Unenrolled, unlicensed preparers had only a 35% accuracy rate in preparing income tax returns, in a test conducted by the Treasury Inspector General for Tax Administration.

More than one-third of the erroneous returns contained misstatements or omissions that TIGTA considered willful or reckless.

TIGTA auditors posed as taxpayers earlier this year at 12 offices of commercial tax preparation chains and 16 small, independently owned offices. Of the 28 tax returns prepared, only 11 were prepared correctly, TIGTA said. If the 17 erroneous returns had been filed with the IRS, they would have resulted in $12,828 in underpaid taxes. TIGTA determined that six returns contained willful or reckless omissions or misstatements. Fees charged by the preparers varied widely—even among similar returns—but averaged $234 per return at commercial chains and $132 at independent offices.

The IRS agreed to study TIGTA’s recommendation that it develop a system for identifying all paid preparers by identification number. As TIGTA noted, anyone, regardless of experience or expertise, who charges a fee may file a return on behalf of a taxpayer. Only CPAs, attorneys, enrolled agents and enrolled actuaries, however, are considered tax practitioners “enrolled” to represent taxpayers before the IRS.

In a separate, ongoing TIGTA study, volunteer preparers in the 2008 filing season were much more accurate. Checks of 36 returns at Volunteer Income Tax Assistance and Counseling for the Elderly sites in 12 cities yielded a 69% accuracy rate—all the more noteworthy, TIGTA said, for its improvement since the 2004 filing season, when the checks began. That year, in a check of 35 returns, the accuracy rate was zero.

A taxpayer must prove material participation in an activity to deduct losses from that activity against nonpassive income. The Ninth Circuit reaffirmed that credible evidence must be presented to prove that one of the material participation tests of IRC § 469 has been met.

In 2007, the U.S. District Court for the Western District of Washington granted the IRS summary judgment disallowing a taxpayer’s attempt to carry back losses without sufficient evidence of material participation in the family company. However, the IRS’s alternate argument that the taxpayer’s claim should also be disallowed pursuant to capital loss rules/limitations was rejected because it wasn’t clear whether the activities in question were conducted in a dealer or trader capacity. In September 2008, the Ninth Circuit Court of Appeals upheld the decision without oral argument. Started in the 1970s, family-run partnership Dean Securities brokered stocks and bonds. In 1998, sharp declines in securities values caused large losses for the company.

Loren Dean, a 20% partner, claimed a refund for carryback losses for 1996 based on his 1998 partnership losses. By his testimony and that of his brother/partner, Dean was unable to satisfy the court that he had materially participated for 500 hours or more in the company in 1998. The firm did not keep records of the partners’ hours, nor did Dean have any other corroborating written records. The Ninth Circuit acknowledged that substantiation requirements for material participation in Temp. Treas. Reg. § 1.469-5T are “somewhat vague” but said that “ballpark guesstimates” are not enough. Therefore, Dean’s losses were deemed to be passive.

Under section 469(b), passive activity losses are generally deductible only to the extent of passive activity gains. If no passive gains exist to offset the loss, the taxpayer may carry the passive loss forward to the next year.

The U.S. District Court for the Western District of Louisiana held that a taxpayer could use the married filing jointly status on delinquent tax returns for the five tax years preceding the year his spouse had died. The government unsuccessfully argued that joint status was available only for the year of his spouse’s death.

Generally, a husband and wife may elect to file a joint tax return if they have the same tax year and both are U.S citizens or residents. If one spouse dies, section 6013(a)(3) allows the surviving spouse to file a joint return with the deceased spouse if no return has been filed for the taxable year by the deceased spouse, no executor has been appointed, and no executor is appointed before the last day a return can be filed by the surviving spouse. Treas. Reg. § 1.6013-1(d)(3) provides an example where a surviving spouse could file a joint return for 1956 and 1957 as long as the death of the other spouse in 1957 occurred before the due date of the 1956 return, assuming the other conditions of section 6013(a)(3) were met.

