In the case of John D. Moore, et al. v. Commissioner, TC Memo 2013-249 (October 30, 2013), the US Tax Court was presented with the saga of John Moore.
Mr. Moore was a CPA. He left the world of public accounting to embark on a career in a new industry. In 1992, he became the Operations Manager of the Dallas, Texas Peterbilt truck distributor. By 1995, Mr. Moore had climbed the corporate ladder and was appointed president of the company.
In 1992, the company granted Mr. Moore an option, good through December 31, 1999, to purchase five percent (5%) of the shares of the company, an S corporation. In 1997, the company merged with another company. As a result of the merger, Mr. Gary Baker entered the picture. Mr. Baker ended up with 1,477,859 shares of the merged entity. On December 30, 1999, Mr. Moore entered into an agreement to purchase all of Mr. Baker’s shares for $5,842,606. The next day, on December 31, 1999, Mr. Moore timely exercised his option and purchased 500,000 shares of the company for $212,334.
As part of the purchase of the Baker shares, Mr. Moore signed a promissory note for the full purchase price of an amount just shy of $6,000,000. It was all due and payable on May 5, 2000. After signing the note, however, the parties revised it so that $3,000,000 would be due on June 14, 2000, and the balance would be paid in three equal annual installments.
Moore had the corporation make the payments on the note to Mr. Baker. He claimed the corporation was lending him the money pursuant to some sort of line of credit arrangement. Interestingly, a promissory note existed which evidenced the loan arrangement, but it was not executed until sixty (60) days after the corporation had already made the payments to Mr. Baker.
In 2002, Mr. Moore, who had not paid a dime on the loan, sued the corporation to rescind the loan. He argued that he entered into the stock purchase agreement with Mr. Baker at the insistence of the corporation and that the shares had been way overvalued by the corporation.
The lawsuit was a heated battle, but the parties eventually managed to settle the case. They agreed:
- The corporation had already advanced Moore $5,357,582 on the line of credit;
- Mr. Moore owes $571,706 of accrued interest;
- Mr. Moore had repaid zero on the loan;
- The true value of the shares at purchase was really $1,000,000 (not $5,842,606); and
- The loan amount shall be reduced to $1,000,000, and the interest shall be adjusted accordingly.
It is interesting to note that Mr. Baker was not a party to the lawsuit. He did not agree to reduce the current amount owing, nor did he agree to return any of the amounts already paid. In fact, Mr. Baker ended up receiving all $5,842,606, plus interest.
In 2005, Moore sold his shares for $3,000,000. BDO Seidman CPA Catherine Fox reported a capital loss of about $1,500,000 from the sale of shares on Mr. Moore’s tax return. She claimed Moore’s stock basis was around $4,500,000.
The Service, on audit, disagreed with Ms. Fox and Mr. Moore. It claimed Mr. Moore’s basis in the stock was actually $1,000,000. So, rather than generating a capital loss of $1,500,000, the transaction had actually generated a capital gain for Moore of around $2,000,000. In addition, the Service assessed a Section 6662 accuracy-related penalty. Together, the tax and penalty amounted to almost $1,000,000.
The parties lawyered up and went off to tax court. Judge Thornton heard the case.
Mr. Moore’s position was that his cost basis in the shares was about $6,000,000, namely, the $5,842,606 that Baker was paid and the $212,334 he had paid for his option shares.
The Service’s position was that the Mr. Moore’s basis in the shares was only $1,000,000 as that was the amount he actually owed the corporation on the line of credit loan. The Service totally ignored the consideration Moore paid for the option shares of $212,334.
If Baker did not reduce the purchase price and return the proceeds over $1,000,000 back to the corporation, why didn’t Moore have cancellation of indebtedness income? I guess this issue was not examined by the court as the parties agreed as part of the civil litigation resolution that the true value of the shares was $1,000,000. This is an interesting conclusion because the seller, Mr. Baker, was not a party to that litigation. Nevertheless, the court ignored that issue.
If Moore didn’t have cancellation of indebtedness income, why should he get to add the amount (almost $5,000,000) he didn’t have to repay on the loan to the corporation? It sure seems logical that he should not get to get the benefit of the reduction in the loan debt since he did not have COD income.
