TAX COURT OPINION

Case: Richard W. Morris
Docket Number: 21413-11
Judge: Holmes
Opinion Type: bench
Filed: 08/16/2012
Pages: 12

UNITE D STATES TAX COURT WASHINGTON, DC 20217 RICHARD W. MORRIsl Petitioner, v. COMMISSIONER OF INTERNAL EVENUE, Respondent ) ) ) ) ) ) ) ) O R D .E R Docket No. 21413-11. Pursuant to Tax Cou Rule 152 (b) , it is ORDERED that the Cle k of the Court shall transmit herewith to Petitioners and to res ondent a copy of transcript of Holmes at San Francisco, California, on June 27, 2012, containing his oral of the trial iln the above case before Judge Mark V. the pages of findings of fact and opinion rendered at the conclusion the trial. the In accordance with the oral findings of fact and opinion, a decision under Rule 155 ill be entered. (Signed) Mark V. Holmes Judge Dated: Washington, D.C. August 16, 2012 . Bench Opinion by Judge Mark V. Holmes June 27, 2012 Richard W. Morris v. Commissioner Docket No. 21413-11 3 THE COURT: In the case of Morris v. Commissioner, Docket No. 21413-11, the Court has decided to render oral findings of fact and opinion in this case, and the following represents the Court's oral findings of fact and opinion. This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court's Rules of Practice & Procedure. Mr. Morris was a California resident when he filed his petition. This dispute is about his 2006 and 2007 taxes. The parties, however, worked together and settled many of the issues, leaving only four left, what I'll call the church property issue, the insurance company income issue, the assertion by the Commissioner that Mr. Morris owes a failure-to-timely-file addition to tax under section 6651(a) (1) for 2006, and a penalty under both years under section 6662. Mr. Morris in general was an extremely energetic man, clearly possessed of great ability as a contractor. He was an honest and credible witness, but not exceptionally well educated. He did not graduate from college and he has no great expertise in law or tax or accounting, which colors 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 4 the Court's findings of fact, particularly on the penalty issues. But addressing the each in its turn, I'll start with the church prop rty issue. This arose from an agreement that Mr. Marris reached with a Mr. Don Cherry. Mr. Cherry and his wife through a living trust owned a decrepit former church in Sacramento in 2005. It needed work, and stood in dunger of condemnation. There is really not much dispute about the facts here. The agreement between Mr. Cherry and Mr. Morris was that Mr. Cherry would put in roughly 70 to 75 thousand dollars in cash to play for supplies and expenses; Mr. Morris would contribute his skill and labor and in exchange would receive 25 percent of the net proceeds from the sale of the rehabilitated church. Their project worked. The church was sold in the fall of 2006 for a tptal of $50,000 in cash, $500,000 in a note, California's apparent equivalent to a mortgage, that was secured by the property in the hands of its new congregation, and a trade-in building worth $250,000, a considerable return on Mr. Morris's investment of time and his labor. The problem for somebody like Mr. Morris is that he was getting compensated in illiquid property. That meant that he didn't get the cash with which he could pay his taxes in 2006. But his problems multiplied when he went to Heritage Reporting Corporation (202) 628-4888 5 a preparer who prepaced a difficult-to-understand return. In any eve t, Mr. Cherry, at least, kept his end of the bargain. The deed for the trade-in building included Mr. Morris as 25 percent owner, the note secured by the original church building, now rehabilitated in the hands of a new congregation, ikewise was 25 percent in Mr. Morris's name. However, on his 2006 return, Mr. Morris reported on his SchedÙle D a long-term capital sale of $200,000 but claimed his basis in the property was $200,000, thus recognizing neither gain nor loss. This was clearly wrong. From the Commissioner's perspective, the tax analysis is easy. Petitioner got something in 2006 that was of considerable value in exchange for the work he did in improving the real estate. He needed to include the value of what he got in e%change for his labor'on his 2006 return. Mr. Morris, however, had a rather more complicated analysis that he urged on the Court, during trial. With due allowance for his h lp with the analysis with a friend who is a non-pfàcticing lawyer, Mr. Morris's understanding of this analysis was imperfect, but as I hope to be able to show, in the end it doesn't make much difference. Mr. Morris's new position is that he actually acquired something cf value in 2005, and so that year being long since past, he asserts that the Commissioner made a timing mistake in asserting that the income should be 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 - Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 included in 2006 rat er than 2005. His analysis begins by saying that when the partnership was formed in -- when his arrangement was reached with Mr. Cherry in 2005 it was a partnership, a partn rship with Mr. Cherry which he got without paying anything to join, and so he got something of value in 2005. The problen is