Federal Tax Bulletin - Issue 134 - February 16, 2017

Engineering Company Fails Two-year Test for Exception to Percentage of Completion Accounting Method

The Tax Court held that an engineering company couldn't use the completed contract method of accounting to report income from contracts to move, refurbish, and reassemble refineries in Bulgaria and Pakistan. The company was required to use the percentage of completion method because the construction contract exception to the percentage of completion method didn't apply because the company could not have estimated that the contracts would be completed within two years. Basic Engineering Inc. v. Comm'r, T.C. Memo. 2017-26.

Background

Basic Engineering (Basic) designed, refurbished, and delivered crude oil processing and refining systems to customers around the world. Upon auditing the company, the IRS was concerned with the proper accounting treatment for two of Basic's contracts that were ongoing in 2009 and 2010: (1) a contract to reconstruct an oil refinery in Bulgaria (the Petromaxx contract); and (2) a contract to transport, refurbish, and reassemble an oil refinery in Pakistan (the Amber contract). Since its incorporation in 2004, and during the tax years at issue, Basic accounted for its long-term contracts using the completed contract method of accounting.

General Long-term Contract Rules

Under Reg. Sec. 1.446-1(c)(1), taxpayers can compute taxable income under the (1) cash method, (2) accrual method, (3) other permissible special method, or (4) any combination of these methods. The long-term contract method fits within categories (3) and (4) because it is a permissible special method explicitly referenced in Reg. Sec. 1.446-1(c)(1)(iii), but only applies to the taxpayer's long-term contracts and so is used in tandem with the taxpayer's overall method (cash or accrual) of accounting for other, non-long-term contract items of income or expense.

Code Sec. 460(f)(1) defines a long-term contract as a contract for the manufacture, building, installation, or construction of property that is not completed within the tax year it is entered into. The general rule under Code Sec. 460(a) is that taxable income from long-term contracts must be recognized over the life of the contract using the percentage of completion method of accounting. The percentage of completion method requires taxpayers to recognize income and expenses over the life of the contract based on the percentage of the contract that is completed each year. However, certain contracts are excluded from the requirement of reporting income under the percentage of completion method. Code Sec. 460(f)(2) excludes certain manufacturing contracts, and Code Sec. 460(e)(1)(B) excludes certain construction contracts, from being reported under the percentage of completion method.

Exception for Manufacturing Contracts

Manufacturing contracts generally are not treated as long-term contracts. But if a contract involves the manufacture of an item that normally requires more than 12 calendar months to complete, the contract is subject to Code Sec. 460. The two contracts in this caseeach for the disassembly, transportation, refurbishing, and reassembly of an oil refinerywould normally require more than 12 calendar months to complete.

Exception for Construction Contracts

In some cases, construction contracts can be accounted for under a method other than the percentage of completion method, including the completed contract method. The construction contract exception applies in pertinent part when the taxpayer can estimate, when the contract is entered into, that it will be completed within the two-year period beginning on the contract commencement date. The "contract commencement date" is defined by Reg. Sec. 1.460-1(b)(7) as the first date that costs allocable to the contract (other than costs incurred in bidding for and/or negotiating the contract) are first incurred.

Contract Completion within Two Years from Commencement Date

For Basic to be eligible for the construction contract exception, it must have reasonably estimated, when each contract was entered into, that the project would be completed within two years from its commencement date. According to Reg. Sec. 1.460-1(f)(4)(i), to be reasonable "an estimate of the time required to complete the contract must include anticipated time for delay, rework, change orders, technology or design problems, or other problems that reasonably can be anticipated . . . . A contract term that specifies an expected completion or delivery date may be considered evidence that the taxpayer reasonably expects to complete or deliver the subject matter of the contract on or about the date specified, especially if the contract provides bona fide penalties for failing to meet the specified date."

Taxpayer's and the IRS's Positions

From 2005 through 2010, Basic accounted for the Petromaxx and Amber contracts using the completed contract method of accounting. As a result, its policy was to recognize all income and expenses associated with the contracts in the year of the contract's completion. Because Basic contended that the contracts were not yet completed, it did not report income or expenses from either contract for 2009 or 2010, the two tax years at issue (or any earlier year either).

In its notice of deficiency, the IRS determined that Basic must account for both contracts using the percentage of completion method because it could not have estimated that either contract would be completed within two years of the contract commencement date. The IRS adjusted Basic's gross receipts and cost of goods sold for the percentage of the contracts completed in 2009 and 2010. The IRS determined that Basic completed 84.23 percent of the Petromaxx contract and 34.33 percent of the Amber contract in 2009, and 84.39 percent of the Petromaxx contract and 34.36 percent of the Amber contract in 2010.

The IRS multiplied those percentages by the estimated total contract price to arrive at the amounts Basic should have recognized as income had it accounted for the contracts using the percentage of completion method.

Tax Court's Decision

The Tax Court held that Basic was required to use the percentage of completion method to report income from the Petromaxx and Amber contracts.

As an initial matter, the Tax Court concluded that both contracts met the definition of "long-term contracts" and thus were governed by Code Sec. 460. The court then had to determine the reasonableness of Basic's estimate of the time it would take to complete each contract. The Tax Court was not required to make this determination based on the contract alone. Where, as here, the parties disagree on whether the two-year rule was met, the Tax Court can look back to the time the contract was entered into and consider all the facts and circumstances in deciding whether the estimate was reasonable. The court noted the following about the different contracts.

