Monday, March 25, 2019

Captain Eddie’s Firefly

The case starts with:
Edward G Kurdziel is the only man in America licensed to fly a Fairey Firefly. He is also the only man in America who has a Firefly to fly.”
I was immediately hooked.

What is a Fairey Firefly?
The Firefly entered service as a carrier-based fighter for the Royal Navy toward the end of the war (WW II - CTG), and became a specialist in antishipping and antisubmarine warfare.”
Mr Kurdziel – also known as Captain Eddie – explained that the Firefly “was the first British airplane to fly over Japan and Tokyo in 1945 during the [occupation] of Japan.”

In the fall of 1993 Captain Eddie learned that a Firefly was for sale in Australia. He travelled; he consulted with mechanics. The plane had not flown in years, possibly decades.

He borrowed against his house and bought the plane for $200,000. It cost another $60,000 to have it shipped.

The plane is a near-museum piece. What was he going to do with it?

His early plan was to sell rides on the plane. He looked into insurance (can you imagine?). He collaborated with the Royal Australian Navy on a plan to restore the plane.

That took eight years, 45,000 man-hours and as many as 10 full-time workers.

Captain Eddie was a bit of an Anakin Skywalker, designing and crafting many replacement parts himself.

In 2002 he received an “air worthiness certificate” from the FAA. He also got the FAA to license him to fly it. To this day, he is the only person in the country with such a license.

He showed the plane. It won prizes. It landed on 20 or 30 magazine covers.

This being a tax blog, there has to be a tax angle. What you think it was?

Yep, Captain Eddie deducted everything.

Problem: to pull this off, Captain Eddie had to persuade the IRS – and then the Court – that he actually had a business. As opposed to … say … a hobby. A really cool hobby, but a hobby nonetheless. A business has to have the intent – perhaps misplaced but nonetheless sincere – that it will show a profit.

How was this old warbird going to show a profit after the near-herculean effort and cost of restoring it?

Rides? Nah, that was nixed immediately by the authorities. No surprise that the FAA was not too keen with public rides on an antique, near-unflyable-by-today’s-standards airplane.

There were airshow appearances and prizes.

Yes, but the winnings were a pittance against what he spent. No chance of a profit there.

The Firefly crashed in 2012. Captain Eddie is still working on its repair.

The IRS brought out its hobby loss hammer and said “no deduction here.”

Off to Court they went.

Captain Eddie had to show that a sane businessperson would keep putting money into a money pit. Granted, one may do it for love, for respect for history or other reasons, but those reasons are not business reasons.

But it can happen. Take thoroughbred horses, for example. The odds of winning the Derby are miniscule, but the payoff is so great – especially if one can win the Triple Crown – that the activity can still make business sense.

Captain Eddie had an ace in his hand: he could sell the plane for a profit.

Mind you, there are a number of factors the Court could consider, such as:
·      Manner in which the activity is conducted
·      Expertise of taxpayer or advisors
·    Time and effort expended by taxpayer
·      Success on carrying on other similar activities
·      History of income or loss
·      Amount of occasional profits, if any
·      Taxpayer’s financial status 
·      Elements of personal pleasure or recreation 
·      Expectation that assets used in activity will increase in value
Captain Eddie won and lost some of these. For example, he received retirement pay pushing $180K from the Navy and Delta. He could afford an expensive hobby. There was no question about the pleasure he derived from the Firefly. He had a real estate business, but that it was a stretch to argue that it was “similar” to the Firefly.

At trial, Captain Eddie brought in experts who testified the plane was worth between $3.5 and $8 million. That would cover the approximately $1.9 million Captain Eddie had put into it.

The IRS quickly pointed out the plane crashed and had not flown since.

But planes can be repaired….

The Court acknowledged that Captain Eddie could have made money by selling the plane, but then it wondered why he did not sell it years before, when it was winning all those awards. That would likely have been its peak price.

The Court considered all the pieces.

