Can GGE Be Deducted By Non-Owners ?


Oil Drilling

Ever wonder how an oil company knows where to drill underneath the sea to get the maximum results for their investment?

They go through an extensive survey of the surface of seabed. Of course this survey involves expenses. There are IRS guidelines specifically addressing these expenses. These expenses are deducted over a two year period and they are governed under Section 167 specifically under paragraph (h) of the code.

What if a company just performs the survey and then sell these survey to companies who later on drill for the oil? Can these expenses be deduced by this “non drilling” or “non owner” of the oil? To get answer to these questions read more.

In 2006 and 2007, CGG Americas, Inc. (CGGA), a Texas corporation, conducted marine surveys of the outer continental shelf in the Gulf of Mexico. The surveys involved the use of geophysical techniques that detected or suggested the presence of oil and gas in the area surveyed. The data initially generated by the surveys was raw acoustic data. CGGA processed this data to create usable information such as visual representations (including maps) of geological formations in the earth’s subsurface. CGGA licensed the data – i.e., both the raw acoustic data and the information that resulted from processing it – to its customers on a nonexclusive basis for a fee. CGGA’s customers were companies engaged in oil and gas exploration and development. The customers used the data to identify new areas where subsurface conditions were favorable for oil and gas development and production, determine the size and structure of previously identified oil and gas fields, determine how to develop oil and gas reserves and produce oil and gas, determine which oil and gas properties to acquire, and determine where to drill wells.

On its 2006 and 2007 tax returns, CGGA deducted the expenses incurred to conduct the surveys and to process data from the surveys as geological and geophysical expenses. Under Code Sec. 167(h)(1), any geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. (as defined in Code Sec. 638) is allowed as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.

The IRS disallowed the deductions. According to the IRS, CGGA’s survey expenses were not geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the meaning of Code Sec. 167(h). The IRS cited two reasons for disallowing the deduction. First, the IRS argued, the phrase “geological and geophysical expenses” used in Code Sec. 167(h) is a term of art that refers only to expenses incurred by taxpayers that own mineral interests, that is, oil or gas interests. For tax purposes, the IRS said, the phrase refers exclusively to expenses related to the exploration for oil or gas incurred by taxpayers who are exploration and production companies or otherwise owners of mineral interests. Since CGGA did not own any mineral interests, the IRS contended that the survey expenses were not “geological and geophysical expenses” as that term is used in Code Sec. 167(h).

Second, the IRS argued that the survey expenses were not paid or incurred in connection with the exploration for, or development of, oil or gas. An expense is paid or incurred in connection with such exploration or development within the meaning of Code Sec. 167(h), the IRS said, only when paid or incurred in connection with the taxpayer’s own exploration or development, not when paid or incurred by a taxpayer in connection with the exploration or development by other taxpayers (i.e., CGGA’s customers).

The Tax Court rejected the IRS’s arguments and held that CGGA was entitled to deduct the survey expenses under Code Sec. 167(h). With respect to the IRS’s argument that the phrase “geological and geophysical expenses” is restricted to expenses incurred by taxpayers that own mineral interests, the court looked at the various court cases cited by the IRS to support this conclusion. The court found that none of the opinions cited defined a “geophysical expense” as including only an expense incurred by owners of mineral interests.

The court also reviewed three IRS rulings for the same proposition, including two that were referred to in the legislative history of Code Sec. 167(h). One of those, the court noted, had an introductory statement which clarified that the ruling was written to apply only to a particular subset of geological and geophysical exploration expenditures, and the other had an introductory sentence which clarified that the ruling governed only the treatment of geological and geophysical expenditures in a particular situation. As to the one that was not referenced in the legislation, the court rejected the IRS’s interpretation that the ruling implied that geological and geophysical exploration expenses included only expenditures by mineral-interest owners, saying that the ruling did not purport to describe all types of geological and geophysical exploration expenditures.

Do You Play Online Poker ? Read This

Online PockerAre you playing online poker? Well be careful because you may end up paying a lot of tax penalty.

Recently there was a case which cost a lot of tax penalty to the online poker player. The Ninth Circuit partially reversed the penalty but still the balance of penalty were hefty.

Here are the details why the penalty were assessed and which were reversed and why.

During 2006, John Hom gambled online through internet accounts with and Both websites allowed Hom to deposit money or make withdrawals. Hom used an account at, an online organization that receives, holds, and pays funds on behalf of its customers, to fund his online poker accounts. In 2006, FirePay ceased allowing U.S. customers to transfer funds from their accounts to offshore internet gambling sites. In 2007, Hom continued to gamble online through his PokerStars account, and used Western Union and other online financial institutions to transfer money from his bank account to his poker accounts.

At various points in both 2006 and 2007, the aggregate amount of funds in Hom’s FirePay, PokerStars, and PartyPoker accounts exceeded $10,000.

After the IRS detected discrepancies in Hom’s federal income tax returns for 2006 and 2007, it opened a Foreign Bank and Financial Accounts Report (FBAR) examination. Individuals generally must file an FBAR by June 30 to report foreign financial accounts exceeding $10,000 maintained during the previous year. Hom did not file his 2006 or 2007 FBARs until June 26, 2010.