Petromaxx Contract: Although Basic and Petromaxx executed the contract on October 28, 2006, the first date that Basic incurred costs allocable to the contract was March 22, 2006, when Basic purchased the refinery. The contract did not contain a project schedule but did require Basic to "use its best efforts" to deliver the last unit to its facility in Houston by April 30, 2007. If Basic failed to do so, there were no penalties. But if Basic failed to deliver the last unit on or before September 12, 2007, it would default under the terms of the contract. At some point during the course of the project, Petromaxx lost its financing and was unable to pay Basic. At the time of trial, the dismantled units from the refinery were still in Basic's construction yard in Texas. The parties disagreed on whether Basic reasonably estimated that the Petromaxx contract could be completed within two years from the March 22, 2006, commencement date. The IRS relied on the terms of the contract and expert testimony that three years was an optimistic estimate of the time required to complete a project like this one. Basic countered that 3-D laser scanning and a parallel processing system allowed it to reasonably estimate that the project would be completed within two years.

The Tax Court concluded that even if the April 30, 2007, best efforts date, and not the September 12, 2007, default date, was the relevant delivery date, the Petromaxx project could not have been completed within two years from March 22, 2006. The time between the commencement and best efforts dates was 13 months, and once the units were delivered, it would take six months to ship them from Texas to Bulgaria. Upon receipt of all of the units, it would take Petromaxx 12 months to assemble the refinery; and once the refinery was assembled, it would take approximately 2months to commission and conduct performance tests. In total, a project similar to the Petromaxx refinery project would take over 33 months to complete using traditional industry practices.

Importantly, Basic did not produce any witnesses, other than its president, or provide documentary evidence that "reflect a meeting of the minds between the parties to use a parallel processing system, or even explain how much time parallel processing would save."

Amber Contract: While Basic and Amber executed the contract on July 17, 2008, the first date that Basic incurred costs allocable to the contract was July 24, 2008, when Basic purchased the desired refinery. The contract did not contain a project schedule but did require Basic to deliver the last unit no later than November 15, 2010. Basic was entitled to bonus payments if the delivery date for the units occurred before November 15, 2010, and subject to penalties if the delivery date occurred after November 15, 2010. On January 18, 2010, the parties agreed to cancel the deal. At the time of trial, the fluid catalytic cracker unit was in Basic's construction yard in Texas, and the refinery units were still in Northern Cyprus.The parties again disagreed on whether Basic reasonably estimated that the Amber contract could be completed within two years from the July 24, 2008, commencement date. The IRS pointed to its expert's testimony that 4years was an optimistic estimate of the time required to complete such a project. Basic countered that 3-D laser scanning and a parallel processing system allowed it to reasonably estimate that the contract would be completed within two years.

The Tax Court noted that the Amber contract clearly stated that Basic was required to deliver the last unit by November 15, 2010, which was approximately 28 months after the July 24, 2008, commencement date. Basic was subject to penalties if it failed to meet this deadline, and was entitled to a bonus if it met this deadline. While the court considered the president's testimony on the benefits of a parallel processing system, there was no evidence of an intent to use a parallel processing system, or how much time that parallel processing would save.

The Tax Court concluded that Basic did not prove that it reasonably expected, at the time it entered into either contract, that it would complete the contract within two years from its commencement date. Therefore, it was not eligible for the construction contract exception to the percentage of completion method of accounting.

Section 6662(a) Accuracy-Related Penalties

Basic argued that it was not liable for the Code Sec. 6662 accuracy-related penalty because, "in view of the complexity of [Code Sec.] 460 and the accompanying regulations, it made a good-faith effort to comply." Under Code Sec. 6664(c), the penalty does not apply to any portion of an underpayment if there was reasonable cause and the taxpayer acted in good faith. One way that reasonable cause can be shown is by establishing reliance on professional advice. However, there was no evidence that Basic requested or received any advice from its CPA concerning the application of the long-term contract exception under Code Sec. 460(e) to either project.

Although other circumstances can establish reasonable cause and good faithsuch as an honest misunderstanding of the facts or law that is reasonable based on the experience, knowledge, and education of the taxpayerBasic's president did not did not provide concrete examples of previous projects he had worked on to support his claim that the Petromaxx and Amber contracts could be completed within two years. In fact, he agreed with the IRS expert's estimates of each project's duration to the extent they were based on traditional (non-parallel processing) industry practices.

The Tax Court concluded that Basic did not act with reasonable cause and in good faith when it accounted for the two contracts using the completed contract method of accounting. Accordingly, the court sustained the IRS's imposition of the accuracy-related penalties for 2009 and 2010.

For further discussion of the long-term contract method of accounting, see Parker Tax ¶245,600.

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Taxpayers Improperly Deducted Legal Fees Related to Former Employment as Negative "Other Income"

The Tax Court held that a taxpayer's legal fees should not have been reported as negative "Other Income", but instead as miscellaneous itemized deductions subject to the 2 percent of AGI floor. Sas v. Comm'r; T.C. Summary 2017-2.

Background

In 2008, Seattle Bank hired Ellen Sas as president and chief executive officer. In July 2010, they paid Ms. Sas a change-of-control bonus of $612,000. In September 2010, the bank terminated Sas' employment, and two months later sued her for breach of fiduciary duty and attempted to recover the entire bonus. In January 2011, Sas countersued, claiming employment discrimination.

The lawsuit was settled in May 2011, with the bank and Sas paying each other nothing and agreeing to release all claims against each other. Ms. Sas paid $25,000 and $55,798 in legal expenses associated with this lawsuit in 2010 and 2011, respectively.

During 2010 and 2011, Sas and her spouse Roger Jones maintained an accounting and consulting business ("accounting business"), although the record was unclear on who owned the business and Sas' role in the business. Sas and Jones filed a Schedule C with their 2010 Form 1040, reporting Jones as the sole proprietor. For the 2011 tax year, they reported no Schedule C income but did report $293,385 of income from the accounting business on Schedule E.

