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Tax Litigation: The Week of August 23 – August 27, 2021
Tax Court Case: Estate of Charles P. Morgan, Deceased, Roxanna L. Morgan, Personal Representative and Roxanna L. Morgan v. Comm’r, T.C. Memo 2021-104 | August 23, 2021 | Pugh, J. | Dkt. No. 592-18
Tax Dispute Short Summary: The case analyzed whether activities carried to acquire a business rise to the level of a trade or business, and thus, whether related expenses are deductible. Additionally, the case discusses the framework applicable to establish reasonable cause based on reliance on a tax professional.
Mr. Morgan (the petitioner) was a real estate developer. During the 1983-2009 period he actively owned and was involved in various real estate companies. During the 2009 financial crisis, his real estate companies were severely impacted because of lack of liquidity and eventually, his creditors requested the appointment of a receiver. Upon the appointment, the receiver was in sole control of the petitioner’s companies, and he was prohibited from incurring expenses on behalf of the companies that were under the receiver’s control.
As a consequence of the above, the petitioner spent vacation time and later decided to start a new business, through a single-member LLC, Legacy. The purpose of his new venture was to acquire a business. Petitioner recorded his time spent working as “business search” and deducted various expenses related to the search of a possible target acquisition. Aside from Legacy, petitioner also owned another entity, Falcon, that was used to hold and operate an aircraft. Legacy paid consulting fees to Falcon, and Falcon’s expenses were related to the use and maintenance of the aircraft. Legacy deducted the consulting fee paid to Falcon. Finally, petitioner claimed Net Operating Losses (NOL) for both Legacy and Falcon, derived from previous years. The IRS disallowed the expenses and issued a notice of deficiency and imposed a penalty under section 6662 (underpayment due to negligence or substantial understatement of income tax).
The Tax Court determined that petitioner business of searching for target acquisition did not constitute a trade or business because no business had been started yet. Therefore the expenses were rejected. However, the Court rejected the imposition of the 6662 penalty because the petitioner showed reasonable cause based on reliance on a tax professional.
Tax Litigation Key Issues: Whether the acquisition of a business constitutes itself a trade or business?
Primary Holdings: The search of an active or existing trade or business is not a trade or business. Related expenses fall within Section 195(c)(1)(A)(i) as start-up expenses rather than expenses related to a trade or business.
Key Points of the Tax Laws:
Section 162 allows taxpayers to deduct expenses paid or incurred on any trade or business. To determine the existence of a trade or business, three main factors are relevant: carrying the activity for profit, that the taxpayer is regularly and actively involved in the activity and that the activity has actually commenced. See Weaver v. Commissioner, T.C. Memo. 2004-108 , 2004 WL 938293 , at *6 ; McManus v. Commissioner, T.C. Memo 1987-457 , 1987 Tax Ct. [54 T.C.M. (CCH) 475], Memo LEXIS 454, at *20. To properly commence a business, the taxpayer must engage in such business. See Cabintaxi Corp. v. Commissioner, 63 F. 3d 614 , 620-621 (7th Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. Memo. 1994-316.
If there is no business yet, Section 195(a) provides that no deduction is allowed for start-up expenses. Legislative history includes as start-up expenses those incurred in the study and choose of potential business, and those to prepare to begin that business. See H. Rept. 96-1278 , at 10-11 (1980), 1980- 2 C.B. 709, 712; S. Rept. 96-1036, at 11-12 (1980), 1980 U.S.C. C.A.N. 7293, 7301. If taxpayer has yet not decided to enter into a business or which business to enter, any expenses is considered as an investigatory cost under Section 195(c). Once the business is chosen, and the business starts functioning as a going concern and performs the activities for which it was organized, any expense incurred falls within Section 162, because there is an existing trade or business.
In this particular case, petitioner argued that his expenses were deductible under Section 162 under two theories. First, petitioner argued that his homebuilding activities never ceased. The Court determined that this argument was without merit because the taxpayer considered himself as no longer carrying a homebuilding business (based on his testimony) and also, because the receivership terms clearly stated that the taxpayer could not be engaged in his previous business.
