Archive for the ‘Tax Court’ Category

Time Running Out on the Miccosukee Tribe’s Battle with the IRS

Wednesday, November 4th, 2015

I have sympathy when taxpayers battle the IRS over legitimate issues. Indeed, I’m all for fighting the IRS when they’re (imho) wrong. However, fighting quixotic battles when you are wrong isn’t a good idea. The Miccosukee Tribe in Florida is in that position.

The Miccosukees operate a successful casino near Miami. The tribe itself is exempt from taxation (it’s a sovereign nation). However, the members of the tribe are not exempt from taxation when they receive income related to the casino. And therein lies the issue.

Beginning in 2012 (or perhaps even earlier) the IRS was wondering why payments to tribe members weren’t being reported (on information reporting forms) and taxes withheld. The IRS sent requests to the tribe, and eventually summonsed material from the tribe and the tribe’s financial institutions. The tribe fought the summonses claiming sovereign immunity. The tribe lost the battles, most recently with this decision in June. (It’s unclear if the tribe has since provided this information to the IRS.)

Meanwhile, approximately 20 tribe members were sent Notices of Deficiency by the IRS pertaining to distributions from 2000-2005. The tribe members filed Tax Court petitions in 2013. As best as I can tell, no case related to this has yet been decided.

Separately, the IRS issued tax, penalties and interest on the non-withholding withholding (that is, the money that the IRS thinks should have been withheld by the Miccosukee tribe). The IRS issued a lien and levy notice. The Miccosukee Tribe had a Collection Due Process hearing. When asked to provided financial information the tribe refused. The tribe lost the Collection Due Process Hearing and then filed a Tax Court petition.

The tribe disputed both the underlying liability and the collection activity (the latter, as an abuse of discretion). In May 2014 the Tax Court used an order for summary judgment against the Miccosukee tribe on the underlying liability. Because the tribe had an opportunity to dispute the underlying liability at Appeals, the Court ruled that the tribe could not dispute it in the Tax Court case.

The Tax Court held a trial in March, and ruled today that the levy was not an abuse of discretion.

It is clear from our review of the record that the SO [settlement officer] verified that the requirements of applicable law and administrative procedure were followed and that in sustaining the filing of the NFTLs and the proposed levy the SO properly balanced “the need for the efficient collection of taxes with the legitimate concern of * * * [petitioner] that any collection action be no more intrusive than necessary.” Petitioner did not raise any valid challenge to the appropriateness of the NFTL filings and the proposed levy. Furthermore, petitioner did not submit the financial information necessary for the SO to consider an installment agreement. There is no abuse of discretion when a settlement officer declines to consider collection alternatives under these circumstances…see also sec. 301.6330-1(e)(1), Proced. & Admin. Regs. (“Taxpayers will be expected to provide all relevant information requested by Appeals, including financial statements, for its consideration of the facts and issues involved in the hearing.”). Therefore, we hold that the SO’s determination to sustain the filing of the NFTLs and proceed with the proposed levy was not an abuse of discretion. [citations omitted]

While I expect the Miccouskee Tribe to file an appeal, and this will delay any IRS action for the time while an appeal is pending, it’s clear that time is running out for the Miccosukee Tribe on this matter. They may not want to provide their financial information to the IRS, but they have to. They also need to start complying with the law in regards to reporting and withholding casino income payments. Years ago, the US government ended up owning part of the Bicycle Casino. It wouldn’t surprise me that at some date in the near future that the Miccosukee’s casino is under new management.

Up In Smoke, Again

Thursday, October 22nd, 2015

A California non-profit corporation tried to find a way around Section 280E of the Tax Code at Tax Court. Would they be successful or would yet another marijuana business fall victim to the difference between federal and state law?

In 1996 California approved medical marijuana. However, federal law make marijuana a Schedule I controlled substance under Section 280E of the Tax Code. The petitioner in the case is a non-profit corporation (technically, a California mutual benefit corporation that is not for profit). The IRS had disallowed business expenses because of Section 280E of the Tax Code. The petitioner timely filed a Tax Court petition.

