The opinion
T.C. Memo. 2015-42
UNITED STATES TAX COURT
JASON CHAI, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18330-09. Filed March 11, 2015.
Frank Agostino, Jeremy M. Klausner, and Lawrence M. Brody, for
petitioner.
Timothy A. Sloane and Andrew M. Tiktin, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a $63,751 deficiency in
petitioner’s Federal income tax and a $12,750.20 accuracy-related penalty under
section 6662(a) for 2003. In an amendment to answer respondent asserted an
increased deficiency and an increased penalty of $627,619 and $125,524,
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[*2] respectively. Petitioner’s motion to dismiss the increased deficiency and the
increased penalty for lack of jurisdiction was granted on February 13, 2015, by
order of the Court. There are two issues for decision: (1) whether the $2 million
payment petitioner received from Delta Currency Trading, LLC (Delta), in 2003 is
nonemployee compensation subject to self-employment tax; and (2) whether
petitioner is liable for the accuracy-related penalty under section 6662(a) for 2003.
Unless otherwise indicated, all section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated facts are
incorporated in our findings by this reference. Petitioner resided in Connecticut
when he filed the petition.
A. The Participants
Petitioner graduated from Harvard University with a master’s degree in
architecture. Petitioner began his career in Los Angeles but moved to New York
in 1999. At all relevant times, petitioner conducted a successful architecture
business. While attending Harvard petitioner met Andrew Beer, who later married
petitioner’s cousin. Beer holds a bachelor of arts degree from Harvard College
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[*3] and a master of business administration degree from Harvard Business
School. He has over 20 years of experience in the investment management
business.
Beer created and marketed several tax shelters directed to wealthy
individuals. The tax shelters were designed to offset prospective clients’ large tax
liabilities for a particular year. To that end, Beer formed several entities to create
the tax shelter structure. Among others, these entities included Delta, Bricolage
Capital, LLC (Bricolage), and Counterpoint Capital, LLC (Counterpoint).
Beer formed Bricolage and Delta as Delaware limited liability companies on
July 21, 1999, and May 30, 2000, respectively. Counterpoint was formed as a
Delaware limited liability company on March 2, 2000. At all relevant times, Beer
indirectly owned all or a majority of the interests in Delta, Bricolage, and
Counterpoint (collectively, Bricolage entities). Petitioner never owned an interest
in Delta or Bricolage. The Bricolage entities were affiliated by common
ownership and shared clients, offices, employees, and resources in 2001 and 2002.
They developed and marketed Beer’s tax shelters and advised their clients on the
same.
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[*4] B. The Structure
Bricolage advised its clients on Partnership Option Portfolio Strategy
(POPS) tax shelters during 2000 and 2001. Counterpoint and Bricolage advised
their clients on Personal Investment Corporation (PICO) tax shelters during 2000
and 2001. Delta also advised its clients on both the POPS and PICO tax shelters
(collectively, tax shelters).
The tax shelters were designed to eliminate Delta’s clients’ tax liabilities by
generating noneconomic tax losses to offset the clients’ taxable income. The tax
shelters shared three key characteristics: (1) each centered around the formation
of a flowthrough entity; (2) each involved a straddle comprising offsetting
derivatives into which the POPS or PICO entity entered; and (3) each required a
transitory partner or shareholder in the POPS or PICO entity to whom the entity
allocated income from the derivatives so that a tax shelter investor could recognize
offsetting tax losses. To facilitate the transactions, Delta provided a transitory
partner or accommodating party. The POPS and PICO entities allocated income to
the accommodating party and allocated noneconomic losses to Delta’s clients to
offset their large tax liabilities. Petitioner was an accommodating party. For its
part, Delta received sizable fees for advising its clients on the tax shelters and
facilitating the clients’ participation.
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[*5] These transactions were especially profitable for Beer as the majority owner
of the Bricolage entities. For instance, for 2001 Delta reported over $88 million of
income, primarily from client fees. Similarly, for 2002 Delta reported over $93
million of income, primarily from client fees.
In 2002 the Commissioner released Notice 2002-50, 2002-2 C.B. 98, and
Notice 2002-65, 2002-2 C.B. 690, advising taxpayers and their representatives that
transactions like POPS and PICO were subject to challenge by the Commissioner
and had been designated “listed transactions”.
C. Petitioner’s Role
After petitioner moved to New York, he lived in Beer’s home during the
summer of 2002. That summer, Beer approached petitioner about participating in
a new tax strategy Beer had developed to reduce tax liabilities of potential clients.
Beer explained to petitioner that he intended to market the tax shelters to
encourage wealthy individuals to become clients of Delta and its affiliated
companies.
