In this case, the IRS disallowed tens of millions of dollars in exclusions for cost of goods sold and business expense deductions claimed by one of the largest medical marijuana dispensaries in the country. Taxpayers cannot claim a deduction for ordinary and necessary expenses if the taxpayer is engaged in an unlawful business such as selling a controlled substance like marijuana. I.R.C. § 280E, 21 U.S.C. § 812(c). While acknowledging it was subject to section 280E, the dispensary, which operated a legal business under California law, petitioned the United States Tax Court for a redetermination of the IRS decision. The Tax Court affirmed the multi-million-dollar deficiency judgment resulting from the dispensary’s corporate income tax liabilities from tax years 2007 to 2012.
On appeal to the United States Court of Appeals for the Ninth Circuit, the dispensary argued that section 280E was unconstitutional or, alternatively, that the denied deductions should qualify as cost of goods sold and therefore be excluded from its gross income. Historically, challenges to the constitutionality of section 280E have been unsuccessful. N. Cal. Small Bus. Assistants Inc. v. Comm'r, 153 T.C. 65, 72 (2019); Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1201 (10th Cir. 2018). Here, the court declined to consider the dispensary’s 16th Amendment argument because it was not raised before the Tax Court.
Excludible Inventory Costs
The dispensary alternatively claimed that the approximately $7 million it incurred by purchasing and processing marijuana qualified as excludible inventory costs. The costs, for example, included employee compensation relating to the negotiation of bud purchases and the cost of laboratory testing of marijuana.
The Tax Court found that the dispensary “purchased” rather than “produced” the products it sold and that taxpayers reselling products that they “purchased” are entitled to include as cost only “the invoice price,” less certain discounts not relevant here, as well as “transportation or other necessary charges incurred.” See Treas. Reg § 1.471-3(b). The dispensary did not appeal the Tax Court’s purchaser determination, but rather claimed that because its inventory method satisfied I.R.C. § 471 by meeting the general requirements for best accounting practice and clear reflection of income, the IRS could not force the dispensary into a particular cost method under Treas. Reg. § 1.471-3. The Ninth Circuit disagreed, stating that § 471 requires taxpayers to take inventory as set forth by the IRS. I.R.C. § 471(a). Therefore, taxpayers must follow the detailed regulations on how to compute their inventories. See Treas. Reg. §§ 1.471-1 to -11.
The dispensary next claimed that because the IRS did not challenge whether the dispensary’s inventory method failed to clearly reflect its income, the IRS could not require a particular accounting method. In rejecting this argument, the court explained that the IRS did not attempt to compel a particular accounting method, but rather disallowed an accounting method that was not in conformance with the applicable regulations.
Lastly, the dispensary argued that under Treas. Reg. § 1.471-3(d), it could include both its production and purchasing costs in the inventory costs. The court stated that § 1.471-3(d) only applies to industries “in which the usual rules for computation of cost of production are inapplicable.” Such industries include famers, some miners and manufacturers, and retail merchants that use the retail method of accounting. The court noted that while the normal inventory accounting rules may be unfavorable to the dispensary, it was still subject to those rules and regulations.
Patients Mutal Assistance Collect Corp. v. Comm'r, 2021 WL 1570288 (9th Cir. April 22, 2021).
Intending to get back to his agrarian roots, a successful banker purchased a 156-acre tract of land which had been used as a timber farm and cattle operation. From 2004 to 2014, the taxpayer reported $1.5 million in losses from his farm, primarily in the form of noncash expenses. The IRS audited the taxpayer for tax years from 2004 to 2008, disallowing the farm’s deductions because the evidence showed that taxpayer’s did not engage in the farming activity for profit.
On appeal, the tax court affirmed. If an activity is not engaged in for profit, an individual cannot deduct the expenses related to the activity. 26 U.S.C. § 183. The court ruled that many factors weighed against the taxpayer. The taxpayer had very limited financial records, no business plan, and failed to implement any changes to the operation despite substantial yearly losses. Despite a family history of farming, the taxpayer lacked experience in managing a timber farm or cattle operation. Although the taxpayer did receive advice on the timber operation, it focused more on timber care rather than the timber business.
While there can be losses due to unforeseen circumstances, the farm’s history showed that the losses were not unexpected, but very consistent for a decade. Additionally, the taxpayer did not show any profit in those ten years. The taxpayer earned a substantial income as a banker and the losses from the farm activity resulted in significant tax savings. Finally, the court found that the taxpayer enjoyed farming as a retreat from his stressful job as a banker. This, coupled with the fact that the business was extremely unlikely to be possible, all weighed against the taxpayer.
Whatley v. Commissioner, T.C. Memo. 2021-11 (Jan. 28, 2021).
From 2007 to 2011, a taxpayer reported net losses for her agricultural pursuits on a Schedule F. For 2012 and 2013, the taxpayer and her husband filed joint returns on Form 1040. The taxpayer claimed $1,068 in farm activity income in 2012 for the sale of excess eggs she did not need and $4,800 in 2013 for the sale of several cows. She also reported deductible expenses for both those years and claimed the losses as a deduction. The IRS disallowed the deductions because it did not believe the taxpayer incurred the losses carrying on a trade or business. The taxpayer appealed.
From 2007 to 2011, the taxpayer raised chickens for meat. She only reported one sale in 2011. The taxpayer switched to raising chickens for egg production, but decided that was financially unfeasible because of the increasing price in chicken feed. She then switched back to raising chickens for meat and began growing her flock. The taxpayer intended to begin selling the product in 2014, but wild dogs destroyed most of her flock that year.The taxpayer also experimented with raising verious fruits and vegetables and cattle on her farm, but those activities were not successful.
The Internal Revenue Code allows a deduction for all ordinary and necessary expenses incurred carrying on a trade or business. 26 U.S.C. § 162(a). The IRS disallowed the taxpayer’s deductions finding that she did not have a true profit motive and her business operation had not yet started in 2012 and 2013 when the deductions were claimed. On review, the tax court found that despite the lack of revenue, the wife did intend to profit. However, startup costs are not currently deductible. 26 U.S.C. § 195(a). Startup costs include cost incurred when starting a business and may be allowed as a deduction prorated equally over a 15-year period once the business begins. 26 U.S.C. § 195(b). The court found that the taxpayers business never moved beyond the initial startup stage. In 2012 and 2013, the taxpayer was still planting test crops and investigating business opportunities because none of her attempts had been successful yet. Because most of the expenses reported were startup expenses, the court affirmed the denial of the deductions.
