On March 24, 2021, the Tax Court issued a Memorandum Opinion in the case of Martin v. Commissioner (T.C. Memo. 2021-35). The primary issues presented in Martin were whether the IRS abused its discretion in disallowing substantial (old and large) deductions and whether the petitioners were liable for penalties for filing (very) late and for being (very) negligent and for (very) substantially understating their liabilities.
Background to NOLs
The petitioner-husband was a racecar driver and mechanic. His racing team lost $1.7 million when a sponsor “fell through.” This loss drove (Judge Holmes strikes again) the petitioners into Chapter 7 bankruptcy. They were discharged in the late 1990s, but the petitioners “remembered” these large NOLs and carried them into the years at issue (2009 and 2010).
The petitioners disagree over who prepared their tax returns for the years at issue. Petitioner-husband claims that he prepared the 2009 return himself, but that their 2010 return was prepared by some man Mr. Martin thought was named Paul Baker. Mr. Baker was not a CPA but was an “ex-IRS agent.” Petitioner-wife, however, claims that she and her late aunt, Betty Azar, prepared the Martins’ 2009 and 2010 returns.
Their 2009 return shows income of $98, which they offset with a $193 Schedule C loss and a $1,705,711 NOL from their 1993-97 tax years. This huge NOL was rolled over onto their 2010 tax return–this time on their Schedule C—easily canceling out their $25,000 in reported income. Their 2009 return was filed late, on December 22, 2010, but they filed their 2010 return on time.
Judge Holmes observes that “this was not the petitioners’ first collision with the IRS.” The IRS had, in fact, also already audited their 2007-08 and 2011-12 tax years. Those audits settled, and the petitioners argued in a motion for partial summary judgment that these settlements precluded the IRS from challenging the existence or amount of their NOL carryforward for the years before us. The Tax Court analyzed and rejected this argument in an order before trial. This is because the IRS’s concessions for prior tax years do not preclude him from challenging the same issues for later years. Cf. Hopkins v. Commissioner, 120 T.C. 451, 456-57 (2003).
The Basic Case at Hand
This is a fairly standard substantiation case, with a bit of unreported income. The gist of the petitioners’ argument is that because their NOLs had been allowed in the past, they should be allowed here as well.
The IRS disagreed.
So, too, did Judge Holmes.
When a taxpayer does not keep adequate records of his income, the IRS may reconstruct it, see IRC § 6001; IRC § 446(b), and may analyze the taxpayer’s bank deposits to do so, see Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir. 1997) (finding that the IRS may “rationally reconstruct income” where taxpayers fail to offer accurate records”); Parks v. Commissioner, 94 T.C. 654, 658 (1990); see also LeBloch v. Commissioner, 311 F. App’x 960, 961 (9th Cir. 2009), aff’g in part, rev’g in part, and remanding T.C. Memo. 2007-145. A bank deposits analysis assumes that all money deposited in a taxpayer’s bank account during a given period is taxable income, and unexplained deposits are considered prima facie evidence of income. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); see also United States v. Helina, 549 F.2d 713, 715 n. 2 (9th Cir. 1977).
Taxpayers then have the burden to show that such deposits shouldn’t be taxed because they were inheritances, loan proceeds, transfers from another personal account, or other nontaxable transfers. See Palmer, 116 F.3d at 1312. The IRS has to subtract reported income and income from nontaxable sources that it knows about. Helina, 549 F.2d at 715 n.2. If taxpayers believe the IRS’s method of computation is unfair or inaccurate, however, they have the burden to show that unfairness or inaccuracy. Palmer, 116 F.3d at 1312.
The NOL Issue
IRC § 172(a) allows a deduction for an NOL for any tax year in an amount equal to the sum of (1) the NOL carryovers to such year and (2) the NOL carrybacks to such year. The Code defines an NOL as the excess of deductions allowed by chapter 1 of the Code over the gross income, subject to certain modifications. See IRC § 172(c). For the years at issue (2009 and 2010), a taxpayer may generally carry any NOL back to each of the two tax years before the year of the loss, and then carry it forward to each of the twenty tax years after the year of the loss. See IRC § 172(b)(1)(A), (2). In 1997, however, the carryforward period was only 15 years. See IRC § 172(b)(1)(A) (1996).
Taxpayers can elect to forgo a carryback, but without a timely action they must carry NOLs back before they can carry them forward. IRC § 172(b)(2), (3). An election to waive a carryback must be made by the due date of the return “for the taxable year of the net operating loss for which the election is to be in effect.” IRC § 172(b)(3).
Burden of Substantiating NOLs
The petitioners bear the burden of substantiating their NOLs by establishing their existence as well as the amount that may be carried over to the years at issue. See Rule 142(a); Powers v. Commissioner, T.C. Memo. 2013-134, at *44. As part of that burden, the petitioners needed to have filed with their 2009 and 2010 returns a concise statement setting forth the amount of the NOL deduction claimed and all material and pertinent facts, including a detailed schedule showing how they computed their NOL deductions. See Treas. Reg. § 1.172-1(c). They did not.
Effect of Bankruptcy on NOLs
The petitioners’ bankruptcy proceedings could also affect the viability of their NOLs, because when someone files a bankruptcy petition, a bankruptcy estate springs to life and takes over his interests in property, which includes certain tax benefits such as NOLs. See 11 U.S.C. § 541. And NOLs might not come out of bankruptcy untouched—a taxpayer who files for bankruptcy may elect to terminate his tax year after he files his bankruptcy petition. IRC § 1398(d)(2). If so, the bankruptcy estate gets to use any existing NOLs to offset income earned during the debtor’s own pre-petition tax year. Id.; Kahle v. Commissioner, T.C. Memo. 1997-91, *3.
But wait, there’s more…
Any amount of debt that is forgiven by the discharge is excluded from a taxpayer’s income. IRC § 108(a)(1)(A). However, it reduces his NOL. IRC § 108(b)(3).
The petitioners argue that prior audits that left their NOLs untouched should control in this case. The Tax Court rejected this argument before trial, but Judge Holmes thought it appropriate to address again. The key point is that each tax year stands on its own, with each year being the origin of new liability and a separate cause of action. Koprowski v. Commissioner, 138 T.C. 54, 60 (2012). This means that the doctrine that the petitioners invoke—res judicata—doesn’t apply. The other legal phrase they use—collateral estoppel—serves them no better because, even if the same issues were on the table, they were settled in earlier cases by stipulated decisions, and collateral estoppel requires a decision, not just a settlement. See Sands v. Commissioner, T.C. Memo. 1997-146, *5; aff’d without published opinion sub nom. Murphy v. Commissioner, 164 F.3d 618 (2d Cir. 1998).
It is well settled that the IRS’s failure to challenge a taxpayer’s treatment of an item in one year is irrelevant in the determination of the proper treatment of a similar item in a different taxable year. Little v. Commissioner, 106 F.3d 1445, 1453 (9th Cir. 1997), aff’g T.C. Memo. 1993-281. This means that just because the IRS accepted the petitioners’ treatment of their NOLs in prior years doesn’t mean it has to in later years. The stipulated decisions from the petitioners’ previous audits, therefore, do not control here.Add to favorites