On their Forms 1040 for 2010 and 2011, the couple reported negative amounts of "Other Income" of $25,000 and $55,798, respectively, for the legal fees paid to settle the Seattle Bank lawsuit. The IRS disallowed the negative Other Income, but allowed the amounts as miscellaneous itemized deductions subject to the 2 percent of adjusted gross income (AGI) floor in Code Sec. 67(a). This treatment reduced the deductible amounts to $4,525 and $50,579 for 2010 and 2011, respectively. The taxpayers timely petitioned the Tax Court for redetermination.

Analysis

At trial, the taxpayers did not press their claim that the legal fees were deductible as negative Other Income. Instead, they argued that the legal fees were fully deductible under either Code Sec. 62(a)(20) because they were paid in connection with an action involving a claim of unlawful discrimination, or Code Sec. 162 as ordinary and necessary expenses of their accounting business. The IRS argued that the legal fees were deductible on Schedule A as miscellaneous itemized deductions under Code Sec. 67(a).

Code Sec. 62(a)(20) allows a deduction for legal fees and court costs in connection with any action involving a claim of unlawful discrimination as defined in Code Sec. 62(e). Code Sec. 62(e) defines "unlawful discrimination" to include a number of specific federal statutes, federal whistleblower statutes, and any federal, state, or local law "providing for the enforcement of civil rights, or regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law."

However, the deduction under Code Sec. 62(a)(20) cannot exceed the amount includible in the taxpayer's gross income for the tax year on account of the judgment or settlement (whether by suit or agreement and whether as a lump sum or periodic payments). The taxpayers attempted to get around this limitation by arguing that Sas included the bonus as income when it was received and was able to retain the bonus because of her countersuit. By this thinking, her bonus was included in the couple's gross income on account of a judgment or settlement relating to her action.

In rejecting this argument, the Tax Court noted that Sas' bonus was received and includible in gross income because of her employment with Seattle Bank, and under the terms of the settlement agreement, neither party received any amount includible in gross income. Therefore, the gross income limitation on the amount of the deduction was zero under Code Sec. 62(a)(20).

The taxpayers argued, in the alternative, that the legal fees were deductible as ordinary and necessary business expenses under Code Sec. 162. Citing the Supreme Court in U.S. v. Gilmore, 372 U.S. 39 (1963), the Tax Court stated that the deductibility of legal fees under Code Sec. 162 depends on -

(1) the origin and character of the claim for which the legal fees were incurred; and

(2) whether that claim bears a sufficient nexus to the taxpayer's business or income-producing activities.

There taxpayers did not argue that Sas' claim was rooted in their accounting business, but rather that the lawsuit would have an adverse effect on Sas' professional reputation which in turn could damage the reputation of the accounting business.

The Tax Court addressed a similar contention in Test v. Comm'r, T.C. Memo. 2000-362, which was affirmed by the Ninth Circuit. In that case, the taxpayer pursued legal claims related to her employment with the University of California, San Francisco, in part because she feared harm to her reputation which in turn would harm a business she operated independently of her position at the university. The Tax Court looked to the origin of the claim and disregarded the taxpayer's motives. Because the claim originated in her employment with the university and not her involvement in the separate business, the legal fees were properly treated as miscellaneous itemized deductions on Schedule A.

While acknowledging that the clawback of Sas' bonus may have harmed her professional reputation and the taxpayers' accounting business, the court focused on the origin of the claim and not the potential consequences of a win or loss. The court noted that Sas' claims arose from her status as a former employee of Seattle Bank, and she hired an attorney because Seattle Bank was attempting to claw back the bonus she received in connection with her employment at the bank. Therefore, taxpayers could not deduct the legal fees as ordinary and necessary business expenses of their business under Code Sec. 162.

Accordingly, the court sustained the IRS's position that the fees were deductible only as miscellaneous itemized deductions subject to the 2 percent floor.

For additional discussion on deducting legal fees, see Parker Tax ¶80,185.

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Return Preparer Liable for Penalty After Failing to Perform Due Diligence

The Court of Federal Claims held that a tax preparer was liable for a $2,500 penalty after failing to perform due diligence with respect to a return on which an earned income credit was claimed. Testimony indicated that the return preparer told the taxpayer that she could receive a tax refund if she reported additional income on her return rather than just the $16 that her W-2 showed. Foxx v. U.S., 2017 PTC 46 (Fed. Cl. 2017).

Background

In February 2008, Shakeena Bryant went to Dr. George Foxx for assistance in preparing her 2007 tax return. She was accompanied by a friend, Herman James. Foxx held himself out as the "Tax Doctor" and claimed to have more than 37 years of tax preparation experience and to have prepared over 7,000 tax returns between 2004 and 2014. Bryant brought her W-2, which indicated that she had received a total of $16 in 2007 from a brief employment at Busch Gardens, and information regarding her children. She did not bring any documents indicating additional income.

According to Bryant and James, Foxx told Bryant that she could receive a tax refund if she reported additional income from a business. Bryant left Foxx's office, applied for and received a business license for auto detailing, and returned to Foxx's office that same day with the license. Foxx then prepared Bryant's tax return and reported $18,288 in business income from Bryant's purported auto-detailing business. As a result, Bryant qualified for earned income tax credits and received a refund of $2,577 from the IRS. Bryant paid Foxx $169 as a tax preparation fee.

The IRS subsequently audited Bryant's tax return. In the course of that audit, Bryant stated that she had never owned an auto-detailing business. She told the IRS that her 2007 tax return was incorrect, while also stating that she reported her false business income under the instructions of Foxx. The IRS then contacted Foxx, who responded in March 2009 that he reasonably relied upon the statements of Bryant and exercised due diligence in preparing her return. Foxx also provided Bryant's auto-detailing business license and two pages of handwritten notes, written by Foxx, relating to that business.

In May 2009, the IRS imposed a $5,000 tax return preparer penalty on Foxx under Code Sec. 6694(b) for his willful, or reckless or intentional disregard of a rule or regulation in preparing Bryant's inaccurate 2007 tax return. According to the IRS, this conduct caused an improper tax refund to be issued to Bryant. Foxx filed a pre-assessment appeal in which he stated that he relied upon the verbal statements of Bryant regarding her business income. Subsequently, the IRS reduced Foxx's penalty to $2,500.

