Eight Circuit Sympathetic to Taxpayer's Arguments that Cattery Was a Trade or Business, but Still Denies Deductions

A recent decision is a cautionary tale of what can happen when a taxpayer tries to turn a hobby into an actual business and what additional steps a taxpayer may want to take to prove the business is genuine. In DKD v. Comm'r, 2012 PTC 191 (8th Cir. 7/17/12), the taxpayer alleged that her kitten business was a legitimate trade or business. In fact, the taxpayer's cattery had won four national championships. While the Tax Court concluded the enterprise was no more than a hobby, the Eight Circuit was not so quick. It found some legitimacy in the taxpayer's argument that her corporation was operating a trade or business with respect to the kitten activities. Had the taxpayer taken a few extra steps to prove she had a good-faith, subjective intention to make a profit, the outcome might have been different. In the end, however, the Eighth Circuit affirmed the Tax Court's decision and held that the taxpayer couldn't deduct the cattery expenses.

Background

DKD is an Iowa corporation wholly owned and managed by Debra Dursky. Debra ran DKD out of her home in West Des Moines, Iowa. DKD's principal source of income was information technology consulting. Debra was DKD's only employee engaged in the consulting business. DKD also operated a cattery to breed, show, and sell pedigree show kittens. Before 2003, Debra and Elizabeth Watkins operated the cattery as an informal, unincorporated business. When Debra and Elizabeth decided to expand the cattery operation, to enhance its national reputation and to increase profits, DKD assumed responsibility for the cattery. Debra and Elizabeth continued to manage the cattery from Debra's home.

To enhance the cattery's national reputation, DKD entered its kittens in national competitions. Debra and Elizabeth anticipated that breeding national champions would increase the value of DKD's premium show-quality kittens to between $1,000 and $5,000 per kitten. Between 2003 and 2005, DKD's cattery won four national championships. For tax years 2003, 2004, and 2005, DKD reported a total income of approximately $198,000, $235,000, and $214,000, respectively.

DKD paid Debra an annual salary of $80,400 plus other compensation, including healthcare benefits and a profit-sharing plan. DKD paid Debra $1,000 per month to rent office space in her home for DKD's consulting and cattery operations. During 2003-2005, DKD reimbursed approximately $61,000, $67,000, and $68,000, respectively, to Elizabeth and Debra for out-of-pocket expenses associated with the cattery, such as travel and competition costs, veterinary bills, cat food, grooming, and supplies. DKD also paid Elizabeth an annual salary of $7,700 for the approximately 1,700 hours Elizabeth devoted to the cattery's operation each year. The cattery produced no revenue in 2003, $250 in 2004 from the sale of three cats, and $1,525 in 2005 from the sale of eight cats.

Due to the substantial costs associated with competing on the national circuit, unexpected expenses and market forces, breeding problems, and inadequate revenues from kitten sales, DKD could not afford to continue operating the cattery. Also, in 2006, Debra and DKD were informed that the IRS was going to audit their 2003 and 2004 tax returns. Around August 2006, Debra and Elizabeth discontinued operating DKD's cattery activity, but continued operating the cattery activity as individuals (i.e., a separate unincorporated venture).

Tax Court's Decision

The IRS audited DKD's and Debra's tax returns from 2003 to 2005 and found substantial tax deficiencies. DKD and Debra appealed the IRS's assessment to the Tax Court. In T.C. Memo. 2011-29, the Tax Court disallowed DKD's claimed deductions for:

(1) operational expenses of the cattery, finding the activity was a personal hobby of Debra rather than a genuine trade or business of DKD;

(2) payments toward the profit-sharing plan that benefitted Debra, deciding that the plan was ineligible for deductions because it discriminated in favor of Debra, a highly paid employee; and

(3) medical benefits paid by DKD for Debra's benefit, determining the payments were not made pursuant to a qualifying plan.

According to the Tax Court, Debra and Elizabeth were just looking for a way to deduct expenses, and there was no evidence they ever intended to make a profit.

With respect to Debra's returns, the Tax Court held that DKD's payments in support of the cattery and to fund the pension plan were constructive dividends to Debra and thus taxable income. The Tax Court also agreed with the IRS that Debra was liable for income taxes on the medical benefit payments made by DKD on her behalf. DKD and Debra appealed to the Eighth Circuit.

Trade or Business Issue

The Eighth Circuit noted that the most important criterion for determining if a trade or business exists is the existence of a genuine profit motive. The court found some legitimacy in the argument that DKD was operating a trade or business with respect to the kitten activities. The court noted that DKD:

(1) operated a website marketing its kittens;

(2) successfully raised four national champion kittens; and

(3) earned some income in 2004 and 2005 from kitten sales.

The mere fact that DKD's cattery expenses vastly exceeded its income, the Eighth Circuit stated, was insufficient to disprove the existence of a genuine profit motive. Additionally, the Eighth Circuit said it would be incorrect for the Tax Court to disallow a trade or business deduction merely because, in the court's view, the business venture was unlikely to produce the desired profits. According to the Eighth Circuit, the rule is clear-the Tax Court should find the trade or business venture lacked a genuine profit motive only if the court finds, as a factual matter, that the taxpayer lacked a good-faith, subjective intention to make a profit and was engaged in the activity for wholly different reasons.

However, the Eighth Circuit said that while it disagreed with some of the Tax Court's reasoning, it could not say the Tax Court clearly erred in finding DKD failed to carry its burden of establishing that for each of the years at issue, DKD's cattery activity constituted a trade or business within the meaning of Code Sec. 162(a). As a result, the Eighth Circuit affirmed the Tax Court on this issue.

PRACTICE TIP: The Tax Court honed in on the fact that Debra and Elizabeth had operated the cattery as an unincorporated venture before and after DKD was involved. And the court noted that they both spent large amounts of time and money and had never made a profit. Had Debra and Elizabeth put together a marketing or business plan showing how they were going to change things so they could make a profit and consulted with experts, they might have had a different outcome.

