Federal Tax Bulletin - Issue 50 - November 20, 2013

Doubt is Growing on Whether Expiring Tax Provisions Will Be Extended

Dozens of temporary tax provisions are scheduled to expire at the end of 2013. Most of the expiring provisions have been part of past temporary tax extension legislation, often referred to as "tax extenders." However, interest in tax reform has led key members of Congress and the Obama administration to propose that the extenders be addressed as part of a larger tax reform process. On this issue, Republicans in Congress and the President seem to be more or less on the same page, with the Republicans pushing for tax reform and Obama pushing to make permanent certain extenders but saying that the remainder should be part of a tax reform package.

Observation: Given the political climate in Washington, it's anybody's guess as to when an agreement on tax reform or the extenders might be reached. The American Taxpayer Relief Act of 2012, which was signed on January 1, 2013, retroactively extended certain credits and deductions that expired at the end of 2011 - most notably the R&D tax credit and the Section 179 expensing provision.

President Obama's budget for fiscal year 2014 identifies several expiring provisions that the Administration would like to see permanently extended (and in some cases substantially modified), including the research and experimentation (R&D) tax credit, enhanced expensing for small businesses, the new markets tax credit (NMTC), the work opportunity tax credit (WOTC), the exclusion of discharge of principal residence indebtedness, and the tax deduction for energy efficient commercial buildings.

But unlike previous budget proposals, the President's budget does not propose or assume that some set of expiring provisions is temporarily extended. The provisions that are scheduled to expire at the end of 2013 are diverse in purpose, including provisions for individuals, businesses, the charitable sector, energy, community assistance, and disaster relief. Among the individual provisions scheduled to expire are deductions for teachers' out-of-pocket expenses, state and local sales taxes, qualified tuition and related expenses, and mortgage insurance premiums.

On the business side, tax provisions set to expire include the increased expensing and bonus depreciation allowances, the R&D tax credit, the WOTC. Charitable provisions scheduled to expire include the enhanced deduction for contributions of food inventory and provisions allowing for tax-free distributions from retirement accounts for charitable purposes. The renewable energy production tax credit (PTC) is set to expire at the end of 2013, along with a number of other incentives for energy efficiency and renewable and alternative fuels.

EXPIRING TAX PROVISIONS AFFECTING INDIVIDUALS

Deduction for State and Local General Sales Taxes

Under Code Sec. 164(b)(5), for tax years beginning after 2003 and before January 1, 2014, taxpayers can elect to deduct state and local general sales taxes, instead of state and local income taxes, as an itemized deduction. This deduction is particularly important to individuals who live in a state that doesn't have an income tax. Taxpayers who elect to deduct state and local sales taxes may deduct either actual sales taxes paid or incurred, as evidenced by appropriate records, or an amount determined under tables provided by the IRS.

Observation: If a taxpayer had a large purchase during the year, such as a vehicle or materials for a home improvement project, using the actual sales tax paid will generally result in a larger deduction.

The deduction is not available for years beginning after 2013. See Parker Tax ¶83,130.

Premiums for Mortgage Insurance Deductible as Qualified Residence Interest

Under Code Sec. 163(h)(3)(E), for years 2007 through 2013, taxpayers can treat amounts they paid during the year for qualified mortgage insurance as qualified residence interest. The insurance must be in connection with acquisition debt for a qualified residence. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance.

No deduction is allowed for amounts paid or accrued after December 31, 2013, or for amounts properly allocable to any period after that date. See Parker Tax ¶83,515.

Deduction for Certain Expenses of Elementary and Secondary School Teachers

Under Code Sec. 62(a)(2)(D), for tax years 2002 through 2013, eligible educators (i.e., teachers) can deduct from gross income up to $250 of qualified expenses they paid during the year. If spouses are filing jointly and both were eligible educators, the maximum deduction on the joint return is $500. However, neither spouse can deduct more than $250 of his or her qualified expenses. An eligible educator is a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide who worked in a school for at least 900 hours during a school year. A school for this purpose is any school that provides elementary or secondary education, as determined under state law.

Qualified expenses include ordinary and necessary expenses paid in connection with books, supplies, equipment (including computer equipment, software, and services), and other materials used in the classroom. Qualified expenses do not include expenses for home schooling or for nonathletic supplies for courses in health or physical education.

This provision does not apply to tax years beginning after 2013. See Parker Tax ¶80,135.

Deduction for Qualified Tuition and Related Expenses

Under Code Sec. 222, taxpayers with modified adjusted gross income within certain limits may deduct up to $4,000 of qualified education expenses paid during the year for themselves, their spouses, or their dependent. The maximum tuition and fees deduction for any tax year is $4,000, $2,000, or $0, depending on the amount of the taxpayer's modified adjusted gross income.

The provision does not apply to tax years beginning after 2013. See Parker Tax ¶80,145.

