t c memo united_states tax_court tracey l topping petitioner v commissioner of internal revenue respondent docket no filed date david d aughtry and hale e sheppard for petitioner travis t vance iii for respondent memorandum findings_of_fact and opinion goeke judge respondent determined the following deficiencies in petitioner’s federal_income_tax year deficiency dollar_figure big_number big_number after concessions the issues for decision are whether petitioner conducts her equestrian and related activities as part of her design business whether these activities are for profit under sec_183 and if the activities are for profit whether the expenses associated with the equestrian activity are ordinary and necessary expenses under sec_162 we hold that petitioner conducts her equestrian and related activities as part of her design business petitioner’s design and equestrian activities are conducted for profit and the equestrian-related expenses associated with her activity are ordinary and necessary expenses findings_of_fact some of the facts have been stipulated and the stipulated facts are incorporated in our findings by this reference petitioner resided in wellington florida at the time of filing the petition in petitioner wa sec_46 years old and in the middle of a bitter divorce she had no means of supporting herself petitioner held no job had no college degree and had not had 1petitioner concedes that she is not entitled to claim schedule c profit or loss from business_expenses amounting to dollar_figure and dollar_figure for her interior design activity in and respectively 2all section references are to the internal_revenue_code in effect for the years at issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated any full-time employment for the past years her significant assets consisted of a 16-year-old horse and a debt-encumbered condo in wellington florida forced to make a living to support herself petitioner developed a plan to use her prominence in the equestrian world to build a business designing horse barns and homes her plan was to establish and maintain herself as a peer worthy of trust among the exceptionally wealthy families who participate in the upper realms of the equestrian circuit own multiple residences and use interior designers even though she had no written business plan she discussed her plan for her business venture with her certified_public_accountant jeffrey borofsky c p a borofsky she also discussed her plan with a longtime friend who had successfully started her own business petitioner did not conduct a formal market study nor did she prepare any cashflow projections in anticipation of starting her new business she did not have any experience in design other than taking a few design courses in college however petitioner possessed the artistic ability to draft structural designs freehand petitioner also was an experienced equestrian having ridden horses and competed on an amateur level since she wa sec_12 or years old in petitioner formed a limited_liability_company topping white design l l c topping white in florida the address of topping white is in west palm beach florida which is also petitioner’s place of residence petitioner uses her home_office to handle all financial aspects of her design business the assets of petitioner’s activities include horses a truck a trailer and an automobile petitioner uses the truck trailer and automobile for both the equestrian and design activities in may of petitioner hired deborah martin ms martin ms martin’s primary responsibilities include general administrative work such as preparing invoices dealing with clients collecting money ordering supplies scheduling contractors and entering information into a computer petitioner also relies upon trainers both to refer clients and improve her performance as a competitor moreover petitioner works with architects electricians plumbers furniture manufacturers and other experts in their trades in order to run the interior design aspect of her business every one of the trainers that petitioner has worked with has referred at least one design client to petitioner petitioner also engages c p a borofsky to handle her accounting matters petitioner’s business methodology consists of entering in and attending horse shows and making contacts with prospective clients at the shows potential clients develop from horse show contacts and then petitioner and ms martin meet with the potential client early on in her business petitioner tried to develop clients through her longtime experience playing golf when golf failed to produce any clients she dropped her golf club membership petitioner develops her equestrian contact clients for topping white while competing during the winter equestrian festival which takes place at the jockey club the jockey club is an elite private club which is not open to the general_public the jockey club consists of a large concentration of extraordinarily wealthy people most of the attendees in the jockey club own horses and all come to watch the equestrian competition on either side of the competing rings the jockey club has up to tables with six seats per table these tables are reserved at the beginning of the season during the period through the cost of a table reservation was dollar_figure for the 7-week season since then the price has climbed to dollar_figure petitioner originally owned a table at the jockey club but when the cost of a table increased she initially split the cost with one client and then later split the cost with two clients at the jockey club there is a rectangular tent situated between two competing rings--the denemethy ring where petitioner sometimes competes and the grand prix ring where petitioner frequently competes the rings contain large leaderboards that are visible throughout the jockey club the events are announced over the loudspeaker which can be heard throughout the jockey club when petitioner enters the grand prix ring during competition her name is flashed on the leaderboards and announced over the loudspeaker as the owner of the horse and once again as the rider she rides her horses in the grand prix ring where the amateur-owner classes are held the grand prix ring is a grass field where riders compete with jumps that can exceed to feet in height those who compete must finish within a prescribed period without any faults to be successful those who successfully complete the first round advance to the second round when petitioner advances to the second round upon entry into the ring her name is once again flashed on the leaderboards and called over the loudspeaker if she finishes in the ribbons class her name is displayed yet again on the leaderboards and announced over the loudspeaker win or lose petitioner returns to the jockey club among competitors and observers where conversations take place over the just-completed competition to continue to develop her design business petitioner believes she cannot rest on her reputation and disappear from the scene but she must continue her client development efforts on the equestrian circuit the membership requirements for the jockey club do not necessitate ownership of a horse or to be a competitor however petitioner believes that if she were to sell all of her horses or were to give up amateur riding both current and prospective clients would perceive that she had failed financially would not rely on her as a designer and thus not trust her with the keys to their homes and their barns petitioner also testified that she has to maintain the reputation she has cultivated as a skilled competitor in order to keep her existing relationships and to cultivate new ones we find petitioner’s testimony plausible in this regard petitioner does not advertise her interior design business through advertising media such as equestrian-related magazines web sites or newspapers in addition she does not display banners or sponsor any events through topping white petitioner intentionally rejects this type of advertising because the ethos of the jockey club and its members perceive that kind of generic advertising of a personal service business as tacky or gauche in addition petitioner does not want to convey the impression that she is desperate for or needs the work rather petitioner relies on her exposure and reputation as both a rider and owner and also her popularity among the members of the jockey club instead of actively seeking new clients petitioner adopts a more subtle approach to attracting prospective clients by making herself available at the jockey club during key times in order for prospective clients to find her in addition petitioner also relies on word of mouth and referrals by members of the jockey club the normal evolution of a design project involves a prospective client’s contacting petitioner at a horse show normally the monday after the horse show ms martin arranges a meeting between petitioner and the prospective client the meeting typically takes place at the design site with the potential client petitioner and ms martin in most meetings approximately half of the discussion is design-related to the actual project while the other half consists of discussion on equestrian-related subjects for each of her clients petitioner has designed at least one horse barn petitioner’s clients often very wealthy entrust her with the keys to their home even after the projects are completed petitioner uses her general knowledge of horses and specifically her knowledge of the idiosyncracies of each of her client’s horses to evolve her barn designs for example her knowledge of a horse’s particular injury or temperament leads her to design a barn with stalls tailored to each horse’s individual needs interior design of a client’s home often requires knowledge related to horses though generally most families do not want an equestrian theme of decoration in their homes the designing process requires petitioner to know the needs of the families who are essentially horse people some of the designs incorporate mudrooms and expanded storage for boots saddles and other equipment in addition in the interior design process petitioner has to consider bringing the outside lifestyle as coming to the inside by testing fabrics for durability cleaning ability and recovery relative to the client's everyday livability petitioner keeps records for her horse barn interior design activities all of the files relating to client development and design implementation are kept together by year petitioner maintains records that keep an inventory of expenses related to both interior design and equestrian-related activities initially petitioner used a manual accounting system but then upgraded to excel and then quickbooks petitioner uses quickbooks to keep records for both the equestrian and interior design activities on a consolidated basis petitioner does not keep records of training costs or costs associated exclusively with horse shows for the purposes of projecting a budget nor does she or c p a borofsky prepare monthly budgets or cashflow projections for either the interior design or