Edward J. Duffy & Shannon L. Duffy v. Commissioner , 2020 T.C. Memo. 108 ( 2020 )

T.C. Memo. 2020-108UNITED STATES TAX COURT
EDWARD J. DUFFY AND SHANNON L. DUFFY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8711-16. Filed July 13, 2020.
In 2009, Ps began renting out a property (Property 1) that they
had previously used as a vacation home. In 2011, Ps sold Property 1.
JPMC, a bank that held debt secured by the property, agreed to accept
an amount of the sale proceeds less than the balance due in full
satisfaction of the debt. In 2013, WF, another bank, agreed to cancel
debt secured by Property 2, which Ps used as their principal
residence. For 2012 through 2014, Ps claimed loss deductions from
IM, a limited liability company of which P-H was a member, as well
as deductions for expenses of IM that P-H paid without
reimbursement. R disallowed Ps' deduction of a loss from their sale
of Property 1, determined that they had unreported income from the
cancellation of their debts to JPMC and WF, disallowed the losses
and other deductions Ps claimed from P-H's involvement in IM,
determined that P-H owed self-employment tax on guaranteed
payments he received from IM, and determined accuracy-related
penalties under I.R.C. sec. 6662(a). To demonstrate compliance with
the requirement of I.R.C. sec. 6751(b)(1) for supervisory approval of
penalties, R submitted a form signed by an individual whom the
-2-
[*2] parties stipulated to be "the manager or supervisor of one or more of
the auditing revenue agents".
Held: Even accepting that Ps' rental of Property 1 constituted a
trade or business, they did not establish that their basis in the property
exceeded the proceeds from its sale because they presented no
evidence as to the property's value when they began renting it out.
See sec. 1.165-9(b)(2), Income Tax Regs.
Held, further, because Ps' debt to JPMC was nonrecourse, the
discharge of the indebtedness is included in their amount realized on
the sale of Property 1 and did not give rise to cancellation of
indebtedness income. See sec. 1.1001-2(a), Income Tax Regs.
Held, further, Ps did not realize income from the cancellation
of their debt to WF to the extent that they were insolvent when the
debt was canceled. I.R.C. sec. 108(a)(1)(B), (3).
Held, further, Ps did not establish that IM allocated to P-H an
ordinary loss for 2012; P-H's basis in his interest in IM was sufficient
to allow him to deduct the full amount of the ordinary loss IM
allocated to him for 2013 without limitation by I.R.C. sec. 704(d);
and P-H's basis in IM was sufficient to allow him to deduct a
sufficient portion of the loss IM allocated to him for 2014 to
eliminate the deficiency R determined.
Held, further, Ps are not allowed to deduct the expenses of IM
that P-H allegedly paid without reimbursement because Ps did not
substantiate those expenses.
Held, further, P-H is liable for self-employment tax on the
guaranteed payments he received from IM in 2012 but not those he
received in 2013 or 2014; even assuming that net earnings from self-
employment can be reduced by partnership losses only to the extent
they are deductible under I.R.C. sec. 704(d), P-H was entitled to
deduct losses from IM for each year sufficient to offset the
guaranteed payments he received in that year.
-3-
[*3] Held, further, R did not meet his burden of establishing
compliance with I.R.C. sec. 6751(b)(1), because he did not
demonstrate that the individual who signed the civil penalty approval
form was "the immediate supervisor of the individual" who made the
determination to assess penalties.
Kevin O'Connell, for petitioner Shannon L. Duffy.
Edward J. Duffy, pro se.
Nhi T. Luu, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: By a notice of deficiency dated January 19, 2016,
respondent determined deficiencies in petitioners' Federal income tax of $44,514
for 2009, $40,469 for 2010, $318,580 for 2011, $59,022 for 2012, $198,329 for
2013, and $1,544 for 2014. Respondent also determined accuracy-related
penalties of $7,943 for 2009, $8,094 for 2010, $63,716 for 2011, $11,804 for
2012, $39,648 for 2013, and $109 for 2014.1 After concessions by the parties we
must decide (1) whether petitioners are entitled to deduct an ordinary loss of
$971,988 from their sale in March 2011 of residential property in Gearhart,
1
All dollar amounts are rounded to the nearest dollar.
