No Time Limit on Excise Tax on Abusive Roth IRA

Originally Published on forbes.com on July 6th,2011

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I was never that excited about converting regular IRAs to Roth’s.  You paid a big bunch of money now, maybe spread over a couple of years, so you wouldn’t have to pay in the future.  Always seemed a little like hitting your head against the wall because it feels so good when you stop.  The plans which projected enormous fortunes for your great grandchildren had two important assumptions.  The first was that you could pay the tax on the rollover with non IRA funds, so that the whole smash could go into the Roth.  The other was that you were some sort of investment genius.

Grant Thornton came up with a method that made the whole thing much more attractive.  Robert K. Paschall liked the idea , although, despite being an MITgraduate, he never quite understo0d how it worked.  In its decision yesterday, the Tax Court explained to him that the plan did not work.

Besides signing a lot of papers, Mr. Paschall had to do two things as part of the plan.  He had to open a Roth IRA funding it with $2,000 and he had to pay Grant Thornton $120,000.  His regular IRA with $1,392,801.96 was then rolled over to a self directed account.  Then two Nevada corporations were formed Telesis and West Star.  Frankly, it gets a little fuzzy here.  The Roth IRA purchased Telesis for $2,000 and the regular IRA purchased West Star for $1,272,801.96 (notice the $120,000 difference).  There was some money shuffled between the corporations.  Then they were merged with Telesis being the survivor.  When the dust had settled all the money was in the Roth.  The court summed up nicely why this was an excess contribution:

The substance of what happened in the instant case is that approximately $1.3 million began the year in Mr. Paschall’s traditional IRA and was transferred to his Roth IRA by the end of the year with no taxes being paid. Mr. Paschall did not attempt to provide a nontax business, financial, or investment purpose for what he did, and this Court cannot ascertain one. Instead, Mr. Paschall, incited by and at the urging of Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.
The Audit

Mr. Paschall’s 2000 return, the year of the transaction, was prepared by Grant Thornton for no extra charge.  His subsequent returns were prepared by Kruse Mennillo, where the Grant Thornton partner who had presented him with the plan had moved.Sometime in 2003 or 2004 Mr. Paschall received some distressing news:
Grant Thornton was turning over the names of people who had engaged in Roth restructures to the IRS. Mr. Stover at this time advised Mr. Paschall that the Roth restructure was legal but that he “might want to disclose on [his] income tax returns the structure”. Mr. Paschall thereafter attached to Telesis’ and his personal tax returns Forms 8886, Reportable Transaction Disclosure Statement.  Sometime in 2004 Mr. Paschall received, via Mr. Coopit, a memo concluding that the Roth restructure “was legal and met with all tax laws”.

Finally in 2008 Mr. Paschall received deficiency notices for the years 2002 through 2006.  The notices were not for income taxes, but for the excise tax for excess contributions to a Roth.  The excise tax is 6% of the lesser of the orignial excess contribution or the balance in the account.  That is each year.  Plus penalties of course.  Now the earnings of the Roth are tax free as are distributions from it.  So how bad is a 6% excise really ?  Suppose you put $1,000,000 into a Roth and you would have been subject to a 30% tax rate.  All you have to do is earn 20% and you beat the excise tax.
Statute of Limitations

Mr. Paschall argued that deficiencies for the earlier years were barred by the statute of limitations.  The excise tax is computed on Form 5329.  Generally the 5329 is attached to Form 1040.  Mr. Paschall had timely filed Form 1040 for all the relevant years.  That did not, however, start the statute of limitations with respect to the excise tax:

Section 4973 imposes an excise tax on excess contributions to Roth IRAs which is to be reported and disclosed on Form 5329. Upon review of Mr. Paschall’s Forms 1040, respondent was not reasonably able to discern that Mr. Paschall was potentially liable for a section 4973 excise tax. While a line on each Form 1040, i.e., line 54 for 2000, line 55 for 2001, line 58 for 2002, line 57 for 2003, line 59 for 2004, and line 60 for 2005 and 2006, states “Tax on qualified plans, including IRAs, and other tax-favored accounts. Attach 5329 if required”, Mr. Paschall left these lines blank, giving respondent no indication of his excess contribution.

Penalties

Mr. Paschall thought that he should not be subject to penalties since he had relied on qualified professionals.  He never went outside the loop of professionals who were being compensated on a value billing basis in seeking advice though.  It is reminiscent of EMC founder Richard Egan’s   doomed tax shelter:
Mr. Paschall should have realized that the deal was too good to be true. See LaVerne v. Commissioner, supra at 652-653. Mr. Paschall is a highly educated and successful businessman. He explained to this Court that because he grew up in the Depression, he was conservative with his investments and worried “about having enough money” to last through retirement. Yet he paid $120,000 for a transaction that he “did not fully understand”.

Mr. Paschall had doubts, repeatedly asking whether the Roth restructure was legal. Despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including Mr. Jaeger, who was preparing his tax returns at the time he met Mr. Stover. This was even after he received a letter warning him that there might be problems with the Roth restructure and that his name was being turned over to the IRS.

Other Recent Case

In the case of Michael Oshman, the IRS failed in its attempt to assert Roth excise taxes.  Mr. Oshman was building up his Roth balance by having his closely held company pay commissions to a foreign sales corporation owned by his Roth.  Since the IRS did not attack the income tax character of those payments, the Court did not allow it to treat the payments as disguised Roth contributions.  In Mr. Paschall’s case, the income tax sins all took place in 2000 and were old and cold by the time the IRS caught up with the transaction.

No Lady Doctor Exception to Late File Penalty

Originally published on Passive Activities and Other Oxymorons on June 10th, 2011.
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Pamela B. Russell v. Commissioner, TC Memo 2011-81

I've mentioned from time to time why I am ill qualified to work for the IRS.  One of the reasons is my tendency to decide that people deserve a break for reasons not supported by any statute or regulations.  I think Dr. Russell who cares for sick babies all day long deserved a break here.  While doing this she had to put up with the indiginity of having a husband who called his waterproofing endeavors the Basement Doctor.  (Apparently its a common name in the industry so maybe it didn't bother her).  Here are some of the basic facts :

Petitioner is a medical doctor in the neonatology unit at the Children's Hospital of Philadelphia, where she worked as an employee for all relevant periods. Petitioner is and was married to Bertram Royce Russell (Mr. Russell) at all relevant times. Petitioner and Mr. Russell (hereinafter sometimes referred to as the couple) maintained separate finances and separate checking accounts. Petitioner was responsible for handling the family's day-to-day living expenses, and Mr. Russell took primary responsibility for their children's tuition and college savings, the couple's retirement savings, and all tax matters. During the periods in issue Mr. Russell owned an interest in Basement Doctor, Inc. (Basement Doctor), a business that waterproofed basements.

It turned out that leaving long term finances and tax compliance to her husband might not have been the optimal family division of labor. Mr.Russell found Mr. Bagdis to help them with some of those issues.  Mr. Bagdis made a bang up first impression:

The Internal Revenue Service (IRS) examined the couple's returns  at some point after Mr. Bagdis had assumed his role as their financial adviser and tax attorney. Mr. Bagdis and his law firm represented petitioner and Mr. Russell during that examination. The examination was resolved in the couple's favor, and they received a refund from the IRS. The successful resolution of the IRS examination by Mr. Bagdis and his firm gave petitioner confidence in Mr. Bagdis, leading her to believe that he was extremely competent. Petitioner relied on Mr. Bagdis for tax advice.

It turns out that the masterful audit representation was the high point of the relationship.