The problem that the petitioner faces is basically that federal law trumps state law. The Federal Drug Enforcement Administration lists marijuana as a Schedule I controlled substance. In Olive v. Commissioner, the Ninth Circuit Court of Appeals stated,

[T]he only question Congress allows us to ask is whether marijuana is a controlled substance ‘prohibited by Federal law.’ * * * If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

The petitioner tried to argue that he was in multiple lines of businesses, so that some portion of the business expenses would be deductible. The Tax Court was having none of that:

Because of the parties’ stipulation, we find that the sale of medical marijuana was petitioner’s primary source of income and that the sale of any other item was an activity incident to its business of distributing medical marijuana. We find that petitioner was engaged in one business–the business of selling medical marijuana.

With Section 280E prohibiting deductions for business expenses, the IRS’s deficiencies were upheld. Medical marijuana might be legal under California law, and expenses are deductible on California tax returns. However, until Congress changes the law business expenses for marijuana dispensaries cannot be taken on federal tax returns.

Case: Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206

Up In Smoke…Again

Monday, August 10th, 2015

Another medical marijuana dispensary owner found himself at Tax Court today. And another marijuana dispensary owner isn’t happy with the results, though in this case much of the damage was self-inflicted.

Jason Beck owned two medical marijuana dispensaries in California (he still owns one of the two locations). He kept records, but his recordkeeping rules reminded me of something out of Get Smart!. In one episode of the 1960s classic television series, the practice of the government agency called Control was to make two copies of vital records, and then destroy them. It’s a method that works well for comedic value, but is best not practiced in accounting:

It was petitioner’s ordinary practice to shred all sales and inventory records at the end of the day or by the next day. However, petitioner was able to recover and produce some of these records.

Tapes and other records were made…but were shredded. Now, in petitioner’s defense, the legal climate regarding marijuana was very different back in 2007. However, the substantiation rules for taxes haven’t changed one iota. Even an illegal business will need records or the IRS’s allegations will be assumed to be correct.

The petitioner asked to deduct business expenses for the dispensary. While a marijuana dispensary can deduct Cost of Good Sold, it cannot deduct business expenses; Section 280E of the Tax Code prohibits business expenses for any business trafficking in a controlled substance. Marijuana is a federally controlled substance. Just one month ago the 9th Circuit Court of Appeals upheld the Tax Court on this issue.

But even if the petitioner could deduct expenses, there’s the problem of substantiation.

Where a taxpayer reports a business expense but cannot fully substantiate it, the Court generally may approximate the allowable amount. However, we may do so only when the taxpayer provides evidence sufficient to establish a rational basis upon which an estimate can be made.

Here, petitioner intentionally and routinely destroyed most documents pertaining to the operation of both dispensaries. Petitioner was able to recover and produce some records; however, those records do not reconcile with the categories or amounts reported on petitioner’s tax return. Petitioner is not entitled to deduct the Schedule C expenses because they are unsubstantiated. [citations omitted]

The Court then disallows the expenses a second time based on Section 280E.

Next, there was the matter of a raid by the Drug Enforcement Administration (DEA). The DEA in early 2007 executed a search warrant and seize marijuana and other items that the petitioner valued at $600,000. He wanted to include them in Cost of Goods Sold, or take a casualty loss on the seized marijuana.

Because of his complete failure to substantiate the value of the seized marijuana, petitioner is not entitled to claim $600,000 as part of his Schedule C COGS. Additionally, if petitioner had provided substantiation, the seized marijuana would still not be allowable as COGS because the marijuana was confiscated and not sold.

In general, section 165(a) allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise. Sec. 165(a). However, section 280E provides that no deduction or credit (including a deduction pursuant to section 165) shall be allowed for any amount paid or incurred in connection with trafficking in a controlled substance. Therefore, petitioner is not entitled to a section 165 loss deduction for the marijuana seized by the DEA.

All-in-all, it was not a good day at Tax Court for the petitioner, especially after the accuracy-related penalty was upheld.

CASE: Beck v. Commissioner, T.C. Memo 2015-149

Where There’s Smoke…

Sunday, July 12th, 2015

Martin Olive operates “The Vapor Room,” a medical marijuana dispensary in San Francisco. His business, a sole proprietorship, was audited by the IRS for 2004 and 2005. He lost. He took that case to Tax Court. Back in August 2012 he lost (Olive v. Commissioner, 139 T.C. No. 2). He appealed that decision to the Ninth Circuit Court of Appeals. On Thursday the Ninth Circuit agreed with the Tax Court.