-4-
[*4] Oregon (Gearhart property), (2) whether petitioners must include in their
taxable income for 2011, in connection with the sale of the Gearhart property,
income from the discharge of indebtedness that property secured, (3) whether
petitioners are entitled to deduct losses they reported from their rental of the
Gearhart property, (4) whether petitioners must include in their taxable income for
2013 income from the discharge of a home equity line of credit secured by their
principal residence in Portland, Oregon (Portland residence), (5) whether
petitioners are entitled to deduct all or a portion of the losses allocated to Mr.
Duffy by Impact Medical, LLC (Impact Medical), (6) whether petitioners are
entitled to deduct other losses reported on Schedules E, Supplemental Income and
Loss, of the returns they filed for 2012, 2013, and 2014, (7) whether Mr. Duffy is
liable for self-employment tax on guaranteed payments he received from Impact
Medical, and (8) whether petitioners are liable for the accuracy-related penalties
respondent determined. Petitioners bear the burden of proof. See Rule 142(a).2
2
All section references are to the Internal Revenue Code in effect for the
years in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
-5-
[*5] FINDINGS OF FACT
The Gearhart Property
Purchase, Financing, and Rental
Petitioners bought the Gearhart property in 2006 for $2 million. In
accordance with the contract governing the purchase, petitioners paid the sellers a
total of $430,500 but were unable to pay the remaining balance of the purchase
price when it came due in July 2008.
In September 2008, petitioners borrowed $1.4 million from JPMorgan
Chase Bank, N.A. (JPMorgan Chase), and used the proceeds to pay part of the
amount they owed to the sellers. In documentation prepared in connection with
the JPMorgan Chase loan, petitioners characterized the Gearhart property as a
second residence. The application petitioners submitted to JPMorgan Chase,
dated September 15, 2008, includes the mortgage on the Portland residence in a
list of their then-existing liabilities and gives its unpaid balance, at that time, as
$470,749.
At trial, Mrs. Duffy testified that, during 2009 and 2010, she and her
husband rented the Gearhart property to family and acquaintances. Until then,
they had used the property as a vacation home.
-6-
[*6] Sale and Cancellation of JPMorgan Chase Debt
Petitioners sold the Gearhart property in March 2011 for $800,000.
JPMorgan Chase agreed to accept $750,841 of the proceeds in full satisfaction of
the mortgage loan that encumbered the property. The documents which the parties
stipulated regarding petitioners' sale of the Gearhart property do not include any
judicial filings by JPMorgan Chase and make no reference to judicial proceedings
to enforce petitioners' obligation to the bank.
Petitioners' Financial Condition in March 2011
In support of their claim to have been insolvent in March 2011 when the
JPMorgan Chase debt was canceled, Mrs. Duffy provided testimony concerning
her and her husband's assets and liabilities at that time. According to that
testimony, Mr. Duffy maintained a retirement savings account that had a balance
of $395,000 when he liquidated it in 2011. Petitioners also owned, among other
things, "a 2009 Chevy Suburban and a 2007 Jeep Commander." Mrs. Duffy
estimated that the Jeep was worth "probably $14,000 or so" in March 2011 and
agreed that valuing the Suburban at $48,000 would be fair.
Regarding petitioners' liabilities in March 2011, Mrs. Duffy testified that
she and her husband owed $200,000 on a home equity line of credit secured by the
Gearhart property and credit card debt of $65,000. She also mentioned auto loans,
-7-
[*7] testifying that the Suburban was subject to a loan of "[p]robably close to
$22,000 or more" and that the loan on the Jeep was "10 to 12,000".
