r , 89 F.2d 725 [19 AFTR 577] (8th Cir. 1937)). Consistent with the IRS's position, courts have held that a taxpayer presently realizes income when he or she possesses sufficient indicia of control over the assets held within an escrow account or escrow-type arrangement.

In Chaplin v. Commissioner, a company delivered shares of stock to Charlie Chaplin in 1928, who then was required to place the shares in escrow, only to be released when he delivered photoplays to the company in later years. 136 F.2d at 300. The Ninth Circuit held that the shares were income to Chaplin at the time of the initial delivery in 1928, not later, when Chaplin delivered the photoplays and the shares were released. Id. The Ninth Circuit emphasized that Chaplin possessed the following indicia of control over the shares in escrow: (1) the contract at issue vested ownership immediately in Chaplin and the shares were issued in his name; (2) Chaplin had voting rights in the shares; (3) dividends on the shares were declared and paid to an escrow agent who held them for Chaplin's benefit; and (4) Chaplin was considered the owner of the shares. Id. at 300–02.

In Bonham v. Commissioner, a taxpayer and a company agreed that the taxpayer would receive title in 750 shares of stock, but the shares would be deposited with the company “as a guarantee for [his] performance.” 89 F.2d at 726–27. The Eighth Circuit held that the taxpayer realized immediate income when he initially received the 750 shares, not when the shares were later withdrawn.Id. at 726–28.

Because Fort was one of multiple former E&Y partners who have argued that receipt of the Restricted Shares did not constitute taxable income in 2000, this court has had the benefit of considering the legal analysis of other courts which have analyzed cases with facts materially identical to those before us today. In each of these cases, the courts held that the receipt of the Restricted Shares constituted income in the year 2000.United States v. Bergbauer , 602 F.3d 569, 581 [105 AFTR 2d 2010-1957] (4th Cir. 2010), cert. denied, 131 S. Ct. 297 (2010);Fletcher , 562 F.3d at 845; Nackel, 686 F. Supp. 2d at 1026; United States v. Berry, No. 06-CV-211-JD, 2008 WL 4526178 [102 AFTR 2d 2008-6447], at 7 (D.N.H. Oct. 2, 2008);United States v. Culp , No. 3:05-CV-0522, 2006 WL 4061881 [99 AFTR 2d 2007-618], at 1 (M.D. Tenn. Dec. 29, 2006).

United States v. Fletcher, the case relied upon most heavily by the government, and cited by the district court, is particularly instructive. In Fletcher, the Seventh Circuit stated that “a taxpayer's willingness to defer consumption does not defer taxation.” 562 F.3d at 843. The court concluded that the CGE&Y agreement was merely a deferral of consumption, not income, for three reasons.Id. First, the partners bore the market risk that the Restricted Shares would appreciate or depreciate from the date of the closing, because the market price of the Restricted Shares could rise or fall while the shares were in the Merrill Lynch accounts. 2 Id. at 844. Second, because Cap Gemini had already paid the Restricted Shares into the partners' Merrill Lynch accounts, the partners merely agreed to postpone unrestricted access to the stock, rather than to allow Cap Gemini to pay them later. Id. Third, the partners agreed to value the Restricted Shares at a discount—95% of the market price of the underlying shares on the closing date—which reflects “not only illiquidity but also the risk that [Cap Gemini] would use its power over the account in an unauthorized way, or that Merrill Lynch might fail in its duty as a custodian.” Id.

We are persuaded by the Seventh Circuit's opinion and agree with its reasoning. We find that the transfer restrictions, which prohibited Fort from accessing the shares in the Merrill Lynch account for several years, were merely a delay of consumption, not a delay of income. Indeed, the partners wanted to restrict transfer of the shares to prevent a massive sell-off shortly after the closing date, which would have depressed Cap Gemini's stock price.

In any event, Fort had several rights over the Restricted Shares that constitute evidence of constructive receipt underChaplin and Bonham. 3First, the Restricted Shares were deposited into a Merrill Lynch account in Fort's name, and were held in that account for Fort's benefit. See Chaplin, 136 F.2d at 300–02 (finding it significant that the stock was issued in the taxpayer's name and that the taxpayer was considered the owner of the stock). Second, Fort had both dividend and voting rights over the Restricted Shares. See id. at 301–02 (finding dividend and voting rights significant). Third, the shares were to be released only if Fort stayed at CGE&Y for four years and 300 days, and therefore, the shares served as a guarantee of Fort's performance. See id. at 300–02 (finding constructive receipt when escrow account deposit acted to ensure taxpayer's performance);Bonham , 89 F.2d at 726–27 (noting that stock was held as a guarantee for taxpayer's performance).

Fort argues that, regardless of the above facts, he did not have “control” over whether he ultimately received the Restricted Shares, because the shares were subject to forfeiture if he was terminated for “poor performance.” Fort contends that “poor performance” really means any reason at all. Fort argues that if he could be fired for any reason at all, then the Restricted Shares were not simply being held as a guarantee for his performance, as in Chaplin andBonham , but rather, they were being held completely at the will of CGE&Y. Fort notes that Gordon testified that approximately 10% of the consulting partners forfeited their shares for reasons he defined as “involuntary” or “involuntary resignation.” Fort further asserted that Gordon described these employees as ones who were terminated “not because they are not trying, [but] because the industry has changed or their expertise is gone.” 4

If the Restricted Shares could be forfeited for reasons completely out of Fort's control, this would be some evidence that Fort lacked control over the Restricted Shares. See Nackel, 686 F. Supp. 2d at 1022 (“The likelihood of the forfeiture provisions being effectuated, and who controls the realization of that fact, are important in determining whether the stock so held is nonetheless constructively received.”) (citing Chaplin, 136 F.2d at 299–302). However, we conclude that Fort had sufficient control over whether his shares would be forfeited.

First, the Partnership Agreement required complete forfeiture on involuntary termination only if the termination was for cause or, in a lesser amount, if it was for poor performance. There was no forfeiture at all if termination was for any other reason. Moreover, factually, CGE&Y did not use the poor performance provision to terminate partners for any reason at all. Instead, Gordon explained that consulting partners who were terminated for poor performance were individuals who “did not meet their objective in one or more of [the] categories” upon which performance was judged and individuals who “were collecting a check and not worrying about trying to do their best.” In fact, when partners were terminated for reasons outside of their control, such as shifts in needs of industries, Gordon stated that those partners were allowed to keep their shares. And, as noted earlier, Fort himself was not required to forfeit any of his Restricted Shares when he was terminated due to downsizing.

Additionally, the Nackel court squarely confronted this issue and concluded that “poor performance” did not mean termination for any reason. Nackel, 686 F. Supp. 2d at 1023. That court concluded that “poor performance” referred to the “poor quality of the ex-consulting partner's performance” and that the “emphasis under this condition remains on the partner's relative performance ... [and this] is something within that partner's means to control.” Id.

We agree, and also note that the plain meaning of being terminated for “poor performance” is not being terminated for any reason at all. Rather, poor performance clearly refers to unsatisfactory performance. It would be a strained interpretation, and one we will not adopt, to hold that “poor performance” does not really mean poor performance, but actually means “any reason at all.” To do so would be to expand the reasons for which forfeiture could be required beyond those to which the partners agreed.

Fort also suggests that “poor performance” allows for termination on the basis of a subjective judgment. While we agree that the term “poor performance” potentially might require some subjective judgment by an employer, we conclude that the mere potential for subjective judgment does not foreclose constructive receipt. Cf. Nackel, 686 F. Supp. 2d at 1023 (suggesting that the “poor performance” provision is an objective measure, which focuses on a partner's relative performance); Fletcher, 562 F.3d at 845 (“The sort of contingencies that could lead to forfeitures were within the ex-partners' control.”).

Additionally, we reject Fort's argument that he lacked control due to the fact that his performance could have been considered “poor” in part due to market conditions. To have sufficient control for constructive receipt does not require “total control.” In any event, as previously noted, CGE&Y in practice did not seek forfeiture when a partner's poor performance was primarily caused by market shifts and not the partner's poor efforts.

In sum, Fort constructively received the Restricted Shares in 2000. The fact that Fort could not access the shares immediately was merely a postponement of consumption, not income: CGE&Y paid the full consideration of the shares into Fort's Merrill Lynch account on the closing date, and therefore, Fort bore the market risk of share appreciation or depreciation beginning on the closing date. This conclusion is buttressed by the fact that Fort possessed indicia of control over the shares: he had dividend and voting rights in the shares, and the shares were held in an individual account in Fort's name. Additionally, constructive receipt was not impossible simply because Fort was required to forfeit the shares upon the occurrence of certain conditions, because Fort had sufficient control over whether those conditions would occur. Therefore, Fort realized income at the time the Restricted Shares were transferred into his Merrill Lynch account in 2000.

IV. CONCLUSION

For the foregoing reasons, we AFFIRM.

AFFIRMED.

*

Honorable W. Harold Albritton, United States District Judge for the Middle District of Alabama, sitting by designation.

1

Sherri E. Fort is also an appellant in this case, because she filed a joint tax return with Danny C. Fort. For sake of simplicity, we will refer only to Danny C. Fort in this case. However, this opinion is equally effective as to Sherry E. Fort.

2

Fort argues that whether he bore the risk is irrelevant in determining constructive receipt. We reject Fort's argument. See, e.g., Rupe Inv. Corp. v. Comm'r, 266 F.2d 624, 630 [3 AFTR 2d 1276] (5th Cir. 1959) (considering, in determining that a taxpayer did not own stock for tax purposes, the fact that the taxpayer “was protected against risk of loss and was not entitled to any enhancement in the value of the stock”); Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981) (en banc) (adopting as binding precedent all decisions of the former Fifth Circuit issued before October 1, 1981); see also Treas. Reg. § 1.83-3(a)(6) (suggesting that in the context of employee stock options, “[a]n indication that no transfer has occurred is the extent to which the transferee does not incur the risk of a beneficial owner that the value of the property at the time of transfer will decline substantially”).

Fort also argues that, factually, due to the potential his shares could be forfeited, other parties besides Fort bore some of the risk. Fort's argument is unpersuasive. While the potential for forfeiture existed in Chaplin andBonham , the courts in those cases did not find that this potential eliminated constructive receipt. We agree with this reasoning.

3

Fort argues that Chaplin and Bonham turned on whether the taxpayers in those cases initially received the shares of stock, and then deposited those shares into an escrow account, a fact not present in Fort's case. We reject that contention, as the Chaplin court did not appear to find this fact significant, and the Bonham court specifically stated that “[t]he circumstance is unimportant that the stock was not physically delivered to petitioner and then redelivered by him to the company upon the pledge.” Bonham, 89 F.2d at 727–28.

4

Fort cites the case of Palowitch v. Cap Gemini Ernst & Young, US., LLC, No. 114312/01, 2004 WL 2964426 (N.Y. Sup. Ct. June 3, 2004), in which the plaintiff claimed that CGE&Y terminated him for “poor performance,” but did so “without stating a reason.”Id. at 1. However, as the government correctly points out, Palowitch does not establish that the taxpayer was terminated for no reason, but rather, it shows that the termination letter sent to the taxpayer did not state a reason for his termination. See id. In any event, the Palowitch court did not analyze whether CGE&Y had a reason for termination in that case.

Sales based royalties

2011-07-05T20:41:00.000-04:00

IRSIG 20110301

Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances

FULL TEXT:

Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances

March 1, 2011

LB&I Control No: LB&I-4-0211-002

Impacted IRM 4.51.2

MEMORANDUM FOR INDUSTRY DIRECTORS DIRECTORS, FIELD OPERATIONS DIRECTOR, FIELD SPECIALISTS DIRECTOR, PRE-FILING AND TECHNICAL GUIDANCE

FROM:

Sergio Arellano, Industry Director Retailers, Food, Pharmaceuticals & Healthcare

SUBJECT:

Field Guidance on the Planning & Examination of Sales-Based Royalty Payments and Sales-Based Vendor Allowances

Introduction

This memorandum provides guidelines for the efficient use of audit time and resources devoted to the examination of payers of sales-based royalties and payees of sales-based vendor allowances. This memorandum does not address issues relating to the examination of other parties to these transactions.

This LB&I Directive is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.

Background

Royalties are costs incurred by taxpayers to secure contractual rights to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property the taxpayer produces or acquires for resale. Sales-based royalties become due only upon the sale of property. Like other royalties, sales-based royalties that are incurred by reason of or that benefit production or resale activities must be capitalized under Section 263A. Taxpayers who use the simplified production method or simplified resale method allocate sales-based royalties, like other costs, between ending inventory and cost of goods sold.

Sales-based vendor allowances are allowances, discounts, or price rebates that a reseller receives, earns, or otherwise becomes entitled to based on the resale of a vendor's merchandise to a third party. Reseller taxpayers generally treat sales-based vendor allowances as a reduction in cost, part of which reduces the cost of goods in ending inventory under the simplified resale method.

Controversy

The taxpayer in Robinson Knife Manufacturing Company, Inc. v. Commissioner, 600 F.3rd 121 (2d Cir. 2010), rev'g T.C. Memo 2009-9, treated sales-based royalty costs as deductible sales expenses rather than production costs. The Service determined that the royalties were production costs that Robinson must capitalize to inventory under § 263A. The Tax Court held that the royalties were production costs because they directly benefited and were incurred by reason of production. The Court of Appeals, however, held that the royalties were not production costs required to be capitalized under the Section 263A regulations. Rather, the royalty costs were incurred by reason of the sale of Robinson's product and were deductible under Section 162.

Litigating Position

The Service has issued an Action On Decision ( AOD 2011-01) that nonacquiesces to the Robinson Knife decision. The AOD concludes that the court confused the timing of the sales-based royalty payments with the purpose of the payments, and failed to recognize that Robinson had to manufacture the items to sell them. The AOD agrees with the Tax Court that the royalty expenses were production costs that must be capitalized under section 263A.

Published Position

Proposed regulations under section 263A, published at 75 F.R. 78940 (December 17, 2010), clarify that sales-based royalties generally are a production cost, despite the fact that the cost is not incurred until property is sold. However, because sales-based royalties are incurred only when property is sold, the proposed regulations provide that sales-based royalties are allocable only to the property sold and are not allocated to ending inventory under the simplified production method and simplified resale method formulas.

The proposed regulations also clarify that sales-based vendor allowances are a reduction in costs and not an increase in gross receipts. However, like sales-based royalties, sales-based vendor allowances properly are allocated to property sold during the taxable year and do not reduce costs in ending inventory under the simplified resale method.

The proposed regulations, although not effective until finalized, represent the government position on the proper accounting treatment of these amounts.

Planning and Examination Guidance

Sales-Based Royalties:

Pending publication of final regulations, agents should not expend further resources challenging a taxpayer's accounting for sales-based royalties as described in the proposed regulations or under a method that reaches a similar result.

Sales-Based Vendor Allowances:

Pending publication of final regulations, agents should not challenge taxpayers' use of a method of accounting for sales-based vendor allowances that is consistent with either (1) the proposed regulations, or (2) the current regulations that allocate a portion of vendor allowances to ending inventory under the simplified resale method.

If you have any questions, please contact the pharmaceutical and biotech technical advisors or the retail technical advisors.

cc: Commissioner and Deputy Commissioner, LB&I

Deputy Commissioner, Operations

Division Counsel, LB&I

Chief, Appeal

Page Last Reviewed or Updated: March 02, 2011

Update On The Move To Forbes

2011-07-04T12:03:00.001-04:00

Things have started off swimmingly with my move to Forbes. I have put up three posts. The first was on the tax implications of New York marriage equality, the second on a decision about the constitutionality of the insurance requirement in health care reform and the third about CCA that talks about bloggers as maybe being part of the new media. The health care post has generated a huge number of hits. No comments yet.

A couple of more senior blogspot tax bloggers have noted my following Taxgirl over to Forbes. I think I detected a tinge of envy in their posts on the subject. Joe Kristan has indicated that he will never sell out, unless the price is right. The Wandering Tax Pro indicates that he is available at the right price.

My current plan is to keep this site going on a Tuesday Thursday basis along with any guest posters I can entice. I'm not sure guest posting works with Forbes. If you have been thinking about doing a guest post for me, it is worth noting that at least in the short run, my move to Forbes has increased traffic to this site, because I link to my previous posts.

Tax Court Got No Splaining to Do But Splaining Anyway

2011-07-01T05:00:00.002-04:00

Scott F. Wnuck v. Commissioner, 136 T.C. No. 24

Mr. Wnuck didn't think the Tax Court explained itself well enough when it ruled against him. So the Court gave him a fairly elaborate explanation as to why it sometimes doesn't explain. Here are some excerpts:

R determined a deficiency in P's 2007 income tax on the basis of wages that P did not report. At trial P admitted, “I exchanged my skilled labor and knowledge for pay”. In a bench opinion the Court held for R, ruled that P's arguments were frivolous, imposed on P a penalty of $1,000 pursuant to I.R.C. sec. 6673(a), and warned P that if he repeated his frivolous positions he faced the risk of a steeper penalty. After the Court entered decision, P moved for reconsideration on the grounds that the Court had not adequately addressed his arguments.

