Taxable Talk

Today, the Tax Court looked at the case of a man who had appeared before the court twice previously. In 2001, "the Court explained to petitioner that taxable income includes money and other goods received in exchange for services and urged petitioner to file returns." In 2005, he returned to the Court: "[T]he Court again rejected petitioner’s arguments and awarded the United States a penalty pursuant to section 6673 in the amount of $5,000. Leggett v. Commissioner, T.C. Memo. 2005-185." In this case, the petitioner didn't file a 2002 tax return but had income from installing air conditioners and from Social Security. Would the third time be the charm?

Hardly.

"The Court shall not further address petitioner’s repeated argument “with somber reasoning and copious citation of precedent; to do so might suggest that these arguments have some colorable merit.” Crain v. Commissioner, 737 F.2d 1417, 1417 (5th Cir. 1984). Therefore, the Court sustains respondent’s determination of petitioner’s 2002 tax deficiency."

To rub a little salt in his wounds, the petitioner also get penalized three times; a Section 6651(a)(1) penalty for failure to file a return (5% per month up to a 25% penalty); a Section 6654(a) penalty for failure to pay estimated taxes; and a Section 6673(a)(1) penalty for "proceedings instituted primarily for delay or in which the taxpayer’s position is frivolous or groundless. “A petition to the Tax Court, or a tax return, is frivolous if it is contrary to established law and unsupported by a reasoned, colorable argument for change in the law.” Coleman v. Commissioner, 791 F.2d 68, 71 (7th Cir. 1986)."

Actually, the petitioner got lucky. In 2005, the Court gave him a $5,000 penalty. In 2006, he gets $6,000. I suspect that if he has another case in 2007, he'll get $7,000.

Case: Leggett v. Commissioner, T.C. Memo 2006-253

Every so often I have to educate my clients that if it sounds too good to be true, it probably is. Today, the Tax Court educated a businessman that S Corporations are flow-through entities: in general, the owners of an S Corporation get the income from the S Corporation and are liable for any tax.

William Tinnerman is the sole stockholder of an S Corporation in Florida. From 1986 through 1998 he used a CPA to prepare his personal and S Corporation tax returns, and all was well. In 1999, he told his accountant to stop preparing his individual tax returns. The accountant still prepared the S Corporation returns.

But Mr. Tinnerman "enhanced" his S Corporation return by adding some verbiage to it:

“The corporation has determined the net income shown on the Schedule K-1 (Form 1120S) does NOT constitute ‘gross income’ as determined by rules set forth in the Treasury Regulations at 26 CFR (4-1-99) Parts 1.61-1(a) and (b) and 1.931-1(b)(1)-(4). Therefore, since there is NO gross income, the net income shown on the K-1 is NOT reportable on your 1040 as taxable income.”

Strike one.

Mr. Tinnerman didn't make estimated tax payments for 1999 through 2002 nor did he file tax returns for those years. He also amended his 1996 through 1998 returns and changed his income to zero and his tax to zero.

Strike two.

Mr. Tinnerman then bought a sham trust package from Bay Point Enterprises, run by John Ellis and Jeff Pollard. Mr. Ellis was sentenced in 2002 to 10.5 years at ClubFed for marketing sham trusts.

The IRS tried to get Mr. Tinnerman to see the error of his ways. They provided him with a pamphlet, "The Truth About Frivolous Tax Arguments." Apparently Mr. Tinnerman believed the trust proponents who were serving time rather than the IRS.

Strike three.

The Tax Court was faced with deciding if Mr. Tinnerman owed taxes and penalties for 1999 - 2002. With three strikes against him, it's not a surprise that the Court found that Mr. Tinnerman owed the tax, a penalty for fraud, failure to file a return, failure to pay the tax shown on the return (here, the substitute for returns prepared by the IRS), and failure to pay estimated taxes.

The Court was sufficently annoyed with Mr. Tinnerman's frivolty that it imposed a $10,000 penalty for persisting in raising frivolous arguments.

That was strike four.


Case: Tinnerman v. Commissioner, T.C. Memo 2006-250

Wouldn't it be nice if you could turn some worthless material, like pyrite, into something quite valuable, like gold? Sure. But the laws of chemistry don't allow it.

Wouldn't it be nice to turn ordinary income into a capital gain, so that the tax you owed would be significantly less? Sure. But the laws of the United States (the Tax Code) don't allow it.

Today the Tax Court took a look at two test cases (out of 59 filed cases) where petitioners were trying to turn ordinary income into a capital gain. The lucky petitioners won the lottery in Florida. That was the good news. They began receiving their annual payments, and decided they wanted to get a lump sum. They contracted with a firm that does this, got approval (Florida law required a Court to approve this), and got their lump sum payment. And then the trouble began.

The petitioners contended that when they received their lump sum, they converted their lottery rights (rights to future payments) into a capital asset. They sold the capital asset; thus, they have a capital gain, not ordinary income, and would be taxed at the much lower rate for capital gains.

The Tax Court felt otherwise. Previously, the Tax Court and three Appeals Courts have held that the "Substitute for Ordinary Income Doctrine" holds; you can't change ordinary income (the lottery winnings) into capital gains through a simple transaction. The Court stated,

"The basic principle of the doctrine was expressed in Commissioner v. P.G. Lake, 356 U.S. 200, 266 (1958): The substance of what was assigned was the right to receive future income. The substance of what was received was the present value of income which the recipient would otherwise obtain in the future. In short, consideration was paid for the right to receive future income, not for an increase in the value of the income-producing property. Stated another way: if a taxpayer merely transfers for consideration the right to receive ordinary income in the future, the right transferred will not be treated as a capital asset."

The petitioners contend that a Supreme Court decision (Ark. Best Corp. v. Commissioner, 485 U.S. 212 (1988)) made the precedents invalid. Interestingly enough, just last year the Tax Court looked at a similar case that I blogged about; the petitioner lost. So it's not surprising that the Tax Court here noted, "Given that the doctrine has not been obviated or limited, we see no reason to depart from the established and uniform precedent. We, accordingly, proceed to decide whether the factual circumstances of the case we consider fall within the
doctrine’s embrace...Under the principle of the doctrine, the sale of the remaining right to the ordinary income payments did not cause their conversion to a capital asset."

So if you win the lottery, congratulations! Just remember to save enough money to pay your taxes.

Cases: Womack v. Commissioner, Spiridakos v. Commissioner (T.C. Memo 2006-240)