This will be my last Lesson From The Tax Court for 2018. Exam-grading season has started and I need every hour to give student exams the time and attention they deserve. I will emerge from the flood of exams by January 4th and so my next Lesson will likely appear on Monday, January 7th. Writing these blog posts is loads of fun and I appreciate the opportunity Paul has given me for sharing my thoughts with you.
For my last Lesson this year, I have saved some cases that I think will make your head shake in disbelief (SMH in text parlance). Sometimes such cases teach a useful lesson, such as the one where the taxpayer took over $100,000 in charitable deductions over several years by using the original prices of clothing she bought on clearance. That taught a useful lesson about valuation and about substantiation, so I blogged it here.
The cases today are simply object lessons. Practitioners probably don’t need this lesson. But still, it may be useful to be reminded that there are perfectly ordinary people out there---folks you might well enjoy spending the holidays with or who might make a marvelous mincemeat pie---who are either so overconfident or greedy when it comes to taxes that they end up being an object lesson for the rest of us. So as you read about the following cases, I invite you to consider whether these taxpayers (and sometimes their attorneys) were unlucky, overconfident, greedy or something else, and whether, but for the grace of God, it could have been you or one of your clients?
1. Receipts? We Don’t Need No Stinkin’ Receipts. Magloire K. Ayissi-Etoh and Katrina D. Sharpe v. Commissioner, T.C. Memo 2018-107 (July 9, 2018). Before Judge Lauber.
During the two tax years at issue Mr. Ayissi-Etoh worked for the International Monetary Fund (IMF) in Washington D.C. He made $62k in 2012 and $207k in 2013. Ms. Sharpe was also employed, by a defense contractor Leidos, but the opinion is silent on her earnings. During the years at issue Mr. Ayissi-Etoh also owned a company, American Management & Consulting, LLC (AMC) that he had formed in 2009. In 2012 Mr. Ayissi formed a second entity, American Management & Consulting Foundation, Inc. (AMC Foundation).
The IRS issued an NOD, determining that the taxpayers had underreported income, overstated Schedule A and Schedule C deductions, and failed to pay employment taxes.
SMH Moment 1: The taxpayers used Schedule C to deduct multiple personal expenses, mostly vehicle expenses and utilities and other home expenses. Their schedule C’s for both years reported zero income and reported between $35k and $40k of expenses. At trial Judge Lauber noted that they “produced no evidence whatever to substantiate the deductions claimed for taxes and licenses, repairs and maintenance, supplies, office expense, depreciation, advertising, utilities, meals and entertainment, ‘other expenses,’ or home office expense.”
SMH Moment 2: The taxpayers here claimed they made $40k in cash charitable contributions to the AMC Foundation. But the AMC Foundation was not even a qualified organization in 2012 or 2013. It did receive its determination letter from the IRS in 2016 (like that means anything anymore), but the letter did not give retroactive approval back to the years at issue. Worse, the AMC Foundation was 100% under their control and yet AMC could not explain what it had done with the money. As to non-cash contributions, the taxpayers claimed deductions of between $9k and $14k to Goodwill but “petitioners produced no receipt, SWA, or other document from Goodwill acknowledging any of these alleged gifts.”
Collateral Damage: Mr. Ayissi-Etoh had the same problem that bedeviled President Obama’s Secretary of Treasury Timothy Geithner in 2009. Here’s Paul’s blog about that if you need a refresher. The IMF does not have to withhold Mr. Ayissi-Etoh’s taxes, because it is an international organization. Moreover, as Judge Lauber explained, the IMF was not responsible for employment taxes, either. It was up to Mr. Ayissi-Etoh to actually pay the full amount of self-employment taxes on his wages, even though he received a W-2 and not a 1099. This was a completely understandable error and in no way an SMH moment. But after Judge Lauber had seen all the other problems with their case, he was not about to accept Mr. Ayissi-Etoh’s Turbo Tax defense.
2. The Middle-Class Tax Shelter Scheme. Kimberly S. Nix v. Commissioner, T.C. Memo 2018-116 (July 30, 2018). Before Judge Lauber.
During the tax years at issue, 2012, 2013 and 2014, Ms. Nix earned between $92k and $94k each year. In 2012 she got hooked into selling Mary Kay cosmetics. She told Judge Lauber that part of her motivation was the 50% discount sellers received on purchases for their own use. After three years, in 2015, she quit Mary Kay.