that in the argument part of Mr. Morris's testimo y, which the Court let in for the sake of convenience, Mr. orris relied on proposed regulations in notice 2005-43. Neither the proposed regulations nor the notice itself are in effect until proposed regulations under section 83 are finalized, which they have not even been. today, much less in tax years 2006 and 2007. So to the extent his position depends on that notice, he's wrong. However, he also made reference to revenue procedure 93,27, as modified by revenue procedure 2001-43. That older revenue procedure, which is still in effect, provides guidance on the treatment of the receipt of a partnership's profits interest for services provided to a partnership, which, Mr. Morris seemed to be saying, was his situation, since he got something from Mr. Cherry in 2005 for his agreement to provide services. However, uþder the terms of revenue procedure 93- 27, there are two kinds of partnership interests, capital interests and profits interests. The revenue procedure Heritage Reporting Corporation (202) 628-4888 7 defines a capital interest as 'an interest that would give the holder a share o the proceeds if the partnership' s assets were sold at air market value and then the proceeds were distributed in complete liquidation of the partnership. This d termination generally is made at the time of receipt of the partnership interest . ' The revenu procedure goes on to define a profits interest as any partnership interest other than a capital interest. Mr. Morris and his helper behind the scenes never actually grappled with the issue of whether he was receiving in his own view a capital interest or a profits interest. And I hold that even if a partnership existed in 2005, this revenue ocedure would not apply, because what Mr. Morris got was capital interest, as indeed when Mr. Cherry and Mr. Morris sold the rehabilitated church to the new congregatio , got stuf f in exchange, that was what they distributed to each other or out of the partnership, and that was something of value . So what Mr. Morris got was a capital interest in this partnership, if the partnership existed. Moreover, the timing of his acquisition of the capital interest is governed by a regulation, 26 CFR 1. 721-1 (b) (1) , which states 'the value of an in erest in such partnership capital so transferred to a pa tner as compensation for services constitutes income o the partner under section 61. The 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 amount of such income is the fair market value of the interest and capital so transferred, either at the time the transfer is made for past services or at the time the services have been r ndered, when the transfer is conditioned on the c mpletion of the transferee's future services. The time hen such income is realized depends on all the facts and. ci cumstances, including any substantial restrictions or con tions on the compensated partner's right to withdraw o otherwise dispose of such interest . ' Here the 1 tter from Mr. Cherry, Exhibit 18-P, that I admitted int evidence for a limited purpose is telling. Mr. Cherry states there that he offered Mr. Morris 25 percent of the net proceeds from the sale. He concludes by saying, 'At the time of the sale I honored my handshake and verbal [i . e . , oral] agreement with Richard Morris . ' . So my conclusion is that even if what Mr. Morris received was a partnership, he had to recognize income for his services, according to the regulation, in 2006, at the time of sale, accorc ing to the terms of the contract that he himself introduced. There are two additional points. The first is that both parties had been saying that $850,000 was the amount realized. However, one of the late-admitted exhibits, Exhibit 6-R, clearly shows closing costs that should have reduced the adjusted price. These costs of Heritage Reporting Corporation 9 closing totalled $46,562.98. However, $6660 worth of that was. described as 'Franchise Tax Board (withhold) for state withholding for deed to Rick Morris.' These closing costs appear to be the normal costs of closing and may a payment and the $6660 item may be a payment of some tax r other obligation owed by Mr. Morris to California. But have no doubt that net of that, in other words, $39,902.98, needs to be shunted off the adjusted sales price, and then 25 percent of that taken off of the amount that Mr. Morris realized in 2006 on this transaction. A second, maller point is that Mr. Morris admitted in his testimony that he received three interest payments at the tail end of 2006 under the note which he did not include in his income. He thought they were about $740, but the note was fo six percent for $500,000, which would add up to roughly $740, but only $625 of that would have been interest, so in doing the computations, $1875 in interest needs be added to Mr. Morris's 2006 income. Nobody introduced any evidence about whether income was received under the note in 2 07, so I'll just let that be. The secon issue in this case, of course, was Mr. Morris's -- whe her Mr. Morris should be penalized under section 6662 -- oh, I'm sorry, the second issue in this case is not actually pen lties, but whether Mr. Morris had to 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 