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.
Plentywood Drug, Inc. | April 26, 2021 | Holmes| Dkt. No. 17753-16
Short Summary: The Tax Court was asked to decide whether rent paid by the Taxpayer was reasonable. The Taxpayer was owned by four related individuals (the “Shareholders”). The Shareholders owned the building where the the Taxpayer was operating. The Taxpayer paid rent of $83,584, $192,000, and $192,000 for 2011, 2012 and 2013, respectively.
The IRS disallowed certain rent deductions by the Taxpayer to the Shareholders because the IRS stated that the rent paid by the Taxpayer was greater than what the fair market rent would have been paid at an arm’s length transaction. The IRS recharacterized the excess rent as dividends, therefore, the Taxpayer would not be able to deduct the dividends.
The Taxpayer and the IRS introduced experts to testify regarding the fair market value of rent for the building. This case is unique because there were no comparable properties in this small town of 1,700 people.
It should be noted the IRS does not often question the reasonableness of a rent agreed to by parties at arm’s length. When there is a close relationship between the lessor and lessee and there is no arm’s length dealing between them, the IRS will inquire into what constitutes reasonable rent.
Key Issues: What is the fair market rent for the building?
Primary Holdings: The Court, after considering each party’s expert witness, concluded that a proper rent would be $15.90 per square foot for the main retail space of the store and $8 per square foot for the basement storage space in the building, resulting in a total fair market value of rent each year of $171,187.50. The Court denied the Taxpayer a deduction of approximately $20,000 for tax years 2012 and 2013.
Key Points of Law:
- IRC section 162(a) allows a taxpayer to deduct the “ordinary and necessary” expenses it pays in carrying on a trade or business. The IRC specifically lists the rent paid by a business as one of these deductible expenses.
- The expense for rent, to be ordinary and necessary, must be reasonable to be deductible. Any part of the rent that is unreasonable is not ordinary and necessary and thus not deductible.
- The Court is not bound by the opinion of any expert witness and may accept or reject expert testimony in the exercise of its sound judgment.
- When measurements were made and accepted by parties operating at arm’s length, the Court may rely on those figures in computing a proper price per square foot.
Ronnie S. Baum and Teresa K. Baum v. Comm’r, T.C. Memo 2021-46 April 27, 2021 | Kerrigan, J. | Dkt. No. 19567-19
Short Summary: The case discusses the substantiation of expenses, and the deductibility of theft losses under I.R.C. 165.
Mr. and Mrs. Baum (the taxpayers) were self-employed during 2015 and 2016 (years at issue). Mr. Baum was a consultant for Harrington Capital Partners, LLC, for which he was the sole owner. Mrs. Baum was a realtor. During the years at issue, the taxpayers claimed multiple deductions on their Schedule C, such as meals and entertainment expenses, offices and car and truck expenses.
In 2012, Mr. Baum acquired stock of Globe Protect, Inc. a company that manufactured filters to clean saline water. It must be noted that this opportunity was presented to Mr. Baum by a third party, a Mr. Zeilinger, and the stock was acquired from Mr. Zeilinger’s mother.
Despite the promising prospective for the Globe, Mr. Zeilinger filed for bankruptcy in 2014 and some other creditors obtained judgment in their favor. Mr. Baum did not receive a favorable judgment. However, the taxpayers claimed the loss suffered from the investment on their 2015 tax return, Schedule A, as a theft deduction. Such return and the 2016 tax return were filed until 2018.
Key Issues: Whether the loss suffered by the taxpayers qualifies as a “theft loss” under Section 165.
To be deductible as a theft loss, the loss must arise from a theft according to the laws of the jurisdiction where the loss was incurred, but also, the taxpayer must determine the amount of the loss and the year in which it was sustained. Failure to meet any of these standards translates in the rejection of the loss.
Key Points of Law:
- Schedule C deductions.
