The Tax Court in Brief - February 2021 #3

The Tax Court in Brief

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.

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The Week of February 15 – February 19, 2021

Kramer v. Comm’r, T.C. Memo. 2021-16 | February 16, 2021 | Gale, J. | Dkt. Nos. 15224-17 & 15368-17

• Opinion

Short Summary: The IRS issued two notices of deficiency to Don Kramer and Lela Arabuli (petitoners). The first notice of deficiency asserted deficiencies for petitioners’ 2006-2010 tax years and various penalties—fraud penalties were asserted solely against Don Kramer for 2006-2008. The second notice of deficiency determined related solely to Don Kramer and asserted, among other things, fraud penalties for his 2004-2005 tax years. Petitoners timely filed a petition with the United States Tax Court to challenge the IRS’ determinations. However, petitioners failed to respond to the IRS’ discovery requests, including request for admissions. In reply to the IRS’ discovery requests, don Kramer filed a document entitled “Tax Statement Affidavit,” which set forth hundreds of pages of tax-protestor rhetoric. Lela Arabuli did not respond at all. Accordingly, after motion by the IRS, the Court deemed stipulated all matters set forth in the IRS’ proposed stipulation of facts and the first supplemental stipulation of facts. The IRS then moved the Court in both consolidated cases for entry of default and decision.

Key Issues:

• Whether the Court should grant the IRS’ motion for entry of default and decision?

Primary Holdings:

• The Court granted the IRS’ motion for entry of default and decision because petitioners failed to cooperate and procced with their case as required by the Tax Court Rules of Practice and Procedure and as required in various orders by the Tax Court.

Key Points of Law:

• Rule 123(a) provides that the Tax Court may hold a party in default and enter a decision against that party if he or she has “failed to plead or otherwise proceed as provided by these Rules or as required by the Court.” Rule 123(b) allows the Court broad discretion to dismiss a case “[f]or failure of a petitioner properly to prosecute or to comply with these Rules or any order of the Court or for other cause which the Court deems sufficient.” In general, entry of default under Rule 123(a) is appropriate as to issues where the Commissioner bears the burden of proof, while dismissal under Rule 123(b) is appropriate where the taxpayer bears the burden of proof. See Smith v. Comm’r, 926 F.2d 1470, 1476 (6^th 1991), aff’g, 91 T.C. 1049 (1988); Putnam v. Comm’r, T.C. Memo. 2015-160.
• The Tax Court has entered judgments of default or dismissal where a taxpayer: (1) unreasonably refused to stipulate facts or the authenticity of documents, Long v. Comm’r, 742 F.2d 1141 (8^th 1984); (2) failed to comply with Court-ordered discovery, Rechtzigel v. Comm’r, 79 T.C. 132 (1982); or (3) failed to appear at trial, Ritchie v. Comm’r, 72 T.C. 126 (1979). The Tax Court has also pointed out that in cases where “a taxpayer does not thin well enough of his case to defend it where the government has the burden of proof, this Court should default him.” Bosurgi v. Comm’r, 87 T.C. 1403, 1408 (1986).
• Where the Tax Court has found petitioners in default, all well-pleaded allegations in the IRS’ answers are deemed admitted. See Bosurgi v. Comm’r, 87 T.C. at 1409. In addition, the IRS may rely on deemed admissions and deemed stipulations to satisfy his burdens of production and proof. See, e.g., Smith v. Comm’r, 91 T.C. at 1052-53.
• If a taxpayer disputes a deficiency determination that is based on unreported income, the presumption of correctness does not apply unless the IRS can establish at least a “minimal” factual predicate or evidentiary foundation connecting the taxpayer to an income-generating activity or to the receipt of funds. See U.S. v. Walton, 909 F.2d 915, 918-919 (6^th 1990). Once the IRS makes the required threshold showing, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the IRS’ determinations are arbitrary or erroneous. Walquist v. Comm’r, 152 T.C. 61, 67-68 (2019).
• The IRS generally bears the burden of production with respect to a penalty where the taxpayer has contested it in a petition. See 7491(c); Funk v. Comm’r, 123 T.C. 213, 216-18 (2004). The IRS’ burden of production includes showing compliance with the supervisory approval requirement of Section 6751(b). See Graev v. Comm’r, 149 T.C. 485, 492-93 (2017); Chai v. Comm’r, 851 F.3d 190, 221 (2d Cir. 2017). The IRS must also offer sufficient evidence to indicate that it is appropriate to impose the penalty. Higbee v. Comm’r, 116 T.C. 438, 446 (2001). If the IRS satisfies his burden of production, the taxpayer bears the burden of proving that it is inappropriate to impose the penalty beause of reasonable cause, substantial authority, or a similar provision. Id. at 446-47.
• Under Section 6751(b), the “initial determination” of a penalty must be “personally approved (in writing) by the immediate supervisor of the individual making such determination” or by a designated higher raning official. See Chai v. Comm’r, 851 F.3d at 220-21. The Tax Court recently explained that the initial determination of a penalty “is embodied in the document by which the Examination Division formally notifies the taxpayer, in writing, that it has completed its work and made an unequivocabl decision to assert penalties.” Belair Woods, LLC v. Comm’r, 154 T.C. 1, 15 (2020). For purposes of this requirement, a revenue agent’s report containing proposed penalties that is transmitted to a taxpayer as part of a 30-day letter package constitutes an initial determination that requires supervisory approval. See Clay v. Comm’r, 152 T.C. 223, 249 (2019).
• The written supervisory approval of an initial determination is not required to tae any specific form. See Palmolive Bldg. Inv’rs, LLC v. Comm’r, 152 T.C. 75, 85-86 (2019). For example, a supervisor’s signature on a cover letter sent to a taxpayer along with an examination report is sufficient. See PBBM-Rose Hill, Ltd. v. Comm’r, 900 F.3d 193, 213 (5^th 2018). Additionally, section 6662 provides for several distinct penalties, and each specific penalty determined thereunder must be approved by a supervisor. See Palmolive Bldg. Inv’rs LLC v. Comm’r, 152 T.C. at 87.
• Where the IRS’ determination of a section 6662 accuracy-related penalty is communicated to a taxpayer through “boilerplate text” indicating that the penalty is “attributable to one or more of specific grounds,” the communication is “interpreted to assert all of the specified grounds as alternative bases for the penalty, unless other portions of the communication explicitly limit the penalty determination to a subset of those grounds. See Oropeza v. Comm’r, 155 T.C. ___, 2020 U.S. Tax Ct. LEXIS 26, *14 (2020). In such instances, the Tax Court’s analysis focuses on which penalties the taxpayer would have understood the communication to assert, since the purpose of the supervisory approval requirement is “to prevent the unapproved threat of a penalty from being used ‘as a bargaining chip’” against the taxpayer. See id.
• Section 6651(a)(1) imposes an addition to tax for any failure to file a return by its due date. The addition is equal to 5% of the amount required to be shown as tax on the return for each month or portion thereof that the return is late, up to a maximum of 25%. The addition is imposed on the net amount due, calculated by reducing the amount required to be shown as tax on the return by any part of the tax which is paid on or before its due date. See 6651(b)(1). To carry his burden of production with respect to the section 6651(a)(1) addition to tax, the IRS must introduce evidence (such as a stipulation) showing that a return was filed after the due date. See Wheeler v. Comm’r, 127 T.C. at 207-208.
• Section 6662 imposes a penalty equal to 20% of any underpayment of tax attributable to, inter alia, negligence or disregard of rules or regulations. See Sec. 6662(a) and (b)(1). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return.” Reg. § 1.6662-3(b)(1).
• The IRS bears the burden of proof with respect to the section 6663 fraud penalties determined against Mr. Kramer and must prove by clear and convincing evidence that for each year: (1) an underpayment of tax exists and (2) at least some portion of the underpayment is due to fraud. See sec. 7454(a); Rule 142(b); DiLeo v. Comm’r, 96 T.C. 858, 873 (1991). Clear and convincing evidence is that measure or degree of proof which will produce in the mind of the trier of fact a firm belief or convinction as to the allegations sought to be established. It is intermediate, being more than a mere preponderance, but not to the extent of such certainty as is required beyond a reasonable doubt as in criminal cases. It does not mean clear and unequivocal. Ohio v. Akron Ctr. for Reprod. Health, 497 U.S. 502, 516 (1990).
• The IRS satisfies its burden of proof in showing requisite fraudulent intent to underpay tax if it can show the taxpayer “intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.” See DiLeo v. Comm’r, 96 T.C. at 874. Fraud “does not include negligence, carelessness, misunderstanding or unintentional understatement of income.” S. v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956).
• The existence of fraud is a question of fact to be resolved upon consideration of the entire record. See DiLeo v. Comm’r, 96 T.C. at 874. Fraud can rarely be established by direct proof of the taxpayer’s intention. Accordingly, fraud may be, and typically is, proved by circumstantial evidence. Courts usually rely on certain indicia (or badges) of fraud in deciding whether a taxpayer had the requisite fraudulent intent. The badges of fraud include: (1) understated income; (2) maintaining inadequate records; (3) failing to file tax returns; (4) implausible or inconsistent explanations of behavior; (5) concealing income or assets; (6) failing to cooperate with tax authorities; (7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated tax payments; and (10) filing false documents. See Estate of Trompeter v. Comm’r, 279 F.3d 767, 773 (9^th 2002).
• The IRS may make an assessment at any time of tax “in the case of a false or fraudulent return with the intent to evade tax.” 6501(c)(1).

