CCH’s Fifth Annual Picks for Quirky Court Cases
CRIME, PUNISHMENT TAKE CENTER STAGE AS NEW CAST OF CHARACTERS CONFRONT THE IRS IN COURT
The tedium of federal tax law is cast aside when disputes over taxes play out in court, according to CCH INCORPORATED (CCH), a leading provider of tax and business law information. In 2000, CCH found that dry tax rules once again took on human, and often humorous, dimensions as a cast of characters confronted the IRS. Good deeds to greed, the IRS tried to tax all of it, but sometimes the courts provided an unexpected plot twist.
"This year, it was especially interesting to see how the courts stepped in to protect taxpayers – even with some surprising results," said Kay Harris, an editor who monitors court opinions for CCH.
From Amway-selling CPAs to scheming CEOs, here’s a look at some of the more interesting tax issues that recently held center stage in the nation’s courts.
So Crime Does Pay?
You’d think this tax scenario would be fairly straightforward: You surreptitiously skim a few hundred thousand dollars from your own company; the IRS finds out about it; they want, and get, their share. Fuhgeddabowdit, said the Tax Court.
The Court held that an officer in a corporation was not required to include in his income amounts that he skimmed from his companies in a false invoice scheme and subsequently paid out in kickbacks to secure business for those companies.
In this case, William D. Zack and his business partner arranged for suppliers to submit false invoices to their companies for work that was not performed. The companies paid the suppliers pursuant to the invoices, and then the suppliers returned the payments to Zack and his partner, less a "handling fee" of 25 percent.
Separately, Zack and his partner began looking into contracting opportunities for their companies with Ford Motor Company. A Ford employee who met with them said that in order for the Ford contracts to be awarded, he would have to be paid bribe money. An arrangement was agreed upon, and using a portion of the cash obtained from the false invoice scheme, Zack and his partner paid the bribes.
When the scheme unraveled, the IRS came looking for its due on Zack’s unreported income of over $300,000. While Zack did not dispute that he had received the money, he claimed that it was not includable in income because he received the money as a "mere conduit" for his business entities’ payment of bribes to the Ford employee.
The Tax Court agreed with this argument, holding that the amount the Court determined was paid as bribe money should be excluded from Zack’s gross income because he received it from his business entities as an intermediary.
William D. Zack v. Commissioner of Internal Revenue
Taxpayer Causes IRS Some Pain
A lawyer got involved in some questionable business, but there was no fraud and he came out a winner. Texas lawyer Jerry S. Payne represented one of the owners of Caligula XXI, a topless dance club. The club fell into difficulties, though, when it was unable to obtain a liquor license and it looked as though it would not be able to get a Sexually-Oriented Business (SOB) permit required by a new city ordinance. The lawyer came to own the club's name and many of its assets and in the end acquired all the stock of the club when the man he was representing was unable to pay his legal fees or repay the loan Payne had made to him to buy out a partner.
At the time, Payne thought the stock was worthless, and he filed no income tax returns for the two years in which Caligula XXI gradually came into his possession. But by 1994, the IRS had found an expert who valued the Caligula stock at over $1 million dollars and the Service issued deficiency notices to Payne, additionally alleging tax fraud – the only course open to them, since the three-year statute of limitations had passed.
While looking into Payne’s taxes, an IRS agent assigned to the case interviewed many of Payne’s clients and business associates, informing them that Payne was the subject of a criminal investigation. Several of Payne’s acquaintances and former employees were asked if they knew if he was a drug user or seller. Predictably, perhaps, the attorney’s law practice faltered.
On the fraud issue, the Tax Court assigned the club a value halfway between the $0 Payne thought the stock was worth and the IRS valuation. Failure to report this sum as income was clear evidence of fraud, in the eyes of the Court, and it affirmed the deficiencies.
On appeal, the Fifth Circuit Court disagreed. It found Payne's records to be a mess, but it also found several flaws in the appraiser’s assumptions. On balance, the evidence on the value of the club was a draw, and, when the issue is fraud, a tie goes to the taxpayer.
Meanwhile, Payne had gone after the IRS for the unauthorized disclosure of confidential return information by an agent investigating his case. A U.S. District Court found that the agent had, in fact, made unauthorized disclosures and acted in bad faith.
The court awarded Payne over $1.5 million in damages and last year tacked on over $100,000 in attorney’s fees because it concluded that the IRS was not "substantially justified" in fighting the disclosure suit. Given the agent’s own description of his conduct, the government was "clearly unreasonable" in maintaining that no unauthorized disclosure had taken place.
Jerry S. Payne v. Commissioner of Internal Revenue; Jerry S. Payne, et al. v. United States of America, et al.
Leave it to Me, I’m a Professional
The tax law can certainly be confounding, but you would have thought that a former IRS attorney and two professional CPAs would have had a better grip on things than this. In both cases, the individuals blundered, but in one case the taxpayer escaped unscathed thanks to the Tax Court.
Amway for Fun, But Not Profit
A husband-and-wife team who consistently lost money as the operators of an Amway distributorship were found not to be engaged in the activity for profit, the Tax Court said, but instead seemed to be in it for personal pleasure and social reasons (not to mention the opportunities to reduce their taxes).