The government argued that when Congress used the phrases “the joint return” and “the taxable year” (emphasis added) in section 6013(a)(3), it intended to limit the ability of a surviving spouse to file a joint return to only the year of the other spouse’s death, and the joint status is not permitted on delinquent returns for previous years. It also argued that the application of Treas. Reg. § 1.6013-1(d)(3) would allow Vidalier to file a joint return only for 2005, since his wife died after the due date for the 2004 return. The district court rejected these interpretations, citing Friedman v. Commissioner (TC Memo 1987-6), in which the Tax Court permitted joint status on returns for 1977 and 1978 filed in 1981, even though the taxpayer’s spouse had died in 1978. It stated the section 6013(a)(3) requirements are applied to each year in question and are not limited to only one year. Since Vidalier met all of the requirements of section 6013(a)(3) for each year, the court stated the joint status was permissible.

n Donald James Vidalier v. U.S., 102 AFTR2d 2008-6076

After the court ruled in August 2007 that the work product privilege applied to some sought documents but not others, Valero supplied additional documents, some of them redacted, but withheld others, claiming they were confidential communications protected by the practitioner privilege (section 7525(a)(3)). The government moved to produce all the documents without redaction.

In two more of at least four similar cases, former Ernst & Young consulting partners were denied refunds of tax they paid on stock received from a merger with Cap Gemini that lost most of its value while in restricted accounts.

In 2000, Cap Gemini agreed to purchase E&Y’s consulting practice for stock. The tax, audit and consulting partners received stock, and the consulting partners agreed to work for Cap Gemini. The purchase contract specifically classified the transaction as a taxable purchase.

The contract permitted the partners to sell 25% of their shares to pay their tax liability from the sale. The remaining 75% was put into a restricted account and could not be sold for more than four years. If partners left Cap Gemini or were fired for specified reasons, they would forfeit stock in the restricted account under a liquidated damages schedule. The sales contract provided that the fair market value of the restricted stock was 95% of its closing price on the date of the transaction (May 23, 2000), or $148.53 per share.

One of the partners, Robert Bergbauer, received 10,740 shares of Cap Gemini. On his 2000 tax return, Bergbauer reported his entire gross proceeds from the sale of $1,613,379 and a total tax liability of $676,493.

The U.S. District Court for Maryland, where the case was tried, pointed out that two other district courts had ruled previously on similar arguments brought by other former E&Y partners. In U.S. v. Culp (99 AFTR2d 2007-618), a district court in Tennessee found the contract documents unambiguous and applied the Danielson rule to determine if a taxpayer could report the transaction differently than provided in the documents. Under Danielson (19 AFTR2d 1356 (3d Cir. 1967)), the taxation may vary from the documents only if there was “mistake, undue influence, fraud or duress.” Given the steps E&Y took to ensure all the partners understood the contract, the Culp court ruled for the IRS. In U.S. v. Fletcher (101 AFTR2d 2008-588), a district court in Illinois also applied the “strong proof” doctrine. Under it, the taxpayer must have strong proof that the partners intended a transaction different from the one in the contract. The Illinois court also considered Treas. Reg. § 1.451-2, which provides that constructive receipt of income does not occur when a taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The provision does not bar enforcement of the contract as contrary to public policy, the court said in also ruling for the IRS.

In Bergbauer, the court did not use either doctrine. Instead, it followed the Fourth Circuit Court of Appeals’ approach (stated in Wrangler Apparel Corp. v. U.S., 78 AFTR2d 96-5674), first examining the tax consequences contemplated by the parties and then the economic substance of the agreement. Based on the negotiations, meetings and signed documents, it was clear that the parties intended a fully taxable transaction, the court said. To test for economic substance, the court examined whether there was independent value grounded in economic reality behind the contract. The restrictions were intended to protect Cap Gemini from immediate sale of the stock, which would have harmed the stock’s value. The restrictions also kept the partners working for Cap Gemini and provided them with anticipated upward growth of the stock value. For the third time, a court ruled for the IRS.

After the Bergbauer decision, the U.S. District Court for New Hampshire ruled similarly in a case brought by another partner, Nancy R. Berry. This court also used the strong proof rule. It rejected Berry’s argument that because she was not a party to the negotiations she had no choice in the transaction. The court also rejected the argument that the true value of the restricted stock and not the agreed value should have been used. The actual value was immaterial, according to the court, since the parties agreed to use the 95% valuation.

