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Berry v. Commissioner (T.C. Memo. 2021-42)

On April 7, 2021, the Tax Court issued a Memorandum Opinion in the case of Berry v. Commissioner (T.C. Memo. 2021-42). The primary issues presented in Berry were whether the petitioners S corporation underreported its income, whether the petitioners’ S corporation is entitled to certain claimed deductions, whether the petitioners are entitled to certain claimed deductions, and whether the petitioners are liable for accuracy-related penalties under IRC § 6662.

Background

In 2013, Ronald Berry and his son, Andrew, owned and operated Phoenix Construction & Remodeling, Inc., which built houses and developed real estate. It used the cash method of accounting and maintained its records using QuickBooks software. Phoenix “retained” H&R Block to prepare its 2013 Form 1120S (U.S. Income Tax Return for an S Corporation). Phoenix reported gross receipts of $1.1 million and net income of $37,000 for 2013. On their 2013 Form 1040, U.S. Individual Income Tax Return, Ronald and his wife claimed 50% of Phoenix’ passthrough profits and losses on their Schedule E (Supplemental Income and Loss), and Andrew his wife claimed the other 50%.

Phoenix bid on and won a project to develop condominiums, and one of the company’s principal clients (who purchased the property to be developed) issued the company a $250,000 check.  The check included a notation on the memo line that read “Start-up 13th Street.” The company deposited the check into a newly opened bank account, but it did not execute any contract with the client.  It also did not include the $250,000 payment in its gross receipts for 2013.

Phoenix did preliminary work on the 13th Street Project and drew from the account to pay subcontractors it hired. However, Phoenix also drew from the account to pay car racing expenses, rent expenses, and miscellaneous personal expenses.

In 2013, the company purchased a 1968 Chevy Camaro, parts, and an engine to the tune of $122,000, all of which the company claimed as deductible on its 2013 return.  All of Andrew’s racing activities were conducted under the name “Berry Racing.” Phoenix did not report the car racing expenses as advertising expenses on its 2013 return, and the only photograph of the Camaro in the record does not show any Phoenix branding or advertising on the car.

Shifting the Burden Regarding Unreported Income

The petitioners argues that IRC § 7491(a) shifts the burden of proof to the IRS with respect to Phoenix’ unreported income. Specifically, IRC § 7491(a)(1) provides that if the taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining his liability and satisfies the requirements of IRC § 7491(a)(2), the burden of proof shifts to the IRS with respect to that issue. IRC § 7491(a)(2), in turn, provides that the taxpayer must comply with all recordkeeping and substantiation requirements and cooperate with reasonable requests by the IRS for information, documents, witnesses, meetings, and interviews. The petitioners, however, did not so respond to the “reasonable requests” of the IRS.  As such, they did not satisfy the IRC § 7491(a)(2) requirements, and the burden remained with the petitioners.

Why the “Deposit” was Gross Income

The petitioners argued that the deposit (less $67,000 that the company admitted to paying itself) is not income to Phoenix because the account was a “trust account” established and maintained for the benefit of the client.  The Tax Court was unimpressed by this argument.

Gross income includes income from all sources unless specifically exempted or excluded. IRC § 61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-430 (1955). Funds that a taxpayer holds in trust, which the taxpayer is obliged to spend entirely for a specified purpose with no profit, gain, or other benefit to himself, are not includible in gross income. Ford Dealers Advert. Fund, Inc. v. Commissioner, 55 T.C. 761, 771 (1971), aff’d, 456 F.2d 255 (5th Cir. 1972); see also Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), aff’d, 407 F.2d 210 (9th Cir. 1969). However, if a purported trustee has the right to use the funds for his own benefit—even if that right is limited—no trust exists, and the funds are includible in gross income. Angelus Funeral Home, 47 T.C. at 398.

The petitioners offered scant evidence that the account was set up and/or administered as a trust account.  Indeed, the only “evidence” offered up was their self-serving testimony and a single check notation reading “Start-Up 13th Street.” In contrast, the IRS argued the account was opened under Phoenix’ name, was not designated as a trust account, Ronald and Andrew had sole signature authority over it. The Tax Court found that the petitioners’ only credible “evidence” (the check notation) merely stated the general purpose of the payment; it did not impose any limitations on the company’s (or the petitioners’) right to use the money or indicate the creation of a trust.