equestrian activities according to petitioner that is because there is no way to predict what those costs will be from month to month and that the equestrian circuit is not her business but is part of her overall plan to develop her interior design clientele at trial petitioner produced documentary_evidence of a profit or loss statement prepared by c p a borofsky that tracked expenses for both her equestrian and interior design activities petitioner also invested in some horses with one of her clients petitioner and her client formed a partnership to make these investments the choice of horses to invest in was based on the recommendations of trainers at least one of whom was a world champion the horses petitioner invested in were sold at an overall tax gain because of the depreciation but the majority resulted in a substantial economic loss on petitioner’s investment petitioner filed her form_1040 u s individual income_tax returns under a married filing separate status for the taxable years and and single status for the taxable_year sec_2001 sec_2002 and c p a borofsky prepared petitioner’s form sec_1040 for the years through for the tax years through c p a borofsky filed separate schedules c profit or loss from business for the horse and design activities with petitioner’s tax returns starting in c p a borofsky combined the activities on one schedule c petitioner reported net losses from her horse activities and net_income from topping white as follows 3petitioner took depreciation_deductions for the horses during the tax years at issue but she did not sell most of them until after the close of those years petitioner did sell one horse named sonic in and reported taxable gain on the sale of dollar_figure petitioner did not realize an economic loss on the sale--in fact she broke even selling the horse for exactly what her purchase_price was tax_year net_loss of horse activity net_income of topping white dollar_figure big_number big_number big_number dollar_figure big_number big_number big_number on a consolidated basis however petitioner’s overall business enjoyed a net profit of the first years of the business year gross_income cash expenses net_income dollar_figure big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number big_number years at issue dollar_figure big_number big_number big_number big_number big_number big_number petitioner is a beneficiary of the daniel topping trust the trust from which she received taxable_income from through for the years in question that income consisted of dollar_figure for dollar_figure for and dollar_figure for for all of the other years the amount received from the trust was under dollar_figure on date respondent mailed to petitioner a notice_of_deficiency asserting deficiencies for the taxable years and the notice contained no determination regarding the relationship between the horse circuit and the horse barn interior design activities the first two adjustments shifted the gross_income which petitioner reported from her horse competition winnings and gain from the sale of one of her horses from her schedule c to other income further the notice disallowed all of petitioner’s schedule c horse-related expenses explaining it has been determined that the amounts claimed as schedule c horse racing expenses for the tax years ending and are not allowable as such since said activity is deemed to be an activity not engaged into for profit it has further been determined that said expenses are allowable as schedule a expenses subject_to the applicable adjusted_gross_income limitations accordingly your taxable_income is increased by the disallowed expenses adjustment amounts the notice also disallowed some of the expenses associated with petitioner's horse barn interior design activity explaining it has been determined that adjustments are warranted to correct your claimed schedule c expenses from your interior decorating activity for the tax years ending and the adjustments are a result of a disallowance of expenses the expenses have been disallowed because you have not established that these amounts were incurred or if incurred paid_by you during the taxable_year for ordinary and necessary business purposes or that these expenses were deductible under the provisions of the internal_revenue_code accordingly your taxable_income is increased by the adjustment amounts petitioner timely filed her petition with this court in her petition petitioner assigned error to respondent’s segregation of the equestrian and interior design activities and also for all other disallowed expenses related to her interior design and equestrian activities opinion sec_183 restricts taxpayers from deducting losses from an activity that is not engaged in for profit sec_183 an activity is engaged in for profit if the taxpayer entertained an actual and honest profit objective in engaging in the activity 78_tc_642 affd without opinion 702_f2d_1205 d c cir sec_1_183-2 income_tax regs the taxpayer’s expectation of profit must be in good_faith 72_tc_28 citing sec_1_183-2 income_tax regs i burden_of_proof petitioner argues that under sec_7491 the burden_of_proof has shifted to respondent conversely respondent contends the burden has not shifted because petitioner was not cooperative within the meaning of sec_7491 and because petitioner failed to introduce credible_evidence necessary for the burden to shift it is unnecessary for us to address the parties’ disagreements and to determine whether the burden_of_proof has shifted because the outcome of this case is determined on the preponderance_of_the_evidence after trial and is unaffected by sec_7491 124_tc_95 citing 394_f3d_1030 8th cir affg tcmemo_2003_212 estate of stone v commissioner t c memo ii application of sec_183 before we address whether petitioner had the requisite profit_motive based on the facts and circumstances we first must address the threshold issue of whether petitioner’s equestrian and design undertakings constitute a single activity for purposes of deciding whether petitioner had the requisite profit_motive under sec_183 we believe in this case that the resolution of this issue skews all of the remaining issues in favor of the party who prevails petitioner’s arguments for profit_motive all revolve around the assumption that the undertakings constitute one activity while respondent’s arguments isolate the equestrian undertaking and its losses to argue that petitioner did not have the requisite profit_motive whether petitioner’s undertakings may be treated as one activity multiple undertakings of a taxpayer may be treated as one activity if the undertakings are sufficiently interconnected sec_1_183-1 income_tax regs the most important factors in making this determination are the degree of organizational and economic interrelationship of the undertakings the business_purpose served by carrying on the undertakings separately or together and the similarity of the undertakings id the commissioner generally accepts the taxpayer’s characterization of two or more undertakings as one activity unless the characterization is artificial or unreasonable id we have considered these and other factors in determining whether the taxpayer's characterization is unreasonable the other factors so considered include a whether the undertakings are conducted at the same place b whether the undertakings were part of the taxpayer's efforts to find sources of revenue from his or her land c whether the undertakings were formed as separate activities d whether one undertaking benefited from the other e whether the taxpayer used one undertaking to advertise the other f the degree to which the undertakings shared management g the degree to which one caretaker oversaw the assets of both undertakings h whether the taxpayer used the same accountant for the undertakings and i the degree to which the undertakings shared books_and_records mitchell v commissioner tcmemo_2006_145 citing 94_tc_41 tobin v commissioner tcmemo_1999_328 estate of brockenbrough v commissioner tcmemo_1998_454 hoyle v commissioner tcmemo_1994_592 de mendoza v commissioner tcmemo_1994_314 scheidt v commissioner t c memo we find petitioner’s characterization of the equestrian and design undertakings as a single activity for purposes of sec_183 to be supported by the facts of this case a close organizational and economic relationship exists between the equestrian and design undertakings petitioner’s success as an equestrian competitor creates goodwill that benefits her design business see keanini v commissioner supra petitioner formed the equestrian and design undertakings as a single integrated business petitioner had been a competitor for most of her adult life and she transformed this sport experience into an avenue to establish goodwill as an interior designer of horse barns and second homes she had a plan for an integrated equestrian-based design business petitioner and her assistant manage and oversee both undertakings and their assets and also use the same books_and_records to track both undertakings further petitioner’s equestrian activities significantly benefit her design business and we find a significant business_purpose for the combination of these undertakings her prominence as a competitor has gained respect among her peers and causes them to seek her out when they are in need of a designer for their horse barns and recreational homes respondent faults petitioner for not advertising in a conventional sense such as putting up ads in equestrian magazines or banners at horse shows respondent argues that petitioner’s failure to specifically advertise the name of topping white through conventional media is indicative of the lack of an economic relationship between the two undertakings however petitioner testified and had witnesses corroborate that traditional advertising of a personal service business is not welcomed by the clientele petitioner sought thus petitioner made a business decision not to advertise conventionally the question is not whether a particular mode of doing business is wise but whether the taxpayer honestly believed the method employed would turn a profit for him in this case petitioner’s judgment has proven prophetic in 78_tc_642 affd without opinion 702_f2d_1205 d c cir we elucidated that the purpose of sec_183 is to allow deductions where the evidence indicates that the activity is actually engaged in for profit even though it might be argued that there is not a reasonable expectation of profit this is the proper legal standard under sec_183 id pincite further the evidence demonstrates that petitioner demonstrated good business judgment her equestrian contacts are responsible for more than percent of her client base and her overall business produced a sizable net profit for all of the years at issue therefore petitioner has not only demonstrated that she honestly believed that her mode of advertising would turn a profit but also has proven that it has been successful and that adopting respondent’s suggestion would probably have backfired respondent cites several cases where we held that the taxpayer’s activities