On January 14, 2020, the Tax Court issued a Memorandum Opinion in the case of Cuthbertson v. Commissioner (T.C. Memo. 2020-9). The issues presented in Cuthbertson v. Commissioner were (1) whether the petitioners were entitled to loss deductions arising from the sale or abandonment of golf course improvements, and (2) whether the installment method of accounting was an appropriate method of accounting to report the transfer of property between two companies, both wholly owned by the petitioners.
Burden of Proof – Statutory Notice of Deficiency (SNOD) in Cuthbertson v. Commissioner
A statutory notice of deficiency (SNOD) must describe the basis for the tax due. IRC § 7522(a). In general, the SNOD is presumed correct, and the petitioner bears the burden of proving otherwise. Welch v. Helvering, 290 U.S. 111, 115 (1933); see also Tax Court Rule 142(a). If, however, the IRS raises new matters in litigation not raised in the SNOD, then the IRS bears the burden of proof with respect to such matters. Tax Court Rule 142(a); Shea v. Commissioner, 112 T.C. 183, 197 (1999). Although a new theory that merely “clarifies or develops” the original determination is not a new matter, a novel theory that either alters the original deficiency or requires the presentation of different evidence is a new matter. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989).
Scrutiny of Family Tax Planning
Taxpayers are generally free to arrange their affairs to minimize their tax liabilities, and a taxpayer has no “patriotic duty” to increase his or her own tax liability. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465, 469 (1935). Nonetheless, although family tax planning is permissible, intra-family transactions will be closely scrutinized by the IRS. Royster v. Commissioner, T.C. Memo. 1985-258, aff’d, 820 F.2d 1156 (11th Cir. 1987); Barnes Grp., Inc. v. Commissioner, T.C. Memo. 2013-109, at *51, aff’d, 593 F. App’x 7 (2d Cir. 2014).
A taxpayer may structure a transaction to minimize tax liability under the Code; nevertheless, the transaction must have “economic substance.” Kirchman v. Commissioner, 862 F.2d 1486, 1491 (11th Cir. 1989); Glass v. Commissioner, 87 T.C. 1087 (1986). If there is nothing of substance to be realized by the taxpayers from the transaction beyond a tax deduction, the IRS will not respect the transaction and will deny any deductions claimed therefrom. Knetsch v. United States, 364 U.S. 361, 366 (1960).
Certain courts, including the Fourth Circuit (where appeal of the present case would lie), apply a two-pronged “economic reality” test, which looks at the parties’ intent as well as the economic substance of the transaction. United States v. Bergbauer, 602 F.3d 569, 577-578 (4th Cir. 2010); Gen. Ins. Agency, Inc. v. Commissioner, 401 F.2d 324, 330 (4th Cir. 1968). Both determinations are questions of fact, and the taxpayer bears the burden of proof. Bergbauer, 602 F.3d. at 578.
When a Sale is Closed for Tax Purposes
In the context of real property, a sale and transfer of ownership is complete upon the earlier of the passage of legal title or the practical assumption of the benefits and burdens of ownership. Keith v. Commissioner, 115 T.C. 605, 611 (2000). A right to possession; an obligation to pay taxes, assessments, and charges against the property; a responsibility for insuring the property; a duty to maintain the property; a right to improve the property without the seller’s consent; a bearing of the risk of loss; and a right to obtain legal title at any time by paying the balance of the full purchase price are each factors that the Tax Court considers indicative of ownership. Id. at 611-612. The Tax Court applies a facts and circumstances test to determine if and when ownership practically shifted from seller to buyer. See Clodfelter v. Commissioner, 426 F.2d 1391, 1393 (9th Cir. 1970).
Taxpayers Bound to Form of Sale Transaction
A taxpayer may not recharacterize a transaction simply to avoid the tax consequences of the form of the transaction actually chosen. Snowa v. Commissioner, 123 F.3d 190, 198 n.11 (4th Cir. 1997). Thus, taxpayers are generally liable for the tax consequences of the transaction they actually executed. They may not recast the transaction to obtain tax benefits. Estate of Leavitt v. Commissioner, 875 F.2d 420, 423 (4th Cir. 1989).
Changes in Accounting Methods
A taxpayer must compute taxable income under the method of accounting it regularly uses in keeping its books. IRC § 446(a). If the IRS determines that a taxpayer’s method of accounting does not clearly reflect income, it has broad discretion to select a method of accounting that (in its opinion) more clearly reflects the income of the taxpayer. IRC § 446(b).
The IRS’s determination with respect to a change in accounting methods may be challenged only upon a showing of abuse of discretion, which, in turn, depends upon whether the IRS’s determination is without sound basis in fact or law. RACMP Enters. v. Commissioner, 114 T.C. 211, 218-219 (2000); see also Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532 (1979).
For purposes of adjustments under IRC § 481(a) (adjustments required by changes in method of accounting), once there has been a change in the method of accounting, no statute of limitations applies to the IRS’s authority to correct errors on old tax returns. See Mingo v. Commissioner, 773 F.3d 629, 636 (5th Cir. 2014), aff’g T.C. Memo. 2013-149.
Substance Over Form for Loss from Sale of Property
IRC § 165 provides for the deductibility of losses from the sale of property. Under Treas. Reg. § 1.165-1(b), a loss must be evidenced by closed and completed transactions, fixed by identifiable events, and actually sustained during the taxable year. Only a bona fide loss is allowable. Substance, not form, governs the determination of a deductible loss. See Du Pont v. Commissioner, 118 F.2d 544, 545 (3d Cir. 1941) (noting that a “controlled or sympathetic vendee” can “divest a sale of its fundamental incident of finality”), aff’g Raskob v. Commissioner, 37 B.T.A. 1283 (1938).
As noted above, taxpayers are liable for the tax consequences of the transaction they actually execute and may not recast the transaction to reap tax benefits under a substantially different in economic theory. Bergbauer, 602 F.3d at 576 (quoting Estate of Leavitt, 875 F.2d at 423). Stated differently, the Tax Court binds taxpayers to the form of their transaction when the taxpayers attempt to recharacterize an otherwise valid agreement bargained for in good faith. Id.
Underpayment Penalty (IRC § 6664(c)) – Reliance on Advice of Tax Advisor – Reasonable Cause
Under IRC § 6664(c)(1), the underpayment penalty does not apply to any portion of an underpayment if a taxpayer had reasonable cause and acted in good faith with respect to such portion, with due consideration given to the taxpayer’s experience, knowledge, and education. Treas. Reg. § 1.6664-4(b)(1). Reliance on the advice of a tax adviser may constitute reasonable cause and good faith if such reliance was itself reasonable and in good faith. Id.
To show reliance on an adviser, a taxpayer must prove that: (1) the adviser was competent and had sufficient expertise to justify reliance, (2) the taxpayer gave the adviser all necessary and accurate information, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Neonatology Assocs. P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). While the IRS bears the initial burden of production to show a substantial understatement of income tax pursuant to IRC § 7491(c), once that burden is satisfied, the burden shifts to the taxpayer to prove any defenses to penalties. Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
(T.C. Memo. 2020-9) Cuthbertson v. Commissioner
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