April AFRs Issued; Unexercised Purchase Option Prevents Taxpayer from Claiming First-time Home Buyer Credit; Guidance on Empowerment Zones Issues; Tax-Exempt Foundation Could Exclude Large Contribution from Public Support Test ...
Formerly Passive S Corp Owner Materially Participates in Loss Year, Reaps $5.2 Million Tax Benefit
An S corporation owner who stepped in and worked 691 hours to help the company recover from the former president's malfeasance passed the material participation test, opening the door to a loss carryback and a $5.2 million tax refund. Lamas v. Comm'r, T.C. Memo. 2015-59.
Good-faith Reliance on Trusted Attorney Absolves Retiree of Sham Transaction Penalties
The Tax Court held that a retired mortician had reasonably relied on the advice of his long-time attorney in participating in a Son-of-BOSS transaction to divest his funeral home business of its real property holdings. Although the court determined the transaction was a sham, it declined to impose gross valuation misstatement penalties due to the unsophisticated taxpayer's reliance on his trusted attorney's advice. CNT Investors, LLC et al. v. Comm'r, 144 T.C. No. 11 (2015).
The Tax Court held that a $2 million bonus paid by an eye surgery center to its head surgeon and sole shareholder was not reasonable compensation. The court rejected the taxpayer's argument that the payment, which resulted in a $50,434 net operating loss, was reasonable because of an increase in the doctor's workload and responsibilities. Midwest Eye Center, S.C. v. Comm'r, T.C. Memo. 2015-53.
Focusing on subjective intent, the Tax Court held that because the taxpayers were genuinely optimistic their failing horse farm would eventually be profitable, and were able to attribute poor results to weak economic conditions, millions in losses sustained over a six year period were not hobby losses. Metz v. Comm'r, T.C. Memo. 2015-54.
The Tax Court held that, despite the fact two minority shareholders were unaware that majority shareholders had stripped away pre-tax profits from their company, the minority shareholders were partially liable as transferees for the unpaid corporate taxes as certain transfers to them were fraudulent. Kardash v. Comm'r, T.C. Memo. 2015-51.
$2 Million Nonemployee Compensation to Accommodating Party in Tax Shelter Scheme was Not a Return of Capital
The Tax Court rejected multiple arguments presented by a Harvard educated architect dabbling in the tax shelter business attempting to explain why $2 million of nonemployee compensation reported on Form 1099-MISC should be treated as a tax free return of capital.
Betrayal of Friend Leads to $7.8 Million Tax Bill; Misappropriated Funds Included in Gross Income
A taxpayer was required to recognize taxable income when he misappropriated funds entrusted to him for investment purposes by an overseas friend. Minchem Int'l, Inc. v. Comm'r, T.C. Memo. 2015-56.
Restauranteur Fails to Pin $1.6 Million Omission on Accountant; Slammed with Fraud Penalty
The Tax Court determined a restaurant owner had vastly underreported his businesses income for multiple years, and found the taxpayer's attempt to shift blame to his accountant unconvincing. The court determined the omission was fraudulent, noting the taxpayer met multiple "badges of fraud," and imposed a 75 percent penalty. Musa v. Comm'r, T.C. Memo. 2015-58.
Formerly Passive S Corp Owner Materially Participates in Loss Year, Reaps $5.2 Million Tax Benefit
An S corporation owner who stepped in and worked 691 hours to help the company recover from the former president's malfeasance passed the material participation test, opening the door to a loss carryback and a $5.2 million tax refund. Lamas v. Comm'r, T.C. Memo. 2015-59.
Background
Jose Lamas, along with his two sisters and one of their husbands, Masoud Shojaee, collectively owned Shoma Development Corp. (Shoma), an S corporation in the business of building and developing homes. Lamas had previously served as CEO of his father's company, which provided the initial funding for Shoma.
In 2004, Shoma formed Greens at Doral, LLC (Greens), a condominium conversion project. Shojaee, while acting as president of Shoma and Greens, used the company's assets for personal gain and usurped business opportunities. Shojaee used the company to guarantee loans for his personal business, and caused Shoma to donate $1.5 million to the University of Miami on his behalf. Shojaee also took a business opportunity from Shoma when he chose to build a real estate project on the company's land using one of his personally owned companies.
In early 2008, Lamas initiated a lawsuit on behalf of Shoma against Shojaee and eventually settled. Throughout 2008, Lamas worked on behalf of Shoma and Greens to restore the corporate assets and to find additional investors for Shoma's projects to fill its capital needs during the year's widespread economic turmoil.
Shoma had four major ongoing projects that required significant cash infusions and needed additional funds to make loan payments. Lamas worked to find investors and purchasers for these projects in an attempt to cure Shoma's capital deficit, using the contacts he had gained from his years as CEO of his father's company.
Lamas also worked in tandem with his father's trusted business advisor, and one of Shoma's board members, David Flinn, to promote Shoma's projects. After Lamas would make the initial pitch, Flinn would have the follow-up conversations. The pair traveled the country throughout 2008, making numerous conference calls and frequently dining with potential clients. Lamas even spoke with foreign investors, though no deals were finalized that year.
