Tax Controversy Litigation

I have recently penned a Law360 article discussing lessons learned from recent tax decisions impacting cannabis businesses.  We will continue to cover this topic on this blog.

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There is not too much to say about the Tax Court’s latest decision involving a marijuana company.  In Loughman v. Commissioner, T.C. Memo 2018-85, the operators of a Colorado marijuana dispensary argued that for a marijuana dispensary operating as an S corporation, Section 280E discriminates against S corporation shareholders by double taxing income when shareholder salary is disallowed pursuant to Section 280E as a deduction from flow-through S corporation income and also included on the shareholder’s individual tax return as W-2 wages.  The Tax Court noted that the regime was not discriminatory, but rather applied equally, because Section 280E disallows salaries not attributable to cost of goods sold whether or not the salaries are paid to the shareholder.

One of the harsh realities of operating a marijuana business is that Section 280E creates double taxation for owners who receive payments for services from marijuana companies.  It would seem the only way to avoid this is if the owner’s sole responsibility is activities related to the production of inventory. However, any officer/owner’s responsibilities are bound to include some sort of management and oversight.  While making an election to be taxed as a C corporation can minimize the cost of double taxation in this situation, it won’t eliminate it.

The Tax Court has shown little sympathy for marijuana companies when it comes to the harsh realities of Section 280E.  The court notes that the taxpayers can elect to be taxed as any type of entity and also elect to operate in any line of business.   Simply, in order to avoid double taxation caused by Section 280E, you are advised to operate a business not subject to Section 280E.

Yesterday, the Tax Court issued its opinion in Alterman v. Commissioner, T.C. Memo 2018-83.  This case involved the operation of a medical marijuana dispensary which was reported on Schedule C.  The opinion includes a long recitation of intricate accounting details that I will address on a summary basis so as to not lose readers other than accountants.  Readers interested in the details should read the opinion linked above.

The important facts are as follows:

  • The taxpayer sold marijuana and non-marijuana products.  The sales of non-marijuana products were 1.4% of gross receipts in 2010 and 3.5% of gross receipts in 2011.
  • On the tax returns, the taxpayer reduced gross receipts by cost of goods sold.  The taxpayer also deducted business expenses.  It does not appear based on the findings of fact that on the original return the taxpayer disallowed any expenses pursuant to Section 280E.
  • It appears the amount of cost of goods sold claimed on the return was, for the most part, amounts paid for purchases of inventory and did not include production costs.  At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory.

The court found:

  • The sales of non-marijuana products were complimentary to the sales of marijuana products and therefore, were not a separate trade or business.  Even if the non-marijuana product sales were a separate trade or business, the record did not give the court any basis for determining the expenses attributable to the secondary business of sales of non-marijuana products.
  • The court applied Section 471 to determine cost of goods sold.  Section 471 allows taxpayers to include direct and indirect production costs in cost of goods sold.
  • The amount of cost of goods sold conceded by the IRS, which does not appear to include production costs, was the allowable amount of cost of goods sold because the taxpayers failed to properly account for beginning and ending inventories.
  • The taxpayer was negligent and subject to the negligence penalty because they did not keep adequate records to compute beginning and ending inventories or adequate books and records.  Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.

Lessons and observations:

  • It is important that taxpayers subject to Section 280E use their best efforts to apply Section 280E when filing returns.
  • It is important that taxpayers subject to Section 280E properly classify costs as inventory costs when filing returns and maintain beginning and ending inventories with integrity.
  • It is important that taxpayers retain records needed to substantiate all accounting entries.
  • The substantiation issues are not unique to the marijuana industry.  However, due to high audit rates and the impact of Section 280E, the cost of the failure to substantiate is uniquely burdensome.  That being said, here, it is unclear how the failure to substantiate beginning and ending inventory also creates a restriction on the production costs that should be allowed.  Careful documentation and preparation of returns should overcome some of these burdens.

