On June 15, 2020, the Tax Court issued a Memorandum Opinion in the case of Sellers v. Commissioner (T.C. Memo. 2020-84). The primary issue before the court in Sellers v. Commissioner was whether the petitioner provided sufficient evidence to substantiate his bases in certain companies and his material participation (for passive activity loss purposes). This case also presents a very interesting question of whether the burden of proof really shifts to the IRS to prove additional deficiencies first asserted subsequent to the initial notice of deficiency (i.e., in the IRS’s answer to the petition).
Brief Background to Sellers v. Commissioner
Randy Sellers, the petitioner, was a Utahan jack-of-all-trades. Among his many trades were CPA, businessman, irascible bulldog collector of defunct real estate and semi-tractor trailer loans, investor, and seller of boats, boat parts, and marine accessories for enthusiasts of the great Salt Lake. The loan collector and boat businesses were formed as LLCs, with Randy owning a percentage and his holding company (an S corporation) holding the remainder of shares.
On the holding company’s amended 2013 Form 1120-S, Randy took a $300,000 deduction for nonpassive, passthrough losses – amongst other deductions. The loan collector reported a loss on its Form 1065. On Randy’s personal 2013 Form 1040, he claimed a $16,000 self-employed health insurance expense deduction. In 2014, the holding company reported a $380,000 nonpassive loss from the boat company and a $100,000 loss from the loan collector company. Randy claimed a modest $4,000 loss on his own return.
The IRS saw things differently and sent Randy a notice of deficiency for 2013 and 2014, disallowing his 2013 self-employed health insurance expense deduction and recharacterizing losses from the boat business and the debt collector business as passive losses. Randy filed a petition for redetermination with the Tax Court disputing all deficiencies.
Playing “Pass the Burden”
The IRS’s determinations in the notice of deficiency are presumed correct, and so the taxpayer bears the burden to prove otherwise. Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). If, however, the IRS has raised a new matter, increased the deficiency in any way, or raised an affirmative defense (or nine), then the burden of proof is on the IRS from the beginning.
Thus, when the IRS presents a new theory to sustain the deficiency, it is treated as a new matter if it either (1) alters the original deficiency, or (2) requires the presentation of new or different evidence. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989). A new theory which merely clarifies or develops the original determination is not a new matter” for which the IRS bears the burden of proof. Id.
Allowable Losses and the Bases of Partnerships
A partner’s outside basis is increased in part by the partner’s distributive share of income and the partner’s contributions to the partnership. See IRC § 705(a)(1); IRC § 722. Any increase in a partner’s share of liabilities or assumption of partnership liabilities also increases the partner’s outside basis. IRC § 752(a). A partner’s basis is decreased by the partner’s distributive share of partnership losses, nondeductible expenses, and distributions. IRC § 705(a)(2).
A partner’s basis in the partnership determines the amount of loss the partner can deduct. A partner may not deduct partnership losses in excess of his adjusted basis, and a loss (attributed to the partner) cannot reduce that partner’s basis below zero. See IRC § 704(a) (no loss in excess of basis); IRC § 705(a)(2) (no negative basis allowed).
The De Facto Shift in Burden of Production to Help IRS Prove Their Case (Manifestly Unfair?)
The IRS contends that Randy cannot show a sufficient basis in the boat and repo companies to deduct the losses. Because the IRS raised this matter after issuing the notice of deficiency, the IRS bears the burden of showing Randy and his holding company cannot substantiate sufficient bases. Randy, however, did not so much provide “documents” as “scraps of evidence” to sustain his positions.
The Tax Court did not appreciate the lack of evidence in front of it. The IRS was stumped. How could it prove substantiation if there was no evidence of substantiation on the record, which evidence the IRS needed to prove that the deductions were unsubstantiated. Substantially agreeing with the IRS’s quandary, the Tax Court threw the IRS a bone, which as I explain below, seems manifestly unfair to the taxpayer.
Although it is true that the IRS bears the burden of proving that Randy did not have a sufficient basis in the boat and repo companies, and the petitioner has no corresponding burden to produce information, the Tax Court may still, nevertheless, draw an adverse inference from a party’s failure to introduce evidence available to the party. Abramson v. Commissioner, T.C. Memo. 1987-276.
So, to be clear, Randy had no burden to produce any substantiation regarding his bases in the companies (for purposes of the IRS’s post-notice-of-deficiency additions), but because Randy did not so produce any evidence substantiating his bases in the companies, the Tax Court is permitted to draw an adverse inference against the evidence not so produced. Well, that is exactly what happened.
Author’s Aside – Fails to Pass the Smell Test
The Tax Court’s decision as to this element of the case causes me some consternation, and by that, I mean that it seems manifestly unfair. I understand that a taxpayer should not be able to avail himself of silence; however, adding to the deficiency (or adding a new element thereto) in an answer is a calculated risk on the part of the IRS. It is the IRS’s burden of proof. If the IRS doesn’t have evidence to “prove” the new assertion, then it should have been included in the original notice of deficiency. Why should the taxpayer be penalized by failing to assist the IRS’s prosecution through an adverse inference? This doesn’t pass the smell test to me.
The Code limits the passive losses available to an individual taxpayer. IRC § 469(a). A “passive loss” is the aggregate losses from the taxpayer’s passive activities that exceed the aggregate income from those activities. In turn, a “passive activity” is a trade or business in which the taxpayer does not materially participate. IRC § 469(c)(1). In turn, a taxpayer “materially participates” in an activity when he or she is involved on a regular, continuous, and substantial basis. IRC § 469(h)(1).
The regulations identify safe harbors that satisfy material participation, including a safe harbor in which the taxpayer participates in the activity for more than 500 hours during the year. See, e.g., Treas. Reg. § 1.469-5T(a). Such participation may be proven by “any reasonable means,” but, once again, appropriate substantiation is a prerequisite. See Treas. Reg. § 1.469-5T(f)(4).
The Tax Court has long held that it is not “bound to accept the unverified, undocumented testimony of taxpayers” including “a post-event ballpark guesstimate.” Goshorn v. Commissioner, T.C. Memo. 1993-578 (1993); Bartlett v. Commissioner, T.C. Memo. 2013-182, *9. Further, testimony alone, will not carry the day for the taxpayer. Speer v. Commissioner, T.C. Memo. 1996-323. However, if a taxpayer provides supporting documentation like telephone records, credit card invoices, and other contemporaneous materials, a narrative summary may show material participation. See Tolin v. Commissioner, T.C. Memo. 2014-65; Lamas v. Commissioner, T.C. Memo. 2015-59.Add to favorites