On March 7, 2022, the Tax Court issued a Memorandum Opinion in the case of Hacker v. Commissioner (T.C. Memo. 2022-16). The primary issues presented in Hacker were whether the petitioners received imputed wages and constructive dividends from their day care centers and whether the petitioners were liable for the civil fraud penalty under IRC § 6663.
A Note on Hacker v. Commissioner
You may remember the Hackers from two Tax Court opinions from 2021, Blossom Day Care Centers, Inc. v. Commissioner (Blossom I), T.C. Memo. 2021-86, and Blossom Day Care Centers, Inc. v. Commissioner (Blossom II), T.C. Memo. 2021-87. Suffice it to say, 2021 was not a good tax year for the couple, and it turns out that 2022 is not shaping up well for them, either.
Procedural Background to Hacker v. Commissioner
If you will recall, the IRS examined the returns of the petitioners and their day care center, a corporation of which the petitioners are the sole shareholders. Following that examination, the IRS issued notices of deficiency to Blossom and determination of worker classification, and to the petitioners a notice of deficiency that is the subject of this opinion.
The petitioners and Blossom petitioned this Court for redetermination of the deficiencies and employment classification, and those cases were consolidated for trial, briefing, and opinion. The Tax Court determined that the petitioners were both employees of Blossom in Blossom I and that Blossom was liable for deficiencies in Blossom II.
Factual Background to Hacker v. Commissioner
The Hackers, Barry and Celeste, were Sooners born and bred. Beginning in 1986 and at all relevant times, the petitioners were the sole shareholders and corporate officers of Blossom, an Oklahoma corporation that operated childcare centers in the Tulsa metropolitan area. In addition to running the daycare centers, Mr. Hacker worked as an electrician, doing business under the name Accurate Electric and reporting income on Schedule C.
The Hackers were also the sole owners of the passthrough entities Hacker Corp., an S corporation, and Hacker Investment, a limited liability company. The petitioners have three children, sons Steven and Ashley, born in 1975 and 1979, respectively, and daughter Whitney, born in 1987.
Mrs. Hacker opened Blossom as an unincorporated business entity in 1982. Blossom was incorporated in 1986 and was a valid corporation in the State of Oklahoma during all years at issue. The petitioners were the sole shareholders of Blossom, with Mrs. Hacker owning 51% and Mr. Hacker owning 49% of Blossom’s stock. Blossom operated five separate day care centers through 2005 and opened a sixth that year.
The petitioners were Blossom’s only corporate officers from its incorporation through the years at issue. Mrs. Hacker served as Blossom’s president, as well as its director of curriculum and education. Her duties included personally overseeing and supervising employees, making hiring and firing decisions, and managing Blossom’s six daycare directors. All of Blossom’s employees ultimately reported to her.
Mr. Hacker, also since 1986 and through the years at issue, served as Blossom’s corporate vice president, as well as its secretary and treasurer. He also served as Blossom’s director and as its director of accounting and finance. He had authority over all of Blossom’s bank accounts, and his daily responsibilities included depositing parents’ payments for childcare into Blossom’s bank accounts and personally writing all of the payroll checks to Blossom’s 90 employees.
Together the petitioners actively participated in Blossom’s daily operation, frequently working 50 to 60 hours per week, performing all levels of tasks from maintenance and custodial duties to classroom instruction and supervision of teachers to purchasing and delivering food. They were also responsible for ensuring that the programs and employees at Blossom complied with the standards of the Oklahoma Department of Human Services.
During the years at issue, the petitioners did not receive a salary or wages from Blossom. Instead, Blossom made payments in the form of management fees to Hacker Corp., which in turn paid wages to the petitioners and the Hacker children for services rendered to Blossom. It is important to note, however, that the Hacker children were not employees of Blossom during the years at issue.
The petitioners and their children used the credit cards to make purchases necessary to operate the daycare centers, but they also regularly used them to pay personal expenses. During 2004 through 2007 the Hackers and their children charged thousands of dollars in personal expenses on Blossom’s credit card account, as well as their own credit cards, all of which Blossom invariably paid.
In addition to routine personal purchases, such as restaurant meals, auto expenses, and personal medical expenses, the Hackers either used the corporate credit card or had Blossom pay for their college tuition, vacations, jewelry, and other luxury items. The Hacker children continued to make personal purchases with the credit cards even though they were not employees of Blossom and during periods when they were not employees of Hacker Corp.
In addition to paying for credit card purchases, Blossom provided petitioners and their children with vehicles. Blossom paid the notes on the cars and claimed depreciation on its return.
