Taxable Talk

A fascinating case came out of the Tax Court today. Being late when you file a challenge is never a good idea; in almost all cases, your filing can be thrown out. But what happens if you file too early?

The petitioners in today’s case received a notice of lien for 1996 to 2000. Then the petitioners received a notice of levy for tax years 1990 to 1994. The petitioners requested a collection due process hearing (CDP) before the thirty day period before the first day of levy.

In appellate court cases, if you file early, your date of filing is presumed to be the first day of filing (your filing date is “related forward” under Federal Rule of Appellate Procedure 4(a)).

But that wasn’t the view of the Tax Court. Instead, it took the statute literally, noting that a request must be made during the 30-day period. The regulations promulgated under the statute use the same terminology: four times the words “during the 30-day period” (or synonyms) are used.

The Court concluded,

Allowing premature CDP requests to be effective, incontrast, would cause prejudice to the Commissioner. The IRS is a bulk-processing organization that sends and receives hundreds of millions of notices and returns each year. If the system is to work, almost all of those notices and returns have to quickly fit into pigeonholes (or their modern-day equivalent, the database field), rather than become the object of contemplation by a IRS clerk charged with finding the right place to put a particular piece of correspondence….We think the Commissioner is right when he argues that allowing a taxpayer to disrupt this sequence with a premature CDP request would be quite likely to cause prejudice.

So if you’re going to contest an IRS notice, check the dates carefully. Being early is just as bad as being late.

Case: Andre v. Commissioner, 127 T.C. No. 4

I can’t, but Joe Kristan of Roth Tax Updates has the story of yet another interesting case from the Tax Court today. If your business is grossing $2.5 million to $3 million each year, and you’re paying about $45,000 in federal and state taxes each year, and a new tax preparer says he can lower your taxes to almost nothing, be sure to ask how he’s going to accomplish that magical feat. And if you later discover your tax preparer is in Leavenworth, well, perhaps you’ve figured out how the magic is done. You can find all the gory details here.

A few years ago, there were two Tax Court cases resolved by closing agreements (a closing agreement is a settlement agreement of the case): God’s Helping Hands Living Estate Plan Trust, John M. & Thelma Smoll, Trustees v. Commissioner, docket No. 8468-01, and John M. & Thelma Smoll, Trustees v. Commissioner, docket No. 8489-01. These cases looked at whether the Trust should be recognized for tax purposes. The closing agreements stated, among other things, that the Trust would not be recognized for tax purposes and that the taxpayers would report their taxes for those years and all future years.

You’re way ahead of me. Of course they didn’t do that, or I wouldn’t be writing this. In 2000 and 2001 the taxpayers used the trust (after signing an agreement that said they wouldn’t do that). In 1999, 2002, and 2003 they didn’t file returns (at least they didn’t use the trust).

So not only do the taxpayers owe the tax, and interest, the IRS asserted that they committed willful fraud. As the Court noted,

“At trial and by facts deemed stipulated, respondent established by clear and convincing evidence that petitioners understated their 2000 and 2001 Federal income tax with the intent to commit fraud and that petitioner failed to file his 1999, 2002, and 2003 returns with the same intent…Petitioners have a pattern of failing to file tax returns and understating their income when they do file income tax returns. Petitioners also failed to maintain adequate records or cooperate with respondent, and they consistently provided respondent’s representatives with implausible or inconsistent explanations for their behavior.”

The Court went on, noting that the actions demonstrated that they deliberately and willfully committed fraud.

There’s a moral to this story. If you sign a closing agreement with the IRS, you had better follow it, because they’ll be watching you.

Case: Smoll v. Commissioner, T.C. Memo 2006-157

Assume that you’re going on permanent disability. You and your employer reach an agreement, with payments structured as though they were from workers compensation (nontaxable to the recipient). Suddenly, your employer backs out and threatens litigation—litigation that would likely take years to resolve. But your employer offers you a “nonindustrial disability retirement,” with payments that are based on age and length of service. Your employer and an IRS representative tell you that the payments aren’t taxable, so you decide to take the settlement.

Just one problem: You get a notice from the IRS saying that the nonindustrial disability retirement money is taxable.

That’s what brought Steven Diem to Tax Court today. He was employed as a fireman for San Francisco. He’s retired, and on his Form 1040 he deducted the payments of $16,617 (for the year in question) as “nontaxable pension in lieu of workers comp.”

Unfortunately for Mr. Diem, the law is settled in this area. As the Court noted, Section 1.104-1(b), Income Tax Regs., states, in part:

“Section 104(a)(1) excludes from gross income amounts which are received by an employee under a workmen’s compensation act * * * or under a statute in the nature of a workmen’s compensation act which provides compensation to employees for personal injuries or sickness incurred in the course of employment. * * * However, section 104(a)(1) does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee’s age or length of service, or the employee’s prior contributions, even though the employee’s retirement is occasioned by an occupational injury or sickness. * * * [Emphasis added.]”

So the law and many court decisions state that the income is taxable. But the petitioner noted that both the City of San Francisco and the IRS told him it wasn’t taxable. Unfortunately,

“Whatever advice or representation that was made to petitioner has no bearing upon the Court’s decision here. The law is well settled that the Commissioner is not estopped and cannot be bound by erroneous acts or omissions of his agents or representations by other parties such as the employer. Authoritative tax law is contained in statutes, regulations, and judicial decisions. Zimmerman v. Commissioner, 71 T.C. 367, 371 (1978), affd. without published opinion 614 F.2d 1294 (2d Cir. 1979); Green v. Commissioner, 59 T.C. 456, 458 (1972). A taxpayer cannot prevail simply because he relied on incorrect advice from his attorney regarding the tax consequences of the settlement. Coats v. Commissioner, T.C. Memo. 1977-407, affd. without published opinion 626 F.2d 865 (9th Cir. 1980). The representations that were made by the city of San Francisco and an IRS agent do not carry the weight of law.”

