Tax Court

The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.

The petitioner had been collecting coins as far back as 1958.  The problem was that the petitioner did not keep records to establish the basis in any of his coins.  In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal.  PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal.  The petitioner earned $37,000 from almost 400 separate transactions in 2013.  But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.

When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency.  The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties.  At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013.  The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs.  The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.

The court then turned to the cost of goods sold issue.  Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records.  If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.

Here, the Tax Court (and the petitioner) relied on the Cohan decision.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics.  Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.

The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation.  On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”  The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.

The petitioner in Huzella did not have any records to establish his cost or bases in the coins.  He purchased some coins and inherited others.  But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000.  Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).

In a case of first impression, the Tax Court held that the U.S.–Canada Tax Treaty (Treaty) did not exempt a Canadian citizen from U.S. income tax on the unemployment compensation she received from the State of Ohio. Pei Fang Guo v. Commissioner, 149 T.C. No. 14. The taxpayer came to the U.S. in 2010 as a post-doctoral fellow at the University of Cincinnati. She worked at UC from 2010 through 2011 on a nonimmigrant professional visa. When her employment contract ended in November 2011, she returned to Canada after she was unable to find other work in the U.S., where she stayed through 2012. When her UC employment contract ended, the taxpayer applied to the State of Ohio for unemployment compensation, which she received in 2012. When the taxpayer filed her 2012 U.S. tax return, she took the position that her unemployment compensation was exemption from income tax under Article XV of the Treaty. Instead, she reported the unemployment compensation on her Canadian tax return. The IRS disagreed, and the taxpayer filed a petition in Tax Court.

Tax Court SealThe Tax Court said that the taxpayer was a nonresident alien in 2012, which means she was neither a U.S. citizen nor resident. Generally, nonresident aliens must pay U.S. tax on their U.S.–source income. Everyone agreed that the taxpayer’s unemployment compensation was U.S.–source income. As a result, the only question left for the Tax Court to decide was whether the taxpayer’s unemployment compensation was exempt from U.S. income tax under the Treaty. But the Treaty does not mention unemployment compensation, except to say it does not count as social security.

The taxpayer focused her argument on the term “remunerations” in Article XV of the Treaty. Article XV governs the treatment of “salaries, wages, and other similar remunerations derived . . . in respect of an employment.” But the Treaty does not define “remunerations” either, so the Tax Court turned to the Code. “Remuneration” appears twice in the Code. Section 3401(a) says that “the term ‘wages’ means all remunerations . . . for services performed by an employee for his employer,” and section 3121(b) says that the “term ‘wages’ means all remuneration for employment.”

The Tax Court held that, just as unemployment compensation is not the same thing as “wages,” unemployment compensation does not constitute “similar remuneration derived. . . in respect to employment” under Article XV. The taxpayer wasn’t employed by UC when she received her unemployment compensation. And she did not receive it from her former employer.  She received it from the State of Ohio. As a result, the Tax Court concluded she was required to pay U.S. taxes on her unemployment compensation.

The Tax Court’s recent decision in Linde v. Commissioner, T.C. Memo. 2017-180, brought good news to taxpayers working outside the United States. In Linde, the Tax Court held that Linde, who worked for a government contractor in Iraq, could exclude the income he earned in Iraq under the foreign earned income exclusion of section 911. Linde served in the military for almost 25 years as helicopter pilot and instructor. After he retired from the military, he began working for a government contractor called DynCorp in Iraq flying government officials around the country. Linde’s work schedule in Iraq was strenuous. He worked 60 to 90 days straight before getting 30 days off. During his 30 day breaks, DynCorp required Linde to leave Iraq. Linde lived in Iraq for 248 days in 2010, 240 days in 2011, and 249 days in 2012. He spent his breaks with his wife and children at their home in Alabama. He kept his vehicles, voter registration, and driver’s license in Alabama too. On his return, Linde claimed he could exclude the income he earned in Iraq between 2010 and 2012 under the foreign earned income exclusion of section 911. The IRS disagreed.

Tax CourtSection 61 says that gross income includes “all income from whatever source derived.” United States citizens must pay tax on their income – even income earned outside the United States – unless there is a specific exclusion. Section 911(a) provides just such an exclusion. It allows a “qualified individual” to exclude from gross income his foreign earned income (subject to annual limitations). To be eligible, a taxpayer must meet two requirements. First, his “tax home” must be in a foreign country. Second, he must be either (1) a “bona fide resident” of a foreign country or countries for an uninterrupted period which includes an entire taxable year or (2) be physically present in one or more foreign countries for at least 330 days during a 12-month period. Linde agreed that he did not meet this physical presence test, so to win, he had to show that his tax home was in Iraq and he was a bona fide resident there during the years at issue.

A taxpayer’s “tax home” is generally his principal place of employment. For Linde, that was Iraq.  The concept of a “tax home” can become murky though. A taxpayer cannot have a tax home in a foreign country if his “abode” is in the United States. To determine Linde’s “abode”, the Tax Court compared his ties to the United States to his ties to Iraq, and found that his ties to Iraq were stronger. He spent two-thirds of each year there; he opened a bank account and accepted a promotion there. He used his free time to make improvements to his living quarters and visit local markets and restaurants. The IRS focused on the fact that Linde owned a home in Alabama and visited his family there. But the Tax Court pointed out that Linde did not have the same opportunities to be a pilot in the United States as he did in Iraq because of his age. It also noted that Linde would have wanted his family to meet him in Europe, but his son-in-law – an Army veteran who was seriously injured fighting in Iraq – made traveling overseas difficult for Linde’s family. That was enough, and the Tax Court held that Linde’s abode was not in the United States, and that his tax home was in Iraq.

As for the second requirement – whether Linde was a bona fide resident of Iraq – the Tax Court focused on the fact that Linde planned to stay in Iraq indefinitely (in fact, he was still working in Iraq when the trial rolled around). He spent two-thirds of each year there; he left during his breaks because DynCorp required him to leave. The court did not buy the IRS’ argument that Linde’s employment was not indefinite because he only signed one-year contracts. Linde’s contracts were routinely renewed and the expectation was that he would stay indefinitely. The IRS also thought it was important that Linde did not plan to retire in Iraq. But the Tax Court was satisfied because Linde did not plan to retire soon. That means Linde was a bona fide resident of Iraq, and he could exclude the income he earned there.