I.R.C. 162 allows taxpayers to deduct ordinary and necessary expenses incurred in carrying a trade or business. Some of these deductions, to be deductible, must comply with certain substantiation rules. Here, the taxpayers did not provide any proof to support the amount, time, and business purpose of the various expenses, such as the travel expenses, meals and lodging, among others. Consequently, such expenses are disallowed, sustaining the Commissioner’s determination.
- Theft loss deduction.
I.R.C. 165 allows taxpayers to deduct three types of losses: those incurred in a trade or business, those incurred in a transaction entered into for profit or losses arising from other causes, such as theft.
Theft is defined broadly, and encompasses various criminal conducts including larceny, embezzlement and robbery. Treas Regs. Sec. 1.165-8 (d). Moreover, the taxpayer must prove that the theft occurred under the law of the jurisdiction wherein the alleged loss occurred, See Monteleone v. Commissioner, 34 T.C. 688 , 692 (1960), the amount of loss and the date that the loss was discovered.
The Court determined that “Theft” under California laws. Under the California Penal Code, the concept of theft consolidates various similar criminal conducts, such as larceny, theft by false pretenses and embezzlement. Cal. Penal Code sec. 484(a). Taxpayers claimed they suffered losses from “fraud in inducement”, directing the analysis to false pretenses, which includes elements on the defendant such as intent to defraud the owner of the property, making false representations and obtaining title of the owner’s property as consequence of the reliance. In this case, the Court found that the petitioners did not provided any evidence that supported that Mr. Zeilinger made false representations or with the intent to defraud. Therefore, this element was not met.
The Court also ruled that even if a theft was present, the petitioners still would not be able to claim the loss because they had failed to prove the amount of the loss and to establish the year that the loss was sustained. If the taxpayer has “reasonable prospect of recovery”, the loss is not sustained. Treas. Regs. Sec. 1.165-1 (d)(3). Here, the taxpayers did not have a reasonable prospect of recovery of their investment in 2015 because the bankruptcy proceeding for Mr. Zeilinger was still in Court.
Alternatively, the taxpayers argued that the loss was deductible as a loss incurred in a trade or business as provided by Section 165(c)(1). This argument is flawed because the involvement of the petitioners in Globe was that of an investor, and investment losses do not fall within this exception.
The second alternative argument was that the loss was deductible as a worthless security. I.R.C. 165(g). Because the taxpayers did not provide any evidence that the shares of Globe became worthless in 2015, such rule does not apply.
The penalties were sustained under I.R.C. 6651(a)(1) because the tax returns were filed after the due date, and the taxpayers failed to prove that the failure to file was due to reasonable cause.
Insight: Theft losses is an area with particular circumstances. However, it is clear that the taxpayers must provide evidence to support the three-factor test mentioned by the Court in this case. More importantly, the determination of a “theft” under State jurisdiction must be given special relevance, because failure to fall within the specific concept of a “theft” in accordance with such jurisdiction, will prevent the taxpayers to move forward in the analysis of the Court.
Mylan, Inc. & Subsidiaries v. Commissioner, 156 T.C. No. 10| April 27, 2021 | Docket No. 26976-16 | Urda, J.
Short Summary: Mylan, Inc. & Subsidiaries (“Mylan”) is a manufacturer of brand name and generic pharmaceutical drugs. To obtain Food & Drug Administration (“FDA”) approval for generic versions of brand name drugs, Mylan was required to provide a certification regarding the status of any patents that the FDA had listed as covering the respective brand name drug.
Mylan certified that listed patents covering the respective brand name drug were invalid or Mylan’s generic version would infringe on them. This type of certification automatically counts as patent infringement and often provokes litigation under 35 U.S.C. Section 271(e)(2). Mylan was required to send notice letters to the brand name drug manufacturer and any patentees stating that Mylan made this certification.
Mylan incurred legal expenses to prepare notice letters and to defend against patent infringement suits. On its 2012, 2013, and 2014 federal income tax returns, Mylan deducted its legal expenses as ordinary and necessary business expenditures.