Ms. Nix reported some minimal income from her Mary Kay activity but reported substantial expenses resulting in net losses of $18k, $45k, and $22k in each of the three years). Yep. That’ll trigger a DIF score to get you audited.
As with Mr. Ayissi-Etoh, it appears Ms. Nix used Schedule C to report personal expenses. Unlike Mr. Ayissi-Etoh, however, the IRS determined Ms. Nix’s Schedule C activity was actually a hobby and so disallowed all expenses that exceeded her minimal Mary Kay income.
SMH Moment 1: The Court methodically considered each of the nine non-exclusive factors in Treas. Reg. 1.183-2 and concluded that “none of the nine factors weighs in favor of petitioner’s contention that she engaged in the Mary Kay activity with the dominant hope and good-faith intention of earning a profit. Several factors weigh heavily against her.” Specifically, Ms. Nix took a lot of supposedly "business trips." Judge Lauber was skeptical, writing: “it is obvious that may of the expenses she claimed had a significant personal component. Her reported travel expenses (for example) were incurred in 27 separate trips during 2012-2014.” It turns out that 20 of the supposed business trips were to volleyball tournaments in which her daughter participated. Two trips involved travel with her daughter to Europe and Disney World! Another two were to attend meetings of her college sorority. Judge Lauber writes that those attempted deductions “would have difficulty passing the straight fact test.”
SMH Moment 2. The kicker on this case for me is that Ms. Nix was represented by counsel, who apparently had amazing facial control. While it is easy to be a Monday-morning quarterback, one has to wonder about the decision to go to trial with a client who, according to the Court, had zero prior sales experience, had no business books or ledgers or balance sheets, hired no one to do that for her, did not consult with anyone about how to run a business, had no business plan, written or otherwise, opened but then failed to actually use a separate bank account, took no significant steps to control expenses, and then tried to write off trips to Europe and Disneyland as business expenses! Counsel tried hard to spin the story that Ms. Nix did the Mary Kay gig for only for three years, got tired of losing money, and then quit. Judge Lauber was unimpressed: “the sequence of events makes this narrative suspect: Petitioner terminated her Mary Kay activity shortly after receiving the IRS notice of deficiency in this case, which suggested that the jig might well be up....”
Perhaps Ms. Nix’s attorney thought she was a good witness and would convince the Court of her genuine profit motive? Perhaps he did this work for free so she would not be wasting her money chasing the Red Queen? It’s hard to know what either Ms. Nix or her counsel was thinking here.
3. Damn the §274 Restrictions and Full Speed Ahead. Damon R. Becnel v. Commissioner, T.C. Memo 2018-120 (August 2, 2018). Before Judge Holmes.
In this opinion Judge Holmes describes the taxpayer as “a serial entrepreneur” who ran “a real-estate empire” in the Florida panhandle town of Destin, through the use of about 11 different business entities. Mr. Becnel was apparently a very successful real estate developer because in 2005 he spent about $2 million to buy a 67-foot fishing yacht, naming it the Britney Jean. Actually, he had one of 100% owned companies---Sunrise Beach Service, LLC---buy the boat, but Sunrise was a disregarded entity.
Mr. Becnel took the yacht to lots of fishing tournaments but otherwise, Judge Holmes writes, “one can usually find the Britney Jean behind Becnel’s house.” Specifically, Mr. Becnel never attempted to engage in any fishing-related business. He never chartered out his yacht, he did not catch and sell fish commercially. He was a real-estate developer and Sunrise Beach Services was just what it seemed: a company that provided beach amenities for beach resorts (many owned by Mr. Becnel).
Nonetheless, for tax years 2009, 2010, and 2011, Mr. Becnel claimed yacht-related deductions of about $400k, $127k, and $113k, respectively. The IRS disallowed the claimed yacht-related deductions, although it was difficult for the Revenue Agent to find them because Mr. Becnel hid many of them in various parts of his Sunrise Schedule C. During audit, Mr. Becnel provided general ledgers but Judge Holmes found that he failed to give the Revenue Agent “any of the other substantiation that she requested.”
As revised in December 2017, §274 now totally disallows any deduction for expanses that are attributable to either entertainment activities or entertainment facilities. For the years at issue in Becnel, however, the old version of §274 permitted deductions for entertainment activity expenses if the taxpayer could show they were directly related to the active conduct of the taxpayer’s trade or business.
SMH Moment 1: Becnel hid deductions for owning and maintaining the yacht under “charter boat expenses” even though Becnel admitted that he had never chartered the boat. He just used it. Similarly, depreciation deductions for the yacht were lumped with depreciation of similar deductions for beach chairs, boxes, and umbrellas.
