Tax Court Rule 142 provides that “the burden of proof” in a Tax Court case is generally on the taxpayer. Among the exceptions is the “new matter” exception. When the IRS introduces a “new matter” it bears the burden of proof. In Alvin E. Keels, Sr. v. Commissioner, T.C. Memo. 2020-25 (Feb. 19, 2020) (Judge Colvin) the NOD disallowed certain deductions for lack of substantiation. After trial the IRS said that taxpayer's error was misapplication of §409A. The Tax Court said that was a new theory and, hence, a new matter. Because the IRS had not introduced any evidence to show how the taxpayer had misapplied §409A, the Court handed the taxpayer a sweet, sweet victory. I read the case as a lesson in how broadly the Tax Court will construe the new matter exception. The result was that while both the taxpayer and the IRS messed up, it was the IRS error that proved fatal thanks to the burden of proof shift in Rule 142. I question the result here. All of that comes below the fold.
Today’s procedural lesson involves the substance of §409A and the taxation of deferred compensation. To better understand the lesson, it may be helpful to review the basics of §409A. I confess this is yet another area I know little about, so this will be a very basic overview and I rely on my readers to catch me out in error.
Section 409A deals with deferred compensation programs that do not qualify for treatment under other Tax Code sections, such as §401, §403, or §408. We call them nonqualified plans. If a nonqualified plan meets the requirements of §409A, however, then taxpayers can still defer tax on compensation they they have earned in a given year but that is withheld from them in that year. They can defer tax until such time as they actually receive payments in the future. As a result, taxpayers can exclude in the current year income they would otherwise have to report, although they will eventually include and pay tax on that income when they receive it under the nonqualified plan.
If a deferred compensation plan does not qualify for treatment under §409A, then taxpayers must report and pay tax on all their earned compensation, even that amount that is withheld from them and won’t be paid until much later. Taxpayers who fail to do that may also be subject to a 20% penalty, plus interest, on the amount not properly included as income.
One of the requirements in §409A is that the plan document must contain a permissible triggering event for future payment. There are six permissible triggering events: a fixed date, separation from service (e.g., retirement), a change in ownership or control of the company, disability, death, or an unforeseen emergency. Other events, such as the need to pay a child’s tuition or buy a home, or pay a heavy tax or medical bill, are not permissible triggering events. See §409A(a)(2)(A)(i)-(vi).
Law: Burden of Proof
Section 6212 says that if the IRS “determines that there is a deficiency” it must send the taxpayer “notice of such deficiency.” Section 6213 then gives taxpayers a period of time (either 90 or 150 days) to petition the Tax Court for “a redetermination of the deficiency.” Section 6214 then gives the Tax Court jurisdiction to “redetermine the deficiency.”
The issue in any Tax Court deficiency case is whether the NOD was correct. Even though §6214 gives the Tax Court the power to “redetermine” the deficiency, the Court has long taken the position that its review is limited to whether the NOD is correct or incorrect. The Supreme Court upheld that idea in the classic case of Helvering v. Taylor, 293 U.S. 507 (1935). Thus, the task for the taxpayer in Tax Court is to show that the NOD was wrong. The taxpayer is not required to prove the correct amount of tax. Id.
The NOD enjoys a strong presumption of correctness. So long as the IRS sticks to the basis described in the NOD, it is the taxpayer who bears the burden to persuade the Tax Court that the NOD was wrong. However, if the IRS tries to introduce any “new matter” after the petition is filed, then Tax Court Rule 142 provides that the burden of proof shifts to the IRS. The rule follows from §7522, which says the NOD must “describe the basis for” the deficiency determination.
The Tax Court takes a very functional approach to what constitutes a “new matter” so as to trigger the burden of proof shift in Rule 142. Basically, if the IRS brings up a new idea during the Tax Court proceeding that is not fairly stated or implied in the NOD, and if that new idea requires evidence not in the record, then the IRS bears the burden of proof. See Shea v. Commissioner, 112 T.C. 183, 197 (1999)(a “new matter” is raised “when the basis or theory on which the Commissioner relies was not stated or described in the notice of deficiency and the new theory or basis requires the presentation of different evidence.”). Notice again that the scope of the Tax Court’s job here is not to “redetermine” the correct tax, but simply to review the NOD’s accuracy.
During the tax years in issue (2012, 2013, and 2014) Mr. Keels sold insurance for State Farm. As part of his compensation package, State Farm deferred some of his compensation. Mr. Keels would become entitled to the deferred compensation at the termination of his Agent’s Agreement with State Farm.
