Paul L. Caron

Monday, November 13, 2017

Lesson From The Tax Court: The Power Of Fact-Finding

In the old Dragnet series, Jack Webb’s character was famous for declaring that “all we want are the facts, ma’am.”  As if “the facts” are pristine jigsaw pieces that, if you find enough, give you an objective truth.  Lawyers know better.  Every “fact” comes from a point of view.  Even police body cams are viewpoint-dependent, as seen this this nifty experiment.  The lawyer’s job is to assemble together facts which, if believed, tell the story from the point of view most favorable to the client’s interest.  They promote “a” truth.  The fact-finder has to decide on “the” truth.

Most courses in law school are not structured to teach this lesson.  We tend to focus our students on appellate opinions where the facts are a given, not a mystery.  Still, in both my Civil Procedure course and my Tax course I take what opportunities I can find to show how the finders of fact have huge power in deciding how a case resolves. 

In Tax Court, most facts are usually stipulated by the parties.  But sometimes the Tax Court judge is called upon to decide the “facts” from witness testimony.  A pair of opinions issued last week illustrate the power of fact-finding.  One came out well for the taxpayer.  The other did not.  More below the fold.

The case of Bullock v. Commissioner, T.C. Memo 2017-219 (Nov. 6, 2017), is simple and worked out well for the taxpayer.  Ms. Bullock had signed as a co-obligor on a loan from her credit union.  The loan was for her son to buy a truck to use in his business.  The vehicle was stolen and the insurance paid off part of the loan.  The credit union forgave the outstanding balance of the loan and send Ms. Bullock a 1099-C (Cancellation of Debt) for $8,164.  Ms. Bullock did not report that on her return, the Service’s computers picked up the discrepancy, and she received an Notice of Deficiency for the unreported COD income.  She petitioned the Tax Court and drew Judge Vasquez.

In order for a taxpayer to have COD income there must be a debt in the first place.  That is a question of fact.  In Ms. Bullock’s case it was her signature on a loan document that supported the fact of a debt.  Against that, she testified she was not supposed to be a co-debtor.  She testified that she was supposed to have been the guarantor of the loan.  She explained that she had unwittingly signed the wrong document and so her signature was an error. 

Judge Vasquez believed her.  He held that there was no bona fide debt:  “When petitioner when to the car dealership she did not intend to be the primary obligor on the loan.  In fact, she did not realize until trial that she had signed paperwork stating otherwise.”  He believed her further testimony that “she received neither phone calls or correspondence from the credit union attempting to collect the outstanding balance.”

Happy taxpayer!  To be believed as a truth-teller is one of the greatest joys in life.  It’s especially sweet when it saves you from paying tax on income you never even received. 

The case of Smith v. Commissioner, T.C. Memo 2017-218 (Nov. 6, 2017), is more complex and worked out poorly for the taxpayers.  This married couple’s financial situation in 2009 seemed like a golden start to their golden years.  Mr. Smith had worked for National Coupling, Inc., for 36 years when, in the middle of 2009, the company was sold.  He retired, took a $600,000 bonus, cashed out his company stock for about $250,000, surrendered his two company-owned life insurance policies for about $180,000.  And that was in addition to $64,000 in regular salary for part of that year and then about $38,000 in consulting compensation for the time after he retired.  Total income was north of $1 million.  Not too shabby.

Wanting to minimize their tax hit, the Smiths consulted with one Richard Shanks, a Houston tax attorney and CPA.  He sold them on a tax shelter scheme that, according to the Tax Court, “he had implemented for 10 to 15 other clients between 1999 and 2009.”  The scheme was for the Smiths to create a family limited partnership to hold all their new wealth (cash and securities).  But they would not just transfer their wealth into the partnership.  Nope.  They would first transfer the wealth into a newly created Subchapter S corporation.  The S Corporation would then immediately put all that wealth into the partnership in exchange for shares in the partnership.  Then the S Corporation would, like a butterfly, die.  In dying it would distribute its partnership interest to...the Smiths!  The Tax Court opinion explains that this distribution would result in a large tax loss because Mr. Shanks (wearing his CPA hat I guess) would determine a really low fair market value for the distributed partnership interest “using large discounts for lack of marketability and lack of control.”

