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Posts from January 2014.

Is a full time gambler in the trade or business of gambling?  If the answer is yes, two results follow (one result which is good and one result which is not so good):  (1) the gambler is able to deduct under Section 162 of the Code all of the ordinary, necessary and reasonable expenses incurred in carrying on the business; and (2) the net income of the gambler, if any, is subject to self-employment tax under Section 1401 of the Code.

In 1987, the United States Supreme Court was presented with the issue of whether a full time gambler was engaged in the trade or business of gambling.  Commissioner v. Groetzinger, 480 US 23 (1987).  Justice Blackmun issued the court’s opinion.  The Supreme Court thoroughly reviewed the history of the phrase “trade or business” in the context of the Internal Revenue Code.  The court stated: “[T]o be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income profit.  A sporadic activity, a hobby, or an amusement diversion does not qualify.”   Whether a taxpayer is engaged in a trade or business is a question of facts and circumstances.

In Groetzinger, evidence revealed the taxpayer spent substantial amounts of time preparing for and actually gambling.  He had been gambling for a long period of time; the activity was not sporadic.  It was continuous.  Mr. Groetzinger had no other “profession or type of employment.”  He engaged in gambling with the intent to make a profit.  The court ultimately concluded, gambling may constitute a trade or business, and based upon the facts presented, Mr. Groetzinger was engaged in the trade or business of gambling.

Mr. Groetzinger won the battle in that his victory allowed him to deduct is ordinary, necessary and reasonable expenses associated with his gambling activities.  He lost the war in part because his net income (if any) would now be subjected to self employment taxes.  The result was likely unsuspected by the taxpayer.

Another interesting twist to the decision in Groetzinger  --  what happens if the expenses of a gambling trade or business generate a net operating loss for the tax year?  Does Section 165(d) of the Code disallow the loss?

Section 165(d) provides:

“Losses from wagering transactions shall be allowed only to the extent of gains from such transactions.”

Groetzinger did not specifically address this issue.  The issue, however, has been encountered over the years since Groetzinger was decided by the courts and the Service.  Unfortunately, the position taken by the Service and the opinions of the courts have not always been consistent.   Taxpayers were left with uncertainty when dealing with this issue.  In 2011, however, the IRS ended the uncertainty when it concluded, while gambling losses alone cannot generate a deductible loss, expenses relating to the activity (provided it rises to a trade or business), may generate a deductible loss.  See Chief Counsel Memorandum AM 2008-013.   See also Reichert, Wagering Losses Not Deductible, Gambling Business Expenses Deductible, Journal of Accountancy (May 2011).

 The US Tax Court will soon be presented with another saga involving a gambler.  On November 29, 2013, Randy Binning, a resident of Nevada and a full time gambler, filed a petition with the tax court.  Based upon his petition, the case involves a deficiency of taxes, interest and penalties exceeding $2,500,000.   Mr. Binning was stopped by an Arizona police officer for a traffic violation while driving through the state.  The officer discovered over $400,000 in cash in the automobile.  Mr. Binning informed the police that the cash came from gambling activities.  The Arizona authorities notified the IRS for further investigation.  After concluding its exam, the Service issued a jeopardy assessment, followed by a Notice of Deficiency, based upon its conclusion the taxpayer failed to properly report his gambling income.  Mr. Binning asserts the income, considering reasonable, ordinary and necessary business expenses, was properly reported.  Stay tuned!  Based upon the petition, this case should turn out to be an interesting battle.

If you have an interest in reading about the history of the phrase “trade or business,” see Brant, The Evolution of the Phrase Trade or Business: Flint v. Stone Trace Company to Commissioner v. Groetzinger – An Analysis with Respect to the Full-Time Gambler and the Investor23 Gonzaga Law Review 513 (1987/1988).   

 

Barack ObamaWithin a few hours after my January 17, 2014 blog post (read here), as we suspected, President Barack Obama signed the Consolidated Appropriations Act, 2014 (“2014 Act”) into law.  Now, at least until September 30, 2014, our federal government may operate without interruption.

Each year, our government must pass bills that appropriate funds for all discretionary spending.  In most years, a bill is passed by each of the twelve subcommittees in the House Committee on Appropriations and each of the twelve subcommittees in the Senate Committee on Appropriations.