Tax-free Distributions from Individual Retirement Plans for Charitable Purposes

Under Code Sec. 408(d)(8), a qualified charitable distribution from an individual's IRA is excluded from the individual's gross income. A distribution is a qualified charitable distribution (QCD) only if all three of the following requirements are met: (1) the distribution is made directly by the trustee of an individual's IRA (other than a SEP or SIMPLE IRA) to an organization eligible to receive tax-deductible contributions, other than supporting organizations and donor advised funds; (2) the contribution would otherwise qualify for a charitable contribution deduction; and (3) the individual was at least age 70-1/2 when the distribution was made. The total QCDs for the year cannot be greater than $100,000.

Observation: The QCD provision can be beneficial for a couple reasons. First, the distribution is taken into account for purposes of determining if the taxpayer has met the minimum distribution requirements but it is not included in the taxpayer's income. Second, while no charitable deduction is allowed for any amount that was contributed to the IRA tax free, this can be a much more tax efficient way of donating for certain types of taxpayers. For example, donating this way reduces a taxpayer's adjusted gross income. This, in turn, potentially reduces the percentage of social security income that is taxed from 85 percent to 50 percent and increases certain deductions by reducing the effects of the limitations on personal exemptions, itemized deductions, and charitable contributions that are tied to higher adjusted gross income amounts.

This special distribution provision is not available for distributions after 2013. See Parker Tax ¶134,560.

Discharge of Indebtedness on Principal Residence Excluded from Gross Income of Individuals

Under Code Sec. 108(a)(1)(E), for years 2008 through 2013, discharge-of-indebtedness income related to a discharge of qualified principal residence debt (i.e., mortgage on the taxpayer's home) is generally excludable from gross income. Qualified principal residence debt is debt that is incurred to buy, build, or substantially improve the principal residence of the taxpayer and that is secured by that residence. It also includes debt secured by the taxpayer's principal residence that is used to refinance qualified principal residence debt, but not in excess of the outstanding principal amount of the debt that is refinanced. It does not apply to refinanced debt used for other purposes - for example, to pay off credit card debt.

This provision does not apply to indebtedness discharged after 2013. See Parker Tax ¶76,125.

Parity for Exclusion from Income for Employer-Provided Mass Transit and Parking Benefits

Under Code Sec. 132(f), the general rule provides that the amount of transportation-related fringe benefits that are provided by an employer to any employee and that are excludible from gross income cannot exceed (1) $100 per month in the case of the aggregate of the benefits relating to employer-provided mass transit (e.g., transit passes and van pooling), and (2) $175 per month in the case of qualified parking, with both amounts subject to annual indexing for inflation. An exception is provided for years before January 1, 2014, in which the same dollar amount applies to employer-provided mass transit benefit as applies to qualified parking. Thus, for 2013, the indexed combined maximum amount an employee can exclude from income for employer-provided mass transit benefits $245 a month - the same as the indexed limit for qualified parking.

Beginning in 2014, the amount of employer-provided mass transit benefits that are excludible from income will revert to $100 per month, subject to indexing. After indexing, the exclusion amount for mass transit benefits for 2014 is $130 a month. The monthly limit for qualified parking for 2014 is $250. See Parker Tax ¶123,140.

Basis Adjustment to Stock of S Corporations Making Charitable Contributions of Property

Under Code Sec. 1367(a)(2), the decrease in shareholder basis in S corporation stock by reason of a charitable contribution of property is equal to the shareholder's pro rata share of the adjusted basis of such property. For other years, the general rule applies, and the amount of the basis reduction is the shareholder's pro rata share of the fair market value of the contributed property.

Observation: This adjustment is favorable because it keeps the shareholder's stock basis higher than it would otherwise be, thus allowing for additional losses to be taken. In addition, if the taxpayer sells the stock, the higher stock basis will result in less gain being recognized.

This basis adjustment rule expires for contributions made in tax years beginning after 2013. See Parker Tax ¶32,825.

Other Expiring Provisions Affecting Individuals

Other provisions expiring at the end of 2013 include:

• the special rules under Code Sec. 1202 for excluding gain on qualified small business stock;
• the credit under Code Sec. 35(a) for health insurance costs of eligible individuals;
• the special expensing rules under Code Sec. 181(f) for certain film and television productions;
• the credit under Code Sec. 25C for certain nonbusiness energy property;
• the credit under Code Sec. 30C for alternative fuel vehicle refueling property;
• the credit under Code Sec. 30D for two- or three-wheeled plug-in electric vehicles; and
• the credit under Code Sec. 40A for incentives for biodiesel and renewable diesel.

EXPIRING TAX PROVISIONS AFFECTING BUSINESSES Read more...