Valiant Attempts at Bookkeeping (by the Bookkeepers, not the Petitioners)
Blossom did not have an in-house bookkeeper before December 2007. Rob Crowder, a certified public accountant, prepared Blossom’s general ledgers and financial statements, which would serve as the basis for its tax returns for 2004, 2005, and 2006.
Mr. Crowder prepared Blossom’s general ledgers and financial statements using information that the petitioners provided. They gave him bank statements from Blossom’s operating, payroll, and loan accounts but failed to provide any records relating to substantial undeposited cash payments received from Blossom parents. The Hackers also provided credit card statements but did not provide Mr. Crowder with any guidance as to which expenditures were business expenses and which were personal.
Despite the lack of guidance, Mr. Crowder determined that many of the expenses were personal, and he marked them in the ledger as “officer” expenses. This personal “officer” account increased from $208,776.22 at the beginning of 2004 to $1,379,408 at the end of 2006—primarily on account of charges to the credit cards. In December 2007 Blossom hired Bonnie King to perform in-house bookkeeping and accounting functions. Like Mr. Crowder, Ms. King posted in the “officer” account those expenses that appeared to her to be personal.
In 2002, the petitioners incorporated Hacker Corp. as an Oklahoma corporation. During all years relevant to this case Hacker Corp. elected to be treated as an S corporation for federal income tax purposes. The petitioners were the sole shareholders of Hacker Corp., each owning 50% of the company’s stock. During 2004 through 2008, Blossom made payments in the form of management fees to Hacker Corp., which in turn paid wages to the petitioners and their children for services they rendered to Blossom.
Except that the children did not, technically, render any such services.
Before May 2005 Blossom or the petitioners owned the real properties on which Blossom’s daycare locations operated. In May 2005 title to each property was transferred by quitclaim deed to Hacker Corp., and the transfers were recorded in the Tulsa County land records. Following the transfers, Blossom continued to operate its daycare centers at the same locations, but Hacker Corp. assumed payment of the property taxes and in June 2005 began making payments on the mortgages securing the properties held by Security Bank.
No formal lease agreement between Blossom and Hacker Corp. was signed, but Blossom began making rent payments either directly to Hacker Corp. or to Security Bank in payment of the mortgages on behalf of Hacker Corp. Beginning on its tax return for 2005, Hacker Corp. claimed deductions for depreciation with respect to the buildings, for payment of property taxes, and for interest paid in connection with the mortgages. The management fees and rent payments from Blossom were Hacker Corp.’s only income for 2004 through 2008.
On their returns, the petitioners reported total tax of $50,775, $6,976, $65,568, zero, and zero for 2004, 2005, 2006, 2007, and 2008, respectively. Their reported income for each year included the wages received from Hacker Corp.; income or loss from Hacker Corp., reported on Schedule E; and income or loss from rental real estate (which they reported directly on Schedule E for 2004 and as flowthrough amounts from Hacker Investment in subsequent years). For 2006, 2007, and 2008, they also reported income from Accurate Electric on Schedule C. They did not report wages, salary, or dividends from Blossom for any year 2004 through 2008.
The (Thorough) Examination
The IRS examined petitioners’ tax returns for 2004, 2005, 2006, 2007, and 2008, as well as the returns of Hacker Corp. for 2004 through 2008, Hacker Investment for 2005 through 2008, and Blossom for 2004 through 2007, as well as Blossom’s worker classifications of petitioners for 2005 through 2008. Beginning in March 2008, the petitioners executed, both for themselves and on behalf of Blossom, a series of timely Forms 872, Consent to Extend the Time to Assess Tax, for 2004, 2005, 2006, and 2007.
During the examination of petitioners’ returns, Revenue Agent Floyd (RA Floyd) conducted a bank deposits analysis of petitioners’ bank accounts, as well as the accounts of their business entities.
This (somewhat foreseeably) did not turn out well for the Hackers.
RA Floyd examined their bank account records, identified all of the deposits, and, after subtracting out reported income and items identified as nontaxable, concluded that petitioners had received unreported income. RA Floyd additionally determined that a 2004 note receivable (which was never repaid) was a personal loan forgiven by Blossom. Throughout the examination, petitioners attempted to conceal their receipt of personal benefits from Blossom.
Mr. Hacker claimed that one of his son’s wedding was “a big celebration of Blossom” and that the various trips of the petitioners and their children to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans, paid for by Blossom, were “for business” or “so that they would not be distracted while performing administrative tasks.” Following the examination, the IRS called bullshit, and it issued the notice of deficiency to the petitioners, as well as notices of deficiency and determination of worker classification to Blossom, determining that the petitioners were employees of Blossom and should have received wage compensation during the years covered.
