Last week the Tax Court issued 19 opinions, including one articulate opinion on Collection Due Process that teaches an interesting, albeit esoteric, lesson about the bulk-processing nature of tax administration. I will save that case, Scott T. Blackburn, v. Commissioner, 150 T.C. No. 9, for another week, or perhaps our colleagues over at Procedurally Taxing will blog it.
In today’s post I want to look at two of last week’s opinions that I think teach a more basic lesson about the important way in which each tax year is separate from all others. The two cases are: (1) Shane Havener and Amy E. Costa v. Commissioner, T.C. Sum. Op. 2018-17 (Apr. 4, 2018); and (2) Gary K. Sherman and Gwendolyn L. Sherman v. Commissioner, T.C. Sum. Op. 2018-15 (Apr. 2, 2018).
Notice that both of these are what are called “Summary” Opinions. That means the taxpayer in each one elected the small case procedures allowed by IRC §7463 and implemented by Tax Court Rules 170 et. seq. As most readers no doubt know, the upside of that election is relaxed procedural rules (notably rules of evidence) and the downside is that the loser may not appeal to a higher court. The idea is that these are cases where the dispute between the taxpayer and the IRS is really one about factual matters and not about the law. That is why when you access these cases through the Tax Court website, the website pops up the following message in all-caps: “Pursuant To Internal Revenue Code Section 7463(b), This Opinion May Not Be Treated As Precedent For Any Other Case.”
The very reason why these cases make for lousy precedent, however, is why they often make for good lessons about basic tax concepts. The lesson I see in these two cases is about the appropriate accounting period, a particularly timely lesson this week since April 16th (the deadline for filing returns this year since April 15th falls on a Sunday) is right around the proverbial corner.
To economists, the most accurate accounting period is one’s lifetime. That is, the best measure of income is what happens over our lifetime. But because governments need revenue sooner, because not all taxpayers die (think corporations), and because even if tax revenue would even out in the long, long, long run, the transition costs to a lifetime accounting period would be untenable, Congress created a yearly accounting period for income tax (and shorter accounting periods for excise taxes such as the employment tax).
That yearly period ends on December 31st for most of us mere mortals. The yearly questions we ask are “how much income did I have during the last year?” and “what expenditures did I make that I can deduct from the income I made?” The point of today's lesson is that we must ask those questions every year and just because we get a wrong answer in one year does not entitle us to continue using that wrong answer in later years.
More below the fold.
In the Havener case, Mr. Havener and Ms. Costa lived in Pembroke, Massachusetts. She was a sales manager and he was a retiree. I am betting he watched flipping shows on A&E or other channels. I say that because the Court found that he “grew restless in his retirement and sought a project that could occupy his time.” So the taxpayers decided to buy and flip a house. But they did not pick a house in Pembroke, or anywhere near it. Nope, they spent $30,000 to buy a house in Salem, N.Y., some 250 miles away. Why Salem? I have no idea. One might speculate it was for martial harmony reasons, but again I’m betting Mr. Havener consulted websites devoted to flipping, like this one on Wallethub and decided that Salem was an area where they could make flipping work.
The taxpayers bought the house in 2010 or 2011 and Mr. Havener started working on it, traveling to the house during the week and then coming back home on weekends. Sometimes Mr. Havener drove to Pembroke and sometimes he fired up his Piper Warrior and flew. On all trips he kept really good records. Folks, record-keeping is not the problem here.
On their 2012 return, Mr. Havener and Ms. Costa deducted all of his expenses, including travel expenses, from their joint income (the income on which, remember, consisted mostly of Ms. Costa’s salary income). They submitted their 2012 return and it was processed without question by the IRS. In other words, they were allowed the deductions.
On their 2013 return, Mr. Havener and Ms. Costa took the same reporting position, deducting again his travel expenses. This time, however, the IRS selected their return for audit and disallowed the deduction for travel expenses. Instead, the IRS said, the taxpayer needed to capitalize those expenses, which would increase the basis in the home and produce a smaller taxable gain on the flip.