So the Smiths transferred about $1.8 million in cash and securities to the S corporation, the S corporation transferred all that into the family limited partnership for partnership shares and then, upon dying, distributed the shares to the Smiths.  From this journey the Smiths claimed a loss of just under $750,000 for 2009.  But fear not for the Smiths!  All of that $1.8 million made it safely into the family limited partnership for them to use.  Well, all of it except for the $23,200 they paid Mr. Shanks to implement this scheme. 

Are you taking notes?  Mr. Smith did.  His handwritten notes include references to the S corporation as a “vehicle to minimize tax event this year.”  I hope you are paying attention because I confess I don’t understand how this works even as I am writing it! It seems. So. Crazy.

But tax law permits taxpayers to have crazy structures to minimize the tax hit on their income.  There is no shame in trying to shelter income from tax.  But sometimes there is a sham in trying to do so, when the crazy schemes have no business or economic purpose other than generating a tax loss.  The line between permissible and impermissible structuring is policed by the economic substance doctrine.  The economic substance doctrine allows a court to disregard a transaction for Federal income tax purposes if it has no effect other than generating an income tax loss.  And that is true even if state law would otherwise recognize the transaction and even if the transaction complies with all the formal requirements in the relevant tax statutes.

Deciding whether the Smiths could actually take a $750k loss depended on whether their Rube Goldberg scheme had any economic substance beyond generating the loss.  And that, dear readers, is a factual determination.  The Tax Court must decide whether, as a matter of fact, there was anything more to this scheme than generating a tax loss.  Since the 2009 tax year was before the effective date of §7701(o), see Notices 2010-62 and 2014-58, the Tax Court used the common law rule, as set out by the Fifth Circuit in Klamath Strategic Inv. Fund v. United States, 568 F.3d 537 (5th Cir. 2009).

The Smiths drew Tax Court Judge Goeke.  They had a great attorney representing them, George Connelly from Chamberlain Hrdlicka.  George’s job was to marshal the facts in a way that would convince the Tax Court that the Smith’s had some legit purpose to this scheme.  He was unable to do so, largely because Judge Goeke simply did not believe Mr. Smith’s testimony.  Judge Goeke repeats no less than seven times that he finds one or another aspect of the taxpayers' claims or testimony not credible. 

Oh unhappy taxpayer!  To not be believed when you are testifying under oath really hurts.  It’s especially hurtful when it means you now face a tax deficiency of $623,795.  Gosh, I sure hope the taxpayers at least made a tax deposit with the Service to stop the running of interest pending the litigation outcome.

But wait, it gets worse.  The Service also sought to impose a $125k accuracy-related penalty.  Once again, the Tax Court’s power of fact-finding worked against the Smiths.  Judge Goeke summarized his factual findings this way (with the most hurtful part bolded):

Petitioners knew that the purpose of the RACR structure was to minimize their 2009 income tax. Their handwritten notes from their first meeting with Mr. Shanks referred to an S corporation as the vehicle to minimize the tax event in 2009. Mrs. Smith emailed the Shanks Firm in August 2009 and sought to confirm that Ventures would dissolve by the end of 2009. Petitioners knew from the time they implemented the RACR structure that Ventures’ sole purpose was to avoid income tax on Mr. Smith’s bonus from the National Coupling sale. They knew that Ventures would never manufacture the sprinkler device. Even if Mr. Smith owned the patent rights as he claims, petitioners had no intent to keep Ventures in existence until the patent was issued but dissolved it after only four months. Yet they continued to perpetuate their tax-avoidance scheme through their testimony at trial that we have found not to be credible or reliable. Nor do we find credible petitioners’ attempts to explain away multiple inconsistencies in the record. Petitioners did not act with reasonable reliance on a professional or act in good faith. Accordingly, we find that petitioners are liable for the section 6662(a) penalty.