The taxpayers sought to use nearly $190,000 in Amway losses to offset their other income, which was principally salary from their full-time positions. But, the Tax Court remained unpersuaded about the business nature of the venture.
Despite the fact that they had losses over eight consecutive years and had no indication that there would be future earnings, these two taxpayers – who both had held senior positions at a Big Five accounting firm and were CPAs – said that they had no intention of getting out of Amway.
Although the taxpayers claimed they spent between 50 to 80 hours per week trying to make a go of it with Amway, the Court could not be convinced that this was a business undertaken with profit in mind. As evidence, the Court noted the lack of a written business plan or budget for the activity. In addition, the separate bank account and records the taxpayers had for their Amway pursuits appeared to be maintained principally to satisfy IRS requirements and guarantee the deductibility of expenses, the Court said.
In the end, the Tax Court concluded that personal pleasure, not profit motive, was the more likely reason for the taxpayers’ Amway pursuits and suggested that the taxpayers enjoyed a congenial sense of family and a gratifying motivational feeling from their relationship with the supplier of household and personal use products. The Court held that the taxpayers were not entitled to deduct the losses from their Amway activity and determined tax deficiencies in excess of $26,000.
Kenneth J. Nissley and Terri C. Connor-Nissley v. Commissioner of Internal Revenue
Tax Lawyer Walks Away From Close Encounter with IRS
The Tax Court concluded that a lawyer who pleaded guilty to willfully failing to supply information on his tax returns and who did not report over $270,000 of income from a series of stock transactions did not fraudulently underpay his taxes. Rather, the understanding Court stated, "We think a more likely explanation is that petitioner's understatements of income were due to negligence."
Unusual? Especially so when you consider that the taxpayer had been a trial attorney for the IRS in the Chief Counsel’s office and tried numerous cases in the Tax Court.
The taxpayer fessed up to several tax law infractions. In order to collect the income tax deficiency, however, the IRS was required to prove that his conduct was fraudulent, which it was unable to do.
The IRS maintained there were several "badges" of fraud present, such as large understatements of income, inadequate books and records, failure to give accurate information to the tax return preparer and failure to cooperate with tax authorities. In addition, it was hard to ignore the taxpayer’s knowledge of income tax laws. However,
the Tax Court took a kinder, gentler approach, refusing to find fraudulent intent behind the apparent violations.
The understanding Court found the taxpayer to be negligent and careless, and concluded that he had not intentionally failed to keep records of his stock transactions in order to underpay tax. As to the IRS’ claim that the lawyer had failed to provide them with requested documentation, the Court found that since the IRS could not show what documents had been handed over, the extent to which the taxpayer was uncooperative could not be determined.
Since the IRS failed to prove fraud, it also was barred from collecting the known tax deficiencies. The IRS notified the taxpayer of his deficiency more than six years after he filed his returns, so any collection of that deficiency was barred by the statute of limitations unless fraud was proven. Because fraud was not proven, the lawyer did not have to pay the taxes or any penalties on the unreported income.
J. Randall Groves and Jane B. Groves v. Commissioner of Internal Revenue
No Good Deed Goes Unpunished
The IRS seemed a little less than sympathetic when it came to treating some health-related issues, but the Tax Court took a different view and administered timely relief.
The IRS maintained that a woman who paid for everything needed or wanted by an ailing man who lived with her prior to his death had to pay income tax on the money she was reimbursed by his estate for her expenses.
To add insult to injury, the IRS also asserted that the taxpayer was not allowed a deduction for any of the expenses she incurred in caring for the man because the expenditures were made in years prior to his death, and not the year in which she received a payment from the estate. To the rescue came the Tax Court, who said this Good Samaritan deserved a break — a tax break, that is.
For five years, Mrs. and Mr. Muegge cared for a man who lived with them, tending to – and paying to meet – his every need. With the expectation of reimbursement, Mrs. Muegge paid for his food, clothing, transportation to and from doctors’ offices, personal items, medicines, a hearing aid, eyeglasses, denture repair, laundry, dry cleaning, office supplies, periodicals, hotel bills and many, many other expenses — including two new beds after he set his own on fire, twice.
When the man died, Mrs. Muegge was reimbursed $182,500 by the estate for her many expenses and services. The Muegges reported half as income, and treated the other $91,250 as a reimbursement of expenses.
The IRS, however, claimed that the money paid by the estate was compensation for services in caring for the man in her home and that she should pay income tax on that amount. The Service also asserted that she was not allowed a deduction for any of her expenses in caring for the ailing man because the expenditures were made in years prior to his death, not in the year she received the payment from the estate.
The Tax Court, however, recognized that this Good Samaritan had done no wrong. The Court believed Mrs. Muegge’s testimony that the man had promised to reimburse her for the expenses and that, in fact, she had incurred even greater expenses than the amount reimbursed by the estate.
The Court concluded that the payment was nontaxable since it was a reimbursement of the expenses, showing that one good turn does, in fact, beget another.
Ralph J. Muegge and Mary H. Muegge v. Commissioner of Internal Revenue
About CCH INCORPORATED
CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH Federal and State Tax group web site can be accessed at http://tax.cch.com .
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