Tax Court In Brief: Case On Substantiation Of Expenses, And The Applicability Of Self-Employment Tax For Income Reported

Tax Court In Brief: Case On Substantiation Of Expenses, And The Applicability Of Self-Employment Tax For Income Reported

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

The Week of March 8 – March 12, 2021

Clarence J. Mathews v. Comm’r, T.C. Memo 2021-28 March 9, 2021 | Wells, J. | Dkt. No. 11829-14

Short Summary:  The case discusses the substantiation of expenses, and the applicability of self-employment tax for income incorrectly reported on a taxpayer’s tax return.

During 2011, Mr. Mathews (the taxpayer) worked for a trucking company. He also was a Minister of the Beulah Missionary Baptist Church. On his tax return, he reported his wage and pension income, but also included a Schedule C, Profit or Loss and stated that his profession was that of a Minister, reporting income and expenses mostly related to car and truck, repairs and maintenance and meals & entertainment.

The IRS issued a notice of deficiency rejecting the deductions of Schedule C and determined self-employment tax on the income reported on such Schedule. The taxpayer filed an amended return and replaced Schedule C with form 2106, Employee Business Expenses. The IRS did not accept such amended return.

During trial, petitioner did not provided evidence to substantiate his expenses. Moreover, he testified that his car and truck expenses represented mileage from commuting from his work to his job. However, the petitioner provided a letter from the pastor of the Beulah Missionary Baptist Church stating that the taxpayer did not receive a W-2 because he was not employed as a paid minister.

Key Issues: Whether the taxpayer has to substantiate his expenses with proper documents and whether the activities of a taxpayer as a Minister, for which he did not receive compensation, are subject to self-employment tax.

Primary HoldingsThe taxpayer has the burden of proof to substantiate his expenses. Moreover, self-employment tax did not apply for the activities of the taxpayer as a Minister, for which he did not received compensation.

Key Points of Law:

  • It is well known that deductions are a matter of legislative grace, and taxpayers must satisfy the statutory requirements for receiving any deduction claimed. See New Colonial Ice Co. v. Helvering, 292 U.S. 435 , 440 , 54 S. Ct. 788 , 78 L. Ed. 1348,1934-1 C.B. 194 (1934). Section 6001 requires taxpayers to maintain records sufficient to support the amount of a deduction.
  • In this case, the taxpayer did not provide any document to support the expenses he claimed. Further, he recognized that his car and truck expenses were related to his commuting from home to his job. In this regard, commuting expenses constitute a personal expense, thereby, such expenses are nondeductible. See sec. 262(a); Fausner v. Commissioner, 413 U.S. 838 , 93 S. Ct. 2820 , 37 L. Ed. 2d 996 (1973); Commissioner v. Flowers, 326 U.S. 465 , 66 S. Ct. 250 , 90 L. Ed. 203 (1946).
  • As for the taxpayer’s Schedule C income, the Court determined that the taxpayer did not received any income based on the letter received from the pastor of the Beulah Missionary Baptist Church which explained that the taxpayer did not received any payment for his services as a Minister. Consequently, the self-employment tax determination made by the IRS was rejected.
  • Finally, the IRS did not provided evidence that it had obtained supervisory approval of the initial penalty determination as provided by Section 6751(b)(1). Based on this, the Court ruled that the taxpayer was not liable for the accuracy-related penalty determined by the IRS.

InsightThis case clearly shows the common items rejected by the IRS concerning business activities reported on Schedule C. As always, it is important that taxpayers maintain appropriate records to substantiate his expenses. Finally, the judgment shows the relevance of Section 6751(b)(1) in any case involving accuracy-related penalties.


Smith v. Comm’r, T.C. Memo. 2021-29 | March 10, 2021 | Halpern, J. | Dkt. No. 1312-16L

Short Summary:  Mrs. Smith submitted four income tax returns, each of which reported zero gross income, zero taxable income, and zero tax.  The returns also sought full refunds of all amounts withheld by employers for Social Security tax, Medicare tax, and Federal income tax.  The IRS assessed civil penalties for frivolous filings under I.R.C. § 6702(a).  When such amounts were not paid, the IRS filed a notice of federal tax lien (NFTL).  During the Collection Due Process hearing, Mrs. Smith continued to advance arguments that she was not subject to Federal income tax.

