When Is Divorce A Tax-Deductible Theft?

 

I am reading a case involving tax consequences from a divorce.

More specifically, the (ex) wife trying to deduct $2.5 million as a theft loss.

That is a little different.

He and she got married in 1987. Husband (Bruno) lifted a successful career in the financial sector, and by 2005 was earning over $2 million annually.

There was an affair.

There was a divorce.

The Court ordered an equitable distribution of marital properties.

That did not seem to impress Bruno, who transferred no marital properties. The court held him in contempt, ordered him to pay interest and yada yada yada.

QUESTION: Can’t a court place someone in jail for contempt?

It appeared that the Court had enough of Bruno, and in 2010 the Court transferred real estate to the (ex) wife, with instructions to sell, keep the first $300 grand and transfer the balance to an escrow account. The property sold for $1.9 million. Th (ex) wife kept all the money, placing nothing in escrow.

Yep, the Court held her in contempt.

By now I am thinking that the contempt of this court is clearly meaningless.

In 2015 our esteemed Bruno filed for bankruptcy. He claimed he was down to his last $2,500.

Which raised the question of where all the money went.

In 2016 the (ex) wife filed suit against Bruno’s new wife and several companies that he, she or both owned.

Methinks we found where the monies went.

She filed a claim against the bankruptcy estate for $3.5 million.

Apparently, there was something to the (ex) wife’s claim, as the bankruptcy trustee filed suit against the new wife, against Bruno’s mother, the Bruno companies previously mentioned and some poor guy Bruno talked to while walking his dog around the neighborhood.

That case was settled in 2019.

Let’s be honest: there is really no likeable character in this story.

The (ex) wife amended her 2015 tax return to report a $2.5 million theft.

That – not surprisingly – created a net operating loss that went springing across tax years like kids at a pre-COVID McDonald’s Playland.

The IRS caught the amended return and said: No way. No theft. No loss. Get outta here.

And that is how we got to the Tax Court.

Establishing the existence of a deductible theft can be tricky in tax law. Yes, one always has the question of what was stolen, how much was it worth and all that. Tax law introduces an additional requirement:

·      One must establish the year in which the loss was sustained.

The blade is in Reg 1.165-1(d):

However, if in the year of discovery there exists a claim for reimbursement to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained  .. until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.”

It is not the “what” that will trip you up; it is the “when.”

There of course some Court guidance over the years, such as:

·      The evaluation should not be made “through the eyes of the ‘incorrigible’ optimist,” or

·      … the “mere possibility or the bare hope of a future development permitting recovery does not bar the deduction of a loss clearly sustained.”

Yep. That is like telling a baseball player to step to the plate against Jacob deGrom and “just swing the bat.”

Thanks for the advice there, pal.

And the Court decided against the (ex) wife.

No one believed Bruno when he filed bankruptcy in 2015 and claimed he was worth only $2,500. The trustee filed suit; the (ex) wife filed suit. Lawsuits were everywhere.

The Court stated that the (ex) wife may well have a theft loss. What she did not have was a theft loss in 2015.

Our case this time for the home gamers was Bruno v Commissioner, T.C. Memo 2020-156.

Withdrawing A Tax Court Petition

 

We have a case coming up in the Tax Court.

Frankly it should never have gone this far. Much of it was COVID, I suspect. However, some of it was the IRS dropping the ball.

What set this off was someone dying. His employer had a life insurance policy on him. I suspect that this came as a surprise to his employer, who probably thought all along that the employee owned the policy with the employer paying the premiums. This would be a “split dollar” arrangement. The taxation of split dollar plans became trickier in the mid aughts, but these arrangements have been around for a long time. 

The employee died. The company received the proceeds. The company intended for the widow to receive the proceeds. How did the company get the proceeds to the widow?

They botched is what they did.

They tried to correct the botch by amending a Form 1099.

Our client is the widow, and she is being chased by the IRS. I reviewed the history of the transaction, the original and amended 1099, e-mails galore.

I have been trying to contact the IRS on the case. I even reached out to the clerk for Judge Morrison (at the Tax Court) for an assist. She was extremely helpful, but getting a response – or a pulse – from the IRS has been frustrating.

Until this week.

It is amazing how quickly some issues can be resolved if people can just talk.

The IRS understood our argument. They were willing to compromise, except for one thing.

The company never filed the amended 1099 with the IRS.

Explains why the IRS was digging in its heels.

Mind you, we can correct this – now that we know. We could also have corrected this long ago and not involved the Tax Court.

We will never appear before the Court.

Procedure here is important. Both the IRS and we will tell the Court the matter has been settled. The Court will be happy to move on.   

By contrast, what happens if we unilaterally pull out of Tax Court?

Bad things.

The seminal case goes back to 1974.

The IRS came after William Ming. Whatever was going on, the IRS was going after the fraud penalty.

There was back and forth. Mr Ming died. The IRS eventually showed some leeway on the fraud issue.

That caught the estate’s attention.

The estate tried to withdraw its case. They may have wanted a jury, and the Tax Court does not have a jury.

Here is the Court:

It is now settled principle that a taxpayer may not unliterally oust the Tax Court from jurisdiction which, once invoked, remains unimpaired until it decides the controversy.”

