Federal Income Tax Update
By This is the second of three installments of this article.
I. Contemporaneous Written Acknowledgment Rules for Charitable Contributions of Aircraft and Vehicles; Izen vs. Commissioner (5th Cir. 2022).
Mr. Izen donated a 50% interest in an aircraft to a charitable organization. The Fifth Circuit Court of Appeals upheld the earlier decision of the Tax Court denying any charitable contribution deduction because the purported contemporaneous written acknowledgment (“CWA”) letter failed the strict requirements of Section 170(f)(8)(B). There are specific substantiation requirements when the subject of the gift is a vehicle or an airplane with a value in excess of $500. Under Section 170(f)(12)(B), the CWA from the donee organization must include the name and taxpayer identification number of the donor.
The donee provided Mr. Izen with an acknowledgment letter. However, the letter was addressed to a Mr. Tangey rather than Mr. Izen. The letter never mentioned Mr. Izen and did not provide his taxpayer identification number. Mr. Izen included, with his federal tax return, the donation agreement between himself, Mr. Tangey, and the charitable organization. However, it did not include Mr. Izen’s name and taxpayer identification number. Mr. Izen included with his tax return Form 8283 signed by the charity, but it did not include his Social Security number.
The court also noted the Form 8283 failed the contemporaneous requirement. Under Section 170(f)(12)(C), an acknowledgement of a donation of a vehicle or an aircraft is contemporaneous only if it is provided by the donee organization within thirty days after the date of the contribution. In the instant case, the Form 8283 was not signed until long after the donation date.
II. Defective Contemporaneous Written Acknowledgment Dooms Charitable Contribution Deduction; Albrecht v. Commissioner, TC Memo 2022-53.
Martha Albrecht donated a large collection of native American jewelry to a museum. There was no CWA that specifically stated whether she received any goods or services in exchange for her gift. The deed of gift did not address the issue. The silence in the CWA was fatal. The court ruled a document that is silent about whether any goods or services were received by the taxpayer is by definition defective.
Further, the deed of gift contained strange language that Mrs. Albrecht had transferred “all rights, title and interest held by the donor included in the donation, unless otherwise stated in the Gift Agreement.” There actually was no other gift agreement. Thus, the CWA inaccurately referred to a document that did not exist. If the gift agreement had existed, it could have conveyed something from the museum to Mrs. Albrecht.
III. Another Failed CWA; Keefer vs. US, 130 AFTR 2d 2022-5406.
Mr. and Mrs. Keefer donated an interest in a limited partnership to a donor advised fund. The District Court disallowed any charitable contribution deductions because the CWA the Keefers received from the donor advised fund was defective. One of the problems with the CWA was it was issued before the donation occurred. The CWA was issued to Mr. and Mrs. Keefer merely in anticipation of their donation.
The court also considered whether the donation was subject to the assignment of income doctrine. When the donation was made, the partnership, called Burbank, was in discussions with a REIT about the sale of Burbank’s hotel to the REIT. The donation occurred while negotiations were ongoing, but before Burbank signed a letter of intent with the REIT. Under the anticipatory assignment of income doctrine, a charitable donation is recast as a sale by the taxpayer-donor, followed by a charitable contribution of the sales proceeds.
The court held the donation did not necessarily violate the anticipatory assignment of income doctrine. The partnership’s right to income from the hotel sale had not yet vested when Mr. and Mrs. Keefer assigned their interest to the donor advised fund even though there was a 95% chance of the sale ultimately closing when the donation was made.
However, when the Keefers gifted their partnership interest to the donor advised fund, the gift was subject to an oral agreement that the donor-partners were retaining the right to cash reserves held by the partnership. Therefore, the donor-partners retained a partial interest in the donated asset. That caused the assignment of income doctrine to apply to the entire donation since the whole asset was not transferred to the donor advised fund. See Dickinson v. Comm’r, 2020 WL 5239242.
IV. Tax Court Reduces Deductible Compensation under the Reasonable Compensation Test; Clary Hood, Inc. v. Commissioner, TC Memo 2022-15.
