Ferguson v. Comm’r, T.C. Summary Opinion 2007-30 (2007).

T.C. Summary Opinion 2007-30

UNITED STATES TAX COURT

MICHAEL FERGUSON, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21315-05S. Filed February 28, 2007.

Michael Ferguson, pro se.

Julie A. Jebe, for respondent.

ARMEN, Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect when the petition was filed.1 The decision to be entered

1 Unless otherwise indicated, all subsequent section references are to the Internal Revenue Code in effect for 2003, the taxable year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

is not reviewable by any other court, and this opinion should not be cited as authority.

Respondent determined a deficiency in petitioner’s Federal income tax for 2003 of $3,068. Petitioner timely filed a petition with the Court. The sole issue for decision is whether petitioner’s gambling activity constituted a trade or business under section 162 and, consequently, whether he was a professional gambler in 2003.

Background

Some of the facts have been stipulated, and they are so found. We incorporate by reference the parties’ stipulation of facts at trial and accompanying exhibits.

At the time the petition was filed, petitioner resided in Berwyn, Illinois.

During the taxable year in issue, petitioner was employed full-time as a building operating engineer in Chicago and earned approximately $51,840 from his employment in 2003.

In addition to his employment, petitioner spent a good deal of time playing video poker. It was his only form of gambling. Petitioner bet an average of $25 on each hand. He began playing video poker in 1997 and spent an increasing amount of time engaged in the activity.

Video poker is a “casino game based on five card draw poker.” Http://en.wikipedia.org/wiki/Video_poker. Players bet money or credits and then play poker against a computerized machine. See id. One does not play against other players but simply tries to obtain the best hand. After the player’s draw, “the machine evaluates the hand and offers a payout if the hand matches one of the winning hands in the posted pay schedule.” Id.

Some people, including petitioner, think that if one were to play video poker in a mathematically and theoretically perfect manner, eventually one would realize a profit. Petitioner testified that he tried to only play on machines with an expected payout value of a 100-percent return, meaning he thought he would never lose money;2 he also testified that the only way to get a return of more than 100 percent is to play on a “progressive” machine.3 He further testified that despite his hours of practice on a computer and diligent study of the perfect way to play the game, “it didn’t work”.4

2 A payout value or payback rate is the expected return a particular game will provide when played over a long enough period of time. See http://en.wikipedia.org/wiki/Expected_value.

3 A progressive machine is one which contributes to a progressive jackpot. A progressive jackpot, the highest payoff possible for a gaming machine, arises from a group of several gaming machines linked together. See http://en.wikipedia.org/wiki/Progressive_jackpot. A small amount from every game played on each of the machines increases the value of the jackpot, and the jackpot winner receives money pooled from the entire group of linked machines. See id.

4 The Court suspects that petitioner’s strategy did not (continued…)

Petitioner spent time traveling to and from the casinos, scouting machines, and studying strategy. He obtained a tutoring program to learn how to play and avoid mistakes. Sometimes he would observe other players and watch for a “positive” machine.5 He would be involved in video poker and related activities two or three times during the workweek and again on weekends.

Petitioner hit at least two big jackpots–approximately $60,000 each–but overall always lost money. Because he lost more money than he made in 2003, he used some of his savings to support himself.

Petitioner filed a Schedule C, Profit or Loss From Business, for the taxable year 2003. Reporting as a professional gambler,6 he claimed $1,311,200 in gross income from gambling, and a

4(…continued) work because, while some video poker games may have a payback rate at or in excess of 100 percent, assuming “error-free, perfect play”, most games offer a payback rate of less than 100 percent, even when played with perfect strategy. See, e.g., http://en.wikipedia.org/wiki/Video_poker. Of course, consistently error-free, perfect play is nearly impossible, and most players will lose a few cents or fractions thereof for each dollar bet over the long term. That said, short-term results do not always follow long-term statistical probabilities, which is why people still gamble.

5 A “positive” machine is a machine with a payout rate of 100 percent or better.

6 H&R Block, petitioner’s tax preparer, determined that petitioner was a professional gambler because he spent more than 20 hours per week on the activity.

corresponding $1,311,200 in gambling losses.7 For the year in issue, petitioner did not keep books and records of his win/loss activity and instead relied on the casinos’ yearly statements to track his activity for him.

Respondent determined that petitioner was not a professional gambler in 2003. Accordingly, his gambling winnings should have been reported on line 21 of the Form 1040, U.S. Individual Income Tax Return (Other income). Respondent also determined that the gambling losses should have been claimed on Schedule A, Itemized Deductions.

Discussion

The issue in this case is whether petitioner’s gambling activity in 2003 constituted a trade or business under section 162. If petitioner were engaged in the trade or business of gambling, his wagering losses, to the extent deductible under section 165(d),8 would be deducted in computing adjusted gross income. See sec. 62. On the other hand, if petitioner were not in the trade or business of gambling, wagering losses, to the

7 In addition to the $1,311,200 in income and losses from gambling, petitioner also reported $3,000 of “Other income” and $2,820 of “Car and truck expenses” on his Schedule C, neither of which is contested by respondent. Respondent did not raise any substantiation issues as to any of the amounts.

8 While sec. 165(a) generally allows losses to be deducted from gross income, sec. 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.”

extent deductible under section 165(d), would be deductible as an itemized deduction in the computation of taxable income. See, e.g., Gajewski v. Commissioner, 84 T.C. 980, 982 (1985); Johnston

v. Commissioner, 25 T.C. 106, 108 (1955); see also secs. 67(a), 68(a), 151(d)(3).

In general, section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. The term “trade or business” is not defined in the Internal Revenue Code or the regulations. That said, it is well established that in order for an activity to be considered a trade or business for the purposes of section 162, the activity must be conducted with “continuity and regularity” and “the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).

Petitioner testified at trial that playing video poker totally consumed his free time and caused him to lose a lot of money. But simply spending all of one’s free time on an activity does not transform that activity into a trade or business, nor does it make the participant a professional. Occasionally, devoting all of one’s free time to a particular activity may be a sign of addiction.9 Further, the amount of time spent engaged in

9 At trial, petitioner testified that he had himself barred from his usual casinos for 5 years to prevent him from continuing to gamble there.

the activity is not the most significant aspect of the trade or business analysis. More important is the taxpayer’s actual or honest objective of making a profit. Keanini v. Commissioner, 94

T.C. 41, 46 (1990); Hulter v. Commissioner, 91 T.C. 371, 392 (1988); Dreicer v. Commissioner, 78 T.C. 642, 644-645 (1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs.

Although a reasonable expectation of a profit is not required, the taxpayer’s profit objective must be actual and honest. Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs. Whether a taxpayer has an actual and honest profit objective is a question of fact to be answered from all the relevant facts and circumstances. Hulter v. Commissioner, supra at 393; Hastings v. Commissioner, T.C. Memo. 2002-310; sec. 1.183-2(a), Income Tax Regs. Greater weight is given to objective facts than to a taxpayer’s mere statement of intent. Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs. The taxpayer bears the burden of establishing he or she had the requisite profit objective.10 Rule 142(a); Keanini

v. Commissioner, supra at 46; Hastings v. Commissioner, supra.

The regulations set forth a nonexhaustive list of factors that may be considered in deciding whether a profit objective exists. These factors include such matters as: The manner in which the taxpayer carries on the activity, the taxpayer’s history of income or losses with respect to the activity, and the financial status of the taxpayer. See sec. 1.183-2(b), Income Tax Regs.

No single factor, not even the existence of a majority of factors favoring or disfavoring the existence of a profit objective, is controlling. See id. In addition, not every factor is relevant in every case.11 Vandeyacht v. Commissioner,

T.C. Memo. 1994-148; Borsody v. Commissioner, T.C. Memo. 1993534, affd. per curiam 92 F.3d 1176 (4th Cir. 1996). Rather, the relevant facts and circumstances of the case are determinative.

10 Generally the Commissioner’s determinations are presumed correct, and the taxpayer bears the burden of proving those determinations wrong. Rule 142(a); INDOPCO, Inc. v Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under sec. 7491, the burden of proof may shift from the taxpayer to the Commissioner if the taxpayer produces credible evidence with respect to any factual issue relevant to ascertaining the taxpayer’s tax liability. Sec. 7491(a)(1). In this case there is no such shift because petitioner neither alleged that sec. 7491 was applicable nor established that he fully complied with the requirements of sec. 7491(a)(2). The burden of proof remains on petitioner.

11 Consequently, we do not analyze in depth all of the factors enumerated in the regulation but rather focus on some of the more important ones that lead to our decision.

See Golanty v. Commissioner, 72 T.C. 411, 426 (1979), affd. without published opinion 647 F.2d 170 (9th Cir. 1981). Given the facts and circumstances in this case, we find that petitioner’s gambling activity in 2003 was not a trade or business. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner did not carry on his video poker activity in a businesslike manner. See sec. 1.183-2(b)(1), Income Tax Regs. He did not maintain adequate books or records, instead relying on casino records to track his wins and losses from the activity, even though he was aware that there was a threshold amount below which amounts were not reported.

Although petitioner expended a great deal of time and effort engaged in his gambling activity, spending more than 1,000 hours gambling in 2003, see sec. 1.183-2(b)(3), Income Tax Regs., he did not seek additional assistance with or adjust his gaming strategy, even when it became apparent that he never had a winning year, see sec. 1.183-2(b)(2), (6), Income Tax Regs.

We are additionally unconvinced that petitioner’s gambling activity meets the standard for being a trade or business because we are not persuaded that an individual who gambles against a machine that is programmed by a casino can have, as his or her primary purpose, income or profit. After all, such a machine is on the floor to make money for the casino and is not there to provide income or profit for the casino’s patrons. For most individuals, gambling against a machine that is programmed to

make money for the casino constitutes what the Supreme Court in

Commissioner v. Groetzinger, 480 U.S. 23 (1987), characterized as

a sporadic activity, hobby, or amusement diversion.12 For other

individuals, gambling against such a machine may become a habit

or an addiction. In neither scenario is it a trade or business

with the participant’s primary purpose being income or profit.

The fact that petitioner did not have the requisite profit

objective to qualify his gambling activity as a trade or business

is by no means to say that petitioner did not wish to make money

gambling. But:

[N]ot every income-producing and profit-making

endeavor constitutes a trade or business. * * *

[T]o be engaged in a trade or business, the

taxpayer must be involved in the activity with

continuity and regularity and * * * the taxpayer’s

primary purpose for engaging in the activity must

be for income or profit. A sporadic activity, a

hobby, or an amusement diversion does not qualify.

Id. at 35.

12 While we acknowledge that a taxpayer can be simultaneously engaged in more than one trade or business, the facts in the present case are different from those in Commissioner v. Groetzinger, 480 U.S. 23 (1987). There, the Supreme Court was heavily influenced by the fact that the taxpayer, following the termination of his 20-year employment in February of the taxable year in issue, spent the balance of the year engaged in parimutuel wagering and looked to such wagering for his livelihood. In contrast, petitioner was employed throughout the year on a full-time basis and relied on his wages to support himself; he did not make his living playing video poker.

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Conclusion

Because petitioner did not have the requisite profit objective, we decide that petitioner’s gambling activity in 2003 was not a trade or business, and consequently, that petitioner was not a professional gambler in the taxable year in issue.

Reviewed and adopted as the report of the Small Tax Case Division.

To reflect our disposition of the disputed issue,

Decision will be entered for respondent.

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February 28th, 2007 | 1 Comment »

Chief Counsel Notice 2007-008 (2007).

Notice

CC-2007-008 February 27, 2007

This Notice provides Chief Counsel attorneys direction in the handling of civil cases involving criminal restitution.

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What is Restitution?

Restitution is a legal remedy that may be ordered as an independent element of a criminal sentence by a United States district court. 18 U.S.C. §§ 3663(a)(1)(A) and 3663A(a)(1). A restitution order requires a defendant to pay money or render services to a victim of a crime to redress the victim’s loss. In criminal tax cases, the Internal Revenue Service is considered a victim. Restitution is often ordered in criminal tax cases pursuant to a plea agreement in which the defendant agrees to pay a specific sum. See 18 U.S.C. § 3663(a)(3) (authorizing restitution in any criminal case to the extent agreed to by the parties to the plea agreement); United States v. Thompson, 39 F.3d 1103, 1105 (10th Cir. 1994). Restitution can also be required of persons convicted of any offense as a condition of probation or supervised release. 18 U.S.C. §§ 3563(b)(2) and 3583(d); United States v. Butler, 297 F.3d 505, 518 (6th Cir. 2002), cert. denied, 538 U.S. 1032 (2003); United States v. Bok, 156 F.3d 157, 166 (2d Cir. 1998).

Restitution is calculated according to the “loss caused by the specific conduct that is the basis of the offense of conviction.” Hughey v. United States, 495 U.S. 411, 413 (1990); Weinberger v. United States, 268 F.3d 346, 357 (6th Cir. 2001); United States v. Baker, 25 F.3d 1452, 1456 (9th Cir. 1994); United States v. Trigg, 119 F.3d 493, 500 (7th Cir. 1997). In most criminal tax cases involving restitution, the probation office calculates the amount of tax loss from evidence admitted at trial or from the plea agreement and generally recommends this amount for restitution in the presentence investigation report. The sum fixed in a restitution order should include interest under Internal Revenue Code provisions to a specified date. Following entry of the restitution order, interest accrues as provided in 18 U.S.C. section 3612(f). Restitution generally does not include civil penalties. See United States v. Daniel, 956 F.2d 540, 543-544 (6th Cir. 1992).

Restitution is not assessable as a tax but payments of restitution for taxes owed should be credited against the civil liability for unpaid taxes, as provided in a plea agreement or court

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order. See United States v. Helmsley, 941 F.2d 71, 102 (2d Cir. 1991) (reducing judgment in civil proceeding for unpaid taxes by amount of restitution paid). Taxpayers responsible for paying restitution remain subject to tax return filing requirements. An assessment of the taxpayer’s civil liability should be made (subject to notice of deficiency procedures, if applicable) as soon as possible after the restitution order to ensure proper application of the payments to the relevant tax year.

Restitution may relate to, but is not the equivalent of, civil tax liability. An award of restitution does not bar the Service from determining civil liability in an amount greater than the amount awarded. Morse v. Commissioner, 419 F.3d 829, 833-35 (8th Cir. 2005); Hickman v. Commissioner, 183 F.3d 535, 537-38 (6th Cir. 1999); M.J. Wood Associates, Inc. v. Commissioner, T.C. Memo. 1998-375. An award of restitution also does not prevent a taxpayer from challenging the Service’s determination that the civil liability exceeds the amount of the restitution ordered. A restitution award may only be contested by direct appeal of the criminal case.

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Creel v. Commissioner

The Eleventh Circuit, in Creel v. Commissioner, 419 F.3d 1135 (2005), affirmed the Tax Court’s unpublished Order and Decision, in a collection due process case under section 6330. In Creel, No. 3037-01 (January 14, 2004), the Tax Court concluded that a taxpayer’s civil tax liabilities had been compromised previously by the United States Attorney in connection with that office’s acknowledgement that a criminal restitution order was satisfied. The Office of Chief Counsel disagrees with both courts’ conclusions.

Creel pleaded guilty in the district court to two counts of willfully failing to file income tax returns for 1987 and 1988. During the plea phase, Creel prepared and filed returns for various years. As part of his plea, he was ordered to pay restitution of $83,830 “plus any applicable penalties and interest” for taxable years 1986 through 1991. From 1994 to 1998, Creel paid $83,830 in restitution. The Service applied these payments first to satisfy Creel’s 1986 tax liability (including penalties and interest) and then to satisfy a portion of his 1987 tax liability.

In 1998, the U.S. Attorney filed a Cancellation and Release stating that the lien of judgment was “fully released, satisfied, discharged and cancelled” because it was “paid in full.” The U.S. Attorney also filed a satisfaction that stated, “the . . . restitution imposed by the Court . . . having been paid or otherwise settled, the Clerk . . . is hereby authorized and empowered to satisfy the Judgment as to the monetary imposition only.”

The Service sent Creel a notice of intent to levy for his 1985 and 1987 through 1991 outstanding tax liabilities from which Creel requested a collection due process hearing with the Service’s Office of Appeals. Appeals issued a determination after the hearing sustaining the proposed levy action.

Creel argued in Tax Court that he did not owe any tax, penalty, or interest for the1987 through 1991 tax years because he believed his restitution payments and the satisfaction of judgment for restitution and release of the judgment lien meant that everything he owed to the Government was paid. The court inferred from petitioner’s testimony and from the inclusion of “applicable penalties and interest” in the restitution order that the civil tax liability was compromised by the satisfaction and release given by the U.S. Attorney for those tax years. The court drew negative inferences, citing Wichita Terminal Elevator Co. v. Commissioner, 6

T.C. 1158, 1165 (1946), from the Commissioner’s failure to call a witness on the restitution

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issue, e.g., from the Department of Justice or the U.S. Attorney’s Office. The court also dismissed the Commissioner’s legal arguments that the U.S. Attorney did not have authority to settle the tax liabilities.