Foxx paid the $2,500 penalty in April 2012 and then filed a claim for a refund of that penalty through submission of a Form 843, Claim for Refund and Request for Abatement. The IRS denied the claim and Foxx filed suit in the Court of Federal Claims, seeking to recover the $2,500 penalty he paid to the IRS. In his complaint, Foxx alleged that he followed the rules of due diligence and acted in good faith and therefore the penalty should not have been imposed.

Court of Federal Claims Upholds IRS Penalty

Code Sec. 6694(b) provides in part that a penalty will be assessed on any tax return preparer who prepares a tax return with respect to which any part of an understatement of liability is due to a willful attempt in any manner to understate the liability for tax on the return or claim, or a reckless or intentional disregard of rules or regulations. Under Code Sec. 6694(e), the term "understatement of liability" is defined as any understatement of the net amount payable with respect to any income tax imposed or any overstatement of the net amount creditable or refundable with respect to any such tax.

The validity of the penalty under Code Sec. 6694, the Federal Claims Court stated, depended on whether (1) Foxx prepared Bryant's 2007 tax return, (2) Bryant's return contained an understatement of liability, and (3) such understatement was due to Foxx's willful action or his reckless or intentional disregard of rules or regulations. The first two elements, the court noted, were undisputed.

During the trial, both Bryant and James stated that Bryant obtained a business license pursuant to Foxx's instruction. According to James, Foxx explained that such a license would allow him to obtain more money for Bryant, and Foxx, not Bryant, created the false business income that appeared on Bryant's tax return.

The Federal Claims Court held that tax preparer penalty assessed against Foxx was justified. The court noted that, under the regulations, Foxx was required to perform due diligence before filing Bryant's tax return for earned income credits and he intentionally or recklessly disregarded tax preparer rules and regulations. This due diligence, the court observed, included an obligation to make reasonable inquiries if the information furnished to, or known by, Foxx appeared to be incorrect, inconsistent, or incomplete.

The Court Declines to Sanction the IRS for Subpoena

Before the beginning of the trial, the government sent a subpoena to Nova Southeastern University to verify Foxx's claim that he had received a doctorate from that university. Foxx argued that the government, through this subpoena, "sought irrelevant evidence," requested the "disclosure of privileged or other protected information," and hindered Foxx's ability to be hired by Nova Southeastern University in the future. He further asserted that the subpoena served no purpose but to hurt him. The IRS countered that it reasonably sought independent information about the legitimacy of Foxx's claimed credentials and his credibility and that such information was relevant to the case. Foxx asked the Court of Federal Claims to sanction the IRS for its inquiry to Nova Southeastern University.

The court also rejected Foxx's request to sanction the IRS. The court concluded that the IRS's request for information from Nova Southeastern University was permissible and sanctions were not appropriate.

For a discussion of the tax preparer penalty under Code Sec. 6694(b), see Parker Tax ¶276,315.

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Payments by Failing S Corporation to Shareholder Were Distributions, Not Wages or Expense Reimbursements

The Tax Court concluded that payments by a failing law firm to its shareholder were not wages as the IRS contended, and were not reimbursements for expenses as the shareholder argued, but instead were a nontaxable return of capital to the extent of the shareholder's basis. Goldsmith v. Comm'r, T.C. Memo. 2017-20.

Background

Scott Goldsmith practiced law for almost 30 years. He worked for two Minneapolis law firms but then struck out on his own. Unfortunately, his S corporation, Goldsmith & Associates (G&A), had problems from the start. Goldsmith had no personal experience, education or background in accounting or the operation of a business or financial background. He kept track of cash flow and expenses on a legal pad, but the legal pads piled up.

G&A had a fair number of clients, but mostly worked on contingency. When business is good for a contingent fee firm, costs can add up more rapidly than fees, and that's what happened to G&A. The firm had no credit and was unable to get a bank loan. Without much money coming in, Goldsmith was forced to fund its operations by taking out mortgages on his personal residence. During the years at issue, he used the proceeds to make at least 13 advances to G&A. By late 1999, one of the two mortgages went into default, and the house entered foreclosure.

Then his luck seemed to turn. A large settlement from an old antitrust case came in during 2000, and G&A received an $880,000 fee. Goldsmith took the full amount as a distribution from G&A, wrote a $700,000 check to redeem his personal residence from foreclosure, and put what was left back into the firm. But within a month, G&A was sinking again. By August 2000, it didn't have enough money to make payroll, and Goldsmith began eyeing the newly restored equity in his home.

G&A took out a five-year loan for $200,000 at an 18% interest rate, guaranteed by Goldsmith and his wife, who again mortgaged their residence to secure the loan. Within two months, the money was gone. In November 2000, G&A borrowed an additional $100,000 at 18%, again guaranteed by Goldsmith and his wife. That money lasted until March 2001. When it ran out, G&A borrowed another $50,000 at 5% per month. The next month G&A borrowed another $25,000 under the same terms. By August 2001, the money had run out again. That last associate left, the secretary left, and the office lease ended. Goldsmith packed up the records and moved G&A to the basement of his home.

By early 2002, Goldsmith had defaulted on all four of the high-interest loans. Two creditors foreclosed on his residence, and he and his wife were evicted in May 2002. In a last effort to save his home, he contracted with yet another lender on even harsher terms. But G&A continued to spiral downward, Goldsmith's license to practice law was suspended in May 2004, and in June 2005, he was indicted for failing to pay over federal income and FICA taxes withheld from employees for 12 quarters, and for failing to file a tax return for four tax years.

