The Tax Court in Brief – May 23rd – May 27th, 2022
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
Tax Litigation: The Week of May 23rd, 2022, through May 27th, 2022
Genecure, LLC v. Comm’r, T.C. Memo 2022-52 | May 23, 2022 | Jones, J. | Dkt. No. 14916-15.
Short Summary: This is a TEFRA partnership-level case. Genecure is a biotech firm and is organized as a member-managed LLC. It is treated as a partnership for federal income tax purposes. See Treas. Reg. § 301.7701-3(b)(1). Frank Tung was Genecure’s tax matters partner. The opinion addresses a number of splintered issues that arose from Genecure’s business transactions in tax years 2009-2012, including taxation of settlement proceeds received in contract dispute, deductibility of item-by-item categories of business expenses, recapture tax for an Affordable Care Act-Qualified Therapeutic Discovery Project (QTDP) grant received by Genecure, characterization of amounts received from an LLC owned by Frank Tung’s wife (i.e., is it a loan, or not a loan), and possible capital contributions from the LLC owned by Frank Tung’s wife. The IRS examined Genecure’s tax returns for years 2009 through 2012. The examining agent prepared a Form 11661, Fraud Development Recommendation-Examination, and Frank Tung was given summary report transmittal Letter 1807 to attend a closing conference, which conference never occurred. Ultimately, the IRS issued Frank Tung, in his capacity as tax matters partner, a separate Notices of Final Partnership Administrative Adjustment (FPAA) for each of the years in issue, as well as a section 6663 civil fraud penalty for underpayment of tax for each year. In the Tax Court proceeding, Frank Tung sought to admit emails, letters, and other documentation from Genecure’s day-to-day business, most of which the Tax Court refused to admit or consider.
- Whether Genecure carried its burden of proof to overcome the presumption of correctness of the IRS’s determinations? Whether the IRS complied with the initial determination requirements to assess fraud-related penalties against Genecure?
- The Tax Court found primarily in favor of the IRS on all tax issues. Frank Tung’s testimony was self-serving, evasive, conflicted, and improbable with respect to his position on the issues. His purported evidence was not in admissible form, and he provided no exceptions to applicable exclusionary rules. Settlement proceeds received constituted gross income that was taxable, and most of the itemized business expenses were not deductible due to lack of substantiation or business purpose. Genecure was subject to a recapture tax for the excess QTDP grant. And, in the absence of any credible and commercially reasonable evidence, a $200,000 payment from Frank Tung’s wife was not a loan for rent and there was no evidence of any capital contribution in the year claimed.
- As for the fraud-related penalties, the IRS Civil Penalty Approval Form and its Form 11661 did not satisfy the written supervisory approval requirements for purposes of assessing section 6663 civil fraud penalties; therefore, such penalties were inapplicable against Genecure at the partnership level.
Key Points of Law:
- Evidentiary Issues. Tax Court evidentiary rulings are determined under the Federal Rules of Evidence. See 7453; Rule 143(a). Irrelevant evidence is not admissible. See Fed. R. Evid. 402. An item of evidence is relevant to the extent it tends to make a fact more or less probable and such fact is consequential to determining the action. See Fed. R. Evid. 401. Hearsay evidence is inadmissible unless another provision of the rules or law provides otherwise. See Fed. R. Evid. 802, 803, 804. Hearsay is an out-of-court statement offered to prove the truth of the matter asserted. See Fed. R. Evid. 801(c).
- Burdens of Proof. The adjustments rendered in an FPAA bear a presumption of correctness, and the taxpayer generally bears the burden of proving erroneous the adjustments at issue. See, e.g., Welch v. Helvering, 290 U.S. 111, 115 (1933); Rule 142(a)(1). The IRS does not bear the burden of production with respect to penalties in a partnership-level proceeding. See 7491(c); Dynamo Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 236 (2018). The IRS must produce some minimal evidentiary foundation. See Blohm v. Commissioner, 994 F.2d 1542, 1548–49 (11th Cir. 1993). For example, a bank deposit presented by the IRS is prima facie evidence of income to a taxpayer. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
- Evaluation of Witness. The Tax Court observes the truthfulness, sincerity, and demeanor of each witness to evaluate his or her testimony. The Court assigns weight to that testimony for the purpose of finding disputed facts based on the record as a whole. In the light of that testimony, the Court weighs the evidence, makes appropriate inferences, and finds what the Court believe to be the truth. The Court is “careful to avoid making the courtroom a haven for the skillful liar . . .” Garavaglia v. Commissioner, T.C. Memo. 2011-228.
- Unreported Income. Gross income means all income from whatever source derived unless specifically excluded by another provision of the Code. It includes gross income derived from business. § 61(a)(2). To the extent a given amount does not fall within a statutorily enumerated category of gross income, gross income is construed broadly. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Settlement proceeds that do not otherwise satisfy an exclusionary provision constitute gross income. See George v. Commissioner, T.C. Memo. 2016-156, at *5–6, *10.
- Business Expense Deductions. Section 162(a) permits a deduction for ordinary and necessary expenses paid to carry on a trade or business during the taxable year. An expense is ordinary if it is normal or customary within the particular trade, business, or industry of the taxpayer. See Welch v. Helvering, 290 U.S. at 114. An expense is necessary if it is appropriate and helpful. at 113. Section 174(a) permits a taxpayer to deduct research and experimental expenses paid in connection with his trade or business. Deductions are a matter of legislative grace, and the taxpayer bears the burden of clearly showing his entitlement to any deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Higbee v. Commissioner, 116 T.C. 438, 440 (2001); § 6001. Expenses for travel (including meals and lodging) and expenses with respect to any listed property under section 280F(d)(4) are subject to heightened burden of proof for deductibility. See § 274(d)(1), (4). No deduction is permitted for personal, living, or family expenses unless expressly permitted under the Code. See § 262(a).
