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 January 25 – January 29, 2021
Costello v. Comm’r, T.C. Memo. 2021-9, January 25, 2021 | Halpern, J. | Dkt. No. 1350-17
Short Summary: Taxpayer-wife was involved in a farming activity (raising chickens, growing vegetables, and raising cattle) from which she incurred seven years of losses. She also engaged in rental real estate activities. The IRS examined the taxpayers’ 2012 and 2013 tax returns and disallowed the farming losses on the grounds the taxpayers were not engaged in an active trade or business. Moreover, the IRS disallowed the rental real estate activity losses on the basis that the property had been flooded, was in no condition to rent, and had not been advertised for rent. Finally, the IRS disallowed the operating loss deductions for other rental properties as passive losses and asserted failure-to-file and accuracy-related penalties.
Key Issues: Whether the taxpayers are: (1) entitled to claim losses from their farming activities; (2) entitled to claim losses from their rental property activities; (3) liable for penalties under I.R.C. § 6651(a)(1) and I.R.C. § 6662.
Primary Holdings: The taxpayers are: (1) not entitled to deduct losses from their farming activities because the losses were startup expenses under I.R.C. § 195(a); (2) not entitled to deduct operating losses related to one rental property because the property was not held for rental; (3) entitled to a loss deduction for certain other rental activities because the IRS erred in determining the losses were passive losses; (4) liable for I.R.C. § 6651(a)(1) and I.R.C. § 6662 penalties.
Key Points of Law:
- Section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.
- Section 183(a) as a general rule disallows any deduction attributable to an activity not engaged in for profit; moreover, the Regulations under Section 183 lay out nine nonexclusive factors for determining whether an activity is engaged in for profit.
- In order for expenses to be deductible under Section 162(a), the expenses must relate to a trade or business functioning when the expenses were incurred. Hardy v. Comm’r, 93 T.C. 684, 687 (1989). A taxpayer has not engaged in carrying on any trade or business within the intendment of Section 162(a) until such time as the business has begun to function as a going concern and performed those activities for which it was organized. Richmond Tel. Corp. v. U.S., 345 F.2d 901, 907 (4th 1965). “Carrying on a trade or business” requires showing more than initial research into or investigation of business potential. Sec. 162(a); Dean v. Comm’r, 56 T.C. 895, 902 (1971). The business operations must have actually commenced. McKelvey v. Comm’r, T.C. Memo. 2002-63. Until the time the business is performing the activities for which it was organized, expenses related to that activity are not currently deductible under Section 162. Heinbockel v. Comm’r, T.C. Memo. 2013-125. They are instead classified as “startup” or pre-opening” expenses. Hardy v. Comm’r, 93 T.C. at 687. Any startup expenses—which include those incurred before the day on which the active trade or business begins—are only deductible over time once an active trade or business begins. See Sec. 195(a), (c)(1)(A)(iii).
- Section 195(a) provides that no deduction shall be allowed for startup expenditures. Section 195(c)(1) defines startup expenditures as, among other things, any amount paid in connection with creating an active trade or business, which, if paid or incurred in connection with the operation of an existing trade or business, would be allowable as a deduction for the taxable year in which paid or incurred. 195(b) provides that startup expenditures may, at the election of the taxpayer, be treated as deferred expenses that are allowed as a deduction prorated equally over a 15-year period beginning with the month in which the active trade or business begins. Startup expenses incurred in an unsuccessful attempt to create a business may be deductible if the attempt is far enough along. See, e.g., Seed v. Comm’r, 52 T.C. 880 (1969); Rev. Rul. 77-254.
- If the aggregate income from passive activities exceeds the aggregate losses from passive activities, no passive activity loss occurs. 469(d)(1).
- Section 6651(a)(1) imposes an addition to tax for failure to file a timely tax return. The addition equals 5% of the amount required to be shown as tax on the delinquent return for each month or fraction thereof during which the return remains delinquent, up to a maximum addition of 25% for returns more than four months delinquent. The addition to tax does not apply if the failure to file timely is due to reasonable cause and not to willful neglect. Id.