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Construing the Creel Decision

The Eleventh Circuit acknowledged in Creel that the government was correct “in the abstract” when arguing that satisfaction of criminal tax liability does not generally include satisfaction of civil tax liability. The court noted the general rule that the government can seek restitution through criminal proceedings and pursue recovery of excess civil tax liability in subsequent civil proceedings. The court, nevertheless, found that the “unique facts and the nuances” of the case dictated a departure from this general rule. Specifically, the court held that ambiguous language in the restitution judgment and the actions of the U.S. Attorney permitted the conclusion that satisfaction of the criminal obligations of the defendant in this instance subsumed civil liability. The court misconstrued the facts of the case.

To reduce the chance that another court would reach a similar conclusion, the distinction between civil and criminal liabilities must also be well understood and clearly articulated in any collection due process case or other litigation in which the issue arises. If a taxpayer suggests, as Creel did, that he paid “everything he owed” related to his tax delinquency when he satisfied his restitution obligation, the taxpayer may be suggesting that unpaid penalties, interest, and tax were compromised in conjunction with resolution of the criminal case. Section 7122(a) vests compromise authority in the Secretary of the Treasury prior to the referral of a case to the Justice Department and reserves such authority to the Attorney General or his delegate following referral.

Post-referral compromises should be set forth in writing. The taxpayer has the burden of proving the existence of a compromise or settlement. See generally Parks v. Commissioner, 33

T.C. 298, 301 (1959) (placing burden on taxpayer to prove existence of settlement or compromise).

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Relevant Documentary Evidence

The taxpayer has the burden of presenting evidence to prove that, contrary to the normal course of events, civil tax liability was compromised by satisfaction of a restitution obligation. Relevant documentary evidence would include: (1) the plea agreement (if applicable); (2) related waivers or exceptions; (3) the criminal judgment; (4) the restitution order; (5) the satisfaction of judgment (if applicable); and (6) any certificate releasing the judgment lien. These documents can be obtained from the U.S. Attorney’s Office for the district where the criminal case was prosecuted by contacting the Criminal Investigation special agent assigned the case. The prosecuting attorney should have items (1) through (4), and the Financial Litigation Unit attorney in the U.S. Attorney’s Office should have items (5) and (6). If the special agent is unavailable or unable to assist, contact the IRS Criminal Tax Division, the prosecuting attorney or Financial Litigation Unit directly.

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Revised Restitution Procedures and Forms

The Department of Justice recently revised the U.S. Attorneys’ Manual to include standardized language for use by U.S. Attorneys in restitution orders and in the restitution portion of plea agreements. See United States Attorneys’ Manual § 6-4.360, Compromise of Criminal Liability/Civil Settlement (September 2006), citing Tax Resource Manual §§ 56-59 (September

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2006). The promulgation of these standards may increase the number of cases in which courts order defendants to pay restitution to the United States. The new standard language reflects the Tax Division’s long-standing policy of not compromising civil tax liability in conjunction with a plea agreement and is intended to ensure that Tax Division trial attorneys and Assistant U.S. Attorneys do not inadvertently compromise civil tax liabilities, penalties or interest for criminal prosecution years.1 It is expected that use of the standard language and forms should significantly reduce latent ambiguities concerning whether civil liabilities were compromised by satisfaction of the restitution obligation.

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Chief Counsel’s Litigating Position

It is Chief Counsel’s position that the Eleventh Circuit fundamentally misconstrued the facts of Creel in concluding that civil liability was compromised by satisfaction of a criminal restitution obligation. In future cases arising in the Eleventh Circuit, attorneys should strive to distinguish Creel on its facts. In factually similar cases arising in other circuits, attorneys should argue that Creel was wrongly decided. In factually dissimilar cases arising outside the Eleventh Circuit, Creel should also be distinguished on its facts.

When restitution related issues arise in the course of litigation or other aspects of Chief Counsel’s practice, attorneys should coordinate promptly with the office of Associate Chief Counsel (Procedure & Administration). General questions regarding restitution should be addressed to Branch 2, Administrative Provisions and Judicial Practice (Procedure & Administration) at (202) 622-4940. Questions concerning collection due process cases involving restitution, including assistance in preparing appropriate motions, should be addressed to Branch 1, Collection, Bankruptcy & Summonses Division, Office of Associate Chief Counsel (Procedure & Administration) at (202) 622-3610.

________/s/___________ Deborah A. Butler Associate Chief Counsel (Procedure & Administration)

1 Authority to compromise criminal or civil liability in settling a criminal case lies with “the Attorney General or his delegate.” Section 7122(a). The Attorney General has delegated this authority to the Assistant Attorney General for the Tax Division. 28 C.F.R. § 0.70. The Assistant Attorney General has not delegated this authority in criminal cases to U.S. Attorneys. The U.S. Attorneys’ Manual directs that “United States Attorneys may not make agreements which prejudice civil or tax liability without the express agreement of all affected Divisions and/or agencies.” United States Attorneys’ Manual §§ 9-16.300, 9-27.630. U.S. Attorneys do not have the authority to settle civil tax liabilities in criminal cases unless proper approval is obtained from the Tax Division.

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February 27th, 2007 | 1 Comment »

Chief Counsel Advice Memorandum 20070801F (2007).

Office of Chief Counsel

IRS

Office of Chief Counsel Internal Revenue Service

MemorandumRelease Number: 20070801F

Release Date: 2/23/07 CC:SB:7:SJ:2:CSHong POSTF-138911-06

UIL: 6324A.00-00

date: December 20, 2006

to: Denice Huber Advisor, Technical Services (San Jose) (Small Business/Self-Employed)

From: Jeffrey L. Heinkel Associate Area Counsel (San Jose, Group 2) (Small Business/Self-Employed)

subject:

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Disclosure Statement

This writing may contain privileged information. Any unauthorized disclosure of this writing may have an adverse effect on privileges, such as the attorney-client privilege. If disclosure becomes necessary, please contact this office for our views.

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Issues

I. What wording would need to be added to the Agreement to Special Lien (“ASL”) signed by the to secure the government’s interests in the four business entities offered as collateral under section 6324A of the Internal Revenue Code of 1986, as amended?

II. Would the partnership and LLC agreements require amendments in order to allow the to pledge the interests?

III. Would the partners and members that are not heirs of the

need to sign the security agreements and consent to the pledging their interest in the entities?

IV. Provide an agreement that would be enforceable as a contract to pledge the interests of the in the partnership and LLCs.

Conclusions

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I. The ASL does not require additional wording. However, please see our comments regarding question IV.

II. The agreements do not require amendment. However, documentation showing that the partnership and LLCs approved the security agreements should be obtained. Furthermore, in this instance, the appropriate agreement is a security agreement rather than a pledge agreement.

III. Other partners or members, as applicable, need not sign the security agreement, but may need to approve the security agreement due to provisions of the applicable organizational agreement.

IV. An agreement based on the ASL is attached as Exhibit A. However, if it is possible to revise the Collateral to be offered, an alternative agreement is attached as Exhibit B.

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Facts

The (“Taxpayer”) elected to defer its estate tax liability for ten (or more) years under section 6166.1 It also elected to grant the Internal Revenue Service (“IRS” or “Service”) a lien on specific property pursuant to section 6324A. The Taxpayer has consented to the imposition of a lien on certain partnership and LLC interests. Due to the nature of the property, Technical Services is concerned that, despite the filing of a notice of federal tax lien, that the value of the interests could be impaired or the assets could be transferred outright. You have asked us to advise regarding securing the Service’s interest in the partnership and LLC interests. The agreement that is the subject of this memorandum is in addition to, and not in lieu of, the lien agreement described under § 6324A.

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Law & Analysis

Section 6166 allows estates to defer payment of estate tax attributable to interests in a closely-held business for up to five years, provided that the interest on any unpaid portion of the tax is paid annually during that period. I.R.C. § 6166(a), (f). The estate must pay the balance of interest and tax due in as many as ten equal

1 Unless otherwise stated, “Code” or “section” shall refer to the Internal Revenue Code of 1986, as amended.

installments with no more than a year between installments. I.R.C. § 6166(a). For purposes of this memorandum, we assume that the Service properly granted the section 6166 election. See Rev. Proc. 79-55; I.R.M. §§ 4.25.1.4.9(4), (13).

Where the Service agrees to defer the estate tax, the Service may require a bond from the estate as security. I.R.C. § 6165. Alternatively, the Service may not require a bond if the Service obtains a section 6324A special lien pursuant to an agreement under section 6324A(c).2

Where the Service accepts Collateral, any person with an interest in the Collateral must sign an agreement with the Service. I.R.C. § 6324A(c) (hereinafter referred to as “6324A lien agreement”). The 6324A lien agreement is governed by Federal law, and perfection and priority rules can be found in section 6324A(d). The fair market value of the property required by the Service may not exceed the sum of the deferred amount and the required interest amount, as defined in Treas. Reg. § 20.6324A-1(e)(1) and (e)(2). I.R.C. § 6324A(b)(2); Treas. Reg. § 20.6324A-1(b)(2). However, the parties to the agreement referred to in section 6324A(c) may voluntarily designate property having a fair market value in excess of that sum. Treas. Reg. § 20-6324A-1(b)(2).

The Service is interested in entering into the proposed Security Agreement in order to secure the Service’s interest in the property to supplement the 6324A lien agreement. The Security Agreement is not specifically authorized by the Code, a nd as such is governed by state law.

The Security Agreement, as a contract between the Service and the estate, is governed at least in part by state law. Under California law, the Service is receiving a security interest in property and the Service must take the proper steps under California law with regard to that security interest.

Under California law, a security interest becomes enforceable only if it has attached. A security interest attaches if: 1) The debtor has rights in the property being offered as security, Ca. Comm. Code § 9203(b)(2); 2) the secured party gives value for

An open question is whether a section 6324A lien extinguishes the general estate tax lien, created by § 6324(a). The Service’s position is that the general estate tax lien continues to attach all estate property except the property subject to the section 6324A lien. See I.R.C. § 6324A(d)(4); see also Treas. Reg. §§ 20.6324A-1, 301.6324A-1(e); I.R.M. § 5.5.8.1(4)(b). This issue has never been directly addressed by any court. In In re Roth, 301 B.R. 451, 454 (Bankr. W.D. Pa 2003), aff’d, 2004 WL 716743 (April 1, 2004,

W.D. Pa.), the Service argued on appeal to the district court that a section 6324A lien on shares of stock displaced the section 6324(a) lien only with respect to those shares of stock. The court held that it need not reach this issue, however, as the other assets the Service was seeking to collect were not assets of the gross estate ever subject to the section 6324A lien. See also Noble v. Soler, 98-1 U.S.T.C. ¶ 60,297

(S.D. Ohio 1997) (court does not reach issue of extent of displacement of section 6324(a) lien because section 6324A lien agreement was never filed). In a bankruptcy case involving section 6324B (which makes the language of section 6324A(d)(4) applicable pursuant to section 6324B(c)(1)), the court again does not directly address this issue, but notes that “[m]oreover, any property against which a Section 6324B lien is filed is divested of the Section 6324 lien regardless of whether the property was Section 2034 to 2042 property.” In re Druse, Sr., Ltd., 82 B.R. 1013, 1016 (Bankr. D. Neb. 1988).

the security interest, Ca. Comm. Code § 9203(b)(1); 3) the parties have a security agreement containing a description of the property being offered as security, Ca. Comm. Code § 9203(b)(3); and 4) the debtor authenticates (i.e., signs) the security agreement, Ca. Comm. Code § 9102(7).

Also, the secured party must take additional steps to make the security interest enforceable against third parties. Absent these additional steps, the security interest is only enforceable against the debtor. The process of making the security interest enforceable against third parties is called perfection. Perfection can occur by filing a financing statement against the Collateral, receiving a pledge on the Collateral (i.e., taking possession of the Collateral), or obtaining control over the Collateral. See Law & Practice of Secured Transactions: Working with Article 9 § 3.02.

The appropriate form of perfection varies depending on the Colla teral. Most security interests can be perfected by filing. See Ca. Comm. Code § 9310(a).3 Even though perfection by filing is adequate, where possible, a pledge is often the best form of perfection. “By depriving the debtor of dominion over the colla teral, the secured party has alerted the world to the possibility of an encumbrance.” Richard F. Duncan et al., Law & Practice of Secured Transactions: Working with Article 9 § 3.02 (2005). A pledge can only be used where the Collateral is in the form of paper, such as money, negotiable instruments, chattel paper, securities and negotiable title documents. See Working with Article 9, at § 3.03[1]. Further, security interests in accounts or general intangibles can be perfected only by filing, and security interests in money or instruments can be perfected only by pledge. Id. Finally, where the Collateral is investment securities, taking control (as well as filing a financing statement or receiving a pledge) is also an appropriate form of perfection. See Working with Article 9, at § 3.03A.

In this case, the Collateral is partnership and LLC interests. Partnership and LLC interests are general intangibles. Ca. Comm. Code § 9102(a)(42).4 General intangibles can only be perfected by filing. See Working with Article 9, at § 3.03[1]; Lynn A. Soukup, It’s a Matter of Collateral, 14 Business Law Today 53 (2005). Therefore, a security agreement, rather than a pledge agreement, is appropriate.

The terms of the security agreement should also be consistent with the law and published guidance dealing with section 6324A liens and section 6166 elections. The Security Agreement should not, in any way, affect the Service’s remedies under the § 6324A lien agreement, as provided for by various provisions of the Code, most notably § 6166(g).

Section 6166 explains the causes and consequences of a default of a section 6166 deferred payment election. Most generally, if fifty percent or more of the interest in the closely-held business is disposed of or withdrawn, the unpaid balance is due and payable upon notice and demand. I.R.C. § 6166(g)(1). Likewise, failure to make a

3 See also Law & Practice of Secured Transactions: Working with Article 9 § 3.03[1].4 See also, Lynn A. Soukup, “It’s a Matter of Collateral,” 14 Business Law Today 53.

payment (left uncured for more than six months) renders the unpaid balance due and payable. I.R.C. § 6166(g)(3). In addition, regulations, Revenue Rulings, and other published guidance issued over the years illustrate particular circumstances that either do or do not cause a default under section 6166. See, e.g., Rev. Rul. 89-4 (“The sale of a portion of the assets of a closely-held business to a llay impending foreclosure does not constitute a disposition of an interest in the business under § 6166(g), if the proceeds are applied to reduce mortgage debt.”).

Rather than create new default terms in the security agreement, the agreement should incorporate the section 6166 default terms. This would allow the Service and the affected taxpayers to refer to the substantial published guidance surrounding section 6166 defaults in order to deal with peculiar fact situations that may develop. As stated recently regarding a related subject, “since the law in this area is not well settled, we recommend that the Service take a conservative approach.” CCA 200027046, 2000 WL 33116163.

For some time, we have encouraged the Service to disclose and agree upon all terms and conditions of the section 6166 installment agreement with the estate and other interested persons before approving the election. “We believe, as in any legally enforceable agreement, that all terms and conditions of the section 6166 installment agreement should be disclosed and agreed upon by all interested parties prior to granting the election.” CCA 200027046, 2000 WL 33116163.

The following addresses the specific questions posed by the Service.

I. What wording would need to be added to the ASL signed by the

to secure the government’s interests in the four business entities offered as collateral under section 6324A of the Internal Revenue Code of 1986, as amended (“Code” or “Section”)?

The ASL is sufficient as drafted. The Security Agreement attached to this memorandum provides additional terms that secure the Service’s interest in the property offered as collateral. However, please see our comments regarding question IV below.

II. Would the partnership and LLC agreements require amendments in order to allow the to pledge the interests?

Per the partnership and LLC agreements, the following provisions must be followed regarding creation of the Service’s security interests:

- -

-

-

-

III. Would the partners and members that are not heirs of the

need to sign the agreements and consent to the pledging their interest in the entities?

As with the § 6324A lien agreement, any parties who have an interest in the Collateral should sign the security agreement. See I.R.C. § 6324A(c). In this case, the Collateral is certain partnership and LLC interests. Therefore, the owners (or agents of the owners) of those particular interests that constitute the Collateral should sign the Agreement. This could include executors, trustees or beneficiaries.

Other partners or members not a party to the section 6324A agreement, as applicable, need not sign the security agreement, but may need to approve the security agreement due to provisions of the applicable organizational agreement (as stated in the previous section).

IV. Provide an agreement that would be enforceable as a contract to pledge the interests of the in the partnership and LLCs.

As previously explained, the appropriate document is a security agreement; and where the Collateral is intangible property, a pledge agreement is not applicable. Therefore, as requested, a security agreement that offers the partnership and LLC interests as collateral is attached as Exhibit A.

In addition, an alternative agreement is attached as Exhibit B. This alternative agreement has the offer the assets of the partnership and LLC interests as Collateral. If the Service can alter the ASL so that the assets of the partnership or LLC interests are the Collateral this would be preferable. See Roth v. U.S., 93 A.F.T.R.2d 2004-1663 (wherein the Service received security in the form corporate shares, but had no recourse where the shareholder disposed of all of the assets of the corporation and caused the shares to have no value).

The following are the differences between the two agreements:

- -

-

-

*****

If you have any questions, please call attorney Chong S. Hong at (408) 8174682.

JEFFREY J. HEINKEL Associate Area Counsel

By: ____________________ CHONG S. HONG General Attorney, Tax (Small Business/Self-Employed)

Encl: Exhibit A – Draft Security Agreement Exhibit B – Alternative Draft Security Agreement

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February 23rd, 2007 | No Comments »

PLR 200708006 (2007).

