On February 19, 2020, the Tax Court issued a Memorandum Opinion in the case of Keels v. Commissioner (T.C. Memo. 2020-25). The issues presented in Keels v. Commissioner were (1) whether petitioner substantiated his expenses underlying his claimed deductions by maintaining adequate records, and (2) whether, because the IRS raised the application of IRC § 409A as a new basis for disallowance of the petitioner’s deductions (which had not been raised in the notice of deficiency), consequently shifting the burden of proof to the IRS as to such new basis of disallowance, the IRS met its burden of proof as to the elements of IRC § 409A.
Substantiation of Expenses Underlying Deductions in Keels v. Commissioner
The fact that a taxpayer claims a deduction on his income tax return is not sufficient to substantiate the deduction. Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979); Roberts v. Commissioner, 62 T.C. 834, 837 (1974). A taxpayer must substantiate expenses underlying each claimed deduction by maintaining records sufficient to establish the amount of the expense to enable the IRS to determine the correct tax liability. See IRC § 6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001); Treas. Reg. § 1.6001-1(a). In addition, the taxpayer bears the burden of substantiating the amount and purpose of the claimed deduction. Higbee, 116 T.C. at 440; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d, 540 F.2d 821 (5th Cir. 1976).
Testimony of Petitioner – Self-Serving, Likely; Disregarded, Not Always
Simply because testimony is self-serving is not a reason to automatically reject the evidence as unreliable. Lupyan v. Corinthian Colls. Inc., 761 F.3d 314, 320-321, 321, n.2 (3d Cir. 2014). The Tax Court decides whether a witness’ testimony is credible by relying on objective facts, the reasonableness of the testimony, the consistency of the witness’ statements, and the witness’ demeanor. See Quock Ting v. United States, 140 U.S. 417, 420-421 (1891); Wood v. Commissioner, 338 F.2d 602, 605 (9th Cir. 1964), aff’g 41 T.C. 593 (1964); Pinder v. United States, 330 F.2d 119, 124-125 (5th Cir. 1964); Concord Consumers Hous. Coop. v. Commissioner, 89 T.C. 105, 124 n.21 (1987). The Tax Court may discount testimony which it finds to be unworthy of belief, see Tokarski v. Commissioner, 87 T.C. 74, 77 (1986), but it may not arbitrarily disregard testimony that is competent, relevant, and uncontradicted. See Conti v. Commissioner, 39 F.3d 658, 664 (6th Cir. 1994), aff’g and remanding 99 T.C. 370 (1992).
Court Raises Issue with “Bluster and Sarcasm”
The Tax Court notes that the petitioner’s testimony was “sometimes argumentative and was sprinkled with bluster and sarcasm.” And this is wrong, because? The petitioner was asked at one point how he knew that expenses at OfficeMax were for items used, wait for it, in his office.*
Author’s Note: I would not have just “sprinkled” my reply with bluster and sarcasm. In the petitioner’s position, it would have been all bluster and sarcasm. Having said that, this case brings me back to the old law school example of stopping while you’re ahead during the cross-examination of a witness. A young cocky defense attorney is questioning a doctor, who alleges that the individual the whippersnapper’s client is accused of murdering was dead on arrival:
Attorney: Did you check the man’s pulse?
Attorney: Did you check to see if he was breathing?
Attorney: But you just testified that you were sure he was dead, isn’t that correct?
Attorney: And how can you be absolutely certain he was dead?
Doctor: Well, his body was on one table, and his head was on another, so I just took a leap of faith.
Basis for Tax Due in Notice of Deficiency Must be in Notice of Deficiency
The basis for tax due in a notice of deficiency must be stated in the notice. IRC § 7522(a); IRC § 7522(b)(1). Although, under IRC § 7522(a), the failure of the IRS to state the basis does not invalidate the notice, the burden of proof shifts to the IRS. Shea v. Commissioner, 112 T.C. 183, 197 (1999). In this way, the Tax Court treats a later-asserted basis for tax due after issuance of a notice is akin to the IRS raising a new issue in the answer to a petition. Shea, 112 T.C. at 196-97.
In the present case, the IRS’s late assertion of IRC § 409A (nonqualified deferred compensation payments) closely resembles the IRS’s assertion in a post-trial brief in Shea that a deduction should be disallowed on the basis of IRC § 66(b) (disregard of community property laws), when the statutory notice of deficiency (SNOD) only provided failure of substantiation as the basis of the IRS’s disallowance of the petitioner’s deductions. In the present matter, the SNOD did not identify any issues relating to deferred compensation or IRC § 409A. Because the SNOD did not include the basis on which the IRS relies, respondent bears the burden of proof on that issue.
Prevailing under IRC § 409A
To prevail under IRC § 409A, a taxpayer must show all three of the following elements. First, the taxpayer must show that distributions from the plan may not occur before the taxpayer’s separation from service, disability, death, an unforeseen emergency, or a change in ownership of the corporation. IRC § 409A(a)(2)(A)(i)-(vi). Second, the taxpayer must show that the plan does not permit acceleration of benefits except to the extent provided by regulations. IRC § 409A(a)(3). Third, the taxpayer must show that the election to defer compensation must be timely made. IRC § 409A(a)(4)(B)(i). These requirements do not apply if the benefits are subject to substantial risk of forfeiture or were previously taxable. IRC § 409A(a)(1)(A)(i).
A Cautionary Tale for IRS Counsel
Because IRC § 409A was not included in the SNOD as a basis for disallowance of deductions, the burden rests on the IRS to prove its application. For the IRS to meet its burden of proof, it must show (1) that the plan fails to include any one of the three requirements above; (2) that petitioner does not have a substantial risk of forfeiture; and (3) that petitioner was not previously taxed on the deferred compensation.
Unfortunately for the IRS, the qualified retirement plan documents weren’t in the record. Why? Because the petitioner failed (or refused, it doesn’t much matter) to provide them to the IRS or put them on the record. But wait, you say, why should the IRS be penalized for something that the petitioner failed to provide? The IRS is “penalized” for not including IRC § 409A as a basis for the disallowance of the deduction. If it had, the burden of proof would have rested squarely on the petitioner. Because the IRS could not prove that the petitioner’s qualified retirement plan failed to meet any of the requirements of IRC § 409A, the IRS did not meet its burden, and the petitioner prevailed on this matter.Add to favorites