Key Issue:  Whether:  (1) the Settlement Officer abused her discretion in concluding that the NFTL was appropriate; (2) Mrs. Smith should be sanctioned under Section 6673 for frivolous and groundless positions instituted or maintained during the Tax Court proceedings?

Primary Holdings

  • (1) The SO did not abuse her discretion in so far as it relates to the penalties related to the 2009 Form 1040X, the 2010 Form 1040, and the 2011 Form 1040; and (2) Section 6673 sanctions are warranted against Mrs. Smith in the amount of $2,500.

Key Points of Law:

  • The Tax Court reviews IRS Appeals’ determination to sustain the filing of an NFTL pursuant to Section 6320(c) and 6330(d)(1). Where the existence or amount of the underlying tax liability is properly at issue, the Tax Court reviews the determination regarding the underlying tax liability de novo.  Goza v. Comm’r, 114 T.C. 176, 181-82 (2000).  The Tax Court reviews all other determinations for abuse of discretion.  at 182.  The phrase “underlying tax liability” includes the tax deficiency, any additions to tax or penalties, and statutory interest.  Katz v. Comm’r, 115 T.C. 329, 339 (2000).  In reviewing for abuse of discretion, the Tax Court must uphold IRS Appeals’ determination unless it is arbitrary, capricious, or without sound basis in fact or law.  See, e.g., Murphy v. Comm’r, 125 T.C. 301, 308, 320 (2005), aff’d, 469 F.3d 27 (1st Cir. 2006).  When the Tax Court remands a case to Appeals and it comes back to the Tax Court after a supplemental determination is issued, the court reviews the supplemental determination.  Hoyle v. Comm’r, 136 T.C. 463, 468 (2011).
  • For purposes of reviewing IRS’ Appeals determinations, the Tax Court limits its review to issues raised by the taxpayer.Lunsford v. Comm’r, 117 T.C. 183, 188 (2001).
  • In exercising its jurisdiction under Section 6330(d)(1) to review an Appeals determination to sustain a collection action, the Tax Court has said that “compliance with section 6751(b)(1) is an issue of ‘verification’ under section 6330(c)(1).” Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 154 T.C. 68, 76 n.8 (2020).  The Tax Court has also stated that it reviews the verification requirement for abuse of discretion.  Blackburn v. Comm’r, 150 T.C. 218, 223 (2018).
  • Section 6702(a) imposes a civil penalty of $5,000 upon a person who files a frivolous tax return. The penalty applies if three conditions are met.  First, the filer must have filed a document that “purports to be a return of a tax imposed by” the Internal Revenue Code.  Second, the purported return must be a document that either “does not contain information on which the substantial correctness of the self-assessment may be judged” or “contains information that on its face indicates that the self-assessment is substantially incorrect.”  6702(a)(1).  Third, the filer’s conduct must either be “based on a position which the Secretary has identified as frivolous” or must “reflect[ ] a desire to delay or impede the administration of Federal tax laws.”  Sec. 6702(a)(2).  Congress directed the Secretary to prescribe and periodically revise a “list of positions which . . . [he] has identified as being frivolous.”  Sec. 6702(c).
  • Unlike the companion penalty for specified frivolous submissions provided for in section 6702(b), Congress did not in specifying a penalty for frivolous tax returns provide the return filer the opportunity to withdraw the frivolous return and, by such withdrawal, avoid the penalty. 6702(b)(3); Kestin v. Comm’r, 153 T.C. at 30.  Nevertheless, by administrative action, the IRS has accorded filers of frivolous returns a similar opportunity.
  • If a person files multiple frivolous returns for a single year, the IRS may assess multiple frivolous return penalties. See Grunsted v. Comm’r, 136 T.C. 455, 456-57 (2011).  Nevertheless, a photocopy of a return marked as a copy and on which a taxpayer does not request action “does not ‘purport to be a return.’”  Kestin v. Comm’r, 153 T.C. at 26.
  • Notice 2010-33, 2010-17 I.R.B. 609 lists positions the IRS has identified as frivolous for purposes of the Section 6702 penalty. Section III(1)(e) of the notice identifies as frivolous the position that “a taxpayer has an option under the law to . . . elect to file a tax return reporting zero taxable income and zero tax liability even if the taxpayer received taxable income during the taxable period for which the return is filed, or similar arguments described as frivolous in Rev. Rul. 2004-34, 2004-1 C.B. 619.
  • Rul. 2004-34 describes as a frivolous position a “zero return position” taken by some taxpayers. The claim is that a taxpayer may avoid tax (and perhaps obtain a refund of taxes withheld) by filing a return showing no income and no tax liability even though the taxpayer has wages, salary, or other income.  Id.
  • Section 6751(b) provides: “No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”  Written supervisory approval must be obtained before a section 6702(a) penalty is assessed.  Kestin v. Comm’r, 153 T.C. at 29, but it need not be obtained before the Commissioner sends the taxpayer a Letter 3176C giving her the option to recant and avoid the penalty.  at 30.
  • Section 6751 requires only personal approval in writing, not any particular form of signature or even any signature at all.”Deyo v. U.S., 296 F. App’x 157, 159 (2d Cir. 2008).
  • Section 6673(a)(1) provides a penalty of up to $25,000 if: (1) the taxpayer has instituted or maintained proceedings before the Tax Court primarily for delay or (20 the taxpayer’s position in the proceeding is frivolous or groundless.  A taxpayer’s position is frivolous if it is contrary to established law and unsupported by a reasoned, colorable argument for a change in the law.  Rader v. Comm’r, 143 T.C. 376, 392 (2014).  Furthermore, the purpose of section 6673 is to compel taxpayers to think and to conform their conduct to settled principles before they file returns and litigate.  Takaba v. Comm’r, 119 T.C. 285, 295 (2002).  Given the public policy interest in deterring the abuse and waste of judicial resources, the authority of the Court to impose this penalty and decide in what amount is broad.  See Leyshon v. Comm’r, T.C. Memo. 2015-104, aff’d649 F. App’x 299 (4th 2016).  The Tax Court may impose the penalty even where taxpayers have raised some issues that were neither frivolous nor groundless, along with issues that were frivolous or groundless.  See, e.g., Powers v. Comm’r, T.C. Memo. 2009-229.

