Kelly v. Commissioner
T.C. Memo. 2021-76

On June 28, 2021, the Tax Court issued a Memorandum Opinion in the case of Kelly v. Commissioner (T.C. Memo. 2021-76). The primary issues presented in Kelly v. Commissioner were whether transfers from a company to the petitioner were loans, and if so, whether the petitioner received taxable distributions or cancellation of indebtedness (COD) income when the loans were cancelled.

Background to Kelly v. Commissioner

Kelly v. CommissionerThe petitioner was a 50% owner of Lucky Bastard Records. As of December 2007, Lucky Bastard owed nearly $1 million to petitioner’s S corporation, First Commercial Corp. (FCC). This was but one of many loans between the petitioner’s numerous companies. This fact bears absolutely no relevance to the decision, but the Tax Court thought it was funny and left it in the opinion.  This, Alanis, is irony…

Over the decades of their operations, the petitioner’s companies developed accounting departments that employed qualified professionals. They also employed in-house legal counsel. In June 2003, the petitioner acquired his first publicly traded company, NSI, a Delaware corporation (NSI-DE), for $113 million (NSI acquisition), with the intention of liquidating its assets and investing the proceeds in other business ventures. The petitioner borrowed the purchase price from institutional lenders and a private investor. He personally guaranteed these loans. At some point, the petitioner caused NSI-DE to organize a California corporation by the same name as a wholly owned subsidiary (NSI-CA). Together, these corporations formed NSI. In 1985, NSI bought asbestos.  Technically, it bought companies that produced asbestos to handle their claims, but still, it invested heavily in asbestos. When the NSI acquisition was completed, NSI-DE had over $1 billion in insurance coverage and equity in its assets, which would have been sufficient to pay its asbestos liabilities in full. Between 2004 and March 2011 NSI transferred approximately $175 million to the petitioner and his affiliated companies that NSI characterized as loans in its books and records.

In 2008, the real estate market dropped out, and the petitioner was in dire financial straits. He wanted to avoid bankruptcy but found it impossible to pay third-party debts. As of December 31, 2007, FCC’s books reflected that there was debt due from the petitioner’s affiliated companies to FCC of $25,594,007. On that date FCC wrote off as bad debts amounts due from the affiliated companies. On December 31, 2010, the petitioner wrote off nearly $87 million of debt owed to NSI. He reported a bad debt write off in the same amount on his 2010 personal income tax return.

The petitioner also owned a Cayman Islands company and he failed to file a Form 5471 in 2008 and 2009 until sometime in 2019.

Statute of Limitations

The period of limitations under IRC § 6501 is in dispute for 2007, 2008, and 2009. The IRS argues the filing of false or fraudulent returns with the intent to evade tax under IRC § 6501(c)(1). It argues that the periods of limitations remain open under IRC § 6501(c)(8) for 2008 and 2009 on the basis that the petitioner failed to file timely Forms 5471 to report the Cayman corporation as a controlled foreign corporation as required by IRC § 6038(a)(1) for these two years. The Tax Court found that because the Forms 5471 were not filed until 2019, the period of limitations for the 2008 and 2009 tax years remain open until 2022, three years from when the petitioner filed the Forms 5471. However, if reasonable cause for the failure to file Forms 5471 exists, then under IRC § 6501(c)(8)(B) only the adjustments related to the Cayman corporation would remain open under the statute of limitations. The petitioner asserts that reasonable cause exists and stems from the failure of his tax return preparer to follow through on the information that the petitioner and his staff provided to it.

Reasonable Cause

IRC § 6501(c)(8) does not define reasonable cause. Nor do the regulations thereunder. However, it is appropriate to rely on the Supreme Court’s definition in United States v. Boyle, 469 U.S. 241, 246 (1985), that the taxpayer must exercise “[o]rdinary business care and prudence” (quoting Treas. Reg. § 301.6651-1(c)(1)). The Tax Court has relied on this definition for the reasonable cause defense to the IRC § 6038(b) penalty for a failure to furnish the appropriate information with a return. See Flume v. Commissioner, T.C. Memo. 2017-21.

Reasonable WCTaxpayers can establish reasonable cause on the basis of their reliance on the advice of a tax professional. Id. Such reliance requires that the taxpayer prove: (i) the adviser was a competent professional with sufficient expertise, (ii) the taxpayer provided necessary and accurate information to the adviser, and (iii) the taxpayer relied in good faith on the adviser’s judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). The taxpayer’s education and business experience are relevant to determine whether he reasonably and in good faith relied on a tax professional. Treas. Reg. § 1.6664-4(b)(1).

