Senney Wins U.S. Tax Court Case

We are migrating this blog to Facebook and our website.

Please visit www.facebook.com/senneysays and "Like" our page.
~Or~
Send your email address to: jsenney@pselaw.com to receive the latest blog by email.

I recently won a U.S. Tax Court case.  The facts in the case are not that unusual and the issues raised by the IRS in this case could likely be raised with respect to most sole shareholder-owned or closely-held "S" corporations.

In my recent case, the taxpayer operated his business as an "S" corporation.  Like a lot of taxpayers, the client took advances from the "S" corporation during the year.  At the end of the year, the client characterized these advances as either W-2 compensation, "S" corporation distributions or loans.   For 3 years in a row, 2006 to 2008, it made more sense for tax purposes to characterize the advances as loans.  In total, the "S" corporation loaned the shareholder about $400,000.

In the following year, the client and his business had some rough financial times and so the client declared personal bankruptcy.  In the bankruptcy, the amounts loaned to the client by  the "S" corporation were discharged, and the "S" corporation took a bad debt deduction.

On audit, the IRS disallowed the "S" corporation's bad debt deduction and assessed the client personally for taxes, penalty and interest in 2009 based on $400,000 of unreported income.  The IRS raised several arguments to justify their assessment of tax in 2009 including: (1) under IRC 108, cancellation of debt in bankruptcy creates income in 2009; (2) under IRC 1368, distributions in excess of basis are taxable as capital gains in 2009; and (3) under IRC 481, the IRS action to treat the advances as taxable distributions in 2009 amounts to a change in accounting method.

All of these arguments were raised by the IRS attorney in the Tax Court case.  The IRS attorney eventually recognized that cancellation of debt does not create income under IRC 108  if the debtor is insolvent.  The IRS attorney also eventually realized that IRC 1368 cannot not apply to the client in 2009 because the distributions were made to the client in 2006-2008.  Finally, the IRS attorney eventually agreed that changing the characterization of the advances from a loan to a distribution is not a change in accounting method.

The IRS attorney finally agreed with me that if the advances were taxable at all, they were taxable as distributions when paid to the client in 2006-2008.   The IRS attorney then closed the case because it was brought only with respect to year 2009.

The IRS attorney cautioned me that the IRS may try to assess tax in years 2006-2008 under the theory that there has been a substantial understatement of income.  Under the tax law, the normal statute of limitations is 3 years and years 2006-2008 are closed.  Hoever, the normal 3 year statute is extended to 6 years if the reported gross income has been understated by more than 25%.  There was no question that the amount in question was more than 25% of the gross reported income.  However, the IRS failed to realize that the amount in question was reported.  It simply was not reported as gross income on the client's tax return.

The amount in question was reported on the "S" corporation information return as a "loan to shareholder."  The case law is clear that such reporting gives the IRS the notice it needs to do further inquiry.  I forwarded this case law to the IRS attorney with the request it be forwarded to the IRS appeals agents.  Accordingly, I do not suspect the client will face assessments for 2006-2008.

If you have been assessed federal or state income taxes and need help with your appeal to the IRS or U.S. Tax Court, please give me a call or email at 937-223-1130 or Jsenney@pselaw.com.


AND ONE MORE THING.  I was listening to WYSO on the way into work this morning.  I heard a news report regarding proper preparation and cooking of chicken.  The story started with a tape of Julia Childs telling her audience that it was very important to thoroughly wash raw chicken in cold water before cooking.  Apparently Julia Childs was wrong.  The USDA has been trying to tell people for years that washing chicken is the wrong thing to do.  The point of washing chicken is to eliminate the salmonella and other germs that are on the chicken skin.  But washing raw chicken splashes the salmonella around in your sink, on your counter and any where else the water gets to.  It is much safer to cook the chicken to at least 165 degrees internal temperature and let the heat kill the salmonella and other germs.  Just thought you might be interested.  You can contact me at 937-223-1130 or Jsenney@pselaw.com.