R is "Respondent" i.e. the IRS. P is "Petitioner" i.e. Mr. Wnuck.

Courts confronting frivolous arguments against the constitutionality, validity, applicability, and mandatory character of the income tax often aptly quote Crain v. Commissioner, 737 F.2d 1417, 1417 [54 AFTR 2d 84-5698] (5th Cir. 1984), which stated, “We perceive no need to refute these arguments with somber reasoning and copious citation of precedent”. We take this occasion to explain why it is usually not expedient to discuss and refute in detail the frivolous arguments that some litigants attempt to press in the Tax Court, and why litigants who press such arguments are not entitled to and should not expect to receive opinions rebutting their frivolous arguments.
At trial the only issue was whether Mr. Wnuck received taxable income in 2007; and he frankly stated, “I do not dispute that I exchanged my skilled labor and knowledge for pay” . However, he explained, “I have come to believe that the— my earnings from the companies that I worked for did not constitute taxable income.”Mr. Wnuck did admit, however, that he is not trained in the law.

The Court both sustained the deficiency as determined by the IRS and imposed on Mr. Wnuck, pursuant to section 6673(a), a penalty of $1,000 for taking frivolous positions. The Court stated:

We take no pleasure in doing so, and we there[fore] impose a relatively modest penalty, given that we have the discretion to impose a penalty as high as $25,000. Mr. Wnuck should be aware, however, that if he should ever repeat his maintenance of frivolous tax litigation, he would stand in peril of a much steeper penalty. Undeterred, Mr. Wnuck has now filed a motion for reconsideration, in which he reasserts (1) his argument that his earnings are not taxable “wages”; (2) his argument based on provisions in title 27 of the Code of Federal Regulations; and (3) his argument about supposed errors in his “Individual Master File” maintained by the IRS—all three of which he had asserted at trial. Mr. Wnuck complains about the Court's characterization of his arguments as “frivolous”, especially since the Court did not separately discuss each argument:

So why does the Court not always thoroughly explain why it is rejecting frivolous arguments ?

A.The number of potential frivolous anti-tax arguments is unlimited.

If one is genuinely seeking the truth, if he focuses on what is relevant, and if he confines himself to good sense and logic, then the number of serious arguments he can make on a given point is limited. However, if one is already committed to a position regardless of its truth, if he is willing to say anything, if he is willing to ignore relevance, good sense, and logic, and if he is simply looking for subjects and predicates to put together into sentences in ostensible support of a given point, then the number of frivolous arguments that he can make on that point is effectively limitless.

B. A frivolous anti-tax argument may be unimportant even to its proponent.

Experience shows that a given frivolous argument may have little actual importance to the person making it. Frivolous anti-tax arguments are often obviously downloaded from the Internet; and by cut-and-paste word processing functions, these arguments are easily plunked into a party's filing. In other instances a promoter of frivolous anti-tax arguments is feeding those arguments to a litigant who adopts them uncritically and submits them to the Court.
The frivolous argument, made from this position of witting and willful ignorance, seems to be merely an incidental ornament that adorns an article of faith—namely, the belief that I don't owe taxes. The tax defier firmly holds that postulate above and apart from any arguments. Anything in favor of that postulate may be advanced, no matter how silly; anything against it can be ignored. If a given frivolous argument is decisively rebutted, then it may or may not be retired; but even if the individual argument is retired, the cause is not abandoned. Thus, the specific argument hardly matters even to the litigant.

C. Many frivolous anti-tax arguments have already been answered.

This Court and other courts have addressed and rejected many of the recurring frivolous anti-tax arguments, including (as is especially pertinent here) the general argument that wages are not subject to the income tax 4 and the particular argument that (1978), affd. 614 F.2d 159 [45 AFTR 2d 80-591] (8th Cir. 1980), this Court explained the fallacy of the argument that wages are not taxable income.
D. The litigant who presses the frivolous anti-tax argument often fails to hear its refutation.

E. Many frivolous anti-tax arguments are patently so. The fallacies of some frivolous arguments are gross and palpable

Held : P was not entitled to a Court opinion addressing his frivolous arguments, and his motion for reconsideration will be denied.

Here is an example of one of his arguments:

To resist paying income tax on his wages, Mr. Wnuck makes this frivolous argument: He points out that “wages” are remuneration for “employment”, see sec. 3121(a), that “employment” means service performed “within the United States”, see sec. 3121(b), and that "[t]he term `United States' when used in a geographical sense includes the Commonwealth of Puerto Rico, the Virgin Islands, Guam, and American Samoa”, sec. 3121(e)(2) (emphasis added). Mr. Wnuck contends that the term “United States” therefore excludes everything else (such as the 50 States) and that his services performed in Pennsylvania (not in Puerto Rico, etc.) were not performed in the “United States” and therefore did not yield taxable wages. His argument fails for obvious reasons: a. “Includes” does not mean “includes only”.

Section 7701(c) provides that “includes” “shall not be deemed to exclude other things”. Anyone fluent in English knows that the word “includes” cannot be assumed to mean “includes only”—especially when such a meaning would have the ludicrous result of excluding from “United States” all 50 States. No tax research at all is necessary to conclude that Mr. Wnuck's position is frivolous. b. The cited statute does not apply.

So Mr. Wnuck has gotten the satisfaction of hearing the Tax Court explain why Pennsylvania is included as part of the United States. something we all know (I have to admit to having doubts about North Dakota, but that's a different story). You need Pennsylvania though - Liberty Bell, Constitutional Convention, Philadelphia Cheese Steak Sandwiches.

I hope it was worth it to him. It cost him 4 grand.

Mr. Wnuck then submitted a motion for leave to file a motion for reconsideration (which we treat as a motion to vacate the decision) and a separate motion for reconsideration. The motion to vacate will be granted, but the motion for reconsideration will be denied, and decision will again be entered in favor of the IRS and against Mr. Wnuck, but this time with an increased penalty of $5,000.

Robin and Terry Tying the Knot ?

2011-06-29T21:58:00.000-04:00

If you want the details of Robin and Terry's nuptials, you'll have to go to my new blog on Forbes. I still haven't gotten the call from Ellen, but it can't be long now. I will keep posting on this site, but at a reduced frequency as I focus on the Forbes platform. Please check it out.

Gifts of California Real Estate - Who's Gonna Know ?

2011-06-29T09:12:00.000-04:00

IN RE: DOES, Cite as 107 AFTR 2d 2011-XXXX, 05/20/2011

I remember the first tax course I ever took. It was at Qunisigamond Community College. The instructor was an attorney and he told a story about a client coming on a large pile of cash in his deceased father's house. The clients attitude was "Who's gonna know ?". I forget the rest of the story except that is didn't have a happy ending. As technology improves, there will be more and more ways that they are "gonna know". The IRS lost this skirmish, but it should be a heads up to people who have made transfers of real estate for less than full consideration.

The essence of the case is pretty well summed up in the John Does who are being defended:

United States taxpayers, who during any part of the period January 1, 2005, through December 31, 2010, transferred real property in the State of California for little or no consideration subject to California Propositions 58 or 193, which information is in the possession of the State of California Board of Equalization, sent to BOE by the 58 California counties pursuant to Propositions 58 and 193.

The IRS has recently realized “a pattern of taxpayers failing to file Forms 709” for real property transfers between non-spouse related parties. The IRS has thus launched a “Compliance Initiative” to investigate those taxpayers who have failed to file Forms 709. As a part of this Compliance Initiative, the government has sought to capture data from states and counties regarding real property transfers taking place between non-spouse family members for little or no consideration during the period of January 1, 2005, through December 31, 2010.

Increases in California property taxes are limited to 2% per year unless there is a transfer of the property. If the transfer is to a child or a grandchild it does not count and will not trigger a reassessment. In order to qualify for this treatment you need to file a form either BOE-58-G or BOE-58-AH, which you can get from your assessors office. Sometimes it can be downloaded. The existence of these forms is pretty convenient for the IRS because they think that maybe if you filed one of them then maybe you should have filed Form 709, which also can be downloaded, but I suggest that you might want to use a professional.

California has argued that their privacy laws prevent them from just turning the forms over to the IRS. It all gets kind of lawerly from here. The short answer is that the Court has initially refused to enforce the John Doe summons against the state because the IRS has not shown that it can't gather the information in some other way. The denial is without prejudice so they may be back.

The lawyerly stuff actually sounds pretty interesting :

It bears mention here as well, however, that, should the United States choose to renew its Petition, this Court has serious concerns about the fact that the United States seeks to utilize the power of a federal court to sanction the issuance of a John Doe Summons upon a state. Indeed, the Court's own review of the case law has revealed no other circumstances on par with the United States' current request. As such, prior to resubmitting the Petition, the United States is cautioned that it must address, inter alia, the following issues:

(1)) Whether a state is a “person” as that word is used in 26 U.S.C. §§ 7602(a) and 7609(f);

(2)) Whether a state's sovereign immunity precludes issuance of a John Doe Summons;

(3)) Whether, assuming a state is subject to the Court's power to issue a John Doe Summons, the United States must exhaust all administrative remedies prior to proceeding in federal court; and

(4)) Whether the United States should be required to attempt to pursue any and all state court remedies prior to seeking relief in federal court.

The Government is strongly advised to be thorough in any future briefing since it will be asking this Court to make a decision ex parte without the benefit of any similar briefing from the state.

The practical take away to me though is that it might be a good idea to see if you kinda of sorta forgot to file the gift tax return because you were so busy with those complicated forms the assessor wanted. Before long, one way or the other, I think they are "gonna know".

Let That Whistle Blow

2011-06-27T05:00:00.003-04:00

CCA 201117033

The IRS is very careful about disclosing confidential information but if you insist that they correspond with you in prison, it's on you that the warden gets to see your tax troubles. Chances are you are not a prime candidate for identity theft.

Subject: RE: ———————-You could continue to send mail to his home address, since it obviously is forwarded to his current “residence.” You could also ask him, in a letter, where he would prefer that you send mail to him. If he lists his current abode, then send it there. We can assume that he knows that some, if not all, of his mail is opened by the authorities. There would be no disclosure violation for using the address that he requests. ————————

COLEBROOK?EL v. IRS, Cite as 107 AFTR 2d 2011-XXXX

The Plaintiff, Noble Roderick Colebrook–El, alleges that Defendants, Internal Revenue Service's (“IRS”) and its agents, Debra Hurst and Beth Jones's, attempt to collect his federal tax debt violated his Constitutional rights, the Moroccan Treaty, and several other Acts of Congress. The factual allegations contained in the Complaint, titled “Affidavit and Petition and Injunction and Order of Protection,” are at times indiscernible and largely irrelevant to the issues in this case. Plaintiff appears to allege that the IRS, a federal “corporate” agency, lacks the requisite statutory authority to collect taxes from him due to his status as a United States citizen who is a Moor of Cherokee descent. Plaintiff owes $19,566.36 in unpaid taxes. Plaintiff seeks to enjoin the IRS from collecting the taxes owed, to have any and all levies lifted, and to be reimbursed for all court costs associated with this action.

It's always interesting to learn something new. I thought that this protester was totally off the wall claiming tax exemption as a "Moor of Cherokee descent". Silly me. There is actually is such a group of people. They are descendants of African Americans held as slaves by the Cherokees. There is a fairly recent controversy about whether members of the group should be considered tribal members. Here is something on that. So this guy is no further off the wall than most protesters and sheds some light on a neglected area of American history. He still has to pay taxes, though.

Murray S. Friedland v. Commissioner, TC Memo 2011-90 This is one of those cases that is interesting for the cautionary tale included in the story behind the story. Mr. Friedland was appealing his denial of a Whistleblower award.

Petitioner, a CPA, submitted a Form 211, Application for Award for Original Information (whistleblower claim), to respondent's Whistleblower Office (Whistleblower Office) in September 2009 concerning alleged violations of the Internal Revenue Code. He alleged that Lawjoy Realty Corporation (Lawjoy) and 601 West 149th Street, Inc. (West 149th), both C corporations, failed to pay millions in Federal corporate income taxes by impermissibly treating real property sales as stock sales in a corporate liquidation. He asserts that the structure of the sales was a sham and solely motivated to evade income taxes. Petitioner appears to have been a shareholder of both Lawjoy and West 149th.

This adds a new wrinkle to tax planning. Mr, Friedland was presumably a minority shareholder in these companies, since some of the tax burden would somehow come out of his share. It happens that Mr. Friedland was unsuccessful, but the IRS did recently award 4.5 million to an accountant who turned in his employer. I find the whole concept extremely distasteful but I think that in planning transactions that are at all aggressive it would be wise to keep out of the loop anyone who is not ethically bound to non-disclosure.

Bruce A. Brown, et ux. v. Commissioner, TC Memo 2011-83

This is another sad life insurance story. Although life insurance is often thought of in the context of estate taxes, it is really not different than any other asset when it comes to transfer taxes. Good planning will structure it so that it is not owned by the decedent keeping the build up in value out of her estate. Any appreciating asset owned outside an estate produces the same benefit. The connection to estate taxes is that the policy provides liquidity at just the right moment. Life insurance is a tax favored vehicle for income tax purposes though. Any build-up in value is tax deferred and proceeds payable by reason of the death of the insured are not taxable income. People figure out ways to use life insurance policies to create income tax problems for themselves though. Usually it has to do with policy loans. This was one of those cases.

In total Mr. Brown paid $44,205 in premiums: $11,999 by check, $28,532 by loans, and $3,674 by dividends.

Northwestern's Computation of Taxable Gain

Northwestern sent Mr. Brown a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The Form 1099-R showed a gross distribution of $37,365.06 and a taxable amount of $29,093.30. The Form 1099-R described the $37,365.06 as “loans repaid at surrender” and described the $29,093.30 as “taxable amt. at surrender”.

According to Northwestern's calculations, the $29,093.30 taxable amount was equal to the policy's cash value of $37,365.06 minus what it called “net cost” of $8,271.76. Net cost was calculated as “total premiums” (the premiums paid by loans, $28,532; by checks, $11,999; and by dividends, $3,674) minus what Northwestern called “total dividends” (in which Northwestern included the $2,986.94 dividend payment to Mr. Brown in 2004, the $31,063.30 received by Mr. Brown on surrender of the paid-up additional insurance in 2004, and the $1,883 dividend payment to Mr. Brown in 2005).

Mr. Brown prepared the Browns' return, which did not report any income from terminating the life insurance contract. Before filing the return, he consulted Mrs. Brown about the Form 1099-R. They believed that Northwestern based its report that Mr. Brown had a $29,093.30 taxable gain on the theory that a debtor has a taxable gain when a creditor cancels a debt. They believed Northwestern was incorrect because Northwestern had not forgiven Mr. Brown's debt. Having concluded that Northwestern analyzed the termination of the policy incorrectly, the Browns made no further attempt to determine the proper tax treatment of the transaction.

Incidentally the Browns are both attorneys and Mrs. Brown has an LLM in taxation.

As I read the case the numbers get a little confusing. It seems pretty clear that the Browns never actually received any money. The problem was the interest:

The policy allowed Mr. Brown to borrow from Northwestern against the policy's cash value. The policy labeled these loans “premium loan[s]” if they were applied to policy premiums or “policy loan[s]” if they were used for anything else. Both types of loans accrued interest at an annual effective rate of 8 percent. If unpaid, the interest was capitalized, meaning Northwestern added accrued interest to principal. ........

By 1997 the annual interest accrual exceeded the premium; by 2002, it was twice the premium.

The interest which was being paid with policy loans did not add to basis. It was a non-deductible expense. That is how you can use an insurance policy to manufacture phantom taxable income for your self. As a counterfactual to this scenario it would be interesting to look at what it would have cost the Browns to have had a term life insurance policy of $100,000 for 23 years (Actually in the later years their net death benefit would have been less than $70,000). My guess is that it would have been a bit less than the $12,000 of actual cash outlay they had on this policy. Maybe half. And there would have been no phantom income when they decided the policy wasn't needed anymore.

To add insult to injury, the Brown's got hit with an accuracy related penalty.

Unfair Lending

2011-06-24T05:00:00.001-04:00

CCA 201112008

Being as attached to double entry as any other accountant, I understand the theory behind making cancellation of indebtedness taxable income. Somebody writes off a loan receivable. If the debtor does not pick up income that big balance sheet in the sky will be out of balance creating severe perturbances in the space time continuum. Still I put it in the same category as the auditors putting a going concern qualification on financial statements. It's kicking somebody when they are down.

There is relief from cancellation of indebtedness income. It does not apply if you are in bankruptcy of if you are insolvent to the extent of your insolvency. It always seemed to me that there should be a presumption of insolvency when there is debt discharge, but nobody ever asks me.

This ruling is a bit of good news for some people who might otherwise be facing debt discharge income. It concerns victims of predatory lending practices :

Payments made by co. to settle allegations of unfair lending practices weren't gross income to borrowers under IRC Sec(s). 61(a)(12) where settlement had effect of equitably reforming loans by adjusting principal amount to amounts that borrowers would have obtained in absence of unfair lending practices, and where trustee's payments to loan holders and/or servicers didn't result in accession of wealth to borrowers.

