The Tax Court in Brief - September 2021

Freeman Law

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.

Tax Court: The Week of August 30 – September 3, 2021

Tax Court Case: Sherrie L. Webb v. Comm’r; T.C. Memo. 2021-105 | August 31, 2021 Weiler, J. | Dkt. No. 7819-20L

Tax Dispute Short Summary: It was not an abuse of the Commissioner’s discretion not to provide a collection alternative when the taxpayer did not furnish necessary documentation that may have justified alternatives, such as currently not collective (CNC) status.

Tax Litigation Key Issues: To justify collections alternatives, including CNC status, the taxpayer must provide the documentation necessary to show that the alternative is warranted.

Primary Holdings:

Although the petitioner sought to have her account placed into CNC status, the Appeals Officer was unable to provide a collection alternative – including granting CNC status – since petitioner did not furnish the necessary documentation. On the basis of these circumstances, Appeals performed a balancing test, concluding that the proposed levy did balance the needs of collection with the concerns of the petitioner. On the basis of its review, the court held that the Appeals Officer did not abuse her discretion in so concluding.

Key Points of the Tax Laws:

The taxpayer may propose the suspension of collection activity as a collection alternative. To justify an account’s being placed into CNC status, the taxpayer must supply all relevant information requested by Appeals, including financial statements for consideration of the facts and issues involved in the hearing. An Appeals officer does not abuse his or her discretion in denying CNC status where the taxpayer has not submitted the financial information necessary for the officer to make such a determination.

Tax Court Motion: Not a profound insight but an obvious and important one: when the Appeals Officer requests additional information, respond. The Appeals Officer here requested information from the taxpayer through her representative and, after he withdrew, multiple times from the taxpayer directly. Having failed to provide that information, the taxpayer could not show that the Appeals Officer abused her discretion.

Tax Court Case: Wai-Cheung Wilson Chow and Deanne Chow v. Comm’r, No. 14249-18W, T.C. Memo 2021-106 | September 1, 2021 | Buch | Dkt. No. 14249-18W

Tax Dispute Short Summary: This case involves a review of a rejected whistleblower claim. The Whistleblower Office determined that the Chows’ claim, in which they alleged that their former landlord owned numerous properties from which she collected rents and did not report income, was not credible. The Chows appealed, and the Tax Court affirmed the IRS’ determination.

Tax litigation Key Issue: Did the Chows, the whistleblowers in this case, make a credible claim that entitled them to an award under the IRS Whistleblower statute?

Primary Holdings:

  • The Chows rented a home in California from an individual (the “Target Taxpayer” or “Target”). The Chows claimed that the Target Taxpayer boasted about owning several other rental properties that she rented to tenants on a cash-only basis to avoid paying taxes on the income.
  • The Chows therefore filed Form 211, Application for Award for Original Information, with the IRS in April, 2018.
  • The Whistleblower Office reviewed the claim and ultimately recommended rejecting the Chows’ claim because the allegations were not credible. As the basis for this recommendation, the classifier stated that the Target Taxpayer’s tax filings indicated income from one rental property and the database revealed that the Target owned only one property.
  • The Chows filed a timely petition for review of the Whistleblower Office’s determination.

Key Points of the Tax Laws:

  • Section 7623 of the Internal Revenue Code provides that a whistleblower award may be paid only if the information provided results in the collection of tax, penalties, interest, additions to tax, or additional amounts. If certain requirements are met, the whistleblower is entitled to receive as an award a percentage of the amount collected, but only if the IRS initiates or expands an “administrative or judicial action” based on the whistleblower’s information and proceeds are collected as a result.
  • A review of the Whistleblower Office’s determination regarding whether a whistleblower is entitled to an award is limited to the administrative record to decide whether there has been an abuse of discretion. See Van Bemmelen v. Commissioner, 155 T.C. 64, 78 (2020).
  • A review of final agency action is conducted under the Administrative Procedure Act, 5 U.S.C. §§ 551-559, 701-706, deciding, as a matter of law, whether the agency action is supported by the administrative record and is not arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.
  • Under §7623(b)(4), the Tax Court has jurisdiction over the appeal of any determination under § 7623, if such appeal is made within 30 days of such determination.
  • Finding that a claim lacks credibility after searching an IRS database and not finding any corroborating information is not arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law. The IRS is not required to perform a deeper evaluation of a whistleblower’s claim before issuing a rejection. Moreover, the Court cannot direct the IRS to commence or continue an audit.
  • When the Whistleblower Office decides to reject a claim, it may, but is not required, first offer the whistleblower a chance to perfect the claim.