Impact Medical
During the 2000s, Mr. Duffy worked as a highly compensated salesman and
consultant for a medical equipment company. In 2009, however, he was moved to
a management position that paid him less. The following year, Mr. Duffy lost his
job entirely. Mr. Duffy remained unemployed, receiving unemployment insurance
he described as "minimal", until February 2011, when he started Impact Medical.
Mr. Duffy was initially the sole member of Impact Medical, a limited
liability company. He formed the entity to design and manufacture equipment to
alleviate a medical condition known as deep vein thrombosis, which involves the
formation of blood clots in a patient's lower extremities. Both petitioners testified
that Mr. Duffy funded his initial investment in Impact Medical with $50,000-
$55,000 of the proceeds from the liquidation of his retirement savings account. In
addition, Impact Medical received a loan of about $250,000 from a friend of Mr.
Duffy's, Richard Edelson.
During 2012, Dr. Edelson converted a loan to Impact Medical into an equity
investment and became a member of the entity. According to Mr. Duffy's
testimony, he (Mr. Duffy) made additional investments in 2012 through 2014.
-8-
[*8] The parties stipulated that Edward Murphy, Mr. Duffy's cousin, provided
Impact Medical with a check for $50,000 in December 2012 and made a wire
transfer to the partnership of $450,000 in January 2013. They also stipulated Mr.
Duffy's execution, in January 2013, of a promissory note for $500,000 payable to
Mr. Murphy. Mr. Duffy and Dr. Edelson remained the only two owners of Impact
Medical through the end of 2014.
Mr. Duffy testified that he served as Impact Medical's manager and, as such,
was obligated to run its day-to-day operations. He understood, on the basis of
advice from legal counsel, that he had authority to make advances to the entity by
paying its expenses. He also claims to have discussed the issue of reimbursement
with Dr. Edelson.
Cancellation of Wells Fargo Debt; Petitioners' Lifestyle and Financial Condition
in October 2013
On October 28, 2013, Wells Fargo Bank N.A. (Wells Fargo) forgave
$391,532 of indebtedness petitioners owed on a home equity line of credit secured
by the Portland residence. Both petitioners testified that they were insolvent when
the Wells Fargo debt was canceled.
Mrs. Duffy testified that the Portland residence was worth "[p]robably
around $750,000" in October 2013. She acknowledged that one of the documents
-9-
[*9] included in the record is an itemized list of personal property covered by
petitioners' homeowners' insurance policy on the Portland residence in effect
between December 18, 2012, and December 18, 2013. The list includes various
items of jewelry valued at $130,311, objects of fine art valued at $1,140, and
silverware valued at $9,863. Mrs. Duffy explained that, because the policy
provided coverage in a "blanket dollar amount", she had not been scrupulous in
keeping the itemized list up to date. By October 2013, she had lost some of the
items of jewelry on the list and sold the rest to raise money after her husband lost
his job. Among the lost items was a wedding ring, valued at about $16,000, that
she had replaced by October 2013.
When petitioners sold the Gearhart property, a security interest securing an
indebtedness to Oswego Bank was transferred to the Portland residence and
remained in place in October 2013. According to Mrs. Duffy's testimony, by 2013
she and her husband had been unable to reduce the credit card debt that had been
$65,000 in 2011.
After liquidating his retirement account in 2011, investing $50,000 of the
proceeds in Impact Medical, and paying off part of the Wells Fargo loan, Mr.
Duffy used the balance of the proceeds to pay family living expenses. Those
expenses included tuition payable to the private schools at which petitioners had
-10-
[*10] enrolled their children (and which they further supported with donations)
and Mr. Duffy's membership in a Portland country club.
Tax Reporting
2009 and 2010 Returns as Originally Filed
Petitioners reported adjusted gross income of $261,181 on their Federal
income tax return for 2009 as originally filed. Schedule E of that return reported a
loss of $135,959 from their rental of the Gearhart property. The reported loss
equals the difference between $9,500 of rents received and expenses of $145,459,
comprising $92,037 of mortgage interest, taxes of $5,590, and depreciation of
$47,832. Petitioners treated the loss as a nondeductible passive activity loss.