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Couple Escapes Penalty after Falsely Claiming Credits and Rebates

In a recent Tax Court case, a couple was hit with a penalty for claiming refundable tax credits to which they were not entitled. In Rand v. Comm'r, 141 T.C. No. 12 (11/18/13), the Tax Court was presented with the issue of whether or not those refundable credits must be taken into account when determining the amount shown as tax on a return for purposes of calculating the accuracy-related penalty under Code Sec. 6662. The taxpayers in Rand claimed a tax refund of over $7,000 based on those refundable credits. Both parties agreed that the correct amount of tax liability was $144, but disputed how the accuracy-related penalty under Code Sec. 6662 should be calculated. Specifically, the disagreement was over the number that should be used as the amount shown as tax on the return for purposes of computing the penalty. In a huge win for taxpayers, the court concluded that the correct number on which to base the penalty was zero.

Observation: With respect to the IRS's argument that the court was letting the couple off easy, the court noted that the IRS could have slapped the taxpayers with penalties for false or excessive claims for credits under Code Sec. 32(k) and Code Sec. 6676, which most likely would have been upheld.

Facts

Married taxpayers Yitzchok Rand and Shulamis Klugman filed a joint return for 2008 on which they reported approximately $18,000 of adjusted gross income. This income was reduced to zero by various deductions. The couple reported self-employment tax of $144, resulting in a total tax of $144. The total tax of $144 was reduced, below zero, by refundable tax credits. The couple claimed an earned income credit of $4,824, an additional child tax credit of $1,447, and a recovery rebate credit of $1,200. After taking into account the refundable credits, Rand and Klugman claimed an overpayment of $7,327, and that amount was refunded to them. Read more...

Fourth Largest Tax Prep Firm in U.S. Shut Down for Fraudulent Conduct

Calling the repeated fraudulent and deceptive conduct by the fourth largest tax preparation firm in the United Stated "astonishing" and the evidence of such conduct "overwhelming," an Ohio district court judge permanently barred the organization, as well as its CEO and owner, from operating, or being involved with in any way, any business relating in any way to the preparation of tax returns. In U.S. v. ITS Financial, LLC, 2013 PTC 349 (S.D. Ohio 11/6/13), the judge found the company's repeated attempts to downplay the gravity of their lawlessness "stunning" and said the injunction was necessary to protect the public and the Treasury. One of the more heinous acts committed by the owner of the company involved forging customers' signatures on duplicate refund checks that subsequently caused collection proceedings against the customers for a situation they knew nothing about. Several of them saw their credit ratings ruined.

Background

Fesum Ogbazion is the founder, CEO, and sole owner of ITS Financial, Tax Tree, and TCA Financial. Instant Tax Service is the brand of the product provided by ITS Financial franchises across the United States. Instant Tax Service is a nationwide tax preparation franchise that Ogbazion developed and that claims to be the fourth largest tax preparation franchise in the nation. As the founder, sole owner, and CEO of Instant Tax Service and ITS Financial, Ogbazion makes all the significant decisions for the company.

Forgery of ITS Financial Customers' HSBC Refund Checks

According to court documents and testimony, in January 2007, Ogbazion instructed an Instant Tax Service employee to forge customers' signatures on a series of 26 HSBC loan checks. These 26 customers had their tax returns prepared at an Instant Tax Service office and received these HSBC checks from Instant Tax Service as part of Instant Tax Service's loan program. Ogbazion, through his corporate entity, owned the particular tax preparation office where these 26 customers had their tax returns prepared and signatures forged. The HSBC checks were physically printed by an Instant Tax Service employee at the Corporate Instant Tax Service office.

An Instant Tax Service employee printed the duplicate checks. The duplicate checks had the 26 customers' names on them and were for the same amount that the customers had originally received. All of the 26 customers took their original HSBC loan check from Instant Tax Services and either deposited the checks into their own account or cashed them at a check cashing establishment.

After these 26 customers cashed their original loan checks, Ogbazion asked an employee of the Corporate Instant Tax Service office to reprint duplicates of those customers' checks. He told the Instant Tax Service employee to bring the duplicate checks over to the corporate headquarters. He then instructed a low-level employee in the corporate call center to sign the customers' names on the duplicate checks. After the call center employee forged the customers' signatures on the checks, Ogbazion instructed his CFO, Peter Samborsky, to deposit the forged checks into the company's corporate checking account. Samborsky deposited the forged checks. The forged duplicate checks totaled approximately $32,000. ITS Financial then used the money from the forged duplicate checks to operate the company. Prior to having the customers' names forged on the checks, Ogbazion did not get permission from the customers to sign their names. In fact, the customers did not even know that their names were being forged on duplicate checks. The forged checks were deposited on January 10, 2007. At that time, ITS Financial had no money in any bank account to operate the business.