Beer also explained the tax strategy and the structure of the tax shelters to
petitioner. Petitioner understood that the clients had large tax liabilities for a
given year. Additionally, petitioner understood that the structure was a series of
transactions designed to offset clients’ tax liabilities and that his role was to serve
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[*6] as a partner with the potential clients. These partnerships were integral to the
overall structure. Furthermore, petitioner understood he would serve as a conduit
and that the potential clients’ tax liabilities then would be transferred to him. Beer
told petitioner the tax obligations transferred to petitioner would be eliminated by
offsetting activities. Petitioner raised concerns about the transactions and asked
Beer whether POPS and PICO were “pure tax shelters”. Beer assured petitioner
these structures had been vetted by attorneys and accountants.
Despite his concerns, petitioner agreed to serve as an accommodating party
for the POPS and PICO transactions in exchange for compensation from the
Bricolage entities. Petitioner agreed to a $100,000 annual salary plus a signing
bonus in exchange for his participation in the transactions. Beer and petitioner
also discussed discretionary bonuses petitioner could receive for his involvement
in PICO.
D. The Economics of Petitioner’s Participation
Petitioner was an accommodating party for at least 131 tax shelters, having
reported over $3.2 billion of noneconomic income, allocated to him by the tax
shelters, on his 2000 and 2001 income tax returns. This income was
approximately equal to the amounts of offsetting noneconomic tax losses allocated
to Delta’s clients. To relieve petitioner’s concerns about increased tax liabilities,
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[*7] Beer assured petitioner that there were strategies they could use to offset
petitioner’s tax liabilities on the basis of his participation in the tax shelters.
Notably, petitioner received and reported offsetting losses from the POPS and
PICO entities for 2000 and 2001 approximately equal to amounts of income
allocated to him from the tax shelters.
E. JJC Trading, LLC
Petitioner’s participation in the tax shelters involved executing numerous
transactions to facilitate each of the 131 tax shelters. This included signing
binders of legal documents (including articles of incorporation, loan agreements,
wire transfers, and redemption request letters) for the PICO and POPS entities. In
2000 petitioner went to the offices of Delta and its affiliates “a lot” and “regularly”
to sign documents executing the tax shelter transactions. This signing
responsibility was problematic for petitioner because he traveled frequently for his
architecture business. He was often unable to be physically present to sign these
documents.
Therefore, at Delta’s suggestion, in 2001 petitioner formed JJC Trading,
LLC (JJC), to facilitate and simplify petitioner’s participation in the Bricolage
entities. Petitioner was the sole owner of JJC, and Bricolage was JJC’s
nonmember manager. JJC relieved petitioner of his signature burden because
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[*8] JJC’s operating agreement (signed by petitioner) gave Bricolage authority to
make decisions and sign documents for JJC in petitioner’s stead. Petitioner also
gave Bricolage power of attorney to make decisions and sign documents for JJC.
Petitioner did not maintain books and records regarding his interests in JJC, the
tax shelter entities, or the transactions.
F. Petitioner’s Compensation
Petitioner received significant compensation from the Bricolage entities in
exchange for his participation in the tax shelters. For instance, in 2000 petitioner
received $1.2 million from Counterpoint as a signing bonus, and in 2001 JJC
received $1 million from Delta. Counterpoint and Delta reported these payments
on Forms 1099-MISC, Miscellaneous Income (Form 1099), as nonemployee
compensation, and petitioner reported them as income on Forms 1040, U.S.
Individual Income Tax Return, and paid the resulting tax. Petitioner also received
several other payments from Bricolage and Counterpoint, totaling $100,000 per
year for 2001 and 2002 and reflecting Beer’s agreement with petitioner that he
would receive an annual salary of $100,000 in exchange for his participation.
Bricolage and Counterpoint reported all of these amounts as petitioner’s wages,
and petitioner paid the resulting tax.
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[*9] G. The 2003 Payment From Delta
In April 2002 petitioner received an email (April 2002 email) from Delta’s
chief financial officer Helen Del Bove, referencing petitioner’s receipt of $1
million from Delta in 2001. The April 2002 email also notified petitioner he
would receive future fees for consulting work he performed for Delta. On March
3, 2003, petitioner received a $2 million payment from Delta.
Before petitioner received the $2 million payment, however, he and Del
Bove had exchanged several emails in February 2003 discussing the proper tax
treatment of the $2 million payment. Del Bove notified petitioner that Delta was
going to wire petitioner the $436,000 remaining in JJC, dissolve that entity, and
pay petitioner an additional $2 million. In response, petitioner asked: “To this
end, can you fill me in on how this money should be treated as far as my
accountant is concerned? Will I be issued a 1099 for the whole amount?” Del
Bove responded that the $2 million payment “will be reported on a 1099, so you
should tax-plan accordingly.” Petitioner again asked for clarification on whether
both the $2 million payment and the balance in the JJC account were going to be
reported on his Forms 1099 for 2003. Del Bove responded that “[t]he amount you
receive from JJC Trading is not income and, therefore, will not be reported on a
1099. That money is from what you had originally invested in JJC Trading. The
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[*10] 2mm we pay you will be reported on a 1099, as well as any other subsequent
payments.”