Yes, if you get advice from the IRS and it’s wrong, you’re out of luck, as the petitioner discovered.

Case: Diem v. Commissioner, T.C. Summary 2006-121

Today the Tax Court decided two cases where the Court basically said, you’re right, the law is unfair, but tough—you have to obey it.

The first case involves a gambler who wanted to net her wins and losses. If you’re a regular reader of this blog, you know that only professional gamblers can do this. In this case, both the IRS and the taxpayer agree that the wife lost more than she won. However, the amount she won—some $13,400—will have to be included as income (Other Income, line 21). As the taxpayer is retired, this caused some social security income to be taxable and that a credit for qualified retirement savings was eliminated. The taxpayer was allowed to deduct her gambling losses as an itemized deduction. The Court noted,

“Petitioners are [non-professional gamblers], and their only entitlement to the deduction for their gambling losses is the manner in which respondent determined it as an itemized deduction. Petitioners have cited no authority, and indeed there is no authority to support their argument that unrelated income and credits are immune from the effects of the manner in which respondent treated their gambling winnings and losses.”

The second case deals with a divorce decree, and which parent gets the tax exemption. The decree, granted in state court, gives the father the exemption as long as he has made child support payments. The father took the exemption, but so did the mother for the year in question. The IRS took away the father’s exemption, and he went to Tax Court.

The Tax Code states that if you’re the non-custodial parent (which the father was), in order to claim the exemption, you must have the other spouse sign and complete Form 8332. That apparently didn’t happen here, so the Tax Court ruled for the IRS and noted, “State courts, by their decisions, cannot determine issues of Federal tax law…His recourse, if any, lies in the State court for enforcement of the divorce decree.”

Cases:
Spencer and Egerton v. Commissioner, Colozza v. Commissioner

The Tax Court today looked at three cases where Native Americans claimed that they did not owe income tax because they’re Native Americans. Section 1 of the Tax Code states that all income is taxable. As the Court noted,

“Native Americans are subject to the same Federal income tax laws as are other U.S. citizens unless there is an exemption explicitly created by treaty or statute. Squire v. Capoeman, 351 U.S. 1, 6 (1956); Estate of Poletti v. Commissioner, 99 T.C. 554, 557-558 (1992), affd. 34 F.3d 742 (9th Cir. 1994); see Allen v. Commissioner, T.C. Memo. 2006-11; see also Rev. Rul. 2006-20, 2006-15 I.R.B. 746.” [Gunton v. Commissioner, T.C. Memo 2006-122]

In all three cases the petitioners could not cite treaties or laws that exempted them from income tax. So they all struck out, and owe the tax.

Cases: Gunton v. Commissioner, T.C. Memo 2006-122
Metallic v. Commissioner, T.C. Memo 2006-123
George v. Commissioner, T.C. Memo 2006-121

Today the Tax Court looked at a §1031 Exchange case. The question before the court was whether a partnership (Peabody) could exchange gold mines for coal mines. The problem: the coal mines were encumbered with supply contracts that sent the coal to electric utilities. Does the encumbrances constitute “boot” that causes tax to be due?

Under a &sect1031 Exchange, like property is exchanged for like property. The exchanger avoids capital gains tax. Like property need not be exactly the same property. You can exchange a rental house for a rental duplex, for example. (There significant restrictions to &1031 exchanges; make sure you talk to your own tax advisor about your situation.)

When cash gets involved in the transaction, it’s considered “boot.” Boot is taxable. The IRS argued that the contracts weren’t real property, but were the equivalent of cash or personal property received along with like-kind property. (There’s no question that you can, in a &sect 1031 exchange, exchange one mine for another mine, even if each mines different substances, assuming the other provisions of &sect 1031 are followed.)

The court had to determine, (1) are supply contracts considered real property and, thus, can be part of a &sect 1031 exchange (the IRS argued that they are contracts to sell personal property); (2) are the servitudes created by the supply contracts real property; and (3) are the supply contracts boot or not?

The court noted that like-kind doesn’t mean exactly the same kind:

In determining whether the like-kind requirement of section 1031 had been met, we found it significant in Koch v. Commissioner, 71 T.C. at 65, that section 1031(a) refers to property of a like, not an identical, kind. The required comparison of the old and new exchanged properties, we reasoned, should be directed to whether the taxpayer, in making the exchange, has used its property to acquire a new kind of asset or has merely exchanged its property for an asset of like nature or character.

The court did note that not all real property exchanges are like-kind exchanges, though.

The idea behind a &sect 1031 exchange is that the taxpayer is exchanging one piece of property for another, and that his original investment has not been sold or liquidated. The court noted,

It is true Peabody is obligated to mine and supply coal to meet the operating needs of power stations and that Peabody is prohibited from impairing the contracted-for supply by selling coal to other buyers. In our view those contract obligations and restrictions constitute a distinction in the grade or quality of the old and new mining properties rather than a difference in their kind or class. The new coal mine property is of a like nature or character to the gold mining property Peabody exchanged. By exchanging the gold mining property for the coal mining property subject to the supply contracts, Peabody is essentially continuing the original investment which remains fully unliquidated.

The court concluded, “In the light of that holding and because the supply contracts cannot be separated from Peabody’s ownership of the Lee Ranch mine coal reserves, it follows that those contracts are not taxable as other property or boot under section 1031(b).”

So Peabody is allowed to turn gold into coal, tax-free.

Case: Peabody Natural Resources Company v. Commissioner, 126 T.C. No. 14