Originally Published on forbes.com on December 24th, 2011
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Sometimes the IRS and the Courts are wrong even when they are right. The taxpayers in these cases might have had the law against them, but I still think they had right on their side. I realize my sympathy is not worth anything to them, but they have it anyway as a Christmas present. I decided to leave it at 8 so as not to be compulsive about lists of 10.
1.Wholly Screwed by Whole Life – John M. Sanders v. Commissioner, TC Memo 2010-279
Mr. Sanders took out a whole life policy in 1979. He paid $31 per month for 27 years. Over the years he borrowed against the policy. Total borrowing was $7,136. New York Life informed him in 2006 that his debt on the policy including interest was $17,203 which was $517 more than the surrender value of the policy. If he did not pay $517, the policy would terminate. That is what happened.
He received a 1099-R from New York Life showing a distribution of $17,292. The taxable amount was $7,175. That is the gross distribution of $17,292 less premiums of $10,117. Mr. Sanders did not understand:
Petitioner testified that he disagrees with the taxable amount shown on the Form 1099-R because he “just did the math basically in my head” and he thinks New York Life’s “mathematics are way off.”
The Tax Court had no sympathy:
These vague contentions do not rise to the level of a “reasonable dispute” so as to impose any burden of production on respondent pursuant to section 6201(d). In any event, stipulated documentation of petitioner’s premium andloan history with New York Life corroborates the information reported on the Form 1099-R.
So what happened ? The mathematics that Mr. Sanders did in his head indicated that he received about $3,000 less than he put into the policy. The problem was that the interest that accumulated on the loan was non-deductible while the dividends on the policy, accumulating at a much lower rate, were taxable income when “paid”.
2. Even a Tax Attorney has Trouble Believing it – Bruce A. Brown, et ux. v. Com. TC Memo 2011-83
The Browns had basically the same story as Mr. Sanders except for larger numbers and the company being Northwestern. The Browns are both attorneys and Mrs. Brown has an LLM in taxation. They thought Northwestern analyzed the transaction incorrectly and ended up with an accuracy related penalty.
There were a couple of other cases like this. My friend, Perry Smith, thinks it is a fair deal, but I think it stinks. These policies were sold as a kind of one stop financial solution to all your problems. If, God forbid, you die young your heirs get a pile of money. If, God willing, you live to an old age you have a pile of money. And if you should have needs in between you can borrow something from the pile. They did not explain that option 3 allows you to generate phantom income from a tax favored vehicle.
3. Being a Landlord is not a Passive Activity Except in the Tax Law – Todd D. Bailey, Jr., et ux. v. Commissioner, TC Summary Opinion 2011-22
Rental activities are per se passive (losses not available to offset other income) unless you can establish that you are in a real estate trade or business. You need 750 hours and more time on the real estate than on anything else. People come up with some pretty lame stories trying to make this case but Mrs. Bailey seemed to have it nailed. She documented the time that she spent on the couple’s various properties (Her husband, Dr. Bailey, was occupied in the emergency room.) as follows:
The Inn on Alisal Road 324
The Second Street property 358
The existing Boise property 24
The new acquisition in Boise 105
Researching potential acquisitions 192
Grand total for all properties 1,003
The Second Street property 358
The existing Boise property 24
The new acquisition in Boise 105
Researching potential acquisitions 192
Grand total for all properties 1,003
The problem was that the Inn was an actual inn. The rentals averaged three days or less. Running that type of inn is not a real estate trade, so Mrs. Bailey only had 679 hours. So the losses on the other properties were suspended. I really thought that one was nasty.
4. Tax Court is not Divorce Court and VisaVersa – Michael F. Wesner v. Commissioner, TC Summary Opinion 2011-5
A non-custodial parent needs Form 8332 signed by the custodial parent in order to claim a dependency deduction. What if you do everything within your power to get the form and come up short:
Petitioner approached Ms. Tokar, the custodial parent, immediately after the entry of the court order and arranged an appointment with her to execute the Internal Revenue Service forms (tax forms) as ordered by the divorce court. Ms. Tokar did not appear at the appointed time and failed to execute the tax forms. After petitioner’s attempt to obtain Ms. Tokar’s signature failed, he sought enforcement of the court order by service of legal process but he did not know her mailing address. He requested Ms. Tokar’s address from the agency to which he made the support payments, and it refused to provide her address. Accordingly, at the time his 2007 income tax return was due, petitioner did not have the required consent form executed by Ms. Tokar; and his income tax return was filed without the form or any other documentation supporting his claim for the dependency exemption deduction.
After more than 6 months of trying to obtain Ms. Tokar’s address, petitioner hired a process server during August 2009 to find and serve her. By the time the matter came before the divorce court it was too late for Ms. Tokar to sign the tax forms.
Tough luck.