Judge Thornton agreed with me. You can’t have your cake and eat it too. In other words, you cannot have a basis in an amount greater than $5,000,000 when your true economic outlay was only $1,212,334, without COD income for the amount written down on the loan.
The court concluded:
- The amount paid for the option shares must be included in the Taxpayer’s stock basis;
- There was no COD income because the debt amount between the corporation and the Taxpayer was in dispute;
- Moore’s basis in his shares was not north of $5,000,000; rather, it was $1,212,334, which represents the amount paid for the option shares and the $1,000,000 owed to the corporation.
- Relative to the Section 6662 penalty assessment, since Moore relied in good faith upon a professional tax advisor, BDO Seidman, Judge Thornton threw out the penalty assessment.
Strange case; probably the correct outcome!
In Peter Knappe v. U.S., 713 F3d 1164 (9th Cir., April 4, 2013), the United States Court of Appeals for the Ninth Circuit was presented with the question whether reliance upon a tax professional may excuse the late filing of a tax return.
Peter Knappe was the personal representative of the Estate of Ingborg Pattee. He was also trustee of her testamentary trust.
Mrs. Pattee died in 2005, leaving a large estate. Mr. Knappe was her long-time friend. Although he had business experience, Mr. Knappe had no experience serving as a personal representative or preparing estate tax returns. So, he engaged the services of Mr. Francis Burns, CPA. Burns had been his company’s outside accountant for several years. Mr. Knapp was always satisfied with his work.
Burns told Knappe that a Form 706 for the estate of would need to be filed by August 30, 2006. Knappe had trouble obtaining the needed appraisals on or before the filing deadline. Burns advised Knappe that he could obtain an extension of one (1) year for both the filing and the payment of the taxes due.
Burns filed a Form 4786, seeking both an extension for filing and for payment of the taxes due. The extension sought was one year.
As we know, the filing extension, unless the personal representative is out of the country, is only six (6) months. The payment extension, however, in the discretion of the Service, may be up to one year. Burns, however, believed both extensions were automatically one (1) year. OOPS!
Given this belief, upon receipt of the extension acknowledgment from the Service, Burns did not examine it carefully. He thought he received the requested one (1) year extension for both filing and payment of taxes. The extension, however, actually provided a new filing date of February 28, 2007, and a new payment date of August 30, 2007.
Burns filed the 706 on May 18, 2007, and enclosed a check in payment of the tax shown due. A few weeks later, Burns received a notice from the IRS that the estate owed a late payment penalty of about $200,000. The penalty assessed is 5% per month, up to a maximum of 25%.
In response to the notice, Burns actually pulled the Code and Regulations off his bookshelf. Once he dusted off the cobwebs, and reviewed the Code, he realized he made an error. Nevertheless, the taxpayer asked the Service to abate the penalty under Section 6651 for reasonable cause. The taxpayer argued his reliance on CPA Burns constituted reasonable cause for the late filing. The IRS denied the request. So, Knappe paid the penalty and filed a claim for a refund with the Service. Upon denial of the claim for refund, he sued in District Court.
Unfortunately, the District Court ruled summarily in favor of the Service. Knappe then appealed to the Ninth Circuit. The court concluded: “To constitute reasonable cause, a taxpayer must prove he or she exercised ordinary business care and prudence, and was nevertheless unable to file the return” on time.
Of course, Knappe argued his reliance on the advice of Mr. Burns constituted ordinary business care and prudence. It was clear that Mr. Burns did not know that a Form 706 filing extension is limited to six (6) months. So the question was: Did Knappe’s reliance on Burns’s bad advice constitute “reasonable cause”?
The court broke reliance into two categories:
1. reliance on substantive advice; and
2. reliance on non-substantive advice.
For substantive advice, reliance upon a tax professional may constitute reasonable cause. For non-substantive advice, however, the court concluded that reliance upon a tax professional will not save the day. The court ultimately concluded the Form 706 due date is not a substantive tax issue. The law is clear—there is no debate!