On Shoma and Greens' 2008 returns, Lamas claimed the significant losses the companies suffered as a tentative net-operating-loss carryback adjustment to 2006, resulting in a tentative refund of $5,260,964. The IRS determined that the 2008 losses were passive and that Lamas was not entitled to the tentative carryback adjustment, issuing a notice of deficiency.
Observation: "Tentative carryback adjustments" are a special procedure under Code Sec. 6411(a) that allows a taxpayer to apply for a quick refund for carryback adjustments made for net operating losses, net capital losses, or excess general business credits. See Parker ¶261,130 for a discussion of tentative carryback adjustments.
Analysis
Code Sec. 469 prevents taxpayers from using losses from passive activities to offset nonpassive income. A passive activity is any trade or business in which the taxpayer does not materially participate (Code Sec. 469(c)). Generally, taxpayers materially participate if they are involved in the operations of the trade or business on a regular, continuous, and substantial basis (Code Sec. 469(h)(1)). Taxpayers can satisfy the material participation requirement if they participate in the trade or business activity for more than 500 hours during the year, as long as an exception does not apply (Reg. Sec. 1.469-5T(a)(1)).
Aggregation of Hours
The Tax Court first reviewed whether it was appropriate to aggregate the hours Lamas worked for Shoma and Greens for 2008 and treat them as a single activity under the five factor test in Reg Sec. 1.469-4(c). The factors are:
(1) Similarities and differences in types of trades or businesses;
(2) The extent of common control;
(3) The extent of common ownership;
(4) Geographical location; and
(5) Interdependencies between or among the activities.
The court found that the two companies meet all five factors and could be treated as a single activity for purposes of aggregating the hours Lamas worked: Shoma and Greens were similar businesses as both engaged in commercial and residential real estate development; they shared common control and ownership; they shared geographic locations as Greens operated out of Shoma offices; and finally, they were interdependent as Greens used Shoma employees and consolidated its financial reporting with Shoma's.
After aggregating the hours Lamas spent working for Shoma and Greens, the court found that he materially participated in managing the companies. Lamas presented witness testimony and phone records to show that he worked at least 691 hours for Shoma and Greens during 2008, restoring corporate assets to Shoma and seeking potential investors. The only conflicting testimony was from Shojaee, but the court gave it little weight, noting it was rife with inconsistencies and his personal conflicts with Lamas which called his credibility into question.
Overcoming Exceptions to the 500-Hour Requirement
The tax court then evaluated whether an exception applied that would preclude counting Lamas' hours as participation, noting the two potentially relevant exceptions under Reg. Sec. 1.469-5T(f)(2) were (1) work not customarily done by owners and (2) participation as an investor.
Under the first exception, a taxpayer's participation is not counted toward the requisite hours if the taxpayer does work that is not customarily done by an owner, and does such work in an attempt to avoid the disallowance of passive losses.
The tax court found Lamas participated in work customarily done by owners, and he did not do the work with a purpose of avoiding the Code Sec. 469 loss limitations. The court noted Lamas worked restoring Shoma assets and opportunities and finding potential investors for company projects. In contrast to the example in the regulations, the court found those activities were customarily done by owners. Further, Lamas' purpose was to protect his investment in Shoma by helping the company to survive, and accordingly, the court found the avoidance exception did not apply.
Under the second exception, a taxpayer is prevented from counting time he worked in his capacity as an investor unless he was directly involved in the day-to-day management or operations of the activity. Investor activity includes:
(1) studying and reviewing financial statements or reports on operations of the activity;
(2) preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and
(3) monitoring the finances or operations of the activity in a non-managerial capacity.
The IRS argued Lamas was merely acting as an investor when he was promoting Shoma and looking for new purchasers, citing Tolin v. Comm'r, T.C. Memo. 2014-65.
The court found the exception did not apply as Lamas' work restoring capital and promoting the companies was an integral part of the day-to-day operations during 2008. The court concluded that the IRS had mischaracterized the Tax Court's findings in Tolin by stating that it did not reach the issue of whether the taxpayer's promotional efforts, such as talking with people over lunch in a social context, amounted to day-to-day management of the taxpayer's stallion breeding business. The court noted that in fact, the Court found the core part of the taxpayer's business in Tolin was the promotional efforts involved his personal solicitation of individuals to breed their mares to his stallion.
The Tax Court ultimately concluded that, like the taxpayer in Tolin, most of Lamas' work was promotion, and this promotion went to the core goal for Shoma at the time, which was to find project investors. Accordingly, the investor exception did not apply, and all of Lamas' work for Shoma, including investor activity, qualified as participation.
Conclusion
Lamas materially participated in Shoma and Greens for 2008, working to restore lost assets, promoting the company, and seeking out potential investors and purchasers for ongoing projects. Lamas' time spent working on these matters during 2008 totaled at least 691 hours, well in excess of the regulations' 500 hour requirement. In addition, neither the avoidance nor investor exceptions applied, as Lamas' promotional activities were activities customarily done by owners and he was involved in the day-to-day operations of the companies. Accordingly, the Tax Court held that the flow-through losses from Shoma and Greens were not passive and allowed the tentative carryback and associated refund.