Goldsmith plead nolo contendere to all 16 counts and was sentenced to 33 months of imprisonment followed by three years of supervised release. After his release, he and G&A both faced a civil audit. The result was a notice of worker reclassification to G&A that determined Goldsmith was an employee, and a notice of deficiency to Goldsmith.

Analysis

Based on its determination that Goldsmith was an employee of G&A, the IRS contended that payments by G&A to him during the years at issue were wages, which meant that G&A owed more in payroll taxes and Goldsmith owed more in income taxes. Goldsmith countered that G&A made no money during those years, so it could not have afforded to pay him wages. Alternatively, any money he took out of G&A was to reimburse himself for firm expenses that he had previously paid.

The court noted that there's no rule that an S corporation has to pay its sole shareholder a wage, especially when it's bleeding money the way G&A was. The court added that the real question is one of fact: were the payments a return of capital, repayments of loans, or wages? Goldsmith had the burden of proving that the funds paid to him by G&A were to repay loans.

While the question of whether transfers to closely held corporations constitute debt or equity is based on the facts and circumstances, in Dunnegan v. Comm'r, T.C. Memo. 2002-119, and other cases the Tax Court established a list of factors to consider when making this determination:  

(1) the names given to the documents that would establish the purported loans, (2) the presence of a fixed maturity date, (3) the source of repayment, (4) the right to enforce payment, (5) participation in management as a result of the advances, (6) subordination of the purported loans to loans from other creditors, (7) the intent of the parties, (8) identity of interest between creditor and stockholder, (9) the corporation's ability to obtain financing from outside sources, (10) thinness of capital structure in relation to debt, (11) the use of the funds, (12) any failure to repay; and (13) the risk involved in making the transfers.

To guide it in the instant case, the Tax Court looked to Scott Singer Installations, T.C. Memo. 2016-161. In that case, the taxpayer raised money for his business from the equity in his home. When he ran out of equity and was unable to continue borrowing from commercial banks, he began borrowing from family members. The taxpayer may have wanted this to create a debtor-creditor relationship with his corporation, but the court held that those infusions of capital would be loans only if he reasonably expected to be repaid. According to the court, the taxpayer had a reasonable expectation of repayment for advances made from 2006 to 2008, but when the recession occurred in 2008 and business dropped off, he should have known that future advances would not result in consistent repayments. After 2008, the only source of capital was from the taxpayer's family and his personal credit cards. No reasonable creditor would make a loan. Consequently, the Tax Court concluded that advances made in 2008 and earlier were bona fide loans but advances made after 2008 were more in the nature of capital contributions.

Drawing a parallel between the facts in Scott Singer Installations and the instant case, the Tax Court pointed out that Goldsmith sought funding for G&A from usurious lenders because reasonable creditors would not finance the firm. Even during the early years when Goldsmith relied on the equity in his home to fund G&A, the business was running at a deficit. The year of the windfall contingent fee, 2000, was the only year that G&A made a profit. Even with that fee, G&A was failing, as shown by the reported losses in the following years and by Goldsmith's own acknowledgment.

The Tax Court concluded that the payments G&A made to Goldsmith were not wages as the IRS contended, and were not expense reimbursements as Goldsmith argued, but were distributions. According to Code Sec. 1368(b), distributions by an S corporation that has no accumulated earnings and profits are tax-free to the extent of the shareholder's stock basis, with any excess treated as gain from the sale or exchange of property (i.e., capital gain). G&A had no accumulated earnings and profits, so the payments were a nontaxable return of capital to the extent of Goldsmith's stock basis.

For additional coverage of the taxation of S corporation distributions, see Parker Tax ¶32,100.

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Tie-Breaker Rule Prevents Grandmother from Claiming Grandkids as Dependents

The Tax Court held that, under the tie-breaker rule, a grandmother was not entitled to dependency deductions, or other tax benefits, with respect to the grandchildren for which she provided almost all financial support during 2012. Although her son told her to file a return and claim the children as dependents to recoup some of the money she had spent supporting his family, he had also filed a return claiming the children as dependents. Smyth v. Comm'r, T.C. Memo. 2017-29.

In 2012, Grisel Smyth, a certified nursing assistant, provided a home for her unemployed son, his wife, and their two small children. Smyth's job does not pay much, but, with her wages and social security benefits, Smyth had a higher adjusted gross income than either her son or his wife. In 2012, she provided all the financial support for the household because her son "did not work, and he was into dealing drugs." Smyth's daughter-in-law stayed home and took care of the children. Smyth timely filed her 2012 income tax return claiming the two grandchildren as her dependents after her son told her that he and his wife were not going to file a return and that she should try to get back some of the money she had spent supporting his family.

In 2014, Smyth received a notice of deficiency from the IRS that increased her 2012 tax by more than $5,000 and determined a penalty of another $1,000. The notice said that the IRS had decided that the grandchildren were not her "qualifying children." Because her grandchildren were not qualifying children, she was not entitled to a dependency deduction, child tax credit, earned income credit, or head-of-household filing status.

At first Smyth thought she might have been the victim of identity theft, but then realized that someone else had claimed dependency exemption deductions for her grandchildren for the same year. Smyth's son later admitted that he and his wife had filed a tax return claiming dependency deductions for the children. Smyth's son then offered to write an affidavit in support of his mother's position and even prepared an amended 2012 return that deleted his claim that his children were his dependents. Smyth's case went before the Tax Court and a copy of this amended return was given to the IRS's counsel two weeks before trial.

Under Code Sec. 151, only one person can claim a "qualifying child" as a dependent. When writing the law relating to dependent deductions, Congress expected that there would be some families where more than one person could say a child was his or her "qualifying child," so the Code has tie-breaking rules. Under Code Sec. 152(c)(4)(A), if the same children are the "qualifying children" of both their parents and someone else, then only the parents can claim the children. However, under Code Sec. 152(c)(4)(C), if the children's parents do not claim them, then another taxpayer may claim the children as his or her "qualifying children" if that taxpayer has a higher adjusted gross income than either parent.