The issue in this case was 26 U.S.C. § 280E. That section of law prohibits a taxpayer from deducting any expenses (but not Cost of Goods Sold) related to a trade or business of trafficking in a controlled substance prohibited by Federal law. Marijuana–which may be legal under state law–is decidedly a controlled substance under Federal law.

The first argument of Mr. Olive was that he had multiple lines of businesses. The Court disagreed.

An analogy may help to illustrate the difference between the Vapor Room and the business at issue in CHAMP. Bookstore A sells books. It also provides some complimentary amenities: Patrons can sit in comfortable seating areas while considering whether to buy a book; they can drink coffee or tea and eat cookies, all of which the bookstore offers at no charge; they can obtain advice from the staff about new authors, book clubs, community events, and the like; they can bring their children to a weekend story time or an after-school reading circle. The “trade or business” of Bookstore A “consists of” selling books. Its many amenities do not alter that conclusion; presumably, the owner hopes to attract buyers of books by creating an alluring atmosphere. By contrast, Bookstore B sells books but also sells coffee and pastries, which customers can consume in a cafe-like seating area. Bookstore B has two “trade[s] or business[es],” one of which “consists of” selling books and the other of which “consists of” selling food and beverages.

Mr. Olive also argued that congressional intent and public policy should have § 280E not apply to medical marijuana.

Application of the statute does not depend on the illegality of marijuana sales under state law; the only question Congress allows us to ask is whether marijuana is a controlled substance “prohibited by Federal law.” I.R.C. § 280E. If Congress now thinks that the policy embodied in § 280E is unwise as applied to medical marijuana sold in conformance with state law, it can change the statute. We may not.

What this means for marijuana distributors and sellers is that they can deduct their Cost of Goods Sold but that they cannot deduct business expenses on their federal tax returns. It is likely, though, that on many state tax returns those business expenses will be deductible; after all, the business is selling a legal product on the state level. (This will likely depend on both the legality of marijuana under state law and the degree of conformity between the state and federal tax law in that state.)

Case: Olive v. Commissioner, No. 13-70510 (July 9, 2015)

The Operation Was a Success, but the Patient Died

Tuesday, July 7th, 2015

No, I’m not veering into medicine today. The title of this post is a homage to the title of a chapter in a book by the late Fred Karpin. Mr. Karpin was writing about doing everything right, but still having your contract fail in bridge. Today, we’ll look at how the IRS won all the arguments in Tax Court but lost the case.

George Starke played in the NFL back in the 1970s and 1980s, and helped lead the Washington Redskins to three Super Bowl victories. After retiring from the NFL Mr. Starke began the Excel Institute; the Washington (DC) area nonprofit provided basic education skills and job counseling and technical training. While Mr. Starke founded the institute, eventually Jack Lyon became the chairman. Mr. Starke and Mr. Lyon came to disagreements, and Mr. Starke left Excel in 2010. Excel sent Mr. Starke a Form 1099-MISC alleging $83,698.45 of income. Mr. Starke didn’t include that on his 2010 tax return and this dispute found its way to Tax Court.

Mr. Starke either received advances or loans of $83,698.45; the IRS argued they were advances and not loans and thus income. Advances are income in the year received.

We agree that the payments are not loans because we find no evidence that Mr. Starke intended to repay them at the time the payments were made. Although Mr. Starke incurred payroll deductions by Excel, he testified that he did not know why the amounts were being deducted. Further, there is no evidence of loan documents or any other document signed by Mr. Starke and a member of Excel memorializing a loan agreement. Even the 2005 letter from Excel’s accountants that set forth a repayment plan makes clear that Excel and its accountants did not consider the payments to be loans, instead characterizing them as advances.

So the IRS wins, right? Not so fast:

Because we agree that the payments were not loans, we would ordinarily look to whether the payments are considered advances; however, whether the payments are advances is irrelevant in this case because all of the items recorded by Excel as advances or prepaid expenses were recorded for years that are not before the Court. According to Excel’s general ledgers, all of the payments were made before 2010. Because advances are taxable for the year in which they are paid, any advance would have been taxable for years that are not before us.

