In 2015, the U.S. Tax Court issued its ruling in the case of David W. Laudon v. Commissioner, TC Summary Option 2015-54 (2015). The case may not raise or even resolve any novel tax issues, but it reminds us of what is hopefully the obvious relative to the deductibility of business expenses. The Court’s opinion and its recitation of the underlying facts, however, make for an extremely interesting and entertaining read.
In March 2014, I reported on the all-out battle that was ensuing in the U.S. Tax Court between the IRS and the Estate of Michael Jackson over the value of the late pop singer’s estate. It began in 2013, when the estate petitioned the court, alleging that the Service’s assessment, based upon the assertion that the estate underreported its estate tax obligation by more than $500 million, was incorrect. In addition, the estate challenged the IRS’s additional assessment of almost $200 million in penalties. Keep in mind that although these numbers are staggering, they do not include the estate’s potential state of California estate tax obligations.
If Michael Jackson could instruct his estate lawyers about case strategy, I am sure he would be recounting the lyrics from his 1982 smash hit Beat It:
Just beat it, beat it, beat it, beat it
No one wants to be defeated
Showin’ how funky and strong is your fight
It doesn’t matter who’s wrong or right
Just beat it, beat it
Unfortunately, the case is not going the way Michael Jackson would have wanted it to go. Rather, victory appears to be nowhere in sight for either the taxpayer or the government.
It is now well over two years after the battle started. It continues to rage. Neither the IRS nor the estate is taking the tack from the title of the late pop singer’s 1991 hit song, Give In to Me.
In July 2014, the IRS added a little more pain to the estate’s already existing misery. It took a deeper look at the value of the estate’s ownership rights to the Jackson Five master recordings and the accrued royalties. As a result, the IRS increased the assessment by almost $29 million. Ouch! I am confident Michael Jackson would have responded to the IRS, quoting from his smash hit Leave Me Alone that appeared on the 1987 album Bad:
Leave me alone, stop it!
The IRS either isn’t hip enough to remember the late pop singer’s hit, Leave Me Alone, or it simply isn’t listening! Last week, it asked the court to add another $53 million in value to the estate.
The battle continues roaring strong. The IRS, in its quest to collect more taxes and penalties, appears to be leaving no stone unturned. I apologize in advance to my readers, but I have to quote Michael Jackson one more time; this time from his hit song Scream that appears on the 1995 album HIStory: Past, Present and Future, Book I:
Tired of injustice
Tired of the schemes
The lies are disgusting
So what does it mean
Kicking me down
I got to get up
As jacked as it sounds
The whole system sucks
Trial in this case is currently scheduled for February 2017. It continues to be interesting. Stay tuned! I will follow up if the case resolves or takes another interesting turn.
On May 11, 2015, after serving as Director of the Office of Professional Responsibility (“OPR”) for approximately six (6) years, Ms. Karen Hawkins announced her intention to step-down and retire, effective July 11, 2015.
The OPR is responsible for interpreting and applying the Treasury Regulations governing practice before the Internal Revenue Service (commonly known as “Circular 230”). It has exclusive responsibility for overseeing practitioner conduct and implementing discipline. For this purpose, practitioners include attorneys, certified public accountants, enrolled agents, enrolled actuaries, appraisers, and all other persons representing taxpayers before the Internal Revenue Service.
The vision of the OPR is “to be the standard-bearer for integrity in tax service.” As stated on OPR’s website, its “vision, mission, strategic goals and objectives support effective tax administration by ensuring all tax practitioners, tax preparers, and other third parties in the tax system adhere to professional standards and follow the law.” Its specific goals include: increasing tax advisor awareness and understanding of Circular 230; applying the principals of due process in all investigations and proceedings; and building, training and motivating its administrative team.