Normally, a cash method taxpayer does not have to report an item of income if it is restricted or forfeitable. However, taxpayers can agree to report it in spite of these limitations. If it turns out that the restrictions cause an economic loss, it is highly unlikely that the courts will allow taxpayers to revise how they reported the transaction originally—all the more so if the Fourth Circuit upholds Bergbauer (notice of appeal has been given).

n U.S. v. Robert L. Bergbauer, 102 AFTR2d 2008-5932

n U.S. v. Berry, 102 AFTR2d 2008-5365

The Second Circuit Court of Appeals affirmed the Tax Court’s decision that an individual’s receipt of patent royalties was ordinary income, not long-term capital gain, because the payments were made in exchange for patent rights transferred to a related corporation.

Nathaniel Garfield was a limited partner in a partnership that was majority owner of a corporation. In 1969, his general partner, Thomas McSherry, filed a patent application for an expansible fastener and the same day assigned the related patent rights to the partnership. Subsequently, the partnership transferred the patent rights to the corporation, which paid royalties to Garfield and McSherry. The IRS in 2004 notified Garfield of deficiencies in returns for 2000 through 2002 stemming from more than $800,000 in royalties for the three years that it said Garfield erroneously characterized as longterm capital gain.

Garfield pointed to section 1235(a), which provides that a property transfer of all substantial rights to a patent is treated as a sale or exchange of a long-term capital asset. However, the Tax Court rejected this argument because under subsection (d), the treatment is not available if the transfer was between a corporation and a related party— in the case of patent rights, a more-than- 25% owner. Garfield held a 36% interest in the corporation and, before that, the partnership had held a 74% interest.

Alternatively, Garfield argued that the patent was a capital asset and that the royalty payments were long-term capital gains under sections 1221 and 1222. The courts rejected this argument also, on the basis that Garfield did not hold any patent right for more than one year as required. In addition, the courts upheld a 20% substantial underpayment penalty under section 6662(a). The Tax Court said that grounds for an exception for reasonable cause and acting in good faith were not evident where Garfield and his wife “do not contend that they followed, or even sought, the advice of a tax professional.” The Second Circuit upheld the penalty while acknowledging the returns were signed by a law firm.

The Tax Court disallowed an IRS auditor’s deductions for breeding greyhounds as a hobby loss. Ralph Thomas Whitecavage bred and raised the dogs for racing. He received a percentage of their race winnings but did not realize a profit. The IRS determined deficiencies totaling $18,601 for tax years 2001 through 2003 stemming from nearly $75,000 in net losses that Whitecavage claimed on Schedule C over the three years.

Under IRC § 183(b)(2), absent a primary goal of earning a profit, deductions related to an activity are allowed only to the extent of the related gross income. The taxpayer generally bears the burden of establishing a profit motive for the activity. The determination is based on all relevant facts and circumstances, with a focus on nine factors:

(4) Expectation that assets may appreciate. Although Whitecavage claimed that at least one of his greyhounds could become a winning “stakes dog” worth $100,000 to $250,000, his dogs generally depreciated in value. At trial, no evidence was presented that a single dog was ever sold. Further, no evidence was presented to indicate that a kennel Whitecavage built in 2002 would be sold for a profit.

(5) Success in other activities. Whitecavage had not previously engaged in any similar activities.

(6) History of income or losses from activity. Whitecavage realized losses from greyhound breeding for 10 consecutive years as of 2003.

(7) Amount of occasional profits. He never realized any profit. IRC § 183(d) provides a presumption of a profit motive if taxpayers show a profit in three out of five years.

(8) Financial status of taxpayer. Having significant financial resources from other activities may indicate lack of a profit motive. His full-time employment by the IRS provided substantial income, the court determined.

(9) Elements of personal pleasure. The presence of personal pleasure or recreation may indicate lack of a profit motive, as it did here, the court said. With all nine factors weighing against Whitecavage, the Tax Court determined that he lacked a profit motive. Furthermore, the court upheld a 20% accuracy-related penalty for 2002, since Whitecavage failed to show reasonable cause and good faith regarding a substantial understatement of tax liability.

n Ralph Thomas Whitecavage v. Commissioner, TC Memo 2008-203