Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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The Week of July 26 – July 31, 2021

Harrington v. Comm’r, T.C. Memo. 2021-95 | July 26, 2021 | Lauber, J. | Dkt. No. 13531-18

Short Summary: Mr. Harrington is a U.S. citizen; his wife is a dual citizen of the United States and Germany. Mr. Harrington sold his house after meeting Mr. John Glube, a Canadian attorney for Eastern Wood Harvesters (EHW). He then provided these proceeds—$350,000—to Mr. Glube, who deposited that amount in a Union Bank of Switzerland (UBS) account under the name of Reed International, Ltd. (the “Reed Account”). At trial, Mr. Harrington testified that he lent this $350,000 as part of his effort to stabilize EHW, a company in which he became an employee. Later, EHW went under due to the European Union banning the import of North American softwood products, products that EHW sold.

In 2007, the Reed Account was closed because Reed International was being dissolved. UBS Bankers advised Mr. Harrington that the funds would be safer in a “stiftung,” a European trustlike vehicle. Mr. Harrington agreed and the funds were transferred under the name Schroder Stiftung, a newly formed Liechtenstein entity, and were held for the benefit of Mr. Harrington and his family.

In 2009, UBS closed the Schroder Stiftung account. Also in that year, the U.S. Department of Justice entered into a deferred prosecution agreement with UBS “based on a charge of conspiracy to defraud the United States by impending the IRS in the ascertainment, computation, assessment, and collection of income taxes[.]” After UBS informed Mr. Harrington that the account would be closed, a UBS banker connected him with a Swiss national who advised Mr. Harrington to contribute the assets from the Schroder Stiftung account to a life insurance policy in Liechtenstein. Mr. Harrington did so and named his wife and children as the beneficiaries.

In 2013, the life policies were canceled, and Mr. Harrington again moved the assets to an account at LGT Bank, a Liechtenstein entity, under his wife’s name. He testified that the account needed to be in his wife’s name because “that bank wasn’t accepting U.S. clients.”

Mr. Harrington and his wife prepared and filed joint income tax returns for 2005-2010. On these returns, they did not report any income attributable to the offshore investment vehicles discussed above. In 2012, the IRS selected the Harringtons’ 2005-2010 returns for examination. The IRS did so on the basis of information and documents it received from UBS pursuant to the deferred prosecution agreement. During the examination, the Harringtons provided the IRS with amended returns for 2005 through 2010 and FBARs. In addition, the Harringtons provided the IRS with Forms 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, after the IRS requested these forms.

Using a sampling method analysis, the IRS determined that Mr. Harrington had received, but failed to report, $791,661 in offshore investment income during the years at issue. The IRS also imposed fraud penalties against the Harringtons under Section 6663 for 2005-2010.

Key Issue: Whether the IRS’ assessment of tax and fraud penalties was barred by the three-year period of limitations for assessment in Section 6501(a).

Primary Holdings:

• The IRS has established by clear and convincing evidence that the underpayments of tax for 2005, 2006, 2008, and 2009, and a portion of the underpayment for 2007, were attributable to fraud. However, because the IRS has not established by clear and convincing evidence that Petitioner underpaid his tax for 2010, he is not liable for that year’s fraud penalty, and the IRS is barred under Section 6501(a) from assessing any deficiency for that year.

Key Points of Law:

• Section 61 provides that gross income “means all income from whatever source derived,” including gains derived from dealings in property, interest, and dividends. 61(a)(3), (4), (7). In cases of unreported income, the IRS must establish “a minimal evidentiary foundation” connecting the taxpayer with the income-producing activity. See U.S. v. McMullin, 948 F.2d 1188, 1192 (10^th Cir. 1991). Once the IRS has established some evidentiary foundation, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’ determinations are arbitrary or erroneous. See Erickson v. Comm’r, 937 F.2d 1548, 1551-52 (10^th Cir. 1991), aff’g, T.C. Memo. 1989-552.
• Section 6501(a) generally requires the IRS to assess a tax within 3 years after the return was filed. The period of limitations is extended to 6 years when the taxpayer omits from gross income an amount “in excess of 25% of the amount of gross income stated in the return.” 6501(e)(1)(A)(i).
• Section 6501(c)(1) provides that, where a taxpayer has filed “a false or fraudulent return with the intent to evade tax,” there is no period of limitations and the tax “may be assessed . . . at any time.” “The determination of fraud for purposes of the period of limitations on assessment under Section 6501(c)(1) is the same as the determination of fraud for purposes of the penalty under Section 6663.” Neely v. Comm’r, 116 T.C. 79, 85 (2001).
• Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” As a threshold matter, the IRS must show that it complied with Section 6751(b)(1). See Chai v. Comm’r, 851 F.3d 190, 221 (2d Cir. 2017). In Belair Woods, LLC v. Comm’r, the Tax Court explained that the initial determination of a penalty assessment is typically embodied in a letter by which the IRS formally notifies the taxpayer that the Examination Division has completed its work and has made a definite decision to assert penalties. Once the IRS introduces sufficient evidence to show supervisory approval, the burden shifts to the taxpayer to show that the approval was untimely, e., that there was a formal communication of the penalty to the taxpayer before the proferred approval was secured. Frost v. Comm’r, 154 T.C. 23, 35 (2020).
• If any part of any underpayment of tax required to be shown on a return is due to fraud, section 6663(a) imposes a penalty of 75% of the portion of the underpayment attributable to fraud. The IRS has the burden of proving fraud, and the IRS must prove it by clear and convincing evidence. 7454(a); Rule 142(b). To sustain this burden, the IRS must establish two elements: (1) that there was an underpayment of tax for each year at issue; and (2) that at least some portion of the underpayment for each year was due to fraud. Hebrank v. Comm’r, 81 T.C. 640, 642 (1983).
• If the IRS asserts fraud for multiple tax years, the IRS must prove fraud “applies separately for each of the years.” Vanover v. Comm’r, T.C. Memo. 2012-79. If the IRS proves that some portion of an underpayment for a particular year was attributable to fraud, then “the entire underpayment shall be treated as attributable to fraud” unless the taxpayer shows, by a preponderance of the evidence, that the balance was not so attributable. 6663(b).
• An amended return may constitute an admission of substantial underpayment for purposes of a penalty determination. Badaracco v. Comm’r, 464 U.S. 386, 399 (1984); see also Lare v. Comm’r, 62 T.C. 739, 750 (1974) (statements made in a tax return may be treated as admissions).
• Fraud is intentional wrongdoing designed to evade tax believed to be owing. Neely, 116 T.C. at 86. The existence of fraud is a question of fact to be resolved upon consideration of the entire record. Estate of Pittard v. Comm’r, 69 T.C. 391, 400 (1977). Fraud is not to be presumed or based upon mere suspicion. Petzoldt, 92 T.C. at 699-700. But because direct proof of a taxpayer’s intent is rarely available, fraudulent intent may be established by circumstantial evidence. at 699. The taxpayer’s entire course of conduct may be examined to establish the requisite intent, and an intent to mislead may be inferred from a pattern of conduct. Webb v. Comm’r, 394 F.2d 366, 379 (5^th Cir. 1968).
• Circumstances that may indicate fraudulent intent, often called “badges of fraud,” include but are not limited to: (1) understating income; (2) keeping inadequate records; (3) giving implausible or inconsistent explanations of behavior; (4) concealing income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) supplying incomplete or misleading information to a tax return preparer; (8) providing testimony that lacks credibility; (9) filing false documents (including false tax returns); 10) failing to file tax returns; and (11) dealing in cash. Schiff v. U.S., 919 F.2d 830, 833 (2d Cir. 1990). No single factor is dispositive, but the existence of several factors “is persuasive circumstantial evidence of fraud.” Vanover, 103 T.C.M. (CCH) at 1420-21.
• A pattern of substantially understating income for multiple years is strong evidence of fraud, particularly if the understatements are not satisfactorily explained. See Vanover, 103 T.C.M. (CCH) at 1421.
• A willful attempt to evade tax may be inferred from a taxpayer’s concealment of income or assets. Spies v. U.S., 317 U.S. 492 (1943).
• The section 6663 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to . . . [it].” 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Sec. 1.664-4(b)(1). Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Id.