Costello v. Commissioner of Internal Revenue, T.C. Memo. 2021-9 (Jan. 25, 2021).
The IRS assessed the owner of a stone mason business for tax deficiencies which occurred between 2005 through 2008. The taxpayer claimed the three-year statute of limitations barred the assessment. The district court found the three-year statute of limitation period never started because the taxpayer did not file the “the return,” specifically the required Form 945 to report backup withholdings for the subcontractors the taxpayer had hired. The 5th Circuit reversed, finding the taxpayer had filed the required Forms 1040 and 1099 for those years, and those forms contained sufficient information to alert the IRS that the taxpayer was liable for taxes assessed as well as the amount of the tax liability. This amounted to a “return” which started the statute of limitations period.
Quezada v. IRS, 2020 WL 7310680 (5th Cir. 2020).
The petitioner is a lawyer that also purchased a 1,300-acre farm. The petitioner entered into a crop-share arrangement with a tenant under which the tenant had responsibility for farming decisions. The petitioner spent time during the tax years in issue performing maintenance activities on the farm including cutting vegetation, maintaining fences and shooting wild hogs. Based on the petitioner's reconstructed records, the court was convinced that the petitioner put in more than 100 hours into the activity and that no one else put in more hours than the petitioner. Thus, the petitioner was deemed to materially participate in the activity and the losses from the activity were not limited by the passive loss rules. Leland v. Comr., T.C. Memo. 2015-240.
This case involved the donation of two permanent "conservation" easements inside a gated residential development on developed golf courses in North Carolina that were expanding with the stated purpose to protect a "natural habitat" or provide "open space" to the public. The sole issue in the case was whether the conservation purpose of I.R.C. Sec. 170(h) had been satisfied by virtue of the easements protecting the natural habitat of various plant and animal species, including the Venus Flytrap. The donated easements at issue generated claimed deductions of approximately $8 million. The court noted that while the easements did include some stand of longleaf pine, the easement terms allowed the pines to be cut back from the fairways and the surrounding housing development. Also, the court opined that the easement did not contain any requirement that an active management plan be followed to mimic the effects of prescribed burning that would allow the pines to mature in a stable condition. Also, the court stated that the I.R.C. Sec. 170 regulations concerning a "compatible buffer" that contributed to the viability of a conservation area were not satisfied. While the mere fact that a golf course was involved did not negate the possibility of a valid conservation easement donation deduction, the fact that the golf course was in a gated community eliminated the argument that the donation was to preserve "open space" for the general public. The court, while denying the claimed deductions, however, did not uphold the imposition of penalties. Atkinson v. Comr., T.C. Memo. 2015-236.
The plaintiff obtained shares of stock upon demutualization of an insurance company. The plaintiff later sold some of the shares of stock and the defendant asserted that the plaintiff's income tax basis in the stock was zero triggering 100 percent gain on the sale of the shares. The trial court rejected the defendant's position, and set forth the computation for calculating basis in stock shares received upon demutualization. The court grounded the computation of stock basis in the same manner in which the insurance company determined the value of demutualized shares for initial public offering (IPO) for purposes of determining how many shares to issue to a policyholder. Based on that analysis, the court noted that the company calculated a fixed component for lost voting rights based on one vote per policy holder and a variable component for other rights lost based on a shareholder's past and anticipated future contributions to the company's surplus. The court estimated that 60 percent of the plaintiff's past contributions were to surplus and 40 percent was for future contributions to surplus which the plaintiff had not actually yet paid before receiving shares and are not part of stock basis; thus, plaintiff's basis in stock comprised of fixed component for giving up voting rights and 60 percent of the variable component representing past contributions to surplus the end result was that the plaintiff's stock basis was slightly over 60 percent of IPO value of stock. On further review, the U.S. Court of Appeals for the Ninth Circuit reversed in a split opinion. The court determined that the plaintiff's didn't pay any additional amount for the mutual rights and that treating the premiums as payment for membership rights was inconsistent with how tax law treats insurance premiums. The court noted that under the tax code gross premiums paid to buy a policy are allocated as income to the insurance company and no portion is carved out as a capital contribution.
Conversely, the policyholder can deduct the "aggregate amount of premiums" paid upon receipt of a dividend or cash-surrender value. No amount is carved out as an investment in membership rights. Because of that, the court held that the plaintiff's couldn't have a tax-free exchange with zero basis and then an increased basis upon later sale of the stock. Accordingly, the court held that the trial court erred by not determining whether the plaintiffs paid anything to acquire the mutual rights, and by estimating basis by using the stock price at the time of demutualization instead of calculating basis at the time of policy acquisition. Thus, because the taxpayers did not prove that they paid for their membership rights as opposed to premiums payments for the underlying insurance coverage, they could not claim any basis in the demutualized stock. Dorrance v. United States, No. 13-16548, 2015 U.S. App. LEXIS 21287 (Dec. 9, 2015), rev'g., No. CV-09-1284-PHX-GMS, 2013 U.S. Dist. LEXIS 37745 (D. Ariz. Mar. 19, 2013).
The petitioner, a banker, and spouse contributed a permanent conservation easement on more than 80 acres to a land trust, valuing the easement at $1,418,500 million. They claimed a phased-in deduction over several years. The IRS, on audit, proposed the complete disallowance of the deduction and sought a 20 percent penalty or a zero valuation of the easement and a 40 percent penalty for gross overvaluation of the easement. IRS Appeals took the position that the 40 percent penalty should apply due to a zero valuation of the easement, and that if that weren't approved judicially a 20 percent penalty for valuation misstatement should apply. The parties stipulated to a easement valuation of $80,000 and that the petitioner had no reasonable cause defense to raise against the 40 percent penalty, but that the defense could apply against the 20 percent penalty. The court upheld the 40 percent penalty. The IRS also conceded, in order to clear the table for the penalty issue, that the petitioner, a non-farmer, was not subject to self-employment tax on CRP rental income for years 2007, 2008, 2009 and 2010. The concession was made after the IRS issued it's non-acquiescence to the Morehouse decision in the 8th Circuit in which the court determined that CRP rents in the hands of a non-farmer were not subject to self-employment tax. Legg v. Comr., 145 T.C. No. 13 (2015).
