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The Tax Court in Brief - May 2021

By Freeman Law
May 24, 2021

The Tax Court in Brief

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

The Week of May 3 – May 7, 2021

Chancellor v. Comm’r, T.C. Memo. 2021-50 | May 4, 2021 | Urda, J. | Dkt. No. 20389-18

Short Summary: Ms. Chancellor claimed deductions on her 2015 federal income tax return related to business expenses, charitable contributions, and State and local tax. The IRS disallowed the deductions and issued a notice of deficiency. Ms. Chancellor filed a petition with the United States Tax Court challenging the proposed adjustments in the notice of deficiency.

Key Issue: Whether Ms. Chancellor has adequately substantiated her claimed deductions.

Primary Holdings: No—not beyond those already conceded by the IRS.

Key Points of Law:

  • The Commissioner’s determinations in a notice of deficiency are presumed correct and the taxpayer generally bears the burden to prove them correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • When deductions are in dispute, the taxpayer must satisfy the specific requirements for any deduction claimed. See INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992). In addition, a taxpayer is required to maintain records sufficient to substantiate items underlying his or her claimed deductions. 6001; Treas. Reg. § 1.6001-1(a). The failure to keep and present accurate records counts heavily against the taxpayer’s attempted proof. See Rogers v. Comm’r, T.C. Memo. 2014-141.
  • If a taxpayer’s records are lost or destroyed through circumstances beyond his or her control, he or she may substantiate expenses through reasonable construction. See Boyd v. Comm’r, 122 T.C. 305, 320 (2004). While the inability to produce a record which is unintentionally lost, whether by the taxpayer or by a third party, alters the type of evidence which may be offered to establish a fact, it does not affect the burden of proving a fact. Malinowski v. Comm’r, 71 T.C. 1120, 1125 (1979). Crucial to this reconstruction is that the secondary evidence be credible. See, e.g., Boyd v. Comm’r, 122 T.C. at 320. If no other documentation is available, the Court may, but is not required to, accept credible testimony of a taxpayer to substantiate any expense.
  • 170(a)(1) allows as a deduction any contribution made within the taxable year to a donee organization described in Section 170(c). Such deductions are allowable only if the taxpayer satisfies statutory and regulatory substantiation requirements. Sec. 170(a)(1); Treas. Reg. § 1.170A-13. The nature of the required substantiation depends on the type and size of the contribution. For contributions of cash, check, or other monetary gift, a donor must maintain “as a record of such contribution a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution. Sec. 170(f)(17). Otherwise, a donor must maintain “reliable written records showing the name of the donee, the date of the contribution, and the amount of the contribution” in the absence of a “cancelled check or receipt from the donee charitable organization.” Treas. Reg. § 1.170A-13(a).
  • Section 164 provides the rules under which taxpayers choosing to use itemized deductions may deduct certain taxes. Figures v. Comm’r, T.C. Memo. 2012-296. Section 164(a)(3) allows a deduction for State and local income taxes paid during the tax year. Section 164(b)(5)(A) permits a taxpayer to elect to deduct State and local general sales tax in lieu of State and local income taxes. A taxpayer may deduct the actual amount of sales taxes paid, which would require substantiation. Figures v. Comm’r, at 11- Alternatively, the Commissioner, as a matter of administrative convenience, permits taxpayers to calculate the amount of the deduction by using guidelines the IRS publishes in the Optional State and Certain Local Sales Tax Tables. Sec. 164(b)(5)(H).
  • Section 162(a) permits a taxpayer to deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. A taxpayer’s general statement that expenses were paid in pursuit of a trade or business is insufficient to establish that the expenses had a reasonably direct relationship to any such trade or business. Sham v. Comm’r, T.C. Memo. 2020-119. Personal expenses are generally not allowed as deductions. 262(a). The taxpayer bears the burden of substantiating expenses underlying her claimed deductions. Sec. 142(a); Treas. Reg. § 1.6001-1(a), (e).
  • Section 274(d) establishes higher substantiation requirements for expenses related to travel, meals, and lodging while away from home, entertainment, gifts, and “listed property,” defined in Section 280F(d)(4) to include passenger automobiles and computers. Section 274(d) provides that no deduction or credit under Section 162 or 212 shall be allowed for these expenses unless the taxpayer substantiates the amount, time, place, business purpose, and business relationship to the taxpayer of the person receiving the benefit for each expenditure by adequate records or sufficient evidence corroborating his own statements. Temp. Treas. Reg. § 1.274-5T(a), (b), and (c). A court may not apply the Cohan rule to approximate expenses covered under Section 274(d). See Sanford v. Comm’r, 50 T.C. 823 (1968).