Company provided funding to Bank to finance Loans to Borrowers. Borrowers used the proceeds of Loans to finance Assets, and the Assets secured Borrowers' obligations under the Loans. State investigated the activities of Company in financing the Loans and alleged that Company had engaged in unfair lending practices under State law. To avoid further investigation and possible legal action by State, Company entered into Settlement with State.

The Settlement states that Company enabled Bank to make unfair Loans with principal amounts in excess of the principal amount that Borrowers would have obtained in the absence of the unfair lending practices. The Company agreed to pay $x to an independent trustee of a settlement fund. The trustee will make payments to a Loan holder and/or servicer of a Borrower's Loan to reduce the amount a Borrower will repay on a Loan.

The Settlement has the effect of equitably reforming the Loans by adjusting the principal amounts to the amounts that the Borrowers would have obtained in the absence of the unfair lending practices. The trustee's payments to the Loan holders and/or servicers do not result in an accession to wealth to Borrowers. Consequently, the payments are not gross income to Borrowers under § 61 of the Internal Revenue Code (including § 61(a)(12)) and are not subject to information reporting requirements under § 6041 or § 6050P.

So if the state regulators finally caught up with the tin men who got your aunt to sign a $50,000 note to put $10,000 worth of siding on her house, she doesn't have to worry about picking up income.

From the Boston Tax Institute

2011-06-22T15:00:00.001-04:00

Boston Tax Alert 2011-33,2011-34, 2011-35,2011-36

I'm late putting up the Boston Tax Alert due to my long weekend on the West Coast to attend the board meeting of Just Detention International

Lu Gauthier of The Boston Tax Institute has given me permission to republish his newsletter. The BTI newsletter is a regular feature of this blog now going up every Tuesday. Be sure to check out the BTI catalog for great CPE value.

Our thanks to Lisa J. Delaney, Esq., one of the drafters of the new Homestead law, for the following email!

The new Homestead Statute provides even greater lien protection for homeowners. Just like the former statute, owners of a primary owner-occupied home may protect up to $500,000 in their accrued equity by declaring and recording a Declaration of Homestead the Registry of Deeds.

The new statute defines and expands homeowners to include properties held in trust or in a life estate. The statute also adds condominiums, co-operative apartments, trailers and 2-4 multi-family dwellings as qualifying homes.

The new statute removes several ambiguities or outdated modes. Now, Homestead is declared by both spouses who are homeowners and removes the archaic construction of one spouse signing for the marriage. Spouses who validly reside separately may hold concurrent Homestead in the two homes at the combined $500,000 exemption amount. No longer will Homestead terminate simply because a divorced owner remarries. And, all new spouses will have the benefit of their spouse's earlier declarations. Deeds within a family will preserve the homestead without requiring any special language or recitation in the deed. And, all homeowners may record multiple declarations for the same home without fear they may unknowingly terminate their exemption rights.

Our thanks to David Klemm, Esq. for the following email!

The IRS ruled in CCA 201011009 that an accrual method taxpayer reporting advance payments on the deferral method under Rev. Proc 2004-34 in accordance with its applicable financial statements must obtain consent before using its new financial statement method of accounting for tax purposes. The taxpayer recognized advance payments in income under its book method of accounting on a pro rata basis over the first 10 months of the 15-month period during which it performed services. The taxpayer's financial auditors determined that the taxpayer's book method of accounting for advance payments improperly overstated revenues. Therefore, the taxpayer changed it book method for advance payments in order to recognize the advance payments in income in its applicable financial statements on a pro rata basis over the entire 15-month period during which the taxpayer performs services. In the first year that the taxpayer began reporting advance payments over the 15-month period for its applicable financial statements it also reported the advance payments in the same manner for tax purposes. The taxpayer restated its financial statements for the prior two years. The IRS was not persuaded by the taxpayer's argument that since it had already received consent to use the deferral method using its applicable financial statement that it was not a change in method of accounting when it changed its book method for computing advance payments in its applicable financial statements. The IRS ruled that the taxpayer changed the timing of including an item in income in the current tax year from the timing of including that item in income in the previous taxable years. Accordingly, the IRS held that the taxpayer must file an application to change its method of accounting in order to obtain consent to use the new book method for tax purposes which would permit application of §481 to account for any omission of gross income resulting from the change in book method.

The final regulations (TD 9527) modifying Circular 230 are available on the Federal Register site at:

http://www.ofr.gov/OFRUpload/OFRData/2011-13666_PI.pdf

The official publication date will be June 3.

Our thanks to Patricia Ann Metzer, Attorney for the following email!

The Tax Code's deferred compensation provisions raise complex interpretative issues. The IRS pronouncements highlight the strong relationship between two of these provisions - 457 and 409A. Last year, the IRS came out with guidance (Rev. Rul. 2010-27) on unforeseeable emergency - one circumstance under which payments can be made to participants under eligible 457(b) plans before their severance from employment. Under the given conditions, an unforeseeable emergency is stated to include significant water damage to your home not covered by insurance, and funeral expenses for an adult child. The IRS adds that the same standards will apply to determine whether a distribution due to an unforeseeable emergency is permitted under a 409A nonqualified deferred compensation plan.

The approach is consistent with that taken by the IRS in 2007, when it said that concepts similar to those developed under 409A would apply to determine whether an arrangement providing severance benefits is not subject to 457, and when a benefit (not provided under an eligible 457 plan) is currently taxable because it is not subject to a substantial risk of forfeiture.

The upcoming seminar on 409A/Non-Qualified Deferred Compensation will deal with both 409A and the other Tax Code provisions you need to know about when it comes to deferred compensation. Items to be addressed include how mistakes in 409A drafting can be corrected on a timely basis without, in some cases, a toll charge. IRS correction procedures were most recently announced in Notice 2010-80.

.

IRS Disses Doggie Diplomas and Other Developments

2011-06-22T05:00:00.003-04:00

FISHER v. U.S., Cite as 107 AFTR 2d 2011-XXXX, 04/19/2011

There has already been a partial decision in this case which I mentioned in a previous post. The government got summary judgement on whether a restrictions on transferability discount would apply to a single asset family limited partnership. Apparently that was not the end of the story. After all there are still discounts for lack of marketability (even if they let you sell the damn thing nobody would want to buy it anyway) and minority interest. This particular decision, which is also not the end of the story is about evidence. The taxpayers want to bring into evidence what the IRS was originally willing to allow. The IRS doesn't think that relevant.

The present Motion in Limine seeks to preclude Plaintiff from introducing evidence of the minority interest and lack of marketability discounts used by the IRS in arriving at the February 13, 2006 assessments. See generally dkt. no. 101. The United States contends that because this case involves a de novo review of the fair market value of the property at issue, the calculations of the IRS at the administrative stage are irrelevant. Id. at 4. Plaintiff contends that evidence should be allowed in rebuttal if Mark Mitchell, CPA (“Mitchell”), the United States' expert, testifies that the minority discount should be seven percent rather than the nineteen percent purportedly used by the IRS in the February 13, 2006 assessment. Dkt. No. 105 at 3.

In this case, introduction of evidence of the minority interest discount used by the IRS in the February 13, 2006 assessment is irrelevant. The issue is what the correct minority interest discount is, not what it was previously determined to be. Accord. Janis, 428 U.S. at 440; see also R.E. Dietz Corp. v. United States, 939 F.2d 1, 4 [68 AFTR 2d 91-5238] (2d Cir. 1991) (“The factual and legal analysis employed by the Commissioner is of no consequence to the district court.”). The previously used minority interest discount has no baring on factfinder's de novo determination of the property's fair market value. Because evidence of the previously used minority interest discount is irrelevant, it must be excluded.

This reminds me a little of the Levy case. They were starting with a 30% discount and took it to a jury which allowed them 0%. (It was also a refund case so being stuck with the 30% was actually as bad as it could get.) In that case the taxpayers were trying to keep out the amount the family actually ultimately received.

Private Letter Ruling 201117036

This was an organization formed to provide credit counselling services that was denied exempt status.

Based on the information you provided in your application and supporting documentation, you are not operated for exempt purposes under section 501(c)(3) of the Code. An organization cannot be recognized as exempt under section 501(c)(3) unless it shows that it is both organized and operated exclusively for charitable, educational, or other exempt purpose. You failed to meet the operational test of section 1.501(c)(3)-1(a)(1) and section 1.501(c)(3)-1(c)(1) of the Regulations because you are organized for substantial private and commercial purposes, and operate in the same manner as a private commercial entity.

To qualify under IRC section 501(c)(3), an organization cannot have a non-exempt purpose that is more than insubstantial. Your primary activity is the provision of pre-bankruptcy certification and post-bankruptcy counseling for fees. You devote most of your time and activities to selling bankruptcy certifications to the general public under the guise of financial counseling. You have not shown that you are operated exclusively to educate individuals for the purpose of improving or developing their capabilities. Rather, the fact that no educational materials will be provided unless the client registers for a counseling session is an indication of operation for a primarily business purpose. Your primary focus is to expand your client base and to issue bankruptcy certificates as quickly as possible in order to generate revenue. Analogous to the organization described in Better Business Bureau of Washington D.C., Inc. v. United States supra, your activities appear to have an underlying commercial motive that distinguishes your educational activities from that carried out by a university or educational institution.

If you want to be recognized as a charity maybe you could kind of like do something charitable.

Private Letter Ruling 201117035

Here the IRS shows its narrow speciesism. Among the possible purposes that qualify for exemption is "education". It turns out, though, that it has to be human beings who are being educated. Doggy University (the name I made up for the anonymous ORG in this ruling) does not qualify.

ORG holds dog obedience training classes, and awards the dogs a degree after completion of the course and also award, them prizes at the shows events. While the owners received some instruction as to the training of the dogs, it is the dog that is primary object of the training.

The nature of obedience training requires that the owner of the dog appear at the classes so that the dog is trained to respond to his owner's commands. While the owner receives some instruction in how to give commands to his dog, it is the dog that is the primary object of the training. The dog is also the primary object of the subsequent training in sporting and show events. Therefore, the organization's training program for dogs is not within the meaning of educational as defined in the regulations.

Dog training in the manner you describe is not exempt purposes as described in IRC section 501(c)(3), because the organization's training program for dogs as well as its dog shows is not within the meaning of educational as defined in the regulations . In fact, you primarily serve the private interests of the dog owners and thus not operated exclusively for 501(c)(3) purposes.

Private Letter Ruling 201117011

Taxpayer was granted 120-day extension from date this letter was issued, to make election under Code Sec. 469(c)(7)(A); to treat all of his interests in rental real estate as single rental real estate activity effective stated year.

Rental activities are "per se" passive. There is an exception for people in real estate trades or businesses if they meet certain requirements. They still have to materially participate in the properties. Absent the election to aggregate the material participation standard can be challenging when there are multiple properties. Taxpayers who have failed to make the election can sometimes get relief with a late election as the taxpayer in this ruling did.

Tax Rate of 131% ? - It Can Happen

2011-06-20T05:00:00.001-04:00

Kevin L. Sherar, et ux. v. Commissioner, TC Summary Opinion 2011-44

I didn't know there was a way for somebody to be taxed 131% on income received, but Mrs. Sherar's attorney managed to find a way. Linda Sherar was collecting workman's compensation insurance. Her attorney advised her that she also qualified for Social Security disability payments. She applied for them. She received a check for $3,796.38. Not a lot of money, but if it was laying on the street I would bend over to pick it up. The reason that she didn't get much in Social Security disability is because her benefit was offset by the workman's compensation. Here is where it gets ugly. Workman's compensation payments are excluded from income. Social Security payments are only partially excluded (85% included 15% excluded). The 85% is applied to the entire benefit including the portion that was offset by workman's compensation. So when the IRS looked at this they increased Mrs. Sherar's tax by $4,988. The Court felt kind of bad for her, but couldn't do anything about it:

We acknowledge that Mrs. Sherar applied for Social Security benefits on the advice of counsel. We also acknowledge that if Mrs. Sherar had not applied for Social Security benefits, then her workers' compensation benefits would not have been subject to Federal income tax. See secs. 104(a)(1), 86(d)(3). Under the circumstances we can appreciate petitioners' dismay. Nevertheless, as the Supreme Court of the United States has instructed, we are duty bound to apply the law as written by Congress to the facts as they occurred and not as they might have occurred.

Freddie Stromatt, et ux. v. Commissioner, TC Summary Opinion 2011-42

I almost didn't bother with this one, but it is a fairly nice hobby loss case that was won by the taxpayers. The IRS made an issue out of them putting that they were raising beef cattle on their Schedule F in the preliminary year when they just sold hay, but they did well on most of the factors.

In 1999 petitioners purchased an approximately 15-acre parcel of land near Dickson, Tennessee. Petitioner Edith Stromatt (Mrs. Stromatt) had retired before the land was purchased, and petitioner Freddie Stromatt (Mr. Stromatt) retired shortly thereafter.

In 2000 petitioners constructed a two-bedroom, one-bath house of approximately 792 square feet on the property. Mrs. Stromatt's father lived in the house from 2000 until his death in 2006. Petitioners did not live in the house or elsewhere on the property during the years at issue (2002-2004).

During 2000 and 2001 petitioners cleared the acreage, which had been untended for approximately 25 years and was overgrown with brush and trees, to prepare it for use as pasture, including the production of hay. Mr. Stromatt and Mrs. Stromatt's father operated the tractor and Bush Hog used for clearing the land, including pulling tree stumps. During 2001 and 2002 petitioners installed fencing and fertilized. This work was also performed by Mr. Stromatt and Mrs. Stromatt's father.

Petitioners harvested their first hay in 2001 and continued producing hay during the years at issue, harvesting it with rented equipment. Mr. Stromatt and Mrs. Stromatt's father performed this labor. Petitioners sold the hay, and these sales constituted the only income generated from the farming activity during the years at issue.

Petitioners first purchased cattle in 2005, acquiring six pregnant heifers. By the end of 2005 petitioners owned 17 head of cattle.

Mrs. Stromatt's father provided advice to petitioners on farming, including the number of cattle that could be supported on 15 acres of land.

Mrs. Stromatt's father was an experienced farmer, and Mrs. Stromatt grew up on a farm.

There were also substantiation issues which they probably should have settled at the agent level, but the Court was satisfied on that score also.

After weighing the regulatory factors and all other facts and circumstances, we conclude that petitioners engaged in their farming activity with an actual and honest profit objective. They and family members expended substantial amounts of physical labor to reclaim and fence land in an effort to establish a viable cattle operation. They did so at a pace that was not unreasonable in the circumstances, and they offset some losses by initially selling hay. They obtained knowledgeable advice. Their loss history was both brief (as of the close of the last year in issue) and not atypical for reclaiming land and establishing a cattle operation. The enterprise did not offer significant recreational opportunities

Jonathan C. Ladue, et ux. v. Commissioner, TC Summary Opinion 2011-41

This is about whether a deputy sheriff was subject to self-employment tax on pay that he received for "off duty services". I've always heard this type of thing referred to as "pay details". There is some support for the position that the deputy is functioning as an employee while on the assignment:

During 2007, petitioner was employed as a deputy sheriff by the Jacksonville Sheriff's Office (JSO). JSO permits deputies to provide off-duty services for entities other than JSO. JSO's General Order LIII. 10 (JSO General Order) contains detailed provisions that an officer must follow to obtain and maintain off-duty work.

Entities desiring to hire JSO deputies for off-duty services must submit an application to the Secondary Employment Unit of JSO. A JSO job scheduler acts as a liaison between JSO and the entity by completing the jobsite schedule for JSO employees working for a particular entity, “ensuring employee attendance is adhered to, and resolving employee/employer conflict when appropriate.” Entities that hire deputies for off-duty services are required to pay an administrative fee to JSO for each hour of off-duty service provided by each officer. Working while off duty is strictly voluntary; JSO deputies are not required to perform off-duty services.

The JSO General Order determines the off-duty minimum pay rate, limits the maximum monthly hours of off-duty work, and requires JSO deputies to wear their uniforms and monitor their police radios when providing off-duty law enforcement-related services. Deputies providing off-duty services are also subject to recall to regular duty by JSO. While working off duty, deputies are governed by all JSO policies, procedures, and directives, and the JSO Watch Commander may suspend a deputy's off-duty work if the work or the officer does not meet policy requirements

That was not enough for the Tax Court, though.

After considering these factors, as discussed below, we conclude that petitioner was not an employee of JSO but performed his off-duty services as an independent contractor.

First, petitioner's off-duty services were performed for, and were directly beneficial to, the third-party entity. See Milian v. Commissioner, supra (stating that performance of services by the employee for the employer is implicit in an employee relationship); March v. Commissioner, T.C. Memo. 1981-339 [¶81,339 PH Memo TC]. “Any benefit *** [the department] received by an increased police presence at petitioner's off-duty assignments was incidental and similar in nature to the benefit to a police department when officers increase the police presence in a community by driving their police cruisers home.”