- Section 6662(a) and (b)(1) and (2) provides for an accuracy-related penalty of 20% of the portion of any underpayment attributable to, among other things, negligence or disregard of rules or regulations or any substantial understatement of income tax. The term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code or a failure to exercise ordinary and reasonable care in the preparation of a tax return. Reg. § 1.6662-3(b)(1).
- Section 6662(d)(2)(A) generally defines the term “understatement” as the excess of the tax required to be shown on the return over the amount shown on the return as filed. In the case of an individual, an understatement is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 6662(d)(1)(A). An understatement is reduced, however, by the portion attributable to the treatment of an item for which the taxpayer had “substantial authority” or, in the case of items adequately disclosed, a “reasonable basis.” Sec. 6662(d)(2)(B). Sec. 6664(c)(1) provides an exception to the imposition of the section 6662(a) accuracy-related penalty if it is shown that there was reasonable cause for the underpayment and the taxpayer acted in good faith.
Insight: Section 195 can act as a trap for the unwary in that it can suspend the immediate deduction of certain losses until later years. The Costello case therefore stands as a reminder that tax planning can be significant, particularly when a taxpayer begins a new business venture.
Grajales v. Comm’r, 156 T.C. No. 3, January 25, 2021 | Thornton, J. | Dkt. No. 21119-17
Short Summary: When the taxpayer was 42, she took loans in connection with her New York State pension plan. The pension plan sent her a Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting the gross distribution. The taxpayer timely filed her tax return for the tax year at issue but did not report any retirement plan distributions as income. The IRS issued a notice of deficiency determining the retirement plan distributions reported on Form 1099-R should have been included in income and were subject to a 10% additional tax on early distributions under Section 72(t).
Key Issues: Whether the requirements under Section 6751(b) apply to the Section 72(t) exaction on early distributions from qualified retirement plans?
Primary Holdings: The Section 72(t) exaction is a “tax” rather than a “penalty,” “addition to tax,” or “additional amount” and is not subject to the written supervisory approval requirement of Section 6751(b).
Key Points of Law:
- Section 6751(c) defines “penalties” to include “any addition to tax or any additional amount.”
- Section 72(t) is captioned “10-percent additional tax on early distributions from qualified retirement plans.” Section 72(t)(1) is captioned “imposition of additional tax” and provides: “If any taxpayer receives any amount from a qualified retirement plan . . ., the taxpayer’s tax under this chapter for the tax year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.”
- In contexts apart from the application of Section 6751(b)(1), the Tax Court has held repeatedly that the Section 72(t) exaction is a “tax” and not a “penalty,” “addition to tax,” or “additional amount.” See Williams v. Comm’r, 151 T.C. 1, 4 (2018); El v. Comm’r, 144 T.C. 140, 148 (2015).
- The Tax Court has consistently held that “additional amounts,” particularly when it appears in a series that also includes “tax” and “additions to tax,” is a term of art that refers exclusively to the civil penalties enumerated in chapter 68, subchapter A.” Whistleblower 22716-13W v. Comm’r, 146 T.C. 84, 95 (2016). “Additional amount” appears in Section 6751(c) in conjunction with the terms “penalty” and “addition to tax.” Because the Section 72(t) exaction is not a civil penalty enumerated in chapter 68, it is not an “additional amount” within the meaning of Section 6751(c).
Insight: The Grajales decision is one of a long-line of Tax Court decisions holding that the Section 72(t)(1) exaction is a tax rather than a penalty. However, taxpayers should continue to make good faith efforts with respect to other provisions in the Code that can be construed as a penalty subject to the written managerial approval requirements of Section 6751(b).
Reynolds v. Comm’r, T.C. Memo. 2021-10, January 26, 2021 | Thornton, J. | Dkt. No. 9864-18L
Short Summary: The taxpayer developed strategies to use corporations to conceal assets and evade income tax. He marketed these strategies to others and even used them for himself with respect to his own personal finances. On October 18, 2010, he pleaded guilty to two counts of subscribing false federal income tax returns under Section 7206(1) for tax years 2002 and 2003. On October 20, 2010, the United States district court entered its judgment and sentenced him to 18 months in prison for each of the two counts on which he was convicted. Pursuant to 18 U.S.C. § 3663(a)(3), the judgment required the taxpayer to pay the United States restitution of $193,812 with respect to his 2000, 2001, 2002, and 2003 tax years.