Refer Reply To: CC:TEGE:EB:HW PLR-125738-06

Date: November 17, 2006

Legend

Employer =

Trust = Plan =

Dear :

This responds to your letter of May 11, 2006 and subsequent correspondence of November 5, 2006 and November 16, 2006, requesting rulings concerning the proper Federal income tax treatment under section 106 of the Internal Revenue Code (Code) of retiree health benefits provided to eligible employees, their spouses and dependents.

Employer proposes to establish a Trust for the benefit of eligible retiring employees, their spouses and dependents. The Trust funds will be used to pay for retiree health benefits payable under the Plan. Under the Plan, retiree health benefits are limited to employees who regularly work 20 hours or more per week and who meet a 30 day waiting period. Coverage under the Plan will be automatic for eligible employees and an eligible employee cannot elect in or out of coverage.

Employer will contribute to the Trust amounts as specified in the Plan or by resolution of the Employer. No other person will be permitted to make contributions. The Employer’s contribution will include the following: discretionary contributions to be made by the Employer on behalf of all participating employees; contributions of all or a portion of employees’ accumulated and unused vacation and sick leave upon retirement; and contributions of all or a portion of employees’ annual excess vacation and sick leave that would otherwise be forfeited or paid out at year end. In accordance with the Plan’s procedures and prior to the beginning of each Plan year, the Employer will designate PLR-125738-06 2

the amounts for the discretionary Employer contributions to be contributed to the Trust and the percentage or fixed amount of the vacation and sick leave to be contributed to the Trust. Also, the Employer will, in its sole discretion, establish a contribution amount applicable to vacation and sick leave accrued prior to the effective date of the plan. All contribution amounts will be determined in the sole discretion of the Employer and under no circumstances will employees be permitted to decide the discretionary Employer contributions to be contributed to the Trust or the amount or percentage of their vacation and sick leave to be contributed to the Trust.

The Plan provides that under no circumstance may the retired eligible employee or the retired eligible employee’s spouse or dependents receive any unused amounts at any time in cash or other benefits. Following the participant’s death, unused amounts shall continue to carryover for the benefit of the participant’s spouse and dependents. After the death of the surviving spouse and dependents, any amounts not applied to reimburse medical expenses will be forfeited.

Section 61(a)(1) of the Code and section 1.61-21(a)(3) of the Income Tax Regulations provide that, except as otherwise provided in Subtitle A, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.

Section 106(a) of the Code provides that the gross income of an employee does not include employer-provided coverage under an accident or health plan. Section 1.106-1 of the regulations states that the gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by the employee, the employee’s spouse, or the employee’s dependents as defined in section 152 of the Code. The employer may contribute to an accident or health plan either by paying the premium on a policy of accident or health insurance covering one or more of the employees, or by contributing to a separate trust or fund which provides accident or health benefits directly or through insurance to one or more of the employees. However, if the insurance policy, trust or fund provides other benefits in addition to accident or health, section 106 applies only to the portion of the contributions allocable to accident or health benefits.

Section 105(a) provides that, except as otherwise provided in section 105, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Section 105(b) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) PLR-125738-06 3

if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in section 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as defined in section 152). Section 1.105-2 of the regulations provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Thus, section 105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care.

Part I of Notice 2002-45, 2002-2 C.B. 93, describes the tax treatment of health reimbursement arrangements (HRAs). The notice explains that a tax-favored HRA is an arrangement that (1) is paid for solely by the employer and not pursuant to a salary reduction election or otherwise under a section 125 cafeteria plan; (2) reimburses the employee for medical care expenses (as defined in section 213(d)) incurred by the employee or by the employee’s spouse or dependents; and (3) provides reimbursements up to a maximum dollar amount with any unused portion of that amount at the end of the coverage period carried forward to subsequent coverage periods.

Part IV of Notice 2002-45 emphasizes that employer contributions to an HRA may not be attributable to salary reduction or otherwise provided under a section 125 cafeteria plan. An accident and health plan funded pursuant to salary reduction is not an HRA and is subject to the rules under section 125. See also, Rev. Rul. 2002-41, 2002-2 C.B. 75; Rev. Rul. 2005-24, 2005-1 C.B. 892; Rev. Rul. 2006-36, 2006-36 I.R.B. 353. Under section 125, unused contributions at the end of a coverage period may generally not be carried forward and used in subsequent coverage periods.

Rev. Rul. 75-539, 1975-2 C.B. 45, describes two labor contracts. Contract A provides that upon retirement, an employee will receive a portion of accumulated unused sick leave credits as a cash payment or, at the election of the employee, the payment may be applied to continue the employee’s participation in the employer’s health plan. Contract B provides that the value of a portion of the accumulated unused sick leave credits will be used to pay for continued participation in the employer’s health plan.

Rev. Rul. 75-539 holds that, under Contract A, the value of unused accumulated sick leave credits used to continue health coverage is constructively received by the retired employee under section 451 of the Code, and therefore is includible in the retired employee’s gross income. Under Contract A, the amount of the premium payments is considered an employee contribution out of salary and not a contribution by the employer under section 106 of the Code. However, under Contract B, the value of unused accumulated sick leave credits, which may not be received in cash, is not constructively received by the retired employee, but is a contribution by the employer to the employer’s health plan that is excludable from the retired employee’s gross income under section 106 of the Code.

PLR-125738-06 4

Rev. Rul 2005-24 describes a health reimbursement arrangement. Situation 1 of the ruling states that when an employee retires, the employer automatically and on a mandatory basis (as determined under the Plan) contributes an amount to the reimbursement plan equal to the value of all or a portion of the retired employee’s accumulated unused vacation and sick leave. Relying on Rev. Rul. 75-539, the ruling concludes that the reimbursement plan described in Situation 1 is an HRA that meets the requirements for tax-favored treatment.

Based on the Trust and Plan as submitted on May 11, 2006, and as subsequently amended by submissions dated November 5, 2006 and November 16, 2006, and on the authorities cited above, we conclude that Employer contributions paid to Trust and payments made from Trust which are used exclusively to pay for eligible medical care expenses of retired employees, their spouses and dependents are excludable from the gross income of retired employees and retired employees’ spouses and dependents under sections 106 and 105 of the Code.

No opinion is expressed as to the federal tax consequences of the transaction under any other section of the Code or statute other than those specifically stated above.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

Harry Beker Chief, Health and Welfare Branch Office of Division Counsel/Associate Chief Counsel (Tax Exempt & Government Entities)

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February 23rd, 2007 | 1 Comment »

Tschetschot v. Commissioner, T.C. Memo 2007-38 (2007).

T.C. Memo. 2007-38

UNITED STATES TAX COURT

GEORGE E. AND GLORIA TSCHETSCHOT, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9498-03. Filed February 20, 2007.

R disallowed losses in excess of Ps’ winnings from gambling and determined both a deficiency and a penalty for substantial understatement for 2000. After conceding that H’s net gambling losses were not properly deductible, Ps argued that, as a professional tournament poker player, W’s net losses should be treated the same as those of any other professional sport participants.

Held: W’s net gambling losses are not exempt from the limitations of sec. 165(d), I.R.C.

Held, further: We leave for the parties to determine as part of their computations under Rule 155, Tax Court Rules of Practice and Procedure, whether there was a substantial understatement for the taxable year in issue; if so, Ps are liable for the accuracy-related penalty.

J. Anthony Hoefer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

ARMEN, Special Trial Judge: Respondent determined a deficiency in petitioners’ Federal income tax for the taxable year 2000 of $10,071, as well as an accuracy-related penalty for a substantial understatement of income tax of $2,014. The grounds for the deficiency were the limitations of section 165(d) as applied to Gloria Tschetschot’s (Mrs. Tschetschot) professional tournament poker playing and George E. Tschetschot’s (Mr. Tschetschot) status as a nonprofessional gambler.1 At trial, petitioners conceded that Mr. Tschetschot was not a professional gambler but argued that Mrs. Tschetschot’s professional tournament poker playing is not gambling and thus not subject to the limitations of section 165(d) on losses from gambling. Respondent conceded that Mrs. Tschetschot’s business expenses related to her professional gambling activity were deductible. Thus, the two issues for decision are: (1) Whether Mrs. Tschetschot’s tournament poker losses are limited by section 165(d) to the amount of her tournament poker winnings, and (2)

1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure.

whether a penalty under section 6662(a) for a substantial understatement of income tax is appropriate. FINDINGS OF FACT At the time the petition was filed, petitioners resided in Cedar Rapids, Iowa.

Mrs. Tschetschot is a database project engineer. She was also a professional tournament poker player in 2000.2 Mr. Tschetschot is not a professional gambler but occasionally plays slot machines and blackjack while accompanying his wife on her poker tournament trips.

Tournament poker is somewhat different from “live-action” poker. A poker tournament consists of a series of individual events hosted by a casino, and it can last anywhere from several days to 2 weeks. Unlike live-action poker, tournament participants cannot exit the game by cashing out partway through the tournament; tournaments are played until there is one player left with all of the chips.

All tournaments have a “buy-in”, or entrance fee, that is paid by the tournament participants to the tournament organizer. A portion of this amount is an administrative fee kept by the casino hosting the event, and the remainder goes directly into the prize fund “pot” that will ultimately be paid out to the

2 Respondent stipulated this fact for purposes of this case only. There are no substantiation issues in this case.

tournament’s winners. No portion of the administration fee is included in the prize fund, and the entire prize fund is dispersed to winning participants. The buy-in may or may not correlate dollar-for-dollar with the amount of chips received at the start of the tournament, and the chips themselves have no intrinsic monetary value. Although “re-buys” are sometimes allowed, tournament play contemplates that each player has only a fixed number of chips and that each player begins the tournament with the same number of chips. When a player runs out of chips, he or she is out of the game. Cash prizes are awarded to a predetermined number of finishing places in the tournament. Because of the buy-in system, the only monetary loss a tournament participant may incur will be the amount of the buy-ins and any re-buys the participant might make; no participant will be able to bet–or subsequently lose–any greater amount. Similar to live-action poker, however, a player’s tournament success depends on a combination of both luck and skill.3 A player might have a decent hand, but as Kenny Rogers tells us in “The Gambler”, he or she would still have to “know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run” to actually be a success.

3 A court in England recently had the opportunity to decide whether Texas Hold ‘Em was a game of chance or a game of skill, and the jury decided on the former. See http://news.bbc.co.uk/1/hi/england/london/6267603.stm.

For 2000, the taxable year in issue, Mrs. Tschetschot earned approximately $49,000 in wages. She also participated in nine poker tournament series, winning in excess of $11,000.4

Mrs. Tschetschot claimed a net loss of $29,933 from her “professional gambler” activity in 2000 on her Schedule C, Profit or Loss From Business. Mr. Tschetschot claimed a net loss of $9,000 from his “professional gambler” activity in 2000 on his Schedule C.

Respondent determined a deficiency of $10,071 based on the view that the deductions claimed by petitioners related to their gambling activities were not appropriately Schedule C deductions, but rather deductions allowable on Schedule A, Itemized Deductions, but only to the extent of petitioners’ winnings. Respondent also determined an accuracy-related penalty under section 6662(a) of $2,014.

At trial, petitioners conceded the issue as to Mr. Tschetschot but disputed the determination as to Mrs. Tschetschot. Respondent conceded Mrs. Tschetschot’s status as a professional, as well as the corresponding treatment of certain expenses related to her professional gambling activity.

4 The amount of Mrs. Tschetschot’s stipulated winnings totals $13,269, whereas she reported only $11,708. Respondent discusses this discrepancy in his posttrial brief by saying that “Respondent did not adjust this discrepancy because the unreported winnings would have been offset by allowance of losses that were disallowed.”

Respondent maintains that section 165(d) limits Mrs. Tschetschot’s losses and that petitioners remain liable for an accuracy-related penalty. Petitioners contend that Mrs. Tschetschot’s professional tournament poker playing activity is more properly classified as “entertainment and professional sports” than professional gambling and should bear the resulting tax treatment; i.e., that her net loss should not be limited by section 165(d) restricting losses from wagering activities. Petitioners also contend that they do not meet the threshold amount for the imposition of an accuracy-related penalty based on a substantial understatement of income tax.

OPINION

I. Tournament Poker5

Central to petitioners’ contention is the thesis that tournament poker, unlike other types of poker, is not a wagering activity.

The term “wagering” has different meanings depending on the context in which the term is used. More often than not, and as it is used in the Internal Revenue Code, the term is synonymous

with “gambling”.6

5 The issue related to tournament poker is essentially legal in nature; accordingly, we decide it without regard to the burden of proof.

6 The legislative history of sec. 23(g) of the Revenue Act of 1934, ch. 277, tit. I, 48 Stat. 680, 689 (subsequently (continued…)

Congress has made a policy decision such that, while section

165 generally allows losses to be deducted from gross income,

“[l]osses from wagering transactions shall be allowed only to the

extent of the gains from such transactions.”7 Sec. 165(d); see

also sec. 165(a). However, neither the Internal Revenue Code nor

the regulations define what constitutes a wagering activity.

When a term is not defined, we must apply the term’s “plain,

obvious, and rational meaning.” Liddle v. Commissioner, 103 T.C.

285, 293 n.4 (1994), affd. 65 F.3d 329 (3d Cir. 1995); see also

Boyd v. United States, 762 F.2d 1369, 1373 (9th Cir. 1985).

According to the dictionary, a “wager” is defined as “something

risked or staked on an uncertain event” or “a bet”. Random House

College Dictionary (1968). Similarly, “to wager” is

6(…continued) redesignated sec. 23(h) by the Revenue Act of 1938, ch. 289, 52 Stat. 461 and then continued as such in the 1939 Code until enacted as sec. 165(d) in the 1954 Code) uses the terms “wagering” and “gambling” interchangeably.

7 Sec. 165(d) applies to both professional and recreational gamblers. See, e.g., Boyd v. United States, 762 F.2d 1369 (9th Cir. 1985); Offutt v. Commissioner, 16 T.C. 1214 (1951); Heidelberg v. Commissioner, T.C. Memo. 1977-133. One of the consequences to professional gamblers is that the loss carryover provisions of sec. 172 are unavailable for amounts attributable to wagering activity. That is not an issue in this case as Mrs. Tschetschot had other income to absorb her expenses properly deductible as a professional. One of the consequences to nonprofessionals is that they may only deduct gambling losses if they itemize deductions on their tax returns. Sec. 62(a); see also Heidelberg v. Commissioner, supra.

defined as: (1) Something risked or staked on an uncertain event; bet; (2) the act of betting. Random House College Dictionary (1973). Courts have often had to differentiate between wagering and related activities on the one hand and those activities not falling into that category on the other. See, e.g., Allen v. U.S. Govt. Dept. of Treas., 976 F.2d 975 (5th Cir. 1992) (“tokes” paid as tips to casino dealers are not gains from wagering transactions); Offutt v. Commissioner, 16 T.C. 1214 (1951) (betting on horse races is wagering); Libutti v. Commissioner, T.C. Memo. 1996-108 (gambler’s receipt of complimentary goods from a casino was sufficiently tied to gambling participation that they were gains from wagering transactions); Whitten v. Commissioner, T.C. Memo. 1995-508 (expenses incurred to be a contestant on Wheel of Fortune were not wagering expenses); Heide v. Commissioner, 2 B.T.A. 451 (1925) (playing bridge for stakes is wagering). However, courts have routinely held that poker is a wagering activity. See, e.g., Boyd v. United States, supra. But here, petitioners ask us to treat tournament poker differently than other kinds of poker.

After a careful review of the record, it is clear that while there are differences between tournament poker and other types of poker,8 none rise to the level of meaningful, substantive

8 The most significant difference is that unlike playing in a live-action poker game, when one buys into a tournament game, (continued…)

differences that would warrant different tax treatment under the current Internal Revenue Code.

A. Tournament Poker as a Sporting Event

Petitioners argue that tournament poker is conducted in much the same way as other professional sporting tournaments. Participants pay an entry fee and compete to win prizes through their good fortune and superior skill. But simply because a sport or activity is played or conducted in a tournament setting does not transform the underlying activity into something

different.9

Tournament poker play, much like live-action poker, necessitates the use of the word “bet” or “wager” even to describe how the game is played. Petitioners argue that the usage of the word “bet” in this context is insignificant. The Court sees it differently.

Betting is so intrinsic to poker that it is nearly impossible to avoid using a word that implies gambling in any way

8(…continued) each player receives the same fixed amount of chips. The game is played, and when a player runs out of chips, the player is out of the tournament. The playing continues until one player has all of the chips. It may take a different skill set to play tournament poker because no endless stream of funds is available, and endurance is a crucial factor to a participant’s success.

9 Similarly, a casino’s decision to issue a Form W2-G, Certain Gambling Winnings, or a Form 1099-Misc., Miscellaneous Income, does not affect the nature of the winnings for tax purposes.

when discussing the topic. Bets are placed on each hand, and each round of betting has consequences. Whether or not the chips being used to make these bets have immediate and tangible monetary value does not change the fact that the players are still placing bets, hoping to win. This is true even in a tournament setting.

Petitioners agree that the first poker tournaments held were, in fact, “wagering events”. For example, in those early games, “Each participant put up $10,000 and received $10,000 in chips.” The fact that the chips being used to place bets in tournament poker today only bear some fractional relationship to the dollar values of the prizes and/or entry fees does not change the basic nature of the game as a wagering activity.