Mr. Bagdis advised petitioner during early 1999 that she should submit a Form W-4, Employee's Withholding AllowanceCertificate, to Children's Hospital claiming that she was exempt from income tax withholding for 1999. In accordance with Mr. Bagdis' advice, petitioner signed a Form W-4 claiming the exemption on January 27, 1999. Mr. Bagdis' law firm submitted the Form W-4 to Children's Hospital, accompanied by a letter from the firm.

Petitioner was required to file a Federal income tax return for 1999. However, petitioner did not timely file her 1999 return because Mr. Bagdis advised her that her husband's business, Basement Doctor, had sustained significant losses during 1999 that would offset the couple's income from petitioner's salary, but that those losses needed to be calculated exactly before the couple filed their return. Petitioner followed Mr. Bagdis' advice and did not timely file her 1999 tax return. On February 21, 2001, respondent sent a delinquency notice to petitioner, informing her that respondent's records showed she had not filed a tax return for 1999 and asking her to file that return. The couple filed a joint tax return for their 1999 tax year on October 31, 2001. On their 1999 return, the couple reported $153,786 in wages and salary income, but the couple reported a loss of $100,000 from Mr. Russell's business. The couple reported an overpayment of $16,289 for 1999, and they received a refund of $16,417.57 on December 24, 2001.

Petitioner likewise was required to file a return for 2001, the year in issue, but was again advised by Mr. Bagdis not to file her return until he had calculated the exact losses from her husband's business. Petitioner understood that Basement Doctor was divided into three “parts” by State, one part each in Delaware, Pennsylvania, and New Jersey. Mr. Bagdis explained to petitioner that Basement Doctor's 1999 losses were from the Pennsylvania business, the 2000 losses were from the Delaware business, and the 2001 losses would be from the New Jersey business. Mr. Bagdis told petitioner that the losses from Basement Doctor's New Jersey business would be even greater than the losses from Pennsylvania and Delaware. Petitioner knew that her 2001 return was due on April 15, 2002, but, in accordance with Mr. Bagdis' instructions, petitioner did not file her 2001 return when it was due.

At some point during October 2004, IRS agents visited petitioner while she was working at Children's Hospital to serve her with a subpoena for records.

There you go with why I am not working for the IRS.  Who wants to be the guy who serves the subpoena on the lady doctor taking care of the sick babies ? Surely I would have pleaded that I needed to go drown some puppies or something.

Around the same time, petitioner understood that the IRS had also seized files from Mr. Bagdis' offices. After she received a subpoena from the IRS and learned of the IRS raid on Mr. Bagdis' offices, she became very concerned and asked to meet with Mr. Bagdis as soon as possible. When petitioner met with Mr. Bagdis, she received the same explanation from him: he expected that large losses from Basement Doctor would offset her salary income from 2001 and that she should wait to file her return until Mr. Bagdis could calculate the exact numbers. Petitioner continued to rely on Mr. Bagdis' advice.

This is the point where my sympathy for Dr. Russell starts turning into impatience.  I hate to state the obvious but figuring out the Schedule C loss of a small service business is not rocket science or brain surgery.  It's not even neonatology.  It's also not something to be entrusted to a lawyer particularly one who after telling you you have to wait for an exact number comes up with exactly $100,000.  Here is another little piece of advice.  When your attorney tax preparer can't get it done because the feds have seized the records you need to call another attorney.

On or about April 6, 2005, Mr. Bagdis sent petitioner and her husband a letter regarding their 2001, 2002, and 2003 taxes. In the letter, Mr. Bagdis informed the couple that he no longer had access to many of the couple's records because his files had been seized by Federal agents. However, he told the couple that he had nevertheless attached “pro forma” Forms 1040, U.S. Individual Income Tax Return, for the couple as married, filing separately. In the letter, Mr. Bagdis explained that the “pro forma” returns were based on “limited historical data” available in some computer files to which he still had access, as well as some new information supplied by the couple. Mr. Bagdis informed the couple that although the “pro forma” returns he had prepared were for the couple filing separately, they probably would have a lower tax liability if they filed a joint return. Specifically, he told the couple that if they filed a joint return for 2001, the Basement Doctor losses would offset petitioner's salary income and result in a tax liability of close to zero.

Mr. Bagdis reassured her that there was no problem with the return being late since there would be a refund.

On or about April 25, 2005, respondent sent petitioner a letter informing her that respondent still had not received her income tax return for 2001 and providing petitioner with respondent's calculation of petitioner's income tax liability for 2001. Upon receipt, petitioner or Mr. Russell delivered the letter to Mr. Bagdis. At that time Mr. Bagdis again explained to petitioner that he was waiting until all of the losses from Basement Doctor had been captured.

Can't you just picture these squirrely little creatures called "losses" racing around an enormous basement while someone who looks like Marcus Welby chases them with a butterfly net.

Mr. Bagdis wrote a letter responding to the IRS' letter for petitioner, which petitioner then typed on her stationery and sent to respondent on or about May 24, 2005. The letter petitioner signed reported that most of her records had been seized by Federal agents when they raided Mr. Bagdis' offices. The letter explained that petitioner was therefore unable to access the records related to her 2001 tax year and that “there is no further action that can be taken at this time.”

Petitioner apparently received at least one more letter from the IRS, dated August 30, 2005, which also included a proposed tax return for 2001. Petitioner again responded to the IRS with a letter drafted by Mr. Bagdis and stating that petitioner did not have access to the records she needed to prepare her 2001 tax return since those records had been seized. The letter objected to the IRS' proposed tax return because it did not include the losses from Basement Doctor, which the letter stated were expected to offset petitioner's remaining income and reduce her tax obligation to “near zero.”

Sometime during December 2005, petitioner received a call from John Pease, an attorney involved in the investigation of Mr. Bagdis, who advised her that she should retain separate counsel and should not be relying on Mr. Bagdis.  As a result of the conversation with John Pease, petitioner began to doubt Mr. Bagdis' advice, and she did retain separate counsel, Thomas Bergstrom (Mr. Bergstrom). From the time around December 2005 when she first spoke with Mr. Bergstrom, petitioner had no further interactions with Mr. Bagdis except to request that he withdraw as her attorney.

Petitioner first met with Mr. Bergstrom, a criminal defense attorney, during January 2006. At the time petitioner retained Mr. Bergstrom, both Mr. Bagdis and Mr. Russell were under criminal investigation by the U.S. Attorney's Office for the Eastern District of Pennsylvania. Mr. Bergstrom was concerned that the investigation might also expand to include petitioner. Over the next 11 months, Mr. Bergstrom met with the U.S. Attorney's Office on several occasions, and he hired a certified public accountant to prepare a tax return for petitioner's 2001 tax year. It took 11 months for Mr. Bergstrom, the certified public accountant, and petitioner to calculate and pay petitioner's 2001 tax liability.

Dr. Russell was in Tax Court over late file / late pay penalties.  Those squirrly little losses in the basement turned out to be on the elusive side so it did matter that she filed and paid late.  I would have let her go but the Tax Court apparently didn't go for the lady doctor sick baby exception.

We find it more plausible to conclude that petitioner was relying on Mr. Bagdis' advice that no tax would be due for 2001. She had relied on his advice when filing late tax returns for the 2 prior years, and she had received a refund both times, as Mr. Bagdis had said she would. Petitioner was, in effect, relying on a scenario that she would also be entitled to a refund for 2001. Unfortunately for petitioner, her hoped-for scenario did not materialize, and she owed tax for 2001. As the Court of Appeals stated in Jackson v. Commissioner, 864 F.2d 1521, 1527 [63 AFTR 2d 89-539] (10th Cir. 1989), affg. 86 T.C. 492 (1986): “a presumed expert's advice concerning the amount of tax owed can be erroneous, and the taxpayer must bear the risk of that error when he fails to comply with a known duty to file a return.” See also Estate of Hollo v. Commissioner, T.C. Memo. 1990-449 [¶90,449 PH Memo TC], affd. without published opinion 945 F.2d 404 (6th Cir. 1991); Gore v. Commissioner, T.C. Memo. 1987-425 [¶87,425 PH Memo TC]. As a matter of law, it was unreasonable for petitioner to file her tax return late on the basis of Mr. Bagdis' advice that no additions would be due because she would owe no tax.

