UNITED STATES TAX COURT
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T.C. Memo. 2012-96
UNITED STATES TAX COURT
F. LEE BAILEY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
F. LEE BAILEY AND ESTATE OF PATRICIA S. BAII!EY, F. LEE BAILEY,
PERSONAL R£PRESENTATIVE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 3080-08, 3081-08.
Filed April 2, 2012.
P, a lawyer, represented a criminal defendant who was
cooperating with the Federal Government by facilitating the transfer
of his foreign assets as restitution. In 1994 P entered into an unusual
unwritten agreement with the Government, pursuant to which he
would use an existing foreign account of his own to hold $6 million
of the client's stock and make expenditures to faóilitate the client's
plan. P sold some of the stock and borrowed against the remainder,
using some of the proceeds for the client's business but also
transferring some to other accounts from which he made personal
expenditures of his own. He later repaid the funds he had spent for
himself.
P conducted a yacht rental activity and an airplane
remanufacturing activity through a wholly owned S corporation.
! SERVED APR - 2 2012
-2Most of the use of the yacht was personal. The airplane
remanufacturing activity was devoted to developing a plane as a
prototype, including the expensive process of obtaining FAA
approval for remanufacturing multiple planes for sale. Neither of the
activities ever generated a profit, and P claimed pass-through losses
from his S corporation on his individual income tax returns.
P failed to report all of his income on his returns, wrongly
reported some income he did not receive, claimed some deductions he
could not substantiate, and failed to deduct certain amounts that he
did expend.
Held: P realized income not when he received the stock, sold
it, or borrowed against it, but only when he transferred sale proceeds
to other accounts from which he later made personal expenditures.
Held, further, the yacht rental activity was not engaged in for
profit under I.R.C. sec. 183 during any of the tax years at issue; but
the airplane remanufacturing activity was engaged in for profit from
1993 until April 1996.
Held, further, for the 1993 through 1995 and 1997 through
2000 tax years, P is liable for the accuracy-related penalty under
I.R.C. sec. 6662.
F. Lee Bailey, for himself.
Carina J. Campobasso, Thomas R. Thomas, Frances F. Regan, and Janet F.
Appel, for respondent.
CONTENTS
FINDINGSOFFACT ............................................... 8
Mr.Bailey's careerand business ventures .......................... 8
Mr. Bailey's representation of Claude Duboc . . . . . . . . . . . . . . . . . . . . . . . 9
Mr. Bailey's unwritten agreement with the Government . . . . . . . . . . . . . . . 9
Theterms oftheunwritten agreement ............................ 10
Payments under the unwritten agreement . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The use of Mr. Bailey's existing Credit Suisse account . . . . . . . . . . . . . . . 14
Mr.Bailey's workunderthe agreement ........................... 15
Mr.Bailey's financialtransactions ............................... 16
Accounting for and return of stock . . . . . . . . . :. . . . . . . . . . . . . . . . . . . . 19
Repayment of unapproved expenditures and personal loans . . . . . . . . . . . 21
Subsequent proceedings L . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Mr.Bailey's subchapter S corporationk v.......................... 24
Mr.Bailey'srecords ...-... ................................... 25
Mr.Bailey'sairplanerentalactivity ............:.:............... 26
Mr.Bailey'syachtrentalactivity ................................27
Mr. Bailey's airplane remanufacturing activity . . . . . . . . . . . . . . . . . . . . . 30
Project288income andexpenses ................................ 37
Preparation of Mr. Bailey's Forms 1040 and 1120S . . . . . . . . . . . . . . . . . 38
Filing of Mr. Bailey's Forms 1040 and 1120S . . . . . . . . . . . . . . . . . . . . . . 39
Mr. Bailey's cooperation with the IRS's examination . . . . . . . . . . . . . . . . 45
Destructionofrecords .......................................... 47
Noticesofdeficiency.......................................... 47
OPINION........................................................ 48
I.
Background evidentiary principles . . . . . . . . . . . . . . . . . . . . . . . . . . 48
A.
BurdenofProof .....O.. ......'.:..................48
1. . Providing IRS access to records . . . . . . . . . . . . . . . . . 49
a.
Taxpayers are required to keep their own
records................................. 50
-4b.
Taxpayers are required to retain their records
as long as they may become material
for tax purposes. . . . . . . . . . ... . . . . . . . . . . . . . . 51
B.
II.
Burden shift under section 7491(a) . . . . . . . . . . . . . . . 52
3.
4.
Alleged animus . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . 53
New matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Collateralestoppel .................................. 56
Income from wrongful appropriations . . . . . . . . . . . . . . . . . . . . . . . 60
A.
B.
C.
D.
III.
2.
Taxable income includes wrongful appropriations. . . . . . . . . 60
A trustee realizes income from the trust corpus
when he actually misappropriates it. . . . . . . . . . . . . . . . . . . . 62
Mr. Bailey realized income when he transferred
stock sale proceeds from the advance account. . . . . . . . . . . . 64
Mr. Bailey did not realize income when he transferred
loan proceeds from the advance account. . . . . . . . . . . . . . . . 66
Due process and Mr. Bailey's income from the
Broderlitigation ........................................ 74
IV.
Whether activities are engaged in for profit:
generalprinciples ........................................ 78
V.
Analysis of Mr. Bailey's yacht rental activity . . . . . . . . . . . . . . . . . 80
A.
Lack of profit motive for yacht refurbishing activity . . . . . . 81
1.
2.
Manner in which the activity is conducted . . . . . . . . . 82
Expertise of the taxpayer and his advisers . . . . . . . . . . 83
3.
Time and effort expended . . . . . . . . . . . . . . . . . . . . . . 83
4.
5.
Expectation that assets may appreciate in value . . . . . 84
Taxpayer's success in similar or
dissimilar activities ........................... 84
- 5-
B.
6-7.
History of income or loss, amount of
8.
occasionalprofits ............................. 84
Financial status of the taxpayer . . . . . . . . . . . . . . . . . . 84
9.
Elements of personal pleasure . . . . . . . . . . . . . . . . . . . 85
10.
Conclusion .................................. 86
Equitableestoppel ................................. 87
1.
2.
VI.
Alleged agreement ............................ 87
Allegedmisleading............................ 88
C.
Lack of nexus between yacht refurbishing and
D.
yachtrental .......................................90
Tax consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Analysis of Mr. Bailey's airplane remanufacturing activity . . . . . . 92
A.
Profitmotiveundersection183 ....................... 92
1.
2.
Manner in which the activity is conducted . . . . . . . . . 92
Expertise of the taxpayer and his advisers . . . . . . . . . . 94
3.
Timeandeffortexpended ...................... 95
4.
5.
Expectation that assets may appreciate in value . . . . . 96
Taxpayer's success in similar or
dissimilar activities . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
B.
6-7.
History of income or loss, amount of
8.
9.
10.
occasionalprofits ............................. 97
Financial status of the taxpayer . . . . . . . . . . . . . . . . . . 98
Elements of personal pleasure . . . . . . . . . . . . . . . . . . . 98
Conclusion .................................. 99
Timingofdeductions .....m........................ 100
1.
The Commissioner's alternative contention . . . . . . . 100
2.
3.
4.
Start-up expenditures . . . . . . . . . . . . . . . . . . . . . . . . . 101
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Analysis ................................... 103
-6VII. Miscellaneousadjustments ................................ 106
A.
B.
Mr.Bailey's position .............................. 106
Analysis ......................................... 108
1.
2.
.. .
Incomeitems ............................... 109
Deductions ................................. 121
VIII. Failure-to-file additions to tax under section 6651(a)(1) . . . . . . . . 138
IX.
Accuracy-related penalty under section 6662 . . . . . . . . . . . . . . . . 139
A.
B.
Negligence ...................................... 140
Defenses ........................................ 141
Conclusion ....................................................... 143
MEMORANDUM FINDINGS OF FACT AND OPINION
GUSTAFSON, Judge: The Internal Revenue Service ("IRS") issued to
petitioner F. Lee Bailey1 two statutory notices of deficiency on November 6, 2007,
pursuant to section 6212,2 showing the IRS's determinations of the following
IFor the years 1993 and 1994, the IRS issued a notice of deficiency to Mr.
Bailey and his wife, Patricia S. Bailey, who died in 1999. Mr. Bailey is the
personal representative of the Estate of Patricia S. Bailey. For the years 1995
through 2001, the IRS issued a notice of deficiency to Mr. Bailey alone.
2Unless otherwise indicated, all citations of sections refer to the Internal
Revenue Code (26 U.S.C.), and all citations of Rules refer to the Tax Court Rules
of Practice and Procedure.
-7deficiencies in income tax and failure-to-file additions to tax and accuracy-related
penalties under sections 6651(a)(1) and 6662, respectively, for the 1993 through
2001 tax years:
Addition to tax
Penalty
sec. 6662
$35,364
427,581
34,843
--43,623
125,842
26,152,
13,262
Year
1993
1994
1995
1996
1997
1998
1999
2000
Deficiency
$176,818
2,137,907
174,217
511,444
218,116
629,209
130,758
66,309
sec. 6651(a)(1)
----------$94,381
19,530
9,946
2001
82,191
---
.
---
The issues for decision are: (i) whether and when Mr. Bailey realized
income from Biochem Pharma stock held in his investment account at Credit
Suisse Bank; (ii) whether Mr. Bailey's yacht rental activity and airplane
remanufacturing activity were engaged in for profit pursuant to section 183;
(iii) whether and to whalextent his Íncome was fully reported or over-feported;
(iv) whether and to what extent his deductions are substantiated and deductible;
and (v) whether he is liable for the addition to tax under section 6651(a)(1) and the
accuracy-related penalty under section 666Z Éo 041
any portions of the deficiencies.
-8FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The parties'
stipulations of facts are incorporated herein by this reference. At the time that he
filed his petitions, Mr. Bailey resided in Massachusetts.
Mr. Bailey's career and business ventures
During the tax years at issue, Mr. Bailey was an attorney who was well
known for his defense of high-stakes, high-profile criminal cases. Mr. Bailey tried
cases in almost every State and in five foreign countries. He was also a speaker
and author. During the years at issue Mr. Bailey's average gross income from
those activities exceeded $1 million a year.
Before his graduation from law school in 1960 and his subsequent career as
an attorney, Mr. Bailey served as a pilot in the U.S. Marine Corps. As a Marine he
flew many types of aircraft, and he developed an interest in small airplanes.
In March 1954 Mr. Bailey received his commercial license to fly aircraft,
and he began to fly small airplanes for personal pleasure and recreation. In 1960,
when he began his law practice, Mr. Bailey purchased a small airplane and used it
to fly himself to and from the locations of his various court cases.
In 1971 Mr. Bailey bought a helicopter manufacturing company named
Enstrom Helicopter Corp. and owned it for 10 years before selling it. The record
-9does not show Mr. Bailey's precise role in Enstrom or the extent of the company's
profitability. The record does not show that Mr. Bailey was involved in any other
ventures related to remanufacturing, refurbishing, leasing, buying, or selling
aircraft (or other luxury vehicles;such as boats).
Mr. Bailey's representation of Claude Duboc
In 1994 Claude Duboe, who was accused of importing marijuana into the
United States on a huge scale, retained Mr. Bailey to negotiate a plea arrangement
and to assist Mr. Duboc in cooperating with the Federal Government's seizure of
his many foreign assets, including multiple pieces of high-value residential real
estate. To influence the prosecutors and the court to,reduce his sentence,
Mr. Duboc wanted to maximize the amounts paid over to the Government, but the
Government's seizure of his assets presented legal, diplomatic, and practical
difficulties.
-
Mr. Bailey's unwritten agreement with the Government
Because of those difficulties, the Government entered into a vague and
unusual agreement with Mr. Bailey, under which)Mr. Bailey would perform
services to facilitate Mr. Duboc's forfeiture of his assets, and Mr. Duboc would
transfer 602,000 shares of Biochem Pharma stock to Mr. Bailey, to provide funds
- 10 that Mr. Bailey could use to maintain and transfer Mr. Duboc's foreign assets 3
Thomas Kirwin, an Assistant U.S. Attorney who worked for the Government on
the Duboc case (and who later became a U.S. Attorney) testified at trial that the
Duboc case was important and complex and that the nature of the work that
Mr. Bailey undertook to do was "extraordinary". Nonetheless, the agreement was
completely unwritten. Bailey v. United States, 54 Fed. Cl. 459, 465 (2002)
(Bailey II).
The terms of the unwritten agreement
As described by Mr. Kirwiri in his testimony in these cases, the unwritten
agreement called for Mr. Bailey to-liquidate the properties, maintain them, you know, worry about the
mechanic's lien, worry about the zoning things, getting all of those
3Some of the facts pertinent to the Biochem Pharma stock issue were
determined in litigation between Mr. Bailey and the Government on two prior
occasions: In United States v. Duboc, No. 94-01009 (N.D. Fla. Oct. 23, 1997),
aff'd in part, rev'd and remanded in part sub nom. United States v. Bailey
175 F.3d 966, 967-968 (11th Cir. 1999) (Bailey I), a forfeiture proceeding in
District Court, the Government successfully claimed the right to Mr. Duboc's
602,000 shares of Biochem Pharma stock, reduced only by expenditures approved
by the district court. In Bailey v. United States, 40 Fed. Cl. 449 (1998),
46 Fed. Cl. 187 (2000), 54 Fed. Cl. 459 (2002) (Bailey II), a contract suit in the
Court of Federal Claims, Mr. Bailey unsuccessfully claimed a contractual right to
the appreciation in value that the Biochem Pharnga stock experienced after it was
transferred to his Credit Suisse account. The parties are here collaterally estopped
from disputing the facts set out in part I.B. below that were found in those prior
cases.
-11 things ready so that thesé houses could be sold and the money
repatriated to the United States.
The asset that was to be used to cover both Mr. Bailey's fees and the other
expenses generated by Mr. Bailey's work-both for Mr. Duboc's defense and for
repatriation of his foreign assets--was Mr. Duboc's Biochem Pharma stock. If the
stock had instead been forfeited immediately to the Government, the
Government's only practical option would have been to sell it promptly; but
flooding the market with that quantity of stock would have yielded diminished sale
proceeds and might have damaged the company. It was therefore in the common
interest of Mr. Duboc (who wanted as large a forfeiture as possible), Mr. Bailey
(who wanted a source for payment of his fees4), and the Government (which
wanted a well-managed repatriation and as large a forfeiture as possible) to leave
the Biochem Pharma stock out of the Government's hands and to let Mr. Bailey
manage it.
4Mr. Bailey believed that nder fhe agreemenf he became entitled to any
appreciation in the value of the Biochem Pharma stock, see p. 12 below; and that
was an additional subjective reason for him to favor the transfer of the stock to
himself. However, the Court of Federal Claims held in Bailey II that the unwritten
agreement did not entitle him to the appreciation.
- 12 Therefore, under the unwritten agreement, Mr. Bailey was to hold the
Biochem Pharma stock in trust for the Government,5 and he was to have the
discretion to sell the stock or to borrow against it as he saw fit.
Mr. Bailey was at risk that, if the Biochem Pharma stock depreciated, there
would be no source from which to pay his attorney's fees. He maintained that, on
the other hand, he was entitled to any appreciation in the value of the Biochem
Pharma stock; but the Court of Federal Claims held to the contrary in Bailey II,
and that holding estops any dispute of the matter here. Under the agreement .
Mr. Bailey was not entitled to the Biochem Pharma stock's appreciation.
However, Mr. Bailey's contrary belief conditioned some of his decisions in
managing the repatriation, as we will show below. In particular, expecting
appreciation in value, he often borrowed against the stock when funds were
needed, rather than selling it; and, in addition to using the stock as collateral, he
assumed personal liability for the loans.
Payments under the unwritten agreement
The repatriation expenses that were incurred under the agreement (including
property maintenance expenses and Mr. Bailey's travel expenses) could be
5The parties are collaterally estopped from disputing this finding of the
District Court. See pt. I.B.2. below.
_13 _
reimbursed as incurred. The defense expen 541es
would include costs (other than
attorney's fees) that defense counsel would incur on the case, and those defense
costs could be reimbursed to counsel as incurred. The defense expenses would
also include attorney's fees for Mr. Bailey and the other attorneys working with
him, Bailey II, 54 Fed. Cl. at 463-466, 491, 492, 505, 506, 508, which the
Government personnel acknowledged might amount to as much as $3 million,id.
at 463, but there was confusion about the permissible timing óf the payment20f
attorney's fees; Mr. Bailey thought that the agreement.allowed him.to withdraw
fees as earned (subject to making a subsequent accounting to the court),6 but the
Government personnel did not agree to such a provision; and the U.S. District
Court for the Northern District of Florida eventually held that Mr. Bailey did not
have this right (and that some of his withdrawals had therefore been improper).
The Government änd Mr: Bailey were both clear that, at the conclusion of
the criminal case, Mr. Bailey would make an accounting to the District Court.
See, e.g., Bailey II, 54 Fed. Cl. at 468, 492. The Court of Federal Claims found,
see id. at 468, that Mr. Bailey explicitly acknowledged in 1994, at the conference
6See Bailey II, 54 Fed. Cl. at 468 ("Mr. Bailey and * * * [his co-counsel]
agreed that under the .arrangement they could take fees as they were necessary or
earned").
- 14 between counsel and the court in which the Biochem Pharma arrangement was
approved, that Mr. Bailey-would account for the $6 million value of the stock transferred to
him, and present an application for payment of fees to Chief Judge
Paul at the end of the case and not on an interim basis, although
Mr. Bailey and * * * [his co-counsel] agreed that under the
arrangement they could take fees as they were necessary or earned.
The use of Mr. Bailey's existing Credit Suisse account
Mr. Bailey had an investment account at Credit Suisse in which he held
investments, and he had a linked account (called an "advance account") into which
cash from transactions involving those investments was deposited and from which
expenditures or cash transfers could be made. In 1994 Mr. Bailey's own funds
totaling $53,397 were in the advance account, apart from the Biochem Pharma transfers.