In 2011, the IRS assessed penalties against Hom for failure to submit FBARs regarding his interest in his FirePay, PokerStars, and PartyPoker accounts. The IRS assessed a $30,000 penalty for 2006, which included a $10,000 penalty for each of the three accounts, and a $10,000 penalty for 2007 based solely on Hom’ PokerStars account.

In 2014, a district court upheld the penalties, finding that Hom’s accounts with FirePay, PokerStars, and PartyPoker were reportable because they functioned as institutions engaged in the business of banking, they were located in a foreign country, and each account had an aggregate of $10,000 at some point during the years at issue. Hom then appealed to the Ninth Circuit.

Generally, under 31 CFR Section 103.24, an individual must file an FBAR for a reporting year if:

(1) he or she is a U.S. person;

(2) he or she has a financial interest in, or signature or other authority over, a bank, securities, or other financial account;

(3) the bank, securities, or other financial account is in a foreign country; and

(4) the aggregate amount in the accounts exceeds $10,000 in U.S. currency at any time during the year.

For purposes of the FBAR requirements, “other financial accounts” include a “financial institution,” which is defined under 31 USC 5312(a) as a number of specific types of businesses, including “a commercial bank,” “a private banker,” and “a licensed sender of money or any other person who engages as a business in the transmission of funds.”

The Ninth Circuit determined that Hom’s FirePay account fit within the definition of a “financial institution.” The court noted that FirePay acted as an intermediary between Hom’s bank account and the online poker sites. Hom could carry a balance in his FirePay account, and he could transfer his FirePay funds to either his bank account or his online poker accounts, the court observed. The court also found that FirePay charged fees to transfer funds and as such, it acted as “a licensed sender of money or any other person who engages as a business in the transmission of funds” and therefore qualified as a “financial institution.” In addition, the court noted that Hom’s FirePay account was also “in a foreign country” because it was located in and regulated by the United Kingdom. Accordingly, the court found that the FirePay account required the filing of the FBAR form, and affirmed the penalties for that account

In contrast, the court remarked, Hom’s PokerStars and PartyPoker accounts did not fall within the definition of a “bank, securities, or other financial account.” PartyPoker and PokerStars primarily facilitate online gambling, the court said; Hom could carry a balance on these accounts, and he needed a certain balance in order to “sit” down to a poker game. But, the court said, the funds were used to play poker and the court found no evidence that the accounts served any other financial purpose for Hom.

While the IRS had argued that the poker sites were functioning as banks, the court found that argument lacked support. Noting that neither the statute nor the regulations define “banking,” the court turned to the plain meaning of the term. The Merriam-Webster dictionary, the court observed, defines “bank” as, “an establishment for the custody, loan, exchange, or issue of money, for the extension of credit, and for facilitating the transmission of funds.” The court found there was no evidence that PartyPoker and PokerStars were established for any of those purposes, rather than merely for the purpose

Finding that Hom’s accounts with the online poker sites did not require him to file FBAR forms, the court reversed the penalties imposed for those accounts.

I will not be surprised if IRS takes a stand that these online poker sites are casinos and therefore they are financial institutions. It will be interesting to see how those cases are decided.

If you have any question please call our office at 951-234-5175

Progressive Vs Sudden-The Case of Illusive Casualty Loss

Casulty Loss

One of the most illusive deduction on a tax return is Casualty Loss deduction. Whenever client tells me that he / she had a casualty loss last year – all the system alerts goes up and on. And for a reason. One of the most illusive hurdle that needs to be crossed in claiming a casualty loss is to prove that the loss was sudden and not a progressive deterioration of the property.

May be an actual case of Alohonso which was just decided will help prove my point. The Tax Court held that because the collapse of a retaining wall was due to progressive deterioration that had begun at least 20 years before the wall’s collapse, the owner of a co-op was not entitled to a casualty loss deduction for amounts paid to fix the wall. The court rejected the taxpayer’s argument that the collapse of the wall was due to excessive spring rain which over-stressed a recently installed drainage system and caused rapidly accelerating movement in the wall in the four weeks immediately preceding the collapse.(emphasis added)

