Offer in Compromise/J. Frank Best, Tax Controversy CPA/U. S. Tax Court Litigator

A recent Tax Court decision was reported dealing with Offer-in-Compromise and IRS Abuse of Discretion.  J.  Frank Best, Tax Controversy CPA/U. S. Tax Court Litigator in Raleigh and Wilmington, NC  & North Myrtle Beach and Myrtle Beach, SC works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.  

Lawyer’s Failure to Provide Required Info Precludes Offer-in-Compromise: In Solny v. Comm’r, T.C. Memo. 2018-71, the Tax Court sustained a proposed collection action by the IRS against a lawyer who had outstanding tax liabilities of almost $200,000. The court noted that at his collection due process hearing, the lawyer sought a collection alternative but did not supply any of the required forms or necessary financial information and thus it was not an abuse of discretion for the IRS to reject collection alternatives and sustain the collection action.

The Tax Court Concluded: Finding no abuse of discretion in any respect, the Tax Court will granted summary judgment for respondent and affirm the proposed collection action. The Court noted that petitioner is free to submit to the IRS at any time, for its consideration and possible acceptance, a collection alternative in the form of an offer-in compromise or Installment Agreement, supported by the necessary financial information.

Tax Controversy CPA/U.S. Tax Court Litigator

IRS Collection and Tax Litigation-Tax Controversy CPA/U.S. Tax Court Litigator: Raleigh and Wilmington, NC/North Myrtle Beach and Myrtle Beach, SC

TRADE OR BUSINESS, BUT FAILED TO SUBSTANTIATE EXPENSES-J. FRANK BEST, TAX CONTROVERSY CPA/U.S. TAX COURT LITIGATOR

Entertainment Company Was a Trade or Business, but Failed to Substantiate Expenses

The Tax Court held that an entertainment company that signed artists and produced, promoted and distributed their work was engaged in a trade or business for profit because, although the company never earned a profit during the years at issue, the owner had prior business successes in the music industry, ran the company in a businesslike manner, and devoted significant capital to make it a profitable business. However, the owner’s losses from the business were denied because the court found that the company’s bank statements, which were the only evidence of the expenses produced by the owner, were insufficient to establish the amounts and business purpose of the expenses. Barker v. Comm’r, T.C. Memo 2018-67.

Cecile Barker is an experienced aerospace engineer with a background in music. In the mid-1960s he formed the group Peaches & Herb, which achieved considerable commercial success, and in 1973 he co-produced a song by Gladys Knight & the Pips. Barker left the music business and formed an aerospace engineering company in the 1970s. In 2001, he sold that company and decided to reenter the music business.

Barker formed SoBe Entertainment International LLC in 2002. He contributed all of SoBe’s capital and owned 95 percent of its profits and losses. His son, Yannique, and daughter, Angelique, split the other five percent. SoBe is an independent entertainment company that signs artists and celebrities, produces music and videos, and promotes its artists and distributes their work. As SoBe’s chief executive officer (CEO) and managing member, Barker devoted 40 to 60 hours per week to the business. He consulted music industry professionals before forming SoBe, and hired several high profile producers to bolster SoBe’s chances of success. SoBe employed a marketing professional and, at one time, chief financial officer (CFO). In total, SoBe had eight employees and regularly hired independent contractors.

Yannique Barker was one of SoBe’s signed artists. SoBe had several artist contracts and renewed at least one. SoBe also contracted with producers and writers to work with its artists. SoBe also entered into a distribution agreement with Universal Music to distribute music digitally. SoBe advertised online and through its websites in addition to placing ads in print magazines. SoBe was also a member of the trade organization Record Industry Association of America.

Barker saw stars like Adele and Taylor Swift as examples of how one artist could make his company profitable. Although none of his artists had achieved such a level of success, they had each contributed to the catalog of songs that SoBe owned. SoBe’s catalog had value in March 2016 and it placed a song in a TV show on ABC.

SoBe was founded at a time of major change to the music industry, as online platforms made it possible to buy or sell music at low cost or share it for free. SoBe cut costs as a result of the effects of these platforms, reducing its employees from 17 to 8, and moving its recording studio to a less expensive location. SoBe had never earned a profit and its cumulative losses increased from year to year.

SoBe employed John McQuagge as its CFO and controller from 2006 through 2010. McQuagge used Quickbooks software to produce SoBe’s general ledger and journals. SoBe had two separate bank accounts, one used as a primary operating account and the other used for payroll. McQuagge balanced the accounts against monthly bank statements. While SoBe kept records of the checks it used to pay its expenses from 2006-2010, other expenses recorded in SoBe’s general ledger were paid by credit card or cash, for which no documentation existed other than bank statements.

SoBe had two outside accounting firms prepare its tax returns for 2003-2011. SoBe provided its accountants with all of its Quickbooks records. Accountant Stanley Foodman prepared SoBe’s returns for 2006-2009. Foodman also prepared Barker’s personal income tax returns for 2005-2011. Foodman calculated Barker’s net operating losses (NOLs) and total capital contributions to SoBe for 2002-2011 and listed each of his individual capital contributions to SoBe in 2006-2009. Foodman determined that Barker made over $45 million in capital contributions to SoBe from 2002-2011. This calculation was based on the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc. from SoBe, supplemented by SoBe’s general ledger and bank statements.

Barker reported income from sources other than SoBe, mostly capital gains, interest and dividends. His 2011 income came mostly from Mistral, a defense contractor Barker helped found. Foodman calculated Barker’s income or loss after taking into account Barker’s interest and dividend income, net capital gains and losses, and share of gain or loss reported on the Schedules K-1 from SoBe and other businesses in which he held an interest.