Ms. Hawkins will undoubtedly be missed by her work government colleagues. She will also be missed by the tax community. During her tenure at the OPR, she not only cleared the decks of a large backlog of pending disciplinary cases, she increased tax practitioner awareness and understanding of Circular 230. Ms. Hawkins consistently made herself available to the tax community, speaking at numerous tax institutes and forums (including the Oregon Tax Institute). In a direct, clear and concise manner, she reminded practitioners of their obligations under Circular 230. Ms. Hawkins did not shy away from tough questions raised by tax practitioner audiences. Instead, she hit the questions head on and provided complete and earnest answers. Ms. Hawkins was likely responsible, in whole or in part, for the amendments to Circular 230 that alleviated the need for tax advisors to insert the silly disclaimers on all written communications that may contain federal tax advice.
While I have to assume Ms. Hawkins was a tough adversary in any disciplinary proceeding, especially given her no-nonsense approach to matters, she gave good and well-needed guidance to the tax community following amendments to Circular 230. The tax community should be thankful for all of Ms. Hawkins’ hard work and her strong dedication to the tax profession. She will be greatly missed.
As of the writing of this blog post, the Commissioner of the Internal Revenue Service had not named a successor Director. I assume that Lee Martin, the Deputy Director, will serve as acting Director until a successor is named.
In accordance with ORS § 314.402, the Oregon Department of Revenue (“DOR”) shall impose a penalty on a taxpayer when it determines the taxpayer “substantially” understated taxable income for any taxable year. The penalty is 20% of the amount of tax resulting from the understated taxable income. ORS § 314.402(1). For this purpose, a “substantial” understatement of taxable income for any taxable year exists if it equals or exceeds $15,000. ORS § 314.402(2)(a). In the case of a corporation (excepting S corporations and personal holding companies), the threshold is increased to $25,000. ORS § 314.402(2)(b). As perplexing as it may be, these thresholds (established in 1987) are not indexed for inflation.
HOUSE BILL 2488
House Bill 2488 changes the penalty terrain in Oregon. It was unanimously passed by the Oregon House of Representatives on March 2, 2015. The bill made its way to the Oregon Senate where it was unanimously passed on April 8, 2015. The Governor signed House Bill 2488 into law on April 16, 2015. Although it becomes law on the 91st day following the end of the current legislative session, taxpayers and practitioners need to be aware, the new law applies to tax years beginning on or after January 1, 2015.
MECHANICS OF THE NEW LAW
House Bill 2488 changes the penalty regime from a penalty for a “substantial” understatement of taxable income to a penalty for a “substantial” understatement of net tax.
A “substantial” understatement of net tax occurs if there is an understatement of the tax due on or measured by net income that exceeds: (i) $2400 for personal income tax; and (ii) $3500 for corporate tax (other than S corporations and personal holding companies). If there is a “substantial” understatement of net tax, the penalty to be imposed is 20% of the underpayment of tax. Unlike the current law, the new law indexes the penalty for inflation.
REASONS FOR CHANGE
The concept of taxable income, for purposes of Oregon taxation, is based upon federal taxable income. Consequently, according to the DOR, taxpayers who file part-year resident returns may understate Oregon taxable income without being subjected to the penalty if federal taxable income is accurately reported. Basing the penalty trigger on the understatement of Oregon tax eliminates this loophole. This appears to be a simple “fix” to the perceived problem.
As stated above, while the new penalty becomes law in Oregon on the 91st day following the end of the current legislative session, it will apply to all tax years beginning on or after January 1, 2015. Lack of knowledge about this law change may create a trap for the unwary. Consequently, a good understanding of the new penalty regime is warranted.
For copy of enrolled House Bill 2488, please see link here.
Thomas v. Commissioner, TC Memo 2013-60 (February 26, 2013)
The saga of Michael and Julie Thomas started in the early part of this decade. Michael was the head of real estate acquisition for DBSI in Idaho. There, he met fellow DBSI employee Don Steeves, who was a CPA with seven (7) years of experience, primarily working in the real estate investment industry. When Michael started two real estate businesses, TIC Capital ("TIC") and TICC Property Management ("TICC"), he hired Steeves as an independent contractor to serve as CFO of TIC and as the managing partner of TICC. His compensation was incentive based—he received compensation which was based on the financial success of the two businesses. In good years, Steeves’ compensation was off the charts. In addition to acting as CFO for the two businesses, Steeves prepared Michael’s and Julie’s income tax returns. They relied upon him to oversee all aspects of accounting and tax compliance for both of the businesses and their personal affairs. They let him take total control of these functions.
