One common error my students make is to confuse asserting an argument with supporting the argument. For example, a student on my Civil Procedure exam might write “We will argue that the Plaintiff’s domicile is in Texas and not Oklahoma.” That sentence tells me only that an argument exists. It does not support the argument with an explanation about why Plaintiff’s domicile might be thought to be in Texas. I try to teach my students they must connect assertions with the evidence necessary to show why the assertions are true. So I feel like a failure when I read exam answers like that. I think most profs have similar feelings when grading.
Lawyers sometimes make a similar error when representing clients in court: they make assertions and even spin a plausible story, but neglect to support those assertions or the story with credible evidence. To be fair, sometimes an attorney has no choice: the client may simply not have provided the needed information, and the attorney must nonetheless argue something! But arguments are not evidence.
Last week’s decision in Brandon Brown and Christi Cloaninger Brown v. Commissioner, T.C. Sum. Op. 2018-6 (Feb. 5, 2018), teaches this lesson. Sure, it’s “just” an S case, but even if those cases are not formal precedent, they can still teach valuable lessons. Here, the case is also a nice illustration of when it makes sense to use the §7463 Small Case procedures and how the burden shift in §7491(a) can sometimes actually be important.
I’ll consider each lesson below the fold.
Mr. and Ms. Brown owned four rental properties. In 2013 they took a $48,000 deduction for $45,000 spent on one of the properties and $3,000 spent on another other. The Service allowed a deduction of $21,000 but required the taxpayers to capitalize the remaining $27,000. The resulting NOD proposed a $6,500 increase in tax and a $1,300 accuracy-related penalty under §6662. The Browns hired the firm of McGee Tax Law (James G. McGee, Jr. principal) and filed a timely Tax Court petition, drawing Judge Laro.
The issue in the case was a classic one: the tension between expensing and capitalization. Section 212 allows taxpayers to deduct from income “all the ordinary and necessary expenses... for the management, conservation, or maintenance of property held for the production of income.” But §263 says no deduction is allowed for “any amount paid out for...permanent improvements or betterments made to increase the value of any property....”
So if the Browns spent the $27,000 on “repairs” then they could deduct all of that amount in 2013. But if that money was for “improvements,” then they would need to capitalize the amount and recover it over time as depreciation deductions. As Judge Laro noted: “It is a factual determination whether an expense is a deductible repair or an expenditure that must be capitalized.”
The S Case Lesson
Mr. McGee elected to use the §7463 small case procedures and so the case was designated as an “S” case. The §7463 election has been around since 1969. Brian Trauman and Jefery Mallo wrote a still-useful article in the Fall 2006 issue of the Practical Tax Lawyer that gives the history of §7463, describes its implementation, and analyzes how the Small Case procedure actually gets used.
The basic idea of the election is to help pro se taxpayers. In Chapter 7 of that great ABA Tax Section publication “Effectively Representing Your Client Before the IRS,” Sean M Akins and Elizabeth A. McGee (no apparent relation to the Brown’s attorney) write: “The main reason for allowing the S designation is to allow easier access to the Tax Court for taxpayers with relatively small amounts in controversy where it is not feasible for the taxpayers to retain attorneys.” The new edition (7th) should be out in the next month. If you do any tax representation work, you would really benefit from this book.
S case procedure helps pro se taxpayers by its informality. The idea is to make the proceeding less intimidating than a regular Tax Court hearing or trial. It’s particularly helpful for pro se taxpayers because the rules on evidence are relaxed. That’s the upside of the election. The downside of the S case election is that the Tax Court’s decision is final. There is no appeal. That means that the best time to choose S case designation is when a case turns on a question of fact ... like this one.
S cases also help taxpayers who have hired an attorney, as the Browns did here. That is because those same relaxed rules mean less attorney time on the case and, thus, less expense. Again, when the main issue in the case is a factual one, where the Tax Court decision would get very deferential review anyway, electing into the S case procedure can make a lot of sense.
The Evidence Lesson
Keeping costs low would seem to be the main reason for the Browns’ attorney Mr. McGee to have here elected S case. I infer that partly from the fact that the total amount in controversy was just under $8,000 and also from seeing that the case went to trial on fully stipulated facts. That meant there was no need to introduce witnesses or evidence and the parties instead simply supplied the court with briefs arguing their position.
But the stipulated facts created a problem for the taxpayer. The only facts introduced by the taxpayers to support the deduction was a schedule of items and cost of those items that the Service had disallowed as §162 deduction expense. For example, one item of expense was listed as “Carpet—Suite B” and the cost for that was $2,085. The next item was “Carpet and ... tile—Suite A” for a cost of $3,788. Then came “Carpet-HOYA for $4,498. Then came “Carpet—Suite E” for $5,435. You get the idea.