The petitioners’ deficiencies were not small, either: $687,020 (2004); $833,610 (2005); $616,349 (2006); $929,201 (2007); and $869,657 (2008).
But wait; there’s more.
In Blossom I and Blossom II, the Tax Court sustained the IRS’s determinations that the petitioners were employees of Blossom and that remuneration provided directly or indirectly to them for their work as such constituted wages. In so finding, the Tax Court observed that the petitioners provided substantial services to Blossom and received compensation in the form of money, property, and other direct and indirect benefits. Such compensation constitutes gross income to them.
The petitioners offered ZERO argument or evidence to show that the wages the IRS determined were erroneous or unreasonable or should be excluded from gross income. Consistent with the Tax Court’s holdings in Blossom I and Blossom II, the Tax Court sustained the wage adjustments in the present case.
IRC § 61(a)(7) includes dividends in a taxpayer’s gross income. When a corporation distributes property to a shareholder as a dividend, whether formally or informally, the shareholder must include the distribution in gross income to the extent of the corporation’s earnings and profits.
A “constructive dividend” arises when a corporation confers an economic benefit upon a shareholder without expectation of repayment and the corporation on the date of the deemed distribution had current or accumulated earnings and profits. The shareholder need not receive the dividend directly and must include in gross income payments the corporation made on the shareholder’s behalf.
In determining whether a shareholder received a constructive dividend, the Court considers whether the payment benefited the shareholder personally rather than furthering the interest of the corporation. Where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred.
As previously discussed, gross income means all income from whatever source derived. Gross income is construed broadly to include all “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Every person subject to income tax is required to maintain books and records to establish the amount of gross income and deductions shown by that person on his or her income tax return.
Bank deposits are prima facie evidence of income. The bank deposits method of proof presumes that all deposits into a taxpayer’s bank account during a given period constitute taxable income unless the taxpayer can show that the deposits were nontaxable. The Government must take into account any nontaxable source or deductible expense of which it has knowledge.
Schedule E Nonpassive Income
An S corporation is not subject to federal income tax at the entity level. Thus, the corporation’s income, losses, deductions, and credits are passed through to the shareholders at their pro rata shares. Where a notice of deficiency includes adjustments for S corporation items with other items unrelated to the S corporation, the Tax Court has jurisdiction to determine the correctness of all adjustments. The substantiation requirements of IRC § 162 also apply to business expense deductions for S corporations.
On its 2005, 2006, 2007, and 2008 returns, Hacker Corp. calculated its depreciation by carrying over the same cost basis in the properties that Blossom had used to calculate the depreciation on its 2004 return. The IRS recalculated a depreciation amount using the fair market value of the buildings at the time of transfer and, in turn, increased Hacker Corp.’s cost basis in the property acquired from Blossom.
IRC § 301(d) provides that the basis of property received in a distribution made by a corporation to a shareholder shall be the fair market value of the property. IRC § 362(a)(1) provides that, in the case of a transaction to which IRC § 351 applies, the transferee corporation’s basis in the transferred property shall be the same as it would be in the hands of the transferor.
In May 2005 Blossom transferred multiple properties to Hacker Corp. in a transaction deemed to be a distribution to the petitioners pursuant to IRC § 301(a). Accordingly, respondent correctly determined that the depreciable bases in those properties should have been the fair market value at the time of distribution.
Distributions in Excess of Basis
IRC § 1366 through IRC § 1368 govern the tax treatment of S corporation shareholders with respect to their investments in such entities. Specifically, IRC § 1366(a)(1) provides that a shareholder shall take into account his or her pro rata share of the S corporation’s items of income, loss, deduction, or credit for the S corporation’s taxable year ending with or in the shareholder’s taxable year.
With respect to basis, IRC § 1012 sets forth the foundational principle that the basis of property for tax purposes shall be the cost of the property. Cost, in turn, is defined by regulation as the amount paid for the property in cash or other property. IRC § 1367 then specifies adjustments to basis applicable to investments in S corporations.
Basis in S corporation stock is increased by income passed through to the shareholder under IRC § 1366(a)(1) and decreased by, inter alia, distributions not includable in the shareholder’s income pursuant to IRC § 1368; items of loss and deduction passed through to the shareholder under IRC § 1366(a)(1); and certain nondeductible, noncapital expenses.
With respect to the treatment of distributions, the typical rule for entities without accumulated earnings and profits is that distributions are not included in a shareholder’s gross income to the extent that they do not exceed the adjusted basis of his or her stock (but are applied to reduce basis), while any distribution amount in excess of basis is treated as gain from the sale or exchange of property.