Petitioners reported adjusted gross income of $266,324 on their 2010 return
as originally filed. Schedule E of that return reported a loss of $65,490 from their
rental of the Gearhart property. The reported loss equals the difference between
$3,200 of rents received and expenses of $68,690, comprising mortgage interest of
$7,622, taxes of $11,164, and depreciation of $49,904. Again, petitioners treated
the loss as a nondeductible passive activity loss.
2011 Return and Carryback of Net Operating Loss to 2009 and 2010
On Form 4797, Sales of Business Property, of their 2011 return, petitioners
reported a loss of $971,988 from their sale of the Gearhart property. That same
-11-
[*11] return reported income from the cancellation of indebtedness of $626,046,
equal to the unpaid principal balance of the JPMorgan Chase loan. On Schedule E
of their 2011 return, petitioners claimed a loss from their rental of the Gearhart
property of $199,875, equal to the excess of the previously suspended passive
losses over $1,574 of income from the property for 2011. As a result of the losses
from the rental and sale of the Gearhart property, as well as other losses and
deductions, petitioners reported a net operating loss (NOL) of $274,002 and
applied for a refund of tax paid for 2009 and 2010 as a result of the carryback to
those years of the 2011 NOL.
Petitioners filed amended returns for 2009 and 2010 reflecting the carryback
of the 2011 NOL. Because the carryback of the 2011 NOL reduced petitioners'
adjusted gross income for each of 2009 and 2010 below $150,000, their amended
returns for those years claimed part of the losses from the rental of the Gearhart
property ($25,000 for 2009 and $13,972 for 2010) that petitioners had treated as
disallowed in their entirety under the passive activity loss rules of section 469.
See sec. 469(i) (allowing for the deduction of up to $25,000 of losses from
specified rental real estate activities, subject to phaseout for taxpayers with
adjusted gross income between $100,000 and $150,000).
-12-
[*12] 2012
The Form 1065, U.S. Return of Partnership Income, that Impact Medical
initially filed for 2012 included a Schedule K-1, Partner's Share of Income,
Deductions, Credits, etc., for Mr. Duffy that allocated to him guaranteed payments
of $175,9643 and an ordinary loss of $250,051. Petitioners' individual return for
that year, filed on April 15, 2013, reported no self-employment tax. On
Schedule E of that return, petitioners reported a nonpassive loss from Impact
Medical of $74,087 (equal to the excess of the ordinary loss over the guaranteed
payments reported on Mr. Duffy's Schedule K-1 from the partnership).
In addition to reporting a nonpassive loss from Impact Medical on their
2012 Schedule E, petitioners also reported a nonpassive loss of $11,690, identified
as "UPE". The return provides no further description of that amount.
In September 2014, Impact Medical filed an amended return for 2012 that
allocated all of its ordinary loss ($390,705) for that year to Dr. Edelson. The
Schedule K-1 for Mr. Duffy included in the partnership's amended return for 2012
reports no losses, nondeductible expenditures, or distributions.
3
Guaranteed payments are payments made by a partnership to a partner for
capital or services in amounts determined without regard to partnership income.
See sec. 707(c).
-13-
[*13] 2013
The Schedule K-1 for Mr. Duffy included with Impact Medical's 2013
partnership return allocates to him an ordinary loss of $328,168, guaranteed
payments of $218,182, a section 1231 loss of $2, and nondeductible expenses of
$889. Mr. Duffy's Schedule K-1 also reports his share of partnership liabilities at
the end of 2013 as $75,613 ($18,922 nonrecourse and $56,691 recourse). It also
includes an analysis of Mr. Duffy's capital account in the partnership, determined
using tax basis amounts, that gives an ending balance of $45,874.