could not be aggregated and argues that those cases are analogous to the facts in this situation in de mendoza v commissioner supra the court refused to aggregate the taxpayer’s farming polo activity and his real_estate law practice despite the taxpayer’s position that one reason he began playing polo was to meet clients for his law firm based on the evidence the court concluded that the farm was formed and operated as a separate business and the court was not convinced that the taxpayer began the polo activity to generate legal business or that the activity materially benefited the taxpayer’s law practice in wilkinson v commissioner tcmemo_1996_39 we held that a plastic surgeon’s horse ranch activities and his medical practice were not interrelated business activities despite the taxpayer’s claim that the publicity he derived from playing polo and hosting social gatherings helped him get patients for his cosmetic_surgery practice id in zdun v commissioner tcmemo_1998_296 affd without published opinion 229_f3d_1161 9th cir we held that a dentist’s organic apple orchard was not part of the same activity as his holistic dental practice even though the apples were sold to the dental practice’s patients at the office we do not find any of the cases respondent relies on to be analogous to petitioner’s situation none of the activities in those cases have the same level of integration and interdependence that petitioner’s equestrian and design activities did we are persuaded that petitioner’s equestrian activities are necessary to the success of her design business in the equestrian-related cases that respondent cites it is apparent that the recreational activities were an afterthought to the taxpayer’s primary business and were more of a social opportunity than an integrated part of a symbiotic business plan in both de mendoza and wilkinson the court found that the benefit of the ranching activities was incidental to the taxpayers’ law and medical practices respectively similarly in de mendoza we were not convinced that the taxpayer’s polo activity materially benefited his business in zdun v commissioner only to percent of the taxpayer dentist’s patients actually took the apples he offered even when he provided the apples to them for no cost here virtually all of petitioner’s clients are equestrian- related contacts who depend on her knowledge and expertise of horses in designing their barns and homes in addition the success of petitioner’s interior design business is far from incidental to her equestrian contacts the evidence shows rather that petitioner’s interior design business materially benefits from her equestrian-related activities which is consistent with the distinctions made between incidental and material benefit in de mendoza and wilkinson the evidence demonstrates that petitioner’s involvement in the equestrian world is the cornerstone of her cultivation of relationships with her clientele given the nature of petitioner’s clientele we find her testimony about the relationship between her equestrian- related activities and her design business to be credible and logical respondent argues that petitioner did not start riding horses for the purpose of promoting her interior design business citing the fact that petitioner had competed for sport since a young age we recognize that petitioner’s interest in horses and participation in competition preceded the formation of her equestrian-based design activity petitioner’s business plan as executed abruptly converted her preexisting hobby into part of an integrated business venture after her divorce respondent also relies on the existence of the l l c entitled topping white design to argue that petitioner’s design business was separate from her equestrian activities respondent argues that petitioner should be held to the form of her structure citing the fact that petitioner used the name of topping white in dealing with third parties however there is no basis to restrict petitioner’s overall activities to topping white petitioner deals with clients and is known in the equestrian world as tracy topping petitioner conducts both aspects of her business through topping white using the same assets computer_program and files the fact that petitioner is known on the basis of her name to her clients in the equestrian world does not somehow make her activities with her equestrian- related contacts separate from her design business which also bears her name we also are aware that for the years at issue c p a borofsky reported the activities on two separate schedules c positions taken by a taxpayer in a tax_return are treated as admissions and cannot be overcome without cogent proof that they are erroneous 121_tc_308 92_tc_312 based on the plethora of evidence that the two undertakings constitute a single activity we find that petitioner has overcome that position we find that a close organizational and economic relationship exists between the equestrian and the design undertakings accordingly we determine that for purposes of sec_183 the equestrian undertaking and the design operation constitute a single activity we need not consider whether petitioner engaged in the equestrian-based design business with the objective of making a profit because the combined activities were profitable in each of the years at issue 4petitioner argues that the presumption under sec_183 applies under sec_183 in the case of an activity consisting in major part of the breeding training showing or continued iii petitioner’s equestrian expenses are ordinary and necessary in carrying on the activities of topping white sec_162 of the internal_revenue_code allows the deduction of all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business 503_us_79 citing sec_162 respondent argues that even if we determine that the equestrian and design undertakings constitute a single activity and that petitioner had a profit_motive petitioner failed to establish all the equestrian expenses were ordinary and necessary to be necessary an expense must be appropriate and helpful to the taxpayer’s business see welch v continued racing of horses if the gross_income derived from the activity exceeds the deductions for any of consecutive taxable years then the activity shall be presumed to be engaged in for profit unless the commissioner establishes to the contrary see bunney v commissioner tcmemo_2003_233 citing 72_tc_411 affd without published opinion 647_f2d_170 9th cir we find that petitioner's equestrian activities were secondary to her activities as a designer therefore this part of the presumption does not apply sec_183 presumes an activity is conducted for profit if the gross_income exceeds the attributable deductions for out of consecutive years the gross_income_test the presumption applies only after the third profit year mitchell v commissioner tcmemo_2006_145 citing sec_183 since we found that petitioner’s equestrian and design activities constitute a single undertaking the sec_183 presumption applies for the year sec_2001 and sec_2002 however we do not analyze the factors in terms of the presumption because we find that this case turns on the fact that the equestrian and design undertakings were an integrated business therefore we find the presumption to be unnecessary since the characterization of petitioner’s design undertaking and equestrian undertaking as a single activity carries the day helvering 290_us_111 83_tc_356 affd 777_f2d_662 11th cir to be ordinary the transaction giving rise to the expense must be of common or frequent occurrence in the type of business involved 308_us_488 even if it is determined that the expenses are ordinary and necessary they are deductible under sec_162 only to the extent that they are reasonable in amount 380_f2d_786 9th cir gill v commissioner tcmemo_1994_92 affd without published opinion 76_f3d_378 6th cir respondent asserts that the expenses of petitioner’s equestrian activities are unreasonable and are not ordinary and necessary because they represent personal expenditures of petitioner see sec_262 respondent relies on 36_tc_879 to support his argument in that case the taxpayer a c p a sought to deduct the expenses for his boat upon which he flew a flag bearing the numerals he asserted that the flag provoked inquiries to which he would reply that he was a c p a and a lawyer experienced in tax law in disallowing the expenses of the boat the court held that the taxpayer failed to prove that the flag made his yacht expenditures necessary to his practice he failed to show exactly how and under what circumstances his boating activities produced a single client id pincite further the taxpayer failed to prove that it was ordinary for people in his profession to incur such expenses id while we are mindful that expenses for personal pursuits do not become deductible expenses simply because they afford contacts with possible future clients the situation in this case is entirely different from the facts in henry petitioner has proven that her equestrian activities are necessary to her success as an interior designer the unique nature of petitioner’s design business made it an ordinary_expense to partake in equestrian-related activities to achieve the peer acceptance to attract clients we have found that petitioner’s design and equestrian activity is part of an integrated business plan and that petitioner’s clientele is almost exclusively derived from her equestrian contacts petitioner also offered corroborating testimony that individuals in service businesses who use conventional advertising evoke a negative reaction from the people at the jockey club respondent’s arguments focus on petitioner’s means to an end but neglect the most important fact of all--petitioner’s plan worked her startup business was a success from the beginning and continues to be successful despite a slight loss in petitioner has credibly demonstrated that the measures she takes to build her client base are both ordinary and necessary the evidence does not establish and respondent has not argued convincingly that any particular expense was unnecessary or excessive obviously keeping and maintaining horses is expensive petitioner demonstrated that she has done what she can to keep costs down from choosing less expensive travel to sharing the cost of a table at the club respondent offers numerous ratios of the expenses associated with the equestrian activities to the profit from topping white petitioner does what is necessary to maintain her reputation in the equestrian world and we find that she does not do so in an extravagant manner the fact remains that petitioner’s design business depends heavily on her equestrian-related activities for its success we therefore find and hold that not only are petitioner’s equestrian expenses ordinary and necessary but that they are reasonable in amount conclusion petitioner’s equestrian and design activities constitute a single undertaking in addition the expenses associated with the equestrian-related activities are ordinary necessary and reasonable in amount to reflect the foregoing and concessions by petitioner decision will be entered under rule