When customers first approached ITS about the fraud, ITS made up stories to cover-up the forgeries. They told one customer at least that the forged checks were the result of a rogue employee, whom ITS Financial had fired due to the misconduct. Ogbazion also lied to one of his employees, Tina Davis, after she discovered the forgeries, telling her that the company's CFO was taking care of it. Ogbazion also told a false story to his leadership team about the forged HSBC checks in December 2009. He lied and said that allegations by one of the ITS customers, Robert Brown, whose signature was forged by ITS, were "completely made up."

HSBC began collection proceedings against Brown and took part of his following year's tax refund to pay for the forged check.

Ogbazion told another story about the HSBC checks to a small number of corporate executives at ITS Financial in June 2009. At that time, he fabricated a story claiming that HSBC had asked him to submit forged checks to help HSBC as part of a fraud detection program it was running. The HSBC fraud detection story was another lie that Ogbazion admitted at trial was a complete fabrication.

Failure to Pay Employment Taxes

Despite knowing he legally had to pay his company's employment taxes, Ogbazion did not pay them for the second two quarters of 2009, the first two quarters of 2010, and three additional quarters. Ogbazion knew it was important not to willfully fail to pay employment taxes. After Ogbazion failed to pay over $1,000,000 in employment taxes, he tried to settle the amount he owed by offering to pay the IRS $5,000 to settle all claims.

Paystub Filings

In January 2006, Ogbazion personally instructed two employees to file paystub prepared returns. The returns Ogbazion instructed the employees to file were prepared using paystubs when customers came in for a holiday loan. After customers were denied the loan, the returns were placed in "hold" status to be filed only if the customer returned with a W-2. Ogbazion nevertheless instructed the employees to submit these returns--which were prepared with paystubs ostensibly for the purpose of submitting a holiday loan application--to the IRS. The motivation at ITS's corporate-owned stores when filing with paystubs was to get the tax return filed to lock in the customer before he or she could go anywhere else. From ITS Financial's standpoint, it did not matter whether the tax return was done correctly. The point was just to get the tax return in.

Criteria for Injunction Against a Tax Preparation Firm

Under Code Sec. 7402, district courts have jurisdiction to issue injunctions. Under Code Sec. 7408, the IRS can seek to enjoin any person from further engaging in specified conduct. Specified conduct includes any action, or failure to take action, which is subject to penalty under Code Secs. 6700, 6701, 6707, or Code Sec. 6708. Code Sec. 6701 provides for the imposition of a penalty on any person (1) who aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document; (2) who knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws; and (3) who knows that such portion (if so used) would result in an understatement of the liability for tax of another person.

District Court's Opinion

The district court concluded that Ogbazion and ITS Financial provided aid, assistance, and advice to others in the preparation of tax returns that they knew, or had reason to believe, if used when preparing tax returns for customers, would result in understatement of tax liabilities on those customers' tax returns. Among the conclusions reached by the court were that Ogbazion and ITS Financial:

(1) prepared false tax documents, filed false documents with the IRS, and encouraged others to do so;

(2) held training sessions for their franchisees and ITS Financial area developers to prepare and file tax returns based on paystubs;

(3) instructed their franchisees how to back-date documents and change dates in computers used to prepare paystub returns to conceal the practice from federal investigators;

(4) instructed their franchisees how to create fake W-2s to place in customer files, as well as to dispose of paystubs used to prepare and file tax returns, to conceal the practice of paystub filing from the IRS;

(5) held off-the-record conference calls with select franchisees to ensure that they did not file too many paystub returns and attract attention from federal authorities; and

(6) filed tax returns for customers without their permission and encouraged their franchisees to do the same, in contravention of internal revenue laws.

The court noted that large-scale filing of paystub returns inevitably leads to the filing of returns that understate a taxpayer's liability, in addition to inevitably resulting in the submission of a false document to the IRS.

Based on the evidence presented at trial, the court concluded that an injunction against Ogbazion and ITS Financial under Code Sec. 7408 and Code Sec. 7402 was appropriate to prevent the recurrence of their conduct violating Code Sec. 6701.

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Interest Paid on Unrecorded Mortgage Isn't Qualified Residence Interest

A married couple failed to show that interest payments made to a family member pursuant to an unrecorded mortgage secured by their residence was qualified residence interest and thus, no deduction was allowed for the interest paid. DeFrancis v. Comm'r., T.C. Summary 2013-88 (11/6/13).

Christopher DeFrancis and his wife, Jennifer Gross, purchased real property in 2001 for $365,000. In 2003, Christopher and Jennifer signed a document described as a mortgage note in which they promised to pay Jennifer's mother, Joan, $425,000 plus interest in return for a mortgage loan. The note provided for a monthly interest payment. The full amount of the principal was due in 2033. The couple signed another document entitled "Mortgage" that provided that they were indebted to Joan for the principal sum of $425,000 and that granted a mortgage to Joan on the property. The documents were not notarized or recorded. In 2008, Christopher and Jennifer secured a $200,000 mortgage from TD Bank and did not disclose their indebtedness to Joan. That mortgage was secured by the property and recorded with the county Registry of Deeds. In 2009, the couple paid Joan $19,230. They treated the amount as deducible home mortgage interest on their tax return. They also paid $1,140 in mortgage interest to TD Bank, which they also deducted on their tax return.