Schedule E of petitioners' 2013 return reports a nonpassive loss from Impact
Medical of $109,986 (again, equal to the excess of the ordinary loss over the
guaranteed payments reported on Mr. Duffy's Schedule K-1 for the year). That
Schedule E also reports a nonpassive loss of $10,397 labeled UPE. Although the
UPE loss is, again, not further identified, a statement accompanying petitioners'
2013 return that lists current year partnership losses includes two items that sum to
$10,397: $6,267 of home office expenses and $4,130 of unreimbursed expenses.
Petitioners' 2013 return reports other income of $1,000. An accompanying
statement describes that amount as the net of three items: "cancellation of debt" of
$391,532, "cancellation of debt--principal residence exclusion" of !$391,532, and
$1,000 labeled only "JP Morgan". The return reports no self-employment tax.
-14-
[*14] 2014
On the Schedule K-1 for Mr. Duffy included in Impact Medical's 2014
return, the partnership allocated to him an ordinary loss of $123,936, guaranteed
payments of $25,082, interest income of $2, and nondeductible expenses of
$239,402. Mr. Duffy's Schedule K-1 also states his share of partnership liabilities
at the end of 2014 as $413,243 ($170,020 nonrecourse and $243,223 recourse).
Petitioners' 2014 individual return reports adjusted gross income of
!$115,091, itemized deductions of $45,066, and exemptions of $23,700. The
return includes an election under section 172(b)(3) to waive the carryback of the
net operating loss it reports. Petitioners' 2014 return, like the ones they filed for
2012 and 2013, reports no self-employment tax.
Schedule E of petitioners' 2014 return reports a nonpassive loss from Impact
Medical of $98,854 (again equal to the excess of the ordinary loss the partnership
allocated to Mr. Duffy for the year over his guaranteed payments). That
Schedule E also reports a $15,399 nonpassive loss identified as UPE without
further identification.4
4
Petitioners provided no substantiation of the nonpassive losses reported on
Schedules E of their returns for 2012, 2013, and 2014 identified as UPE.
-15-
[*15] Return Preparers
Petitioners relied on accountants to prepare their individual returns for 2009
through 2014 and Impact Medical's partnership returns for 2012 through 2014.
Ronald Stefani prepared the returns for 2009 through 2013, and Edwin O'Hanlin
prepared the returns for 2014.
The Notice of Deficiency
Respondent disallowed the loss deductions petitioners claimed from the
rental and sale of the Gearhart property on the grounds that the property was a
personal residence. He also increased petitioners' cancellation of indebtedness
income for 2011 by $108,661, equal to the unpaid interest on the JPMorgan Chase
loan that had accrued upon its cancellation. Because those adjustments eliminated
petitioners' reported NOL for 2011, respondent also disallowed the carryback of
that NOL to 2009 and 2010.
Respondent determined that petitioners were not entitled to exclude from
their taxable income the cancellation of $391,532 of indebtedness owed to Wells
Fargo. He also determined that petitioners were not entitled to deduct the
partnership losses reported on their Schedules E. In regard to the losses from
Impact Medical, the notice of deficiency explains that petitioners "did not
establish that * * * [Mr. Duffy] had sufficient partnership basis to claim" them.
-16-
[*16] Respondent disallowed petitioners' deduction of the losses labeled UPE
because they "did not establish that the partnership agreement requires the partners
to pay partnership expenses."5 And respondent determined that Mr. Duffy was
liable for self-employment tax for each year on his guaranteed payments from
Impact Medical for the year.
The adjustments underlying the deficiency respondent determined for
petitioners' 2014 taxable year (primarily, the disallowance of the deduction of
Mr. Duffy's ordinary loss from Impact Medical and the loss labeled UPE) sum to
$137,727. By contrast, the notice of deficiency states "Taxable Income Per Return
or as Previously Adjusted" for 2014 as !$183,857 (the adjusted gross income
shown on petitioners' 2014 return (!$115,091) reduced by itemized deductions of
$45,066 and exemptions of $23,700). Thus, respondent determined that
petitioners' "Corrected Taxable Income" for 2014 was !$46,130 (!$183,857 +
$137,727). Even after respondent's adjustments, therefore, petitioners owe no
regular income tax liability for 2014. The deficiency respondent determined for
that year is attributable to self-employment tax on Mr. Duffy's guaranteed
5
Respondent's disallowance of petitioners' deduction of the UPE losses
reflects his understanding that those losses consist of expenses of Impact Medical
paid by Mr. Duffy without reimbursement from the partnership. See infra part VI.