A yacht is an entertainment facility if it is “owned, rented, or used by a taxpayer...in connection with entertainment.” Treas. Reg. 1.274-2(e)(2)(I). That means if Mr. Becnel had been a commercial fisherman, then he might have been able to avoid the §274(a) restriction if the yacht was used as part and parcel of that business. But, as Judge Holmes found: “Becnel is not a professional fisherman---he isn’t even in the boat business.” So what conceivable basis did Mr. Becnel have to deduct yacht expenses? SMH.
SMH Moment 2: Becnel hid deductions for his fishing tournament entry fees on his Schedule C as “dues & subscriptions.” As Judge Holmes points out, even if the expenses of acquiring and maintaining an entertainment facility are disallowed per se, expenses associated with entertainment activities that occur using the facility may still be deductible if they are directly related to the taxpayer’s business. The best Mr. Becnel could do was to say the yacht helped his real-estate business because he could use it to show potential clients a good time. Judge Holmes believed him, but that’s not the kind of direct connection that meets the former §274(a) test.
SMH Moment 3: Mr. Becnel’s attorneys---whether through inexperience or carelessness---disobeyed Judge Holmes’s standing order that the parties exchange exhibits 14 days before trial. At trial, the attorneys attempted to proffer a mass of receipts to substantiate claimed expenses. Judge Holmes rejected the proffer. The error was not fatal. It did not matter whether Mr. Becnel met the §274(d) substantiation requirements because he could not even get past §274(a). But, still, why would one ignore a standing order from the Court?
4. Riding the Expensive Hobby-Horse. Larry W. MacDonald v. Commissioner, T.C. Memo 2018-138 (August 27, 2018). Before Judge Pugh.
Mr. MacDonald is a serial hobbyist who apparently has repeatedly appeared before the Tax Court, offering the same or similar hobbyist arguments. He has been told, also repeatedly, that his arguments are stupid. This time Judge Pugh used §6673 to give him 5,000 more reasons to dismount from his hobby-horse.
5. Keeping It All In the Family. Rian D. Ray and Betsy Ray v. Commissioner, T.C. Memo 2018-160 (September 20, 2018). Before Judge Nega.
During the six tax years at issue (2006-2011) Mr. and Mrs. Ray lived on a six-acre farm in Oregon with six of their eight children ranging in age over the years from 13 to 25. During those Mr. Ray was the sole researcher and sole financial officer for a 501(c)(3) entity that he co-founded, called National Home Education Research Institute (NHERI). NHERI was apparently funded primarily by outside donations, but also generated revenue from book sales and research contracts. NHERI had no written employment contracts with any of its workers. Instead, Judge Nega found, “Mr. Ray had the exclusive authority to determine wages and salaries for all of NHERI’s workers, including himself.” And who might these other workers be? Why, they were five of Mr. and Mrs. Ray’s kids! If there were any other workers employed by NHERI they are not mentioned in Judge Nega’s opinion. And what did his kids do? Why...they were office assistants. All five!
Mr. and Mrs. Ray also engaged in a variety of consulting work related to the home education industry.
During the years at issue, Mr. and Mrs. Ray did not file tax returns. But they hopped to it quick-like-a-bunny after the IRS opened an audit for the 2010 year and then, within a couple of months, expanded the audit to all the years at issue.
On their belated returns Mr. Ray reported between $15,000 and $24,000 in gross receipts from his Schedule C consulting activity during the years at issue. He reported receiving no income from NHERI. The couple also reported zero gross receipts from Mrs. Ray’s work. During the audit, the taxpayers had such poor records that the Revenue Agent had to do a bank deposits analysis to determine income.
SMH Moment: During all six years, NHERI did not pay Mr. Ray a dime. But, during that same period, NHERI managed to pay the five child “office assistants” over $260,000---without ever issuing them a W-2 or 1099. The kids then deposited “their” money into the family’s shared OSU Credit Union’s Visa account, which the Court treated as a depository account because of the OSU Credit Union’s account policies.
As you might imagine, the Court found that “we believe that petitioners engaged in a pattern of behavior to replace what ordinarily would be taxable salary payments to Mr. Ray with what petitioners argue are nontaxable payments to their children.” No kidding.
May all of you, dear readers, have a safe and happy holiday season. I certainly hope your behavior was such that you don't end up with the proverbial coal in your stockings, a fate that may be faced by some of these taxpayers.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.