The Costs of Being Too Clever By Half: Designated Orders, January 27 – 31, 2020 Part 2 of 2

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In my previous post I provided some in-depth coverage on the designated order stemming from Zhang v. C.I.R. about the definition of a prior “opportunity” to dispute the underlying tax. It is an issue that I would very much like to see raised in more appellate courts, as we in the tax community continue to develop the case law around Collection Due Process. The remaining designated orders from that week do not raise such substantive issues, but nonetheless provide important lessons. Foremost among them, the potential consequences of being “too clever by half” in your tax positions.

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Being Too Clever By Half in with Your Business: Paying Yourself So You Have Income, But No Corresponding Deduction. Provitola, et. al. v. C.I.R., Dkt. # 12357-16 and 16168-17 (order found here)

The Provitola case provides us with a fact situation that could have easily been pulled from a law school exam. At its simplest, petitioner husband has two businesses: one as a lawyer, and one as an inventor. With regards to the inventing business, Mr. Provitola has a B.S. in physics, seven patents, experience in patent law, and an LLC that plans on selling some sort of TV enhancing product. Well, actually Mr. Provitola doesn’t have an LLC: his wife is the sole owner (very little information is provided about her background). Mr. Provitola does, however, have an S-Corp for his law practice which he is the sole owner of, so he isn’t completely missing out on the ownership game.

And, in fact, the legal business Mr. Provitola owns appears to be the more profitable (or at least more active) one. His wife’s LLC was created in 2007, but through 2012 remained pretty much dormant: no expenses or receipts to report. Then, in late 2013, something went off in the mind of Mr. Provitola: he had actually been providing legal services to his wife’s LLC since 2009. In fact, he was due $12,000 per year for those services and sent a bill to his wife’s LLC for $60,000. 

I am happy to say this did not cause marital discord. In fact, the LLC paid $36,000 of the amount owed to Mr. Provitola from its (just created) capital account. The arrangement seemed so happy, in fact, that they basically repeated it in 2014.

Maybe the couple was fine with this arrangement because of how it shaked out on their joint tax return. You might be inclined to see it as a wash: Mr. Provitola has taxable income, whereas his wife has a corresponding deduction. But in fact it worked out a little better for the couple than that, because Mr. Provitola’s business had enough other expenses to pretty much completely offset the income. So really, his business continued to have $0 income and his wife still has a large net operating loss. Quite the fortuitous circumstance, it would seem.

Were this a law school exam, this is where the prompt would be: “Imagine the Provitola’s return is audited and ends up going to Court. You are the IRS attorney: what arguments would you raise for why the Provitola’s should not be allowed to deduct the expenses paid by the LLC?”

The real-life IRS attorney was (somewhat) bound by the SNOD’s rationale, since they didn’t raise alternative arguments in their answer (see Tax Court Rule 36) to the petition. (I’d note that the real-life IRS attorney also made some strained evidentiary arguments that were dismissed in a previous designated order here.) With regards to the SNOD, the IRS took the boilerplate position that the expenses were disallowed because the Provitolas (1) did not establish the expenses were paid/incurred in the years at issue, plus (2) it was not proven that the expenses were ordinary/necessary. In other words, the expenses didn’t in fact happen (as a matter of timing or reality), and even if they did they weren’t statutorily allowable under IRC 162

But the IRS attorney fleshed these positions out a bit (one may say, changed them) as litigation went on. Before Judge Buch, the argument became: (1) the LLC isn’t even a real business at all, so everything having to do with it is a fiction, and (2) even if it was a business, the payments it made were non-deductible start-up expenses. Judge Buch calls these the “substance over form” and “start-up expenditures” arguments, respectively. Query whether the change in argument should result in a burden shift, and what that even entails -see Professor Camp’s article here. For my money, I’d say both arguments fall within the original, extremely broad and vague rationales of the SNOD. A fictitious entity only makes fictitious payments, which would seem to be the equivalent of saying “expenses were not paid/incurred” in tax years at issue. And capitalized start-up expenses are, by definition, not ordinary and necessary under IRC 162 -arguably, a core component of the ordinary and necessary test is to determine whether it must be deducted or capitalized. See C.I.R. v. Tellier, 383 U.S. 687, 689-90 (1966).

