Psychometrician ≠ Tax Expert

Professor Emeritus Lawrence M. Aleamoni is a psychometrician.  I am not exactly sure what that means, but I assure you that it does not mean “tax expert.”  Actually, it seems that one may not have to have taken a single accounting course to be a psychometrician.

Professor Aleamoni many years ago established a corporation in which to operate his “outside” consulting and work activities.  In the years before the Tax Court – 2010, 2011, and 2012 – the corporation was taxed as a C corporation.  Professor Aleamoni and his wife owned 50% of the corporation and his children owned the other 50%.  So far, so good.

In the years in question, Professor Aleamoni made loans to the corporation.  In each of those years, the corporation duly recorded the loans as shareholder loans (liabilities) on its balance sheet in its tax return.  In each of those years, the corporation reported gross income and deductions that yielded “negative taxable income,” or what we accounting cognoscenti call a “loss.”  One could logically conclude that the losses were funded by the shareholder loans.  Nothing’s wrong with this.

At the same time that the loans were being recorded by the corporation as being a liability to the shareholder, such shareholder was not recording the loans as assets on his books.  Professor Aleamoni was reporting the advances as deductions on Schedule C of his tax return, entitling them “Personal Loan to Business.”  So, Professor Aleamoni was deducting the payments that he was making to his corporation that was not reporting such payments as income and was apparently using that money to pay for deductions that caused the losses for the corporation.  Oops, on so many fronts.

I would wager that sometime about the third or fourth week of an Accounting 101 class, the students would unanimously recognize that you can’t do what Professor Aleamoni did.

Professor Aleamoni went on to argue that the IRS had not caught this problem on a prior audit.  Thus, says he, the IRS cannot bring up the issue in this later audit.  Wrong.

After I finished reading this summary opinion by the Tax Court, I wondered what self-respecting tax attorney would bring this case before the Tax Court.  I went back to the beginning of the court’s opinion to advance that inquiry.  The answer was that no self-respecting lawyer had involvement in the case.  Professor Aleamoni represented himself.  I should have guessed that.

VKM

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Didn’t know about your ownership in a partnership? Doesn’t excuse you from paying tax on income from the partnership.

Divorces can be nasty. Just ask Mrs. M. (a prominent Dallas family (aka, divorce) lawyer with whom I live). In this Tax Court Memorandum decision, you get an idea of how ugly things can get, particularly when you drag the IRS into the fray.

Vince (not Vance) and Ann Carrino were married in 1990 and legally separated in June 2002. Their divorce dragged on for four more years. The Tax Court described Vince as “an exceptionally skilled financial manager.” He was a hedge fund guru. He was also crafty.

Vince initiated a new hedge fund in January of 2002 – CR LP. He did not tell Ann about it. The new hedge fund started business later in 2002. CR LP did really well in 2003. Ann was not listed as a partner in legal documents, did not get a K-1, and did not know about CR LP until quite a bit later.

When Ann got wind of CR LP, she took action. The California divorce court ruled that she owned a piece of the partnership under community property law and she received over $6 million to liquidate her interest in CR LP in November 2006. In December 2006 the divorce was granted.

On what appeared to be the last day to file a 2003 amended return for CR LP (April 15, 2007), Vince filed an amended partnership return and sent Ann a 2003 K-1 in 2007 showing her share of income of over $750,000 and reduced his general partner entity share of income by the same amount. She did not file an amended return for 2003 to report her income on the K-1. The IRS noticed that omission. The parties went to Tax Court.

Ann tried to argue that she was not really a partner under California community property law. She lost that argument. The Tax Court said she owed the money.

Of course, Vince filed an amended return for 2003 seeking a refund. Apparently his refund claim was disallowed by the IRS. It seems that Vince filed a Tax Court petition pro se seeking relief from an IRS determination to disallow his refund claim. He did not go through the right channels to appeal the initial disallowance, so he lost the right to get a refund.