The IRS has announced that it has changed its policy of not allowing defrauded taxpayers to see the tax return that had been fraudulently filed using the taxpayer's stolen identity number and name. Now, a defrauded taxpayer will be able to see the fraudulently filed tax return, subject to certain redacted information (apparently so that the IRS can protect the identity of the defrauding party). Requests to see the fraudulently filed return can be made for returns filed within the prior six tax years. A request letter can be obtained at https://www.irs.gov/Individuals/Instructions-for-Requesting-Copy-of-Fraudulent-Retuns.
The petitioner bought a business and along with the purchase came a contract giving the petitioner an exclusive right to tow cars for a local police department. The petitioner amortized the contract over 15 years. However, the contract expired after five years and the petitioner wrote off the unamortized amount. The IRS claimed that value remained and that the unamortized amount, therefore, could not be written off. The court agreed because it found that the petitioner retained the rights to tow and store vehicle even after the contract expired and until a new contract was entered into. The court also determined that the willing-buyer/willing-seller test of Treas. Reg. Sec. 20.2031-1(b) did not result in the contract having no value. Steinberg v. Comr., T.C. Memo. 2015-222.
In an attempt to decrease the administrative burden imposed by the repair and capitalization regulations, the IRS has increased the deminimis safe harbor for taxpayers without an applicable financial statement (AFS) from $500 to $2,500. The safe harbor establishes a floor for automatic deductibility for costs associated with tangible personal property acquired or produced during the tax year that are ordinary and necessary business expenses associated with the taxpayer's trade or business. The safe harbor provides for automatic deductibility for amounts up to $2,500 for the acquisition or production of new property or for the improvement of existing property which would otherwise have to be capitalized. The IRS Notice points out that deductibility is available for repair and maintenance costs irrespective of amount. The higher threshold on the safe harbor is effective for costs incurred during tax years beginning on or after January 1, 2016, however, the IRS will not raise on exam the issue of whether a taxpayer without an AFS can use the $2,500 safe harbor if the taxpayer otherwise satisfies the requirements of Treas. Reg. Sec. 1.263(a)-1(f)(1)(ii). In addition, if a taxpayer is under exam concerning the $500 safe harbor and the amount or amounts in issue do not exceed $2,500 per invoice, the IRS will not further pursue the matter. IRS Notice 2015-82
The petitioner operated a sports memorabilia activity that he claimed occupied 12 hours of his time daily, seven days a week. The court didn't believe him because he had a different full-time job. The court also noted that the petitioner didn't have any expertise in the sports memorabilia business. Similarly, the petitioner did not follow accepted business practices, did not insure his inventory and didn't operate the activity in a business-like manner. Akey v. Comr., T.C. Memo. 2015-227.
In this private ruling from the IRS, the taxpayer sought to use his IRA funds to buy a partnership interest. The paperwork was prepared and the partnership interest was purchased with the IRA funds, with the result that the IRA held the partnership interest. However, the advisor that prepared the paperwork failed to realize that the custodian could not hold the partnership interest (while other custodians could), and the IRA custodian reported a distribution by issuing Form 1099-R. The taxpayer sought relief from the 60-day rollover provision based on the bad advice received. The IRS denied relief on the basis that the IRA funds were used to start a business venture rather than being rolled-over exclusively for retirement purposes. Thus, a taxable distribution occurred along with any earnings on the distributed amount. Priv. Ltr. Rul. 201547010 (Aug. 26, 2015).
In these companion cases, the taxpayers sought to acquire a low-speed electric vehicle (LSEV) by the end of 2009 to be able to offset it's cost with the credit then available through 2009 under I.R.C. Sec. 30D. The taxpayers ordered and paid for a LSEV by the end of 2009, and title passed to them in 2009. However, neither taxpayer actually received delivery of the LSEV until mid-2010. I.R.C. Sec. 30D required that, to get the credit, the LSEV must have been placed in service by the end of 2009. The court held that because the actual date of production occurred after 2009 and the taxpayers didn't actually take delivery of the vehicles under after 2009, that the credit was not available because the vehicles had not been placed in service as they were not available for the taxpayers' personal use by the end of 2009. Trout v. Comr., T.C. Sum. Op. 2015-66 and Podraza v. Comr., T.C. Sum. Op. 2015-67.
The petitioner made advances during the year in issue totaling $808,000 to a family-owned business that the petitioner was a part owner of. The petitioner later claimed a bad debt deduction of $808,000 upon not being repaid. The note called for 10 percent interest, but no collateral was required and the line of credit remained unsecured. The Tax Court determined that the petitioner failed to prove that the advances were loans. There was no proof of repayment expectation or an intent to enforce collection. In addition, there was no documentation of the business's credit worthiness. The petitioner's conduct was inconsistent with that of an outside third party lender. Also, the petitioner did not prove that the advances were worthless in 2009, the year for which the deduction was claimed. The business had not filed bankruptcy even by mid-2011. Thus, no default occurred in 2009 and the court denied the bad debt deduction. On appeal the court affirmed. Shaw v. Comr., No. 13-73687, 2015 U.S. App. LEXIS 20563 (9th Cir. Nov. 18, 2015), aff'g., T.C. Memo. 2013-70.