Insight: The Chancellor decision reaffirms the significance of maintaining good records for each tax year. To the extent a taxpayer has lost such records, the taxpayer can attempt to reconstruct such records with the information available—however, the taxpayer will continue to have the burden of showing his or her entitlement to any claimed deductions as reported on the return at issue.

Barnes v. Comm’r, T.C. Memo. 2021-49 | May 4, 2021 | Lauber, J. | Dkt. No. 6330-19L

Short Summary: The taxpayers challenged a proposed deficiency in the Tax Court related to their 2003 tax year. Prior to the Tax Court issuing an opinion, the taxpayers filed a voluntary chapter 11 petition in the U.S. Bankruptcy Court for the District of Columbia. The IRS participated in the bankruptcy proceedings and filed a proof of claim for tax deficiencies—however, the 2003 tax year was not included.

After the plan was confirmed, the IRS moved to lift the automatic stay to permit the Tax Court to render a decision on the taxpayers’ 2003 tax year. The bankruptcy court granted the motion, and the Tax Court held that taxpayers owed deficiencies, penalties, and additions to tax for 2003 as determined in the notice of deficiency.

The IRS later assessed the 2003 liability and issued a Notice of Federal Tax Lien for the taxpayers’ 2003, 2008, and 2009 tax years. The taxpayers filed a timely request for a Collection Due Process (CDP) hearing. The IRS Settlement Officer agreed to a partial release of the NFTL, finding that the 2008 and 2009 tax liabilities were including in the taxpayers’ bankruptcy. However, the SO concluded that the lien filing as to 2003 was appropriate.

Key Issue: Whether the SO abused its discretion in determining that the 2003 tax debt was collectible after the bankruptcy discharge.

Primary Holdings: The SO did not abuse his discretion in determining that the 2003 tax debt was collectible after the bankruptcy discharge because unassessed tax liabilities are nondischargeable.

Key Points of Law:

  • The purpose of summary judgment is to expedite litigation and avoid costly, time-consuming, and unnecessary trials. Peach Corp. v. Comm’r, 90 T.C. 678, 681 (1988). The Tax Court may grant summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v. Comm’r, 98 T.C. 518, 520 (1992).
  • Section 6320(c) does not prescribe the standard of review that the Tax Court should apply in reviewing an IRS administrative determination in a CDP case. The general parameters for such review are marked out by the Tax Court’s precedents. Where the validity or amount of the taxpayer’s underlying liability is at issue, the Tax Court reviews the IRS’ determination de novo. Goza v. Comm’r, 114 T.C. 176, 181-82 (2000). Where the taxpayer’s underlying liability is not properly before the Tax Court, the Tax Court reviews the IRS action for abuse of discretion. See id. at 182. Abuse of discretion exists when a determination is arbitrary, capricious, or without sound basis in fact or law. Murphy v. Comm’r, 125 T.C. 301, 320 (2005), aff’d, 469 F.3d 27 (1st 2006).
  • Taxpayers may challenge the existence or amount of their underlying tax liability in a CDP case but only if they did not receive a statutory notice of deficiency or otherwise have a prior opportunity to dispute their liability. 6330(c)(2)(B). Whether a debt is still collectible, as opposed to having been paid or discharged, is not a challenge to the underlying tax liability. Accordingly, it is a question properly addressed in considering whether the SO abused his or her discretion. Melasky v. Comm’r, 151 T.C. 89, 92 (2018), aff’d, 803 F. App’x 732 (5th Cir. 2020).
  • In deciding whether an SO abused his discretion in sustaining an NFL, the Tax Court considers whether he: (1) properly verified that the requirements of any applicable law or administrative procedure have been met; (2) considered any relevant issues that the taxpayer raised; and (3) determine whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the taxpayer that any collection action be no more intrusive than necessary. 6320(c), Sec. 6330(c)(3). If the SO’s determination was based on an erroneous view of the law and the taxpayer’s liability was discharged in bankruptcy, then the Tax Court must reject the IRS’ views and find that there was an abuse of discretion. See Swanson v. Comm’r, 121 T.C. 111, 119 (2003).
  • Generally, an unassessed income tax liability is nondischargeable. 11 U.S.C. Sec. 523(a)(1)(A). And the provisions of 11 U.S.C. Sec. 1141(d)(2) prohibit a bankruptcy court from discharging a debt that is nondischargeable under 11 U.S.C. Sec. 523.

