On April 26, 2021, the Tax Court issued a Memorandum Opinion in the case of Plentywood Drug, Inc. v. Commissioner (T.C. Memo. 2021-45). The primary issues presented in Plentywood Drug, Inc. were whether the petitioner’s owners received “fair rent” or constructive dividends for the rental of the petitioner’s drug store, and whether the petitioner (a corporation) satisfied its burden to show that the IRS failed to receive prior supervisory approval for the accuracy-related penalties at issue under IRC § 6751(b)(1).
Up in Big Sky country, there is the town of Plentywood, Montana. The town is sparsely populated, even by Montana standards, at approximately 2 people per square mile. Plentywood Drugs serves a four-county area (approximately 7,200 square miles, or 14,400 people). There is also a post office in Plentywood, which will come into play when the IRS came a’knockin’ and cast aspersions towards the fine folks who own the drug store, the Manns and their daughter and son-in-law, the Eberlings. The Eberlings each own 49.42% of the corporation’s stock, while the Manns each own 0.58%.
Plentywood Drug pays rent to the four owners of the building. The two couples set the terms by oral agreement at the beginning of each year. They did not, for the years at issue here or for any other years, put these terms into a formal written lease signed by themselves once in their capacity as owners of the pharmacy and then again as owners of the building.
The IRS wandered into Plentywood and accused the Manns and Eberlings of receiving constructive dividends, because they were paid too high a rent. The folks of Plentywood did not take kindly to the stranger’s accusations, and the drug store saddled up and filed a petition with the Tax Court seeking a redetermination of the deficiency regarding the drug store’s Forms 1120 for 2011, 2012, and 2013. The case moseyed its way to Judge Holmes, who, needless to say, had a field day with every Big Sky pun he could wrestle up.
The Audit and Trial
The IRS audited Plentywood Drug for tax years 2011-13; it “then lassoed the Manns and the Eberlings into an expanded audit and finally issued notices of deficiency to both them and their corporation.” The IRS did not introduce any evidence during trial that it had complied with IRC § 6751(b)(1) before he determined that Plentywood Drug and its owners owed penalties. See Graev v. Commissioner, 149 T.C. 485, 493, n. 14 (2017). The trial took place in the big city (St. Paul, Minnesota), but the petitioner fared fairly well, even though there were some practical issues of valuation, because the townsfolk weren’t too keen on discussing property values with those “expert” types.
Ordinary and Necessary Business Expenses
IRC § 162(a) allows a taxpayer to deduct the “ordinary and necessary” expenses he pays in carrying on a trade or business. The Code specifically lists the rent paid by a business as one of these deductible expenses. IRC § 162(a)(3). For an expense like rent to be ordinary and necessary, it must also be reasonable in amount. United States v. Haskel Eng’g & Supply Co., 380 F.2d 786, 788 (9th Cir. 1967). Any part of rent that is unreasonable is not ordinary and necessary and, thus, not deductible. Velvet Horn, Inc. v. Commissioner, T.C. Memo. 1981-227.
Although the IRS does not often question the reasonableness of a rent agreed to by parties at arm’s length, where the landlord and tenant “might not have an incentive to drive a hard bargain,” the IRS looks a bit more closely. The Tax Court has previously noted that when there is a close relationship between lessor and lessee and no arm’s length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm’s length with a stranger. Place v. Commissioner, 17 T.C. 199, 203 (1951), aff’d, 199 F.2d 373 (6th Cir. 1952); see also Safway Steel Scaffolds Co. of Ga. v. United States, 590 F.2d 1360, 1362 (5th Cir. 1979).
The IRS is wont to raise the specter that a corporation might call a payment to its shareholders something like rent, which is deductible, when the economic reality is that it’s a distribution of profits. If its suspicion turns out to be true, the seemingly deductible expense is actually a nondeductible dividend. Tax law calls such a dividend a “constructive” dividend because the corporation itself doesn’t call it that on its books. See Rosser v. Commissioner, T.C. Memo. 2010-6; Benson v. Commissioner, T.C. Memo. 2004-272. Shareholders must include constructive dividends in their taxable income under IRC § 61(a)(7). Ultimately, these types of cases are disputes about value, and the Tax Court relies on testimony from experts. Harmon City, Inc. v. United States, 733 F.2d 1381, 1383-84 (10th Cir. 1984).
Finding Fair Market Rent in a Town like Plentywood
A fair market rent is one at which “the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Treas. Reg. § 1.170A-1(c)(2). The parties in these cases quickly realized that finding comparable properties in a town of 1,700 people in frontier Montana and then using them to come up with a fair market rent would be difficult. There was, in fact, only one “comparable property,” the aforementioned post office.