Insight: The Kramer decision shows the potential dangers to taxpayers when they file a petition in the United States Tax Court but fail to follow the Tax Court Rules of Practice and Procedure and the Tax Court’s own orders. As shown in the decision, in these instances taxpayers may be held in default under Rule 123(a).

Estate of Warne v. Comm’r, T.C. Memo. 2021-17 | February 18, 2021 | Buch, J. | Dkt. Nos. 7019-18 and 7020-18

• Opinion

Short Summary: In the final years of her life, Mariam Warne gave fractional interests in limited liability companies to family members. The LLCs were owned by a family trust and held ground leases in various properties in California. When Ms. Warne passed away, the family trust held the remaining interests in the LLCs. Her estate also donated its entire interest in one LLC by splitting that donation between two charitable organizations, with 25% going to a church and the remaining 75% to a family foundation. The IRS issued notices of deficiency determining a gift tax deficiency for 2012 and an estate tax deficiency. The IRS disagreed with the valuations used by the estate for the LLCs and also determined lower discounts for lack of control and marketability than used by the estate for several LLCs. The estate timely filed petitions in response to the proposed deficiencies.

Key Issues: (1) What are the values of the respective LLC interests as of Ms. Warne’s date of death; (2) What is the value to the estate of the charitable contribution deduction; and (3) Whether the estate is liable for a late-filing penalty with respect to the late-filed gift tax return?

Primary Holdings: (1) Both sides’ experts erred in certain respects regarding the valuations; accordingly, the Tax Court determined the respective valuations of the LLCs based on its own analysis of the data; (2) The estate must include 100% of the value of the property related to the charitable contribution deduction in the estate but may deduct 25% and 75% interests received by the respective charities, respectively; (3) The estate is liable for a late-filing penalty for filing the gift tax return late because the IRS met is burden of production in showing the penalty applies, and the estate has failed to show reasonable cause.

Key Points of Law:

• Generally, the IRS’ determinations in a notice of deficiency are presumed correct, and the taxpayer has the burden of proving otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). However, the IRS bears the burden of proof on any new matter, increases in deficiency, or affirmative defenses pleaded in his answer.
• Section 2501(a) imposes a gift tax for gifts made during the calendar year by individuals. The donor is liable for this tax, which is based, in part, on the aggregate sum of gifts made during the tax year. The value of a gift is the fair market value of the property on the date the donor made the gift. 2512(a). Unless an alternative valuation date is elected, the value of a decedent’s gross estate is the fair market value of the property included in the estate on the date of death. Sec. 2031(a); Sec. 2032. For both estate and gift tax purposes, the fair market value of property is the price a willing buyer would pay a willing seller when neither is acting under compulsion and both have reasonable knowledge of the facts and circumstances. Treas. Reg. § 20.2031-1(b); Treas. Reg. § 25.2512-1.
• Valuation of property is a question of fact that we may resolve by considering the entire record. After we determine the value of the gross property, that value may increase or decrease if premiums or discounts apply. The Tax Court may use expert reports to guide its conclusions but it is not bound by their methods or opinions. Indeed, one party’s expert may be persuasive on one matter while the other party’s expert is persuasive on another matter.
• A leased fee interest in property is the right of the owner of income-producing property to receive contract rent plus the reversionary rights of the property once the lease has expired. Appraisals of leased fee interests should reflect actual leases and expense structures, not hypothetical ones.
• The Supreme Court in Olson v. U.S. stated: “Elements affecting value that depend upon events or combinations of occurrences which, while within the realm of possibility, are not fairly shown to be reasonably probable should be excluded from consideration for that would be to allow mere speculation and conjecture to become a guide for the ascertainment of value.”
• In Ahmanson Foundation v. U.S., the Ninth Circuit Court of Appeals stated that “[t]here is nothing in the statutes or the case law that suggests that valuation of the gross estate should take into account that the assets will come to rest in several hands rather than one.” Thus, under Ahmanson Foundation, when valuing an asaset as part of an estate, the Tax Court values the entire interest held by the estate, without regard to later disposition of that asset. But, when property is split as part of a charitable contribution, a different principle applies. “The valuation of these same sorts of assets for the purpose of the charitable deduction . . . is subject to the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity—a principle required by the purpose of the charitable deduction.” In short, when valuing charitable contributions, the Tax Court does not value what an estate contributed; rather, it values what the charitable organization received.
• Section 6651(a)(1) imposes an addition to tax on taxpayers who fail to timely file a required return unless the taxpayer can show that the failure to file was due to reasonable cause and not willful neglect. A failure to timely file results in an addition of 5% of the net amount due for every month the return was late, not to exceed 25% of the base amount owed. The IRS bears the burden of production showing the taxpayer filed a later return. The taxpayer bears the burden of showing reasonable cause.