TIC acquired real estate and then broke it into tenancy-in-common interests, and sold the interests to passive investors who were generally acquiring property through Section 1031 exchanges. In most cases, the acquisition and resale of the tenancy-in-common interests occurred simultaneously. After the properties were sold, TICC would manage the properties for the tenancy-in-common owners for a fee.
While the economy and the real estate markets were hot, both of the companies made significant profits. As we all know, the booming economy and real estate markets did not last forever.
In September 2007, Steeves resigned from the two businesses, but continued to perform bookkeeping work for both of the businesses, as well as for Michael and Julie, until about March 2008. He continued to prepare the Thomas’s tax returns until about 2009.
In late 2008, the IRS entered the picture. It audited the Thomas’s 2006 and 2007 income tax returns. Guess who appeared on IRS Form 2848 (Power of Attorney and Declaration of Representative) for the Thomas’s? You guessed correctly – CPA Don Steeves!
The IRS quickly learned the tax returns did not comport to the Thomas’s business records. Upon learning this, Mr. Thomas demanded CPA Steeves produce accounting records to support the entries he placed on their tax returns. Apparently, CPA Steeves did not comply with the Service’s request.
Mr. Thomas hired a CPA named Dave Stewart to take over the audit. Mr. Stewart, who had thirty-four (34) years of experience, quickly learned that CPA Steeves did a very poor job of maintaining the accounting records for Michael and Julie and likely misappropriated funds. He worked with the auditor and they ultimately agreed to a tax deficiency for both years under review.
Michael and Julie eventually turned the matter over to the Boise Police Department; they alleged CPA Steeves had committed theft, fraud, and misappropriation of their funds. Also, they sued Don Steeves in a civil suit for more than $1.2 million.
This case focused on the applicability of the Code Section 6662 accuracy-related penalty.
Under Code Section 6662(a), a taxpayer is liable for a 20% penalty on any under-payment of tax attributable to:
- negligence; or
- disregard of rules or regulations; or
- a substantial underpayment of a tax. For this purpose, a substantial underpayment of tax is an underpayment which is more than the greater of: 10% of the tax required to be shown; or $5,000.
There is a major exception to the application of this penalty. The penalty does not apply to any portion of an underpayment of tax if it is shown the underpayment was due to reasonable cause and the taxpayer acted in good faith.
In this case, Michael and Julie Thomas alleged they relied upon Don Steeves, an experienced tax advisor. They turned all accounting and tax matters over to him. Accordingly, they argued that they acted with reasonable cause and in good faith. They had no reason to believe that Mr. Steeves was other than competent and honest.
Reliance on the advice of a tax professional may establish reasonable cause and good faith. In accordance with Treasury Regulation Section 1.6664-4(b)(1), if a taxpayer relies upon the professional judgment of a competent tax advisor who has been provided all of the necessary and relevant information, the taxpayer will generally be cleared of an accuracy-related penalty.
To prove “reasonable reliance,” the taxpayer must jump over three hurdles:
Hurdle #1: The tax advisor must have sufficient experience or expertise to justify reliance;
Hurdle #2: The taxpayer must have provided the advisor with the necessary and accurate information; and
Hurdle #3: The taxpayer must have relied in good faith on the tax advisor’s guidance.
Here, Don Steeves was a CPA; he had 7 years of experience in the real estate industry. Mr. Thomas knew CPA Steeves from his work with DBSI. According to testimony at trial, Mr. Thomas provided Mr. Steeves with all documents and information he requested, including mortgage and interest records.
So, the court concluded Hurdle #1 and Hurdle #2 were met. Steeves had sufficient experience and expertise. Also, the taxpayers provided him with all of the information required to accurately prepare the tax returns. The ultimate question came down to whether the Thomas’s reliance upon CPA Steeves was in good faith.