-17-
[*17] payments from Impact Medical, net of a $2,000 child tax credit respondent
would allow.
Finally, the notice of deficiency determined that petitioners were liable for
an accuracy-related penalty for each year in issue as a result of either a substantial
understatement of income tax or negligence.
Approval of Penalties
On December 16, 2015, Patricia Crespi signed a civil penalty approval form
that authorized the assertion of accuracy-related penalties for petitioners' taxable
years 2011 through 2014 on the grounds of substantial understatement of income
tax and negligence. The form shows Leah Kelly as “Examiner”. The parties
stipulated that Ms. Crespi, a supervisory internal revenue agent (also known as an
exam group manager), "was the manager or supervisor of one or more of the
auditing revenue agents".
Stipulation of Settled Issues
In a stipulation of settled issues, the parties stipulated: "Guaranteed
payments made by Impact Medical LLC to petitioner Edward Duffy during taxable
years 2012, 2013, and 2014 * * * are subject to income and self-employment
taxes."
-18-
[*18] OPINION
I. Loss on Sale of Gearhart Property
Section 165(a) allows a deduction for "any loss sustained during the taxable
year and not compensated for by insurance or otherwise." Losses of individual
taxpayers, however, are deductible only if they were incurred in a trade or business
or transaction entered into for profit or arising from a casualty or theft.
Sec. 165(c).
Although losses from sales of personal residences are generally
nondeductible under section 165(c), section 1.165-9(b)(1), Income Tax Regs.,
provides: "If property purchased or constructed by the taxpayer for use as his
personal residence is, prior to its sale, rented or otherwise appropriated to income-
producing purposes and is used for such purposes up to the time of its sale, a loss
sustained on the sale of the property shall be allowed as a deduction". In general,
the allowable loss is the excess of the property's adjusted basis over the amount
realized from the sale. Sec. 1.165-9(b)(2), Income Tax Regs. For that purpose,
however, the property's adjusted basis upon conversion cannot exceed its fair
market value at that time. Id. The basis would be further reduced by any
depreciation allowed between the conversion of the property and its sale. See
sec. 1016(a)(2); secs. 1.167(g)-1, 1.1011-1, Income Tax Regs.
-19-
[*19] Respondent argues that "petitioners failed to present any evidence that they
held and/or operated the Gearhart beach house as a business asset or an investment
asset." He observes that, while petitioners' tax returns for 2009 through 2011
claimed deductions for depreciation in respect of the Gearhart property, they did
not claim deductions for other expenses that respondent views as "customary with
respect to rental activities operated as a trade or business" such as "advertising,
commissions, insurance, utilities, repairs, and/or supplies expenses". He also
notes that "the trial record does not contain * * * documentation" of rentals of the
Gearhart property.
In her opening brief, Mrs. Duffy claims that petitioners "effectively changed
the use of the * * * [Gearhart] property in 2009" and that, as a consequence, their
loss on the sale of that property was a "Section 1231 loss".6 Thus, she implicitly
claims that, when she and her husband sold the Gearhart property, they had used it
in a trade or business. See sec. 1231(a)(3).
Respondent overstates his case when he claims that petitioners presented no
evidence that they used the Gearhart property as a business asset. Respondent
6
Mrs. Duffy filed an opening brief on her own behalf because her attorney
did not also represent her husband. She did not file an answering brief. Mr. Duffy
filed no briefs at all.