When Congress cannot pass separate bills, it rolls the bills into one omnibus bill like the 2014 Act.  This has become the norm rather than the exception over the past several years.  You may be asking yourself why would Congress roll the bills into one single act rather than pass several smaller bills which will be easier for our lawmakers to review and debate.  There may be many reasons, including:

  • Too much party disagreement to pass individual specific bills;
  • Too many issues pending before lawmakers to deal with several pieces of legislation;
  • Time constraints that may prevent dealing with appropriations in a piece meal fashion; and/or
  • The desire to bury in a single massive act some controversial spending provisions.

In the case of the 2014 Act, the answer is likely “all of the above.”  In recent years, party disharmony appears to have heightened the difficulty of passing separate bills.  With our government’s fiscal year being October 1 to September 30, timing is always a critical issue, making passing separate bills cumbersome.  Not wanting to repeat the disastrous “fiscal cliff” historic event, however, lawmakers were likely especially anxious to get the 2014 Act passed as soon as possible.  It is also the case that lawmakers currently have many other legislative matters on their plates, including tax reform and health care.  With these pressures, an omnibus bill results.

The combined piece of legislation usually has buried in its 1000 plus pages some spending provisions that may be considered by some to be controversial.  Given the size of the 2014 Act, over 1500 pages, lawmakers had little time to debate, let alone study, the entire bill and its nuances.  Regardless of your party affiliation, you can find some provisions in the 2014 Act that you believe are troublesome.  Maybe that is what compromise is all about.  The 2014 Act includes many provisions that could have, standing alone, stalled or prevented the passing of individual smaller bills, including:

  • $90 billion of funding for the war in Afghanistan;
  • $1 billion of funding cuts to the Affordable Care Act’s Prevention & Public Health fund;
  • 1% increase in federal workers’ pay;
  • Cutting the IRS budget by over $500 million when the Tax Gap seems to keep growing;
  • Prohibition against the US Postal Service from eliminating Saturday delivery service; and
  • Prohibition against the US government transporting military prisoners in Guantanamo Bay, Cuba to the United States.

If you find none of these provisions the least bit troublesome, hopefully you will find humor in the provision in the 2014 Act that bans the funding of new portraits for our government officials.  I guess lawmaking is akin to sausage making in that you throw all the contents in one end and a finished product comes out the other end.

 

On January 15, 2014, the House, by a vote of 359-67, passed an appropriations bill to fund our federal government through September 30, 2014.  The next day, January 16, 2014, the Senate passed the bill by a vote of 72-26.  The bill will now make its way to President Obama for signature.

 Once signed by President Obama, the bill, commonly known as the “Consolidated Appropriations Act, 2014,” will become law (the “Act”).  The Act spans 1,524 pages and contains some interesting provisions.  Title I of Division E of the Act focuses on the Department of Treasury. 

  • The Act provides the IRS with a 2014 budget of $11.3 billion.  This represents a budget decrease of $526 million or 4.4% from its 2013 budget. 

The $11.3 billion budget is primarily allocated among four areas: 

1.   Taxpayer Assistance -- $2.123 billion

  • tax counseling for elderly
  • low-income taxpayer clinics
  • community volunteer income tax assistance programs
  • taxpayer advocate service

2.   Enforcement -- $5.022 billion

3.   Operation Support -- $3.741 billion

  • rent
  • facilities services
  • printing
  • postage
  • administration
  • security
  • technology

4.   Business Systems Modernization -- $313 million

The Service has some flexibility in spending its budget.  For example, it may allocate 5% or less of any specific appropriation or 3% or less of its “enforcement” appropriation to other IRS budget items.  Advance approval, however, of the Committees for Appropriations is necessary.

  • The IRS is directed to maintain an employee training program which includes education about taxpayer rights, “dealing courteously” with taxpayers, ethics, and the impartial application of tax law.

 

  •  The IRS is directed to use funds from its budget to improve taxpayer service, including its 1-800 helpline services. 

 

  • None of the IRS’s budget may be available to target taxpayers for “regulatory scrutiny based on ideological beliefs,” or “for exercising any right guaranteed under the First Amendment.” 

 

  • $92 million of additional funds will be made available to the Service (through September 15, 2015) to be used “solely to improve the delivery of services to taxpayers, to improve identification and prevention of refund fraud and identity theft, and to address international and offshore compliance issues.” 

