The Tax Court in Brief - August 2021 #4

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Freeman Law

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.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

The Week of August 16 – August 20, 2021

Catlett v. Comm’r, No. 13058-14, T.C. Memo 2021-102 | August 16, 2021 | Lauber | Dkt. No. 13058-14

Short SummaryThe taxpayer was convicted in 2011 on Federal criminal charges, including tax crimes and conspiracy to defraud the United States. In March 2011 he was sentenced to 210 months in prison. After he was remanded to custody, the IRS completed a civil examination of his 2006-2010 tax years.  The IRS subsequently assessed substantial deficiencies, along with additions to tax and penalties.  The taxpayer timely petitioned the Tax Court in June 2014.  However, because of his incarceration, the case was repeatedly continued.  The taxpayer died in January 2020, and the IRS filed a motion to dismiss the case based on lack of prosecution.

Key Issue:  The key issue is the standard for dismissal when a taxpayer fails to prosecute their case.  Various burdens come into play that the IRS must still meet despite the failure of the taxpayer to prosecute his case.

Primary Holdings

  • The IRS satisfied its burden of production by introducing extensive banking records obtained from third-party institutions. These records establish that the taxpayer during 2006-2010 deposited more than $1.7 million into various accounts that he controlled. The checks thus deposited were issued by the taxpayer’s clients for services he provided in connection with the tax shelter scheme, including tax return preparation. Taxpayer failed to report most of these payments on his tax returns for 2006-2008, and he filed no return for 2009 or 2010.
  • The balance of the deficiencies for 2006-2008 resulted from the disallowance of expense deductions. Taxpayer bears the burden of proving his entitlement to these deductions. Rule 142(a); see sec. 1.6001-1 (a), Income Tax Regs. At no point during the examination (or subsequently) did the taxpayer supply any evidence to substantiate his claimed deductions. Therefore, the Court sustained the deficiencies to the extent they are not barred by the period of limitations.
  • Analyzing limitations, the Court first found that, for 2009 and 2010, the taxpayer filed no return. Therefore, pursuant to I.R.C. § 6501(c)(3), the tax for those years can be assessed at any time.
  • For tax years 2007 and 2008, the Court found that the taxpayer omitted more than 25% of the gross income stated in the return, and therefore, the 6-year statute of limitations applied pursuant to I.R.C. § 6501(e).
  • Looking at 2006, the Court first found that the 6-year statute of limitations applied and that it would normally have expired on August 21, 2013 – prior to the IRS assessment. However, applying § 7609(e)(1), the Court found that the limitations period was suspended during the 330 days in which the taxpayer had litigated motions to quash the IRS summonses to his banks.  Therefore, the 6-year period had been extended to July 17, 2014, and the notice of deficiency was therefore timely.
  • Finally, the Court found, alternatively, that the IRS satisfied its burden of proving the taxpayers’ fraud for tax years 2006-2008. Therefore, § 6501(c)(1), which provides that a tax may be assessed at any time where a taxpayer has filed a false or fraudulent return, provided an alternative basis for finding the notice of deficiency timely as to all years at issue
  • The Court assessed fraud penalties after conducting an analysis of various badges of fraud, in which it found the existence of at least six badges of fraud on the part of the taxpayer
  • The Court found that the IRS had satisfied all of its burdens related to the assessment of penalties, and therefore all penalty assessments—including fraud penalties, failure to file penalties, and failure to pay penalties—were all upheld.

Key Points of Law:

  • Under Tax Court Rule 123(b), the Court may dismiss a case at any time and enter a decision against the taxpayer for failure to prosecute his case properly or failure to comply with the Court’s orders and Rules.
  • If a taxpayer dies while his case is pending, ordinarily the taxpayer’s representative or successor would be substituted as the proper party. See Rule 63(a).
  • If there is no representative or successor, the Court can ask the IRS to furnish the identities of individuals who possess a “monetary interest” in the outcome of the case. If no individual expresses an interest, then the case will be dismissed for lack of prosecution.
  • The IRS’ determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proving them erroneous. See Rule 142(a) .
  • In unreported income cases, the Commissioner must generally establish a “minimal evidentiary showing” connecting the taxpayer with the income-producing activity, see Blohm v. Commissioner, 994 F.2d 1542, 1548-1549 (11th Cir. 1993), aff’g T.C. Memo. 1991-636 , or demonstrate that the taxpayer actually received unreported income, see Edwards v. Commissioner, 680 F.2d 1268, 1270 (9th Cir. 1982).
  • Once the Commissioner makes the required threshold showing, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary or erroneous.
  • If a taxpayer fails to file a return, then the tax for those years may be assessed at any time. 6501(c)(3).
  • Where a taxpayer substantially underreports income by 25% or more, the normal 3-year statute of limitations becomes 6 years. 6501(e)(1)(A)(i)
  • The limitations period is suspended during any period in which a taxpayer litigates motions to quash IRS summonses to parties with respect to that taxpayer’s liability. 7609(e)(1).
  • When determining fraudulent intent on the part of a taxpayer, Courts look at various badges of fraud to determine the existence of the required intent. Such badges of fraud include:
    • Understating income;
    • Keeping inadequate records;
    • Giving implausible or inconsistent explanations of behavior;
    • Concealing income or assets;
    • Failing to cooperate with tax authorities;
    • Engaging in illegal activities;
    • Supplying incomplete or misleading information to a tax return preparer;
    • Providing testimony that lacks credibility;
    • Filing false documents (including false tax returns);
    • Failing to file tax returns; and
    • Dealing in cash.

InsightThis case represents a tragic set of facts in which a taxpayer checked all the boxes to earn a finding of filing fraudulent returns.  From a procedural standpoint, however, this case provides a useful guide to the various burdens applicable to both taxpayers and the IRS in Tax Court.

Catherine S. Toulouse v. Comm’r, 157 T.C.| August 16, 2021 | Goeke, J. | Dkt. No. 19122-19

Short SummaryThe case discussed the applicability of the foreign tax credit (FTC) against the Net Investment Income Tax (NIIT) under the tax treaties between the U.S. and France and Italy. The Court concluded that under the text of such treaties, the foreign tax credit cannot be applied against the NIIT.

Catherine Toulouse (the petitioner), a U.S. citizen residing in a foreign country, filed her tax return for 2013 claiming FTC paid to France and Italy to offset her income tax. She also reported a carryover of FTCs to offset her income tax. Despite having NIIT in the amount of $11,540.00 USD, the petitioner claimed that her NIIT was zero. This calculation resulted because the petitioner added two lines to the return: the first to claim an FTC against the NIIT and the second resulting in NIIT due in the amount of zero. The petitioner disclosed her tax position by filing forms 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), and form 8275, Disclosure Statement, where she explained that under article 24(2)(a) of the U.S.-France tax treaty, and article 23(2)(a) of the U.S.-Italy tax treaty, she was allowed to apply FTC against the NIIT.

The IRS issued a notice of math error to the petitioner adjusting the NIIT amount owed and eventually disallowed the FTC and issued an assessment. Upon the issuance of the notice of intent to levy and notice of a right to a hearing, the petitioner timely filed a Collection Due Process (CDP) request. Appeals sustained the assessment and issued a notice of determination.

The Tax Court determined that the FTC is not applicable to offset the NIIT, under the text of the tax treaties between the U.S. and France and Italy respectively and in accordance with the provisions of the Code.

Key Issues: Whether under the tax treaties between the U.S. and France and Italy, a U.S. taxpayer is allowed to apply a FTC against the NIIT.

Primary Holdings: The petitioner is not allowed to apply the FTC against the NIIT under the tax treaties between the U.S. and France and Italy.

Key Points of Law:

Section 6330 of the Code provides that a taxpayer that timely requests a CDP is entitled to a hearing, where the taxpayer can challenge can raise any relevant issue related to the unpaid tax or proposed levy, and also, can challenge the underlying tax liability. When the underlying tax liability is at issue on a CDP hearing, the Court reviews the liability de novo. See Davis v. Commissioner, 115 T.C. 35, 39 (2000). In this case, petitioner challenged the underlying liability, and the Court reviewed such assessment de novo.

Section 27 of Chapter 1 of the Code allows the taxpayers to apply a credit for the amount of taxes imposed by foreign countries against the tax imposed by “this chapter” to the extent provided in section 901. Section 901 establishes a FTC against regular tax. These two provisions state that the FTC reduces only tax imposed under chapter 1 of the Code.