Christina Alphonso is a tenant-stockholder of Castle Village Owners Corp., a New York cooperative housing corporation (i.e., co-op). Castle Village owns a tract of land in Manhattan on which five high-rise residential buildings sit. Before May 12, 2005, the grounds near those five Castle Village apartment buildings were supported by a retaining wall of stone masonry construction that had been built between 1921 and 1925. Before May 12, 2005, the retaining wall in question ran parallel to Riverside Drive for approximately 800 feet and had an average height of 65 feet.
In 1985, Castle Village retained an engineer to perform an inspection of the retaining wall. In a letter to Castle Village, the engineer indicated that a portion of the retaining wall showed signs of movement and instability and that several cracks were observed and that relief drains appeared not to function properly. For the next 20 years, various engineering and architectural firms were hired to address issues with the retaining wall. There were two documented times when work was performed either directly on the wall or close to the wall – the installation of rock anchors/bolts in 1986 and drainage modifications beyond the top of the wall in 2004.
On May 12, 2005, a 150-foot portion of the retaining wall collapsed onto Riverside Drive. The various consultants whom Castle Village had retained over the previous 20 years had reported their findings about the retaining wall in numerous letters, reports, proposals, and/or memoranda sent to Castle Village. Most of the major problems in and around the retaining wall that those consultants had observed and described in those respective documents were observed in and around the 150-foot section of the retaining wall that collapsed.
On her 2005 Form 1040, Alphonso reported a casualty loss of $26,390 and, after making reductions required by Code Sec. 165(h)(1) and (2) (relating to the dollar limitation per casualty and the limitation on the deductible amount), she claimed a casualty loss deduction of $23,188. The IRS disallowed the deduction.
Under Code Sec. 165(a), (c) and (h), an individual can deduct losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty. A loss is treated as sustained during the tax year in which the loss occurs, as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such tax year. As defined in Code Sec. 165(c)(3), the term “other casualty” refers to an event that shares characteristics with a fire, storm, or shipwreck. A casualty is an event which is due to a sudden, unexpected, or unusual cause.

In Fay v. Helvering, 120 F.2d 253 (2d Cir. 1941), the Second Circuit held that the progressive deterioration of property through a steadily operating cause is not a casualty. The Tax Court, in Carlson v. Comm’r, T.C. Memo. 1981-702, held that a collapse, even one that occurs suddenly, is not a casualty when the collapse is caused by progressive deterioration. Similarly, in Hoppe v. Comm’r, 42 T.C. 820 (1964), the Tax Court held that a loss that is accelerated by a contributing factor such as rain or wind is not a casualty if the loss is caused by progressive deterioration.
However, in Helstoski v. Comm’r, T.C. Memo. 1990-382, the Tax Court held that the taxpayers sustained a casualty loss when a storm caused a dam to fail, which resulted in damage to the taxpayers’ property and a decrease in the fair market value of the property. The court rejected the IRS’s contention that the cause of the damage was gradual erosion of the earth that occurred over a period of years.

In Alphonso v. Comm’r, 136 T.C. 247 (2011) (Alphonso I), the Tax Court initially denied Alphonso’s casualty loss deduction on the grounds that Alphonso held no property interest in the cooperative’s grounds sufficient to entitle her to the deduction. She appealed to the Second Circuit, arguing that her right to use the grounds and to exclude persons who are not tenants or the guests of tenants, coupled with her obligations as a tenant-stockholder under the cooperative lease, constituted a property interest in the land sufficient to entitle her to the casualty loss deduction. In Alphonso v. Comm’r, 2013 PTC 17 (2d Cir. 2013), the Second Circuit agreed with Alphonso and vacated the Tax Court’s holding and remanded the case back to the Tax Court. According to the Second Circuit, under New York law, Alphonso’s right to use the grounds, shared with other residents of Castle Village and their respective guests but not with anyone else, was a property interest in the grounds.

Alphonso’s Arguments

Before the Tax Court, Alphonso argued that the cause of the collapse of the retaining wall was excessive rainfall during the months of January through May 2005, which overstressed the recently installed drainage system (i.e., the 2004 drainage modifications) and caused rapidly accelerating movement in the wall in the four weeks immediately preceding the collapse. Proceeding from that core contention, Alphonso argued that the Tax Court’s decision in Helstoski supported her position that the collapse of the retaining wall was a casualty within the meaning of Code Sec. 165(c)(3).

Tax Court’s Decision

The Tax Court disagreed with Alphonso and held that the collapse of the retaining wall was not a casualty within the meaning of Code Sec. 165(c)(3) and thus Alphonso was not entitled to a casualty loss deduction. According to the court, the cause of the collapse of the retaining wall was due to a progressive deterioration in and around that wall that had begun at least 20 years before the wall’s collapse on May 12, 2005. The court found that although the spring 2005 rainfall and the 2004 drainage modifications may have been contributing factors to the particular time at which the retaining wall collapsed, they did not cause that collapse.
With respect to Alphonso’s reliance on the decision in Helstoski, the court said that reliance was misplaced. The court found the facts in Helstoski with respect to the cause of the failure of the dam and the loss to the taxpayers’ property to be materially distinguishable from the facts dealing with the cause of the collapse of the retaining wall and the loss to Alphonso’s property value.

Selling Idea is not a shelter

A bankruptcy court held that a taxpayer was not liable for $40 million in penalties, assessed by the IRS for the taxpayer’s failure to register tax shelters he allegedly sold, because what the taxpayer sold was an “idea” and not a “tax shelter.” In re Canada, 2016 PTC 203 (Bankr. N.D. Tex. 2016).


William Canada graduated from Harvard law school in 1979 and worked at a variety of law firms, primarily as a commercial litigator. In 1994, Canada decided he was unhappy practicing law and should do something different. He left the firm he was working for and went to work for Heritage Organization, LLC.