… petitioner does not meet the requirements of the statutory exception and is not entitled to claim the minor child as a dependent. This is so even though a State court with jurisdiction over the parties to a divorce proceeding ordered that petitioner was entitled to the dependency exemption deduction for 2007 and even though the custodial parent had been ordered but failed to execute the consent form required by the Federal statute. The consent form requirement is in absolute terms and is unambiguous.
… petitioner does not meet the requirements of the statutory exception and is not entitled to claim the minor child as a dependent. This is so even though a State court with jurisdiction over the parties to a divorce proceeding ordered that petitioner was entitled to the dependency exemption deduction for 2007 and even though the custodial parent had been ordered but failed to execute the consent form required by the Federal statute. The consent form requirement is in absolute terms and is unambiguous.
5. Most Powerful Force in the Universe ? – Beverly B. Bang v. Commissioner, TC Summary 2011-1
I was disappointed to find that Albert Einstein probably did not say that compound interest was the most powerful force in the universe. I don’t care. He should have said it and I bet that Beverly Bang certainly thinks so. Ms. Bang was involved in a tax shelter in 1983. It took a while to sort out:
The IRS didn’t like the partnership’s deductions which led to some litigation. It took a while. Finally Ms. Bang got a notice that she owed an additional $2,636 in tax for the year 1983. She paid it. She also paid a negligence penalty of $131.80 So what’s the big deal ? The big deal is that she didn’t think she should have to pay $21,553.52 in interest (That was figured at 120% of the regular rate) and a 50% of interest penalty bringing the total tab to $32,343.46. She didn’t think it was her fault that the IRS had taken over 20 years to settle this case and finally bill her.
This was a collection due process case with a lot of moving parts, but ultimately she got no relief from the Tax Court.
6. You Think 39.6% is Bad ? How About 131%? – Kevin L. Sherar, et ux. v. Com. TC Summary 2011-44
Linda Sherar was collecting workman’s compensation insurance. Her attorney advised her that she also qualified for Social Security disability payments. She applied for them. She received a check for $3,796.38. Not a lot of money, but if it was laying on the street I would bend over to pick it up. The reason that she didn’t get much in Social Security disability is because her benefit was offset by the workman’s compensation. Here is where it gets ugly. Workman’s compensation payments are excluded from income. Social Securitypayments are only partially excluded (85% included 15% excluded). The 85% is applied to the entire benefit including the portion that was offset by workman’s compensation. So when the IRS looked at this they increased Mrs. Sherar’s tax by $4,988.
The Tax Court admitted that she was getting a raw deal, but they gave her the raw deal anyway:
We acknowledge that Mrs. Sherar applied for Social Securitybenefits on the advice of counsel. We also acknowledge that if Mrs. Sherar had not applied for Social Security benefits, then her workers’ compensation benefits would not have been subject to Federal income tax. See secs. 104(a)(1), 86(d)(3). Under the circumstances we can appreciate petitioners’ dismay. Nevertheless, as the Supreme Court of the United States has instructed, we are duty bound to apply the law as written by Congress to the facts as they occurred and not as they might have occurred.
7. Somethimes it Really is a Church – Thomas Chambers v Com – TC Memo 2011-114
Thomas Chambers wanted to focus on foreign missions but a small group of people convinced him to be their minister. He then proceeded apparently naively and innocently to do just about everything that people who start phony churches do. Like taking title to property in “corporation sole”, which makes sense for Catholic archbishops, who have somebody who can remove them, but not for small congregations in non-hierarchical polities. The IRS phony church squad was all over him looking for 75% penalties, which is about as bad as it can get short of forfeiting your liberty. The Tax Court recognized that there was a real church there, so there were no penalties, but they could not save him from his poor record keeping. I used this case as a commercial for the Evangelical Council for Financial Accountability, which provides guidelines which would have saved Rev. Chambers from his IRS problems. The guidines make a lot of sense, even if you do not agree with the Council’s theology.
8. It Can Happen to Tax Attorneys – Thomas F. Liotti v. Com. TC Summary 2011-73
Attorney Liotti had a long running dispute with MBNA, which he finally settled agreeing to pay them $5,200. They accepted the $5,200 and then sent him a 1099-C for $11,974.65. He tried several arguments to avoid the debt discharge income, but to no avail:
Petitioner admits to making payments on the underlying obligation in his letters and never argues that he did not incur the charges on the account or that he did not owe the principal balance of the account. The interest charged to petitioner’s account is part of his debt obligation. ….. Petitioner’s challenge to the amount of interest he is charged does not rise to a contested liability.
I really did not understand where the Tax Court was coming from on this one. Mr. Liotti indicated that he had not received the 1099-C, but that was no help:
Petitioner is an attorney and a member of the Tax Court bar with legal acumen and a fundamental knowledge of legal research. The fact that petitioner did not know that there were tax ramifications associated with settling a debt for less than its face value does not negate his enjoyment of the economic benefit from the discharge of his debt.