On audit, the IRS noted that the home mortgage interest claimed by the couple exceeded the amount reported on Form 1098, Mortgage Interest Statement from TD Bank. In a notice of deficiency, the IRS disallowed the $19,230 paid to Joan and assessed an accuracy-related penalty.

Code Sec. 163 provides that generally a taxpayer may claim a deduction for all interest paid or accrued within the tax year on indebtedness. Individual taxpayers are prohibited from claiming a deduction for personal interest paid or accrued during the tax year with an exception for qualified residence interest. Qualified residence interest is defined as interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. Acquisition indebtedness is any indebtedness incurred in acquiring a qualified residence of the taxpayer and that is secured by such residence. One of the requirements of being a secured debt is that the debt must be recorded, where permitted, or otherwise perfected in accordance with state law.

The Tax Court held that Christopher and Jennifer failed to show that the payments made to Joan in 2009 were qualified residence interest. As a result, the interest deduction of $19,230 was disallowed. There was no dispute that the property was the couple's principal residence or that the couple's interest in the property was the specific security for the payment of the debt to Joan. However, because the mortgage to Joan was unrecorded, Joan did not have priority in the event of default over the recorded TD Bank mortgage because TD Bank did not have actual notice of the unrecorded mortgage. The court noted that, although the mortgage may be valid and enforceable under state (Massachusetts) law as between the couple and Joan, the couple failed to show that the mortgage was otherwise perfected under state law and, therefore, was a secured debt.

The court concluded, however, that Christopher and Jennifer were not liable for the accuracy-related penalty for substantial understatement of income tax. The IRS did not assert that the loan was fiction or otherwise fraudulent. In addition, although the loan failed to satisfy the requirements of a secured loan, the couple acted with reasonable cause and in good faith in claiming the interest deduction.

For a discussion of qualified residence interest, see Parker Tax ¶83,515.

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Mortgage Broker's Securities Trading Losses Denied

A mortgage broker failed to establish that she was in the trade or business of buying or selling securities on her own account and, thus, expenses claimed for her trading activities were disallowed and an accuracy-related penalty for substantial underpayment of tax was imposed. Nelson v. Comm'r, T.C. Memo. 2013-259 (11/15/13).

In 2005 and 2006, Sharon Nelson was the sole shareholder of Clear Concepts, Inc., a C corporation, which was engaged in the mortgage broker business. Sharon worked as a mortgage broker and, in return for her services, she was paid wages. John Zabasky, who was living with Sharon, was the chief executive officer and sole shareholder of SoftEx, Inc. John was involved in the trading of stocks, bonds, and currencies. During those years, Sharon executed trades of securities on an investment account she maintained. She had no clients on any trades she executed from her investment account. In 2005, of the 250 trading days available, 535 trades were executed on Sharon's investment account. The holding period for securities traded on her account ranged from one to 48 days. There were eight periods of time when no purchases or sales occurred on Sharon's investment account. The trades executed on Sharon's investment account generated over $470,470 of net short-term capital gain for that year. In 2006, of the 250 available trading days, 235 trades were executed on Sharon's investment account. With respect to the amount of money involved in the trades, (1) during 2005, Susan had purchases of approximately $32.5 million and sales of approximately $32.9 million, and (2) during 2006, Susan had purchases of approximately $24.2 million and sales of approximately $24.3 million. The holding period for securities traded on her account ranged from one to 101 days. There were seven periods when no purchases or sales occurred on Sharon's investment account. The trades executed on Sharon's investment account generated over $36,850 of net short-term capital gain for that year.

Sharon filed Form 1040 for 2005 and 2006 and included Schedule C, Profit or Loss From Business, with each of her returns. She described her principal business or profession as a stock or securities trader. On her Schedule C, Sharon claimed business-related expenses for advertising, travel, depreciation, interest, rent, supplies, taxes, and other expenses in connection with buying and selling securities for her own account. The IRS issued a notice of deficiency, disallowing all the expenses claimed on her Schedule C and imposing an accuracy-related penalty.

Sharon argued that she was a trader in the business of purchasing and selling securities on her own account and thus entitled to the losses. The IRS contended that Sharon was an investor in securities and the losses should be disallowed.