For a discussion of the material participation requirements, see Parker ¶247,115.
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Good-faith Reliance on Trusted Attorney Absolves Retiree of Sham Transaction Penalties
The Tax Court held that a retired mortician had reasonably relied on the advice of his long-time attorney in participating in a Son-of-BOSS transaction to divest his funeral home business of its real property holdings. Although the court determined the transaction was a sham, it declined to impose gross valuation misstatement penalties due to the unsophisticated taxpayer's reliance on his trusted attorney's advice. CNT Investors, LLC et al. v. Comm'r, 144 T.C. No. 11 (2015).
Background
Charles Carroll began operating a funeral home in 1954 through a corporation owned with his family, Charles Carroll Funeral Home, Inc. (CCFH), which held the titles to the mortuary buildings and the underlying real property. In early 1999, Carroll began contemplating retirement and decided to sell the business, but wanted to retain ownership of the underlying real estate in order to lease it so the family could maintain a periodic stream of income.
Carroll's attorney, J. Roger Myers, initially struggled to identify a way of transferring the real estate out of CCFH without triggering recognition of substantial built-in gain due to the property's low basis. In time, Myers encountered a colleague who suggested using the now-infamous Son-of-BOSS transaction. Initially skeptical, Myers met with his colleague and numerous other tax advisors who explained the transaction in detail. On the basis of the information he received, including a memorandum from a large accounting firm, Myers believed the transaction was a legitimate way to resolve CCFH's low basis dilemma. He presented the strategy to Carroll who agreed to go ahead with the transaction.
The series of transactions divested CCFH of its real estate holdings and concluded with Carroll and his two daughters owning the mortuary properties through a newly formed partnership, purportedly generating only $623,284 of taxable long-term capital gain in the process. Absent the Son-of-BOSS transaction, the amount would have been $3,496,623 due to the low basis of the real property. The accounting firm charged $116,000 for its services and also delivered opinion letters describing the transactions and attesting to their probable tax consequences.
The considerably less favorable actual consequences arrived in 2008 when the IRS issued a Final Partnership Administrative Adjustment (FPAA) disregarding the transaction as a sham and assessing a gross valuation misstatement penalty.
Analysis
A gross-valuation misstatement exists if the value or adjusted basis of any property claimed on the partnership return is 400 percent or more of the correct amount (Code Sec. 6662(e)(1)(A)). Any underpayment of tax attributable to a gross-valuation misstatement is subject to a 40 percent penalty (Code Sec. 6662(h)(1)). A taxpayer can avoid the penalty by showing there was a reasonable cause for the misstatement and the taxpayer acted in good faith (Code Sec. 6664(c)). Taxpayers may argue that he or she had reasonable cause and showed good faith by relying on professional advice (Reg. Sec. 1.6664-4(c)).
After collapsing the steps involved, the Tax Court determined the transaction was a sham and consequently the partnerships misstated the correct value of the property by 400 percent or more. As such, the court determined the Code Sec. 6662 penalty could apply to the underpayments of tax. Carroll argued, however, that while the transaction may have been a sham, the penalty was inapplicable as he had reasonable cause and acted in good faith with respect to the underpayments, as he had relied on the advice of Myers, his trusted attorney of over twenty years.
The court noted there were three factors for this defense established by prior case law:
(1) Was the adviser a competent professional who had sufficient expertise to justify reliance?
(2) Did the taxpayer provide necessary and accurate information to the adviser?
(3) Did the taxpayer actually rely in good faith on the adviser's judgment?
The court found the first requirement was met, as Myers possessed sufficient expertise to justify reliance by Carroll. As of 1999, Myers had represented Carroll for almost 20 years, and Carroll had relied on his advice in growing his business and he had previously advised Carroll on general tax law principles.
The IRS argued that Carroll could not satisfy the second requirement, as he failed to inform Myers of the fee the accounting firm would charge for the transaction. The court disagreed, finding that given Carroll's lack of sophistication, he would not have recognized the fee amount's relevance to Myers' evaluation of the proposed transaction.
The IRS also claimed that Carroll could not have relied on Myer's advice in good faith, as Carroll himself ignored IRS warnings about Son-of-BOSS transactions and had performed no independent research on the transaction. However, the tax court disagreed, noting that while Carroll was an intelligent businessman, he had no tax or investment expertise and would not have been aware of IRS warnings about such transactions. The court also concluded Carroll was under no obligation to personally verify the validity and accuracy of the transactions and returns, as he had retained and relied on counsel exactly for that purpose.
As the Tax Court found that Carroll satisfied all three of the necessary prongs to establish reasonable cause and good faith within the meaning of Code Sec. 6664(c), the court declined to impose the Code Sec. 6662 accuracy related penalty.