Insight:  The Smith decision serves as a cautionary tale to taxpayers that frivolous positions maintained during Tax Court and frivolous filings with the IRS can result in harsh civil penalties.

Caylor Land & Development, Inc. v. Commissioner, T.C. Memo. 2021-30 | March 10, 2021 | Holmes, J. | Dkt. No. 17204-13 

  • Opinion

Short Summary

The case involved IRS challenges to a captive insurance arrangement.  The IRS issued notices of deficiency to various entities owned or controlled by the taxpayer.  Those issues were consolidated in the case.

For nearly three decades Caylor Construction bought traditional third-party commercial property, casualty, and liability insurance through its longtime insurance broker.  But in the years at issue, the taxpayers utilized a captive insurance arrangement.

The Caylors’ captive insurance company, named Consolidated, Inc., was incorporated under the laws of Anguilla7 and licensed as an Anguilla insurance company. It was owned by the principal of taxpayers. The captive insurance facilitator filed the articles of incorporation for Consolidated on December 20, 2007. On December 21, Consolidated elected under section 953(d)8 to be treated as a domestic U.S. corporation for tax purposes, as well as an election under section 831(b)(2)(A)(ii) to be taxed solely on investment income so long as its annual premiums did not exceed $1.2 million–which is what made Consolidated a microcaptive. That same day Caylor Construction paid Consolidated $1.2 million, which it deducted as an insurance expense on its 2007 tax return.  It utilized the captive arrangement thereafter.

The payment of Consolidated’s 2009 premiums began on December 30, 2008 when Caylor Construction paid Caylor Land $1,224,160 for “consulting”. Caylor Land’s only workers in 2009 were Rob and Paula, and Carly and Casey–who at the time were only 11 and 18 years old. The consulting payments were made without any contract between Caylor Construction and Caylor Land, and indeed without any records that described when the consultation took place, what advice was received, or even what subjects were discussed.

After Caylor Construction sent this $1.2 million payment to Caylor Land for consulting at the end of 2008, Caylor Land made two payments that totaled $168,000 to Consolidated in 2009. It then paid another $1.1 million for “professional-consulting fees” to the other Caylor entities that were covered under Consolidated’s program.  Those entities utilized the funds on insurance from Consolidated.