t c summary opinion united_states tax_court william r and deborah l cramer petitioners v commissioner of internal revenue respondent frank e and gail l dunda petitioners v commissioner of internal revenue respondent docket nos 2341-02s 2644-02s filed date frank eb and gail l dunda pro sese william r and deborah l cramer pro sese brin k huss for respondent wolfe special_trial_judge these consolidated cases were heard pursuant to the provisions of sec_7463 of the internal_revenue_code in effect at the time that the petitions were filed the decisions to be entered are not reviewable by any other court and this opinion should not be cited as authority unless - - otherwise indicated all section references are to the internal_revenue_code in effect for the taxable years in issue and all rule references are to the tax_court rules_of_practice and procedure respondent determined a deficiency of dollar_figure in the federal_income_tax of frank e and gail l dunda and a deficiency of dollar_figure in the federal_income_tax of william r and deborah l cramer the issue for decision is which couple is entitled to dependency_exemption deductions for for two children of petitioner frank e dunda dunda and petitioner deborah l cramer cramer formerly deborah l dunda during their former marriage some of the facts in each case have been stipulated and are so found when dunda and his wife filed their petition and their amended petition they resided in glendale arizona when cramer and her husband filed their petition and their amended petition they resided in peoria arizona the court consolidated these cases for purposes of trial briefing and opinion because they involve common questions of fact and law arising from the separation and divorce of petitioners dunda and cramer dunda and cramer divorced on date pursuant to the decree of dissolution of marriage divorce decree issued by the superior court of the state of arizona in and for the county of maricopa divorce court the divorce decree incorporated the provisions of the shared custody agreement custody agreement executed by cramer on date and by dunda on date pursuant to the divorce decree dunda and cramer share custody of their children melissa j dunda born on date charles e dunda born on date charles and daniel f dunda born on date daniel the divorce decree designates cramer’s home as the children’s primary residence and orders dunda to pay cramer dollar_figure per month in child_support paragraph of the divorce decree states that father shall be entitled to claim the three children as dependents for income_tax purposes dunda and his attorney appeared before the divorce court but neither dunda nor his attorney signed the divorce decree neither cramer nor her attorney appeared before the divorce court but they both signed the divorce decree on the last page to indicate their approval as to form and content subsegquently the divorce court issued an order filed date decreasing dunda’s child_support obligation to dollar_figure per month child_support order paragraph t of the child_support order stated the obligor has a child_support obligation of at least dollar_figure per year if obligor has paid at least that amount in full during the calendar_year and all support due for the calendar_year as well as any court ordered arrearage payments due for the calendar_year by december or if by order of assignment by january of the following year the federal tax exemption for minor children is allocated as follows as previously ordered obligee shall execute the necessary internal_revenue_service forms to transfer the exemption s consistent with this order the order was effective date charles and daniel lived with cramer for most of on their joint federal_income_tax return the dundas’ return dunda and his wife claimed dependency_exemption deductions for both charles and daniel the dundas attached a copy of the last page of the divorce decree to their tax_return for but they failed to attach to that tax_return a copy of irs form_8332 release of claim to exemption for child of divorced or separated parents on their joint federal_income_tax return the cramers’ return cramer and her husband also claimed dependency_exemption deductions for charles and daniel dunda and his wife and cramer and her husband each received a notice_of_deficiency the notices disallowed the deductions for the dependency_exemptions claimed for charles and daniel generally sec_151 allows a taxpayer to deduct an exemption_amount for each child of the taxpayer who is a dependent as defined in sec_152 under sec_152 the term dependent means certain individuals over half of whose support was received from the taxpayer during the calendar_year for which such individuals are claimed as dependents eligible individuals who may be claimed as dependents include among others the sons and daughters of the taxpayer sec_152 special rules establish which parent may claim a minor child as a - - dependent where the parents are divorced or separated see sec_152 e generally if a child’s parents are divorced the child is in the custody of one or both for the year and the parents provide over half of the child’s support the custodial_parent the parent with custody for the greatest portion of the year is treated as having provided over half of the child’s support for the year and that parent may deduct the exemption_amount with respect to such child for the year sec_152 the applicable regulations provide that in the event of so-called ‘split’ custody ‘custody’ will be deemed to be with the parent who as between both parents has the physical custody of the child for the greater portion of the calendar_year sec_1_152-4 income_tax regs the noncustodial_parent however may claim the child as a dependent if the custodial_parent signs a written declaration that such custodial_parent will not claim such child as a dependent and the noncustodial_parent attaches such written declaration to the noncustodial parent’s return for the taxable_year sec_152 the declaration required under sec_152 e must be made either on a completed form_8332 or ona statement conforming to the substance of form_8332 see sec_1_152-4t a q a-3 temporary income_tax regs fed reg date for a noncustodial_parent to satisfy the written declaration requirement of sec_152 the custodial_parent is required to provide the following on form_8332 or a statement conforming to the substance of form the names of the children with respect to whom the exemptions are released the years for which the claims to exemptions are released to the noncustodial_parent the signature of the custodial_parent confirming his or her consent the social_security_number of the custodial_parent the date of the custodial parent’s signature and the name and social_security_number of the parent claiming the exemption 114_tc_184 affd on another ground sub nom 293_f3d_1208 10th cir satisfying the signature requirement is critical to the successful release of the dependency_exemption within the meaning of sec_152 id see horn v commissioner tcmemo_2002_290 neal v commissioner tcmemo_1999_97 in addition the signature of the custodial_parent must confirm the custodial parent’s intention to release the dependency_exemption to the noncustodial ' temporary regulations are entitled to the same weight as final regulations peterson marital trust v commission102_tc_790 affd 78_f3d_795 2d cir 98_tc_141 - parent and signify her agreement not to claim the dependency_exemption herself miller v commissioner supra pincite emphasis added because charles and daniel lived with cramer for the majority of the year cramer is the custodial_parent accordingly cramer is entitled to claim the children as dependents unless she expressly releases the dependency_exemptions to dunda the noncustodial_parent dunda contends that although cramer did not execute a form_8332 cramer’s signature on the divorce decree attached to the dundas’ return satisfies the requirements of a statement conforming to the substance of form_8332 we disagree dunda’s attaching a copy of the divorce decree to his tax_return does not satisfy the requirements of sec_152 and does not conform to the substance of form_8332 see miller v commissioner supra pincite see also loffer v commissioner tcmemo_2002_298 holding that attaching a copy of the divorce decree which included a signature of the custodial_parent but no specification of the child claimed as a dependent or of the year did not conform to the substance of form cramer’s signature on the last page of the divorce decree executed by her several weeks prior to the court hearing in that matter in does not indicate cramer’s intent to release the dependency_exemptions for on a tax_return prepared more than years later at trial dunda not only stated that he did not --- - attach a completed form_8332 to his tax_return but he also testified that he believed cramer would have refused to sign a form_8332 cramer’s direct testimony that she wouldn’t have signed confirmed that she had no intention of releasing the dependency_exemptions for the cramers’ return on which cramer claimed the dependency_exemptions for charles and daniel for further confirms that she did not intend to release the dependency_exemptions for that year moreover the last page of the divorce decree fails to specify the names of the children for which the exemption claims would be released the year for which the exemption claims would be released and cramer’s social_security_number see miller v commissioner supra pincite see also loffer v commissioner supra horn v commissioner supra holding that a handwritten note did not conform to the substance of form_8332 in part because the note failed to identify the specific years to which it was meant to apply white v commissioner tcmemo_1996_ holding that a letter purporting to release the dependency_exemptions and signed by the custodial_parent taxpayer did not cramer contends that pursuant to the child_support order dunda is not entitled to the exemption deductions because dunda allegedly was in arrears on his child_support payments we do not address the question whether dunda was precluded from claiming the dependency_exemptions because his child_support payments were in arrears cramer’s testimony regardless of the validity of her contention clearly indicates that she had no intention of releasing the dependency_exemptions to dunda in --- - conform to the substance of form_8332 in part because it failed to include the years for which the exemption claims would be released and the social_security numbers of either parent cafarelli v commissioner tcmemo_1994_265 holding that the form_8332 was not an effective release of the custodial parent’s dependency_exemption in part because the noncustodial_parent did not specify the year for which the exemption claims would be released the copy of the last page of the divorce decree that the dundas attached to their return plainly is not an effective release of cramer’s claim to dependency_exemption deductions for dunda contends that he relied on a publication provided by the internal_revenue_service indicating that form_8332 was unnecessary and that the copy of the divorce decree granting him the right to claim the dependency_exemption deductions was sufficient well-established precedent however states that taxpayers rely on such publications at their peril miller v commissioner supra pincite administrative guidance contained in irs publications is not binding on the government nor can it change the plain meaning of the tax statutes id citing 620_f2d_153 7th cir affg tcmemo_1978_426 330_f2d_91 9th cir affg t c memo the authoritative - sources of federal tax law are the statutes regulations and judicial decisions they do not include informal irs publications see zimmerman v commissioner 71_tc_367 affd 614_f2d_1294 2d cir accordingly dunda may not rely on the irs publication he reviewed as the reason he failed to attach to his return a properly completed and signed form_8332 or a statement conforming to the substance of form_8332 because dunda did not satisfy the requirements of sec_152 he and his wife are not entitled to claim the dependency_exemption deductions with respect to charles and daniel for because cramer is the custodial_parent and cramer did not expressly release the dependency_exemptions with respect to charles and daniel for cramer and her husband are entitled to deduct the dependency_exemptions for charles and daniel for reviewed and adopted as the report of the small_tax_case division to reflect the foregoing decision will be entered for petitioners in docket no 2341-02s decision will be entered for respondent in docket no