At first, Canada was hired by Heritage as a “contractor,” and would meet with prospective clients in order to interest them in Heritage’s services, including the Heritage Transactions. Canada described the Heritage Transaction as a transaction in which a client would form an entity, an LLC, or some other type of pass-through entity like an S corporation, would open a brokerage account with a major brokerage firm, would sell Treasury securities short, and would then reinvest those into what were called “reverse repurchase agreements.” The brokerage account would then be contributed to a partnership, and at that point in time, the lawyers at Heritage would opine that the client created basis in the partnership equal to the amount of the proceeds of the Treasury short. The Heritage Transactions created a variety of opportunities to manufacture capital losses or to artificially offset capital gains.

By 1998, Canada was a key player at Heritage who was heavily involved in the marketing and sale of the Heritage Transactions to clients. Beyond his responsibility for marketing and selling the
Heritage Transactions, at some point Canada became Heritage’s President and/or Chief Operating Officer.

In 2007, the IRS began investigating Canada for possible liability for penalties for failing to register the Heritage Transactions he marketed between 1998 and 2001 as tax shelters under pre-2004 Code Sec. 6707 and pre-2004 Code Sec. 6111. Failure to register a “tax shelter” under pre-2004 Sec. 6111 led to penalties under pre-2004 Code Sec. 6707 equal to 1 percent of the aggregate amount invested in such tax shelter. However, it was not until April 2015 that the IRS told Canada of its intention to impose over $40 million in penalties against him pursuant to pre-2004 Code Sec. 6707 as a result of his actions as a Heritage employee. Canada then filed a voluntary petition for bankruptcy under Chapter 11 in September of 2015 in order to address the IRS’ penalty claim against him. The IRS filed an Original Proof of Claim on October 15, 2015, and Canada subsequently filed an objection to that claim.

Observation: Code Sec. 6111 and Code Sec. 6707 were revised from the ground up in 2004, after the relevant time period discussed above. Code Sec. 6111 now requires that any “material advisor with respect to any reportable transaction” file a return regarding that reportable transaction. Under the current version of Code Sec. 6111(c), the IRS determines via regulations whether something constitutes a reportable transaction. The legislative history of Code Sec. 6111 and Code Sec. 6707 does not shed much light on the reasons for the change to these provisions, but it seems clear that the potential realm of reporting requirements under the current version of Code Sec. 6111 sweeps far broader than it did under the prior version of the statute.


Under pre-2004 Code Sec. 6111(c), the definition of “tax shelter” begins with the phrase “[t]he term ‘tax shelter’ means any investment and goes on to characterize an “investment” as something
of which “interests” are “offered for sale.” Before a bankruptcy court, Canada argued that he was not liable for the $40 million in penalties because the Heritage Transactions were not “tax shelters” as that term was defined in pre-2004 Code Sec. 6111(c) because tax shelters under that provision had to be an “investment” and the Heritage Transactions were an idea or strategy
rather than an investment. Canada also argued that even if pre-2004 Code Sec. 6111 required him to register the Heritage Transactions as a tax shelter, he should not be liable for the penalties because he established reasonable cause for his failure to register them.

The bankruptcy court held that the Heritage Transactions were not investments as that term was used in pre-2004 Code Sec. 6111 and, thus, they could not be tax shelters. As a result, Canada was not liable for the $40 million in penalties assessed by the IRS. The court concluded that the plain meaning of the word “investment” did not encompass the Heritage Transactions. Black’s Law Dictionary, the court observed, defines “investment” as an expenditure to acquire property or assets to produce revenue, a capital outlay, or the asset acquired or the sum invested. The phrase “capital outlay” is then defined as “an outlay of funds to acquire or improve a fixed asset” or as “money expended in acquiring, equipping, and promoting a business.” The Heritage Transactions, the court observed, were not covered by any of these senses of the word “investment,” or by a common sense, everyday understanding of the word because the transactions were not (1) a revenue-producing asset such as real estate, (2) a share of a business entity, or (3) funds expended to acquire those kinds of assets or to fund a business.

The bankruptcy court also held that, in the event that an appellate court disagrees with its decision and concludes that the Heritage Transactions were “investments” and thus a “tax shelter” under pre-2004 Code Sec. 6111(c), Canada established reasonable cause under pre-2004 Code Sec. 6707 for his failure to register the Heritage Transactions as a tax shelter. The court stated it was satisfied that Canada’s own examination of his possible reporting obligations under pre-2004 Code Sec. 6111, combined with a lack of an obvious way to fit the Heritage Transactions into the statutory framework of pre-2004 Code Sec. 6111 and the dearth of authority interpreting that statute, was sufficient to establish his reasonable cause in not registering the transactions.

Tax Fraud Busted – Cost $1 Billion!!

Texas Tycoon Liable for Over $1 Billion to IRS for Using Offshore Entities to Avoid Taxes

A Texas bankruptcy court found a former billionaire liable for back taxes, interest, and penalties totaling more than $1 billion. While the court held that the billionaire and his late brother were guilty of tax fraud as a result of their use of offshore trusts and corporations to avoid the payment of income taxes, the court found the late brother’s widow was eligible for innocent spouse relief. In re Wyly, 2016 PTC 233 (Bankr. N.D. Tex. 2016).