Beer had authorized, on behalf of Delta, the $2 million payment to
petitioner. Beer viewed the $2 million payment as a discretionary bonus for
services petitioner had provided to Delta. Consistent with past practice, Delta
reported the $2 million on Form 1099 for 2003 as nonemployee compensation.
H. Petitioner’s Tax Reporting
Petitioner did not report the $2 million payment from Delta as taxable
income, contending that it was a return of capital from his investments. However,
petitioner was not a partner of Delta and did not invest any capital in Delta.
Neither petitioner nor JJC reported receiving a share of Delta’s income or loss.
No Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc., was
prepared by Delta for petitioner.
All of petitioner’s interests in the other tax shelter entities were either sold
or redeemed before he received the $2 million payment in 2003. In closing
agreements executed between petitioner and the Internal Revenue Service (IRS)
with respect to POPS and PICO, petitioner agreed that he had disposed of all his
interests in the tax shelter entities by the end of 2001. Petitioner reported the
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[*11] amounts he received before 2003 on Forms 1040 for 2000 and 2001. JJC
reported amounts received in completed sales of its interests in 2001.
Petitioner reported zero total tax on his income tax return for 2003.
Stephen Ellspermann, a certified public accountant, prepared petitioner’s income
tax return for 2003. Petitioner and Ellspermann discussed the nature of the $2
million payment before filing petitioner’s return for 2003. Petitioner told
Ellspermann that he did not know the nature of the $2 million payment. He
indicated to Ellspermann that the $2 million was from activities managed by
Bricolage and that Ellspermann should contact Bricolage to clarify its nature.
Before filing petitioner’s income tax return for 2003, Ellspermann asked
Del Bove’s replacement, Barney Taglialatela, about money transfers between
petitioner, JJC, Mercato Global Opportunities Fund, LP (Mercato Global), and
Bricolage. He did not ask Taglialatela about money transfers to petitioner from
Delta. Ellspermann understood, on the basis of his conversation with Taglialatela,
that everything pertaining to the partnerships was included on the Mercato Global
Schedule K-1 issued to petitioner. Ellspermann believed that the $2 million
payment was included on the Schedule K-1. He believed this, even though he did
not specifically ask Taglialatela if the $2 million payment was included on the
Schedule K-1. Taglialatela did not tell Ellspermann that the $2 million payment
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[*12] from Delta was not income or that it would not be reported on Form 1099
for 2003. Similarly, Taglialatela never told petitioner or Ellspermann that the $2
million would be reported on Schedule K-1. The $2 million payment was not
reported as a withdrawal or distribution on any Schedule K-1 or any combination
of Schedules K-1 that petitioner received for 2003.
Before filing his income tax return for 2003, petitioner did not tell
Ellspermann about his email correspondence with Del Bove regarding the $2
million payment and that Delta intended it to be income reported on a Form 1099
for 2003. He also did not tell Ellspermann that Del Bove had notified petitioner
that he would receive future fees for his consulting work with Delta. Ellspermann
first learned of the Delta Form 1099 for 2003 in 2008 during the examination of
petitioner’s income tax return for 2003. Had Ellspermann known of the Form
1099 for 2003, he would have discussed the tax treatment of the $2 million with
Taglialatela.
OPINION
The parties’ fundamental dispute is over the character of the $2 million
payment Delta made to petitioner in 2003. Petitioner contends that the $2 million
payment from Delta is either a return of capital or, alternatively, a gift from Beer
to petitioner. Neither would be subject to self-employment tax. Respondent
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[*13] contends the $2 million payment is nonemployee compensation subject to
self-employment tax that should have been reported on petitioner’s return.
I. The $2 Million Dollar Payment
A. Burden of Proof and Production
Generally, the taxpayer bears the burden of proof. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). Petitioner contends, however, that pursuant
to sections 6201(d) and 7491(a) respondent should bear the burden of proof.
If a taxpayer asserts a reasonable dispute with respect to an item of income
reported on an information return filed by a third party and meets certain other
requirements, the Commissioner bears the burden of producing reasonable and
probative evidence, in addition to the information return, concerning the
deficiency attributable to that item. Sec. 6201(d). Respondent has presented
evidence, other than the information return filed by Delta, as to the character of the
income in issue. We therefore are not relying on the characterization reported in
that information return.
The parties stipulated petitioner’s receipt of the $2 million payment and
Delta’s characterization of that payment for tax purposes. Thus, petitioner must
show the nontaxable character of the payment. See Tokarski v. Commissioner, 87
T.C. 74, 76-77 (1986) (holding that the taxpayer had the burden of proof to show
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[*14] nontaxable nature of payment where the taxpayer indisputably received the
income in issue); Price v. Commissioner, T.C. Memo. 2004-103.