Insight: As shown in Harrington, issues of fraud can arise when taxpayers fail to report income from foreign sources and file appropriate informational returns (e.g., FBARs, Forms 3520, etc.). If the IRS can successful show fraud, it is permitted to open up those tax years for additional assessments, provided it can demonstrate fraud by clear and convincing evidence.

Ononuju v. Commissioner, T.C. Memo. 2021-94 | July 26, 2021 | Lauber, J. | Dkt. No. 22401-18

Short Summary:

Petitioner’s husband had founded American Medical Missionary Care, Inc. (AMMC) in 1998. AMMC applied to the IRS for recognition of tax-exempt status in 2000, claiming the tax exempt status of operating a “clinic to provide medical examination and treatment” for those who are unable to afford such services. The IRS granted AMMC’s application, thereby categorizing AMMC as a tax-exempt entity under section 501(a) and (c)(3).

Petitioner held various positions in AMMC between 2000 and 2014. In particular, Petitioner was listed as a member of AMMC’s board of directors in 2000 and was listed as secretary and treasurer in an annual report filed in October 2012 with the State of Michigan, AMMC’s state of incorporation. Petitioner was also listed as director on AMMC’s Form 990 for 2013, and as its secretary on the Form 990 for 2014. Petitioner regularly attended AMMC’s board meetings during 2013 and 2014, but neither she nor her husband had an employment contract with AMMC in either year. Nevertheless, AMMC provided on its Form 990 for 2013 that it provided compensation to Petitioner in her capacity as “Secretary/Dir” and to Petitioner’s husband in his capacity as “Pres/Dir.” AMMC issued Petitioner and her husband W-2 forms and a Tax Statement for 2013, and Petitioner reported these wages on a jointly filed Form 1040. However, AMMC reported on its Form 990 for 2014 that Petitioner and her husband had each received zero reportable compensation from the organization. AMMC did not issue the Ononujus a Form W-2 for 2014, and Petitioner and her husband reported that they received no salaries or wages from any sources on their 2014 return.

During 2014, AMMC maintained at least three checking accounts: a Bank of America account; a Saginaw Medical Federal Credit Union account; and a Financial Plus Credit Union account. Petitioner had signature authority over all three accounts. During that year, AMMC had issued petitioner several checks from the Saginaw and the Financial Plus accounts, totaling to $115,000 for the taxable year. Additionally, AMMC had paid $15,000 to Blue Cross Blue Shield of Michigan for health insurance covering Petitioner and her family.

In October 2015, the IRS commenced an examination of AMMC’s Form 990 for 2013, and the revenue agent (RA) later expanded the examination to include AMMC’s Form 990 for 2014 and the potential excise tax liability of Petitioner and her husband. The RA found Petitioner to have received excess benefits in the amount of $130,000 (the proceeds from the Saginaw and Financial Plus accounts, plus the health insurance benefits).[1]

The RA determined that Petitioner was required to file a return reporting the excess benefit transactions on Form 4720. However, neither AMMC nor Petitioner filed such return. As a result, in May 2018, the examining agent prepared on Petitioner’s behalf a substitute Form 4720 (SFR), reporting for 2014 a first-tier excise tax of $32,500 as mandated by section 4958(a) of the Code (which allows excise tax to be computed as 25% of the excess benefits Petitioner had received). In August 2018, the IRS issued Petitioner a timely notice of deficiency for 2014, which determined a first-tier excise tax of $32,500 and a second-tier excise tax of $260,000 (200% of the excess benefit, as allowed under section 4958(b), when a disqualified person fails to correct the excess benefit transaction in a timely fashion). The notice also determined additional taxes for failure to file a return on Form 4720 and failure to pay the excise tax shown on the SFR. Petitioner sought a redetermination of the excise tax liability.

Additionally, the IRS had determined that AMMC failed to establish that it was operating exclusively for a tax exempt purpose. As such, the IRS revoked AMMC’s tax-exempt status in October 2018, retroactive to January 1, 2014. This determination was sustained by the Tax Court in November 2020. See Am. Med. Missionary Care, Inc. v. Commissioner, T.C. Dkt. No. 318-19X (Nov. 6, 2020).