The NIIT is in chapter 2A, subtitle A, Income taxes. Consequently, the FTC under section 27 (applicable only for taxes under chapter 1), does not apply by its terms to offset the NIIT. Treas. Reg. 1.411-1(a) provides that all the IRC provisions that apply for chapter 1 purposes in determining taxable income, as defined in section 63(a), also apply in determining the NIIT. Section 63(a) does not include credits to determined taxable income, thereby, the FTC (a credit) is not applicable to the NIIT.

Article 24(2)(a) of the tax treaty between the U.S. and France provides respectively the following: “In accordance with the provisions and subject to the limitations of the law of the U.S, the U.S. shall allow to a citizen… of the U.S. as a credit against the U.S. income tax:(i) the French income tax paid by or on behalf of such citizen…”. Art. 23(2)(a) of the tax treaty between U.S.-Italy is in similar terms.

Such treaties must be interpreted using their ordinary meaning, and must be construed liberally to give purpose of the treaty. Under this approach and under the express terms of the treaties, the Court stated that any allowable foreign tax credit must be determined in accordance with the Code and is limited to by the Code’s provision of a credit. Accordingly, if the Code provides for a credit, then such credit will be allowable under the treaty. Because section 1411(c)(1)(B) expressly provides for deductions to compute the NIIT, but does not provide for credits, it is clear that the FTC is not applicable against the NIIT.

This interpretation is supported by additional arguments. First, the purpose of the treaties is to provide general protection against double taxation, not to provide absolute protection. Nothing in the text of the tax treaty between the U.S. and France and Italy, respectively, provide for the elimination of all double taxation. Second, the Court’s interpretation is affirmed by the contemporary explanation provided by the Treasury Department of both treaties, which basically states that the credits under the “Convention are allowed in accordance with the provisions and subject to the limitations of U.S. law”… “thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions of the U.S. statutory credit at the time the credit is given”.

Based on the previous, the Court concluded that the FTC, applicable only to the tax under section 1 (income tax) is not applicable to the NIIT, under the terms of the texts of the U.S.-France and the U.S.-Italy tax treaties.

Insight:  Tax treaties are relevant when determining the tax implications of international taxpayers. Careful consideration must be given to the text of each treaty because relevant differences are usually found among the multiple treaties. In this particular case, there was an express provision in the Code that limited the FTC to income tax disallowing its application to the NIIT.

More problematic is the application of a treaty for newly enacted measures, for example, a unilateral measure on digital taxation imposed by the other treaty jurisdiction. This case is relevant in the short-term for the prospective tax reform and the implementation of Pillar 1 & 2 currently in development by the OECD.

Lissack v. Comm’r, 157 T.C. No. 5 | August 17, 2021 | Lauber, J. | Dkt. No. 399-18W

Short Summary

The taxpayer Lissack was a whistleblower who submitted Form 211, Application for Award for Original Information, claiming that taxpayer Target (an affiliated group of entities) had failed to report membership fees as gross income. The membership fees in question were for golf and beach club memberships to residents of Target’s condominiums. The taxpayer claimed that Target had improperly treated the membership fees as nontaxable deposits in the years received. Upon receiving the whistleblower claim, the IRS Whistleblower Office (Office) referred the claim to the Office’s senior tax analyst. The analyst determined that the claim appeared to identify a discernible Federal tax issue and accordingly, she forwarded the case to the IRS Large Business & International Division (LB&I), which then assigned the investigation to a revenue agent (RA) who reviewed the taxpayer’s allegations.

The RA noted that the information provided by the taxpayer whistleblower was sufficient to warrant the beginning of the examination. Upon further examination, the RA concluded that Target properly treated the membership fees as nontaxable deposits in the years received, as Target “did not have unfettered right and dominion over the deposits.” However, the RA also recognized a separate issue with taxpayer Target’s return for the same tax year, namely that Target had improperly claimed a deduction in excess of $60 million for “intercompany bad debt.” The RA noted that this bad debt issue was “unrelated to the subject of the whistleblower[‘s] claims.” Once the RA had completed his examination, the IRS had issued Target notices of proposed adjustments, disallowing the $60 million bad debt deduction.

The RA had informed the Office’s assigned tax analyst that the the taxpayer had not “provided any information for the adjusted issues.” The tax analyst relayed the same to the Office, which then issued a final determination letter to the taxpayer denying the taxpayer’s claim for a whistleblower award. The reason provided by the Office was that the “IRS took no action on the issues you raised.”