10 include in his gross income $113,322 for 2006 and $11,248 in 2007 from a project he worked on after a tree fell into somebody's house and the insurance company's service provider hired him to fix it. This was an extensive repair job for which Mr. Morris received a form 1099 which was not reflected in any normal way on his return. The answer is yes, he clearly has to include this in his income in the year that he received it, as he himself acknowledged. Mr. Morris did also have expenses in producing this income, of course, as contractors will. The parties agreed on many of those expenses for 2006. He stated in his testidony that he had cell-phone and mileage expenses for which he had no substantiation, but section 274 of the Code means that I can't allow any of those for not meeting the enhanced substantiation requirements.that that section requires. He said, however, that he had storage for materials and tools that he used on that job of $150 for seven or eight months. I found him to be believable witness, and so I'll give him seven months worth of storage at $150 each month, or $1050 in additional expense, under Cohan, a case in which I am allowed to estimate expenses for which there is not normal documentation. In addition, he introduced evidence that the Commissioner accepted during trial of an additional $10,400 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 11 of expense for 2007, that's Exhibit 23-P. With that, I now come to the penalty issue.· There were two here. The third, which was Mr. Morris's failure to timely file, trigge ing a penalty under 6651(a) (1) for 2006, resolution is easy. Mr. Morris conceded in his testimony that he owed this penalty. The last i sue, however, is whether he owes a penalty for negligence or other accuracy-related reasons under 6662(a). Und r that section, a 20 percent.penalty applies to an under tatement in tax due to negligence or substantial underst tement. Section 6662(d) provides that there is a substant al understatement if the amount of the understatement in tax exceeds the.greater of 10 percent of the tax required to 1×3 shown on the return, or $5000. Mr. Morris did not keep records of expenses that he claimed or demonstrate that all the expenses that he claimed were deductible. In addition, for his 2006 year, the Commissioner determined that his understatement exceeded $5000, which was mofe in that year than 10 percent of the reported tax liability. The Commissioner therefore met his burden of production on this issue. However, ection 6664 allows a defense of reliance in good faith on a rofessional tax adviser. The accompanying regula ion, 26 CFR 1.6664-4 (c) (1), states, 'All facts and circumstances must be taken into account in 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Herit ge Reporting Corporation (202) 628-4888 12 determining whether a taxpayer has reasonably relied in good faith on advice...as to the treatment of the taxpayer.... For example, the taxpayer's education, sophistication, and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith.... For example, reliance may not be reasonable or in good faith if the taxpayer knew or reasonably should have known that the adviser lacked knowledge in the relevant aspects of federal tax law.' There were, I find, two causes for Mr. Morris's understatement of his tax liability in 2006. The first was his reporting of the income that he 'received from the insurance company and perhaps his other business activities somehow was filtered through a partnership interest and that he was partners wit a friend who had 0.5 percent interest in partnership, but who had no real role in any business and was described by him as just a friend. There coul be no possible reliance on this kind of scheme to reduce his income tax liability, so any portion of the understatement attributable to the understatement of his gross income or adjusted gross income from the insurance company payments is subject to the accuracy-related penalty. But his reporting of his partnership income or perhaps the income from the transfer of property for services in 2006, in other words, the church property agreement that he had 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 13 with Mr. Cherry, is a little different, I think. somewhat because of Mr. Morris's lack of higher education, a f training and experience in tax law, and because I find that he held nothing back from his challenged preparer, I do find that it was reasonable for him to rely on the Elmers for tax year 2006. They had done his taxes before for a number of years without incident, and under these circumstances where the effect might seem to have been postponing the tax until he disposed of the illiquid properties, I find it more likely than not that it was reasonable for somebody like Mr. Morris to rely on the Elmers in reporting it the way they dici, and find that he acted in good faith. So the penalty is upheld in part and not upheld in part. A decision will have to be entered under Rule 155. This concludes the Court's oral findings of fact and opinion in this case (Whereupon, at 5:22 p.m., the bench opinion in the above-entitled matter was concluded.) // // // // // // Heritage Reporting Corporation (202) 628-4888