If a taxpayer produces credible evidence to support her or his position,
complies with substantiation requirements, and cooperates with the Commissioner
with regard to all reasonable requests for information, then the burden of proof
shifts to the Commissioner. Sec. 7491(a); see Higbee v. Commissioner, 116 T.C.
438, 440-441 (2001). A prolonged discussion of burden of proof is unnecessary
because we decide this case on the preponderance of the evidence. See Knudsen
v. Commissioner, 131 T.C. 185, 189 (2008) (“In a case where the standard of
proof is preponderance of the evidence and the preponderance of the evidence
favors one party, we may decide the case on the weight of the evidence and not on
an allocation of the burden of proof.”); see also Estate of Jorgensen v.
Commissioner, T.C. Memo. 2009-66, aff’d, 431 Fed. Appx. 544 (9th Cir. 2011).
B. Character of the Payment
Gross income generally includes all income from whatever source derived,
including compensation for services in the form of fees, commissions, or fringe
benefits. Sec. 61(a)(1). The character of a payment for tax purposes is determined
by the intent of the parties, particularly the intent of the payor, as disclosed by the
surrounding facts and circumstances. See Smith v. Commissioner, T.C. Memo.
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[*15] 1995-410; Keck v. Commissioner, T.C. Memo. 1993-538; Watson v.
Commissioner, T.C. Memo. 1960-255. A receipt of capital or a return of capital
does not constitute taxable income. See Doyle v. Mitchell Bros. Co., 247 U.S.
179, 185 (1918); Veenstra & DeHaan Coal Co. v. Commissioner, 11 T.C. 964, 966
(1948); Monico v. Commissioner, T.C. Memo. 1998-10. Similarly, receipt of a
gift is not taxable income. See Estate of Maycann v. Commissioner, 29 T.C. 81,
85 (1957); McDermott v. Commissioner, T.C. Memo. 2003-269.
The trial testimony supports the conclusion that the $2 million payment was
compensation subject to self-employment tax. Although petitioner attempts to
minimize his role in the tax shelters and describes his activities as investments, the
record reflects that he provided services to Delta to facilitate the tax shelter
transactions. Beer testified that petitioner’s role in the tax shelters was a critical
component of the transactions and the tax shelters could not have functioned as
planned without petitioner’s participation. Delta could not have allocated
noneconomic losses to its clients without petitioner’s acting as the accommodating
party. The allocation of $3.2 billion of noneconomic income to petitioner enabled
Delta’s clients to reap the benefits of an almost equal amount of noneconomic
losses to offset their taxable income. Petitioner’s role was far from nominal.
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[*16] Petitioner argues that because he delegated decisionmaking authority to
Bricolage, he did not perform any meaningful services for Delta (or any of the
other Bricolage entities). Petitioner’s income cannot escape taxation merely
because he delegated certain duties to Bricolage and Beer. The risky nature and
large receipts of the tax shelters provide ample justification for the high
compensation relative to the low amount of personal effort involved.
Petitioner also provided services in a more apparent manner. Petitioner’s
primary responsibility was to sign binders of formation and organizational
documents for the PICO and POPS entities. He testified that there was often a
flurry of activity requiring him to go to the Bricolage entities’ offices “a lot” and
“regularly” to sign large volumes of legal documents to execute the tax shelter
transactions. This was a burden for petitioner because he traveled frequently for
his architecture business. To alleviate the burden, Delta suggested that he form
JJC and sign a document granting a power of attorney to Bricolage.
Petitioner argues that the $2 million payment could not have been
compensation for services because after JJC was formed he was completely
removed from that process. Contrary to petitioner’s assertions, signing the
formation and organizational documents was not a menial task but an integral
component of creating the tax shelter entities. Whether petitioner subjectively
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[*17] understood and appreciated the nature of his actions does not eliminate the
significance of the services he provided to Delta and the other tax shelters by
signing the formation and organizational documents. Petitioner’s subsequent
delegation of his signature authority does not absolve him from liability for tax on
the compensation he received.
The remainder of the record also reflects that the $2 million payment was
compensation. Beer agreed to pay petitioner a $100,000 annual salary plus a
signing bonus in exchange for petitioner’s involvement. Beer and petitioner also
discussed possible discretionary bonuses. Petitioner received several payments
consistent with his agreement with Beer.
Petitioner received significant payments from the Bricolage entities
characterized and reported as nonemployee income. In 2000 petitioner received a
$1.2 million signing bonus from Counterpoint. Counterpoint reported it as
nonemployee income on its Form 1099 for 2000, and petitioner paid income tax
on the full amount. Similarly, in 2001 petitioner received a $1 million payment
from Delta through JJC. Petitioner testified that he viewed it as another bonus.