  • Initially Captain Eddie had thought of selling rides. The Court was unimpressed. A moment’s research would have told him there was no chance the FAA would allow this.
  • A businessperson would respond by revising the business plan. The Court was looking at things titled “Original Plan 1999-2000?,” which did not increase its confidence that Captain Eddie had landed on his feet. 
  • He had listed the activity on his personal tax return as “airplane leasing,” The Court was not humored, as nothing had ever been leased. 
  • He filed a local property tax exemption for the Firefly, stating that he was not using it for commercial purposes or holding it for sale. 
    •  Oh oh
  • If he had thought of selling the plane, he waited a long time – 2014 – before obtaining an appraisal. The Firefly was rocking it in the early aughts – many years before 2014. 

It didn’t add up. The Court was bothered by the rides, as that would have taken minimal effort to discover. Why didn’t Captain Eddie entertain offers for the plane? Why would he sign property tax paperwork saying the plane was personal and not commercial-use or held for sale?

The Court said hobby. No loss for Captain Eddie.

A taxpayer can win a hobby loss challenge. It happens quite a bit, actually. The key is that the taxpayer should respond as a businessperson would. If one door shuts the taxpayer must show that he/she went after another open door, always with the objective of making a profit. Maybe it played out, maybe it did not – but the taxpayer tried.

And it helps to be consistent, the one thing Captain Eddie failed to do.

Our case this time is Edward G. Kurdziel, Jr v Commissioner.

Sunday, March 17, 2019

No Harm No Foul? Fuhgeddaboudit!

I am looking at a case involving whether a penalty requires a supervisor’s approval before being imposed.

It is dry stuff.

The rest of the case is what caught my eye.

Mr and Mrs Allen extended their individual tax return. They also owned 100% of an S corporation.
COMMENT: An S corporation’s income is reportable on its shareholder’s personal return. Since M/M Allen owned 100% of their S, all of the S corporation’s income would be reported on their return.
Somebody somewhere forgot to extend the S corporation return. It was due March 15, and it was filed on September 13.
COMMENT: Meaning it was filed 6 months late. The penalty is $195 per month per owner. The math is ($195 times 2) times 6 = $2,340. Not filing that extension got expensive.
The Allens thought that this was outrageous. After all, all of the corporation’s income went on their return, and their return was properly extended. There was no harm to the Treasury. Surely that lack of harm was reasonable cause for abatement.

The IRS told them to pound salt.

Off to Tax Court they went.

Let’s slide to the side a bit. If this had been a partnership, they would have requested abatement under Rev Proc 84-35. A partnership comes under 84-35 scope if:

·        There are 10 or fewer partners
·        Who are individuals (except nonresidents) or an estate
·        The partners each have the same income/loss allocation percentage
·        Each partner has reported his/her share of the income/loss on a timely filed return
·        There is one more requirement concerning audit procedures, which need not concern us here

Rev Proc 84-35 says that – if you meet the above – you have “reasonable cause.” Consider that reasonable cause is grounds to abate a penalty and 84-35 is a way out of a penalty.

Guess what: S corporations have no equivalent to Rev Proc 84-35. Why? Who knows? Is it fair? What does fair have to do with anything?

So the Allens have no 84-35 pass. They instead based everything on their correctly extended underlying personal return.

Here is the Court:
[] evidently conceives that the sole purpose of the Form 1120S is to give the shareholder the information that he or she needs in order to file a Form 1040 tax return; and since Mr. and Mrs. Allen knew the affairs of [], did eventually file their Form 1040 timely …, and did not fail to report any income, the intended purpose of the S corporation’s filing requirement was accomplished and the penalty was moot.”
Lots of shade here, Tax Court. The Allens were instead arguing no loss to the Treasury, so the Treasury could afford to be magnanimous and not impose an otherwise burdensome penalty just because. Save us from the French court of Louis XVI, why don’t you?

Back to the Court:
[] cites no authority in support of its claim that the penalty should be waived on the grounds that its two shareholders were aware of the information to be shown on the return. Section 6699 does not include a condition of harm before the penalty is imposed; it simply imposes a penalty when the filing is late (without reasonable cause).”
I am at a loss why the Court is looking for “authority” when all the Allens are requesting is reasonable cause. Reasonable cause is an equity and not statutory argument. It does not need to be based on chapter and verse from the dustiest tome in the most unvisited tax library in the land. Statutory says you stop and wait at a red light. Equity says you stop and then run the light because you are transporting someone experiencing a heart attack to the hospital.