In Graev III, issued late last year, the Tax Court held that the Commissioner must comply with section 6751(b)(1) as part of his burden of production for tax penalties.  Section 6751(b)(1) requires that an initial penalty determination be approved in writing by the immediate supervisor of the individual making the determination.  As a result of Graev III, the Commissioner faces significant issues in penalty cases, as shown most recently by Becker v. Commissioner, a Judge Holmes decision released last week.

In Becker, a key issue was the fraud penalty under section 6663.  Section 6663 imposes a penalty on any underpayment of tax due to fraud equal to 75% of the underpayment.  The Commissioner determined that the taxpayer, Mr. Becker, was liable for the fraud penalty because he filed his tax returns with the intent to evade tax.  For the fraud penalty, the Commissioner must show by clear and convincing evidence that the taxpayer underpaid and that the underpayment was attributable to fraud.  A number of things can show fraudulent intent, including understating income, keeping inadequate records, failing to file tax returns, implausibly explaining behavior, and concealing assets.

Judge Holmes found that Mr. Becker almost certainly had fraudulent intent.  He consistently understated his income, took large deductions to zero out his returns, and failed to keep sufficient records.  Mr. Becker also provided implausible and inconsistent explanations for his behavior.  At trial, he said that his Schedules C were completely fabricated, but he told the IRS that his accountant told him to report what he reported.  Mr. Becker gave varying explanations for his lack of records as well.  Once he told the IRS that he would give it the documents it requested; later he said that the documents were destroyed by a hurricane.

The Tax Court would normally sustain the Commissioner’s fraud penalty determination on these facts.  But Graev III held that the Commissioner must comply with the section 6751(b)(1) written supervisory approval requirement as part of his burden of production for penalties.  In Becker, the Commissioner never raised section 6751 before or at trial – even though Mr. Becker put the penalties at issue.

As a result, Judge Holmes considered the consequences of failing to comply with Graev III.  Section 6751 is not a new Code section, and Graev III did not create new law.  It simply interpreted section 6751(b)(1).  The Tax Court treats Graev III’s construction of section 6751(b)(1) as the correct construction, even before Graev III was decided.  Thus, Judge Holmes held that Mr. Becker was not liable for the fraud penalty because the Commissioner failed to meet the section 6751(b)(1) supervisor approval requirement – even though Mr. Becker’s fraud was evident.

In Wendell Falls Development, LLC v. Commissioner, T.C. Memo. 2018-45, the Tax Court denied a charitable contribution deduction for a taxpayer’s contribution of a conservation easement because the taxpayer expected to receive a substantial benefit from the donation.

The taxpayer purchased 27 contiguous parcels of unimproved land, comprising 1,280 acres. The taxpayer planned to subdivide the 1,280 acres into a master-planned community with residential areas, commercial spaces, an elementary school, and a park. The taxpayer would then sell the lots to builders.

The taxpayer identified 125 acres of the 1,280 acres as land upon which a park would be placed. The taxpayer and the County discussed the County acquiring the 125 acres for use as a county park. The taxpayer sought to ensure that the 125 acres would be restricted to park use and proposed placing a conservation easement on the 125 acres. Ultimately, the taxpayer and the County entered into a purchase agreement for the 125 acres, and placing a conservation easement on the land was a precondition to the sale. The taxpayer granted a conservation easement on the 125 acres in favor of a land trust and transferred ownership of the 125 acres to the County. The taxpayer claimed a charitable deduction for its contribution of the conservation easement on its tax return.

The issue here is the “substantial benefits” test. No deduction for a charitable contribution is allowed if the taxpayer expects a substantial benefit from the contribution. The taxpayer owned and intended to sell the 1,280 acres of land adjoining the 125 acres that was designated as park land. The taxpayer’s master-planned community was designed so that all residential areas would have access to the 125-acre park.  According to the Court, the taxpayer expected a substantial benefit from the donation because it sought to ensure that the 125 acres was restricted to park use, and as the prospective seller of the lots the taxpayer “would benefit from the increased value to the lots from the park as an amenity.” Because the taxpayer expected a substantial benefit from the donation, the Court disallowed the charitable deduction. (Note: alternatively, the Court determined that the value of the easement was zero because the park land did not diminish the value of the 125 acres).