In 2010, the Securities and Exchange Commission (SEC) sued Sam Wyly and his brother, Charles Wyly, and others, for securities fraud in connection with certain transactions undertaken by various offshore trusts and offshore corporations that the brothers were involved with setting up. The case was tried in a New York district court. The fraud was alleged to have been accomplished through an elaborate sham system of trusts and subsidiary companies located in the Isle of Man and the Cayman Islands (the “Offshore System”). The Offshore System enabled the Wylys to hide their ownership and control of certain securities through trust agreements that purported to vest complete discretion and control in the offshore trustees. In actual fact and
practice, the court found, the Wylys never relinquished their control over the securities and continued throughout the relevant time period to vote and trade these securities at their sole discretion. Through their use of the Offshore System, the Wylys were able to sell, without disclosing their beneficial ownership, over $750 million worth of securities, and to commit an insider trading violations resulting in unlawful gain of over $31.7 million.

The brothers were found guilty and a judgment was entered against Sam and the probate estate of Charles, who died in 2011, for approximately $124 million and $64 million, respectively, plus prejudgment interest. In 2014, following the verdict, Sam and Caroline Wyly, Charles’ widow, filed for bankruptcy. The IRS assessed multiple fraud penalties against the Wylys relating to tax underpayments as a result of the Offshore System, including underpayments of gift tax relating to transfers of property to family members. A trial before a Texas bankruptcy court ensued. Because of the determinations by the district court in the SEC trial, and because the bankruptcy court gave collateral estoppel effect to the district court’s determinations, the parties
agreed that there were substantial underpayments of income taxes by the Wylys as a result of the Offshore System. The Wylys asked the bankruptcy court to determine the amount of allowed IRS claims against them.

In defense of its charges against the Wylys, the IRS claimed that Sam and Charles, along with their army of lawyers and other professionals, set up one of the most complicated offshore structures ever seen, and then manipulated that structure in such a way as to evade their legitimate tax obligations.

The Wylys first argued that the IRS failed to prove fraudulent intent because the Wylys relied on the advice of various professionals in preparing and filing their tax returns in each of the relevant years and that negated any possible fraudulent intent. Alternatively, the Wylys asserted reasonable cause and good faith defenses to the imposition of fraud penalties for their income tax underpayments.

In addition, Caroline claimed that she was eligible for innocent spouse relief under Code Sec. 6015(b) and Code Sec. 6015(c).


The bankruptcy court upheld the majority of the IRS’s penalty assessments against Sam, resulting in a liability of more than $1 billion in back taxes, interest, and penalties. The court found him liable for $427 million in penalties alone for failing to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, and Form 5471, Information return of U.S. Persons with Respect to Certain Foreign Corporations. The court rejected the argument that the
penalty, which was more than three times Sam’s tax liability, was excessive. The court also found Charles guilty of fraud, leaving his estate subject to assessments for back taxes, interest, and penalties.

The court noted that Sam is a sophisticated and well-educated businessman that accumulated great wealth through his business acumen and hard work. And, while he may have left the day-to-day business details to professional managers and advisors he hires, it was clear to the court that he expected results and was knowledgeable about the results various professionals obtained on his behalf. He did not, the court said, simply turn his wealth over to others and wish them luck. The bankruptcy court was convinced Sam knew what was happening in connection with the offshore system and that no money or assets moved within that system without Sam’s knowledge and express direction. While Sam’s directions to the offshore trustees was usually done through the formality of Sam making his “wishes” known to them, the court observed, the trustees never refused to follow Sam’s “wishes” as they understood that their jobs depended upon it. If a Sam “wish” was not granted, the court noted, the trustees would be removed. Sam, the court continued, could not expect to hide behind others and claim not to have known what was going on around him. The documents introduced into evidence, including those that were created to attempt to shield Sam, pointed to fraud, the court said.

However, the court did not find that Sam owe gift taxes relating to transfers of property to family members. The court rejected the IRS’s theory that Sam made a gift of cash to his children by way of the property transfers. According to the court, since the properties at issue were purchased using mostly offshore funds, Sam never gave up control over those properties after their purchase. The court noted that while one of Sam’s daughters was allowed to exercise control over those properties day-to-day, Sam had the ability to remove her at any time. Moreover, the court said, the fact that Sam’s children could use the properties did not make them, or the cash used to purchase, improve, and maintain them, a gift. And the court observed, one of the offshore trusts still owned the properties at issue, albeit indirectly.

Finally, the bankruptcy court held that Caroline was innocent of any wrongdoing. The court found that she did not know the details of what Sam and her husband, Charles, had done offshore. And, the court said, there was nothing that should have “tipped her off” that something was amiss. She did not commit fraud, she did not participate in any fraud, she was not willfully blind, and the court concluded she was thus entitled to innocent spouse relief.

Consistency – So Costly ! Tax on $1.6 Million

Duty of Consistency Required Taxpayers to Adhere to Improper Accounting

The Tax Court determined that a calendar year S corporation could not exclude from income for the year at issue checks that were received in the prior year but not deposited or reported until the following year. Although the court, the IRS, and the S corporation’s shareholders all acknowledged that this accounting was incorrect, because the IRS had relied on the original reporting and the prior year was closed, the doctrine of consistency required the shareholders to stick with their initial reporting. Squeri v. Comm’r, T.C. Memo. 2016-116.