Delta reported the $1 million payment as nonemployee income on Form 1099 for
2001, and petitioner paid income tax on the full amount. Additionally, in 2001
and 2002 petitioner received a $100,000 salary paid by Bricolage and
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[*18] Counterpoint and consistent with petitioner’s agreement with Beer.
Bricolage and Counterpoint reported these amounts as wages, and petitioner paid
the resulting tax. There is neither discernable reason nor persuasive justification
for treating the 2003 payment differently.
Moreover, Del Bove informed petitioner that the $2 million payment in
issue would be reported on the Form 1099 for 2003. In April 2002 Del Bove and
petitioner exchanged several emails regarding the $2 million payment and how
Delta intended to characterize it. After responding to petitioner’s multiple
requests for clarification, Del Bove unequivocally notified him that Delta intended
to report the $2 million payment on the Form 1099 for 2003. After his email
exchange with Del Bove, petitioner still questioned Del Bove’s calculations and
did not believe that all or part of the $2 million payment was taxable income.
Petitioner’s testimony is implausible and unpersuasive. He had received
compensation in prior years pursuant to his agreement with Beer, and he had
notice that the payment was to be treated as compensation by the payor, Delta.
At trial and in his posttrial supplemental brief petitioner objected to the use
of the Del Bove emails as hearsay. They are admissible, however, for purposes
other than proving that Del Bove was correct in her characterization of the
payment, i.e., for purposes other than the truth of her statements. The emails are
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[*19] admissible to show that petitioner was on notice that the $2 million payment
would be treated as taxable income. See Biegas v. Quickway Carriers, Inc., 573
F.3d 365, 379 (6th Cir. 2009) (holding statement admissible for nonhearsay
purpose to prove plaintiff was on notice of imminent danger, ignored warning, and
acted negligently). The Del Bove emails are also admissible under the state of
mind exception to the hearsay rule to show how Delta intended to report and
characterize the $2 million payment. See Fed. R. Evid. 803(3); Estate of Pruitt v.
Commissioner, T.C. Memo. 2000-287 (holding testimony regarding decedent’s
stated intent to include a power to make gifts in powers of attorney admissible
under rule 803(3) of the Federal Rules of Evidence); Pan Am. Acceptance Corp. v.
Commissioner, T.C. Memo. 1989-440 (holding check with notation “repay debt”
admissible under rule 803(3) of the Federal Rules of Evidence as evidence of
intent to repay loan).
Petitioner additionally argues that respondent prevented material evidence
from being introduced by not providing Del Bove with limited immunity.
Petitioner also argues that respondent’s failure to do so should create an adverse
inference that Del Bove’s testimony would not have supported respondent’s
position. Contrary to petitioner’s assertions, only the Department of Justice can
grant immunity. See 18 U.S.C. sec. 6003 (2012). Moreover, even if respondent
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[*20] could have granted immunity to Del Bove and chose not to, a negative
inference cannot be drawn from that prosecutorial decision. See United States v.
Myerson, 18 F.3d 153, 158 (2d Cir. 1994) (citing United States v. St. Michael’s
Credit Union, 880 F.2d 579, 598 (1st Cir. 1989), and relying on that court’s
determinations that “the government’s failure to immunize a witness, without
more, does not give rise to a missing witness instruction” and that no “negative
inference may be drawn from that prosecutorial decision”); United States v.
Forbes, 2007 WL 141952, at *7 (D. Conn. Jan. 17, 2007).
Delta’s treatment of the $2 million payment as nonemployee income was
consistent with Delta and Counterpoint’s treatment of the 2001 and 2002 “bonus”
payments. Delta reported both prior payments as nonemployee compensation, and
petitioner reported them as self-employment income and paid tax on them.
Petitioner has provided no persuasive justification for distinguishing the 2003
$2 million payment from the 2001 or 2002 “bonus” payments. The evidence
establishes that the intent of the parties and specifically the intent of the payor
Delta was to treat the $2 million payment as nonemployee income subject to tax.
Therefore, the character of the $2 million payment is nonemployee income subject
to self-employment tax.
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[*21] Petitioner additionally argues that he is not subject to self-employment tax
on the $2 million payment because he was not engaged in a trade or business as a
tax shelter accommodating party. The term “trade or business” has the same
meaning under section 1402(a) as under section 162. Sec. 1402(c); see Bot v.
Commissioner, 118 T.C. 138, 146 (2002), aff’d, 353 F.3d 595 (8th Cir. 2003). In
Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the Supreme Court
determined that to be engaged in a trade or business under section 162 (and, in this
case, section 1402(a)), the taxpayer must be involved in an activity with continuity
and regularity and with the primary purpose of receiving income or profit.