Observation: The Tax Court recently decided a similar case involving a Son-of-BOSS transaction in which the taxpayer also argued reasonable reliance on professional advice to avoid penalties (436, Ltd. v. Comm'r, T.C. Memo. 2015-28). In that case, the professional was a tax promoter who not only participated in structuring the transaction, but was responsible for arranging the entire deal and sold similar transactions to other clients. Because of the professional's promoter status, the court did not believe the taxpayer could have relied on his advice in good faith. By contrast, Myers was working only for Carroll, billed him monthly for work on the transaction at his regular hourly rate, and received no other compensation or incentive for recommending the transaction.
For a discussion of tax penalties, see Parker Tax ¶262,100.
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Tax Court: Doctor's Bonus from Wholly Owned Surgical Center Not Reasonable
The Tax Court held that a $2 million bonus paid by an eye surgery center to its head surgeon and sole shareholder was not reasonable compensation. The court rejected the taxpayer's argument that the payment, which resulted in a $50,434 net operating loss, was reasonable because of an increase in the doctor's workload and responsibilities. Midwest Eye Center, S.C. v. Comm'r, T.C. Memo. 2015-53.
Background
Midwest Eye Center, S.C. ("Midwest") was an eye surgery and care center, operating four different locations and employing around 50 employees during 2007. Dr. Afzal Ahmad was the C corporation's president, medical director, 100 percent shareholder, and also its CEO, COO, and CFO. On top of the various managerial tasks these positions required, Dr. Ahmad was an active surgeon in the practice and received a salary of $30,000 every other week, and also received a substantial bonus at the end of each year.
In June 2007, Dr. Ahmad's workload increased dramatically when one of Midwest's busier surgeons quit unexpectedly and Dr. Ahmad was required to take over his prescheduled patients. Additionally, Midwest's only other retinal specialist reduced her workload, requiring Dr. Ahmad to take on many of her surgeries as well.
Dr. Ahmad received four bonus payments totaling $2,000,000 toward the end of 2007. On its 2007 Form 1120, Midwest deducted $2,780,000 for Dr. Ahmad's salary and bonus compensation. The IRS determined that part of the bonus was really a disguised dividend, disallowing $1,000,000 of the claimed deduction.
Analysis
Compensation is deductible as a trade or business expense if the amount is reasonable (Code Sec. 162(a)(1)). Taxpayers may deduct bonuses paid to employees as additional compensation, provided the bonus combined with the employee's salary does not exceed a reasonable compensation for the services actually rendered (Reg. Sec. 1.162-9). Amounts that would ordinarily be paid for like services by like enterprises under like circumstances are reasonable compensation (Reg. Sec. 1.162-7(b)(3)).
Midwest argued that there were no "like enterprises" under "like circumstances" from which to draw comparable salaries, instead pointing to several other reasons why Dr. Ahmad's large bonus was reasonable. Midwest pointed to his increased workload during 2007 and the various roles he performed contending the extent of Dr. Ahmad's duties, and the associated income he produced for the company, sufficiently justified the large bonus it paid him in 2007.
However, the Tax Court noted that Midwest failed to provide a methodology showing how Dr. Ahmad's bonus was determined in relation to those responsibilities. Midwest did not explain how the amount of the bonus was determined and why it was divided into four payments, nor did Midwest explain how the increased billings translated to bonus payments. Absent these explanations, the court could not find suitable evidence to show that the full $2 million bonus was reasonable.
Observation: Many reasonable compensation cases are decided under the Seventh Circuit's "independent investor test, " which asks whether an independent investor would be willing to compensate the employee as he was compensated (see Exacto Spring Corp. v. Comm'r, 196 F.3d 833 (7th Cir. 1999). Courts using this test often look to other companies in the area for a suitable comparison of the employee's compensation, reasoning an investor would be satisfied if the compensation was similar to that of employees performing analogous services in analogous businesses. Because there were no comparable businesses in Midwest's region from which the court could analyze similar employee compensation, the independent investor test couldn't be used.
Because Midwest could not show the bonus payment was reasonable, the Tax Court sustained the IRS's notice of deficiency, disallowing Midwest a deduction for $1 million of Dr. Ahmad's compensation.
For a discussion of the deductibility of employment compensation, see Parker ¶91,101.10.
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Not a Hobby: Tax Court Disregards Horse Farm's Staggering History of Losses
Focusing on subjective intent, the Tax Court held that because the taxpayers were genuinely optimistic their failing horse farm would eventually be profitable, and were able to attribute poor results to weak economic conditions, millions in losses sustained over a six year period were not hobby losses. Metz v. Comm'r, T.C. Memo. 2015-54.
Background
For over two decades, Henry and Christie Metz owned an Arabian horse farm, Silver Maple Farm, Inc. (SMF), an S corporation specializing in "Straight Egyptian" Arabian horses, prized for their elite genetics.
Despite great effort by the Metzes, the venture was decidedly unprofitable. SMF had only one profitable year, and that was a result of the sale of a piece of real estate used in the business. SMF averaged annual losses in excess of $1,000,000 between 1999 and 2009. Undeterred, the Metzes attempted to outrun these losses, moving the farm several times in the hopes of finding a better market and eventually settling in California.