The IRS, in this case, reclassified a significant portion of the taxpayers' (a married couple) income from non-passive to passive resulting in an increase in the taxpayers' tax liability of over $120,000 for the two years at issue - 2009 and 2010. The husband had practiced law, but then started working full-time as President of a property management company. He was working half-time at the company during the tax years in issue. He also was President of a company that provided telecommunications services to the properties that the property management company managed. The couple had minority ownership interests in business entities that owned or operated the rental properties and adjoining golf courses that the property management company managed, and directly owned two rental properties, two percent of a third rental property and interests in 88 (in 2010) and 90 (in 2009) additional entities via a family trust. They reported all of their income and losses from the various entities as non-passive, Schedule E income on the basis that the husband was a real estate professional under I.R.C. Sec. 469(c)(7) and that they had appropriately grouped their real estate and business activities. The IRS claimed that the husband was not a 5 percent owner of the property management company, thus his services as an employee did not constitute material participation. IRS also claimed that the husband was not a real estate professional and that the activities were not appropriately grouped. The court agreed with the taxpayers, determining that the husband was a real estate professional on the basis that he owned at least 5 percent of the stock of the property management company. The court determined that he had adequately substantiated his stock ownership and he performed more than 750 hours of services for the property management company - a company in the real property business. The court also determined that the taxpayers had appropriately grouped their rental activities, rejecting the IRS argument that real estate professional couldn't group rental activities with non-rental activities to determine income and loss. The court held that that Treas. Reg. Sec. 1.469-9(e)(3)(i) only governs grouping for purposes of determining material participation, and doesn't bar real estate professional from grouping rental activity with non-rental activity when determining income and loss (as the IRS argued). Accordingly, the taxpayers had appropriately grouped their renal activity with the activities of the telecommunications company and the adjacent golf courses as an appropriate economic unit. As such, the grouped non-rental activities were not substantial when compared to the aggregated rental activity. The activities were under common control and, under Treas. Reg. Sec. 1.469-9(e)(3)(ii), the husband could count as material participation everything that he did in managing his own real estate interests - his work for the management company could count as work performed managing his real estate interests. Note - in CCA 201427016 (Apr. 28, 2014), the IRS said that the aggregation election under Treas. Reg. Sec. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional and the 750-hour test is not applied as to each separate activity. This was not involved in the case. Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015).
The petitioner had an unpaid tax liability exceeding $600,000 and submitted an offer-in-compromise (OIC) at a collection due process (CDP) hearing. The OIC was for $2,938. The IRS rejected the OIC on the basis that the petitioner had withdrawn over $400,000 from his retirement accounts and that the reasonable collection potential exceeded over $500,000. The court held that the IRS did not abuse its discretion in rejecting the OIC. Chandler v. Comr., T.C. Memo. 2015-215
The petitioner claimed deductions for meals and entertainment, parking fees, tolls and transportation-related expenses, cost-of-goods sold for solar panels and a home office. As for the solar panels, the only documentation provided was a quote for 1,000 units. Concerning the home office, the only substantiation was the petitioner's testimony and the floor plan and area used for the office. No business interest deduction was allowed because there was no evidence that the use of the loan proceeds was for something other than personal purposes. The court agreed with the IRS position on the deductibility of the expenses (some were allowed, but most denied). Smith v. Comr., T.C. Memo. 2015-214.
The petitioner was a surgeon that had a private practice in one location and also was an “on-call” surgeon at a hospital about 25 miles away from his private practice location. At the hospital he had to work a 24-hour period three days monthly and had to be available during emergencies. He had various medical conditions and bought a motor home that he could park near the hospital that he could use for rest and sleep during the 24-hour shifts. He reviewed patient charts in the motor home and referred to his medical books and other information while in the motor home. He did maintain mileage logs that separated out the business and personal use of the motor home. On audit, the IRS allocated the allowable depreciation (including expense method) between his business and personal use. The petitioner claimed that he used the motor home for business purposes 85% of the time during his 24-hour work days. The court upheld the IRS position, noting that the motor home was used only 27 days for business in 2008 and 36 days in 2009. The petitioner’s own logs showed that his business use was approximately 20 percent for the two tax years in issue. Cartwright v. Comr., T.C. Memo. 2016-212.
In the facts of this ruling, the question arose as to whether notices of a non-judicial sale could be delivered to the IRS by private delivery services such as United Parcel Service (UPS) or FedEx. The IRS noted that under I.R.C. §7425(c), the notice of sale must be given in writing, by registered or certified mail or by personal service, not less than 25 days prior to sale. The fact that the IRS actually received the documents does not matter. Delivery by private delivery service such as FedEx or UPS didn’t count. C.C.A. 201545025 (Jun. 12, 2015).
The petitioner was a licensed real estate appraiser and director of real estate valuation at two national CPA firms, but did not own an equity interest in either businesses. After getting married, the petitioner had three condominiums that he and his wife rented out. He claimed that he put in more than 750 hours in managing the rental activities and that he spent most of his time on rental activities, but did not provide any log to document his time. His wife had some notes, but nothing that carefully substantiated the time she spent on rental activities. However, she did construct an activity log after the IRS selected their return for audit. For the year at issue, the petitioner and spouse claimed about $40,000 in losses from the rental activity. The IRS denied the losses due to failure to satisfy the real estate professional exception to rents being passive. The court agreed, and noted that the petitioner's work for the CPA firms did not count toward the750-hr test because he didn't have an ownership interest in those businesses. The evidence also did not support the argument that petitioner's wife met the 750-hr requirement. The court upheld the imposition of an accuracy-related penalty. Calvanico v. Comr., T.C. Sum. Op. 2015-64.
Tax preparers must pay an annual fee to obtain a preparer tax identification number (PTIN). Effective November 1, 2015, the annual fee for a 2016 PTIN is $50 for new applications and renewals of existing PTINS. The $50 fee will split between the IRS and a third-party administrator with the third-party receiving $17 for administration of the online system and provision of customer support and the IRS retaining $33. IR-2015-123.
The petitioner claimed that he was a trader in securities and had, in an earlier year, made a mark-to-market election. To do so, a Form 3115 must be attached to the return. However, IRS didn’t have any evidence from the petitioner that a Form 3115 had been filed and the petitioner could not prove his claim that he had filed one in an earlier year. The court held for the IRS that a valid mark-to-market election had not been made. Poppe v. Comr., T.C. Memo. 2015-205.
The IRS has issued a news release to inform non-credentialed tax return preparers (preparers other than CPAs, attorneys or enrolled agents) of certain continuing education requirements that must be satisfied after 2015. Specifically, the IRS noted that non-credentialed preparers must participate in the IRS' "voluntary" education program, the Annual Filing Season Program (AFSP). Effective for tax returns and claims for refunds prepared and signed after 2015, non-credentialed preparers must complete either 15 or 18 hours of continuing education from IRS-approved continuing education providers which must be completed by December 31, 2015, to be able to receive a 2016 Annual Filing Season Program Record of Completion. IR 2015-123.