A second factor of an employer-employee relationship is the ability to select and discharge at will. March v. Commissioner, supra. The mere approval from JSO to work off-duty jobs and the ability to suspend if department policies were not adhered to do not amount to the ability to hire and fire with regard to the off-duty positions.

Third, the source and method of payment may also help establish whether an employer-employee relationship exists. March v. Commissioner, supra. All of the third-party entities for which petitioner provided off-duty services operated separately from the city of Jacksonville and JSO; the third-party entities paid petitioner directly and treated him as an independent contractor, issuing him Forms 1099. The city of Jacksonville did not include off-duty pay in petitioner's Form W-2.

Slight changes in the way the pay details are structured would probably produce a different result.

CCA 201115022

If you think your joint account holder might be someone who is apt to be levied, it's time to get a separate account.

For purposes of determining ability to pay, ownership is presumed to be in equal shares unless the taxpayer demonstrates otherwise. See IRM 5.8.5.5. In the levy context, the Supreme Court held in the National Bank of Commerce case that where under state law the taxpayer has the unrestricted right to withdraw funds from a jointly held account a levy attaches to the entire account. The levy, however, is provisional and subject to a later claim by a codepositor that the money in fact belongs to him or her.

Divorce Attornies Need to Watch Their Language

2011-06-17T05:20:00.000-04:00

Betty L Klebanoff v. Commissioner, TC Summary Opinion 2011-46

I've been going back and forth whether to make much of this one or not. Taxpayer entered into a business venture, whether as a partner or not is a little unclear. They received a $51,000 "draw" against profits that never materialized. When her return was due it wasn't clear what she was supposed to report so she didn't report anything. Then they gave her a K-1 which said she had received a guaranteed payment. The venture had by then fizzled. Soon after the IRS audited her. Her position was that the $51,000 was not reportable. IRS said it was ordinary income subject to SE tax.

The Tax Court ended up with short term capital gain - distribution from a partnership in excess of basis. Not only was there no SE tax, there was also no penalty, which I think was on the generous side :

Petitioner was aware that she received $51,000 in payments from Mirus during 2007. She did not understand the legal or technical ramifications of those payments. She made attempts to contact Mirus and Messrs. Buck and Colson, but she did not receive any response regarding the $51,000 in payments. Petitioner did not receive any notification from Mirus before her 2007 income tax return was due and was filed. At the time her 2007 income tax return was due and being filed in 2008, petitioner's lawyer was engaged in negotiations in an attempt to work out some settlement of her interest in Mirus. There was uncertainty about whether petitioner would receive additional amounts from Mirus and/or Messrs. Buck and Colson and as to the nature of the payments already received. Petitioner decided to wait and file an amended return for 2007 after she was able to better address the taxability of the $51,000 in payments.

The events that culminated in the filing of the first Mirus partnership return and petitioner's income tax return were followed in relatively short order by respondent's audit of petitioner's return and the issuance of a notice of deficiency. Petitioner consulted tax professionals who advised her and caused her to file an amended partnership return for Mirus reflecting that the $51,000 in payment was a draw and that Hospice and Rock were the partners of Mirus.

It was therefore reasonable for petitioner to take the position that the $51,000 was not taxable in her 2007 tax year. Under those circumstances, petitioner's actions were reasonable and she is not liable for an accuracy-related penalty.

I really don't see a defensible argument for not reporting the $51,000 somehow or other, but it was a confusing mess, so I'm glad she got a break on the penalty.

Tuwana J. Anthony v. Commissioner, TC Summary Opinion 2011-50

If you have a business that involves selling various items, inventory is likely to enter into your tax computations. You can't just deduct what you spent on the stuff from what you got paid for stuff in each year. You have to consider stuff that is bought in one year and sold in a different year. If you are talking about big items you might specifically identify them, but if its a lot of small stuff you need to take a short cut. The short cut is this. To figure your cost of goods sold you take the amount that you spent on stuff during the year ("purchases") and add the cost of stuff you had on hand at the beginning of the year "opening inventory". That is your cost of goods available for sale. To get your "cost of goods sold" (which is the number that you get to reduce your income by) you need to subtract the cost of stuff you didn't sell, "ending inventory". Getting that number can be a bit of production. It's one thing if you have an auto dealership with paper work on each vehicle from the factory. If you have a retail store with all sorts of little tchotchkes it can be more of a production. One way to approach it is to list out all the items with their selling prices and then reduce the total by your mark-up.

Ms. Anthony apparently forgot that last step. She was audited for 2004 and was able to convince the Tax Court that her ending inventory was overvalued because it was at retail selling price.

During settlement negotiations in docket No. 5791-07S, petitioner affirmatively raised, inter alia, the issue of whether the $41,097 reported ending inventory on petitioner's 2004 Federal income tax return should have been reported as $20,548. Specifically, petitioner took the position that she erroneously reported her 2004 ending inventory using her retail selling price—rather than her cost—for the inventory.

The 2004 case was settled in 2009. There was a little problem though. The incorrect 2004 closing inventory was used as the 2005 opening inventory. This could have been a gotcha on the IRS, since the statute was closed on 2005, but that is not the way it worked out:

In Tuwana J. Anthony v. Commissioner, Docket No. 5791- "07S”, based on representations made by you, the Tax Court made a determination that your ending inventory for 2004 was $20,548, instead of $41,097 as reported by you. Under section 1311, the same adjustment is required to be made to your beginning inventory for 2005. *** This results in an increase to your [2005] income of [$20,549]. On the basis of the above inventory adjustment and other adjustments that petitioner and respondent agreed to, respondent determined a $5,516 deficiency in petitioner's 2005 Federal income tax. Although the section 6501 3-year period of limitations for 2005 had expired at the time respondent issued the notice of deficiency on January 7, 2010, respondent relied on the mitigation provisions of sections 1311 through 1314 to issue the notice of deficiency to petitioner.

On the basis of the foregoing, we find that all requirements of the applicable mitigation provisions have been met and that respondent properly relied thereon in issuing petitioner the notice of deficiency for 2005. Petitioner's opening inventory for 2005 is reduced from $41,097 to $20,548 consistent with the adjustment made to her 2004 ending inventory.

Jose B. Magno, et al. v. Commissioner, TC Summary Opinion 2011-43

This was another case about the real estate trade or business exception to the passive activity loss rules. The taxpayer hadn't made the aggregation election and his testimony about time spent was not persuasive:

During the audit stage of this proceeding, Mr. Magno told respondent's revenue agent that he worked approximately 25 to 30 hours per week on his financial planning and services business. That conversation was documented in the revenue agent's notes, and the revenue agent testified credibly to its contents at trial. At trial, however, Mr. Magno testified that he worked principally as a financial consultant from January through August 2005. He also testified that he became a full-time manager of the first and second residences in 2006 and 2007 and that he reduced the number of hours which he devoted to his financial consulting services business to “about” 500 hours per year.

We credit the testimony of respondent's revenue agent and therefore conclude that Mr. Magno must have worked more than 1,250 hours during each subject year in real property trades or businesses to qualify as a real estate professional under section 469(c)(7)(B)(i). 6 Mr. Magno was not able to corroborate with written documentation his assertions that more than one-half of the personal services he performed in trades or businesses during the subject years were performed in real property trades or businesses. Accordingly, we find that Mr. Magno has not proven that he meets the requirements of section 469(c)(7)(B)(i).

I'm starting to find these cases a little tedious, but I'm going to continue to report on them.

Timothy O. Micek v. Commissioner, TC Summary Opinion 2011-45

In 1999 petitioner and Ms. Micek orally agreed that petitioner would help support Ms. Micek by paying her $1,250 every 2 weeks. To memorialize this agreement, on November 10, 1999, petitioner signed a spousal support affidavit, stating that he promised to pay Ms. Micek $1,250 biweekly via direct deposit. A notary public of the State of New Jersey notarized the spousal support affidavit. Throughout the years at issue, petitioner made payments to Ms. Micek pursuant to the spousal support affidavit.

While petitioner was making payments, he was diagnosed with multiple sclerosis and was forced to stop working. As a result, in 2003 petitioner stopped making the required payments. On April 21, 2003, petitioner's attorney received a letter from Ms. Micek's attorney inquiring why petitioner had terminated the “alimony/expense payments”.

The issue before us is whether the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2). The spousal support affidavit is a written instrument, signed by petitioner, promising to pay Ms. Micek $1,250 every 2 weeks. As discussed above, a separation instrument does not require a specific medium or form and does not have to be signed by both husband and wife. Further, even though Ms. Micek did not sign the spousal support affidavit, petitioner testified that he reached an oral agreement with Ms. Micek with respect to support payments during their separation. This meeting of the minds not only is memorialized by the spousal support affidavit, but also is supported by the letter from Ms. Micek's attorney received by petitioner's attorney on April 21, 2003, describing the payments she had been receiving from petitioner as alimony payments. Accordingly, the spousal support affidavit qualifies as a written separation instrument as defined by section 71(b)(2), and petitioner is entitled to his claimed alimony deductions for the years at issue.

It looks like the IRS may have been whipsawed by this decision. If not I would not like to be in the shoes of Ms. Micek's attorney since his use of the word "alimony" was an important element in the decision. He should have been aware of whether his client was reporting the payments as taxable income.

Selling Soap as a Hobby - Amway IBO's in Tax Court

2011-06-15T21:24:00.003-04:00

Roger S. Campbell, et ux. v. Commissioner, TC Memo 2011-42

The Amway distributorship system is well known to respondent and this Court
Friscia Construction, Inc., et al. v. Commissioner, TC Memo 2000-192

I included the Campbell case in one of my group posts. It concerned someone whose Amway activities were considered a hobby by the Tax Court denying them deductions for losses. That portion of the post was picked up by someone who calls himself Joecool and posted on his blog under the title "Do IBO's have a clue about business?". I found that there are quite a few blogs dedicated to pointing out the downside of the Amway experience including Married To An Ambot by Anna Banana :

My story of what its like to be married to an Amway cult follower. I expose the lies that our upline told and what happens at Amway meetings and functions. I leave the explanations of why Amway is a poor business opportunity or the tool scam to other bloggers. This blog mainly exists to curse out my former upline, aka the cult leaders, and to let everyone know what kind of idiots I had to put up with. Feel free to join in or live vicariously.

Come on Anna, stop holding back. Tell us how you really feel.

So I got motivated to look at what was in the database I prowl for my little tax jewels on Amway. As the above quote from Friscia Construction indicates, there is quite a bit. "The Court" is the Tax Court. "Respondent" is the IRS (In all Tax Court cases the taxpayer is "The Petitioner" and IRS is "The Respondent"). Friscia Construction is unusual among the cases I found. It is about the IRS challenging the deductions of a profitable Amway distributor.

Although originally focused on soap, Amway sells a variety of household products through its multi-level marketing system. In case you have never been invited to an Amway presentation or, more likely, didn't go when you were invited, the emphasis is not so much on the products or even selling the products. It's about getting other people to sell the product, who in turn get other people and so on with you sitting at the top of your pyramid (only they make it real clear its not a pyramid).

Bloggers like Joecool and Anna Banana claim that there are very few people who make money at it. Those that do probably don't make as much as they claim, since those in the "upline" need to paint a glowing picture to motivate the "downline" IBO's (Independent Business Owners). Further, the bloggers claim that most of the soap and other stuff is actually bought by the IBO's themselves. Finally, the "upline Diamonds" make most of their money from selling "tools" (i.e. motivational tapes and the like) to the downline.

The other attraction of Amway to some people is that it might allow them to deduct as business expenses things like cars, part of their home or entertainment that they would have spent anyway. That's probably the aspect of Amway that the IRS finds most interesting. Joecool did a post on how some IBO's think of their income tax refunds (generated by Amway losses sheltering other income) as profit.

To me the most interesting thing that I found in my search is this excerpt from the Internal Revenue Manual for examiners who are doing information requests:

.4.4.3.39 — Amway Corporation
[Last Revised: 12-10-2007]
(1) Amway Corporation has waived the hand delivery requirements of 26 USC §7603 and will accept summonses by personal service, mail, or overnight service at Amway Corporation, 7575 E. Fulton, Ada, MI 49355, Attn.: Director, Legal Division. Direct distributors who further qualify for profit sharing bonuses receive the non-cash part of that bonus through a mutual fund account administered by Amway Mutual Fund, Inc., 7575 E. Fulton, Ada, MI 49355, which requires a separate summons

Now I am subject to the AICPA Statements of Standards on Tax Practice, which among other things forbids me from giving clients advice based on what I believe the audit selection process of a taxing authority is. I wouldn't do it anyway, because I think most people who give that type of advice are guessing. Even if you happen to be one of my clients, I'm speaking to you purely as a reader here when I give you this advice:

                                                You don't tug on Superman's cape
                                                You don't spit into the wind
                                                You don't pull the mask off that old Lone Ranger

And you don't take no Schedule C losses from an arrangement with a company that IRS examiners have on speed-dial.

I found 23 cases of IBO's who fought the IRS in Court. (A couple appealed, but I only counted them once)They pretty much all lost. In these type of cases there are really three ways you are denied deductions. The first is substantiation. You didn't prove it. Next is that the expenses are not really ordinary and necessary expenses of the business. When you are talking about cars and business use of the home, those two issues can get blurred together. The third is that there really isn't any business there. Taxpayers fight the IRS and win on that issue frequently even a Vietnamese couple whose "business" was playing slot machines using the principles of Feng Shui. Amway IBO's who take on the IRS on the Section 183 "hobby loss" issue almost always lose.

One of the most common themes is that IBO's seek advice generally only from their "uplines", who of course are not disinterested. They also do not seem to put any energy into trying to control their expenses. I'm going to give you a little snippet from each of the cases and comment a bit on some of them.

LOPEZ v. COMM., Cite as 94 AFTR 2d 2004-7075
Jorge N. Lopez, et ux. v. Commissioner , TC Memo 2003-142

Tax Court properly determined that engineer and wife weren't entitled to business deduction for expenses incurred in connection with their Amway products distribution activity because they didn't engage in activity for profit: although taxpayers showed proof of profit motive, such wasn't sufficient to override govt.'s evidence that included their failure to keep businesslike records, their failure to alter unprofitable methods, their non-dependence on activity income, and their use of activity to socialize with friends and family.

In their own Amway activities, which began in 1996, the Lopezes sold products at cost to both their downline distributors and their customers, which practice eliminated retail sales as a source of gross income. They chose instead to focus their efforts on developing a network of downline distributors to generate performance bonuses. Relying on Amway brochures, the Lopezes concluded that they would need to achieve and maintain a monthly point value of 4,000 for their Amway activities to be profitable. In 1998 and 1999, the Lopezes' point value did not exceed 372 points in any month.

The only advice they sought for their Amway activities was from upline distributors, and when they received unsolicited advice from their accountant, they disregarded it. During the years in question, Mr. Lopez was employed full-time as a petroleum engineer, and Mrs. Lopez was a homemaker.

The tax court ultimately was not persuaded that the Lopezes' primary motive for conducting their Amway activities was for income or profit. It found that the conduct of their Amway activity “virtually precluded any possibility of realizing a profit.” The Lopezes' lack of a business plan for recouping losses and achieving profitable levels of activity indicated the absence of a profit motive. In the face of four consecutive years of losses, the Lopezes still did not change their approach to increase the likelihood of earning a profit. The tax court further found that the Lopezes did not conduct market research to help them assess the potential profitability of their activities. It also noted that, although the Lopezes had no prior business experience, they accepted the advice of upline distributors rather than seeking advice from unbiased, independent business sources.

Since the Mr and Mrs Lopez appealed, they got to lose twice.

OGDEN v. COMM., Cite as 87 AFTR 2d 2001-1299
Michael A. Ogden, et ux. v. Commissioner, TC Memo 1999-397
Contrary to the Ogdens' contention, evidence of profit is not determinative of whether a profit motive exists. See id. at 876 (no single tax regulation factor, nor the existence of a majority of factors, is determinative of whether a profit motive exists). There is overwhelming evidence in the record that, if believed, supports a conclusion that the Ogdens maintained their Amway activity for deductions, personal pleasure and to offset wages. The tax court did not abuse its discretion in denying the motion for reconsideration.

Amway does not have a quota for sales, its products do not have to be sold above cost, and its distributors are not required to sponsor downline distributors. An Amway brochure, The Amway Business Review, states that the potential for earning income increases as the number of distributors in a sponsor's group grows and as sales increase. Distributors devote as little or as much of their time to Amway activities as they desire. The eight page Amway Business Review in large blocks on four of its pages highlights the fact that “The Average Monthly Gross Income for “Active” Distributors was $88.”

We believe Amway distributors may be biased when discussing Amway because they have a natural desire to advance the organization and/or obtain income from a downliner.

ELLIOTT v. COMMISSIONER, 90 TC 960

Deductions denied for business expenses and depreciation connected with Amway distributorship. Activities were conducted in unbusinesslike manner, taxpayers maintained full-time jobs, and little distinction was made between Amway activities and personal social activities. Also, IRS properly imposed penalties for failure to timely file and negligent or intentional disregard of rules.