Clary Hood, Inc. employed its founder and primary shareholder, Mr. Hood, as its chief executive officer. Hood, Inc. was a C corporation. The case involved the amount of reasonable compensation the Hood, Inc. could deduct for 2015 and 2016.
Mr. Hood ran Hood, Inc. starting in 1980. The company grew into a large and successful construction company operating out of South Carolina. By the end of 2016, the company had 150 employees and over $70 million in annual revenue. During 2015 and 2016, Mr. Hood received $168,000 and $196,000 of base salary and a $5 million bonus each year. There was no written employment agreement between Mr. Hood and his company. Instead, Mr. Hood’s compensation was set by the board of directors, which was Mr. Hood and his wife. The Hoods used an outside CPA firm, Elliott Davis, as to the appropriate compensation to be paid Mr. Hood for 2015. In the fall of 2014, Mr. Hood asked his accountants to consider whether he should be issued a bonus in 2015 to account for his having been undercompensated in prior years.
The IRS substantially reduced Mr. Hood’s deductible compensation for 2015 and 2016. It also imposed accuracy related penalties under Section 6662 and the substantial understatement penalty under Section 6662(a) and (b)(2).
The Tax Court noted the Fourth Circuit Court of Appeals (in which South Carolina is located) had always applied the multi-factor approach when making a reasonable compensation determination. The Fourth Circuit has never adopted any iteration of the independent investor test used by other courts, such as in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999). The multi-factor test looks at the following factors: the employee’s qualifications; the nature, extent and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions and comparable concerns; and the salary policy of the taxpayer as to all employees.
The court recognized Mr. Hood was the “epitome of the American success story.” The court stated the IRS should not be able to substitute its own business judgment for that of the taxpayer in setting the appropriate amount of an employee’s compensation. However, it was up to the court to determine the amount of compensation that may be deducted for Federal income tax purposes. The court found there were a number of the factors supporting the compensation paid to Mr. Hood, including (a) Mr. Hood’s background and qualifications; (b) the nature and extent of Mr. Hood’s work; and (c) the size and complexity of the company’s business.
Compensation vs. Net Income. The court compared Mr. Hood’s compensation to the income earned by his company. The court noted it is more important to consider compensation as a percentage of net income than a percentage of gross receipts because net income is usually a better gauge of whether a corporation is disguising the distribution of dividends. For 2015 and 2016, the company paid Mr. Hood compensation equal to 42% and 26% of its pre-tax net income. The court found those percentages did not demonstrate an egregious pattern of disguised dividends.
Prevailing General Economic Conditions. The court also looked at the prevailing economic conditions of the company and the construction industry in general. This factor helps determine whether the success of a business is attributable to the efforts and business acumen of the employee as opposed to general economic conditions. Between 2013 and 2016, the company’s revenue jumped from $16 million to over $68 million, which was a trend that could not be credited only to economic conditions. The company had down years with the construction industry but continued to thrive and survive. That demonstrated the importance of Mr. Hood to the company even during economically turbulent years.
Dividend History. The court next looked at dividend history. Hood, Inc. had never paid a cash dividend to its shareholders.
Expert Testimony about Compensation Comparables. The company offered the testimony of Mr. Kursh of BLDS, LLC, an economic consulting firm. The court criticized the BLDS report for lacking supporting calculations and for failing to include underlying data, which prevented the court from being able to verify Mr. Kursh’s findings. Therefore, the court gave little to no weight to Mr. Kursh’s testimony.
Theodore Sharp, a senior partner at the management consulting firm of Korn Ferry, testified although he reviewed and agreed with the Korn Ferry report, he did not write it himself. The Korn Ferry report consisted of only a dozen or so Power Point slides in bullet point format. The court was unimpressed.
David Fuller, who founded Value, Inc., testified for the IRS. The court was very impressed with the thoroughness of his testimony. The court determined Mr. Fuller’s report was the most credible and complete source of data, analysis and conclusions as to what similar companies might be willing to pay Mr. Hood for his services.