Constructive Dividend Issue

The Eighth Circuit agreed with Debra that a shareholder does not receive a constructive dividend merely because the shareholder derives personal pleasure or satisfaction from the operation of a business. However, the court disagreed with Debra's interpretation of the Tax Court's findings. The Tax Court's constructive dividend findings, the court stated, had to be considered in light of its determination that DKD lacked a genuine profit motive to operate the cattery. Because DKD lacked a legitimate business purpose to operate the cattery, the Tax Court reasonably inferred DKD operated the cattery for no other reason than to finance Debra's personal hobby.

Debra also argued that the Tax Court erred by calculating the constructive dividend in terms of the cost to DKD rather than explicitly determining the financial benefit to Debra. What Debra failed to recognize, the court stated, was that, in certain circumstances, the value of a constructive dividend may be measured by the cost to the corporation. DKD financed the cattery solely for the personal benefit of Debra, the court stated, thereby relieving Debra of the substantial hobby costs associated with the cattery's operation. According to the Eighth Circuit, it was not clear error for the Tax Court to find, as a matter of fact, that the economic benefit conferred on Debra was equal to the costs incurred by the corporation. Thus, the Eighth Circuit affirmed on the constructive dividend issue.

Profit-Sharing Plan Issue

In 2003, DKD contributed $10,000 to a profit-sharing fund established by DKD and managed by Fidelity Brokerage Service, LLC. In 2004, DKD contributed $20,000 to the plan. DKD claimed contribution deductions under Code Sec. 404. The notices of deficiency provided to DKD asserted that these payments were not an ordinary and necessary business expense and that the deductions were therefore improper. Before the Tax Court, the IRS raised a different argument, alleging the pension plan discriminated in favor of Debra, a highly compensated employee, because Elizabeth was not included in the plan. The Tax Court agreed and denied DKD's claimed deductions and included the contributions in Debra's taxable income as constructive dividends.

The Eighth Circuit reversed on this issue, finding that because the IRS raised a new issue at trial, it had the burden of proof. The court concluded that the IRS clearly failed to establish DKD's pension plan discriminated in favor of Debra. Further, the court said, because funds properly allocated to a qualifying pension plan are taxable to the beneficiary only when they are actually distributed, DKD's contributions to the pension plan did not constitute taxable income to Debra. The court concluded that DKD was entitled to deduct contributions to the plan, and those contributions are not taxable to Debra as a constructive dividend.

DKD and Debra also argued that DKD was entitled to deduct a $5,000 contribution made to the profit-sharing fund in 2006, which DKD attempted to deduct on its 2005 tax return. The Tax Court found DKD bore the burden of proof on this matter, because DKD raised the issue for the first time before the Tax Court. DKD and Debra did not challenge the Tax Court's conclusion with respect to the burden of proof.

The Eight Circuit remanded to the Tax Court for further consideration the questions of (1) whether DKD's 2006 contribution to the profit-sharing plan qualified for deduction in tax year 2005; and (2) whether that distribution was taxable to Debra as a constructive dividend.

Health Insurance Issue

Finally, DKD and Debra asserted that the Tax Court erred in deciding payments made by DKD to provide health insurance for Debra were neither an ordinary and necessary business expense nor an accident or health plan excludable from Debra's income. However, the Eighth Circuit affirmed the Tax Court on this issue because the Tax Court permissibly found that DKD failed to prove the payments were made pursuant to a pre-determined plan for the benefit of employees.

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U.S. Taxpayer Runs Afoul of Citizen/Resident Requirements for Childrens

For a taxpayer to take a dependency deduction, the dependent must be a citizen or resident of the United States at some time during the calendar year. In Carlebach v. Comm'r, 139 T.C. No. 1 (7/19/12), the question arose as to when that citizenship test must be satisfied. Although the children that were the subject of the dependency exemptions in this case were born to a U.S. citizen, they were born overseas and had not yet applied for citizenship in the United States. The Tax Court rejected the taxpayers' argument that the regulations interpreting the U.S. citizen or resident requirement for dependents was invalid. The court also rejected the taxpayers' argument that their children had derivative U.S. citizenship as a result of being born to a U.S. citizen. Siding with the IRS, the Tax Court held that the children did not become U.S. citizens until they appeared in the United States and received their certificates of citizenship and, thus, the taxpayers were not entitled to the dependency deductions. The Tax Court also held they were liable for penalties.

Background

Leah Carlebach and Uriel Fried have been married since 1990. Leah was born in the United States in 1968 and is a U.S. citizen. Leah and Uriel have six children, all of whom were born in Israel. During 2004-2006, Leah and Uriel and the children lived in Israel. The children have never lived in the United States. The oldest child was born in 1993. In June 2007, the Director of the United States Citizen and Immigration Services, Department of Homeland Security granted certificates of citizenship to four of the children who were then in the United States and who applied for, and were issued, social security cards. In April 2008, the Director granted certificates of citizenship to the remaining two children who were then in the United States and who applied for, and were issued, social security cards.

In December 2007, Leah and Uriel filed three joint Forms 1040A, U.S. Individual Income Tax Return, one each for 2004, 2005, and 2006. On each return, they claimed dependency exemption deductions - three for 2004, and four for 2005 and 2006. They also claimed a child tax credit, a child care credit, and an additional child tax credit. On each return, they reported an overpayment of tax and claimed a refund.

In October 2008, Leah filed a Form 1040A for 2007, showing her filing status to be single. On that return, she claimed six dependency exemption deductions and an additional child tax credit. She also reported an overpayment of tax and claimed a refund. In June 2009, Leah filed a Form 1040A for 2008, showing her filing status to be married filing separately. On that return, she claimed six dependency exemption deductions, a child care credit, an additional child tax credit, and a recovery rebate credit. She also reported an overpayment of tax and claimed a refund.

The IRS issued refunds for 2004-2006 to Leah and Uriel and issued a refund for 2007 to Leah. They subsequently audited those returns and issued no more refunds. The IRS issued notices of deficiency in which they disallowed the claimed dependency exemptions deductions and credits on the basis that none of the children met the definition of qualifying child under Code Sec. 152.