Judge Panuthos heard the case and sustained the Notice of Deficiency, finding that the whole idea of “flipping” a house was “to make the property habitable and to increase its value for eventual resale.... Thus, all expenses paid or incurred as part of this plan of capital rehabilitation or improvement are eligible for treatment only as capital expenditures.”
Mr. Havener and Ms. Costa protested that this result for 2013 was not consistent with their 2012 returns where they had been able to take the deductions. Judge Panuthos explained how each tax year is a separate accounting period, so that the IRS “is not bound for any given year to allow a deduction permitted for a prior year.”
This result is common sense as applied to this case. After all, the 2012 return had not been examined and so just because Mr. Havener and Ms. Costa “got away” with erroneous treatment of those expenses in the earlier year did not create an entitlement to the same treatment in later years. Each year stands alone.
The Sherman case presents a variation on this lesson because there the IRS had audited the taxpayers and allowed in an earlier year deductions which it then denied in a later year.
Here’s what happened. Mrs. Sherman sold Mary Kay products for some 30 years, receiving commissions and property reporting them as self-employment income on which she paid self-employment tax. Starting in the mid-1990’s she joined the Mary Kay “Family Security Program” which was, in essence a deferred compensation program to help the Mary Kay sales force plan for retirement. In 2005 Mrs. Sherman began receiving retirement benefits under the Family Security Program. For the two tax years at issue, 2013 and 2014, those payments hovered around $173,000 per year.
The tax issue was how to treat these retirement benefits. Were the payments really deferred compensation, subject to self-employment tax, or were they compensation for something else, such as a non-compete agreement that Mrs. Sherman had to sign in order to receive the benefits, or the goodwill she had created for Mary Kay products during her long and successful sales career. In 1995, the Sherman’s had received some advice in a letter from Mary Kay’s general counsel that described the Program payments as subject to self-employment tax. The Program Agreement’s own terms says that the Program “is intended to be a non-qualified deferred compensation arrangement and...is intended to meet the requirements under section 409A of the Code.”
When the Sherman’s began receiving the payments in 2005, they did not try to solve this tax puzzle on their own. They hired a CPA by the name of Muscio and he decided to report the payments as “termination payments” that were not subject to self-employment income.
Like Mr. Havener, the Sherman’s position was not challenged by the IRS for many years for the simple reason that the IRS did not select their returns for audit. Unlike Mr. Havener, however, when the IRS eventually audited their 2011 return, the Shermans (represented by the CPA Mr. Muscio) convinced the examining agent of the correctness of their position and the IRS issued a no-change letter. Sweet!
But each year stands alone. So when the IRS came back a few years later to look at the 2013 and 2014 returns, the Shermans may have thought they were in the clear because of the good result for their 2011 year. They thought wrong. The IRS issued a Notice of Deficiency and the Shermans then hired lawyers to take it to Tax Court. Unlike in the Havener case, which was argued pro se by the taxpayer, the lawyers representing the Shermans knew this lesson and did not try to argue that the prior audit result for the 2011 return bound the IRS for the 2013 and 2014 returns. On the merits, Judge Buch ruled that because the payments were deferred compensation the taxpayers owed employments tax.
In tax, you take it one year at a time.
Coda: The silver lining for the Shermans is that the IRS Chief Counsel attorney dropped the accuracy related penalties during litigation. That is likely because this whole issue was up in the air, at least until a Tax Court decision in Peterson v. Commissioner, T.C. Memo 2013-271 was upheld by the 11th Cir. Court of Appeals in 2016 (827 F.3d 968). All three judges on the Court of Appeals agreed that the payments from the Program were deferred compensation that was subject to self-employment tax, but they differed in their reasoning. So until then I think a reasonable return preparer might take the position taken by the Shermans. And the Shermans, of course, were entitled to rely on their return preparer. However, I don’t know if that would work today; after reading that 11th Circuit opinion I would not think a return preparer could meet even the reasonable basis standard, which applies to disclosed positions, and so would be subject to penalties under §6694.