During its lifespan, SMF lost over $14.5 million, leading the IRS to determine the business couldn't possibly be motivated by a desire to turn a profit. The IRS issued notices of deficiency for 2004 through 2009 disallowing the passthrough losses from SMF, as well as related net-operating-loss carryforwards.
Analysis
To be entitled to business deductions under Code Sec. 162(a), taxpayers must show that they engaged in the activity with an objective of making a profit (Code Sec. 183(a)). Under Reg. Sec. 1.183-2(a), losses are not allowable for an activity a taxpayer carries on primarily for sport, as a hobby, or for recreation.
Reg. Sec. 1.183-2(b) provides a nonexclusive list of nine factors relevant in ascertaining whether a taxpayer conducts an activity with the intent to earn a profit. The factors listed are: (1) the way the taxpayer conducts the activity; (2) expertise of the taxpayer or his advisers; (3) time and effort the taxpayer spends in carrying on the activity; (4) expectation that assets used in the activity may appreciate in value; (5) taxpayer's success in carrying on other similar or dissimilar activities; (6) taxpayer's history of income or losses with respect to the activity; (7) amount of occasional profits earned, if any; (8) taxpayer's financial status; and (9) elements of personal pleasure or recreation.
Noting that courts don't substitute their own business judgment for the taxpayer's, the Tax Court focused on the Metzes' subjective intent in running SMF. The court used the nine factors to establish that intent, ultimately concluding that seven factors were in the Metzes' favor and the other two were neutral.
Six factors strongly favored the taxpayers. Under Factor (1), the court found the Metzes ran SMF in a manner similar to successful horse breeders: they kept businesslike records, wrote annual business plans, conducted extensive advertising and promotion, and also changed their operating methods and adopted new technologies in an effort to improve their profits. The court concluded Factor (2) favored the Metzes, as they demonstrated knowledge and leadership in the Arabian horse breeding industry. Factor (3) also favored the couple as they spent significant time and effort in their management and development of SMF. Taking into consideration land acquisition and ownership in addressing Factor (4), the court concluded the Metzes subjectively expected their assets to appreciate. The court found Henry's previous experience turning an ailing bakery into a profitable business sufficiently demonstrated his business acumen, reasoning Factor (5) weighed in their favor. Further, as a very large proportion of their net worth was attached to SMF, the court concluded that Factor (8) favored them as well.
The court made closer calls on the remaining three factors.
Despite the horse farm's consistent losses, the Tax Court concluded the Metzes did have a subjective, although possibly unreasonable, intent of making a profit, finding that Factor (6) was neutral and Factor (7) ultimately favored the Metzes. In evaluating Factor (6) the court disagreed with the IRS's argument that the Metzes needed a bona fide expectation that future profits would offset the losses, concluding the Metzes' only needed to show a subjective expectation, and found the Metzes' explanation for the losses was reasonable. The Metzes argued the losses were outside of their control, citing the 2008 financial crash, subfertile breeding stock, and significant downturns in the Arabian horse market.
The court further concluded that Factor (7) favored the taxpayers, noting that although they had incurred frequent large losses, they did have a substantial profit in 2004. The court reasoned that the long time frame required for building a multigenerational-breeding program and the low probability any particular horse would be worth a great deal made the Metzes' business very speculative, but the probability existed that they could one day hit the jackpot, and a sale of one horse could offset years of losses. The court noted that the riskiness of the venture alone did not render it a hobby and instead chose to focus on the subjective intent of the Metzes, who optimistically believed that they would one day become profitable.
Finally, the court found that while Metzes enjoyed trips to horse show events and rode horses, those elements alone did not render SMF a hobby, and concluded Factor (9) was neutral.
The court focused heavily on the Metzes' involvement and time spent working on SMF, and despite the staggering $14.5 million of loss, concluded the Metzes did have a subjective intent of making a profit. Thus, the Tax Court held that the losses were not hobby losses under Code Sec. 183 and allowed the Metzes' claimed losses.
For a discussion of the hobby loss rules, see Parker Tax ¶ 97,505.
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Minority Shareholders Liable as Transferees for Corporate Taxes, Required to Disgorge Fraudulent Dividends
The Tax Court held that, despite the fact two minority shareholders were unaware that majority shareholders had stripped away pre-tax profits from their company, the minority shareholders were partially liable as transferees for the unpaid corporate taxes as certain transfers to them were fraudulent. Kardash v. Comm'r, T.C. Memo. 2015-51.
Background
William Kardash and Charles Robb ("taxpayers") owned minority interests in Florida Engineered Construction Products Corp. (FECP), a Florida company making precast concrete products used in home construction. Kardash was an engineer for FECP's operations, and Robb managed the company's sales team. During the Florida housing boom in the early 2000s, FECP experienced a period of growth and profitability, and its annual revenues peaked in 2006 at more than $100 million. However, at the direction of the majority shareholders, FECP failed to report any income between 2003 and 2007.