Barker was the victim of identity theft when someone filed a tax return for 2011 using his social security number. Barker eventually filed his 2011 Form 1040 in August 2016. His return showed a loss from SoBe of over $800,000 and an NOL carryover of $19.6 million for 2011. The IRS issued a notice of deficiency in June 2014, determining various adjustments to Barker’s income and deductions. The notice showed that Barker owed approximately $1.2 million in tax for 2011 and that a 25 percent addition to tax applied for Barker’s failure to file his return on time. Barker challenged the notice in the Tax Court.

The IRS asserted that SoBe did not incur any operating losses (and thus, no losses flowed through to Barker) because SoBe was a hobby rather than a trade or business. In the IRS’s view, Barker lacked the actual and honest objective of making a profit. The IRS also argued that Barker could not substantiate the expenses giving rise to SoBe’s operating losses. Barkley contended that SoBe was run as a business from its formation and that making a profit was always its primary objective. He also challenged the addition to tax by arguing that his late filing was due to the identity theft.

The Tax Court held that, under the facts and circumstances, Barker operated SoBe as a trade or business with the actual and honest objective of making a profit. The Tax Court found that Barker had prior business successes in the music industry and had run successful defense contracting businesses, having helped to turn one of them around after several years without a profit. In the court’s view, Barker leveraged his experience and contacts in the music industry as he prepared for SoBe’s formation. He also ran SoBe in a businesslike manner, working there full time and devoting significant capital to it.

Although SoBe had never been profitable, the court found that it had positioned itself to make a profit by amassing a catalog of songs that it had been able to monetize. The court also took into account the turmoil in the music industry and the difficulties faced by artists and producers during the years at issue. The fact that Barker’s son, Yannique, was a SoBe artist did not mean that SoBe was merely a vehicle to fund Yannique’s musical aspirations, according to the Tax Court, because SoBe had other artists and did not devote most of its resources to Yannique. Nor did the fact that Barker enjoyed the creative aspects of the music industry, and had income from other sources. prevent SoBe from being engaged in a trade or business, given the other factors indicating a profit motive.

Although SoBe was engaged in a trade or business for profit, the Tax Court found that Barker failed to provide evidence on which the Tax Court could determine or even estimate the amount of SoBe’s business expenses for all prior years of its operation. The court found that the only documentation to support SoBe’s business expense deductions for previous years were SoBe’s bank statements. Those statements, in the court’s view, did not document the amounts of SoBe’s expenses paid by cash or credit card, nor did they describe the business purpose of the expenditures. The court found that Barker had produced SoBe’s general ledger only for 2005-2009 and that his testimony was insufficient to fill in the gaps. The Tax Court reasoned that Barker had access to additional documentation, including SoBe’s general ledger for all years of its existence, but failed to produce it; therefore the court presumed that such documentation would be unfavorable to Barker.

The Tax Court also held that Barker failed to provide enough evidence for it to determine his NOL deduction for 2011. Barker failed to substantiate SoBe’s income and business expenses for all prior years and, in turn, the amount of losses for which he claimed a deduction for 2011. If the court could not estimate the amount of SoBe’s operating losses, it could not know how much flowed through to Barker. Moreover, even if Barker had substantiated SoBe’s expenses, the court could not determine how much of those losses were absorbed by Barker’s other income in the years before 2011, because Barker did not produce his returns for 2002-2004 and those that he produced for later years were missing crucial information.

The Tax Court also upheld the penalty assessment after rejecting Barker’s argument that his identity theft issue excused his failure to file his 2011 return on time. The court reasoned that Barker was a sophisticated businessman who should have known that he was required to file his return, and that his accountants and return preparers could have made inquiries.

Trust Fund Recovery Penalty & IRS Abuse of Discretion/J. Frank Best, CPA/U.S. Tax Court Litigator-Raleigh & Wilmington, NC North Myrtle Beach & Myrtle Beach, SC

Trust Fund Recovery Penalty & IRS Abuse of Discretion. J. Frank Best, Tax Controversy CPA/U.S. Tax Court Litigator. Rated  in Top 5 Tax Controversy CPA Profiles/Linkedin.com. More than 30 years experience. Representation for NC, SC, & All States. PHONE. 800.230.7090  WEB: bestirscpa.com  Email: bestcpa@bestirscpa.com

United States Tax Court Decision for the Week-Trust Fund Recovery Penalty & IRS Abuse of Discretion

A recent Tax Court decision was reported dealing with Trust Fund Recovery Penalty and IRS Abuse of Discretion.  J.  Frank Best, Certified Public Accountant and United States Tax Court Litigator in Raleigh, Wilmington, NC & North Myrtle Beach and Myrtle Beach, SC works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.  

Hearing Officer Not Required to Substantively Analyze Supervisor’s Approval of Trust Fund Recovery Penalty. No IRS Abuse of Discretion.

The Tax Court held that there was no abuse of discretion by a settlement officer (SO) in a collections due process hearing where the SO determined that a computer-generated IRS record showing a supervisor’s printed name but not the supervisor’s signature was sufficient evidence of IRS supervisory approval. The Tax Court found that the SO was not required to analyze the thought process of the approving supervisor but only to verify that the supervisor approved in writing the initial determination of the penalty. Blackburn v. Comm’r, 150 T.C. No. 9 (2018).

Beginning in 2000, Emergency Response Training, Inc. (ERT) fell behind on its employment tax liabilities. Specifically, ERT failed to file a number of Forms 941, Employer’s Quarterly Federal Tax Return, or satisfy numerous self-reported employment tax liabilities during 2000 through 2011.