For receiving and holding the Biochem Pharma stock, Mr. Bailey did not
open a new account. Rather, the "Government attorneys understood that
MriBailey possessed * * * a Swiss bank account", Bailey II, 54 Fed. Cl. at 464,
and by agreement it was Mr. Bailey's own account at Credit Suisse that was used
for the Biochem Pharma transactions, id. at 486, 505.
On April 26, 1994, 602,000 shares of Biochem Pharma stock, then worth
$5,891,352, were transferred to Mr. Bailey's Credit Suisse account. Mr. Bailey
- 15 did not report income from his receipt of that stock on any income tax return for
any year.
Mr. Bailey's work under the agreement
From April 1994 until late 1995, Mr. Bailey worked very intensively on the
Duboc matter. He made frequent trips to Europe, maintained and sold
Mr. Duboc's properties, paid European creditors with claims against the
properties, dealt with complications of foreign law, negotiated with foreign
prosecutors and customs officials who had their own interest in Mr. Duboc's
assets, dealt with a French magistrate.who froze certain of the assets, did most of
the work in a joint effort with Government counsel to obtain a necessary order
from the District Court, and visited regularly with Mr. Duboc in a prison in the
rural United States. Mr. Kirwin acknowledged that Mr. Bailey's work on the
repatriation of Mr. Duboc's assets was very good; and the Court of Federal Claims
found that his work was "far more than usual for a defense attorney". Bailey II,
54 Fed. Cl. at 484.
- 16 Mr. Bailey's financial transactions
In 1994 and 1995, Duboc-derived funds came into the Credit Suisse
advance account from three sources--(1) sales of Biochem Pharma stock, (2) loans
collateralized by Biochem Pharma stock, and (3) sales of other stock owned by
Mr. Duboc. First, Mr. Bailey made two sales of Biochem Pharma stock in his
Credit Suisse account: In October 1994 he sold 150,000 shares for $1,550,850;
and in April 1995 he sold 52,000 shares for $850,005. The two sales thus yielded
total proceeds of $2,400,855. Second, in 1994 and 1995 Mr. Bailey borrowed a
total of $3,013,4637 from Credit Suisse against the remaining 400,000 shares.
Mr. Bailey was personally liable for the loans, but he used the Biochem Pharma
shares as collateral. Third, at the request of the U.S. Marshals overseeing the
forfeiture, Mr. Bailey received and sold $730,000 worth of other stock owned by
7By eliminating the stock sale proceeds, the Commissioner concludes that
the remainder of the transferred funds were borrowings and amounted to $550,041
in 1994 and $2,500,230 in 1995, totaling $3,050,271. Mr. Bailey objects to this
analysis only by asserting that "[t]he fees of two other clients were deposited in
the Credit Suisse account during 1994 (as the records show) and were included in
the transfers as earned". We infer that the "records" must be Exhibit 5-J (Credit
Suisse statements) and that the two non-Duboc deposits are for $17,169.96 on
October 28 and $19,637.63 on December 21, totaling $36,807.59. We accept the
Commissioner's analysis subject to that correction, so that the 1994 loans were
$513,233 and the two-year total was $3,013,463. Because we find that loan
proceeds are not income to Mr. Bailey, the precise amounts of the loans are not
necessary to our decision.
- 17 Mr. Duboc (in Obayashi Corp. and Pasco Corp.), to facilitate the forfeiture of the
proceeds.
From the Duboc-derived proceeds in the Credit Suisse advance account
(i.e., sale proceeds of $2,400,855 plus loan proceeds of $3,013,463, totaling
$5,414,318), Mr. Bailey both made expenditures for the benefit of Mr. Duboc and
for the repatriation of his assets (hereinafter, "Duboc-related expenditures") and
made transfers to his money market account at Barnett Bank (hereinafter, "the
Barnett account"); and from the Barnett account he both made Duboc-related
expenditures and made transfers to his personal checking account. These
cascading transactions were as follows:
From the Credit Suisse advance account, Mr. Bailey made Duboc-related
expenditures8 that totaled $931,698 in 1994 and $302,454 in 1995; and he made
transfers of Biochem Pharma stock sale and loan proceeds to the Barnett account
totaling $688,2709 in 1994 and $2,750,249 in 1995 (totaling $3,475,327), of which
8From this account Mr. Bailey also made a $57,487 personal purchase of
stock. This stock purchase was apparently made from Mr. Bailey's own money in
the account, which, according to Arthur Andersen, consisted of an opening
balance of $5,526 and non-Duboc-related depo 541its
of $49,006 and $17,170.
9The parties stipulated that the 1994 transfers from the Credit Suisse
account to the Barnett account totaled $725,078. Of this amount, $688,270 was
from Duboc-derived funds, and the remaining $36,808 was from fees paid by other
(continued...)
- 18 the sale proceeds constituted $175,037 in 1994 and $250,019 in 1995 (totaling
$425,056) and loan proceeds constituted the remainder of $3,013,463.1°
Mr. Bailey also transferred from the Credit Suisse account to the Barnett account
the $730,000 in proceeds from the sales of the Obayashi and Pasco stock.
From the Barnett account, Mr. Bailey paid $730,000 in 1995 to the U.S.
Marshals, for the Obayashi and Pasco stock. (The record shows no complaint at
that time from the U.S. Marshals that this $730,000 payment was made from the
Barnett account rather than directly from the Credit Suisse advance account, and
we find that his use of this account did not result in any appropriation by
.
Mr. Bailey.) Mr. Bailey also made transfers from the Barnett account to his
personal checking account totaling $2,863,000 in 1995 (including the $425,056
that constituted Biochem Pharma sale proceeds, rather than loan proceeds). From
the Barnett account Mr. Bailey also made substantial personal expenditures, both
in 1994 and 1995, but they were evidently made from his non-Duboc-related
9(...continued)
clients.
1°These expenditures and transfers of Biochem Pharma-derived funds from
the Credit Suisse advance account total only $4,672,671, whereas the gross totals
of Biochem Pharma-derived funds credited to the Credit Suisse advance account
(from sales and loans) was $5,414,318. The difference of $741,647 apparently
consists of amounts paid back to Credit Suisse from time to time during 1994 and
1995.
- 19 personal funds in the account, which were adequate to cover those expenditures.
The record does not show that Mr. Bailey regarded the funds in the Barnett
account as subject to any restrictions on their use resulting from his agreement
with the Federal Government.
From the personal checking account (which had received $2,863,000 of
Duboc-derived funds from the Barnett account in 1995 (including the $425,056 in
sales proceeds)), Mr. Bailey made $35,705 in Duboc-related expenditures,
apparently in 1995. He spent the remainder of the Duboc-derived funds (more
than $2.8 million) on non-Duboc-related matters. When the money was in that
personal checking account, Mr. Bailey treated it (and spent it) as his own.
Accounting for and return of stock
In late 1995 or early 1996, Mr. Duboc replaced Mr. Bailey with another
lawyer. For the prior year and a half, the Government had not inquired about the
Biochem Pharma stock. However, Mr. Duboc's retention of new counsel focused
attention on the situation at a time when the stock had more than quadrupled in
value (from under $10 per share in the spring of 1994 to abóut $44 in
February 1996). The 400,000 unsold shares had thus increased in value by about
$34 per share, so that appreciation of $13.6 million was at stake. At the
Government's request, the District Court ordered Mr. Bailey to transfer the
- 20 400,000 unsold Biochem Pharma shares to the Federal Government. At that time,
however, Mr. Bailey owed $2,332,743 for loans that had been made against
236,000 of the remaining 400,000 unsold shares (and he had spent the proceeds);
and Credit Suisse would not make any transfer of the shares until the loans were
repaid. Mr. Bailey therefore did not immediately comply with the District Court's
order, and the court found him in contempt in March 1996 and ordered him
incarcerated.
Mr. Bailey had induced Credit Suisse to transfer 164,000 of the unsold
shares to the Federal Government in February 1996. However, because the
remaining 236,000 of those unsold shares served as collateral for the loans of
about $2.3 million, Mr. Bailey had to repay those loans before Credit Suisse would
transfer those shares to the Government. He did repay the Credit Suisse loans
(from funds he borrowed from others); but the difficulty of borrowing such
amounts from third parties (accomplished while Mr. Bailey was incarcerated for
contempt) accounted for his delay in complying with the District Court's order.
After Mr. Bailey repaid the Credit Suisse loans, Credit Suisse transferred the
remaining 236,000 shares to the Government in April 1996. See Bailey I,
175 F.3d at 968.
- 21 Repayment of unapproved expenditures and personal loans
Having thus paiél off the Credit Suisse loans, Mr. Bailey then had to account
to the District Court for (and inake up the balance of) the $2;400,855 in proceeds
of his sales of 202,000 shares in 1994 and 1995. "The district court determined
that Bailey incurred $1,221,177.06E"1 in legitimate, reimbursable expenses,"
Bailey I, 175 F.3d at 968,.apparently leaving $1,179,678 that the court ordered
him to repay.
.
Of that amount, $700,000 was repáid in April 1997. That $700,000
payment was from an amount due to Mr. Bailey in unrelated litigation he had
against Aaron J. Broder. Pursuant to court order, Mr. Broder paid that amount to
trustees who had been appointed by the District Court in the Duboc case, toward
Mr. Bailey's obligations in that case. In 1998 the remainder of the Broder lawsuit
was settled for $1,100,000 (in addition to the $700,000 paid in 1997); however,
$829,639.01 of that $1,100,000 in settlement payments from Mr. Broder was paid
not to Mr. Bailey himself but to third parties." Specifically, $150,000 of the
"As we have foùnd, Mr. Bailey had paid Duboc-related expenses from the
Biochem Pharma proceeds totaling $1,269,857 (i.e., from the advance account,
$931,698 in 1994 and $302,454 in 1995; and from the personal checking account,
$35,705 in 1995).
"The $1,100,000 in settlement payments from Mr. Broder consisted of (i) a
(continued...)
- 22 $829,639.01 was paid to Mr. Bailey's attorneys for legal fees, which the
Commissioner concedes is deductible under section 162, and the remaining .
$679,639;01 was paid to Mr. Bailey's creditors, who had lent to Mr. Bailey in
April 1996 to enable him to pay off the Credit Suisse loans and obtain release of
the 236,000 shares of Biochem Pharma stock. Mr. Bailey did not include, in the
income he reported on his tax returns, the payments totaling $1,650,00013 that
Mr. Broder made to him or to his creditors on his behalf in 1997 and 1998.
The $700,000 payment from Mr. Broder in April 1997 left a balance of
$479,678 of disapproved expenditures that Mr. Bailey was required to repay. Two
and a half years later, the unpaid balance was only $423,237.77, so that the
"(...continued)
$100,000 check to Michael Armstrong for legal fees, (ii) a $485,000 check to
Wayne Smith for loan repayment, (iii) a $50,000 check to Fishman, Ankner &
Horstmann for legal fees, (iv) a $270,360.99 check to Mr. Bailey, and a wire
transfer of $194,639.01 to Truman Bank for loan repayment, totaling $465,000.
"In his response to a request for admissions, Mr. Bailey admitted that he did
not include the $700,000 payment from Mr. Broder to the trustees, the $485,000
payment from Mr. Broder to Mr. Smith, and the $194,639.01 payment from
.
Mr. Broder to Truman Bank in the income he reported on his tax returns. In that
response, Mr. Bailey denied that he failed to include the $270,360.99 payment
from Mr. Broder to himself. However, the IRS included that amount as unreported
income for 1998 in the notice of deficiency, and Mr. Bailey had the burden to
prove that he reported that amount on his tax returns. Since Mr. Bailey failed to
do so, we find that he did not include any of the $1,650,000 in the income he
reported on his tax returns.
- 23 difference--$56,440--was evidently paid sometime before then. Since the record
does not show exactly when, and Mr. Bailey has the burden of proof, we assume
that a $56,440 payment was made in 1999 and not earlier. Mr. Bailey repaid the
remaining balance of $423,237.77 by two additional payments in late 1999.
Subsequent proceedings
As a result of his handling of the Duboc matter and the Biochem Pharma
stock, Mr. Bailey was disbarred.14
Notwithstanding the District Court's orders, Mr. Bailey still claimed that he
was entitled to the Biochem Pharma stock appreciation that had occurred after
April 1994, but in Bailey II the Court of Federal Claims rejected that claim. As a
result, Mr. Bailey was left with none of the proceeds of the Biochem Pharma
stock. He was reimbursed only for the pörtion of his out-of-pocket expenditures
that the District Court approved, and he was not paid any fee for his services.
Nonetheless, the IRS issued a notice of deficiency on November 6, 2007, in
which it determined, inter alia, that Mr. Bailey received income of $5.9 million
14The court orders concerning Mr. Bailey's disbarment are, of course, public
records. See In re Bailey, 2005 WL 2901885 (D. Mass. Nov. 1, 2005), aff'd, 450
F.3d 71 (1st Cir. 2006); Florida Bar v. Bailey, 803 So.2d 683 (2001); In re Bailey,
786 N.E.2d 337 (Mass. 2003). However, the Commissioner did not attempt to
bind Mr. Bailey to any findings reflected therein, and we do not derive facts from
them nor attempt to reconcile our findings with them.
- 24 when the Biochem Pharma stock was transferred in 1994 to Mr. Bailey's Credit
Suisse account.
Mr. Bailey's subchapter S corporations
During the tax years at issue, Mr. Bailey was the sole owner of a subchapter
S corporation known as Palm Beach Roamer, Inc. (PBR). During 1993 and part of
1994, Mr. Bailey was also the sole owner of an S corporation known as Bahamas
Enterprises, Inc. (BEI). Through these S corporations Mr. Bailey conducted three
activities--yacht rental, airplane rental, and airplane refurbishing. Mr. Bailey
admits that none of these activities ever turned a profit. We discuss those
activities in detail below and explain here the corporate structure.
In 1993 BEI held title to a number of small airplanes, which Mr. Bailey
rented to the general public. In 1994 Mr. Bailey merged BEI into PBR and
renamed it Roamer Aircraft Division for accounting purposes. After the merger,
Mr. Bailey sold off most of the small airplanes and ceased to rent airplanes to the
general public.
Mr. Bailey incorporated PBR in 1987. PBR was a calendar year taxpayer
and used the accrual method of accounting. PBR purchased and refurbished a
yacht, which PBR chartered from 1993 to 1996 and sold in 1998.
- 25 In 1993 Mr. Bailey decided to use PBR to remanufacture airplanes rather
than yachts. In 1994 PBR purchased a used airplane and began the airplane
remanufacturing activity, which continued until 1996.
In sum, through BEI and PBR Mr. Bailey was engaged in three distinct
activities:" the airplane rental activity (through BEI from 1993, until he merged
BEI into PBR in 1994); the yacht rental activity (through PBR from 1993 to
1996), and the airplane remanufacturing activity (through PBR from 1994 to
1996).
Mr. Bailey's records
The record does not show the type ror quality of the records that Mr. Bailey
kept for BEI and PBR (or the three activities that he conducted through them).
Mr. Bailey initially stored all of his records for BEI and PBR at his law offices in
Palm Beach, Florida. In 2000 he moved those records to an airplane hangar at the
Palm Beach County Park Airport in Lantana, Florida ("the Lantana hangar"),
which he had used for the conduct of the airplane rental and manufacturing
activities. (As we explain below, these records were destroyed sometime after
June 2002.)
15See note 42 below.
- 26 Mr. Bailey used "Quicken" software to maintain registers for his several
personal and business accounts and to generate various summaries and reports of
the information in those registers. Using this software, he or his staff entered
deposits and expenditures, coded according to source or category, and various
reports could thereafter be printed out using these data. Our record includes
Quicken printouts of registers and summaries for three of the years (1996, 1999,
and 2000), and the data they show appear to correspond generally to the amounts
reported on Mr. Bailey's returns for those years.
Mr. Bailey's airplane rental activity
Mr. Bailey rented small airplanes to the general public through BEI during
1993 and part of 1994--an activity the IRS contends was not engaged in for profit.
Mr. Bailey generally stored those airplanes in the Lantana hangar. After
Mr. Bailey merged BEI into PBR in 1994, he sold off most of the small airplanes
and ceased the rental activity. On his returns for 1993 and 1994, Mr. Bailey
reported losses from this activity. On audit, the only portions of the claimed losses
that the IRS disallowed were for expenses of $6,425 in 1993 and $3,850 in 1994
that cannot be substantiated.
- 27 Mr. Bailey's yacht rental activity
In 1989 PBR purchased a used Chriseraft Roamer yacht from a bank in
Rhode Island. Mr. Bailey christened the yacht the Spellbound, and PBR
refurbished it, with the services of Dennison Marine (a yacht manufacturing
company and a client of his law practice) and the Roscioli Yachting Center.
Mr. Bailey hoped to use the Spellbound as a prototype to refurbish and sell other
used yachts, but at trial he did not prove how serious that hope was, nor how
critical it was to his purchase and refurbishing of the yacht. During the
refurbishing process, the Spellbound's plumbing, electronics, and heating and airconditioning systems were all replaced. With the help of Ann Dennison, a
decorator at Dennison Marine, Mr. Bailey personally redesigned the interior layout
of the Spellbound. He fitted the yacht with new carpeting, wall coverings, and
furniture. When the Spellbound was fully refurbished (before the years at issue),
it was built to Mr. Bailey's specifications, and he considered it beautiful.
In 1993 Congress repealed the luxùry tax (which had applied to new yachts,
and not refurbished yachts),l' and Mr:Bailey concluded that the price advantage
16See Omnibus Budget Reconciliation Act of 1993, Pub.;L. No. 103-66, sec.
13161, 107 Stat. at 449 (repealing the luñury tax-on the first retail sale of boats).
