Smith v. Comm’r: Before You Take that Business-Related Tax Loss, Ask “Does My Business Have a Bona Fide Purpose?”

Last fall, the U.S. Tax Court decided the case of Smith v. Comm’r.[1] It’s not a pivotal case, but it stands as a good reminder of the adage “you don’t get something for nothing.” At the heart of the case was a complicated tax planning strategy using an S corporation, a family limited partnership and a trust, which, the taxpayers asserted, generated a substantial tax loss. Upon review, the U.S. Tax Court could not find an actualbusiness operating within these structures. As a result, itagreed with the IRS on boththedisallowance of the tax lossand the assessment ofsignificant penalties.

Background:

In June 2009, the taxpayers met with an attorney to address their estate planning issues. The husband had recently retired and was to receive employee compensation of $664,007 that year. The taxpayers hired the estate planning attorney, who was also a CPA, to create a will and other estate planning documents. Additionally, they implemented a tax planning strategy the attorney suggested, which was intended to offset the taxpayers’ tax liability for the husband’s 2009 compensation income.

Structure of Tax Planning Strategy: The strategy involved setting up (1) an S corporation, (2) a family limited partnership (FLP), and (3) a revocable management trust. The S corporation was to own 98% of the FLP as limited partnership interests and the taxpayers each held a 1% general partnership interest in the FLP. These general partnership interests were placed in the revocable management trust. The taxpayers then transferred more than $1.8 million of personal assets, consisting of cash and marketable securities, to the S corporation. The S corporation then transferred these assets to the FLP.

Valuation Discounts Applied to Generate Loss: Within about four months, the S corporation was dissolved. Almost all of the assets of the FLP were distributed back to the taxpayers and the 2009 S corporation’s tax return reported an ordinary loss of about $750,000. This was the result of deducting approximately $1.9 million (basically, the amount distributed to the taxpayers) as the cost of goods sold, from gross receipts of approximately $1.12 million. The gross receipts were calculated, generally, by applying a 40% discount for lack of marketability and lack of control against the amount of personal assets transferred to the S corporation.

• It should be remarked that the taxpayers’ former accountant did not feel comfortable preparing thereturns, so they were prepared by the attorney’s firm.

The IRS reviewed the return and issued a notice of deficiency for income tax of $623,795. It also applied an accuracy-related penalty of $124,759 under section 6662(a).

Analysis by the U.S. Tax Court:

While the Tax Court didn’t use the phrase “sham transaction” directly, that was the basic result of its analysis. A “sham transaction” is generally one in which there is no real business purpose for the transaction and the taxpayers entered into it for the sole purpose of avoiding tax liabilities. Courts determine this under the “economic substance doctrine.”

Loss Deduction and the Economic Substance Doctrine: The Tax Court held that the loss deduction did not meet the Section 165 requirements of a bona fide loss incurred in a trade or business or transaction entered into for profit because the business structure created for the taxpayers lacked economic substance. Under the economic substance doctrine, courts are permitted to disregard a transaction for federal tax purposes, even if it is compliant with the Code, if it has no other purpose than generating a tax loss. A business transaction may be structured to reduce taxes, but an underlying business purpose must exist.

While the IRS is presumed correct, the determination of whether economic substance exists is facts and circumstances based, and the taxpayer bears the burden of proof. The Tax Court looked to the Fifth Circuit[2] and applied a multi-factor test[3] for making the fact-based determination. A standard element for testing economic substance requires making objective and subjective inquiries.

• Objective inquiries into economic substance look at whether there was a reasonable possibility that the business transaction would make a profit or provide another business benefit.
• The subjective economic substance inquiry is to determine whether the taxpayers actually had a non-tax business purpose for their business transaction.

The Tax Court found that the taxpayers never intended to operate a business. The taxpayers did not follow any corporate formalities and there were no offices, issuances of stock certificates, meeting minutes. Particularly, the court found that the “circular flow of funds among related entities” was used to generate an artificial tax loss in 2009. Thus, the income tax deficiency was upheld.

Penalties for Substantial Understatement of Income Tax: In addition to the tax loss being disregarded, the taxpayers were subject to penalties. An accuracy-related penalty under Section 6662(a) of 20% of the amount of underpayment of tax may be applied in cases where income tax has been substantially understated. “Substantial” refers to an understatement that exceeds greater than 10% of the tax required to be shown on the return or $5,000.

Apenalty may be abated for reasonable cause under Section 6664(c)(1) if the taxpayers can show they acted reasonably and in good faith. Additionally, reliance on a tax professional may constitute reasonable cause and good faith.[4]

The Tax Court considered this defense and agreed that the taxpayers had relied on their tax professional, but not to the extent that Section 6664(c)(1) could provide relief. The Tax Court determined that the taxpayers never intended to conduct business activities and that they knew from the beginning that the sole purpose of the transaction was tax avoidance. Therefore, the penalty was also upheld.

Conclusion:

It was unfortunate that this case involved retirees. However, taxpayers who implement complex tax planning strategies involving business structures must also have a bona fide business purpose for those structures in order to receive any tax benefits. To support that a business purpose exists, at a minimum, taxpayers should at least be following the corporate formalities listed above. More importantly, taxpayers should evaluate whether their business would pass muster under the objective and subjective inquiries. As seen above, disallowance of the tax loss was not the only consequence; the taxpayers also incurred penalties of almost $125,000.

Finally, although not mentioned, this case is a reminder that attorneys and/or law firms who prepare tax returns should be aware that they are also subject to penalties for understatement of a taxpayer’s income tax in certain situations. Click here for a list of tax preparer penalties.

Footnotes:

[1]Smith v. Comm’r, T.C. Memo. 2017-2018, (November 6, 2017).

[2] The Fifth Circuit was the jurisdiction for an appeal in this case.

[3]Klamath Strategic Inv. Fund ex. Re. St. Croix Ventures v United States, 568 F.3d 537, 544 (5ht Cir. 2009).

[4]United States v. Boyle, 469 U.S. 241, 250 (1985).

The materials in this publication does not constitute legal advice. It is intended for general information purposes only.