B. Professional Tournament Poker as a Business

Petitioners also raise an equal protection argument and argue that there is no valid reason to treat tournament poker differently, for tax purposes, from tournament golf or tennis. Petitioners argue that the benefits of being able to offset “exaggerated income” from very successful years by losses sustained in less successful years should be available to professional tournament poker players as much as they are to other professions.

Congress made a policy decision to treat businesses based on wagering activities differently. In the absence of Congressional action, we are not free to correct any perceived unfairness stemming from a rationally based policy choice. In Valenti v. Commissioner, T.C. Memo. 1994-483, the Court noted that treating businesses based on wagering and gambling differently from other businesses is a rational differentiation and not one that rises to the level of being violative of due process or equal protection. See also Steward Mach. Co. v. Davis, 301 U.S. 548, 584 (1937) (holding that Congress, like the states, has the freedom to tax businesses differently). Thus, it has been held:

[A] classification that differentiates the business ofgambling from other business has “a rational basis, and when subjected to judicial scrutiny, it must be presumed to rest on that basis if there is any conceivable state of facts which would support it.” * * *

Valenti v. Commissioner, supra (quoting Carmichael v. Southern

Coal Co., 301 U.S. 495 (1937)).

II. Substantial Understatement of Tax

With respect to a taxpayer’s liability for any penalty, section 7491(c) places on the Commissioner the burden of production, thereby requiring the Commissioner to come forward with sufficient evidence indicating that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Once the Commissioner meets his burden of production, the taxpayer must come forward with persuasive evidence that the Commissioner’s determination is incorrect. See id. at 447; see also Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Section 6662(a) imposes a penalty equal to 20 percent of the amount of any underpayment attributable to a substantial understatement of income tax. Sec. 6662(b)(2). An understatement is the amount by which the correct tax exceeds the tax reported on the return. Sec. 6662(d). The understatement is substantial if it exceeds the greater of $5,000 or 10 percent of the tax required to be shown on the return. Sec. 6662(d)(1)(A)(i) and (ii).

Section 6664(c)(1) provides that no penalty shall be imposed if the taxpayer demonstrates that there was reasonable cause for the underpayment and the taxpayer acted in good faith. The determination of whether a taxpayer acted with reasonable cause and in good faith depends on the facts and circumstances of the situation and includes an “honest misunderstanding of fact or law”. Sec. 1.6664-4(b)(1)(c), Income Tax Regs. Insofar as Mr. Tschetschot is concerned, petitioners have not demonstrated either good faith or that there was reasonable cause for their position. As to Mrs. Tschetschot, petitioners were clearly aware of the mandate of section 165(d); their wish that it be inapplicable to tournament poker does not constitute the type of misunderstanding contemplated by the statutes or the regulations.

An understatement is reduced by the portion of the understatement that is attributable to the tax treatment of an item for which there is substantial authority or with respect to which there is adequate disclosure and a reasonable basis. See sec. 6662(d)(2)(B); sec. 1.6662-4(a), Income Tax Regs. However, no substantial authority exists to support petitioners’ position as to either the inapplicability of section 165(d) to tournament poker or Mr. Tschetschot’s status as a professional gambler. Substantial “authority [exists] for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” Sec. 1.6662-4(d)(3)(i), Income Tax Regs. Types of authority on which a taxpayer may rely include the Internal Revenue Code and regulations, revenue rulings and procedures, technical advice memoranda, and private letter rulings. See sec. 1.6662-4(d)(3)(iii), Income Tax Regs. Additionally, whether or not there was adequate disclosure, there is no reasonable basis to support petitioners’ position on tournament poker given the clear mandate of section 165(d) and the existing caselaw interpreting it. Accordingly, we are not permitted to make a reduction in the understatement attributable to respondent’s determination on that issue.

In view of respondent’s concession that Mrs. Tschetschot’s expenses are deductible, it is unclear whether there exists a substantial understatement of income tax. We therefore leave for the parties to determine as part of the Rule 155 computation whether there was, in fact, a substantial understatement for the taxable year in issue. If a substantial understatement exists for the year in issue, petitioners are liable for the accuracy-related penalty.

III. Conclusion

The moral climate surrounding gambling has changed since the tax provisions concerning wagering were enacted many years ago. Not only has tournament poker become a nationally televised event, but casinos or lotteries can be found in many States. Further, the ability for the Internal Revenue Service to accurately track money being lost and won has improved, and some of the substantiation concerns, particularly for professionals, no longer exist. That said, the Tax Court is not free to rewrite the Internal Revenue Code and regulations. We are bound by the law as it currently exists, and we are without the ability to speculate on what it should be. Accordingly, we hold that tournament poker is a wagering activity subject to the limitations of section 165(d).

Decision will be entered under Rule 155.

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February 20th, 2007 | 1 Comment »

US v. Pesaturo, 2007 U.S. App. LEXIS 3483 (1st Cir. 2007).

UNITED STATES OF AMERICA, Appellee, v. AUGUSTINE E. PESATURO, Defendant, Appellant.

No. 04-1285

UNITED STATES COURT OF APPEALS FOR THE FIRST CIRCUIT

2007 U.S. App. LEXIS 3483

February 16, 2007, Decided

PRIOR HISTORY: [*1] APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS. [George A. O’Toole, Jr., U.S. District Judge].

COUNSEL: William J. Cintolo, with whom Thomas R. Kiley, Nicholas A. Kenney, and Cosgrove, Eisenberg & Kiley were on brief, for appellant.

S. Robert Lyons, with whom Eileen O’Connor, Assistant Attorney General, and Alan Hechtkopf were on brief, for appellee.

JUDGES: Before Lynch, Circuit Judge, Stahl, Senior Circuit Judge, and Lipez, Circuit Judge.

OPINION BY: LIPEZ

OPINION: LIPEZ, Circuit Judge. At the heart of this appeal is a complex regulatory scheme governing federal fuel excise taxes. Augustine Pesaturo was convicted by a jury on charges that he evaded such taxes, conspired with his employees to do so, and provided a false statement leading to a fraudulent tax return. On appeal, he argues primarily that he was never liable for the taxes he allegedly evaded. The relevant statute was amended in 1993, and the charged conduct occurred when the regulations implementing the statute were in a state of transition. Nonetheless, we conclude that a jury could permissibly find that Pesaturo was liable for the taxes that underlie his conviction, and that he willfully failed [*2] to pay those taxes. We also find Pesaturo’s additional arguments meritless and therefore affirm.

I.

Pesaturo owned and operated Covenant Oil (”Covenant”), a fuel delivery company that purchased fuel from “terminals” - fuel storage and distribution facilities supplied by pipeline or vessel. Covenant’s employees loaded the fuel onto trucks and delivered it to customers who used the fuel to power trucks, heating and refrigeration units, and railroad cars, as well as in other applications. In 1995 and 1996 Covenant was a small operation. Pesaturo managed the business with the help of one clerical worker and a handful of drivers to operate its three trucks. Aside from the storage tanks of these trucks, Covenant had no fuel storage facilities.

Covenant primarily distributed diesel fuels, including No. 1 diesel, No. 2 diesel (also referred to as home heating oil), and kerosene. While these three fuels differ only slightly in chemical composition, the methods for taxing them differed significantly. The government imposes a tax upon all three fuels when they are used to power vehicles on the road. n1 A tax is not imposed for off-road uses, such as powering farm equipment, heating homes, [*3] or operating the refrigeration and heating units that “piggyback” on trucks and railroad cars, known as “reefers.” This case arises from the government’s allegation that Pesaturo failed to pay taxes due on substantial amounts of fuel he sold during 1995 and 1996.

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n1 The tax rate at the time was 24.4 cents per gallon.

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During that period, No. 1 diesel was taxed upon its removal from a terminal. In practice, Covenant’s suppliers included the federal excise tax in the price of No. 1 diesel and remitted the tax to the government, much like a gas station collects gasoline taxes from consumers at the pump. Customers who used the No. 1 diesel in off-road applications could file for a refund of the tax directly from the government. The price of home heating oil and kerosene purchased at a terminal did not include federal excise taxes. Home heating oil, which is intended for off-road use, was dyed red to alert buyers and inspectors to its tax-free status and to deter unscrupulous sellers from selling it for on-road use [*4] without collecting the tax and remitting it to the government. Kerosene was not dyed out of concern that the dye would impair the function of unvented space heaters commonly run on kerosene. Instead, most terminals required their customers to sign exemption forms accepting responsibility for paying the excise taxes directly to the government if the kerosene was subsequently sold for on-road use. n2

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n2 At trial, employees of Sprague Energy (Covenant Oil’s main supplier) testified that they operated their terminals using a card system. Each customer would drive up, insert a card into the pumping machine, and enter a pin number before being allowed to purchase fuel. If the card and pin number indicated that the customer had signed an exemption form, the customer could obtain kerosene at a price that did not include federal fuel excise taxes; otherwise, the customer would be charged a price that included these taxes.

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Because all three fuels could power vehicles on the road, and companies like Covenant only paid [*5] the tax-inclusive price for No. 1 diesel upon purchase from a terminal, an unscrupulous company had incentives to mix No. 1 diesel with kerosene (which was cheaper to obtain because its price at the terminal did not include the excise tax) and to sell the resulting mixture as fully taxed No. 1 diesel or as a blend of No. 1 diesel and kerosene on which the excise tax had been fully paid. Through this scheme, the unscrupulous seller could charge the tax-inclusive price for the fuel and keep the “tax” owed to the government on the kerosene portion of the blend. Alternatively, sellers could undercut their competitors’ prices for No. 1 diesel by blending untaxed kerosene with the taxed No. 1 diesel and collecting only a portion of the tax on the kerosene intended for on-road use, thus passing on some of the savings to the customer, while still turning a profit. n3 Even if the seller did not collect the tax on the kerosene intended for on-road use, it had an obligation to remit that tax to the government.

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n3 Blending kerosene with No. 1 diesel is a common and legitimate practice. Kerosene contains a lower concentration of wax in its composition than does No. 1 diesel; therefore, the mixture remains liquid at lower temperatures than pure diesel. The gelling of No. 1 diesel can clog vehicle fuel lines at low temperatures, disabling vehicles. However, when one mixes kerosene with No. 1 diesel for on-road use, tax becomes payable to the government for the kerosene added to the blend.

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Pesaturo was indicted in 2002 on three counts of evading federal excise taxes on sales of fuel in 1996, in violation of 26 U.S.C. § 7201; n4 one count of conspiring with two Covenant drivers to evade excise taxes, in violation of 18 U.S.C. § 371; and two counts of filing materially false tax returns, for 1995 and 1996, in violation of 26 U.S.C. § 7206(1). After an eight-day trial, a jury found Pesaturo guilty on all counts, except the final count of filing a false tax return for 1996, which the district court dismissed. n5 Pesaturo was sentenced to 24 months incarceration on each count, to run concurrently, and three years supervised release; he was ordered to pay a fine of $ 5,000, restitution of $ 108,878.61, and a $ 400 assessment. In support of the sentence, the district court found that tax was due on all kerosene purchased by Covenant in 1995 and 1996 that was not accounted for by sales to Covenant’s largest customer, Merchant’s Despatch Transportation (MDT), a railroad company that used the fuel in off-road applications.

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n4 While Covenant was the primary entity responsible for the fuel tax, section 7201(1) applies to “[a]ny person who willfully attempts in any manner to evade or defeat any tax . . . or the payment thereof,” thus encompassing the individual actions of those who contributed to Covenant’s failure to pay these taxes. See, e.g., United States v. Tanios, 82 F.3d 98, 100 (5th Cir. 1996) (sustaining defendant’s conviction for conspiracy to evade federal fuel excise taxes owed by a corporate entity with which he conducted business); United States v. Fawaz, 881 F.2d 259, 266 (6th Cir. 1989) (affirming the conviction of a gas station owner who evaded the retail dealer’s excise tax on diesel fuel). [*7]

n5 The district court dismissed this charge at the government’s suggestion because the government failed to present any evidence to support it.

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On appeal, Pesaturo’s primary argument is that the district court misconstrued the statute and regulations governing fuel taxes during the relevant period and that, as a matter of law, he was not liable for the taxes he allegedly evaded and conspired to evade. He asserts four additional claims of error: (1) the trial court impermissibly allowed the government to shift the burden of proof to him; (2) the evidence did not support a finding that he made false statements on his 1995 tax return; (3) the evidence was insufficient to establish a conspiracy; and (4) the court erred in calculating the tax loss on which his sentence was based and, moreover, his sentence is unconstitutional because it was based on a fact — the amount of untaxed kerosene — that was neither charged by the grand jury nor found beyond a reasonable doubt by the petit jury.

II.

Before addressing the arguments that Pesaturo makes on appeal, we must explain the regulatory regime [*8] that governed the payment of excise taxes on sales of No. 1 diesel and kerosene from 1994 to 1996, the period covered by the indictment.

A. Regulatory Overview

The government has historically imposed an excise tax on fuel used in motor vehicles driven on public roads. Concerned about tax evasion, n6 Congress amended the statute governing fuel excise taxes in 1993. In part, these amendments added diesel fuels to the fuels on which federal excise taxes are collected upon their removal from a refinery or terminal by bringing them under 26 U.S.C. § 4081 (1994). n7 This effectively moved the point of taxation further back in the distribution chain, away from the many small-scale wholesalers like Covenant and toward the less numerous terminals and refineries. n8 Sales of kerosene, however, did not become subject to tax upon removal from a refinery or terminal until 1998. n9 During the transitional period between the 1993 amendments and this 1998 decision on the taxation of kerosene, Congress continued to study whether kerosene should be taxed at the terminal. In the meantime, kerosene was exempt from § 4081’s imposition of tax at the terminal by regulation, [*9] n10 and sales of kerosene were governed by the so-called “back-up tax,” § 4041(a), which applies to sales of fuel that are exempt from § 4081.

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n6 The Department of Treasury noted that:

Congress has found that considerable evasion may be occurring under the pre-1994 taxing structure. See Shortfall in Highway Trust Fund Collections: Hearing before the Subcommittee on Investigations and Oversight of the House Committee on Public Works and Transportation, 102d Cong., 2d Sess. (1992). Congress sought to correct the weaknesses of pre-1994 law by amendments made to the Code . . . .

58 Fed. Reg. 63,069 (1993).

n7 Section 4081 states, in pertinent part, “There is hereby imposed a tax . . . (i) on the removal of a taxable fuel from any refinery, [and] (ii) the removal of a taxable fuel from any terminal . . . .” 26 U.S.C. § 4081(a)(1)(A) (1994).

Section 4083 defines “taxable fuel,” for the purposes of Section 4081, to include gasoline and diesel fuel, where “diesel fuel” is further defined, in relevant part, as “any liquid (other than gasoline) which is suitable for use as a fuel in a diesel-powered highway vehicle.” 26 U.S.C. § 4083(a)(1), (3)(A)(i) (1994). [*10]

n8 Section 4091, which governed sales of diesel until the 1993 amendments, imposed the tax on the sale of diesel fuel “by the producer or importer thereof.” 26 U.S.C. § 4091(a) (1992). Section 4092 further defined “producer” to include registered wholesale distributors. 26 U.S.C. § 4092(b)(1)(B)(i) (1992). In practice, therefore, the tax was not imposed under the old regime until a registered wholesale distributor like Covenant sold the fuel to a retailer, or at the wholesaler’s own retail pumps.

n9 Sales of home heating oil have never become subject to taxation upon removal from a terminal. Instead, home heating oil is sold untaxed but dyed; if inspectors find dyed fuel in the tanks of vehicles traveling on the road, the owners of those vehicles are fined.

n10 26 C.F.R. § 48.4081-1(c)(2)(i) (1996) states: “Effective April 1, 1996, diesel fuel means any liquid (other than gasoline) that, without further processing or blending, is suitable for use as a fuel in a diesel-powered highway vehicle, diesel-powered train, or diesel-powered boat. However, diesel fuel does not include kerosene [or other enumerated fuels] . . . .” Temporary regulations to the same effect were in place between 1994 and 1996.

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Section 4041 imposes the federal excise tax at the point of sale to consumers, requiring sellers to collect the tax in some circumstances and buyers to pay the tax directly to the government in others. In relevant part, § 4041 requires the tax to be imposed when fuel is: “(i) sold by any person to an owner, lessee, or other operator of a diesel-powered highway vehicle . . . or (ii) used by any person as a fuel in a diesel-powered highway vehicle.” 26 U.S.C. § 4041(a)(1)(A)(i), (ii) (1994) (emphasis added).

Although § 4041 was not changed by the 1993 amendments, the relevant regulatory body — the Internal Revenue Service of the Treasury Department — responded to the Congressional action by changing the regulation implementing § 4041, expanding the conditions under which sellers of kerosene are liable for the federal excise tax. The “old rule” specified that a “taxable sale” occurred if the “fuel is delivered by the seller into the fuel supply tank of the vehicle” or, if the fuel is not delivered directly into a fuel supply tank of a vehicle, if the purchaser “furnishes a written statement to the seller before or at the time of the sale” stating [*12] that the fuel will be used for a taxable purpose. 26 C.F.R. § 48.4041-5 (1996). In the absence of a “taxable sale,” the buyer would be liable for the tax if the fuel was used on the road.