Tax practitioners should be asking themselves a few questions about the Act as it pertains to the Service, including:

  •  With the budget cuts, how will the enforcement side of the Service be impacted from the taxpayer and/or practitioner perspective? 

 

  • With over $2 billion allocated to taxpayer assistance, will taxpayers and practitioners actually feel any positive impact?

It is expected President Obama will sign the Act into law.  Time will tell how the Service’s budget under the Act will actually impact taxpayers and tax practitioners.  

 

On December 17, 2013, the US Tax Court issued its opinion in Chaganti v. Commissioner, TC Memo 2013-285.  The interesting issue before the court was whether the taxpayer, an attorney, was allowed under Section 162 of the Code to deduct amounts he was personally ordered to pay a trial court and opposing counsel in a case in which he was representing a client. 

Mr. Chaganti was initially ordered to pay a “fine” of $262, representing the charges of opposing counsel and his court reporter, for his role in his client’s failure to appear for a deposition.  When he did not pay the fine, the court held Mr. Chaganti in contempt and ordered immediate payment (with a daily penalty for late-payment).  About a month later, Mr. Chaganti finally paid the fine (without the late payment penalty). Throughout the case, he engaged in behavior the judge labeled as “unnecessarily protracting and contentious.”  The court eventually ruled against Mr. Chaganti’s client in the case.  The other attorney asked the court for sanctions against Mr. Chaganti (not Mr. Chaganti’s client) as a result of his “bad faith, unreasonable, and vexatious multiplication of the proceedings.”  The judge ultimately ordered Mr. Chaganti to pay opposing counsel around $18,000 (to compensate for the additional attorney fees incurred due to his actions) and to pay the court around $2,300 for paying the original penalty late.

Past Due PaymentMr. Chaganti paid these amounts on December 28, 2007.  He had trouble filing his 2007 tax return on a timely basis (big surprise).  More than three years later, after the Service prepared substitute returns, the taxpayer claimed the court-ordered payments constituted deductible business expenses under Section 162 of the Code.  The IRS respectfully disagreed.  Eventually, the case made its way to the US Tax Court and was presented to Judge Paris.  Not surprisingly, the taxpayer represented himself.

The court first addressed the amounts paid to the court.  Under Section 162(f) of the Code, “[n]o deduction shall be allowed … for any fine or similar penalty paid to a government for the violation of any law.”  This deduction disallowance is not limited to criminal fines or penalties.  Judge Paris noted, without lengthy discussion, that the court is a government agency.  Thus, the fine is nondeductible.

The remainder of the court-imposed sanctions consisted of payments to opposing counsel (rather than a government agency).  Thus, the payments are not governed by Section 162(f).  So, the issue is whether the payments constitute ordinary and necessary expenses to be deductible under Section 162(a).  For an expense to be ordinary, it must be common and acceptable in the taxpayer’s particular business, and to be necessary, it must be appropriate and helpful in carrying out his business.  Judge Paris quickly concluded from the record of the trial court that ordered the sanctions that they were not ordinary and necessary expenses to carry out Mr. Chaganti’s representation of a client.  The sanctions were ordered as a result of the taxpayer’s “willful and unreasonable protraction of the litigation.”   They are not ordinary in the practice of law; rather, the order of sanctions against an attorney is extraordinary.  “[T]he mere fact that petitioner was ordered to pay opposing counsel attorney’s fees … demonstrates that those amounts were not ordinary and necessary to the practice of law.”  Mr. Chaganti lost again!

Two take-aways:  First, penalties or fines paid to the government or an agency thereof are generally not deductible for income tax purposes.  Second, even if the fines or penalties are not paid to the government, unless they are ordinary and necessary, they are not deductible.

 

On December 10, 2013, the US District Court for the District of New Jersey ended a long and drawn out saga between the IRS, and John and Francis Purciello.  The court’s decision (assuming the government does not appeal) should provide the Purciellos with much needed finality and a sense of vindication to end 2013.

The Purciellos filed their joint 2000 tax return, showing a refund due of about $42,000.  Although they contacted the IRS on several occasions, in writing and by telephone, inquiring about the refund, the Service failed to provide any response.  In late 2002, out of the blue, the IRS notifies the Purciellos that the refund was being applied to civil penalties assessed against Mr. Purciello for tax year 1998.  What civil penalties cried the Purciellos?  