Just to add a little salt to the wounds of Vince and Ann, the Tax Court decision contained some dicta. It pointed out that the California divorce court, while criticizing Vince’s hasty and unilateral action, slapped him with all of Ann’s penalties, interest, fees and costs above the actual federal and state taxes she owes. Then the Tax Court mentioned in a footnote to the case that Ann and her lawyers did not argue innocent spouse relief, hinting that she may have received some tax relief from those provisions. The Court pointed out that it can’t address arguments not made.

Did I say that divorces can be nasty?

VKM

Tax Court is Not Nice to a Lady in Distress

Linda Sharp, a former university professor of choral music, received a settlement from the University of Northern Iowa for “emotional distress damages only,” according to the settlement agreement, in the amount of $210,000. She claimed that she had been treated badly by her superiors and, based on the several newspaper accounts in Cedar Rapids, Iowa (where the story got a lot of press coverage), I can see why she complained. She had severe clinical depression and a host of other psychiatric diagnoses.

She excluded the first $70,000 payment, which was received in 2010, from gross income on her 2010 return. She attached to a her return a note (not the prescribed form) that she was doing so. She relied on the advice of her attorney. The IRS disagreed with her exclusion.

Professor Sharp lost the case. Basically, in a recent memorandum decision, Tax Court Judge Kroupa said that the plain language of the settlement agreement kept the payment from being excludable under IRC Section 104(a)(1) and (2), which allows exclusion from gross income for (1) amounts received under workmen’s compensation insurance for personal injuries or sickness and (2) damage amounts received on account of physical injuries or physical sickness.

Then, Judge Kroupa upheld the IRS’s imposition of a 20% accuracy penalty for substantial understatement of tax. One of the ways to avoid the penalty is for the taxpayer to have relied the advice of a competent tax professional. Possibly because of a procedural matter, there was not much proof offered into evidence that the attorney who advised her was knowledgeable about taxes. (Yet, it appears from footnote 4 in the opinion that this same attorney was representing her in this Tax Court case!)

Judge Kroupa lowered the boom on Professor Sharp: “It is difficult to imagine how petitioner, a professional, accomplished woman, could reasonably rely on an attorney whose tax advice was so contrary to such an established body of law. In any case the record fails to reflect that petitioner reasonably believed her attorney to be a competent tax adviser with sufficient expertise to justify reliance.”

Judge Kroupa, I respectfully dissent. She’s a music educator! I know a bunch of professional, accomplished, very bright music professors. I doubt seriously if any of one of them has a sufficient grasp of the tax code to overrule the attorney who is representing her or him before the Tax Court. It’s like I told someone today: as smart as he/she is, I wouldn’t want a brain surgeon doing my taxes.

-VKM

Michael Jackson’s Estate Tax Liability – Dangerous Dollars

The executor of Michael Jackson’s estate and the IRS have rather divergent opinions of the value of his estate at the time of his death. Recent filings with the Tax Court reveal that the executor declared a value of $7 million. The IRS tells the Tax Court that the value is about $1.125 billion. This Tax Court case promises to be a Thriller.

We learned in August of 2013 that the estate was going to Tax Court with the IRS’ calculation of the estate tax and try to Beat It; we learned the particulars only a few days ago. A couple of the biggest differences of opinion are eye-popping. The estate valued the value of Jackson’s likeness at $2,105; the IRS says it was worth $434 million. (Heck, my likeness may be worth $2,105!) The estate valued the value of a music catalog comprised of works of Michael Jackson and of the Beatles (!) at zero; the IRS valued the catalog at $469 million.

The IRS says that the valuations by the estate were really Bad, so they have assessed the penalty for gross understatement. The total of taxes and penalty that the IRS wants is $702 million.

Valuation cases are never Black or White. This one will be very interesting to follow. If you are interested in the results of this conflict, You Are Not Alone.

-VKM

It Has Been a Bad Spell for Charitable Donors Who Don’t Follow the Rules

In the last three weeks, the Tax Court has issued two decisions that demonstrate the importance of complying with the rules for substantiating a charitable contribution.    These cases are cautionary tales writ large!