The advances all occurred prior to 2010, so the income was earned in the past–not 2010, not the year in question. Each tax year stands on its own. So Mr. Starke wins, and while the IRS won the arguments they lost the battle.

Case: Starke v. Commissioner, T.C. Summary 2015-40

Voluntary Human Egg Retrieval and Damages

Thursday, January 22nd, 2015

A very interesting full decision of the Tax Court was released today in Perez v. Commissioner. The issue was whether a woman who had eggs retrieved from her body after undergoing fertility treatments in exchange for compensation could exclude the compensation because of the pain and suffering she went through in the procedure.

Today’s decision was written by Judge Mark Holmes, so it’s very readable for the layman. The petitioner, Nichelle Perez, agreed to undergo treatments so eggs could be taken from her body; in return she received compensation of $10,000. She did this twice in 2009; the egg donation agency issued her a 1099-MISC for $20,000. She didn’t include it as income because under Section 104(a)(2) income from damages from personal injuries and pain and suffering can be excluded from taxation. This is noted in Regulation Sec 1.104-1(c)(1):

Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.

The Court had to decide whether excluding her compensation qualified as damages per this regulation. The regulation notes that damages are required; this causes the Court to look at a Chevron test. Unlike Loving v IRS where the first step of the Chevron test failed, here the Court looked at the second step. I’m going to extensively quote Judge Holmes’ opinion here as there’s no need for paraphrasing:

On this step, we find a regulation invalid only if it is “‘arbitrary or capricious in substance or manifestly contrary to the statute.’” Perez argues that the definition of “damages” in the regulation is invalid because it requires prosecution (or threat of prosecution) of a legal suit as a prerequisite for a payment’s exclusion from income…[citations and footnotes omitted]

Perez very clearly has a legally recognized interest against bodily invasion. But we must hold that when she forgoes that interest–and consents to such intimate invasion for payment–any amount she receives must be included in her taxable income. Had the Donor Source or the clinic exceeded the scope of Perez’s consent, Perez may have had a claim for damages. But the injury here, as painful as it was to Perez, was exactly within the scope of the medical procedures to which she contractually consented. Twice. Her physical pain was a byproduct of performing a service contract, and we find that the payments were made not to compensate her for some unwanted invasion against her bodily integrity but to compensate her for services rendered…

This small change just helped tax regulation keep up with a bit of a shift in American law toward administrative or statutory remedies and away from common-law tort for some kinds of personal injuries. It is not at all arbitrary, capricious, or manifestly contrary to the Code. But it also doesn’t help Perez. We completely believe Perez’s utterly sincere and credible testimony that the series of medical procedures that culminated in the retrieval of her eggs was painful and dangerous to her present and future health. But what matters is that she voluntarily signed a contract to be paid to endure them. This means that the money she received was not “damages”.

We conclude by noting that the result we reach today by taking a close look at the language and history of section 104 is also a reasonable one. We see no limit on the mischief that ruling in Perez’s favor might cause: A professional boxer could argue that some part of the payments he received for his latest fight is excludable because they are payments for his bruises, cuts, and nosebleeds. A hockey player could argue that a portion of his million-dollar salary is allocable to the chipped teeth he invariably suffers during his career. And the same would go for the brain injuries suffered by football players and the less-noticed bodily damage daily endured by working men and women on farms and ranches, in mines, or on fishing boats. We don’t doubt that some portion of the compensation paid all these people reflects the risk that they will feel pain and suffering, but it’s a risk of pain and suffering that they agree to before they begin their work. And that makes it taxable compensation and not excludable damages.

It would be nice if tax professionals could claim part of the fees were damages from the myriad of paper cuts we get each year. Or if I could claim damages for my chipped and fake teeth (yes, I played hockey). That said, Judge Holmes’ decision, as harsh as it may be for Ms. Perez, does seem absolutely right to me. Under the US Tax Code, any accession to income is taxable (unless Congress has exempted it). Ms. Perez willingly signed a contract prior to her procedures for compensation.

Lew Tashioff has more on this.
There’s also an interesting discussion on this case from last March at the Faculty Lounge.