In 2012, Scott Blackburn and another individual were determined by the IRS to be responsible persons and an IRS revenue officer asserted trust fund recovery penalties (TFRPs) against them. At the time, Senior Revenue Officer Janet Reed was the manager of the officer who made the initial TFRP determination. Later in 2012, the revenue officer changed her determination regarding the second individual’s TFRP liability and submitted a request for supervisory approval to assert TFRP liabilities against Blackburn. A Form 4183, Recommendation re: Trust Fund Recovery Penalty Assessment, was generated showing Reed’s approval of the TFRP determination against Blackburn. The computer-generated Form 4183 did not contain Reed’s signature but showed her name in the supervisor signature block. In November 2012, the IRS assessed TFRP liabilities against Blackburn for the fourth quarter of 2003 and the fourth quarter of 2004. After a collections due process hearing, a settlement officer (SO) upheld the TFRP assessment.

Blackburn appealed the SO’s decision in the Tax Court. He did not contest his liability for the TFRP, but argued that the SO had failed to fulfill the requirement under Code Sec. 6330(c)(1) to verify that the IRS had fulfilled all of its legal and procedural requirements. Blackburn reasoned that under Code Sec. 6751(b)(1), the IRS may not assess a penalty unless an IRS supervisor has personally approved the determination in writing; supervisory approval is part of the IRS’s burden of production under Graev v. Comm’r, 149 T.C. No. 23 (2017). According to Blackburn, the SO’s verification responsibility required a meaningful review, including a factual analysis of the supervisor’s thought process, and he argued that by relying solely on the Form 4183 to verify that a supervisor approved the TFRP determination, the SO did not fulfill the Code Sec. 6330(c)(1) verification requirement. The IRS filed for summary judgment, arguing that Code Sec. 6751(b)(1) does not apply to a TFRP assessment and that even if it did, the Form 4183 fulfilled that requirement.

The Tax Court ruled in favor of the IRS, finding that the SO properly verified the assessment of the TFRP. The Tax Court held that Code Sec. 6330(c)(1) does not require an analysis of the thought process of the approving supervisor under Code Sec. 6751(b), but rather verification that the supervisor approved in writing the initial determination of the penalty. The Tax Court explained that, because it found no abuse of discretion regarding verification of compliance with Code Sec. 6751(b), it did not need to address the legal question of whether Code Sec. 6751(b) applies to the TFRP.

In the Tax Court’s view, Blackburn was arguing that the SO’s verification responsibility under Code Sec. 6330(c)(1) included making a determination of a meaningful approval of the merits of the liability. The Tax Court found no case law support for requiring a substantive review of the SO’s thought process. Rather, the court found that the SO’s review of the administrative steps taken before assessment is accepted as adequate under Code Sec. 6330 as long as there is supporting documentation in the administrative record. Imposing the requirement of a substantive review on the SO would, in the view of the Tax Court, allow the taxpayer to avoid the limitations of pursuing the underlying liability in a CDP hearing and apply a level of detail in the verification process that had never previously been required.

The Tax Court found that the treatment of Form 4340, Certificate of Assessment and Payments, as presumptive evidence that a tax was validly assessed was an apt parallel to the issue regarding Form 4183. Form 4340 is used to prove that an assessment has been made and is considered presumptive proof of a valid assessment. The Tax Court explained that the IRS may rely on Form 4340 where the taxpayer has not shown any irregularity in the assessment procedure that would raise a question about the validity of an assessment. An assessment requires a signature and is made by an IRS officer’s signing the summary record of assessments; the officer’s signature is not required on the Form 4340. In the court’s view, even though Form 4183 does not have an actual signature, in the context of a review for abuse of discretion, its mere existence in the administrative record supports the SO’s verification.

The Tax Court found that it had consistently held in prior decisions that reliance on standard administrative records was acceptable to verify assessments. The court reasoned that Form 4183 was similar to Form 4340, which had previously been found to be an IRS record that reflected compliance with administrative procedures. Form 4183, in the court’s view, provided a similar mechanism to demonstrate supervisory approval. The Tax Court concluded that, regardless of whether supervisory approval was required before the TFRP assessment, a record of such prior approval was present in this case.

 

Innocent Spouse- Raleigh & Wilmington, NC North Myrtle Beach & Myrtle Beach, SC

IRS Innocent Spouse Relief. J. Frank Best, Tax Controversy CPA/U.S. Tax Court Litigator. Rated  in Top 5 Tax Controversy CPA Profiles/Linkedin.com. More than 25 years experience. Representation for NC, SC, & All States. PHONE. 800.230.7090  WEB: bestirscpa.com  Email: bestcpa@bestirscpa.com

 

United States Tax Court Decision for the Week-Innocent Spouse

A recent Tax Court decision was reported dealing with Innocent Spouse.  J.  Frank Best, Certified Public Accountant and United States Tax Court Litigator in Raleigh, Wilmington, NC & North Myrtle Beach and Myrtle Beach, SC works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.  

UNITED STATES TAX COURT

T.C. Summary Opinion 2018-1

January 4, 2018.

COLIN C. BISHOP, Petitioner, AND LISA BISHOP, Intervenor v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22108-16S.

Michael S. Sterner , for petitioner. Jan R. Pierce and Myla Sepulveda (specially recognized), for intervenor. Jeffrey D. Rice , for respondent.