During that time, the majority shareholders, John Stanton and Ralph Hughes, began to systematically transfer all of the company's pretax profits to themselves, unbeknownst to Kardash and Robb. The taxpayers received several transfers from the corporation for their services during these years, although they never had a hand in FECP's financial matters. After FECP suspended its bonus program for 2003 and 2004, the taxpayers were given "advances" of their bonuses for those years, characterized as "loans" that were never repaid and eventually forgiven. In 2005, 2006, and 2007 FECP declared and paid dividends to the shareholders based on their percentage of stock ownership.
The IRS eventually caught on to Hughes and Stanton's income stripping, audited FECP, and determined it owed over $120 million in unpaid tax, penalties, and interest. However, FECP was unable to pay the full amount, and entered into an agreement where it was to pay installments of $70,000 a month. Because at that rate it would take FECP more than 150 years to pay off its liability, the IRS looked to collect from the four shareholders.
The IRS reached agreements with Hughes and Stanton to recover some of the illicit transfers, and then sought to recover from Kardash and Robb, arguing the $5 million they received as dividends and bonus advances between 2003 and 2007 were fraudulent under Florida law, thus making the two taxpayers liable as transferees.
Analysis
Under Code Sec. 6901(a), the IRS may establish transferee liability for the transferor's debts if a basis exists under applicable state law (Comm'r v. Stern, 357 U.S. 39 (1958)).
The tax court looked to the Florida Uniform Fraudulent Transfer Act (FUFTA) to determine whether the bonus advances and dividends were fraudulent transfers. If the transfers were fraudulent, the IRS could hold Kardash and Robb liable as transferees and recoup those fraudulent transfers. The court found that under FUFTA, if the debtor did not receive reasonably equivalent value for a transfer, it was fraudulent if the debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.
The taxpayers argued that each transfer was compensation, and the work they performed for FECP constituted reasonably equivalent value. The IRS argued that FECP did not receive reasonably equivalent value because the 2003 and 2004 transfers were loans that were never repaid and the transfers in 2005, 2006, and 2007 were dividends.
The court noted that although Hughes told the taxpayers they would have to repay the bonus advances, they did not sign loan agreements or make interest payments, and the amounts were roughly what they would have received under the suspended bonus program. The court believed that these "advances" were really compensation received in lieu of bonuses, and that FECP never expected repayment. As such, the court found the taxpayers gave reasonably equivalent value for the 2003 and 2004 transfers, meaning they were not fraudulent under Florida law, and the IRS could not hold Kardash and Robb liable as transferees under Code Sec. 6901(a) with respect to those transfers.
However, the court noted that under the Uniform Fraudulent Transfer Act, a distribution of dividends is not a transfer in exchange for reasonably equivalent value. Although the taxpayers argued that the payments were compensation for their work, neither they nor FECP treated the payments as compensation. FECP issued Forms 1099-DIV for the payments, and the taxpayers reported the payments as dividends on their individual tax returns. Because the transfers were dividends, the court held that FECP did not receive reasonably equivalent value for the 2005, 2006, and 2007 transfers and consequently, the dividends would be fraudulent if FECP was insolvent at the time of the transfer or became insolvent as a result of the transfer.
The Tax Court determined that an analysis of the experts' reports showed that FECP was insolvent for all transfers starting in 2005. Accordingly, the dividend transfers Kardash and Robb received after those years were fraudulent under FUFTA, and the IRS could hold the taxpayers liable under Code Sec. 6901(a) as transferees for those portions, requiring them to disgorge the dividends to help pay off FECP's tax liability.
For a discussion of transferee liability, see Parker ¶262,530.
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$2 Million Nonemployee Compensation to Accommodating Party in Tax Shelter Scheme was Not a Return of Capital
The Tax Court rejected multiple arguments presented by a Harvard educated architect dabbling in the tax shelter business attempting to explain why $2 million of nonemployee compensation reported on Form 1099-MISC should be treated as a tax free return of capital.
Background
In 2003, Jason Chai made a small fortune doing work for a fellow Harvard graduate, Andrew Beer, very far afield from his professional architecture practice. Beer created and marketed tax shelters designed to reduce his wealthy clients' tax liabilities. In order to achieve the tax shelters' goals, Beer enlisted Chai to act as an accommodating party to whom noneconomic income would be allocated in order to offset equal amounts of noneconomic tax losses, which clients would use to reduce their tax liabilities.
Chai was an accommodating party for at least 131 entities, which involved executing numerous transactions to facilitate the strategy. Executing the transactions required signing binders of legal documents, which included articles of incorporation, loan agreements, wire transfers, and redemption request letters. At Beer's suggestion, Chai created JJC Trading, LLC (JJC), a disregarded entity, and gave signature authority to one of Beer's numerous companies, absolving him of the need to travel to sign documents.
Chai received significant compensation from Beer's companies in exchange for his participation in the tax shelters. In 2000, he received $1.2 million as a signing bonus, and in 2001, JJC received $1 million, ostensibly for use in investing in Beer's companies. These amounts were reported as nonemployee compensation on Forms 1099-MISC, and Chai reported them as income on his returns.
