Tax Court Rule 155 and Gifts from the Service

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From time to time it can feel as if the IRS is giving your client a bit of a gift. It could be in the form of the IRS settling on weak arguments -perhaps with inflated fears over the “hazards of litigation” the facts present (see post here). It could also be in the form of the IRS informing your client of deductions or credits they are eligible for but never actually claimed -something I have seen in practice on numerous occasions.

But the IRS may also make an inadvertent “gift,” less charitably described as an “error.” And when this happens in your client’s favor it raises all sorts of ethical and legal issues. This post will focus only on the legal issues, and particular the timing of the IRS’s “gift” and when the IRS is no longer able to take it back. These valuable and interesting lessons were issued as (presently on hiatus, but hopefully to be revived) Designated Orders the week of September 7, 2020…

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The designated order at issue stems from a rather old and interesting case: Householder v. Commissioner, Dkt. # 6541-12 (order here). The Tax Court issued its findings of facts and an opinion on the case way back in August, 2018 (T.C. Memo. 2018-136, here). From that time until the order above, however, no decision could be entered because the parties could not agree on their Tax Court Rule 155 computations. Note that in deficiency cases the Tax Court is required to issue a decision that directly addresses the amount (if any) of the deficiency -which isn’t always done through the opinion. This exact issue was very briefly discussed in the only other designated order of the week, Hopkins v. C.I.R., Dkt. # 19747-19 (order here).

Nonetheless, when the Tax Court issues an opinion that addresses all the substantive legal issues the final deficiency should be a fairly simple matter of math. As we have seen before (see Keith’s post here) when dealing with Rule 155 there is little room for gamesmanship, and even less room to raise new issues. Ultimately, as we’ll see, that latter concern dooms the IRS. But before getting there let’s take a second to ponder all the work that went into this case prior to the decision finally being rendered.

The Householders are highly educated, wealthy and successful. Scott Householder is adept with financial planning, and Debra Householder, in addition to having a Ph.D. in psychology, has a lifelong affinity for horses and horse riding. So it seems a perfect marriage of passions and proclivities when they are approached with an investment opportunity involving horse breeding and leasing…

If you’ve ever read any tax case on “hobby-losses” (the colloquial term for the IRC § 183 prohibitions) you probably know where this is going. Rich people apparently love horses. For some it may be genuine (like Debra’s). For others it may be because horses tend to generate (potentially) tax-deductible business losses. It is also almost always the case that the IRS wins in arguing that these losses are not actually businesses with a profit motive, but instead hobbies. This is true even though Congress has created a less demanding presumption for showing a “business motive” specifically pertaining to the “breeding, training, showing, or racing of horses.” IRC § 183(d).

The mechanics of the Householder’s arrangement was a bit more complex than the usual “rich-people owning horses and pretending it’s a business” scheme, but not by much. The entity that pitched and ran the horse-leasing enterprise (“ClassicStar”) to the Householders yielded at least five separate Tax Court decisions where no loss was allowed because the horse breeding/leasing was not engaged for profit. If anything, the ClassicStar scheme is more bald-faced and upfront as a tax scam than most. I encourage people to read the facts of the opinion: ClassicStar all-but-asks the Householders “how much of a loss do you want?” in multiple years.

Yes, ClassicStar advised that the Householders take all sorts of business-like steps with this investment (create an LLC or S-Corp! have a separate bank account just for this business! spend 100+ hours on meetings and such!), but the writing is on the wall: this is a sham, and almost certainly not a business that is being operated for profit by the Householders. As but one more in a long line of examples, the Householders didn’t even know what specific horses they’d be breeding/leasing when they paid the money: knowing the horse you’re forking over hundreds of thousands of dollars for is usually something you care about when trying to make money. Bad facts (there are many more in the opinion, including that one of the horses was castrated and thus not particularly suited for breeding), make for very dim prospects of deducting the expenses.

But it goes beyond the IRS just auditing the Householders on a bad hobby loss. ClassicStar was eventually raided by the IRS and completely shut down. Some of the ripple effects included $200 million in tax fraud charges and $65 million in damages to certain defrauded investors. This was a widespread scam, and it did end up costing a lot of other people quite a bit of money on what they appeared to genuinely believe was an investment opportunity.

But what about for the Householders, who only ever really seemed to care about generating inflated tax losses in the first place? Almost incredulously, the Householders continued to argue in Tax Court that they were engaged in the business for profit. But Judge Holmes has no problem shooting this down: the system works!