Apparently, on April 3, 2002, the Service assessed Mr. Purciello with trust fund penalties for two quarters of 1998 relating to a company he had worked for in a strictly sales capacity.  The penalties, in the aggregate, amounted to more than $168,000.

Over the next two years, the Purciellos went back and forth with the IRS attempting to resolve the matter.  While they eventually received a small refund, the bulk of their claim appeared to be unsuccessful.  Consequently, the Purciellos were forced to file a claim for refund in the US District Court for the District of New Jersey. 

On June 5, 2012, both parties filed motions for summary judgment.  The Service asserted the Purciellos suit must fail because they failed to first seek an administrative refund claim before filing the lawsuit as required by Code Section 7422(a).  The Purciellos, on the other hand, argued that they had, through numerous oral and written communications, informally satisfied the requirement that a taxpayer first seek administrative relief before filing suit.  The court ultimately agreed with the Purciellos.

With the court’s decision in their favor, the taxpayers immediately filed a motion for attorney fees and costs as the prevailing party pursuant to Code Section 7430(a).  To be entitled to an award of attorney fees and costs, four (4) requirements must exist:

  • The party seeking the award must be the prevailing party;
  • The award must be for reasonable administrative and litigation costs;
  • The party seeking the award must have exhausted his or her administrative remedies with the IRS before filing suit; and
  • The party seeking the award must not have unreasonably protracted or prolonged the proceedings (administrative and judicial).

In this case, the IRS conceded the last two requirements, but it argued the taxpayers did not meet the first two requirements.  The IRS first asserted the Purciellos were not the prevailing party.  At first blush, you have to say to yourself, “what is the IRS thinking?”  The taxpayers prevailed.  They won the battle.  It is just that simple.  Unfortunately, the law is not that simple.

1.  In order to meet the first requirement, the taxpayer must have substantially prevailed relative to the amount or most significant issues in controversy.  Even if the taxpayer can prove he or she substantially prevailed, however, if the government can establish it was substantially justified in its position, the claim for attorney fees and costs fails.  In fact, the taxpayers have the burden to prove the government’s position was not justified to a degree that would satisfy a reasonable person or that the position had no reasonable basis in law or fact.

In the instant case, the Service argued the taxpayers originally sought a greater refund, but that they later (upon getting more information from the IRS) lowered their prayer.   The court noted the reduction in the prayer was voluntary on the part of the taxpayers.  The court was not persuaded by this argument.

Traffic ConeNext, the government argued that its position in the case that the taxpayers had not exhausted their administrative remedies before filing suit was reasonable.  It specifically asserted it did not know Mr. Purciello’s written correspondence was an actual claim for refund.  What a strange argument:  the taxpayers were screaming for their refund throughout the entire saga!  The court determined the numerous written and oral communications, as a whole, made it clear to the Service that the Purciellos were seeking a refund.  It found the government’s argument unpersuasive.

Last, on the first requirement, the government asserted it was justified in denying the claim for refund on the grounds of equitable estoppel.  The court struck this argument down without much discussion.  It held the IRS “clearly accepted [the taxpayers] position that they filed an informal claim” for refund when it issued a partial refund to the taxpayers. 

The court ultimately ruled the Purciellos were the prevailing party.  So, it was forced to look at whether the amount of fees and costs sought were reasonable.

2.  Whether the amount sought as attorney fees and costs is reasonable is a question of fact.  The taxpayers originally sought a total of about $45,000 in fees (there is a statutory cap for legal fees; during the years at issue the cap was about $180 to $190 per hour).  The parties scoured the billing statements of the attorneys representing the Purciellos.  While the court found some entries related to another matter for the taxpayers, it ultimately found the other time entrees were reasonable under the circumstances.  In fact, it ended up increasing the reward from the amount originally sought by the Purciellos by about $6,000 for the time the taxpayers’ counsel spent fighting over the fees and cost award. 

Not only did the Purciellos prevail on the tax refund, they received an award of fees and costs exceeding $50,000.  While the fees and costs award did not likely cover the total amount they were out of pocket, the taxpayers did recover part of these expenses.  Overall, the Purciellos did well.  Awards of fees and costs against the IRS are not common. 

One take away from this case is the requirement that a taxpayer exhaust administrative remedies before filing a suit for refund in district court.  If that requirement is not met, the lawsuit may be summarily dismissed.  Caution is required.

 

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Larry Brant
Editor

Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.

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