Accordingly, reliance upon a tax professional will not save the day in the context of a tax filing deadline. The $200,000 late filing penalty was upheld. OUCH!
The United States Sixth Circuit Court of Appeals was actually presented earlier this year with the “$64,000 Question.” In Robert W. Stocker, II and Laurel A. Stocker v. U.S., 111 AFTR 2d 2013-556 (705 F3d 225) (6th Cir., January 17, 2013), the court examined what sort of evidence a taxpayer must introduce in order to support the timely filing of a tax return in which a $64,000 refund was claimed.
In this case, Bob and Laurel Stocker filed an amended 2003 return, seeking a $64,000 refund. The Service denied the claim on the ground that they did not file the return within the 3-year statutory period.
The Stockers filed suit in District Court. The court quickly dismissed the case for lack of subject matter jurisdiction—the Stockers could not establish the jurisdictional prerequisite of timely filing the return by methods recognized by the Service or the courts.
The taxpayers argued that testimony and circumstantial evidence may support the timely filing requirement. Mr. Stocker and his office manager, Karrin Fennell, testified that the return was timely deposited at a United States post office, postage prepaid. They forgot, however, to attach the registered mail customer return receipt. The taxpayers were, however, able to produce evidence that the Department of Revenue timely received the amended return. So, they argued the IRS must have likewise received the federal return on time. Unfortunately, the IRS’ records showed the return was postmarked 4 days after its due date.
The court surveyed the law to determine when a return is deemed filed. There are two basic ways to establish when a return is filed under Section 7502:
- the date of the US postmark; or
- for registered mail, the date stamped on the registration.
In this case, because the return was not filed by registered mail, and because the physical postmark showed that it was 4 days late, the taxpayer lost its $64,000 refund.
The moral to the story is: File all returns or tax reporting filings by registered mail, return receipt. It is that simple!
Thank you for your support and friendship. I wish you a wonderful holiday season and terrific 2014.
Earlier this year, the First Circuit United States Court of Appeals issued its decision in United States v. Albania Deleon, 704 F.3d 189 (1st Cir., January 11, 2013). This case illustrates that worker misclassification may, in addition to the imposition of taxes and civil penalties, lead to criminal sanctions, including imprisonment.
Albania Deleon owned and operated two businesses: an asbestos abatement training school (“ECT”) and a temporary employment agency (“MSI”). This case focuses on Ms. Deleon and MSI. MSI supplied temporary workers to asbestos abatement contractors.
MSI maintained two separate payrolls for its workforce. One payroll reported a minority of the workers as employees, proper withholding of payroll and income taxes was done, and Form W-2s were issued to the employees. MSI reported in writing to both its customers (including governmental entities) and the occupational safety division of local government that it was responsible for and was complying with all employee withholding tax obligations.
The second payroll, which encompassed most of MSI’s workers, treated the workers as independent contractors—no withholding was done. Rather, IRS Form 1099s were issued to the workers. MSI told its accountants that these workers were independent contractors. Evidence in the trial record indicated Ms. Deleon had absolutely no factual basis for that conclusion.
In late 2006, as a result of an anonymous tip to the government that MSI was violating immigration laws and was involved in fraudulent payroll activity, state and federal investigators raided the offices of both companies. Based upon the information gathered in the raid, including computer records, the IRS concluded MSI had fraudulently avoided paying over $1,000,000 in payroll taxes.
Ms. Deleon, owner of both companies, was charged with several counts of:
1. mail fraud;
2. making false tax returns;
3. procuring false tax returns; and
4. conspiracy to violate multiple federal criminal laws.
After an eleven-day trial, Ms. Deleon was convicted on all counts. She is now serving 87 months in federal prison.
Ms. Deleon had no basis for her characterization of a majority of the workers as independent contractors. She simply reported them as independent contractors to reduce her tax liability. She told her customers and the government she was properly treating the workers as employees. Worker misclassification cost her 87 months behind bars.