Whether Petitioner's Reliance on Her Adviser's Advice That It Was Necessary To Have Accurate Information Constitutes Reasonable Cause Petitioner's reliance claim includes the contention that Mr. Bagdis advised her that she should wait until she had complete information about Mr. Russell's business losses before filing her return.  We have held that reliance on an attorney's advice that it was necessary to wait for complete information before filing a return does not constitute reasonable cause for a delay in filing.

It turns out that getting nailed for some late file/late pay penalties was pretty mild given the maelstorm that Dr. Russell had found herself on the edge of.  Last year after trial and a six year investigation Mr. Bagdis was sentenced to 10 years in prison.  There was radioligist convicted along with him.  Dr. Betram Russell was sentenced to 66 months.  I stick pretty much with tax research so I leave it to an ambitious reader to trace whether there is a family connection.

Looks Like a Duck -Walks Like a Duck - Talks Like a Duck - Not a Duck

Originally published on Passive Activities and Other Oxymorons on June 9th, 2011.
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Thomas F. Chambers, et ux. v. Commissioner, TC Memo 2011-114
U.S. v. MAGGERT, Cite as 107 AFTR 2d 2011-XXXX

“For we are taking pains to do what is right,not only in the eyes of the Lord but also in the eyes of men.”2 Corinthians 8:21 From the Evangelical Center for Financial Accountability Seven Standards of Responsible Stewardship

He said he talked to Jesus all the time. Even when he was driving his car. That killed me. I just see the big phony bastard shifting into first gear and asking Jesus to send him a few more stiffs. From The Catcher in the Rye.

The First Amendment tells us that the government should not establish religion.  On the other hand, it also tells us that government is not supposed to interfere with the free exercise of religion.  People with a very secular perspective like the Freedom from Religion Foundation focus on the first aspect.  Deeply religious people might focus more on the second.  The tension shows up in the relationship that IRS has with churches. It is very hands off not requiring the level of reporting that other not for profits are subject to.  On the other hand it is put in the awkward position of having to decide what is and is not a church.  Although this seems to contradict the establishment clause it is necessary so that the sphere of religion where government is hands off does not become a gaping hole that tax cheats drive trucks through. The favorable tax treatment of churches, that in my view is mandated by the free exercise clause, is, quite predictably, a magnet for "phony bastards".  Two recent cases illustrate this problem.

U.S. v Maggert is an extreme case:

Maggert, a dentist, worked for several dental offices as an independent contractor. In 1998, Maggert and his wife attended a seminar by American Rights Litigators (“ARL”) and Eddie Kahn at which they were told they did not have to pay federal income tax. Maggert relayed this information to his accountant, who counseled Maggert against ARL's advice and ended their professional relationship when Maggert persisted. Maggert dissolved his professional association, Mark S. Maggert, D.D.S., P.A., and, from 1998 to 2005, did not file a federal tax return or pay federal income tax.

Eddie Kahn, by the way, was Wesley Snipes "tax adviser". I might have missed that if I wasn't following Joe Kristan's blog.  Joe frequently gets to the same cases I do, usually before I do.

Beginning in 2002, Maggert instructed the accountants for the dental offices where he worked to make his paychecks payable to Total Business Systems, LLC, a Florida corporation, or to Mark's Word of Faith International, a Nevada corporation. The accountants complied and issued Form 1099s, using the corporate identification numbers for these organizations rather than Maggert's social security number. Maggert deposited the paychecks into accounts he opened in these organization's names and withdrew money from the accounts on a regular basis (over $40,000 in 2002, over $52,000 in 2003, $178,000 in 2004 and $128,000 in 2005, for a total of $398,600).

The articles of organization for Total Business Systems, LLC identified the managing member as Geneva Holdings, Inc., in Australia and the registered agent as Ronald Saltzer. The articles of organization were signed by Saltzer and Alan R. Horne, the “Director” of Geneva Holdings, Inc. Saltzer admitted that he knew nothing about Total Business Systems, LLC or Geneva Holdings, Inc., and had never met Maggert or Horne. Saltzer had agreed to act as the registered agent and sign the articles of incorporation in exchange for a meal provided by Eddie Kahn.

Panhandlers are facing a generational problem right now.  I sometimes want to shake the guys to explain to them that they can't be Vietnam veterans if they are more than a couple of years younger than I am.  Offering to be registered agents could open up a whole new field.  Somebody once explained to me that one of the ways to get an individual to take on unlimited liability so you could have a partnership was to trade a bottle of Thunderbird for the signature.  I wonder if cheap wine sales went down when they put in the check the box regulations.  At any rate on to the religious patina of the plan.

The articles of incorporation for Mark's Word of Faith International listed Maggert as the “Presiding Patriarch (Overseer).” Maggert's wife signed the articles of incorporation as a witness and “Scribe.”

It can be the little things that screw up a plan.  If Dr. Maggert wanted to be Patriarch, why couldn't he have made his spouse "Chief Priestess" rather than something that sounds like the medieval version of secretary and reminds you of Pharisees ? Maybe she would have been more enthusiastic.

Maggert's wife admitted there was no such religious organization and that Maggert was not a spiritual leader or priest

We really don't want the IRS inquiring as to who is really a spiritual leader or a priest, but it is these type of shenanigans that makes it necessary.  Sadly, I think that the IRS agents who are tasked with dealing with this nonsense get a little jaded, which may have been part of the problem in the Chambers case.

The case of Thomas Chambers is much more troubling.  It was not being proposed that he be deprived of his liberty but the IRS was asserting a 75% fraud penalty, which is about as bad as it gets short of doing time.  It is pretty clear that Reverend Chambers (and I'm not being ironic with the Reverend) was not running a tax scam:

Mr. Chambers is an ordained minister who, during the years in issue, was the sole pastor of Biblical Church Ministries (sometimes also referred to as Biblical Church or Biblical Church and Global Ministries). Before he founded Biblical Church during 2003, Mr. Chambers had been the senior pastor of Pilgrim Bible Church since 1991. He resigned from his position at Pilgrim Bible Church because he wanted to concentrate more on global evangelism and planned to be out of the country for many weeks during the year. However, about a dozen of his former congregants at Pilgrim Bible Church asked him to continue leading them in studying the Bible on Sunday mornings. Mr. Chambers agreed to continue leading them in Sunday worship with the understanding that he would be ministering abroad a number of weeks during the year and that someone else would lead worship when he was absent.

On the other hand, if he had been endeavoring to make himself look like he was running a tax scam, he would have been hard pressed to find more effective means than what he stumbled on. It is fairly clear that in his choice of organizational structure Reverend Chambers made a mistake.

During 2003 Mr. Chambers organized Biblical Church as a “corporation sole” under Utah law. He designated himself as “overseer” of Biblical Church. As overseer, he had full control over the corporation sole, including the authority to amend its articles of corporation sole and appoint his successor. During 2006 petitioners transferred the ownership of their home from themselves as individuals to Mr. Chambers as overseer of Biblical Church, a corporation sole.

A corporation sole is a way to associate ownership of property with the holder of an office.  Who owns all those church buildings and schools that make up a Catholic diocese?  The bishop does as a corporation sole.  This can come as something of a shock to parishioners as a lengthy drama in Worcester Mass several years ago illustrates.  On the other hand you don't have to worry about your parish becoming affiliated with another denomination, which can happen with a congregational polity.  I suspect that Reverend Chambers chose corporation sole because it fit a "strong pastor" model of church governance that was consistent with his theology.  Then again, you can't rule out bad advice.