office_of_chief_counsel internal_revenue_service memorandum number release date cc ebeo br4 wta-n-116761-98 date to date group manager cc ebeo subject your request for technical assistance uilc from assistant chief_counsel employee_benefits and exempt_organizations this responds to your request for technical assistance regarding the treatment of certain stock under sec_83 of the internal_revenue_code this document is not binding on examination and is not a final_determination it is not to be cited as precedent legend x y z company a company b h j country k state n shares m shares o shares p shares date f year u year w date c d shares date e issues when restricted_stock transferred in_connection_with_the_performance_of_services and upon which no elections under sec_83 of the code have been filed is canceled more than days after its issuance are elections filed within days of the issuance of stock replacing the canceled stock timely filed or should an argument be raised that the transfer date of the stock remains its original transfer date in which case the elections would be untimely if the transfer date is the date the replacement stock is issued are the sec_83 elections filed relative to that stock and additional stock valid timely elections under sec_83 of the code whether the purported gift of stock from x and y to z is a valid completed_gift conclusions an argument can be made that the cancellation and re-issuance of the stock is a sham and thus should be ignored the sec_83 elections filed relative to the reissued stock would thus not be timely the service should also challenge x s claim that the sec_83 elections were filed timely with respect to the additional stock and the reissued stock if the argument advanced in issue is rejected unless x produces more evidence showing that such elections were in fact timely filed the service should argue that the purported gift from x and y to z was not a completed_gift and thus should be ignored facts x and y husband and wife are resident aliens who live in state z is x s mother-in-law and resides in country k for the taxable years at issue x worked for company a a small closely-held state corporation several years after beginning work for company a x became its chief_executive_officer ceo by written consent a company a committee determined that before x became ceo company a sold n shares of restricted_stock at a specified price to x neither the plan under which this stock was sold nor x s promissory note given to company a in payment for the restricted shares was submitted with this request during the same year x became ceo when m shares of this initial grant vested company a canceled the outstanding grants approved new grants and entered into separate agreements with x in which x agreed to purchase company a restricted_stock the information submitted does not reveal company a s business_purpose in deciding to cancel the restricted_stock previously sold to x according to the first agreement x purchased m shares of company a stock at a price determined by company a to be its fair_market_value x paid the purchase_price by delivering a promissory note for the total purchase_price to company a when the agreement was signed and company a delivered the stock to an escrow holder pursuant to the agreement x had all of the rights and privileges of a stock holder including the right to vote and receive dividends however x was required to deliver any dividends or other distributions of property to the escrow holder according to the agreement if x voluntarily terminated employment company a had the right to repurchase any unvested shares held by x repurchase option and any unvested shares would not vest the agreement however does not specify at what price company a would be required to pay for the unvested shares in the event it exercised its repurchase option we assume that since the parties considered the repurchase option to subject the stock to a substantial_risk_of_forfeiture the payment price was the original purchase_price according to the vesting schedule in the agreement percent of the shares was vested on the purchase date and percent was scheduled to vest annually at a specified date following the purchase date if x s employment terminated for any reason other than his voluntary departure prior to the last vesting date percent of the shares would vest according to the agreement x could not assign transfer or otherwise dispose_of this stock other than by will or the laws of descent and distribution the promissory note does not indicate that it was secured_by any property or that x was not personally liable for the purchase_price under the terms of the note all unpaid principal and interest was due on the earlier of x s termination_date or the last vesting date according to the attached escrow agreement the stock would be held by the escrow holder until company a gave the escrow holder notice that the note had been paid in full or that x s employment had terminated the interest rate on the note wa sec_5 percent per annum the legend on the back of the certificate representing these shares states that the stock is subject_to an employee stockholder agreement which includes a repurchase right a market stand-off agreement and a right_of_first_refusal according to x this certificate is incorrectly dated pursuant to the second agreement x purchased o shares of company a stock for the same amount per share paid_by x under the first agreement the terms of the second agreement are the same as the first agreement with the exception that no shares were vested on the purchase date the stock certificate representing these shares is identical to the one described above pursuant to the third agreement x purchased another p shares of company a stock under the same terms and conditions as the first and second agreements with the exception again that no shares were vested on the purchase date the stock certificate representing the shares purchased under the third agreement contains a different issue_date but according to x this stock certificate is incorrectly dated the legend on the back of this certificate is identical to the two described above during the same year x was paid a bonus equal to the difference between the fair_market_value and the purchase_price of the canceled shares according to a le tter from x s attorney x filed elections under sec_83 of the code at the location h service_center in an attached document x stated that he had received company a stock and that he understood that it was his responsibility to file an election under sec_83 of the code with the internal_revenue_service this document contains the date the stock was issued according to x s attorney x mailed the elections on date f to support this statement a certified mail receipt was attached to the letter although x s attorney stated in the letter that the certified mail receipt is dated date f the receipt actually is dated years later x s attorney also stated that x mailed these elections with his year u return which were sent to the location j service_center based on the return receipt submitted to support this statement we assume x's attorney meant that x attached the elections to his year w return which was filed in year u the date stamp was made by the location j service_center and indicates that the article mailed was a year u tax_return three other statements were provided by x but not with the above-described letter according to the first statement x performed services and received property with respect to which an election under sec_83 was being made this statement indicates that company a had the right to repurchase the property at the original purchase_price if x s employment terminated that the repurchase right terminated on a specific date that the fair_market_value at the time of transfer was the purchase_price of the stock and that the property was transferred within days prior to the filing of the election the second and third statements are the same with the exception of the date the repurchase right lapsed the location h service_center has no record that x filed elections in year w under sec_83 of the code the location j service_center could not locate any elections filed by x under sec_83 of the code according to the incoming memorandum x filed elections under sec_83 of the code with company a according to sec_64 of company a s bylaws no shareholder could sell assign pledge or in any manner transfer any company a stock whether voluntarily by operation of law by gift or otherwise unless he or she first provided written notice to company a for thirty days following receipt of the notice company a had the option to purchase the stock specified in the notice at the price and on the terms specified in the notice in the event of gift or other transfer for less than full price the price of the stock would be the fair_market_value of the stock as determined by the board_of directors on date c x and y executed a deed_of_gift for d shares of company a stock to z the deed_of_gift was acknowledged and accepted by z according to the legend on the back of the certificate representing these shares the stock was subject_to the terms and conditions of an employee restricted_stock agreement which included a repurchase right a market stand-off agreement and a right_of_first_refusal in favor of company a x and y filed gift_tax returns but based on the fair_market_value assigned to the stock no gift_tax was due in an action by unanimous written consent of company a s board_of directors