Mr. Bailey testified that the"luxury tax was important to his idea of selling
refurbished used yachts. He said he began the venture believing that the
(continued...)
- 28 of used yachts over new yachts was now insufficient for his yacht refurbishing
activity to be profitable. He therefore abandoned his idea of refurbishing and
reselling used yachts (and dëcided to use PBR as a vehicle to remánufacture and
sell used airplanes, as is discussed below)." Although running a yacht rental
business had not ever been one of PBR's objectives, and although Mr. Bailey had
no expertise in yacht rental, he decided to rent the Spellbound to help to cover the
cost of its dockage fees until he sold it.
Mr. Bailey did not expect that the Spellbound would appreciate in value but
believed on the contrary that yabhts generally depreciate very quickly.
16(...COntinued)
10 percent tax that was imposed by section 4002 on sales of new yachts would
work to his advantage by increasing the prices of new yachts as compared to used
yachts, but that the repeal frustrated his original plan. However, the tax was
enacted in 1990, after he purchased the Spellbound. See Omnibus Budget
Reconciliation Act of 1990, Pub. L. No. 101-508, sec. 11221(a), 104 Stat. at
1388-438 (imposing a 10% luxury tax, effective January 1, 1991, on the first retail
sale of passenger vehicles, boats, aircraft, and furs and jewelry). His trial
testimony was sincere but evidently mistaken about.this almost 20-year-old
sequence.
"Despite the fact that PBR exitedsthe yacht refurbishing business in 1993
and never intended to enter the yacht rental business, it purchased a 22-foot ski
boat in 1995, which Mr. Bailey christened the Glacier Bay. Mr. Bailey kept the
Glacier Bay docked at his personal residence, and concedes that the principal.use
of PBR's ski boat was personal.
- 29 Mr. Bailey did not personally expend any time or effort in renting the
Spellbound. Instead, PBR hired Jim Hunter and his wife, Cynthia Walsh, to sail
and maintain the Spellbound as its captain and crew. From 1993 to 1996, PBR
sporadically chartered the Spellbound to members of the general public, but most
of the use of the Spellbound was by Mr. Bailey's family and friends.
Mr. Bailey's summaries of the revenue and expenses for the yacht rental
activity indicate that the activity generated 10 times more expenses than charter
fees. We conclude that the activity consistently generated losses and that
Mr. Bailey's nonbusiness use of the Spellbound exceeded the rental use.
The crew of the Spellbound kept timesheets for·1995," and those timesheets
show that in that year the crew devoted only 106.5 hours to paid charters but
devoted 320 hours to personal trips. The timesheets also show that the Spellbound
was used for business reasons on only 34 days but was used for personal or unpaid
trips on 71 days. Most of the use of the Spellbound was personal during the tax
years at issue.
Other than the few records discussed here, Mr. Bailey failed to offer into
evidence any logs, books, records, business plans, profit analyses, or market
The record does not include any copies of timesheets kept by the crew of
the Spellbound for other years.
- 30 studies with respect to the yacht rental activity. Mr. Bailey testified that he kept,
in the Lantana hangar, logs and other records for PBR that would have
demonstrated a profit objective and would have substantiated the business use of
the Spellbound in his rental activity; but as is discussed below, Mr. Bailey
discarded those records after he stopped renting the Lantana hangar in June 2002.
The yacht rental activity ended in April 1996. Mr. Bailey was incarcerated
for contempt on March 6, 1996, and remained in prison for 44 days.. Shortly
thereafter, the Government took control of the Spellbound as a condition of
Mr. Bailey's release. In April 1996 PBR dismissed the captain and crew and
ceased to charter the Spellbound. PBR sold the Spellbound in March 1998.
PBR received modest amounts of gross income from the yacht rental
activity (reported as $5,707 in 1993, $7,364 in 1994, $56,396 in 1995, $68,998 in
1996) and $39,449 of capital gain in 1994 from the sale of an airplane
(presumably obtained from BEI); but the activity turned no profit. We need not
verify the precise amounts of the yacht-related expenses to know that they
swamped the yacht-related income in every year.
Mr. Bailey's airplane remanufacturing activity
In 1993 Mr. Bailey decided to use PBR as a vehicle to remanufacture and
sell used airplanes. Mr. Bailey determined to purchase, repair, and modify used
- 31 airplanes, and then to sell them at about half the price of comparable new
airplanes. Mr. Bailey planned first to re 041anufacture
a single airplane as a
prototype and then to remanufacture and sell other used airplanes.
Mr. Bailey considered two similariairplane models--the Piper PA-30 Twin
Comanche and the Beechcraft Baron--for PBR to modify and resell. Piper
Aircraft's production of the Twin Comanche had ceased in 1972, whereas
Beechcraft's production of the Baron was ongoing. Mr. Bailey ultimately chose
the Twin Comanche over the Beechcraft !Baron after consulting with Robert A.
Hoover, an air show and test pilot; Charlës B. Cusick, an aeronautical engineer
and former executive with Narco (an avionics manufacturer for small aircraft) and
Cessna Aircraft Co.; and LeRoy Patrick LoPresti, an aeronautical engineer and
former executive with Beechcraft and Pijer Aircraft, Inc. All three men favored
Piper's Twin Comanche and advised against remanufacturing Beechcraft's
Baron--an airplane model that was still in production--since to do so would
involve direct competition with a major nianufacturer and might prompt the
manufacturer to pressure suppliers into denying him good prices on the parts that
he would need to remanufacture the used planes. Piper's Twin Comanche was
also favored because (i) it was readily available in large numbers on the secondary
market, (ii) it was originally manufactured with a zinc chromate coating on both
- 32 the inside and outside of the hull to prevent corrosion, and (iii) it was a relatively
fuel-efficient airplane at a time when fuel prices were rising.
In 1994 PBR purchased a used Twin Comanche and began the airplane
remanufacturing activity. The plane he purchased had the serial number 30-288,
and Mr. Bailey therefore dubbed his remanufacturing activity "Project 288". PBR
also purchased two more used Twin Comanches between the years 1994 and 1996.
All three of the airplanes were stored at the Lantana hangar.
Project 288 principally consisted of repairing and modifying one of the
three used Twin Comanches for use as a prototype, which Mr. Bailey dubbed the
"Bailey Bullet". The activity also involved (i) obtaining approval from the Federal
Aviation Administration (FAA) to modify the Tvéin Comanche for resale; and
(ii) promoting.the sale of PBR's line of modified Twin Comanches by displaying
the Bailey Bullet at trade shows and meetings for aviation enthusiasts.
042
During the remanufacturing process, PBR disassembled the airframe,
engines, and moving parts of the Bailey Bullet and reconstructed it using å number
ofnew and reconditioned parts. The Bailey Bullet was cleaned, repainted, and
reconstructed with a new interior, new upholstery, and new engines. When the
process was complete, the Bailey Bullet was equipped with all of the most up-todate features, and Mr. Bailey considered it "better than new".
- 33 .
Mr. Bailey, as the sole owner and president of PBR, personally chose the
features that were added to the Bailey Bu let. iHowever, PBR hired about a dozen
employees to disassemble añd reconstruct the airplanes. Mr. Bailey's son, Scott
Bailey, served as the vice president of PB!R and was the highest paid employee in
Project 288. After interviewing with Scott Bailey, Douglas Vasco was hired as the
chief inspector and director of maintenanòe-for Project 288 in1May 1995. During
the tax years at issue, Mr. Vasco was an F:AA-certified designated airworthiness
representative. In that capacity he.was authorized to perform examination,
inspection, and testing services for Project 288 that were necessary in order to
obtain FAA permission to modify Twin Comanches. See 14 C.F.R. sec. 183.33
(1996). During his tenure at PBR, Mr. Vasco had about nine employees working
under him in Project 288, two of which were FAA-certified airframe and
powerplant mechanics.
In addition to PBR's employees, Project 288 contracted for the services of
Bill Wall. Mr. Wàll wore twö håts with respecTtó Project 288. During the tax
years at issue, Mr. Wall served as the president of East Coast Aerospace, an
aircraft engineering dompany. In that capacity, he helped to develop modifications
to the Twin Comanche design arid install those modifications^on the Bailey Bullet.
Mr. Wall also served as the administratór of East Coast Avionics, an FAA-
- 34 certified designated alteration station. In that capacity, he was authorized to issue
supplemental type certificates on behalf of the FAA to approve modifications to
aircraft designs.19 See id. sec. 21.451. On September 21, 1995, Mr. Wall issued to
PBR five supplemental type certificates that approved a number of the
modifications that he helped to develop for Project 288. The approved
modifications to the Twin Comanche design included the conversion of its 14-volt
electrical system to a 28-volt electrical system with dual alternators, as well as the
installation of various avionics systems.and engine instruments, an instrument
panel, and a heating and air-conditioning system. As Mr. Bailey's expert witness,
19The FAA is charged by.Congress with promoting air safety. See 49 U.S.C.
sec. 106(g)(1)(A) (1994). When the FAA approves an aircraft design, the FAA
issues a type certificate. See id. sec. 44704(a). Modifications to an FAAapproved aircraft design must also be FAA approved. Id. The FAA may issue a
field approval to approve a minor modification to one serial numbered aircraft, see
FAA Order 8900.1 (2009), or a supplemental type certificate to approve a
modification to an aircraft design, see 14 C.F.R. sec. 21.113 (1995).. As Mr.
Vasco testified, the process for obtaining a "multi-use" supplemental type
certificate to modify an aircraft design is considerably more difficult and
expensive than obtaining a "one-off" field approval to modify a single aircraft.
- 35 John Whiting Olcott,20 credibly testified, obtaining a supplemental type certificate
is a sophisticated and costly process that hobbyists do not engage in.
By 1995 the Bailey Bullet was fully remanufactured and airworthy. In that
year, PBR rented booth space at the Annual Meeting and Convention of the
National Business Aviation Association (¡"NBAA")--a civil aviation trade show-to display the Bailey Bullet. Mr. Olcott, ivho was the president of the NBAA at
the time and presided over the conventiori, testified that the NBAA rented booth
space only to commercial venders--never(to hobbyists. He also testified that at the
convention the Bailey Bullet generated "a lot of interest" from serious aviators.
We find that by this time-1995--Project 288 was an active trade or business.
Despite the positive receptiori of thé Bailey Bullet at the NBAA convention,
the airplane remanufacturing activity ended abruptly in April 1996, as we have
explained. Mr. Bailey ¿vas incarcerated for contempt on March 6, 1996, and
20Mr. Olcott currently serves as pre¼ident of General Aero Co., Inc., a
business aviation consulting firm. From 1992 to 2003, he served as president of
the National Business Aircraft Association, a trade organization for corporate
aviation. From 1973 to 1992, he served as an editor for two aviation magazines-FLYING and Business & Commercial. Aviation--published by Ziff Davis
Publishing Co. From 1974 to 1986, Mr. Ólcott served on advisory committees for
the National Aeronautics and Space Administration. He is a licensed.transport
pilot and holds a bachelor's and a master's degree in aeronautical engineering
from Princeton University and a master's degree in business administration from
Rutgers University.
- 36.remained in prison for 44 days until he was able to raise over $2 million to comply
with the District Court's order to return the remaining shares of Biochem Pharma
stock. While he was in prison, Mr. Bailey had his son, Scott Bailey, call
Mr. Vasco to tell him that Project 288 was being shut down indefinitely. In
response, Mr. Vasco left Project 288 in April 1996. By the time that Mr. Bailey
raised the money to comply with the District Court's order and was released from
prison, he had no funding to continue the airplane remanufacturing activity and all
of his employees, with the exception of his son, had left Project 288.- Mr. Bailey's
son was on PBR's payroll until the end of 1996.
Beginning in 1996 PBR tried to sell its one remanufactured plane, the
.
Bailey Bullet. However, PBR had mortgaged the Bailey Bullet "right to the hilt"
(over $400,000) to raise money for Project 288, and it was unable to sell the
remanufactured airplane for a high enough price to satisfy the mortgagor. In the
absence of better evidence, we use this to conclude that Mr. Bailey's cost basis in
the Bailey Bullet was $400,000. At some point after the tax years at issue, PBR
was dissolved and Mr. Bailey became the direct owner of the Bailey Bullet.
Although at the time of trial the Bailey Bullet was still subject to the mortgage, the
mortgagor had yet to foreclose, and Mr. Bailey remained in possession of the
airplane.
- 37 The Bailey Bullet was the only used Twin Comanche that Project 288 fully
remanufactured. In 1996 PBR sold the tivo other Twin Comanches that Project
288 had purchased and had begun to disassemble.
When beginning Project 288 Mr. Bailey had no expectation that the Bailey
Bullet or the other used Twin Comanches held by PBR would appreciate.
However, Mr. Bailey did expect the "multi-use" supplemental type certificates that
Mr. Wall issued on behalf of the FAA to appreciate, since they were in effect the
licenses that would permit PBR to install i|n Twin Comanches thé modifications
permitted by those certificates, which PBlì would sell in increasing numbers as he
promoted the Bailey Bullet (for example, Åt events like the NBAA convention).
Mr. Bailey failed to submit into evidence any logs, books, records, business
plans, profit analyses, or market studies viith respect to the airplane
remanufacturing activity. When Mr. Bailey discontinued rental of the Lantana
hangar, he discarded any records there that might have demonstrated a profit
objective.
Project 288 income ànd expenses
PBR never realized aný ordinary inbome from Pi.óject 288, although it did
realize capital gain of $59,203 in 1996 from the sale of two airplanes. PBR's
- 38 expenses incurred in connection with Project 288 totaled $424,787 in 1994,21
$456,286 in 1995, and $125,694 in 1996. Approximately $339,814 of PBR's
expenses were for the building of the Bailey Bullet prototype,22 presumably about
half in 1994 and half in 1995.
Preparation of Mr. Bailey's Forms 1040 and 1120S
Mr. Bailey hired Mary C. Dunay, a certified public accountant, to prepare
his Forms 1040, U.S. Individual Income Tax Return, for 1993, 1994, and 1995.
Mr. Bailey filed joint returns with his wife for 1993 and 1994 and filed separate
returns for the other years at issue. Mr. Bailey self-prepared his Forms 1040 for
1996 through 2000. Then Mr. Bailey hired Richard Paladino, an attorney, to
prepare his Form 1040 for 2001. The record does not show whether Mr. Bailey or
2iFor 1994, when both the yacht activity and the airplane remanufacturing
activity were underway, PBR's reported cost of goods sold ($427,166) and
deductions ($200,657) totaled $627,823, of which the yacht-related expenses
totaled $203,036, leaving the difference--$424,787--attributable to Project 288.
22PBR purchased three Twin Comanches in 1994; and if we assume that
PBR's entire increase in capital in that year ($180,599) is allocated among the
three planes that PBR acquired, then $60,186 was the capital cost of acquiring the
plane that PBR then remanufactured. The remainder of the Bailey Bullet's
$400,000 presumed cost and value (i.e., $400,000 - $60,186 = $339,814) was
therefore incurred by PBR in 1994 and 1995 (i.e., $169,907 in each year). The
imprecision of these assumptions is obvious; but as we explain below, the
Commissioner has the burden of proof on alternative contentions for which the
amounts attributable to the plane itself are relevant, and in the absence of such
proof we therefore make assumptions favorable to Mr. Bailey.
- 39 anyone else prepared a Form 1120S, U.S. Income Tax Return for an S
Corporation, for BEI for either 1993 or 1994. Mr. Bailey prepared the Forms
1120S for PBR for 1993 through 1998 with help from his daughter-in-law, Lainey
Bailey. Mr. Bailey hired Mr. Paladino to prepare the Form 1120S for PBR for
1999. No one prepared a Form 1120S for PBR for 2000 or 2001.
Printouts of reports from Mr. Bailey's "Quicken" database were evidently
used for preparing the income tax returns at issue, but our record includes
contemporaneous printouts for only three years, 1996, 1999, and 2000.
In August 1998 Mrs. Bailey was diagnosed with pancreatic cancer. In July
1999 Mrs. Bailey was hospitalized and required Mr. Bailey's almost constant
presence at her bedside. Mrs. Bailey died on September 9, 1999, a month after the
1998 return was due (on an extension to August 15, 1999). Mr. Bailey filed the
return 50 days after Mrs..Bailey's death on October 19, 1999.
Filing of Mr. Bailey's Forms 1040 and 1120S
On the dates given in the table belåw, Mr. Bailey and his S corporations
filed their required returns," the IRS con menced examination on those returns;
and the IRS issued notices of deficiency.
The record does not show whether BEI filed a Form 1120S for 1993 or
1994, but it does show that PBR failed to file Forms 1120S for 2000 and 2001.
- 40 Year
Form
Filina date
Notice of deficiency
1993
1040
1120S (PBR)
Oct. 17, 1994
Undated
Nov. 6, 2007
1994
1040
1120S (PBR).
Oct. 15, 1995
Sept. 15, 1995
Nov. 6, 2007
1995
1040
1120S (PBR)
Octc21, 1996
Oct. 13, 1996
Nov. 6, 2007
1996
1040
1120S (PBR)
Oct. 22, 1997
Sept. 15, 1997
Nov. 6, 2007
1997
1040
1120S (PBR)
Oct. 16, 1998
Sept. 15, 1998
Nov. 6, 2007
1998
1040
1120S (PBR)
Oct. 19, 1999
Undated
Nov. 6, 2007
1999
1040 042
1120S (PBR)
- Oct. 16, 2000 .
Oct. 19, 2001
Nov. 6, 2007
2000
1040
Oct. 22, 2001
Nov. 6, 2007
2001
1040
Oct. 22, 2002
Nov. 6, 2007
For the nine years at issue (1993 through 2001) Mr. Bailey reported income
and losses from his law practice and related speaking services on Schedule C,
Profit or Loss From Business, of his Forms 1040. His reported gross income for
the nine-year period was $10.1 million, and his reported expenses were
$9.5 million. For four years he reported iet income and in five years net loss. On
Schedules E, "Supplemental Income and Loss", attached to those Forms 1040,
Mr. Bailey claimed net losses from BEI nd PBR.