Unfortunately it is also a property ownership device that is part of one of the IRS's dirty dozen.  Unless the office holder is subject to removal by some higher authority (other than the highest authority that we are all ultimately subject to) corporation sole is an excellent scamming structure.  Too excellent.  I think that when he chose corporation sole Reverend Chambers painted a target on his back.



Here is a portion of Revenue Ruling 2004-27:

The Service is aware that some taxpayers are attempting to reduce their federal tax liability by taking the position that the taxpayer’s income belongs to a “corporation sole” created by the taxpayer for the purpose of avoiding taxes on the taxpayer’s income. The Service also is aware that promoters, including return preparers, are advising or recommending that taxpayers take frivolous positions based on this argument. Some promoters may be marketing a package, kit, or other materials that claim to show taxpayers how they can avoid paying income taxes based on this and other meritless arguments.

By choosing "corporation sole" Reverend Chambers made himself look like a duck.

Mr. Chambers followed through on his plans to participate in many overseas evangelism trips. In addition to his job as a pastor at Biblical Church, he is on the staff of e 3 Partners, 3 an organization that is exempt from tax pursuant to section 501(c)(3). Mr. Chambers' role with e 3 Partners is “church planter”, and his primary responsibility is to lead short-term mission trips to other countries, where he trains local pastors and other volunteers in evangelism.

e3 Partners Ministry is a substantial organization.  According to their most recent 990 they grossed over 18,000,000.  They have many hallmarks of legitimacy.  Not the least of which is having an accounting firm with a blogging partner.  I think the IRS phony church hit squad should have backed off when they saw that Reverend Thomas was affiliated with them.  When I looked at the board I saw a substantial business person I happen to know who is honest as the day is long and sharp as tack.

The team members were responsible for raising their own funds for each trip, but e 3 Partners coordinated fundraising by receiving donations on behalf of individual team members and using those donations to pay trip expenses for those team members. Portions of the funds raised by all of the team members were directed to the team leaders, like Mr. Chambers, who were responsible for handling all of the day-to-day expenses the team would encounter on the trip. Before each trip, e 3 Partners deposited funds into a bank account provided by the team leader, who then withdrew the cash needed for the trip. All expenses incurred during the trip had to be documented by receipts, and the team leader was responsible for returning any unused funds to e 3 Partners at the end of the trip. During the years in issue Mr. Chambers received into his personal bank account numerous deposits to cover trip expenses from e 3 Partners, and the parties agree that such funds were properly excluded from petitioners' income.

So apparently if the Reverend Chambers had followed his first impulse and devoted all his time to foreign missions under the supervision of e3 Partners, he wouldn't have had any tax problems or at least not ones of the magnitude that he encountered.

During both 2005 and 2006 petitioners maintained a personal checking account at M and T Bank (M and T account). Petitioners also maintained checking accounts for Biblical Church at National Penn Bank (National Penn account) and the Bank of Lancaster County (Lancaster account) (collectively, the Biblical Church bank accounts or the church bank accounts). Petitioners were the only authorized signatories for the Biblical Church bank accounts. The name listed on the church bank accounts was “Biblical Church and Global Ministries”, but petitioners usually deposited checks made payable to “Biblical Church” into the National Penn account and checks made payable to “Global Ministries” into the Lancaster account. Biblical Church had two bank accounts because Mr. Chambers was trying to separate funds for the church itself from funds that were intended to support its overseas mission trips. He had originally planned to save some of the church funds to purchase a building; but because he was very passionate about the mission work, he put most of the money toward missions.


Petitioners opened the Lancaster account before they had obtained an employment identification number (EIN) from the Internal Revenue Service (IRS). They told the bank representative that they had applied for an EIN but had not yet received it. The bank representative nonetheless allowed them to open a bank account, and she typed all of the information required on the new deposit account coversheet but left blank the space for the EIN. She then printed out the new deposit account coversheet, had petitioners sign it, and instructed them to inform the bank as soon as they received the EIN from the IRS. The bank representative's actions in setting up the account, printing out the new account coversheet, and leaving blank the space for the EIN were consistent with protocol established by the Bank of Lancaster County at that time.

We have a saying that it is better to be lucky than good.  A corollary of that might be that it is worse to be unlucky than bad.  I suspect Reverend Chambers piece of bad luck with the EIN  might have been what really got the IRS swat team that was working him over excited.

At some point, a nine-digit number was handwritten in the space for the tax identification number on the new account coversheet. The nine-digit number written on the new account coversheet and subsequently associated with the Lancaster account is the Social Security number of a minor child unrelated to petitioners, not the EIN assigned to Biblical Church. The minor child who was assigned the Social Security number was not an account holder at the Bank of Lancaster County when petitioners created the Lancaster account.

His next misstep would appear to many of us to be the act of a godly man, who is also humble.

During the years in issue petitioners performed part-time janitorial work for Superior Walls of America, Ltd. (Superior Walls). Petitioners were paid $13 per hour for performing cleaning services about 15 hours each week. Mr. Chambers intended the compensation from Superior Walls as a fundraiser for his mission trips and for Biblical Church. He spoke with the financial controller at Superior Walls and explained his desire to perform janitorial services as a fundraiser for Biblical Church. Pursuant to an agreement with Superior Walls, instead of paying petitioners themselves for the work, Superior Walls paid Biblical Church directly. Mr. Chambers executed a Form W-9, Request for Taxpayer Identification Number and Certification, on behalf of Biblical Church, which he submitted to Superior Walls, claiming to be exempt from Federal tax withholding.

Unfortunately one of the things that scamsters do with phony churches is assign their income to them.  This would probably be the first instance of somebody doing it with the $13 per hour he was getting for mopping floors.  And lets not forget that Reverend Chambers actually did spread the Gospel in foreign places.  On the other hand by assigning his income, modest as it was, to the "corporation sole", Reverend Chambers was walking like a duck.

Petitioners later learned that the law required them to report the compensation from Superior Walls as taxable income, and they began to report the compensation as income during 2006.  Petitioners reported their income from Superior Walls during 2006 on a Schedule C attached to their Form 1040, U.S. Individual Income Tax Return.

That was a bit of unducklike behaviour that the Tax Court noted with approval.

Then there is the matter of the language in the governing document that to the IRS indicated  a “tax-hostile” entity

This Corporation Sole is a full-time Ministry and Spiritual Order which *** is mandatorily excepted by an “unrestricted” right, as referenced in United States law Title 26, §§ 6033(a)(2)(A)(i) and (iii), § 1341(a)(1) and § 508(c)(1)(A), from any form of taxation and from filing any returns or reports/documents ***

Although the Tax Court noted that the objectionable language was "largely a recitation of the tax law applicable to all churches", that is part of the style of tax protester rhetoric which frequently includes quotations from valid authority, ofter wildly out of context.  So Reverend Chambers with that governing document was talking like a duck.  (Although there is nothing to indicate that Reverend Chambers was constantly seen in the company of ducks, there is a chance that he purchased his paper work from one).  It is interesting to note that in the entire body of tax authority the term "tax-hostile" entity only appears in this case.  I wonder if it is a coinage by the agents who have to deal with this stuff. I used to have a third shift job in a hotel where a lot of cops would stop by to take their breaks.  They often referred to a crime that was not in the statute books called B and A, which stood for "being an asshole"

During the years in issue, the deposits into the Biblical Church bank accounts primarily consisted of numerous small checks written by individuals. Members and regular attendees of Biblical Church wrote checks that accounted for the largest number of deposits. Many of those individuals contributed a regular tithe or offering. Other checks were written by individuals who made only a few donations during the years in issue. Some checks were written by other churches. In total, about 50 individuals and three churches wrote at least one check to Biblical Church during the years in issue

The Tax Court was able to get Reverend Chambers out of a significant part of the trouble he had gotten into, primarily it appears from naivete.  First of all they determined that the Biblical Church was a church.