The “new rule” stated that § 4041 imposes a tax on, inter alia, “[a]ny diesel fuel on which tax has not been imposed by section 4081 . . . or [] [a]ny liquid other than gasoline or diesel fuel,” that is delivered into “the fuel supply tank . . . of a diesel-powered highway vehicle.” 26 C.F.R. § 48.4082-4(a)(1)(i), a(1) (1996). It is likely that the “diesel fuel” referred to in this regulation includes kerosene; however, even if it does not, kerosene is surely at least a “liquid other than gasoline or diesel fuel,” and is thus subject to the tax. n11

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n11 As discussed below, Pesaturo argues that 26 C.F.R. § 48.4081-1 (1996) excludes kerosene from the definition of “diesel fuel” for purposes of § 4081; however, we do not agree that the regulation extends to the definition of diesel fuel under § 4041.

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The new rule made the seller of the fuel “jointly and severally liable for the tax . . . if the seller knows or has reason to know that the fuel will not be used in a nontaxable use.” n12 Id. at (a)(2)(ii). The new rule expanded the seller’s tax liability by (1) eliminating the requirement that fuel be supplied to the fuel tank by the seller or that the seller receive written notice from the buyer that the buyer intends to use the fuel on the road before the seller is liable for the tax, and (2) by making the seller jointly and severally liable if he knows or has reason to know that the fuel will be used on the road.

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n12 The new rule states, in pertinent part:

(1) In general. Tax is imposed by section 4041 on the delivery into the fuel supply tank of the propulsion engine of a diesel-powered highway vehicle . . . of –
(i) Any diesel fuel on which tax has not been imposed by section 4081;
(ii) Any diesel fuel on which a credit or payment has been allowed under section 6427; or
(iii) Any liquid other than gasoline or diesel fuel.
(2) Liability for tax –
(i) In general. The operator of the highway vehicle . . . is liable for the tax imposed . . . .
(ii) Joint and several liability of the seller. The seller of the fuel is jointly and severally liable for the tax imposed . . . if the seller knows or has reason to know that the fuel will not be used in a nontaxable use.

26 C.F.R. § 48.4082-4(a)(1)-(2) (1996).

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To summarize, the amendments tightened control over the taxation of diesel fuels by: (1) making No. 1 diesel taxable upon removal from a terminal, and (2) strengthening the regulation governing kerosene sales by broadening the circumstances under which sellers were liable for the tax and imposing joint and several liability on sellers where they had actual or constructive knowledge that the fuel would be put to on-road use.

B. Arguments Based on Statutory Provisions and Rules

On appeal, Pesaturo argues that the old rule governs his tax liability for sales of kerosene. Alternatively, he argues that, even if the new rule applies, it should be read to require the seller to deliver the taxable fuel into the fuel supply tank of a vehicle before tax liability attaches to the seller and, except for the sales to the undercover IRS agents (accounting for roughly 1,000 gallons of liquid fuel, in total), the government’s evidence involves only deliveries into fuel storage tanks. Finally, Pesaturo argues that even if delivery into a fuel storage tank is enough to trigger tax liability on the seller of taxable fuel, the government provided insufficient evidence that Pesaturo knew [*15] or should have known that such sales were for on-road uses. 1. The Old Rule or the New Rule?

In arguing that the old rule applies, Pesaturo points out that the regulation implementing § 4081 (26 C.F.R. § 48.4081-1(c)(2) (1996), supra note 10) excludes kerosene from the definition of “diesel fuel” between 1994 and 1998. He also cites a 1994 notice in the Federal Register informing taxpayers that the IRS would not change the tax treatment of kerosene until it had determined how best to implement the tax on kerosene used on the road. n13 Pesaturo interprets these texts as indicating that the taxation of kerosene would proceed precisely as it had before the 1993 amendments - through § 4041 as construed by the old rule. The government argues that the exclusion of kerosene from the definition of diesel fuel during this period serves only to exempt sales of kerosene from automatic taxation upon removal from a terminal, and not from the new regulations governing the “back-up tax.”

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n13 This notice was described as follows: “Notice 94-72 (1994-2 C.B. 553) informed taxpayers that the IRS was reviewing this issue and would not change the treatment of kerosene until the issuance of further guidance. The IRS is continuing its review of this issue. Accordingly, the final regulations do not treat kerosene as diesel fuel.” 61 Fed. Reg. 10,450 (1996).

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We agree with the government that the better reading of these texts and Congress’s intent is to exclude kerosene only from taxation upon removal from a terminal. Indeed, the regulation Pesaturo cites for the proposition that “diesel” does not include “kerosene,” 26 C.F.R. § 48.4081-1(a) (1996), makes clear that this regulatory section only provides definitions “for purposes of the tax on taxable fuel imposed by section 4081,” (emphasis added) and thus has nothing to say about whether “diesel” includes “kerosene” for the purposes of § 4041. Moreover, a further regulation arising from the 1993 amendments, 26 C.F.R. § 48.4041-0 (1996), tellingly entitled “Applicability of regulations relating to diesel fuel after December 31, 1993,” provides that “[s]ections 48.4041-3 through 48.4041-17 n14 do not apply to sales or uses of diesel fuel after December 31, 1993.” The old rule is contained within that range. The regulation continues: “For rules relating to the diesel fuel tax imposed by section 4041 after that date, see § 48.4082-4,” the new rule. Id. In sum, the regulations provide no support for the proposition that [*17] “diesel” should be defined to exclude “kerosene” in relation to § 4041 and they unequivocally state that the “old rule” is inapplicable after 1993.

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n14 These sections relate to the application of taxes on various types of fuel, including aviation fuel, and taxable liquid fuels with dual uses.

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Finally, Congress adopted the 1993 reforms to plug the loopholes through which tax dollars were being siphoned away from the government and into the pockets of unscrupulous sellers. The principal tactic employed by Congress was to make sales of No. 1 diesel taxable at the terminal; however, as discussed above, the Internal Revenue Service also tightened the regulations that governed sales of fuel not taxed at the terminal, such as kerosene.

2. Delivery into a Fuel Supply Tank

Pesaturo argues that, even if the new rule applies, Covenant was not liable for the tax because the seller incurs tax liability only when the seller delivers the fuel into the fuel supply tank of a diesel-powered vehicle. This argument relies on [*18] a misunderstanding of the text and purpose of the new rule. Under the old rule, sellers were liable for the tax upon delivery “by the seller into the fuel supply tank of the vehicle,” (emphasis added). The new rule takes a different approach, as reflected in its text. Sellers are now jointly and severally liable for the tax if the seller knew or had reason to know the fuel would later be “deliver[ed] into the fuel supply tank” by any party. The obligation to collect and remit the tax is no longer linked to the delivery by the seller into the fuel supply tank of the vehicle.

Pesaturo would have us ignore these subtle but significant changes to the text and urges us to read “delivery by the seller into the fuel supply tank of the vehicle” back into the new regulation. However, we find the government’s interpretation of the regulation more persuasive both textually and in the context of the government’s stated purpose of increasing fuel tax compliance. If fuel is delivered into a bulk supply tank temporarily for later use on the road and the seller knew or had reason to know of this later use, the seller is jointly responsible for the tax due. The objective is to ensure payment [*19] of taxes, and the new provision casts a wider net by extending the seller’s liability to uses of which he is aware even if they occur further down the supply path. n15

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n15 Pesaturo also argues that the district court should have applied the rule of lenity — interpreting an ambiguous statute in the light most favorable to the defendant — because of the transitional nature of the regulations during this period. Specifically, he argues that the court should have interpreted the new regulation to require delivery of the fuel into the fuel supply tank by the seller before a sale becomes taxable. However, we find the new rule regulating the taxation of kerosene unambiguous and we therefore do not entertain Pesaturo’s argument for lenity.

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3. Knowledge

Pesaturo argues that, even if the new rule applies and delivery into a storage tank does not insulate the seller from tax liability, the government presented insufficient evidence that Pesaturo knew or should have known how much, if any, of the fuel at issue would [*20] be used on the road.

We find Pesaturo’s argument disingenuous. Direct testimony at trial established that Covenant sold No. 1 diesel mixed with 20%-55% kerosene (on which no tax was remitted to the government) to bulk storage tanks owned by three trucking company customers — JAG Enterprises, M&M Transport, and M. Korson & Company, Inc. — on 13 different occasions between May 1995 and March 1996. Although Pesaturo contends that all three companies had both on-road and off-road uses for fuel, representatives of all three companies testified that they believed the price they paid Covenant for fuel included the on-road tax. Also, representatives of Korson and JAG indicated that they bought different fuel from Covenant for their on-road and off-road uses. There is no reason to think that Pesaturo’s customers would have paid the much higher tax-inclusive price for fuel they intended to use in nontaxable applications. They paid the tax because their on-road use of the fuel required it.

It is true that the jury was given no instruction that the regulation governing § 4041 required Pesaturo to know that sales of kerosene would be put to on-road use. Pesaturo failed to object to this omission [*21] from the jury instructions at the time of the trial, focusing instead on the judge’s refusal to instruct the jury that the seller was only liable for the tax when the seller delivered the fuel into the fuel supply tank of a vehicle. However, any error on this point was harmless. The jury was duly instructed that tax evasion required not just that a tax be due and owing, but that defendant “willfully attempt[ed]” to evade the tax. See 26 U.S.C. § 7201. The jury could only find such willfulness if it also found that Pesaturo knew that the fuel sold to buyers such as Korson, JAG and M&M Transport would be used on the road. n16

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n16 The government offers an alternative basis for Pesaturo’s tax evasion under 26 U.S.C. § 4081(b)(1) (1996), which imposes a tax on blended fuels. Section 4041(a)(1)(B) says, “No tax shall be imposed by this paragraph on the sale or use of any liquid if tax was imposed on such liquid under section 4081.” There may be an argument that § 4041 was intended to apply exclusively to unmixed kerosene (since § 4081 imposes a tax on blended kerosene). However, this argument was not raised, and thus we assume for our purposes that § 4041 applies to blended kerosene on which no tax was actually paid. We also do not reach the merits of the government’s argument basing Pesaturo’s liability under § 4081 because the evidence supports Pesaturo’s liability under § 4041.

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C. Burden-Shifting by the Government

Pesaturo argues that the government impermissibly shifted the burden of proof to him through a summary witness, Gary Lindahl, an IRS revenue agent who was unconnected to the case but who was present in the courtroom during most of the trial. n17 Since Covenant’s records indicated no sales of kerosene, Lindahl used evidence from the trial to calculate the amount of kerosene Covenant could have sold for on-road use. Lindahl began with the amount of kerosene purchased by Covenant and subtracted kerosene sales to MDT (Covenant’s largest customer, who used all of the fuel it purchased from Covenant in off-road applications). Because sales of kerosene to MDT were also not recorded, the amount of kerosene sold to MDT was imputed based on the total fuel sales to MDT and the testimony of several witnesses that Covenant blended kerosene into the fuel sold to MDT at a ratio of 30% kerosene to 70% No. 2 diesel. Kerosene, which has a lower viscosity than either No. 1 or No. 2 diesel, was added to the fuel to prevent the fuel from “gelling” in the fuel lines in cold temperatures. Although the witnesses agreed on this ratio, they disagreed as to whether [*23] or not Covenant sold blended fuel to MDT exclusively during the winter months. Those who testified that blended fuel was sold to MDT outside of the winter months noted that railcars were often sent through cold climates — across the Rocky Mountains, for instance — before they reached their destinations. As a result, the government assumed the 30:70 ratio for sales throughout the year. Since this would overestimate the gallons of kerosene sold to MDT if the fuel sold to MDT outside of winter was not blended, this approach resulted in a conservative estimate of the gallons of kerosene unaccounted for by sales to MDT and therefore available for sale in taxable uses.

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n17 Lindahl testified that he had been present for “99 percent” of the testimony; he had missed part of one witness’s testimony but had since read the transcript of that testimony.

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Pesaturo argues that, by subtracting non-taxable kerosene sales to MDT from Covenant’s kerosene purchases to arrive at a figure of 358,740 gallons available for sale in [*24] taxable uses, the government impermissibly shifted the burden of proof to defendant to account for the legitimate sale of that fuel. n18 In response, the government characterizes its approach as the normal process of establishing a fact through the use of circumstantial evidence, and notes further that its estimate was necessitated by Pesaturo’s own lack of accurate record-keeping. Indeed, Covenant’s bookkeeper testified that Pesaturo instructed her to record all kerosene sales as sales of home heating oil, leading to the absurd accounting result that Covenant’s records showed purchases — but no sales — of kerosene, notwithstanding that Covenant had no fuel storage facilities save the storage tanks of its three trucks.

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n18 Pesaturo’s trial counsel urged the judge to issue a curative instruction to the jury, reminding the jurors that the government has the burden of proving each and every fact necessary to establish the alleged crime and that there is “no burden on the defendant to come forward with any evidence at all.” The judge refused, stating: “I think I’ve covered it.”

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The prosecution never argued to the jury that it had to find that the unaccounted-for kerosene was sold for taxable use because of the absence of records otherwise accounting for its sale. Instead, the prosecution noted the amount of unaccounted-for kerosene, asked the rhetorical question “where did the rest go?”, and answered the question by pointing to the evidence. n19 Furthermore, the judge carefully instructed the jury:

The burden of proof rests with the government. A defendant has no burden to prove that he is not guilty of what is charged. The burden is always with the government to prove that he is guilty of what the government charges him with. . . . The government must establish each element of the offense charged by proof that convinces you and leaves you with no reasonable doubt.

We agree with the government that there was no impermissible burden shifting in this case.

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n19 The prosecution’s argument continued:

Well, the evidence shows where it went. . . . You heard testimony from David Genarro from Korson [Trucking]. He was purchasing diesel fuel. He owned a trucking company. Diesel fuel, by definition, is on-the-road fuel. Yet, he received kerosene with that diesel fuel. You heard testimony from JAG, James Gasbarro, he was purchasing diesel fuel, and he received kerosene. Ladies and gentlemen, you can look at the tickets. It shows kerosene being purchased. This was diesel fuel being sold to trucking companies for use in their trucks.

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D. Materiality of the Adjustments to Pesaturo’s Tax Return

Pesaturo challenges the jury’s determination that he willfully made a material false statement regarding Covenant’s 1995 tax return in violation of 26 U.S.C. § 7206(1). The government’s burden under this statute is to prove the following elements:

(1) that the defendant made or caused to be made, a federal income tax return for the year in question which he verified to be true; (2) that the tax return was false as to a material matter; (3) that the defendant signed the return willfully and knowing it was false; and (4) that the return contained a written declaration that it was made under the penalty of perjury.

United States v. Boulerice, 325 F.3d 75, 79-80 (1st Cir. 2003). We review de novo whether there was sufficient evidence for the jury to find that Pesaturo’s instruction to his accountant resulted in a materially false representation on Covenant’s tax return. We will affirm if “‘after assaying all the evidence in the light most amiable to the government, and taking all inferences in its favor, a rational factfinder could find, beyond a reasonable [*27] doubt, that the prosecution successfully proved the essential elements of the crime.’” United States v. Lavoie, 433 F.3d 95, 98 (1st Cir. 2005) (quoting United States v. O’Brien, 14 F.3d 703, 706 (1st Cir. 1994)).

Covenant’s accountant testified that, when he found that the company’s cash balance exceeded its receipts by $ 62,359, Pesaturo explained the discrepancy by claiming that the higher number reflected various cash sales for which receipts were unavailable. He further explained that a commensurate amount of cash had been used to purchase fuel from Sprague Energy and thus both sales and cost of goods sold should be adjusted to reflect these cash transactions.

Pesaturo offered no documents supporting the cash purchase of kerosene. Moreover, representatives of Sprague Energy testified at trial that the company rarely sold fuel on a cash basis and only to customers whose credit-worthiness was at issue; further testimony established that Covenant’s credit-worthiness was not questioned by Sprague during this period. In addition, both the government and Pesaturo stipulated at trial that “it was not the policy or practice of Valero Energy [*28] Corporation [Covenant’s other fuel supplier] to accept cash . . . for payment.”

Based on this evidence, a reasonable jury could have found that Pesaturo, alerted to the existence of unaccounted-for cash in Covenant’s account, fabricated cash purchases to inflate Covenant’s cost of goods sold in a misguided attempt to neutralize the extra receipts discovered by his accountant. The correct adjustment would have been a $ 62,359 adjustment in sales with no adjustment to cost of goods sold. However, that would have increased Covenant’s tax liability, which Pesaturo wanted to avoid.

E. Sufficiency of Evidence on the Conspiracy Charge

Pesaturo also argues that the government presented insufficient evidence to support the conspiracy charge. To prove liability under 18 U.S.C. § 371, the government must show that “two or more persons conspire[d] either to commit any offense against the United States, or to defraud the United States . . . and one or more of such persons d[id] any act to effect the object of the conspiracy.” Pesaturo argues specifically that there was insufficient evidence of an agreement between him and the drivers who sold untaxed kerosene [*29] to undercover IRS agents. However, Pesaturo errs in focusing solely on these sales. The taxable sales were made to numerous customers, by multiple Covenant drivers, and over an extended amount of time.

Pesaturo insists that neither mere employment in a common business enterprise, see Ingram v. United States, 360 U.S. 672, 677-80, 3 L. Ed. 2d 1503 (1959), nor mere association with conspirators, see United States v. Gomez-Pabon, 911 F.2d 847, 853 (1st Cir. 1990), is sufficient to prove that an agreement existed on which the government could ground a conspiracy charge. The government’s evidence established more than mere association. Testimony at trial established that Pesaturo controlled all business decisions at Covenant. He scheduled fuel purchases and deliveries, set the price at which fuels were sold, marketed the company’s products, and even instructed the bookkeeper in how to account for sales of different products.