Key Issue:

• Whether Petitioner is liable for the first-tier and second tier excise taxes imposed by the IRS under sections 4958(a) and (b), respectively.

Primary Holdings:

• The Tax Court sustained Respondent’s determination that petitioner is liable for both first-tier and second-tier excise taxes. However, the Court removed AMMC’s payment for Petitioner’s health insurance from the excise tax, holding that such health insurance benefits do not constitute an excess benefit transaction. Thus, Petitioner was found to have received $115,000 in excess benefits, and the first-tier and second-tier excise taxes were adjusted to $28,750 and $230,000, respectively. Moreover, the Court found that Petitioner may avoid second-tier taxes by curing the deficiency during the correction period, which has not yet expired.

Key Points of Law:

• Section 4958 (titled “Taxes on Excess Benefit Transactions”) defines an “excess benefit transaction” as “any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.” § 4958(c)(1)(A).
• Section 4958 (c)(1)(A) further dictates: “For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for the performance of services unless such organization clearly indicated its intent to so treat such benefit.” (emphasis added). Such clear intent is only visible upon the organization’s written confirmation, contemporaneous with the transfer of the economic benefit at issue, that the benefit is to be treated as compensation for services. This is known as the “contemporaneous substantiation” requirement, and it may be satisfied in one of two ways: (1) by timely reporting or (2) via “other written contemporaneous evidence.” Absent satisfaction of the “contemporaneous substantiation” requirement, the benefit is deemed an excess benefit.
• Timely reporting method: satisfied if the organization reports a payment to the disqualified person as compensation on a Form W-2 or Form 990 prior to the IRS’ commencement of its examination. This is also satisfied when the disqualified person reports the payment as income on an original or amended Form 1040 filed before the IRS either: (1) commences its examination, or (2) supplies written documentation of a potential excess benefit transaction (whichever date is earlier).
• Other written contemporaneous evidence method: satisfied by written evidence indicating that the “appropriate decision-making body or an officer authorized to approve compensation approved a transfer as compensation for services in accordance with established procedures.” See 53.4958-4(c)(1), Foundation Excise Tax Regs. This writing needs to be contemporaneous with the transferred benefit.
• Employer-provided health benefits are nontaxable benefits. These benefits do not constitute an excess benefit transaction if they were properly excluded from the disqualified person’s income for income tax purposes.
• Section 4958(e)(1) defines an “applicable tax-exempt organization” as one that is described in section 501(c)(3) and is exempt from tax under section 501(a).
• Section 4958(a)(1) allows for the imposition of an excise tax “equal to 25 percent of the excess benefit” on each excess benefit transaction. This tax is to be paid by “any disqualified person…with respect to such transaction.” Under section 4958(b), if the excise tax is not reported in a timely fashion, the disqualified person is subject to a second-tier tax equal to 200% of the excess benefit.
• Section 4958(f)(1)(A) defines a “disqualified person” as “any person who was, at any time during the 5-year period ending on the date of…[an excess benefit] transaction, in a position to exercise substantial influence over the affairs of the organization.”
• The following are considered disqualified persons: founders, voting members of the governing body, presidents, CEOs, COOs, treasurers, and CFOs, as well as anyone who is a position to exercise substantial influence over the organization’s affairs.
• Further, family members of disqualified persons, down to the level of great-grandchildren, are disqualified as well under 4958(f)(1)(B).
• An organization can still be recognized as tax exempt under section 4958, even when it has lost its tax exempt status by the time of determination. The key inquiry is whether the organization was tax exempt “at any time during the 5-year period ending on the date of the transaction.”
• While second-tier taxes are mandated, they can be avoided if the Petitioner cures the deficiency within the correction period. The correction period generally begins on the date on which the taxable event occurs and ends 90 days after the date of mailing of a notice of deficiency with respect to the second tier tax imposed on that taxable event. This period pay be extended by: (1) any period in which a deficiency cannot be assessed under section 6213(a), and (2) any other period which the Secretary determines is reasonable and necessary to bring about correction of the taxable event. § 4963(e)(1).