Key Issues:

  • Whether the “consulting payments” made between Caylor Construction and Caylor Land were ordinary and necessary businesses expenses
  • Whether the payments from the Caylor entities to Consolidated were “insurance expenses;”
  • Whether any penalties are owed

Primary Holdings

  • The premiums paid to Consolidated and deducted by the Caylor entities are not “insurance” for federal tax purposes.
  • The Tax Court found that the microcaptive didn’t actually provide insurance because it failed to distribute risk and didn’t act as an insurer commonly would.
  • With respect to penalties, the Tax Court reasoned as follows:

The taxpayer was pitched the idea of a microcaptive as a “tax planning solution” and a “tax planning tool.” The presentation he attended stated that this scheme would provide “a tax deduction of up to $1,200,000 * * * per year.” A sophisticated businessman like Rob should have seen this as “too good to be true.” We find that they had no reasonable cause and did not take their position in good gaith and that “[p]enalites apply across the board.”

Key Points of Law:

  • Section 162 allows the deduction of all ordinary and necessary business expenses.
  • Courts are more skeptical with respect to the allowance of expense payments between related parties.
  • Insurance premiums are deductible under section 162(a) as ordinary and necessary expenses if paid or incurred in connection with a trade or business. Sec. 1.162-1(a), Income Tax Regs.
  • Insurance companies are generally taxed on their income in the same manner as other corporations. See sec. 831(a).
  • An insurance company with premiums that don’t exceed $1.2 million for the year can elect under section 831(b) to be taxed only on its investment income. Sec. 831(b)(1) and (2)
  • while insurance is deductible, amounts set aside in a loss reserve as a form of self-insurance are not.
  • The Supreme Court has stated that insurance is a transaction that involve “an actual ‘insurance risk’” and that “[h]istorically and commonly insurance involves risk-shifting and risk-distributing.”
  • Courts look to four factors to differentiate between nondeductible self-insurance and deductible insurance:
    • risk-shifting;
    • risk-distribution;
    • insurance risk; and
    • whether an arrangement looks like commonly accepted notions of insurance.
  • Risk distribution is one of the common characteristics of insurance identified by the Supreme Court, see Le Gierse, 312 U.S. at 539, and courts will find it when an insurer pools a large enough collection of unrelated risks.
  • Alternatively, a company may adequately distribute risk through the law of large numbers–by insuring a sufficient number of unrelated risks to allow the law of large numbers to predict losses.
  • In analyzing whether an arrangement looks like commonly accepted notion of insurance, the Tax Court has looked to the following factors:
    • whether the company was organized, operated, and regulated as an insurance company;
    • whether the insurer was adequately capitalized;
    • whether the policies were valid and binding;
    • whether the premiums were reasonable and the result of an arm’s length transaction; and
    • whether claims were paid.
    • whether the policies covered risks people typically insure and if there was a legitimate business reason for buying insurance through a captive.

Insight: The IRS continues its efforts to crack down on captive insurance arrangements that it views as abusive.  The Caylor Land case follows in the line of recent Tax Court cases, such as Avrahami v Commissioner, finding that the captive insurance arrangement at issue did not provide “insurance” within the meaning of the Internal Revenue Code.  The case demonstrates why taxpayers with captive insurance arrangements should consult with an independent, competent tax attorney for a review of their compliance with the governing statutory provisions.

Brian E. Harriss, T.C. Memo. 2021-31 | March 11, 2021 | Thornton, J. | Dkt. No. 23017-17

  • Opinion

Short Summary

On August 2, 2017, the Internal Revenue Service (IRS) issued to petitioner a notice of deficiency for taxable year 2012, determining a deficiency of $31,862. The notice explained that the IRS had adjusted petitioner’s gross wages to $146,003 as shown on Form W-2.

On August 22, 2017, the IRS issued to petitioner a notice of deficiency for taxable year 2013, determining a deficiency of $46,692. The notice explained that the IRS had adjusted petitioner’s gross wages to $149,802 as shown on Form W-2.

The notice also adjusted petitioner’s gross income to include the $36,830 distribution reported by Fidelity on Form 1099-R and imposed $3,683 of additional tax for an early distribution, pursuant to section 72(t).

On December 20, 2017, the IRS issued to petitioner a notice of deficiency for taxable year 2014, determining a deficiency of $43,730. The notice explained that the IRS had adjusted petitioner’s gross wages to $175,600 as shown on Forms W-2.

