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Eleventh Circuit Upholds Denial of Entertainment Company Founder's $19 Million NOL Deduction

(Parker Tax Publishing May 2021)

The Eleventh Circuit affirmed the Tax Court's denial of a taxpayer's net operating loss deduction because (1) the taxpayer did not prove that all of the claimed expenses were trade or business expenses, (2) his documentation included largely vague descriptions, and (3) he provided no documentation of his business's cash or credit card expenses. The Eleventh Circuit also held that the Tax Court did not abuse its discretion in adopting the IRS's Rule 155 computations after finding that the taxpayer attempted to raise issues that had not been previously addressed in the trial. Barker v. Comm'r, 2021 PTC 124 (11th Cir. 2021).


In 2002, Cecile Barker started an entertainment company, SoBe Entertainment International, LLC (SoBe), with $10 million of his own money. SoBe's business was finding musical talent and then recording, producing, and marketing music and videos from its signed talent. SoBe has never earned a profit, and its cumulative losses increased from year to year. SoBe is a partnership whose losses flow through to Barker individually. For years, Barker reported losses stemming from SoBe on his personal income tax returns. But, in 2011, Barker became the victim of identity theft when someone else filed a tax return using his social security number. Barker did not file his true personal tax return for 2011 until August 2016.

In 2014, the IRS issued a notice of deficiency to Barker based on the 2011 fraudulent tax return. The IRS had reconstructed Barker's personal income from third-party sources and determined he owed $1,259,279 in federal income taxes for the year 2011. Barker challenged the notice in the Tax Court. In 2016, during the Tax Court proceedings, Barker late-filed his true 2011 tax return. On the return, Barker included a deduction for a net operating loss (NOL) carryover of $19,604,416 from SoBe. As a result of that large NOL deduction, Barker's 2011 tax return showed no personal income taxes due. Barker's late-filed 2011 tax return also reported capital gains and interest and dividend income that was not included in the IRS's notice of deficiency.

Barker filed an amended petition in the Tax Court, arguing that he was entitled to offset any income he personally had during 2011 with the NOL of SoBe that carried over from prior years. The IRS disagreed, and the case went to trial. Barker presented evidence to support his claimed NOL deduction from SoBe. He introduced SoBe's financial records, including: (1) SoBe's general ledger from 2005 - 2009; (2) SoBe's bank account statements from 2002 - 2012; and (3) copies of SoBe's cancelled checks from 2006 - 2010. SoBe's partnership tax returns for 2003 - 2011 and Barker's individual returns for 2005 - 2011 were also provided. At the start of the trial, the IRS stated that it intended to file an amended answer because Barker's late-filed 2011 tax return included additional items of income.

At trial, three people testified: (1) Barker; (2) John McQuagge, SoBe's CFO and controller from 2006 - 2010; and (3) Stanley Foodman, the accountant who prepared Barker's personal tax returns for 2005 - 2011 and SoBe's partnership returns for 2006 - 2009. Barker testified that he personally approved SoBe's expenses that were in excess of a few thousand dollars. McQuagge testified that all of SoBe's expenses were recorded by him in QuickBooks around the time that the expenses were incurred. McQuagge then used QuickBooks to generate SoBe's general ledger.

Some of SoBe's expenses were paid with cash or credit cards. The general ledger listed all expenses and sometimes included a description of the expense. But often the descriptions were as vague as "Expenses" or "Travel." The general ledger also contained adjusting journal entries. One such adjusting journal entry was a 2009 entry for $3,417,238.48 with the description "Artist Advance." Barker was unable to provide any more granular detail on this expense at trial and acknowledged that he could not identify which of the cancelled checks corresponded to that expense. Similarly, McQuagge testified that he did not know the breakdown of the $3.4 million or which checks corresponded to it. McQuagge testified that there were multiple adjusting journal entries throughout the general ledger, but he was unable to give specifics behind any of them. Foodman explained how he calculated Barker's 2011 NOL deduction by using the losses reported on SoBe's partnership tax returns and on the Schedules K-1 furnished to Barker by SoBe. No one testified as to how SoBe's partnership tax returns were prepared.