- Rent Expenses. A rental expense paid for property used in a trade or business is deductible as an ordinary and necessary business expense. § 162(a)(3). A cash method taxpayer may only deduct an expense that is actually paid during the taxable year. See Saviano v. Commissioner, 80 T.C. 955, 964 (1983), aff’d, 765 F.2d 643 (7th Cir. 1985); Treas. Reg. § 1.461- 1(a)(1)), 1.446-1(c)(1)(i). A rental expense paid with a promissory note executed in lieu of cash payment may be deducted only when the note is satisfied. See Helvering v. Price, 309 U.S. 409, 413 (1940).
- Legal Expenses. A capital expenditure may not be deducted for the taxable year in which it is paid, notwithstanding the fact that it may otherwise be an ordinary and necessary expense paid to carry on a trade or business. See§ 161, 263(a). A capital expense is one that either (1) creates or enhances a separate and distinct asset or (2) otherwise generates significant benefits beyond the taxable year. See Mylan, Inc. & Subs. v. Commissioner, 156 T.C. 137, 149 (2021). “A taxpayer must capitalize amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade name, copyright, . . . or other similar right granted by that governmental agency.” See Treas. Reg. § 1.263(a)-4(d)(5)(i). A “patent” is treated as a “similar right” for these purposes. A taxpayer must capitalize any amounts paid to facilitate the acquisition or creation of such an intangible. See id. § 1.263(a)-4(b)(1)(v), (e)(1)(i). Fees paid for legal services ancillary to the renewal of a patent must also be capitalized. Id. However, if such costs in the aggregate do not exceed $5,000 in a given taxable year, they are deemed de minimis and are not treated as facilitative costs subject to capitalization. See id. § 1.263(a)-4(e)(4)(i), (iii).
- Tax Expenses. Property tax payments may be deducted under section 162(a) to the extent they are ordinary and necessary business expenditures. See Bello v. Commissioner, T.C. Memo. 2001-56, 2001 Tax Ct. Memo LEXIS 72, at *17–19.
- Research and Development Expenses. A taxpayer may “treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account.” § 174(a)(1). Such expenses may be deducted. “[R]esearch and experimental expenditures” are research and development costs in the experimental or laboratory sense and include incidental costs. See Reg. § 1.174-2(a)(1). Amounts which are paid to others for research or experimentation on the taxpayer’s behalf may also be deducted. See Treas. Reg. § 1.174-2(a)(8).
- QTDP Grant Recapture. Section 48D permits taxpayers to claim a credit (or receive a grant in lieu of a credit) equal to 50% of the qualified investment a taxpayer makes with respect to a QTDP in a taxable year beginning in 2009 or 2010. Generally, a “qualified investment” is defined as “the aggregate amount of the costs paid . . . for expenses necessary for and directly related to the conduct of a qualifying therapeutic discovery project.” § 48D(b)(1), (2), and (3). However, the ACA provides for a recapture of excessive grant amounts in the taxable year the grant was actually disbursed. See 9023(e)(5)(B)(i); Silver Med., Inc. v. Commissioner, 147 T.C. 547, 554–56 (2016). A portion of a grant is excess to the extent the qualified investment for which it was awarded (i.e., the amount certified by the IRS upon its review of the participating taxpayer’s Form 8942) was not actually paid. See Wang v. Commissioner, T.C. Memo. 2017-81, at *21–22. Recapture is effected in the form of an increase in federal income tax equal to the excess portion of the grant. See ACA § 9023(e)(5)(A), 124 Stat. at 882.
- Section 6663 Civil Fraud Penalties. Section 6751(b)(1) provides that no penalty, including the penalty under section 6663, may “be assessed [against a taxpayer] unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” In a partnership-level proceeding under TEFRA, section 6751(b)(1) generally requires that written supervisory approval of a penalty determination occur no later than the issuance of the FPAA. See Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152 T.C. 75, 83 (2019). The “initial determination” for purposes of section 6751(b)(1) must reflect, in a formal writing, that the IRS Examination Division “completed its work and made an unequivocal decision to assert penalties.” See Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020). A Letter 1807 generally does not constitute the “initial determination.” Non-compliance with section 6751(b)(1) is treated as an affirmative defense to the section 6663 penalties and must be included in the pleadings or considered tried by consent in the proceeding.
- Jurisdiction. The Tax Court lacks subject matter jurisdiction to determine a partner’s outside basis in a partnership-level proceeding.
Insights: Frank Tung, in a pro se capacity and as tax matters partner for Genecure, sought to admit an array of documentary evidence during the Tax Court proceeding. Due to evidentiary standards and Frank Tung’s failure to provide available exceptions to the rules, his proffered evidence was not admitted. From a substantive tax perspective, Genecure failed to document and substantiate most of the claimed business expenses it sought to deduct in the returns in issue. And, Genecure was negligent in failing to report taxable income such as amounts received in settlement from a business contract dispute. Genecure also claimed deductions and other tax benefits for rent, loans and capital contribution, none of which were properly substantiated. This case is another reminder of the due care the taxpayer must take in documenting all aspects of the business that are relevant for taxation, deductions, and fraud-related assessments or defense purposes.