The Tax Court in Brief
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 November 14 – November 20, 2020
Bruno v. Comm’r, T.C. Memo. 2020-156 | November 16, 2020 | Lauber, J. | Dkt. No. 15525-18
Short Summary: The Internal Revenue Service determined deficiencies of $15,438, $20,409, and $12,527 with respect to petitioner’s Federal income tax for 2013, 2014, and 2016, respectively.
Petitioner divorced from ex-spouse. The divorce decree directed an equitable distribution of the their marital property, which required that petitioner’s ex-spouse transfer certain properties to her. Petitioner did not receive this property because the ex-spouse persistently disregarded the orders of the divorce court, which repeatedly held him in contempt and ordered him to pay interest on his unpaid obligations.
On her returns for 2013 and 2014 petitioner claimed and the IRS disallowed NOL carryforward deductions of $12,622,635 and $12,543,221, respectively. These carryforwards included an alleged 2012 loss attributable to an asserted “illegal transfer, conveyance and fraudulent concealment of * * * [the ex-spouse’s] LLC business interests.”
Key Issue: The sole issue or decision is petitioner’s claim that she sustained in 2015 a deductible theft loss of approximately $2.5 million. Petitioner contends that this loss resulted from her ex-husband’s refusal to transfer marital property awarded to her in 2008 by order of a Connecticut divorce court. Petitioner contends that this theft loss generated a net operating loss (NOL) in 2015, which she seeks to carry forward to 2016 and back to 2013 and 2014.
- Petitioner failed to establish that she sustained a theft loss in 2015 (or in any other year at issue).
- The Tax Court concluded that petitioner in December 2015 had “bona fide claims for recoupment” from [ex-spouse] and his co-defendants and that there was “a substantial possibility that such claims w[ould] be decided in * * * [her] favor.” Because petitioner had “a claim for reimbursement with respect to which there [wa]s a reasonable prospect of recovery,” no portion of her alleged loss is deemed sustained “until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.”
Key Points of Law:
- With respect to certain items, such as NOL carryforward and carryback deductions, the Tax Court may need to consider evidence from other tax years. As a rule, however, it has no power to determine an overpayment or underpayment of tax for a year not in issue. See sec. 6214(b).
- Section 7491(a)(1) provides that, if “a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer * * * , the Secretary shall have the burden of proof with respect to such issue.” “Credible evidence is the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no con- trary evidence were submitted[.]”
- Any shift in the burden of proof under section 7491(a)(1) is subject to the limitations set forth in section 7491(a)(2). Among these limitations is that the taxpayer must have “maintained all records required under this title and ha[ve] cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews.” Sec. 7491(a)(2)(B). The taxpayer bears the burden of proving that she has met these requirements.
- Theft Losses. The Code allows individual taxpayers to deduct losses arising from theft that are sustained during the taxable year and not compensated by insurance or otherwise. Sec. 165(a), (c)(3). To establish a theft loss, a taxpayer must first prove the occurrence of a theft under the law of the relevant jurisdiction.
- The taxpayer must then establish the amount of the loss and the year in which the loss was sustained. See sec. 1.165-1(c) and (d)(1), Income Tax Regs. A loss arising from theft is generally treated “as sustained during the taxable year in which the taxpayer discovers such loss.” Sec. 165(e); see 1.165- 1(d)(3), Income Tax Regs.
- To establish a theft a taxpayer need not demonstrate a criminal conviction. But she must prove by a preponderance of the evidence that an actual theft occurred.
- Petitioner is not entitled to a deduction unless she can establish the amount of the loss and the year in which it was sustained. See sec. 1.165-1(c) and (d)(1), Income Tax Regs.
- A theft loss is generally treated as sustained in the year “in which the taxpayer discovers such loss.” Sec. 165(e); sec. 1.165-1(d)(3), Income Tax Regs. However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Sec. 1.165-1(d)(3), Income Tax Regs.; see also id. sec. 1.165-8(a)(2).
- “A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor.
- Whether a taxpayer had a reasonable prospect of recovery at the end of a particular year “is a question of fact to be determined upon an examination of all facts and circumstances.” Sec. 1.165-1(d)(2)(i), Income Tax Regs.
Insight: The Bruno case demonstrates yet again that the theft-loss provisions of the Code require careful analysis and present significant hurdles for taxpayers. Particularly with respect to complex embezzlement and similar theft losses, taxpayers should generally seek legal advice from a qualified attorney to ensure that all technicalities are satisfied.