Recently, the written supervisory approval requirement of Section 6751(b) has been one of the primary issues in Tax Court litigation concerning penalties that the IRS has asserted against taxpayers. The focus of this litigation is the effect of Section 6751(b) and its interplay with the Commissioner’s burden of production as to penalties in court proceedings under Section 7491(c). In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Tax Court addressed these issues in a partnership-level proceeding.

Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…” (note that Section 6751(b)(2) provides certain exceptions to this general rule).

Section 7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”

Until the Chai and Graev III opinions, there had been little litigation over the effect of Section 6751(b).

In Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017), the taxpayer argued in his post-trial brief that compliance with the written-approval requirement in Section 6751(b)(1) is an element of the Commissioner’s claim for penalties and is therefore part of the Commissioner’s burden of production under Section 7491(c). The Second Circuit Court of Appeals agreed, holding that Section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty. Chai held that Section 6751(b) is part of the Commissioner’s burden or production in a deficiency case in which a penalty is asserted.

In Graev v. Commissioner (Graev III), 149 T.C. No. 23 (Dec. 20, 2017), the Tax Court held that the Commissioner’s burden of production under Section 7491(c) includes establishing compliance with the written supervisory approval requirement of Section 6751(b). Thus, in a deficiency case in which a penalty is asserted, it is the IRS’s burden to introduce sufficient evidence establishing compliance with the supervisor approval requirement.

In Dynamo Holdings, the Tax Court addressed the interplay between the supervisor approval requirement and the IRS’s burden of production in a partnership-level proceeding. The Court held that the IRS does not bear the burden of production with respect to penalties under Section 7491(c) in a partnership-level proceeding. The Court reasoned that Section 7491(c) provides that the IRS has the burden of production “with respect to the liability of any individual for any penalty…” Because partnership-level proceedings do not determine liabilities and are not with respect to individuals, the IRS does not bear the burden of production as to penalties. In a similar vein, the IRS does not bear the burden of production with respect to penalties asserted against corporations.

The Court further held that where the IRS does not bear the burden of production as to penalties, the lack of supervisory approval of penalties may be raised as a defense to those penalties. However, taxpayers should note that they must affirmatively argue that the IRS failed to comply with the supervisory approval requirements of Section 6751. Failure to make such an argument can be costly, as the taxpayer will be deemed to have waived the defense.

On May 30, the newly-formed Philadelphia Chapter of the Federal Bar Association’s Section on Taxation will host a meet-and-greet event with the Honorable Mark V. Holmes of the United States Tax Court. The event is free and open to all tax practitioners in the greater Philadelphia area. To RSVP for this event, please email events@foxrothschild.com.

Judge Holmes was appointed to the Tax Court by President George W. Bush in 2003, and was recently re-appointed for a second fifteen-year term. Judge Holmes is a prolific jurist known for delightfully colorful opinions that bring to life often dreary tax concepts. In recent years, he has authored numerous opinions addressing cutting edge tax issues, including his decision last year in Avrahami, the first judicial opinion to tackle the validity of micro-captive insurance arrangements. Judge Holmes also presided over the lengthy trial involving a dispute between the Internal Revenue Service and the estate of pop star Michael Jackson, and practitioners are eagerly awaiting his decision in this closely-watched case. In recent months, Judge Holmes has authored multiple opinions addressing the fallout from the Chai and Graev decisions, which held that IRS supervisory approval is required before penalties may be asserted, including decisions involving the aforementioned Jackson estate as well as pro football Hall of Famer Warren Sapp. In another case that is generating significant interest, Judge Holmes is set to rule on the application of Internal Revenue Code section 280E to a marijuana business in Patients Mutual Assistance Collective Corporation.