A further indication of the unbusinesslike fashion in which petitioners conducted their Amway activity was the thin line dividing business activities from personal and [pg. 973]recreational activities. Petitioners offered scant evidence that their Amway activity required them to do anything other than to maintain an active social life. Although they occasionally attended seminars, most of their activity involved giving parties and taking people out to restaurants. While there is no requirement that profit-oriented work be onerous and unpleasant, the evidence presented by petitioners does not indicate activity motivated by a profit objective. On the contrary, the evidence shows that petitioners made some small modifications in their routine social life, kept cursory notes about their activities, and claimed deductions for the cost of nearly everything they owned or did. On this record, we find as a fact that petitioners' activities were motivated by a desire to avoid tax rather than a desire to generate income.

Roger S. Campbell, et ux. v. Commissioner, TC Memo 2011-42

Activities not for profit—profit objective—distributorship and direct marketing activities. Code Sec. 183 deduction limits applied to expenses pro se married real estate and construction business operators claimed in connection with Amway distributorship activity that they engaged in without requisite profit objective. Lack of profit objective was shown by facts that taxpayers commingled expenses, had no idea if they were making profit for any given year until they filed that year's return, didn't keep complete records, and otherwise didn't conduct activity in businesslike manner. It was also telling that taxpayers didn't have experience in this type of activity, didn't seek out independent advice, used activity losses to offset their real estate and construction business income, and stated that they would continue with activity regardless of whether it ever turned profit. Countervailing facts that they spent significant time on activity and increased gross receipts during years at issue weren't dispositive considering overall record.

Kenneth J. Nissley, et ux. v. Commissioner, TC Memo 2000-178

Activities not for profit—Amway distributorship. Husband and wife/CPAs didn't engage in Amway distributorship activity for profit: taxpayers incurred substantial losses for 8 consecutive years; and didn't conduct activity in business-like manner where they kept separate bank account and records to “guarantee” deductions

Kenneth C. Theisen, et ux. v. Commissioner, TC Memo 1997-539

Full-time IRS agent and travel agent-wife didn't operate Amway distributorship for profit, so weren't entitled to deductions from activity: taxpayers didn't conduct activity in business-like manner where they didn't have business plan, perform break-even analysis or have budget; admitted that benefits included ability to buy discounted products for personal use; testified that distributorship was for financial gain and personal purchases were more than purchases acquired for resale; reported losses for 5 consecutive years; couldn't explain how or when distributorship would become profitable or why auto and telephone expenses increased without corresponding revenue increase; kept income and expense ledger for substantiation purposes only; and intentionally excluded cost of motivational tapes from costs of goods sold to avoid disclosing negative gross income on returns

Generally, no. The way the plan is written is, you're taught to purchase things from yourself for yourself, and you get other people — say, Look. Just change your buying habits. Don't go to HEB. Don't go to Eckerd's. Don't go to Sam's. You get access to all these products. Change your buying habits. Buy things for yourself

Petitioner also conceded that petitioners' personal purchases were more than the purchases they acquired for resale to other customers or downline distributors. Specifically, petitioner admitted that in 1992 he bought $4,500 of products for personal use and $3,262 of products for other purposes. For 1993, he conceded he bought $10,729 of products for personal use and $4,991 of products for other purposes.

Bryan J. Brennan, et ux. v. Commissioner, TC Memo 1997-60

1. Litigation costs—substantial justification for IRS position—distributorship conducted for profit. Taxpayers were denied litigation costs with respect to underlying case challenging IRS's disallowance of their business deductions: IRS was substantially justified in its position that taxpayer didn't conduct household product distributorship with requisite profit objective under Code Sec. 183 . Taxpayers had losses for 7 consecutive years, yet earned substantial income from other sources for 2 of those years, and didn't provide IRS with business plan or profit projection; and similar distributorship-related activities had been found to contain elements of personal pleasure. Also, IRS's concession of the issue within 5 months of filing answer and 2 months of receiving additional information was reasonable.

This is a case of the taxpayer actually settling favorably with the IRS. They were, however, not able to recoup attorneys fees.

William B. Hart, et ux. v. Commissioner, TC Memo 1995-55

Taxpayers weren't entitled to deduct business loss related to Amway distributorship: taxpayers didn't engage in activity for profit. Expenses of distributorship activity related mainly to social functions: taxpayers attended seminars in Colorado and California, and monthly dinners with their “network”; taxpayer-husband took guest who was interested in finding out more about distributorship on fishing trip; and “supplies” expense included groceries bought while taxpayers were away delivering products or visiting clients. Court rejected argument that activity was conducted in businesslike manner because taxpayers kept records, sought expert counseling, and devoted time and effort to distributorship: they didn't utilize records in way to help them make profit; they didn't seek advice on how to cut back on expenses; many of expenses claimed had significant elements of personal pleasure; and due to distributorship's low receipts it appeared that taxpayers used their time spending money on entertainment rather than focusing on earning profit.

Negligence penalty was upheld: despite Tax Court's warning in prior case that taxpayers couldn't translate their Amway business into deduction for personal aspects of their lives, taxpayers again attempted to deduct clearly personal expenses in guise of distributorship activity, which they had failed to show was being operated for profit. But taxpayers weren't liable for penalty for filing late return: recent death of taxpayers' son was reasonable cause for delay in filing return; and there was no willful neglect.

Petitioners do not appear to have heeded our warning, and respondent was not as charitable this time. Again petitioners have attempted to deduct clearly personal expenses in the guise of an Amway activity that they failed to show was being operated for a profit. We sustain respondent on this issue.

Thomas P. Poast, TC Memo 1994-399

IRS proved that taxpayers, full-time automobile workers, lacked requisite profit objective in carrying on their Amway distributorship activity. Taxpayers failed to conduct activity in businesslike manner: taxpayers maintained incomplete sales records, used solely to help to substantiate claimed deductions; they failed to isolate business expenses from personal expenses; and taxpayers kept no realistic and reasonable budget despite incurring substantial net losses in all prior years. Further, taxpayers' claim that they sought expert counseling regarding business techniques was rejected: taxpayers abandoned "ineffective" techniques without performing cost/benefit analysis of techniques; and techniques received from "upliners" (who had financial stake in taxpayers' sales) were never seriously utilized. Also, much of the time taxpayers spent on Amway activity involved substantial pleasurable personal aspects.

Shortly before becoming involved with their Amway activity, petitioners attended a seminar conducted by an insurance agent, Donald Fletcher, who conducted similar seminars nationwide. Fletcher promoted his life insurance product, while suggesting to the participants of the seminars that the premiums be funded by tax savings generated by deducting largely personal expenses through a home based business like Amway. Fletcher offered to prepare participants' tax returns and provide representation in audits for a cost of $125.

We find not only that the techniques were not seriously utilized, but also that, for the most part, petitioners' advisers were not experts as much as they were upliners with a financial stake in petitioners' retail and downline sales. Neither petitioners nor their advisers appeared to be even vaguely interested in the importance of cutting back their expenses.

Gerald Eugene Swaffar, TC Memo 1992-180

IRS failed to prove that taxpayer's Amway activities weren't carried on for profit. Deductions for expenses related to Amway activities were allowed only to extent conceded by IRS: taxpayers failed to substantiate expenses in excess of that amount. Penalties for negligence and substantial understatement were imposed

At trial, respondent contended for the first time that petitioner's Amway activities were not engaged in with the requisite profit objective under section 183. Such new matter requires that the burden of proof be placed on respondent. See Rule 142(a). Respondent further contends that, assuming the Amway activity was entered into with a bona fide profit objective, petitioner has failed to establish that the above expenditures were incurred and were ordinary and necessary in carrying on a trade or business, pursuant to section 1.

An analysis of petitioner's Amway activities requires this Court to conclude, without analyzing in depth all nine factors, that respondent has not carried her burden of showing that petitioner did not engage in the Amway activity with an actual and honest objective to make a profit. We emphasize that we do not affirmatively conclude that petitioners had a profit objective, but only that respondent has failed to prove that petitioners lacked such an objective.

Sometimes it is better to be lucky than good. If in its deficiency notice the IRS asserts that you didn't have a profit motive, it is up to you to prove that you did. In this case, the IRS raised the issue later, which shifted the burden of proof. The IRS couldn't prove that they didn't have a profit motive.

Gerald W. Jordan, TC Memo 1991-50

Amway distributor was allowed to deduct expenses for travel, incentive prizes, and seminars: expenses were ordinary and necessary. Deductions were allowed in part for meal and car expenses, and were denied for gift expenses, because taxpayer didn't fully substantiate claims.

Another win for an IBO. Hooray. Too bad they didn't do a better job on substantiation.

Joseph M. Ransom, TC Memo 1990-381

Taxpayer wasn't engaged in Amway distribution activity with profit objective. Factors tending to indicate lack of profit motive were: absence of separate checking account; failure to cut costs or recruit new distributors; and substantial income from other sources (with attempted Amway deductions that would have almost eliminated tax he would otherwise owe on that income).

Peter S. Rubin, TC Memo 1989-290

Deductions attributable to Amway distributorship activities were disallowed to extent they exceeded gross income from those activities, which weren't engaged in for profit: taxpayers kept records in cursory and sloppy manner, and they engaged in distributorship activities to claim tax deductions for personal expenditures and to purchase Amway products at sizeable discounts for their own use.

Dewitt Talmadge Ferrell, Jr., TC Memo 1987-102

Losses claimed by airline pilot and housewife were limited where their business activities, involving selling of Amway products, sundials, and posters, weren't engaged in with profit objective, but rather were conducted primarily to generate tax deductions and credits for personal expenses. Revenues were of secondary importance to taxpayers who had no sales expertise and made no effort to obtain any, didn't maintain reliable records, and devoted little effort to sales. Burden of proof was on taxpayers since they didn't show that business ever reported profit before years in issue; Sec. 183(d) presumption didn't apply.

J.H. Schroeder, TC Memo 1986-583

As to the Amway distributorship fee, petitioner failed to show that he conducted his Amway affairs in connection with a trade or business or an activity engaged in for profit. Petitioner made no sales of Amway products and had no income from his Amway operations during 1981. He failed to possess the requisite profit objective, since he admittedly became a distributor solely for the purpose of being able to purchase items at discount prices by virtue of his status as a "dealer". See section 183.

Harry Mitchell Goldstein, TC Memo 1986-339

Taxpayers' Amway activities weren't trade or business and weren't engaged in for profit but were undertaken primarily to obtain tax deductions and credits; business expenses, investment credit, and child care credit denied. Taxpayers' (husband and wife) activities weren't carried on in businesslike manner, they both had full-time jobs, and they had very little success in obtaining other distributors or selling products. Taxpayers had become Amway distributors and claimed losses based on business deductions and credits.

Q. How many sales did you make in 1980?
A. Sales—1980—Probably not even $5 worth, because we did not get any new people coming in, you see. We just mostly went in for ourselves and then get the other people coming in with us.
Q. So it is your testimony that your total income from Amway in 1979 and 1980 was less than $5?
A. Yes.
Q. Are you still in the Amway business?
A. Yes. We like the products and you can't get them any other way.

John Alcala, TC Memo 1984-664

On this record, there arises the strong suspicion that petitioners became Amway distributors primarily for the purpose of providing themselves with Amway merchandise which they could not otherwise obtain, while, at the same time, providing themselves with considerable tax deductions. Compare Barcus v. Commissioner, T.C. Memo. 1973-138 We make no such finding herein, but we do hold that petitioners have failed to carry their necessary burden of proof to establish that they entered into a bona fide business enterprise with the intention and objective of making a profit. McCormick v. Commissioner, T.C. Memo. 1969-261

Randall B. Ollett, et ux. v. Commissioner, TC Summary Opinion 2004-103

In addition to the travel-related expenses, petitioners also had expenses of $3,571 in 1999 and $710 in 2000 for professional books and other materials that were part of Amway's “training program”. These books were recommended by petitioners' upline network and may be described as general self-motivation books. Petitioners also purchased various audio tapes that included stories told by other Amway distributors of how they built successful networks.

As noted above, petitioners' revenue from the Amway activity for the years in issue was minimal, and even that amount was attributable in part to petitioners' purchases of household goods for their own personal use. When asked about how they intended to turn their losses into profits, Mr. Ollett responded: “The only way I can solve it is to talk to more people. And there, in essence, is the challenge that I have, which is finding those people”.

Petitioners did not have any sales experience prior to becoming Amway distributors. Petitioners relied exclusively on their upline distributors, who stood to benefit from petitioners' participation, for advice and training. They did not seek independent business advice at the beginning of their Amway activity to assess their potential for success, and they did not seek independent business advice for turning around years of operating losses. Petitioners' failure to seek independent business advice strongly suggests that petitioners did not carry on the Amway distributorship in a businesslike manner.

Joe Guadagno, et ux. v. Commissioner, TC Summary Opinion 2003-88

Included with petitioners' timely filed return for each year is a Schedule C, Profit or Loss From Business. Each return was prepared by a certified public account who also was an Amway distributor. Petitioners' Schedules C for 1996 and 1997 list their principal business as “Amway”. For 1998, petitioners' Schedule C lists their principal business as “DistConsumerProduct”. Petitioners reported net losses of $26,264, $24,047, and $19,810 on their Schedules C for 1996, 1997, and 1998, respectively.

Before becoming Amway distributors, petitioners had neither experience with Amway nor experience in running a business. Nevertheless, they did not seek independent business advice at the outset, and they did not seek independent business advice afterwards even though losses were sustained year after year. Instead, they relied upon other Amway distributors whose advice is more accurately characterized as personal motivational advice than strategic business advice.

Larry Minnick, et ux. v. Commissioner, TC Summary Opinion 2002-147

As previously stated, more weight must be given to objective facts indicating a profit objective than to petitioners' statement of intent. Dreicer v. Commissioner, supra. After considering the objective factors detailed above, we find especially relevant the manner in which petitioners carried on the Amway activity and petitioners' history of losses and lack of profits. We find from these and the other objective facts in the record that petitioners did not have an actual and honest intent to profit from the Amway activity in 1996 and 1997.

Broadrick R. Moore, et al. v. Commissioner, TC Summary Opinion 2001-173

Considering the record in its entirety, we are satisfied that petitioners did not have the actual, honest, and bona fide objective of making a profit. It appears that they became Amway distributors simply to deduct expenses for items of a personal nature

Karl Meyer, et ux. v. Commissioner, TC Summary Opinion 2001-157

The Amway “pyramid” incentive system is promoted by Amway in the form of the “9-4-2 plan”. Under the “9-4-2 plan”, each Amway distributor is encouraged to personally recruit 9 “downline” distributors, each of whom in turn is encouraged to recruit at least 4 “downline” distributors, each of whom in turn is encouraged to recruit at least 2 “downline” distributors (for a total of 117 “downline” distributors in the initial distributor's organization). The “9-4-2 plan” is promoted as the theoretical break-even point for a distributorship, assuming that (1) the distributor and each “downline” distributor within the distributor's organization purchases $200 of Amway products per month and that (2) the distributor does not have expenses exceeding $2,000 per month. At least in theory, the potential for profit is enhanced as each of the 117 “downline” distributors in the distributor's network successfully implements the “9-4-2 plan”.

The Amway “9-4-2 plan” does not provide meaningful guidance to distributors regarding how expenses incurred in pursuing an Amway activity may be reduced

Despite their lack of experience with either Amway or an Amway type activity, petitioners never sought meaningful counsel from disinterested third parties. Rather, petitioners relied principally on advice from “upline” distributors and other interested Amway individuals

James R. Landrum, et ux. v. Commissioner, TC Summary Opinion 2001-112

Prior to the years in issue, petitioners had three separate experiences with Amway, beginning in 1974. Mr. Landrum was a corporal in the Marine Corps and was stationed in Hawaii in 1974. His Amway activity consisted of purchasing cases of wax from an Amway distributor at wholesale, selling “a case or two a month to [his] friends,” and keeping the difference between the wholesale and retail prices. He ceased his activities with Amway in 1976 when he was transferred from Hawaii and then released from active duty with the Marine Corps. After their marriage in 1977, petitioners participated in an Amway distributorship. Their experience with Amway was unprofitable, and they terminated it after 2 years. Petitioners became involved with Amway a third time in 1985, while Mr. Landrum was employed at Goodyear. Although petitioners had about 50 persons reporting to them, directly or indirectly, in the pyramid structure of Amway, there were insufficient sales for profit. Petitioners' third Amway venture lasted approximately 2 years, and again, petitioners terminated the activity for lack of profit. In late 1995, petitioners were introduced to Amway a fourth time by friends of Mrs. Landrum. This fourth Amway experience is the subject of the present controversy.

Mr. Landrum estimated that the person who established a successful 6-4-2 grouping would receive $1,800 to $2,200 in monthly commissions and then might proceed to gain even greater benefits as a “direct distributor” who might then triple his organization and receive an “Emerald bonus” and then expand to have six legs and a “Diamond organization”. According to Mr. Landrum, Amway distributors with an emerald organization make $75,000 to $100,000 annually, and those with a diamond organization make $125,000 to $250,000 yearly, “And it goes up from there” as he put it.

