Monday, June 28, 2021
The U.S. Tax Court has issued several interesting and important decisions in recent days. Among other matters, the Tax Court has addressed when cost of goods sold can be deducted; when basis reduction occurs as a result of debt forgiveness; the requirements for a theft loss deduction; and the substantiation required for various deductions.
Recent Tax Court cases of interest – it’s the topic of today’s post.
To Recover Cost of Goods Sold, Taxpayer Must Have Gross Receipts From Sale of Goods
BRC Operating Company LLC v. Comr., T.C. Memo. 2021-59
During tax years 2008 and 2009, the petitioner paid about $180 million to acquire minerals and lease interests in West Virginia, Pennsylvania, Ohio and Kentucky. The petitioner planned to explore for, mine and produce natural gas for sale. On Form 1065, the petitioner reported, as costs of goods sold, estimated drilling costs for natural gas exploration and mining in the amount of $100 million for tax year 2008 and $60 million for tax year 2009 and passed those amounts through to investors. However, the petitioner did not drill (except for two test wells), receive drilling services from third parties or receive drilling property during these years. In addition, the petitioner didn’t report any gross receipts or sales during these years that were attributable to the sale of natural gas. The IRS fully disallowed the amounts claimed for costs of goods sold on the basis that the petitioner had failed to satisfy the “all-events” test and the economic performance requirement of I.R.C. §461(h)(1).
The Tax Court upheld the IRS determination, noting that the petitioner conceded that the drilling of the test wells was irrelevant and that it had not received any income from the wells. Thus, it was inappropriate to characterize the passed-through amounts as costs of goods sold in the amount of $100 million for 2008 and $60 million in 2009 for drilling costs for natural gas mining. There were no gross receipts for natural gas for either 2008 or 2009. There were no receipts from the sale of goods to offset by costs.
The Timing of Basis Reduction Associated With Discharged Debt
Hussey v. Comr., 156 T.C. 12 (2021)
In 2009 the petitioner purchased 27 investment properties on which he assumed outstanding loans totaling $1,714,520. By 2012 he was struggling to make payments on the loans. He sold 16 of the properties in 2012, with 15 of them being sold at a loss. After the sales, the lender restructured the the debt and issued a Form 1099-C for each property sold at a loss evidencing the amount of debt forgiven. The petitioner sold additional investment properties in 2013 at a loss. The lender again restructured the debt, but didn’t issue Form 1099-Cs for 2013. In late 2015, the lender noted that $493,141 was the remaining amount to be booked as a loan loss reserve recovery as of October 25, 2015.
After filing an initial return for 2012, the petitioner filed Form 1040X for 2012 on January 14, 2015. The Form 4797 attached to the amended return stated that petitioner had sold 17 properties for a loss totaling $613,263. On Form 982 petitioner reported that he had excludable income of $685,281 "for a discharge of qualified real property business indebtedness applied to reduce the basis of depreciable real property" (i.e., the debt discharged from the lender). On October 15, 2014, the petitioner filed Form 1040 for 2013. On Form 4797 included with that return, petitioner reported that in 2013 he had sold six investment properties and his primary residence (which was also listed as an investment property) for a loss totaling $499,417 ($437,650 for the investment properties and $61,767 for his primary residence). On October 15, 2015, the petitioner filed Form 1040 for 2014. The petitioner reported a net operating loss carryforward of $423,431 from 2013. On Form 982 petitioner reported he had excludable income of $65,914 from a discharge of qualified real property business debt. A Form 1099-C showed that the petitioner received a discharge of debt of $65,914 from the 2014 sale of his primary residence (the same residence reported as sold in his 2013 tax return). The IRS disallowed the loss deductions claimed on petitioner’s 2013 Form 4797. For 2014, the IRS disallowed the loss carryover deduction from 2013.
The issue was whether the basis reduction as a result of the debt discharge occurred in 2012 or 2013. Also, at issue was whether there was any debt discharge in 2013. The Tax Court, in a case of first impression, laid out the statutory analysis. The Tax Court noted that, in general, a taxpayer realizes gross income under I.R.C. §61(a)(11) when a debt is forgiven. But, under I.R.C. §108(a)(1)(D), forgiveness of qualified real property business debt is excluded from income. However, the taxpayer must reduce basis in the depreciable real property under I.R.C. §108(c)(1)(A). I.R.C. §1017 requires the reduction of basis to occur at the beginning of the tax year after the year of discharge. But, I.R.C. §1017(b)(3)(F)(iii) provides that in the case of property taken into account under I.R.C. §108(c)(2)(B) which is related to the exclusion for qualified real property business debt, the reduction of basis occurs immediately before the disposition of the property (if earlier than the beginning of the next taxable year).
