Taxable Talk

The Third Circuit Court of Appeals ruling in Swallows Holding, Ltd. v. Commissioner is now available online. The summary of the ruling is:

“This case, grounded in the principles of administrative law, requires that we review the validity of an Internal Revenue Service (IRS) regulation. The Tax Court, in considering this regulation, analyzed it under the factors provided in National Muffler Dealers Ass’n v. United States, 440 U.S. 472, 477 (1979), and concluded that the regulation was invalid. In coming to this conclusion, the Tax Court explained that the standard established in National Muffler had not been replaced by Chevron U.S.A., Inc. v. Natural Resources Defense Counsel, Inc., 467 U.S. 837 (1984), and that the result under either standard would be the same. We do not agree with the outcome reached by the Tax Court. We have determined that the result would not be the same under Chevron analysis as it would be under National Muffler and that the regulation here should be given Chevron deference.”

The TaxProf Blog has more.

I remember the Michael Myers movie, So I Married an Axe Murderer. Today the Tax Court looked at a related issue: What happens if you marry a tax cheat but don’t know about it?

The basic facts weren’t in dispute. The petitioner’s ex-wife was a parking lot cashier at the Philadelphia Airport in the early 1990s. She participated in a scheme to steal money from the airport. She earned about $90,000 in illegal (stolen) income. As you might expect, when the theft was discovered her employment was terminated.

There’s no dispute that illegal income is taxable. There’s also no argument that when a joint return is filed, both spouses are responsible for paying the tax on the income. In this case, both the IRS and the petitioner agree that about $36,000 in tax is owed.

However, there is a protection for the true innocent spouse. Section 6015(c) of the Tax Code:

“…That section limits an individual’s liability for a deficiency to the portion of the deficiency properly allocable to that individual under section 6015(d). In general, an item that gives rise to a deficiency on a joint Federal income tax return will be allocated to the individuals who file the return in the same manner as that item would have been allocated had those individuals filed separate returns.”

Given that when the returns were signed the petitioner knew nothing about the ex-wife’s illegal income, all of the income would be attributable to the wife.

However, the IRS disputed whether the petitioner had actual knowledge of the illegal income. If that were the case, he would not be eligible for relief by filing a Section 6015(c) election.

Luckily for the petitioner, for this section of the Tax Code the burden of proof is with the IRS (per Section 6015(c)(2)). While petitioner’s ex-spouse testified that the petitioner knew about the illegal income, that was apparently the only evidence that the IRS had. The petitioner also testified that he had no knowledge of the illegal income, and “…we find petitioner’s version of the events to be the more credible. Other evidence supports our finding in this regard. “

So if you marry a tax cheat, don’t despair. The Tax Code does actually offer you some protection. On the other hand, if you marry an axe murderer….

Case: Eller v. Commissioner, T.C. Summary 2007-215

Wouldn’t it be nice if you could conduct an audit of that conniving guy or gal that you have to deal with? You’d make his or her life a total pain.

Well, that’s just no doable. Only the IRS (and various state tax agencies) conduct audits. Today, the Tax Court turned down Creed Pearson’s request to audit The Organization:

Petitioner asks that we allow him to audit the Organization, which is not a party to this case, and that he be able to pay his taxes out of the proceeds of that audit. There is no provision in the Code that gives us the authority to allow one taxpayer to audit another taxpayer in order to reduce his tax deficiency. Therefore, we deny petitioner’s request.”

Joe Kristan has lots more on this case.

One of the vexing matters for tax professionals are side businesses. If they’re profitable, it’s usually not an issue. It’s another Schedule C for the return. However, when they are unprofitable problems can arise if the IRS scrutinizes the return.

The Tax Court looked at this again on Thursday when the decided the case of a Kansas couple who had an exotic animal breeding business. The husband is a successful physician, with a medical practice that brought in $750,000 or more annually. Starting in 1989, the began to breed exotic birds. They then expanded into all sorts of exotic animals, including (but not limited to) “Watusi cattle, miniature donkeys, miniature horses, elk, reindeer, zebras, African antelope, kangaroos, Clydesdale horses, and primates.”

The Kansas couple did some things right: They did keep a separate set of books and a separate bank account. But they didn’t bother with sales receipts to customers. They did treat the employees of their business as employees. They withheld taxes, offered health insurance, etc.

However, they never turned a profit. And when the IRS audited the couple’s tax return for 2001 and 2002, the IRS ruled that the couple could not deduct the losses at the business. The case was then appealed to the Tax Court.

The Court looked at their records, and found them deficient.

“Although we are satisfied that petitioners kept financial records of their breeding activity, we are not convinced that petitioners’ record keeping represented anything other than an effort to substantiate expenses claimed on their return…Petitioners presented no evidence that their books and records were used to review profitability or to implement cost-saving measures. While a taxpayer need not maintain a sophisticated cost accounting system, the taxpayer should keep records that enable the taxpayer to make informed business decisions…Although petitioners kept extensive financial records, they were not used to review and reduce expenses or to enhance the possibility of generating income…Petitioners did not introduce any evidence that they used their financial and breeding records to determine whether a specific breed was profitable…Because petitioners failed to use the existing books and records to minimize their expenses or otherwise foster profitability, the fact that they maintained records does not indicate that the activity was carried on with a profit motive.”

And that basically was the case. Yes, the couple kept records. But the records appeared incomplete, and were apparently not utilized completely. The couple couldn’t show that they expanded breeding of profitable exotic animals because they couldn’t show which animals were profitable. Add to that 16 years of large losses, and the case flew the coop.

Case: Knudsen v. Commissioner, T.C. Memo 2007-340