In 2003, Chai was notified that he would be receiving a $2 million payment from one of Beer's companies. Unsure of how the payment would be characterized, Chai contacted the company's CFO who informed him the payment would be reported on a 1099, just as his previous bonuses had been. Chai declined to tell his accountant about this conversation, and did not report the payment as taxable income.
The IRS determined a deficiency in Chai's 2003 return, and assessed an accuracy related penalty.
Analysis
The character of a payment for tax purposes is determined by the intent of the parties, particularly the intent of the payor, as disclosed by the surrounding facts and circumstances (Smith v. Comm'r, T.C. Memo. 1995-410).
Chai first asserted that the $2 million payment was a return of capital. However, aside from his blanket assertions, the court found no evidence establishing that Chai was a partner in any of Beer's companies or had invested capital in those entities. Simply stated, the court said, the payment could not have been a return of capital because Chai did not have any capital invested. Additionally, any investments he may have had were impossible to trace, given the complex structure of Beer's companies.
Chai alternatively argued that if the $2 million payment was not a return of capital, then it was a gift from Beer. The court disagreed with this characterization, citing a lack of any evidence suggesting that the payment met the requirement that a gift result from detached and disinterested generosity. Notably, the court stated, Beer testified that he viewed the $2 million payment as a discretionary bonus for services Chai provided.
Lastly, Chai argued that the $2 million payment could not have been compensation for services because after JJC was formed and he assigned his responsibilities, he no longer performed any services. However, the court emphasized that signing the formation and organizational documents was an integral component of creating entities for Beer's tax strategy, and Chai's subsequent delegation of his signature authority did not absolve him from liability for tax on the compensation he received.
The Tax Court found the treatment of the $2 million payment as nonemployee income was consistent with the treatment of the 2001 and 2002 "bonus" payments, both of which had been reported as nonemployee compensation, and Chai himself had reported them as self-employment income and paid tax accordingly. The court held the evidence established that the intent of the parties was to treat the $2 million payment as nonemployee income subject to tax, and Chai had no reasonable explanation as to why he treated the payment differently. The court upheld the IRS's $627,619 deficiency judgement, and imposed a $125,524 accuracy-related penalty under Code Sec. 6662(a).
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Betrayal of Friend Leads to $7.8 Million Tax Bill; Misappropriated Funds Included in Gross Income
A taxpayer was required to recognize taxable income when he misappropriated funds entrusted to him for investment purposes by an overseas friend. Minchem Int'l, Inc. v. Comm'r, T.C. Memo. 2015-56.
Background
Jerry Sun came to the United States in 1986 for a position with an international mineral trading company and in 1993, he organized Minchem International, Inc. (Minchem), a C corporation, to import and distribute industrial minerals from China. That same year, Sun met Bill Cheung, a resident of Hong Kong and an owner of several shipping companies. The two men became friends, frequently discussing American investment opportunities.
In 2006, the two verbally agreed on an investment strategy for Cheung after discussing potential opportunities in the United States: Cheung would transfer funds through his shipping companies' bank accounts to Sun, who would then invest the money in the United States and send portions of the returns back to Cheung.
Minchem opened a loan account for funds Cheung sent to Sun for investment. The loan account would be debited and the balance would be increased when funds were drawn by, or paid for the benefit of, Sun. Conversely, the account would be credited and the balance would decrease when funds were paid to Minchem. Minchem did not sign any contracts with Sun regarding the loan account, and he was not required to pay interest on any loans from Minchem, nor was Minchem was required to pay interest on any loans from Sun.
By the beginning of 2008, Sun began using the loan account as a slush fund for his personal expenses. He would either pay his personal expenses directly from the loan account or he would withdraw cash and use it at his discretion. For example, in 2008 Minchem paid $135,874 for home automation, $158,517 for a new car, and $49,598 for personal real estate tax, all for his own benefit. Large amounts of the personal expenditures also included gambling expenses, and over the course of 2008 and 2009, Sun lost $2,105,550 gambling with funds from the officer loan account.
Sun did use some of Cheung's funds for investment, directing transfers of $304,411 to his investment corporation (Sun Investment) and $2,900,000 to his personal online stock brokerage service account. However, Sun failed to distinguish whether the money was his or Cheung's.
Neither Minchem nor Sun reported money received from Cheung as income for 2008 or 2009, and the IRS sent deficiency notices to both. The IRS determined that the money from Cheung's foreign companies was either gross receipts to Minchem, which then made a distribution to Sun or, alternatively, represented direct income to Sun.
Analysis
Income is taxable to the person who earns it (Lucas v. Earl, 281 U.S. 111 (1930)). The
"true earner" of income is the person or entity who controls the earning of such income, not necessarily the recipient of the income, and the crucial question is whether the person retains sufficient dominion and control over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes (Barmes v. Comm'r, T.C. Memo. 2001-155).
The Tax Court determined that Minchem did not retain sufficient dominion and control over the funds transferred by Cheung to make it the recipient of the income for tax purposes. Instead, the court found Minchem acted as a conduit for the money, and noted that taxpayers acting merely as a conduit do not receive taxable income.