Judge Buch resolves this case with a bench opinion, so the correctness or incorrectness of the IRS’s arguments was clear enough without the need for post-trial briefing. With regards to the first argument, Judge Buch finds that the LLC is, in fact, a business under the two-prong test of Bertoli v. C.I.R., 103 T.C. 501 (1994). The LLC was, in fact, created for a business purpose (to sell/market the technology, and the business did carry on that business activity (the facts show a website was created, though not made public, and about a thousand units were actually manufactured, even if none were yet sold). So the “not a real business” argument is going to fail. Good news for the Provitolas!

Or maybe not.

In fact, this is (probably unwittingly) bad news for the Provitolas. Judge Buch notes that if it were true that the LLC was not really a business and all the transactions would be disregarded and there would not be corresponding income to Mr. Provitola’s law firm: the income and deductions would vanish (what I originally would have thought to be the correct outcome, but is not the position taken on the SNOD). But that’s not what happens here. And what happens here is much worse for the Provitolas. 

Since it is, in fact a business, the substance of the payments to Mr. Provitola are respected. But as law students learn in Fed Income Tax I, not every expense is immediately deductible. Some, including “start-up expenses,” must (generally) be capitalized. The question is whether expenses (1) incurred for a business that has not made its website public, (2) had not generated any revenue, and (3) had not even really appeared to have marketed its products at the time of the expense are “start up expenses” or expenses for a going concern. The conclusion reached appears to be an easy one: these are definitely non-deductible start up expenses. (Note that in some circumstances you can deduct start-up expenses under IRC 195, but that there are time-limits and phasing rules for taking that deduction. Professor Camp covers some other niceties with that code section here)

So what does that mean? Effectively, Mr. Provitola has income that he (and his wife) paid him, but no offsetting deduction. Worst of both worlds. Oh, and the Court upheld an IRC 6662 penalty on both years for substantial understatement of tax, in part because Mr. Provitola is an attorney (and admitted to the US Tax Court) so he should have known better.

A somewhat convoluted set of transactions that resulted in the worst possible tax consequences. By “creating” income without creating a corresponding deduction the Provitolas were too clever by half.

Remaining Orders (Quick Hits):

Si v. C.I.R., Dkt. # 18748-18 (order found here

I briefly mentioned a previous order from this case, where the petitioner argued that the Tax Court had no jurisdiction because the SNOD was improperly addressed. The “Tax Court has no jurisdiction” argument won’t fly when you file a timely petition, regardless of where the IRS sent the Notice of Deficiency. So, by anxiously filing their petition on time to raise this procedural argument, the petitioner was too clever by half.

This order makes it a bit clearer to me why the petitioner would be in a hurry to raise that argument: on the merits (the usual substantiation of expenses issue) their case was quite weak. 

Wright v. C.I.R., Dkt. # 21509-18 (order found here)

Rather than the petitioner being too clever by half, here the offending party is Congress. Specifically, the drafters of code section 6015(e)(7). That section was intended to clarify the standard and scope of review in Innocent Spouse cases -an issue that years ago was contentious, but since had been resolved through case law. See Carl’s post here. It is also questionable that it really helps taxpayers at all (interesting outcome, given that it was part of the “Taxpayer First Act.” See posts here and here.

In any event, rather than clarify it has led to a slew of questions from practitioners, the Court, and the IRS. Basically, any and all affected parties. This order stems from Judge Gale asking the IRS for some clarification on how the provision will apply and being unsatisfied with their answer (petitioner appears to not really address the issue at all). It’s almost as if Congress may have benefitted from asking practitioners in the tax community about this provision before enacting it…

Easterwood v. C.I.R., Dkt. # 11485-17S (order found here)

I’m not even going to try to fit the final order under the “too clever by half” theme: it is a page of Judge Leyden lightly admonishing a practitioner for (1) failing to redact, and (2) submitting something illegible. If someone wants to try to fit that order with the week’s theme I’ve selected, your suggestions are welcome in the comment section.

Caleb Smith About Caleb Smith

Caleb Smith is Visiting 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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