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.

The Tax Court’s recent opinion in Roth v. Commissioner, T.C. Memo. 2017-248, raises interesting issues about the need for supervisor approval when the IRS asserts penalties.  In 2007, the petitioners in Roth donated a conservation easement encumbering 40 acres of land in Colorado to a charitable organization.  The petitioners claimed a charitable contribution deduction of $970,000, but the IRS disallowed the deduction.

On examination, the IRS determined that the petitioners improperly valued the conservation easement and that the easement was actually worthless.  The examiner also determined that the petitioners were liable for a 40% gross valuation misstatement penalty under section 6662, and his determination was approved in writing by his immediate supervisor.  The examiner determined that the petitioners were alternatively liable for a 20% accuracy-related penalty.

The petitioners submitted a protest letter to IRS Appeals.  The parties did not reach an agreement, however, and Appeals ultimately issued a notice of deficiency.  In a closing memorandum, the Appeals officer informed the petitioners that “[t]he proposed penalties are fully sustained for the government.”  The closing memorandum was signed by the Appeals officer’s immediate supervisor.

The notice of deficiency omitted the 40% penalty and included only the 20% accuracy-related penalty.  The petitioners then filed a petition in Tax Court.  In its answer – which was signed by an IRS senior counsel and her immediate supervisor – the IRS asserted the 40% penalty.

The parties eventually settled the case.  They agreed that the petitioners were entitled to a charitable contribution deduction of $30,000 and that the petitioners had reasonable cause for the value of the conservation easement.  As a result, the IRS conceded that the petitioners were not liable for a 20% accuracy-related penalty.

The difference between the settlement value of $30,000 and the claimed value of $970,000, however, met the gross valuation misstatement test under section 6662(h).  Unlike for the 20% accuracy-related penalty, taxpayers cannot claim reasonable cause to avoid liability for the 40% penalty.  So the petitioners tried another escape route – they argued that the 40% penalty was inappropriate because the IRS failed to comply with the procedural requirements of section 6751(b).

Section 6751(b)(1) states 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 or such higher level official as the Secretary may designate.”  Complying with this requirement is part of the IRS’ burden of production under section 7491(c).  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016).

The petitioners argued that “initial determination” means the issuance of the notice of deficiency.  Although written approval for the 40% penalty was obtained before the notice of deficiency was issued, the petitioners argued that the Appeals officer made the “initial determination,” not the examiner.  As a result, the petitioners argued that, because the Appeals officer did not receive approval from his immediate supervisor before issuing the notice of deficiency, the IRS did not comply with section 6751(b) and could not assess the penalty.

The court observed that this issue was controlled by its decision in Graev and Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), vacating and remanding in part, aff’g in part, and rev’g in part T.C. Memo. 2015-42.  The court held that each time the IRS sought to assert penalties, the individual proposing the penalties received approval from his or her immediate supervisor.  The examiner who proposed the 40% penalty received written approval from his group manager.  The Appeals officer received written approval from his team manager.  The senior counsel who filed the IRS’ answer received written approval from her associate area counsel, which was demonstrated by the associate area counsel’s signature on the answer.

The Tax Court held that regardless of which of these instances was the initial determination of the 40% penalty, section 6751(b) was satisfied because each instance was approved in writing by an immediate supervisor.  Thus, the court concluded that the IRS complied with section 6751(b) and found the petitioners liable for the 40% penalty.

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.