Insight: Estate of Warne reminds taxpayers, among other things, that the IRS can impose significant penalties for failure to file a gift tax return (IRS Form 709) when one is otherwise required to be filed.

Blum v. Comm’r, T.C. Memo. 2021-18 | February 18, 2021 | Urda, J. | Dkt. No. 20020-17

• Opinion

Short Summary: Petitioner received a payment of $125,000 in 2015 in settlement of a lawsuit she had filed against lawyers who had previously represented her in an unsuccessful personal injury lawsuit. She did not report the amount on her 2015 return, and the IRS issued a notice of deficiency with respect to the settlement payment.

Key Issues:

• Whether Petitioner was entitled to exclude from her gross income the $125,000 settlement payment as damages received “on account of personal physical injuries or physical sickness” under Section 104(a)(2).

Primary Holdings:

• The settlement payment does not fall within Section 104(a)(2)—accordingly, it is gross income to Petitioner.

Key Points of Law:

• The Commissioner’s determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proviing those determinations erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Merkel v. Comm’r, 192 F.3d 844, 852 (9^th 1999), aff’g 109 T.C. 463 (1997). In cases involving failure to report income, the Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, see Sec. 7482(b)(1)(A), 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, Weimerskirch v. Comm’r, 596 F.2d 358, 361-62 (9^th Cir. 1979). Once the Commissioner has established such a foundation, the burden of proof shifts to the taxpayer to prove that she is entitled to an exclusion from gross income. See Simpson v. Comm’r, 141 T.C. 331, 338-39 (2013), aff’d, 668 F. App’x 241 (9^th Cir. 2016).
• Gross income includes all income from whatever source derived. 61(a); see also Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955). Exclusions from gorss income “must be narrowly construed.” Comm’r v. Schleier, 515 U.S. 323, 328 (1995).
• Settlement proceeds constitute gross income unless the taxpayer proves that they fall within a specific statutory exception. See id. at 328-37; Save v. Comm’r, T.C. Memo. 2009-209. Section 104(a)(2) supplies one such exception, excluding from gross income “any damages (other than punitive damages) received (whether by suit or agreement * * *) on account of personal physical injuries or physical sickness.”
• For a taxpayer to fall within this exclusion, he must show that there is a direct causal link between the damages and the personal injuries sustained. Doyle v. Comm’r, T.C. Memo. 2019-8. When damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for the settlement controls whether the damages are excludable under Section 104(a)(2). See Burke, 504 U.S. at 237; see also Bagley v. Comm’r, 105 T.C. 396, 406 (1995) (“[T]he critical question is, in lieu of what was the settlement amount paid[?]”).
• The nature of the claim is typically determined by reference to the terms of the agreement. See Rivera, 430 F.3d at 1257; Ghadiri-Asli v. Comm’r, T.C. Memo. 2019-142. If an agreement fails to answer the question, the Tax Court looks primiarly to “the intent of the payor.” Devine v. Comm’r, T.C. Memo. 2017-111. The intent of the payor may be determined by taking into consideration, inter alia, the amount paid, the factual circumstances leading to the settlement, and the allegations in the injured party’s complaint. See Green v. Comm’r, 507 F.3d 857, 868 (5^th 2007). The nature of the underlying claims cannot be determined from a general release of claims that is broad and inclusive. Ahmed v. Comm’r, T.C. Memo. 2011-295.
• Generally, a recovery of capital is not income. See U.S. v. Safety Car Heating & Lighting Co., 297 U.S. 88, 98 (1936). Whether a payment received in settlement of a claim represents a replacement of capital depends on the nature of the claim that was the actual basis for the settlement. See Spangler v. Comm’r, 323 F.2d 913, 916 (9^th 1963). The Tax Court has held previously that “an amount paid to a taxpayer in order to compensate the taxpayer for a loss that the taxpayer suffered because of the erroneous advice of the taxpayer’s tax consultant generally is a return of capital and is not includible in the taxpayer’s income.” Cosentino v. Comm’r, T.C. Memo. 2014-186.