Robert Squeri and Gregory Dellanini organized Preferred Building Services, Inc. (PBS), a full-service janitorial business, as a California subchapter S corporation in 1992. PBS was a cash basis taxpayer and determined the gross receipts reported on its Forms 1120S using deposits made into its bank accounts during the calendar year. The reported gross receipts for the years at issue did not include the checks that were actually received in the last quarter of that year. Rather, each year’s gross receipts included checks received in the fourth quarter of the prior year, but deposited the following January.

The IRS issued Squeri and Dellanini notices of deficiency relating to the reporting of their proportionate shares of income from PBS for 2009 and 2010. In the notices, the IRS determined that PBS had improperly computed its gross receipts by excluding the checks that were received during the last quarter of the prior year. In calculating the adjustment to PBS’s gross receipts for 2010, the IRS: (1) included the checks that were received in 2010 but deposited by PBS in January of 2011, and (2) excluded the checks that were deposited in January of 2010, but received in 2009. For 2009, however, the IRS included the checks received in 2009 but deposited in 2010, but did not exclude the checks that had been received in 2008, but deposited in January 2009, because 2008 was a closed tax year.


Code Sec. 441(a) requires that taxable income be computed on the basis of the taxpayer’s tax year. For purposes of calculating taxable income, Code Sec. 451(a) provides that all items of income received in a tax year must be reported as income for that tax year unless the method of accounting requires that the item be accounted for in a different tax period.

The Tax Court noted that the taxpayers and the IRS did not dispute that PBS incorrectly computed its gross receipts by using bank account deposits. Instead, the taxpayers argued that gross receipts of $1,634,720 should be excluded from their 2009 income because they were actually received in 2008 and that the IRS did not have authority to make adjustments for the 2008 tax year as it was outside the period of limitations for adjustments. The IRS argued that under the duty of consistency, the taxpayers should be required to include on their 2009 returns amounts of 2008 income, as they originally reported.

The Tax Court agreed with the IRS. Citing Est. of Letts v. Comm’r, 109 T.C. 290 (1997), the court stated that the duty of consistency is an equitable doctrine which prevents a taxpayer from benefiting in a later year from an error or omission in an earlier year which cannot be corrected because the limitations period for the earlier year has expired. In invoking the duty of consistency, the court said, three conditions must be met:

(1) a representation or report by the taxpayer;

(2) reliance by the IRS; and

(3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or to re-characterize the situation in such a way as to harm the IRS.

In the instant case, the court said, the taxpayers made a clear representation on the 2009 Form 1120S for PBS when they represented that PBS had received the $1,634,720 of gross receipts
in 2009. Thus, the court determined, the first element of the duty of consistency had been met.

With regard to the second element (reliance by the IRS on the taxpayer’s representation), the taxpayers argued that the IRS did not reasonably rely on their representation because the IRS knew
that the notices of deficiency did not accurately reflect their income from 2009. The court disagreed, noting that the IRS had already relied on the taxpayers’ representations by accepting the 2008 tax returns and allowing the statutory period of limitations to expire. The court thus determined the second element had also been met.

The third element of the duty of consistency, the court observed, requires an attempt by the taxpayer after the statutory period of limitations has expired to change the previous representation or to re-characterize the situation in such a way as to harm the IRS. The court noted that the taxpayers admitted that reporting the 2008 payments for 2008 rather than for 2009 would be inconsistent with their previous reporting. The period of limitations had expired on the 2008 tax year, the court said, and allowing the taxpayers to re-characterize their income as
belonging in 2008 would harm the IRS because it would allow the taxpayers to avoid tax on $1,634,720. The court thus found that the third element had been met.

Because the IRS had established that all of the elements for the duty of consistency had been met, the court concluded that the $1,634,720 in gross receipts that PBS received in 2008 but reported for 2009 were required to be recognized as income for tax year 2009.

IRA Rollover Requirement Not Waived

Rollover Requirement Not Waived Where Taxpayer Used IRA Funds as Short-Term Loan

The IRS declined to waive the 60-day rollover requirement for a distribution a taxpayer took from her IRA. The taxpayer had used the funds to purchase her daughter’s home in order to avert its foreclosure and intended to sell her vacation home to replace the withdrawn amounts, but the sale was not completed until after the 60-day period. PLR 201625022.


In PLR 201623003, a taxpayer’s daughter’s home was in foreclosure in early 2015. In April, the taxpayer and her spouse put their vacation home up for sale in order to raise funds to purchase their daughter’s home. On April 24, 2015, before the sale of the vacation home was completed, the taxpayer took a distribution from her IRA. She used the IRA proceeds to buy the daughter’s house in order to avert its foreclosure.