Biblical Church satisfies many of the criteria. Mr. Chambers is an ordained minister, the church has a distinct legal existence as a corporation sole, the church has been meeting regularly on Sundays since 2003, its worship services include a core group of 15 to 25 attendees who exclusively attend Biblical Church, its worship services are consistently held at the same place, and Mr. Chambers teaches recognized Christian doctrine. On the basis of the foregoing, we conclude that Biblical Church is a church.

That did not solve the problems entirely. Reverend Thomas had unfettered control of the various accounts.  Some of the expenditures went for personal purposes


The IRS reconstructed petitioners' income for the years in issue by examining the deposits to the M and T account, the Lancaster account, and the National Penn account. The IRS did not include deposits into the Northwest account when it reconstructed petitioners' income. However, the parties have included bank statements and canceled checks from the Northwest account among the stipulated exhibits before the Court. Those records show that petitioners used the debit card from the Northwest account to pay for numerous purchases at Wal-Mart, K-Mart, Staples, Dollar General, and a variety of other retailers, as well as many purchases at gas stations and restaurants. Petitioners wrote checks on the Northwest account to pay for many household expenses, including their gas bills, cable bills, and sewer bills. They also wrote checks to a tile company, a chimney sweep, a mattress store, a dentist, a newspaper, a mechanic, and a cement company.


Petitioners contend that even if some of the expenses paid from the Northwest account were personal, those amounts are not includable in petitioners' income because they were for the purpose of providing a home for Mr. Chambers, a minister of the gospel, and therefore are exempt from taxation under section 107. However, in order for a minister's housing allowance to be exempt from taxation under section 107, it must be designated as a housing allowance by an official action of the church in accordance with section 1.107-1(b), Income Tax Regs.

I think the Tax Court may have missed a chance to cut Reverend Chambers a break here.  They had recognized that the church was a church and he had transferred ownership of the house to the entity so this was arguably not a rental allowance situation.  They did prevent the IRS from piling it on to some extent.

The deposited checks in 2005 include federal income tax refund checks. In light of the circumstances and facts of this case, respondent is unwilling to concede that those refunds were correctly and properly made to petitioners. Therefore, respondent does not concede that those refunds are non-taxable in 2005. It appears that respondent is contending that petitioners are liable for deficiencies in income taxes from prior years and is attempting to recover some of those deficiencies by including petitioners' tax refunds from 2004 in their income for 2005. Respondent cites no authority that would permit such a determination, and we find none. Accordingly, we conclude that petitioners' Federal tax refunds should not be included in their income for 2005.

But there was only so much they could do.  The Chambers had sold gold coins inherited from Mrs. Chambers father to help with church expenses.  In their reconstruction of income the IRS treated these amounts as income and the Chambers did not have sufficient evidence to refute the presumption of correctness.


Respondent's contention is based on the premise that Mr. Chambers stated that Mrs. Chambers inherited the gold coins directly from her parents, which would contradict Mrs. Chambers' testimony that petitioners used cash they inherited from Mrs. Chambers' parents to purchase the coins. However, Mr. Chambers never clearly explained where the gold coins originated. In addition, he separately testified that petitioners had received cash from the inheritance. Although petitioners' testimony regarding the gold coins was somewhat difficult to follow, we do not find it contradictory. Nonetheless, because petitioners have the burden of proving that the $30,281 should not be included in their income and because petitioners failed to provide any evidence to corroborate their testimony, we conclude that petitioners have failed to carry their burden of proof that the income from the Surgical Resources Business Trust checks should be excluded from petitioners' gross income.

The big thing that the Tax Court did do for Reverend Chambers was making the 75% fraud penalty go away.  Acknowledging all the various things that Reverend Chambers had done to make himself appear like a duck, they could clearly see that he wasn't one.  Most important was the determination that there was an actual church there.

There are some other interesting aspects of the case that I have glossed over.  I recommend it as a good read.  I think it is worth commenting on how Reverend Chambers might have avoided these problems short of just working for organizations like e3 Partners, that have good infrastructure in place.  He might have looked at the ECFA Standards and Best Practices for Churches.  In the interest of full disclosure, I should probably say that the churches I have attended would not qualify for ECFA membership. Most Unitarian Universalists have a different theological perspecitve than that required by Standard 1.  Our principles do encourage us to heed "Wisdom from the world's religions which inspires us in our ethical and spiritual life" ECFA's standards and best practices clearly fall in that caterogy.  One excerpt from the standards might have been particularly apt for Reverend Chambers Biblical Church:

Every member shall be governed by a responsible board of not less than five individuals, a majority of whom shall be independent, which shall meet at least semiannually to establish policy and review its accomplishments.


If the group of people that asked Reverend Chambers to stay on as their preacher even while working on his evangelical missions did not include five people capable of seeing that mundane matters like setting a salary for him, most if not all of which could have been excluded as parsonage, then he really should have passed.

I have been sparing in my criticism of the IRS in this case.  I have often commented on how ill qualified I am to work for them.  If I was in charge of the team that was working on this I would have said "This guy is a real minister.  Let's leave him alone and go fight crime someplace else."  ignoring the laundry list of duck like characteristics that he was exhibiting.  What would be very sad is if this case ends up being viewed as an instance of the Satanic IRS persecuting the godly.  If you are of the mindset to look at it that way, I'd point you to ECFA who will teach you how to avoid even the appearance of impropriety.


I haven't seen a lot of commentary on this case.  At least one blogger has observed that it was quite a harsh result.  I've seen the identical commentary in more than one place, so I am not sure of the original source.

How to Make a Small Fortune in Day Trading ?

Originally published on Passive Activities and Other Oxymorons on April 8th, 2011.
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VINES v. COMM., Cite as 107 AFTR 2d 2011-XXXX, 03/24/2011

I won't make you hold your breath for the punch line.  As with real estate and many other endeavors, the only sure way to make a small fortune in day trading is to start with a large fortune.  Of course the small fortune may be a stepping stone to no fortune.  Mr. Vines was a veteran attorney who settled a class action suit receiving fees in the vicinity of 25 million dollars.  Maybe a bit over 10 million (allowing for taxes and a few celebratory impulse purchases) isn't exactly a large fortune.  I mean if you're married they won't even bother taxing a joint estate with a lousy 10 mil any more, I'm going to stick my neck out a call it a moderately large fortune.

Having done so well as an attorney, he decided to take up day trading.  He did moderately well initially, but in relatively short order lost 23 million.  Kind of odd because by my reckoning he would have had maybe 16 million tops to start with.  Well meaning no disrespect to the profession but attorneys in general have pretty strong egos or at least that's what they project.  So Mr. Vine threw the whole 25 million into his day trading and thanks to the magic of margin loans was able to lose almost all of it before his taxes were due.

The IRS assessed a failure to pay penalty.  Talk about rubbing salt into the wound.  I mean he would have paid, probably anyway, if he had the money.  He just didn't have it.  Tough luck, says the Court:

A failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless ... unable to pay the tax.... Further, a taxpayer who invests funds in speculative ... assets has not exercised ordinary business care and prudence in providing for the payment of his tax liability unless, at the time of the investment, the remainder of the taxpayer's assets and estimated income will be sufficient to pay his tax or it can be reasonably foreseen that the speculative or illiquid investment made by the taxpayer can be utilized (by sale or as security for a loan) to realize sufficient funds to satisfy the tax liability.


