Doctor Contests Whether He Had Cancellation Of Debt Income

I suspect that I am one of few people who know where Palatka, Florida is.

When I came out of graduate school I worked as an accountant in Tampa. The firm that I was with was quite aggressive in pursuing contracts for government audits, and one of the accountants there would go to Palatka on a routine enough basis. I remember him not being overly excited about it.

In case you are curious, draw a line from Gainesville (where the University of Florida is) to St Augustine and one (sort of) crosses Palatka.  

The reason we are talking about it is that I am reading a Tax Court decision about a doctor in Palatka. It is a “pro se” decision, which means that the taxpayer represented himself/herself before the Court. I can tell that the doctor tried to ramp up on IRS procedure, but he might have been better advised to hire a CPA experienced in this area.

MEMO: We have commented on this before, but many CPAs do not practice tax, and those who do may not necessarily practice IRS procedure (other than maybe answering the occasional tax notice). 

Dr Darrell Wyatt graduated from the University of Arkansas in 1978 and is board certified in obstetrics and gynecology.

He is a baby doctor.

In 2006 he was wooed by Putnam Medical Center to move to rural Florida.

Nice thing about being a doctor is that hospitals are willing to provide “incentive” payments for things, such as moving to Putnam county Florida. The hospital made a deal with the doctor - move here and we will subsidize (read: “loan”) your practice up to $32,953 per month. That will go on for one year, and then we stop subsidizing you. At that time we would like for you to stay here and work for another 3 more years. Every month that you stay we will forgive 1/36 of the loan. Stay for 3 years and we will forgive the entire loan. Leave before then and you have to pay back whatever is still due on the loan.

He spent the year, and then he easily spent 3 more years.

The loan was forgiven in monthly increments.

The deal with Putnam Medical Center started in July, 2006. Spot the doctor a year. The 36 month period would then run from August, 2007 through July, 2010. 

He filed his 2009 return. He reported the amount forgiven in 2009. He paid no estimated taxes. He owed the IRS a boat. The IRS came in and wanted taxes and several varieties of penalties.

Let talk a little procedure.

The IRS issued a Final Notice of Intent to Levy for 2009. 

OBSERVATION: The IRS had sent a lot of correspondence to the doctor, as this is pretty far along. Levy means that the IRS can go in and tap your bank account, among other things. It is a step up from a Lien and is not a good thing.

Dr. Wyatt in turn requested a Due Process Hearing.

NOTE: The taxpayer has 30 days from the issuance of the Final Notice of Intent to Levy to request an Appeals hearing. One is still inside the IRS, but one is moving the file from Collections to Appeals. This is important as Collections truly does not care whether you owe the tax or can pay the tax, it just wants money. Appeals might cut one some slack on the amount or period over which the tax can be paid.

So far I understand. He did not pay 2009 taxes, so I presume he was under some financial distress. Surely he wanted to propose some payment alternative, and he requested the hearing because the IRS machine was going to run him over otherwise.

Wrong. The doctor presented an offer in compromise based on doubt as to liability.

OBSERVATION: The common offer in compromise is based on collectability: one does not have two nickels to rub together and is trying to get the IRS to accept some greatly reduced amount. This second type is based on the assertion: “IRS, I do not owe you, period.”

This tells me the doctor has done some homework. He submitted amended tax returns and proposed to pay approximately what his tax would have been, excluding the loan forgiveness, for tax years 2007 through 2010. 

           COMMENT: He evidently did not pay tax for four years.

The doctor did not follow certain procedural formalities, which we will spare ourselves for the time being. 

The IRS did not accept his offer. The IRS issued its Statutory Notice of Deficiency (a/k/a “SNOD”) and off they went to Tax Court.

The IRS did not his accept his offer because he did not establish doubt as to liability. In and of itself that does not bother me, as convincing the IRS on that point is like expecting your dog to not want the leftovers from your T-bone steak. 

In Court the doctor leads off his argument with:

(1) The loan was nonrecourse.

Huh? 