On August 26, 2013, the IRS assessed restitution against the taxpayer under Section 6201(a)(4) for the 2000, 2001, 2002, and 2003 tax years, which matched the restitution order by the United States district court. Later, the IRS audited the taxpayer’s 2002 and 2003 tax returns and issued a notice of deficiency to the taxpayer. In the notice of deficiency, the IRS determined that the taxpayer was liable for civil fraud penalties under Section 6663(a) for tax years 2002 and 2003. The Tax Court later entered a stipulated decision that the taxpayer was liable for deficiencies for both years and for civil fraud penalties under Section 6663(a).
The IRS issued the taxpayer a Final Notice of Intent to Levy and Notice of Your Right to a Hearing to the taxpayer. The IRS also issued a Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320. The taxpayer filed Forms 12153 in response to both the proposed levy and the notice of federal tax lien filing. The taxpayer indicated he “cannot pay balance”.
The IRS requested Forms 433-A and 433-B—however, the taxpayer refused to provide them. The taxpayer subsequently hired legal counsel to represent him during the Appeals hearing. However, the proposed levy and notice of federal tax lien were sustained, and the taxpayer filed a timely petition with the Tax Court.
Key Issues: Whether the IRS Appeals office abused its discretion in sustaining the proposed levy and the filing of the notice of federal tax lien?
Primary Holdings: The IRS Appeals office did not abuse its discretion in sustaining the proposed levy and the filing of the notice of federal tax lien.
Key Points of Law:
- Sections 6320 and 6330 establish procedures for administrative and judicial review of collection actions. Section 6330(c)(2) prescribes the matters that a person may raise at an Appeals hearing, including challenges to the appropriateness of the collection action and collection alternatives. In addition to considering issues properly raised by the taxpayer under Section 6330(c)(2), the Appeals officer shall at the hearing obtain verification from the Secretary that the requirements of any applicable law or administrative procedure have been met. 6330(c)(1). The existence or amount of the underlying tax liability may be contested at an Appeals hearing only if the taxpayer received no notice of deficiency or otherwise had no opportunity to dispute the tax liability. Sec. 6330(c)(2)(B); see Sego v. Comm’r, 114 T.C. 604, 609 (2000). An issue may not be raised at the hearing if it was raised and considered in any previous administrative or judicial proceeding. Sec. 6330(c)(4)(A).
- Where the underlying liability is not properly at issue in a collection proceeding, the Tax Court reviews Appeals’ determination for abuse of discretion, asking whether it was arbitrary, capricious, or without sound basis in fact or law. See, e.g., Murphy v. Comm’r, 125 T.C. 301, 320 (2005). And when faced with questions of law, the standard of review makes no difference. Whether characterized as a review for abuse of discretion or as a consideration “de novo”, the court must reject erroneous views of the law. Kendricks v. Comm’r, 124 T.C. 69, 75 (2005).
- Generally, the amount of restitution may not be challenged by the person against whom assessed on the basis of the existence or amount of the underlying liability in any proceeding authorized under the Code. Carpenter v. Comm’r, 152 T.C. 202, 219 (2019) (“A taxpayer is strictly prohibited from challenging the existence or amount of an underlying tax liability that is related to an order of criminal restitution.”).
- When court-ordered restitution is due and payable, the IRS is permitted under Section 6201(a)(4) to proceed to collect it by lien or levy. See Carpenter v. Comm’r, 152 T.C. at 218.
- In determining whether the IRS Appeals office abused its discretion in sustaining collection actions, the Tax Court considers whether it: (1) properly verified that the requirements of any applicable law or administrative procedure have been met; (2) considered any relevant issues the taxpayer raised; and (3) determined whether any “proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the taxpayer that any collection action be no more intrusive than necessary. See 6330(c)(3); Pazzo Pazzo, Inc. v. Comm’r, T.C. Memo. 2017-12.