We find as follows concerning Mi Bailey's re'porting of specific items of
income he had received and deductions lie had claimed.24 In the years at issue,
Mr. Bailey received the following additiònal items of income (not discussed
above) that were not reported on his tax returns:
Year
Item
Amount
1993
Barnett Bank interest income
Pension income
$207
1,951
1994
Fees deposited to Credit Suisse
86,808
1995
Deposits to offibe account
California State income tax refund
Interest from thkee sources
3,955
1,469
389
1996
Mathematical eiTor
Speaking income
Boston fees
100,000
15,700
58,374
1997
Deposits to offi e account
Fees from client McCorkle
33,696
26,713
1998
Fees from client Vidu
Speech income
Fees from client McCorkle
7,280
20,000
110,000
24These miscellan eous items are discussed in p art VII below.
.
- 42 Deposits to office account
Payment from Phoenix
9,257
11,288
1999
Wages from Entertainment Partners
Interest from Principle Life
1,541
. 61-
2000
Fees from client Dubey
Deposits to office account
Royalty income
Deposits to N. Bailey's account
63,473
7,526
26,500
38,333
2001
Unexplained items
16,561
Pension income
Pass-through income from Tel-Share
69,527
2,423
.
(We do not sustain the following adjustments for additional income that were
included in the IRS's notice of deficiency: $10,183 of barter income in 1995;
$106,758 of checks returned·to Credit Suisse in 1995; and royalty income of
$20,000 in 1999.)
Mr. Bailey did not receive the following items of income that were
mistakenly reported on his tax returns:
Year
Item
Amount
1995
Reimbursed income
Twice-included income
$1,300
40,394
1996
Three adjustments by IRS
23,017
- 43 For the years at issue, Mr. Bailey claimed on his tax returns deductions for
the following items that he did not substàntiate or to which he was otherwise not
entitled:
Year
Amount
Item
Charitable ded etion (Aventura)
$13,383
2,750
1,558
3,447
1 161
12,976
6,425
1,000
1994
Dues and publi ations
Legal and accounting fees (Sch. C)
Office expense (computers)
Office expenses (billed but not paid)
Flow-through loss from BEI
10,200
2,289
5,457
3,322
3,850
1995
Contract labor
Credit Suisse interest
Double-deduct d expenses
Travel & entertainment
1,974
5,741
215,612
48,199
1996
Boston office e pense
202,082
Travel & entertainment
Mortgage inter st
Real estate taxes
22,080
14,244
2,362
1993
Dues and publications
Legal and acco nting fees (Sch. C)
Telephone expense
Travel expense (Tel-Share)
Means & entertainment
Travel expenses
Flow-through lpss from BEI
1997
Household maintenance
Travel & entertainment
Office expense
Mortgage interest
.
24,000
20,480
206,484
14,986
- 44 Real estate taxes
11,327
1998
Travel & entertainment
Office expense
45,201
579,098
1999
Travel & entertainment
Office expense
25,229
533,191
2000
Travel & entertainment
Office expense
Nine miscellaneous items
23,408
30,519
133,421
2001
Household expenses
Life insurance premiums
Payment to attorney
735
19,660
1,150
Mr. Bailey substantiated the following deductions that were disallowed in the
notice of deficiency: $15,852 to Republic Bank in 1995; a greater portion of the
office expen 541e
in 1996; and hangar expenses of $5,751 and $19,469 in 2001.
Mr. Bailey is entitled to the following additional deductions that he did not
claim on his returns:
Year
Item
Amount
1993
Tax preparation (Sch. A)
$2,750
1994
Computer depreciation
Tax preparation (Sch. A)
Charitable contribution
273
2,250
10,000
1995
Computer depreciation
1,091
1996
Computer depreciation
1,091
- 51997.
Computer depreciation
1998
Computer depreciation
, .
.
1,091
818
Mr. Bailey's cooperation with the IRS's examination
The IRS opened examinations of
. Bailey's Forms 1040 for 1993 in
December 1994, for 1994.in February 1996; for 1995 in December 1996, and
thereafter for 1996 through 2001.
In 1996 the IRS assigned Revenue Agent James J. Tabor to conduct the
examination of Mr. Bailey's tax returns. Beginning in May 1997, Revenue Agent
Tabor partnered with Revenue Agent Bobbie Kay Campbell to issue to PBR a
series of at least 29 information document requests (IDRs) with respect to the
.
airplane rental activity, the yacht rental activity, and the airplane remanufacturing
activity. The latest of these IDRs is date April 5, 2002. The IDRs request, inter
alia, (i) records to substantiate PBR's gross income and expenses; (ii) a breakdown
of the expenses for the airplane rental activity,·yacht rental activity, and airplane
remanufacturing activity; (iii) copies of ány ads purchased by PBR to promote the
sale or rental of boats or airplanes; (iv) PBR's bank records; (v) market studies or
records that indicate the airplane remanufacturing activity:was "economically .
viable"; (vi) records to show the project d sales price of the airplanes and "per
plane profit" in the airplane remanufacturing activity; and (vii) "[a]ny records not
- 46 previously provided that show efforts made to increase profitability of Palm Beach
Roamers' businesses". The last five IDRs in the record, dated April 5, 2002, made
requests with respect to the "profitability" of Mr. Bailey's activities. Those same
IDRs gave Mr. Bailey until May 6, 2002, to respond.
The record includes five letters from Mr. Bailey's counsel, Mr. Paladino, to
Revenue Agent Tabor, which appear to respond to a number of IDRs that are not
in the record. The record also includes a "breakdown" of the revenue and
expenses of PBR's three activities for 1995 and 1996; it is addressed from Lainey
Bailey to Revemie Agent Tabor in response to "IDR #19". Mr. Bailey failed to
fully comply with the IDRs, and he repeatedly failed to provide the IRS with
requested information.
In 2002 Mr. Bailey's representative did provide printouts of his Quicken
reports for 1996, 1999, and 2000 to-the IRS's examining agent and of workpapers
generated during the preparation of the returns. The agent did a painstaking
analysis of the data Mr. Bailey provided, correlated them to the tax returns as filed,
and identified income items and deductions not reported on the returns. The audit
adjustments reflected in the notice of deficiency (described below) are largely
based on that analysis.
·
- 47 Destruction of records
By 2002 the cost of renting the Lantana hangar became burdensome to
Mr. Bailey. He notified the IRS that he
ould discard his records for BEI and
PBR when he stopped renting the Lantana hangar, and he invited the IRS's
representatives to visit the hangar and make copies of his records. Revenue
Agents Tabor and Campbell and their su ervisor visited the hangar and met with
Mr. Bailey and his attorney, Richard Paladino, on June 24, 2002. The record does
not show what records, if any, the IRS re iewed or copied. At some point
thereafter, Mr. Bailey discarded his recor s at the Lantana hangar.
Notices of deficiency
In the notices of deficiency? the IRS (i) determined that Mr. Bailey had
numerous items ofunreported income from his law practice and speaking services,
(ii) determined to disallow some, but notlall, of Mr. Bailey's deductions for his
"By stipulation and on brief, both parties have resolved several of the issues
raised in the notices of deficiency. Mr. Bailey concedes that he had additional
interest income of $207 under section 61(a)(4) from Barnett Bank of Palm Beach
County in 1993. The Commissioner concedes that Mr. Bailey is entitled to an
additional depreciation deduction under section 167 in the amount of $273 in 1994
with respect to the cost of two computers. The Commissioner also concedes the
adjustment to Mr. Bailey's 1996 Form 1040 with respect to a $365,000
malpractice insurance policy payment made by the Home Insurance Co. on his
behalf. Although this payment is includible in income under section 61(a), the
Commissioner agrees that Mr. Bailey is entitled to a corresponding deduction in
the same amount pursuant to section 162(a).
- 48 expenses from those businesses, (iii) largely disallowed the net losses from BEI
and PBR that Mr. Bailey claimed on his Forms 1040, and (iv) made numerous
other miscellaneous adjustments to Mr. Bailey's reported income and deductions
on his Forms 1040 for the 1993 through 2001 tax years.26
OPINION
I.
Background evidentiary principles
A.
Burden of Proof
Generally, the Commissioner's determinations set forth in a notice of
deficiency are presumed correct, and the taxpayer generally bears the burden of
proving the determinations are erroneous. Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115 (1933). Moreover, deductions are a matter of legislative grace, and
the taxpayer bears the burden of proving that he is entitled to any deduction
claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Mr. Bailey
makes three attempts to shift the overall burden of proof to the Commissioner.
Each of these attempts is unsuccessful, but we do find that the Commissioner
bears the burden of proof in one respect.
26During trial and on brief the parties collectively referred to the
miscellaneous adjustments as "Issue C" or "the 'C' issues".
- 49 1.
Providing IRS access to records
Mr. Bailey stored all of his records for BEI and PBR in the Lantana hangar
where he conducted the airplane rental and remanufacturing activities. The record
does not show the type or quality of those records. Mr. Bailey testified and
contended on brief that those records could have substantiated his profit motive
for all three activities.
Mr. Bailey notified the IRS that h would discard his records after he lost
access to the Lantana hangar, and he invited its representatives to visit the hangar
to review and copy his records. Reven
Agents Tabor and Campbell, and their
supervisor, visited the hangar on June 2 , 2002, but the record does not show what
records, if any, they reviewed or copied. At somÈ point thereafter, Mr. Bailey
discarded his records at the Lantana han ar.
Mr. Bailey now protests that his I ek of records is the IRS's fault, because it
should have copied his records or should have warned him, before he discarded
his records, that he might need them. Hi contention is not well founded.
- 50 a.
Taxpayers are required to keep their own records.
Even assuming arguendo that the Lantana hangar once contained sufficient
records to substantiate Mr. Bailey's expenses and 15rofit motive," his attempt to
shift the burden of proof on this basis must fail. The record-keeping requirements
for the income tax are set forth in section 6001, which requires thatEvery person liable for any tax imposed by this title, or for the
collection thereof, shall keep such records, render such statements,
make such returns, and comply with such rules and regulations as the
Secretary may from time to time prescribe. * * * [Emphasis added.]
Taxpayers are thus required to keep sufficient records to substantiate their gross
income, deductions, credits, and other tax attributes. See also 26 C.F.R.
sec. 1.6001-1(a), Income Tax Regs. There is no provision in section 6001 or the
regulations thereunder that imposes a record-keeping requirement on the IRS or
that allows a taxpayer, like Mr. Bailey, to obligate the IRS to store his records.
The fact that he offered to let the IRS review and copy his records before
discarding them does not absolve him of that requirement or shift the burden of
proof in these cases.
"The record does not show the type or quality of records that Mr. Bailey
kept in the hangar, and the Commissioner disputes Mr. Bailey's contention that
those records were sufficient to substantiate his profit motive.
- 51 b.
Táxpayers are required to retain their records as long as
they may become material for tax purposes.
Even assuming arguendo that before the date on which he discarded his
records, the IRS gave Mr. Bailey no indication that it would challenge his profit
motive,28 that supposed lack of notice did not shift the burden of proof. There is
no provision in section 6001 or the regulations thereunder that excuses taxpayers
from retaining their records if the IRS fails to notify them of an imminent
challenge. Instead, taxpayers are required to retain their books and records as long
as they may become material:
(e) Retention of records.--The books or records required by
this section shall be kept at all times available for inspection by
authorized internal revenue officers or employees, and shall be
retained so long as the contents thereof may become material in the
administration of any internal revenue law. [Emphasis added.]
26 C.F.R. sec. 1.6001-1(e), Income Tax Regs. A taxpayer's books and records for
a given tax year "may become material" for purposes of section 6001 as long as
the period of limitations on assessment for that year remains open under
section 6501. Since the period of limitations is still open with respect to the tax
28The record contradicts Mr. Bailey's contention that he was given no notice
that the IRS might challenge his profit m tive. Revenue Agent Tabor issued five
IDRs to Mr. Bailey in April 2002 that each made requests with respect to the
profitability of his activities--well before June 2002, when Mr. Bailey gave the
IRS a final opportunity to review and copy his records before he discarded them.
- 52 years at issue,29 Mr. Bailey was required to retain his books and records with
respect to those years, whether or not the IRS gave Mr. Bailey notice of a possible
challenge to his profit motive.
2.
Burden shift under section 7491(a)
Under certain circumstances, the burden of proof as to factual matters may
shift pursuant to section 7491(a) from the taxpayer to the Commissioner, but only
if the taxpayer introduces credible evidence regarding a factual matter affecting
his liability and only if he has complied with substantiation requirements, has
maintained all required records, and has cooperated with the IRS's reasonable
requests. Sec. 7491(a)(1) and (2). Mr. Bailey contends that section 7491(a) shifts
the burden of proof to the Commissioner.
However, in general Mr. Bailey has not introduced credible evidence raising
factual questions about his liabilities (rather, he has made conclusory arguments
without supporting references to exhibits in the record); he did not comply with
substantiation or record-keeping requirements (rather, he discarded his records);
29The period of limitations for assessment was open with respect to all seven
of the tax years at issue on November 6, 2007, when the IRS issued the notices of
deficiency to Mr. Bailey, because he signed Forms 872, Consent to Extend the
Time to Assess Tax, by which he agreed to extend the period of limitations on
assessment. See sec. 6501(c)(4). The period of limitations for assessment will
remain open for a minimum of 60 days after the decision of this Court becomes
final. See secs. 6213(a), 6503(a).
- 53 and he did not fully cooperate with the IRS, specifically with Revenue Agent
Tabor's requests for information about BEI and PBR (rather, it appears that
Mr. Bailey was unresponsive to a series of IDRs). Accordingly,-section 7491(a)
does not shift the burden to the Commissioner, and Mr. Bailey therefore retains
the burden of proof with respect to the d ficiencies. See Rule 142(a)(1).
3.
Alleged animus
Another contention that Mr. Bailey makes to assail the notice of
determination is a recurring observation that the agent's notes (on which the
notices of deficiency are based) include erasures: Mr. Bailey perceives that in
2001, after the judge in~Bailey II made remarks encouraging to Mr. Bailey, the IRS
agent's "investigation took a hard reversal in direction. Friendly communication
stopped, and [the IRS] Agent * * * started changing his notes to favor the
government." From this timing, and from erasures and revisions in the revenue
agent's workpapers, Mr. Bailey infers that the prosecutors influenced the revenue '
agent. Mr. Bailey speculates that these e asures reflect changes that occurred after
developments adverse to the Governmen in their litigation concerning the Duboc
stock. Mr. Bailey believes that the agent made these changes not because of his
bona fide conclusions about Mr. Bailey's income and deductions but cynically at
the behest of the Government's attorneys. For issues as to which the agent's notes
- 54 include erasures, Mr. Bailey implicitly contends that the burden of proof should
shift to the Government.
However, Mr. Bailey's only evidence to support this timeline and this
scenario is his own perception of a change in the agent's attitude. . The agent . .
contradicted Mr. Bailey's contention and testified that he was "not in
communication with other branches of the government". We found him credible.
Having observed the agent's testimony, including under cross-examination by
Mr. Bailey, we find no basis for Mr. Bailey's speculation.
Moreover, the issue of the Biochem Pharma stock (the subject of
Mr. Bailey's litigation with the Government) has little relation to this argument of
Mr. Bailey's, even if the argument were well grounded. . The agent's notes pertain
principally to substantiation issues, whereas the Biochem Pharma issue was
conspicuous and well known apart from anything the agent might have done, and
the parties have stipulated or broadly agreed about the basic facts of the stock
transfers, loans, and expenditures that are pertinent to that issue.
But even if there were reason (there is none, we stress) to be suspicious
about the agent's sincerity in the adjustments he made, such suspicion would not
affect the burden of proof. As a general rule, we do not look behind the notice to
examine the motives of the IRS in making its adjustments to a taxpayer's liability.
-55Graham v. Commissioner, 82 T.C. 299 (1984), aff'd, 770 F.2d 381 (3d Cir. 1985).
This is not an instance in which the tax ayer alleges that he was selected for audit
on the basis of an impermissible criterion, such as ethnicity, see Greenberg's
Express, Inc. v. Commissioner, 62 T.C. 24, 328 (1974), or that the statutory
notice is based on illegally seized evide ce, see Suarez v. Commissioner, 58 T.C.
792, 813-814 (1972), overruled in part, Guzzetta v. Commissioner, 78 T.C. 173,
184 (1974). To the extent that the IRS's adjustments are supported not by reason
or evidence but only by ill motive, then the taxpayer's burden to prove his actual
liability "should be concomitantly easie ", cf. Church of Spiritual Tech. v. United
States, 20 Cl. Ct. 762, 765 (1990), so that the IRS's motive for the adjustments is
unimportant.
4. 042 New matters
The notice of deficiency disallowed Mr. Bailey's deduction of expenses
attributable to Project 288 on the groùnd that the activity was not engaged in for
profit. We have found, however, that th activity was engaged in for profit. The
Commissioner contends in the alternativ that the expenditures either were startup expenses under section 195 or were expenditures for the creation of a capital
asset (i.e., the Bailey Bullet). However, as an exception to the general rule,
Rule 142(a)(1) provides that "in respect of any new matter * * * pleaded in the
- 56 answer,® it [the burden of proof] shall be upon the respondent." The
Commissioner's two alternative coritentions are "new matter[s]", and the
Commissioner therefore has the burden of proving that substantiated Project 288
expenditures were capital expenses or start-up expenses.
B.