SUMMARY OPINION

COHEN, Judge : This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect when the petition was filed. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case. Respondent determined a $3,545 deficiency in petitioner’s Federal income tax for 2014. The issue for decision is whether petitioner should be relieved from liability for all or part of the deficiency that resulted from failure to report on a joint return a distribution from intervenor’s separately owned retirement account. The resolution depends on whether petitioner had actual knowledge of the distribution, or any portion thereof, for purposes of section 6015(c). Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for 2014.

Background

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. Respondent and petitioner have agreed that petitioner is not liable for the deficiency after application of section 6015(c). Intervenor, however, objects to that conclusion.

Petitioner and intervenor were married on October 31, 2007. They were temporarily separated twice during 2014, finally separated in June 2015, and divorced in 2016. At the time his petition was filed, petitioner resided in Washington. At the time her notice of intervention was filed, intervenor resided in Oregon.

Intervenor inherited a retirement account from her father in 2009. The account was maintained at Edward D. Jones & Co. (Edward Jones) in intervenor’s name. Taxable distributions were received before 2014, ranging from $4,000 to $48,000, and were reported on joint Federal income tax returns filed by petitioner and intervenor.

During 2014 and until the time of the permanent separation in 2015, petitioner and intervenor maintained a joint checking account into which their payroll checks were deposited. They made transfers to and from other accounts, and family expenses were paid out of the joint account. Petitioner and intervenor both had access to the funds in the joint account by the use of debit cards.

During 2014 intervenor received a $15,068 distribution from the Edward Jones retirement account. Edward Jones withheld $2,712 from the distribution and reported both of those amounts to the Internal Revenue Service (IRS). On August 1, 2014, $6,000 was deposited into the joint checking account that petitioner and intervenor maintained. The balance of the distribution was used for the benefit of intervenor’s daughter.

As they had in prior years, petitioner and intervenor together provided information to the preparer of a joint tax return for 2014. They did not report the Edward Jones distribution on that return.

Before the petition was filed, petitioner filed a Form 8857, Request for Innocent Spouse Relief, with the IRS. Intervenor provided information during the review process. The IRS determined that petitioner was not entitled to relief under section 6015(b) because he had constructive knowledge of the distribution but was entitled to relief under section 6015(c) because of the absence of proof of actual knowledge.

Neither petitioner nor intervenor disputes the amount of the deficiency. Petitioner contends that he is entitled to relief from the full amount of the deficiency and in the alternative that at most he should be liable for the deficiency relating to the $6,000 deposited into the joint bank account. Intervenor requests that petitioner be held liable for tax on $7,080, which intervenor infers was the portion of the distribution plus withheld tax reflected in the $6,000 deposit.

Discussion

Section 6013(d)(3) provides the general rule that if spouses make a joint return the liability for the tax shall be joint and several. Subject to other conditions, section 6015(c) allows a divorced or separated spouse to elect to limit his or her liability for a deficiency assessed with respect to a joint return to the portion of such deficiency allocable to him or her under subsection (d). Pursuant to section 6015(d)(3)(A), “any item giving rise to a deficiency on a joint return shall be allocated to individuals filing the return in the same manner as it would have been allocated if the individuals had filed separate returns for the taxable year.” Further, “[e]rroneous items of income are allocated to the spouse who was the source of the income.” Sec. 1.6015-3(d)(2)(iii), Income Tax Regs.; see also Agudelo v. Commissioner , T.C. Memo. 2015-124, at *16. Denial of relief requires evidence that the requesting spouse had “actual knowledge, at the time such individual signed the return, of any item giving rise to a deficiency (or portion thereof) which is not allocable to such individual.” Sec. 6015(c)(3)(C); see also sec. 1.6015-3(c)(2), Income Tax Regs. Section 6015(c) differs from the relief provisions of subsections (b) and (f), under which relief may be denied if the party requesting relief had constructive knowledge of the item giving rise to the deficiency. See Culver v. Commissioner , 116 T.C. 189, 197 (2001); Richard v. Commissioner , T.C. Memo. 2011-144.

A question exists as to where the burden of proof lies in cases when, as here, the IRS favors granting relief and the nonrequesting spouse intervenes to oppose it. The Court has resolved such cases by determining whether actual knowledge has been established by a preponderance of the evidence as presented by all parties. See Pounds v. Commissioner , T.C. Memo. 2011-202; Knight v. Commissioner , T.C. Memo. 2010-242; McDaniel v. Commissioner, T.C. Memo. 2009-137; Stergios v. Commissioner , T.C. Memo. 2009-15.

To determine whether the requesting spouse had actual knowledge, the IRS considers “all of the facts and circumstances.” Sec. 1.6015-3(c)(2)(iv), Income Tax Regs. Similarly, the Court looks to the surrounding facts and circumstances for “an actual and clear awareness (as opposed to reason to know)” of the items giving rise to the deficiency. See Cheshire v. Commissioner , 115 T.C. 183, 195 (2000), aff’d , 282 F.3d 326 (5th Cir. 2002); Pounds v. Commissioner , T.C. Memo. 2011-202.

In this case, petitioner denies actual knowledge of the distribution although he admits that he knew about the retirement account and about withdrawals made in other years for various family expenditures. He argues that intervenor deliberately deceived him, but he relies on her silence and does not identify any specific misrepresentations by her. He acknowledges that he was at fault for not checking the records on the joint bank account maintained by him and intervenor.

Intervenor disputes petitioner’s credibility. She argues that he had actual knowledge of the 2014 distribution because it was deposited in their joint bank account about seven months before the return was prepared and petitioner continued to write checks from the account and use debit cards accessing funds in the account. Intervenor does not claim that she specifically told petitioner about the distribution when it was received or at the time that the return was prepared or point to any evidence that petitioner had “an actual and clear awareness (as opposed to reason to know)” of the items giving rise to the deficiency. Intervenor testified that they both forgot about the distribution at the time the return was prepared.

