Last week, Charles Allen wrote about Blossom Day Care Centers, Inc. (“Blossom”) and its owners regarding their employment tax case.[1] Frequently, we write articles intending to remind readers of the importance of substantiation, especially in the income tax world. In reviewing Charles Allen’s article, I kept finding myself wondering about the income tax implications of the case. Low and behold, as cited by Charles, there was a sibling-case involving the income tax side of the controversy. Like many before it, this is a bad facts case. It is also a sad case as disorganization appears to be a culprit here as many of the necessary pieces of good planning appeared to be in place. Unfortunately, that planning was not utilized in the organized manner which would have potentially achieved the intended tax results.
Review of the Blossom Employment Tax Controversy
In the other case, discussed by Charles Allen, (“Employment Tax Case”), the Tax Court determined that Blossom was liable for the employer share of the employment taxes on the imputed reasonable compensation of its owners, Mr. and Mrs. Hacker, each owning 51% and 49% of Blossom, respectively. In reaching its determination of reasonable compensation, the Tax Court reviewed the facts and circumstances surrounding Mr. and Mrs. Hacker’s involvement with Blossom, their respective responsibilities and undertakings on behalf of Blossom, and their financial transactions with Blossom. In the end, the Tax Court sided with the IRS on all issues in the case, assessing employment taxes on the reasonable compensation amounts and associated penalties.
Reviewing the Employment Tax Case, many of the facts presented raised income tax issues. These issues included those pertaining to the implications of the reasonable compensation determinations, deductibility of management fees and treatment of the management company engaged by Blossom, treatment of the personal use of company funds by the Hackers and their family, and personal use of vehicles owned by others but claimed and depreciated by Blossom. Unsurprisingly (and unfortunately for the Hackers and Blossom), an associated controversy and Tax Court opinion immediately followed, discussed here.[2] Neither boded well for the taxpayers.
The Income Tax Controversy
Following review, the IRS issued a notice of deficiency, dated November 14, 2011, assessing additional federal income tax of $70,239, $109,813, $109,557, and $130,967 and civil fraud penalties under section 6663 of $52,679.25, $82,359.75, $82,167.75, and $98,225.25 for 2004, 2005, 2006, and 2007, respectively. Additionally, the IRS determined Blossom was liable for an addition to tax under section 6651(a)(1) of $32,741.75 for 2007. These assessments were made with respect to Blossom, a corporation taxed as a C corporation. Following concessions, the following issues were before the court:
- Adjustment of gross receipts;
- Failure to report capital gain on recapture of prior-year depreciation on two vehicles on trade-in of a third vehicle;
- Failure to report gain on distribution of appreciated property;
- Whether Blossom received rental income with respect to certain real estate;
- Whether Blossom was entitled to deduct:
- depreciation for certain assets;
- non-business or personal expenses, as determined by the IRS, as business expenses;
- management fees paid to affiliated management company (Hacker Corp.);
- certain disallowed interest expense deductions;
- certain repair expenses; and
- supplies expenses.
- Whether Blossom is entitled to claimed Indian employment tax credits;
- Whether Blossom is entitled to deduct wage expenses on the bases of the determinations made by the IRS as to reasonable compensation;[3]
- Whether Blossom is liable for a failure to file penalty; and (finally)
- Whether civil fraud or accuracy penalties apply.
Not all of the issues will be discussed specifically. Instead, the focus is on the case as a whole, taken together with the Employment Tax Case. Reviewing the above and considering the fact that the IRS prevailed on virtually all issues, the cases were a bear for the taxpayer (and likely the Hackers as well).
The Management Structure
Blossom was the operating company, owned and operated by the Hackers, employing approximately 90 employees across multiple locations. Blossom purportedly entered into a management arrangement which was not formally documented with Hacker Corp.. Hacker Corp. was an S corporation which was structured to provide management services to Blossom and in turn pay wages to the Hackers and their children in exchange for their management services. Again, there was no written contract or fee agreement prepared with respect to this relationship.
