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.
On April 4, 2014, the Chief Counsel’s Office issued Chief Counsel Advice 201414017 (CCA). The CCA offers guidance on this topic. Unfortunately, the guidance reflects the Service’s position that the “reasonable cause” exception under IRC § 6656(a) is narrow.
In the CCA, the taxpayer was subjected to a IRC § 6656(a) penalty when it failed to timely deposit employment taxes as the result of some of its employees exercising nonqualified stock options. The taxpayer claimed “reasonable cause” existed because its failure to timely deposit employment taxes was the error of its third-party payroll service. The taxpayer bolstered its position with two important facts.
- Its deposits had always been timely filed in the past; and
- The taxpayer immediately remedied the failure upon learning of it and
instituted procedures to avoid future repetition of the failure.
The Service commended the taxpayer for its historic compliance and its prompt remedial efforts. It concluded, however, that “[t]hese actions may amount to the exercise of ordinary business care that the reasonable cause defense requires and to the absence of willful neglect. The reasonable cause defense, however, also requires the taxpayer to demonstrate that despite its exercise of ordinary business care and prudence, it was ‘rendered unable to meet its responsibilities.’” The General Counsel’s Office ultimately concluded the taxpayer was liable for the penalty. It stated that the taxpayer’s reliance on its third-party payroll service provider is insufficient to obtain a penalty waiver as the reliance did not render it unable to otherwise meet its responsibilities.
Next, the General Counsel’s Office looked at whether the taxpayer could raise the first-time depositor defense under IRC § 6656(c) on examination rather than be required to wait until an assessment has been issued. It concluded, on the basis of administrative efficiency, the defense may be raised by the taxpayer on audit and the examiner should grant the request when appropriate.
The moral to the story is two-fold. First, the “reasonable cause” exception may be difficult to obtain. Whether it exists requires a facts and circumstances analysis. The burden of proof is on the taxpayer.
Reliance on third parties alone is generally insufficient. Likewise, failures due to mistake, ignorance of the laws or forgetfulness will not carry the day. Also, a taxpayer’s financial problems alone will generally not constitute “reasonable cause.”
The “reasonable cause” exception is narrow. Failures resulting from matters totally outside the taxpayer’s control appear to be required in order to obtain this penalty waiver. Examples of qualifying “reasonable cause” likely include situations where an otherwise compliant taxpayer, with adequate payroll procedures in place, encounters a natural disaster (e.g., fire, flood, storm), rendering it unable to process payroll and make the required deposits in a timely manner. Other examples of “reasonable cause” may include: (i) the death or serious illness of the taxpayer or the taxpayer’s immediate family; (ii) inability of the taxpayer to obtain necessary records due to no fault of the taxpayer; or (iii) embezzlement by the bookkeeper when and only when the taxpayer has reasonable protections in place.*
Second, taxpayers should raise the first time depositor defense, if applicable, on audit. The examiner should be able to accept the defense if the taxpayer qualifies. As confirmed by General Counsel’s Office, taxpayers are not required to wait for an actual assessment before raising this defense.
The courts presented with the “reasonable cause” exception to the imposition of a penalty under IRC § 6656(a) have taken varying positions—some more taxpayer friendly than others. The Service, however, is clearly taking a narrow view of the exception, leading to less taxpayer friendly results. Caution is advised.
*Reliance on a bookkeeper who embezzled funds from the taxpayer was not reasonable cause because the taxpayer did not have adequate checks and balances in place to prevent the embezzlement. Leprino Foods Co. v. U.S., 85 AFTR 2d 2000-1729 (D. Colo. 2000). Financial difficulties when adequate funds existed, but the taxpayer decided to use the funds for other things, trumped a reasonable cause defense. Van Camp & Bennion, P.S. v. U.S., 251 F.3d 862 (9th Cir. 2001). Failure of the bookkeeper delegated the responsibility of making deposits does not constitute reasonable cause when the bookkeeper was supervised by the owners of taxpayer and the outside CPA. Janet Nesse v. IRS, 93AFTR 2d 2004-1022 (DC MD 2004).
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.
Estates are not often subjected to a substantial valuation understatement penalty. The reason is obvious. The Code is very generous in this regard. The understatement of value must be significant for a penalty to apply. First, a penalty cannot be triggered unless the underpayment of tax exceeds $5,000. Next, there must be a “substantial understatement of value” for a penalty to apply. IRC § 6662(g)(1) provides a substantial estate tax valuation understatement occurs if the value of property on the return is 65% or less of the correct value. Pursuant to IRC § 6662(a), the resulting penalty is 20% of the tax underpayment. If, however, the value of the property on the return is 40% or less of the correct value, the penalty is increased to 40% of the tax underpayment. IRC § 6662(h)(2)(C).
So, the threshold for a penalty of this nature is high. The resulting tax must exceed $5,000 and the understatement of value itself must be more than 35%. In cases where the understatement of value is more than 60%, the penalty doubles. Consequently, in this case, if the Service’s values are correct, the 40% penalty is applicable.
The bulk of the Service’s fight with Michael Jackson’s estate appears to center around the value of Michael Jackson’s image, the estate’s intellectual property rights to certain songs, including some of the Beatles song catalog which Michael Jackson acquired prior to his death, and an interest in a trust. The estate valued the image at a little over two thousand dollars, while the Service’s experts put the value at over $434 million. The estate valued the estate’s interest in the musical collection at zero. The IRS, on the other hand, valued this asset at around $469 million. Last, the estate valued its interest in the trust at around $2 million, but the Service asserts its actual value is closer to $61 million.
Other items in dispute include: (a) stocks and bonds which the Service values at $64.4 million more than the estate reported on the return; (b) Jackson 5 master recordings which the Service values at over $34 million more than the estate reported on the return; and (c) three Rolls Royces and a Bentley which the Service values at about $160,000 more than the estate reported on the return.
This will be an interesting case for at least two reasons: (1) the valuation issues, including valuation of a person’s likeness, are interesting and will result in a battle of the experts; and (2) application of the 40% valuation understatement penalty is not terribly common.
Stay tuned! The decision of the U.S. Tax Court will likely be an interesting read.
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 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