The history of withdrawals from the retirement account used by the parties over a period of years and the transactions by petitioner with reference to the joint bank account support a conclusion that petitioner should have known about the distribution. The amount was very large in relation to the average balances and other transactions in the account. There is no evidence, however, that petitioner saw the bank records before the joint return for 2014 was filed. His denials are not incredible, implausible or contradicted by direct evidence. See Culver v. Commissioner , 116 T.C. 189; Richard v. Commissioner , T.C. Memo. 2011-144. Regardless of the strong indications of constructive knowledge, the evidence falls short of establishing actual knowledge of any specific amount of the distribution in 2014.

While the parties make other arguments about “equitable” factors, the absence of proof of actual knowledge is determinative in this case.

Therefore,

Decision will be entered for petitioner .

United States Tax Court Decision for the Week-Civil Fraud by CPA

A recent Tax Court decision was reported dealing with Civil Fraud by a CPA. J.  Frank Best, Certified Public Accountant and United States Tax Court Litigator works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.

UNITED STATES TAX COURT

T.C. Memo. 2018-1

January 8, 2018.

CURTIS EUGENE ANKERBERG, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21104-16.

Curtis Eugene Ankerberg, pro se.

Jeffery D. Rice and Erik W. Nelson , for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge : Respondent determined deficiencies of $13,247, $29,800, and $17,207; accuracy-related penalties under section 6662(a) of $1,029, $646.80, and $1,193.20; and fraud penalties under section 6663 of $6,076.50, $19,699.50, and $8,093.25, for 2012, 2013, and 2014, respectively. In the answer respondent asserts for all three years larger penalties than those determined in the notice of [*2] deficiency. Respondent asserts that the section 6663 fraud penalty should apply to the entire amount of the deficiency determined for each year and, in the alternative, asserts that the section 6662(a) accuracy-related penalty should apply to the entire amount of each deficiency.

The issue for decision is whether petitioner is liable for penalties under either section 6663 or section 6662(a) for the years in issue. He contends that medical problems he suffered constitute reasonable cause for his underpayments under section 6664(c)(1). All section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. Petitioner resided in Oregon when he filed his petition.

Petitioner received a bachelor’s degree in business administration from California State University at Los Angeles. He was licensed as a certified public accountant (C.P.A.) in Oregon in 1994 and practiced continuously through the years in issue. He satisfied continuing education requirements to keep his license active through the years. He worked for various public accounting firms until [*3] 2005, when he started practicing on his own without any employees. During the years in issue petitioner operated his business out of his home.

Through the years in issue, petitioner prepared tax returns, gave tax advice to clients, and represented clients before the Internal Revenue Service (IRS). He prepared over 70 returns for clients in 2012, over 60 in 2013, and over 50 in 2014. He prepared returns for individuals, partnerships, S corporations, and C corporations. He drove a car during each year, and he ran for local office nine times in nine years, including the years in issue.

Petitioner prepared his own individual tax returns for 2012, 2013, and 2014. He underreported gross receipts and claimed excessive deductions on Schedules C, Profit or Loss from Business, in the amounts now stipulated as set forth below. He claimed 50% of his personal residence expenses as deductions on each Schedule C, but he did not attach a Form 8829, Expenses for Business Use of Your Home, to any of his filed returns for 2012, 2013, and 2014.

On his return for 2013 filed in October 2014, petitioner reported gross receipts of $26,150 from his business. The IRS commenced an examination of petitioner’s returns for 2012 and 2013 (and later expanded the examination to include 2014). On October 5, 2015, the IRS sent petitioner a notification of proposed changes proposing additional tax attributable to identified omissions of [*4] $8,850 in income for 2013, which were reported to the IRS on information returns by petitioner’s clients. Petitioner paid the proposed amount of additional tax. However, the amount of unreported gross receipts that petitioner agreed to was less than his actual unreported gross receipts for 2013. Petitioner signed his 2014 return on October 14, 2015.

The examination of petitioner’s returns was conducted at petitioner’s residence, and the examining agent observed and inspected the areas that petitioner claimed were used as his office. Petitioner referred to documents in his possession but failed to turn over documents requested by the examining agent. He gave several alternative explanations for repeated delays and failures to cooperate with the examining agent, including: he was scheduled for cataract surgery (which occurred in July 2015); he wanted to await the outcome of a Treasury Inspector General for Tax Administration (TIGTA) complaint that he had made; records had been lost; and his liability for 2013 had been closed when he accepted the proposed adjustment attributed to the unreported income reported by his clients. He explained that he had not attached the form required to claim business use of the home expenses because that “would be a red flag for an audit.”

Although petitioner claimed to have bank statements when first interviewed, he declined to turn them over, contending that he could not see them. Because [*5] petitioner failed to turn over records, the examining agent summoned petitioner’s bank account records and analyzed deposits into the account for each year. The agent determined unreported income for each year. He also obtained information about the number of filed returns in each year identifying petitioner as the preparer.

Before trial, the parties entered into a stipulation in which petitioner conceded unreported gross receipts of $20,423, $69,960, and $20,983 for 2012, 2013, and 2014, respectively. Petitioner also conceded the disallowance of deductions for unsubstantiated insurance, taxes and licenses, office expenses, repairs and maintenance, utilities, mortgage interest, car and truck expenses, depreciation and business use of the home, and other expenses reported on his returns for the years in issue. The disallowed and conceded deductions exceeded $29,000 for 2012, $14,000 for 2013, and $24,000 for 2014.