A management company arrangement is a typical and sometimes very prudent planning. Aside from the tax aspects of the arrangement (considering Blossom was a C corporation, subject to two levels of tax, and Hacker Corp. was an S corporation, subject to passthrough treatment), such an arrangement can provide for segregation of risk, management, operations, and asset holdings. This structure can also dictate the economic benefits of the business enterprise as well. However, the facts must support the structure and the structure must be able to be substantiated. In the case at hand, the IRS allowed some of the deductions for management fees paid to Hacker Corp. but in reviewing ledgers and bank accounts, disallowed a large portion of these deductions due to lack of substantiation and explanation as to the excess amounts.
Recordkeeping Failures and Adjustments
Deduction Adjustments
Many adjustments were due to either just wrong information provided on the returns or failures to keep and maintain adequate records to substantiate deductions claimed. Among these items, including the management fees mentioned above, were interest payments, repair expenses for personal and non-business-owned assets, supply expenses , items deducted as business expense deductions instead being classified constructive dividends, deductions for depreciation of vehicles not owned by Blossom and not used in conjunction with Blossom’s business.
For the items above which could have been properly deducted by Blossom (ex. supply expenses which were just checks written to the Hackers, personally), the failure to keep and provide adequate records, including receipts, mileage logs, and other evidence as to business purposes rendered Blossom helpless before the Tax Court. Without the facts and evidence to support its positions and satisfy any applicable statutory and regulatory requirements, Blossom was not entitled to these deductions. The amounts at issue added up quickly.
Income Adjustments
Blossom’s problems did not end with disallowed deductions and constructive dividends. The problems continued with additional assessments of income in the form of gross receipts, capital gains on disposition of appreciated property, and rental income. With respect to gross receipts, Blossom overreported gross receipts and underreported cash received for 2004 and 2005, overstating income by approximately $500,000 while underreporting cash received for 2006 and 2007 to the tune of approximately $180,000. While perhaps a net win for the taxpayer, and without knowing more, the effect could have been a whipsaw effect as a result of timing issues.
Next, the IRS assessed Blossom with recapture of excess depreciation with respect to a 2002 Nissan, 2003 Hummer, and gain on the trade in of a Ford Expedition. Blossom having failed to produce evidence to the contrary, the Tax Court sustained the IRS’ determination.
Interestingly, and unfortunately for the unwary taxpayer, there were two dreadful, albeit smaller value (relatively speaking), adjustments. These adjustments related to the trade-in of the Ford Expedition for a 2004 BMW in the Hackers’ son’s name and a transfer of real property to Hacker Corp. Each of these were appreciated assets which were effectively distributed by Blossom, thus triggering recognition of gain under Section 311(b).
Section 311(b) is the proverbial “Wrong Way” or “One Way” sign with respect to a corporation. While some tax structures (disregarded entities and partnerships) generally provide for tax-free transfers to and from entities, tax corporations operate in a different manner. Many unwary taxpayers fall into the bear-trap that is Section 311(b) of the Internal Revenue Code. A taxpayer may generally, subject to certain requirements and restrictions, transfer appreciated property to a corporation as or in exchange for equity and a substituted basis without recognition of gain or loss. However, upon the distribution of appreciated property from a corporation to a shareholder, gain is recognized to the extent the fair market value of the property exceeds the corporation’s basis in the distributed asset. In a small win for the Hackers with respect to two purportedly transferred properties, transfers did not occur as Blossom was not the transferor. The Hackers were, thus Section 311(b) did not apply with respect to those properties because the corporation (Blossom) did not distribute those specific properties.