The record demonstrates that petitioner’s activities were continuous and
regular. Petitioner testified that he went to Bricolage’s offices “a lot” and
“regularly” to execute large volumes of legal documents consisting of formation
and organization documents for the tax shelter entities. This fact remained even
after petitioner formed JJC in 2001. By forming JJC, making Bricolage JJC’s
nonmember manager, and giving Bricolage power of attorney over JJC,
petitioner’s activities remained continuous and regular. Bricolage’s actions with
respect to JJC are imputed to petitioner as his agent. Petitioner established the
legal machinery for others to act on his behalf and cannot now use that delegation
of authority as a shield. The record also demonstrates petitioner’s profit motive.
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[*22] Petitioner was paid for his services through large lump-sum payments that
were reported by the payors as nonemployee compensation on Forms 1099, and
petitioner reported the payments as self-employment income. In short, the record
demonstrates that petitioner accommodated tax shelters with sufficient continuity,
regularity, and a profit motive such that he was engaged in a trade or business as a
tax shelter accommodating party.
Next, petitioner asserts that the $2 million payment was a return of capital.
Aside from his blanket assertions, the evidence establishes that petitioner was not
a partner in Delta and did not invest capital in Delta. The parties stipulated that
petitioner received the $2 million payment from Delta and Delta’s characterization
of that payment. Simply stated, the payment could not have been a return of
capital because petitioner did not have any capital invested in Delta.
The evidence establishes that petitioner did not have a capital investment in
any tax shelter entity after 2001. In closing agreements with the IRS, petitioner
agreed that both he and JJC sold or redeemed all of their respective interests in the
tax shelter entities by the end of 2001. He recorded amounts received in sales or
redemptions of his interests in the tax shelter entities on his income tax returns for
2000 and 2001. Similarly, JJC recorded amounts received in sales or redemptions
of its interests in the tax shelter entities on its income tax return for 2001.
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[*23] Nevertheless, petitioner asserts that he had investment capital in the tax
shelter entities when he received the $2 million payment. Petitioner argues that he
understood the initial $1.2 million payment from “Bricolage” would be a signing
bonus in 2000 to be used as his investment capital in the tax shelter entities.
Similarly, petitioner argues that the $1 million deposit into JJC was “ostensibly”
used to invest in the Bricolage entities.
Petitioner did not know which, or how many, of the Bricolage entities’
partnerships he had invested in. He did not keep track of the partnerships, his
investments in the partnerships, or the transactions they engaged in. He concedes
that it is impossible to trace his investments in the Bricolage entities because the
tax shelters’ structures were too complex and vast to unwind. Finally, he notes
that tracing his investments is impossible because he has repeatedly been denied
access to necessary financial records.
Petitioner’s argument appears to be that the circumstantial evidence of his
investment in the Bricolage entities demonstrates that the $2 million payment was
a return of capital. We disagree. The preponderance of the evidence establishes
that the $2 million payment was not a return of capital from Delta.
Petitioner alternatively argues that if the $2 million payment is not a return
of capital, then it was a gift from Beer. Petitioner notes that “[w]hile the Court
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[*24] may think the suggestion that the payment was part gift somewhat
far-fetched, this case must be decided on the evidence presented.” We agree with
petitioner’s characterization of his suggestion and the necessity of deciding the
case on the evidence, but we reject his conclusion. A gift results from a detached
and disinterested generosity motivated by affection, respect, admiration, charity, or
the like. Commissioner v. Duberstein, 363 U.S. 278, 285 (1960). The record is
devoid of any evidence suggesting that the payment resulted from detached and
disinterested generosity. Rather, the evidence establishes that the payor, Delta,
intended the payment as compensation. Notably, Beer testified that he viewed the
$2 million payment as a discretionary bonus for services petitioner provided to
Delta. The evidence compels the conclusion that the $2 million payment in
question was received for services and was neither a gift nor a return of capital
contributions that neither petitioner nor Beer could identify.
II. Accuracy-Related Penalty
Finally, we consider whether petitioner is liable for the accuracy-related
penalty. See sec. 6662(a). Respondent has the burden of production and must
present sufficient evidence that it is appropriate to impose the penalty. See sec.
7491(c); Higbee v. Commissioner, 116 T.C. at 446-447. Once respondent satisfies
his burden of production, petitioner must present evidence sufficient to persuade
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[*25] the Court that respondent’s determinations are incorrect. See Higbee v.
Commissioner, 116 T.C. at 447.
A. Section 6751(b)
Petitioner raises for the first time in his posttrial brief an argument that
respondent failed to carry his burden of production by not introducing evidence of
his compliance with section 6751(b)(1). Petitioner theorizes that for respondent to
meet his burden of production, respondent must introduce evidence that the
individual making the penalty determination had his or her immediate supervisor
approve the accuracy-related penalty in writing. A party may not raise an issue for
the first time on brief if the Court’s consideration of the issue would surprise and
prejudice the opposing party. See Smalley v. Commissioner, 116 T.C. 450, 456
(2001); Seligman v. Commissioner, 84 T.C. 191, 198-199 (1985), aff’d, 796 F.2d
116 (5th Cir. 1986). In deciding whether the opposing party will suffer prejudice,
we consider the degree to which the opposing party is surprised by the new issue
and the opposing party’s need for additional evidence to respond to the new issue.
