Federal Income Tax Update
By I. No Reasonable Cause Penalty Defense where CPA did not Give Specific Advice about Erroneous Items; Johnson v. Commissioner, TC Memo 2023-116
Mr. and Mrs. Johnson hired a CPA to prepare their tax returns for 2015-2018. From 2006 to 2013, Mr. and Mrs. Johnson improperly claimed depreciation deductions on certain commercial buildings by using a seven-year depreciation life, rather than the 39-year life applicable to commercial property. As a result, the Johnsons overstated their depreciation deductions between 2006 and 2013 by $1.5 million.
The Johnsons sold their property in 2016 for $5 million. Because of the improper depreciation deductions claimed between 2006 and 2013, the IRS made a Section 481 accounting method adjustment of almost $2 million for 2015. In addition, for 2015, the Johnsons claimed a charitable contribution deduction. However, they filed an incomplete Form 8283 (Non-cash Charitable Contributions) that was fatally defective in numerous respects.
The IRS assessed a 20% negligence penalty under Section 6662(a). During the Tax Court proceeding, the Johnsons did not dispute the additional tax assessments but challenged the 20% negligence penalty, asserting they had a reasonable cause defense. However, the Johnsons presented no evidence their CPA actually told them a seven-year depreciation schedule was applicable to commercial buildings. Likewise, the Johnsons did not testify their CPA advised them a county property tax valuation would suffice for charitable contribution purposes instead of a qualified appraisal. The CPA testified she had “never had that discussion with Mr. Johnson” about charitable contribution deduction requirements. The Johnsons asserted they were entitled to the reasonable cause and good-faith exception merely because their CPA prepared their tax returns. However, courts have held an accountant’s preparing a tax return does not mean he or she opined on any of the items in the return. Neonatology Associates, PA, 115 T.C. 43 (2000). Indeed, taxpayers have a nondelegable duty to review a return for accuracy.
II. Limited Partners under State Law are not Automatically Exempt from Self-employment Tax; Soroban Capital Partners, LP, 161 TC No. 12 (2023)
Background
Section 1402(a)(13) contains the well-known limited partner exception that excludes from net earnings for self-employment taxes a limited partner’s distributive share of partnership income other than guaranteed payments. The historical problem is Section 1402(a)(13) does not define limited partner. In 1997, the IRS issued proposed regulations to define the limited partner exception. After public outcry, Congress prohibited the IRS from issuing any temporary or final regulations regarding the limited partner definition. Since that moratorium, Congress has not taken further action as to the definition.
In Renkemeyer, L.L.P., 136 TC 137 (2011), the Tax Court held limited partners in a law firm operating as a limited liability partnership, rather than as a traditional limited partnership, are subject to a functional analysis test to determine whether the limited partner exception applies. However, the court did not address whether a limited partner in a state law limited partnership must satisfy a functional analyses test to be entitled to the limited partner exception. Other cases involving limited liability companies have found certain professional members are not limited partners for purposes of Section 1402(a)(13). Castigliola v. Commissioner, TC Memo 2017-62.
Soroban Capital Partners, LP, 161 TC No. 12, (2023)
Soroban Capital Partners was a limited partnership owned by three limited partners and its general partner. The limited partnership reported guaranteed payments to its limited partners plus the general partner’s share of ordinary business income as income from self-employment earnings. The IRS argued Soroban’s net earnings from self-employment should also include the share of ordinary business income allocated to the limited partners because the individuals were limited partners in name only.
Soroban Capital Partners filed a motion for summary judgment asking the court to rule the ordinary income allocated to the limited partners is exempt from self-employment tax by virtue of the partners being limited partners under state law. Soroban argued limited partners of a state law limited partnership are automatically entitled to the limited partner exception.
The court held a limited partner’s distributive share of partnership income is not automatically excluded from self-employment tax due to the partners’ state law status. The court stated, in enacting Section 1402(a)(13), Congress intended the limited partner exception to apply to earnings that are of an investment nature. Determining whether earnings allocated to limited partners are of an investment nature necessarily requires an inquiry into the functions and roles those partners provide to the limited partnership.
III. Taxpayer Must Prove Material Participation to Avoid the Net Investment Income Tax; Senty v. United States, No. 22-CV-283-WMC (W.D. Wis. 2023)
Mr. Senty was involved in several businesses, including gas companies, banks, and a surveillance camera company. For 2014 and 2015, he and Mrs. Senty filed joint tax returns showing investment income from some of those companies. The IRS determined they owed net investment income tax on some of this investment income. Mr. Senty contended he met one of the material participation tests (the more-than-100-hour test), thus exempting them from the tax. Mr. Senty claimed he spent more than 100 hours, but less than 500 hours, working for each of the three companies in both 2014 and 2015. However, Mr. Senty did not maintain a work calendar, appointment book, log journal, timesheet register, or any other document to keep track of the hours or what type of work he performed. Also, he rarely used email or text messages for work.
The District Court concluded Mr. Senty failed to meet his burden of establishing the number of hours actually devoted to the different activities, and therefore failed to satisfy the Section 469 material participation test. The court stated although taxpayers may use narrative summaries to demonstrate the amount of hours spent on an activity, they must identify the specific number of hours spent on specific tasks by providing contemporaneous evidence, such as phone records, flight and travel records, or credit card receipts.