Following the trial, the IRS moved to amend its answer to Barker's amended petition. The IRS filed the proposed amendment, which added, among other things, the additional items of income that Barker included in his late-filed 2011 tax return and admitted at trial. The IRS also disputed Barker's entitlement to the NOL deduction of $19,604,416 and sought a late filing penalty under Code Sec. 6651. The Tax Court granted the IRS's motion to amend its answer, noting that Barker had included those amounts of additional income on his late-filed 2011 tax return and stipulated to them.

In Barker v. Comm'r, T.C. Memo. 2018-67, the Tax Court upheld the IRS's determinations after finding that Barker failed to substantiate his 2011 NOL deduction. Following the issuance of the Tax Court's opinion, the IRS submitted its Rule 155 computations of the proper deficiency and penalty amounts. Barker objected on the basis that the IRS failed to take into account the items listed on his 2011 tax return in its computations. These items, which were unrelated to SoBe, included itemized deductions, costs of goods sold, and other expenses and losses. Alternatively, Barker requested that the Tax Court reopen the record to introduce evidence about the items on his 2011 return. The Tax Court adopted the IRS's computations and denied Barker's motion and adopted the IRS's computations. Barker appealed to the Eleventh Circuit.

Eleventh Circuit's Analysis

The Eleventh Circuit affirmed the Tax Court's decision after finding that the Tax court did not err in finding that Barker failed to prove his entitlement to the NOL deduction on his 2011 return and did not abuse its discretion by adopting the IRS's Rule 155 computations or by denying Barker's motion to reopen the record.

The Eleventh Circuit agreed with the Tax Court that Barker failed to substantiate his claimed NOL deduction in 2011. The court found that, although Barker provided a patchwork of documents showing that SoBe incurred expenses, he did not carry his burden of proving that all of the expenses were in fact deductible trade or business expenses. The court noted that the general ledger contained largely vague descriptions and numerous adjusting journal entries, and neither Barker nor SoBe's former CFO and controller could give a breakdown of the $3.4 million adjusting entry or point to checks that corresponded to it. Further, with a description of "Artist Advance," they did not even know on which artist the money was spent. Worse still, in the court's view, was that Barker did not put the 2003, 2004, 2010, or 2011 general ledgers into evidence, despite those ledgers being the only documentation of SoBe's credit card and cash expenses. The Eleventh Circuit noted the bank statements did not detail the amounts of SoBe's expenses paid by cash or credit cards and did not describe the business purpose of each expenditure. The court also found that the witnesses' testimony did not fill in these gaps, and SoBe's tax returns could not, by themselves, establish those losses. Accordingly, the Eleventh Circuit concluded the Tax Court did not clearly err in finding that Barker was unable to substantiate SoBe's losses and therefore, by extension, the allowable NOL deduction on Barker's personal 2011 tax return could not be calculated.

The Eleventh Circuit concluded that the Tax Court did not abuse its discretion by overruling Barker's objections to the IRS's Rule 155 computations, which included the income but not the deductions from Barker's late-filed 2011 return. The court noted that after late-filing his 2011 return, Barker expressly raised the NOL issue in his challenge to the notice of deficiency, but he did not raise an issue as to any of the additional deductions claimed on his return. According to the court, Barker had the burden to prove that he was entitled to those claimed deductions. Further, even after the trial, when the IRS amended its answer to increase the deficiency amount and assert a penalty, Barker did not raise any issue concerning the additional deductions and, as a result, those deductions were never litigated. The Eleventh Circuit found that Barker waited to raise the issue until the very end of the case and said that the Rule 155 computation process is not intended to be one by which a party may raise for the first-time issues which had not been previously addressed. By the same reasoning, the Eleventh Circuit also concluded that the Tax Court did not abuse its discretion by denying Barker's motion to reopen the record to allow him to introduce new evidence to substantiate the unlitigated deductions.

For a discussion of net operating losses, see Parker Tax ¶99,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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