Easter approaches. On that day our church grounds will be overrun with children scampering to collect eggs into the various baskets, bags, and other containers they bring (or we give them if they need). They do not have to worry about what kind of container they use to collect their eggs. The candy will taste just as sweet.
You can think of business entities as being like Easter baskets. They are containers taxpayers use to collect their income. But unlike the happy children, taxpayers must take care in their choice of container. That choice can affect the amount of income collected. And it can leave a sour taste when the basket chosen is not the proper form. In today’s Lesson, we learn how a taxpayer’s choice of business containers affects their ability to take deductions, and even affects their ability to litigate in Tax Court.
In Greatest Common Factor v. Commissioner, T.C. Memo. 2023-39 (Mar. 23, 2023) (Judge Kerrigan), the individual taxpayer chose to collect income through a C corporation and that choice affected the deductibility of the individual’s home office expenses. In Techtron Holding, Inc. v. Commissioner, T.C. Memo 2023-29 (Mar. 9, 2023) (Judge Vasquez), the individual taxpayers collected income through ever-changing, multiple baskets of various kinds of business entities. When the IRS audited and found deficiencies in one of the entities, the Tax Court decided it had no jurisdiction over that entity’s petition because the entity no longer existed at the time the petition was filed. Details below the fold.
Facts and Lesson in Greatest Common Factor: Corporations Don't Have a “Home” Office
The tax years at issue are 2013 and 2014. In those years the taxpayer here was a C corporation. Mr. Glen Fyfe was a 50% shareholder. His then-wife was the other 50% shareholder.
Mr. Fyfe provided technical consulting services to a military contractor, Kinsey Technical Services. But he was not an employee of Kinsey. Instead he was an independent sub-contractor. And he did not collect his income as a sole proprietorship. Instead, he chose to collect his income through the basket of his C corporation, Greatest Common Factor.
Mr. Fyfe apparently worked from home. His C corporation claimed deductions of $13,700 in home office expenses for 2013 and $13,600 in such expenses in 2014.
We usually think of home office deductions as something individual taxpayers take and that those deductions are governed by the rules in Evil §280A, including the requirement that the space in the home be “exclusively used on a regular basis—(A) as the principal place of business for any trade or business of the taxpayer....” That is because the entire thrust of §280A—similar to surrounding statutes—is to address situations of mixed personal and business use. Section 280A regulates situations where personal use of a residence is mixed with business use. It applies when individual taxpayers choose to collect their income as sole proprietorships or through S Corps.
Here, however, Mr. Fyfe chose to run his business through a C corp. As Judge Kerrigan explains, a C corporation is not restricted by §280A. The corporate taxpayer could take a deduction if it rented out space in Mr. Fyfe’s home and the rental payments fit the §162 requirements of being ordinary and necessary for the carrying on of the C corp.’s trade or business. The taxpayer needs to be careful, however, to establish the rental.
Mr. Fyfe was not careful. He did not fully consider the consequences of his choice of a C corp. basket to collect income. As Judge Kerrigan notes: “there is no evidence in the record indicating that there was any such rental agreement. Further, there is no evidence that petitioner expended any of its fund in maintaining the alleged home office.” Op. at 3 (emphasis added).
There were similar problems with other aspects of this case. For example, Greatest Common Factor attempted to take depreciation deduction for three vehicles, but could not prove ownership of the vehicles. They were likely owned by Mr. Fyfe and not the C corp. which is why Judge Kerrigan finds that “Petitioner did not provide supporting documents to show the purchase prices of the vehicles and documents supporting its ownership of the vehicles.” Op. at 5. (emphasis added).
I am sure many of us have had clients like Mr. Fyfe, clients who do not fully understand the importance of the basket use to collect income, confusing themselves with the entity they have created. But not all baskets are equal. Which basket a taxpayer uses affects the taxpayer’s taxable income.
Facts and Lesson in Techtron Holdings: IRS Can Issue NOD to Dead Corporation But It Cannot File A Tax Court Petition
The tax year at issue here is 2000. Wowsa! That’s old! You will see why shortly. The taxpayer was a C corporation, Techtron Holdings, Inc (THI). The underlying individuals were Alvin Trenk and his son Steven Trenk who were majority shareholders and principal officers (CEO and President). They had created multiple corporate baskets to collect income from various activities. Among their entities were Diatronics, Inc., Thermatech, In., Physicians Healthcare of American, Inc., Pizza Piazza, Inc., and Pizza Piazza of NY, Inc. Op. at 2, not 2.
THI timely filed a consolidated return for 2000, naming itself as the parent corporation for the “Techtron Holding, Inc. and Subsidiaries (FKA Techron, Inc.)” consolidated group, and listing all those entities as part of the consolidated group. Baskets within baskets.
Shortly after THI filed its 2000 return, the Trenks engaged in a bunch of restructuring, creating new baskets and dropping out old ones. Judge Vasquez explains it in detail. The end result was that THI merged into a company called Techtron which then merged into a company called Gold Crown Insurance, Ltd., a British Virgin Islands corporation. When the merger was complete in December 2001, it was Gold Grown that was left standing. THI had ceased to exist.