IV. Tax Court Petition Dismissed for being Filed One Day Late even though Sent by Federal Express; Nguyen, TC Memo 2023-151
Mr. Nguyen received a 90-day statutory notice of deficiency on October 13, 2022, advising him January 11, 2023, was the last day to file a petition with the U.S. Tax Court to challenge the notice of deficiency. On January 10, 2023, Mr. Nguyen sent his petition to the Tax Court via Federal Express. The Tax Court received it on January 12, 2023.
Unfortunately, Mr. Nguyen used FedEx Ground. Although Federal Express Overnight delivery is on the list of approved designated private delivery services, FedEx Ground is not. As a result, the court dismissed Mr. Nguyen’s untimely petition for lack of jurisdiction.
V. Inter-Company Loans Treated as Capital Contributions from Shareholders; Estate of Fry, TC Memo 2024-8
Mr. Fry was the sole shareholder of two S corporations called Crown and CR Maintenance. Crown was profitable, but CR Maintenance was not. From 2010 to 2013, Crown provided financial support to CR Maintenance to allow it to continue operating. Mr. Fry instructed Crown to transfer funds directly to CR Maintenance (the “Transfers”). In addition, Crown, on behalf of CR Maintenance, made payments directly to CR Maintenance’s creditors for operating business expenses (the “Payments”). Over time, the Transfers and Payments exceeded $36 million. CR Maintenance never issued any promissory notes evidencing the Transfers. Also, there was no security granted by CR Maintenance and no evidence CR Maintenance made any promises to pay interest or principal relating to the Transfers or Payments. Nevertheless, in its books, records, and tax returns from 2010 through 2017, CR Maintenance accounted for each of the Transfers and Payments from Crown as either a Loan Payable to Crown or as a Due to Crown. Thus, the Payments and Transfers were characterized as debts owed by CR Maintenance to Crown. In addition, CR Maintenance never treated Crown’s Transfers and the Payments as capital contributions. Likewise, Crown recorded the Transfers and the Payments as a Receivable Due From CR Maintenance on its tax returns and characterized the transactions as indebtedness.
During 2015, Crown and CR Maintenance sold most of their assets for about $70 million. Crown distributed all of its cash from the sale of its assets to Mr. Fry. Ultimately, Crown wrote off the debts owed by CR Maintenance as uncollectable bad debts.
For 2013, CR Maintenance reported ordinary losses in excess of $5.6 million. Mr. and Mrs. Fry claimed flow-through loss deductions for CR Maintenance of over $4.7 million on their tax return. The IRS disallowed Mr. Fry’s flow-through losses from CR Maintenance on the grounds Mr. Fry was bound by the form of the transaction he had chosen. Mr. Fry had clearly indicated in all of the books and records of Crown and CR Maintenance the capital infusions to CR Maintenance came directly from Crown rather than from Mr. Fry in the form of capital contributions or personal loans.
Mr. Fry contended the Payments and Transfers from Crown should be treated as (1) distributions from Crown to Mr. Fry and (2) subsequent capital contributions by Mr. Fry to CR Maintenance. He argued, regardless of the tax return and financial statement reporting, the substance of the Transfers and Payments from Crown to CR Maintenance were not bona fide debts but instead constructive equity distributions from Crown to Mr. Fry followed by equity contributions by Mr. Fry to CR Maintenance. That recharacterization would allow Mr. Fry to have sufficient stock basis in his CR Maintenance stock to deduct over $3.4 million of flow-through losses from CR Maintenance on his 2013 tax return.
The Tax Court sided with Mr. and Mrs. Fry. The court looked at the facts and circumstances considered by the 9th Circuit in determining whether a transfer to a corporation by a shareholder is debt or a contribution of capital. Citing Hardman vs. US, 827 F.2d 1409 (9th Circuit 1987), the court noted the 9th Circuit has identified the following 11 factors as potentially relevant to the debt vs. equity inquiry: (1) the names given to the certificates evidencing the debt; (2) the presence or absence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payments of principal and interest; (5) whether the advances increase participation in management; (6) whether the lender has a status equal or inferior to that of regular creditors; (7) objective indicators of the parties’ intent; (8) whether the capital structure of the borrower is thin or adequate; (9) the extent to which the funds advanced are proportional to the shareholder’s capital interest; (10) the extent to which interest payments come from dividend money; and (11) the ability of the borrower to obtain loans from outside lending institutions. See Hardman, 827 F.2d at 1412; NA Gen. P’ship & Subs. v. Commissioner, T.C. Memo. 2012-172.
After weighing all 11 factors, the court determined it was more likely than not the Transfers and the Payments did not constitute true indebtedness. The court stated, even though the evidence of the transactions reflected a debt from CR Maintenance to Crown, that was not determinative. It was especially important CR Maintenance’s ability to satisfy its debt to Crown was completely dependent on the future profitability of CR Maintenance. Also, there were no documents evidencing indebtedness and no specific maturity date for any loans from Crown to CR Maintenance. Mr. Fry never made a written demand on CR Maintenance on behalf of Crown for repayment of any debt. The amount owed by CR Maintenance to Crown was effectively subordinate to the claims of its general creditors. No third parties would extend credit to CR Maintenance. Finally, Mr. Fry was in charge of both corporations.
Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro, North Carolina.