This case illustrates worker misclassification can lead to more than simply a tax liability and civil penalties. If you are interested in reading more about worker classification, please click on the links below:
In the circumstance where substantially all of the assets of a closely-held C corporation are being sold, the shareholder of the seller may desire to receive part of the purchase price directly from the buyer for his or her personal goodwill. The result is beneficial to both the buyer and the selling shareholder. The buyer gets to amortize the amount paid for the goodwill ratably over fifteen (15) years, and the shareholder enjoys two tax advantages, namely he or she gets capital gain treatment on the amount received for the goodwill and he or she avoids the corporate level tax. This approach works provided certain facts exist:
- The selling shareholder has created personal goodwill;
- The selling shareholder has the ability to take the personal goodwill with him or her to another company and has the ability to compete with the corporation;
- There is no contractual arrangement limiting the selling shareholder’s ability to use the personal goodwill in the pursuit of work for a business competitor or the ability to sell it to a business competitor; and
- The amount of the sale proceeds allocated to the personal goodwill is reasonable.
The leading cases on personal goodwill include: Martin Ice Cream v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissioner, 76 TCM 208 (1998). Commentators often refer to these cases as foundational in this area of tax law.
In 2011, it appeared using personal goodwill as an asset in the sale of a business may have been curtailed a bit. In Howard v. US, 108 AFTR.2d 2011-5993 (Ninth Cir., August 29, 2011), affg 106 AFTR.2d 2010-5533 (DC Wash., July 30, 2010), the court was presented with a case involving a dentist from Spokane, Washington. Dr. Howard began practicing dentistry in 1972. In 1980, he incorporated his dental practice and it remained a C corporation for its duration. Dr. Howard was the only shareholder, director and officer of the corporation. His attorney prepared, along with the basic incorporation documents, an employment agreement between Dr. Howard and the corporation. In that agreement, it provided that Dr. Howard could not, during his employment with the corporation and for a period of three (3) years thereafter, compete with it in the practice of dentistry.
Twenty-two (22) years later, Dr. Howard decided to sell the assets of the corporation. Once he learned about the tax consequences of selling the assets of a C corporation, his accountant likely suggested an allocation of some of the purchase price to personal goodwill would be beneficial. It appears that nobody remembered the non-competition provision contained in the employment agreement or considered that it may have an impact on the sale of personal goodwill. The purchase price for the business assets was $613,000. It was allocated as follows:
$549,900 Personal Goodwill
$ 16,000 Dr. Howard’s Non-Compete Covenant
$ 47,100 The Assets of the Corporation
On audit, the Service re-characterized the amount allocated to personal goodwill as corporate goodwill. Consequently, the corporation had income from the sale of the goodwill, and Dr. Howard had dividend income resulting from the distribution of the sale proceeds he received from the corporation. Dr. Howard paid the deficiency, and filed a claim with the IRS for refund. When his claim for refund proved to be unsuccessful, he sued for refund in the Federal District Court for the Eastern District of Washington. Dr. Howard argued that the purchase and sale agreement was dispositive of the issue – the parties, acting at arms length, allocated $549,900 of the sale proceeds to personal goodwill. The Service, of course, responded by displaying for the judge’s eyes the non-competition provision that was contained in Dr. Howard’s employment agreement, and argued it voided the parties attempt to buy and sell personal goodwill.
Dr. Howard then got quite creative. He asserted that, as the sole shareholder, officer and director of the corporation, he terminated the non-competition provision by entering into the purchase and sale agreement. Good try! The astute attorney for the government pointed out that, even if Dr. Howard’s assertion was correct, termination of the non-competition provision did not change the character of the goodwill generated for the twenty-two (22) years before the termination – it was and still is corporate goodwill.
Larry J. Brant
Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationNew York, NY, 10.24.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.14.19
- "The Oregon Corporate Activity Tax," Oregon Society of Certified Public Accountants (OSCPA) 2020 OSCPA State & Local Tax ConferencePortland, OR, 1.6.20
- "The Road Between Subchapter C and Subchapter S – It May Be A Well-Traveled Two-Way Thoroughfare, But It Isn’t Free of Potholes and Obstacles," The J. Nelson Young Tax InstituteChapel Hill, NC, 4.23.2020-4.24.2020