Originally published on Forbes.com.
The business lesson contained in the Tax Court decision in the case of Cecile Barker is probably a variation of an old joke- How do you make a small fortune creating a record label? Start with a large fortune. – The tax lesson is an illustration of Reilly’s Sixteenth Law of Tax Planning – Being right without substantiation can be as bad as being wrong.
There is something else that does not come up as often. I am speculating, but I think in this case we find another example of the problems created by the narrow educational requirement to become an IRS revenue agent – a bachelor’s degree with thirty hours in accounting. As is not uncommon, the story behind the story is fundamentally more interesting, so I will start with that.
The Aerospace Entrepreneur
I have not been able to find out that much about Cecile Barker, but there is little question that there should be a movie made about him. Let’s pretend we are meeting him in 1999 in a story by Nick Wakeman about OAO Corp which Mr. Barker founded.
Last month, the privately held Greenbelt, Md., firm was selected to provide desktop services to more than 25,000 users at four NASA centers. That task order – part of NASA’s Outsourcing Desktop Initiative (ODIN) contract and potentially worth $500 million – comes just one year after it won a $200 million contract to provide similar services to 7,000 users at NASA’s Jet Propulsion Laboratory.
Those NASA wins are crown jewels that have made OAO very popular with companies on the prowl for acquisitions, said Cecile Barker, chief executive and founder of the company, which had about $196 million in revenue in 1997.
On OAO, we have a story in 2001 by Patience Wait
Lockheed Martin Corp. is buying OAO Corp., a move that will bring Lockheed Martin additional intelligence and NASA business and bolster its already formidable place in the government information technology market.
My fishing around including poking at the Lockheed 10-K did not get me to how much Lockheed paid or what Cecile Barker’s piece of it was, but it is reasonable to infer that it was, as we say, a number. So there you have the probable source of the large fortune.
Before Being An Aerospace Entrepreneur
Let’s fire up the wayback machine to the seventies with this story about Peaches and Herb where we find
Herb and Francine reconciled in ’75 for a one-shot single on the obscure BS label; the disco-flavored “(Hump and Bump) Down Where It’s At” was produced by Francine’s husband, Cecile Barker, with Dan Sayres and Tony Camillo, whose “Dynomite” (with studio band Bazuka) was hot at the time.
You can then go to the substantial discography of Cecile D. Barker thanks to his founding of Venture Records.
That’s an example, I wanted to embed one video and there are reasons, I won’t go into, why I won’t be doing any more current ones.
And Now
And now we have SoBe Entertainment, which is pretty substantial. Among the entertainers is YNIQ who also now serves as President. The handle is a shortened form of the first name of Yannique Barker, Cecile Barker’s son. He also was known as Stack$.
There is a pretty fascinating story involving Hulk Hogan, which is really beyond the scope of this piece except to note that Hulk Hogan was upset that his daughter, Brooke Hogan, had an offer from a “black billionaire guy” to back her music career, possibly to please his son. There are reports, which I won’t link to that the son was Stack$ and you can find if you look a Brooke Hogan video produced by SoBe.
Overall none of this is very edifying, but I note that Hulk Hogan, to the contrary notwithstanding, Mr. Barker does not appear on the Forbes list of billionaires. The revelation of Hulk Hogan’s remarks came about in some litigation that you can read about in Conspiracy: Peter Thiel, Hulk Hogan, Gawker, and the Anatomy of Intrigue by Ryan Holiday.
The point here is that Mr. Barker’s role as a big-time record producer has made him the subject of celebrity gossip however tangential. There is an interview on youtube in which Shack$ discusses his relationship with Brooke Hogan and identifies his father as a billionaire, but I will have to let you hunt that down yourself.
The amount of backing that Shack$ got from SoBe was germane to the Tax Court decision, because the IRS actually attacked Mr. Barker on hobby loss grounds. And that is where the culture gap might have been.
Hip Hop Is Serious Business
You probably know more about hip-hop, Shack$’s genre, than I do. Here is what wikipedia has to say about it:
Hip hop, or hip-hop, is a subculture and art movement developed in the Bronx in New York City during the late 1970s. The origins of the word are often disputed. It is also argued as to whether hip hop started in the South or West Bronx. While the term hip hop is often used to refer exclusively to hip hop music (also called rap), hip hop is characterized by nine elements, of which only four elements are considered essential to understand hip hop musically.
Personally I prefer the Clancy Brothers and the Wolfe Tones. We all have our roots. I really could have a little sympathy for somebody who had a hard time taking hip-hop seriously as business at first blush, but you really have to go further in the article.
According to the U.S. Department of State, hip hop is “now the center of a mega music and fashion industry around the world” that crosses social barriers and cuts across racial lines.
It reminds me when I was trying to explain to my partners why we should pursue the accounting work of a business that was promising to create the next World of Warcraft. I had to explain to them what an MMORPG was, which they found stupid, so they could not take the business seriously. Fortunately we did not land the account, but that is another story. We might note a similar phenomenon at work in the case of Susan Crile which I covered in a post titled Tax Court Judge Appreciates Art More Than Average Revenue Agent.
Judge Cary Douglas Pugh had no trouble dismissing the hobby loss argument.