He is hanging his hat on that fact that the hospital never reduced the employment incentive to a promissory note. No note equals no personal liability, right?

Wrong. You can be liable and not have a written note. Granted, the written note makes it easier to prove the existence of debt, but the absence of a note does not mean that there is no debt. Had he failed to stay for 36 months, the hospital would have had right to sue under the paperwork that did exist.

He had no argument (2). 

What was he thinking? Did he really believe …?

And then it dawned on me. 

The IRS proceeded against the doctor for one year only – 2009. He would have had debt discharge income in 2007 and 2008 also, but those years were not before the Court.

But there is a logical fallacy here: The absence of something does not necessarily mean the presence of something else. The Court was looking only at 2009, which does not mean that the IRS flubbed 2007 and 2008. 

However, consider the following language by the Court:

In his Form 12153 petitioner referenced three taxable years: 2007, 2008, and 2009. The record in the instant case does not include a copy of the final notice that prompted petitioner to file Form 12153, nor does the record include a transcript of account for any year other than 2009. As discussed infra in the text, the offer-in-compromise based on doubt as to liability that petitioner subsequently submitted referenced 2007 through 2010, i.e., the four taxable years for which amounts were forgiven and canceled by the hospital. However … the notice of determination upon which the instant case is based was issued solely in respect of petitioner’s outstanding liability for 2009.”

The doctor lost on all counts for 2009.

But I cannot help but wonder if the doctor was not so much practicing procedure for 2009 as much as running out the statute of limitations for 2007 and 2008.

Less-Than-10% Shareholders Responsible For Corporate Income Tax

I have a question for you:  if you and I work for a company and it goes bankrupt, might we have to pay back some of the money we were paid?

The answer – presumptively – is no, as long as we were employees and received payment as fair compensation for our services.

Let’s stir the pot a bit, though, and say that you and I are shareholders – albeit (very) minority shareholders. What if there were bonuses? What if we received dividends on our stock?

Let’s talk about Florida Engineered Construction Products Corp (FECP), also known as Cast Crete Corporation.

FECP had the luck of being a concrete company in Florida in the aughts when the housing market there was booming. FECP had four shareholders, but the two largest (John Stanton and Ralph Hughes) together owned over 90 percent. The balance was owned by William Kardash, who was an engineer, and Charles Robb, who headed sales.

FECP made madman-level money, although they reported no profits to the IRS.

CLUE: If one is thinking of scamming the IRS, one may want to leave a few dollars in the till. It does not take a fraud auditor to wonder how a company with revenues over $100 million uniformly fails to report a profit – any profit – year after year.

The numbers are impressive.  For example, FECP paid Messrs. Hughes and Stanton interest of the following amounts:

                                          Hughes                      Stanton

            2005                    $5,147,000              $4,250,000

            2006                    12,914,000             12,101,000

            2007                      6,468,000               9,046,000

FECP also paid hefty dividends, paying over $41 million from 2005 through 2007.

I am thinking this was a better investment than Apple stock when Steve Jobs came back.

What was their secret?

It started off by being in the right place at the right time. And then fraud. FECP had a loan with a bank, and the bank required an annual audit. FECP made big money quickly enough, however, that it repaid the bank.  Rest assured there were no further audits.

Mr. Stanton opened a bank account in FECP’s name. Problem is that the account did not appear on the company’s books. When the accountants asked what to do with the cash transfers, he told them to “mind their own business.” The accountants, having no recourse, booked them as loans. Eventually they just wrote the amounts off as an operating expense.

COMMENT:  Here is inside baseball: if you have questions about someone’s accounting, pay attention to the turnover in their accounting department, especially the higher-level personnel. If there is a different person every time you look, you may want to go skeptical.

Those massive interest payments to Messrs. Stanton and Hughes? There were no loans. That’s right: neither guy had loaned money to FECP.  I cannot help but wonder how the loans got on the books in the first place, but we are back to my COMMENT above.

Mind you, our two minority shareholders – Kardash and Robb – were making a couple of bucks also. They had nice salaries and bonuses, and they received a share of those dividends.

