Of Thongs and Sheet Music – 10 Lamest Taxpayer Arguments of 2011

I find that it is much more fun reading tax cases if I root for somebody.  Usually I root for the taxpayer unless they are being lame. Here are the cases in 2011, where I was glad the IRS won or in one case, that of Todd Dagres, sorry that the taxpayer won.

Anietra Y. Hamper is a TV anchorwoman.  She had developed a theory about deducting her clothing expenditures:

Apparently, and unfortunately for Ms. Hampers case, TV anchorwomen are required to dress like, well, CPAs :

Work clothing suitable for ordinary wear is just not deductible.  Even if her theory had merit, though, inquiring minds still wanted to know how it related to cotton bikini underpants and thongs.  Reports of the case went viral.  It definitely qualifies as the funniest decision in 2011.

This was a scheme cooked up by some attorney to avoid SE tax.

I thought it was a great touch that the attorneys did not introduce their own partnership agreement into evidence.

The basic idea is that Dr. Robucci’s return from his psychiatric practice consisted of two elements.  One was from the value of the goodwill of his practice and the other was from the work that he did.  The structure segregated the two elements .

Regardless of the execution issues, I think the plan was fundamentally flawed.  It is based on the premise that 85% of the net income of a singledoctor psychiatric practice is attributable to the goodwill.  We had an acronym we used to use for notions such as this.  It was RFD which stood for “Reeee – diculous”. (Many of our acronyms contained a silent F). As my own admittedly fairly limited exposure doing tax consulting for mental healthprofessionals and this story in the New YorkTimes indicates psychiatry is fairly labor intensive and given the educational qualifications not all that lucrative.  There is very little opportunity for leveraging the work of others, which is critical for a return on the goodwill of a professional practice.  It might be that Mr. Carson (Dr. Robucci’s CPA) could have plausibly made the argument about his own firm, which had 3,500 clients, but I doubt that there is a single physician medical practice of any type, where it would be reasonable.  Unlike CPAs psychiatrists cannot subdivide their deliverables into pieces some of which can be provided by other psychiatrists or para-professionals who are paid somewhere between 30 to 40 per cent of what they are billed out for. Outsourcing portions of the work to India would probably be impossible as opposed to just a bad idea.

I felt bad for Dr. Robucci as he relied on his CPA but got hit with penalties anyway.

4. Having Your Cake and Eating it Too – Todd A. Dagres, et ux. v. Commissioner, 136 T.C. No. 12 .

Mr. Dagres, being a venture capitalist, had a pretty good salary $2,640,198. That is, of course, chump change compared to his capital gains of $40,579,41.  The capital gain was not mainly from his own investing.  It was the “profits interest” or “carry” from being a managing member of a venture capital partnership.  He loaned $5,000,000 to a business associate, who in addition to paying AFR would provide him leads on profitable investments. Apparently the business associate was not himself such a great investor as he was unable to pay the interest on the loan.  Ultimately it was settled with Mr. Dagres taking a loss of $3,635,218 on the transaction.  His position was that it was a business bad debt. The IRS said it was a non business bad debt, which would give rise to a capital loss.  Alternatively they argued that if it was a business bad debt it was related to his business of being an employee of a venture capital firm, which would subject it to the 2% floor and make it non deductible for AMT.

OK, Mr. Dagres, you are being allocated the partnership’s long term capital gain (the partnership being an investor), but when you see an ordinary loss opportunity, all of a sudden it’s business income.  Just for purposes of characterizing the deduction, mind you.  We used to have a saying at Joseph B. Cohan and Associates – “Pigs get fed.  Hogs get slaughtered”.  The same sentiment was expressed in the phrase – “Don’t be a khazzer !” Still the Tax Court bought it and the IRS is not going to appeal.

It looks to me like the Tax Court is letting the venture capitalists have their cake and eat it too.  The partnership gets investor treatment which is attributed to the manager, but the manager is allowed trade or business treatment for purposes of taking a deduction. What is really interesting is that a former treasury official thinks this decision gives the IRS a basis to convert capital gains from carried interests to ordinary income.  I ran with that thought in a series of posts and have concluded that the Obama administration’s attack on “carried interest” is phony.

Mr. Aniyka was an engineer who wanted to claim real estate professional status.  He was aware that he needed to spend 750 hours on his real estate activities, but was unaware that he needed to spend more time on the real estate than on anything else.

It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.

6. We Pay Oursleves More Because We Can – Mulcahy, Pauritsch, Salvador and Co., LTD. v. Commissioner TC Memo 2011-74

This was a group of CPAs who got way too clever with their entities.