While the government did not present evidence of an explicit agreement between Pesaturo and his drivers, we do not require evidence of an explicit agreement to ground a conspiracy conviction. See United States v. Patrick, 248 F.3d 11, 20 (1st Cir. 2001) [*30] (noting the “well-established legal principle that a conspiracy may be based on a tacit agreement shown from an implicit working relationship”). Given the extent of the evidence regarding the tax evasion, the small size of Covenant Oil, and Pesaturo’s pervasive control over that enterprise, it is simply implausible to argue that the drivers were acting on their own.

F. Propriety of Pesaturo’s Sentence

Under the Federal Sentencing Guidelines, Pesaturo’s sentence was linked to the amount of tax loss attributable to his crimes. See USSG § 2T1.1. At his sentencing, the judge calculated the tax loss based on the taxes due on 358,740 gallons of kerosene bought by Covenant but not sold to MDT for use in its off-road applications, n20 and the tax loss resulting from the false inflation of Covenant’s cost of goods sold on its 1995 tax return, n21 resulting in a total tax loss of $ 108,878. n22

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n20 358,740 gallons x $ 0.244/gallon (tax).

n21 $ 62,359 at a tax rate of 34%.

n22 In addition to basing the length of sentence on this figure, the court imposed restitution on Pesaturo in this amount. The government sought additional restitution in the amount of $ 75,335 for the Commonwealth of Massachusetts for state taxes evaded; the judge refused this request.

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Pesaturo was sentenced in February 2004, before the Supreme Court’s decision in United States v. Booker, 543 U.S. 220, 160 L. Ed. 2d 621 (2005). Although Pesaturo’s challenge to his sentence is difficult to decipher, we understand that it reduces to two points: (1) that the jury had to find the amount of tax loss beyond a reasonable doubt and (2) that, even if a court could make the tax loss finding, the court’s calculation of the tax loss was erroneous.

Pesaturo bases his first argument on Booker. However, Booker does not help him. The sentencing flaw at issue in Booker was not judicial factfinding per se, but the application of the sentencing guidelines as mandatory rather than advisory. United States v. Antonakopoulos, 399 F.3d 68, 79-80 (1st Cir. 2005). To the extent we construe Pesaturo’s argument as a challenge also based on the mandatory nature of the sentencing regime, we review for plain error because, despite his arguments to the contrary, Pesaturo failed to argue below that his sentence violated either Apprendi v. New Jersey, 530 U.S. 466, 147 L. Ed. 2d 435 (2000), or Blakely v. Washington, 542 U.S. 296, 159 L. Ed. 2d 403 (2004). [*32]

Under the plain error standard, a defendant ordinarily must “point to circumstances creating a reasonable probability that the district court would impose a different sentence more favorable to [him] under the new ‘advisory Guidelines’ Booker regime.” Antonakopoulos, 399 F.3d at 75. We further stated there that the “use of judicial fact finding . . . ordinarily cannot alone meet [this] standard,” id. at 80. Pesaturo’s only other possible plain error argument is his claim that the court erred in calculating the tax loss.

On this point, Pesaturo argues that the judge erred because there was evidence at trial that at least some of the fuel sold to Korson, JAG and M&M Transport was used in off-road applications. The government points out, however, that because the amount of a tax loss is often uncertain, the Sentencing Guidelines “contemplate that the court will simply make a reasonable estimate based on the available facts.” See USSG § 2T1.1 cmt. n.1 (2006); accord United States v. Hart, 324 F.3d 575, 578 (8th Cir. 2003) (finding no clear error where the trial court accepted the government’s [*33] calculation of defendant’s personal income where defendant failed to keep financial records); United States v. Bishop, 291 F.3d 1100, 1114-15 (9th Cir. 2002) (finding no error where the court based its sentence on the government’s calculation of tax loss, which assumed “married filing jointly” rather than “married filing separately” tax status, used standard deductions rather than itemized deductions, and failed to deduct certain sums from defendant’s income). Here, it was defendant’s own lack of accurate record-keeping — he recorded no sales of kerosene although his records indicated that he purchased 662,105 gallons — that made the court’s estimation necessary.

Even if we allowed that some of the kerosene was sold for purely off-road use, Pesaturo’s sentence is unlikely to change. As the government points out, such non-taxable sales of pure kerosene would have had to account for upwards of 44% of Covenant’s kerosene sales before his sentencing range would be affected. Since several witnesses testified that Covenant made no sales of pure kerosene and no witness testified to a single instance of such a sale, the judge’s determination that Pesaturo should be [*34] sentenced based on the full amount of the tax owing on all of its unaccounted-for kerosene sales is not plainly erroneous.

III.

For the foregoing reasons, we affirm the conviction and sentence. So ordered.

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February 16th, 2007 | No Comments »

CCA 200707001 (2007).

Office of Chief Counsel Internal Revenue Service

Memorandum

Number: 200707001

Release Date: 2/16/2007

CC:PA:APJP:1:KEBriscoe FILEN-144625-06

UILC: 6050I.00-00

-

from: Stuart D. Murray Senior Counsel, Administrative Provisions & Judicial Practice (Procedure & Administration)

subject: Form 8300 Reporting of Bank Deposits that Are Payments on Used Auto Sales

This Chief Counsel Advice responds to your request for assistance. This advice may not be used or cited as precedent.

ISSUES

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-

FILEN-144625-06 2

CONCLUSIONS

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-

FACTS

The two issues addressed herein are based on the following non-taxpayer-specific scenario. Taxpayer (in the general sense of an individual or entity subject to liability for failure to file a required information retrun) is a Schedule C sole proprietorship that sells used motor vehicles. Individual A, an independent contractor of the Taxpayer, sells Taxpayer’s vehicles exclusively. Individual A receives a commission for every vehicle sold.

Taxpayer purchases most of Taxpayer’s inventory of vehicles through auctions. Individual A buys his inventory at auction as well, making the purchases under the Taxpayer’s dealer’s license. Individual A then sells the vehicles to customers at a price in excess of what was paid at auction. The Taxpayer weekly pays for all the vehicles purchased through the auctions with a business check, including all vehicles purchased by Individual A. Taxpayer keeps track of all vehicles Individual A buys and sells and also creates a list, by month, of the amounts owing from Individual A for the cars Individual A purchased using the Taxpayer’s dealer’s license. All of Individual A’s retail sales in a year are reported on Schedule C of the Taxpayer’s income tax return for the year, and the Taxpayer pays all sales taxes.

Individual A sells one of the cars purchased at auction to a retail customer for $11,000. After deducting his commission ($500), Individual A pays Taxpayer $10,500.1 By way of payment, Individual A deposits $6,000 in cash (United States currency) and a $4,500 cashier’s check into Taxpayer’s business bank account.

LAW AND ANALYSIS

Issue 1

Section 6050I(a) provides that any person who is engaged in a trade or business, and who, in the course of that trade or business, “receives” more than $10,000 in cash in one transaction (or two or more related transactions), shall make the return described in

1

Presumably, the Taxpayer is making a profit on the transaction (for example, the auction price was $8,000, in which case, Taxpayer has netted $2,500, minus any costs related to the transaction).

FILEN-144625-06 3

section 6050I(b) with respect to the transaction (or related transactions) at the time the Secretary prescribes. Section 6050I(b) requires the information return to be made on whatever form is prescribed for this purpose. Form 8300 is the designated form.

A “recipient” of cash for purposes of section 6050I reporting means “the person receiving the cash.” Treas. Reg. § 1.6050I-1(c)(8)(i). On prior occasions we have opined that a person’s deposit into someone else’s bank account is not receipt by the accountholder of a payment within section 6050I. While the contexts were somewhat different from the current one, and the prior advice is certainly not precedential (just as this advice is not precedent) or determinative of what we decide now, our analysis here does not lead to a different outcome. We construe the word “receives” in section 6050I(a) to mean actual, physical receipt. In that sense, the Taxpayer in your scenario does not “receive” a $10,500 payment. The Taxpayer does not physically (in hand) receive the money that Individual A deposits into the Taxpayer’s bank account. Consequently, we conclude that the deposit—even though it exceeds $10,000 and the transaction on which it is being paid was conducted in the course of the Taxpayer’s trade or business—is not a reportable payment under section 6050I.2

Issue 2

Even where a payment falls within section 6050I(a), section 6050I(c)(1)(A) sets forth a specific exception to avoid double reporting. Namely, cash received in a transaction that is reported by any financial institution to Treasury under the Bank Secrecy Act’s reporting and recordkeeping requirements in Title 31 is excluded from section 6050I reporting where it would be duplicative of the BSA reporting. Additionally, a bank or other financial institution is not required to file a Form 8300 reporting the receipt of cash exceeding $10,000. I.R.C. § 6050I(c)(1)(B); Treas. Reg. § 1.6050I-1(d)(1).

Section 5313 of Title 31 governs the circumstances under which financial institutions, including banks, are required to report monetary transactions. Section 5313(a) states that when “a domestic financial institution is involved in a transaction for the payment, receipt, or transfer of United States coins or currency (or other monetary instruments the Secretary of the Treasury prescribes), in an amount, denomination, or amount and denomination, or under circumstances the Secretary prescribes by regulation,” the

2 Given that, it is irrelevant, and we need not decide, whether more than $10,000 in “cash” is present, i.e., whether the $4,500 cashier’s check is “cash.” See Treas. Reg. § 1.6050I-1(c)(7)(i) (defining “cash” as (A) the coin and currency of the United States or of any other country if circulated and customarily used and accepted as money in the issuing country, and (B) a cashier’s check, bank draft, traveler’s check, or money order having a face amount of not more than $10,000 received in a “designated reporting transaction” or in any transaction in which the recipient knows that the instrument is being used in an attempt to avoid the reporting requirements of section 6050I). Please note that we are not deciding here that if Individual A made the payment ($6,000 in cash, and $4,500 in a cashier’s check) directly to the Taxpayer—which unquestionably would be receipt under section 6050I—the payment would, or would not, be reportable on Form 8300. The answer would depend on whether the payment is received in a “designated reporting transaction” or one in which the Taxpayer knows that the split form of payment is an attempt to avoid Form 8300 reporting.

FILEN-144625-06 4

financial institution must file a report as the Secretary directs. Per the implementing regulations, financial institutions, other than casinos, must generally file a report of each deposit of “currency” of more than $10,000. 31 C.F.R. § 103.22(b)(1).

“Currency” is defined as the coin and paper money of the United States or of any other country that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange in the country of issuance, and includes U.S. silver certificates, U.S. notes and Federal Reserve notes, and official foreign bank notes customarily used and accepted as a medium of exchange in a foreign country. 31

C.F.R. 103.11(h). “Monetary instruments,” which are defined separately, include not only currency but all negotiable instruments, including personal checks, business checks, official bank checks, cashier’s checks, third-party checks, promissory notes under the UCC, and money orders. 31 C.F.R. 103.11(u)(1).

Because a cashier’s check is not currency and Individual A’s deposit into the Taxpayer’s bank account is of less than $10,000 in currency, then, as we read the Tile 31 requirements, the bank would not be obligated to file a CTR. In any event, the applicability or inapplicability of these requirements has no effect on our conclusion that a Form 8300 is not required from the Taxpayer. A payment that is otherwise reportable under section 6050I is excepted from Form 8300 reporting if a CTR is required for the transaction. But we have determined that the deposit is not reportable under section 6050I for other reasons.

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

Please call 622-4910 if you have any further questions.

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February 16th, 2007 | 1 Comment »

Stulter v. Internal Revenue Service, 2007 U.S. App. LEXIS 3448 (3d Cir. 2007).

LARRY L. STULER v. INTERNAL REVENUE SERVICE Larry Stuler, Appellant

No. 06-2251

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

2007 U.S. App. LEXIS 3448

February 12, 2007, Submitted Pursuant to Third Circuit LAR 34.1(a)

February 15, 2007, Filed

NOTICE: [*1] RULES OF THE THIRD CIRCUIT COURT OF APPEALS MAY LIMIT CITATION TO UNPUBLISHED OPINIONS. PLEASE REFER TO THE RULES OF THE UNITED STATES COURT OF APPEALS FOR THIS CIRCUIT.

PRIOR HISTORY: On Appeal from the United States District Court for the Western District of Pennsylvania. D.C. Civil Action No. 05-cv-1717. (Honorable Arthur J. Schwab).

COUNSEL: LARRY L. STULER, Appellant, Pro se, Washington, DC.

For INTERNAL REVENUE SERVICE, Appellee: Thomas J. Clark, Anthony T. Sheehan, John Schumann, United States Department of Justice, Tax Division, Washington, DC.

JUDGES: Before: SCIRICA, Chief Judge, FUENTES and SMITH, Circuit Judges.

OPINION: PER CURIAM.

Larry Stuler appeals pro se from an order of the United States District Court for the Western District of Pennsylvania, granting the Internal Revenue Service’s motion for summary judgment in this action brought under the Freedom of Information Act (”FOIA”), 5 U.S.C. § 552. For the following reasons, we will affirm.

On March 21, 2005, Stuler submitted a FOIA request to the IRS seeking copies of various records from the years 1990 through 1993. Specifically, he asked for records: 1) citing the partnership of which he was considered [*2] a partner; 2) listing the “breakdown within the Capital construction fund . . . of the taxpayer . . . by dollar amount for the capital account, the capital gain account, and the ordinary income account as defined within 26 C.F.R. Sec. 3.0 (e)“; 3) listing the dollar amount for the capital of self-employment income he derived as a partnership; and 4) listing “all the ‘agreement vessels’ which were subject to the agreement established pursuant to 26 C.F.R. § 3.0.”

On April 8, the IRS responded that Stuler’s request was improper under FOIA and that he appeared to be challenging the income tax system. It directed Stuler to a website which addresses several anti-tax arguments, and stated that for any question concerning his correspondence, he could contact the IRS’s Senior Disclosure Specialist, Anne Jensen. Stuler filed an administrative appeal to the Office of Disclosure, which on May 12, 2005, affirmed the agency’s initial determination.

On December 14, Stuler filed in the District Court a petition for release of records, challenging the IRS’s failure to disclose documents and records in response to his FOIA request. In response, the IRS [*3] conducted a search but found no responsive documents or records. The IRS then moved for summary judgment and submitted Anne Jensen’s declaration in support of its motion. On March 31, 2006, the District Court granted summary judgment in favor of IRS. Stuler filed a timely appeal. n1

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n1 We have jurisdiction under 28 U.S.C. § 1291.

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FOIA imposes upon each agency a duty to make records “promptly available” that are “reasonably describe[d]” in a written request “made in accordance with published rules stating the time, place, fees (if any), and procedures to be followed.” 5 U.S.C. § 552(a)(3)(A). Under the IRS’s regulations, a proper FOIA request “must describe the records in reasonably sufficient detail to enable the IRS employees who are familiar with the subject matter of the request to locate the records without placing an unreasonable burden upon the IRS.” 26 C.F.R. § 601.702(c)(5)(i); see § 601.702(c)(4)(D). A request reasonably [*4] describes records if “the agency is able to determine precisely what records are being requested.” Kowalczyk v. Dep’t of Justice, 315 U.S. App. D.C. 286, 73 F.3d 386, 387 (D.C. Cir. 1996) (quoting Yeager v. DEA, 220 U.S. App. D.C. 1, 678 F.2d 315, 326 (D.C. Cir. 1982)). The agency is not required to create responsive records or answer questions posed as FOIA requests. See Yeager, 678 F.2d at 321; Zemansky v. United States EPA, 767 F.2d 569, 574 (9th Cir. 1985).

Here, Stuler’s request did not comply with the above requirements as it did not sufficiently describe the records sought. In her declaration in support of summary judgment, Jensen stated that none of Stuler’s requests was clear in articulating the documents sought and that each would require the IRS to perform substantial research. Jensen also stated that she had nonetheless attempted to locate records based on Stuler’s requests and was unable to locate any responsive documents. In opposing the IRS’s motion for summary judgment, Stuler offered no evidence undermining Jensen’s declaration. Because Stuler failed to offer any evidence demonstrating compliance [*5] with the requirement to reasonably describe the records he requested, the IRS was not required under FOIA to conduct any search and properly refused his request.

For the reasons given, we conclude that the District Court properly granted summary judgment in favor of the IRS. Accordingly, we will affirm its judgment.

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February 15th, 2007 | No Comments »

Schwartz v. Commissioner, 128 T.C. No. 2 (2007).

128 T.C. No. 2

UNITED STATES TAX COURT

THEODORE C. AND DENISE M. SCHWARTZ, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2914-06L. Filed February 14, 2007.

Pursuant to sec. 6330(d), I.R.C., Ps filed a petition challenging R’s determination to proceed with collection. Ps elected to have this case conducted under the small tax case procedures authorized by sec. 7463, I.R.C. The unpaid income tax involved is for the 1997-2003 years. The unpaid tax for any single year does not exceed $50,000, but the total tax for all years exceeds $150,000.

Held: Sec. 7463(f)(2), I.R.C., provides that a sec. 6330, I.R.C., collection case petitioned to this Court is eligible to be conducted under the small tax case procedures “in the case of * * * a determination in which the unpaid tax does not exceed $50,000.” The total unpaid tax in this case with respect to which R determined to take collection action exceeds $50,000, and, therefore, the case is not eligible to be conducted under the small tax case procedures provided in sec. 7463, I.R.C.