The omitted income and disallowed deductions resulted in an underpayment attributable to a substantial understatement of income tax for each year, the precise amounts of which will require computations under Rule 155.

OPINION

The fraud penalty is a civil sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy [*6] expense of investigation and the loss resulting from the taxpayer’s fraud. See Helvering v. Mitchell , 303 U.S. 391, 401 (1938). The Commissioner has the burden of proving fraud by clear and convincing evidence. Sec. 7454(a); Rule 142(b).

To impose the 75% penalty provided by section 6663, the Commissioner has the burden of proving for each relevant year (1) an underpayment of tax and (2) that the underpayment was due to fraud. See, e.g. , May v. Commissioner , 137 T.C. 147 (2011), aff’d per order , 2013 WL 1352477 (6th Cir. Feb. 19, 2013); Sadler v. Commissioner , 113 T.C. 99, 102 (1999); Parks v. Commissioner , 94 T.C. 654, 660-661 (1990). The latter burden is met if it is shown that the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of such taxes. DiLeo v. Commissioner , 96 T.C. 858, 874 (1991), aff’d , 959 F.2d 16 (2d Cir. 1992).

Petitioner has conceded unreported income and the disallowance of substantial Schedule C deductions for each year. Respondent’s burden of proving the underpayments for each year thus has been met.

As to respondent’s second burden, fraud may be proven by circumstantial evidence, and the taxpayer’s entire course of conduct may establish the requisite fraudulent intent. Rowlee v. Commissioner , 80 T.C. 1111, 1123 (1983). In [*7] determining whether petitioner’s underpayment was due to fraud, we apply long-recognized “badges of fraud” evolved from cases analyzing section 6663 or former section 6653(b)(1). See, e.g. , Niedringhaus v. Commissioner , 99 T.C. 202, 211 (1992); see also Bradford v. Commissioner , 796 F.2d 303, 308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601. Badges of fraud include (but are not limited to) a pattern of understated income, inadequate records, implausible or inconsistent explanations of behavior, concealing assets, failure to cooperate with tax authorities, filing of false documents, and lack of credibility. Bradford v. Commissioner , 796 F.2d at 307; Toussaint v. Commissioner , 743 F.2d 309, 312 (5th Cir. 1984), aff’g T.C. Memo. 1984-25. Misstatements during an audit, even by an unsophisticated taxpayer, may support a finding of fraud. See, e.g. , Ruark v. Commissioner , 449 F.2d 311 (9th Cir. 1971), aff’g T.C. Memo. 1969-48. Petitioner’s education and experience may be considered in determining whether he acted with fraudulent intent. See Scallen v. Commissioner , 877 F.2d 1364, 1370-1371 (8th Cir. 1989), aff’g T.C. Memo. 1987-412; Solomon v. Commissioner , 732 F.2d 1459, 1461 (6th Cir. 1984), aff’g T.C. Memo. 1982-603; Wright v. Commissioner , T.C. Memo. 2000-336, slip op. at 14.

The evidence establishes a pattern of unreported income and overstated deductions, failure to keep or produce records, and failure to cooperate with the [*8] IRS. As a C.P.A. and tax professional, petitioner knew what the tax laws required in relation to his tax reporting for the years in issue. Petitioner claims that the understated income, overstated deductions, and loss of records are attributable to his various serious medical problems during the years in issue, which constitute reasonable cause under section 6664(c)(1). However, he has not overcome the clear and convincing evidence of fraud in this case. The most telling additional badge of fraud is the lack of credibility in petitioner’s attribution of the “mistakes” on his returns to medical problems, particularly those affecting his eyesight. During the years in issue, he continued to prepare scores of returns for clients and to prepare his own returns without seeking assistance. He continued to drive a car. He prepared his return for 2014, which continued the pattern of omissions and erroneous deductions, after he had cataract surgery. His admissions and misrepresentations to the examining agent are further evidence of fraud. We do not accept his explanations, and we conclude that respondent has established fraudulent intent for each year by clear and convincing evidence. To allow for necessary computations,

Decision will be entered under Rule 155 .

United States Tax Court Decision for the Week-Legal Fees for Alimony Payments

A recent Tax Court decision was reported dealing with tax litigation and legal fees for alimony payments. J. Frank Best, Certified Public Accountant and United States Tax Court Litigator works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.

Legal Fees to Recoup Alimony Payments Were Nondeductible Personal Expenses

The Tax Court held that a taxpayer could not deduct legal fees incurred in an action to recover alimony payments that he alleged were made in excess of the amount provided for under a separation agreement with his ex-wife. The Tax Court found that the legal fees were nondeductible personal expenses because the underlying claim did not originate from any profit seeking activity. Barry v. Comm’r, T.C. Memo. 2017-237.

William and Beth Barry were divorced in 2002. The judgment of dissolution ordered Mr. Barry to pay alimony of $2,400 per month. In 2011, Mr. Barry sued Ms. Barry for breach of contract. He alleged that under a separation agreement they had previously signed, Ms. Barry was entitled to total alimony of approximately $45,000 and that he had paid that amount in full. He said that Ms. Barry was in default of the separation agreement when she filed for divorce in 2000 and demanded alimony. Mr. Barry sought a judgment of approximately $201,000 – an amount equal to the excess of the total alimony he paid over the amount he claimed Ms. Barry was entitled to under the separation agreement. Mr. Barry’s lawsuit was dismissed in 2011 as time barred.