Ahh, you know how this case turned out.

And I continue to point out that the IRS long ago stopped using penalties to disincentive bad tax behavior and abatement to incentivize good tax behavior. The IRS is now using penalties to pad its budget. In that world, abatement is tantamount to the IRS taking money from its own wallet, something it will not do willingly.

I was saddened to see the Tax Court drink the same Kool-Aid. To be fair, I suppose the Court did not want to go where the IRS has been reluctant to proceed regulatorily. I nonetheless argue that the Court whiffed on a chance to force the IRS to be reasonable when determining reasonable cause.

Our case this time was ATL & Sons Holding Inc v Commissioner.

Sunday, March 10, 2019

The IRS Tests Deductibility Of Business Interest

You may be aware that the new tax law changed the deductibility of your mortgage interest. It used to be that you could borrow and deduct the interest on up to a million-dollar mortgage. That amount has now been further reduced to $750,000, although there is a grandfather exception for loans existing when the law changed.
COMMENT: I have never lived in a part of the country where a million-dollar mortgage would be considered routine. There was a chance years ago to relocate the CTG family near San Francisco, which might have gotten me to that rarified level. I continue to be thankful I passed on the opportunity.
There is also business interest. Let’s say you have a general contracting business. This would be the interest incurred inside the business. Maybe you have a line of credit to smooth out cash flows, or maybe you buy equipment using a payment plan. The business itself is borrowing money.

Business interest has traditionally avoided most of the revenue-rigging shenanigans of the politicians, but business interest got caught this last time. There is now a limit on the percentage-of-income that a business can deduct, and that amount is scheduled to decline as the years go by. You might see the limit referred to as the “163(j)” limitation, which is the Code section that houses it. Fortunately, you do not have to worry about “163(j)” if your sales are under $25 million. If you are over that limit (BTW related companies have to be added together to test the limit), you probably are already using a tax pro.    

Then there is investment interest. In its simplest form, it is interest on money you borrowed to buy stock in that general contracting business. The distinction can be slight but significant: it is interest on monies borrowed to own (as opposed to operate) the business.

There is a limit on the deductibility of investment interest: the income paid you as a return on investment. If the business is a corporation, as an example, that would be dividends paid you. If you do not have dividends (or some other variation of investment income), you are not deducting any investment interest expense. It will carry-over to next year when you get to try again.

I am looking at a case involving an electrical engineer and his sole-proprietor software development company. He was kicking-it out of the park, so he borrowed money to purchase two vacant lots. He also bought two steel buildings, with the intent of locating the buildings on his vacant lots and establishing headquarters for his company.

The business lost a major customer. Employees fled. He sold the steel buildings for scrap.

But he kept paying interest on the loan to buy the lots.

He deducted the interest as business interest, meaning he deducted it in full.

Oh nay-nay, said the IRS. You have investment interest and – guess what – you have no investment income. No deduction for you!
OBSERVATION: The business was still limping along, and as a proprietorship all its numbers were reported on his individual tax return.
The IRS had one principal argument: the buildings were never moved; the headquarters was never established; the land never used for its intended purpose. The “business” of business interest never happened. What he had was either investment interest or personal interest.

Let’s look at the definition of investment interest:

163(d)(5)  Property held for investment.

For purposes of this subsection

(A)  In general. The term "property held for investment" shall include-
(i)  any property which produces income of a type described in section 469(e)(1) , and
(ii)  any interest held by a taxpayer in an activity involving the conduct of a trade or business-
(I)  which is not a passive activity, and
(II)  with respect to which the taxpayer does not materially participate.

I say we immediately throw out 163(d)(5)(A)(ii), as the taxpayer is and has been working there. I say that he is materially participating in what is left of the software company.