Almost. Hold that thought for now.

There is an alternative argument that the Householders make, which is that the money they paid to ClassicStar should be deductible as a “theft loss” in 2006 when it became clear they could not get their “investment” back.

I want to pause to consider the chutzpah of this argument. Imagine you spend approximately $500,000 on a complete scam, that you know is a scam, but have been assured that the scam will generate $2 million in tax losses. It later turns out that the scam generates $0 in tax losses… because it is a scam. You want your $500K back from the scam artist but, having been shut down by the IRS for being a scam artist, they have no money left to pay you with. Should you get to take a loss of the $500K as a “theft” because the scam was exactly what it sounded like: a scam?

The Tax Court, again, says “no” though for different reasons. There was also an exchange of stock in this case, and the Householders want to argue that it was worth very little, due to “discounts in marketability.” The Householders are likely wrong on this as a matter of fact, but they also raise this issue too late: for the first time, on brief. Judge Holmes determines that the Householders didn’t really “lose” the money they put down in the first place. If anything, they likely came out slightly ahead. You need to lose something to have a theft loss, and the Householders didn’t lose anything here. So no business deduction and no theft loss: the only real issues in play. The system works!

Not quite. For, as we will see, despite their ludicrous legal arguments and return positions the Householders end up having no deficiency. A gift from the Service. This is where we arrive at the designated order, several years later.

I’ve noted before how important it is to “raise all of your arguments” (here). Petitioners must be wary of failing to assign error to items in a Notice of Deficiency they would like to dispute. Generally failing to do so means that it is conceded (Tax Court Rule 34(b)(4)), unless (1) you amend the petition, or (2) are able to argue that it was tried by consent. See Tax Court Rules 41(a) and (b) respectfully.

But the IRS runs similar risks. In this respect, it is helpful to conceptualize the Notice of Deficiency (NOD) as the IRS’s complaint. If the IRS fails to raise an issue in a NOD, they can generally add it to the “complaint” later, with the Court’s consent. However, even if the Court allows, this carries the potential complication that IRS position does not have the presumption of being correct -as it would if it were included on the NOD. See Welsh v. Helvering, 290 U.S. 111 (1933) and Tax Court Rule 142(a).

The IRS gift to the Householders goes one step further than that usual, fairly excusable mistake. Rather than forgetting to bring up an issue in the NOD, the IRS actually creates a new, very taxpayer friendly one. Somehow, likely in a mix-up of papers, the IRS agent drafting the NOD gave the Householders a loss of $317,029 (on an issue that had nothing to do with the horse fiasco), where the Householders had actually reported a gain of $145,000.

The Householders, on seeing this gift in the NOD, kept their mouths shut. In other words, they didn’t assign it as an error on their petition. This effectively meant that the numbers were conceded, and not properly before the court. Note, again, the IRS could have recognized this at numerous points up to the trial and properly raised the issue. But the IRS was in tunnel-vision mode with this case and didn’t see their own error on the NOD.

By the time it becomes obvious that there was a mistake the train had left the station. All the parties had left to do was run through the computations based on the items as reflected in: (1) the original return items that weren’t challenged in the NOD, (2) the NOD as conceded or agreed upon, and (3) the unagreed items as determined by the Tax Court. The magical gift of converting a $145,000 gain into a $317,029 loss was in the second category: agreed upon by the parties, as evidenced by the NOD and the lack of any mention of it in the pleadings, stipulations, or any other point of the trial up until the awkward moment the IRS had to add things up and find that their win in court resulted in a $0 deficiency.

I feel for IRS Counsel seeing this far too late and trying desperately to find a way to the right outcome. Valiantly, the Service tries a motion for reconsideration (Rule 161), but to no avail. These motions are pretty uphill battles in any case (see Keith’s post here), but a motion for reconsideration is not appropriate for instances where the Court didn’t make a mistake, but you did. For more, you can see my post on the three usual “flavors” of a motion to reconsider here.

So at the end of the day through the Householders agreeing to accept the IRS gift they walk away with no deficiency in case where the Court found they took some absolutely nonsense deductions. A pretty unsatisfying outcome for everyone but the Householders I’m sure. But likely the correct one as a matter of Tax Court procedure.

In a follow up post I’ll look a bit further at a question that may be on people’s minds: Can you, as an attorney, ethically accept that kind of a gift from the IRS in a court proceeding?

About Caleb Smith

Caleb Smith is Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

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