However, the court did not believe the transfers from Minchem to Sun alone indicated the funds were income to Sun. Instead, the court found that Cheung entrusted the money to Sun for the specific purpose of having him invest the funds. The court noted a transferee does not receive income when he and the transferor agree that money received is held in trust for the benefit of others (Seven-Up Co. v. Comm'r, 14 T.C. 965 (1950)), and that under the relevant state law, a trust may arise at the implication of an intention to create a trust (Mills v. Gray, 210 S.W.2d 985 (Tex. 1948)). The court found that Sun and Cheung's conduct created an implied trust, with Sun acting as the trustee of Cheung's funds.
Although trustees generally do not include the funds in their control in income, those funds become taxable income if the trustee misappropriates the money. A trustee misappropriates funds when money has been entrusted for the sole purpose of investing and is instead used for personal activities (DeGoff v. Comm'r, T.C. Memo. 1966-89). The court found that Sun used the money held for Cheung's benefit for his own personal gain, pointing to Sun's use of the funds in his gambling activities, his purchase of a luxury car, and his use of the funds to pay personal tax liabilities. The court further noted that rather than pursuing investment opportunities, Sun left what money he didn't use for personal expenses sit idle. That deviation from the agreed-upon investment strategy, the court stated, amounted to a misappropriation.
Sun argued that he did invest some of the money Cheng sent to him, but the court noted that only a fraction of the funds were invested, and all of it was comingled with Sun's personal money, further evidencing misappropriation.
Because Sun clearly misappropriated the funds for personal use and did not invest the money in accordance with the agreed-upon strategy, the Tax Court held that all the money transferred to Minchem's officer loan account from Cheung constituted taxable income to Sun.
Despite the large understatement of tax Sun incurred by not reporting the funds received from Cheung as income, the Tax Court declined to impose a fraud penalty, finding Sun did not display the requisite "badges of fraud" under Spies v. U.S., 317 U.S. 492 (1943). The court did, however, impose the 20 percent accuracy related penalty under Code Sec. 6662(a).
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Restauranteur Fails to Pin $1.6 Million Omission on Accountant; Slammed with Fraud Penalty
The Tax Court determined a restaurant owner had vastly underreported his businesses income for multiple years, and found the taxpayer's attempt to shift blame to his accountant unconvincing. The court determined the omission was fraudulent, noting the taxpayer met multiple "badges of fraud," and imposed a 75 percent penalty. Musa v. Comm'r, T.C. Memo. 2015-58.
Alaa Musa formed Casablanca Restaurant, LLC (Casablanca) as a single-member limited liability company in 2005. The restaurant used an industry standard point-of-sale system to fulfil orders and record sales reports from cash and credit card purchases. Musa kept diligent records of credit card receipts, but he would frequently throw away the records of the cash receipts. Musa never deposited more than a minimal amount of Casablanca's cash receipts into the operating account and would generally take the cash home with him.
In early 2006, Musa hired J&M Accounting & Tax Services (J&M) to provide accounting and tax services for Casablanca. J&M prepared monthly sales tax returns for Casablanca based on sales numbers Musa provided over the phone. Musa did not provide J&M with copies of daily sales reports, and the sales numbers he provided were far below what was reflected on the reports.
The IRS audited Casablanca for 2006 to 2009, and issued a notice of deficiency. The audit found Musa had vastly underreported the restaurant's income in excess of $1.6 million, and the IRS assessed a civil fraud penalty under Code Sec. 6663(a).
Code Sec. 6663(a) imposes a 75 percent penalty equal to any part of any underpayment of tax if the underpayment is attributable to fraud. Courts have developed a nonexclusive list of "badges of fraud" to demonstrate fraudulent intent (Bradford v. Comm'r, 796 F.2d 303 (9th Cir. 1986)).
The Tax Court found multiple badges of fraud were present in Musa's conduct. For all the years the IRS audited, the court determined Musa: (1) underreported his income, (2) maintained inadequate records, (3) concealed income and assets from both his accountants and the IRS, (4) failed to file Forms W-2 and Forms 1099-MISC, (5) filed false documents, (6) failed to make estimated tax payments, and (7) dealt extensively in cash. He also failed to cooperate with revenue agents during the audit, refusing to comply with multiple information document requests. Finally, Musa offered inconsistent and implausible explanations to the IRS and to the Tax Court for his behavior.
Musa argued that his accountant at J&M was to blame for the inaccuracies in his tax returns, claiming that J&M had access to his financial records and chose to underreport his income. The tax court found this unconvincing and implausible, noting that J&M did not have access to the point-of-sale reports until after the audit began, that Musa failed to disclose all of his bank accounts, and that he gave no explanation as to why his accountant would be motivated to prepare grossly inaccurate returns. Further, the court noted that under Metra Chem Corp. v. Comm'r, 88 T.C. 654 (1987), as a general rule, taxpayers cannot avoid the duty of filing accurate returns by placing responsibility on a tax return preparer.
Considering his conduct, the Tax Court found that Musa was liable for the Code Sec. 6663 civil fraud penalty for each year at issue.
For a discussion of the fraud penalty on underpayments of tax, see Parker ¶262,125.