Under Section 170(f)(8)(A) of the Internal Revenue Code, no charitable contribution deduction for any contribution of $250 or more is allowed unless the taxpayer substantiates the contribution with a contemporaneous written acknowledgment of the contribution by the donee organization that meets certain specified requirements.  A written acknowledgement is contemporaneous if it is obtained by the taxpayer on or before the earlier of: (1) the date the taxpayer files the original return for the tax year of the contribution; or (2) the due date (including extensions) for filing the original return for the year. 

In David P. Durden, et ux., TC Memo 2012-140, the Durdens gave over $22,000 to their church in 2007.  The IRS disallowed the charitable contributions in a notice of deficiency sent April 13, 2009.  (The case does not explain how the notice of deficiency came into existence, but it may have simply come over the transom as part of a correspondence audit:  you, the taxpayer, can’t deduct the contributions until you submit to us, the IRS, proper documentation.)  The petitioners sent the IRS a letter from the church dated January 10, 2008, which acknowledged contributions from them during 2007 of the amount deducted.  The IRS did not accept this acknowledgement because, while it was “contemporaneous,” it lacked a statement regarding whether any goods or services were provided in consideration for the contributions, such statement being one of the “certain specified requirements” mentioned above.

No problem, thought the Durdens.  They obtained a letter from the church dated June 21, 2009 that contained the right language.  Sorry, says the IRS.  That acknowledgement is not acceptable because it was not “contemporaneous” as defined.  The Tax Court agreed with the IRS and the Durdens did not get a charitable contribution deduction.

There are a lot more rules concerning substantiation and documentation of charitable contributions.  In Joseph Mohamed, Sr., et ux. TC Memo 2012-152, the Mohameds lost charitable contribution deductions of over $18,500,000, because they did not follow the extensive regulatory requirements for substantiating charitable contribution deductions over $5,000.  In this case, Mr. Mohamed prepared his own return and found the instructions for Form 8283 confusing and, apparently, too burdensome to spend much time reading.

Sorry, says the Tax Court.   “We recognize that this result is harsh – a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued, their contributions – all reported on forms that even to the Court’s eyes seemed likely to mislead someone who didn’t read the instructions.  But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules.”

So, in the past, we may have seemed a bit picky when we asked for and poured over the documentation for your charitable contributions.  Hopefully, you now understand a little better why we do what we do.

 

Vance

Revisiting the Hobby Loss Rules

When a case is styled Lee Storey, et vir., that is a hint that the story is about a lady.  The lady in Tax Court Memo 2012-115, issued last month, is quite interesting.

Lee Storey is a very successful attorney who has always had an interest in the arts.  (Reminds me of a lady I live with, whose biography would also be styled et. vir.)  A number of years into her marriage, she learned that her husband had been a performer with the “peppy” singing group Up With People.  (Seems like something you would know pretty early about your spouse; he must have not been too proud of his involvement with the group that has been parodied on The Simpsons and SouthPark.  I digress too much.)

When her children matured sufficiently to leave home and to allow her some free time, Mrs. Storey undertook a project of making the film “Smile ‘Til it Hurts:  The Up with People Story,” which had an initial working title of “Power and Passion: The Up With People Story” that had to be changed because internet searches for the title ended up at porn sites.  (Darn, I digress again.)   She started in earnest in 2005.  In the three years considered in the case – 2006-2008, it appears that she deducted over $750,000 in costs.  In 2010 she made her first revenue off of the project – $250.  At the time of trial, presumably in late 2011, she was still optimistic about someday making a profit.  The IRS challenged the deductions under Section 183 of Code, the hobby loss rules.

The Feds sure picked on the wrong lady.  Mrs. Storey was entirely business-like in her approach to film-making.  She took a sabbatical to attend a film school; she took an additional filmmaking course; she wrote a business plan; she hired a bookkeeper; she retained an accounting firm; she kept careful records; she bought appropriate filmmaker insurance; she hired experienced filmmakers to work on the project; she tirelessly promoted the film; she looked at different ways to create revenue.  Tax Court Judge Kroupa said that “her work product demonstrates time-consuming care and attention to detail.”  Judge Kroupa went on to analyze whether the movie-making was engaged in for profit using nine nonexclusive factors found at Regulation Section 1.183-2(b).  By my count, the IRS won one round, Mrs. Storey won five rounds, and three rounds were scored as draws.  Victory to Mrs. Storey.