The petitioners’ basis in Hacker Corp. at the end of 2004 was zero, because of distributions in excess of basis in 2004. The Tax Court determined that in 2005 the Hackers contributed daycare center properties to Hacker Corp. The IRS’s calculation of basis, however, fails to take into account their 2005 contributions of the daycare center properties, which increase petitioners’ basis in Hacker Corp. by their bases in those properties.
The parties have stipulated that the petitioners’ basis in Hacker Corp. at the end of 2004 was zero. Therefore, the petitioners’ basis for 2005 should include the adjustments for the contribution of the properties.
2005 Capital Gains Income
The IRS determined that petitioners failed to report capital gains income on the sale of a piece of real property in 2005. Gross income includes gains from dealings in property. A taxpayer must recognize gain on the sale of property in an amount equal to the difference between the amount realized and basis. The petitioners bear the burden of establishing basis in their property.
IRC § 162(a) allows as a deduction all ordinary and necessary business expenses paid or incurred in carrying on any activity that constitutes a trade or business. Critically, however, no current deduction is allowed for capital expenditures.
Capital expenditures include amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. The capitalization rules of IRC § 263(a) and the regulations thereunder do not treat an expense to repair property as a capital expenditure. Such an expense is not a capital expenditure because it does not increase the value or prolong the useful life of the property (or adapt the property to a different or new use).
Whether an expense is for a repair is a factual determination that turns on a finding that the work did or did not prolong the useful life of the property, increase its value, or make it adaptable to a different use. As a general, though not absolute, rule, an important factor in determining whether the appropriate tax treatment is an immediate deduction or capitalization is the taxpayer’s realization of benefits beyond the year in which the expenditure is incurred.
IRC § 6663(a) Civil Fraud Penalty
IRC § 6663(a) imposes a penalty equal to 75% of the taxpayer’s underpayment of Federal income tax that is due to fraud. Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax believed to be owing. If any portion of the underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud.
The IRS has the burden of proving fraud by clear and convincing evidence. To carry that burden of proof, respondent must show, for each year, that (1) an underpayment of tax exists and (2) some portion is attributable to the Hackers’ fraud. Fraud is a question of fact to be resolved upon consideration of the entire record. Fraud is never presumed and must be established by independent evidence.
The Tax Court found that the IRS “clearly and convincingly demonstrated for each year at issue that petitioners failed to report income from various sources.” Therefore, the first element of the fraud penalty has been established.
The Tax Court then turned to the second element of the fraud penalty and must determine whether petitioners had the requisite fraudulent intent. Because direct evidence of fraudulent intent is seldom available, fraud may be proven by circumstantial evidence and reasonable inferences drawn from the facts. The taxpayer’s entire course of conduct may be indicative of fraudulent intent.
Circumstances that may indicate fraudulent intent, commonly referred to as “badges of fraud,” include but are not limited to
- understating income;
- maintaining inadequate records;
- giving implausible or inconsistent explanations;
- concealing income or assets;
- failing to cooperate with authorities;
- engaging in illegal activities;
- providing incomplete or misleading information to one’s tax return preparer;
- lack of credibility of the taxpayer’s testimony;
- filing false documents, including false income tax returns;
- failing to file tax returns; and
- dealing in cash.
No single factor is dispositive; however, the existence of several factors “is persuasive circumstantial evidence of fraud.” The IRS argued that the petitioners’ fraudulent intent was demonstrated by a number of the badges of fraud, including their failure to maintain records with respect to personal expenses and cash receipts, the extravagant uses of Blossom’s funds on personal expenses, and Mr. Hacker’s vague, misleading, or uncorroborated statements to RA Floyd.
Simply put, the Tax Court agreed.
Blossom consistently reported gross receipts over $2,000,000 while during the same period petitioners received no wages from Blossom. Even though Blossom paid a management fee to Hacker Corp., the Hackers were paid only relatively low wages.
Despite these low wages, the petitioners and their children financed a lavish lifestyle through Blossom. Blossom provided petitioners and their children with the use of personal vehicles; paid for vacations for the petitioners and their children to the Bahamas, Europe, Hawaii, Las Vegas, and New Orleans; purchased jewelry and other luxury items; and paid numerous routine personal expenses, including restaurant meals, auto expenses, personal medical expenses, mortgage payments, and college tuition.
Petitioners did not report on their personal returns the receipt of these benefits, providing incomplete information to their bookkeepers and return preparers. During the examination of their returns, petitioners attempted to conceal them from respondent through the examination, such as by providing vague, misleading, or outright false statements to RA Floyd.
