Wednesday, March 05, 2003
Tax Court�s decision in the case of Ed and Patricia A. Montgomery was mostly correct, but the opinion was a mess. Let me try to parse through this. I will take the issues in the order Tax Court discussed them, even though that order makes no sense. The original deficiency and negligence penalty were based on the IRS�s denial of business losses. The increased deficiency and increased penalty for failure to properly report litigation proceeds was added in the IRS�s response filed in the Tax Court. The logical order is to deal with the original substantive issue, the new issue, the original penalty, and then the increased penalty. Or maybe separate the penalties and discuss each after the issue that caused them. Instead, Tax Court discussed the increases before the original assessments.
First issue: Litigation proceeds. Mr. Montgomery filed suit against a school board that fired him for breach of contract and violation of Constitutional rights. He asked for $250,000 in economic damages and $500,000 in punitive damages. A judgement order awarded $185,000, reduced from $450,000 suggested by the jury, and costs and attorney�s fees of $15,556.70, plus interest on all of these amounts. A couple years later he gets a writ from the district court requiring payment of the judgement, and directing the county to raise taxes if necessary. In each of the tax years at issue, Mr. Montgomery received $30,000. In 1996, this was allocated $21,489 to interest and $8,511 to principal. In 1997, this was allocated $19,966 to interest and $10,034 to principal. Mr. Montgomery claimed the interest but excluded the principal. Under the controlling Supreme Court precedent at the time, litigation proceeds that compensated for �personal injury or sickness� were excluded from income, and the Constitutional claims were considered personal injuries. Economic and punitive damages were not excluded. Tax Court said that the entire principal should have been included in income, because economic and punitive damages were the only damages asked for in the complaint. That is probably correct, but it was also noted in the fact that when the district court granted to writ to compel payment, it cited case law that such measures were appropriate where needed �to vindicate constitutional guarantees�. This would strongly suggest that the district court believed the damages were compensation for constitutional violations as well as economic and punitive damages. There may be authority for ignoring this and sticking to what was asked for in the complaint, but it was not cited or discussed by Tax Court.
Second issue: Business losses. The Montgomerys claimed business losses flowing from an S Corp solely owned by Ed engaged in numerous business activities, most related to several different multi-level marketing schemes. Other than the S Corp�s tax returns, Mr. Montgomery provided no corroborating evidence of income, expenses, or activity, such as a ledger, time log, bank account record, receipt or invoice. Tax Court ruled for IRS, which is correct, but the reasoning was nonsensical. Tax Court said the lack of records was evidence of a lack of a profit motive. Sorry, but no. The lack of records is simply a lack of evidence that any activity actually took place. Taxpayers are required to provide substantiation of their claimed expenses. Mr. Montgomery provided no substantiation, therefor his claimed losses should be disallowed. If you can not prove there was any actual activity, a profit motive is irrelevant. If there were proper substantiation that such activities took place, how could a profit motive be denied? Do people try to sell real estate, pre-paid calling cards, gold coins, �a vitamin-type product that kind of replaces Viagra� or a �program for debt freedom� as a hobby? Most people who get involved in these multi-level marking schemes intend to make money, then end up losing. Selling to their failed independent contractors is how most of these scams actually make their money. The claim that Mr. Montgomery had no profit motive with regard to these activities is unbelievable and irrelevant.
Negligence penalty on litigation proceeds: To me, the fact that the Montgomerys included the bulk of the litigation payments (the interest) and excluded an amount to which there was reasonable disagreement as to whether it was �personal injury� is reason enough to conclude they were not �negligent� in excluding that amount, even if they turned out to be wrong. When you add that there was prior case law which the ruling Supreme Court case had overruled stating that even economic damages are not included in income, the case against the penalty should be solid. Tax Court notes all of this, but then said neither side presented actual evidence, and so they ruled for the Mongomerys because the IRS had the burden of proof on the issue. This suggests that if the IRS had charged this unjust penalty before the case got to Tax Court, it would have been upheld.
Negligence penalty on claimed business losses: Tax Court upheld the penalty because the Montgomerys failed to provide any documentation of their business or expenses. This was done in the last paragraph of the opinion and was concise and logical, unlike most of what preceded it.