Collateral estoppel
In connection with the Biochem Pharma stock issue, the Court previously
advised the parties, in an order dated March 26, 2009, t'that the Court-will consider
sua sponte (see Monahan v. Commissioner, 109 T.C. 235, 250 (1997)) the
preclusive effect of those prior decisions"--i.e.,.Bailey I and Bailey II. The rule of
collateral estoppel provides that "[w]hen an issue of fact or law is actually litigated
and determined by a valid and final judgment, and the determination is essential to
the judgment, the determination is conclusive in a subsequent action between the
parties, whether on the same or a different claim.". 1 Restatement, Judgments 2d,
sec. 27 (1982); see also Allen v. McCurry, 449 U.S. 90, 94 (1980) ("Under
collateral estoppel, once a court has decided an issue of fact or law necessary to its
judgment, that décision may preclude relitigation of the issue in a suit on a
"Altfiough these alternative contentions were not pleaded in the
Commissioner's answer, they were addressed at trial without objection.by
Mr. Bailey and were therefore tried by consent. We therefore treat them as
pleaded and do not require the Commissioner to file a motion to amend his
answer, which motion we would grant.
- 57 different cause of action"); Montana v. United States, 440 U.S. 147, 153-154
(1979). The nature and terms of Mr. Bailey's agreement with the Federal
Government were "actually litigated" b Mr. Bailey and the Federal Government
in those prior cases, in which cases the issues were "essential to the judgment".
See 1 Restatement, supra,.sec. 27. Consequently, the findings of those prior cases
are "conclusive" in these subsequent cas s, though these cases are founded on a
"different claim" (i.e., assignment of error in,the IRS's determination of
deficiencies).
. .
Mr. Bailey objects to the application of collateral estoppel here, although it
is not completely clear why he does so. This Court has no jurisdiction to award
Mr. Bailey the attorney's fees for his rep esentation of Mr. Duboc that the District
Court denied him, nor to hold that he is ntitled to the Biochem Pharma stock's
appreciation that the Court of Federal Claims denied him. One reason that
Mr. Bailey resists collateral estoppel is.to make the contentions discussed in
part III below (i.e., that a denial of due process in the District Court should undo .
his liability for tax on income that the court seized), but we show there that his due
process contentions are unavailing. Mor over, the findings that we import here by
way of collateral estoppel--e.g., that Mr. 3ailey received the stock in trust (rather
than as payment)--are largely favorable to Mr. Bailey.
-58 In any event, Mr. Bailey's objection to the application of collateral
estoppel--in particular, his contention that the issue of whether he held the
Biochem Pharma stock "in trust" was not fully and fairly litigated in the prior
proceedings--is not well founded. Mr. Bailey's claims about his ownership of the
stock were the focus of the litigation in Bailey I, in which the District Court issued
an order of January 12, 1996, that directed Mr. Bailey to make a-full accounting of the monies and properties held in trust by him for
the United States. * * * This should include * * * a full accounting
of the 602,000 shares of stock in Biochem Pharma, Inc., that was
delivered to Bailey to be held in trust for the United States.
[Emphasis added.]
Order of Contempt (Feb. 3, 1996) at 1. In addressing Mr. Bailey's appeal from the
decision of the District Court, the Court of Appeals for the Eleventh Circuit
observed:
At one time, Bailey contested ownership of the Biochem Pharma
stock. He argued that the government had given him the stock in fee
simple and not in trust: Bailey dismissed that claim in May 1996.
Bailey I, 175 F.3d at 967. Thus, Mr. Bailey's dispute of the trust character of his
stock holding was decided by the District Court and was not overturned on appeal.
There can thus be ño doubt that the issue was litigated.
However, Mr. Bailey evidently contends that the issue was not fully and
fairly litigated because of defects in the District Court proceedings--chiefly, that
- 59 the trial judge had prejudged Mr. Bailey's claims, and Mr. Bailey "was never able
to remove him from the case". This cornplaint about the judge was raised (as it
must have been) on appeal from the jud e's ruling. If the Court of Appeals erred
in that regard, Mr. Bailey's remedy was to petition for a writ of certiorari from the
Supreme Court, not to attack the decision collaterally in this Court.
The Court of Federal Claims did later entertain in Bailey II Mr. Bailey's
dispute on the trust issue, but only long enough to determine that it was only a
"semantic" dispute, since the Government contended that Mr. Bailey held the
Biochem Pharma stock "in trust", 54 Fed. Cl. at 466, 471, 500, while Mr. Bailey
contended that the arrangement was "in he nature of a trust", id. at 472, 501. This
semantic dispute--"trust" vs. "in the nature of a trust"--is not material in these
cases.
Since Bailey I clearly held at least that the Biochem Pharma stock when
transferred to Mr. Bailey was for specifi uses for which he must give an
accounting, and Bailey II held that Mr. Bailey was not entitled to the subsequent
appreciation, the parties are precluded fr m relitigating those issues here, and we
find that Mr. Bailey held the Biochem P1 arma stock not on his own account but
for others.
- 60 II.
Income from wrongful appropriations
The IRS determined that Mr. Bailey received $5.9 million in income in 1994
when his client Claude Duboc transferred Biochem Pharma stock to Mr. Bailey's
investment account at a Swiss bank." Mr. Bailey contends, on the other hand, that
none of the $5.9 million was ever income to him, since he eventually had to
transfer the stock and its proceeds to the Federal Government.
A.
Taxable income includes wrongful appropriations.
Under section 61(a), "gross income means all income from whatever source
derived". Money received may be income even when the recipient has no right to
it--even when the recipient misappropriated it--and is obliged to pay it back. The
Supreme Court "has given a liberal construction to the broad phraseology of the
'gross income' definition statutes in recognition of the intention of Congress to tax
all gains except those specifically exempted." James v. United States, 366 U.S.
213, 219 (1961) (citing Commissioner v. Jacobson, 336 U.S. 28, 49 (1949), and
Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 87-91 (1934)). In James,
The IRS determined that the $5.9 million was income in .1994 when
Mr. Bailey received the stock and allowed subsequent deductions for his
reimbursement of sale proceeds and his return of the unsold stock. Since
Mr. Bailey fully reimbursed and repaid those amounts, the Commissioner
acknowledges that his income in 1994 is fully offset by deductions in later years;
but under the Commissioner's approach Mr. Bailey still may be liable for interest,
additions to tax, and penalties for tax year 1994.
- (1 366 U.S. at 219-220, the Supreme Court held that "wrongful appropriations" are
includible in gross income. For that reason, Mr. Bailey's principal position--that
he realized no income from the stock simply because he was eventually required to
return it--must be rejected. It does not carry the day for Mr. Bailey to prove (as he
easily can, in light of Bailey I and Bailey II) that he never truly owned the
beneficial interest in the stock. Rather, a ounts that were misappropriated and
then later returned can nonetheless be ta able income in the year of the
misappropriation if the taxpayer had dominion and control over those amounts.
The Supreme Court has defined gross in ome under section 61 "to encompass all
'accessions to wealth, clearly realized, and over which the taxpayers have
complete dominion.'" James, 366 U.S. at 219 (quoting Commissioner v.
Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). In James, the Supreme Court
applied this standard to conclude that "w ongful appropriations" (but not "loans")
are "within the broad sweep of 'gross income'". Id.
The Commissioner's principal pos tion here, in reliance on those principles,
is that Mr. Bailey received income of $5.9 million when the Biochem Pharma
stock was first transferred to his Credit S aisse investment account in 1994,
pointing out that Mr. Bailey had completb dominion and control over the stock at
that time. If Mr. Bailey had prevailed in Bailey I (or maybe even in Bailey II),
- 62 then the Commissioner's position would have much to commend it; but in light of
the holdings in those opinions, that position, too, must be rejected. Given that the
Government proved that the stock was not Mr. Bailey's and that he held it only in
trust-and especially given that the Government persuaded the District Court to jail
Mr. Bailey until he lived up to the terms of that trust--the Commissioner's
principal position is not tenable.32
B.
A trustee realizes income from the trust corpus when he actually
misappropriates it.
Not every remittance of funds is income to the recipient. Bank deposits are
not income to the bank; a bailment is not income to the bailee; and funds received
in trust by a trustee are excludible from gross income when those funds are subject
to a restriction that they be expended for a specific purpose, and the taxpayer does
not profit, gain, or benefit in spending the funds for the stated purpose. Ford
Dealers Adver. Fund, Inc. v. Commissioner, 55 T.C. 761, 771 (1971) (citing
Seven-Up Co. v. Commissioner, 14 T.C. 965 (1950), aff'd, 456 F.2d 255 (5th Cir.
"Because the IRS treated the receipt of the $5.9 million of stock as income,
it allowed, in subsequent years, deductions for the return of the stock and the
reimbursement of the sale proceeds. To the extent we hold that Mr. Bailey did not
realize income from the Biochem Pharma stock, the corresponding deductions are
not allowable and the adjustments therefor in the notice of deficiency must be
reversed. However, under section 1341 Mr. Bailey may deduct his repayment of
amounts of Biochem Pharma stock sale proceeds that we conclude were income to
Mr. Bailey.
- 63 1972), Broad. Measurement Bureau, In . v. Commissioner, 16 T.C. 988 (1951),
Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), aff'd, 407 F.2d 210
(9th Cir. 1969), and Dri-Powr Distrib. Ass'n Trust v. Commissioner, 54 T.C. 460
(1970)). On the other hand, it is true that funds held in trust by a trustee do
become includible in his gross income once he has misappropriated them. Webb
v. IRS, 15 F.3d 203, 207 (1st Cir. 1994) Adams v. Commissioner, T.C. Memo.
1970-104 (1970).
The question whether income has been misappropriated in a given instance
is a question of fact. See, e.g., BancInsure, Inc. v. BNC Nat'l Bank, N.A., 263
F.3d 766, 771 (8th Cir. 2001) ("'where an individual's conduct falls somewhere
between the two extremes of embezzlement and simple poor judgment, intent
becomes a question of fact'") (quoting FDIC v. Oldenburg, 34 F.3d 1529, 1540
(10th Cir. 1994)); United States v. Wall ce, 300 F.2d 525, 532 (4th Cir. 1962)
("Whether funds were embezzled is a qu stion of fact"). The mere fact that
Mr. Bailey had dominion and control over the Biochem Pharma stock--to such an
extent that he had discretion to sell it--does not compel the conclusion that it was
income to him, since "[d]iscretion to sell stock is consistent with a requirement for
a full accounting", Bailey II, 54 Fed. Cl. at 495, and therefore consistent with the
- 64 fiduciary arrangement. As a result, facts beyond "dominion and control" must be
consulted.
C.
Mr. Bailey realized income when he transferred stock sale proceeds
from the advance account.
If a fiduciary commingles trust funds with his own money (as Mr. Bailey
did in the Credit Suisse accounts, the Barnett account, and the personal checking
account), then in certain circumstances this fact would suggest that he had
abandoned his fiduciary role, was now treating and using the funds as his own,
and therefore realized income. However, in these cases the commingling cannot
be decisive of the point. Mr. Bailey's agreement with the Government explicitly
contemplated that he would use his existing Credit Suisse account for the Biochem
Pharma stock. Consequently, the transfer of the shares to his Credit Suisse
investment account and of the loan and sale proceeds to his Credit Suisse advance
account did not constitute an appropriation of those proceeds. The relatively small
personal expenditures he made from that advance account (to purchase other stock
for himself) were in amounts consistent with the amounts of his own funds that
were already in that advance account; and when the Government asked that he use
his existing account for the Biochem Pharma stock, such commingling was made
- 55 inevitable and did not affect the tru 541t
chtracter ofthe funds placed there for the
repatriation and legal defense expenditures.
In 1995 Mr. Bailey transferred funds from the Credit Suisse advance
account to two other accounts of his-th Barnett money market account and the
personal checking account. The Governnient had not agreed that he should use
these accounts, and from these accounts Mr. Bailey made substantial personal
expenditures totaling $2.8 million. The use of the Barnett money market account
was arguably consistent with the trust character of the funds, since (a) the
Government may have implicitly approved the use of the account by acquiescing
to its use for the repatriation of the proceeds from the Pasco and Obayashi stock
(whereas there is no basis for suggesting that the Government acquiesced in his
putting the funds in his personal checking account), and (b) from the Barnett
account Mr. Bailey's personal expenditu:es were covered by his personal funds in
the account (whereas from the personal checking account he made substantial
personal expenditures from Biochem Plurma-derived proceeds). For those
reasons, our prior order dated April 29, 2009, found that a genuine issue of
material fact precluded the resolution of his point on summary judgment. At trial,
however, Mr. Bailey bore the burden to prove that in transferring the funds to his
Barnett account he did not depart from h s fiduciary role, and he did not carry that
- 66 burden. The record does not show that he regarded the funds in the Barnett
account as subject to restrictions on their use. We therefore hold that Mr. Bailey
wrongly appropriated Biochem Pharma stock sale proceeds when he made
transfers thereof to his Barnett money market account in the amounts of $175,037
in 1994" and $250,019 in .1995 (totaling $425,056) and that he received income
for those amounts in those years.
.
D. · Mr. Bailey did not realize income when he transferred loan proceeds
from the advance account.
The sale proceeds of $425,056, discussed above, constituted only about an
eighth of the transfers of Biochem Pharma-derived funds from the Credit Suisse
advance account. The remainder--slightly more than $3 million--was the proceeds
not of sales but of loans that Mr. Bailey had taken out, using the Biochem Pharma
stock as collateral. The Commissioner contends in the alternative that if the
602,000 shares of stock were not income to Mr. Bailey when he first received
them in 1994, then the loan proceeds, like the sale proceeds, were income to
Mr. Bailey when he actually appropriated them. The Commissioner argues that, if
the Court holds that Mr. Bailey realized income only when he actually
Mr. Bailey did not actually spend any of the sale proceeds on personal
expenditures until 1995, but we hold that he nonetheless realized the income when
he appropriated the funds by transferring them to an account on which he
acknowledged no restrictions.
- 57 appropriated the funds, then the computation of that income should take into
account the fact that Mr. Bailey could borrow up to only 25 percent of the value of
the stock. The Commissioner argues that Mr. Bailey's $3 million of loans in fact
employed $12 million of stock value, and $12 million of income should therefore
be imputed to him from the value of the atock.
This valuation argument, however, is upside down. The Commissioner
would value the $3 million of cash that Mr. Bailey received in loans by the
$12 million worth of collateral that he had to use to obtain it, and would impute
$12 million in income-but this reverses the economics of the situation. The
question should be: How much income did Mr. Bailey actually realize from his
use of $12 million of Biochem Pharma stock? The answer to that question is easy:
He was actually able to obtain $3 million (in loans); and $3 million was therefore
the value to him of the use of the stock a d is therefore the amount of income that
would be imputed to him if loan proceed were income to him.
The Commissioner's second alternative argument is that Mr. Bailey realized
income in the actual amounts of the loan proceeds (about $3 million) when he
received them. Mr. Bailey denies that these-amounts constituted income. He
personally guaranteed the loans, and witl great difficulty he borrowed from others
and repaid the loans in 1996. He therefo e invokes a basic tax principle: "[I]t is
- 68 settled that receipt of a loan is not income to the borrower." Commissioner v.
Indianapolis Power & Light Co., 493 U.S. 203, 207 (1990). This principle is
correct; but when Mr. Bailey previously made this contention in a motion for
summary judgment, the Court denied his motion because the issue is complicated
by Mr. Bailey's use of the Biochem Pharma stock as collateral for those loans, and
this use of the stock generated factual issues that could not be resolved under
Rule 121. After a trial, we can now decide this question.
In these cases, as in Webb v. IRS,,15 F.3d at 205, the loan-proceeds-asmcome issue-is centered at the confluence of two fundamental principles of federal
tax law. On the one hand, bona fide loan proceeds are not gross
income to the borrower, see Commissioner v. Indianapolis Power &
Light Co., 493 U.S. 203, 207-08, 110 S.Ct. 589, 592-93, 107 L.Ed.2d
591 (1990), because the contemporaneous economic benefit realized
upon receipt of the loan proceeds is counterbalanced by the
borrower's legal obligation to repay the loan. See McSpadden v.
Commissioner, 50 T.C. 478, 491, 1968 WL 1490 (1968). The factual
determination as to whether a particular transaction is a bona fide
loan turns on whether there are sufficient indicia of the parties'
intention that the monies advanced were to be repaid. See Crowley v.
Commissioner, 962 F.2d 1077, 1079 (1st Cir. 1992); Moore v. United
States, 412 F.2d 974, 978 (5th Cir.1969). At the same time, a line of
Supreme Court cases indicates that monies and other property
acquired by misappropriation must be reported as income in the year
of their receipt. See James v. United States, 366 U.S. 213, 221, 81
S. Ct. 1052, 1056, 6 L. Ed.2d 246 (1961) (embezzlement proceeds);
Rutkin v. United States, 343 U.S. 130, 137-38, 72 S.Ct. 571, 575-76,
96 L.Ed. 833 (1952) (extortion proceeds).
- 69 Aided by the Court of Appeals for the First Circuit's analysis in Webb,34 we hold
that the Credit Suisse loan proceeds were not income to Mr. Bailey.
In Webb, a trustee misrepresentec the eligibility of his solely owned
Massachusetts business trust for a storm disaster loan from the U.S. Small
Business Administration (SBA) and diverted a portion of the loan proceeds from
the trust for his personal use. Id. at 204. The IRS determined that the trustee had
unreported embezzlement income in the amount of the diverted loan proceeds and
the District Court granted summary judgment to the IRS. Id. at 205. On appeal,
the trustee argued (i) that the divertediloan proceeds constituted a de facto loan
from the SBA to him, and (ii) that loan proceeds are not income under James v.
United States, 366 U.S. 213 (1961). Webb, 15 F.3d at 206-207.
Although the Court of Appeals for the First Circuit agreed that loan
proceeds are not income, it upheld the IRS's determination and affirmed the
District Court because it found that the diverted loan proceeds were not a loan
under the so-called James "consensual recognition" test. Id. at 207-208. Under
the James test, a loan is recognized as su h for tax purposes if there is "the
consensual recognition, express or impli d, of an obligation to repay" the loan.