Aghadjanian v. Comm’r, T.C. Memo. 2020-155| November 16, 2020 | Greaves T. | Dkt. No. 9339-18W
Short Summary: Petitioner filed a petition with the Tax Court appealing the denial of his whistleblower claim. The IRS filed a Rule 121 motion for summary judgment, arguing that Petitioner failed to timely file his petition or alternatively that the IRS Whistleblower Office (“WBO” did not abuse its discretion in denying Petitioner’s claim for an award. The Tax Court granted the IRS’ motion finding that the Petitioner did not timely file his petition.
Key Issue: Did the Petitioner timely file his petition with the Tax Court in accordance with IRC § 7623(b)(4)?
- A taxpayer has 30 days from the date that the determination is mailed or personally delivered to the taxpayer at his last known address to file a Tax Court petition appealing the denial of a whistleblower claim from the WBO.
Key Points of Law:
- IRC § 7623(b)(4) permits the Tax Court to review a WBO award determination if a petition is filed within 30 days of the determination.
- A IRC § 7623(b)(4) review applies to determinations under paragraph (1), (2), or (3) of IRC § 7623(b). Although the WBO’s denial letter says it “does not contain a determination regarding an award under section 7623(b)”, that disclaimer does not deprive the Tax Court of jurisdiction. See Cooper v. Commissioner, 135 T.C. 70,75-76 (2010).
- The 30-day period of IRC § 7623(b)(4) begins on the date that the determination is mailed or personally delivered to the whistleblower at his last known address. See Kasper v. Commissioner, 137 T.C. 37, 45(2011)
- A taxpayer timely mails a petition to the Tax Court when it is delivered to the U.S. Postal Service on or before the due date. See IRC § 7502(a); See also 26 CFR § 301.7502-1(a), (c)(1)(iii)(A).
Insight: This case highlights the importance of meeting filing deadlines. It shows that taxpayers who do not timely file have little or no recourse to appeal a denial of a claim.
Kane v. Comm’r, T.C. Memo. 2020-154 | November 16, 2020 | Morrison, J. | Dkt. No. 17338-16
Short Summary: Padda, who filed joint returns with spouse, Kane, practices medicine through his wholly owned C corporation, Interventional Center, a pain-management clinic. Between 2008 and 2012, Padda and CFO, Grimes, opened five restaurants.
During the relevant years, Padda owned a 50% interest in each of the five restaurant partnerships; Grimes owned the other 50%. Grimes did not contribute cash or other property to acquire her interests in the partnerships. Although Padda owned only 50% of each of the five restaurant partnerships, he was allocated 100% of the losses. Grimes was not allocated any losses. The IRS does not challenge this loss allocation.
Padda also invested in a brewery operated by Ninkasi, LLC. During the years at issue, Padda owned a 90% interest in Ninkasi; Grimes owned 5% and Padda’s brother (who was also his attorney) owned the remaining 5%. Ninkasi opened for business in 2008 and operated under the name Cathedral Square Brewery. Although Padda owned 90% of Ninkasi, he was allocated 100% of the losses. Grimes and Padda’s brother were not allocated any of the losses. The IRS does not challenge this loss allocation.
On their 2010 return, Padda and Kane filed an “Election to Group Activities”. They elected to group the following activities: (1) Ninkasi with 3914 Lindell, LLC; and (2) Cafe Ventana with 3919 West Pine, LLC.
On May 2, 2016, the IRS issued a notice of deficiency to Padda and Kane for the 2010, 2011, and 2012 taxable years. The notice determined deficiencies for all three years based on the following determinations: (1) the restaurants and the brewery were passive activities for all three years and (2) Padda and Kane failed to report constructive-dividend income for 2010. As indicated at the beginning of the opinion, the notice of deficiency determined section 6662(a) penalties for all three years.
- Did Padda meet the material-participation requirements of section 469 for the activities of five restaurants and a brewery?
- Did Padda receive a constructive dividend in 2010 because his wholly owned medical corporation2 paid $81,828 of his expenses?
- Are Padda and Kane liable for a section 6651(a)(1) addition to tax for failing to timely file their 2012 return?
- Are Padda and Kane liable for accuracy-related penalties under section 6662(a) for 2010, 2011, and 2012?