The IRS determined that Leah and Uriel were liable for accuracy-related penalties on the basis of negligence for 2004 and on the basis of negligence and substantial understatement for 2005 and 2006. The IRS also determined that Leah was liable for accuracy-related penalties on the basis of negligence for 2007 and 2008 but subsequently conceded the penalty for 2008.

Relevant Code and Regulations

With the exception of special rules that apply to adopted children, Code Sec. 152(b)(3)(A) provides that the term "dependent" does not include an individual who is not a citizen or national of the United States unless such individual is a resident of the United States or a country contiguous to the United States.

Reg. Sec. 1.152-2(a)(1) generally provides that, to qualify as a dependent, an individual must be a citizen or resident of the United States or be a resident of the Canal Zone, the Republic of Panama, Canada, or Mexico, or, for tax years beginning after 1971, a national of the United States, at some time during the calendar year in which the tax year of the taxpayer begins.

IRS and Taxpayers' Positions

According to the IRS, Leah and Uriel were not entitled to the dependency exemption deductions because some or all of the children were not U.S. citizens in the tax years for which they were claimed as dependents. None of the children, the IRS said, met the citizenship test for 2004, 2005, or 2006, and only four of the six met the citizenship test for 2007, because the children did not become citizens until they received their certificates of citizenship. Without the children's having satisfied the citizenship test, the IRS contended, Leah and Uriel were not entitled to the dependency exemption deductions, nor were they allowed the child-related credits, which require that the children satisfy the same statutory test.

Leah and Uriel argued that they were entitled to the dependency exemption deductions because the children were citizens at the time Leah and Uriel filed tax returns for those years. Reg. Sec. 1.152-2(a)(1), they claimed, was invalid. That regulation requires that an individual be a citizen at some time during the calendar year in which begins the tax year of the taxpayer claiming the individual as a dependent. Using the analysis set out in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984) (Chevron), Leah and Uriel claimed that Code Sec. 152(b)(3)(A) is unambiguous and that Congress specifically addressed the temporal requirement of citizenship by declining to require that an individual be a citizen "at some time during the calendar year in which the taxable year of the taxpayer begins in order to be a dependent." Alternatively, Leah and Uriel argued that the children satisfied the citizenship test for 2004-07 because each child had derivative citizenship at some time' during the tax years in which he or she was claimed as a dependent. Thus, Leah and Uriel asserted that the children satisfied the citizenship test for each of the tax years in question except for the formality of traveling to the United States to receive their certificates of citizenship.

Derivative Citizenship Claim

In addressing Leah and Uriel's derivative citizenship claim, the Tax Court began by citing the Supreme Court's decision in U.S. v. Wong Kim Ark, 169 U.S. 649 (1898) in which the Court held that there are only two sources of citizenship: birth and naturalization. Under the Fourteenth Amendment to the Constitution, every person born in the United States, and subject to the jurisdiction thereof, becomes at once a citizen of the United States, and needs no naturalization. Individuals born outside the United States may only become a citizen by being naturalized, either by treaty or by authority of Congress.

The Tax Court noted that the Child Citizenship Act of 2000 amended certain provisions of the Immigration and Nationalization Act governing the acquisition of citizenship by certain children born outside the United States. The relevant provisions, the court noted, are contained under 8 U.S.C. Section 1433. That section provides the conditions that must be met for children born and living outside the United States for acquiring a certificate of citizenship. Those requirements include the application by a U.S. citizen parent and, upon approval of the application, the receipt of a certificate of citizenship. The receipt of the certificate occurs upon the child taking and subscribing before an officer of the Immigration and Naturalization Service within the United States the required oath of allegiance.

Thus, the Tax Court said, citizenship under this provision is not automatic - it must be applied for. After being applied for, it must be approved by the Attorney General and the applicant must appear in the United States to take the oath of allegiance. The children could not fulfill the conditions for naturalization until they personally appeared before the Attorney General in the United States in 2007 and 2008. While other courts have recognized that the conferral of a certificate of citizenship is ministerial rather than discretionary, the Tax Court said that no matter how insignificant the appearance and subsequent oath may seem, those elements are mandated by Congress, which, except in cases governed by treaty, has the sole authority to govern the process by which those born abroad may become naturalized citizens. The actual certificate itself, the court observed, recognizes that citizenship is conferred only at the time the certificate is bestowed. Thus, while the children may have derived their citizenship from the status of their mother and grandparents as citizens, the Tax Court concluded that they did not become citizens until they were in the United States in 2007 and 2008 and fulfilled all of the applicable conditions to become naturalized citizens.

Validity of Reg. Sec. 1.152-2(a)(1)

The court then addressed Leah and Uriel's argument that Code Sec. 152(b)(3)(A) simply provides that a dependent "does not include an individual who is not a citizen or national of the United States" and that it includes no requirement that a child be a citizen at some time during the calendar year in which begins the tax year of the taxpayer claiming the individual as a dependent. Thus, because the children were citizens at the time the tax returns were filed, Leah and Uriel argued that they were entitled to the claimed dependency exemption deductions and any additional requirement imposed by the regulations was invalid.

The Tax Court noted that last year, in Mayo Foundation for Medical Educ. and Research v. U.S., 131 S. Ct. 704 (2011), the U.S. Supreme Court confirmed that courts apply Chevron deference to government agency regulations (named after the decision in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984)). Determining whether a Treasury regulation merits Chevron deference, the Tax Court said, often involves a two-step process. The first step is determining whether Congress has directly spoken to the precise question at issue. If not, the second step is to determine whether the agency's chosen interpretation is a "reasonable interpretation" of the enacted statutory text. If it is, then the regulation will stand. A regulation is ruled invalid, the court noted, only if it is found to be arbitrary or capricious in substance, or manifestly contrary to the statute.