Conclusion:

23 cases on the same issue is a goodly number, but of course they are over a long period of time. It's clearly not a random sample. If you are say the 20th case like this either you didn't do your homework or you are really stubborn. The other thing that biases this is that the IRS picks the worst cases to contest. Before you get a "90 day letter", which is what allows you to go to Tax Court, you can have an independent appeal in the IRS. Once you file to go to Tax Court, the case will get kicked back to appeals to see if they can settle. At that point appeals can consider "hazards of litigation". So there are probably many people who got decent settlements from the IRS. Of course there are also many who just wrote a check to close out the audit. All in all, though, if the reason you want to start a business is so that you can deduct money you spend anyway (Something I advise you not to do), Amway is probably one of the worst things that you could pick. It's worse than horse breeding, which the IRS seems to have a particular antipathy for, but the Tax Court often allows.

Interestingly, I did not find any cases of people who were using other types of tax shelters to shelter their Amway income. Also, if the Amway dream is really true, you would think I would find a case like that of Peter Morton, who was being challenged on deducting his jet expenses, only with the taxpayer being a Quintuple Diamond Super Duper Amway guy. At the Amway meeting I went to they said that they were glad not everybody took advantage of the Amway opportunity, since they needed pilots for their planes and the like.

All in all, I would say that while not determinative, the record in the tax court is supportive of Joecool and Anna Bannana. At least, there are some more stories for them.

Ignore Those Bad Idea Bears-IRA Not a Good Bridge Loan Source

2011-06-15T05:00:00.003-04:00

Private Letter Ruling 201118025
Private Letter Ruling 201116044
Private Letter Ruling 201116040
Private Letter Ruling 201117046

My friend suggested we get a series of tickets to plays at Hanover Theater. I don't regret it, but I have to say I was a little disappointed. My idea of what a play is was more or less fixed while I was in high school. I had the good fortune to attend Xavier High School in Manhattan and we had a fantastic English teacher Brian Moroney who would get us discount tickets to plays. It was quality stuff, but not first run Broadway stuff - off-Broadway, Lincoln Center etc. So I always think of plays as kind of deep and profound and maybe a little depressing. When I reflect on it, I sometimes wonder what the point of bringing a bunch of Irish Catholic kids to see Long Days Journey into Night was. Half of us could just go visiting to find that kind of alcoholic dysfunction and the other half could just stay home. Turns out that Hanover at least in this series was all musicals all the time. I like musicals as well as the next guy although maybe not quite as much as The Wandering Tax Pro, but I'm still aching to see something like Hedda Gabler. Maybe next year. Which is not to say you can't get something worthwhile out of musicals, even an extremely silly one like Avenue Q.

In Avenue Q the characters are people, Muppet like creatures and people walking around with Muppet like characters. Among the latter were "the bad idea bears". They kept telling the main character to do foolish things like spending all his money on beer. They weren't giving much financial advice, but if they thought of it I'm sure one of their suggestions would have been to use your IRA for a bridge loan. Most people think its a bad idea to take money out of your IRA before you are 59 1/2 (I'm counting the days by the way) and even then if you don't need it. What if you have a temporary need for money though ?

Here is what the bad idea bears have to say on the subject. If you withdraw money from your IRA you have sixty days to roll it over into another IRA. So if you need some money for a short period like five or six or seven weeks just take it from your IRA and put it into another IRA before the sixty days are up. Besides if the IRS is pretty forgiving if you somehow foul up and go past the sixty days. They give favorable rulings on that all the time.

I mean just recently there were two rulings where people were allowed to make late rollovers PLR 201116040 and PLR 201116044. Some crook stole the money so the taxpayers got more time to make the rollovers. So if something goes wrong maybe you can just say you thought it was 90 days like the lady in PLR 201117046. Oh, that didn't work did it ? That lady was denied relief.

Well what about the fellow in PLR 201118025, who was trying to help out his mom. If anybody deserves relief it is him. I mean check out the story:

Taxpayer A represents that when his elderly mother, Individual B, developed mobility limitations which made it unsafe for her to remain in her two-story residence, Taxpayer A's siblings developed a plan which, in pertinent part, involved Taxpayer A and his siblings pooling their money to add to the sale proceeds of the first residence in order for Individual B to make a cash purchase of suitable housing. Individual B would then enter into reverse-mortgage financing of the new residence and receive a lump-sum cash payment which she would use to repay Taxpayer A and the others. Taxpayer A would then redeposit Amount N into IRA X.

On Date 1, Taxpayer A received a distribution of Amount N from IRA X. On Date 2, seven days after Date 1, Amount N was applied to the above described purchase. Also, on Date 2, Bank D began processing the reverse mortgage. Taxpayer A represents that Bank D gave assurances that the mortgage process, including payment to Individual B, would be completed within a time frame which would have allowed Taxpayer A to meet the 60-day period for rolling over Amount N into IRA X, however, numerous delays by Bank D resulted in the mortgage not having been processed as of the 60th day after the distribution of Amount N from IRA X.

Taxpayer A represents that upon completion of the processing of the reverse mortgage, Taxpayer A was reimbursed in full and immediately mailed an amount equal to Amount N, to Financial Institution C with instructions to redeposit Amount N into IRA X. On Date 3, Amount N was redeposited into IRA X, however, as explained above, the 60-day period for rolling over Amount N into an IRA had already expired.

Bad idea- Bank D may have screwed up, but Bank D wasn't involved in the IRA either outgoing or incoming:

Taxpayer A has stated that error by Bank D is responsible for his failure to make a timely rollover of Amount N, however, when Amount N was presented to Bank D, Taxpayer A did not intend that Bank D transact any financial matter relating to an IRA. Rather, Amount N was withdrawn from IRA X at Financial Institution C and was presented to Bank D for the purpose of contributing Amount N, on a temporary basis, toward the purchase price of a suitable residence for Individual B. In essence, Taxpayer A made a short term loan when he withdrew Amount N from IRA X and while he had the intent at the time of withdrawal to redeposit Amount N into IRA X prior to the expiration of the 60-day rollover period, he assumed the risk that Amount N might not be returned to him timely.

The ruling would have been better if they had said that the residence involved was on Avenue Q, but you can't have everything.

I Stick My Neck Out - For A Change

2011-06-14T15:00:00.001-04:00

I have mentioned that the general policy of this blog is to not take a stand on tax issues. "It is what it is. Deal with it" is my motto. I do violate the rule from time to time, but not nearly as often as Captain Kirk violated the Prime Directive.

I was, however, invited to guest post on a tax policy blog. So at the end of a rather meandering analysis of a convoluted case that bears a vague connection to the literary reference I lead in with, I make a policy recommendation - well more of an observation really.

You'll have to go to Annette Nellen's 21st Century Taxation, if you want to read it. Professor Nellen was kind enough to do a guest post here not long ago. Maybe this could be the start of something.

From the Boston Tax Institute

2011-06-14T05:00:00.001-04:00

Boston Tax Alert 2011-30,2011-31, 2011-32

Lu Gauthier of The Boston Tax Institute has given me permission to republish his newsletter. The BTI newsletter is a regular feature of this blog now going up every Tuesday. Be sure to check out the BTI catalog for great CPE value.

On or about 06/01/11, final regulations were published governing practice before the Internal Revenue Service. The regulations generally are effective 60 days after publication in the Federal Register. Among other things, the regulations define practice to include preparing and filing documents such as tax returns and define disreputable conduct to include willfully failing to file tax returns on eletronic media, willfully preparing or signing a return without a valid PTIN, and willfully representing a taxpayer without being authorized to do so. The regulations also generally conform the standards under Circular 230 for preparing returns with the standards under section 6694. These topics will be discussed in detail in our 4 hour seminars entitled Preparer Penalties/Circular 230 which provide 4 CREDIT HOURS OF INSTRUCTION ON ETHICS. -------------------------------------------------------------------------------------------------------------

Our thanks to Patricia Ann Metzer, Attorney for the following email!

The Tax Code's deferred compensation provisions raise complex interpretative issues. The IRS pronouncements highlight the strong relationship between two of these provisions - 457 and 409A. Last year, the IRS came out with guidance (Rev. Rul. 2010-27) on unforeseeable emergency - one circumstance under which payments can be made to participants under eligible 457(b) plans before their severance from employment. Under the given conditions, an unforeseeable emergency is stated to include significant water damage to your home not covered by insurance, and funeral expenses for an adult child. The IRS adds that the same standards will apply to determine whether a distribution due to an unforeseeable emergency is permitted under a 409A nonqualified deferred compensation plan.

The approach is consistent with that taken by the IRS in 2007, when it said that concepts similar to those developed under 409A would apply to determine whether an arrangement providing severance benefits is not subject to 457, and when a benefit (not provided under an eligible 457 plan) is currently taxable because it is not subject to a substantial risk of forfeiture.

The upcoming seminar on 409A/Non-Qualified Deferred Compensation will deal with both 409A and the other Tax Code provisions you need to know about when it comes to deferred compensation. Items to be addressed include how mistakes in 409A drafting can be corrected on a timely basis without, in some cases, a toll charge. IRS correction procedures were most recently announced in Notice 2010-80.

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Our thanks to Maurice Gilbert, CPA, MST for the following email!

The New Hampshire Legislature on June 1st passed new legislation that radically changes the New Hampshire Reasonable Compensation deduction under the Business Profits tax and is sending the law to Governor Lynch for his signature. The new statute will apply to 2011 taxable periods creating 3 different standards: pre-2010 taxable periods, 2010 taxable periods and post-2010 taxable periods. The new statutory language and the various standards will be discussed in detail at our seminar entitled NH Reasonable Compensation and NH Combined Reporting on June 13 at the Chateau Restaurant in Andover. Please remember to add $17 to your registration fee for the required lunch.

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A Ruling on Fraud and Some Innocent Spouse Cases

2011-06-13T05:00:00.003-04:00

Private Letter Ruling 201114005

LLC was qualified investor for purposes of claiming theft loss deduction under Rev. Proc. 2009-20 and discovery year for purposes of claiming deduction was stated year.

Cases and rulings involving fraud have an almost pornographic appeal to me. I always want some detailed descriptions in there. This ruling measured up in that regard:

In Year 4, some of Company's loans began to default. Individual A, President of Company from Year 2 until Date 6, and Individual B, chairman and CEO of Company from Year 1 until Date 6, the lead figures, concealed from investors that loans were not performing and caused Company to continue to pay interest to investors regardless of whether the underlying borrowers had made loan payments to the Account X. As a result, the Account X had insufficient funds to make payments to all of its investors, and Individuals A and B began to look for sources of money to cover the shortage in the Account X. One of the ways Individuals A and B covered the shortage was by not remitting principal payments to investors when borrowers paid off the loans. Individuals A and B made it appear as if the loans were still performing by paying the investors an amount calculated as if the borrowers had made only interest payments on the loans. Individuals A and B also funded the shortage in the Account X with money collected from new investors and by withholding payments from the Account X owed to Taxpayer. By the end of Year 5, Individuals A and B had used more than Amount 1 of Taxpayer's funds to make payments to other Company investors on non-performing loans.

Oh what a tangled web we weave, when first we practice to deceive. The tax problem you have when dealing with a mess like this is like unscrambling an egg. The taxpayers recognized income that wasn't really there. In principle you should amend open returns and to some extent might not have any relief. Rev Proc 2009-20 which was issued in light of the Bernie Madoff mess

allows taxpayers to take a theft loss in the year that the excrement strikes the air moving device in the amount of their unrecovered investment including fictitious income they reported. It's a lot easier and possibly more favorable for something that went on a long time. The treatment is an optional safe harbor. At least according to this ruling you didn't have to have your money stolen by Bernie Madoff to qualify.

(1) Taxpayer is the qualified investor for purposes of claiming a theft loss deduction under Rev. Proc. 2009-20.

(2) The discovery year for purposes of claiming a theft loss deduction under Rev. Proc. 2009-20 is Year 8.

Songie S. Milhouse, et vir., v. Commissioner, TC Summary Opinion 2009-012
Stacey L. Cody, et vir. v. Commissioner, TC Summary Opinion 2011-49

The box on the return where you check "Married Filing Jointly" should have a big warning label maybe something like "Just because many gay people are mad that they aren't supposed to check this box, doesn't mean it's always such a good idea." I must say I admire the principled civil disobedience approach of the Refuse to Lie campaign. It happens that my own attitude toward taxes is generally "It is what it is. Deal with it." The dark side of Married Filing Jointly is known as "joint and several liability". It means that the IRS can collect the entire tax deficiency from which ever of the pair they can lay their hands on. There is a very easy defense against joint and several liability. It is called filing a separate return. Then there is the much more challenging "innocent spouse" defense which often turns the Tax Court into a soap opera.

The Milhouse case was not particularly dramatic:

Throughout the marriage, petitioner mostly separated herself financially from Mr. Todd because of a "pattern" of "financial mismanagement" which she perceived on the part of Mr. Todd. Wages and child support payments which petitioner received were therefore deposited into her individual bank account. Mr. Todd, however, deposited his wages into a bank account jointly held with petitioner (joint account). Funds deposited into the joint account were used to pay household expenses and make improvements to Mr. Todd's house. While petitioner had access to the joint account, she never in fact accessed it. Instead, petitioner periodically transferred money to the joint account when Mr. Todd requested that she do so.

Petitioner sent to respondent a Form 8857, Request for Innocent Spouse Relief, which respondent received on August 27, 2008. In her request for relief, petitioner stated that she reported "all" of her income and that she was "under the impression" that Mr. Todd had provided her with all yearend tax statements he received for inclusion on the joint return. Before petitioner's entitlement to relief was determined, respondent provided Mr. Todd with the opportunity to oppose relief by filing with respondent a Form 12509, Statement of Disagreement.

Mr. Todd sent to respondent his statement of disagreement, which respondent received on February 26, 2009. In that statement Mr. Todd asserted that petitioner "knew" about the retirement income because she had access to the joint account both online and through statements that were mailed to their residence. Mr. Todd also stated that he gave petitioner all year-end tax statements to be reported on the joint return. Respondent subsequently forwarded petitioner's request for relief to respondent's Office of Appeals for further consideration.

The Tax Court resolved the "He said. She Said" in favor of Ms. Milhouse:

Petitioner testified credibly that she transferred money to the joint account but did not access the account or have any knowledge regarding the funds being deposited into that account. This testimony supports petitioner's claim that she did not have actual knowledge of the items giving rise to the deficiency at the time she signed the return. We generally reject Mr. Todd's contradictory testimony as self- serving and incredible. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). Such is especially appropriate given that Mr. Todd did not offer any corroborating evidence to support his allegations of actual knowledge on the part of petitioner.

The Cody case has more drama to it:

Petitioner and intervenor's marriage was not stable. Petitioner moved out of the marital home with the children on more than one occasion. After each departure petitioner and the children returned to the marital home. At some point during the marriage intervenor was charged with misdemeanor domestic assault. Near the end of the marriage petitioner and intervenor began to experience financial difficulty. Petitioner became aware that the amount of intervenor's income was decreasing. They received foreclosure documents for the marital home dated October 26, 2007. On November 18, 2007, petitioner permanently separated from intervenor. Petitioner and intervenor eventually divorced on September 17, 2008.

As of the time of trial, petitioner, as the custodial parent, supported herself and the three children on her Social Security income. Petitioner received $916 a month for herself and $152 a month for each child. Petitioner's expenses exceeded her income by approximately $800 a month. When petitioner ran out of money each month, she visited a food bank to provide meals for her children.

Here is my advice to IRS collections. You will probably do better chasing people who are eating at high end restaurants rather than lining up at the food pantries. Just an opinion. Don't want to tell you how to do your job.

Petitioner and intervenor initially did not file Federal income tax returns for the years 2002, 2003, 2004, and 2005. Respondent prepared substitutes for returns (SFRs) for each of the tax years at issue for intervenor, and intervenor was sent a notice of deficiency. Intervenor did not respond to the notice, and taxes and additions to tax of $370, $5,242, $13,959, and $11,517 for 2002 through 2005, respectively, were assessed against intervenor.

Note that Mrs. Cody probably was not required to file a return. I would have advised her to file one anyway, married filing separate, because in some situations taxpayers have been deemed to have consented to a joint return. What Mrs. Cody ended up doing was, I must say, less than smart :

After the assessments, intervenor prepared joint Federal income tax returns for all of the years at issue. Intervenor contacted petitioner and asked that she execute those joint returns. Because she was afraid to meet intervenor alone, petitioner, accompanied by her adult niece, met with intervenor in a parking lot to sign the returns. Petitioner signed the returns without reviewing them on November 26, 2007. The returns reported tax liabilities due of $332, $2,713, $9,793, and $6,927 for 2002 through 2005, respectively.

Above we see the allure of the joint return. By getting his estranged spouse to sign joint returns Mr. Cody reduced the liability for four years from slightly over 30,000 to slightly less than 20,000. What was Mrs. Cody getting out of this other than an opportunity to demonstrate to Mr. Cody what a formidable niece she had ? Further what did Mr. Cody get out of it ultimately other giving the IRS somebody else to chase ? I suppose he got the satisfaction of seeing his ex-spouse have some more aggravation.