On his 2013 tax return, Mr. Barry claimed a deduction of over $34,000 for the legal fees he paid with respect to the action against Ms. Barry. The IRS determined a deficiency of approximately $5,000 and an accuracy-related penalty of $1,000. Mr. Barry petitioned the Tax Court for redetermination of the deficiency.

Personal and family expenses are generally not deductible. However, a deduction is allowed under Code Sec. 212 for ordinary and necessary expenses for (1) the production or collection of income, or (2) the maintenance or conservation of property held for the production of income. In U.S. v. Gilmore, 372 U. S 39 (1963), the Supreme Court held that legal fees incurred by a taxpayer in resisting his wife’s property claims in a divorce were not deductible because the claims that gave rise to the fees stemmed from the marital relationship rather than from any profit seeking activity. The Supreme Court stated that the origin of the claim with respect to which an expense was incurred, rather than its potential consequences, is the controlling test of whether an expense is deductible.

Barry argued that Gilmore was decided based on the language of Code Sec. 212(2), which applies to expenses incurred in the conservation of property held for the production of income, but that his his claim was based on Code Sec. 212(1), which allows a deduction for expenses paid for the production of income. Barry said that the origin of the claim test therefore did not apply. Barry also cited Wild v. Comm’r, 42  T.C. 706 (1964), where the Tax Court held that legal fees paid by a wife in obtaining alimony includible in gross income were deductible under Code Sec. 212(1). Barry argued that his legal expenses should also be deductible because they were incurred for the purpose of collecting money that would be included in his income under the tax benefit rule.

The Tax Court held that Barry’s legal fees were not deductible under Code Sec 212(1). First, it found that, contrary to Barry’s argument, the Gilmore origin of the claim test applied to both paragraphs (1) and (2) of Code Sec.212. According to the Tax Court, Gilmore interpreted the predecessor statute to Code Sec.212, which contained in one paragraph the provisions now codified in Code Sec. 212(1) and Code Sec.212(2). The Tax Court also cited language from the Gilmore opinion stating that the only kind of expenses deductible under the predecessor to Code Sec. 212 were those that related to a profit seeking purpose and did not include personal, living, or family expenses.

Next, the Tax Court cited several of its previous decisions applying the origin of the claim test to deductions for legal fees under Code Sec. 212(1). The Tax Court noted that in Sunderland v. Comm’r, T.C. Memo. 1977-116, it applied the Gilmore test to disallow a deduction claimed under Code Sec.212(1) for legal expenses the taxpayer incurred in a legal action which resulted in a reduction of the alimony paid to his former wife. The Tax Court also cited Favrot v. U.S., 550 F.Supp. 809 (E.D. La. 1982), where a district court applied Gilmore in disallowing a claimed deduction for legal expenses incurred in an attempt to recoup alimony payments. The Tax Court rejected Barry’s assertion that his legal fees should be deductible because any recovered alimony payments would have been includible in his income. In the Tax Court’s view, Barry improperly focused on the potential consequences of his lawsuit rather than on the origin and character of his claim.

The Tax Court also disagreed with Barry’s reading of its decision in Wild, finding that it turned on an exception to the Gilmore rule in the regulations under Code Sec. 262 specifically providing for the deductibility of legal fees of a wife incurred for the collection of alimony and similar amounts received by a wife in connection with a marital relationship. The Tax Court concluded by citing the general rule as stated in the regulations under Code Sec. 262, which is that attorney’s fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife.

Finally, the Tax Court reasoned that if Barry had filed suit in the same year as his divorce to challenge the alimony obligations, his legal expenses would have been nondeductible personal expenses. In seeking to deduct legal expenses incurred in an action to recoup the alimony payments, Barry was seeking to do indirectly what could not have been done directly, according to the Tax Court.

United States Decision for the Week-Interest and Penalties on Criminal Restitution Award

A recent Tax Court decision was reported potentially dealing with tax litigation and interest and penalties added to a Criminal Restitution Award. J. Frank Best, Certified Public Accountant and United States Tax Court Litigator works to stay current on all IRS decisions concerning tax litigation to ensure we are fully informed and prepared for our clients.

IRS Cannot Add Interest and Penalties to Criminal Restitution Award

The Tax Court, in a case of first impression, held that the IRS may not assess and collect interest and penalties on a restitution award in a criminal conviction for failure to pay tax. The Tax Court found that restitution is treated as if it were a tax, but only for the limited purpose of allowing the IRS to create an account receivable against which the restitution can be credited. Klein v. Comm’r, 149 T.C. (2017).

Zipora and Samuel Klein, a married couple, pleaded guilty to willfully filing a false federal income tax return for 2006. Each was sentenced to prison and the couple was jointly ordered to pay restitution to the IRS. Mr. Klein admitted in his plea agreement that he had underreported income on the couple’s joint returns for 2003-2006. For sentencing purposes, the government presented a tax loss calculation of approximately $560,000 based on a reconstruction of the Kleins’ income for 2003-2006. The sentencing court disregarded the Kleins’ objections that the calculation did not include any deductions other than those reported on the returns filed for those years. U.S. sentencing guidelines permit the tax loss amount to be uncertain, and the sentencing court may make a reasonable estimate based on the available facts.

Pursuant to their plea agreements, the Kleins signed an IRS closing agreement acknowledging that their overall tax liabilities for 2003-2006 remained indeterminate. The Kleins waived all defenses, including the statute of limitations, and agreed that the IRS could audit their 2003-2006 returns at any time. Six years later, the IRS had not completed or even begun a civil examination for the Kleins’ 2003-2006 tax years.