Somewhere in this story, there is a lesson.  When I figure it out, I will let you know.

IRS Memo Muddies the Water for Blackwater Employee

Originally published on Passive Activities and Other Oxymorons on February 10, 2011.
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Nathaniel J. Holmes v. Commissioner, TC Memo 2011-26

I have probably over used Dr. Johnson's observation that "Every man thinks meanly of himself for not having been a soldier or been to sea.", but I quote it again to account for my odd fascination with the combat pay exclusion.  From a logical tax policy viewpoint, it doesn't make a lot of sense.  Presumably you could figure out the tax effect it has, gross that number up and increase the bonus pay for being in a combat zone thereby simplifying the Code with no significant net effect on either the deficit or military compensation.  Somehow that seems emotionally unsatisfying, though.

You would think, however, that this is not something that could give rise to tax litigation since the people issuing your W-2 should know whether you qualify for the exclusion or not.  No such luck.  There is a regulation, for example, that if you are not assigned to a combat zone, but you go there for your own amusement while on leave from a non-combat zone you are not entitled to the exclusion.  Maybe they needed that rule because the night life in Saigon was so exciting.  Then we have cases like that of Charles Gasche.  He was a pilot for Braniff airlines transporting US military personnel to Vietnam.  He was issued a special card :

The purpose of this identification card was to accord plaintiff the privileges of the rank of major in the United States Air Force under "all applicable treaties, agreements and the established practice of nations" in the event of his capture by hostile forces in Vietnam.


That was just what you needed when you were checking into the Hanoi Hilton in 1968.

At any rate First Officer Gasche never needed the card that said he should be treated like a major and he was getting paid by Braniff, so he was not entitled to the combat pay exclusion.  There are quite a few similar examples.

The case of Nathan J. Holmes might be distinguishable from the airline pilots delivering the troops to Saigon in that he appears to have been performing actual combat duties.  Nonetheless he was not being paid directly by the Department of Defense and was not a member of the armed services.  He worked for a company called Blackwater.  Perhaps you have heard of them.

 Mr. Holmes did not get the exclusion.  A blogger who writes on military contractor issues groused a little about it in his post on the case noting that there is talk of subjecting contractors to the Uniform Code of Military Justice, but no prospect of them getting the favorable tax treatment granted to member of the military.  For a little perspective on that, Mr. Holmes was trying to exclude $98,400 for 2005.  In 2005 the maximum pay for an enlisted member of the military was $6,300 per month, which sets the limit for what officers are entitled to exclude (Along with the couple of hundred bucks a month they get for being in a combat zone).Enlisted personnel in a combat zone exclude their entire income, such as it is.  So Mr. Holmes was trying to exclude more than anybody in the official armed services was entitled to exclude.

The interesting part of the case is actually how it was that Mr. Holmes was not assessed a penalty.  He was relying on a copy of a memo.

While in Iraq, petitioner was given a memorandum issued by Robert L. Hunt, the Acting Deputy Director, Compliance Field Operations, Internal Revenue Service (IRS). This memorandum discussed the appropriate steps for civilian personnel to take when engaged in an IRS examination and collection activity involving a taxpayer deployed to a Qualified Combat Zone. Petitioner did not remember who gave the memorandum to him.


This memorandum was an internal memorandum written to give the Commissioner's employees field guidance for examination and collection activity involving taxpayers in Iraq. The memorandum, titled “Memorandum for Acting Deputy Director, Compliance Field Operations”, was issued by the Internal Revenue Service Small Business/Self- Employment Division on June 28, 2004. The memorandum states that civilian or military personnel who are in direct support of a combat zone military initiative and physically located in the combat area are entitled to the exclusion. It also states that time spent in a combat zone by an individual serving in support of the Armed Forces will be disregarded with respect to “certain acts required under the Internal Revenue Code.” It goes on to state that “This change in procedure will be reflected in the next revision of the IRM, which is in the process of being written
Petitioner satisfies all the criteria found in the memorandum. He was serving in Iraq alongside the military, provided security to Government officials, and aided in giving air support, medical aid, and emergency response assistance. Petitioner had no background in tax law and was given this memorandum written by an IRS employee while serving in Iraq. We believe that receiving this memorandum while serving in Iraq could give someone reasonable cause to believe that his payments from Blackwater were excluded from gross income. Therefore, petitioner is not liable for the addition to tax under section 6651(a)(1).

Respondent also determined a section 6651(a)(2) addition to tax. Section 6651(a)(2) imposes an addition to tax for failure to pay the amount shown as tax on a return on or before the due date prescribed unless the taxpayer can establish such failure was due to reasonable cause and not willful neglect. The amount of the addition is equal to 0.5 percent of the amount shown as tax on the tax return but not paid, with an additional 0.5 percent each month or fraction thereof during which the failure to pay continues (up to a maximum of 25 percent). See Cabirac v. Commissioner, 120 T.C. 163, 170 n.12 (2003). For the reasons stated above, we find that petitioner had reasonable cause and is not liable for the section 6651(a)(2) addition to tax.

I have been assiduously hunting for this magical memo.  Feral Jundi, the blogger I previously mentioned, posted this.  It appears to be the first page of the memo. I don't know whether that is the entire memo or not.   In 2007 a firm called Palazzo posted a warning about the memo indicating that it was being misinterpreted.

Everyone I know working overseas in a combat zone probably has seen this memo. Let me tell you once and for all this memo does not apply to civilian contractors working in combat zones. This memo was released for a very small group of Coalition Provisional Authority Personnel and the only thing it did was allow them additional time to file their tax returns. It did not provide a full Combat Zone tax exclusion. There is no such thing. It did not waive their 330 day overseas requirement. This still must be met every twelve months. The only exclusion of income must be earned by meeting the presence test or in some instances the bona fide residence test.

Apparently civilian contractors rather than writing "Kilroy was here" on all available blank walls spent their time photocopying an internal IRS memo that "proved" that their income was excludable.  Perhaps Mr. Holmes couldn't remember who gave him the memo, because he got it from more than one person.  Oddly enough, the tax court found his reliance on the memo reasonable.  It will be interesting to see if there will be a string of these cases in the next few months.

Saying Goodbye to 2010

Originally published on Passive Activities and Other Oxymorons on February 7th, 2011.
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I know that you haven't been wondering how I do my blog, but I am going to tell you anyway.  I look at every federal court tax decision and an alphabet soup of IRS pronouncements (PLR, CCA, PMTA etc) as they are released by the Research Institute of America.  A small percentage of them strike me as interesting for one reason or the other (practical utility, humor, cause for reflection).  Those I copy into a draft post, which I will then labor over as the spirit moves me.  Having the full text in my draft post allows me to easily paste quotes into the body of my post.  The effect of this method is to leave me with a collection of draft posts.  Sometimes when I look at them I wonder why I thought they were interesting in the first place.  I've committed to a Monday Wednesday Friday schedule.  If something seems of immediate interest, I will put it up as a bonus post.  The side effect of this process is the accumulation of material that doesn't quite turn into a full length post.  Rather than consign it to the dustbin (You might be surprised at the number of developments than nobody would write about if I didn't), I will group a bunch of them together.  So in this post and maybe a subsequent one I will clean out anything left over from last year.  The only thing the items have in common is that they came out in the waning days of 2010.  If you can detect a theme, congratulations.