The petitioner was in the land development business and sold land to builders for home construction. The petitioner accounted for the income from the sales under the completed contract method which applies to home construction contracts and other real estate construction contracts if the taxpayer estimates that the contracts will be completed within two years of the contract commencement date and the taxpayer satisfies a $10 million gross receipts test under the Treasury Regulations. Under the completed contract method, no income is reported until the contract is complete irrespective of when contract payments are actually received. The IRS asserted that the contracts didn't qualify for the completed contract method of accounting because the contracts could not be considered long-term and were not construction contracts because the taxpayer did no construction activities. The court determined that the custom lot and bulk sale contracts were long term contracts and were construction contracts. However, the court determined that none of the contracts were home construction contracts because the taxpayer merely paved the road leading to a home. Thus, gain under the contracts could not be reported under the completed contract method. The court also determined that none of the contracts involved a general contractor or subcontractor relationship. The Howard Hughes Company, LLC v. Comr., No. 14-60915, 2015 U.S. App. LEXIS 18726 (5th Cir. Oct. 27, 2015), aff'g., 142 T.C. No. 20 (2014).
The petitioner, a family operated business that employed family members, rented a beach house for a week for the enjoyment of the family and employees of a customer. The business claimed deductions for the rental expense and entertainment as “advertising” on the basis that the week-long retreat was for the business purpose of building customer relationships. The IRS disallowed the expenses and the court agreed. The petitioner had scant documentation and no proof that the expenses claimed were paid for what the petitioner claimed they were paid for. Accordingly, the deduction failed for lack of substantiation. The petitioner also claimed expense method depreciation for two vehicles, but again did not have records that could substantiate the deduction. Karras v. Comr., T.C. Memo. 2015-204.
The petitioner invested $285,000 into a scrap metal business (C corporation) operated by his brother. The business filed bankruptcy. The petitioner operated a profitable landscaping business. On this joint return, the petitioner included a Schedule C for the landscaping business and another Schedule C showing a loss from the scrap metal business claiming a $359,000 loss for 2008. The loss was reported as “other expenses” on line 27 of the Schedule C. All other lines of the second Schedule C were blank. The loss more than offset the gain from the Schedule C landscaping business. The IRS disallowed the loss and the court agreed. The loss was not a bad debt, a worthless security or a capital loss. The loss did not become worthless in the year at issue, and his brother kept the scrap metal business operational after the tax year in issue. The petitioner’s short-term capital loss was also disallowed that he was initially allowed upon the IRS initially believing that the petitioner had a bad debt. The negligence penalty was not applied. Espaillat v. Comr., T.C. Memo. 2015-202.
The petitioner submitted what he thought was a joint income tax return, but IRS sent it back for lack of the spouse's signature. On audit for the tax year involved, the petitioner claimed that IRS could not review the return because the three-year statute of limitations had expired. However, the IRS claimed the statute was not tolled because a legitimate return for the year was not filed. The court agreed with the IRS because the return did not substantially comply with the rules for a properly filed joint return, and there was no tacit consent by the other spouse to filing the joint return, and the petitioner did not sign the spouse's name on the return nor try to fix the problem when the IRS sent the return back to the petitioner. Reifler v. Comr., T.C. Memo. 2015-199.
The petitioner was in the construction business and also rented out two floors of a four-floor multi-family house. The petitioner claimed approximately $70,000 in losses associated with the rental activity for 2010 and 2011 combined which the IRS denied for failure to satisfy passive loss rules of I.R.C. Sec. 469. However, the petitioner's construction business counted as a real property trade or business for purposes of the 50% test and the 750-hour test of I.R.C. Sec. 469(c)(7)(B)(i). Based on the petitioner's records, the court was able to discern that the petitioner materially participated in the rental activity by putting in more than 500 hours into the rental activity during the tax years at issue. Simmons-Brown v. Comr., T.C. Sum. Op. 2015-62.
The South Dakota Department of Revenue (SDDOR) has updated its guidance on the sales tax implications of selling farm machinery. The guidance notes that all sales of farm machinery, attachment units and irrigation equipment that are exclusively used for agricultural purposes in South Dakota are subject to a four percent excise tax. For purposes of the tax, "agricultural purposes" means the "producing, raising, growing, or harvesting of food or fiber upon agricultural land," and "agricultural land" is defined under S.D.C.L. Sec. 10-6-31.3. The services of custom harvesters, chemical applicators, fertilizer spreaders and cultivators are considered to be agricultural purposes. Repair parts, repair services, maintenance supplies and services to farm machinery and attachment units that are used exclusively for ag purposes are exempt from the excise tax as well as sales and use tax. That is the case for repair parts if the repair parts replace a part that the manufacturer assigned a specific or generic part number. The SDDOR states that the buyers have the responsibility to pay the excise tax directly to the SDDOR if the retail seller does not collect the tax and report it as a use tax on the state sale tax return. South Dakota Tax Facts No. Oct. 1, 2015 (Farm Machinery Attachment Units and Irrigation Equipment).
The petitioners, a married couple, failed to fully report their income on their joint return. The wife worked for an attorney promoter of fraudulent tax schemes, and she put her paychecks into a bank account from which she paid personal living expenses without reporting the wage income. The husband was aware that her income was not being reported and he didn't report his income for one year at issue. The husband sought innocent spouse relief and the court, based on the factors set forth in Rev. Proc. 2013-34, determined that the husband knew of the unpaid tax liability, and denied innocent spouse relief. Williams v. Comr., T.C. Memo. 2015-198.
In this case, the president of a corporation impeded an IRS audit of the corporation by creating and backdating promissory notes, issuing false Forms 1099, among other things. From 2004 to 2008 the corporations earned over $100 million but didn't file any tax corporate tax returns. The IRS claimed that the corporation owed $120 million in taxes, interest and penalties. The petitioner was a minority shareholder that had received bonuses and dividends during the years that the corporation was not paying taxes. The IRS sought to recover $5 million from the two minority shareholders. The petitioner received over $3.5 million in dividends during the years at issue while the company was insolvent and another minority shareholder received about $.5 million. Under state (FL) law, the IRS did not have to pursue all reasonable collection efforts against the corporation, but could go directly after the minority shareholders to the extent of dividends received during the years at issue. Kardash v. Comr., T.C. Memo. 2015-51. On reconsideration, the court determined that the corporation was solvent in 2005, but determined that the transfers were constructively fraudulent as a part of a series of transactions that led to the corporation's insolvency. Consequently, the post-2004 transfers were fraudulent because they were for less than fair market value and resulted in the corporation's insolvency. Kardash v. Comr., T.C. Memo. 2015-197.