The IRS selected the 2000 THI return for examination in 2004. In 2015 the Exam division proposed deficiencies and a fraud penalty. Part of the reason it took so long was apparently six years of litigation over a summons issued to Steven. The IRS wanted records that Steven thought were protected by attorney-client privilege. The IRS invoked the crime/fraud exception and the District Court agreed. Trenk appealed and in U.S. v. Trenk, 385 F. App'x 254 (3d Cir. 2010), the Circuit remanded the case to allow Trenk a hearing on crime/fraud exception. But in 2011 Trenk waived the hearing.
So in 2015 THI went to Office of Appeals. Eventually, in 2017, Appeals issued an NOD. It asserted both a deficiency and a fraud penalty. The IRS eventually dropped the fraud penalty.
The 2017 NOD was addressed both to THI and to Gold Crown, at the same address. But only THI’s EIN was listed, and the accompanying Form 5278 (“Statement—Income Tax Changes”) and Form 886-A (“Explanation of Items”) had only THI’s name and EIN.
THI timely petitioned the Tax Court. Eventually, both the Court and the parties realized they needed to address the effect of THI’s dead corporate status. Both THI and the government argued that the Tax Court lacked jurisdiction to redetermine the deficiency proposed in the NOD. As is usual in Tax Court however, each side’s jurisdictional arguments would have drastically different consequences.
THI argued that because it was a dead corporation in 2017, the NOD was invalid. If that was right, then there would be no proposed deficiency for the Tax Court to redetermine and, hence, no liability to be assessed. The effect of dismissal would be to nullify the NOD, forcing the IRS to start over, assuming the assessment statute of limitations permitted it to do so.
Judge Vasquez rejects THI’s argument. He points out that §6212(b)(1) explicitly says that an NOD properly mailed to the taxpayer’s last known address “shall be sufficient for purposes of...this chapter even if such taxpayer is deceased, or is under a legal disability, or, in the case of a corporation, has terminated its existence.” So, yes indeedy, the IRS can issue an NOD to a dead person or a dead corporation....as long as it sends the NOD to the last known address.
Section 6212(b)(1), however, also permits another person to let the IRS know that it is the fiduciary of the taxpayer the IRS wants to proceed against. If that fiduciary gives notice under §6903, then the IRS needs to issue the NOD to the fiduciary for the NOD to be valid.
THI tried to argue that the successor corporation, Gold Crown, was its fiduciary. So the NOD was invalid because it was not sent to Gold Crown but only to THI. In rejecting that argument Judge Vasquez assumes that the NOD was only sent to THI. But he still rejects that argument, pointing out the difference between a successor in interest and a fiduciary. Since Gold Crown was the former and not the latter, no separate NOD was required. Rather, stepping into THI's shoes, Gold Crown was the one that should have filed the petition in 2017: “Petitioner acknowledges that Gold Crown is the successor in interest to petitioner and is responsible for the potential tax liabilities at issue in this case under Delaware law. A petition filed by a surviving corporation for redetermination of a deficiency determined against a merged corporation is within our jurisdiction where the surviving corporation is primarily liable for the debts of the merged corporation under applicable state law. [citations omitted] Neither party disputes that Gold Crown could have petitioned this Court in lieu of petitioner.” Op. at 11, not 12.
So the NOD was valid. Now it was the IRS's turn.
The IRS argued that because THI was a dead corporation in 2017, it had no capacity to litigate in Tax Court. A dead corporation cannot file a valid petition. If that was true, then the effect of dismissal would be to nullify the petition, allowing the IRS to assess the proposed deficiency.
Judge Vasquez accepts the IRS argument. Generally, a corporation must have had the capacity to engage in litigation at the time it files its petition. See e.g. Timbron Holdings Corporation v. Commissioner, T.C. Memo. 2019-31 (corporation not allowed to ratify petition when it did not have capacity at time of filing even when it later regained capacity under state law). For more details, see Lesson From The Tax Court: Corporations In The Bardo, TaxProf Blog (Jan. 30, 2023).
THI argued that the Court should treat the petition as having been indeed filed by Gold Crown because of a string of cases where the Tax Court has permitted such substitution pursuant to Tax Court Rule 60(a), to correct an error as to the proper party.
Judge Vasquez explains that yeah, substitution can happen, but only when the Court is convinced that the party seeking substitution has shown that it intended to file the petition such as, for example, by ratifying the petition incorrectly filed. Here, he points out, Gold Crown was doing the opposite. It was refusing to either file an amended petition or ratify the petition filed. Why? Well, as best I can tell, Gold Crown thought that by doing so it would lose its ability to argue the invalidity of the NOD. It offered to ratify the petition if Judge Vasquez rejected its argument about the NOD's invalidity. If I got that right, I don't understand it. That is, I don't see why Gold Crown could not have filed a petition and argued that the NOD was invalid. Taxpayer do that all the time. I welcome comments on that.
Finally, THI argued that Tax Court Rule 63 should permit Gold Crown to now be substituted as the proper party for THI. Judge Vasquez rejects that idea as well, writing that Rule 63 substitutions apply only “where a case has been properly filed in this Court by a proper party petitioner and a change occurs such as the death of the petitioner.” Op. at 12-13.
Bottom Line: The individuals here were using the corporate THI basket to collect their income in 2000. In doing their fancy basket-shuffling in 2001 they were not careful to make sure that the entity filing the Tax Court petition in 2017 had the proper capacity to file. They used a basket they had discarded.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.