Before the Tax Court, the IRS argued that the exception in Code Sec. 152(c)(4)(C) did not apply because Smyth's son and his wife, the children's parents, claimed the grandchildren as dependents on their tax return.

Smyth argued that even if her son and his wife did file an original return, they also filed an amended return before trial in which they released any claim they had to the children as their "qualifying children."

Smyth testified that she didn't know her son and his wife had filed their own 2012 return claiming her grandkids as their "qualifying children" and that she never would have claimed her grandchildren as her own "qualifying children" if she thought her son had done so too. Smyth also testified that her son admitted he filed a return in order to get the refund "for his drugs" and prepared an amended return in which he and his wife released any claim they had to the children as their "qualifying children." According to Smyth, this amended return was "filed" when it was delivered to IRS legal counsel.

While expressing extreme sympathy for Smyth, the Tax Court nonetheless held that she was not eligible to claim her grandchildren as her dependents. First, the court found that Smyth's son's amended return was not properly "filed" and thus could not be the basis for a claim that Smyth's son and his wife gave up their right to claim Smyth's grandchildren as their "qualifying children." In so finding, the court cited its decision in Quarterman v. Comm'r, T.C. Memo. 2004-241, where it held that hand delivery of a return to IRS counsel does not constitute the filing of that return. The problem, the court said, is that the IRS's counsel is neither the service center that serves taxpayers living in El Paso nor a person that the IRS has assigned to receive returns for the local IRS office. Similarly, in Espinoza v. Comm'r, 78 T.C. 412 (1982), the Tax Court found that delivery of a return to an IRS agent did not amount to the filing of a return. Thus, the Tax Court concluded that Smyth's son and his wife did not give up their right to treat their children as their qualifying children and, under the tie-breaker rules, they get to claim the children as dependents. The court also found that, because the children were not Smyth's "qualifying children," she did not qualify for the earned income credit, child tax credit, or head-of-household filing status.

In closing the court said: "it is impossible for us to convince ourselves that the result we reach today that the IRS was right to send money meant to help those who care for small children to someone who spent it on drugs instead is in any way just. Except for the theory of justice that requires a judge to follow the law as it is but explain his decision in writing so that those responsible for changing it might notice."

For a discussion of the tie-breaker rule that applies when more than one person is eligible to claim a child as a dependent, see Parker Tax ¶10,720.

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How to Handle Missing or Incorrect Forms W-2

If a missing or corrected Form W-2 is not received by the end of February, the IRS should be contacted, and will attempt to obtain the information from the employer.

The Protecting Americans from Tax Hikes (PATH) Act now requires employers to submit Form W-2 to the Social Security Administration (SSA) by January 31. The PATH Act did not alter the long-standing January 31 deadline for furnishing copies of these forms to employees. According to the IRS, if a Form W-2 is not received by January 31 or the information is incorrect on the form, the taxpayer should contact the employer.

Missing or Incorrect Forms W-2

If a missing or corrected Form W-2 is not received by February 28, the IRS should be contacted at 800-829-1040 for assistance. When calling the IRS, have the following information on hand:

(1) The taxpayer's name, address (including zip code), social security number, phone number, and dates of employment.

(2) The employer's name and complete address (including zip code), employer identification number if known (taxpayers can look at the prior year's form if the same employer), and phone number.

The IRS will send the employer a letter requesting it furnish a corrected Form W-2 within 10 days. The letter also reminds the employer of its responsibility to provide a correct Form W-2 and the penalties for failing to do so.

The IRS will send the taxpayer a letter with instructions and Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The taxpayer can submit the Form 4852 with their Form 1040 if the employer doesn't provide a corrected Form W-2 by the return filing deadline. If that occurs, the taxpayer will need to estimate the wages earned and taxes withheld by that employer, which can be based on the end-of-year pay stub, if available. As would be expected, filing Form 4852 with the return may result in processing delays while the IRS verifies the information provided.

The IRS recommends that taxpayers keep a copy of the Form 4852 until they begin receiving social security benefits, in case there's a question about their work record and/or earnings for the year. After September 30 following the year entered on line 4 of the Form 4852, taxpayers can access their online Social Security account or contact their local SSA office to verify the wages reported by the employer.

Amended Return May be Necessary

Taxpayers must file their tax return or request an extension of time by the due date of the return, even if Form W-2 has not been received. Taxpayers who receive a corrected form after they file their return with information differing from what was reported on the return should amend the return on Form 1040X, Amended U.S. Individual Income Tax Return.

For further discussion on missing Form W-2s, see Parker Tax ¶252,595.

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Tax Court Takes Issue with Professional Gambler's Approach to Reporting his Activities

The Tax Court held that a taxpayer was a professional gambler and so he could deduct wagering losses from his winnings as well as gambling-related travel expenses. But because he lacked adequate records and misreported his activities, he was liable for the negligence penalty. Alabsi v. Comm'r, T.C. Summary 2017-5.

Background

For many years before 2009, Emad Alabsi regularly played poker at various tournaments. In fact, from late 2003 through 2010, he won monetary prizes 30 times for total winnings of $858,447. To participate in the tournaments, Alabsi had to pay an entry fee and a buy-in fee. The tournament organizer retained the entry fee, but the buy-in amounts were paid out to the winners at the end of a tournament.