Insight: The following method proves useful in determining tax liability for excise taxes. First, the organization must be a tax-exempt organization within five years from the date of the transaction at issue (it is immaterial whether the organization is still tax-exempt after the five year period). Second, the Petitioner must be a disqualified person (either on her own accord by way of family relation to a disqualified person). Third, there must be no clear intent that the transferred benefit was for compensation for services (this intent would be either evidenced by timely reporting or (2) via “other written contemporaneous evidence” as noted above). Fourth, nontaxable benefits, such as employer-provided health benefits, are excluded from the excise tax calculation. Lastly, second-tier taxes may be avoided if the Petitioner corrects the deficiency during the correction period, which generally remains open 90 days after the date of mailing the notice of deficiency with respect to the second tier-tax.

[1] Additionally, the RA found Mr. Ononuju to have received excess benefits of $658,168; however, as Mr. Ononuju did not appear for trial, his case was dismissed for lack of prosecution and the excise tax deficiencies and additions to tax were sustained as to him. As a result, this case concerns only Petitioner’s, Mrs. Ononuju’s, tax liability for 2014.

Zuo v. Comm’r, No. 5716-19S, 2021 BL 279235, 2021 Us Tax Ct. Lexis 53 (T.C. July 26, 2021) | July 26, 2021 | Panuthos | Dkt. No. 5716-19S

Short Summary: This Small Tax Case involved a deduction claimed by Petitioner for expenses related to his pursuit of a Master of Business Administration (“MBA”) degree. Such expenses were claimed as unreimbursed employee expenses on Schedule A, Itemized Deductions. Respondent denied the entirety of Petitioner’s claimed deduction and assessed an accuracy-related penalty pursuant to 26 U.S.C. § 6662(a).

Key Issue: Whether Petitioners’ education expenses constituted a deductible business expense.

Primary Holdings:

• Petitioner was qualified in the trade or business of being an entrepreneur before enrolling in the MBA program at MIT on the basis of the time and money he had previously spent founding, organizing, and assuming the financial risks of his two entrepreneurial ventures.
• Petitioner had likely developed significant business acumen that was useful in pursuing these ventures while obtaining an undergraduate degree in business administration and working as an investment analyst. Petitioner continued to develop his entrepreneurial skillset when he helped found and served as the CEO of of a consulting company starting in 2016.
• Although petitioner’s business courses at the MIT MBA program may have honed his leadership, communication, organization, and other skills necessary to run a successful business, they did not “qualify” him for a new trade or business as an entrepreneur. Rather, they maintained and refined skills he was already using in his current business.
• A taxpayer may be engaged in a trade or business, although not working, if he was previously involved in and actively sought to continue in that trade or business while pursuing a defined degree program related to his or her line of work. Petitioner satisfied that requirement.
• Based on these findings, Petitioner’s pursuit of an MBA degree improved and maintained skills related to his established trade or business as an entrepreneur and that he is therefore entitled to a deduction for education expenses associated with that degree under section 162.
• Having satisfied the requirements for deduction, an accuracy-related penalty was inappropriate.

Key Points of Law:

• R.C. § 162(a) authorizes a deduction for “ordinary and necessary expenses paid or incurred . . . in carrying on any trade or business”;
• An individual’s expenditures for education are deductible as ordinary and necessary business expenses if the education maintains or improves skills required in his employment or other trade or business. Treas. Reg. §1.162-5(a);
• Reg. §1.162-5(a) requires a taxpayer to be presently engaged in a trade or business in order for education expenses to be deductible. See Link v. Commissioner, 90 T.C. 460 , 463-464 (1988), aff’d, 869 F.2d 1491 (6th Cir. 1989);
• The regulations disallow a deduction for education expenses for: (1) education required to meet the minimum requirements of a taxpayer’s trade or business or (2) a program of study that qualifies a taxpayer in a new trade or business. Treas. Reg. §1.162-5(b)(2) and (3);

Insight: This case provides a good roadmap for satisfying the requirements for the deduction of a graduate-level degree as an unreimbursed employee expense.

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