- For each activity for each year (i.e., for each of the restaurants and the brewery), Padda’s hours exceeded the 100-hour threshold required for an activity to be a significant participation activity. Each activity was therefore a significant participation activity for each year. Because for each year Padda had at least these six significant participation activities, his aggregate participation in all significant participation activities during the year exceeded the 500-hour threshold of section 1.469-5T(a)(4), Temporary Income Tax Regs., supra. The five restaurants and the brewery were not passive activities.
- Held that Padda and Kane received an $81,828 constructive dividend in 2010 for the travel, dining, and entertainment expenses paid by Interventional Center.
- Held taxpayers liable for section 6651(a)(1) penalties, and section 6662(a) penalties for the portion of the underpayment related to constructive dividends.
Key Points of Law:
- Taxpayers are allowed deductions for certain business and investment expenses under sections 162 and 212. However, a taxpayer may not deduct losses from passive activities to the extent the losses exceed the taxpayer’s income from passive activities.
- A passive activity is generally an activity involving the conduct of a trade or business in which the taxpayer does not materially participate.
- Generally, taxpayers materially participate in an activity if they are involved in the operations of the activity on a regular, continuous, and substantial basis. Sec. 469(h)(1). Material participation in an activity may be established by any reasonable means.
- Generally, “reasonable means” include the “identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Id. While daily time reports, logs, or similar documentation are not required, a taxpayer must provide other reasonable means to establish participation in the activity.
- A taxpayer can establish material participation in an activity by satisfying any one of seven tests set forth in section 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988).
- Paragraph (a)(4) provides that the fourth test (at issue here) is met if the “activity is a significant participation activity * * * for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours”. A significant participation activity is a trade or business activity in which the individual participates for more than 100 hours during the year. Id. para. (c), 53 Fed. Reg. 5726.
- A taxpayer may treat one or more trade or business activities as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of the passive-activity rules. Sec. 1.469-4(c)(1), Income Tax Regs. Once a taxpayer has grouped activities, the taxpayer may not regroup the activities in later taxable years unless the taxpayer complies with disclosure requirements prescribed by the IRS.
- A distribution of property made by a corporation to a shareholder with respect to its stock is governed by section 301(c). Sec. 301(a). Under section 301(c)(1), a distribution that is a “dividend” is includable in the shareholder’s income. See also sec. 61(a)(7). A dividend is any distribution a corporation makes to its shareholders out of earnings and profits. Sec. 316(a).
- One type of distribution governed by section 301(c) is a constructive distribution. United States v. Smith, 418 F.2d 589, 593 (5th Cir. 1969). To determine whether a shareholder received a constructive distribution, this Court looks to whether the distribution was primarily for the shareholder’s benefit rather than for the corporation’s benefit. The determination of whether the shareholder or the corporation primarily benefits is a question of fact.
- The IRS bears the burden of production for additions to tax determined under section 6651(a)(1). See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). The IRS satisfies its burden by producing sufficient evidence to establish that the taxpayer failed to timely file a required return. See Wheeler v. Commissioner, 127 T.C. 200, 207-208 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008); Higbee v. Commissioner, 116 T.C. at 447. Once the IRS has satisfied its burden of production, the taxpayer has the burden of proving that the lateness was due to reasonable cause and not willful neglect. Higbee v. Commissioner, 116 T.C. at 447. Reasonable cause excusing a failure to timely file exists if the taxpayer exercised ordinary business care and prudence but nevertheless was unable to file the return by the deadline. See sec. 301.6651- 1(c)(1), Proced. & Admin. Regs. Willful neglect means a conscious, intentional failure, or reckless indifference.
- In considering whether a taxpayer has exercised reasonable care and prudence, courts have held that the taxpayer’s duty to file a timely return cannot be avoided by delegating to another party, including an accountant, the responsibility for preparing and filing the return. Mauldin v. Commissioner, 60 T.C. 749, 762 (1973); see also Boyle, 469 U.S. at 251-252 (holding that reliance on an agent to file a return does not establish reasonable cause because “[i]t requires no special training or effort to ascertain a deadline and make sure that it is met”)
- Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of any portion of an underpayment of tax that is attributable to negligence or to a substantial understatement of income tax. An underpayment is the difference between the correct tax and the tax reported on the return, with exceptions not relevant here. Sec. 6664(a). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence may also include the failure to properly substantiate an item. Higbee v. Commissioner, 116 T.C. at 449;
1.6662-3(b)(1), Income Tax Regs. A substantial understatement of income tax exists if (1) the understatement exceeds 10% of the tax required to be shown on the return and (2) the understatement exceeds $5,000. Sec. 6662(d)(1)(A). An understatement is the difference between the correct tax and the tax reported on the return, with exceptions not relevant here. Sec. 6662(d)(2)(A).