- What is the proper characterization of legal expenses incurred to prepare notice letters to send to the brand name drug manufacturer and any patentees?
- What is the proper characterization of legal expenses incurred to defend patent infringement lawsuits?
- Mylan had to capitalize the legal expenses incurred to prepare notice letters because these expenses were necessary to obtain FDA approval of Mylan’s generic drugs.
- The legal expenses incurred to defend patent infringement suits were deductible as ordinary and necessary business expenses because the patent litigation was distinct from the FDA approval process.
Key Points of Law:
- I.R.C. Section 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”
- I.R.C. Section 263(a) provides that no deduction shall be allowed for a capital expenditure.
- Where I.R.C. Section 162 and I.R.C. Section 263 each apply to a given expenditure, the capitalization requirement controls and functions to bar the deduction. See R.C. Sec. 161.
- Treasury Regulation Section 1.263(a)-4(b)(i)(v) requires capitalization of amounts paid to facilitate the acquisition or creation of an intangible, which includes “certain rights obtained from a governmental agency,” such as “rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency.”
- Since Congress made the notice a prerequisite for approval, the legal expenses incurred to prepare, assemble, and transmit the notice letters constitute amounts incurred “investigating or otherwise pursuing” the transaction of creating FDA approved applications, and thus the amounts must be capitalized. See Reg. Section 1.263(a)-4(e)(1)(i).
- It is the patent holder’s decision whether to bring litigation. If the patent holder does not file a suit, the generic drug manufacturer is under no obligation to demonstrate that a patent is invalid or not infringed to obtain FDA approval. Since the patent holder controls litigation and is the primary beneficiary of litigation, litigation is not a step in the FDA approval process for the generic drug. Expenses incurred in defending Section 271(e)(2) suits were not “paid to facilitate” the transaction, and thus the expenses are not required to be capitalized.
- Under the origin of the claim test, litigation expenses incurred in defending Section 271(e)(2) suits (e., patent infringement suits arising in response to the generic drug maker’s certification) arose out of the ordinary and necessary business activities of the taxpayer’s generic drug business and accordingly are deductible.
Insight: The Mylan decision demonstrates that the deductibility of a legal expense generally depends on the origin and character of the underlying claim or transaction out of which the legal expense was incurred. An expenditure, such as legal expenses, may be deductible in one setting but nevertheless required to be capitalized in another. Legal expenses directly connected with (or pertaining to) the taxpayer’s trade or business are deductible under I.R.C. Section 162 as ordinary and necessary business expenses, while expenses arising out of the acquisition, improvement, or ownership of property are capital expenditures under I.R.C. Section 263(a) and are not currently deductible.
Aschenbrenner v. Comm’r, Bench Opinion | April 28, 2021 | Marvel, J. | Dkt. No. 2676-20S
Short Summary: As early as 2017, Petitioners purchased health insurance from Kaiser Permanente and were entitled to an Advance Premium Tax Credit (“APTC”) to subsidize their health insurance premiums. In 2018, the Petitioner-husband found employment. Petitioners could have secured less expensive health insurance through one of Petitioners’ employers, but they elected not to do so. The Petitioners continued with their insurance and continued to receive an APTC. In 2018, the Petitioners’ APTC totaled $7,842.
Petitioners timely filed their 2018 income tax return. The Respondent issued a Notice of Deficiency determining a deficiency of $14,964 and a penalty under Section 6662(a) of $2,992.80. The Respondent then issued a Letter 555, reducing the deficiency to $7,482 and eliminated the penalty. Petitioners timely petitioned the Tax Court.
- Whether the Respondent correctly determined that Petitioners’ 2018 tax liability should be increased by $7,842 of excess APTCs that were applied against their monthly health insurance premiums in 2018.
- The Respondent correctly determined that Petitioners’ 2018 tax liability should be increased by $7,842 of excess APTCs that were applied against their monthly health insurance premiums in 2018.