Arguably, the court said, Code Sec. 152(b)(3)(A) is, as Leah and Uriel claimed, unambiguous. In the Tax Court's view, however, the statute could only be read as being consistent with, not contrary to, Reg. Sec. 1.152-2(a)(1). The Tax Court said that it had to interpret Code Sec. 152(b)(3)(A) in the context of subtitle A of the Code, which deals with income taxes, and in which the concept of an annual accounting system is material. In the narrower context of Code Sec. 152 and its immediate environs, the court stated, the allowance of dependency deductions is cast in terms of an additional exemption for each individual who is a dependent of the taxpayer for the tax year. Likewise, the court noted, the qualification "taxable year" appears over 30 times in Code Sec. 152. Generally, the court observed, a federal income tax return reflects the events that affect income during the tax year for which it is filed. Four of Leah and Uriel's children were naturalized and became U.S. citizens in 2007, and yet, the court noted, those children were claimed by Leah and Uriel as dependents on their 2004 through 2006 income tax returns, despite the fact that they were not yet U.S. citizens. The other two children became citizens in 2008, and yet, were claimed as dependents in 2007. The court ruled that, allowing Leah and Uriel dependency exemption deductions with accompanying credits for children failing to meet the citizenship test, as construed in Reg. Sec. 1.152-2(a)(1), would be against Congress' expressed preference in the Code's income tax provisions for a system of annual accounting.

Child Care Credit, Child Tax Credit, and Additional Child Tax Credit

The Tax Court noted that, for a taxpayer to claim a child care credit, Code Sec. 21(b)(1)(A) provides that the taxpayer must incur employment-related expenses on behalf of a dependent of the taxpayer as defined in Code Sec. 152(a)(1). Additionally, married taxpayers must file a joint return. To claim the child tax credit and additional child tax credits, the court stated, Code Sec. 24 requires that a child be a "qualifying child" and a modified version of the citizenship test applies in that case.

Since the court already determined that Leah and Uriel's children only met the citizenship test for the year in which they received their certificates of citizenship, it upheld the IRS's disallowance of those credits for the prior years. The court also agreed with the IRS that, for 2008, each child satisfied the citizenship test but Leah was not entitled to the child care credit because, although married at the time, she did not file a joint return.

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Recovery by Individuals under the False Claims Act Is Ordinary Income, Not Capital Gain

The False Claims Act (FCA) imposes civil liability on any person who presents to the federal government a false or fraudulent claim for payment or approval. The government may itself bring a suit, or a private person may bring a suit in the name of the government as a relator. In Alderson v. U.S., 2012 PTC 206 (9th Cir. 7/19/12), the Ninth Circuit, in an issue of first impression, was asked to decide whether a relator's share of a penalty received under the FCA is ordinary income or capital gain. The taxpayers in Alderson were not able to cite any cases in which a relator's share had been given capital gains treatment. The IRS said that it was unaware of a single instance in which a relator's award received capital gains treatment. However, as the Ninth Circuit noted, the IRS could not provide any case supporting the proposition that such awards consistently have been treated as ordinary income, nor could it even cite any case addressing the question. Unfortunately for the taxpayers, the Ninth Circuit sided with the IRS and held that such income is ordinary income.

Facts

James Alderson was the Chief Financial Officer for North Valley Hospital in Whitefish, Montana, in 1990. That year, Quorum Health Group, Inc., an affiliate of Hospital Corporation of America (HCA), began managing the hospital. Quorum asked James to prepare two sets of books, one for the hospital's financial auditors and one to serve as the basis for the hospital's Medicare cost reports. James refused to prepare separate books. Quorum fired him in September 1990.

In May 1991, James filed a wrongful termination suit. During discovery, James deposed several Quorum officials and obtained sample Medicare cost reports. The depositions and documents suggested widespread accounting fraud. James settled his wrongful termination suit in 1993.

Using information obtained during discovery in his wrongful termination suit, James filed a qui tam action under the False Claims Act (FCA), alleging Medicare fraud by Quorum and several related entities including HCA. The False Claims Act imposes civil liability on any person who presents to the federal government a false or fraudulent claim for payment or approval. The government may itself bring a suit, or a private person may bring a suit in the name of the government as a relator. In a qui tam action, a relator with knowledge of the fraud committed against the federal government brings a suit on the government's behalf and is eligible to collect a portion of the penalty assessed against the defendant. James made available to the government the documents he had received during discovery. In a subsequent conversation between James and the Department of Justice, James identified for government personnel the categories of documents that the government should subpoena from Quorum to advance most effectively the government's investigation. The government issued subpoenas that resulted in the production of cost reports from 197 hospitals covering a seven-year period. At the government's request, James analyzed the reports and prepared a spreadsheet for the government based on 2,500 documents. James presented his analysis to the government in early 1995.

James spent five years trying to persuade the United States to intervene in his FCA suit. At his own expense, he retained counsel in 1993, and different counsel in 1995, to represent him. The United States finally intervened in 1998. After intervening, the United States severed the suits against HCA and Quorum.

In 2001, the government settled the suit against Quorum for $85.7 million. James received a 24 percent relator's share, 1 percent below the maximum percentage allowed under the qui tam statute. In explaining its decision to award James a significant share of the recovery, the district court referred to the heroic effort by many, including prominently James and the team he assembled, [that] contributed to the development of the factual information, documentary evidence, and legal arguments necessary to prevail.

In 2003, the government settled the suit against HCA for $631 million. James received a 16 percent relator's share. After accounting for attorney's fees and expenses, James received over $27 million.

Family Limited Partnership Used to Distribute Relator's Share of Penalties Received

Before the settlement of the HCA suit, James gave portions of his potential relator's share to members of his family, using a family partnership he established for this purpose. James transferred to the Alderson Family Limited Partnership 40 percent of his interest in the relator's share. James retained ownership of the remaining 60 percent of his relator's share. James gave each of his two children, Justin and Jennifer, a 49 percent interest in the partnership. He gave his wife, Connie, a 1 percent interest in the partnership and retained a 1 percent interest in the partnership in his own name. In 1999, an appraiser estimated the present value of the entire relator's share as approximately $3,047,000. The appraiser used that estimate to value the partnership shares. James and his wife relied on this valuation to pay a gift tax on the partnership shares transferred to their children.

Characterization of Relator's Share Income

In 2003, the Alderson parties received their relator's share income and filed tax returns for 2003 reporting their share of the settlement. James and Connie Alderson filed a joint return reporting income from the 60 percent ownership interest that James had retained and from their 2 percent interest in the partnership. Justin Alderson and his wife, Kristen, and Jennifer Alderson Page and her husband, Walter Page, reported on their joint returns the partnership income they received based on Justin's and Jennifer's 49 percent interests in the partnership. All three couples characterized the income as ordinary income.