In this case, Michael and Julie Thomas gave CPA Steeves their power of attorney at the outset of the audit. It was not until the IRS uncovered the numerous return problems that Mr. Thomas terminated Mr. Steeves, instituted a civil lawsuit against him, and went to the police so criminal action could be pursued. Before that, Michael and Julie believed in Don Steeves and they relied upon him.
Judge Gerber of the US Tax Court concluded that Michael and Julie Thomas met their burden and showed they had acted in good faith and with reasonable reliance on the advice of a professional tax advisor. Consequently, the Code Section 6662 penalty was tossed out.
This is a textbook case for applying the reasonable reliance defense to a Code Section 6662 penalty. The Tax Court clearly and thoughtfully reviewed the elements of the reliance defense. So, this decision should serve as a good textbook reference if you come across a case where the defense may be viable. The take-away is simple: The accuracy-related penalty does not apply to any portion of an underpayment of tax where the taxpayer acted with reasonable cause and in good faith. A reasonable cause determination takes into account all of the relevant facts and circumstances. The taxpayer claiming reliance on a tax professional must prove that:
- The tax adviser was a competent professional who had sufficient expertise to justify reliance;
- The taxpayer provided necessary and accurate information to the tax adviser; and
- The taxpayer actually relied in good faith on the tax adviser’s judgment.
IRC § 6656(a) provides, in the case of any failure to timely deposit employment taxes, unless the failure is due to “reasonable cause and not due to willful neglect,” a penalty shall be imposed. The penalty is a percentage of the amount of underpayment.
- 2% for failures of five (5) days or less;
- 5% for failures of more than five (5) days, but less than 15 days;
- 10% for failures of more than 15 days; and
- 15% for failures beyond the earlier of: (i) 10 days after receipt of the first delinquency notice under IRC § 6303; or (ii) the day on which notice and demand is made under IRC §§ 6861, 6862 or 6331(a)(last sentence)(jeopardy assessment).
In addition to the “reasonable cause” exception contained in IRC § 6656(a), there are two other means by which taxpayers may avoid the imposition of the penalty.
1. Secretary has authority under IRC § 6656(c) to waive the penalty if:
- The failure is inadvertent;
- The return was timely filed;
- The failure was the taxpayer’s first deposit obligation or the first deposit obligation after it was require to change the frequency of deposits; and
- The taxpayer meets the requirements of IRC § 7430(c)(4)(A)(ii) [submits a request within 30 days and comes within certain net worth parameters].
2. The Secretary has authority under IRC § 6656(d) to waive the penalty if:
- The taxpayer is a first time depositor; and
- The amount required to be deposited was inadvertently sent to the Secretary instead of the appropriate government depository.
As the exceptions are limited in application, most taxpayers seeking abatement of the penalty are required to pursue the “reasonable cause” exception.
The Estate of Michael Jackson is battling it out with the IRS in a dispute over the value of the late pop star’s estate. To borrow the titles from two of Michael Jackson’s hit songs, the Service is alleging the estate is “Bad” in that it substantially understated the value of the decedent’s assets, while the estate is telling the Service that it is wrong and it should simply “Beat It.”
What is the battle about? The answer is simple: Lots of money! The Service asserts the understatement results in the estate owing taxes of over $500 million more than actually reported on the estate’s tax return, plus almost $200 million in penalties. If the Service is correct, the State of California will likely have its hand out, asking the estate for a significant amount of additional taxes, plus penalties.
According to the petition filed by the estate in the United States Tax Court, representatives of the estate placed a date of death value on the decedent’s property at a little over $7 million. The IRS, on the other hand, asserts the value was closer to $1.125 billion dollars. If the Service is correct, the estate was undervalued by more than 160 times.
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
- "A Good Look At The Limitations to Code Section 1031 and Other Possible Deferral Alternatives," OSCPA 2021 Annual Real Estate ConferenceVirtual Event, 6.9.21
- To be rescheduled