Folks, while you might believe — with Mulder and Scully — that “the truth” is out there, you must accept that, for the resolution of tax disputes, the “truth” is what the Tax Court Judge finds.  That’s the power of fact-finding.  In both of these cases there was evidence supporting “a” truth different from what the Tax Court found and in both cases it was the credibility (or lack thereof) of the taxpayer acting as witness that made the difference.      

Post-script:  When I told the Smiths' story to my wife, she felt sorry for them and asked why the lawyer who sold them on this scheme, Mr. Shanks, did not have to pay any penalty.  That’s a great question and when the Tax Court next issues a case dealing with § 6694 or § 6700, that may become another Lesson from the Tax Court.  In the meantime, I hope Mr. Shanks at least gave the Smiths back the fees they paid him.

Bryan Camp, New Cases, Tax | Permalink


you would have to be an idiot to stipulate those facts away not a good article.

Posted by: lawrence e stirtz | Nov 14, 2017 9:10:03 AM

Everyone has got it all wrong - Ms Bullock was a scintillating witness who convinced the court through sheer force of personality. - case closed

Posted by: Pedestrian Accountant | Nov 14, 2017 9:03:02 AM

Case 1.. Ms Bullocks...
She 'knew' what she did but lied years later that she didn't know. BS!
The judge should be thrown out!

Case 2.. Mr Shanks..
It's horrible how attorneys/CPAs collude with taxpayers with tax evasion schemes.
Worse, he wasn't penalized which is a Major FAILING of the US Tax Court and MUST be addressed!
Hopefully, he was reported to the TX Bar and accounting board as well as to OPR.
The taxpayer should consider taking him to court.

Posted by: McD | Nov 14, 2017 7:11:01 AM

Someone had a loss on the truck. She should have taken the income as the nominee and then expensed it on a 1099 to her son. Then his losses on the truck offset the cancellation of debt income and everyone is happy.

Posted by: George | Nov 14, 2017 6:57:12 AM

No. I was referring the the concern that a court's fact-finding power could be used to nullify actual facts, such as what a written contract or even statute actually says, substituting instead what the court concludes the party or legislator actually meant to write.

Posted by: Mike Petrik | Nov 14, 2017 4:25:06 AM

"Ms. Bullock had signed as a co-obligor on a loan from her credit union."

I fail to see why the credit union did not make demand for the balance of the loan owed. The fact that she later claimed she meant to guarantee the loan and not co-borrower is irrelevant; even her guarantee would've meant she was on the hook for the entire loan amount, should the primary borrower be unable to repay. At least that's how it works in a normal loan situation.

Posted by: MM | Nov 13, 2017 8:17:44 PM

@Mike: I have never heard of a criminal case like that. Do you have any particular case in mind?

Posted by: Bryan Camp | Nov 13, 2017 6:48:46 PM

PN is right. Taken to its logical conclusion this case stands for the following proposition:

Legislature enacts law saying X, Y and Z are illegal. Mrs. A commits T, but not X, Y or Z. Judge says, yeah but legislature thought it was criminalizing T, too. Off to prison, Mrs. A!

Posted by: Mike Petrik | Nov 13, 2017 5:59:29 PM

The taxpayers won their case in Bullock because the judge was Vasquez. He is easily the most pro-taxpayer judge on the bench. Any other TC judge would have found a bona fide debt arrangement. The judge you draw matters more than the facts because the judge does the fact-finding and can decide which facts to find and which to ignore.

Posted by: Chris P. | Nov 13, 2017 4:13:43 PM

Great piece. The Smith case caught my eye too.

Posted by: Jim Malone | Nov 13, 2017 12:55:27 PM

Bullock is a real beauty. Judge Vasquez believed the taxpayer that she had not intended to become a co-obligor on a debt. Wow. Whether he believed the taxpayer's testimony or no, she was in fact a co-debtor. How ridiculous. Creditors may as well just tear up their loan paper. It apparently means nothing.

Posted by: Publius Novus | Nov 13, 2017 10:39:57 AM

Great article! Is it common practice to give clients back their fee when something like this happens?

Posted by: Nick D. | Nov 13, 2017 5:39:19 AM