Use Of Wrong Form Costs A Tax Refund

Let’s talk about the following Regulation:

26 CFR § 301.6402-2

Claims for credit or refund

(b) Grounds set forth in claim.

(1) No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefor except upon one or more of the grounds set forth in a claim filed before the expiration of such period. 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. The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

That last sentence is critical and – potentially – punishing.

I suspect the most common “claim for refund” is an amended return. There are other ways to claim, however, depending on the tax at issue. For example, businesses requested refunds of federal payroll taxes under the employee retention credit (“ERC”) program by filing Form 941-X. You or I would (more likely) file our claim for refund on Form 1040-X. 

File a 1040-X and the tax “variance doctrine” comes into play. This means that the filing must substantially inform the IRS of the grounds and reasons that one is requesting a refund. Both parties have responsibilities in tax administration. A taxpayer must adequately apprise so the IRS can consider the request without further investigation or the time and expense of litigation.

Here is a Court on this point in Charter Co v United States:

The law requires a taxpayer “to do more than give the government a good lead based on the government’s ability to infer interconnectedness.”

Another way to say this is that the IRS is not required to go all Sherlock Holmes to figure out what you are talking about. 

Let’s look at the Shleifer case.

Scott Shleifer was a partner in an investment firm. He travelled domestically and abroad to investigate new and existing investment opportunities. Scott was not a fan of commercial airfare, so he used his personal plane. He waived off reimbursement from the partnership for his air travel.

COMMENT: Scott is different from you or me.

The Shleifers filed their 2014 joint individual tax return. Whereas it is not stated in the case, we can assume that their 2014 return was extended to October 15, 2015.

In October 2018 they filed an amended return requesting a refund of almost $1.9 million.

COMMENT: And there you have your claim. In addition, notice that the two Octobers were three years apart. Remember that the statute of limitations for amending a return is three years. Coincidence? No, no coincidence.

What drove the amended return was depreciation on the plane. The accountant put the depreciation on Schedule C. It was – in fact – the only number on the Schedule C.

In July 2020 the IRS selected the amended return for audit.

COMMENT: A refund of almost $1.9 million will do that.

The Shleifer’s accountant represented them throughout the audit.

In March 2022 the IRS denied the refund.

Why?

Look at the Schedule C header above. It refers to a profit or loss “from business.” Scott was not “in business” with his plane. It instead was his personal plane. He did not sell tickets for flights on his plane. He did not rent or lease the plane for other pilots to use. It was a personal asset, a toy if you will, and perhaps comparable to a very high-end car. Granted, he sometimes used the plane for business purposes, but it did not cease being his toy. What it wasn’t was a business.

The accountant put the depreciation on the wrong form.

As a partner, Scott would have received a Schedule K-1 from the investment partnership. The business income thereon would have been reported on his Schedule E. While the letters C and E are close together in the alphabet, these forms represent different things. For example:

·       There must be a trade or business to file a Schedule C. Lack of said trade or business is a common denominator in the “hobby loss” cases that populate tax literature.

·       A partnership must be in a trade or business to file Schedule E. A partner himself/herself does not need to be active or participating. The testing of trade or business is done at the partnership - not the partner - level.

·       A partner can and might incur expenses on behalf of a partnership. White there are requirements (it’s tax: there are always requirements), a partner might be able to show those expenses along with the Schedule K-1 numbers on his/her Schedule E. This does have the elegance of keeping the partnership numbers close together on the same form.   

After the audit went south, the accountant explained to the IRS examiner that he was now preparing, and Scott was now reporting the airplane expenses as unreimbursed partner expenses. He further commented that the arithmetic was the same whether the airplane expenses were reported on Schedule C or on Schedule E. The examiner seemed to agree, as he noted in his report that the depreciation might have been valid for 2014 if only the accountant had put the number on the correct form.

You know the matter went to litigation.

The Shleifers had several arguments, including the conversation the accountant had with the examiner (doesn’t that count for something?); that they met the substantive requirements for a depreciation deduction; and that the IRS was well aware that their claim for refund was due to depreciation on a plane.

The Court nonetheless decided in favor of the IRS.

Why?

Go back to the last sentence of Reg 301.6402-2(b)(1):

A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

The Shleifers did not file a valid refund claim that the Court could review.

Here is the Court:

Although the mistake was costly and the result is harsh …”

Yes, it was.

What do I think?

You see here the ongoing tension between complying with the technical requirements of the Code and substantially complying with its spirit and intent.

I find it hard to believe that the IRS – at some point – did not realize that the depreciation deduction related to a business in which Scott was a partner. However, did the IRS have the authority to “move” the depreciation from one form to another? Then again, they did not have to. The accountant was right: the arithmetic worked out the same. All the IRS had to do was close the file and … move on.

But the IRS also had a point. The audit of Schedule C is different from that of Schedule E. For example, we mentioned earlier that there are requirements for claiming partnership expenses paid directly by a partner. Had the examiner known this, he likely would have wanted partnership documents, such as any reimbursement policy for these expenses. Granted, the examiner may have realized this as the audit went along, but the IRS did not know this when it selected the return for audit. I personally suspect the IRS would not have audited the return had the depreciation been reported correctly as a partner expense. 

And there you have the reason for the variance doctrine: the IRS has the right to rely on taxpayer representations in performing its tax administration. The IRS would have relied on these representations when it issued a $1.9 million refund – or selected the return for audit.

What a taxpayer cannot do is play bait and switch.

Our case this time was Shleifer v United States, U.S. District Court, So District Fla, Case #24-CV-80713-Rosenberg.

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.