During 2009, Alabsi participated in the following poker tournaments:

• Borgata Hotel Casino and Spa in Atlantic City, where he won $2,209, $20,425, and $5,250 on his January 17, June 19, and August 2 visits, respectively (net of entry and buy-in fees). The Borgata issued a Form W-2G, Certain Gambling Winnings, for 2009 reporting the $20,425 of winnings but not the $2,209. The record did not disclose whether the Borgata issued a Form W-2G reporting the $5,250 that Alabsi won on August 2, 2009.
• Bellagio Casino in Las Vegas, where he won $832 and $10,130 at the July 9 and July 16 tournaments (net of the buy-in). The Bellagio issued a Form W-2G for 2009 reporting the $10,130 of winnings but not the $832.
• Mountaineer Racetrack and Casino in Chester, West Virginia, where he won $9,840. The Mountaineer issued a Form W-2G for 2009 reporting the $9,840 of winnings (net of entry fee and buy-in).

Alabsi and his wife filed a professionally prepared 2009 federal tax return listing Alabsi's occupation as a consultant. On Schedule C attached to the return, they reported gross receipts of $20,045 and no business expenses. The Schedule C listed Alabsi's principal business as consultant. The preparer concluded that Alabsi was a professional poker player (at the time of trial, Alabsi was listed as a notable player on a website devoted to poker tournaments, along with records of his winnings). But given the lack of expense records, he advised Alabsi to report the net income from his gambling activities on Schedule C as gross receipts and not report any offsetting business expenses.

The IRS examined the 2009 return and issued a notice of deficiency determining that taxpayers failed to report gambling income of $40,395, on the basis of Forms W-2G from the following payers: Marina District Development (Borgata) for $20,425; Bellagio, LLC, for $10,130; and Mountaineer Racetrack for $9,840.

Unreported Income

The Alabsis conceded that they received the $40,395 in wagering income as reported on the Forms W-2G. But they disagreed with the IRS about whether the $20,045 of income reported on the Schedule C constituted part of the gambling income reported on the Forms W-2G or whether it was additional income. The Alabsis contended that the $20,045, despite the consulting designation, was Alabsi's gambling income reduced by his estimated gambling expenses. The IRS sought to hold taxpayers to their return position that they had $20,045 of income from a consulting business unrelated to gambling, plus an additional $40,395 of unreported income from gambling.

The Tax Court agreed with the taxpayers, noting that the Schedule C consultant description was a misguided attempt to head off the closer scrutiny of the return that would likely be triggered by a description of Alabsi's business as poker or gambling. The court then concluded that Alabsi's poker tournament winnings exceeded the $40,395 reported on the Forms W-2G. He won $2,209 on January 17, 2009, $832 on July 9, 2009, and $5,250 on August 2, 2009, that were not reported to the IRS or were not included in the IRS's determination of unreported gambling income. Alabsi's corrected winnings of $48,686 for 2009, less the $20,045 reported on the return, resulted in unreported income of $28,641 for 2009.

Alabsi's Status as Professional Gambler

Alabsi contended that he was a professional tournament poker player in 2009, while the IRS argued that his poker playing was a recreational activity. The distinction is important because if Alabsi was a recreational gambler in 2009, his wagering losses, to the extent of wagering gains, would be deductible only as itemized deductions under Code Sec. 165(d). On the other hand, if Alabsi was in the trade or business of gambling, his wagering losses would be deductible to the extent of his wagering gains, and his related nonwagering expenses, such as lodging and travel (if substantiated), would be fully deductible under Mayo v. Comm'r, 136 T.C. 81 (2011).

According to Comm'r v. Groetzinger, 480 U.S. 23, 35 (1987), gambling is a trade or business if it "is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby." Although the test for trade or business status would take into account Alabsi's subjective intent, the Tax Court gave greater weight to the objective facts. During 2009, Alabsi participated in at least 29 poker tournaments. Many took place in Atlantic City or Las Vegas, which are a fair distance from taxpayers' home in Ohio. Based on these facts, the Tax Court concluded that Alabsi was engaged in the trade or business of a professional tournament poker player in 2009.

Wagering Losses and Business Expenses

Alabsi's entry and buy-in fees in 2009 totaled $1,560 and $17,260, respectively. (Omitted from these totals were fees for tournaments where Alabsi won prize money, since those winnings were net of the entry and buy-in fees.) The Tax Court found the buy-in fees to be a direct cost of the wagers because they were distributed to the winning players, as were the entry fees even though they were retained by the sponsoring casino. Subtracting the entry and buy-in fees reduced taxpayers' unreported gambling income to $9,821.

Professional gamblers can deduct nonwagering gambling expenses related to the trade or business of gambling and, subject to Code Sec. 165(d), the cost of the wagers themselves. The Alabsis did not report any business expenses on Schedule C, but contended that they are entitled to business expense deductions that were not claimed.

The Tax Court was satisfied that hotel invoices provided by Alabsi, coupled with his receipts for entry fees and buy-ins for poker tournaments on or about the same dates, met the Code Sec. 274(d) substantiation requirements for business travel because they established the amount, time and place, and business purpose of the lodging expenditures.

Alabsi paid $3,783 for lodging at the Borgata, of which $664 constituted nondeductible personal expenditures (room movies, etc.); and $1,088 for lodging at the Bellagio, of which $175 constituted nondeductible personal expenditures. In addition, he substantiated a $40 baggage fee for a return flight from Las Vegas. He did not substantiate any business expenses for his stay at the Mountaineer. Accordingly, taxpayers were entitled to deduct $4,072 of business expenses for 2009.

Accuracy-Related Penalty

The IRS imposed a Code Sec. 6662 accuracy-related penalty for the taxpayers' failure to keep adequate records of Alabsi's gambling activities, including the related expenses. Lacking adequate records, they filed a return that reported an estimate of their net income as if it were gross receipts. As a consequence, they understated both gross receipts and net income. They also misrepresented Alabsi's business as a consultant rather than a poker player.

While their 2009 return was prepared by a qualified accountant (who had a master's degree in accounting and had previously prepared tax returns for professional poker players), the return reported a gross receipts figure that Alabsi knew to be inaccurate and further identified the nature of his business in a way that both taxpayers knew to be inaccurate. The Alabsis did not show that they acted with reasonable cause and in good faith with respect to any portion of the underpayment, and so were liable for the negligence penalty on the entire underpayment under Code Sec. 6662(a).