The Tax Court held that Sharon was not engaged in the trade or business of buying and selling securities on her own account and disallowed the deductions relating to her trading activities. The court cited King v. Comm'r., 89 T.C. 445 (1987), in which the Tax Court found that an individual who purchases and sells securities may be either a trader, dealer, or investor. A trader is someone who engages in the business of purchasing and selling securities on his or her own account. Generally, a trader reports losses as ordinary losses and thus is not limited by the capital loss rules. The court also noted that, in Endicott v. Comm'r., T.C. Memo. 2013- 199 (2013), it held that, although an investor purchases and sells securities on his or her own account, an investor is not considered to be in the trade or business of purchasing and selling securities. There was no dispute that Sharon was not a dealer. In evaluating the number of trades executed each year, the court found that Sharon's trading activities during the years at issue were not substantial in that they were not frequent, regular, and continuous enough to qualify as a trade or business. The court said that, while the amounts of purchases and sales were considerable, the amounts were not determinative of whether Sharon's securities trading activities were substantial. The court noted that, although both Sharon and John executed trades on Sharon's investment account, it could not determine how many trades were executed by Sharon and how many trades were executed by John. However, the court said, assuming Sharon executed all the trades, it would nonetheless find on the record that she failed to establish that she was engaged in the trade or business of buying and selling securities on her own account. The court concluded that the number of trades executed on Sharon's account for each year were not substantial.

Finally, Sharon was liable for the accuracy-related penalty for substantial underpayment of tax. Her testimony that she made a reasonable attempt to comply with the tax laws was unsubstantiated and not credible, and the court concluded that she failed to show that she acted with reasonable cause and in good faith regarding her underpayments of tax.

For a discussion of the rules relating to trader, investors, and dealers in securities, see Parker Tax ¶242,355.

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Officer Who Received Substantial Assets from Company While Taxes Remained Unpaid Is Liable for Responsible Person Penalty

The officer of a corporation was a responsible person, liable for trust fund recovery penalties, because she had the effective power to pay the trust fund taxes of the business and also received substantial assets from the corporation while payroll taxes remained unpaid. Johnson v. U.S., 2013 PTC 334 (4th Cir. 11/5/13).

In 1969, Ford Johnson formed a nonprofit corporation, Koba Institute, Inc., to perform various government contracts in conjunction with Koba Associates, Inc., a for-profit corporation that he owned and managed. When Koba Associates failed to pay its payroll taxes in the mid-1990s, the IRS assessed trust fund recovery penalties under Code Sec. 6672 against Ford. The outstanding payroll taxes, accompanied by the lien subsequently imposed on Ford for the trust fund recovery penalties, ultimately led Ford to close Koba Associates. The presence of the lien severely limited his ability to obtain credit for Koba Institute.

Ford then approached his wife, Mary, about restructuring Koba Institute so as to facilitate a continuation of their business. In 1998, Koba Institute converted to a for-profit corporation under Maryland law, with Mary as its sole shareholder. According to the couple, because they had agreed that Mary would be the primary caregiver of the couple's children, she "delegated" and "entrusted" her authority in the corporation to her husband, and thereafter elected Ford as president of Koba Institute. Mary, in turn, served as the corporation's vice president.

Although her involvement at Koba Institute was limited during the 2001 through 2004 period, Mary had an office at Koba Institute and received a significant annual salary ranging from approximately $100,000 to $193,000, as well as a corporate car and cell phone. Koba Institute also paid the rent for the Johnsons' home, totaling between $40,000 and $50,000 in 2001, 2002, and 2004.

Near the end of 2004, Mary received a notice from the IRS that Koba Institute had not paid its payroll taxes for several quarters from 2001 through 2004. Before that time, Mary was unaware that the payroll taxes were unpaid. Upon receiving the notice, Mary had "a serious talk" with her husband and told him that the situation was "unacceptable" and that Koba Institute had to take steps to make sure that it did not happen again. She then fired the finance director, who had been tasked with making payroll tax payments and directed her husband to personally handle all future tax payments as of January 2005. Due to Mary's revamped oversight of tax payments, Koba Institute began remitting its post-2004 payroll taxes to the IRS in full and, generally, on time. The corporation did not, however, pay the outstanding delinquent payroll taxes for the 2001 through 2004 delinquent periods.

Subsequently, the IRS assessed trust fund recovery penalties against Mary and her husband, individually, pursuant to Code Sec. 6672. Mary paid part of the assessment and filed suit in a district court to obtain a refund. The IRS filed a counterclaim seeking to recover $304,000 from Mary and $240,000 from Ford. The IRS contended that each was liable for the penalty as a responsible person who had willfully failed to pay over the withheld payroll taxes. The district court upheld the IRS's assessment, and the couple appealed to the Fourth Circuit.

The Fourth Circuit affirmed the district court's holding and held that the IRS presented undisputed evidence that established as a matter of law that Mary was a responsible person under Code Sec. 6672 during the relevant tax periods because she had the effective power to pay the trust fund taxes of Koba Institute.