TAX PRACTICE MANAGEMENT, INC. v. COMMISSIONER OF INTERNAL REVENUE JOSEPH ANTHONY D'ERRICO v. COMMISSIONER OF INTERNAL REVENUE, TC Memo 2010-266

This was a fairly run of the mill substantiation case although the numbers were respectable (over 200k in deficiencies).  The fact that it was a tax preparation business added a touch of irony.  The most interesting feature was an airplane.  It was purchased in December.  Mr. D'Errico took it on a test flight which allowed him to visit some clients.  He then leased it out, because he was to busy to fly around during tax season.  He sold his tax business before he got to use the airplane to visit clients.  He, of course, took a 179 deduction in the year of acquisition.  The tax court didn't buy it.

TPM has not demonstrated that the airplane was acquired with the requisite intent or motive of making a profit. Other than D'Errico's self-serving testimony, TPM has not presented any evidence that it contemplated using the airplane for purposes of TPM's management or marketing operations. Further, the airplane leasing agreement specifically provides that TPM entered into the agreement with the intention of generating revenue to offset the airplane's operating costs.

Private Letter Ruling 201048025

This was a fairly convoluted like-kind exchange that was allowed.  As far as I could make out an entity swapped with a related party, which then acquired property.  The key to the whole thing seemed to be that as a group there was no net increase in cash.

Related Party intends to reinvest an amount equal to the total sale price of the Related Party Relinquished Properties less exchange costs. In the event that Related Party acquires replacement properties having a value less than 100 percent of the value of the Related Party Relinquished Properties, the difference will result in the Related Party recognizing gain arising from the exchange in the full amount of such difference, but the amount of gain so recognized will not exceed x% of the gain realized by Related Party on its transfer of the Related Party Relinquished Properties.

If somebody has studied this ruling and could post a comment I'd really appreciate it.

Edward Daoud, et ux. v. Commissioner, TC Memo 2010-282

This was also a substantiation case.  It was notable for two reasons.  The first was the introduction:

The Daouds owned two Wienerschnitzel franchises in Southern California, both of which gobbled up unusually large amounts of money. These expenses grabbed the Commissioner's attention and during his audit of the Daouds' 2000 and 2001 returns, he found that they had reported a large loss on kitchen equipment they never owned, and lacked substantiation for many of the other deductions that they claimed. The Commissioner determined a large deficiency for each year, and wants to add fraud or at least accuracy-related penalties. We make our way through the resulting menu of possibilities to determine the correct taxes and penalties.

You don't read a lot of stories about Tax Court judges shooting themselves, so you know that they have to have a sense of humor.  Sometimes it comes through.

The story of the unallowed loss on the kitchen equipment is one that Robert Flach, The Wandering Tax Pro will love.  (Mr. Flach still prepares returns by hand rather than use expensive and unreliable software):

Mr. Daoud conceded that he and his wife were not entitled to the loss on the sale of kitchen equipment, but he tried to explain why he reported a loss for equipment he had neither bought nor sold. He testified that he was unsure how the $110,015 loss got on his return, but he speculated that the bid was mixed up with all the other paperwork on his desk, which caused him to enter it into Turbo Tax by mistake. He also testified that the date he recorded on the Form 4797, Sales of Business Property, as the date that he sold the equipment was simply one that he chose at random after Turbo Tax prompted him to enter a date. He went on to explain that he gave the altered document to the revenue agent "out of panic."

The Turbotax made me do it defense was unavailing:

This case is a good example of why we allow the Commissioner to prove fraudulent intent using circumstantial evidence and the taxpayer's entire course of conduct. Mr. Daoud claims that he reported the loss by mistake, and he asks us to believe that he first learned about it when the revenue agent brought it to his attention. We do not believe him--Mr. Daoud's credibility suffered during trial. His testimony was often suspect, and the records he provided have proven not to be what he said they were on many subjects.

The judge elaborated on the credibility theme.  He didn't yell "Pants on fire", but it was close.

Private Letter Ruling 201051025

In my more paternalistic moments, there is a provision of the tax law that I would keep secret from some people.  One of the ways that you can avoid a 10% penalty on early withdrawal from you IRA is by committing to a series of distributions.  I just turned 59, myself, and I am looking forward to my 1/2 birthday so I wouldn't need to consider something like that myself.  And of course I'm glad my younger self never thought about it.  Nonetheless, there might be circumstances where it makes sense.  The ruling was about someone who adopted that course then managed to screw it up.  The IRS was forgiving.

1. The failure to distribute the entire required distribution amount for Year 6, and a proposed makeup distribution for Year 7 will not be considered a modification of a series of substantially equal periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.
2. The fact that the amount of the annual payment computed pursuant to section 72(t)(2)(A)(iv) of the Code was paid in a single sum in Year 1 and in monthly distributions in Year 2 through Year 7 will not be considered a modification of a series of periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.

That is not a complete wrap on 2010, but it will do for now.

Courts and Value Billing

Canal Corporation and Subsidiaries v. Commissioner, 135 T.C. No. 9
KELLER, ET AL. v. U.S., Cite as 106 AFTR 2d 2010-6343, 09/15/2010

This was originally published on PAOO on November 3rd, 2010.

My father was fond of saying you need three things in life – a good doctor, a forgiving priest, and a clever accountant


I have these little stories I use to keep perspective. They are a combination of fact and speculation. The proportions vary. I sometimes hear that being a CPA is very stressful. I can get into that, but then I have my perspective story. Sometime, during the early part of the second Gulf War, my daughter's eighth grade class wrote encouraging letters to our service people abroad. I wasn't surprised that she got a reply, but the person replying was a bit of a surprise. He was a major, the executive officer of a helicopter battalion. I tried to imagine what his job must be like. It involves seeing that machines that don't look like they should fly keep flying. And that's just the tip of the iceberg. My speculation was that he received a stack of letters and that faced with the challenge of making sure that his collection of extremely stressed young people appropriately answered the schoolchildren in a way that reflected credit on the Army, he answered them all himself. Regardless it was a nice letter and I hope that he is now full colonel at a nice post in pleasant circumstance or perhaps even better collecting a well earned lieutenant colonel's pension. And when ever I think I have stress I think about him.

I believe that the biggest hazard CPA's face is not stress, but envy. It is in the nature of things that most CPA's who do well have client's who do even better, much better. In a free capitalist society, the most highly compensated people will be the successful entrepreneurs. That does not mean that entrepreneurial activity is over rewarded. Unsuccessful entrepreneurship garners fairly heavy penalties. In the process of failure, they may generate some complicated accounting work, but not the revenue to pay for it. A practice where those clients predominate, unless it is that of some sort of workout specialist, will not last. So a prosperous CPA sitting down to eat with a collection of his most prosperous clients will often be the least prosperous person at the table. Ironically, the more prosperous the CPA is, the more likely that he or she will be the least prosperous person at that particular table.

The concept of value billing has some very sound reasoning behind it, but I also think that the envy factor is the source of some of its attraction. I couldn't help but notice it in the banter between professionals that was such a rich part of Fidelity International Currency, the epic tale of EMC founder Richard Egan's doomed tax shelters

On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day's meeting and her discussions with Helios after the meeting concerning fees:


... after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!

The writer was an attorney and the recipient a CPA, who was CFO of a family office. She was expressing the same frustration that led the CPA's at KPMG into a new and interesting way to do business. She or her firm was apparently getting paid by the hour to find a brilliant maneuver to save Mr. Egan's tax dollars. KPMG had already invested some hours in designing a brilliant scheme. They would not get paid for the additional hours they spent applying these principles to Mr. Egan's situation. They would get paid a percentage of the tax savings while incurring a relatively small marginal cost.

The outcome of the whole enterprise was not pretty for KPMG or many of their clients. KPMG found itself fortunate to be in any business. They were even pressured by the federal government to stop paying defense costs for some of their partners, a tactic which back fired on the government on constitutional grounds, but you should go to the federal tax crimes blog if you want to read about that type of thing. More to the point of this post, none of the opinions that the Egans paid for protected them from the imposition of penalties. They were viewed as part of the package and tainted by a lack of independence.