Theodore C. and Denise M. Schwartz, pro sese.

Michele E. Craythorn, for respondent.

OPINION

RUWE, Judge: This case is before the Court for judicial review of a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330 (determination letter). The petition was filed pursuant to section 6330(d).1 Petitioners requested that this case be conducted under section 7463, which provides for what are commonly referred to as “small tax case” or “S case” procedures. There was no objection to this request, and the case was designated and tried as a small tax case under section 7463.

Section 7463 generally allows disputes in small tax cases to be decided in proceedings in which the normally applicable procedural and evidentiary rules are relaxed. For example, Rule 174(b) provides: “Trials of small tax cases will be conducted as informally as possible consistent with orderly procedure, and any evidence deemed by the Court to have probative value shall be admissible.” Tax Court decisions in small tax cases cannot be appealed. Sec. 7463(b).

1 Unless otherwise indicated, all section references are to the Internal Revenue Code, and all Rule references are to the Tax Court Rules of Practice and Procedure.

For a case to qualify as a small tax case under section 7463, the amount involved may not exceed a specified dollar amount. This amount is generally expressed as $50,000. However, as later explained, the $50,000 limit is expressed in different statutory language, depending on the type of tax in issue (e.g., income, estate, or gift) and the type of proceeding (e.g., deficiency cases, section 6015(e) spousal relief cases, or section 6330 collection proceedings).

Section 7463 procedures are available in a section 6330 collection case where the taxpayer challenges the Commissioner’s collection determination “in which the unpaid tax does not exceed $50,000.” Sec. 7463(f)(2). In posttrial filings, the parties agree that the following amounts of unpaid income tax are involved in this section 6330 collection case:

Year Unpaid Balance of Tax1 1997 $2,052.96 1998 12,861.03 1999 27,040.65 2000 20,154.68 2001 37,315.70 2002 30,729.60 2003 23,566.81 Total 153,721.43 1These amounts include interest and penalties. Interest and penalties are generally treated as tax, and any reference in the Internal Revenue Code to “tax” (with exceptions not applicable to this case) shall be deemed to include interest and penalties. Secs. 6601(e)(1), 6665(a). These are the amounts stated in the Final Notice, Notice of Intent to Levy and Notice of Your Right to a Hearing, dated June 7, 2005. The determination letter upholding the proposed levy to collect this unpaid tax was issued on Jan. 3, 2006.

Because the total unpaid tax exceeds $50,000, but the tax for any

single year in issue is less than $50,000, we ordered the parties

to file responses to the question of whether this case could be

decided as a small tax case pursuant to section 7463. Respondent

and petitioners both took the position that it was appropriate to

proceed pursuant to section 7463 because the unpaid tax for any

single year was less than $50,000.2 Nevertheless, because this

issue concerns the Court’s authority to proceed under section

7463 and is in the nature of a jurisdictional question,3 we will

2 Respondent’s response filed Jan. 16, 2007, states: “Respondent’s National Office has approved the position taken in this Statement.” Shortly after the trial, the Court became aware of a motion that the Commissioner had filed in an unrelated case, docket No. 17199-06S, where he took the position that a collection case brought pursuant to sec. 6330(d) could not proceed under the small tax case procedures of sec. 7463 because the total unpaid tax for the years in issue exceeds $50,000 even though the unpaid tax for each separate year was less than $50,000. The Commissioner has recently withdrawn the motion in that case.

3 We have previously referred to the dollar limits in sec. 7463 as “the jurisdictional maximum for a small tax case”. Kallich v. Commissioner, 89 T.C. 676, 681 (1987); Page v. Commissioner, 86 T.C. 1, 13 (1986). While there is no question that we have jurisdiction to decide whether the proposed sec. 6330 collection action is appropriate, there is a question whether we can proceed to decide this matter as a small tax case under sec. 7463. Sec. 7463(c), Limitation of Jurisdiction, prohibits decisions in excess of the prescribed amounts. Sec. 7463(d), Discontinuance of Proceedings, provides for discontinuance of proceedings under sec. 7463 where the amount placed in dispute “exceeds the applicable jurisdictional amount”. Appellate court jurisdiction is also affected because a decision in a case decided under the sec. 7463 procedures is final and may not be reviewed by a Court of Appeals. Sec. 7463(b).

decide whether the Court has the authority to decide this case

pursuant to the small tax case provisions of section 7463.

Section 7463(a) allows the small tax case procedures to be

used for cases

filed with the Tax Court for a redetermination of a deficiency where neither the amount of the deficiency placed in dispute, nor the amount of any claimed overpayment, exceeds–

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-

-

-

Prior to December 21, 2000, there was no statutory authority for

utilizing the small tax case procedures for section 6330

collection cases. However, effective December 21, 2000, the

Community Renewal Tax Relief Act of 2000, Pub. L. 106-554, sec.

313(b)(1), 114 Stat. 2763A-642, added section 7463(f), which

provides:

SEC. 7463(f). Additional Cases in Which Proceedings May Be Conducted Under This Section.–At the option of the taxpayer concurred in by the Tax Court or a division thereof before the hearing of the case, proceedings may be conducted under this section (in the same manner as a case described in subsection (a)) in the case of–

- -

-

Section 7463(f)(2) is the provision that controls whether the instant section 6330 collection case qualifies under the small tax case procedures.

The difference between the expressions of the dollar limit in subsections (a) and (f) of section 7463 presents the issue that confronts us. Subsection (a) deals with deficiency cases where a petition is filed on the basis of a notice of deficiency. A deficiency notice and a petition can encompass a number of tax years or periods. For example, a deficiency case might involve 3 taxable years where the amount of the tax deficiency in dispute is $40,000 per year. Such a case would be eligible for small tax case treatment because the amount of the deficiency placed in dispute does not exceed “$50,000 for any one taxable year”. Sec. 7463(a)(1). However, a section 6330 collection case is not a

4 Sec. 6330(d) was amended by the Pension Protection Act of 2006, Pub. L. 109-280, sec. 855(a), 120 Stat. 1019, for determinations made after the date which is 60 days after Aug. 17, 2006. As a result, the amendment eliminated subsec. (d)(1)(A). However, the reference to subsec. (d)(1)(A) in sec. 7463(f)(2) was not changed. The amendment does not affect this case because the determination was made on Jan. 3, 2006.

case for “redetermination of a deficiency”.5 Rather, a section

6330 collection case deals with the propriety of collecting tax

that has already been assessed. Because, as in this case, the

tax has already been assessed when the section 6330 collection

procedures are initiated, there is no deficiency in existence

when the proposed collection action is initiated.6

5 Sec. 6211(a), Definition of a Deficiency, provides:

SEC. 6211(a). In General.–For purposes of this title in the case of income, estate, and gift taxes imposed by subtitles A and B and excise taxes imposed by chapters 41, 42, 43, and 44 the term “deficiency” means the amount by which the tax imposed by subtitle A or B, or chapter 41, 42, 43, or 44 exceeds the excess of–

- -

-

-

(2) the amount of rebates, as defined insubsection (b)(2), made.

Sec. 6213 generally requires the issuance of a notice of deficiency before assessment and collection of a deficiency. Sec. 6213 allows taxpayers to petition this Court in order to contest the Commissioner’s deficiency determination. If they do so, assessment is generally prohibited before the Tax Court’s decision becomes final. These cases are what we refer to as deficiency cases.

6 In certain limited circumstances, the “underlying (continued…)

Congress obviously recognized that section 7463(a) failed to

encompass section 6330 collection cases when it enacted section

7463(f) to clarify that a section 6330 collection case can be

litigated as a small tax case.7 However, in section 7463(f),

Congress provided an articulation of the $50,000 limit for

section 6330 collection cases that was different from that

expressed in section 7463(a) for deficiency cases. Section

7463(f) provides for the availability of the small tax case

procedures in a section 6330 collection case challenging “a

determination in which the unpaid tax does not exceed $50,000.”

The “determination” being appealed to the Tax Court referenced in

section 7463(f) is the same determination referenced in section

6330(c) and (d). In the instant case, the determination is that

6(…continued) liability” can be placed in issue in a sec. 6330 collection case. See sec. 6330(c)(2)(B). However, the underlying liability is not a deficiency, and a sec. 6330 collection case is not a case for the redetermination of a deficiency within the meaning of sec. 7463(a). This is why Congress added sec. 7463(f). Petitioners have not attempted to contest the underlying liability in this case.

7 In enacting sec. 7463(f), Congress also recognized the distinction between deficiency cases within the purview of sec. 7463(a) and cases petitioned under sec. 6015(e), in which taxpayers seek relief only from joint liability. Cases brought under sec. 6015(e) have become known as “stand alone” cases because only the right to spousal relief is in issue. See Fernandez v. Commissioner, 114 T.C. 324, 329 (2000). Similarly, Congress has authorized the use of small tax case procedures in employment tax cases “if the amount of employment taxes placed in dispute is $50,000 or less for each calendar quarter involved.” Sec. 7436(c).

of an Appeals officer to proceed with collection by levy with respect to petitioners’ 1997 through 2003 unpaid income tax liabilities, which total more than $150,000. The “case” referred to in section 7463(f) is the case before us in which petitioners are disputing respondent’s determination to collect the unpaid tax. Unlike the dollar limitation in section 7463(a) that refers to tax dollars in dispute for each year, period, or taxable event, the limitation in section 7463(f)(2) refers to the amount of unpaid tax involved in a section 6330 collection case. The unpaid tax in the instant case far exceeds that $50,000 limitation.

Respondent argues: While section 7463(f)(2) may on its face appear to suggest that the Court should consider the entire unpaid balance of tax in determining whether the unpaid tax exceeds $50,000.00, section 7463(f) provides, in pertinent part, “… proceedings may be conducted under this section (in the same manner as a case described in

subsection (a))”. From this respondent concludes that the dollar limit in section 7463(f)(2) should be applied on a per-year basis as in deficiency cases controlled by section 7463(a). The problem with this argument is that it is contrary to the plain meaning of the language in section 7463(f)(2). The dollar limit is clearly expressed in terms of the “case” of “an appeal * * * to the Tax Court of a determination in which the unpaid tax does not exceed $50,000.” The dollar limit refers to the amount of unpaid tax the collection of which is being challenged. The dollar limit in section 7463(f)(2) is a condition that must be met before a section 6330 collection case can qualify to be conducted as a small tax case in the same manner as a case described in subsection (a). If Congress had intended that the $50,000 limitation in subsection (f)(2) be applied to the amount of tax for each year, period, or taxable event, it surely knew how to do so; and it presumably would have used the same terminology as in

section 7463(a).8

In interpreting a statute, our purpose is to give effect to Congress’s intent. Fernandez v. Commissioner, 114 T.C. 324, 329 (2000); see also Gati v. Commissioner, 113 T.C. 132, 133 (1999). We begin with the statutory language. Allen v. Commissioner, 118

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8 Sec. 7436, dealing with employment taxes, contains language similar to that of sec. 7463(a); i.e., the tax may not exceed $50,000 for each quarter in order for the case to qualify for small tax case procedures. See supra note 7.

Commissioner, 83 T.C. 742, 747-748 (1984). If the statute is ambiguous or silent, we may look to the statute’s legislative history to determine congressional intent. Burlington N. R.R. v. Okla. Tax Commn., 481 U.S. 454, 461 (1987); Fernandez v. Commissioner, supra at 329-330.

As indicated, we believe that the relevant statutory language is clear. Neither party has cited any legislative history that is inconsistent with the plain language of the statute and we have found none. The parties have not argued that a literal application of section 7463(f)(2) produces an absurd result, and it is certainly not unreasonable for Congress to have articulated different dollar thresholds for different types of cases. Indeed, before the enactment of section 7463(f) in December 2000, there was no provision for using the small tax case procedure in section 6330 collection cases. We therefore hold that the $50,000 limit in section 7463(f)(2) refers to the total amount of unpaid tax which the Commissioner has determined to collect. The fact that the unpaid tax for each year, period, or taxable event does not exceed $50,000 is irrelevant.9

As previously indicated, a trial in this case has already been conducted. Ideally, removal of the small tax case designation should occur before trial. See Rule 171(c).

9 We express no opinion on the application of the dollar limit contained in sec. 7463(f)(1) regarding cases under sec. 6015(e).

However, Congress foresaw the possibility that the parties and

the Court might, at any time prior to entry of decision, discover

that the relevant amount of tax exceeds the applicable

jurisdictional amount. Section 7463(d) thus provides:

SEC. 7463(d). Discontinuance of Proceedings.–At any time before a decision entered in a case in which the proceedings are conducted under this section becomes final, the taxpayer or the Secretary may request that further proceedings under this section in such case be discontinued. The Tax Court, or the division thereof hearing such case, may, if it finds that (1) there are reasonable grounds for believing that the amount of the deficiency placed in dispute, or the amount of an overpayment, exceeds the applicable jurisdictional amount described in subsection (a), and (2) the amount of such excess is large enough tojustify granting such request, discontinue further proceedings in such case under this section. Upon any such discontinuance, proceedings in such case shall be conducted in the same manner as cases to which the provisions of sections 6214(a) and 6512(b) apply.

Section 7463(d) was enacted prior to section 7463(f) and does not

reference section 6330 collection cases. Nevertheless, the

procedures for discontinuance of small tax case proceedings

contained in section 7463(d) apply to “a case in which the

proceedings are conducted under this section”. Since it is now

apparent that this case does not qualify for small tax case

treatment under section 7463, section 7463(d) provides a logical

remedy.10

10 Sec. 7436(c) provides for availability of sec. 7463 small tax case procedures in employment tax cases where the amount in dispute is $50,000 or less for each calendar quarter and provides for use of the discontinuance procedures in sec. 7463(d). Sec.

(continued…)

The unpaid tax in this case is more than three times the $50,000 limit provided in section 7463(f)(2). We have therefore removed the small tax case designation and discontinued the proceedings under section 7463. We will take appropriate action so that proceedings in this case will be conducted in conformity with procedures applicable to section 6330 collection cases that are not designated as small tax cases under section 7463.

An appropriate order will be issued.

10(…continued) 7436(c)(3) provides: “Rules similar to the rules of the last sentence of subsection (a), and subsections (c), (d), and (e), of section 7463 shall apply to proceedings conducted under this subsection.”

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February 14th, 2007 | 1 Comment »

Jones v. Commissioner, T.C. Summary Opinion 2007-21 (2007).

T.C. Summary Opinion 2007-21

UNITED STATES TAX COURT

ANDREW LENARD JONES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 18523-05S. Filed February 12, 2007.

Andrew Lenard Jones, pro se.

Ashley F. Giles, for respondent.

POWELL, Special Trial Judge: This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect at the time the petition was filed.1 The decision to be entered is not reviewable by any other court, and this opinion should not be cited as authority.

Unless otherwise indicated, subsequent section references are to the Internal Revenue Code in effect for the year in issue.

- 2 Respondent determined a deficiency of $2,214 and an accuracy-related penalty under section 6662(a) of $442.80 in petitioner’s 2002 Federal income tax. At the time the petition was filed, petitioner resided in Covington, Georgia. The relevant facts may be summarized as follows. During 2002, petitioner was employed full-time at an airport in Atlanta, Georgia. For approximately 15 years, petitioner owned a so-called “dirt” motorcycle or bike. In 2001, he sold the dirt bike and on May 15, 2002, purchased a so-called “street” motorcycle or bike for $9,490. On May 6, 2002, prior to purchasing the street bike, petitioner completed an Introduction to Motorcycle Riding course provided at the Atlanta Motorcycle Schools. Petitioner alleges that in 2002 he was engaged in the business of providing motorcycle lessons to other parties. Petitioner allegedly operated the business, Safe Cycle, as a sole proprietorship. On Schedule C, Profit or Loss From Business, of his 2002 return petitioner reported income of $425 received from two alleged clients and claimed deductions totaling $8,621 as follows: Car & truck expenses $1,721 Advertising 50 Depreciation 5,472 Office expense 75 Supplies 104 Other expenses 1,199

The “other expenses” include $550 for Internet service. However, Safe Cycle did not have a Web page. Petitioner did not obtain a

business license, liability insurance, or a bank account for Safe Cycle. Petitioner did not “do any kind of financial analysis”, nor did he prepare a budget for the motorcycle activity. He “just shoestringed it.” Respondent disallowed the claimed deductions.

Petitioner’s 2002 tax return was prepared by “My Tax Man, Inc.”, which was organized and operated by Daniel Gleason. Mr. Gleason was subsequently enjoined from promoting, marketing, or selling fraudulent tax schemes by a Federal District Court. Petitioner had discovered Mr. Gleason through an advertisment.

Discussion

A. Business Activity

Section 162(a) allows a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. Petitioner claims to be in the trade or business of providing motorcycle lessons, and we are, therefore, faced with the initial question whether he is in a trade or business within the meaning of section 162. In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the Supreme Court held that “if one’s * * * activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business”.

Furthermore, generally, under section 183(a) and (b) an individual is not allowed deductions attributable to an activity “not engaged in for profit” except to the extent of gross income generated by the activity. Section 183(c) defines an activity “not engaged in for profit” as any activity other than one for which deductions are “allowable * * * under section 162 or under paragraph (1) or (2) of section 212.” Essentially the test for determining whether an activity is engaged in for profit is whether the taxpayer engages in the activity with the primary objective of making a profit. See Antonides v. Commissioner, 893 F.2d 656, 659 (4th Cir. 1990), affg. 91 T.C. 686 (1988). Although the expectation need not be reasonable, the expectation must be bona fide. See Hulter v. Commissioner, 91 T.C. 371, 393 (1988). Furthermore, in resolving the question, greater weight is given to the objective facts than to the taxpayer’s statement of intentions. See Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256 (4th Cir. 1986).