the board indicated that x had notified company a of his desire to transfer d shares of stock some of which was unvested to z company a resolved to amend the terms of the stock awards to allow x to transfer the stock to z provided z agreed to be bound by company a s repurchase right with respect to any unvested stock in the event of x s voluntary termination company a also waived any rights including the right_of_first_refusal and consented to the transfer to z provided that on the transfer company a retained its right of repurchase with respect to any unvested stock and a first and present security_interest in the stock as collateral to secure payments under the promissory notes shortly thereafter company a s compensation committee adopted a formula to determine the fair_market_value of company a for purposes of determining the fair_market_value of stock awarded to employees under that formula the fair_market_value of company a was the product of a multiple of company a s revenues and a combination factor derived from a risk factor minority discount factor and the amount of cash held by company a at the time of the valuation of the stock awarded to employees the plan under which x purchased the stock was amended on date e under this amendment x s unvested stock would receive accelerated vesting in the event company a experienced a change_of control as defined in the amendment interestingly the agreement refers only to the shares purchased by x under the first two agreements and not those purchased under the third agreement during that same year company a agreed to merge with company b by unanimous written consent company a s board_of directors resolved that the d shares of stock purchased by z as transferee of x vested immediately on consummation of the merger the board also approved the extension of the maturity_date for the repayment of two of x s promissory notes according to the agreement and plan_of_reorganization on the effective date of the merger all company a common_stock was converted into company b stock based on a formula contained in this agreement all company a stock which prior to the merger was subject_to certain limitations would be subject_to those limitations after the substitution of company b stock for company a stock certain company b stock issued in substitution for certain company a stock would contain a legend stating that the stock was subject_to the terms and conditions of an agreement which included a repurchase right of company b any substituted company b stock would remain subject_to any existing escrow agreement sometime the following year z sold the company b stock according to a letter from company b x paid the principal_amount on three promissory notes and payment of these notes was a condition to delivery of the stock certificate to z law and analysis under sec_83 of the code if in_connection_with_the_performance_of_services property is transferred to any person other than the service_recipient the excess of the fair_market_value of the property on the first day that the rights to the property are either transferable or not subject_to a substantial_risk_of_forfeiture over the amount_paid for the property is included in the service provider's gross_income for the first taxable_year in which the rights to the property are either transferable or not subject_to a substantial_risk_of_forfeiture for purposes of sec_83 of the code property is substantially nonvested when it is both subject_to a substantial_risk_of_forfeiture and is nontransferable under sec_1_83-3 of the income_tax regulations a substantial_risk_of_forfeiture exists where rights in property that are transferred are conditioned directly or indirectly on the future performance or refraining from performance of services by any person or the occurrence of a condition related to a purpose of the transfer and the possibility of forfeiture is substantial if such condition is not satisfied under sec_1_83-3 of the regulations the rights of a person in property are transferable if such person can transfer any interest in the property to any person other than the transferor of the property but only if the rights in such property are not subject_to a substantial_risk_of_forfeiture property is substantially_vested when it is either transferable or is not subject_to a substantial_risk_of_forfeiture if nonvested property is disposed of in a transaction that is not at arm s length and the property remains substantially nonvested under sec_1_83-1 of the regulations the person who performed the services realizes compensation equal to the sum of any money and the fair_market_value of any substantially_vested property received in such disposition in addition sec_83 and the regulations continue to apply to the property with the exception that any amount previously includible in gross_income under sec_1_83-1 of the regulations will be treated as an amount_paid for the property also it has long been settled that the anticipatory_assignment_of_income does not relieve the earner of the income from tax since income is taxed to the person or entity earning the income 281_us_111 sec_83 of the code and sec_1_83-2 of the regulations provide that if property is transferred in_connection_with_the_performance_of_services the service provider may elect to include in gross_income the excess if any of the fair_market_value of the property at the time of transfer determined without regard to any lapse_restriction as defined in sec_1_83-3 over the amount if any paid for the property as compensation_for services if this election is made the substantial-vesting rules of sec_83 and the regulations thereunder do not apply to the property and with an exception not applicable here any subsequent appreciation in the value of the property is not taxable as compensation to the service provider thus the value of property with respect to which a sec_83 election is made is includible in gross_income as of the date that the property is transferred even though the property is substantially nonvested when transferred and no compensation is includible in gross_income when the property becomes substantially_vested in computing the gain_or_loss from the subsequent sale_or_exchange of such property its basis is the amount_paid for the property increased by the amount included in gross_income under sec_83 under sec_1_83-2 of the regulations an election under sec_83 must be filed no later than days after the date the property was transferred under sec_1_83-2 of the regulations the election under sec_83 is made by filing one copy of a written_statement with the internal revenue_officer with whom the person who performed the services files his or her return in addition one copy of such statement shall be submitted with his or her income_tax return for the taxable_year in which such property was transferred under sec_1_83-2 of the regulations the statement must be signed by the person making the election and it shall indicate that it is being made under sec_83 of the code the election must contain the name address and taxpayer_identification_number of the taxpayer a description of each property with respect to which an election is being made the date on which the property was transferred and the taxable_year for which such election was made the nature of the restriction or restrictions to which the property is subject the fair_market_value at the time of the transfer the amount_paid for the property and a statement that copies have been furnished to other persons as provided in sec_1_83-2 of the regulations under sec_1_83-2 of the regulations the person who performed the services must submit a copy of the statement referred to in section c to the person for whom the services are performed under sec_83 of the code the holding_period of transferred property to which sec_83 applies begins just after the property is substantially_vested however if the person who has performed the services in connection with which property is transferred has made an election under sec_83 then the holding_period of such property begins just after the date that the property is transferred if property to which sec_83 and the regulations thereunder apply is transferred at arm's length the holding_period of such property in the hands of the transferee is determined in accordance with the rules provided in sec_1223 of the code see sec_1 a of the regulations the determination of whether a transaction is a sham involves consideration of first whether the transaction is a factual sham and second whether the transaction is an economic sham a factual sham is one in which the alleged transaction never took place 103_tc_29 see also 85_tc_127 aff d 845_f2d_746 7th cir aff d 800_f2d_266 11th cir aff d 808_f2d_1219 6th cir aff d 810_f2d_197 5th cir aff d 813_f2d_293 9th cir whether a transaction amounts to a sham is a factual determination even if a transaction has a factual basis the transaction may still lack economic_substance and thus the transaction is an economic sham in 435_us_561 the supreme court applied a two-prong test to determine whether the transaction considered therein a sale_and_leaseback should be considered a sham and therefore ignored for tax purposes there must be a finding that the taxpayer was motivated by no business_purpose other than the obtaining of tax benefits there must be a finding that the transaction had no economic_substance because there was no reasonable possibility of a profit see also 909_f2d_1360 9th cir aff g tcmemo_1987_628 820_f2d_1543 9th cir aff g tcmemo_1987_23 these prongs represent related factors both of which are considered to determine whether the transaction had sufficient substance apart from its tax consequences to be respected for tax purposes casebeer pincite under the business_purpose prong the court determines whether the taxpayer has shown that he or she had a business_purpose for engaging in the transaction other than tax_avoidance casebeer pincite this factor involves an examination of the subjective factors which motivated a taxpayer to make the transaction at issue id under the economic_substance prong the court determines whether the transaction had economic_substance beyond the tax benefits bail bonds pincite this factor involves a broader examination of whether the substance of a transaction reflects its form and whether from an objective standpoint the transaction was likely to produce economic benefits id note that it is well established that a taxpayer has the legal right to minimize his or her taxes or avoid them totally by any means which the law permits 293_us_465 however the right to minimize or avoid taxes does not include the right to engage in transactions that have no economic_substance but are solely for the purpose of avoiding or evading taxes 79_tc_714 aff d 731_f2d_1417 9th cir if the purported transaction does not alter the economic relationship of the parties the court will look beyond the form in which the transaction is cast to determine whether the transaction has any substance id pincite what was the effect of the cancellation of n shares of stock based on the