34Under section 7482(b)(1)(A), an appeal from a decision in these cases
would be made to the Court of Appeals for the First Circuit.
- 70 James, 366 U.S. at 219. The Court of Appeals found that the only borrower with a
"consensual recognition" of an obligation to repay the SBA was the trust, and
further found that there was no proof of any loan or obligation between the trust
and the trustee. Webb, 15 F.3d at 207-208.
However, the facts of Webb are very unlike those of the instant cases.
There is no dispute (i) that Credit Suisse made directly to Mr. Bailey the loans that
were collateralized by the Biochem Pharma stock, (ii) that he was personally liable
for those loans, (iii) that he intended to repay Credit Suisse, (iv) that Credit Suisse
insisted that he repay the loans-even when he became incarcerated--before it
would release the collateral, and (v) that he actually repaid Credit Suisse in 1996.
On those facts and in the absence of any evidence to the contrary, we find that
there was a "consensual recognition" of Mr. Bailey's obligation to repay the loans
to Credit Suisse. Under the James test, the loan proceeds from Credit Suisse were
the product of a loan to Mr. Bailey, and thus, are not includible in his gross
mcome.
However, the Commissioner contends that Mr. Bailey must nonetheless
recognize the loans from Credit Suisse as income, because he misappropriated the
value of the Biochem Pharma stock by using it as collateral for those loans. We
disagree. The receipt of a loan is not income to the borrower where the borrower
- 71
uses another person's property as collateral to obtain that loan--even where the
collateral is obtained under false preten es or is otherwise misappropriated--as
long as there is a "consensual recognitio " that the borrower will repay the loan.
See Kreimer v. Commissioner, T.C. Me o. 1983-672 (holding that loan proceeds
were not income to taxpayers who borrowed money through a series of shell
companies and fraudulently issued bonds in another corporation's name to secure
those loans, because the taxpayers treated the loans as bona fide debt and the facts
showed a "consensual recognition" of all parties involved that the loans would be
repaid).
Even though Mr. Bailey received most of the alleged income as loan
proceeds, the Government argues here ti at it was income to him because his use of
the Biochem Pharma stock as collateral was a knowing misappropriation that they
criticize in no uncertain terms. It is inde:d clear--with the benefit of hindsight-that Mr. Bailey was not entitled to use the Biochem Pharma stock as collateral to
secure loans for his personal use, and we certainly do not condone Mr. Bailey's
failure to draw clear lines between his personal financial interests and the other
interests he was bound to promote; but v)ewing Mr. Bailey as a taxpayer, we find
that the Government entered into a "vague and unusual" agreement with
Mr. Bailey under which: he was given ti;e broadest possible discretion to sell the
- 72 stock or use it as collateral; he and his co-counsel were led to believe that their
compensation might amount to as much as $3 million; he and his co-counsel
believed (wrongly) that they could take fees as they earned them (subject to a later
accounting); he bore the risk (eventually realized) of zero compensation; he
performed very substantial services for the Government's benefit" for which he
was never paid; and his belief that he owned the right to any appreciation in the
value of the stock, though mistaken, survived two dispositive motions in the Court
of Federal Claims36 and was eventually decided only after a nine-day trial, after
which the court, though holding against Mr. Bailey, stated that it found him to be
one of the three "most consistently credible of the witnesses testifying at the trial."
Bailey II, 54 Fed. Cl. at 463.
In these cases the Court asked Mr. Kirwin "Why was this arrangement not
reflected in a written agreement?", and Mr. Kirwin answered candidly:
35The Court asked U.S. Attorney Thomas Kirwin, "How many of your
criminal defense attorneys end up taking on responsibilities of the sort that
Mr. Bailey took on?" Mr. Kirwin answered, "in my experience, almost none. But,
this case is different than many of our cases." Mr. Kirwin acknowledged that he
has never heard of any other case in which a criminal defense attorney agreed with
the Government to manage assets, to postpone for years any payment of his fees,
and to risk complete nonpayment of fees if the assets' value declined.
36See Bailey II, 40 Fed. Cl. 449 (denying motion to dismiss for lack of
jurisdiction); Bailey II, 46 Fed. Cl. 187 (denying motion to dismiss for lack of
jurisdiction and for failure to state a claim).
- 73 Well, I ask myself that question about every three months, your
Honor. You know, it should have been. It absolutely should have
been. That is a huge mistake that Nas made. * * * I just don't think
anybody thought about the need tc put it in writing.
The Government thus admits that its failure to reduce to writing its agreement with
Mr. Bailey was a mistake; and we find tl at part of the Government's mistake was
its failure to make clear the restrictions t at it intended about Mr. Bailey's use of
the stock. On the record before us we fi d that Mr. Bailey did not know he was
violating the agreement when he used the Biochem Pharma stock as collateral for
his loans from Credit Suisse. Rather, he borrowed the money from Credit Suisse
in good faith, in his own name, and with a full expectation of paying it back
(which he did).
However, even if Mr. Bailey had intentionally misappropriated the stock as
collateral (more like the taxpayers in Kreimer), that fact would not convert
bona fide loans into misappropriation income so long as Mr. Bailey and Credit
Suisse had a "consensual recognition" th t he would repay the loans. There is no
exception to the James test for loans that were secured by another person's
collateral"--no matter how it was obtaine d--and "any broader reading of the
In our prior order dated April 29, 2009, denying the parties' cross-motions
for summary judgment, we overstated the significance of the Biochem Pharma
stock as collateral, suggesting that "here the borrower's legal obligation to repay'
(continued...)
- 74 language in James would be unwarranted on the basis of the facts of that case and
all subsequent decisions which have considered the issue." Kreimer v.
Commissioner, T.C. Memo. 1983-672.
IIL
Due process and Mr. Bailey's income from the Broder litigation
Among the items of income that Mr. Bailey did not report in the years at
issue, and that the IRS attributed to him, was the $1,650,000 from Mr. Broder that,
Mr. Bailey says, constituted "fees due him", but part of which was paid to the
District Court on Mr. Bailey's behalf in 1997 and the remainder of which was paid
in 1998 to third parties who had lent Mr. Bailey money in 1996 to repay Credit
Suisse's advances to Mr. Bailey so that Credit Suisse would release his collateral,
the Biochem Pharma stock, and the Broder payments were used to repay their
loans in 1998. It is true that Mr. Bailey did not get to keep any of the Broder
payments, and that the payment made directly to the District Court was compelled
by that court; but income earned by a taxpayer is taxable to him, even if he directs
that it be paid to someone else, see Lucas v. Earl, 281 U.S. 111 (1930), or if it is
"(...continued)
was overwhelmed by the fact that the lender held highly marketable collateralcollateral that did not belong to the borrower-which would satisfy the unpaid
loan." In so saying we implied a standard not acknowledged in Webb or James
and contradicted in Kreimer. The existence of collateral (to protect the lender),
whether rightly obtained or wrongly obtained, does not undermine the borrower's
obligation.
applied to satisfy his debt, Old Colony Trust Co. v. Commissioner, 279 U.S. 716,
729 (1929) ("The discharge by a third peeson of an obligation to him is equivalent
to receipt by the person taxed"); Tuckeræ. Commissioner, 69 T.C. 675, 678-679
(1978).
Mr. Bailey argues, however, that these Broder payments should not be
treated as income to him because of violttions of the Fifth Amendment to the U.S.
Constitution, which provides that "No person shall * * * be deprived of life,
liberty, or property, without due process of law". Mr. Bailey contends that he was
denied due process" when the Government contrived a debt he did not really owe
(i.e., the Biochem Pharma stock) and forced him to satisfy it with the Broder
"Mr. Bailey also seems to invoke the takings clause of the Fifth
Amendment ("nor shall private property be taken for public use, without just
compensation") when he asserts, "There i s no question but what the government
'took'" the Broder payments. However, when the Goverhment takes a person's
property not "for public use" but rather to pay the person's private debt, that is not
a Fifth Amendment "taking". See Skillo v. United States, 68 Fed. Cl. 734, 743
(2005) ("'This Court and other courts have routinely held that the lawful exercise
of the Government's collection powers does not amount to a prohibited Fifth
Amendment "taking".'") (quoting Kerrigan v. Unite'd States, 1997 WL 685275, at
*5 (Fed. Cl. Apr. 30, 1997)). Moreover, this Court has not been granted
jurisdiction to adjudicate a Fifth Amendment "taking" claim. Rather, such claims
must be litigated in the Court of Federal Claims (under 28 U.S.C. sec. 1491(a)(1)
(2006)) or in Federal District Court (under 28 U.S.C. sec. 1346(a)(2) (2006)).
- 76 payments.39 This due process argument stumbles at the starting block, for two
related reasons. First, these allegations concern supposed defects in prior judicial
proceedings, which were (or could have been) reviewed on appeal from those
proceedings 4° The Tax Court does not sit as a court of review of the decisions of
other courts. Second, these allegations ultimately dispute a holding--i.e., that
Mr. Bailey did not acquire rights to the Biochem Pharma stock in 1994 and was
therefore required to return the stocli and its proceeds--that Mr. Bailey is
collaterally estopped from disputing, for the reasons explained above in part I.B.
39Specifically, Mr. Bailey alleges that in Bailey I he was wrongly denied the
ownership of the Biochem Pharma stock; that he was denied compensation for his
labor in repatriating Duboc's assets; that by misrepresentations the Department of
Justice induced the Federal District Court to demand immediate return of the
Biochem Pharma stock in 1996; that the Federal District judge refused to hear
some of his arguments and evidence and refused to recuse himself though he
ought to have been a witness; that Mr. Bailey was unjustly jailed until he,could
come up with $2.3 million; that the appellate court "missed or avoided the central
argument"; and that the Department of Justice held up the renomination of the
Court of Federal Claims judge who was handling Bailey II, thereby prompting an
adverse outcome that denied him the appreciation on the Biochem Pharma stock.
4°In Bailey I, decisions of the District Court for the Northern District of
Florida had to be appealed to the U.S. Court of Appeals for the Fifth Circuit, 042
28 U.S.C. secs. 1291, 1294(1), and decisions of the Court of Appeals for the Fifth
Circuit had to be appealed to'the U.S. Supreme Court, 28 U.S.C. sec. 1254. In ~ ·
Bailey II, decisions of the Court of Federal Claims had to be appealed to the U.S.
Court of Appeals for the Federal Ciròuif. 28 U.S.C. sec. 1295(a)(3).
41Mr. Bailey also alleges that the Department of Justice violated due process
042
(continued...)
- 77 Mr. Bailey was held by the District Court to be obliged to reimburse the
Government for the stock sales; and he Ldmits that he was personally obliged to
repay the Credit Suisse loans, which in t2rn were paid by third parties whom he
was then liable to pay. That being the cLse, the Broder payments made to the
District Court and to these third parties satisfied obligations of Mr. Bailey, and
they are income to him even if he never had the money in hand.
Mr. Bailey's last due process argument is that pressure from the Department
of Justice fomented errors in the notice of deficiency. It certainly is in our
jurisdiction to review the notice of deficiency, and we do have the power to
remedy any errors in it. However, this contention is little more than a repetition of
Mr. Bailey's argument that IRS animus should affect the burden of proof. As we
stated in part I.A.3. above, there is no warrant here to look behind the notice of
deficiency and examine the IRS's motiveis. If the evidence shows that adjustments
in the IRS's notice of deficiency cannot i e sustained, then the Commissioner
could not prevail by proving that the agerit was sincere; likewise, if the evidence
(...continued)
by engineering his disbarment. Of cours , the Tax Court does not have (and Mr.
Bailey does not suggest that we have) jur sdiction to review his disbarment
proceedings or the power to reinstate his license to practice law. And even if we
could determine that he had been unjustly disbarred, we could not remedy that
wrong by excusing him from tax liability on income that we find he did receive.
- 78 shows that the adjustments were correct, Mr. Bailey could not prevail by proving
that the agent was prejudiced. The issue here is not the agent, the agency, or the
audit but rather Mr. Bailey's tax liability.
IV.
Whether activities are engaged in for profit: general principles
Next at issue is Mr. Bailey's entitlement to deductions for the 1993 through
2001 tax years that arose from the yacht rental activity and the airplane
remanufacturing activity" that he conducted through his two wholly owned S
corporations. A taxpayer who is carrying on a trade or business may deduct
ordinary and necessary expenses incurred in connection with the operation of the
business. Sec. 162(a). However, a taxpayer generally may not deduct expenses
incurred in connection with a hobby or other nonprofit activity to offset taxable
income from other sources. Sec. 183(a). Section 183(c) defines an "activity not .
engaged in for profit" as "any activity other than one with respect to which
deductions are allowable for the taxable year under section 162 or under paragraph
"The regulations provide that "all the facts and circumstances" must be
taken into account to determine the activity or activities of the taxpayer. 26 C.F.R.
sec. 1.183-1(d)(1), Income Tax Regs. On the basis of all the facts and
circumstances, we find that Mr. Bailey conducted the airplane rental activity,
yacht rental activity, and airplane remanufacturing activity as (three) separate
activities for purposes of section 183. See Keanini v. Commissioner, 94 T.C. 41,
46 (1990). Mr. Bailey conducted the three activities as separate activities for
accounting purposes. He also hired a different set of employees to manage and
carry out each activity.
- 79 (1) or (2) of section 212." An activity constitutes a "trade or business" within the
meaning of section 162--and it escapes t2e limitation of section 183--if the
taxpayer's actual and honest objective is to realize a profit. Osteen v.
Commissioner, 62 F.3d 356, 358 (11th Cir. 1995), aff'g in part and rev'g in part
T.C. Memo. 1993-519. The expectation of profit need not have been reasonable;
however, the taxpayer must have entered into the activity, or continued it, with the
objective of making a profit. Hulter v. C mmissioner, 91 T.C. 371, 393 (1988);
26 C.F.R. sec. 1.183-2(a), Income Tax R gs. Whether the requisite profit
objective exists is determined by looking at all the surrounding facts and
circumstances. Keanini v. Commissioner, 94 T.C. 41, 46 (1990); 26 C.F.R. sec.
1.183-2(b). Greater weight is given to o jective facts than to a taxpayer's mere
statement of intent. Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), aff'd,
792 F.2d 1256 (4th Cir. 1986); 26 C.F.R. sec. 1.183-2(a).
Section 1.183-2(b) of the regulatio:1s provides a list of factors to be
considered in the evaluation of a taxpáyer's profit objective: (1) the manner in
which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his
advisers; (3) the time and effort expendec by the taxpayer in carrying on the
activity; (4) the expectation that assets us d in the activity may appreciate in
value; (5) the success of the taxpayer in c irrying on other similar or dissimilar
- 80 activities; (6)-the taxpayer's history of income or losses with respect to the_
activity; (7) the amount of occasional profits, if any, from the activity; (8) the
financial status of the taxpayer; and (9) elements of personal pleasure or
recreation. This list is nonexclusive, and the number of factors for or against the
taxpayer is not necessarily determinative. Rather, all facts and circumstances must
be taken into account, and more weight may be given to some factors than to
others. Id.; see Dunn v. Commissioner, 70 T.C. 715, 720 (1978), äff'd, 615 F.2d
578 (2d Cir. 1980).
We now address these nine factors with respect to the yacht rental activity
and the airplane remanufacturing activity.
V.
Analysis of Mr. Bailey's yacht rental activity
. Mr. Bailey conducted the yacht rental activity through PBR from 1993 until
the Government took control of the Spellbound in 1996. Mr. Bailey concedes that
he never intended to profit from yacht rentals per se, and we therefore do not
analyze that activity for a profit motive. Rather, Mr. Bailey contends that the
yacht rental activity was really the continuation and winding down of his previous
yacht refurbishing activity, which (he alleges) was engaged in for profit.
Mr. Bailey also contends that the Commissioner is estopped by a settlement
agreement from contesting his profit motive for the yacht rental activity.
- 81 Even if Mr. Bailey's ya ht rental activity is viewed as a continuation of his
previous yacht refurbishing activity, we find that it was not engaged in for profit
during tax years 1993 though 1996.* We also find that'the Commissioner is not
estopped from contesting Mr. Bailey's p ofit motive.
A.
Lack of profit motive for yacht refurbishing activity
Mr. Bailey contends that the yacht rental activity was really the continuation
and winding down of his previous yacht hefurbishing activity. He contends that
the yacht refurbishing activity was enga ed in for profit (i) before the tax years at
issue, when he attempted to use the Spellbound as a prototype to refurbish and-sell
other used yachts, and (ii) during the tax years at issue, when he was winding
down the yacht refurbishing activity. As Mr.'Bailey correctly notes, a taxpayer
does not lack a profit motive merely because his business fails and he takes a
reasonable time to unwind it and minimi e his losses.44
"Mr. Bailey contends that he is entitled to deduct "yacht-based expenses"
from 1993 until PBR sold the Spellbound in 1998. We find that the yacht rental
activity was not engaged in for profit. Se pt. V.C. below. In addition, we find
that the record provides even less support for Mr. Bailey's contention that his
attempts to sell the Spellbound during the 1996 through 1998 tax years constitute
an activity that was engaged in for profit. Accordingly, we hold that Mr. Bailey
lacked the requisite profit motive for the yacht rental and sale activities during all
of the tax years at issue.
44See Helmick v. Commissioner, T. . Memo. 2009-220, slip op. at 27-28
(continued...)
- 82 However, if the deductibility of the suit-years' yacht-related expenditures
depends on the for-profit character of the pre-suit-years' yacht refurbishing
activity, then it was incumbent on Mr. Bailey to prove that for-profit character. He
did not do so, as the following consideration of the nine factors listed above
shows.
1.