For further discussion of reporting gambling winnings and losses, see Parker Tax ¶85,120.

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Court Affirms Former Trucking Company CEO's 90-Month Prison Sentence for Tax Evasion and Bank Fraud

The Tenth Circuit upheld a 90-month prison sentence and $21 million restitution order handed down to the CEO of a trucking company after he had been found guilty of tax evasion and bank fraud. The CEO had inherited the company after his father's untimely death and then proceeded to run it into the ground by spending lavish amounts on himself, committing bank fraud, and not paying payroll taxes and other bills. Pielsticker v. U.S., 2017 PTC 47 (10th Cir. 2017).

In 1968, Jim Pielsticker bought Arrow Trucking, a small Tulsa, Oklahoma trucking company. He built it into a major corporation with more than 1,400 employees and $250 million a year in revenue. In October of 2001, Jim and several other wealthy Oklahomans were involved in a tragic plane crash while on a hunting trip. Jim, the pilot, and the CEO of another company died in the crash. Jim's son, James Douglas Pielsticker, took over Arrow Trucking almost immediately.

By 2008, Arrow was struggling to pay its expenses. It bounced checks to its lenders, employees, and vendors. Despite this, Pielsticker received an annual salary of $1.2 million and drew personal expenses from Arrow totaling more than $3.5 million, for such things as payments for his Porsche, Bentley, and Maserati automobiles.

In November 2008, Transportation Alliance Bank (Alliance) entered into an agreement with Arrow in which Arrow sold its accounts receivable to Alliance to obtain advanced funds. Before Alliance purchased Arrow's accounts receivable, it required that Arrow submit its customer invoices, listing among other information the total amount owed, the account debtor's name, and the payment's due date. After receiving the invoices, Alliance would pay Arrow a percentage of the total amount owed in exchange for the exclusive right to collect on the accounts.

In January 2009, Arrow's payroll-service provider dropped Arrow as a client after Arrow missed a payment. Rather than hire another provider, Pielsticker and Jonathan Moore, Arrow's chief financial officer, decided to self-report. For the rest of the year, Arrow withheld payroll taxes from its employees' salaries but never sent these collections to the IRS or filed the corresponding tax returns. In total, Arrow withheld and failed to remit to the IRS over $9.5 million in payroll taxes.

In March 2009, an Arrow billing clerk sent Alliance an invoice accidentally overstating an account receivable by about $100,000. Alliance advanced this sum to Arrow. When Moore learned of the overstated invoice, he told Arrow's legal counsel, Joseph Mowry. Mowry advised against notifying Alliance. In May 2009, during a meeting about Arrow's finances, Pielsticker told Moore, "[w]e just need to create another invoice like we did the first time," referencing the mistakenly overstated invoice. In previous meetings, Moore suggested that Pielsticker decrease his personal expenses, but Pielsticker refused. So based on Pielsticker's request and the need to cover cash-flow shortages, Moore directed an Arrow billing clerk to overbill an invoice before sending it to Alliance. Arrow then began intentionally overbilling invoices.

By September 2009, Alliance was suspicious and demanded verification of the accuracy of Arrow's invoices by calling Arrow's account debtors directly. Initially, Pielsticker refused to allow this, but when Alliance insisted, Pielsticker, Mowry, and Moore devised a scheme to have Arrow employees answer Alliance's calls. They provided Alliance with a list of account debtor's fictitious phone numbers. In fact, all of the phone numbers belonged to out-of-state cell phones that Pielsticker, Mowry, and Moore had obtained to deceive Alliance. Then, they staged four to five Arrow employees who would answer Alliance's calls, identify themselves as account debtors, and confirm the overbilled invoices. In December 2009, Pielsticker, Mowry, and Moore executed the scheme a second time after Alliance wanted to verify more invoices. That same month, the bank-fraud conspiracy ended when Mowry told Alliance about the fraudulent invoices. In total, Arrow submitted false invoices to Alliance totaling approximately $21 million.

Three days before Christmas 2009, Arrow closed its doors and laid off all its employees. With their Arrow credit cards cancelled and no paychecks in sight, hundreds of truckers were stranded throughout the United States with no money to get home.

From 2009 to 2011, Pielsticker underreported his wages and failed to pay his federal income taxes, creating a personal tax debt of more than $1 million.

By January 2010, Moore had begun cooperating with law enforcement and, in 2014, he pleaded guilty to conspiracy to defraud the United States and to commit bank fraud. Newspaper reports of Moore's testimony said he attested to Pielsticker's lavish spending while the company struggled, saying Pielsticker spent $70,000 for a portrait of his wife and $80,000 for a baby nursery. Mowry died before facing charges.

In 2015, Pielsticker pleaded guilty to one count of conspiracy and one count of tax evasion. The conspiracy charge set forth two independent crimes: (1) conspiracy to defraud the United States by not providing the IRS payroll taxes collected from Arrow's employees; and (2) conspiracy to commit bank fraud by obtaining bank funds with fraudulently inflated invoices for Arrow's accounts receivable. An Oklahoma district court imposed a 90-month prison sentence and ordered Pielsticker to make restitution for approximately $22 million. Pielsticker appealed.

On appeal, Pielsticker disputed the district court's loss calculation and the amount of restitution. He also challenged the increased prison time resulting from the court's imposition of an aggravating-role adjustment for his acting as a manager or supervisor of at least five participants in the bank-fraud conspiracy.

The Tenth Circuit held that the district court did not err in calculating the amount of loss and that the record supported its factual findings. The court also affirmed the 90-month prison sentence imposed on Pielsticker.

For a discussion of the penalties for tax evasion, see Parker Tax ¶265,110.