Case: Perez v. Commissioner, 144 T.C. No. 4

The Second Time Wasn’t the Charm

Monday, January 12th, 2015

There’s a cliche I like, “If you don’t succeed, try, try again.” In the Bozo world things work a bit differently; for them it should be, “If you don’t succeed, stop!” Today, the Tax Court looked at Joseph Banister, an individual making his second appearance at the court. The petitioner had a B.S. in accounting, a CPA license from California, and worked for the IRS as a special agent in Criminal Investigations. He also wrote a book on taxes. He must know about tax law, right?

Well, his book titled “Investigating the Federal Income Tax: A Preliminary Report” is out of print. There’s likely a good reason for that:

In the book petitioner presented a variety of arguments that he and other citizens were not obligated to pay Federal income tax for reasons including that such payment was voluntary, that the Sixteenth Amendment was not legally ratified, and that Government financing operations are unconstitutional. Petitioner began providing tax consultation services, speaking at conventions throughout the country, operating Web sites, and selling books, CDs, and DVDs setting forth his views on income tax and the Internal Revenue Code.

The petitioner was disbarred from practicing before the IRS in December 2003, largely for advising taxpayers that they weren’t liable for income taxes because the 16th Amendment wasn’t legally ratified (and some other frivolous arguments). He appealed, both administratively and via the courts, and lost the appeals.

He also lost his California CPA license “…because of the conduct that led to his disbarment from practice before the IRS.” He appealed that and also lost those appeals.

Now, let’s move to today’s decision. From 2003-2006 the petitioner made money from consultations, speeches, books, and other activities; however, he never filed returns. The IRS examined the petitioner, but the petitioner didn’t cooperate. Eventually the IRS issued Substitute for Returns with income of between $87,000 and $177,000 for each of the four years.

At trial, the petitioner didn’t deny the income.

Instead, His arguments, his motions, his attempts to conduct discovery, and his cross-examination of respondent’s witnesses at trial have been directed to his claim that the statutory notice was invalid because it was not signed by an authorized person and that, as a result, this Court lacks jurisdiction over his case. In his pretrial memorandum he also asserted that his U.S. income was not subject to tax and that he had no obligation to file tax returns, repeating or restating the arguments that had led to his disqualification to practice before the IRS and his loss of his certified public accountant’s license…

Petitioner has a history of pursuing frivolous arguments and rejecting the conclusions of every agency or court that has considered them. His argument that domestic income is not subject to Federal income tax has been restated by him in various filings, but the same conclusion has been rejected as frivolous in his administrative proceedings and in the Court of Appeals’ opinion sustaining his disbarment by the OPR. No further discussion of petitioner’s stale theories is warranted.

Petitioner was not only accused of failing to file, he was assessed the fraudulent failure to file penalty. That penalty is a whopping 75% of the tax that is due.

The additions to tax for fraud have frequently been imposed on taxpayers like petitioner “who were knowledgeable about their taxpaying responsibilities * * * [and] consciously decided to unilaterally opt out of our system of taxation…Because petitioner refused to testify, he has shown no plausible nonfraudulent explanation for his behavior.”

Ouch. But that was not all:

Petitioner was warned of the possibility of a penalty under section 6673 if he persisted in his frivolous contentions. He has presented neither evidence nor arguments showing a reasonable dispute as to the income, tax, penalties, or additions to tax determined in the statutory notice. Under these circumstances, section 6673(a)(1) provides for a penalty not in excess of $25,000 when proceedings have been instituted or maintained by the taxpayer primarily for delay or where the taxpayer’s position is frivolous or groundless. Petitioner has been undeterred despite loss of his privilege to practice before the IRS, loss of his license as a certified public accountant, and other losses in litigation. Adding a penalty to his substantial tax debt may not dissuade him. However, serious sanctions also serve to warn other taxpayers, particularly those that he purports to counsel, to avoid pursuing similar tactics.

Yes, he was assessed a $25,000 penalty for being frivolous.

I don’t know if the petitioner has any other cases floating around the IRS or the Tax Court. If he does, he might want to change his tune. I can guarantee that the third time won’t be the charm, either. He did earn one other item today: The first nomination for the 2015 Tax Offender of the Year.