The plaintiff bought a property at a non-judicial sale. The IRS had an I.R.C. Sec. 6321 lien against the property that had been filed more than 30 days before the sale. The IRS was not given notice of the sale at least 25 days before the sale. The IRS lien had been filed with the county. The plaintiff claimed that the lien was not valid, but the court determined otherwise. The IRS, the court held, did not get effective notice of the sale of the property. Thus, the IRS could foreclose the lien and had priority position against other creditors as to the proceeds of sale. Mendoza v. Cisneros, et al., No. 14-cv-3324-WJM-KMT, 2015 U.S. Dist. LEXIS 141416 (D. Colo. Oct. 14, 2015).
The plaintiff retired in 2004 from being an airline pilot. The airline had filed bankruptcy in 2002. The plaintiff's non-qualified deferred compensation plan benefits vested upon his retirement, and the airline computed the present value of the benefits to be paid in accordance with I.R.C. Sec. 3121(v)(2) and withheld Medicare taxes. The value of the benefits exceeded the FICA limit in 2004, and the computation of the present value of the benefits was computed without regard to the possibility that the benefits might not actually be paid because based on the definition of "amount deferred" in terms of "present value" in Treas. Reg. Sec. 31.3121(v)(2)-(c)(2)(ii). Based on that value, the airline withheld over $4,000 of payroll tax. The deferred compensation liability of the airline, however, was largely discharged in bankruptcy such that the plaintiff received just over $60,000 of the approximately $300,000 of benefits owed to him - even though he paid payroll tax on the full amount. The plaintiff challenged the regulations as invalid, but the IRS maintained that the regulations were appropriate and required payroll tax on the full benefit. The court upheld the regulation as rational and a reasonable interpretation of I.R.C. Sec. 3121 and there was nothing in the statute requiring the IRS to refund the payroll taxes on account of the airline's bankruptcy. The statute provided no exception when there was a risk of nonpayment. Balestra v. United States, No. 2014-5127, 2015 U.S. App. LEXIS 17756 (Fed. Cir. Oct. 13, 2015), aff'g., 119 F. Cl. 109 (2014).
In this advice, the IRS concluded that an employer can exclude from an employee's gross income amounts paid for health insurance coverage that is provided through the group health plan of the spouse of the employee to the extent that the spouse paid for all or part of the coverage on an after-tax basis and not through a salary-reduction under an I.R.C. Sec. 125 cafeteria plan. The payment can also include the after-tax amounts paid for both spouses by the employee's spouse. Thus, an employer would be able to reimburse the payments tax free for the portion that represents the employee's cost and the portion that represents the cost of the employee's spouse. While not addressed, it would appear that because the amounts in issue are tied to the spouse's employer's group health plan, the Obamacare restrictions would not come into play because the reimbursement plan is integrated with the group health plan. However, Obamacare bars an insured plan from discriminating under the same rules as those that apply to reimbursement plans once regulations are promulgated that put the discrimination rules in place (See Notice 2011-1). C.C.A. 201547006 (Oct. 7, 2015).
The petitioner was 76 and dying of cancer. For his business, he had taken out a $50,000 line of credit with his bank in 2008. He couldn't pay off the credit line and the bank agreed to accept $15,628 as full payment on the loan in 2009. The petitioner also couldn't pay other debts totaling over $68,000 and that amount was also canceled in 2009. The petitioner received Form 1099-C from the bank with box 5 checked, indicating that that the petitioner was not liable for repaying the debt balance. However, the petitioner did not report his canceled debt in income on the 2009 return. He attached a statement to the return that the local IRS office had told him that "it would likely come under the hardship rules for approval." While the petitioner believed that he was not liable for reporting the cancellation of debt income (CODI), the IRS and the court disagreed. The court noted that there is no exception under I.R.C. Sec. 108 for "hardship." In addition, the court noted that administrative guidance from the IRS is not binding on the court and it cannot change the plain meaning of tax statutes. While the court agreed that the petitioner had suffered from hardships, such hardships did not absolve him from reporting the CODI. The petitioner was neither insolvent or in bankruptcy. Dunnigan v. Comr., T.C. Memo. 2015-190.
The petitioner occasionally made loans to friends, acquaintances and business associates, doing so 12 times over a six-year period without the normal formalities associated with a lending business. He did not hold himself out as in the business of lending money and did not keep business records that were close to adequate, and did not perform "due diligence" with respect to any loans that he made. He made a loan to a construction company which failed to pay its $925,000 loan upon it becoming due in 2007. The company filed for reorganization bankruptcy in 2008 showing assets of over $62 million and liabilities of over $34 million. The petitioner did not file a claim in the bankruptcy. Ultimately, the case was converted to Chapter 7 from Chapter 11. The petitioner filed an amended return claiming a business bad debt deduction (ordinary loss deductible on debt that becomes partially worthless) on the 2008 return. The petitioner argued that if the loss wasn't deductible in 2008, it was in 2009. The court held that the loan would not qualify as a business bad debt, but that any bad debt would be a non-business bad debt (deductible as a short-term capital loss in the year in which the debt becomes wholly worthless). The court determined that the plaintiff had failed to show that the debt was completely worthless in either 2008 or 2009. Instead, the court pointed out that the petitioner first acted as if the debt was worthless in 2010 when he filed his amended 2008 return. The company's filing of bankruptcy that year was insufficient to show that the debt was worthless in 2008 because it was not clear at that time that the company was insolvent. Cooper v. Comr., T.C. Memo. 2015-191.
The regular percentage depletion rate for independent producers and royalty owners remains at 15 percent for calendar year 2015. The regular percentage depletion rate for independent producers and royalty owners is 15 percent. For qualifying marginal production (less than 15 daily barrels of oil equivalent per day) the 15 percent rate is increased by one percentage point for each dollar the price of crude oil is less than $20 per barrel. With the barrel price exceeding $20 per barrel, there is no increase to the 15 percent rate. Percentage depletion for oil and gas production is 15 percent of gross revenue limited to 100 percent of a property’s net income. IRS Notice 2015-65, 2015-40 IRB 466.