There is a Hotel California vibe here: the Tax Court will hold against you should you withdraw. This triggers the legal doctrine of res judicata, and you then cannot relitigate the issue in another court.

You can leave by winning, losing or settling. What you cannot do is walk out.

Our case this time for the at-home tax historians was Estate of Ming 62 T.C. 519.

How Much Paperwork Does the IRS Want?

Sometimes practitioners disagree on how much supporting paperwork – if any – should go with a tax return.

The issue can take on a keener edge when one is working with amended returns or claims for refunds.

COMMENT: For the nerds, an amended return can technically be a claim for refund – if the amended return shows a refund.

It also can vary with the tax issue at play.

I am looking at two cases – the first being the initial hearing and the second the appeal – involving a research tax credit.

The research credit is easier to understand if we think of companies such as Johnson & Johnson or Pfizer. Lab coats, scientific equipment, people wearing safety glasses and so forth. The image screams research.

Mind you, there are accounting and recordkeeping issues that go with this credit.

A routine accounting system would capture functional costs (think payroll, rent, utilities), departmental costs (think auto parts versus auto service at a car dealership) and divisional costs (consumer and industrial, for example). The research credit wants even more detail from the accounting system. It wants detail at the research activity level.

What is a research activity?

You could be an activity. Say that you are an engineer. You work in manufacturing, but a portion of your time is spent on activities that might qualify for the credit. What would be an example? Let’s say improving a product or the process to manufacture that product.  

The accounting system easily captures your payroll as a functional cost.

The system also captures your payroll as a manufacturing cost.

What the system perhaps doesn’t do – at least without upgrades – is break-down your lab time into specific projects, some of which might qualify for the credit and others which might not. Yep, your time sheets going forward are going to be a bear.

Let’s be clear: if you are Pfizer, you likely have tweaked-out your accounting and reporting system to capture 360 degrees of data, including whatever is needed for the research credit. Our discussion here concerns more routine companies.

The Harpers owned a company that specializes in military design build projects. They initially filed returns not claiming a research tax credit.

Now pause and consider what they do.

Chances are that some of what they do has an element of uncertainty: what to, how to do it, what order to do it and so on. Depending upon, that uncertainty might trigger the research credit.

There are four principal requirements to the research credit:

(1)  There must be a reduction in uncertainty about the development or improvement of a product or process.

(2)  That development or improvement in turn involves experimentation – that is, there are different ways to get there from here. The experimentation involves determining which ways work and which ways do not.

(3)  The experimentation must involve hard sciences: engineering, chemistry and so forth. Experimenting with tax law, for example, will not work (sadly).

(4)  The purpose of the activity must be a new or improved product or process: performance, function, quality, reliability, that kind of thing.

The Harpers reviewed what they did and determined that the company had research activities qualifying for the credit. They amended their returns for 2008 and 2010. The credit amount was impressive:

         2008                    $437,632

         2010                    $388,325

The IRS reviewed the amended returns and denied the credit.

Off to Court they went. The first case was in California district court.

The IRS position was both straightforward and cynical:

The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.”

Let me rephrase the position: we (the IRS) decide when we have enough facts and in any event the facts you submit are not sufficient to apprise us of anything until we say that they are sufficient.

The district court agreed with the IRS.  The taxpayer was required to establish all facts and details for its refund claim. The IRS said that the taxpayer had not, and the Court said that was all it needed to know.

Wow. Let me think how can this standard can possibly be abused….

The Harpers appealed the case to the 9^th Circuit Court of Appeals.

Their argument?

• The IRS has the right to notice of a claim and its underlying facts so it can make an informed and appropriate determination. This is referred to as the “specificity” requirement.
• The IRS can always ask one more question. This makes attaching ALL possible paperwork to a claim virtually impossible.
• In practice, the IRS can review a claim with a taxpayer. One way is to audit the claim, of course. This act is considered a waiver of the specificity requirement.
• Why would the IRS review a claim and thereby waive anything? Consider the alternative. Tax practitioners would attach so much documentation to the research tax credit that the IRS would have to lease additional storage to house it all.  It is in both parties’ mutual interest to go along and get along.

The Harpers argued that the IRS had waived the specificity requirement.

How did the IRS do this?

By auditing the claim.

The IRS spent four years auditing the amended returns. The Harpers provided over 100,000 pages of supporting documentation. At no point in time did the IRS tell the Harpers that they had not provided ENOUGH documentation.

I am trying to be fair, but I am distressed by the IRS behavior.

It is common professional knowledge that the IRS can always ask for additional information. One can provide it and still get turned down, but the give and take allows the system – the IRS and tax practitioners - to function and not be overwhelmed.

Is that what happened here?

Nope.

The IRS did not go to Court arguing that it had reviewed 100,000 pages of supporting documentation and decided the Harpers did not qualify for the research credit.

The IRS argument was that the Harpers did not meet the specificity requirement – meaning the Harpers did not include enough paperwork.

The Appeals Court called out the IRS. It had waived the specificity requirement by auditing the amended returns.

The Appeals Court sent the case back to the district court. The case should never have been dismissed for the specificity requirement.

The Harpers may win or may lose, but they will have their day in court.

Our case this time for the home gamers was Harper v United States.