The Tax Court in Brief – March 7th, 2022 – March 11th, 2022

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Tax Litigation:  The Week of March 7, 2022, through March 11, 2022

Hacker v. Comm’r, T.C. Memo. 2022-16 | March 8, 2022 | Paris, J. | Dkt. No. 3870-12


Short Summary: Taxpayers, Barry Hacker and Celeste Hacker (the Hackers), were sole shareholders and sole officers of Blossom Day Care Centers, Inc. (Blossom), Hacker Corp. (an S corporation), and Hacker Investments, a limited liability company. The IRS examined the Hackers, with a focus on, among other things, unreported cash deposits, income received from Blossom and Hacker Corp., and numerous transactions among and between the Hackers and their companies that were not reported, or that were underreported on the Hackers’ federal tax returns for the five years examined. In a previous proceeding, the IRS examined Blossom, and judicial determinations of that matter affected the resolution of many issues in this case. The focus in this case is the propriety of the IRS’s deficiency findings relating to imputed wages, constructive dividends, corporate spending and credit card abuse, classification of capital expenditures, interest deductions, related-party property transfers, and unexplained deposits, as well as fraud-related penalties assessed against the Hackers.

Primary Holdings:

  • The Court sustained, in substantial part, deficiencies for each of the five years examined. The Court also sustained the determinations of fraud penalties for all years in relation to underreporting of wages, dividends, and unexplained deposits, and the determinations of accuracy-related penalties for all years were sustained to the extent not accounted for in the fraud-related penalties.
  • The Hackers attempted to conceal matters from the IRS, such as by providing vague, misleading, or false statements to the examining agent. Such conduct, coupled with other factors, was sufficient to sustain fraud-related penalties.

Key Points of Law:

  • The Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of showing the determinations are in error. When a case involves unreported income, the Commissioner’s determination of unreported income is entitled to a presumption of correctness only once some substantive evidence is introduced demonstrating that the taxpayer received unreported income.
  • Compensation in the form of money, property, and other direct and indirect benefits is gross income for purposes of federal income tax. See Reg. § 1.61-2(a)(1).
  • Every person subject to income tax is required to maintain books and records to establish the amount of gross income and deductions shown by that person on his or her income tax return. See 26 U.S.C. § 6001; Treas. Reg. § 1.6001-1(a).
  • When a corporation distributes property to a shareholder as a dividend, whether formally or informally, the shareholder must include the distribution in gross income to the extent of the corporation’s earnings and profits. See 26 U.S.C. §§ 301(a), (c)(1), 316. A constructive dividend arises when a corporation confers an economic benefit upon a shareholder without expectation of repayment and the corporation had current or accumulated earnings and profits. Unsubstantiated company credit card use by a shareholder may be classified as income to the shareholder.
  • Bank deposits are prima facie evidence of taxable income of a taxpayer unless the taxpayer can show that the deposits were nontaxable.
  • An S corporation is not subject to federal income tax at the entity level. 26 U.S.C. § 1363(a). The corporation’s income, losses, deductions, and credits are passed through to the shareholders at their pro rata shares. 26 U.S.C. § 1366(a).
  • The basis of property received in a distribution made by a corporation to a shareholder is the fair market value of the property. 26 U.S.C. § 301(d). For a transfer of property to a corporation controlled by the transferor, the transferee corporation’s basis in the transferred property shall be the same as it would be in the hands of the transferor. at § 362(a)(1).
  • Sections 1366 through 1368 govern the tax treatment of S corporation shareholders with respect to their investments in such entities. Section 1368 addresses treatment of distributions. Section 1366(a)(1) provides that a shareholder shall take into account his or her pro rata share of the S corporation’s items of income, loss, deduction, or credit for the S corporation’s taxable year ending with or in the shareholder’s taxable year. The basis of property is the cost of the property. See Reg. § 1.1012-1(a). Basis in S corporation stock is increased by income passed through to the shareholder and decreased by, among other things, distributions not includable in the shareholder’s income; items of loss and deduction passed through to the shareholder; and certain nondeductible, noncapital expenses. See 26 U.S.C. § 1367(a).
  • Generally, partnerships are not subject to federal income tax; items of partnership income, loss, deduction, and credit are reflected on the partners’ individual tax returns. See 26 U.S.C. § 701.
  • Section 162(a) allows as a deduction all ordinary and necessary business expenses paid or incurred in carrying on any activity that constitutes a trade or business. No current deduction is allowed for capital expenditures. See id. at § 263(a). Capital expenditures include amounts paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. See id. at § 263(a)(1).
  • An addition to tax up to 25% is imposed for failure to timely file a federal income tax return unless it is shown that the failure is due to reasonable cause and not due to willful neglect. See id. at § 6651(a)(1).
  • Section 6663(a) imposes a penalty equal to 75% of the taxpayer’s underpayment of federal income tax that is due to fraud. See id. at § 7454(a) (IRS bears the burden of proof). Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading a tax believed to be owing. If any portion of the underpayment is attributable to fraud, the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that part of the underpayment is not due to fraud. Id. at § 6663(b).
  • The Code imposes an accuracy-related penalty equal to 20% of the portion of an underpayment of tax required to be shown on a tax return that is attributable to a “substantial understatement of income tax.” An understatement of income tax is a “substantial understatement” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. See id. at § 6662(a)-(b), (d)(1)(A). Taxpayers may avoid a section 6662(a) penalty if they can show that they had reasonable cause and acted in good faith. at § 6664(c). The accuracy-related penalty does not apply to any portion of an underpayment on which a fraud penalty is imposed. Id. at § 6662(b) (flush language).

Insights:  This case involves numerous issues of mismanagement of the assets of closely held companies and poor accounting practices relating to transactions and property transfers. Abuse of company credit cards, unexplained deposits, and indirect financial benefit from related companies may constitute reportable gross income to the recipient control person or shareholder who benefits in any way from those transactions. Individuals and business entities alike are subject to the substantiation and documentation requirements of the Code and Treasury Regulations. Without proper documentation, the IRS may, by circumstantial evidence, establish accuracy- and even fraud-related penalties, which can be substantial. And, in an IRS examination it is advisable to refrain from providing vague, misleading, or false statements to the examining agent.

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