Second, taxpayer argued that the search for a new trade or business to acquire was itself an active trade or business. The Court rejected this argument for both entities, Legacy and Falcon. For Legacy, the Court ruled that the business investigation expenses that were claimed, fell within the start-up expenditures of Section 195(c)(1)(A)(i) as “amounts paid or incurred in connection with investigating the creation or acquisition of an active trade or business”. These included paid employees and outside consultants. This argument was supported by the fact that no business was acquired by petitioner. For Falcon, the Court concluded that such entity did not lease the aircraft and only income came from petitioner and Legacy, thereby no trade or business existed.
In sum, the Court concluded that no trade or business was carried by both Legacy and Falcon and rejected the related expenses.
The Court also ruled on NOLs related to the trade or business which were rejected based on the same conclusion that there was no trade or business for both Legacy and Falcon. A determination for partnership was also made and followed the same conclusion as above (no existence of trade or business).
Finally, as for the Section 6662(a) penalty, the Court determined that reasonable cause existed in this case because the taxpayer relied on professional advice, and the adviser was a competent professional with sufficient expertise to justify reliance, the taxpayer provided all necessary and accurate information to the adviser and the taxpayer actually relied in good faith on the adviser’s judgment. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225 , 246 (2018); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 , 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). In this case, the tax preparer, a CPA, was professionally licensed and knew the petitioners’ personal and business affairs. Secondly, petitioner provided necessary and accurate information to his tax adviser and third, petitioner relied on his tax adviser, because he had been preparing his returns for over a decade.
Tax Court Motion: This case is relevant especially in certain business ventures, for example, SPACs (Special Purpose Acquisition Ventures), whose main purpose is to acquire an existing venture. Special consideration must be given to the determination as to whether a trade or business exists in those cases and if not, determine the most appropriate manner on how to characterize the expenses related.
This case is also relevant to understand the general framework of establishing reasonable cause, which usually applies in multiple settings around the Code.
Tax Court Case: Vera v. Comm’r, 157 T.C. No. 6 | August 23, 2021 | Buch, J. | Dkt. No. 9921-19
Tax Dispute Short Summary:
- For 2010 and 2013, the years at issue, Petitioner Vera filed joint returns with her (then) spouse. For 2010, the Commissioner determined a deficiency that was assessed as a joint liability. For 2013, the tax shown on the return was not paid in full, resulting in an underpayment of tax. The Commissioner assessed the tax liability and associated penalties.
- In early 2015, Petitioner filed a request for innocent spouse relief relating solely to the 2013 underpayment. She submitted Form 8857, Request for Innocent Spouse Relief, setting forth her grounds for relief. In March 2016, the Commissioner issued a final determination denying relief to Petitioner, writing that she did not meet the requirements for relief.
- Petitioner challenged the Commissioner’s determination in Court, and that determination was ultimately dismissed for lack of jurisdiction.
- Several months later, Petitioner submitted a request for relief for 2010, but in that request, she also re-raised her 2013 liability. The Commissioner denied the request for relief in a Final Appeals Determination Letter (dated March 14, 2019). The header of that letter specified only 2010 as the tax year, but the substance of the letter denied the request for relief as to both the 2010 and 2013 tax years. It read:
- For tax year 2010, the information we have shows that you didn’t meet the requirements for relief.
- For tax year 2010, you didn’t have a reasonable expectation that the person you filed the joint return with would or could pay the tax.
- For tax year 2013, you didn’t comply with all income tax laws for the tax years that followed the years that are the subject of your claim.
- Petitioner filed a timely petition challenging the Commissioner’s determination. She used the Tax Court’s petition form (T.C. Form 2 as revised in November 2018). Line 3 of the form requests: “Provide the year(s) or period(s) for which the NOTICE(S) was/were issued.” Petitioner wrote “Tax Year 2010, Tax Year 2013.”
- Petitioner included in her petition a copy of the Commissioner’s notice, as well as a statement of facts that also mentioned both 2010 and 2013.
- The Commissioner filed a motion to dismiss for lack of jurisdiction as to tax year 2013. He averred the following in his motion:
- that the March 14, 2019, determination is not a second determination for 2013,
- that a second request for innocent spouse relief is available only when seeking to allocate a deficiency, and
- that because the 2013 liability is an underpayment, it cannot be subject to a second election for relief
Tax Litigation Key Issue:
- Whether the Court has jurisdiction to determine the appropriate relief available to a Petitioner who has received the Commissioner’s final determination denying innocent spouse relief on the merits.