Insight: The Blum case shows that the language of a settlement agreement, in many cases, may be the most important factor in determining the taxability of the proceeds received under the agreement. In many cases, taxpayers should consult with tax counsel early on with respect to their damages claims to ensure that proper language is utilized vis-à-vis the taxability of the proceeds.

San Jose Wellness v. Comm’r, 156 T.C. No. 4 | February 17, 2021 | Toro, J. | Dkt. Nos. 12313-15, 12353-15, 15714-18

• Opinion

Short Summary: Petitioner operated a medical cannabis dispensary pursuant to California law. It incurred certain expenses in connection with its operations and deducted those expenses on its federal income tax returns for the taxable years 2010, 2011, 2012, 2014, and 2015. The returns included deductions for depreciation and charitable contributions. The IRS disallowed all of the deductions pursuant to Section 280E for all of the years at issue.

Key Issues:

• (1) Whether Petitioner’s deductions are foreclosed under Section 280E; and (2) Whether Petitioner is liable for an accuracy-related penalty for 2015?

Primary Holdings:

• (1) Petitioner may not claim depreciation and charitable contribution deductions under Section 280E; and (2) Petitioner is liable for an accuracy-related penalty for 2015 because when Petitioner filed its 2015 return the relevant caselaw, legislative history, and published guidance all indicated that Petitioner’s claimed deductions would be disallowed.

Key Points of Law:

• The Code imposes a tax “on the taxable income of every corporation” for each tax year. 11(a). “Taxable income” is defined in section 63(a) as “gross income minus the deductions allowed by this chapter.” The Code further provides that “[i]n computing taxable income under section 63, there shall be allowed as deductions the items specified in this part.” Sec. 161. The referenced “part” includes sections 167 and 170.
• Section 167(a)(1) allows “as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) . . . of property used in a trade or business.” Similarly, Section 170(a)(1) allows “as a deduction any charitable contribution . . . payment of which is made within the tax year.”
• As the Supreme Court has explained, the “deductions specified in Part VI of Subchapter B of the Income Tax Subtitle of the Code [which includes sections 167 and 170] are subject to the exceptions provided in part IX.” Comm’r v. Idaho Power Co., 418 U.S. 1 (1974).
• Section 280E provides no deduction or credit shall be allowed for any amount paid or incurred during the tax year in carrying on a trade or business if such trade or business (or the activities which compromise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.
• In Patients Mutual, 151 T.C. at 196-97, the Tax Court read Section 280E to deny business expense deductions to any trade or business that involves trafficking in controlled substances, even if that trade or business also engaged in other activities.
• Section 7701(a)(26) provides that “[w]hen used in this title, where not otherwise distinctly expressed or manifestly incompatiable with the intent thereof, the terms ‘paid or incurred’ . . . shall be construed according to the method of accounting upon the basis of which . . . taxable income is computed under subtitle A.” Generally, “taxable income shall be computed under the method of accounting on the basis of whch the taxpayer regularly computes his income in keeping his books.” 446(a).
• As the Supreme Court has observed, Congress authorized the accrual method of accounting “to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during that period. S. v. Anderson, 269 U.S. 422, 440 (1926).
• Idaho Power leaves no doubt that as a “cost . . . certainly presently incurred,” depreciation constitutes an “amount paid or incurred during the taxable year.”
• Section 6662 imposes a 20% accuracy-related penalty on the portion of an underpayment of tax attributable to any substantial understatement of income tax. 6662(a), (b)(2). For corporations, a understatement of income tax is substantial if it exceeds the lesser of $10 million or “10% of the tax required to be shown on the return for the taxable year (or, if greater, $10,000.” Sec. 6662(d)(1)(B).
• To decide whether a taxpayer acted with reasonable cause and in good faith, the Tax Court considers all relevant facts and circumstances, such as the “taxpayer’s efforts to assess the taxpayer’s proper liability” and its “experience, knowledge, and education.” Reg. § 1.6664-4(b)(1). A taxpayer may demonstrate reasonable cause through good-faith reliance on the advice of an independent professional, such as a tax adviser, a lawyer, or an accountant. Treas. Reg. § 1.6664-4(b). An honest and reasonable misunderstanding of fact or law may indicate reasonable cause and good faith. Id. And in the penalties context more generally, a wide range of potential authorities—e.g., statutory text, regulations, caselaw, legislative history, and IRS guidance—is relevant to evaluating a taxpayer’s position. Treas. Reg. § 1.6662-4(d)(3)(iii).

Insight: San Jose Wellness shows the substantial reach of Section 280E in denying deductions to those engaged in the cannabis industry.

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