The taxpayer intended to redeposit the withdrawn amounts into her IRA within the 60-day rollover period, which ended on June 23, 2015. However, the sale of the vacation home was not completed until July 1, 2015, after the 60-period had expired. As a result, the taxpayer did not have sufficient funds during the 60-day period to complete the rollover. The taxpayer’s spouse was willing to take a distribution from his IRA to complete the rollover, but the taxpayer claimed a medical condition prevented this from occurring. Upon the receipt of the funds from the sale of her vacation home on July 1, 2015, the taxpayer attempted to complete the rollover but realized the rollover period had expired. The taxpayer requested that the IRS waive the 60-day rollover period in Code Sec. 408(d)(3) with respect to the distribution from her IRA.


Under Code Sec. 408(d)(3), a taxpayer can roll over, tax free, a distribution from a traditional IRA into the same or another traditional IRA, or into an eligible retirement plan that accepts rollovers. Generally, the individual must make the rollover contribution by the 60th day after the day the individual receives the distribution from the IRA.

The IRS may waive the 60-day requirement where the failure to do so would be against equity or good conscience. Rev. Proc. 2003-16 provides that in determining whether to grant a waiver, the IRS will consider multiple factors, including the taxpayer’s inability to complete a rollover due to the following causes:

(1) death;

(2) disability;

(3) hospitalization;

(4) incarceration;

(5) restrictions imposed by a foreign country; or

(6) postal error.

In the instant case, the IRS found that the taxpayer did not demonstrate how any of the factors in Rev. Proc. 2003-16 resulted in her failure to accomplish a timely rollover. The IRS noted that the taxpayer represented that her inability to complete a rollover was caused by a medical condition during the 60-day period. However, the IRS said, it was not convinced that the taxpayer’s medical condition prevented a timely rollover considering that she continued to work and travel during the relevant period. As a result, the IRS declined to waive the 60-day rollover requirement with respect to the distribution.

State Support Not Income

State’s Payments to In-Home Care Providers Are Excludable from Gross Income as “Difficulty of Care Payments”

The IRS ruled privately that Medicaid and state-funded payments made to individual care providers under a state’s in-home supportive care programs would be treated as “difficulty of care” payments excludable from gross income under Code Sec. 131. The IRS noted that although Code Sec. 131 generally applies only to foster care payments, Notice 2014-7 treats certain other payments, like the ones made to the care providers, as difficulty of care payments. PLR201623003.


Under the facts of PLR 201623003, a state offers in-home supportive care to qualifying individuals through four programs. The taxpayer, a department of the state, is responsible for directing and overseeing the programs.

For three of the programs, Medicaid payments are made to individual care providers pursuant to sections 1905, 1915(j), and 1915(k) of the Social Security Act. The state provides funding for payments to the care providers for the fourth program. Each program shares the common purpose of assisting qualifying aged, blind, or disabled
persons who are unable to perform one or more activities of daily living independently and who cannot remain safely at home without assistance.

All four of the state’s in-home supportive care programs are administered by the county welfare departments (CWDs) under the direction and oversight of the taxpayer. The taxpayer facilitates the federal and state funding to the CWDs, and the taxpayer operates the information and payroll system for all four programs. Under the programs, care recipients (as employers) and individual care providers (as employees) verify, sign, and submit bi-monthly timesheets. The taxpayer is required to perform all the federal taxrelated duties and obligations that the care recipient would have been required to perform as the employer of the care provider. The taxpayer requested rulings from the IRS on whether the Medicaid and state-funded payments to individual care providers under the state’s in-home supportive care programs will be treated as difficulty of care payments excludable from the gross income of the provider under Code Sec. 131.


Code Sec. 131(a) excludes qualified foster care payments, including “difficulty of care” payments, from the gross income of a foster care provider. Code Sec. 131(c) defines difficulty of care payments as compensation to a foster care provider for the additional care required because the qualified foster individual has a physical, mental, or emotional handicap.

Notice 2014-7 provides that the IRS will treat qualified Medicaid waiver payments as difficulty of care payments under Code Sec. 131(c) that are excludable from the gross income of the individual care provider. The notice defines qualified Medicaid waiver payments as payments by a state, a political subdivision of a state, or an entity that is a certified Medicaid provider, under a Medicaid waiver program to an individual care provider for nonmedical support services provided under a plan of care to an eligible individual (whether related or unrelated) living in the individual care provider’s home.

The IRS noted that the underlying rationale in Notice 2014-7 for treating Medicaid waiver payments as excludable difficulty of care payments under Code Sec. 131(c) is the similarity in the purpose and design of Medicaid waiver programs and foster care programs. The purpose of Medicaid waiver programs and the legislative history of Code Sec. 131, the IRS observed, reflect the fact that home care programs prevent the institutionalization of individuals with physical, mental, or emotional handicaps. Thus, the IRS stated, whether the payments under the state’s programs will be excluded from the gross income of the provider depended on the purpose and design of the programs, and the nature of the payments.

The IRS noted that all four of the state’s in-home supportive care programs had the shared purpose of preventing institutionalization and enabling an eligible individual to be cared for in a home setting. The IRS thus determined that the purpose of all four programs was similar to the purpose of foster care programs as stated in Notice 2014-7.

Like foster care programs, all four programs require state approval and oversight of the care in the provider’s home, the IRS found. The programs, the IRS observed, were administered by CWDs under the direction and oversight of the taxpayer, a department of the state. As such, the IRS determined that the design of all four programs was similar to the design of foster care programs.