Key Points of Law:
- With exceptions, the premium assistance tax credit (under the Affordable Care Act) is available to taxpayers whose income in the tax year was between 100% and 400% of the Federal poverty line. ACA, § 36B(c)(1)(A), (d)(3)(B); see McGuire v. Comm’r, 149 T.C. 254, 258-263 (2017).
- The ACA provides for advance payment of the premium assistance tax credit if taxpayers qualify under an advance eligibility determination. McGuire v. Comm’r, 149 T.C. at 260-61.
- If taxpayers receive more APTC than they are due, they owe the excess credit back to the Government and must repay it as an increase in tax. ACA, § 36B(f)(2).
Insight: The Aschenbrenner case notes that the APTC creates a potential trap for taxpayers. For those taxpayers who qualified for a premium tax assistance credit in one year and then increase their income to more than 400% of the Federal poverty line in a following year, they may receive an APTC for which they are not entitled. Taxpayers may be caught in sympathetic situations, but they must consider their changing household income with respect to an APTC.
Stankiewicz v. Comm’r, 2021 BL 156162 (T.C. Apr. 28, 2021) | Kerrigan | Dkt. No. 3139-20
Short Summary: By notice of deficiency dated November 20, 2019, the Internal Revenue Service (IRS or Respondent) determined a deficiency in Petitioner Jeffrey Stankiewicz’s Federal income tax for 2017 of $6,796, a penalty of $1,359 pursuant to section 6662 , and an addition to tax of $667 pursuant to section 6651(a)(2) .
Key Issue: Whether Petitioners received unreported taxable wages and are liable for a penalty pursuant to § 6662 and an addition to tax pursuant to § 6651(a)(2).
- This is a tax protester case in which the taxpayer did not dispute receipt of the unreported income. Instead, they advanced “frivolous arguments that his wages are not taxable.” The Court went on to note that, “[w]e shall not painstakingly address petitioner’s assertions ‘with somber reasoning and copious citation of precedent; to do so might suggest that these arguments have come colorable merit.”
- Based on that reasoning, the Court upheld the IRS assessment of additional tax and penalties.
Key Points of Law:
- Gross income generally includes all income from whatever source derived, including wages. R.C. § 61(a).
- The United States Supreme Court has held consistently that Congress defined gross income to exert “the full measure of its taxing power.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955).
- Under § 6662 an accuracy-related penalty of 20% is imposed for either negligence or a substantial understatement of income tax. A substantial understatement of tax is an understatement which exceeds the greater of 10% of the tax required to be shown on the return or $5,000. R.C. § 6662(d). The deficiency in this case met those thresholds.
- Section 6651(a)(2) imposes an addition to tax if the taxpayer fails to pay his or her income tax return by the required due date, including any extension of time for filing. A taxpayer has the burden of proving that failure to pay was due to reasonable cause and not willful neglect. See sec. 6651(a) [*3] . Petitioners have not argued or presented any evidence that their failure to timely pay was due to reasonable cause.
Insight: As with every tax protester case, the Court here confirms the U.S. Government’s right to collect taxes. The taxpayer here was no different. While no one likes to pay taxes, courts have held time and again that the government has such authority, and fighting that basic principle is futile.
Haghnazarzadeh v. Comm’r, T.C. Memo 2021-47| April 29, 2021 | Kerrigan, J. | Dkt. No. 27031-17
Short Summary: During 2011 and 2012 (“Years at Issue”), taxpayer-husband was in the real estate business. The taxpayers held nine bank accounts in the name of taxpayer-husband and/or taxpayer-wife during the Years at Issue. The IRS selected the taxpayers’ 2011 and 2012 income tax returns for examination and determined that they had unreported taxable income of $4,854,849 and $1,868,212 for 2011 and 2012, respectively, based on bank deposit analyses. After the IRS issued a notice of deficiency for the Years at Issue, the taxpayers filed a timely petition with the Tax Court seeking a redetermination.