Manner in which the activity is conducted
Mr. Bailey kept his records for the yacht activity in the Lantana hangar
before discarding them, but the record contains only Mr. Bailey's general claims
about the adequacy of the records, and does not provide needed details about their
type or quality. Mr. Bailey discarded those records (after giving the IRS an
opportunity to review and copy them). Mr. Bailey thus failed to prove whether he
kept records for the activity in a business-like manner. Mr. Bailey does not allege,
nor does the record show, that he changed his operating methods to improve the
profitability of the yacht refurbishing activity. This factor--the manner in which
the activity is conducted--is strongly in the Commissioner's favor.
(...continued)
(after "a catastrophic loss that could never be recouped," a taxpayer who
"thereafter expected to generate an overall prospective profit * * * could not be
said to lack a profit objective after the disaster merely because he would never
recoup the prior loss").
- 83 2.
Expertise of the taxpa er and his advisers
Mr. Bailey was an aviator, a lawye , a speaker, an author, and a past owner
of a helicopter company; but when he ac uired the Spellbound he had no prior
experience in yacht selling or refurbishing. Mr. Bailey did hire experts--Dennison
Marine and the Roscioli Yachting Center-to-execute his plans to refurbish the
Spellbound; but he offered no evidence 0:her than his own general testimony to
show that they actually collaborated with or advised him in establishing a business
of which the Spellbound was to be a prototype. We are not convinced that he was
much more than a retail customer of Demtison Marine and the Roscioli Yachting
Center. This factor--expertise--is in the Commissioner's favor.
3.
Time and effort expendéd
Mr. Bailey did not establish how much time or effort he spent in
refurbishing the Spellbound or develbping a plan to sell yachts. Instead, Mr.
Bailey was otherwise employed with his law practice. This factor--time and
effort--is in the Commissioner's favor.
- 84 4.
Expectation that assets may appreciate in value
Mr. Bailey testified that he did not expect the Spellbound to appreciate.
This factor--expectation that assets may appreciate--is in the Commissioner's
favor.
5.
Taxpayer's success.in similar or dissimilar activities
Though Mr. Bailey's career has been remarkably varied, he was not ever
involved in a business venture similar to refurbishing and selling yachts. This
factor--success in similar or dissimilar activities--is in the Commissioner's favor.
6-7.
History of income or loss, amount of occasional profits
Mr. Bailey refurbished only one yacht, the Spellbound, had difficulty selling
it, and never used it as a prototype. Mr. Bailey's summaries show that the
Spellbound generated a significant loss every year and a total loss of $922,137
over its brief four-year course. These factors-history of income or loss, and
occasional profits--are moderately in the Commissioner's favor.
8.
Financial status of the taxpayer
Substantial income from sources other than the activity in question,
particularly if offset by claimed losses from the activity, may indicate that the
activity is not engaged in for profit. On the other hand, a lack of income from
sources other than the activity in question may make a profit objective more likely.
- 85 26 C.F.R. sec. 1.183- 2(b)(8). Mr. Bailey's average gross income from his law
practice and speaking services exceeded $1 million a year during the tax years at
issue, and he claimed the activity's losses to significantly reduce.his income tax
liabilities.
Mr. Bailey concedes that he "had a solid income from other sources" but
insists that he "did not purposefully arrange to lose money through aircraft rental
operations". However, in determining whether, under section 183, an activity is
engaged in for profit, greater weight is given to objective.facts than to a taxpayer's
mere statement of intent. Mr..Bailey could afford to maintain a yacht for his use
even if there was no expectation of future profit.
This factor--financial status--is in the Commissioner's favor.
9.
.
Elements of personal pleasure
The Commissioner contends that Mr. Bailey took a great deal of personal
pleasure from sailing on the Spellbound with his family and«friends, but
Mr. Bailey claims that "[i]t's no fun to drive a boat". Mr. Bailey testified that the
steering wheel and navigational instruments of the Spellbound are isolated from
the rest of the deck, and the pilot is therefore isolated from the party-goers on the
deck.
e-s
· . .
- 86 While it may be true that Mr. Bailey did not enjoy piloting the yacht, the
record belies the claim that he derived no personal pleasure from it. First, the
Spellbound was built to.Mr. Bailey's specifications, and he testified that it was
beautiful. Second, the record does not show that Mr. Bailey always took on the
job of piloting the Spellbound. PBR hired a captain and crew to sail and maintain
the Spellbound, and Mr. Bailey could have used their services to pilot the yacht
any number of times. Even assuming arguendo that Mr. Bailey piloted the
Spellbound on every personal trip--and that he disliked the task--we find that he
derived pleasure from sharing the yacht with his family and friends and that he
anticipated doing so when he purchased the yacht in 1989.
This factor--elements of personal pleasure--is in the Commissioner's favor.
10.
Conclusion
We do not conclude that Mr. Bailey's contention that he intended to
refurbish and sell yachts is a complete fabrication. He may well have
contemplated the idea when deciding to buy the yacht, and he may have
entertained the possibility as another justification for going ahead and making the
purchase. But there is no indication that operating an activity of refurbishing and
selling yachts for profit was the real or principal reason he bought the yacht.
Consequently, we find that the yacht refurbishing activity before the years at issue
- 37 was not entered into for profit; therefore the winding down of that activity in the
years at issue, involving the rental of the.yacht, was not-the continuation of a forprofit activity.
B.
Equitable estoppel
1.
Alleged agreement
Mr. Bailey contends that the Commissioner is estopped by:a settlement
agreement from contesting his profit motive for the yacht rental activity.
Mr. Bailey alleges that he and the IRS entered into a settlement agreement in 1996
which stipulated that Mr. Bailey's yacht efurbishing activity had been engaged in
for profit for the 1990 through 1992 tax years. Revenue Agent Tabor
acknowledges that he allowed Mr. Bailey favorable treatment on this issue for
1990 through 1992; but the only evidence of any written agreement is Mr. Bailey's
testimony that "I think there's a letter out there, somewhere" that memorialized the
alleged settlement agreement. Mr. Bailey did not submit into evidence a copy of
the alleged settlement agreement or any o:her evidence to suggest that a settlement
was reached, and we find that there was n3 such settlement.
Even if there had been a settlement as to the years 1990 through 1992, it '
would not govern the subsequent years that are now before us. Generally, "each
taxable year stands alone, and the Commissioner may challenge in a succeeding
- 88 year what was condoned or agreed to in a previous year.", Rosemann v.
Commissioner, T.C. Memo. 2009-185 (citing Auto. Club of Mich. v.
Commissioner, 353 U.S. 180 (1957), and Rose v. Commissioner, 55 T.C. 28
(1970)).
2.
Alleged misleading
Mr. Bailey also asserts estoppel arising from his allegation that the IRS
misled him. He asserts that the IRS misled him about its intention to challenge his
profit motive for the yacht rental activity by agreeing that the yacht refurbishment
activity was engaged in for profit. Equitable estoppel is a judicial doctrine that
precludes a party from denying that party's own acts or representations that induce
another to act to his or her detriment; and in extraordinary circumstances,
equitable estoppel may bar the Commissioner from challenging his previous
determinations; but the doctrine is to be applied against the Commissioner only
with caution and restraint. See McCorkle v. Commissioner, .124 T.C. 56, 68
(2005). The essential elements of estoppel are: (i) there must be a false
representation or wrongful misleading silence;' (ii) the error must be in a statement
of fact and not in an oliinion or a statement of law; (iii) the person claiming the
benefits of estoppel must be ignorant of the true facts; and (iv) he must be
- 89 adversely affected by the acts ör statements of the person against whom estoppel is
claimed. Id.; see also Dickow.v.,United States, 654 F.3d 144,.152 (1st Cir. 2011).
In particular, Mr. Bailey contends that he discarded his records for the yacht
rental activity after June 2002 only because Revenue Agent Tabor "never
suggested, until 2004, that * * *[the yacht rental activity] was anything but a
business".
However; Mr. Bailey has not met his burden to prove that (i) the IRS
deceived or misled him (ii) about a factual issue that relates to his profit motive for
the yacht reñtal activity (iii) of which he was ignorant and (iv) as to which relied
on the IRS on to his detriment. In fact, the record contradicts Mr. Bailey's
contention that Revenue Agent Tabor "never suggested" that the IRS might
.
challenge his profit motive for the yadht rental activity until 2004. Revenue Agent
Tabor issued five IDRs to Mr. Bailey in April 2002 that each made requests with .
respect to the profitability of the yacht rental activity--two years before 2004, and
only weeks before June 2002, when.Mr. Bailey.gave the IRS a final opportunity to
review and copy his records before he discarded them. Thus, Revenue Agent
Tabor was visibly investigating Mr. Bailey's profit motive weeks before the
records were discarded, and Mr. Bailey had no reason to suppose that the IRS had
conceded the issue.
- 90 Accordingly, we hold that the Commissioner is not estopped from
contesting Mr. Bailey's profit motive for the yacht rental activity.
C.
Lack of nexus between yacht refurbishing and yacht rental
Even if we were to fmd that Mr. Bailey's yacht refurbishing had been a forprofit activity in the prior years, or were to hold that the Commissioner was
estopped from contending otherwise, we would still have to evaluate his claim that
his yacht rental activity in the years at issue was merely the unwinding of that
prior activity. Mr. Bailey did not simply rent out the yacht to pay his docking fees
and other inevitable expenses of holding the Spellbound for sale. Mr. Bailey
entertained his family and friends on the Spellbound. Although he claims that his
personal use constituted only a "small percentage" of the total use of the
Spellbound,45 the record shows otherwise. First, Mr. Bailey's summaries of
revenue and expenses show that the yacht rental activity generated more than 10
times higher expenses than charter fees. Second, the timesheets kept by the crew
of the Spellbound for 1995 show that the crew devoted at least twice as much time
45Mr. Bailey testified that he deducted only 90 percent of the expenses of the
Spellbound, because he operated under the assumption that 10 percent of the total
use of the Spellbound was personal. However, in his reply brief, Mr. Bailey
requests this Court to fmd that 20 percent of the total use of the Spellbound was
personal.
- 91 to personal or unpaid trips as it did to paid charters. Most of the use of the
Spellbound was personal during the tax years at issue.
If the Spellbound had been originally purchased and refurbished for:
business purposes, we would conclude that·in the years at issue it was converted to
personal use and that the rentals were siriply a means of covering some of the cost
of that personal use.
D.
Tax consequences
Because the yacht rental activity was not engaged in for profit, under
section 183(b)(2) Mr. Bailey can deduct 1is yacht expenses only to the extent of
yacht income. The notices of deficiency accomplish this effect by including in
Mr. Bailey's income PBR's yacht rental receipts and capital gains and then
allowing him deductions for PBR's expenses in the same amounts-deductions,
howeverithat are subject to the limit of soätion 67(a) (i.e., as ''miscellaneous
itemized deductions" allowable only to tl e extent that in2the aggregate they exceed
2 percent of adjusted gross income), because they are not among those excluded
from that limit by section 67(b). The notice of deficiency is sustained in this
regard.
- 92 VI.
Analysis of Mr. Bailey's airplane remanufacturing activity
Mr. Bailey's airplane remanufacturing activity presents a sharp contrast to
his yacht activity. He conducted the airplane remanufacturing activity--"Project
288"--from 1994 until its chief inspector and director of maintenance resigned in
April 1996. On the basis of all the facts and circumstances, we do find that Project
288 was engaged in for profit from 1994 to April 1996.
A.
Profit motive under section 183
Examining the nine factors suggested in the regulations under section 183,
we find that the activity was engaged in for profit.
1.
Manner in which the activity is conducted
Mr. Bailey failed to prove that he kept records for the airplane
remanufacturing activity in a business-like manner. Although we found that
Mr. Bailey kept his records for the activity in the Lantana hangar before discarding
them, the record does not show their type or quality. This tends against a finding
of a profit motive.
However, a strong business-like feature of Project 288 was Mr. Bailey's
attempt to obtain FAA approval for the modifications his company developed for
the Twin Comanche design and then applied to the Bailey Bullet. PBR contracted
for the services of Bill Wall, who served as the administrator of East Coast
- 93 Avionics, an FAA-certified designated alteration station. In that capacity, he was
authorized to issue supplemental type certificates on behalf of the FAA to approve
modifications to aircraft designs. On September 21: 1995, Mr. Wall issued five
supplemental type certificates to PBR, which approved a number of the
modifications that he helped to develop for Project 288.
As the Commissioner correctly notes, the issuer of a supplemental type
certificate is required to file, inter alia, two copies of the certificate with the FAA
within 30 days of the date of issue. 14 C.F.R. sec. 21.463 (1995). Mr. Wall
apparently failed (unbeknownst to Mr. Bailey) to file the required copies of the
five supplemental type certificates with t ie FAA, and this failure makes
questionable the validity of those certificates. However, even if the five .
supplemental type certificates are invalid, that fact does not indicate that
Mr. Bailey failed to conduct Project 288 in a business-like manner. Mr. Bailey
reasonably relied on Mr. Wall to carry or t his regulatory duty and file the required
copies with the FAA. Mr. Bailey had no reason to suspect that Mr. Wall would
fail to do his job. Mr. Wall's lapse did not evidence any lack of seriousness on
Mr. Bailey's part about obtaining permission to resell remanufactured planes.
Ultimately, the fact that Mr. Bailey engaged in the sophisticated and costly
process of obtaining "multi-use" supplerr ental,type certificates to modify an
- 94 aircraft design--rather than simply applying for the simpler and cheaper "one-off"
field approval to modify a single aircraft for his personal use--is weighty evidence
that he conducted Project 288 in a business-like manner. It is difficult to explain
this effort unless Project 288 was undertaken with an intention to make a profit as
Mr. Bailey alleges.
We conclude that this factor--the manner in which the activity is
conducted--is overall in Mr. Bailey's favor, indicating that he had the requisite
profit objective.
2.
Expertise of the taxpayer and his advisers
By 1993 Mr. Bailey had modest relevant expertise: He had decades of
experience in flying small airplanes, which acquainted him with the industry, the
product, and its market. His law practice gave him general experience in running
a business. And for 10 years he had owned Enstrom Helicopter Corp. While that
relevant expertise was arguably modest, Mr. Bailey consulted with and hired an
impressive array of experts in the aviation industry to assist him with the conduct
of Project 288. First, Mr. Bailey consulted with Robert A. Hoover, a famed air
show and test pilot; Charles B. Cusick, an aeronautical engineer and former
executive with Narco and Cessna Aircraft Co.; and LeRoy Patrick LoPresti, an
aeronautical engineer and former executive with Beechcraft and Piper Aircraft,
- 95 Inc., before selecting the Twin Comanc e over the Beechcraft Baron as the focus
of Project 288. Second, Mr. Bailey hire Douglas Vasco, an FAA-certified
designated airworthiness representative, as the chief inspector and director of
maintenance for Project 288. He also hi ed two FAA-certified airframe and
powerplant mechanics to work under Mr. Vasco. Third, Mr. Bailey contracted for
the services of Bill Wall, the administrator of an FAA-certified designated
alteration station, to develop and approv modifications to the Twin Comanche
design and apply those modifications to the Bailey Bullet. The quantum,
sophistication, and content of this advice was beyond what any hobbyist would
have obtained and makes sense only in v ew of Mr. Bailey's plan to refurbish
airplanes as a business.
We conclude that this factor--expepise--is in Mr. Bailey's favor and
indicates that he had the requisite profit ebjective.
3.
Time and effort exper ded
Mr. Bailey contends that he was very "hands-on" in managing Project 288,
and spoke with his employees and contra:tors on a regular basis. Mr. Bailey did
personally choose the features that were Ldded to the Bailey Bullet, but Mr. Bailey
was busy with his law practice: He hired about a dozen.employees to disassemble
- 96 and reconstruct the airplanes, and the record does not show how closely he
managed Project 288.
We conclude that this factor--time and effort--is neutral for assessing
whether Mr. Bailey had the requisite profit objective.
4.
Expectation that assets may appreciate in value
Mr. Bailey concedes that Project 288's "hardware", such as the Bailey
Bullet, could not be expected to appreciate, but he contends that its "intangibles",
such as the supplemental type certificates, could be expected to appreciate. We
agree. Mr. Bailey expected the "multi-use" supplemental type certificates to
appreciate, as his anticipated reselling business grew. He expected to install the
modifications permitted by those certificates to an increasing number of Twin
Comanches, and he actively tried to increase the value of that prospect by
promoting the Bailey Bullet at the NBAA convention.
We conclude that this factor--expectation that assets may appreciate--is in
Mr. Bailey's favor for assessing ivhether he had the requisite profit objective.
5.
Taxpayer's success in sintilar or dissimilar activities
Mr. Bailey contends that he had prior success in two similar activities--his
ownership of Enstrom Helicopter Corp. and his participation in an airplane
refurbishing and rental company named Marshfield Aviation, both of which he
- 97 asserts were profitable. However, the record does not show much detail of
Mr. Bailey's role in Enstrom and does not show whether the company was
profitable. Morever, Mr. Bailey failed to establish that he was involved with
Marshfield Aviation or any other busineas ventures related to leasing, buying, or
selling aircraft. Thus, the record does not support Mr. Bailey's contention that he
was involved with two profitable aircraft companies.
We conclude that Mr. Bailey failed to show success in similar activities and
that this factor is in the Commissioner's favor.
6-7.
History. of income or oss, amount of occasional profits ,
In the tax years at issue, Mr. Bailey claimed losses from PBR, and
Project 288 incurred losses for every year of its short history and never generated
any profits. However, the Commissioner acknowledges that Project 288 was in its
start-up phase during the 1994 through 1996 tax years. 26 C.F.R. section 1.1832(b)(6), provides that a series of losses and a lack of occasional profits during the
start-up phase of an activity may not necessarily be an indication that the activity
is not engaged in for profit. See Strickland v. Commissioner, T.C. Memo.
2000-309. Accordingly, we decline to take the fact that Project 288 never
generated a profit as an indication that it was not engaged in for profit.