The disdain for professional imprimaturs unsupported by work has moved beyond the Son of Boss unbalanced entries to a deal that tax professionals felt deserved a bit more respect. Canal Corporation and Subsidiaries was a deferral deal. Instead of selling a subsidiary the taxpayer contributed it to a partnership and took a large distribution. The debt that funded the distribution was allocated to the contributing partner, which avoids the disguised sale rules. Of course, they didn't really want a liability, so the guarantee that supported the allocation was pretty tenuous.

Not to worry, they got a "should" opinion, the highest assurance possible from none other than PWC. If you can't rely on the people who count the votes for the academy awards, who can you rely on ? Turns out the client should have been a little more diligent than just cutting a check and asking for the envelope, please :

Chesapeake paid PWC an $800,000 flat fee for the opinion, not based on time devoted to preparing the opinion. Mr. Miller testified that he and his team spent hours on the opinion. We find this testimony inconsistent with the opinion that was admitted into evidence. The Court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors, disorganized and incomplete. Moreover, Mr. Miller failed to recognize several parts of the opinion. The Court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion.
We are also nonplused by Mr. Miller's failure to give an understandable response when asked at trial how PWC could issue a “should” opinion if no authority on point existed. He demurred that it was what Chesapeake requested. The only explanation that makes sense to the Court is that no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion


Chesapeake did not act with reasonable cause or in good faith as it relied on Mr. Miller's advice. Chesapeake argues that it had every reason to trust PWC's judgment because of its long-term relationship with the firm. PWC crossed over the line from trusted adviser for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag—$800,000.

The Keller opinion sheds a different light on the subject. It is a follow up to the Keller case which I mentioned briefly at the dawn of this blog noting that the role of the accountant bordered on the heroic. There was a family limited partnership all set to go with assets identified, etc., etc. Then the matriarch dies before she can sign anything. Don't you hate when that happens ? So her estate tax of 147,000,000 or so was computed with no valuation discount. Then one of the family's accountants got the notion that maybe they had gone far enough. So they sued for refund and in August of 2009, they won. The case came up again to determine deductible fees. Although the court was very deferential to the executor/accountant, they decided that a $2,400,000 "bonus" for future worker was not ordinary and necessary. They also disallowed a $9,470,606 contingency fee to attorneys (presumably the ones who handled the litigation on the valuation discounts).

Pricing on Purpose is a really good book and it offers some valuable perspectives on approaches for billing for professional services. I think, though, that these decisions raise some issues on the value of tax services that are detached from the amount of work that is involved. It is almost as if when you try to bill based on the value, the value disappears.

My final reflection is advice for the financial professionals who have those twinges of envy when they see the big checks is to try three techniques. The first is to go to the kitchen and get a glass of water from the tap and drink it. While you do that reflect on how few people in world historical terms have had such easy access to reasonably potable water. The second is that the next time somebody in the street asks your for money, engage with them. Ask them when they have last eaten and then sit down and have lunch with them. (If they are professional pan handlers, they will find this rather frustrating). If all else fails do a google search on "KPMG Tax Shelter Prison". It may well be that Attorney Denby was in the wrong business, but that didn't mean KPMG was in the right business.

I'm not giving up on the quote identifying contest. The one at the top is from a film and at the risk of making it too easy I will say the real hero of the film was an accountant (although he is not the "hero" of the film). Also Xavier graduates and old people probably don't have an edge on this one.

Debit by the Window - Credit out the Window

KRAUSE v. U.S., Cite as 106 AFTR 2d 2010-5382, 10/12/2010

This was originally published on October 18th, 2010.

There is an old joke about a CPA who used to come to work everyday, open his desk drawer and look at a slip of paper.  After he retired someone found the slip of paper and saw written on it "Debits by the Window - Credits by the Door".  If he went to law school and started doing Son of BOSS deals, he would have had to change it to something more in line with the title of this post.
My readers, who may well number in the scores, vary in their degree of tax geekiness.  Those of you who come here out of friendship or because I have grovelled may want to just click on a few ads and move on, because this is one of those points that is a stretch for me.  I feel I must comment on this synchronicity.  My last two posts have been about Fidelity International Currency.  The rather long decision was issued in May.  It disallowed two partnerships which had been used by EMC founder Richard Egan to shelter capital gains from the sale of stock and ordinary income from the exercise of non-qualified options.

The decision was amended on October 6 to indicate that penalties would apply.  Talk about waiting for the other shoe to drop. The Egans had already put up the 60 million or so in tax.  Somehow I doubt they had been counting on the refund they were suing for to do their Christmas shopping.  So the October 6 amendment might be what they were really sweating out.  If the judge had wanted to make life even more difficult he would have waited until January.  Mr. Egan died in August 2009 making the extended due date of his estate tax return fairly imminent.  Presumably the penalty will go in as a debt of the estate.

In my post I indicated that since this was a partnership case, I was leaving it to the tax litigators as to whether that really was the venue for deciding individual penalties.  Next time I take a break from October 15 returns and start crawling through decisions I find the case of J. Winston Krause.  Mr. Krause was a tax attorney and CPA who built his own Son of BOSS shelter.  I have to wonder if he has two sides to his personality. Right now the CPA side is yelling "Language of 752, language of 752 - I knew it couldn't work.  The entry didn't balance.  You can't get all that basis without crediting something."  The tax attorney side has answers. I can show you an example of a CPA making beautifully balanced entries that make no impression on judges, who are lawyers.

Mr. Krause's partnership did not fight the disallowance of the Son of BOSS losses.  He paid the assessed tax, penalty and interest and then sued for refund of the penalties.  Mr. Krause, not being a high tech billionaire. "only" has about $112,000 in penalties. (I have a rule that the word "only" should not be used in connection with sums of money greater than four dollars, but I'm relaxing it in light of the Egan's 20 million plus penalty).  In arriving at its ruling he court goes into a discussion on the partnership provisions of TEFRA. (Tax Equity and Fiscal Responsibility Act of 1982).  The partnership provisions of TEFRA are a more subtle part of the war against tax shelters than passive activity loss rules of the Tax Reform Act of 1986.  Without them each parter in a partnership could litigate the same transactions in tax court.

To avoid duplicative litigation stemming from the tax treatment of partnerships, Congress enacted TEFRA, which creates a unified procedure for determining the treatment of partnership tax transactions. TEFRA requires the differentiation between the tax treatment of partnership-level and partner-level items.Id . § 6221. Partnership items include all items of “income, gain, loss, deduction, or credit of the partnership,” along with “optional adjustments to the basis of partnership property pursuant to an election under section 754,” and “the accounting practices and the legal and factual determinations that underlie the determination of... items of income, credit, gain, loss, deduction, etc.”

The penalties assessed under the FPAA were directly attributable to the fraudulent $2.79 million loss KAAS alleged it incurred when it sold its Canadian currency. This loss, which passed through to Krause Holdings and then to Krause, occurred because of the overstated basis KAAS had claimed in the Canadian currency due to an earlier basis election. Thus, the penalty related to basis, basis adjustments, and losses, all of which are considered partnership items under § 6231

 Further, the refund sought by Krause relates to penalties and penalty-related interest that are associated with partnership-level items, both of which are in and of themselves considered partnership-level items. I.R.C. §§ 6221, 6230(c)(4). In this regard, the Code is clear: these are items that must be contested before the IRS finalizes an FPAA. The district court did not err by concluding that it could not consider Krause's refund claims.

So if this decision holds, the Egan family might be able to appeal the Fidelity decision, but they won't get to have a fresh hearing on the penalties when they are assessed against the individual returns.