Friday, January 14, 2011

The Stuff You Find In Tax Court Opinions

Dean F. Pace, et ux. v. Commissioner, TC Memo 2010-273

The Sovereign Military Hospitaller Order of St. John of Jerusalem, of Rhodes, and of Malta was established in the mid- eleventh century, when merchants from Amalfi founded the Benedictine Abbey of St. Mary of the Latins in Jerusalem. By 1080 the abbey built St. John's hospital--located on the traditional site of the angel's announcement of John the Baptist's conception--which provided a place of refuge for poor and sick pilgrims visiting the Holy Land. Under the leadership of Brother Gerard, the Hospital of St. John grew to include several ancillary hospices in Palestine along the pilgrimage route. Pope Paschal II officially recognized the hospital in 1113, establishing the Order of St. John.

I thought there was something wrong with my browser, but there wasn't.  The above is actually the second paragraph of a Tax Court decision.  Dean Pace is a member of the Sovereign Military Hospitaller Order of St. John of Jerusalem.  He is also a successful trial attorney.  Naturally he represented himself in Tax Court.  I will refrain from quoting the saying as to what that indicates about the intelligence of his client.

There is a logical division of labor between attorneys and accountants in the compliance area of the tax world.  (Construe accountants very liberally to included bookkeepers and serious tax return preparers). If we want to consider a compliance matter that goes the distance the continuum would be basic record keeping, return preparation, initial audit, appellate conference, tax court, appellate court.  (That's for tax determination, we don't need to get into actual collection starting another sequence).  As you run along the continuum the matter becomes less a matter for accountants and more a matter for attorneys.  Viewed in another way as you go backwards things are less a matter for attorneys and more a matter for accountants.  Most of the work in the initial audit is accountants work.  Revenue agents are accountants and want to see a trail of numbers adding up into totals that then goes to a particular line on the return.  They don't want a story.  Although, the best case is not to be audited at all, having an audit that stops at the agent level is the next best possible result.  If the basic record keeping and return preparation have been done well, coming up with a package to present to the revenue agent is a fairly painless process.  If they have not been done well it can be a major project, but it is mainly an accountants project.

Cases like that of Dean Pace or Thomas Hale show you the result of applying the attorney sensibility from the outset.  Here are some of the highlights in Mr. Pace's case:

Pace traveled extensively in 2001, spending thousands of dollars on airfare, hotels, and incidentals. But he has failed to adequately substantiate such expenses under section 274. He provided credit-card statements and his appointment book as evidence, but the appointment book didn't include the purpose of the travel. A substantial portion of the travel expenses also appears to be related to nonbusiness travel--including a pilgrimage to Lourdes that he undertook as a Knight of Malta and wine-tasting events in Paris. We therefore uphold the Commissioner's denial of all travel expenses.

He depreciated his car using a novel method,  but the Code does not allow such creativity.

Pace attempts to substantiate $1,711 in office expenses with a list of expenses containing check numbers, dates, and descriptions. He did not, however, introduce into evidence the underlying canceled checks, and the only testimony supporting the deduction was conclusory statements by Pace and his secretary that the office expenses were “incurred in the ordinary course of business.” Therefore, we disallow in full these office expenses.

Pace deducted custom-made shirts and a tie as office expenses. He explained that he found it difficult to buy some of his clothes off the rack because of his unusual physique. Our own observation makes us suspect that Pace was being modest, but no inspection could affect our necessary conclusion: expenses in this category are not deductible because Pace failed to establish that the clothing was not suitable for everyday wear. See, e.g., Hamilton v. Commissioner, T.C. Memo. 1979-186 [¶79,186 PH Memo TC]; Rev. Rul. 70-474, 1970-2 C.B. 35. And he wore one of his bespoke shirts to trial-- showing without any doubt its suitability for everyday use.

We find Pace's evidence--both records and testimony--of the amounts of these contributions credible, and his grand tour through the Order's medieval and early modern history engaging. But his argument for treating them as business expenses, rather than charitable contributions, is another matter. Payments that qualify as charitable contributions are not deductible as ordinary and necessary business expenses under section 162 if they fail to qualify as legitimate business expenses.