,
- 98 We conclude that these factors--history of income or loss, and occasional
profits--are neutral for assessing whether Mr. Bailey had the requisite profit
objective.
8.
Financial status of the taxpayer
As we discussed above in connection with the yacht activities, Mr. Bailey
does not dispute that he was a successful attorney who earned millions of dollars
during the tax years at issue. He therefore had an incentive to claim the activity's
losses to reduce his income tax liability.
We conclude that this factor--financial status--is in the Commissioner's
favor.
9.
Elements of personal pleasure
Mr. Bailey contends that the Bailey Bullet was not developed or used for his
personal enjoyment. Instead, he contends that Project 288 was his latest attempt to
generate a stream of "business income" that would allow him, as he got older, to
step back from his stressful and labor-intensive law practice.
Mr. Bailey is a veteran pilot who chose to work with small airplanes his
entire career. Despite his protestations to the contrary, we have no doubt that Mr.
Bailey enjoyed heading up Project 288 and flying the Bailey Bullet. However,
several critical facts contradict the Commissioner's contention that Mr. Bailey
- 99 conducted Project 288 for personal pleasure or recreation. First, Mr. Bailey,
already owned several aircraft (through 3EI and then PBR). He did not need to
purchase or design a new airplane to tak to the skies. Second, as is noted above,
Mr. Bailey went to great lengths to obtain "multi-use" supplemental type
certificates to modify an aircraft design. If pleasure had been the goal, and
Mr. Bailey had merely sought to custom.ze a single airplane for his personal use,
then applying for a "one-off" field approval would seem to have been preferable.
We conclude that this factor--elerr ents of personal pleasure--is neutral in
determining whether Mr. Bailey had the requisite profit objective.
10.
Conclusion
While some of the factors discusséd above support the Commissioner's
position and some are neutral, we are convinced that as a whole the record
supports Mr. Bailey's contention that his airplane remanufacturing activity was
engaged in for profit from 1993 through April 1996, and that he is therefore
entitled to deduct the expenses attributable to that activity if and to the extent he
substantiated them and showed that they are currently deductible.
- 100 B.
Timing of deductions
1.
The Commissioner's alternative contention
With small exceptions,46 the Commissioner contends that the expenses
incurred in connection with Project 288 are not currently deductible and must be
disallowed. The Commissioner's principal position--the one reflected in the
notices of deficiency--is that the expenses for Project 288 were not deductible
because it was not entered into for profit, a position we have rejected. The
Commissioner makes an alternative contention--not reflected in the notices of
deficiency--that since Project 288 had only begun to produce a prototype and did
not ever develop a production line for the remanufacture and sale of airplanes, its
expenses are nondeductible, because they were either start-up expenditures under
section 195 (i.e., incurred before the airplane refurbishing business was a going
concern)47 or capital expenditures pursuant to section 263(a)(1) (i.e., incurred to
46The Commissioner concedes that PBR incurred in connection with Project
288 research expenditures of $30,635 in 1994 and $21,774 in 1995 that would be
currently deductible if the activity was entered into for profit.
47"A taxpayer is not carrying on a trade or business under section 162(a)
until the business is functioning as a going concern and performing the activities
for which it was organized." Glotov v. Commissioner, T.C. Memo. 2007-147.
Until that time, expenses related to that activity are not "ordinary and necessary"
expenses currently deductible under section 162 (nor are they deductible under
section 212) but rather are "start-up" or "pre-opening" expenses. Hardy v.
(continued...)
- 101 develop a capital asset, the Bailey Bullet). ,The Commissioner has the burden of
proof for these contentions (which are " ew matter[s]", see Rule 142(a)(1)).
2.
Start-up expenditures
If the expenditures were start-up expenditures of a business, then they are
not currently deductible. Section 195(a) generally disallows a current deduction
for start-up expenditures, and there is no evidence that Mr. Bailey made the
election under section 195(b) that would have entitled him to amortize his start-up
expenditures over 180 months. Section 95(c)(1) defines "start-up expenditure" to
mean
any amount-
(A) paid or incurred in connection with-(i) investigating the creation or acquisition of an active trade
or business, or
(ii) creating an active trade or business, or
(iii) any activity eng ged in for profit and for the production of
income before the da on which the active trade or business
begins, in anticipatior of such activity becoming an active
trade or business, and
(B) which, if paid or incurred in connection with the operation of an
existing active trade or business (in the same field as the trade or
4(...continued)
Commissioner, 93 T.C. 684, 687-688 (1989).
- 102 business referred to in subparagraph (A)), would be allowable as a
deduction for the taxable year in which paid or incurred.
That is, an enterprise ceases to incur "start-up expenditures" when it becomes an
"active trade or business".
When a taxpayer fails to make the election permitted by section 195, the
consequence is that any start-up expenses incurred must be capitalized, see
Vianello v. Commissioner, T.C. Memo. 2010-17, and can be deducted only when
the activity ceases altogether, see Krebs v. Commissioner, T.C. Memo. 1992-154.
Under these principles, the Project 288 expenditures incurred in 1994 were
start-up expenditures. However, in 1995 Project 288 was no longer a start-up but
rather had graduated to going concern status. "[A]n enterprise need not have
generated sales or other revenue to have begun to carry on a business, [but] it must
nonetheless have started to function in a particular and identifiable line of work."
Weaver v. Commissioner, T.C. Memo. 2004-108. Mr. Bailey established that in
1995 the Bailey Bullet was operational and airworthy and that in that year PBR,
acting as a commercial vendor, presented the plane at a trade show to generate
orders. The Commissioner presented no evidence to seriously contradict the
conclusion that the Project 288 business was a going concern at this point,
however ill fated it may have been. Project 288 continued briefly as a going.
- ;03 concern until 1996, when Mr. Bailey was incarcerated and the activity was
decisively terminated.
3.
Capital expenditures
If the expenditures were capital expenditures of building a specific asset
(such as the supplemental type certificates, or the Bailey Bullet prototype), then
they are part of the basis of that asset. T1e supplemental type certificates arguably
became worthless when they were not filed in October 1995, but the Bailey Bullet
remained unsold during the years at issue. The record does not show whether
there were other distinct assets created by Project 288 expenditures.
To determine the timing of the dec uctibility of the Project 288 expenditures,
we must determine whether and the extent to which the expenses for Project 288
are capital expenditures or start-up costs (a determination as to which, again, the
Commissioner has the burden of proof).
4.
Analysis
We first address the question whether specific amounts can be allocated to
any assets other than Project 288 as a whale. The record suggests no assets
created by Project 288 other than the Bailey Bullet plane and the supplemental
type certificates. Beyond the research expenditures whose current deduction the
- 104 Commissioner concedes, no distinct expenditures can be allocated to the
supplemental type certificates.
We therefore turn to the question of expenditures incurred to create the
Bailey Bullet. We begin by noting the difficulty of distinguishing between
expenditures for the start-up of a plane remanufacturing business and expenditures
for the construction of.the prototype plane. Simply to state that distinction is to
indicate its difficulty, since those two notions overlap.48 The development of a
prototype is often a major part of starting up a business. The work done on a
prototype may have a value that exceeds--and would not be justified by--the
making of a single item. When the prototype plane was finished; PBR häd not
only one plane but also a substantial body of know-how and expertise that its team
hoped to employ in building more planes. To attribute the entire cost of their work
to the single plane they had produced might be completely contrary to business
sense. Consequently, a well-prepared attempt to prove a distinction between the
capital expenses of the Bailey Bullet and the start up expenses of Project 288
would include substantial evidence, and perhaps expert testimony.
48One can even say "that 'start-up' or 'pre-opening' expenses are capital in
nature, given that they spring from the taxpayer's efforts to create or acquire a
capital asset." Sorrell v. Commissioner, 882 F.2d 484, 488 (11th Cir. 1989)
(emphasis added), rev'g T.C. Memo. 1987-351.
-105However, no evidence was'offered at trial to make the distinction (which the
Commissioner first raised during the coirse of trial) between start-up expenditures
for the business per se and capital expen itures for the Bailey Bullet. We find, see
sprra note 22, in the absence of any more specific information, that PBR's
expenditures fairly allocable to the building of the-plane were $169,907 for 1994
and $169,907 for 1995.3hese amounts áre capital and go toward Mr. Bailey's
basis.
The remainder of the Project 288 expenses for 1994 (i.e., the total of
$424,787, minus the $169,907 spent on the Bailey Bullet and the currently
deductible research expenses of $30,635 yielding $2243245) constituted general
expenses of the development of the Project 288 business--i.e., start-up
expenditures not currently deductible thet are deductible instead for.1996, the year
that Project 288 was decisively terminat d.
We have held that for 1995 Projec 288 was no lónger a start-up but rather
had graduated to going-concern status. ,We therefore hold that.the general
expenses of Project 288 were currently deductible for 1995 and 1996. For 1995
those consisted of the total of $456,286, ninus the Bailey Bullet expenses of
$169,907 and the currently deductible research expenses of $21,744, yielding
- 106 $264,635. For 1996 those consisted of the entire Project 288 expenses of
$125,694.
VII. Miscellaneous adjustments
The notices of deficiency reflect numerous miscellaneous adjustments made
by the agent to Mr. Bailey's income and deductions. We uphold them in large
part, as is detailed below. The IRS's adjustments include computational
adjustments prompted by changes to his adjusted gross income. Recomputation of
these computational adjustments will be necessary and can be made when the
parties recompute Mr. Bailey's liability pursuant to Rule 155. We therefore do not
include them in the following discussion.
A.
Mr. Bailey's position
The primary counter-evidence that Mr. Bailey produced at trial to support
his position and contradict the agent on these miscellaneous adjustments was
Quicken registers and cashflow reports for the 1993 through 2001 tax years. That
is, he did not offer receipts or other transactional documents to substantiate the
items on his return; he simply relied on his secondary Quicken records.
For several of the years he lâcked even those records; but on the eve of trial
in 2009, Mr. Bailey was f'mally able to "unlock" password-protected copies of his
Quicken database, from which he made new printouts for all nine years. The data
- 107 on the three available printouts made earlier (printed in October 1997 for tax year
1996, in October 2000 for tax year 1999 and in October 2001 for tax year 2000)
and the data on the 2009 printouts for those same two years are not identical and
cannot be correlated with each other. We do not conclude that the later-produced
printouts constitute an attempt to falsify he·data; we presume that Mr. Bailey
presented them in good faith; but we find them unreliable. The differences
between the 2009 printouts and the prior ones apparently arise from post-2002
data entries, so it is clear that the entries were not made contemporaneously during
the years at issue (1993-2001). Rather, t:1ey were evidently made after 2002 and
before the later reports were printed in 2 109. In his testimony Mr. Bailey
expressed the belief that the database used in 2009 might actually be an earlier
version, not a later version, of the databaae that produced the printouts in 2002,
but we cannot tell whether that is correct The later printouts may reflect entries
made in good faith as intended correctior s of the data; but the record does not
show--and Mr. Bailey does not even clai
to know--who made the corrections nor
the information on which the corrections were based.
And in any event, the corrected da a (if they are correct) on the later
printouts (if they really are later) do not dorrespond to the tax returns.
Mr. Bailey's arguments on brief often an ount to demonstrating that amounts in
- 108 dispute are duly reflected in the 2009 printouts; but if he would thus rely on a later
printout, then he would have to show that a disputed item of income that does
appear on that printout also appears on the return, or that expenses that appear on
the printout are not among those that the notice of deficiency allowed and did not
adjust. To show that fees were duly reported on the 2009 printout is to prove only
that they should have been reported on Mr. Bailey's tax returns; that showing does
not prove that they actually were reported.
Rather than correlating the 2009 printouts with the returns, Mr. Bailey
simply criticizes the Commissioner's position for failing to take into account the
2009 printouts. The Court has attempted to puzzle through Mr. Bailey's factual
assertions and determine whether the 2009 printouts can be reconciled with the
returns and correlated to the notices of deficiency, but the record does not include
sufficient information to make possible such comparisons. That is, Mr. Bailey has
largely failed in his burden of proof. Mr. Bailey did not show how the 2009
Quicken printouts support or tie to the amounts reported on his returns.
B.
Analysis
We now address the particular adjustments that the IRS made:
- T 09 1.
Income items
a.
. Barnett Bank interest
Mr. Bailey acknowledges that he received interest income of $207 in 1993
from Barnett Bank of Palm Beach County that was not reported on his 1993.
Federal income tax return:
b.
.
.
Gross receipts
The IRS determined that Mr. Bailey had additional gross receipts under
section 61(a)(2) in the amount of $86,80 3 in 1994, consisting of amounts (not
related to Claude Duboc) that were deposited into Mr. Bailey's Credit Suisse -
account. However, Mr. Bailey contends that the fees so paid were retainers not yet
earned. Mr. Bailey says that he treated the Credit Suisse account as if it were a
sort of trust account for certain,clients (in a manner siniilar to the arrangement he
made with the Government for Duboc stock) and that when he had earned the fees,
he transferred them to his Barnett account, which (he says) would have resulted in
their being reported as income at that time, given the method he used for reporting
income. His contention is not implausible, but he does'not point to any entry in
the record showing any later-reported income items as including these amounts,
and the Court is not able to find any such entries. The IRS's adjustment in this
respect is therefore sustained.
- 110 c.
Capital gain
The IRS determined that in 1994 Mr. Bailey had additional long-term
capital gain income from the sale of 150,000 shares of Biochem Pharma stock on
October 20, 1994. However, we have held that the deposit of stock sale proceeds
into Mr. Bailey's Credit Suisse advance account did not constitute an
appropriation of those proceeds by him. Rather, Mr. Bailey realized ordinary
income upon his receipt of proceeds from the sale of the shares when the money
was transferred to his Barnett account in 1994 and 1995. The IRS's capital gain
adjustment is therefore not sustained.
d.
Pension income
The IRS determined that Patricia Bailey had additional unreported pension
income of $1,951.00 in 1993. Mr. Bailey's response is to state in his brief that "I
believe" that a Form 1099 for the income "was given to" his return preparer and so
it was presumably reported on the return. But Mr. Bailey did not show that he
actually reported this item on his return, and the IRS's adjustment is sustained.
The IRS determined that Mrs. Bailey had additional pension income under
section 61(a)(11) of $69,527 in 1999. Mr. Bailey contends that $60,000 of the
amount received "went to another, specifically Lana McGovern" (i.e.,
Mrs. Bailey's mother). However, Mr. Bailey did not show that he or his wife
- 111 reported this item, and he did not show I ow a payment to his mother-in-law could
have reduced their liability for tax on the pension income.
e.
Bartering inco e
The IRS attributed $10,183 of unreported bartering income to Mr. Bailey
for 1995, but we conclude that the IRS n isunderstood the transaction. In return
for work done by a Project 288 employen, Mr. Bailey wrote a check from his law
practice's account to pay a legal expense on behalf of that employee (i.e., fees to
another law firm). If in return for the employee's services Mr. Bailey had
rendered his own services, then that wou.d have been barter--but that is not what
happened. Instead, Mr. Bailey wrote a check for the employee's services.
f.
Deposits to office accounts
The IRS determined that in 1995, Mr. Bailey received $3,955 of
reimbursements for expenses that had been deducted on the return, so those
deposits should be included in income.
owever, those checks were deposited
into an office account from which incom was not reported on his return.
Mr. Bailey offers no evidence that such deposits were not made to the account or
that deductions were not claimed for the related expenses. We therefore sustain
the adjustment.
.
-112Likewise, the IRS determined that in 1997 Mr. Bailey received fees of
$33,696 that he deposited into an office account from which fees were not
included on his return. These unreported fees came from three sources that the
agent named, and they were evidenced by canceled checks that were admitted into
evidence, in amounts that the agent specified.- Mr. Bailey's response is to state
that he "cannot divine the source of Respondent's claimed $33,696 'additional
income'". Since the source was plainly given, and since Mr. Bailey did not make
any showing that these amounts had already been included in income, we sustain
the IRS's adjustment.
The IRS determined that in 1998 Mr. Bailey received and deposited into his
office account, but did not report on his return, fees and reimbursements from six
named payers, in amounts totaling $9,257. Mr. Bailey responds as to only one of
the deposits (the largest) and states that it "appears to be" a payment for overhead,
i.e., reimbursement of a deductible expense. His implicit position seems to be that
since the expense being reimbursed was deductible, then the non-reporting of the
corresponding income would be a "wash", with no tax effect (and that including
the item in income would in effect deny him a deduction to which he was entitled).
That would be true only if he had not in fact claimed on his return a deduction for
the overhead expense, which he did not attempt to show (and which seems highly
- 113 unlikely). He makes no response as to the other five items in this group. The
IRS's adjustments must be sustained.
The IRS identified specific checks totaling $7,526 that were deposited to his
office account in 2000 but not reported as income. Mr. Bailey's response is that
"The alleged additional income deposited in Petitioner's Office Account is
incorrect"; but he cites no evidence and does not explain how or why the
determination is incorrect. We therefore sustain the adjustment.
Also in 2000, checks totaling $38,333, in apparent payment of fees owed to
Mr. Bailey by three clients, were deposit d to his sister's office account; but the
IRS determined that they were not amon , the amounts in his "Cash Flow Report"
that he reported as income. Mr. Bailey responds: "The amounts deposited into
Nancy Bailey's account was [sic] all transferred to # 1443 [Mr. Bailey's account
from which fees were reported], as [t]he records and testimony show, but which
Respondent has chosen to ignore." He cites no such records or testimony, and we
are aware of none that contravenes the IRS's analysis. We sustain the adjustment.
g.
Arithmetic error
The IRS determined that Mr. Bailey had under-reported his 1996 fee income
because of a $100,000 mathematical error. At trial the Commissioner
demonstrated the error by showing the total income reported on Schedule C for
- 114 Mr. Bailey's law practice ($1,870,209), showing on the workpaper of Mr. Bailey's
assistant the component thereof t
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