The takeaway is that it is alright to do something you love and try to make a profit at it, even if you are ultimately unsuccessful (at least not yet at the time of trial).  Approach the project in a businesslike fashion and early in the endeavor document your path to profits.  Keep good records and use appropriate expertise.  Above all, don’t mess with Lee Storey.

Vance

One Case – Two Enterprises – One a Business and One a Hobby

A Tax Court Summary Opinion is an opinion issued under the Tax Court’s small case procedures.  While a Summary Opinion cannot be precedential, it can be instructive.  The Tax Court addressed the issue of hobby loss disallowance under IRC Section 183 in Ryberg, T.C. Summary Opinion 2012-24 filed March 12, 2012.  One can deduct losses from a business.  One cannot deduct losses from a hobby. 

 

The case addressed the tax year 2006.  Each of the Ryberg spouses pursued an interest.  The wife (referred to herein as “Mrs. R.”) bred horses for about nine years.  The husband (referred to herein as “Bubba”) was a “professional” drag racer for about 20 years.  Both had 40-hour per week day jobs.

 

Mrs. R. was a certified horse judge.  In preparation for starting her operation, she took university courses concerning horse breeding.  She took a law school class on horse breeding contracts.   She studied the markets, attended horse auctions, and delved into the technical and business aspects of horse breeding.  Mrs. R. devised a business plan focusing on a niche market.   When she was not at her day job, Mrs. R. was working in the breeding operation and doing everything there was to do in the enterprise.  She kept a ledger and prepared monthly financial and analytical reports.  When he wasn’t drag racing, Bubba helped Mrs. R.  According to the Tax Court:  “On some occasions, [Bubba] would spend the entire weekend spreading manure for compost.”   After a series of setbacks – a bad market, West Nile virus, unusually high feed costs, her cancer and Bubba’s injuries, Mrs. R. gave up the breeding operation in 2006.

 

Bubba had a 1968 Chevrolet Rally Sport Camaro, modified it for drag racing, and started racing in 1990.  By the time the case went to trial, he had raced for 20 years and never had a money-making season.  He had a few people sponsor him; in exchange, they put their decals on his Camaro and his trailer.  He solicited drag racing tips from his buddies, but never consulted with anyone about the business aspects of racing.  The Tax Court pointed out that Bubba “allegedly tracked his expenses using a spreadsheet.”  He did not provide at trial a copy of the spreadsheet or any documents that he “allegedly” maintained.  The Tax Court seemed to conclude that his full-time job as a spray painter probably did not give him any “particular expertise in the business, financial, or economic aspects of drag racing.”

 

The Tax Court ruled that Mrs. R. had a business and that Bubba had a hobby.  Can you see the difference between a business and a hobby?

 

Vance

Stock received on option exercise was taxable event even though it became worthless in about six months: OUCH!

Patrick Sheedy worked for People’s Choice Financial Corporation (“PCFC”) from October 2001 through June 2006.  In 2004 he received nonqualified stock options to purchase 271,067.30 shares of PCFC common stock for $0.0221347 per share.  The options expired three months after Sheedy’s termination with his employer.

Sheedy left his employer in June 2006 and exercised most of his options on September 22, 2006, purchasing 250,000 shares that were “restricted securities” if the company went public.  As set forth in the option agreement, the compensation committee of the board of directors set the fair market value of the shares of privately held PCFC on the date of exercise.  The committee determined the value to be $3.00 per share, a price at which shares had changed hands infrequently in the last several months before the sale through an investment adviser who acted as an intermediary for trades of PCFC shares.  Sheedy signed a typical “accredited investor” letter stating that he knew what he was doing and knew about the company’s business and financial condition.