When the Commissioner issues a final determination denying innocent spouse relief on the merits, the Tax Court has jurisdiction to determine the appropriate relief available, even if the Commissioner had previously denied relief. The Court’s jurisdiction extends to both the 2010 and 2013 tax years, as the substance of the Commissioner’s final determination unambiguously denied innocent spouse relief as to both years.
Key Points of the Laws:
- R.C. § 6015(e) grants tax courts the jurisdiction to determine the appropriate relief with regard to a taxpayer’s petition for innocent spouse relief.
- Final determination letters issued under § 6015 are not subject to any statutory or regulatory form or content requirements.
- A predicate to the Court’s jurisdiction pursuant to § 6015(e) is the mailing of a final determination.
- Although § 6015(e)(1)(A)(i)(I) refers to a final determination, nothing in that provision prohibits the Commissioner from issuing more than one final determination as to a given tax year.
- The regulations clarifying § 6015 limit claimants to a single qualified request for a given year. Income Tax Regs § 1.6015-1(a)(2) , (h)(5).
- A qualified request is defined as the “first timely claim for relief.” para. (h)(5).
- Moreover, the “requesting spouse is entitled to only one final administrative determination of relief.” Income Tax Regs § 1.6015-5 (c)(1).
- But these regulations leave open the possibility for the Commissioner to issue a second final determination. See Income Tax Regs Secs. 1.6015-1(h)(5) , 1.6015-5(c)(1) , 1.6015-3 (stating that if a requesting spouse changes marital status, the regulations permit a second claim, resulting in a second final determination); see also Internal Revenue Manual (IRM) pt. 126.96.36.199(1) (Mar. 5, 2019) (allowing for a second claim when a “delay or error” imposes an “unfair burden” on the requesting spouse and the Commissioner exercises his discretion to issue a second final determination).
- The Internal Revenue Manual provides following instructions with respect to final determinations:
- A second determination issued under these limited circumstances grants the requesting spouse the right to petition the Tax Court. I.R.M. 188.8.131.52.
- Upon request, the Commissioner also may reconsider previous requests. pt. 184.108.40.206(1).
- If he determines relief is appropriate, the Commissioner may change his final determination as to the previous requests. pt. 220.127.116.11(3). However, I.R.M. pt. 18.104.22.168 specifically cautions agents that reconsideration decisions should not be issued through final determination letters.
- While the I.R.M. does not carry the force of law, but courts have considered it when understanding the Commissioner’s procedures
- The I.R.M. instructs the Commissioner to issue a Letter 3657C (No Consideration Innocent Spouse) to taxpayer petitioners when taxpayers submit a second request for relief concerning the same tax year. IRM pt. 22.214.171.124(4) (Mar. 5, 2019).
- However, where, as here, the Commissioner issues a second final determination as to any tax year, then the requesting spouse has the right to petition the Tax Court for a determination of relief. See IRM pt. 126.96.36.199.
- This is all the more true when the Final Determination Letter unambiguously relates solely to the merits of relief for the prior tax years, and does not describe a rejection on the basis of an improper second request.
- Moreover, courts have jurisdiction to review final determinations issued in error. This rule applies in the context of final determination letters pertaining to: (1) innocent spouse relief, (2) whistleblower awards, (3) deficiencies, and (4) collections.
- If the Petitioner taxpayer timely files a petition and the notice of final determination serves as the predicate for the court’s jurisdiction, then the court will first look to the face of the notice. Courts will only look beyond the face of the notice if it is ambiguous or inconsistent.
Tax Court Motion:
- When a taxpayer submits a second request for innocent spouse relief concerning the same tax year, the I.R.M. instructs the Commissioner to issue a Letter 3657C (No Consideration Innocent Spouse).
- If instead, the Commissioner issues a second final determination as to any tax year, then the requesting spouse has the right to petition the Tax Court, and the Tax Court has jurisdiction to determine, the appropriate relief.