If any portion of an underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud. Suffice it to say, the petitioners did not carry their burden. Thus, the entire underpayment was subject to the IRC § 6663 fraud penalty.
- A Civil Penalty Approval Form was signed on November 10, 2009, by the immediate supervisor of RA Floyd, who examined petitioners’ returns, approving the imposition of the fraud penalties and the accuracy-related penalties for underpayments due to substantial understatements of income tax. The IRS issued the notice of deficiency on November 14, 2011. Thus, there is no IRC § 6751(b)(1) issue. ↑
- See Treas. Reg. § 1.61-2(a)(1) (stating that “[w]ages…are income to the recipients unless excluded by law”). ↑
- See IRC § §§ 301(a), (c)(1), 316; see also Welle v. Commissioner, 140 T.C. 420, 422 (2013). ↑
- See Welle, 140 T.C. at 422. ↑
- See Epstein v. Commissioner, 53 T.C. 459, 474-75 (1969); Vlach v. Commissioner, T.C. Memo. 2013-116, at *32-33. ↑
- Hagaman v. Commissioner, 958 F.2d 684, 690-91 (6th Cir. 1992), aff’g in part and remanding on other grounds T.C. Memo. 1987-549; Vlach, T.C. Memo. 2013-116, at *33. ↑
- Welle, 140 T.C. at 423. ↑
- IRC § 61(a). ↑
- Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). ↑
- See IRC § 6001; Treas. Reg. § 1.6001-1(a). ↑
- Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Bolles v. Commissioner, T.C. Memo. 2019-42, at *14. ↑
- Clayton v. Commissioner, 102 T.C. 632, 645 (1994). ↑
- DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). ↑
- IRC § 1363(a). ↑
- IRC § 1366(a). ↑
- See Winter v. Commissioner, 135 T.C. 238 (2010); Berry v. Commissioner, T.C. Memo. 2018-143, at *6. ↑
- Tabe v. Commissioner, T.C. Memo. 2019-149, at *21; see also IRC § 1363(b). ↑
- IRC § 351 relates to the transfer of property to a corporation controlled by the transferor. ↑
- See also Blossom II, at *26. ↑
- Treas. Reg. § 1.1012-1(a). ↑
- IRC § 1367(a); see also Gleason v. Commissioner, T.C. Memo. 2006-191, *5. ↑
- IRC § 1368(b). ↑
- See IRC § 358(a). ↑
- IRC § 61(a)(3). ↑
- IRC § 1001; IRC § 1012; see also O’Boyle v. Commissioner, T.C. Memo. 2010-149, *3, aff’d per curiam, 464 F. App’x 4 (D.C. Cir. 2012). ↑
- See Rule 142(a); O’Boyle v. Commissioner, T.C. Memo. 2010-149, at *3. ↑
- See IRC § 263(a). ↑
- INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83 (1992); see also IRC § 263(a)(1). ↑
- See Gibson & Assocs., Inc. v. Commissioner, 136 T.C. 195, 232 (2011). ↑
- Id. at 232-33. ↑
- Id. at 233. ↑
- INDOPCO, Inc., 503 U.S. at 87; Tsakopoulos v. Commissioner, T.C. Memo. 2002-8, *7-8. ↑
- Petzoldt v. Commissioner, 92 T.C. 661, 698 (1989); Minchem Int’l, Inc. v. Commissioner, T.C. Memo. 2015-56, *43, aff’d sub nom. Sun v. Commissioner, 880 F.3d 173 (5th Cir. 2018). ↑
- IRC § 6663(b); see also Minchem Int’l, Inc., T.C. Memo. 2015-56, at *43-*44. ↑
- See IRC § 7454(a); Rule 142(b). ↑
- See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983); Benavides & Co., P.C. v. Commissioner, T.C. Memo. 2019-115, at *31. ↑
- DiLeo, 96 T.C. at 874. ↑
- Minchem Int’l, Inc., T.C. Memo. 2015-56, at *45. ↑
- Niedringhaus v. Commissioner, 99 T.C. 202, 210 (1992); Benavides & Co., P.C., T.C. Memo. 2019-115, at *34. ↑
- Niedringhaus, 99 T.C. at 210. ↑
- Minchem Int’l, Inc., T.C. Memo. 2015-56 at *46. ↑
- Vanover v. Commissioner, T.C. Memo. 2012-79, *4. ↑
- IRC § 6663(b); see also Minchem Int’l, Inc., T.C. Memo. 2015-56, at *43-44. ↑
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