In 2007, all three couples filed amended returns for 2003, in which they re-characterized their portions of the relator's share as capital gain. This re-characterization significantly reduced their tax liability for 2003. James and his wife sought a refund of approximately $3.3 million. His two children and their spouses each sought just over $1 million per couple.

The IRS denied the refund requests in 2008. All three couples then filed suit in district court for refunds. A district court held that the relator's share was ordinary income and granted summary judgment to the government. The three couples appealed to the Ninth Circuit.

Taxpayers' Arguments

The Aldersons contended that James exchanged his documents, information, and know-how and received cash in return, thus consummating a sale or exchange. They argued that the information supplied by James to the government was a capital asset. Alternatively, they argued, the relator's share itself is a capital asset. The Aldersons contended that the increase in value of the relator's share between 1993, when Alderson filed his suit, and 2003, when he actually received his relator's share of approximately $27 million was capital gain.

To support their argument, the Aldersons cited several cases, including U.S. v. Maginnis, 356 F.3d 1179 (9th Cir. 2004), in which the Ninth Circuit set forth the following two factors that may, in some circumstances, be used to identify a capital assets: (1) whether the taxpayer made an underlying investment of capital in return for the receipt of his right, and (2) whether the sale of his right reflected an accretion in value over cost to any underlying asset.

Ninth Circuit's Analysis

The Ninth Circuit began its analysis by noting that, in Vermont Agency of Natural Resources v. U.S., 529 U.S. 765 (2000), the Supreme Court characterized a relator's share under the FCA as a bounty and as a fee. In that case, the Supreme Court said that the relator's bounty is simply the fee he receives out of the United States' recovery for filing and/or prosecuting a successful action on behalf of the Government. The Court further referred to the relator's share as the bounty the relator will receive if the suit is successful, and to the qui tam suit as the relator's suit for his bounty.

The Ninth Circuit rejected the Aldersons' argument that they exchanged information for cash, thus completing a sale or exchange transaction. According to the court, James did not sell or exchange his information. His right to a relator's share, the court stated, was a right conferred by the FCA. James provided his information to the government as a precondition for pursuing his qui tam suit, as required by the statute. According to the court, if James had offered simply to sell or exchange the information to the government in return for a sum of money, the government would almost certainly have refused the offer. In the unlikely event the government had accepted the offer, the court said, it would have done so based on some authority other than the FCA. Further, the court observed, James did far more than simply hand information over to the government - he performed numerous acts in connection with that information: He spent five years after filing his pro se complaint trying to persuade the government to intervene in his suit, prepared numerous spreadsheets, and performed an extensive analysis of documents the government had obtained through subpoenas.

With respect to the question of whether the information or the relator's share was a capital asset, the Ninth Circuit noted that the Supreme Court has long held that the term capital asset is to be construed narrowly in accordance with the purpose of Congress to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time.

With respect to the Aldersons' first argument - that the information supplied by James to the government was capital gain property - the court said that James had to show that the information provided was his property as required by Code Sec. 1221(a). The Ninth Circuit noted that general principles of property law require that a property owner have the legal right to exclude others from using and enjoying that property. James, the court stated, had no legal right to exclude others from use of the information that he obtained through discovery and subsequently provided to the government. The information was known to other officials in the company, and James had no right to prevent those officials from providing it to others. Thus, the Ninth Circuit concluded, the information James provided to the government was not his property and therefore did not qualify as a capital asset.

With respect to the taxpayers' second argument that the relator's share was a capital asset, the court noted that a relator's share-even a potential relator's share-can be property for some purposes. For example, the court noted, a potential relator's share can be assigned to others, as James did when he assigned part of his share to his wife and children. But the fact that a relator's share can be property for some purposes, the court said, does not make it a capital asset under Code Sec. 1221(a). With respect to the taxpayers' reliance on the Ninth Circuit's decision in U.S. v. Maginnis and the factors described in that case, the court said that James did not receive his right to a relator's share in return for an underlying investment of capital. Uncovering accounting fraud, receiving documents during discovery, and interpreting those documents are not activities that constitute an investment of capital, the court said. In addition, the increase in value between 1993 and 2003 did not reflect an accretion in value over cost to the underlying asset, the court stated; the increase in value of James's relator's share-of his underlying asset-was not the sort of accretion in value that characterizes a capital gain. James was not an investor who bought and held an asset that increased in value during the holding period, the court concluded; rather, he worked intensively after 1993 to increase the likelihood that his qui tam suit would be successful.

In the end, the Ninth Circuit held that James' qui tam award under the FCA was ordinary income and affirmed the district court's grant of summary judgment in favor of the IRS.

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Property Tax Assessment Can't Be Used to Value Property for Purposes of Meeting the Insolvency Exception to Recognizing COD Income

Because the taxpayers did not meet their burden of proving the fair market value of their principal residence and beach house immediately before their credit card debt was discharged, they could not exclude the related discharge-of-indebtedness income under the insolvency exception. Shepherd v. Comm'r, T.C. Memo. 2012-212 (7/24/12).

In January 2009, Capital One issued to Bernard Shepherd a Form 1099-C, Cancellation of Debt, showing that $4,412 of indebtedness had been canceled on September 3, 2008. Bernard and his wife did not report the $4,412 as income on their 2008 joint federal income tax return because they claimed they were insolvent and thus, under Code Sec. 108(a)(1)(B), were entitled to exclude cancellation-of-debt (COD) income from their gross income. In documenting their insolvency, the Shepherds listed all their assets and liabilities and the IRS agreed with most of the values listed. However, there were three areas of disagreement: (1) the value of the Shepherds' principal residence; (2) the value of the Shepherds' beach home; and (3) whether Bernard's pension was an asset for purposes of determining whether the Shepherds were insolvent.

According to the IRS, the Shepherds did not meet their burden of proving the fair market value of their beach house and principal residence immediately before the discharge and thus could not exclude the COD income. In addition, the IRS argued, the Shepherds neglected to include Bernard's pension as an asset in calculating their solvency.