Established in February 2018, the Philadelphia Chapter is the newest chapter of the Federal Bar Association Section on Taxation. The Philadelphia Chapter is co-chaired by Matthew D. Lee of Fox Rothschild and Kevin M. Johnson of Baker Hostetler.

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United States v. Gerard, a recent case from the Northern District of Indiana, demonstrates how a tax lien, once attached, can stay with property even after the property is conveyed to someone other than the taxpayer.  In 1990, a husband and wife named Robert and Cynthia Gerard bought a residence as tenants by the entirety.  Although the Gerards bought the residence together, Robert paid at least 90% of the purchase price.  Between 2003 and 2008, Cynthia owned a business with outstanding employment and unemployment taxes.  The Gerards and the government generally agreed that the assessments for these tax liabilities attached to Cynthia’s interest in the property.  As time went on, Robert and Cynthia decided to convey the property solely to Robert.  The deed stated that the conveyance was “by way of gift and without any consideration other than for love and affection.”

The government, however, still wished to enforce the liens.  Litigation ensued, and the government moved for summary judgment.  The key issue was whether the liens that were attached to Cynthia’s interest in the property survived the severance of the tenancy by the entirety.  Section 6323 provides that a lien is not valid against a purchaser until the IRS files proper notice.  Thus, according to the court, Robert would not be liable for Cynthia’s outstanding tax balance if Robert was a “purchaser.”  A “purchaser” is “[a] person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is valid under local law against a subsequent purchaser without actual notice.”  IRC § 6323(h)(6).  “Adequate and full consideration in money or money’s worth” is “a consideration in money or money’s worth having a reasonable relationship to the true value of the interest in property acquired.”  Treas. Reg. § 301.6323(h)-1(f)(3).

The Gerards argued that Robert was a purchaser because Cynthia used marital assets to pay her business’s expenses and then transferred her interest in the property in repayment of those debts.  The government, however, pointed out that the deed specifically stated that the transfer was made “by way of gift and without any consideration other than for love and affection,” and that any consideration would have been past consideration, which was insufficient.

The court was not concerned that the deed stated that the property was a gift.  It noted that “[i]t is a well-known fact that often a conveyance recites a nominal consideration whereas the true consideration is not nominal.  It is therefore never certain that the recited consideration is the true consideration.”  Clark v. CSX Transp., Inc., 737 N.E.2d 752, 759 (Ind. Ct. App. 2000).  The court was, however, concerned with the fact that the parties agreed that the use of marital assets to pay Cynthia’s business expenses was “past consideration.”  Under the regulations, “adequate and full consideration” includes past consideration only if, “under local law, past consideration is sufficient to support an agreement giving rise to a security interest. . .”  Treas. Reg. § 301.6323(h)-1(a)(3); (f)(3).  Accordingly, the court turned to Indiana law to determine whether past consideration could create a security interest.

The Gerards could not cite any Indiana authority indicating that past consideration gives rise to a security interest.  Also, other federal courts hold that past consideration does not make a party a “purchaser” under section 6323(a).  See, e.g., United States v. Register, 727 F. Supp. 2d 517, 526 (E.D. Va. 2010).  Thus, the court concluded that Robert was not a purchaser under section 6323(a) and that the liens attached to Cynthia’s interest in the property survived the conveyance.

The parties still disputed the extent to which the liens attached to the property.  The government argued that the liens remained attached to a one-half interest in the property.  The Gerards, however, argued that Cynthia’s actual interest was worth less than one-half of the property when it was conveyed, so the liens only attached to something less than a one-half interest.  Here again, the court found that Indiana law did not support the Gerards’ argument.  For example, in Radabaugh v. Radabaugh, the court held that the trial court erred by “conclud[ing] that appellee was the owner of less than an undivided one-half interest in the mortgage loan” for real estate owned by a husband and wife as tenant by the entirety.  35 N.E.2d 114, 115-16 (Ind. Ct. App. 1941).  Thus, the court concluded that the liens were still attached to one-half of Robert’s interest in the property, even after the conveyance.