The IRS contends that it was not enough for the petitioner to inform his return preparer that the Cayman corporation was a foreign entity, and it implies that the petitioner should have advised the preparer that Form 5471 was required. The failure to file the Forms 5471 does not present an obvious tax obligation which was negligently omitted from information that a taxpayer provided to the return preparer. The petitioner, through his staff, provided the necessary information to the preparer, identified the corporation as a foreign corporation, and stated that he was unsure of the reporting requirements. Having done this, the petitioner reasonably relied on the preparer to prepare his returns properly. While it could be argued that the preparer should have done more to ascertain the petitioner’s filing obligations, it was reasonable for him to rely on the preparer do so. A taxpayer need not question the advice provided, obtain a second opinion, or monitor the advice received from the professional. Boyle, 469 U.S. at 251.

No facts suggest that the failure was the result of a conflict of interest or a “too good to be true” situation for either year. Ultimately, the petitioner’s reliance on the preparer to help meet his filing obligations was reasonable and done in good faith, and the periods of limitations for 2008 and 2009 do not remain open for adjustments unrelated to the Cayman corporation under IRC § 6501(c)(8)(A) after the application of IRC § 6501(c)(8)(B).


The IRS determined fraud penalties under IRC § 6663, for which the IRS bears the burden of proof by clear and convincing evidence. See IRC § 7454(a); Tax Court Rule 142(b). The IRS’s burden is to prove, for each year, by clear and convincing evidence, that (1) the petitioner underpaid his tax for that year and (2) some part of that underpayment for that year was due to fraud. See Parks v. Commissioner, 94 T.C. 654, 660-661 (1990).

Fraud for these purposes is defined as intentional wrongdoing with the specific purpose of avoiding a tax believed to be owed. DiLeo v. Commissioner, 96 T.C. 858, 874 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). Stated differently, imposition of the civil fraud penalty is appropriate upon a showing by the Commissioner that the taxpayer intended to evade taxes believed to be owing by conduct designed to conceal, mislead, or otherwise prevent the collection of taxes. Id.; see also Petzoldt v. Commissioner, 92 T.C. 661, 698 (1989). But fraud “does not include negligence, carelessness, misunderstanding or unintentional understatement of income.” United States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956). Fraud “is not proven when a court is left with only a suspicion of fraud, and even a strong suspicion is not sufficient to establish a taxpayer’s liability for the fraud penalty.” Branson v. Commissioner, T.C. Memo. 2012-124, slip op. at 23 (citing Olinger v. Commissioner, 234 F.2d 823, 824 (5th Cir. 1956), aff’g in part, rev’g in part on another ground T.C. Memo. 1955-9, Davis v. Commissioner, 184 F.2d 86, 87 (10th Cir. 1950), and Green v. Commissioner, 66 T.C. 538, 550 (1976)). Moreover, even when a taxpayer “engage[s] in aggressive tax planning to minimize his taxes”, this Court has found that such action alone is not enough to establish the requisite fraudulent intent. Klaas v. Commissioner, T.C. Memo. 2009-90, slip op. at 33, aff’d, 624 F.3d 1271 (10th Cir. 2010).

As direct proof of a taxpayer’s intent is seldom available, fraud has been established by circumstantial evidence and reasonable inferences drawn from the record. Stoltzfus v. United States, 398 F.2d 1002, 1005 (3d Cir. 1968); DiLeo, 96 T.C. at 874. Courts have thus developed a list of “badges of fraud” useful in determining whether there is circumstantial evidence of fraudulent intent. Niedringhaus v. Commissioner, 99 T.C. 202 (1992).

Among the badges of fraud are the following: (1) an understatement of income, (2) inadequate maintenance of records, (3) a failure to file tax returns or the filing of false returns, (4) offering implausible or inconsistent explanations of behavior, (5) concealment of income or assets, and (6) failure to cooperate with tax authorities. Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601. Courts have also considered: (7) engaging in illegal activities; (8) dealing in cash; (9) failing to make estimated payments; (10) offering false or incredible testimony; and (11) filing false documents. Niedringhaus, 99 T.C. at 211; Parks, 94 T.C. at 664-665.

Additionally, the taxpayer’s background, level of education, and prior history of filing proper returns are relevant. Niedringhaus, 99 T.C. at 211. A taxpayer’s education and sophistication are not themselves badges of fraud but are relevant factors in determining “whether a taxpayer could have formed the intent necessary to be found liable for the fraud penalty.” Holmes v. Commissioner, T.C. Memo. 2012-251, at *31 n.16 (quoting Wickersham v. Commissioner, T.C. Memo. 1999-267, slip op. at 12), aff’d, 593 F. App’x 693 (9th Cir. 2015).