The taxpayer petitioned the Tax Court for review of the Office’s determination. In response, Respondent Commissioner filed a motion for summary judgment.

Key Issue:

  • Whether a whistleblower is entitled to an award under I.R.C. § 7623 when the IRS uses information provided by the whistleblower to initiate an investigation on a taxpayer, but finds a separate error than the one claimed by the whistleblower?

Primary Holding

  • If the error found is one that is unrelated to the facts and the claim alleged by the whistleblower, then the whistleblower is not entitled to a whistleblower award for that error.

Key Points of Law:

  • While summary judgment is traditionally granted when there is no dispute of any material fact, this standard is “not generally apt” when reviewing whistleblower award determinations.
    • Instead, the Tax Court will decide the summary judgment issues by reviewing the Office’s determinations under an abuse of discretion standard. The Court will review the administrative record in performing its analysis.
  • R.C. § 7623 authorizes the payment of whistleblower awards to those who bring information which aid the IRS in detecting underpayments of tax. I.R.C. § 7623(b) states that these awards are mandatory and must be between 15-30% of the collected proceeds if all requirements are met. Under § 7623(b)(1), the award can be paid only if the IRS “proceeds with an administrative or judicial action…based on information brought to the Secretary’s attention.” As such, the whistleblower is entitled to an award only if the IRS collects money “as a result of the action.” I.R.C. § 7623(b)(1).
  • Section 301.7623-2 of the Procedural & Administrative Regulations clarify I.R.C. § 7623, stating the following with relation to “proceeds based on” as used in § 7623(b):
    • The IRS “proceeds based on” the whistleblower’s information when his information “substantially contributes to an [administrative or judicial] action against a person identified by the whistleblower.” See & Admin. Regs. § 301.7623(b).
    • That is true when the IRS “initiates a new action, expands the scope of an ongoing action, or continues to pursue an ongoing action, that the IRS would not have initiated, expanded the scope of, or continued to pursue, but for the information provided.” See id.
    • On the other hand the IRS does not “proceed based on” the whistleblower’s information when it merely “analyzes the information provided or investigates a matter raised by the information provided.”
  • Additionally, the regulations provide examples for further clarification. One such example is similar to the case at hand. This example illustrates that if a whistleblower brings forth information relating to a taxpayer’s deficiency for year 1, and if, during the course of investigation, the IRS obtains through other sources “additional facts that are unrelated to the activities described in the information provided by the whistleblower,” then the portion of the examination that is unrelated to the facts and issue(s) identified by the whistleblower constitute a separate administrative action. In other words, the whistleblower is not entitled to an award for the issues that are unrelated to the facts and issues provided by the whistleblower, as the whistleblower’s facts did not substantially contribute to the action.
  • Here, although the RA’s examination was initiated by information provided by the the taxpayer whistleblower, the RA discovered an entirely separate issue from that alleged by the whistleblower. This issue, namely that of a deduction for intercompany bad debt, did not stem from any of the facts alleged by the whistleblower. As such, it was not related to the the taxpayer whistleblower’s claims. Thus the Office did not abuse its discretion in disallowing the taxpayer’s claims for a whistleblower award.
  • The Court further provided the following two reasons why the bad debt issue was not a “related action”:
    • (1) The action was not “an action against a person other than the person(s) identified in the information provided.” See & Admin. Regs. § 301.7623(c)(1) (providing that a “related action” is “an action against a person other than the person(s) identified in the information provided and subject to the original action(s)”).
    • (2) The facts relating to the bad debt action and the membership deposits action were not “substantially the same.” See id., at (c)(1)(i) (stating an action is not a “related action” unless “[t]he facts relating to the underpayment of tax…are substantially the same as the facts described and documented in the [original] information provided”).

InsightWhen determining whether a whistleblower is entitled to an award under I.R.C. § 7623, the Court will first look at whether the claims brought forth by the whistleblower and the claims the IRS has pursued against the taxpayer at issue are essentially the same. When the claims are different, a Tax Court will look at whether the claims pursued are related to those alleged by the whistleblower (i.e., whether the underlying facts as to the whistleblower’s claim and the claims actually pursued as substantially the same). The whistleblower is only entitled to an award if the IRS collects proceeds from the action AND if the action is related to the allegations brought forth by the whistleblower.

Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103 | August 18, 2021 Lauber, J. | Dkt. Nos. 23239-18, 23260-18

Short Summary:  The IRS determined that Wood, a government contractor who earned all her income on a U.S. military base in Afghanistan, owed roughly $95,000 in income tax deficiencies, plus additional tax and accuracy-related penalties. Wood petitioned the tax court, which mainly found in her favor. The court held that she qualified for section 911(a)(1)’s “foreign earned income” exclusion and that she was not liable for a late-filing addition to tax under section 6651(a)(1) because she was serving in support of the military in a combat zone during the relevant time.

Key Issues: The two requirements for qualifying for the foreign earned income exclusion turn on a variety of factors. Here, the taxpayer’s somewhat unique work circumstances easily qualified her for the exclusion.

Primary Holdings:

Section 61(a) provides that gross income means “all income from whatever source derived.”  Section 911(a)(1) provides that a “qualified individual” may elect to exclude from gross income, subject to certain limitations, “foreign earned income.” Foreign earned income is “the amount received by such individual from sources within a foreign country or countries which constitute earned income attributable to services performed by such individual.” Sec. 911(b)(1)(A).

There was no dispute that Wood’s compensation for her work as a contractor in Afghanistan was “foreign earned income.” The issue was whether she was a “qualified individual” and eligible to exclude that compensation from her gross income. The court agreed with Wood that she was.

There are two requirements to qualify for this exclusion: “First, she must either be a ‘bona fide resident’ of one or more foreign countries or be physically present abroad for a specified period. Sec. 911(d)(1). Second, she must show that her ‘tax home is in a foreign country.” Sec. 911(d)(1) (flush language).” Wood at 11-12.

To establish bona fide foreign residency, the taxpayer must provide “strong proof” (more than a preponderance) of that residence. Courts look at a number of factors, including: “(1) intention of the taxpayer; (2) establishment of her home temporarily in the foreign country for an indefinite period; (3) participation in the activities of her chosen community on social and cultural levels, identification with the daily lives of the people, and, in general, assimilation into the foreign environment; (4) physical presence in the foreign country consistent with her employment; (5) nature, extent, and reasons for temporary absences from her temporary foreign home; (6) assumption of economic burdens and payment of taxes to the foreign country; (7) status of resident contrasted to that of transient or sojourner; (8) income tax treatment accorded by her employer; (9) marital status and residence of her family;(10) nature and duration of her employment and whether assignment abroad could be completed more expeditiously; and (11) whether residence abroad reflects good faith (as opposed to a tax evasion purpose).” Wood at 12-13 (citations omitted).

In reviewing Wood’s testimony and other evidence at trial to analyze these factors, the court also considered the unique circumstances of a government contractor in Afghanistan. Factors that might have ordinarily weighed in the government’s favor, were neutral at best, in those circumstances. For example, Wood maintained a Texas driver’s license as a condition of her employment. Likewise, doing her banking locally in Afghanistan would have been impractical, if not impossible. Participation in the local community was similarly impossible; she was not permitted to leave the base where she was stationed.

Based on its analysis of these factors, the court held that Wood was a bona fide resident of Afghanistan during 2012-2015. Wood was not a bona fide Afghanistan resident in 2016; she lived in her house in Texas from April (after losing her job) until December (when she returned to Afghanistan for a different contractor). She did, however, qualify for the exclusion (for part of the year) via the 330-day physical presence requirement. This requires that the taxpayer, “during any period of 12 consecutive months, * * * [be] present in a foreign country or countries during at least 330 full days in such period.” Sec. 911(d)(1)(B).” Id. 17-18.

The second requirement for the foreign earned income exclusion is to show that the taxpayer’s “tax home is a foreign country.” Sec. 911(d)(1). As the court noted, this inquiry overlaps with the first requirement.

The court concluded that Wood met both requirements for the exclusion for tax years 2012-2015 and part of 2016. The court also found that Wood was not liable for any additional tax or penalty for her late filing based on extensions for taxpayers serving in support of U.S. Armed Forces in a combat zone.

Key Points of Law:

Proof of bona fide foreign residency requires strong evidence, more than a preponderance. The inquiry is fact-intensive.

Insight: Wood’s fairly unique circumstances (government contractor in Afghanistan) limit the application of this case. The court would likely review the relevant factors differently for a government contractor stationed elsewhere (for example, Europe), and very different for taxpayers earning income abroad in less restrictive circumstances.

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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.

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