Penalties Oh Penalties
Following all of the above, which does not go into nearly as much detail as the opinion, it is unsurprising the IRS sought to impose fraud penalties on Blossom. The records, returns, facts, and positions in light of the foregoing were just an absolute mess and many of Blossom’s positions appear to potentially rise to the level of fraud. However, fraud penalties under Section 6663(a), assessed at a rate of 75% of the underpayment of tax, require actual fraud and carry a higher standard of proof of the IRS. Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose of evading tax believed to be owning.[4] Thus, if any portion of the underpayment in tax is attributable to fraud, then the entire underpayment will be treated as attributable to fraud unless the taxpayer establishes by a preponderance of the evidence that a specific portion is not due to fraud.[5]
Fraud penalties can be properly imposed and then subsequently subject to a haircut, pending certain circumstances if the taxpayer can show not all of the underpayment was attributable to fraud. Specifically, fraud requires the proving of fraud by clear and convincing evidence (the IRS has the burden of proof and cannot coast on its usual presumptive correctness).[6] Further, this burden needs to be met at the higher clear and convincing standard. Typically, circumstantial evidence is used to prove fraudulent intent by showing certain “badges of fraud.” These include, but are not limited to: (1) understating income; (2) maintaining inadequate records; (3) giving implausible or inconsistent explanations; (4) concealing income or assets; (5) failing to cooperate with authorities; (6) engaging in illegal activities; (7) providing incomplete or misleading information to one’s tax return preparer; (8) lack of credibility of the taxpayer’s testimony; (9) filing false documents, including false income tax returns; (10) failing to file tax returns; and (11) dealing in cash.[7] In a major break for Blossom (and the Hackers), the Tax Court concluded the IRS did not meet its heightened burden. Pointing to and emphasizing many of the issues raised in its notice of deficiency and aligning with multiple cited badges of fraud, including failing to report cash, claiming personal expenses as business expenses, and vague, uncorroborated, and purported misleading statements to the Revenue Agent (who had one massive bear of a job in this case), the IRS tried, unsuccessfully to sway the Tax Court in sustaining fraud penalties. The Tax Court, in its opinion and respecting the gravity of such a penalty and the heightened burden required, disagreed, and instead noted that such issues more stemmed from “sloppiness and lack of sophistication more than an effort to defeat tax.” Elaborating on its conclusion, the Tax Court conceded that Blossom specifically understated income in 2006 and 2007, but it also reiterated the fact that Blossom overstated its 2004 and 2005 gross receipts and cooperated during exam, even consenting to an extension of time for the IRS to assess tax, allowing the IRS time to complete its examination. The Tax Court upheld the alternative request of the IRS, accuracy-related penalties.
Conclusion
I would rather just write “ouch” here and leave it at that. But, after reading this opinion in conjunction with the Employment Tax Case, this case is another reminder of the key importance of organization and documentation. Specifically, here, there were sophisticated and more complicated structures, likely ideal for the Hackers and Blossom, including a C corporation operating entity (Blossom), a management company taxed as an S corporation (Hacker Corp.), and a number of complex tax items including a multitude of business deductions and even tax credits. In the end however, the failure to respect the structure appears to have caused a whipsaw effect upon the Hackers. By failing to properly utilize and respect the complex structure put in place, keep adequate records, and respect the basic separateness of the corporate structure. Even with some sympathy and understanding of their plight by the Tax Court, the results appear to be tragic. If a simple, more manageable structure were put in place, such as a limited liability company with no special tax election, thus being a partnership for tax purposes, perhaps several of these problems (albeit not all or perhaps even most of them) could have been avoided or at least mitigated to some extent.
Hopefully this case will remind readers to keep records, respect the structure, and do not over-complicate structures unnecessarily or undertake a strategic structure for which one does not intend to administer properly. A complex structure can be a perfect fit and provide a multitude of wonderful benefits. Generally though, that structure comes with additional recordkeeping, administration, and formalities. If a taxpayer wants their structure respected, the taxpayer ought show some respect to the structure first.
[1] See Charles J. Allen, J.D., LL.M., C.P.A., Corporation Liable for Employment Tax on Reasonable Compensation of Corporate Officers (July 28, 2021) and Blossom Day Care Centers, Inc. v. Comm’r, T.C. Memo 2021-86.
[2] Blossom Day Care Centers, Inc. v. Comm’r, T.C. Memo 2021-87.
[3] This issue was resolved in the Employment Tax Case and Blossom was entitled to a deduct such wage expenses.
[4] Edelson v. Comm’r, 829 F.2d 828, 833 (9th Cir. 1987).
[5] See Section 6663(b)
[6] See Section 7454(a);Rule 142(b).
[7] See Minchem Int’l, Inc. v. Comm’r, T.C. Memo 2015-56 at 46.