The founders (or in my terms – the big guys) owned 78% of the firm (MPS) and the other three partners (little guys) owned 22%.  The big guys weren’t content to just set their own salaries and decide how the remaining crumbs would be allocated among the little guys. For some reason not entirely clear from the record they paid some of what would have been their comp to various entities:

The case doesn’t tell us what the big guys were up to.  The deferral is pretty apparent and maybe multiple use of corporate graduated rates.   Of course it is not inconceivable that they were doing it all just for the hell of it. Whatever, they were trying to accomplish, though, I think it turned out not to be worth it.  The IRS disallowed the deductions for fees paid to the three other entities

The IRS argument is very simple. The entities didn’t perform any services.  Only the IRS can argue “substance over form”.  The taxpayer got to choose the form and is stuck with it.  You can’t now say that the payments were really to the big guys, themselves, rather than the entities.  It seems like the Court is neither agreeing or disagreeing with that position. Instead it is saying that it doesn’t matter because the payments have not been established to be reasonable compensation to the big guys.  So much of the discussion is what you would find in a reasonable compensation case.

They then wheeled out their most powerful argument.  The actual salaries that the big guys took were not that much more, possibly even less, than what the little guys and even some of the non-shareholders were making.  It is a fundamental law of nature that the big guys are supposed to be making a lot more, because, well, they are the big guys.  Apparently the judge wasn’t aware of that fundamental principle:

Nonetheless, the case would be much less disturbing if the Court had just gone with the IRS theory. The entities did not do anything and that’s who you paid instead of yourselves.  Instead the court accepted, arguendo, that the payments might be compensation to the “big guys” and did a reasonable compensation analysis, which is very disturbing.  The IRS may use this decision as a weapon against personal service C corporations.  Whatever you think you are getting out of remaining a C corporation may no longer be worth it in light of this case

IM sold sheet music to the public.  It purchased the sheet music from HRI. IM was on the accrual basis of accounting.  From 1998 to 2003 it recorded over $800,000 in cost of sales for sheet music that it purchased from   HRI. Both companies were S corporations with identical shareholders.

HRI did not do a very good job of collecting its receivables.  During the six year period it collected exactly nothing from IM. It should come as no surprise that HRI was on the cash basis of accounting.  The IRS finally caught up with this when they audited 2004.  They disallowed any cost of sales for 2004 under Section 267 which limits accruals to related parties who are not themselves on the accrual basis.

The statute of limitations was closed on years prior to 2004.  So the service took the position that the accruals had constituted an impermissibleaccounting method.  This required a cumulative adjustment for all the accruals hitting the couple with just shy of $300,000 in tax and $60,000 in penalties for the 2004 year.

The Plaintiff, NobleRoderick Colebrook–El, alleges that Defendants, Internal Revenue Service’s (“IRS”) and its agents, Debra Hurst and Beth Jones’s, attempt to collect his federal tax debt violated his Constitutional rights, the Moroccan Treaty, and several other Acts of Congress. The factual allegations contained in the Complaint, titled “Affidavit and Petition and Injunction and Order of Protection,” are at times indiscernible and largely irrelevant to the issues in this case. Plaintiff appears to allege that the IRS, a federal “corporate” agency, lacks the requisite statutory authority to collect taxes from him due to his status as a United States citizen who is a Moor of Cherokee descent. Plaintiff owes $19,566.36 in unpaid taxes. Plaintiff seeks to enjoin the IRS from collecting the taxes owed, to have any and all levies lifted, and to be reimbursed for all court costs associated with this action.  

It’s always interesting to learn something new.  I thought that this protester was totally off the wall claiming tax exemption as a “Moor of Cherokee descent”.  Silly me.  There is actually is such a group of people.  They are descendants of African Americans held as slaves by the Cherokees.  There is a fairly recent controversy about whether members of the group should be considered tribal members.  Here is something on that.  So this guy is no further off the wall than most protesters and sheds some light on a neglected area of American history.  He still has to pay taxes, though.

This was one of a group of easement cases I wrote about.  In valuing a conservation easement, one approach is to conceive a hypothetical development and then subtract the hypothetical costs of the development and the fair market value of the property in its current use as a cow pasture or whatever.  To conceive a hypothetical development you have to use some imagination, but you really should not use too much:

This was actually a fourth amendment case.  CID had assessed Harry Stonehill based on information handed to them on a “silver platter” by Philippine officials who had conducted a search that turned out to be illegal under Philippine law.  The exclusionary rule does not apply if no US officials are involved in the illegal search.  Representatives of Stonehill’s estate claimed to have uncovered new evidence that there was US involvement in the search and was seeking to overturn the assessments.  The lame part of the case is that the assessments are of taxes for the years 1958 through 1960 and the search took place in 1962.  It has been unsuccessfully challenged in litigation in 1967, 1968 and 1983.  Harry Stonehill’s story is quite colorful.  He was a good friend of Marvel Comics Stan Lee.

You can follow me on twitter @peterreillycpa.