The Court then went into the various factors considered in innocent spouse cases

I. Marital Status

II. Economic Hardship

III. Knowledge or Reason To Know

IV. Nonrequesting Spouse's Legal Obligation

V. Significant Benefit

VI. Compliance With Federal Tax Laws

VII. Abuse and Mental or Physical Health

The only thing that was clearly against her was that the divorce decree had called for the parties to split the income tax liability. The parking lot incident, in the analysis, kind of split. All the surrounding circumstances of her signing the return indicate that she knew that the tax was not going to be paid. On the other hand the fact that she brought her, presumably formidable, adult niece along helped support her abuse contention.

Of course if she had been my aunt, I would have prepared married filing separate returns for her driven her to the post office to mail them and then taken her for ice cream at a Friendly's on the opposite side of the city from where she was supposed to meet my ex-uncle. That would probably have been a better result. It's exciting to have a niece in special ops, but sometimes a CPA nephew is what you really need.

No Lady Doctor Exception to Late File Penalty

2011-06-10T05:00:00.162-04:00

Pamela B. Russell v. Commissioner, TC Memo 2011-81

I've mentioned from time to time why I am ill qualified to work for the IRS. One of the reasons is my tendency to decide that people deserve a break for reasons not supported by any statute or regulations. I think Dr. Russell who cares for sick babies all day long deserved a break here. While doing this she had to put up with the indiginity of having a husband who called his waterproofing endeavors the Basement Doctor. (Apparently its a common name in the industry so maybe it didn't bother her). Here are some of the basic facts :

Petitioner is a medical doctor in the neonatology unit at the Children's Hospital of Philadelphia, where she worked as an employee for all relevant periods. Petitioner is and was married to Bertram Royce Russell (Mr. Russell) at all relevant times. Petitioner and Mr. Russell (hereinafter sometimes referred to as the couple) maintained separate finances and separate checking accounts. Petitioner was responsible for handling the family's day-to-day living expenses, and Mr. Russell took primary responsibility for their children's tuition and college savings, the couple's retirement savings, and all tax matters. During the periods in issue Mr. Russell owned an interest in Basement Doctor, Inc. (Basement Doctor), a business that waterproofed basements.

It turned out that leaving long term finances and tax compliance to her husband might not have been the optimal family division of labor. Mr.Russell found Mr. Bagdis to help them with some of those issues. Mr. Bagdis made a bang up first impression:

The Internal Revenue Service (IRS) examined the couple's returns at some point after Mr. Bagdis had assumed his role as their financial adviser and tax attorney. Mr. Bagdis and his law firm represented petitioner and Mr. Russell during that examination. The examination was resolved in the couple's favor, and they received a refund from the IRS. The successful resolution of the IRS examination by Mr. Bagdis and his firm gave petitioner confidence in Mr. Bagdis, leading her to believe that he was extremely competent. Petitioner relied on Mr. Bagdis for tax advice.

It turns out that the masterful audit representation was the high point of the relationship.

Mr. Bagdis advised petitioner during early 1999 that she should submit a Form W-4, Employee's Withholding AllowanceCertificate, to Children's Hospital claiming that she was exempt from income tax withholding for 1999. In accordance with Mr. Bagdis' advice, petitioner signed a Form W-4 claiming the exemption on January 27, 1999. Mr. Bagdis' law firm submitted the Form W-4 to Children's Hospital, accompanied by a letter from the firm.

Petitioner was required to file a Federal income tax return for 1999. However, petitioner did not timely file her 1999 return because Mr. Bagdis advised her that her husband's business, Basement Doctor, had sustained significant losses during 1999 that would offset the couple's income from petitioner's salary, but that those losses needed to be calculated exactly before the couple filed their return. Petitioner followed Mr. Bagdis' advice and did not timely file her 1999 tax return. On February 21, 2001, respondent sent a delinquency notice to petitioner, informing her that respondent's records showed she had not filed a tax return for 1999 and asking her to file that return. The couple filed a joint tax return for their 1999 tax year on October 31, 2001. On their 1999 return, the couple reported $153,786 in wages and salary income, but the couple reported a loss of $100,000 from Mr. Russell's business. The couple reported an overpayment of $16,289 for 1999, and they received a refund of $16,417.57 on December 24, 2001.

Petitioner likewise was required to file a return for 2001, the year in issue, but was again advised by Mr. Bagdis not to file her return until he had calculated the exact losses from her husband's business. Petitioner understood that Basement Doctor was divided into three “parts” by State, one part each in Delaware, Pennsylvania, and New Jersey. Mr. Bagdis explained to petitioner that Basement Doctor's 1999 losses were from the Pennsylvania business, the 2000 losses were from the Delaware business, and the 2001 losses would be from the New Jersey business. Mr. Bagdis told petitioner that the losses from Basement Doctor's New Jersey business would be even greater than the losses from Pennsylvania and Delaware. Petitioner knew that her 2001 return was due on April 15, 2002, but, in accordance with Mr. Bagdis' instructions, petitioner did not file her 2001 return when it was due.

At some point during October 2004, IRS agents visited petitioner while she was working at Children's Hospital to serve her with a subpoena for records.

There you go with why I am not working for the IRS. Who wants to be the guy who serves the subpoena on the lady doctor taking care of the sick babies ? Surely I would have pleaded that I needed to go drown some puppies or something.

Around the same time, petitioner understood that the IRS had also seized files from Mr. Bagdis' offices. After she received a subpoena from the IRS and learned of the IRS raid on Mr. Bagdis' offices, she became very concerned and asked to meet with Mr. Bagdis as soon as possible. When petitioner met with Mr. Bagdis, she received the same explanation from him: he expected that large losses from Basement Doctor would offset her salary income from 2001 and that she should wait to file her return until Mr. Bagdis could calculate the exact numbers. Petitioner continued to rely on Mr. Bagdis' advice.

This is the point where my sympathy for Dr. Russell starts turning into impatience. I hate to state the obvious but figuring out the Schedule C loss of a small service business is not rocket science or brain surgery. It's not even neonatology. It's also not something to be entrusted to a lawyer particularly one who after telling you you have to wait for an exact number comes up with exactly $100,000. Here is another little piece of advice. When your attorney tax preparer can't get it done because the feds have seized the records you need to call another attorney.

On or about April 6, 2005, Mr. Bagdis sent petitioner and her husband a letter regarding their 2001, 2002, and 2003 taxes. In the letter, Mr. Bagdis informed the couple that he no longer had access to many of the couple's records because his files had been seized by Federal agents. However, he told the couple that he had nevertheless attached “pro forma” Forms 1040, U.S. Individual Income Tax Return, for the couple as married, filing separately. In the letter, Mr. Bagdis explained that the “pro forma” returns were based on “limited historical data” available in some computer files to which he still had access, as well as some new information supplied by the couple. Mr. Bagdis informed the couple that although the “pro forma” returns he had prepared were for the couple filing separately, they probably would have a lower tax liability if they filed a joint return. Specifically, he told the couple that if they filed a joint return for 2001, the Basement Doctor losses would offset petitioner's salary income and result in a tax liability of close to zero.

Mr. Bagdis reassured her that there was no problem with the return being late since there would be a refund.

On or about April 25, 2005, respondent sent petitioner a letter informing her that respondent still had not received her income tax return for 2001 and providing petitioner with respondent's calculation of petitioner's income tax liability for 2001. Upon receipt, petitioner or Mr. Russell delivered the letter to Mr. Bagdis. At that time Mr. Bagdis again explained to petitioner that he was waiting until all of the losses from Basement Doctor had been captured.

Can't you just picture these squirrely little creatures called "losses" racing around an enormous basement while someone who looks like Marcus Welby chases them with a butterfly net.

Mr. Bagdis wrote a letter responding to the IRS' letter for petitioner, which petitioner then typed on her stationery and sent to respondent on or about May 24, 2005. The letter petitioner signed reported that most of her records had been seized by Federal agents when they raided Mr. Bagdis' offices. The letter explained that petitioner was therefore unable to access the records related to her 2001 tax year and that “there is no further action that can be taken at this time.”

Petitioner apparently received at least one more letter from the IRS, dated August 30, 2005, which also included a proposed tax return for 2001. Petitioner again responded to the IRS with a letter drafted by Mr. Bagdis and stating that petitioner did not have access to the records she needed to prepare her 2001 tax return since those records had been seized. The letter objected to the IRS' proposed tax return because it did not include the losses from Basement Doctor, which the letter stated were expected to offset petitioner's remaining income and reduce her tax obligation to “near zero.”

Sometime during December 2005, petitioner received a call from John Pease, an attorney involved in the investigation of Mr. Bagdis, who advised her that she should retain separate counsel and should not be relying on Mr. Bagdis. As a result of the conversation with John Pease, petitioner began to doubt Mr. Bagdis' advice, and she did retain separate counsel, Thomas Bergstrom (Mr. Bergstrom). From the time around December 2005 when she first spoke with Mr. Bergstrom, petitioner had no further interactions with Mr. Bagdis except to request that he withdraw as her attorney.

Petitioner first met with Mr. Bergstrom, a criminal defense attorney, during January 2006. At the time petitioner retained Mr. Bergstrom, both Mr. Bagdis and Mr. Russell were under criminal investigation by the U.S. Attorney's Office for the Eastern District of Pennsylvania. Mr. Bergstrom was concerned that the investigation might also expand to include petitioner. Over the next 11 months, Mr. Bergstrom met with the U.S. Attorney's Office on several occasions, and he hired a certified public accountant to prepare a tax return for petitioner's 2001 tax year. It took 11 months for Mr. Bergstrom, the certified public accountant, and petitioner to calculate and pay petitioner's 2001 tax liability.

Dr. Russell was in Tax Court over late file / late pay penalties. Those squirrly little losses in the basement turned out to be on the elusive side so it did matter that she filed and paid late. I would have let her go but the Tax Court apparently didn't go for the lady doctor sick baby exception.

We find it more plausible to conclude that petitioner was relying on Mr. Bagdis' advice that no tax would be due for 2001. She had relied on his advice when filing late tax returns for the 2 prior years, and she had received a refund both times, as Mr. Bagdis had said she would. Petitioner was, in effect, relying on a scenario that she would also be entitled to a refund for 2001. Unfortunately for petitioner, her hoped-for scenario did not materialize, and she owed tax for 2001. As the Court of Appeals stated in Jackson v. Commissioner, 864 F.2d 1521, 1527 [63 AFTR 2d 89-539] (10th Cir. 1989), affg. 86 T.C. 492 (1986): “a presumed expert's advice concerning the amount of tax owed can be erroneous, and the taxpayer must bear the risk of that error when he fails to comply with a known duty to file a return.” See also Estate of Hollo v. Commissioner, T.C. Memo. 1990-449 [¶90,449 PH Memo TC], affd. without published opinion 945 F.2d 404 (6th Cir. 1991); Gore v. Commissioner, T.C. Memo. 1987-425 [¶87,425 PH Memo TC]. As a matter of law, it was unreasonable for petitioner to file her tax return late on the basis of Mr. Bagdis' advice that no additions would be due because she would owe no tax.

Whether Petitioner's Reliance on Her Adviser's Advice That It Was Necessary To Have Accurate Information Constitutes Reasonable Cause Petitioner's reliance claim includes the contention that Mr. Bagdis advised her that she should wait until she had complete information about Mr. Russell's business losses before filing her return. We have held that reliance on an attorney's advice that it was necessary to wait for complete information before filing a return does not constitute reasonable cause for a delay in filing.

It turns out that getting nailed for some late file/late pay penalties was pretty mild given the maelstorm that Dr. Russell had found herself on the edge of. Last year after trial and a six year investigation Mr. Bagdis was sentenced to 10 years in prison. There was radioligist convicted along with him. Dr. Betram Russell was sentenced to 66 months. I stick pretty much with tax research so I leave it to an ambitious reader to trace whether there is a family connection.

Looks Like a Duck -Walks Like a Duck - Talks Like a Duck - Not a Duck

2011-06-09T12:20:00.007-04:00

Thomas F. Chambers, et ux. v. Commissioner, TC Memo 2011-114
U.S. v. MAGGERT, Cite as 107 AFTR 2d 2011-XXXX

“For we are taking pains to do what is right,not only in the eyes of the Lord but also in the eyes of men.”2 Corinthians 8:21 From the Evangelical Center for Financial Accountability Seven Standards of Responsible Stewardship

He said he talked to Jesus all the time. Even when he was driving his car. That killed me. I just see the big phony bastard shifting into first gear and asking Jesus to send him a few more stiffs. From The Catcher in the Rye.

The First Amendment tells us that the government should not establish religion. On the other hand, it also tells us that government is not supposed to interfere with the free exercise of religion. People with a very secular perspective like the Freedom from Religion Foundation focus on the first aspect. Deeply religious people might focus more on the second. The tension shows up in the relationship that IRS has with churches. It is very hands off not requiring the level of reporting that other not for profits are subject to. On the other hand it is put in the awkward position of having to decide what is and is not a church. Although this seems to contradict the establishment clause it is necessary so that the sphere of religion where government is hands off does not become a gaping hole that tax cheats drive trucks through. The favorable tax treatment of churches, that in my view is mandated by the free exercise clause, is, quite predictably, a magnet for "phony bastards". Two recent cases illustrate this problem.

U.S. v Maggert is an extreme case:

Maggert, a dentist, worked for several dental offices as an independent contractor. In 1998, Maggert and his wife attended a seminar by American Rights Litigators (“ARL”) and Eddie Kahn at which they were told they did not have to pay federal income tax. Maggert relayed this information to his accountant, who counseled Maggert against ARL's advice and ended their professional relationship when Maggert persisted. Maggert dissolved his professional association, Mark S. Maggert, D.D.S., P.A., and, from 1998 to 2005, did not file a federal tax return or pay federal income tax.

Eddie Kahn, by the way, was Wesley Snipes "tax adviser". I might have missed that if I wasn't following Joe Kristan's blog. Joe frequently gets to the same cases I do, usually before I do.

Beginning in 2002, Maggert instructed the accountants for the dental offices where he worked to make his paychecks payable to Total Business Systems, LLC, a Florida corporation, or to Mark's Word of Faith International, a Nevada corporation. The accountants complied and issued Form 1099s, using the corporate identification numbers for these organizations rather than Maggert's social security number. Maggert deposited the paychecks into accounts he opened in these organization's names and withdrew money from the accounts on a regular basis (over $40,000 in 2002, over $52,000 in 2003, $178,000 in 2004 and $128,000 in 2005, for a total of $398,600).

The articles of organization for Total Business Systems, LLC identified the managing member as Geneva Holdings, Inc., in Australia and the registered agent as Ronald Saltzer. The articles of organization were signed by Saltzer and Alan R. Horne, the “Director” of Geneva Holdings, Inc. Saltzer admitted that he knew nothing about Total Business Systems, LLC or Geneva Holdings, Inc., and had never met Maggert or Horne. Saltzer had agreed to act as the registered agent and sign the articles of incorporation in exchange for a meal provided by Eddie Kahn.

Panhandlers are facing a generational problem right now. I sometimes want to shake the guys to explain to them that they can't be Vietnam veterans if they are more than a couple of years younger than I am. Offering to be registered agents could open up a whole new field. Somebody once explained to me that one of the ways to get an individual to take on unlimited liability so you could have a partnership was to trade a bottle of Thunderbird for the signature. I wonder if cheap wine sales went down when they put in the check the box regulations. At any rate on to the religious patina of the plan.

The articles of incorporation for Mark's Word of Faith International listed Maggert as the “Presiding Patriarch (Overseer).” Maggert's wife signed the articles of incorporation as a witness and “Scribe.”

It can be the little things that screw up a plan. If Dr. Maggert wanted to be Patriarch, why couldn't he have made his spouse "Chief Priestess" rather than something that sounds like the medieval version of secretary and reminds you of Pharisees ? Maybe she would have been more enthusiastic.

Maggert's wife admitted there was no such religious organization and that Maggert was not a spiritual leader or priest

We really don't want the IRS inquiring as to who is really a spiritual leader or a priest, but it is these type of shenanigans that makes it necessary. Sadly, I think that the IRS agents who are tasked with dealing with this nonsense get a little jaded, which may have been part of the problem in the Chambers case.

The case of Thomas Chambers is much more troubling. It was not being proposed that he be deprived of his liberty but the IRS was asserting a 75% fraud penalty, which is about as bad as it gets short of doing time. It is pretty clear that Reverend Chambers (and I'm not being ironic with the Reverend) was not running a tax scam:

Mr. Chambers is an ordained minister who, during the years in issue, was the sole pastor of Biblical Church Ministries (sometimes also referred to as Biblical Church or Biblical Church and Global Ministries). Before he founded Biblical Church during 2003, Mr. Chambers had been the senior pastor of Pilgrim Bible Church since 1991. He resigned from his position at Pilgrim Bible Church because he wanted to concentrate more on global evangelism and planned to be out of the country for many weeks during the year. However, about a dozen of his former congregants at Pilgrim Bible Church asked him to continue leading them in studying the Bible on Sunday mornings. Mr. Chambers agreed to continue leading them in Sunday worship with the understanding that he would be ministering abroad a number of weeks during the year and that someone else would lead worship when he was absent.