- The IRM lacks the force of law and does not create rights for taxpayers. See Urban v. Comm’r, 964 F.2d 888, 890 (9th 1992) (noting that the IRS’ compliance with IRM requirements is not mandatory).
- Section 6159(a) authorizes the IRS to enter into written agreements allowing taxpayers to pay tax in installments if it is deemed that the “agreement will facilitate full or partial collection of such liability.” The decision whether to accept or reject installment agreements lies within the discretion of the IRS. Thompson v. Comm’r, 140 T.C. 173, 179 (2013); Treas. Reg. § 301.6159-1(a), (c)(1)(i). The Tax Court does not make an independent determination of what would be an acceptable collection alternative. Thompson, 140 T.C. at 179. If Appeals followed all statutory and administrative guidelines and provided a reasoned, balanced decision, the Court will not reweigh the equities.
- The Tax Court has generally held that there is no abuse of discretion when an Appeals officer relies on guidelines published in the IRM to evaluate a proposed IA. See Orum v. Comm’r, 123 T.C. 1, 13 (2004). At all relevant times the IRM has stated that the IRS may not enter into an IA that would ultimately result in the taxpayer paying an amount less than, or less frequently than, a court-ordered restitution payment. IRM pt. 22.214.171.124.5(1)(Oct. 6, 2017). The IRM further states that the IRS should enter into an IA only if the entire amount of restitution ordered is satisfied at the conclusion of the IA. pt. 126.96.36.199.5(2).
- In certain circumstances, a taxpayer’s account may be placed in currently not collectible status, which has the effect of suspending all collection action against that taxpayer. Wright v. Comm’r, T.C. Memo. 2012-24. Suspension of collection activity is a collection alternative that the taxpayer may propose and that the Appeals office must consider. 6330(c)(2). But to justify an account’s being placed in CNC status, the taxpayer must supply evidence of his financial circumstances, including the money that is available to him and the expenses that he bears. Pitts v. Comm’r, T.C. Memo. 2010-101.
- In reviewing a determination under Section 6330(c)(2) including challenges to the underlying liability, the Tax Court considers only issues that the taxpayer properly raised during the CDP hearing. Reg. § 301.6320-1(f)(2), Q&A-F3; Lunnon v. Comm’r, T.C. Memo. 2015-156.
Insight: The Reynolds decision shows how difficult it can be for a taxpayer to settle with the IRS after a court-ordered restitution payment has been made for criminal tax evasion.
Whatley v. Comm’r, T.C. Memo. 2021-11, January 28, 2021 | Holmes, J. | Dkt. No. 6838-12
Short Summary: The taxpayer was a successful entrepreneur and banker who purchased real estate in Alabama. He later added two dozen more acres of real property an formed an LLC to report his use of the property on his returns from 2004 to 2008. He recorded large losses for farm activities. The IRS disallowed the losses, and the taxpayer petitioned the Tax Court for a redetermination.
Key Issues: Whether the taxpayer is entitled to claim losses related to his LLC for the tax years 2004 to 2008?
Primary Holdings: The taxpayer is not entitled to claim the losses related to the farming activities because the taxpayer was not engaged in such activities for profit. See Sec. 183.
Key Points of Law:
- Whether an activity is a trade or business is an evergreen source of tax litigation because the Code sections do not draw a bright line. Section 162 allows a deduction for all ordinary and necessary business expenses, but Section 183 bars any deduction for an activity that is not engaged in for profit.
- Whether someone engages in an activity for profit should be a simple question of fact, but the IRS and federal courts have utilized several nonexclusive factors to help with this determination. One of these nonexclusive lists is in a Treasury Regulation. See Reg. § 1.183-2(a). That regulation provides that although the expectation of profit might not be reasonable, the facts and circumstances must indicate that the taxpayer entered into the activity with the objective of making a profit. Treas. Reg. § 1.183-2(a). The nine factors in the regulations are: (1) the manner in which the taxpayer carries on the activity; (2) his own expertise or that of his advisers; (3) the time and effort he expends on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) his success in carrying on similar activities; (6) his history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) his financial status; and (9) any elements of personal pleasure or recreation. No one factor is determinative.