The Deduction Shenanigans

The petitioners presented three alternative arguments as to why the IRS should have allowed the claimed deductions:

  1. the racing expenses are ordinary and necessary advertising expenses of Phoenix;
  2. Phoenix purchased the race car as an investment; and
  3. the racing activity was a separate business, distinct from Phoenix, that was engaged in for profit.

Once again, the Tax Court was unimpressed by the petitioners’ arguments.

IRC § 162(a) allows a taxpayer to deduct the ordinary and necessary expenses paid or incurred in carrying on a trade or business. Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971). Whether an expense is deductible under IRC § 162 is a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). An expense is ordinary if it is normal, usual, or customary within a particular trade or business, and it is necessary if it is appropriate and helpful for the development of the business. Welch v. Helvering, 290 U.S. 111, 113-14 (1933). To satisfy the “ordinary” requirement, there must be a proximate—rather than remote—relationship between the reported expense and the operation of the taxpayer’s business. Deputy v. du Pont, 308 U.S. 488, 495-496 (1940); Challenge Mfg. Co. v. Commissioner, 37 T.C. 650, 660 (1962).

To establish that the racing expenses were proximately related to its business, the petitioners would have had to show that Phoenix’ sponsorship was reasonably calculated to advertise its business. See, e.g., Schulz v. Commissioner, 16 T.C. 401, 407 (1951). This is because an expense that is primarily motivated by purely “personal gratification” is not deductible under IRC § 162. Henry v. Commissioner, 36 T.C. 879, 884 (1961). The Tax Court held that the reported advertising expenses cannot be (but ultimately were) “merely a thin cloak for the pursuit of a hobby” by Andrew. Rodgers Dairy Co. v. Commissioner, 14 T.C. 66, 73 (1950).

The Tax Court record contained no evidence of advertising, nor does it contain any evidence that any contacts made at the racetrack led to any business for Phoenix. Further, the expenses weren’t even reported as “advertising” but were “buried” betwixt and between other construction expenses.  Seems the Berry boys missed the mark a bit.

Petitioners admit that the Camaro was not raced or ready for racing until 2014. Expenses paid in 2013 with respect to the Camaro would be deductible, if at all, through depreciation or as startup expenses under IRC § 709 (applicable to partnerships) or IRC § 195 (general start-up expenditures). If the expenses were properly classified as startup expenses, they would become deductible only for the year in which the business actually began, and the amount of the deduction would be limited to no more than $5,000. See secs. IRC § 709(b)(1)(A); IRC § 195(b)(1)(A).

If the Camaro were a depreciable asset, the cost of acquiring the race car and getting it ready for racing would constitute an acquisition cost, which would not currently be deductible. See Treas. Reg. § 1.263(a)-2T(d), (k). A capital asset that is used in an activity for profit may be depreciated beginning for the tax year in which the asset was placed in service. Treas. Reg. § 1.167(a)-10(b). Property is placed in service when it is “first placed in a condition or state of readiness and availability for a specifically assigned function.” Treas. Reg. § 1.167(a)-11(e)(1). Because the Camaro was not raced or ready for racing in 2013, and the petitioners did not sell the car or any of its parts in 2013, “their ill-conceived alternative arguments must be rejected.”

Felicia Strikes Again

The IRS stipulated that it bungled the prior supervisory approval requirement of IRC § 6751(b)(1).  Although the initial determination was made in April 2016, the penalty approval form was not signed by the revenue agent’s supervisor until May 2016.  Because IRC § 6751(b)(1) requires the initial determination of a penalty assessment to be personally approved (in writing) by the immediate supervisor of the individual making such determination prior to the initial determination, the IRS completely dropped the ball.  This is just another in the long line of cockups by Felicia, the Grade 3 mail clerk, who first gained fame in the 2020 case of McCarthy v. Commissioner, T.C. Memo. 2020-74. Because the approval was untimely, the IRS utterly failed to bear their burden of production with respect to the petitioners’ accuracy-related penalty. IRC § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

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