The petitioner, 47 years old, withdrew funds from her IRA to pay her son’s medical expenses. Her son was not claimed as a dependent on her return. She did not pay the additional 10 percent penalty on the withdrawal required under I.R.C. Sec. 72(t). The IRS assessed the additional penalty and the court upheld the IRS position. The court noted that the petitioner did not claim her son as a dependent on her return for the tax year in issue and that he did not otherwise qualify as a dependent under I.R.C. Sec. 152, which would have avoided the penalty on the withdrawn amount to the extent of what the taxpayer could have claimed as a deduction for qualified medical expenses under I.R.C. Sec. 213. Unlike a health savings account, where the withdrawn amounts used to pay for the son’s medical expenses would have also been tax-free if the son had been a dependent, the withdrawn amounts from the IRA are taxable. Ireland v. Comr., T.C. Sum. Op. 2015-60.
The petitioners, a married couple, bought a 10-acre tract in 2006 on which they built their residence and also barns and a horse riding arena used in their LLC's horse boarding and sales business. The business sustained a loss of almost $100,000 in 2009 showing up as negative gross income on their joint return. The riding arena suffered from construction defects, requiring additional sums to be spent to resolve the problem. During 2009, the husband conducted his (very limited) law practice from an office in the residence. The petitioner shared the office with his (much younger) wife who is an equestrian a realtor and experienced horse jumper. The couple's joint return included over $12,000 of "other expenses" consisting, in part, of telephone expenses and $25 of "miscellaneous" expenses. The petitioners claimed expenses for five telephone lines and internet service. The IRS disallowed half of the deductions for telephone expenses and all of the miscellaneous expenses, and a claimed casualty loss deduction. The IRS also imposed an accuracy-related penalty. the court sustained the IRS determinations. On the telephone expenses, the court noted that the petitioners did not tie any expenses to any particular telephone line or business activity. The miscellaneous deductions were also disallowed for lack of explanation. The riding arena did not sustain a casualty loss because the construction defects giving rise to the extra expenses were not "sudden, unusual or unexpected in nature." Costs associated with faulty construction are not deductible. In addition, the loss was not sustained in the conduct of a trade or business and the petitioners continued to use the asset. The riding arena was not sold, abandoned or permanently withdrawn from use during 2009. The court upheld the accuracy-related penalty with respect to the adjustments conceded to and the disallowance of the deduction for miscellaneous expenses. Wideman v. Comr., T.C. Summary Op. 2015-61.
The petitioner claimed that he lost his business records in a flood, but he was still able to produce large amounts or records that were disorganized. The court held that the records failed to show the business purposes of particular expenses and were not helpful in distinguishing the type of expenses incurred - reimbursed or non-reimbursed. While the petitioner had information for the years in issue, he made no attempt to reconstruct his claimed business expenses. Consequently, some of his claimed business expenses were denied. Young v. Comr., T.C. Memo. 2015-189.
The petitioner sought a redetermination from the Tax Court and the petition was delivered to the court on the 98th day - 8 days beyond the 90-day deadline. Normally, the petition is considered to have been filed at the time of mailing. The petition's envelope included a "postmark" by Stamps.com on the 90th day. However, the envelope also had a certified mail label with a tracking number and tracking data of the U.S. Postal Service showed that the USPS received the envelope on the 92nd day. The court ignored the Stamps.com "postmark" and held that the petition had not been timely filed. Tilden v. Comr., T.C. Memo. 2015-188
The petitioner's S corporation claimed a net operating loss (NOL) as a result of writing down real estate holdings due to the collapse of the real estate market. The petitioner claimed that the properties had been abandoned in that same year or had become worthless. The IRS disallowed the NOL and the court agreed. The petitioner never abandoned the properties and a loss on account of worthlessness of property that is mortgaged, the court noted, means worthless of the petitioner's equity in accordance with I.R.C. Sec. 165. The court noted that, with respect to recourse debt, the petitioner could not claim any loss deduction until the year in which a foreclosure sale occurs. Thus, the petitioner was not entitled to any deduction until some point in the future. Tucker v. Comr., T.C. Memo. 2015-185.
The petitioner's S corporation sustained losses which the petitioner carried forward to offset income in the carry forward years. The IRS denied the carry forward of the NOLs because the petitioner did not establish that he had waived the carryback period, failed to show that the losses had not been absorbed in an earlier year, and even failed to show that the S corporation incurred the losses. The court agreed with the IRS and also noted that the petitioner failed to show that the petitioner had sufficient basis in the S corporation shares. Jasperson v. Comr., T.C. Memo. 2015-186.
The plaintiff was in the business of selling “unit doses” of drugs in non-reusable container intended for single-dose administration to patients. The plaintiff bought the drugs it identifies as suitable for unit doses in bulk and then engages in operating procedures for the processes and equipment to be used in converting the drugs purchased in bulk into unit doses. The IRS denied a domestic production activities deduction (DPAD) under I.R.C. Sec. 199 on the basis that the plaintiff’s activities constituted “packaging, repackaging, labeling and minor assembly” under Treas. Reg. Sec. 1.199-3(e)(2). The plaintiff claimed that its activities were comparable to the taxpayer’s activities in United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) where the taxpayer assembled gift baskets and was allowed a DPAD. The court agreed with the taxpayer in this case and allowed the DPAD on the basis that the activities involved were analogous to those in Dean. The court believed that activities beyond mere packaging and repackaging were involved, including market research to identify which drugs to buy, testing of drugs, studies involving the mixing of drugs, testing of plastics, and other related activities. As such, the plaintiff was engaged in a production process and was entitled to a DPAD on its qualified production income. While the case was decided after the IRS proposed new DPAD regulations containing an example noting the disagreement of the IRS with the result of Dean, the court’s opinion did not involve any analysis or application of those regulations. Precision Dose, Inc. v. United States, No. 12 C 50180, 2015 U.S. Dist. LEXIS 128115 (N.D. Ill. Sept. 24, 2015).