See Pagel, Inc. v. Commissioner, 91 T.C. 200, 212 (1988), aff’d, 905 F.2d 1190
(8th Cir. 1990). In addition, a party may not rely upon a new theory unless the
opposing party has been provided with fair warning of the intention to base an
argument upon that theory. See id. at 211-212. “Fair warning” means that a
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[*26] party’s ability to prepare its case was not prejudiced by the other party’s
failure to give notice, in the notice of deficiency or in the pleadings, of the
intention to rely on a particular theory. Id.
Petitioner’s new argument is untimely. We do not rule on the issue of
whether the section 6751(b) requirement is part of respondent’s burden of
production and express no opinion as to the merits of petitioner’s argument.
Petitioner did not allege in the petition, in his pretrial memorandum, or at trial that
respondent failed to comply with section 6751(b). By belatedly raising this
argument in his posttrial opening brief, petitioner would prejudice respondent by
denying him an opportunity to introduce evidence of the IRS’s compliance with
section 6751(b). This case was tried before and submitted to a judge who is no
longer available to decide it. The parties were given an opportunity for a further
trial but did not request one. There is no justification for reopening the record at
this late stage, and we will not address the section 6751(b) argument.
B. Substantial Understatement of Income Tax
A taxpayer is liable for an accuracy-related penalty as to any portion of an
underpayment attributable to, among other things, a substantial understatement of
income tax or negligence. Sec. 6662(a) and (b)(1) and (2). There is a substantial
understatement of income tax if the amount of the understatement exceeds the
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[*27] greater of 10% of the tax required to be shown on the return or $5,000. Sec.
6662(d)(1)(A); sec. 1.6662-4(a), Income Tax Regs. Because we determine that
there is a substantial understatement of income tax, we need not address
negligence.
Petitioner reported zero total tax for 2003, and we are sustaining the
determination in the notice of deficiency that he owes $63,751. Thus, petitioner
understated the tax on his return by $63,751. Accordingly, respondent has met his
burden of producing evidence that petitioner’s underpayment was attributable to a
substantial understatement of income tax and therefore petitioner is liable for the
accuracy-related penalty absent a showing of reasonable cause or some other
defense.
C. Reasonable Cause and Good Faith
Once the Commissioner has met the burden of production, the taxpayer
must come forward with persuasive evidence that the penalty is inappropriate
because, for example, he or she acted with reasonable cause and in good faith.
Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at 448-449. The decision as
to whether a taxpayer acted with reasonable cause and in good faith is made on a
case-by-case basis, taking into account all pertinent facts and circumstances. See
sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the
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[*28] extent of the taxpayer’s effort to assess her or his proper tax liability. Id.;
see Halby v. Commissioner, T.C. Memo. 2009-204.
While reliance on the advice of a professional tax adviser does not
necessarily demonstrate reasonable cause and good faith, it may when “under all
the circumstances, such reliance was reasonable and the taxpayer acted in good
faith.” Sec. 1.6664-4(b)(1), Income Tax Regs. The requirements for reasonable
cause are not satisfied if the taxpayer fails to disclose a fact that he knows, or
reasonably should know, to be relevant to the proper tax treatment of an item.
Sec. 1.6664-4(c)(1)(i), Income Tax Regs.; see Diaz v. Commissioner, T.C. Memo.
2012-280. Additionally, a taxpayer’s education, sophistication, and business
experience are relevant in determining whether the taxpayer’s reliance on the tax
advice was reasonable and made in good faith. Sec. 1.6664-4(c)(1), Income Tax
Regs.
Petitioner seeks to defend against the accuracy-related penalty by asserting
that he relied on Ellspermann, his tax professional, to prepare the tax return and to
assure him that the $2 million payment was not taxable income. However,
Ellspermann’s advice was only as good as the information that petitioner provided
to him. Petitioner did not provide Ellspermann with necessary and accurate
information.
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[*29] In the April 2002 email Del Bove discussed petitioner’s receipt of the
$1 million payment from Delta in 2001 and notified petitioner that he would
receive future fees for consulting work that he had performed for Delta. In
February 2003 Del Bove emailed petitioner and notified him that he would be
receiving the balance of funds from his JJC account and the $2 million payment
from Delta. Petitioner and Del Bove exchanged several followup emails
discussing the proper tax treatment of the $2 million payment. Del Bove
responded that the $2 million “will be reported on a 1099, so you should tax-plan
accordingly.” Petitioner asked for additional clarification on whether both
amounts would be included on Form 1099 for 2003. Del Bove responded
unequivocally that “[t]he amount you receive from JJC Trading is not income, and
therefore, will not be reported on a 1099. That money is from what you had
originally invested in JJC Trading. The 2mm we pay you will be reported on a
1099, as well as any other subsequent payments.” Petitioner asserts that, after this
email exchange, he questioned Del Bove’s conclusion and exchanged several
emails with Bricolage’s general counsel regarding how much was due to him and
how it would be treated for tax purposes.