Tax Court Motion :
The Whistleblower provision of the Internal Revenue Code could prove valuable under the right circumstances. However, the circumstances of this case did not rise to the level necessary to satisfy the requirement of I.R.C. § 7623.

Tax Court Case: Gaston v. Comm’r, T.C. Memo. 2021-107| Sept. 2, 2021 |Marvel, J. | Dkt. No. 25899-17

Tax Dispute Short Summary:

  • Petitioner is a former national sales director (NSD) for the Mary Kay, Inc (Mary Kay). As an NSD, Petitioner was entitled to participate in Mary Kay’s deferred compensation program known as the Family Security Program (FSP), which she joined in September 1991.
    • The FSP imposed a mandatory retirement age of 65 and provided that, upon her retirement, Petitioner would be paid a monthly distribution scaled to a percentage of the average of her three highest commission years during the five years before retirement. In 2008, two years before she reached the mandatory retirement age, Petitioner established the Gayle Gaston Sole Proprietor Profit Sharing Plan (plan).
    • The plan does not identify a specific line of business to which the plan relates, and it was not created with respect to any particular trade or business of Petitioner.
  • In 2010, Petitioner retired from Mary Kay. After her retirement from Mary Kay, Petitioner took up a number of non-Mary Kay activities.
    • First, through a wholly-owned S corporation, Gayle Gaston, Inc., Petitioner began to sell jewelry to her former Mary Kay associates. This activity remained small, with Petitioner devoting little more than 10 hours per week to its progress. Petitioner attempted to sell her jewelry to the general public but spent very little time or effort doing so, and she ceased her jewelry sales activity shortly thereafter. Petitioner’s jewelry sales activity generated losses in each year at issue.
    • Petitioner also decided to start acting. To further her acting activity Petitioner retained an assistant who helped her identify casting opportunities and manage her applications. Petitioner also engaged various casting services, retained an agent and a business management company, secured professional headshots, advertised her skills, and took acting and voice lessons. Petitioner devoted significant time to this activity. Between the preparatory work, securing auditions, and acting in roles she secured, Petitioner personally spent at least 40 hours per week on her acting activity. Petitioner worked hard at this activity, but she also enjoyed acting. Although Petitioner did not generate a profit from the acting activity in the years at issue or in subsequent years, by 2011 she had secured her first film credit. In 2013 Petitioner performed in at least one feature-length film. By 2019 Petitioner had secured at least 10 film credits and various other roles in commercials.
  • Upon receiving her distributions from the FSP in 2013 and 2014, Petitioner contributed $51,000 from each year’s distribution to the retirement plan she had established in 2008. On each of her 2013 and 2014 income tax returns, Petitioner reported the distribution from the FSP as income from a sole proprietorship on a Schedule C and claimed a deduction for the contribution to her retirement plan. On each Schedule C Petitioner also claimed deductions for numerous expenses relating to her acting activity. Additionally, in each year Petitioner claimed passthrough loss deductions from her S corporation on Schedules E, Supplemental Income and Loss, which were generated by her jewelry sales activity.
  • Petitioner’s 2013 and 2014 returns were selected for examination. On September 12, 2017, the Commissioner issued a notice of deficiency that disallowed Petitioner’s claimed acting activity expense deductions, her claimed passthrough loss deductions from her jewelry activity, and her claimed deductions for retirement contributions and determined income tax deficiencies, additions to tax, and penalties for Petitioner’s tax years 2013 and 2014. It is these determinations that Petitioner contests in Tax Court.