Case: Banister v. Commissioner, T.C. Memo 2015-10

The Tax Court Looks for $1,410 in Dividends

Wednesday, January 7th, 2015

Today I generated my first 1099s for clients. The Tax Court looked at a case where the petitioners said they didn’t receive three $470 dividends. The issuer said they sent the checks and a Form 1099-DIV. Who was right?

In the case of information returns, the burden of proof can shift to the IRS.

If a taxpayer asserts a reasonable dispute with respect to any item of income reported on a third-party information return and the taxpayer has fully cooperated with the Secretary, the Secretary has the burden of producing reasonable and probative information concerning that deficiency in addition to such information return.

But the Court never looked at that as it based its decision on “the preponderance of the evidence.”

The only evidence that the IRS had was a letter from Computerserve (the registered agent for BNSF, the company that might or might not have issued the dividends) that said they were issued and that a 1099-DIV was sent to the petitioner.

Petitioner husband has made numerous unsuccessful attempts in recent years to contact Computershare and Wells Fargo regarding various matters relating to his BNSF stockholdings, including payment of the disputed dividends…

Petitioner husband testified that petitioners did not receive the disputed dividend payments in 2009 or a Form 1099-DIV reporting those payments and that he does not recall having negotiated any checks. His testimony included details regarding the acquisition of BNSF by Berkshire Hathaway and his persistent but unsuccessful attempts to make inquires with Computerserve and Wells Fargo about the disputed dividend payments. He called the phone number provided in the February 28, 2014, letter, but was unable to speak to anyone regarding that

Petitioner husband has devoted a substantial amount of time to contest the relatively small amount of tax liability at issue here, and he testified consistently, clearly, and with considerable conviction in explaining the negative–that he did not receive the disputed dividend payments. He has persuaded us that he did not receive the disputed dividend payments in 2009.

I suspect that the petitioner had documentation of his phone calls to Computerserve and Wells Fargo. If you do ever find yourself in such a situation, keep good records of your attempts to obtain information.

In any case, this case does show that when there’s an incorrect information return (a 1099) it is possible to dispute it and win. It would have been a lot easier for the petitioners if they could have reached someone at Computerserve or Wells Fargo and explain their situation but we have to treat life as it is, not as we want it to be.

Case: Ebert v. Commissioner, T.C. Memo 2015-5

Math Is Hard (Tax Court Edition)

Monday, November 3rd, 2014

One of my favorite sayings at the poker table is, “Math is hard.” Yesterday, the Tax Court explained some basic math to a petitioner who almost completely struck out.

Eugene Kernan didn’t file tax returns since sometime before 2000. Eventually the IRS caught up to him and issued notices of deficiency for 2001 through 2006. The IRS wanted the tax due, interest, and penalties for fraudulent nonfiling (or late filing if that wasn’t upheld) and the late payment penalty. Mr. Kernan though he didn’t have to file at all.

When the findings of fact include the words “tax avoidance,” things aren’t looking up for the petitioner.

During the years at issue Mr. Kernan had income from at least two sources: he sold various tax avoidance products, and he performed various paralegal functions, including advising people in matters before the Internal Revenue Service (IRS). Deposits into Mr. Kernan’s personal checking account from those business activities exceeded $79,000 per year.

The Tax Court decision notes that Mr. Kernan “…owned a Web site titled ‘The American Republic.'” I don’t know if he still owns it, but the website is still up and still advertising his CD-ROM titled “How to STOP the IRS.” A helpful hint to anyone who buys the cd: Yes, you must pay your taxes. But I digress….

A trial was held and the Court asked both parties (the IRS and the petitioner) to file briefs. The Court limited the size (in pages) of the briefs. Math is hard, but 88 is greater than both 75 and 30. The Court asked for a 75-page brief and a 30-page answer (those were the maximum lengths). I remember a commercial from when I was growing up: “When E.F. Hutton talks, people listen.” Well, when a judge tells you to limit something to x, you had better listen.