The Shepherds contended that they offered sufficient evidence to prove that the fair market value of the beach house was approximately $340,000. At trial, Bernard testified that in his opinion, based on comparable sales that he assembled for the purpose of a property tax appeal, the value of the beach house immediately before the discharge was approximately $340,000. The Shepherds offered into evidence a 2011 Civil Action Stipulation of Settlement between themselves and the City of Brigantine. The settlement provided that the value of the beach house for local property tax purposes was $380,000 for the 2010 tax year. With respect to their principal residence, the Shepherds offered the following evidence to support their valuation: (1) a letter dated March 29, 2011, from Chase Home Finance LLC showing the value of the principal residence as $380,000 based on an exterior broker price opinion/appraisal; and (2) a 2008 final/2009 preliminary tax bill.

The Tax Court agreed that the Shepherds did not meet their burden of proving the fair market value of their properties and also held that Bernard's pension was includible as an asset in calculating insolvency.

With respect to the beach house valuation, the Tax Court noted that it has previously held that a value placed on property for the purpose of local taxation, unsupported by other evidence, is not determinative of fair market value for federal income tax purposes in the absence of evidence of the method used in arriving at that valuation. The court noted that the settlement offered into evidence did not describe the beach house or the method used to determine the value of the beach house. Additionally, the court stated, the settlement showed the beach house's valuation for tax purposes for 2010, whereas the Shepherds' debt was discharged in 2008. Thus, the Tax Court held that the settlement was not convincing evidence of the fair market value of the beach house immediately before the Shepherds' debt discharge.

With respect to the valuation of the Shepherds' home, the court noted that Chase determined the fair market value of the principal residence as of March 2011, almost three years after the date of debt discharge. Further, the court stated, the letter from Chase did not describe the property or explain, even briefly, the methodology used to determine its value. As a result, the court concluded that Chase's valuation of the principal residence as of March 2011 was not convincing evidence of the fair market value of the Shepherds' home. Similarly, the court stated, the Shepherds' property tax bill did not suffice to establish their home's fair market value.

Finally, with respect to Bernard's pension, the Tax Court said that it had previously, in Carlson v. Comm'r, 116 T.C. 87 (2001), held that the word assets as used in the definition of the term insolvent for Code Sec. 108(d)(3) includes assets exempt from the claims of creditors under applicable state law.

For a discussion of the insolvency exception to including discharge of indebtedness in income, see Parker Tax ¶76,110.

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Fourth Circuit Reverses District Court; Taxpayer Liable for Additional Penalties for Failing to File FBAR

By signing tax returns that stated he had no foreign bank accounts, the taxpayer willfully violated the FBAR provisions and thus was subject to additional penalty assessments. U.S. v. Williams, 2012 PTC 202 (4th Cir. 7/20/12).

Taxpayers must report annually to the IRS any financial interests they have in any bank, securities, or other financial accounts in a foreign country. The report is made by filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The FBAR must be filed on or before June 30 of each calendar year with respect to foreign financial accounts maintained during the previous calendar year. Civil monetary penalties may be imposed on any person who fails to timely file the report. Moreover, in cases where a person willfully fails to file the FBAR, an increased maximum penalty of up to $100,000 or 50 percent of the balance in the account at the time of the violation may be imposed. The authority to enforce such assessments has been delegated to the IRS.

In 1993, J. Bryan Williams opened two Swiss bank accounts in the name of ALQI Holdings, Ltd., a British Corporation. From 1993 through 2000, Williams deposited more than $7 million into the ALQI accounts, earning more than $800,000 in income on the deposits. However, for each of the tax years during that period, Williams did not report to the IRS the income from the ALQI accounts or his interest in the accounts. By the fall of 2000, Swiss and Government authorities had become aware of the assets in the ALQI accounts. Williams retained counsel and on November 13, 2000, he met with Swiss authorities to discuss the accounts. The following day, at the request of the IRS, the Swiss authorities froze the ALQI accounts.

Williams completed a tax organizer in January 2001, which had been provided to him by his accountant in connection with the preparation of his 2000 federal tax return. In response to the question in the tax organizer regarding whether he had an interest in or a signature or other authority over a bank account, or other financial account in a foreign country, Williams answered No. In addition, he checked no on the box in Schedule B of Form 1040, which asked if he had an interest in or a signature or other authority over a financial account in a foreign country, such as a bank account, securities account, or other financial account. Williams did not file an FBAR by the June 30, 2001, deadline.

Subsequently, upon the advice of his attorneys and accountants, Williams fully disclosed the ALQI accounts to an IRS agent in January 2002. In October 2002, he filed his 2001 federal tax return on which he acknowledged his interest in the ALQI accounts. Williams also disclosed the accounts to the IRS in February 2003 as part of his application to participate in the Offshore Voluntary Compliance Initiative. At that time he also filed amended returns for 1999 and 2000, which disclosed details about his ALQI accounts.

In June 2003, Williams pled guilty to conspiracy to defraud the IRS and criminal tax evasion in connection with the funds held in the ALQI accounts from 1993 through 2000. As part of the plea, Williams agreed to allocute to all of the essential elements of the charged crimes, including that he unlawfully, willfully, and knowingly evaded taxes by filing false and fraudulent tax returns on which he failed to disclose his interest in the ALQI accounts.

In January 2007, Williams finally filed an FBAR for each tax year from 1993 through 2000. Thereafter, the IRS assessed two $100,000 civil penalties against him for his failure to file an FBAR for tax year 2000. Williams failed to pay these penalties, and the IRS took him to court. A district court held for Williams, finding that the IRS failed to establish that Williams willfully violated the FBAR provisions. The IRS appealed.

The parties agreed that Williams violated the law by failing to timely file an FBAR for tax year 2000. The only question was whether the violation was willful. The district court found that (1) Williams lacked any motivation to willfully conceal the accounts from authorities because they were already aware of the accounts and (2) his failure to disclose the accounts was not an act undertaken intentionally or in deliberate disregard for the law, but instead constituted an understandable omission given the context in which it occurred. Therefore, the district court found that Williams' violation of the FBAR provisions was not willful. The IRS appealed the decision.