- No section 6662 penalty is imposed with respect 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 such portion. Circumstances that indicate reasonable cause and good faith include reliance on the advice of a tax professional. Sec. 1.6664-4(b), Income Tax Regs. The taxpayer has the burden of proving that he or she acted with reasonable cause and in good faith. Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.
Insight: The Bruno case demonstrates the IRS’s continued focus on passive activity losses and constructive dividends. Passive Activity Losses (PALs) have long been a focus for the IRS and a basis for denying deductions attributable to passive activities. The Bruno case, however, demonstrates an important planning consideration: activity “grouping.” In addition, the IRS has often asserted that distributions or payments from closely-held corporations are constructive dividends under certain circumstances. Courts often look to the Fifth Circuit’s decision in United States v. Smith, 418 F.2d 589, 593 (5th Cir. 1969) to analyze constructive dividend claims.
U.S. Tax Court Summaries
The Coca-Cola Company & Subsidiaries v. Comm’r, 155 T.C. No. 10 | November 18, 2020 | Lauber, J. | Dkt. No. 31183-15
Short Summary: The case involved the validity of the transfer pricing methodology used by the IRS to reallocate income to Coca-Cola from its subsidiaries, under section 482 for the 2007-2009 period.
Coca-Cola (the taxpayer) licensed its intellectual property (IP) to foreign manufacturing affiliates (called supply points and referred here as foreign affiliates). The foreign affiliates used this IP to manufacture concentrate, which was then sold to bottlers, who produced the beverages using the concentrate. In return for using the IP, the foreign affiliates compensated Coca-Cola using a “10-50-50” method, which allowed them to retain profit equal to 10% of the gross sales, and the remainder to be split 50-50 with Coca-Cola. It must be mentioned that this formulary apportionment method had been agreed by the taxpayer and the IRS in 1996 as part of a settlement (the 1996 agreement) entered by the taxpayer and the IRS for tax liabilities concerning the 1987-1995 period. The 1996 agreement also allowed the foreign affiliates to cover their royalty payments – for the use of the IP-, by actually paying royalties or remit dividends to the taxpayer. During the 2007-2009, the foreign affiliates remitted “dividends” to the taxpayer in the amount of $1.8 billion as royalties’ payment.
The IRS examined the 2007-2009 taxpayer’s return and determined that the methodology used by the taxpayer did not reflected arm’s-length rules, by undercompensating the taxpayer (and reducing taxable income in the U.S.) and overcompensating the foreign affiliates. To reallocate income to the taxpayer under section 482, the IRS applied the Comparable Profits Method (CPM) and used unrelated bottlers, as comparable parties. Using this methodology, the IRS assessed a $9M deficiency in taxable income.
The taxpayer challenged such deficiency in Tax Court alleging that the IRS had abused its discretion to reallocate income to the taxpayer under the CPM. The taxpayer also argued that the 1996 agreement prevented the IRS from changing its allocation method. Finally, it argued that the remitted dividends from the foreign affiliates in satisfaction to the royalty obligations should reduce the reallocations of the IRS.
The Court ruled in a 244 pages judgment that the IRS did not abused its discretion when applying the CPM and using the independent bottlers as comparable parties. Moreover, it ruled that the 1996 agreement did not prevented the IRS from reallocating income during the period of examination; it also ruled that the IRS did not erred by recomputing section 987 losses of the taxpayer after the CPM change the allocable income to the taxpayer’s Mexican affiliate; and finally the Court sided with the taxpayer by allowing the remitted dividends to reduce the reallocations considering the timely election to employ dividend offset.
Key Issues: (i) Whether the IRS abused its discretion by applying the CPM method to the taxpayer’s transactions using the independent bottlers as comparable parties; (ii) Is the IRS allowed to recompute section 987 losses of the taxpayer after making a section 482 allocation? and (iii) Is the taxpayer allowed to apply dividend offset even if it did not meet the formal requirements established on the Regulations?
Primary Holdings: (i) The IRS did not abuse its discretion under section 482 by using the CPM to reallocate income to the taxpayer from its subsidiaries; (ii) the IRS did not erred by recomputing the taxpayer’s section 987 losses after the CPM changed the income allocable to the taxpayer’s Mexican affiliate and (iii) the taxpayer made a timely election to employ dividend offset treatment regarding the dividends paid by the foreign affiliates, and consequently such dividends should be allowed to reduce the IRS’ reallocation amount.