Insight: The Whatley decision shows the challenges a taxpayer may face when the taxpayer is engaged in other activities outside of their regular work.
Sells v. Comm’r, T.C. Memo. 2021-12, January 28, 2021 | Holmes, J. | Dkt. Nos. 6267-12, 6801-12, 6835-12, 6836-12, 6837-12, 6838-12, 19246-12, 13553-13
Short Summary: In August 2002, Burnish Bush Farms, LLC was formed with eight members—each a 12.5% owner. Later, Mr. and Mrs. Moses sold mountainous land to Burnish Bush for $1.4 million. In 2003, Burnish Bush deeded a conservation easement on the acres that it owned to Chattoawah Open Land Trust, Inc. The conservation deed contained various provisions, including an extinguishment-proceeds clause.
Burnish Bush filed a Form 1065, U.S. Return of Partnership Income. Attached to the Form 1065 was Form 8283, Noncash Charitable Contributions. On page 2 of this form Burnish Bush reported the donation of the conservation easement to COLT as a noncash charitable contribution with a value of less than $5.4 million. Burnish Bush attached a “qualified appraisal” to the return. The IRS audited the return, disallowed the charitable contribution, and proposed penalties.
Key Issues: Whether the taxpayers are entitled to a charitable conservation easement deduction and whether they are liable for penalties?
Primary Holdings: The taxpayers are not entitled to the charitable conservation easement deductions. Moreover, with respect to some taxpayers, the IRS failed to comply with Section 6751(b) with respect to certain proposed penalties—accordingly, those penalties are waived. Moreover, some taxpayers are not liable for penalties due to reasonable cause.
Key Points of Law:
- Section 170 sets the rules for the deductibility of charitable contributions, and there are regulations that go into much greater detail. Reg. § 1.170A-13. Those regulations distinguish between cash and noncash contributions. See id.
- One type of noncash charitable contribution is the donation of a partial interest in real estate. The Code generally disallows a charitable contribution deduction for a gift of real property that consists of less than the taxpayer’s entire interest in such property. 170(f)(3)(A). But there is an exception for the donation of conservation easements. Sec. 170(f)(3)(B)(iii).
- A qualified conservation contribution is a contribution: (A) of a qualified real property interest; (B) to a qualified organization; (C) exclusively for conservation purposes. 170(h)(1).
- A contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity. 170(h)(5)(A).
- As the Tax Court held in Oakbrook, a conservation easement must be protected in perpetuity. C. Memo. at *10. Part of this protection must be the allocation of proceeds to the donee if the easement is condemned or otherwise extinguished. Treas. Reg. § 1.170A-14(g)(6)(i).
- Proportionate value” demands the creation of a fraction, the numerator of which is the fair market value (FMV) of the easement and the denominator of which is the FMV of the contributed property unburdened by the easement, both on the date of donation. We followed the Fifth Circuit’s lead in holding that this section of the regulations requires that the donee be entitled to receive this fraction multiplied by the gross proceeds of any extinguishment. PBBM Rose Hill, Ltd. v. Comm’r, 900 F.3d 193, 207-208 (5th 2018). And in Oakbrook v. Comm’r, 154 T.C. 180, we held that this regulation was valid. That opinion binds us.
- Section 6662(b)(1) penalizes understatements due to negligence or disregard of rules or regulations; Section 6662(b)(2) penalizes substantial understatements of tax due; and Section 6662(b)(3) penalizes substantial valuation misstatements. All of these carry a 20% penalty.
- Section 6662(h) imposes a 40% penalty for gross misstatements of value on a return. In Palmolive Bldg. Inv’rs, LLC v. Comm’r, 152 T.C. 75, 79 n. 3 (2019), we concluded that the substantial and gross misvaluation penalties were distinct with each requiring supervisory approval under Section 6751(b).
Insight: The decision in Sells shows that the IRS will continue to aggressively go after perceived, abusive conservation easement deductions. It also shows the potential use of Section 6751(b) as a defense against proposed penalties.