I'll bet the stories about the Order drove the revenue agent crazy.
He has failed to establish that the California state taxes he deducted on his 2001 return were paid in 2001. His 2001 California return shows a $34,989 tax liability--precisely the amount of state and local taxes deducted on his 2001 federal return. But Pace couldn't possibly have paid his 2001 California state taxes during 2001, because the California return wasn't executed until 2003 (and he showed us no evidence of withholding, estimated payments, or designated use of the prior year's refund to the California Franchise Tax Board). He hasn't offered any other evidence to establish that state and local taxes were paid in 2001. We therefore uphold the disallowance of this deduction in full.
Although the Court upheld 84% of the deficiency and allowed the assessment of the accuracy related penalty, they didn't seem to have any hard feelings toward Mr. Pace.  Judges, of course, are lawyers not accountants.  They refused to sanction him for his behavior in Tax Court.
 Pace vigorously contested the Commissioner's determination, resulting in a weeklong trial, 760 pages of trial transcript, and thousands of pages of credit-card statements, canceled checks, and other documents. But Pace's aggressive advocacy doesn't rise to the level of sanctionable behavior. He may be long winded--as many lawyers and even some judges are--but delay and frivolous positions were not the crux of his case.

This is the first tax court opinion I have encountered that has a reference to a papal encyclical

In the best of all possible worlds, perhaps, Pace's pursuit of the unified life would be recognized and rewarded. See, e.g., Pope Paul VI, Pastoral Constitution on the Church in the Modern World--Gaudium et Spes sec. 43 (December 7, 1965). But the Code imposes a more exact and less merciful accounting: business expenses, charitable contributions, and the costs of everyday life must be identified, segregated, and substantiated by reliable documents and credible testimony.

The difference between the trial attorney viewpoint and that of the accountant is probably best summed up in his defense to the accuracy penalty.

Pace offers a novel defense to the accuracy-related penalty in his opening brief--that it's the IRS's fault because it didn't settle. Review of the caselaw fails to find any support for this penalties-don't-apply-when-the-IRS-won't-settle argument. And Pace never argued any of the valid defenses to the penalty. See secs. 6662(d)(2)(B), 6664(c)(1). We therefore find that he is subject to this penalty.

An accountant is thinking that a tax return is supposed to come out to a correct answer (possibly resolving any doubtful elements in favor of the client).  Of course if a return has enough moving parts she will expect that someone else might come up with a different answer, but a third accountant would be able to do a reconciliation that accounted for the difference. That is not what a return is to a trial attorney.  A return is a first offer.

If you will forgive me going into the realm of fantasy, I'd like to imagine how things would have come out if Mr. Pace had been my client.  It would, of course, vary depending on what point in the process he had hired me.  If he were a regular client I would have had him have at least a part time bookkeeper.  His actual return would probably have had a tax due greater than the return he filed (possibly not if there were some planning done).  I would have gone to the initial audit with a neat package and might have gotten a no change or possibly given up some travel and entertainment and auto expense.  I have little doubt that Mr. Pace would have done better on his 2001 return under that scenario than he actually did.  But consider, that was just one year.  What about all the years that he didn't get audited ?  I really can't say that he would be better off.

If he had hired me at the point of the initial audit, I have little doubt that he would have done better.  I would not have let him talk to the revenue agent except fairly late in the process.  The agent would have as neat a package with as many possible numbers tied out as possible.  Probably the agents proposal would have been more than Mr. Pace wanted to pay, but possibly not.  The package going up to appellate would not, however, be something from an utterly exasperated agent who disallowed everything.  Although I would never have deducted the charitable contributions on Schedule C had I prepared the return, I would have had a plausible reason if the agent brought that issue up.  Since the package was so neat, they might not have brought it up.  Depending on the exact mix of the issues, I would probably have totally unleashed Mr. Pace in dealing with appellate, although I probably would have tried to keep him off the medieval history.  Bottom line, he probably still could have had a blast representing himself in Tax Court, but there would have been a much smaller deficiency at stake. (I probably would have told him to use a tax attorney).

The most interesting scenario is if he hired me after botching the initial audit.  Appellate is the point where for the most part the accountants work is done if things have been done right from the start.  Whether the case is handed off almost totally to attorneys at that point is a fairly complex question.  But, of course, this case was probably handled wrong from the start resulting in an exasperated agent who disallowed everything.  The first thing that I would do is make up the same package I would have made for the agent tying out as many numbers as possible. It is possible that the appellate conferee, who might be an attorney, would not examine the package like an accountant would.  They might just accept it.  Then appellate and Mr. Pace could negotiate.  I would supplement Mr. Pace's persuasiveness with research on whatever technical issues there might be left.

I think I would have enjoyed working for Mr. Pace.  Of course, he might have driven at least one of my firms staff members to distraction, so I'm not sorry that he didn't think to call me.  Besides one of the most intellectually stimulating Tax Court decisions of all time would not have been written.

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