Insight: The Barnes decision shows the complexities involved when a taxpayer attempts to discharge tax liabilities through bankruptcy proceedings. In these cases, taxpayers should ensure that they have an attorney knowledgeable in both tax and bankruptcy cases to ensure that their best arguments are put forward in those two proceedings.

Jacobs v. Comm’r, T.C. Memo. 2021-51 | May 5, 2021 | Toro, J. | Dkt. No. 7118-19

Short Summary: Mr. Jacobs is a full-time college professor. He published a book on the BP oil spill and also represents clients as a lawyer. On his personal income tax returns for 2014 and 2015, Mr. Jacobs claimed deductions on Schedule C. Generally, these deductions related to payments for meals and lodging for his visiting scholar position at UCLA, costs for the business use of his home, bar dues and other professional fees, and travel expenses. The IRS disallowed the claimed deductions at the examination level. At IRS Appeals, the IRS conceded some of the deductions but issued a statutory notice of deficiency because the statute of limitations for assessment was about to expire. Mr. Jacobs filed a timely Tax Court petition, and Mr. Jacob’s case was forwarded back to IRS Appeals. IRS Appeals conceded some additional deductions but closed the case with deficiencies due. When IRS counsel received the case, IRS counsel conceded that there were no deficiencies for either year. Thereafter, Mr. Jacobs filed a motion for an award of his litigation costs.

Key Issue: Whether Mr. Jacobs is entitled to an award of his litigation costs under Section 7430?

Primary Holdings: No, the IRS was substantially justified in disallowing the claimed deductions at the time it filed its Answer in the Tax Court.

Key Points of Law:

  • Section 7430 provides for an award of reasonable litigation costs to a taxpayer in a proceeding brought by or against the United States involving the determination of any tax, interest, or penalty. Such an award may be made where the taxpayer can demonstrate that he: (1) is the prevailing party; (2) has exhausted available administrative remedies within the IRS; (3) has not unreasonably protracted the proceeding; and (4) has claimed “reasonable” costs. 7430(a) and (b)(1), (3), (c)(1) and (2); Morrison v. Comm’r, 565 F.3d 658, 661 (9th Cir. 2009). These requirements are conjunctive; failure to satisfy any one of them precludes an award of costs to the taxpayer. See Alterman Tr. v. Comm’r, 146 T.C. at 227; see also Minahan v. Comm’r, 88 T.C. 492, 497 (1987). The decision to award fees is within the sound discretion of the Tax Court. Morrison v. Comm’r, 565 F.3d at 661 n.3.
  • To be the “prevailing party,” a taxpayer must satisfy certain net-worth requirements and must “substantially prevail” with respect to the amount in controversy or “the most significant issue or set of issues presented.” 7430(c)(4)(A). The taxpayer will generally not be treated as the prevailing party, however, if the IRS establishes that the “position of the United States in the proceeding was substantially justified.” Sec. 7430(c)(4)(B)(i). The IRS bears the burden of making that showing. Id. The “position of the United States” in a Tax Court proceeding is that set forth in the Commissioner’s answer. Sec. 7430(c)(7)(A); Huffman v. Comm’r, 978 F.2d at 1148.
  • A position is “substantially justified” if it is “justified to a degree that could satisfy a reasonable person” or has a “reasonable basis both in law and fact.” Swanson v. Comm’r, 106 T.C. 76, 86 (1996). The determination of reasonableness is based on all the facts of the case and the available legal precedents. Maggie Mgmt. Co. v. Comm’r, 108 T.C. at 443. A position has a reasonable basis in fact if there is such relevant evidence as a reasonable mind might accept as adequate to support a conclusion. Underwood, 487 U.S. at 565. A position has a reasonable basis in law if legal precedent substantially supports the Commissioner’s position given the facts available to him. Maggie Mgmt. Co. v. Comm’r, 108 T.C. at 443.
  • As the Supreme Court has observed, substantially justified means more than merely undeserving of sanctions for frivolousness. S. v. Yochum, 89 F.3d 661, 671 (9th Cir. 1996). The Commissioner’s position may be substantially justified even if incorrect if a reasonable person could think it correct. Maggie Mgmt. Co. v. Comm’r, 108 T.C. at 443. Courts have found that the Commissioner’s position was substantially justified in cases that involve primarily factual questions. See, e.g., Bale Chevrolet Co. v. U.S., 620 F.3d 868 (8th Cir. 2010). And the fact that the IRS loses a case or makes a concession “does not by itself establish that the position taken is unreasonable,” but is “a factor that may be considered.” Maggie Mgmt. Co. v. Comm’r, 108 T.C. at 443.
  • To deduct an expense under section 162, a taxpayer must establish that the amount was an ordinary and necessary expense paid or incurred in carrying on a trade or business. 162(a); INDOPCO, Inc. v. Comm’r, 503 U.S. at 84. To deduct the expense on Schedule C, the taxpayer must also show that the expense was not associated with the taxpayer’s activities as an employee. See, e.g., Weber v. Comm’r, 103 T.C. 378, 386 (1994).
  • Both the Tax Court and the U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this case would lie unless the parties agree otherwise, see 7482(b), have repeatedly held that the IRS’s actions at the administrative level do not determine whether its position in litigation was substantially justified. Rather, the Tax Court evaluates the reasonableness of the IRS’ position separately for administrative and judicial proceedings. See Maggie Mgmt. Co. v. Comm’r, 108 T.C. at 442; see also Kenney v. U.S., 458 F.3d 1025, 1032-33 (9th Cir. 2006). Thus, for purposes of awarding litigation costs, the Tax Court considers the IRS’ actions after the petition is filed and does not base its decision on the activity at the administrative level, even if that activity gave rise to the litigation. Pac. Fisheries Inc., 484 at 1110-1111.

Insight: The Jacobs decision reminds taxpayers that they can be awarded litigation costs (i.e., costs of their attorney) in certain instances. However, the Jacobs decision also reminds taxpayers how difficult a task that may be.

Berry v. Comm’r, T.C. Memo. 2021-52| May 5, 2021| Kerrigan, J. | Dkt. Nos. 6584-19 and 11180-19

Short Summary: Mr. Berry is a realtor and reported his income on Schedules C. He also participated in car racing during the years at issue. For 2014 and 2015, he earned $8,700 and $1,200, respectively, from winning drag racing tournaments. He assigned these winnings to Phoenix Construction and Remodeling, Inc. (Phoenix). For the years at issue, Phoenix also paid expenses related to Mr. Berry’s race car driving.

Phoenix is an S corporation owned equally by Mr. Berry and his father. Phoenix was involved in construction projects in California. On June 13, 2016, Phoenix filed its 2014 Form 1120S, reporting gross income of $1,664,364 and cost of goods sold of $1,329,575, including $150,414 for building permits. Phoenix also claimed a Section 179 deduction totaling $135,297 for 11 items, including an excavator and a utility trailer.