Mr. Kernan avoided the Court’s page limits in perhaps the least creative way of all; he just ignored them…

The generous page limit for the opening brief was to accommodate proposed findings of fact, yet Mr. Kernan’s proposed findings of fact were only two pages and consisted of argument, not findings of fact. Counting pages in the manner instructed by the Court, Mr. Kernan’s opening brief came in at 88 pages. The Court did not need to go to great effort to discover Mr. Kernan’s excess pages; he numbered them as instructed. His page 1 begins after his table of authorities, and his signature appears on page 88. Perhaps Mr. Kernan is fond of the number 88; his answering brief also came in at a whopping 88 pages, not counting attachments.

The petitioner’s briefs were stricken.

Indeed, Mr. Kernan acknowledged in his objection to respondent’s motion to strike that “there is no doubt that the Tax Court ‘has the right to set limit[s] as to brief length and has discretion as to whether to accept and/or not consider deficient briefs’.” Accordingly, we will deem Mr. Kernan’s opening and answering briefs stricken in a separate order.

As for the case itself, Mr. Kernan may want to read the Tax Protester FAQ or the IRS’s webpage on frivolous tax arguments. Either would have explained that you have to file a return.

However, Mr. Kernan did win one argument: He honestly believed (in the view of the Court) that he didn’t have to file a return, so the fraudulent failure to file penalty was not upheld. However, he does owe the failure to file and failure to pay penalties (and the estimated tax penalty). And the Court warned Mr. Kernan that if he keeps making frivolous arguments, he’ll likely have to pay a penalty in Tax Court for making frivolous arguments.

Case: Kernan v. Commissioner, T.C. Memo 2014-228

A Passive Activity Case Goes to the Taxpayers

Wednesday, August 20th, 2014

We’re going to see a lot more IRS activity regarding “passive” activities in the coming years. The Affordable Care Act (aka ObamaCare) added a new Net Investment Tax that impacts passive activities. Many taxpayers will be attempting to state activities are active (that the taxpayer materially participates) rather than passive to avoid this tax. Today, the Tax Court looked at a taxpayer who claimed large losses from his business (it will be a few years before we see Net Investment Tax cases at the Tax Court). He said he was actively involved in the businesses; the IRS said he wasn’t.

The Tax Court noted that a passive activity is one where a taxpayer is not materially participating in.

A taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” Id. A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who participate in a management or investment capacity. See sec. 1.469-5T(b)(2)(ii) and (iii), (f)(2)(ii), Temporary Income Tax Regs., 53 Fed. Reg. 5726, 5727 (Feb. 25, 1988).

Yes, this relates to temporary regulations issued over 16 years ago. Perhaps we’ll see final regulations given the Net Investment Tax. But I digress….

In the decision, the Court noted that while the petitioner’s son managed the day-to-day business, the petitioner himself was anything but an absentee owner.

Although Mr. Wade took a step back when Ashley became involved in the companies’ management, he still played a major role in their 2008 activities. He researched and developed new technology that allowed TSI and Paragon to improve their products. He also secured financing for the companies that allowed them to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous, regular, and substantial during 2008, and we accordingly hold that Mr. Wade materially participated in TSI and Paragon.

But what about the petitioner’s wife? The IRS argued that she wasn’t involved in the business (and she wasn’t), so her share of the loss is passive. The Court found that didn’t matter:

This argument is irrelevant because for purposes of the passive loss limitation, we treat married taxpayers who file a joint return as a single taxpayer, sec. 1.469-5T(f)(3), Temporary Income Tax Regs., supra, and because we treat participation by a married taxpayer as participation of his or her spouse, sec. 1.469-1T(j)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5711 (Feb. 25, 1988). Mr. Wade’s material participation in the companies is sufficient to establish material participation for both petitioners.

In a footnote, the Court noted why the passive activity loss rules were enacted:

Congress enacted sec. 469 to reduce the opportunity “for taxpayers to offset income from one source with tax shelter deductions and credits from another.” S. Rept. No. 99-313, at 713 (1986), 1986-3 C.B. (Vol. 3) 1, 713. Congress’ concern was over taxpayers who invested in businesses simply to benefit from losses. The tests and standards in sec. 469 were not meant to apply to taxpayers in petitioners’ situation.

So here the petitioner was able to show he was active on a continuous basis in his businesses, and that made the losses active rather than passive. Hopefully the IRS can get more of these cases right at audit and appeals–they’ll be dealing with many more of these over the coming years.

Case: Wade v. Commissioner, T.C. Memo 2014-169