Petitioner had prior business successes in the music industry—he founded Peaches & Herb and co-produced a Grammy-winning song for Gladys Knight & the Pips—and he ran successful defense contracting businesses, having helped to turn one of them around after several years without a profit. Petitioner leveraged his prior experience and contacts in the music industry as he prepared for SoBe’s formation and he ran SoBe in a businesslike manner, working there full time. He also devoted significant capital to make it a profitable business. While SoBe was not profitable from its founding in 2002 through 2011—nor, indeed, through the time of trial—petitioner testified that SoBe positioned itself well to make a profit by amassing a catalog of songs that it has been able to monetize. Petitioner also convincingly testified about the turmoil in the music industry and the difficulties faced by artists and producers over the years in issue.
The fact that petitioner’s son, Yannique, was one of SoBe’s signed artists and that SoBe had advanced him the costs of recording, producing, and promoting his music does not mean that SoBe was merely a vehicle to fund Yannique’s musical aspirations or that SoBe had no profit objective. SoBe had other artists; it did not devote most of its resources to Yannique. We also conclude that the other facts favoring characterization as a hobby, such as the fact that petitioner enjoyed [*18] the creative aspects of the music industry and had income from other sources and that SoBe had yet to make a profit as of trial, are outweighed by the facts indicating a profit motiiveThus, we conclude for years 2003 through 2011 that SoBe is a trade or business and is eligible to claim deductions
To be fair to the revenue agent, he or she may have been blinded by the total of almost $38 million in losses from 2003 to 2011.
The Sixteenth Law.
Mr. Barker was carrying a net operating loss of nearly $17 million into 2011, the year in question. IRS had determined a deficiency of $1,259,279 for 2011. Things were further complicated by his being an identity theft victim in 2011, but that was not the big problem. The big problem was substantiation and when it comes to a return with an NOL, that arises from a non-TEFRA partnership, that substantiation issue can go back pretty far.
Mr. Barker made $45 million in capital contributions to SoBe beginning in 2003 and, as noted above, had nearly $38 million in losses. The losses started in 2003. I picture myself in 2012 working on Mr. Barker’s 2011 return. At that point the 2003 return is what we call “old and cold”. It is conceivable that there was a big software change in there somewhere, maybe a conversion to paperless. There is also an indication that Mr. Barker switched accountants for one year. Maybe there is a record retention policy and 2003 material is on the eve of destruction. Those type of considerations are perilous when you are dealing with a net operating loss that, if you can forgive the military metaphor, has not been combat tested.
Petitioner has failed to substantiate SoBe’s income and business expenses for all prior years of existence and, in turn, the amount of losses for which he claimed a deduction for 2011; if we are not able to estimate the amount of SoBe’s operating losses, we cannot know how much flows through to petitioner.
Further, even if petitioner was able to substantiate SoBe’s business expenses, we cannot know how much of those losses was absorbed by petitioner’s other income in the years prior to 2011. Petitioner did not produce his tax returns for the years 2002 through 2004. And those that he produced for 2005, 2006, and 2007 are missing crucial information, such as the amount of loss that flowed through to him from SoBe, his NOL carryover from previous years, or whether he elected to waive the carryback period
That is the really important lesson for both tax professionals and clients who have substantial net operating losses . Each tax year stands on its own. The net operating loss in a particular year is not substantiated by picking it off the prior year return (If you have good software it will be waiting there for you after you “roll over” the previous year, an arcane process that is handled by my business and life partner). In Mr. Barker’s case, the number included deductions taken eight years in the past, that still required substantiation.
Another Nasty Hit By The IRS
Mr. Barker was also hit with a late file penalty which is related to the identity theft.
Petitioner filed his 2011 Form 1040 close to two years after the deadline. He explained that he did not file his return because he was the victim of identity theft and was under the impression that the IRS would have to resolve any conflicts relating to the identity theft. That does not excuse his failure to file his return when due. There is a personal and nondelegable duty to file a tax return by the due date. United States v. Boyle, 469 U.S. at 247. While being a victim of identity theft may have been inconvenient, he is a sophisticated businessman and should know that he is required to file his tax return on time. He engaged accountants and return preparers and could have made inquiries.
Frankly if he had “made inquiries” of me, I might have been stumped at least initially. Is an identity theft return actually a return that needs to be amended or is it a nullity? That is the sort of stuff that ends up with the Chief Counsel’s office.
Appeal Coming
I heard from Jeffrey Rubinger, who represented Mr. Barker in Tax Court.
My comment is the tax court got it wrong. The taxpayer more than met the burden of proof under section 7491 and produced credible evidence that the expenses should be deductible and result in valid NOLs. I just think the tax court was surprised by the size of the NOLs. The taxpayer is considering whether to appeal.He couldn’t produce every last shred of evidence which is what the tax court was requiring for these NOLs many of which were more than 15 years old.
SoBe Entertainment is a pretty sexy business, but what would have saved it, in this case, is a lot of pretty boring, meticulous record keeping. Once you grasp that the long carryover period of net operating losses means that as long as the NOL lives the returns are never old and cold, you keep all those shreds. No disrespect to the accountants involved. Accountants who claim this could never happen to them are either kidding themselves or lying. The proportions vary.
Other Coverage
By tax blogging standards this case is old and cold, but I give myself permission to consider ancient history, such as a mid May decision in July.
Thomson Reuters had – Taxpayer had profit motive for entertainment company but failed to substantiate losses.
I was surprised that Lew Taishoff did not cover the case. He wrote me:
Mr. Reilly, although there’s that celebrity angle, it’s just another non-substantiation case.
What I think makes this a little different from a standard non-substantiation case is the unusual level of substantiation that the Tax Court was requiring and the lesson about net operating losses.
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