The Fourth Circuit held that, taking the evidence as a whole, the district court clearly erred in finding that Williams did not willfully violate the FBAR provisions. Williams signed his 2000 federal tax return, the court noted, thereby declaring under penalty of perjury that he had examined this return and accompanying schedules and statements and that, to the best of his knowledge, the return was true, accurate, and complete. Williams' signature on the tax return, the court stated, is prima facie evidence that he knew the contents of the return, and at a minimum the return's directions to see the instructions for exceptions and filing requirements for Form TD F 90-22.1 put Williams on notice of the FBAR requirement. Williams' guilty plea allocution further confirmed to the Fourth Circuit that his violation was willful.

For a discussion of the FBAR requirements, see Parker Tax ¶203,170.

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Change in Airplane's Use Results in a Change in Depreciation Classification

Because the primary use of an airplane changed from business use to leasing, the plane was reclassified from 5-year property to 7-year property for depreciation purposes. CCM 201228036.

In CCM 201228036, two individuals own 100 percent of a partnership. One of the partners, A, is the sole shareholder of several S corporations that own automobile dealerships located in various areas of the country. A, through the partnership, provides management services to the dealerships. The partnership purchased an airplane for business travel to the automobile dealerships and began to depreciate the plane as 5-year property.

In later years, the plane became less necessary and less affordable, but the partnership was unable to sell the plane due to its depressed value. Subsequently, the partnership entered into a dry lease agreement with J, a certified air carrier in the business of chartering aircraft, to offset the cost of maintaining the plane. Under the dry lease agreement, the partnership agreed to dry lease the plan when it was not using it and J agreed to pay the partnership a certain amount per flight hour. The partnership also agreed to pay J a certain amount per month to keep the plane on J's charter certificate. J agreed to solicit charter business appropriate to the airplane and to dry lease the airplane from the partnership when not in use by the partnership. The partnership agreed to pay all reasonable and necessary costs or expenses relating to maintenance, repair, and servicing of the airplane. Finally, at the end of the lease term, the agreement provided that J would return the airplane to the partnership. The airplane was used for more hours by J's charter business than by the partnership for A's business travel to various automobile dealerships.

The question arose as to whether the partnership's leasing of the airplane to J for the commercial and contract carrying of passengers during the tax year was a change in use of the airplane for purposes of the depreciation provisions of Code Sec. 168.

The Office of Chief Counsel advised that, because the primary use of the airplane during the years at issue was the leasing of the plan to J for use in its charter business, the classification of the airplane for the years at issue changed from 5-year property to 7-year property. The Chief Counsel's Office noted that A's business use of the airplane is described in asset class 00.21 of Rev. Proc. 87-56. Because the partnership leased the airplane to J, who used the airplane in its charter business, the leasing use of the airplane is described in asset class 45.0 of Rev. Proc. 87-56. The cost of the airplane is not allocated between these two activities, the Chief Counsel's Office noted. Instead, the total cost of the airplane is classified, for depreciation purposes, according to the activity in which the airplane is primarily used during the tax year. This determination may be made in any reasonable manner. Citing Clajon Gas Co, L.P. v. Comm'r, 354 F. 3d 786 (8th Cir. 2004), the Chief Counsel's Office noted that several appellate decisions discuss the primary use standard for asset classification under Reg. Sec. 1.167(a)-11(b)(4)(ii)(b), and have concluded that the actual purpose and function of an asset determines its asset class (a use-driven functional standard) rather than the terminology used to describe an asset by its owners or others. Generally, the use of an asset used for transportation is measured in miles. For an airplane, another appropriate measurement of use is flight hours. In this case, the Chief Counsel's Office noted, the information provided was the airplane's flight hours during the tax year.

Based on the information provided about the airplane's flight hours during the tax year, the airplane was used 83 percent for the leasing (charter) activity, 15 percent for A's business travel to automobile dealerships, and 2 percent for the partners' personal use. Applying the use-driven functional standard, the Chief Counsel's Office concluded that the airplane was primarily used in the leasing (charter) activity during the tax year and is classified as 7-year property.

For a discussion of classifying property for purposes of depreciation according to its use, see Parker Tax ¶94,315.

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The Fact that OPR Employees Acted with a Retaliatory Motive Didn't Mean They Weren't Acting Within Scope of Official Duties

The investigation of a tax attorney's returns after the attorney filed administrative complaints against an IRS collection officer did not violate Code Sec. 6103 and thus were not unconstitutional. Kenny v. U.S., 2012 PTC 205 (3d Cir. 7/19/2012).

From 2004 to 2007, Robert Kenny, a tax attorney authorized to practice before the IRS, filed three administrative complaints with the Treasury Inspector General for Tax Administration (TIGTA) against IRS collection officer Steven Wald, alleging interference with taxpayers' representation. The Inspector General referred the complaints to Andria Greenidge, Wald's supervisor, who dismissed the complaints and, according to Robert's allegations, recommended that Wald file a practitioner misconduct complaint against Robert, which he did. The Office of Professional Responsibility (OPR) then opened an investigation into Robert's potential misconduct. In the course of its investigation, the OPR examined Robert's tax returns and discovered he had twice filed late without an extension. In May 2008, OPR sent Robert a letter alleging he committed misconduct under Circular 230, Section 10.51(a) by failing to file timely returns, and by giving false information and attempting to coerce an IRS officer through false accusations in connection with his complaints against Steven Wald.

In August 2008, Robert filed suit in a district court seeking monetary and injunctive relief. He alleged (1) retaliation in violation of Code Sec. 7804, (2) an unauthorized collection action in violation of Code Sec. 7433, (3) unauthorized inspections of return information in violation of Code Sec. 7431, and (4) violation of his First and Fourth Amendment rights. The district court dismissed all four counts. After numerous procedural filings and hearing, Robert appealed to the Third Circuit, citing a violation of Code Sec. 7431, and asked for damages under Bivens v. Six Unknown Named Agents of Fed. Bureau of Narcotics, 403 U.S. 388 (1971) (i.e., Bivens).