In 2014, Mrs. Klein was released from custody and paid to the IRS the restitution amount in full. The government then released a previously filed notice of lien against her, stating that she had satisfied her payment obligations with respect to the restitution, together with all statutory additions. Two months later, the IRS filed a notice of federal tax lien (NFTL) against the Kleins, seeking interest and penalties for failure to pay with respect to the restitution amount. The IRS treated the tax loss amount as the underpayment for each year and used the original due dates of the returns as the commencement date for calculating interest.

The Kleins requested a collection due process hearing seeking withdrawal of the NFTL because they had paid the restitution. A settlement officer noted that the restitution portion of the assessment had been paid but that the assessed interest and penalties had not. The Kleins did not propose a collection alternative and the IRS issued notices of determination sustaining the NFTL filings. The notice showed a total balance due of almost $360,000, consisting entirely of assessed interest and penalties calculated on the amount of the restitution. The Kleins challenged the notice in the Tax Court.

Interest applies to any unpaid tax under Code Sec. 6601, and a penalty applies under Code Sec. 6651(a)(3) for the failure to pay the tax required to be shown on a return. Under Code Sec. 6201(a)(4), the IRS may assess and collect a criminal restitution award for failure to pay any tax in the same manner “as if” the amount were such a tax. The IRS acknowledged that restitution is not literally a tax, but argued that there was no meaningful difference between an amount that is assessed and collected as if it were a tax and an amount that is assessed and collected as a tax.

According to the IRS, interest and penalties are an inevitable adjunct of the civil tax collection procedure authorized by Code Sec. 6201(a)(4). The IRS cited language in the Internal Revenue Manual (IRM) stating that, because criminal restitution is assessed and collected the same as any civil tax assessment, interest and failure to pay penalties would apply as they would for any other civil tax assessment. It also drew a negative inference from Code Sec. 6305(a), which authorizes the IRS to assess and collect delinquent spousal support as if it were a tax. The wording of Code Sec. 6305(a) is similar to Code Sec. 6201(a)(4), but explicitly provides that no interest or penalties can be assessed or collected. The IRS argued that Congress could have included the same limiting language in Code Sec.6201(a)(4) if it had intended such treatment to apply.

The Tax Court held that Code Sec. 6201(a)(4) does not authorize the IRS to add underpayment interest or failure-to-pay penalties to a title 18 restitution award, and the IRS cannot assess or collect from the Kleins underpayment interest or additions to tax without first determining their civil tax liabilities. The court reasoned that the purpose of the “as if” language in Code Sec. 6201(a)(4) is to treat restitution as a tax only for the limited purpose of enabling the IRS to assess the amount in order to create an account receivable against which the restitution payment can be credited. According to the Tax Court, the inclusion of the word “if” in Code Sec 6201 was significant and had to be given effect.

Reviewing the legislative history, the Tax Court determined that Congress’s intent was to address the IRS’s lack of a proper accounting mechanism to credit receipts of restitution payments by giving the IRS early assessment authority for such awards. The Tax Court noted that the IRS usually waits until after a criminal proceeding to begin an audit to determine the taxpayer’s civil liabilities, so the timing created a bookkeeping issue for the IRS. Although the legislative history included a legislator’s floor speech expressing the belief that the bill would permit the assessment and collection of restitution awards for victims of crime in the same manner as delinquent taxes are assessed and collected, the Tax Court found that contemporaneous remarks of a sponsor of legislation are not controlling in analyzing legislative history.

The Tax Court rejected the IRS’s reliance on the IRM, finding the relevant IRM provisions to be short on analysis. The Tax Court noted that IRM provisions do not bind the courts and reasoned that the deference due to an agency manual depends on its thoroughness, logic and expertness. According to the Tax Court, on a question of statutory construction, the IRM would have limited power to persuade in any event and especially given its lack of analysis on this issue.

The Tax Court also disagreed with the IRS’s conclusion that Code Sec. 6305(a) proved Congress knew how to draft limiting language and would have done so in Code Sec. 6201(a)(4) if it intended to limit assessments of interest and penalties on restitution awards. The Tax Court reasoned that such an inference is strongest when the provisions were considered simultaneously and that there was no reason to believe that the Congress that enacted Code Sec. 6201(a)(4)35 years after Code Sec. 6305(a)(4) considered, but decided against, providing such an exclusion in Code Sec. 6201(a)(4).

The Tax Court noted that the differences between a tax loss calculation in a criminal tax case and civil tax liability supported its conclusion. According to the Tax Court, restitution is designed to compensate the IRS for the loss caused by the wrongdoing, while civil tax liability is typically determined after the criminal proceeding. The civil tax liability may be higher or lower than the tax loss that formed the basis of the restitution award. To the Tax Court, this showed the basic flaw in the IRS’s argument that a restitution award should be equated with a tax. A tax loss calculation is a simplified calculation intended to avoid complex disputes over adjustments and deductions during sentencing, where the yardstick for measuring tax loss is typically not understated taxable income but underreported gross income. By contrast, unclaimed deductions for legitimate expenses are fully available to the taxpayer in determining civil tax liability in an IRS audit. To the Tax Court, the difference between a restitution award and civil tax liability showed why restitution could not be equated to a tax.

The Tax Court concluded that a restitution obligation is not a civil tax liability and that Congress did not change that fact when it authorized the IRS to assess and collect restitution in the same manner as if it were a tax. According to the Tax Court, the Kleins had waived all defenses so the IRS was free to begin an audit of their civil tax liabilities, to which interest and penalties could be imposed; in that event, the interest and penalties would be determined by reference not to the tax loss calculation but to the Kleins’ actual tax liabilities.