The Tax Court heard “entirely credible testimony that Montanans—perhaps especially Montanans in small communities—don’t commonly share details of their financial lives very readily with strangers,” whom one can assume they likewise don’t take kindly to. The IRS’s expert was “particularly credible” in his statement that when he tried to find information in Plentywood, he made the conscious decision not to identify himself as an IRS agent. That there’s a sure way to get run out of a town like Plentywood with the horse you rode in on, one assumes.
The Tax Court is not bound by the opinion of any expert witness and may accept or reject expert testimony in the exercise of its sound judgment. Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Williams v. Commissioner (In re Williams Estate), 256 F.2d 217, 219 (9th Cir. 1958), aff’g T.C. Memo. 1956-239. The Tax Court may also choose which part of an expert’s opinion, if any, it will accept. Parker v. Commissioner, 86 T.C. 547, 562 (1986). Ultimately the Tax Court fixed the total fair market rent at $171,000 per year, north of what the petitioner paid in 2011, but about $20,000 south of what it paid in 2012 and 2013. Thus, for the latter two years, the Tax Court found constructive dividends of $20,000.
An Interesting Twist on IRC § 6751(b)(1) – A Corporate Petitioner’s Burden of Production
The IRS asserted that the petitioner owed accuracy-related penalties under IRC § 6662(a), which imposes a 20% penalty on the portion of an underpayment of tax that is attributable to any of the various causes listed in IRC § 6662(b), in this case negligence or disregard of rules or regulations. See IRC § 6662(b)(1).
IRC § 6751(b)(1) states that no penalty is allowed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination. This written approval must be obtained no later than the date the notice of deficiency is issued or the date the Commissioner files an answer or amended answer in which he asserts the penalty. Graev, 149 T.C. at 493.
No party produced any evidence that the IRS either did or did not comply with the approval requirements of IRC § 6751. Ordinarily, IRC § 7491(c) places the burden of production on the IRS with respect to liability for any individual for any penalty. However, because the petitioner is a corporation, it bears the initial burden of production to show that the IRS did not comply with IRC § 6751(b)(1). NT, Inc. v. Commissioner, 126 T.C. 191, 195 (2006).
When the burden lies on the IRS, the Tax Court has historically held that it must introduce evidence that it complied with IRC § 6751. See, e.g., Dynamo Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 227 (2018); Higbee v. Commissioner, 116 T.C. 438, 446 (2001). However, when, as here, the burden lies on an estate or corporation or some other nonindividual, that nonindividual must show that the IRS did not obtain supervisory approval.
The Tax Court notes that this is a somewhat unusual burden—the burden of producing evidence that no evidence exists of the IRS’s compliance with its obligation to show supervisory approval of penalties. However, the Tax Court notes that it can be met, for example, by asking for the penalty-approval form through a FOIA request or an informal discovery request and then showing that none exists, or if it does exist, it was untimely. Plentywood Drug did not do that in this case, so it cannot take shelter from the penalties under IRC § 6751(b)(1).
Reasonable Cause “Bucks Against” the IRS’s “Effort to Saddle” the Petitioner with Penalties
I told you Judge Holmes had fun with his cowboy puns.
Taxpayers, both corporate and individual, can buck against the IRS’s effort to saddle them with both negligence and substantial-understatement penalties if they can show their underpayments were due to reasonable cause and they acted in good faith. IRC § 6664(c)(1). Due to the difficulties of professional appraisers to calculate fair rent, and due to the fact that the petitioner’s figure was not too far afield of the eventually settled upon value, the Tax Court held that the petitioner acted in a reasonable way and reached a reasonable result in good faith. See Estate of Thompson v. Commissioner, T.C. Memo. 2004-174 (stock valuation in good faith where no comparable companies and “difficult judgment calls” led taxpayer to valuation closer to Court’s than Commissioner’s), vacated and remanded, 499 F.3d 129 (2d Cir. 2007), aff’d on appeal after remand by 370 Fed.Appx. 141 (2d Cir. 2010).
Footnote on the Estate of Thompson Case:
 This case had a rather interesting history. The Second Circuit found that the Tax Court failed to find that the executor’s reliance on attorney’s valuation, without a finding of reasonableness and good faith, fell short of the criteria for the reasonable cause exception to the substantial understatement penalty. On remand, the Tax Court supplemented its findings and opinion and declined to impose accuracy-related penalty. Satisfied by the supplementation, the Second Circuit ultimately affirmed the Tax Court’s opinion. Considering the discrepancy of the valuations of the company at issue ($1.75 million by the estate, and $32 million by the IRS), this long appellate road was worth it for the petitioner, as the potential penalty was approximately $5.4 million. Yikes.Add to favorites