On the other hand, if he had been endeavoring to make himself look like he was running a tax scam, he would have been hard pressed to find more effective means than what he stumbled on. It is fairly clear that in his choice of organizational structure Reverend Chambers made a mistake.

During 2003 Mr. Chambers organized Biblical Church as a “corporation sole” under Utah law. He designated himself as “overseer” of Biblical Church. As overseer, he had full control over the corporation sole, including the authority to amend its articles of corporation sole and appoint his successor. During 2006 petitioners transferred the ownership of their home from themselves as individuals to Mr. Chambers as overseer of Biblical Church, a corporation sole.

A corporation sole is a way to associate ownership of property with the holder of an office. Who owns all those church buildings and schools that make up a Catholic diocese? The bishop does as a corporation sole. This can come as something of a shock to parishioners as a lengthy drama in Worcester Mass several years ago illustrates. On the other hand you don't have to worry about your parish becoming affiliated with another denomination, which can happen with a congregational polity. I suspect that Reverend Chambers chose corporation sole because it fit a "strong pastor" model of church governance that was consistent with his theology. Then again, you can't rule out bad advice.

Unfortunately it is also a property ownership device that is part of one of the IRS's dirty dozen. Unless the office holder is subject to removal by some higher authority (other than the highest authority that we are all ultimately subject to) corporation sole is an excellent scamming structure. Too excellent. I think that when he chose corporation sole Reverend Chambers painted a target on his back.

Here is a portion of Revenue Ruling 2004-27:

The Service is aware that some taxpayers are attempting to reduce their federal tax liability by taking the position that the taxpayer’s income belongs to a “corporation sole” created by the taxpayer for the purpose of avoiding taxes on the taxpayer’s income. The Service also is aware that promoters, including return preparers, are advising or recommending that taxpayers take frivolous positions based on this argument. Some promoters may be marketing a package, kit, or other materials that claim to show taxpayers how they can avoid paying income taxes based on this and other meritless arguments.

By choosing "corporation sole" Reverend Chambers made himself look like a duck.

Mr. Chambers followed through on his plans to participate in many overseas evangelism trips. In addition to his job as a pastor at Biblical Church, he is on the staff of e 3 Partners, 3 an organization that is exempt from tax pursuant to section 501(c)(3). Mr. Chambers' role with e 3 Partners is “church planter”, and his primary responsibility is to lead short-term mission trips to other countries, where he trains local pastors and other volunteers in evangelism.

e3 Partners Ministry is a substantial organization. According to their most recent 990 they grossed over 18,000,000. They have many hallmarks of legitimacy. Not the least of which is having an accounting firm with a blogging partner. I think the IRS phony church hit squad should have backed off when they saw that Reverend Thomas was affiliated with them. When I looked at the board I saw a substantial business person I happen to know who is honest as the day is long and sharp as tack.

The team members were responsible for raising their own funds for each trip, but e 3 Partners coordinated fundraising by receiving donations on behalf of individual team members and using those donations to pay trip expenses for those team members. Portions of the funds raised by all of the team members were directed to the team leaders, like Mr. Chambers, who were responsible for handling all of the day-to-day expenses the team would encounter on the trip. Before each trip, e 3 Partners deposited funds into a bank account provided by the team leader, who then withdrew the cash needed for the trip. All expenses incurred during the trip had to be documented by receipts, and the team leader was responsible for returning any unused funds to e 3 Partners at the end of the trip. During the years in issue Mr. Chambers received into his personal bank account numerous deposits to cover trip expenses from e 3 Partners, and the parties agree that such funds were properly excluded from petitioners' income.

So apparently if the Reverend Chambers had followed his first impulse and devoted all his time to foreign missions under the supervision of e3 Partners, he wouldn't have had any tax problems or at least not ones of the magnitude that he encountered.

During both 2005 and 2006 petitioners maintained a personal checking account at M and T Bank (M and T account). Petitioners also maintained checking accounts for Biblical Church at National Penn Bank (National Penn account) and the Bank of Lancaster County (Lancaster account) (collectively, the Biblical Church bank accounts or the church bank accounts). Petitioners were the only authorized signatories for the Biblical Church bank accounts. The name listed on the church bank accounts was “Biblical Church and Global Ministries”, but petitioners usually deposited checks made payable to “Biblical Church” into the National Penn account and checks made payable to “Global Ministries” into the Lancaster account. Biblical Church had two bank accounts because Mr. Chambers was trying to separate funds for the church itself from funds that were intended to support its overseas mission trips. He had originally planned to save some of the church funds to purchase a building; but because he was very passionate about the mission work, he put most of the money toward missions.

Petitioners opened the Lancaster account before they had obtained an employment identification number (EIN) from the Internal Revenue Service (IRS). They told the bank representative that they had applied for an EIN but had not yet received it. The bank representative nonetheless allowed them to open a bank account, and she typed all of the information required on the new deposit account coversheet but left blank the space for the EIN. She then printed out the new deposit account coversheet, had petitioners sign it, and instructed them to inform the bank as soon as they received the EIN from the IRS. The bank representative's actions in setting up the account, printing out the new account coversheet, and leaving blank the space for the EIN were consistent with protocol established by the Bank of Lancaster County at that time.

We have a saying that it is better to be lucky than good. A corollary of that might be that it is worse to be unlucky than bad. I suspect Reverend Chambers piece of bad luck with the EIN might have been what really got the IRS swat team that was working him over excited.

At some point, a nine-digit number was handwritten in the space for the tax identification number on the new account coversheet. The nine-digit number written on the new account coversheet and subsequently associated with the Lancaster account is the Social Security number of a minor child unrelated to petitioners, not the EIN assigned to Biblical Church. The minor child who was assigned the Social Security number was not an account holder at the Bank of Lancaster County when petitioners created the Lancaster account.

His next misstep would appear to many of us to be the act of a godly man, who is also humble.

During the years in issue petitioners performed part-time janitorial work for Superior Walls of America, Ltd. (Superior Walls). Petitioners were paid $13 per hour for performing cleaning services about 15 hours each week. Mr. Chambers intended the compensation from Superior Walls as a fundraiser for his mission trips and for Biblical Church. He spoke with the financial controller at Superior Walls and explained his desire to perform janitorial services as a fundraiser for Biblical Church. Pursuant to an agreement with Superior Walls, instead of paying petitioners themselves for the work, Superior Walls paid Biblical Church directly. Mr. Chambers executed a Form W-9, Request for Taxpayer Identification Number and Certification, on behalf of Biblical Church, which he submitted to Superior Walls, claiming to be exempt from Federal tax withholding.

Unfortunately one of the things that scamsters do with phony churches is assign their income to them. This would probably be the first instance of somebody doing it with the $13 per hour he was getting for mopping floors. And lets not forget that Reverend Chambers actually did spread the Gospel in foreign places. On the other hand by assigning his income, modest as it was, to the "corporation sole", Reverend Chambers was walking like a duck.

Petitioners later learned that the law required them to report the compensation from Superior Walls as taxable income, and they began to report the compensation as income during 2006. Petitioners reported their income from Superior Walls during 2006 on a Schedule C attached to their Form 1040, U.S. Individual Income Tax Return.

That was a bit of unducklike behaviour that the Tax Court noted with approval.

Then there is the matter of the language in the governing document that to the IRS indicated a “tax-hostile” entity

This Corporation Sole is a full-time Ministry and Spiritual Order which *** is mandatorily excepted by an “unrestricted” right, as referenced in United States law Title 26, §§ 6033(a)(2)(A)(i) and (iii), § 1341(a)(1) and § 508(c)(1)(A), from any form of taxation and from filing any returns or reports/documents ***

Although the Tax Court noted that the objectionable language was "largely a recitation of the tax law applicable to all churches", that is part of the style of tax protester rhetoric which frequently includes quotations from valid authority, ofter wildly out of context. So Reverend Chambers with that governing document was talking like a duck. (Although there is nothing to indicate that Reverend Chambers was constantly seen in the company of ducks, there is a chance that he purchased his paper work from one). It is interesting to note that in the entire body of tax authority the term "tax-hostile" entity only appears in this case. I wonder if it is a coinage by the agents who have to deal with this stuff. I used to have a third shift job in a hotel where a lot of cops would stop by to take their breaks. They often referred to a crime that was not in the statute books called B and A, which stood for "being an asshole"

During the years in issue, the deposits into the Biblical Church bank accounts primarily consisted of numerous small checks written by individuals. Members and regular attendees of Biblical Church wrote checks that accounted for the largest number of deposits. Many of those individuals contributed a regular tithe or offering. Other checks were written by individuals who made only a few donations during the years in issue. Some checks were written by other churches. In total, about 50 individuals and three churches wrote at least one check to Biblical Church during the years in issue

The Tax Court was able to get Reverend Chambers out of a significant part of the trouble he had gotten into, primarily it appears from naivete. First of all they determined that the Biblical Church was a church.

Biblical Church satisfies many of the criteria. Mr. Chambers is an ordained minister, the church has a distinct legal existence as a corporation sole, the church has been meeting regularly on Sundays since 2003, its worship services include a core group of 15 to 25 attendees who exclusively attend Biblical Church, its worship services are consistently held at the same place, and Mr. Chambers teaches recognized Christian doctrine. On the basis of the foregoing, we conclude that Biblical Church is a church.

That did not solve the problems entirely. Reverend Thomas had unfettered control of the various accounts. Some of the expenditures went for personal purposes

The IRS reconstructed petitioners' income for the years in issue by examining the deposits to the M and T account, the Lancaster account, and the National Penn account. The IRS did not include deposits into the Northwest account when it reconstructed petitioners' income. However, the parties have included bank statements and canceled checks from the Northwest account among the stipulated exhibits before the Court. Those records show that petitioners used the debit card from the Northwest account to pay for numerous purchases at Wal-Mart, K-Mart, Staples, Dollar General, and a variety of other retailers, as well as many purchases at gas stations and restaurants. Petitioners wrote checks on the Northwest account to pay for many household expenses, including their gas bills, cable bills, and sewer bills. They also wrote checks to a tile company, a chimney sweep, a mattress store, a dentist, a newspaper, a mechanic, and a cement company.

Petitioners contend that even if some of the expenses paid from the Northwest account were personal, those amounts are not includable in petitioners' income because they were for the purpose of providing a home for Mr. Chambers, a minister of the gospel, and therefore are exempt from taxation under section 107. However, in order for a minister's housing allowance to be exempt from taxation under section 107, it must be designated as a housing allowance by an official action of the church in accordance with section 1.107-1(b), Income Tax Regs.

I think the Tax Court may have missed a chance to cut Reverend Chambers a break here. They had recognized that the church was a church and he had transferred ownership of the house to the entity so this was arguably not a rental allowance situation. They did prevent the IRS from piling it on to some extent.

The deposited checks in 2005 include federal income tax refund checks. In light of the circumstances and facts of this case, respondent is unwilling to concede that those refunds were correctly and properly made to petitioners. Therefore, respondent does not concede that those refunds are non-taxable in 2005. It appears that respondent is contending that petitioners are liable for deficiencies in income taxes from prior years and is attempting to recover some of those deficiencies by including petitioners' tax refunds from 2004 in their income for 2005. Respondent cites no authority that would permit such a determination, and we find none. Accordingly, we conclude that petitioners' Federal tax refunds should not be included in their income for 2005.

But there was only so much they could do. The Chambers had sold gold coins inherited from Mrs. Chambers father to help with church expenses. In their reconstruction of income the IRS treated these amounts as income and the Chambers did not have sufficient evidence to refute the presumption of correctness.

Respondent's contention is based on the premise that Mr. Chambers stated that Mrs. Chambers inherited the gold coins directly from her parents, which would contradict Mrs. Chambers' testimony that petitioners used cash they inherited from Mrs. Chambers' parents to purchase the coins. However, Mr. Chambers never clearly explained where the gold coins originated. In addition, he separately testified that petitioners had received cash from the inheritance. Although petitioners' testimony regarding the gold coins was somewhat difficult to follow, we do not find it contradictory. Nonetheless, because petitioners have the burden of proving that the $30,281 should not be included in their income and because petitioners failed to provide any evidence to corroborate their testimony, we conclude that petitioners have failed to carry their burden of proof that the income from the Surgical Resources Business Trust checks should be excluded from petitioners' gross income.

The big thing that the Tax Court did do for Reverend Chambers was making the 75% fraud penalty go away. Acknowledging all the various things that Reverend Chambers had done to make himself appear like a duck, they could clearly see that he wasn't one. Most important was the determination that there was an actual church there.

There are some other interesting aspects of the case that I have glossed over. I recommend it as a good read. I think it is worth commenting on how Reverend Chambers might have avoided these problems short of just working for organizations like e3 Partners, that have good infrastructure in place. He might have looked at the ECFA Standards and Best Practices for Churches. In the interest of full disclosure, I should probably say that the churches I have attended would not qualify for ECFA membership. Most Unitarian Universalists have a different theological perspecitve than that required by Standard 1. Our principles do encourage us to heed "Wisdom from the world's religions which inspires us in our ethical and spiritual life" ECFA's standards and best practices clearly fall in that caterogy. One excerpt from the standards might have been particularly apt for Reverend Chambers Biblical Church:

Every member shall be governed by a responsible board of not less than five individuals, a majority of whom shall be independent, which shall meet at least semiannually to establish policy and review its accomplishments.

If the group of people that asked Reverend Chambers to stay on as their preacher even while working on his evangelical missions did not include five people capable of seeing that mundane matters like setting a salary for him, most if not all of which could have been excluded as parsonage, then he really should have passed.

I have been sparing in my criticism of the IRS in this case. I have often commented on how ill qualified I am to work for them. If I was in charge of the team that was working on this I would have said "This guy is a real minister. Let's leave him alone and go fight crime someplace else." ignoring the laundry list of duck like characteristics that he was exhibiting. What would be very sad is if this case ends up being viewed as an instance of the Satanic IRS persecuting the godly. If you are of the mindset to look at it that way, I'd point you to ECFA who will teach you how to avoid even the appearance of impropriety.

I haven't seen a lot of commentary on this case. At least one blogger has observed that it was quite a harsh result. I've seen the identical commentary in more than one place, so I am not sure of the original source.

Regards To Your Single Member LLC

2011-06-08T15:00:00.002-04:00

CCA 201116019

One of the great simplifications of income tax law was not done by legislation but rather by regulation. There had been an issue about whether entities that were not legally corporations should be considered "associations taxable as corporations". The controversy involved the analysis of four factors, each of which probably had several books written about them. The simplification was to the effect that if the entity is not a corporation then it won't be considered one for tax purposes unless it wants to be. If it is a business entity with more than one member it will be a partnership. If there is only one member it will be disregarded - for income tax purposes. This simplification really makes the LLC the entity of choice.

Having the entity be disregarded for income tax purposes means that any transactions between the owner and the entity will have no income tax effect and that any transactions of the LLC will be reflected on the owners return. I should clarify that "for income tax purposes". It's really for the "determination of income taxes" as this missive from the chief counsel makes clear. When it comes to collection, the LLC is regarded, which means that the IRS cannot seize assets owned by the LLC to satisfy the tax obligations of its single member:

From: ————————- Sent: Monday, March 21, 2011 12:06:29 PM To: —————————————- Cc: Subject: FW: LLC wrongful levy case ————-, this is to confirm your opinion that the Service can't levy on the property of a disregarded LLC to satisfy the tax liability of the LLC's sole member. As you've noted the sole member has no ownership interest in LLC's property under local law and disregarding the LLC for federal tax purposes doesn't allow the Service to disregard the entity for purposes of collection.

A levy might be made for distributions by the LLC that are based on the sole member's interest in LLC; e.g., if TP is supporting himself from the net income of the LLC the lien attaching to TP's interest in LLC should allow the Service to issue a levy notice to LLC for the distributions of that income. Compare United States v. Moskowitz, Passman and Edelman, 603 F.3d 162 (2d. Cir. 2010) (frequent and regular partnership “draws” which are advances or loans on annual profits are subject to a lien any may be levied as salary or wages).

And as you said, the RO could consider whether an alter ego lien is appropriate. The lien might be based on the common law concept of piercing the corporate veil which courts generally apply to LLCs and which some LLC statute reference. A reverse veil piercing in some states would subject the LLC property to the claims of a member's creditors. Some states set a high standard for piercing; e.g. piercing must be needed to prevent an injustice or acts approaching fraud. In some states an alter ego analysis is used to allow piecing and in others it's a separate approach for disregarding an entity, and the standards vary state by states. In some states a member's control of the LLC might make the two indistinguishable; e.g., the books and records may show the sole member and the LLC don't have a separate economic existence. The Government has argued for the application of a Federal common law of alter ego, but that argument was rejected in Old West Annuity and Life Ins. Co. v. Apollo Group, 605 F3d 856, 861 (11th Cir. 2010).

This ruling makes clearer than ever my observation that the systems for determining tax and actually collecting it are separate and distinct and practitioners must be cautious to not let concepts from one area leak into the other.