The IRS examined the Berrys’ tax return for 2014. It later issued a notice of deficiency determining that the Berrys had underreported their Schedule E income from Phoenix. The IRS also disallowed the claimed Section 179 deduction and cost of goods sold for building permits.

Later, the IRS also examined the Berrys’ 2015 Form 1040. In the notice of deficiency, the IRS disallowed a depreciation expense of $8,000.

Key Issue: Whether: (1) $8,700 and $1,200 for 2014 and 2015, respectively, should be recharacterized as the Berrys’ other income and not gross receipts of Phoenix; (2) Phoenix is entitled to deduct car racing expenses for 2014 and 2015; (3) Phoenix is entitled to a deduction pursuant to section 179 for an excavator and a utility trailer for 2014; (4) Phoenix has cost of goods sold of $33,294 for building permits for 2014; (5) the Berrys are entitled to deduct depreciation of $8,000 reported on Schedule C for 2015; (6) the Berrys are liable for an addition to tax pursuant to section 6651(a)(1) for 2014; and (7) the Berrys are liable for the accuracy-related penalty under section 6662(a) for 2014.

Primary Holdings:

  • (1) Because the evidence does not show that car racing was part of Phoenix’s business, the income is includible in the Berrys’ Other Income for the years at issue.
  • (2) Because the Berrys failed to show the connection between Phoenix’s construction business and the reported race car expenses, Phoenix is not entitled to deduct car racing expenses for 2014 and 2015.
  • (3) Because the Berrys were unable to substantiate the Section 179 expenses for the excavator and the utility trailer, Phoenix is not entitled to deductions pursuant to Section 179 for those items.
  • (4) Because the Berrys were unable to substantiate the cost of goods sold disallowed by the IRS, Phoenix is not entitled to a cost of goods sold deduction for 2014.
  • (5) Because the Berrys failed to provide any showing of the cost of the truck, when it was placed in service, the business percentage of the use of the vehicle, and the previously allowed depreciation, the Berrys are not entitled to a Schedule C depreciation deduction of $8,000.
  • (6) Because the Berrys did not establish reasonable cause, the Berrys are liable for the failure-to-file penalty under Section 6651(a)(1) for 2014.
  • (7) Because the Berrys did not contest the accuracy-related penalty, the penalty is sustained.

Key Points of Law:

  • Generally, the Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that those determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 89 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Generally, an S corporation shareholder determines his or her tax liability by taking into account a pro rata share of the S corporation’s income, losses, deductions, and credits. 1366(a)(1). Where a notice of deficiency includes adjustments for S corporation items with other items unrelated to the S corporation, the Tax Court has jurisdiction to determine the correctness of the adjustments. Winter v. Comm’r, 135 T.C. 238 (2010).
  • A taxpayer claiming a deduction on a federal income tax return must demonstrate that the deduction is allowable pursuant to a statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. 6001; Hrasdesky v. Comm’r, 65 T.C. 87, 89-90 (1975).
  • A taxpayer may not determine the nature of his or her income merely by using a particular form, or by labeling it as he or she wishes, but must report his or her income according to the economic realities of the situation. Walker v. Comm’r, 101 T.C. 537, 544 (1993).
  • Section 162 permits taxpayers to deduct all ordinary and necessary business expenses paid or incurred during the tax year. An ordinary expense is one that commonly or frequently occurs in the taxpayer’s business. Deputy v. du Pont, 308 U.S. 488, 495 (1940). A necessary expense is one that is appropriate and helpful in carrying on the taxpayer’s business. Comm’r v. Heininger, 320 U.S. 467, 471 (1943); Treas. Reg. § 1.162-1(a).
  • Section 179 provides that a taxpayer may elect to treat the cost of any Section 179 property as an expenses which is not chargeable to a capital account. If a taxpayer makes such an election, the cost shall be allowed as a deduction for the tax year in which the Section 179 property is placed in service. 179(a). Section 179 property includes tangible property that is section 1245 property required for use in the active conduct of a trade or business. Sec. 179(d)(1)(B). To be entitled to a section 179 deduction a taxpayer must maintain records reflecting how and from whom the Section 179 property was acquired and when it was placed in service. Treas. Reg. § 1.179-5(a).
  • Cost of goods sold is an offset subtracted from gross receipts in determining gross income. Reg. § 1.61-3(a); Treas. Reg. § 1.61-6(a). It is not a deduction. Metra Chem. Corp. v. Comm’r, 88 T.C. 654, 661 (1987). Any amount claimed as a cost of goods sold must be substantiated, and taxpayers are required to maintain records sufficient for this purpose. Sec. 6001; Nunn v. Comm’r, T.C. Memo. 2002-250; Treas. Reg. § 1.6001-1(a).
  • To substantiate entitlement to a depreciation deduction, a taxpayer must establish the property’s depreciable basis by showing the cost of the property, its useful life, and the previously allowable depreciation. Cluck v. Comm’r, 105 T.C. 324, 337 (1995). In addition, a claimed deduction with respect to any “listed property,” a category including “any passenger automobile,” is subject to the heightened substantiation requirements under section 274(d)(4). See Sec. 280F(d)(4).
  • Section 6651(a)(1) imposes an addition to tax if the taxpayer fails to file his or her income tax return by the required due date (including any extension of time for filing). A taxpayer has the burden of proving that failure to timely file was due to reasonable cause and not willful neglect. 6651(a)(1); Higbee v. Comm’r, 116 T.C. 438, 447 (2001).
  • Under section 7491(c), the Commissioner bears the burden of producing evidence with respect to the liability of the taxpayer for any additions to tax. See Higbee v. Comm’r, 116 T.C. at 446-47.
  • The Commissioner bears the burden of production with respect to the penalty imposed by section 6662(a). 7491(c). The burden of production includes producing evidence that the Commissioner has complied with the procedural requirements of section 6751(b). Frost v. Comm’r, 154 T.C. 23, 34 (2020). Once the Commissioner meets this burden, the taxpayer must come forward with contrary evidence. Id.
  • The Commissioner must show compliance with section 6751(b), which requires that certain penalties be personally approved in writing by the immediate supervisor of the individual making the determination. See Graev v. Comm’r, 149 T.C. 485, 493 (2017).
  • Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return if, as provided by section 6662(b)(1), the underpayment is attributable to “negligence or disregard of rules or regulations.” Negligence includes any failure to make a reasonable attempt to comply with the internal revenue laws and disregard includes any careless, reckless, or intentional disregard. 6662(c). Negligence also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. Treas. Reg. § 1.6662-3(b)(1).

Insight: The Berry decision shows that shareholders of an S corporation are subject to IRS audit at the shareholder level. Accordingly, shareholders should ensure that they have the ability to request books and records from the company to substantiate items related to the S corporation that are disallowed by the IRS during examination.

Tikar, Inc. v. Comm’r, T.C. Memo. 2021-53 | May 6, 2021 | Leyden, J. | Dkt. No. 14410-17X

Short Summary: Tikar, Inc. (Tikar) was organized as a Texas nonprofit corporation on May 14, 1999. According to its articles of incorporation, Tikar was organized “to present expositions of objections belonging to the corporation. To negotiate contracts with Museums and other organizations to organize expositions. To promote African Art by exhibits through the corporation itself or through museums. To do any and all necessary and incidental to the stated purpose but in no . . . [way] in violation of Section 501(c)(3) of the Internal Revenue Code.”

The IRS examined the activities of Tikar, Inc. (Tikar) and issued a final adverse determination letter revoking its tax-exempt status. The IRS determined that Tikar was not operated exclusively for tax-exempt purposes. Tikar challenged the IRS’ determination by timely filing a petition with the Tax Court seeking declaratory judgment.

Key Issue: Whether Tikar was operated exclusively for one or more exempt purposes as set forth in Section 501(c)(3).

Primary Holdings: No, because it has not proven: (1) that it owned the African artifacts or the Seghers Collection and (2) that all of its activities with respect to those artifacts primarily benefit the private interest of Dr. Seghers or the Seghers Foundation or both.