Company’s Compensation and Salary Policies. Hood, Inc. had no structured compensation system for establishing non-shareholder compensation. The company did not have any compensation agreement with Mr. Hood. Instead, Mr. Hood’s compensation was simply established by the board of directors, which was comprised of himself and his wife
Catch-Up Compensation. The court next looked at the company’s argument that its 2015 and 2016 bonuses were designed to provide Mr. Hood with catch-up compensation. The court noted Mr. Hood’s compensation increased over 300% in 2015, but his duties and responsibilities did not increase correspondingly. Although Mr. Hood was likely undercompensated in past years, his undercompensation did not allow the company complete latitude in deducting his back-pay bonus. The company did not demonstrate how the full amount of 2015 and 2016 compensation was proportionate to purported past services rendered by Mr. Hood.
The court held the company had not adequately established how the amounts paid to Mr. Hood in 2015 and 2016 were both reasonable and paid solely as compensation for his services. While there were certain factors in the company’s favor, the court did not simply rule in favor of the side with the most factors in its favor, since all factors are not given equal weight.
Court Reduces Deductible Compensation. Based on Mr. Fuller’s testimony on behalf of the IRS, the court reduced Mr. Hood’s deductible compensation to around $3.7 million for 2015 and just under $1.4 million for 2016.
Penalties. The court next addressed whether the 20% substantial understatement penalty under Section 6662(a) and (b)(2) applied. Since the taxpayer was a C corporation, the understatements were deemed substantial because the understatement succeeded 10% of the tax required to be shown on the return. The company asserted it had reasonable cause and a good faith defense for the imposition of penalties under Section 6664(c)(1).
As to 2015, the court stated since the company had sought advice from its accounting firm as to potential compensation and applicable tax consequences, Mr. Hood had reasonable cause for his position on his 2015 return. However, for 2016, the court found that neither the testimony of Mr. Hood nor of his expert witnesses supported the amount of compensation. The court determined the company failed to establish reasonable basis for its positions for 2016.
The company argued it had substantial authority for its position that negates the substantial understatement penalty. The substantial authority test is met where there is about a 40% chance of success. Canal Corp. vs. Commissioner, 135 TC 199 (2010). The company contended it had substantial authority for setting Mr. Hood’s compensation based on the independent investor test adopted by the Seventh Circuit Court of Appeals in Exacto Spring. However, only the Seventh Circuit has adopted the independent investor test as the exclusive test. In the Fourth Circuit, courts have applied the multi-factor approach without considering the hypothetical investor test. Since no Fourth Circuit cases support the independent investor test, no substantial authority existed for the company’s position for 2016.
V. Another Disguised Dividend Case; Aspro, Inc. v. Commissioner, 32 F.4th 673 (4th Circuit 2022).
Aspro was a paving company that claimed tax deductions for management fees paid to its shareholder employees. There were no written employment or managerial services agreements nor any evidence how Aspro determined the amount of management fees paid to the owners. Also, the shareholders did not bill Aspro or send it invoices for purported management services.
The Eighth Circuit upheld the Tax Court’s decision that the management fees were not purely for services rendered but were instead disguised dividends. Aspro had never paid any dividends. All management fees were paid roughly in proportion to the ownership interests of the stockholders.
The Court of Appeals agreed with the earlier Tax Court’s decision to exclude certain expert testimony submitted by Aspro. The court held the witnesses could not provide admissible expert testimony because they did not have specialized knowledge to determine the value of services rendered by the owners. Instead, the two merely stated the nature of the services provided and how important those services were to the success of Aspro. Aspro’s experts did not articulate what principles and methods they used to conclude valuable services were provided to Aspro for the management fees paid to the owners.
VI. No Customer Use Precludes Qualifying Under Passive Activity Exception; Rogerson vs. Commissioner, TC Memo 2022-49.
Mr. Rogerson bought two luxury yachts he intended to lease. During 2014, 2015 and 2016, Mr. Robinson offered the yachts for lease, but no one chartered them. Nonetheless, Mr. Rogerson claimed millions of dollars of passive activity losses relating to his yacht charter activities.
Under Section 469(c)(2), subject to certain exceptions, rental activities are per se passive regardless of the taxpayer’s level of participation in the activity. However, under Section 469(c)(1), there are two exceptions that may apply to rentals of tangible property: (1) if the average period of customer use is seven days or less, and (2) if the average period of customer use is 30 days or less, and the taxpayer provides significant personal services to the customers.