You see, these stipulation were only an assertion of the cost of an item, not an explanation for what the money was spent on. Was the carpet just patched or repaired or was it replaced? Was the carpet replacement contract multiple contracts at different times for Suites A, B, E and HOYA? Or was it all one big job costing just under $16,000?
Mr. McGee and Mr. Webb argued the case for the taxpayers on brief. Judge Laro recites all their lovely arguments about what those items and costs might be. But the problem, as Judge Laro notes, is that Mr. McGee and Mr. Webb are simply making arguments, contentions, allegations:
“we have before us an itemized list of the work performed and the costs therefor [but] we have no evidence about the context in which that work was performed.... Petitioner on brief have provided certain explanations that purport to establish such a context. However, because petitioners’ statements are not supported by any evidence---that is, by any stipulation or exhibit thereto, or any other source—those statements cannot be treated as anything more than unsworn allegations.”
Arguments are not evidence.
The Burden of Proof Lesson: Of §7491
Burden of proof is a concept that has two components: a burden of production and a burden of persuasion. The former is a question of evidence: who has the burden to produce the information necessary for decision. The latter is a question of decision: who bears the risk that the decision-maker cannot make up its mind. I offer students a baseball analogy. The burden of production is a question of who must hit the ball to score. If your team is up to bat and you don’t produce runs you are not meeting your burden of production. The burden of persuasion is who wins if you fail the burden of production. If your team is ahead and you score no runs in a inning, you can still win the game. That’s why when the home team is ahead after the top of the 9th inning, there is no need to play the bottom of the inning.
In Deficiency cases the issue before the Court is whether the proposed deficiency is correct. The IRS always starts out ahead in the scoring because the NOD gets a presumption of correctness and it’s up to the taxpayer to overcome that presumption. Put another way, the taxpayer bears the risk of non-persuasion. Welch v. Helvering, 290 U.S. 111 (1933).
Another way to think about the “arguments are not evidence” lesson is to see that a taxpayer must meet its burden of production (evidence) in order to meet its burden of persuasion. Arguments just don’t do it. But because of the presumption of correctness, the IRS doesn’t need no stinkin’ evidence---it can just point to holes in what the taxpayer produces, unless the taxpayer can invoke §7491.
When a taxpayer introduces credible evidence in court on a particular issue, then IRC §7491(a) provides that the IRS “shall have the burden of proof with respect to such issue.” That means both that the IRS must bring forward contrary evidence and now bears the risk of non-persuasion.
Section 7491(a) is not as easy to trigger as it may seem, however. That is because §7491(b) requires that taxpayers don’t get the burden shift unless they have also have maintained required records and have cooperated with reasonable IRS requests for information, including documents and witnesses. And the Tax Court rarely goes into a §7491 burden shift analysis because it almost always finds that the IRS has submitted enough counter-evidence to carry its burdens even assuming the burden is shifted. For a nice discussion of those issues, see: (1) Megan Brackney, The Impact of Code Sec. 7491 Burden-Shifting in Tax Controversy Litigation, 9 Journal of Tax Practice and Procedure 27 (2007); and (2) John A. Jr. Lynch, Burden of Proof in Tax Litigation under I.R.C. Sec. 7491 - Chicken Little Was Wrong, 5 Pitt. Tax Rev. 1 (2007). I am sorry I don’t have a link to Professor Lynch’s paper. But he still teaches at U. Baltimore Law School and no doubt would be happy to supply a copy. And you can find it on Hein Online if you have a subscription to that service.
Still, in deduction cases like this one, §7491 could be important if the taxpayer actually has any evidence or has a good excuse why documentary evidence no longer exists. Like the taxpayers, the IRS had zero evidence that the taxpayer’s expenses here were not for repairs. If one is going to do a Hail Mary pass on the briefs (to change the sports analogy) then would it cost that much more to put the witnesses on the stand and have them bat their baby blues as the judge? Witnesses are evidence, after all and would give some grounding to what are otherwise unsupported arguments in a brief.
Those kind of calls are difficult for practitioners to make and I don’t pretend to know the answer or second guess a tactical decision. I’m just an academic. But I do know that this week’s case teaches a timeless lesson: arguments are not evidence. And electing S case procedures does not mean you can ignore that lesson.
Coda: The IRS conceded the accuracy-related penalty in Court. I think that was probably a good call. The fact that the Browns were able to show over half the total expenditures were for repair suggests that they were not unreasonable in treating all the expenditures that way. The rest of the expenditures may indeed have been for repairs, but the taxpayer simply had insufficient evidence. That does not seem not worth a penalty to me, although I am no expert on penalties.