Key Points of Law:

  • Section 7428(a)(1)(A) confers jurisdiction on the Tax Court to make a declaration in a case of actual controversy involving a determination by the IRS with respect to the initial qualification of a continuing qualification of an organization as an organization described in section 501(c)(3) which is exempt from tax under section 501(a). “A determination with respect to a continuing qualification . . . includes any revocation of or other change in a qualification.” 7428(a). The taxpayer bears the burden of establishing that the IRS’ determination is erroneous. Rule 142(a); Partners in Charity Inc. v. Comm’r, 141 T.C. 151, 162 (2013).
  • Section 501(a) exempts from federal income tax organizations described in section 501(c). In order to be exempt under section 501(c)(3), an organization must be both organized exclusively for one or more of the exempt purposes specified in the section, known as the organizational test, and operated exclusively for such purposes, known as the operational test. Reg. § 1.501(c)(3)-1(a)(1). Failure to satisfy either test forecloses a section 501(c)(3) exemption. Id.
  • In application of the operational test, “exclusively” does not mean “solely” or “absolutely without exception.” Nationalist Movement v. Comm’r, 102 T.C. 558, 576 (1994). Nonetheless, the presence of a single nonexempt purpose, if substantial, precludes exempt status regardless of the number or importance of truly exempt purposes. Better Bus. Burea of Wash., D.C. v. U.S., 326 U.S. 279, 283 (1945).
  • With respect to the operational test, an organization will be regarded as operated exclusively for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose. Reg. § 1.501(c)(3)-1(c)(1).
  • The operational test also reinforces the express dictates of section 501(c)(3) in that an entity is deemed not to operate exclusively for exempt purposes if net earnings are distributed or otherwise inure to the benefit of private individuals. Reg. § 1.501(c)(3)-1(c)(2), (3). Additionally, although an organization may be engaged in only a single activity directed toward multiple purposes, both exempt and nonexempt, failure to satisfy the operational test will result if any nonexempt purpose is substantial. Redlands Surgical Servs. v. Comm’r, 113 T.C. at 71. Exempt purposes, in turn, are those specified in section 501(c)(3), such as religious, charitable, scientific, and educational. Treas. Reg. § 1.501(c)(3)-1(d)(1)(i).
  • If an organization can be shown to benefit private interests, a limitation substantially overlapping but encompassing more than simply the inurement of earnings to insiders, it will be deemed to further a nonexempt purpose. Campaign Acad. v. Comm’r, 92 T.C. at 1066, 1068-69. Private benefits within the scope of the prohibition may include an advantage, profit, fruit, privilege, gain, or interest. Id. at 1065-66.
  • A substantial body of caselaw has explored the concept of private benefit within the framework of the relationship between an organization claiming tax-exempt status and its founder (or small group of related insiders). Founding Church of Scientology v. U.S., 412 F.2d 1197, 1199-1202 (Ct. Cl. 1969); Church of Eternal Life & Liberty, Inc. v. Comm’r, 86 T.C. 916, 927-28 (1986). Factors emerging repeatedly as indicative of prohibited inurement and private benefit include control by the founder over the entity’s funds, assets, and disbursements; use of entity money for personal expenses; payment of salary or rent to the founder without any accompanying evidence or analysis of the reasonableness of the amounts; and purported loans to the founder showing a ready private source of credit. See Founding Church of Scientology, 412 F.2d at 1200-1202; Church of Eternal Life & Liberty, Inc. v. Comm’r, 86 T.C. at 927-28.
  • Upon a conclusion that the relevant facts reveal private benefit, the organization will not qualify as operating primarily for exempt purposes “absent a showing that no more than an insubstantial part of its activities further the private interests or any other nonexempt purposes.” Campaign Acad. v. Comm’r, 92 T.C. at 1066.

Insight: The Tikar decision shows that a tax-exempt organization can lose its exempt status under Section 501(c)(3) if it benefits the founder or a close group of related persons. If the organization loses its tax-exempt status, the organization is taxable on its income and any donors who contribute to the organization will not be permitted a charitable contribution deduction for such donations.

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