Key Issues: Whether the taxpayers had unreported income for the Years at Issue.
Primary Holdings: Based on the IRS’ bank deposit analyses, which was sustained, the taxpayers had unreported income for the Years at Issue.
Key Points of Law:
- Section 61(a) provides that gross income includes “all income from whatever source derived.” See also Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955). A taxpayer is required to maintain books and records sufficient to establish his or her income. See 6001; DiLeo v. Comm’r, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). If a taxpayer failed to maintain these records, the Commissioner may determine income under the bank deposits method. DiLeo v. Comm’r, 96 T.C. at 867. A bank deposit is prima facie evidence of income. Id. at 868.
- Once the Commissioner has made the prima facie case that a taxpayer received income, the taxpayer bears the burden of showing that the deposits made into his or her account represent nontaxable income. at 869. The taxpayer must present credible evidence to shift the burden of proof to the Commissioner under section 7491(a).
- In unreported income cases, the Commissioner must establish “some evidentiary foundation” connecting the taxpayer with the income-producing activity or demonstrating that the taxpayer actually received unreported income. See Weimerskirch v. Comm’r, 596 F.2d 358, 361-62 (9th 1979), rev’g 67 T.C. 672 (1977); see also Edwards v. Comm’r, 680 F.2d 1268, 1270-71 (9th Cir. 1982) (holding that the Commissioner’s assertion of a deficiency due to unreported income is presumptively correct once some substantive evidence is introduced demonstrating that the taxpayer received unreported income).
Insight: The Haghnazarzadeh case shows that once the IRS has made a prima facie case that a taxpayer received income, the taxpayer then bears the burden of showing that any deposits made into his or her account represent nontaxable income.
Woll v. Comm’r, Bench Opinion| April 29, 2021 | Holmes, J. | Dkt. No. 7024-20
Short Summary: Petitioner Molly Woll was laid off from her employer in 2017, resulting in the termination of her 401(k) savings plan that had a balance of more than $86,000. Ms. Woll and her husband spent part of the proceeds from the plan on paying back a loan, as well as paying medical expenses, student loan payments, mortgage bills, house expenses, and other bills. This resulted in a taxable distribution.
Ms. Woll prepared the couple’s 2017 tax return and reported the taxable distribution but did not add the extra 10 percent tax imposed by I.R.C. § 72(t). This triggered an IRS audit, which resulted in the assessment of the 10 percent tax, as well as a substantial understatement penalty. Mr. and Mrs. Woll timely filed their tax court petition.
- (1) Whether the taxable distribution is subject to the 10 percent tax imposed by I.R.C. § 72(t); and
- (2) Whether the substantial understatement penalty applies to the Wolls’ 2017 tax return.
- (1) Because an exception did not apply, the taxable distribution was subject to the 10 percent tax imposed by I.R.C. § 72(t).
- (2) The substantial understatement penalty applies to the Wolls’ 2017 tax return.
Key Points of Law:
- If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income, unless an exception applies. I.R.C. § 72(t).
- The increase in tax on withdrawn amounts from retirement accounts imposed by Section 72(t) is not in fact a penalty, but an increase in tax. See Grajales v. Comm’r, 156 T.C. 3 (Jan. 25, 2021).
- The penalty determined mathematically by computer software without the involvement of a human IRS examiner is one that is “automatically calculated through electronic means”, Section 6751(b)(2)(B) is the plain text the statutory exception requires. See Walquist v. Comm’r, 152 T.C. 3 (Feb. 25, 2019).
- The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all the pertinent facts and circumstances . . . . generally the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” See 26 C.F.R. § 1.666-4(e)(1).
Insight: Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis. Woll highlights the fact that a taxpayer who has an advanced degree, such as an attorney, will likely have more difficulty showing reasonable cause. Reliance on a computer program or failure to read a tax form, such as a Form 1099-R, are not sufficient alone to prove reasonable cause.
Have a question? Contact Jason Freeman, Freeman Law.
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