Under Code Sec. 7431, a taxpayer can sue for damages for unauthorized access to tax return information. To establish a claim, a taxpayer must demonstrate (1) a violation of Code Sec. 6103, and (2) that the violation resulted from knowing or negligent conduct. Code Sec. 6103 specifies that tax returns and return information are confidential and bars disclosure by U.S. employees, but provides a number of exceptions. One of the exceptions permits inspection by, or disclosure of returns to, officers and employees of the Treasury Department whose official duties require such inspection or disclosure for tax administration purposes. Disclosure to officers and employees of the Department of the Treasury for use in any action or proceeding relating to legal practice before the Department is permitted to the extent necessary to advance or protect the interests of the United States.

The Third Circuit affirmed the district court. According to the court, because the Office of Professional Responsibility is responsible for matters related to practitioner conduct and discipline, including disciplinary proceedings and sanctions under Section 10.1(a)(1) of Circular 230, and because practitioners' failure to comply with federal tax law, including late filing, could constitute disreputable conduct subject to sanction and disbarment under Section 10.51(a)(6) of Circular 230, the investigation of Robert's returns by employees of OPR fell within their official tax administration duties under Code Sec. 6103(h). Moreover, the court stated, the investigation was permitted under Code Sec. 6103(l)(4)(B) because OPR employees investigated Robert's returns in preparation for a proceeding under 31 U.S.C. Section 330(b) to suspend . . . disbar . . . or censure a representative who . . . is disreputable. In short, the court said, because the facts Robert alleged did not establish a violation of Code Sec. 6103, he could not sustain a claim under Code Sec. 7431. The court also noted that Robert was suggesting that, because the OPR employees acted with a retaliatory motive, they could not have acted within the scope of their official duties. However, the court observed, the plain text of Code Sec. 6103 does not provide such a limitation. The court also noted that, in CCM 201001019, the IRS Chief Counsel has suggested that compliance checks on practitioners by IRS Collection employees may exceed their official duties. However, the Third Circuit stated, this circumstance was not implicated in Robert's case.

With respect to Robert's Bivens claim, the court noted that the provisions governing potential disbarment or suspension before the IRS create a comprehensive remedial scheme for addressing allegations of practitioner misconduct, including any constitutional concerns raised by practitioners. Because Congress and the Department of the Treasury have elected to provide this scheme to regulate the relationship between the IRS and practitioners, the court declined to infer a Bivens remedy in this instance.

For a discussion of sanctions imposed on tax practitioners under Circular 230, see Parker Tax ¶273,100.

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Post-petition Tax Refunds Constitute Projected Disposable Income Subject to Distribution in a Debtor's Chapter 13 Plan

Tax refunds are projected disposable income, subject to inclusion in the bankruptcy estate, if there is evidence that refunds were received by the debtor in the past. In re Murchek, 2012 PTC 201 (Bankr. N.D. Iowa 7/17/12).

Tara Murcheck declared bankruptcy under Chapter 13. However, the bankruptcy trustee objected to language in the bankruptcy plan limiting payment of projected disposable income into the plan. The trustee's objection related to plan language stating that tax refunds and/or bonuses received over the course of the plan are not projected disposable income payable to the bankruptcy trustee. Tara argued that prior case law established that projected disposable income is derived only from funds that are known or virtually certain. The trustee argued that tax refunds are projected disposable income if there is evidence that refunds were received by the debtor in the past. According to the trustee, this conclusion is consistent with the Supreme Court's decision in Hamilton v. Lanning, 130 S. Ct. 246 (2010). The trustee argued that without such a rule, debtors could manipulate their tax withholdings to keep refunds out of reach of a bankruptcy trustee.

An Iowa bankruptcy court concluded that post-petition tax refunds generally should be treated as projected disposable income subject to distribution in a debtor's Chapter 13 plan. Accordingly, the bankruptcy court found that Tara's bankruptcy plan and other plans currently pending before the court with similar - if not identical - language, could not be confirmed.

The court noted that Bankruptcy Code Section 1325(b)(1) provides that if the trustee or the holder of an allowed unsecured claim objects to the confirmation of a Chapter 13 bankruptcy plan, then the court may not approve the plan unless, as of the effective date of the plan (1) the value of the property to be distributed under the plan on account of the claim is not less than the amount of the claim; or (2) the plan provides that all of the debtor's projected disposable income to be received in the applicable commitment period beginning on the date that the first payment is due under the plan will be applied to make payments to unsecured creditors under the plan. Section 1325(b)(2) defines disposable income as monthly income received by the debtor, less amounts reasonably necessary to be spent (1) (a) for the maintenance or support of the debtor or a dependent of the debtor, or for a domestic support obligation, that first becomes payable after the date the petition is filed; and (b) for charitable contributions to a qualified religious entity or organization in an amount not to exceed 15 percent of gross income of the debtor for the year in which the contributions are made; and (2) if the debtor is engaged in business, for the payment of expenditures necessary for the continuation, preservation, and operation of the business.

The bankruptcy court noted that while disposable income is defined by the Bankruptcy Code, projected disposable income is not. The Supreme Court in Hamilton was asked to decide how a bankruptcy court should calculate a debtor's projected disposable income. The two different approaches argued by the parties to determine projected disposable income were (1) a mechanical approach, in which projected disposable income means past average monthly disposable income multiplied by the number of months in a debtor's plan, and (2) a forward-looking approach, under which a mechanical approach is determinative in most cases, but in exceptional cases, where significant changes in a debtor's financial circumstances are known or virtually certain, a bankruptcy court has discretion to make an appropriate adjustment. The Supreme Court held that when a bankruptcy court calculates a debtor's projected disposable income, the court may account for changes in the debtor's income or expenses that are known or virtually certain at the time of confirmation. The Court said that the language in Section 1325(b)(1) that references disposable income to be received in the applicable commitment period favors a forward-looking approach.

The bankruptcy court concluded that the starting point of the mechanical approach essentially equated with the trustee's initial burden. The trustee may point back to the past, the court stated, to show that refunds have been received under similar income in the past. The burden would then shift to the debtor to show this is an unusual case.

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