facts submitted it is probably safe to surmise that what transpired in this case is that after x was initially awarded restricted_stock he was advised that since a timely sec_83 election was not filed at each vesting date he would be in receipt of ordinary compensation income and due to the provisions of sec_1_83-1 of the regulations dealing with non-arm s length transfers of nonvested stock income would be taxable to him even if he gifted the stock to z facing this unattractive prospect x with company a s approval took steps to have n shares of restricted_stock canceled and reissued so that he could file a timely sec_83 election because the cancellation was engineered solely for tax purposes and has not been shown to have any business_purpose or to have altered the economic positions of the parties taking into account that x was paid a bonus equal to the increase in the face_amount of the promissory note we think a reasonable argument can be advanced based on the above-referenced authorities that the form of the transaction meaning the cancellation and repurchase should be ignored under this argument we would contend that the transfer date for purposes of determining whether the sec_83 elections were timely relative to the n shares is the date those shares were initially transferred to x no documents were presented to indicate that x filed timely and valid elections under sec_83 of the code with respect to the n shares issued under the initial grant if this argument prevails then x received ordinary compensation as those shares vested regarding the full block of d shares of stock whether x filed valid timely elections under sec_83 of the code even if the cancellation and repurchase of the n shares is honored in the event we do not prevail on the argument that the transfer date occurred earlier with regard to the n shares purchased under the first and second agreements and with regard to the p shares purchased under the third agreement the documents submitted by x and his representative do not indicate that the sec_83 elections were filed within the 30-day requirement x s representative stated that x mailed the elections to the location h service_center and that x attached the elections to his filed return to support the latter representation x s representative submitted a copy of a certified mail receipt however this certified mail receipt is dated two years later clearly beyond the 30-day requirement it is possible that x s representative accidentally included this receipt and that x has a timely dated receipt more facts are needed to determine whether x mailed elections or included them with his return within the 30-day requirement we note that the facts indicate that x filed elections under sec_83 of the code with company a even if those elections were filed with company a within the 30-day requirement filing elections with company a is not filing with the service and would not satisfy the requirements of the regulation aside from the timeliness issue an election must meet the requirements of sec_1_83-2 of the regulations to be a valid election the document submitted by x's representative does not meet the requirements of sec_1_83-2 of the regulations and thus does not constitute a valid election this document appears to be the type of document that would have been filed with company a rather than the service because among other things the document does not contain a statement that an election under sec_83 of the code is being made it does not describe the property transferred and it does not describe any restrictions with respect to the property however this document may not have been the document purportedly filed with the return or at the service_center accordingly more facts are needed to determine whether x timely filed the elections and if so whether the elections were valid if it is determined that x did not file timely valid sec_83 elections sec_83 of the code applied to each of the blocks of stock purchased under the three agreements as they became substantially_vested and x received ordinary compensation as the stock vested this would be the case even if it is determined that x and y made a valid gift of the stock to z see sec_1_83-1 of the regulations though we think that not to have been the case for purposes of determining whether the amounts paid to z to redeem the stock should have been reported by x did x and y make a valid gift of the stock to z under sec_25_2511-1 of the gift_tax regulations the gift_tax applies to a transfer by way of gift whether the transfer is in trust or otherwise whether the gift is direct or indirect and whether the property is real or personal tangible or intangible under sec_25_2511-2 a gift is complete as to any property or part thereof or interest therein of which the donor has so parted with dominion and control as to leave in him no power to change its disposition whether for his own benefit or for the benefit of another even though the name on the stock certificates was changed to z and x and y filed a gift_tax_return further development of the facts may show that x did not relinquish control of the n shares of stock and that x actually acted as owner of the stock if there was no valid and effective gift then a sham_transaction argument should be raised and capital_gain income should be charged to x if it is determined that x failed to make timely valid sec_83 elections and that x received ordinary compensation as the stock vested then the capital_gain income generated by the sale of the stock is attributable to x but x s basis is increased by the amount includible in gross_income as compensation alternatively if it is determined that there were timely valid sec_83 elections and x did not receive ordinary compensation as the stock vested then the capital_gain generated by the sale of the stock is attributable to x but the basis is only the amount_paid for the stock case development and other hazards regarding the issue of whether x timely filed elections under sec_83 a showing that the parties intended that x wo uld file the elections is not enough evidence to show that elections were actually filed however if x filed elections with his return and the return was filed within days after the stock was transferred or if x demonstrates that elections were timely filed but that they were mailed to the wrong service_center we recommend that the elections be accepted on the basis that x substantially complied with the regulations see 88_tc_1453 67_tc_1071 ------------------------------------------------------------------------------------------------------------ --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------- if you have any questions about this memorandum please call assistant chief_counsel employee_benefits and exempt_organizations by robert b misner robert b misner assistant chief branch


o f f i c e o f t h e c h i e f c o u n s e l department of the treasury i n t e r n a l r e v e n u e s e r v i c e w a s h i n g t o n d c date cc ita b04 conex-112566-14 number release date uil the honorable mark r warner united_states senate washington dc dear senator warner ---------------- i am responding to your letter dated date on behalf of your constituent ------------------ employment discrimination must treat the settlement proceeds as an accession to wealth that is included in gross_income she believes that losses suffered by the victim such as additional finance_charges late payment fees loss of a car or home and emotional distress due to financial losses should be deductible from any recovery asked why a taxpayer who recovers a settlement for ------ gross_income includes all income from whatever source derived unless excluded by law sec_61 of the internal_revenue_code the supreme court of the united_states has stated that congress intended to exercise the full measure of its taxing power in enacting sec_61 and that the definition of gross_income sweeps broadly to all accessions to wealth clearly realized and over which the taxpayers have complete dominion 348_us_426 the supreme court has also ruled that economic damages recovered for employment discrimination are accessions to wealth included in gross_income 504_us_229 title vii of the civil rights act and 515_us_323 age discrimination gross_income also includes back pay front pay and emotional distress damages recovered in an action for disability discrimination 228_fsupp2d_1218 d colo a taxpayer can exclude from gross_income damages received on account of personal physical injuries or physical sickness sec_104 of the code however damages received for emotional distress do not qualify for this exclusion unless they are recovered because of a personal physical injury or physical sickness or are not in excess of the amount_paid for medical_care due to the emotional distress sec_104 of the code conex-112566-14 deductions from gross_income are allowable only as specifically provided by statute 503_us_79 nothing in the law allows deductions for the types of losses mentions in her letter ---------------- also the law does not permit taxpayers to limit the additional marginal tax_liability that results from including in income a lump sum settlement award resulting from an employer’s discrimination over a period of years thus statutory changes to the internal_revenue_code would be necessary to allow taxpayers to exclude employment discrimination awards from gross_income to deduct the types of losses lump-sum awards that represent several years of compensation describes in her letter or to limit their tax_liability on ---------------- i am sorry that my response is not more favorable but i hope this information is helpful if you have any questions please contact me at ------------------ ------- ------------------------------------------ ---------------------- --------------------- at or sincerely andrew j keyso associate chief_counsel income_tax and accounting