That leaves 163(d)(5)(A)(i) and its reference to 469(e)(1):
     469(e)  Special rules for determining income or loss from a passive activity.
For purposes of this section -
(1)  Certain income not treated as income from passive activity.
In determining the income or loss from any activity-
(A)  In general. There shall not be taken into account-
(i)  any-
(I)  gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business,
(II)  expenses (other than interest) which are clearly and directly allocable to such gross income, and
(III)  interest expense properly allocable to such gross income, and
(ii)  gain or loss not derived in the ordinary course of a trade or business which is attributable to the disposition of property-
 (I)  producing income of a type described in clause (i) , or
(II)  held for investment.

I am not clear what the IRS is dredging here, other than a circular argument that the interest was not incurred in a trade or business and was therefore held for investment.

The Court said that was an argument too far.

The Court could accept that the properties were not “used” in the trade or business, but it also accepted that the properties happened (the Court used the term “allocable”) because of the trade or business.

The Court allowed the interest as a business deduction.

Our case this time was Pugh v Commissioner.

Sunday, March 3, 2019

Downside To A Tax Election

Many tax professionals believe that computerization has led to increasing complexity in the tax Code. If one had to prepare returns by hand – or substantially by hand – the current tax Code could not exist. Taxpayers would almost certainly need the services of a professional, and professionals can only prepare so many returns in the time available – despite any wishes otherwise.
COMMENT: There is, by the way, a practitioner in New Jersey who still prepares tax returns by hand. His name is Robert Flach, and he has a website ( which I visit every now and then. I do not share his aversion to tax software, but I respect his stance.
That complexity has a dark side. It occurred to me as I was reading a recent case concerning tax elections.

Tax elections are no longer the province of the big wallets and the Fortune 500. You might be surprised how many there are and further surprised with the hot water in which they can land you.

Examples include:

(1)  If you are a small landlord there is an election that will allow you to deduct repairs below a certain dollar limit without second guessing by the IRS. It is called the “safe harbor small taxpayer” election, and it is available as long as the cost of your property is $1 million or less. Mind you, you can have a collection of properties, but each property has to be $1 million or less.
(2)  There is an election if you want out of first-year depreciation, which is now 100% of the cost of qualifying property. Why would you do this? Perhaps you do not need that all 100%, or the 100% would be used more tax-efficiently if spread over several years.
(3)  You may have heard about the new “qualified business income” deduction, which is 20% of certain business income that lands on your individual tax return, perhaps via a Schedule K-1. The IRS has provided an opportunity (a very limited opportunity, I would argue) to “aggregate” those business together. To a tax nerd. “aggregate” means to treat as one, and there could be compelling tax reasons one would want to do so. As you guessed, that too requires an election.

The case I am looking at involves an election to waive the carryback of a net operating loss.
COMMENT: By definition, this is a pre-2018 tax year issue. The new tax law did away with NOL carrybacks altogether, except in selected and highly specialized circumstances.
The taxpayers took a business bath and showed an overall loss on their individual return. The tax preparer included an election saying that they were giving up their right to carryback the loss and were electing instead to carryforward only.
COMMENT: There can be excellent reasons to do this. For example, it could be that the loss would rescue income taxed at very low rates, or perhaps the loss would be negated by the alternative minimum tax. One has to review this with an experienced eye, as it is not an automatic decision
Sure enough, the IRS examined a couple of tax years prior to the one with the big loss. The IRS came back with income, which meant the taxpayers owed tax.

You know what would be sweet? If the taxpayers could carryback that NOL and offset the income the IRS just found on audit.

Problem: the election to waive the carryback period. An election that is irreversible.

What choice did the taxpayers have? Their only argument was that the tax preparer put that election in there and they did not notice it, much less understand what it meant.

It was a desperation play.

Here is the Court:

Though it was the error of the [] return preparer that put the [] in this undesirable tax position, the [] may not disavow the unambiguous language of the irrevocable election they made on their signed 2014 tax return.

As the Code accretes complexity, it keeps adding elections to opt-in or opt-out of whatever is the tax accounting de jour. I suspect we will read more cases like this in upcoming years.

Our case this time was Bea v Commissioner.