 

Earlier this week the United States Tax Court announced that Judge Maurice B. Foley has been elected Chief Judge to serve a two-year term beginning on June 1, 2018.

Judge Foley was appointed President William J. Clinton on April 9, 1995. He was reappointed by President Barack Obama on November 25, 2011, for a second term ending November 24, 2026. He received a bachelor of arts degree from Swarthmore College, a juris doctor from Boalt Hall School of Law at the University of California, Berkeley, and a master of laws in taxation from Georgetown University Law Center. Before his appointment to the Tax Court, he was an attorney for the Legislation and Regulations Division of the Internal Revenue Service, Tax Counsel for the United States Senate Committee on Finance, and Deputy Tax Legislative Counsel in the United States Treasury’s Office of Tax Policy. Judge Foley is an adjunct professor at American University Washington College of Law, the University of Colorado Law School, and the University of Baltimore School of Law.

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In Rajagopalan v. Commissioner, Judge Holmes confronted what he called the Chai ghoul.  See Rajagopalan v. Commissioner, Docket No. 21394-11, Order, Dec. 20, 2017.  In Chai v. Commissioner, the Second Circuit held that the section 6751(b)(1) written approval requirement “requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.”  Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), aff’g in part, rev’g in part 109 T.C.M. 1206.  The Tax Court agreed with the Second Circuit’s holding in Chai soon after it was released.  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017).

These decisions prompted the Commissioner to ask the court to reopen the record in Rajagopalan (and in a number of other cases) so that he could introduce penalty-approval forms to show he complied with section 6751(b)(1) for the 20% accuracy-related penalties.  Trial and briefing in Rajagopalan took place long before Chai and Graev, and the Commissioner did not introduce evidence that he complied with section 6751 at trial.

In support of his motion, the Commissioner submitted an IRS supervisor’s declaration to authenticate the penalty-approval forms and to show how the supervisor approved the penalty determination.  The forms also listed the applicable IRS examiner.  In her declaration, the supervisor stated that she was the examiner’s immediate supervisor and that she signed the forms approving the examiner’s penalty determination.

As a general rule, the Tax Court has broad discretion to reopen the record.  But its discretion is not unlimited.  The court will not reopen the record to admit evidence that is merely cumulative or impeaching.  Instead, the evidence must be material and likely to change the outcome of the case.  Butler v. Commissioner, 114 T.C. 276, 287 (2000), abrogated on other grounds by Porter v. Commissioner, 132 T.C. 203 (2009).  The court must also weigh the Commissioner’s diligence against the possibility of prejudice to the petitioners.  Prejudice here turns on whether the submission of evidence after trial prevents the petitioners from questioning the evidence as they could have during trial.

Judge Holmes found that the penalty-approval forms met the first requirement, and would have actually been admissible at trial under the business-records exception to the hearsay rule.  Judge Holmes was also unconvinced that the petitioners would be prejudiced by the court’s decision to reopen the record.  The petitioner’s main argument was that they should have been “entitled to question” the supervisor and examiner to confirm that the penalties “were properly asserted and whether [the Commissioner] complied with Code section 6751(b).”  But it was unclear how the petitioners would have benefited from cross-examination.  Judge Holmes pointed out that the penalty-approval forms either did or did not answer those questions, and would have been admitted under the business-records exception regardless.

As a result, Judge Holmes granted the Commissioner’s motion to reopen the record.  Despite the court’s decision to admit the penalty-approval forms, Chai continues to present the Commissioner with major challenges as he seeks to assert penalties in cases tried before Chai.