t c memo united_states tax_court robert m and nancy i stewart petitioners v commissioner of internal revenue respondent docket no filed date martin brant fenster for petitioners matthew a mendizabal for respondent memorandum findings_of_fact and opinion ruwe judge respondent determined deficiencies of dollar_figure and dollar_figure in petitioners’ federal income taxes and accuracy-- related penalties under sec_6662 of dollar_figure and dollar_figure ‘a111 section references are to the internal_revenue_code in effect for the years at issue all rule references are to the tax_court rules_of_practice and procedure for and respectively after concessions ’ the issue for decision is whether petitioners are entitled to deductions for certain amounts that mr stewart paid to a wholly owned corporation for general management services he performed findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the attached exhibits are incorporated herein by this reference at the time of filing the petition petitioners resided in san jose california petitioner robert m stewart owned a real_estate business which he operated as a sole_proprietorship in mr stewart incorporated r m stewart inc and he was its sole shareholder and director the corporation was formed to protect the assets of the sole_proprietorship including the real_estate sales office it was engaged in real_estate development a screen printing sign business and the operation of a computer company petitioners concede the adjustment to car and truck expenses of dollar_figure and the adjustment to interest_expense of dollar_figure for respondent concedes the adjustment to rent expense of dollar_figure for and dollar_figure of the adjustment for commission expenses for ‘the corporation also provided property management services to certain clients of the sole_proprietorship the clients were required to list their properties with the sole_proprietorship when and if the properties came up for sale the sole_proprietorship was prohibited by its franchise agreements from performing those services the corporation paid a property manager for managing the various rental properties involved however he did not provide general management services for either the corporation or the sole_proprietorship the sign business and the computer company sold products to the general_public the corporation held real_estate and it provided management services to the sign business and the computer company in date r m stewart inc and mr stewart entered into a management agreement which provided the purpose of this agreement is to establish a management agreement for robert m stewart’s real_estate business rm stewart inc is by this agreement to have full management control_over the real_estate office located pincite berryessa road san jose r m stewart inc is to be paid a sic annual retainer of dollar_figure which is not to exceed of the net profit before taxes if the annual fees are not paid due to capital improvements or expansion than sic the short fall may carry forward upto two full calendar years this agreement is to be reviewed every three years or sooner x signed robert m stewart for both rm stewart inc and robert m stewart mr stewart executed four subsequent addendums to this agreement in date the annual retainer was raised to dollar_figure in date the annual retainer was raised to dollar_figure in date and in date addendums were executed providing that all terms and conditions to remain the same there was no independent third party involved in the contract and no party other than mr stewart signed the contract or the addendums q4e- the general management of the sole_proprietorship consisted of running the company overseeing the training of the managers overseeing the sales manager overseeing accounts_receivable and accounts_payable motivating agents and reviewing contracts for residences and businesses mr stewart performed the general management functions for the sole_proprietorship in and there was no written_agreement between the corporation and mr stewart regarding any services he was to provide as an employee of the corporation mr stewart paid dollar_figure in and dollar_figure in to r m stewart inc as fees for the general management services petitioners filed form sec_1040 u s individual_income_tax_return in and in which they deducted those payments on schedules c profit or loss from business or profession attached to those returns the corporation reported those amounts as income on its forms u s_corporation income_tax return for and this income allowed the corporation to absorb losses arising from deductions claimed on its and returns mr stewart received no compensation or draws from the corporation in and opinion sec_162 allows as a deduction all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business including a reasonable - - allowance for salaries or other compensation_for_personal_services actually rendered deductions are a matter of legislative grace and the burden of clearly showing the right to any such deductions is on the taxpayer 503_us_79 respondent determined that the amounts paid to r m stewart inc as management fees were not ordinary and necessary business_expenses or were not expended for the purpose designated petitioners argue that the management fees were ordinary and necessary expenses of mr stewart’s real_estate business they contend that the type of services provided to the real_estate business involved classic ordinary and necessary business_expenses and that they were provided pursuant to a binding and written contract petitioners suggest that r m stewart inc performed those services as a separate taxable entity ordinary expenses arise from transactions that are of common or frequent occurrence in the type of business involved 308_us_488 108_tc_147 necessary expenses are respondent submits that the examination of petitioners’ and returns began on date petitioners do not raise an issue as to the application of sec_7491 and we find that code section inapplicable to this case respondent suggests that the fees were essentially capital contributions from mr stewart to the corporation -- - expenses that are appropriate and helpful to a taxpayer’s trade_or_business 290_us_111 77_tc_1124 affd without published opinion 9th cir date we agree with petitioners that the general management services provided to the real_estate business were ordinary and necessary to that business we also agree that mr stewart incorporated r m stewart inc for legitimate business reasons and that it was a separate taxable entity see 319_us_436 however we disagree that the payments to r m stewart inc were expenses paid for management services performed by that entity or its employees as a general matter the income and expenses of a sole_proprietorship are the income and expenses of the individual who owns the business see sec_61 lebouef v commissioner tcmemo_2001_261 the sole_proprietorship unlike the corporation was not a separate taxable entity from mr stewart and any payments from that business that were paid for services mr stewart performed in his individual capacity are not deductible thus it is essential that the corporation in the first instance and not mr stewart be viewed as the party providing the general management services mr stewart was the individual who actually performed the general management services for his sole_proprietorship during - the years at issue mr stewart has not shown that he performed those services as an employee or independent_contractor of the corporation mr stewart was not paid_by the corporation as an employee independent_contractor or executive in and and it does not appear that the corporation ever compensated him for the general management services he performed in and there was no employment agreement between mr stewart and the corporation and there are otherwise no records which show mr stewart provided the services in any capacity as an employee of the corporation also there is no documentation showing the number of hours that mr stewart spent providing the management services to the sole_proprietorship there is no reasonable basis to distinguish the services that mr stewart provided generally to his sole_proprietorship and those that he might have performed through the corporation and there is no reasonable basis for us to find that the corporation or any of its employees actually rendered services to the sole_proprietorship in and petitioners point to the management fee agreement between mr stewart and the corporation the agreement does not specify or otherwise describe the management services to be performed by the corporation and the annual retainer does not relate to any services actually to be rendered by the corporation the agreement was not the product of arm’s-length negotiations the --- - agreement was executed and signed solely by mr stewart in his individual capacity and as the only shareholder and director of r m stewart inc the payments under the agreement are capped and they are not payable in the case of capital improvements or expansion transactions among related_taxpayers are subject_to close scrutiny and in these circumstances it is the nature and origin of a transaction rather than its form that must be accorded controlling weight 513_f2d_800 5th cir pan am foods inc v commissioner tcmemo_1997_136 affd 163_f3d_1354 5th cir petitioners have not shown that the corporation rendered any general management services to the sole_proprietorship and we cannot agree that mr stewart’s payments of dollar_figure in and dollar_figure in to that entity as compensation_for those services are deductible business_expenses accordingly we sustain respondent’s determination respondent also determined accuracy-related_penalties for and an accuracy-related_penalty of percent is imposed on any portion of an underpayment_of_tax that is attributable to negligence or to any substantial_understatement_of_income_tax sec_6662 and b there is a substantial_understatement_of_income_tax if the amount of the understatement for the taxable_year exceeds the --- - greater of percent of the tax required to be shown on the return for the taxable_year or dollar_figure sec_6662 a an understatement is the excess of the tax required to be shown on a return for the taxable_year over the amount of the tax imposed which is shown on the return sec_6662 a the understatement is reduced where the taxpayer has substantial_authority for his tax treatment of any items or where the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return and there is a reasonable basis for such tax treatment sec_6662 d b petitioners rely on sec_162 and sec_1_162-1 income_tax regs as substantial_authority for taking their deductions however given the particular circumstances of this case we cannot agree that those authorities represent substantial_authority for petitioners’ deductions further simply claiming the deductions on the schedules c attached to their and returns does not constitute adequate_disclosure petitioners did not disclose any relevant facts or attach any statement to their returns we find a substantial_understatement_of_income_tax in this case the accuracy-related_penalty is not imposed if the taxpayer shows there was a reasonable_cause for the underpayment and that he acted in good_faith with respect to the underpayment sec_6664 mr stewart was previously audited by respondent for -- - his tax_year and on date respondent issued a no- change letter petitioners claim that they reasonably relied on this letter in claiming the deductions in and a failure by the commissioner to disallow similar deductions in a prior year’s audit of a taxpayer’s return may be a factor to be considered with respect to the imposition of the accuracy- related penalty sheehy v commissioner tcmemo_1996_334 however petitioners have produced no evidence regarding the circumstances of the previous year’s audit and whether they claimed deductions on a similar basis as in their and returns the no-change letter they produced is silent regarding the circumstances of the audit and the facts in are not necessarily comparable to those that existed in and we hold that petitioners have not shown reasonable reliance on respondent’s no-change letter we sustain the accuracy-related_penalties as determined decision will be entered under rule