Petitioner’s testimony on these points is not persuasive. Del Bove
unequivocally explained to petitioner, after several clarifications, that the
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[*30] $2 million would be included on his Form 1099 for 2003 and that he should
“tax-plan accordingly.” Del Bove’s emails clearly explained how Delta intended
to characterize the payment. Delta subsequently reported the $2 million payment
as nonemployee compensation on petitioner’s Form 1099 for 2003, consistent with
Del Bove’s emails and explanation. Petitioner never informed Ellspermann of his
February 2003 email exchange with Del Bove regarding the tax treatment of the
$2 million payment or that petitioner was notified it would be treated as income
and included on Form 1099 for 2003.
Apparently, petitioner’s argument is that he had satisfied himself on the tax
treatment of the $2 million payment. We reject petitioner’s explanation of why he
did not tell Ellspermann about his email exchanges with Del Bove. Instead,
petitioner erroneously told Ellspermann that the $2 million payment was part of
the activities Bricolage managed and that, if Ellspermann had any questions, he
should contact Bricolage regarding the classification and nature of the payment.
Ellspermann testified that he would have followed up with Delta regarding a
potential Form 1099 for 2003 if he had been informed of petitioner’s
correspondence with Del Bove.
Petitioner must demonstrate by a preponderance of the evidence that he
relied in good faith on his adviser’s judgment to establish good cause. See
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[*31] Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d,
299 F.3d 221 (3d Cir. 2002); see also 106 Ltd. v. Commissioner, 136 T.C. 67, 77
(2011), aff’d, 684 F.3d 84 (D.C. Cir. 2012). Petitioner cannot establish good-faith
reliance because he withheld from Ellspermann a crucial and probative email
exchange. Petitioner’s decision to withhold that information from Ellspermann
was negligent at best or intentionally obstructive at worst. In either event,
petitioner failed to inform Ellspermann of facts that he knew, or should have
known, were relevant to the proper tax treatment of the $2 million payment. A
reasonably prudent person would have informed his or her tax professional as to
the disputed characterization of a payment. It was objectively unreasonable for
petitioner to fail to do so.
Additionally, petitioner cannot demonstrate good-faith reliance because he
knew, or should have known, that Ellspermann’s advice was based on incomplete
information and an unreasonable assumption. The advice of a professional must
not be based on unreasonable factual and legal assumptions and must not
unreasonably rely on the representations, statements, findings, or agreements of
the taxpayer or any other person. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.; see
Canal Corp. v. Commissioner, 135 T.C. 199, 218 (2010); Dunn v. Commissioner,
T.C. Memo. 2010-198. The advice must not be based on a representation or
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[*32] assumption that the taxpayer knows, or has reason to know, is unlikely to be
true. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.
Ellspermann determined the $2 million payment could be omitted from
petitioner’s tax return on the basis of an unreasonable and erroneous assumption--
that the payment was recorded on Schedule K-1 as to a partner’s distributive share.
That assumption is erroneous and unreasonable for several reasons. Del Bove’s
replacement, Taglialatela, credibly testified that he never told petitioner or
Ellspermann that the $2 million would be reported on Schedule K-1 or any
combination of Schedules K-1. Similarly, Taglialatela credibly testified that he
never told Ellspermann that the $2 million payment was not income or that it
would not be reported on Form 1099 for 2003. The $2 million payment does not
appear on petitioner’s 2003 Schedules K-1. Petitioner’s failure to inform
Ellspermann about his email exchange with Del Bove bolstered Ellspermann’s
erroneous assumption. Petitioner knew, or had reason to know, that the $2 million
would be reported on Form 1099 for 2003. Therefore, Ellspermann’s advice was
based on a representation or assumption that petitioner knew, or had reason to
know, was unlikely to be true.
Finally, we note that petitioner is a highly educated businessperson.
Petitioner received his undergraduate and master’s degrees from Harvard, and he
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[*33] owned and operated a successful architecture business. On the basis of
petitioner’s education, sophistication, knowledge, and experience, we find that he
should have known of the importance of informing Ellspermann that he knew, or
had reason to know, the $2 million payment would be treated as nonemployee
compensation.
In sum, petitioner has not demonstrated reasonable cause for his failure to
report the $2 million payment on his income tax return for 2003. Petitioner did
not provide the necessary and accurate information to Ellspermann and, as a result,
did not rely in good-faith on Ellspermann’s judgment.
We have considered all remaining arguments the parties made and, to the
extent not addressed, we conclude they are irrelevant, moot, or meritless.
To reflect the foregoing,
Decision will be entered
for respondent.