Under this agreement State Farm deferred approximately $154,000 in 2012, $36,000 in 2013, and $28,000 in 2014. These are dollars that Mr. Keels did not actually receive. Nonetheless, it appears that State Farm reported those amounts on the 1099-MISC forms for each year because State Farm did not believe those amounts qualified for deferral treatment under §409A.
Well, that’s a bummer! Here was State Farm reporting to the IRS that it had paid him money when Mr. Keels knew darned well it had not. He certainly felt no wealthier. So Mr. Keels did what any red-blooded American would do: he made up a deduction to offset the deferred amounts! While he appears to have properly reported the deferred compensation as income, he also took a corresponding deduction on his Schedule C, using different labels each year. In 2012, for example, he labeled the deduction “Employee benefit programs.” In 2013 he labeled the deduction “Pension and profit-sharing plans.” The opinion does not recite how Mr. Keels deducted the 2014 deferred comp.
I am guessing that Mr. Keels thought he could create phantom payments to match what he considered to be phantom income. It was also a clever way to hide his disagreement with the State Farm 1099-MISC by ensuring that his income matched what State Farm reported, thus escaping the eyes-in-the-sky AUR system. Using the less obvious deduction side to knock off the income would perhaps make his overall position harder for the IRS to detect. But that is just a guess. I could be wrong.
It turned out, however, that Mr. Keels’ reporting approach did not shield him from scrutiny. The IRS selected his returns for examination. The resulting NOD for 2012 and 2013, however, missed the 409A issue. It did not give any evidence that the IRS employee saw what Mr. Keels was doing. Instead, the NOD disallowed the deferred compensation deductions as part of a general disallowance of a bunch of other deductions. The NOD grouped those deductions into a category it labeled “Unidentified Expenses.” The NOD made a categorical denial of those deductions, giving the standard reason of "you did not prove it." Here is the actual wording of the NOD:
“Since your 2012 and 2013 Federal Tax Returns were submitted on paper a portion of your Schedule C1 expenses could not be traced to a specific line item and have been grouped as “Unidentified Expenses.” We will be able to better identify these individual expenses once you submit complete copies of these returns. Since we could not verify whether these Unidentified Expenses were (a) ordinary and necessary to your business, and (b) paid, we have disallowed the amount shown.”
Mr. Keels filed a timely petition in Tax Court and, at trial, he continued to argue that he should not have to pay tax on the deferred compensation because he did not actually receive those amounts. And he would not actually received the money until the termination of his Agent’s Agreement with State Farm. To support his contention he introduced a letter he had received from State Farm that explained the deferred compensation program. The letter also explained why State Farm was reporting the amounts to the IRS on the 1099-MISC, box 15b, which at that time was the box for reporting “Section 409A Income.” Here’s the 2103 1099-MISC if you want to see it.
Hmmmm. It appears that the first time that anyone at the IRS spotted the 409A issue was after Mr. Keels introduced the State Farm letter. Op. at 12. Judge Colvin was careful to note that it was only in the post-trial briefs that IRS Chief Counsel attorneys argued “for the first time...that under section 409A...petitioner’s State Farm deferred compensation program are income to him....”
Neither the relevant 1099-MISC forms nor the actual State Farm deferred compensation agreement were in the record before the Court. The State Farm letter than Mr. Keels introduced was the only evidence relating to the 409A issue.
Judge Colvin was not impressed with Mr. Keels. If you want to read more about that you cannot do better than Lew Taishoff’s colorful post “Knock Not."
The lesson I want to explore here is the burden of proof shift. Judge Colvin shifted the burden of proof to the IRS and then concluded the NOD could not be sustained because the IRS did not meet its burden. Let’s look at that.
Judge Colvin found that the NOD “did not identify any issues relating to deferred compensation or section 409A.” He then found that the first time the IRS raised the application of §409A to Mr. Keels’ tax years was in a post-trial brief. From those two findings, Judge Colvin concluded that the IRS “bears the burden of proof on that issue.”
Judge Colvin then looked to see whether the State Farm deferred compensation plan met the requirements of §409A. The only evidence was the State Farm letter which explained that State Farm did not think the plan met the §409A requirements because the trigger for payments would not always be termination. Judge Colvin does not address that in the opinion but it appears he really wanted to see the actual 1099-MISC. Since those were not in the record, Judge Colvin concludes that "respondent has not shown that the plan fails to meet at least one of the requirements of §409A.... Therefore, respondent did not meet the burden of proving that section 409A applies, and on this record petitioner is not taxable on [the amounts State Farm credited to the deferred compensation account under its deferred comp. program].”