Sheedy paid PCFC a total of $225,278:  $5,534 for the purchase price of the shares and withholding tax of $ 219,744.  In March 2007, PCFC declared bankruptcy.

Let’s summarize.  Sheedy recognized almost $750,000 of ordinary income and was out of pocket almost $250,000 in taxes on stock that was worthless six months later.

Sheedy filed an original return for 2006 reporting the income.  He filed an amended return claiming a theft loss in the amount of the income recognized.  Nice try.

The law is clear, but punitive in the instant case.  The Tax Court got it right.  Sheedy was taxable on the difference between the $3.00 per share purchase price and the purchase price of $0.0221347 per share; no refund for 2006 for Sheedy.

As a consolation prize, the IRS awarded Sheedy a worthless stock loss in the form of a short-term capital loss.  If Sheedy lives an exceptionally long life and his investing acumen does not improve, he’ll recoup his money in 250 years.

Back in the 1980s, I witnessed this same phenomenon strike a number of employees of a client of mine.  These good folks were featured in a Fortune magazine article that trumpeted their sudden wealth when their employer went public and they held very valuable stock following the IPO.  Only a six-month restriction period kept them from being cash rich:  sort of an East Texas and low-tech version of Facebook millionaires.  During that six months the stock tanked.  They could not pay their taxes, even if they sold all their stock.  I and my colleagues from around the country tried to find a solution.  There was no way out.

So, let Sheedy be a cautionary tale if you get a chance to get in on the ground floor through nonqualified stock options.  Be sure that you understand the price you pay and the risks you take for the opportunity.

Vance

Tax Court disallows cost segregation of apartment buildings in AmeriSouth XXXII, Ltd., TC Memo 2012-67, issued in March, 2012.

Cost segregation studies performed on depreciable real estate give taxpayers a basis for depreciating certain components of the properties over much shorter depreciable lives than 27.5 years for residential real property and 39 years for nonresidential real property.  If there is any meaningful interest rate to use to present value the accelerated tax savings, the results of a cost segregation study are quite valuable to taxpayers.  As you might guess, the IRS has some reservations about cost segregation.   It took issue with AmeriSouth, a Dallas-based company, about its cost segregation results on its Garden House Apartments, located in Mesquite, Texas and owned by its partnership AmeriSouth XXXII, Ltd.

From this new case, we are reminded of or learn several things.  First, bad facts make bad law.  Second, pigs get fat and hogs get slaughtered. Third, Tax Court Judge Holmes (or one of his law clerks) is a funny person.

Bad facts make bad law.  AmeriSouth didn’t show up for the trial – definitely a bad fact.  By the time this case was tried, AmeriSouth XXXII had sold the property.   It did not answer court summons and orders.  Its attorneys withdrew.  The court could have dismissed the case entirely, but instead decided the case, deeming any factual matters not contested to be conceded by AmeriSouth.   The court sided with the IRS in almost all of its contentions and held that most components were structural components, integral to an apartment building’s operation and maintenance, and therefore depreciable over the life of the building – 27.5 years.

Pigs get fat and hogs get slaughtered.  At least some commentators have said that the cost segregation study was overly aggressive, even by the normally aggressive standards of cost segregators.  The IRS had plenty to pick on.

I suppose that Judge Holmes had some time on his hands, since he did not have to weigh many factual arguments.  He used that extra time to write quite an entertaining opinion; even a casual reader, let alone a tax nerd like me, would get a number of laughs.  For example, at the beginning of the opinion, Judge Holmes says:  “We are tempted to say [the benefit of shorter depreciable lives] is why AmeriSouth throws in everything but the kitchen sink to support its argument – except it actually throws in a few hundred kitchen sinks, urging us to classify them as “special plumbing,” depreciable over a much shorter period than apartment buildings.”  Well, I thought it was funny.

The upshot of this case is that the IRS has something, if only a memorandum decision, that it can rely on to go after cost segregation studies of apartment buildings.  Be forewarned.

 

Vance