The IRS’s position is in effect that the petitioner had been engaged in tax fraud since the 1990s with his practice of using intercompany loans or that the petitioner’s practice became fraudulent with the NSI acquisition. The Tax Court found that the IRS has failed to establish fraudulent intent by clear and convincing evidence on the basis of either premise. Regardless of whether the loans were properly characterized as such for tax accounting purposes, the evidence does not prove that the loan characterizations were made with fraudulent intent.

Intercompany Transfers

An intent to establish a debtor-creditor relationship exists if, when the transfers were made, the debtor intended to repay the funds and the creditor intended to enforce repayment. See, e.g., Beaver v. Commissioner, 55 T.C. 85, 91 (1970); Fisher v. Commissioner, 54 T.C. 905, 909-910 (1970). This is also a question of fact to be determined upon a consideration of all pertinent facts. Haber v. Commissioner, 52 T.C. 255, 266 (1969), aff’d, 422 F.2d 198 (5th Cir. 1970).

A bona fide debt is a debt that arises from a debtor-creditor relationship on the basis of a valid and enforceable obligation to pay a fixed or determinable sum of money. 2590 Assocs., LLC v. Commissioner, T.C. Memo. 2019-3, at *21. Whether an advance gives rise to a bona fide debt for Federal tax purposes is determined from all the facts and circumstances. Id. To constitute a bona fide debt, at the time of the transfer there must be a real expectation of repayment and an intent on the part of the purported creditor to secure repayment. Id.

Caselaw has established objective factors to consider when answering the question of whether a bona fide debtor-creditor relationship exists. Those factors include: (1) whether the promise to repay is evidenced by a note or other instrument that evidences indebtedness, (2) whether interest was charged or paid, (3) whether a fixed schedule for repayment and a fixed maturity date were established, (4) whether collateral was given to secure payment, (5) whether repayments were made, (6) what the source of any payments was, (7) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan, and (8) whether the parties conducted themselves as if the transaction was a loan. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980); see also Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121; Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Commissioner v. Valley Morris Plan, 305 F.2d 610, 618 (9th Cir. 1962) (defining a loan for Federal tax purposes as “an agreement, either expressed or implied, whereby one person advances money to the other and the other agrees to repay it upon such terms as to time and rate of interest, or without interest, as the parties may agree” (quoting Nat’l Bank of Paulding v. Fid. & Cas. Co., 131 F. Supp. 121, 123 (S.D. Ohio 1954))), rev’g in part 33 T.C. 572 (1959); Knutsen-Rowell, Inc. v. Commissioner, T.C. Memo. 2011-65. By 2008, the petitioner no longer had a reasonable prospect of repaying the “loans.”

The respect for loan formalities also wanes as the economy made repayment all but impossible beginning in 2008. Ultimately, the Tax Court held that all NSI transfers and other intercompany transfers are not properly characterized as loans beginning on January 1, 2008. Thus, the transfers beginning on January 1, 2008, were shareholder distributions under IRC § 301 and IRC § 1368.

COD Income and Bad Debt Deduction for 2010

The Tax Court held that the petitioner cannot create a deduction by recording intercompany debt and then canceling it. There must be a debt owed to the petitioner that is uncollectible to create a business bad debt. The petitioner has not established such debt exists or was worthless in 2010. Therefore, the petitioner had COD income of $145 million in 2010.

In Combrink v. Commissioner, 117 T.C. 82, 94 (2001), the Tax Court stated that cancellation of shareholder debt “is considered the equivalent of a distribution of money in the face amount of the obligation.” In an analogous situation, the assumption of shareholder debt under section 1001(b) is deemed money received in the face amount of the debt. Maher v. Commissioner, 55 T.C. [*63] 441, 456 (1970), aff’d in relevant part and remanded in part, 469 F.2d 225 (8th Cir. 1972). Accordingly, the Tax Court held that the distributions caused by cancellation of shareholder debt are properly set at the face amounts of the debts canceled.

The IRS argued that third-party debt owed by the Cayman corporation and personally guaranteed by the petitioner should be removed from his liabilities. However, the Tax Court held that such debt is appropriate to consider as liability of the petitioner where it is “more probable than not that he will be called upon to pay that obligation in the amount claimed.” Merkel v. Commissioner, 109 T.C. 463, 484 (1997) (establishing a liability on the basis of a personal guaranty), aff’d, 192 F.3d 844 (9th Cir. 1999). Additional computations were necessary to determine whether the petitioner was actually insolvent.

(T.C. Memo. 2021-76) Kelly v. Commissioner

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