The Tax Court reasoned that because the petitioner received a discharge of qualified real property debt and sold properties in 2012, he was required to reduce his bases in the disposed properties immediately before the sales of those properties in 2012. The Tax Court rejected the taxpayer’s arguments that because the aggregated bases in his unsold properties in 2012 exceeded the discharged amount, he did not need to reduce his bases until 2013. The Tax Court noted instead that selling properties from the group triggered I.R.C. §1017(b)(3)(F)(iii) with respect to the bases of the properties sold regardless of the remaining bases in the properties not sold.
Note. The key point of the case is that the basis reduction rule associated with the forgiveness of qualified real property debt is an exception to the general rule that basis reduction occurs in the year following the year of debt discharge.
No Deductible Theft Loss Associated With Stock Purchase
Baum v. Comr., T.C. Memo. 2021-46.
The petitioners, a married couple, bought corporate stock from a third party’s mother after the third party “encouraged” them to do so. The petitioners lost money on the stock and deducted the losses as theft losses on the basis that they were defrauded in the purchase based on false pretenses. The IRS denied the deductions.
Under state (CA) law, theft by false pretenses requires that the defendant to have made a false pretense or representation to the owner of property with the intent to defraud the owner of that property, and that the owner transferred the property to the defendant in reliance on the representation. Here, the Tax Court noted, the petitioners did their own investigation, confirming the information presented to them. They also provided records of communications between them and the promoter about the investments. But they failed to provide specific evidence that the third party’s representations were false or that they were made with the intent to defraud. The Tax Court held that the taxpayers failed to prove the elements for theft by false pretenses and that there was no reasonable prospect of recovery. Accordingly, the Tax Court upheld the IRS position.
Deductions Fail For Lack of Substantiation
Chancellor v. Comr., T.C. Memo. 2021-50
It’s a well-known principle that deductions are a matter of legislative grace. For a taxpayer to take advantage of that grace, the deductions must be substantiated. This grace isn’t freely bestowed. It’s also important to properly categorize deductions. Some reduce gross income to adjusted gross income, while others are of the “below-the-line” type that reduce adjusted gross income to taxable income. Most of the business-related deductions are “above-the-line” while most of those that are non-business are below-the line. There are also substantiation requirements that apply, and another rule that can come into play when the taxpayer doesn’t have the proper documentation to substantiate deductions – the “Cohan” rule (named after entertainer George M. Cohan). The Cohan rule allows the Tax Court to guess at the correct amount of a deduction for a taxpayer when the taxpayer can show that expenses were actually incurred and meet the legal requirement for the deduction being claimed. But, the Cohan rule can be wiped-out by a statute that has very specific substantiation requirements. One such statute is I.R.C. §274(d).
In this case, the petitioner reported approximately $40,000 of income on her 2015 return and claimed about $33,000 of deductions. The deductions included Schedule A deductions of $6,500 for charitable donations and $4,500 for sales taxes. Schedule C deductions were claimed for meals and entertainment; car and truck expense; utilities for a home office; legal fees; advertising; and “other” expenses. The IRS disallowed all of the Schedule C deductions and the Schedule A deductions for charity and sales taxes.
The Tax Court determined that the petitioner could not meet the specific receipt substantiation requirements for the cash donations to charity under I.R.C. §170(f) or for sales taxes. However, the Tax Court could use the sales tax tables to substantiate the sales tax deduction. The Tax Court determined that the petitioner could not satisfy the heightened substantiation deduction requirements of I.R.C. §274(d) or §280A for the Schedule C (business-related) deductions. Claimed deductions associated with the petitioner’s home office, advertising, legal and post office expense could be estimated under the Cohan rule. For those expenses, the petitioner could show some expenditures that were connected to the legal requirements for the particular deduction.
Note. The case is a good one for how the Tax Court sorted out the various types of deductions in terms of the applicable substantiation rules, and whether or not the Cohan rule would apply.
These recent Tax Court decisions are a continuing illustration of the interesting and important issues that are seemingly constantly before the court.