Proceed into the mid-aughts and there was a reversal in business fortune. The company was not doing so well. They cut back on the bonuses. The two principal owners however wanted to retain Kardash and Robb, so they decided to “loan” them money – to be paid out of future profits, of course. There were no loan papers signed, no interest was required, and Kardash and Robb were told they were not expected to ever “pay it back.” Other than that it was a routine loan.

Do you wonder where all this money was coming from?

FECP filed fraudulent tax returns for 2003 and 2004, reporting losses to Uncle Sam.

Ouch.

FECP tightened up its game in 2005, 2006 and 2007: they did not file tax returns at all.

Well, if you are going to commit tax fraud ….

But the IRS noticed.

After the mandatory audit, FECP owed the IRS more than $120 million. FECP agreed to pay back $70,000 per month. While impressive, it would still take a century-and-a-half to pay back the IRS.

Mr. Stanton went to jail. Mr. Hughes passed away. And the IRS wanted money from the two minority shareholders – Kardash and Robb. Not all of it, of course not. That would be draconian. The IRS only wanted $5 million or so from them.

There is no indication that Kardash and Robb knew what the other two shareholders were up to, but now they had to reach into their own wallets and give money back to the IRS.

On to Tax Court.  

And we are introduced to Code section 6901, which allows the IRS to assess taxes in the case of “transferee liability.”

NOTE: BTW if you wondered the difference between a tax attorney and a tax CPA, this Code section is an excellent example. We long ago left the land of accounting.

There is a hurdle, though: the IRS had to show fraud to get to transferee liability.

It is going to be challenging to show that Kardash and Robb knew what Stanton and Hughes were doing. They cashed the checks of course, but we would all do the same.

But the IRS could argue constructive fraud. In this context it meant that Kardash and Robb took from a bankrupt company without giving equal value in return.

The IRS argued that those “loans” were fraudulent, because they were, you know, “loans” and not “salary.” However the IRS had come in earlier and required both Kardash and Robb to report the loans as taxable income on their personal tax returns. Me thinketh the IRS was talking out of both sides of its mouth on this matter.

The Court decided that the “loans” were “compensation,” fair value was exchanged and Kardash and Robb did not have to repay any of it.

That left the dividends (only Stanton and Hughes had loans). Problem: almost by definition there is no “exchange” of fair value when it comes to dividends. FECP was not paying an employee, contractor or vendor. It was returning money to an owner, and that was a different matter.

The Court decided the dividends did rise to constructive fraud (that is, taking money from a bankrupt company) and had to be repaid. That cost Kardash and Robb about $4 million or so.

And thus the Court pierced the corporate veil.

But consider the extreme facts that it required. Stanton and Hughes drained the company so hard for so long that they bankrupted it. That might work if one left Duke Energy and the cleaning company behind as vendors, but it doesn’t work with Uncle Sam.  You knew the IRS was going to look in every corner for someone it could hold responsible.

Distinguishing Capital Gains From Ordinary Income

The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:

1. The purpose for acquisition of property
2. The extent of developing the property            
3. The extent of the taxpayer’s efforts to sell

The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.

A Waitress, A Waffle House And A Lottery Ticket

It’s fun to think about winning the lottery

There is a (former) waitress in Grand Bay, Alabama who did. She worked at a Waffle House. Enter Edward Seward, a regular at the restaurant. Seward liked the lottery. As Alabama did not have a lottery, he would travel to Florida to buy tickets. He also liked giving away the lottery tickets to the waitresses at the Waffle House. Our protagonist – Tonda Lynn Dickerson – had an agreement with four other waitresses that – if they ever won – they would share the winnings equally.

Would you know that the lottery ship docked, and Tonda Lynn had the winning ticket? The winnings were more than $9 million if paid out over 30 years, and over $5 million if paid in lump sum. First thing Tonda did was quit her job.

Tonda Lynn took the matter to her dad – Bobby Reece. Turns out her family was quite close and had talked about sharing lottery winnings if ever anyone won. Bobby seemed the most invested in the lottery discussion. Johnny Reece - the brother - was not so much into it.   