The IRS also determined that the nature of the Medicaid and state funded payments to individual care providers under all four of the state’s programs was similar to the nature of difficulty of care payments. Difficulty of care payments, the IRS said, compensate a provider for the additional care required because an individual has a physical, mental, or emotional handicap. Similarly, the IRS noted, the in-home supportive care providers receive compensation for the additional care required by an individual who needs assistance with one or more activities of daily living to remain safely at home and to prevent institutionalization.

Finding that the purpose and design of all four of the state’s programs were similar to the purpose and design of foster care programs, and that the nature of the payments to the in-home care providers was similar to the nature of difficulty of care payments under Code Sec. 131, the IRS ruled that the Medicaid and state-funded payments were excludable from the gross income of the providers.

The IRS noted that although the state’s payments to the individual care providers were excludable from their gross income, such payments generally are wages subject to FICA and FUTA unless an
exception applies (e.g. the exception for payments for services performed for a spouse or a child).

When business is considered as Hobby

When business is considered as Hobby

The Tax Court held that a couple could not deduct losses from their Amway distributorship in excess of the income they derived from that business. Because the couple did not have a business plan, a budget, nor did they change their operations after consistently generating losses, the court determined that they were not operating their business with a profit motive. Hess v. Comm’r, T.C. Summary 2016-27.


James Hess worked as a software engineer and his wife, Robyn, was a housewife. The couple became Amway distributors in 2005. Amway is a supplier of household, health, and cosmetic products that are sold by individual distributors through direct marketing. Amway distributors purchase Amway products at a wholesale rate and then sell those products at normal retail prices to earn a profit. The distributors generate revenue by: (1) selling products directly to consumers; (2) earning points through Amway’s reward point system; and (3) sponsoring other individuals who join Amway as distributors. In the latter case, the original distributor is called an “upline” distributor, or a sponsor, in relation to his new recruit, the “downline” distributor. To maximize Amway-related income, a distributor must sell Amway products and also try to enlist other individuals as Amway distributors.

Amway was the couple’s first independent business venture, and they did not consult with anyone other than their sponsoring distributors before deciding to become Amway distributors. They conducted their Amway activity in their free time on evenings and weekends and attended Amway training functions organized by Worldwide Group, LLC (Worldwide Group). According to James, the meetings provided him and his wife with training that was necessary for them to start, and eventually grow, their Amway business. The couple attended each of Amway’s quarterly meetings, as well as local monthly meetings.

The Hesses did not create a business plan before beginning their Amway activity or for any of the years that followed. Instead, they used a document that Worldwide Group had distributed to them as their business plan for each year in which they conducted their Amway activity.

The Hesses also did not create a budget or a profit and loss statement, and did not maintain a general ledger before beginning their Amway activity or for any of the years that followed. Instead, the couple carefully maintained receipts to substantiate all expenses they incurred for their Amway activity. Although the couple maintained records of their expenses, they did not have any records showing how much product they sold, to whom they sold product, or the names of their alleged downline distributors.

Despite generating losses from their Amway activity year after year, the Hesses operated their Amway activity in the same manner regardless of the prior year’s results and did not seek advice from anyone other than their sponsoring distributors. From 2005 through 2011, the Hesses reported a total of approximately $5,000 of income from their Amway business and deductions of approximately $129,000. The IRS determined that the couple’s losses from the Amway activity were limited by Code Sec. 183 because the couple did not engage in the activity for profit. Thus, all deductions in excess of income were disallowed.


The Tax Court agreed with the IRS and limited the couple’s deductions relating to their Amway activity to the income from that activity. The court found that, although the Hesses maintained that they engaged in and continued their Amway activity with the actual and honest objective of making a profit, the objective facts indicated otherwise. With respect to the business plan distributed by Worldwide Group and used by the couple, the court found that it did not contain information that is generally found in a formal business plan. Rather, the document promoted a performance-bonus-generated structure whereby an upline distributor receives performance bonuses from Amway based on the volume – not profitability – of merchandise he or she sells to his or her downline distributors. Because the Hesses did not conduct their Amway activity in a businesslike manner, did not seek advice from disinterested third parties, did not maintain records for the purpose of monitoring and improving business performance, and consistently produced losses while generating nominal gross receipts, the court concluded that the couple did not engage in the activity with the requisite objective of making a profit. In reaching its conclusion, the court examined the various factors set forth in Reg. Sec. 1.183-2(b) in determining if a taxpayer had a requisite profit motive and found that no factors weighed in favor of the couple.

Miss a Check box, pay a HUGE price !!

The IRS ruled privately that because a decedent had designated his estate as his IRA’s beneficiary at the time of his death, the IRA had no “designated beneficiary” for purposes of Code Sec. 401(a)(9) and the assets had to be paid out over the applicable distribution period in Reg. Sec. 1.401(a)(9)-5. The IRS also determined that a state court’s order retroactively amending the designation to list trusts as the beneficiaries was ineffective because retroactive reformations cannot change the tax consequences of a completed transaction. PLR 201628004.  (more…)