The petitioner issued residual value insurance policies that insured lessors and lenders against not properly estimating the residual value of leased property at the end of the lease term. Such policies insure the expected residual value remaining on an asset at the end of a lease. The petitioner utilized the accounting rules of I.R.C. Sec. 832 applicable to insurers. However, the IRS claimed that the petitioner was not an insurance company and that the policies they issued were merely a hedge against investment risk rather than truly insurance. As a result, the IRS claimed that the I.R.C. Sec. 832 rules were inapplicable and that the petitioner had to use the rules contained in I.R.C. Secs. 451 and 461 resulting in a $55 million deficiency. The IRS also cited Tech Adv. Memo. 201149021 (Aug. 30, 2011) to support its position. The states that the petitioner operated in regulated the petitioner as an insurance company, and Fitch, Moody’s and S&P rated the petitioner as an insurer. The petitioner offered evidence that it insured against “low frequency/high severity” risks such as earthquakes or floods,” but the IRS claimed that the risk was illusory. The court rejected the IRS position because of evidence showing risk-shifting and risk-distribution. A real risk of loss was being covered. In addition, the court noted that every state in which the petitioner did business the state regulates the petitioner as an insurer. R.V.I. Guaranty Co., Ltd. & Subsidiaries, 145 T.C. 9 (2015).
The decedent died testate in late 2008. At the time of his death, the decedent was not married, had no children, and both of his parents had predeceased him. The Form 1041 for the estate was filed in April of 2012 reporting $335,854 of income and claimed a $314,942 charitable deduction. The IRS disallowed the charitable deduction in its entirety, claiming that the amount had not been permanently set aside for charity as required by I.R.C. §642(c)(2). The decedent’s will, executed in 1983, instructed the executor to pay all estate expenses and costs from the general estate, and conveyed 100 percent of the residuary estate to the church that the decedent regularly attended. There was no provision in the will specifically providing for gross income to be permanently set aside or separated into distinct accounts. Over a timeframe of several years, the estate tried to determine whether there were any unascertained heirs with several being identified as potential heirs. Ultimately, the will was challenged and a proposed settlement was reached with two thirds of the decedent’s gross probate estate. The court noted that, to claim a charitable deduction, the estate must show that the contribution was from the estate’s gross income, that the will/trust terms made the charitable contribution, and that the charitable contribution was permanently set aside for charitable purposes in accordance with I.R.C. Sec. 170(c). The IRS did not challenge the first two requirements, but claimed that the residue of the estate was not permanently set aside for charitable purposes. The court agreed with the IRS that it had not. The court noted that the chance the charitable amount was go to non-charitable beneficiaries for the year in issue was not so remote as to be negligible. The proposed settlement was evidence of the ongoing legal battle that had not yet concluded. he court noted that for the year in issue the estate was in the midst of a legal battle and had ongoing undetermined expenses, and their remained a possibility that the amount set aside for the churches that the decedent attended would go to the challengers. Estate of DiMarco v. Comr., T.C. Memo. 2015-184.
The petitioner was a cardiologist and his wife also worked in his practice. They constructed a house in 1997 and tried to sell it for four years, after which they rented the house for four years to an unrelated tenant, and then to their daughter at one-third of the amount it was rented to the unrelated tenant. They resumed sales efforts in 2010. On their 2008 return, the petitioners indicated the house was rental property with a net loss of $134,360 which they characterized as a passive loss on Form 8582. On the 2009 and 2010 returns the petitions again showed net losses on the property, but indicated they were in the construction business. They filed a 2008 amended return claiming a refund relating to expenses claimed on the house, which IRS disallowed and also assessed an accuracy-related penalty. The IRS determined that the house was held for the production of income and that the losses were passive losses under I.R.C. Sec. 469. The IRS also asserted that the deductions attributable to the house were limited by I.R.C. Sec. 280A. The court agreed with the IRS because a related party lived in the house and used it for personal purposes for more than the greater of 14 days a year or 10% of the number of days the house was rented at fair rental. The court rejected the petitioners’ claim that they were real estate developers that needed to have their daughter live in the house to keep it occupied as required by their homeowners policy which would then make Sec. 280A inapplicable. Thus, the deductions attributable to the house were limited to the extent of rental income. The court upheld the application of the accuracy-related penalty, and did not need to determine whether the losses were passive. Okonkwo v. Comr., T.C. Memo. 2015-181.
An IRS Form 2848 named three representatives to represent the taxpayer with the IRS. One of the representatives had not signed the form and another representative signed the form on that representative's behalf. The IRS determined that the third representative had not been duly appointed. The representative signing on the third representative's behalf simply signed his own name and did not indicate he was signing on the other party's behalf. In addition, Form 2848 Section 5(a), Part I did not provide that representatives had the power to appoint another representative. C.C.A. 201544024 (Sept. 16, 2015).
Under I.R.C. §170(f)(8), a taxpayer claiming a charitable contribution deduction exceeding $250.00 must substantiate that deduction with a contemporaneous written acknowledge from the donee, showing the amount of the contribution, whether any good and services were received in return for the donation and a description and good faith estimate of any goods and services provided by the donee or that the donee provided only intangible religious benefits. However, I.R.C. §170(f)(8)(D) says that the substantiation rules don’t apply if the donee files a return including the contemporaneous written acknowledgement information that the taxpayer was otherwise supposed to report. This provision allows taxpayers to “cure” their failure to comply with the contemporaneous written acknowledgement requirement by the donee exempt organization filing an amended Form 990. However, without any regulations, the IRS has taken the position that the statutory provision does not apply. Apparently believing that their position was weak and would not be supported judicially, the proposed regulations acknowledge the exception and allow the charitable organization to file a form (yet to be announced) on or before February 28 of the year after the year of the donation that shows the name and address of the donee, the donor’s name and address, the donor’s tax identification number, the amount of cash and a description of any non-cash property donated, whether the donee provided any goods and services for the contribution, and a description and good faith estimate of the value of any goods and services the donee provided or a statement that the goods and services were only intangible religious benefits. The form must be a timely filed form and cannot be filed at the time the taxpayer is under examination, and a copy of the form must be provided to the donor. REG-138344-13 (Sept. 16, 2015); Prop. Treas. Reg. §§1.170A-13(f)(18)(i-iii).