Tax Litigation Key Issues:

(1) Whether Petitioner engaged in acting as a trade or business in the tax years at issue and, if so, whether Petitioner is entitled to deduct any reported expenses relating to that trade or business

(2) Whether Petitioner engaged in jewelry sales as a trade or business in the tax years at issue and, if so, whether Petitioner is entitled to deduct any claimed flowthrough losses relating to that trade or business, and

(3) Whether petitioner is entitled to deduct contributions to an alleged qualified profit-sharing plan for the tax years at issue

Primary Holdings:

(1) Petitioner taxpayer proved that she had a primary purpose of making a profit from acting, and thus was entitled to deduct any reported expenses relating to that trade. However, not all of these expenses were substantiated. Thus, Petitioner is entitled to deducting the following substantiated ordinary and necessary business expenses as they relate to acting:

  • expenses inherently connected with acting (e.g., photography costs, fees paid to a casting agency, cost of refining Petitioner’s acting skills, etc.)
  • a portion of the compensation paid to Petitioner’s personal assistant insofar as that compensation relates to services which aided Petitioner’s acting career
  • a portion of Petitioner’s professional service expenses

(2) Petitioner taxpayer is not entitled to deduct any claimed flowthrough losses relating to her jewelry trade, as she did not meet the “primary purpose” requirement of claiming the jewelry sales activity as a business deduction

(3) Petitioner taxpayer may not deduct the contributions that she made to her allegedly qualified plan because she has not proven that the income contributed was derived from a trade or business with respect to which the plan was established.

Key Points of the Tax Laws:

Deducting Ordinary and Necessary Expenses

  • The burden of proving ordinary and necessary business expenses under I.R.C. § 162 rests with the Petitioner taxpayer. The taxpayer must prove the following:
    • (1) that she engaged in the activity as a trade or business, i.e., the taxpayer engaged in the activity with the “predominant, primary or principal objective” of making a profit, and
    • (2) the taxpayer can substantiate the reported expense as an ordinary and necessary business expense.
  • Engaging in the Activity as a Trade or Business
    • The Court considers the following factors (set forth in the Income Tax Regs section 1.183-2(a) and (b)) in determining whether a taxpayer engaged in an activity with “the predominant, primary or principal objective” of making a profit:

(1) the manner in which the taxpayer carried on the activity;

(2) the expertise of the taxpayer or his advisors;

(3) the taxpayer’s time and effort expended in carrying on the activity;

(4) the expectation that assets used in the activity may appreciate in value;

(5) the taxpayer’s success in carrying on other similar or dissimilar activities;

(6) the taxpayer’s history of income or losses with respect to the activity;

(7) the amount of occasional profits, if any, which are earned;

(8) the financial status of the taxpayer;

(9) consulting with experts in a given industry; and

(10) the presence of personal pleasure or recreation.

  • The Court considers all factors together, taking into account the totality of the circumstances and giving greater weight to the objective evidence than to the taxpayer’s statements of intent.
  • In conducting this factor-based analysis, courts consider only the presence or absence of the taxpayer’s intent to profit from the activity, not necessarily the taxpayer’s actual success in that regard.
    • An objectively “reasonable expectation of profit is not required”. In addition, the presence or absence of profits is a factor, but is not determinative. It is sufficient that the taxpayer engages in the activity with the primary purpose of making a profit.
  • When analyzing whether taxpayers have proven that they entered into acting activities with an intent to profit, courts consider such industry-specific factors as whether they:

(1) belong to an acting network or union,

(2) take classes or otherwise formally develop their skills,

(3) develop industry contacts,

(4) seek or secure multiple auditions or roles,

(5) advertise their services,

(6) prepare headshots or a portfolio,

(7) retain an agency or assistant to help secure roles, and

(8) maintain their efforts over time, given the nature of the industry

  • Taxpayers can enjoy their work while still intending to profit off their work
  • Substantiation
    • R.C. § 162(a) permits a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”.
    • A taxpayer is not automatically entitled to deduct every expense paid in the ordinary course of work
    • The taxpayer must provide adequate substantiation to prove entitlement to a deduction for a particular expense. A taxpayer is required to maintain records sufficient to substantiate the items underlying the deductions claimed on the taxpayer’s return.
    • If a taxpayer proves that she is entitled to some deduction but cannot substantiate the full amount claimed, generally the Court may estimate the amount of the allowable expense deduction to the best of its ability, “bearing heavily * * * upon the taxpayer whose inexactitude is of * * * [her] own making.” Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930) (Cohan rule). For the Court to estimate the amount of an expense, there must be a reasonable basis in the record to support that estimate.
    • The Cohan rule does not apply to certain expenses outlined in I.R.C. § 274(d). See Temporary Income Tax Regs. § 1.274-5T(a), 50 Fed. Reg. 46014 (Nov. 6, 1985). For those expenses (e.g., expenses relating to travel, meals and entertainment, gifts, or other “listed property” as defined in section 280F(d)(4)), a taxpayer must meet the strict substantiation requirements set out in I.R.C. §274.
      • To satisfy the strict substantiation requirements, a taxpayer must introduce sufficient evidence to corroborate:

(1) the amount of the expense or other item;

(2) the time and place of travel, entertainment, or use of the property;

(3) the business purpose of the expense or other item; and

(4) the business relationship of the taxpayer to the persons entertained or using the property.

See I.R.C. § 274(d).

  • With respect to the use of listed property, the taxpayer must establish the amount of business use and the amount of total use. Temporary Income Tax Regs. § 1.274-5T(b)(6)(i), 50 Fed. Reg. 46016 (Nov. 6, 1985).
  • The expenses must be both actually paid for by the taxpayer and ordinary and necessary to the business
  • When a taxpayer has claimed deductions for items, a portion of which relates to an ordinary and necessary business expense and a portion of which does not, courts apply the Cohan rule to approximate what portion of those items should be properly deducted
    • Usually, courts use a proportional approach, so if, as here, a taxpayer’s assistant spent 75% of her time aiding with the taxpayer’s business and 25% of her time assisting the taxpayer with other activities, then 75% of the assistant’s compensation can be properly deducted on the taxpayer’s taxes
    • The same proportional analysis applies under the Cohan rule for other business expenses, such as professional service expenses, whereby only the portion of those expenses which relate to taxpayer’s acting activity will be deducted

For Determining whether S corporations Qualify for Business Expense Deductions

  • Although I.R.C. § 183 applies at the corporate level with respect to the activities of an S corporation (see Income Tax Regs. § 1.183- 1(f)) courts examine the intent of the Petitioner, the S corporation’s sole shareholder, in deciding whether the S corporation had the requisite profit objective.
  • The same factors under Income Tax Regs. § 1.183-2 (listed above) are considered in analyzing whether the taxpayer engaged in this business activity for profit
  • To prove an intent to obtain profit from this jewelry sales activity, taxpayer was required to show that she carried on in the activity in a businesslike manner or took actions which would elevate this activity to a business capable of generating profit

For Determining Whether Contributions to a Profit-Sharing Plan are Deductible

  • R.C. § 404(a) allows an employer to deduct certain contributions to deferred compensation plans that are paid or accrued on account of an employee.
  • With respect to self-employed individuals, § 404(a)(8)(C) provides that contributions to a plan are deductible “to the extent that such contributions do not exceed the earned income of such individual * * * derived from the trade or business with respect to which such plan is established”.
  • 404(a)(8)(B) provides that “earned income” has the meaning assigned by § 401(c)(2), which, in turn, provides that “earned income” means the net earnings from self-employment as defined by section 1402. However, for purposes of § 401(c), such net earnings are determined only with respect to a trade or business in which the personal services of the taxpayer are a material income-producing factor. § 401(c)(2)(A)(i).
  • There are two hurdles to surpass when determining whether Petitioner’s FSP payments are deductible:

(1) Contributions are deductible only to the extent that they do not exceed the “earned income…derived from the trade or business with respect to which…[the] plan is established”. I.R.C. § 404(a)(8)(C) (emphasis added).

(2) Contributions made must qualify as “earned income” within the meaning of sections 401 and 404 of the Code

[View source.]

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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