The signature blocks for the notices of deficiency for taxable years 2012, 2013, and 2014 each state identically “Commissioner By Christine L. Davis, Program Manager, Return Integrity and Compliance Services, Integrity and Verification Operation” and include the signature of Christine L. Davis.

Petitioner chose not to testify at the trial, pleading the Fifth Amendment in response to respondent’s questions.

Key Issues:

  • Whether the notices of deficiency are valid;
  • Whether petitioner had unreported gross income for taxable years 2013 and 2014 as respondent determined; and
  • Whether for taxable year 2013 petitioner is liable under section 72(t) for a 10% additional tax on an early distribution from a qualified retirement plan.

Primary Holdings

  • The notices of deficiency are presumptively valid. Petitioner has offered no evidence that Ms. Davis lacked delegated authority to issue the notices of deficiency. Rather, he relies primarily on the fact that the notices show Ms. Davis’ position as “Program Manager, Return Integrity and Compliance Services, Integrity and Verification Operation”–a position not expressly listed among those to which Delegation Order 4-8 delegates authority to sign and issue notices of deficiency. As such, Petitioner has failed to meet his burden of proof to overcome the presumption of official regularity and show that Ms. Davis lacked such delegated authority.
  • The Tax Court held that the subject notices of deficiency were valid. Consequently, it denied petitioner’s motion to dismiss these cases for lack of jurisdiction.
  • Respondent has established an adequate evidentiary foundation for the unreported income. Because that showing has not been rebutted, the Tax Court concluded that respondent’s determinations of unreported income as set forth in the notices of deficiency for 2013 and 2014 were correct.

Key Points of Law:

  • A notice of deficiency beyond the statute of limitations period does not [a]ffect its validity. The statute of limitations is a defense in bar and not a plea to the jurisdiction of this Court.
  • By regulations the Secretary has extended the authority to determine deficiencies and to issue notices of deficiency to the Commissioner of Internal Revenue and to district directors, directors of service centers, and regional directors of appeals. See secs. 301.6212-1(a), 301.7701-9, Proced. & Admin. Regs. These regulations authorize the Commissioner to redelegate the performance of such functions to other officers or employees under his supervision and control; the Commissioner may also authorize further delegation of such authority by his delegates. See sec. 301.7701-9(c), Proced. & Admin. Regs. As permitted by these regulations, the authority to sign and issue notices of deficiency has been redelegated under Delegation Order 4-8, Internal Revenue Manual (IRM) pt., (2), and (3) (Sept. 4, 2012). The list of positions authorized under Delegation Order 4-8 includes “Department Managers, Campus Compliance Services (Small Business/Self-Employed)” and “Director, Return, Integrity and Compliance Services (Wage & Investment).”
  • “Whenever an official has acted, it is presumed ‘that whatever is required to give validity to the official’s act in fact exists.’” As the Supreme Court has stated: “Acts done by a public officer ‘which presuppose the existence of other acts to make them legally operative, are presumptive proofs of the latter.’”
  • In cases involving failure to report income, the U.S. Court of Appeals for the Ninth Circuit has held that the Commissioner must establish “some evidentiary foundation” linking the taxpayer to an alleged income-producing activity before the presumption of correctness attaches to the deficiency determination. Once the Commissioner has established such a foundation, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’ determinations are arbitrary or erroneous.
  • When a taxpayer receives a distribution from a qualified retirement plan, section 72(t)(1) generally provides that his tax shall be increased “by an amount equal to 10 percent of the portion of such amount which is includible in gross income.” The statute provides various exceptions, e.g., where the taxpayer receiving the distribution has attained the age of 59ó. See sec. 72(t)(2)(A)(i).
  • Because section 72(t) imposes a “tax” rather than a “penalty”, “addition to tax”, or “additional amount” within the meaning of section 6751(b) and (c) or section 7491(c), petitioner has the burden of production on this issue.

InsightThe Harriss case arose in a somewhat peculiar procedural posture, as the taxpayer (after filing a Tax Court petition) filed a motion to dismiss for lack of jurisdiction.  That posture aside, the case breaks no major doctrinal ground with respect to the underlying substantive tax issues.  The taxpayer’s arguments regarding delegation and re-delegation, however, were rather creative.  Ultimately, however, they were not sufficient to overcome the presumption of validity that attaches to a duly-issued notice of deficiency.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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