Smith v. Comm’r: Before You Take that Business-Related Tax Loss, Ask “Does My Business Have a Bona Fide Purpose?”

by M. Robinson & Company, P.C.
Contact

Last fall, the U.S. Tax Court decided the case of Smith v. Comm’r.[1] It’s not a pivotal case, but it stands as a good reminder of the adage “you don’t get something for nothing.” At the heart of the case was a complicated tax planning strategy using an S corporation, a family limited partnership and a trust, which, the taxpayers asserted, generated a substantial tax loss. Upon review, the U.S. Tax Court could not find an actual business operating within these structures. As a result, it agreed with the IRS on both the disallowance of the tax loss and the assessment of significant penalties.

Background:

In June 2009, the taxpayers met with an attorney to address their estate planning issues. The husband had recently retired and was to receive employee compensation of $664,007 that year. The taxpayers hired the estate planning attorney, who was also a CPA, to create a will and other estate planning documents. Additionally, they implemented a tax planning strategy the attorney suggested, which was intended to offset the taxpayers’ tax liability for the husband’s 2009 compensation income.

Structure of Tax Planning Strategy: The strategy involved setting up (1) an S corporation, (2) a family limited partnership (FLP), and (3) a revocable management trust. The S corporation was to own 98% of the FLP as limited partnership interests and the taxpayers each held a 1% general partnership interest in the FLP. These general partnership interests were placed in the revocable management trust. The taxpayers then transferred more than $1.8 million of personal assets, consisting of cash and marketable securities, to the S corporation. The S corporation then transferred these assets to the FLP.

Valuation Discounts Applied to Generate Loss: Within about four months, the S corporation was dissolved. Almost all of the assets of the FLP were distributed back to the taxpayers and the 2009 S corporation’s tax return reported an ordinary loss of about $750,000. This was the result of deducting approximately $1.9 million (basically, the amount distributed to the taxpayers) as the cost of goods sold, from gross receipts of approximately $1.12 million. The gross receipts were calculated, generally, by applying a 40% discount for lack of marketability and lack of control against the amount of personal assets transferred to the S corporation.

  • It should be remarked that the taxpayers’ former accountant did not feel comfortable preparing the returns, so they were prepared by the attorney’s firm.

The IRS reviewed the return and issued a notice of deficiency for income tax of $623,795. It also applied an accuracy-related penalty of $124,759 under section 6662(a).

Analysis by the U.S. Tax Court:

While the Tax Court didn’t use the phrase “sham transaction” directly, that was the basic result of its analysis. A “sham transaction” is generally one in which there is no real business purpose for the transaction and the taxpayers entered into it for the sole purpose of avoiding tax liabilities. Courts determine this under the “economic substance doctrine.”

Loss Deduction and the Economic Substance Doctrine: The Tax Court held that the loss deduction did not meet the Section 165 requirements of a bona fide loss incurred in a trade or business or transaction entered into for profit because the business structure created for the taxpayers lacked economic substance. Under the economic substance doctrine, courts are permitted to disregard a transaction for federal tax purposes, even if it is compliant with the Code, if it has no other purpose than generating a tax loss. A business transaction may be structured to reduce taxes, but an underlying business purpose must exist.

While the IRS is presumed correct, the determination of whether economic substance exists is facts and circumstances based, and the taxpayer bears the burden of proof. The Tax Court looked to the Fifth Circuit[2] and applied a multi-factor test[3] for making the fact-based determination. A standard element for testing economic substance requires making objective and subjective inquiries.

  • Objective inquiries into economic substance look at whether there was a reasonable possibility that the business transaction would make a profit or provide another business benefit.
  • The subjective economic substance inquiry is to determine whether the taxpayers actually had a non-tax business purpose for their business transaction.

The Tax Court found that the taxpayers never intended to operate a business. The taxpayers did not follow any corporate formalities and there were no offices, issuances of stock certificates, meeting minutes. Particularly, the court found that the “circular flow of funds among related entities” was used to generate an artificial tax loss in 2009. Thus, the income tax deficiency was upheld.

Penalties for Substantial Understatement of Income Tax: In addition to the tax loss being disregarded, the taxpayers were subject to penalties. An accuracy-related penalty under Section 6662(a) of 20% of the amount of underpayment of tax may be applied in cases where income tax has been substantially understated. “Substantial” refers to an understatement that exceeds greater than 10% of the tax required to be shown on the return or $5,000.

A penalty may be abated for reasonable cause under Section 6664(c)(1) if the taxpayers can show they acted reasonably and in good faith. Additionally, reliance on a tax professional may constitute reasonable cause and good faith.[4]

The Tax Court considered this defense and agreed that the taxpayers had relied on their tax professional, but not to the extent that Section 6664(c)(1) could provide relief. The Tax Court determined that the taxpayers never intended to conduct business activities and that they knew from the beginning that the sole purpose of the transaction was tax avoidance. Therefore, the penalty was also upheld.

Conclusion:

It was unfortunate that this case involved retirees. However, taxpayers who implement complex tax planning strategies involving business structures must also have a bona fide business purpose for those structures in order to receive any tax benefits. To support that a business purpose exists, at a minimum, taxpayers should at least be following the corporate formalities listed above. More importantly, taxpayers should evaluate whether their business would pass muster under the objective and subjective inquiries. As seen above, disallowance of the tax loss was not the only consequence; the taxpayers also incurred penalties of almost $125,000.

Finally, although not mentioned, this case is a reminder that attorneys and/or law firms who prepare tax returns should be aware that they are also subject to penalties for understatement of a taxpayer’s income tax in certain situations. Click here for a list of tax preparer penalties.

 

Footnotes:

[1] Smith v. Comm’r, T.C. Memo. 2017-2018, (November 6, 2017).

[2] The Fifth Circuit was the jurisdiction for an appeal in this case.

[3] Klamath Strategic Inv. Fund ex. Re. St. Croix Ventures v United States, 568 F.3d 537, 544 (5ht Cir. 2009).

[4] United States v. Boyle, 469 U.S. 241, 250 (1985).

The materials in this publication does not constitute legal advice. It is intended for general information purposes only.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© M. Robinson & Company, P.C. | Attorney Advertising

Written by:

M. Robinson & Company, P.C.
Contact
more
less

M. Robinson & Company, P.C. on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.