While she may not have been running the day-to-day operations of the corporation between 2001 and 2004, the court stated, Mary had a non-delegable responsibility to monitor Koba Institute's financial affairs. Mary had the effective power to exercise authority when she chose to do so, even though she chose at times to voluntarily limit her involvement in corporate affairs. The court noted that, although Mary often chose not to exercise the authority she possessed, such a decision is insufficient to permit a taxpayer to avoid Code Sec. 6672 responsibility.

Further, the court stated, the fact that Mary was knowingly receiving substantial assets from the corporation while the payroll taxes remained unpaid bolstered the proof of her "responsible person" status.

For a discussion of the responsible person penalty under Code Sec. 6672, see Parker Tax ¶210,108.

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Bad Debt Deduction Denied Where There Was No Legal Obligation to Pay Debt

An engineer and his wife could not take a business bad debt deduction for a payment made by the husband's limited liability company (LLC) to satisfy the debt of a second company that he owned because the couple failed to show that the LLC was legally obligated to satisfy the debt. Herrera v. Comm'r, 2013 PTC 352 (5th Cir). Read more...

IRS Appeals Officer Could Not Unilaterally Accept Musician's OIC after His Nonpayment of Taxes Was Referred to DOJ

An IRS Appeals Officer could not unilaterally accept an offer in compromise from a popular entertainer after his nonpayment of taxes was referred to the Department of Justice; however, the Appeals' determination to sustain the notices of levy and proceed with collection was rejected, and the case was remanded to Appeals to explore the possibility of a new OIC or installment agreement. Isley v. Comm'r., 141 T.C. No. 11 (11/6/13).

Ronald Isley was a founding member of the Isley Brothers singing group, which generated substantial income from personal appearances and record sales. From 1971 to 1995, Ronald failed to pay federal income taxes on his music income. Ronald filed for bankruptcy in 1984 and 1997. The IRS sought the collection of unpaid taxes for 1971 to 1995 with the exception of the years for which it filed proofs of claim in Ronald's two bankruptcy proceedings. A settlement was approved in which Ronald made a $2 million payment to the IRS that was applied to his outstanding liabilities for the years at issue. In 2002, Ronald filed a refund claim challenging the application of payments in his first bankruptcy. The refund claim was dismissed on the basis of lack of standing, failure to state a refund claim, and res judicata.

Ronald was convicted of tax evasion and willful failure to file returns with respect to 1997 to 2002. He was sentenced to prison and a three-year probationary period after which he was required to pay his tax liabilities. In 2006, the IRS issued notices of lien and levy for Ronald's assessed tax liabilities for 1997-2004 and 2006. Ronald requested a collection due process (CDP) hearing with an Appeals officer, which resulted in an offer-in-compromise (OIC) and accompanying 20 percent payment under Code Sec. 7122. The Appeals officer preliminarily accepted the OIC and submitted it to the Office of Chief Counsel for review. The Chief Counsel's Office rejected the OIC because Ronald's unpaid taxes were referred to the Department of Justice (DOJ) for prosecution, so the IRS was prohibited from unilaterally compromising Ronald's liabilities for those years. In addition, the Appeals officer overlooked potential sources for collection of back taxes. Ronald filed a petition seeking reinstatement of the OIC, renewing his refund claim regarding the allocation of payments in his first bankruptcy, and requesting a refund of the 20 percent partial payment he made on the grounds that he was induced to submit the OIC under false pretenses.

Code Sec. 6331 authorizes the IRS to levy against property when a taxpayer liable for taxes fails to those taxes within 10 days of notice and demand for payment. The IRS is required to notify a taxpayer of his right to a CDP hearing before the Appeals Office at least 30 days for any levy begins. At the hearing, the taxpayer may raise any relevant issue, including collection alternatives. Code Sec. 6330 provides that the Appeals officer must determine whether and how to proceed with collection. The taxpayer may dispute the underlying tax liability at the hearing if he did not receive a notice of deficiency or have an opportunity to dispute it. Under Code Sec. 7122, the IRS is allowed to compromise any civil or criminal case arising under the Internal Revenue laws before referral to the DOJ for prosecution or defense, and after the referral to the DOJ, the Attorney General may compromise any such case.

Ronald sought to have the OIC reinstated on the ground that (1) Code Sec. 7122(a) did not prohibit the Appeals officer from entering into an OIC; (2) the Chief Counsel attorney's involvement effectively made him the "de facto" Appeals officer, and, because of his earlier involvement in Ronald's second bankruptcy case, his involvement in the CDP hearing violated the "impartial officer" requirement of Code Sec. 6330(b)(3); and (3) as the "de facto" Appeals officer, his improper ex parte communications with non-Appeals IRS personnel required that the Tax Court disregard his rejection of the OIC and ratify Appeals' initial acceptance of it. The IRS contended that the Appeals Officer had no authority to accept Ronald's OIC because it sought to compromise tax liabilities for years that had been referred to the DOJ for prosecution.