Bobby contacted Louisa Warren, the general counsel for the Florida Lottery Commission. Bobby explained the family understanding about the lottery. She told Bobby:

Don’t sign that ticket, period.”

She recommended that they form an entity to claim the winnings.

Enter an attorney and an S Corporation named 9 Mill, Inc.

NOTE: Get it?

Bobby sat down at the table and decided the ownership percentages while Tonda Lynn and her husband went car shopping. Turns out that Tonda and James (the husband) owned 49% of 9 Mill, Inc.

OBSERVATION: Bobby seems to have an intuitive grasp of tax issues.

Bobby and Mrs. Reece and James went to Florida to claim the ticket. They decided to take a 30-year payout of $354,000 per year.

... and they were notified of a competing claim against the winnings.

Remember the other waitresses at the Waffle House? They lawyered up. Their attorney filed suit in the Circuit Court of Mobile County, claiming that his clients were entitled to 80% of the winnings. The waitresses had an agreement. They also had a witness – Mr. Seward – who started the whole thing by giving Tonda Lynn the lottery ticket.

Tonda seemed to have forgotten any agreement, any Waffle House, any other waitresses. She had bought the ticket herself, it seems. There was a small problem with that, however. The tickets were sequentially numbered at the bottom, and her ticket – number 18 – was missing

The Circuit Court entered an order saying that the other four waitresses were right and that Tonda Lynn had to part with 80%.

Well, 9 Mill, Inc was not going to stand for that. They countersued, and the case went to the Alabama Supreme Court. The Supreme Court overturned the Circuit Court.

Tonda Lynn was back in the money, but not for the reason that you may think. The Court agreed that there was an agreement between the five waitresses, but the Court also pointed out that it could not enforce that agreement on public policy grounds. Alabama could not enforce a contract based on gambling. Gambling was not allowed in Alabama.

I suspect that Tonda Lynn can never go back to that Waffle House.

Not too long after, the IRS contacted Tonda Lynn. The IRS wanted its gift tax – approximately $770,000.

Tonda Lynn had a lottery ticket.  The winnings went into an entity of which she and her husband owned 49%. What happened to the other 51%? According to the IRS, Tonda Lynn must have gifted it.

You have to admit, they have a point.

Now Tonda Lynn and the IRS go to Court. She presents two arguments:

(1)     No gift occurred because at the time of transfer there existed an enforceable contract under Alabama law.

(2)     Alternatively, she and her family were all members of an existing partnership that was the true owner of the lottery ticket.

Let’s address this in reverse order.

The Court noted that the partnership, if one existed, was an odd partnership because it did not observe the formalities of a business activity. Ownership had never been spelled out, for example. The members were not required to contribute to the partnership or to buy lottery tickets regularly. A family member did not even know if another member bought a lottery ticket. There may have been an understanding, but that understanding did not rise to the level of an”activity” which could be housed in an entity.

Additionally, Tonda did not buy the ticket. It was given to Tonda, who would still have to explain how the ticket got into the entity.

On the first argument the Court reminded Tonda that there could have been no enforceable contract.  Alabama did not recognize gambling.

NOTE: Odd that Tonda Lynn would forget this, as this is the same reason Tonda won her case against the other waitresses. Short memory, I suppose.

Tonda Lynn owed gift tax.

The story is not done, though. There was one more issue before the court.

It turns out that the delay in cashing the winning ticket was a tax boon to Tonda, as it allowed time for the other waitresses to submit their claim. Had they not, then Tonda would have owed gift tax of approximately $770,000. The claim introduced uncertainty about the value of the gift. What would an independent party pay for that ticket at that moment, knowing there was a cloud, the resolution of which could mean forfeiture of 80% of the winnings?

The Court discounted the gift by more than two-thirds.

It was Tonda Lynn’s only victory with the IRS.

How did it turn out for Tonda Lynn? Her husband divorced her. He then supposedly kidnapped her.  She later declared Chapter 13 bankruptcy.

Do you still want to win the lottery?