If Mr. Rogerson qualified under one of those exceptions, he may have been able to show material participation, thereby allowing him to deduct the PAL losses. However, no one chartered his yachts during the three years. Without any customer use, it was impossible to determine the average period of customer use. Thus, Mr. Rogerson could not qualify under the seven days or less or thirty days or less exception to the passive activity loss rules.
The court considered whether the Section 6662(a), (b)(1) and (b)(2) 20% underpayment penalty should apply based on whether the underpayment was due to negligence, disregard of rules, or substantial understatement of tax. The IRS asserted penalties for both negligence and substantial understatement. Under Section 6664(c)(1), the taxpayer may avoid the Section 6662(a) penalties by showing there was reasonable cause for the underpayment, and the taxpayer acted in good faith. Mr. Rogerson contended he had reasonable cause for his return position because he reasonably relied on the advice of his accountant. Courts have held reliance on a professional advisor may constitute reasonable cause and good faith as long as the taxpayer establishes (1) the advisor is a competent professional, (2) the taxpayer provided necessary and accurate information to the advisor, and (3) the taxpayer actually relied in good faith on the advisor’s judgment. See Neonatology Associates, PA v. Comm’r, 299 F.3d 221 (2002).
Mr. Rogerson and his accountant both testified they discussed the proper reporting of the yachting activities. The accountant suggested Mr. Rogerson could claim these losses under exceptions to the passive activity loss rules. The court concluded because the accountant gave advice and because Mr. Rogerson actually relied on that advice, no penalties apply.
VII. S Corporation Advances to a Shareholder Recharacterized as Taxable Distributions; Kelly vs. Commissioner, TC Memo 2021-76.
Kelly involved a complicated series of inter-company transfers Mr. Kelly affected over several years between various entities he controlled. The inter-company transfers were used to fund certain business purchases and sales and associated real estate transactions. The inter-company transfers were treated and booked as loans from various companies directly to Mr. Kelly. In the early years, Mr. Kelly took care to document the transfers as loans. In some years Mr. Kelly made repayments of loan principal and interest. Because of downturns in the economy, Mr. Kelly had no realistic ability to repay any of the loans. Also, over time, loan formalities were less often observed.
The court held for 2007, the inter-company transfers to Mr. Kelly were indeed bona fide loans. However, for transfers beginning in January 2008, the purported loans were recharacterized as taxable distributions in excess of Mr. Kelly’s basis in his stock. The court also upheld the Section 6662(a) accuracy-related penalty that applies for any year in which there is a 25% omission from gross income.
VIII. IRS Issues Numerous Avenues for PLR Relief for S Corporation Mistakes.
As in past years, the IRS this year issued a number of private letter rulings granting relief to taxpayers that failed to meet statutory and regulatory requirements under the S corporation rules. The following are some of the more interesting rulings:
- Failure to File QSST Election after Shareholder’s Death (PLR 202218004, 202218006 and 202218005);
- Failure to File ESBT Election where Revocable Grantor Trust Ceased to be Qualifying Shareholder Two Years after Grantor’s Death (PLR 202233001);
- Failure to Timely File QSST Election (PLR 202210001);
- Failure to Timely File ESBT Election PLR 202234003;
- Beneficiary Failure to Consent to a QSST Election (PLR 202210002);
- Second Class of Stock Problems for an LLC Making an S Election (PLR 202209001 and PLR 202219005); and
- S Corp Stock Transferred to Ineligible Shareholder (a Section 501(a)(4) Organization) but then Transferred to an Eligible Shareholder upon Discovery the 501(c)(4) Org. was not a Qualified Shareholder (PLR 202234004).
IX. S Corporation Status is Not a Bankruptcy Property Interest; In Re: Gypc, Inc., 129 AFTR 2d 2022-693.
The bankruptcy court held a prepetition conversion of a bankruptcy debtor from an S corporation to a C corporation was not a voidable preferential or fraudulent transfer. Because the debtor’s tax status was controlled by its shareholders under federal law, its tax status was not an asset of the bankruptcy estate.
Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.