Key Points of Law:
Section 482 allows the IRS to apportion or allocate gross income, deductions, credits between related parties. The discretionary action of the IRS under this section can be invalid if the IRS abuses its discretion when the determination is arbitrary, capricious, and unreasonable. See Guidant LLC v. Comm’r, 146 T.C. 60, 73(2016). To determine whether the IRS abuses its discretion is a question of fact. See Amazon.com, Inc. 148 T.C. at 150. Additionally, the abuse of discretion is determined upon the reasonableness of the IRS’ result and not the methodology involved. To evidence such, the taxpayer requires evidence of comparable uncontrolled transactions, but in certain cases, considering that there are not comparable transactions because of the uniqueness of the property, the taxpayer must establish the unreasonableness of the methodology.
Considering the standard described, the Court considered some important factors to determine whether the IRS’ reallocation result was unreasonable because of the method employed:
- First, it determined that the 1996 Agreement (which included the use of the 10-50-50 formula) was solely executed as a closing agreement to settle a dispute for the 1987-1995 period and should not be understood as making a reference about the transfer pricing methodology to be used after the 1995 year. Additionally, the Court considered that the agreement recognized the possibility that the IRS make transfer pricing adjustments because the penalty protection provided by such agreement to the taxpayer.
- Second, under Treas. Regs. 1.482-1(b)(1), the Court must determine the “true taxable income of a controlled taxpayer”. In this regard, the Court determined that the IRS properly treated the foreign affiliates and foreign serving companies as controlled taxpayers that engage in a set of discrete controlled transactions.
- The standard to determine the allocation is the arm’s length with an uncontrolled taxpayer as provided by Treas. Regs. 1.482-1(b)(1) and supported by a myriad of caselaw. In the case of controlled transfers of intangible property, Regulations provide that the methods to determine the arm’s length result are the Comparable Uncontrolled Transaction (CUT), the CPM, the profit split method and unspecified method. In this case, the IRS employed the CPM which is allowed and contrary to the taxpayer’s argument, it is not inferior to any other allowed method.
Based on these assumptions, the Court determined that the CPM used by the IRS was proper considering the nature of assets and the activities performed by the controlled taxpayers (foreign affiliates) and that the IRS selection of the independent bottlers as comparable parties (to determine this point, the Court analyzed factors such as functions performed, contractual terms, risks, economic conditions and property employed or transferred).
Moreover, it determined that the CPM methodology was reasonable in this case, considering that the foreign affiliates act as wholly owned contract manufacturers. This is because the CPM evaluates the profitability only of the tested party (foreign affiliates) and determines the arm’s length profit range of such affiliates without attempting to value the hard-to-value intangible assets, which is reasonable in this case (considering the uniqueness of the intangibles of the taxpayer). Finally, the Court determined that the data employed by the IRS was reliable and represented the universe of independent bottlers. Based on these factors, the Court concluded that the IRS’ methodology to reallocate income from the foreign affiliates to the taxpayer was reasonable and not arbitrary.
As for the second question, concerning collateral adjustments including the IRS’ recomputation of the taxpayer’s section 987 loss as consequence of reallocating income from the Mexican affiliate to the taxpayer, the Court determined that as consequence of the allocation of income, the losses reported in the Mexican branch were no longer correct and consequently, the IRS was correct in recomputing them.
Finally, the Court determined that dividends remitted from the foreign affiliates to the taxpayer to meet their royalty obligations with the taxpayer, should be offset against the reallocation made by the IRS. This is because Rev. Proc. 99-32 afforded a qualifying taxpayer two forms of relief, which were available to the taxpayer here. And despite the procedural requirement added by this revenue procedure was not met by the taxpayer (which basically required the taxpayer to include a statement jointly with the tax return for each year of the section 482 allocation period), the Court held that IRS regulations and guidance can be satisfied by substantial rather than strict compliance. In this case, the taxpayer substantially complied by claiming dividend offsets as agreed in its 1996 Agreement which provided for such treatment.
Insight: This case is relevant because it introduces an opinion that is favorable to the IRS when electing a new transfer pricing methodology to allocate income among related parties. Past cases, such as Amazon, had been favorable to the taxpayer in the methodology election and rejection of the choice elected by the IRS. This case will set a foundation for future tax litigation in the transfer pricing area. Special analysis must be given to the CPM method in cases where hard-to-value-intangibles are main part of the business structure.