The Tax Court held that, after Ronald's nonpayment of tax was referred to the DOJ for prosecution, the Appeals Office could no longer unilaterally accept his OIC, although the terms of a potential OIC could be negotiated. The court looked to case law in U.S. v. Jackson, 511 Fed. Appx. 200 (3d Cir. 2013) and Faust v. U.S., 28 F.3d 105 (9th Cir. 1994), which found that once a taxpayer's case is referred to the DOJ for prosecution, the IRS loses authority to compromise the tax liabilities unless authorized by the DOJ. Any compromise of Ronald's tax liabilities would have violated the sentencing order that required Ronald to pay his liabilities in full. The court noted that prior approval of the OIC was not sought by either Ronald or the Appeals officer. Further, since the Appeals Office could not unilaterally accept the OIC, the Chief Counsel's determination to reject the OIC, whether proper or not, was inconsequential. Therefore, Ronald's arguments that the Chief Counsel became a de facto Appeals officer, violated the impartial officer requirement of Code Sec. 6330(b)(3), or engaged in improper ex parte communications between Appeals and non-Appeals office personnel, were moot.

The court also held that Ronald was not entitled to a refund of the 20 percent partial payment required by Code Sec. 7122, since he presented no evidence of false representation or fraudulent inducement to submit the OIC. In addition, Ronald represented in the OIC that he voluntarily submitted the payment with the offer and acknowledged that the tax payments were nonrefundable.

Finally, the determination of the Appeals Office not to withdraw its notices of federal tax lien was sustained due to its good faith processing of the OIC. However, the court rejected the Appeals Office determination to sustain its notices of levy and proceed with collection as premature and remanded the case to the Appeals Office to consider the possibility of a new OIC or installment agreement, which may not be finalized until approved by the DOJ.

For a discussion of offers in compromise, see Parker Tax ¶263,165.

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Travel Guide and Video Sales Activities Weren't Engaged in For Profit, Tax Court Holds

While the taxpayers sincerely hoped to profit from their travel guide and video sales activities, that was not their primary motive for engaging in those activities, and they did not in fact engage in those activities for profit. Geyer v. Comm'r, T.C. Summary 2013-90 (11/14/13).

John Geyer and Christin Wildfeuer are avid travelers. While traveling in Mexico in 1999, they learned about Adventure Caravans, an RV tour company. For each trip, Adventure Caravans contracts with independent contractors to serve as the wagon master or the tailgunner. The wagon master has primary responsibility for running the trip. The tailgunner is an assistant who follows the RVs and helps resolve any problems that arise. For each trip, Adventure Caravans gives the wagon master a budget. Wagon masters are strongly advised to stay within this budget and must personally pay for unjustified cost overruns. In addition, wagon masters and tailgunners receive tips from customers.

After learning of Adventure Caravans, John and Christin went to work for the company. The couple went on their first trip with Adventure Caravans in 2000. For each year thereafter, they led tours for Adventure Caravans, until their last trip in 2008. In addition to guiding RV tours, the couple also created videos of the trips, which they sold as tour memorabilia. To learn about filmmaking, John and Christin attended seminars about creating successful videos and sought advice from the company from which they purchased their video equipment. The couple edited, narrated, and added music to the video footage of customers engaging in tour activities. In addition to selling the videos, John and Christin used them for marketing purposes. The couple stopped touring with Adventure Caravans after 2008 because it was not profitable and because Adventure Caravans did not offer them any more trips to lead. In their Schedules C, Profit or Loss From Business, for their travel guide activity for 2003 to 2009, the couple reported losses for each year except one, where they reported a profit of $615.

The Tax Court held that John and Christin's travel guide and video sales activities were not activities engaged in for profit and thus the losses relating to those activities were not deductible. The court looked at the various factors involved in determining if an activity is engaged in for profit. The personal pleasure or recreational aspect of the couples' activities was undeniable, the court said, and that weighed against them, as did most of the other factors. Further, the Tax Court noted that it routinely holds that no primary profit motive exists where international travel is involved. The court cited Wright v. Comm'r, 31 T.C. 1264 (1959), aff'd, 274 F.2d 883 (6th Cir. 1960), in which it held that a couple was not entitled to deduct the costs of a trip around the world as ordinary and necessary expenses of writing a book about such travels, since they had multiple purposes for making the trip, including their personal interest and enjoyment. The court also cited Bentley v. Comm'r, T.C. Memo. 1988-444, where it held that the taxpayer could not deduct the costs of travel to Europe as ordinary and necessary business expenses of selling photographs from his trip.

For a discussion of the factors examined by the courts to determine if an activity is engaged in for profit, see Parker Tax ¶97,505.