Section 1.183-2(b), Income Tax Regs., contains a nonexclusive list of factors to be used in determining whether an activity is engaged in for profit. These factors are: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on similar or dissimilar activities; (6) the history of income or losses with respect to the activity; (7) the amount of occasional profit, if any; (8) the financial status of the taxpayer; and (9) any elements of personal pleasure or recreation. No single factor, nor simple numerical majority of factors, is controlling. See Cannon v. Commissioner, 949 F.2d 345, 350 (10th Cir. 1991), affg. T.C. Memo. 1990-148.

Petitioner presented little evidence concerning many of the factors contained in the regulations.2 We, therefore, focus on the factors that form our decision.

What concerns us most is the lack of any financial planning whatsoever. Petitioner “had basically faith” in his belief that he would make a profit. Moreover, there is nothing in the record to reasonably suggest that the activity, as petitioner operated it during the year in question, would ever be profitable. He may have had a written business plan, but a plan without any financial data would have been useless.

Furthermore, there is little to distinguish the personal aspects of the activity from the business aspects. Petitioner had no business license, no business insurance, no business bank account, and no books of accounts that one would generally associate with a trade or business. We also note that most of

Petitioner does not argue, nor does the record establish, that petitioner satisfied the requirements of sec. 7491(a).

petitioner’s expenditures (helmet, jacket, etc.) would relate to a hobby as well as a business activity.

In sum, we do not find that petitioner’s motorcycle activity constituted a trade or business entered into for profit.

B. Negligence

Section 6662(a) provides that, if the section applies, there is imposed a penalty in an amount equal to 20 percent of the portion of the underpayment. The penalty applies, inter alia, to an underpayment due to negligence or disregard of the rules or regulations. Sec. 6662(b)(1). The term “disregard” includes “any careless, reckless, or intentional disregard.” Sec. 6662(c). Negligence includes “any failure to make a reasonable attempt to comply”. Id.

We focus on whether petitioner was negligent in deducting expenses of his motorcycle activity on his tax return. Petitioner launched into this activity with little, if any, experience in running a business to teach others to operate motorcycles. He had no financial idea of how he could get customers in sufficient number to meet the expenses of starting and operating such a business, and he maintained no meaningful records. Petitioner used a tax return preparer, but there is no indication that the return preparer was competent. On the other hand, petitioner had ridden motorcycles for many years as a hobby, albeit perhaps of a different nature. Petitioner has not satisfied the Court that profit, rather than hobby, was the motive for his expenditures.3 We sustain respondent’s determination under section 6662(a).

Reviewed and adopted as the report of the Small Tax Case Division. Decision will be entered for respondent.

Respondent has established his burden of production under sec. 7491(c).

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February 12th, 2007 | 1 Comment »

Yilmaz, Inc. v. Director, 2007 N.J. Super. LEXIS 32 (2007).

2007 N.J. Super. LEXIS 32,*

YILMAZ, INC., Plaintiff-Appellant, v. DIRECTOR, DIVISION OF TAXATION, Defendant-Respondent.

DOCKET NO. A-0080-05T5

SUPERIOR COURT OF NEW JERSEY, APPELLATE DIVISION

2007 N.J. Super. LEXIS 32

 November 8, 2006, Argued

 February 2, 2007, Decided

SUBSEQUENT HISTORY:    [*1]  Approved For Publication February 2, 2007.

PRIOR HISTORY:   On appeal from the Tax Court of New Jersey, Docket No. 240-2003, whose decision is reported at 22 N.J. Tax 204 (Tax 2005).

DISPOSITION:   Affirmed.

COUNSEL:   Todd W. Heck argued the cause for appellant (Basile & Testa, attorneys; Mr. Heck, on the brief).
 
Michael J. Duffy, Deputy Attorney General, argued the cause for respondent (Stuart Rabner, Attorney General, attorney; Patrick DeAlmeida, Assistant Attorney General, of counsel; Mr. Duffy, on the brief).

JUDGES:   Before Judges Axelrad, R.B. Coleman and Gilroy. The opinion of the court was delivered by AXELRAD, J.T.C. (temporarily assigned).

OPINION BY:   AXELRAD

OPINION:   The opinion of the court was delivered by AXELRAD, J.T.C. (temporarily assigned).

This case presents the novel issue of the standard of proof necessary to overcome the presumed correctness of the Director, Division of Taxation’s (”Director’s”) state tax assessments based on an audit of a cash business, involving only factual issues and the methods employed by the Director. In a reported opinion, the Tax Court judge applied the standard utilized in local property tax cases, Pantasote Co. v. City of Passaic, 100 N.J. 408, 413, 495 A.2d 1308 (1985),  [*2]  i.e., cogent evidence that is “definite, positive and certain in quality and quantity to overcome the presumption” of correctness of the assessment. Yilmaz, Inc., v. Dir., Div. of Taxation, 22 N.J. Tax 204, 236 (Tax 2005). We affirm.

The following facts were adduced during the three-day trial before Judge Menyuk. Plaintiff Yilmaz, Inc. operated a restaurant and bar known as the Bridgewater Pub. In March 1999, the Division commenced an audit of plaintiff’s business. Plaintiff had virtually no record of its receipts for the 1995 through 1998 audit period as required by statute from which to verify the gross receipts reported on its tax returns; it did not retain cash register receipts, did not use guest checks and did not maintain summary records of sales. n1 Accordingly, the Director’s auditor used an indirect “markup” procedure to reconstruct the income and receipts of plaintiff’s cash business and determine the sales tax assessment and deficiency and resulting increases in the corporate business tax (CBT) and gross income tax (GIT) withholding assessments. Under this methodology, the auditor selects a test period, which in this case was the calendar year 1997. The  [*3]  auditor then compared the cost of goods sold by plaintiff for that period, as developed from invoices and the records of suppliers, to the menu prices, developing a ratio of selling price to cost, or “markup.” The auditor then applied that ratio to the cost of purchases for each year covered by the audit to arrive at an estimate of gross receipts subject to sales tax for the audit period. n2

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n1 See N.J.S.A. 54:32B-16 (requiring records of sales to be retained for examination and inspection by the Division for a three-year period from the filing of the return, or longer if required by the Director); N.J.A.C. 18:24-2.3(a)(requiring the retention of cash register tapes for three years, amended effective June 1, 1998 to require a four-year retention period, 30 N.J.R. 2070(b)(June 2, 1998)); N.J.A.C. 18:24-2.4(a), (b)(permitting cash register tapes to be discarded after a certain period where summary records of sales are maintained; the summary records must be retained for four years).

n2 In developing his markup ratio, the auditor reduced plaintiff’s audited gross receipts by various allowances for discounts, giveaways and specials.
 

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Using the gross sales determined from his markup analysis, the auditor computed a sales tax deficiency and recomputed plaintiff’s CBT for 1995, 1996 and 1997 and computed the tax for 1998 because no return had been filed for that year, and made assessments for all of the audit years. He also made an assessment of additional GIT (withholding) based on his calculation of adjusted employee wages and estimated salary attributed to Mr. Yilmaz in the absence of any documentation or evidence presented by plaintiff to support the information reported on the returns. On August 21, 2001, the Director issued a notice of assessment related to the final audit determination.

Following a protest and conference hearing, the overall markup ratio was reduced slightly and the tax assessments were reduced. Plaintiff appealed to the Tax Court, contending the Director utilized unreasonable and arbitrary assumptions in the markup analysis and failed to account for inventories it maintained. The Director contended plaintiff’s records were wholly deficient, and the State auditor’s assumptions were reasonable in light of the inadequacy of records or other evidence to support plaintiff’s claims. Judge Menyuk  [*5]  affirmed the Director’s final determination, assessing deficiencies of sales tax, N.J.S.A. 54:32B-1 to -29, and corporate business tax, N.J.S.A. 54:10A-1 to -41, for the January 1, 1995 through December 31, 1998 audit period; and gross income tax (withholding), N.J.S.A. 54A:7-1 to -7, for the January 1, 1996 through December 31, 1998 audit period. On August 11, 2005, the court entered an order for judgment against plaintiff in the amount of $ 129,531.78.

On appeal, plaintiff argues the Tax Court erred in: (1) establishing as the burden of proof that it had to present “cogent evidence that must be ‘definite, positive and certain’” in order to overcome the presumption of correctness attaching to the assessments; (2) excluding evidence regarding the markup factor used in an audit conducted subsequent to the one at issue; (3) rejecting the testimony of its accountant as not credible; and (4) failing to recognize alleged inherent flaws and wholly arbitrary assumptions in the State auditor’s markup methodology and calculations. We are not persuaded by any of these arguments and affirm substantially  [*6]  for the reasons articulated by Judge Menyuk in her cogent and comprehensive written opinion. We add the following comments regarding the court’s adoption of the Pantasote standard to state tax assessments.

As appropriately defined by the court, the principal issue at trial was the “reasonableness of the methods employed by the Director for an audit period where the plaintiff had virtually no records of its receipts.” Yilmaz, supra, 22 N.J. Tax at 230. The Tax Court began its analysis with the well settled principle that the Director’s assessments of tax are presumed to be correct and the plaintiff has the burden of overcoming the presumption. Id. at 231 (citing Atlantic City Transp. Co. v. Dir., Div. of Taxation, 12 N.J. 130, 146, 95 A.2d 895 (1953) (other citations omitted)). The cases have recognized that the “naked assertions” of the taxpayer, without supporting records or documentation, are insufficient to rebut the Director’s presumption. See ibid.; TAS Lakewood, Inc. v. Dir., Div. of Taxation, 19 N.J. Tax 131, 140 (Tax 2000); Ridolfi v. Dir., Div. of Taxation, 1 N.J. Tax 198, 202-03 (Tax 1980).  [*7]  The court noted, however, that the extent of the burden of proof placed on the taxpayer to overcome the presumption was ill-defined, and the case law needed a specific, workable standard.

Judge Menyuk articulated a logical and viable standard, supported by case law and consistent with the state tax reporting and recordkeeping statutes, which we expressly endorse. Taking guidance from our Supreme Court’s reference to local property tax case law in Atlantic City Transportation Company, supra, the Tax Court adopted the standard applied in local property taxation, as it was a “reasonable and practical one.” Yilmaz, supra, 22 N.J. Tax at 236. The Tax Court held that when a taxpayer challenges an assessment by the Director based on an audit of a cash business, involving only factual issues and the methods employed by the Director, the taxpayer can rebut the presumption that the assessment is correct only by cogent evidence that is “definite, positive and certain in quality and quantity to overcome the presumption.” Pantasote, supra, 100 N.J. at 413 (quoting Aetna Life Ins. Co. v. City of Newark, 10 N.J. 99, 105, 89 A.2d 385 (1952)).  [*8] 

In the absence of evidence that the amount of the assessment is “far wide of the mark,” the taxpayer cannot overcome the presumption simply by attacking the Director’s methodology. Id. at 414-15. As the court noted, the Director is given broad authority to determine the tax from any available information and, if necessary, to estimate the tax from external indices. See N.J.S.A. 54:32B-19; Ridolfi, supra, 1 N.J. Tax at 203. The court appropriately rejected plaintiff’s suggestion that the onus should be on the Director to establish that it used “the most reasonable means available” or “the best possible method” to estimate the taxpayer’s receipts. The court reasoned that it would be contrary to the purpose of the recordkeeping statute to place such a high burden and expense on the Director when it was plaintiff’s own failure to maintain proper records that “forced the Director to resort to the markup method in the first place.” Yilmaz, supra, 22 N.J. Tax at 235-36. Looking to another local property tax case, which provided for a limited hearing where a taxpayer failed to comply with a statute that required  [*9]  it to provide financial information to a taxing district, the Tax Court elaborated upon the extent of evidence required to satisfy the burden of proof:

[The taxpayer’s] evidence must focus on the reasonableness of the underlying data used by the Director and the reasonableness of the methodology used. An “aberrant” methodology will overcome the presumption of correctness. An imperfect methodology will not.
 
[Yilmaz, supra, 22 N.J. Tax at 236 (citing Ocean Pines, Ltd. v. Borough of Point Pleasant, 112 N.J. 1, 11-12, 547 A.2d 691 (1988)).]
Contrary to plaintiff’s assertion, utilization of the Pantasote standard is not a wholesale change of the burden of proof. The burden has always been on the taxpayer to rebut the presumed correctness of the Director’s assessment by competent evidence. Now there is a viable articulated standard as to the type of evidence required to be produced by the taxpayer. It is logical and consistent with case law and the purpose of the recordkeeping statute to hold a taxpayer who does not maintain business records as required by law to a higher standard, particularly for assessment of a “trust fund  [*10]  tax.” n3

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n3 Under N.J.S.A. 54:32B-12(a), the vendor collects the sales tax from its customers and holds it in trust until it is reported and turned over to the State. GIT, which is required to be withheld by the employer, is also a trust fund tax. N.J.S.A. 54A:7-5.
 

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Plaintiff argues the Tax Court’s decision places it in a “Catch-22″ position in that, without adequate records, it can never overcome the Pantasote presumption. We disagree. There is nothing to prevent a taxpayer from producing competent independent evidence, expert or otherwise, to challenge that presented by the Director and demonstrate that the Director’s methodology was aberrant or the amount of the assessment was far wide of the mark. Moreover, a taxpayer can produce evidence through cross-examination of the auditor that is sufficient to overcome the presumed correctness of the Director’s assessment and to establish that the sales tax assessment should be reduced. Charley O’s,  [*11]  Inc., t/a Scotty’s Steakhouse v. Director, Division of Taxation, 23 N.J. Tax 171, 172 (Tax 2006). Citing Yilmaz, supra, 22 N.J. Tax at 236, the Tax Court found the Director’s methodology to be “aberrant and not merely imperfect.” Charley O’s, supra, 23 N.J. Tax at 186. Recognizing the Director had the authority to use the markup method, the court found he did not have the authority to adopt the gross receipts reported on the taxpayer’s CBT returns over the gross receipts reported on the sales tax returns “merely because it was more convenient to do so or because the use of the gross receipts reported on the CBT return produced a larger sales tax liability.” Ibid. Additionally, and most critical to the court’s determination, was that the auditor was directed to stop his markup analysis before it was complete and to arbitrarily increase the taxpayer’s purchases which, when multiplied by the markup ratio, would equal the gross receipts reported on the CBT returns. Ibid. In fact, the court noted that had the auditor been permitted by his superior to complete his markup analysis, “it would have been difficult to find fault”  [*12]  with the Director’s methodology. Id. at 188.

In the present case, after adopting the Pantasote standard, Judge Menyuk made evidentiary rulings, credibility assessments, and set forth detailed factual findings. The court found the Director’s documentary evidence to be more credible than plaintiff’s naked assertions, concluding that plaintiff failed to meet its Pantasote burden. Judge Menyuk was satisfied the circumstances of the audit warranted the use of the markup method to estimate plaintiff’s gross receipts and the data and methodology used by the Director were reasonable in light of what was available. The Tax Court also found the adjustments for gross receipts for CBT purposes made by the State auditor were consistent with the findings of the markup analysis.

The scope of appellate review from a Tax Court determination is the same as that applicable to a non-jury determination of any other trial court. 125 Monitor St. v. Jersey City, 23 N.J. Tax 9, 13 (App. Div. 2005). “As a general rule, admission or exclusion of proffered evidence is within the discretion of the trial judge whose ruling is not disturbed unless there is a clear abuse  [*13]  of discretion.” Dinter v. Sears, Roebuck & Co., 252 N.J. Super. 84, 92, 599 A.2d 528 (App. Div. 1991); see also Purdy v. Nationwide Mutual Ins. Co., 184 N.J. Super. 123, 130, 445 A.2d 424 (App. Div. 1982). Moreover, “‘judges presiding in the Tax Court have special expertise; for that reason their findings will not be disturbed unless they are plainly arbitrary or there is a lack of substantial evidence to support them.’” Alpine Country Club v. Bor. of Demarest, 354 N.J. Super. 387, 390, 807 A.2d 257 (App. Div. 2002)(quoting Glenpointe Assoc. v. Township of Teaneck, 241 N.J. Super. 37, 46, 574 A.2d 459 (App. Div.), certif. denied, 122 N.J. 391 (1990)). Our scope of review “is limited to determining whether the findings of fact are supported by substantial credible evidence with due regard to the Tax Court’s expertise and ability to judge credibility.” First Republic Corp. of Am. v. Borough of E. Newark, 17 N.J. Tax 531, 536-37 (App. Div. 1998)(citations omitted), certif. denied, 157 N.J. 647 (1999). Other than plaintiff’s challenge to the extension of the Pantasote  [*14]  standard to state tax assessments, its arguments on appeal are attacks on the trial court’s credibility determinations and the weight of the evidence. We are not persuaded that any of the factual findings or discretionary rulings challenged by plaintiff are arbitrary or unsupported by the evidence, and thus discern no basis to disturb them. R. 2:11-3(e)(1)(A), (E).

Affirmed.

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February 3rd, 2007 | No Comments »