Comment: Confusion Over Income Items and Deduction Items
I confess confusion. I need your help to figure this out. I do understand that the IRS totally missed the application of 409A in the audit and did not bring that provision to the Court’s attention until after trial. But what confuses me is this: §409A deals with the proper reporting of income items. Section 409A(a)(1)(A)(i) says a taxpayer must report as income those deferred compensation amounts paid under a plan that does not meet the §409A requirements (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, neither of which applies here).
But it seems that Mr. Keels did, actually, report the deferred compensation amounts as income. The issue in the case is about his deduction items, not his income items. The inclusion rules are based on notions of constructive receipt. Section 409A)(a) is even titled “Rules Relating to Constructive Receipt.” But there is no doctrine of “constructive payment” that parallels the doctrine of constructive receipt. See Vander Poel, Francis & Co., Inc. v Commissioner, 8 T.C. 407 (1947). Since Mr. Keels appears to have actually reported the income, I do not understand why the question of whether the State Farm program met the requirements of §409A is an issue. The IRS did not ding him for that.
Again, I thought the NOD disallowed Mr. Keels’ deduction items. As to that, this “new matter” of §409A was not one that required the introduction of any new evidence. While the actual Forms 1099-MISC were not in evidence, State Farm’s letter to Mr. Keels was. It said that State Farm had reported the deferred compensation amounts in box 15b. That seems to make it more likely than not that Mr. Keels properly reported the income.
Again, the IRS was not faulting Mr. Keels’ income reporting. It was faulting his deductions. The NOD said “we could not verify whether these Unidentified Expenses were (a) ordinary and necessary to your business, and (b) paid....” The §409A issue was simply new in the sense that the IRS was pointing out to the Court why it would be impossible for Mr. Keels’ to substantiate these deduction items: they did not reflect amounts actually paid or incurred but were instead just created to offset income that he reported but did not think he was supposed to report. The failure to substantiate was in the NOD.
I could be way off base here. Are taxpayers actually supposed to report as income the deferred compensation subject to 409A, and then take a corresponding deduction? If so, perhaps Mr. Keels’ reporting position was correct. But then why did the 2013 Form 1099-MISC have a box 15a (“Section 409A Deferrals”) and 15b (“Section 409A Income”)? Was Box 15g just supposed to be amounts actually paid out under a §409A plan rather than amounts withheld and credited to the taxpayer’s account? Did State Farm mess up its reporting obligation?
Folks, have mercy on a poor West Texas law professor and explain why the 409A issue was relevant to the deduction items. Judge Colvin thinks the case is like Shea. I am less sure. Shea involved a California taxpayer who filed a joint return. On audit the IRS changed his filing status to married-filing-separately but then proceeded to ignore community property rules for both income items and deduction items. The IRS caught the error at trial only after the taxpayer pointed out that application of §66(a) significantly undercut the NOD. The IRS said "yeah, but we would have disallowed you the benefits of 66(a) because of 66(b)." The Tax Court said that because the IRS had totally missed the §66(a) issue in the NOD, raising §66(b) was a new matter and so the IRS needed to prove up the application of 66(b).
This case differs from Shea because, not to be tiresome, the IRS and taxpayer appear to agree on the income items: the deferred compensation was reported as gross income. Where the IRS and taxpayer disagree is on the deduction items. The IRS said "prove it." The taxpayer says in effect "oh, it just adjusts the amounts I should have been able to exclude." The IRS says in effect "dude, you cannot exclude." The judge says in effect: "IRS, you did not prove he could not have excluded." I'm tearing my hair trying to understand why it matters whether Mr. Keels "could have" excluded the withheld deferred comp. from income when it appears that he did, in fact, include it in gross income.
It just seems to me that this was a very lucky taxpayer who won on a dubious procedural point what he should have lost on the merits. As usual, I welcome comments from readers to set me (and others) straight.
Coda: The fun may continue for Mr. Keels. Since his victory allowed him to effectively exclude all the deferred compensation withholdings made in 2012, 2013 and 2014, I wonder whether he will properly report those payments when he does actually receive them? What if he claims basis in them and thus turns what is supposed to be a deferral into a true exclusion? After all, who is going to know otherwise?
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law