-20-
[*20] would have us ignore Mrs. Duffy's testimony concerning petitioners' rental
of the Gearhart property to family and acquaintances.7
We need not decide whether petitioners' occasional rentals of the Gearhart
property to family and acquaintances are sufficient to establish a trade or business.
Even if we were to accept that petitioners converted the property to use in a rental
business in 2009, we would still sustain respondent's disallowance of the loss
deduction they claimed from their sale of the property because they have not
established that the adjusted basis of the property at the time of sale exceeded the
amount realized on the sale. If the Gearhart property were worth less than its cost
when petitioners converted it to rental use, their basis in the property would have
been reduced to its value. See sec. 1.165-9(b)(2), Income Tax Regs. The basis
would have been further reduced by the depreciation petitioners claimed in respect
of the property. Petitioners would thus have incurred a loss on their sale of the
property only if its date-of-conversion value (less depreciation) exceeded the
amount realized. See sec. 1001(a). The record includes no evidence, however,
concerning the value of the Gearhart property when petitioners began renting it
7
Respondent emphasizes the characterization of the Gearhart property as a
second residence in the documentation prepared in connection with the JPMorgan
Chase loan. Because petitioners obtained that loan in September 2008, the
characterization of the property at that time is not inconsistent with Mrs. Duffy's
claim that she and her husband began renting the property in 2009.
-21-
[*21] out in 2009. Because petitioners have not established that the adjusted basis
of the Gearhart property upon its sale exceeded the amount realized, respondent
properly disallowed the loss deduction petitioners reported from the sale.
II. Income From Cancellation of JPMorgan Chase Loan
Section 61(a) defines gross income to mean "all income from whatever
source derived". That section goes on to list items specifically included in gross
income, including "[i]ncome from discharge of indebtedness". Sec. 61(a)(12).
Section 108(a)(1)(B), however, excludes from a taxpayer's gross income amounts
otherwise includible as a result of the discharge of indebtedness if "the discharge
occurs when the taxpayer is insolvent".8 In addition, section 108(e)(2) provides:
"No income shall be realized from the discharge of indebtedness to the extent that
payment of the liability would have given rise to a deduction."
When a creditor forgives debt in connection with the sale or exchange of
property that secures the debt, the discharge of debt can either result in
cancellation of indebtedness income or instead be included in the taxpayer's
amount realized from the sale, thereby increasing the taxpayer's gain or reducing
the taxpayer's loss on the sale. The varying treatment of the debt discharge turns
8
The sec. 108(a)(1)(B) exclusion is limited to "the amount by which the
taxpayer is insolvent." See sec. 108(a)(3).
-22-
[*22] on whether the indebtedness was recourse or nonrecourse--that is, whether
the creditor's remedies were limited to the transferred property. Section 1.1001-
2(a)(1), Income Tax Regs., provides as a general rule that "the amount realized
from a sale or other disposition of property includes the amount of liabilities from
which the transferor is discharged as a result of the sale or disposition." Section
1.1001-2(a)(2), Income Tax Regs., however, provides: "The amount realized on a
sale or other disposition of property that secures a recourse liability does not
include amounts that are (or would be if realized and recognized) income from the
discharge of indebtedness under section 61(a)(12)."
In her brief, Mrs. Duffy disavows the position she and her husband took on
their 2011 return and claims that the cancellation of indebtedness income they
realized in 2011 "is not taxable" to them "as a result of their insolvency".
Respondent has conceded that petitioners did not realize income from the
cancellation of $32,572 of unpaid interest on the JPMorgan Chase loan because
their payment of that portion of the interest would have been deductible. But
respondent maintains that petitioners realized unreported cancellation of
indebtedness income of $76,089 ($108,661 total unpaid interest subtracting
$32,572 deductible portion).
-23-
[*23] Respondent's position reflects his determination that the JPMorgan Chase
loan was a recourse liability of petitioners because the lender, had it chosen to do
so, could have proceeded against petitioners for the unpaid balance of the loan
after application of $750,841 of the proceeds from the sale of the Gearhart
property. Respondent acknowledges that, if the JPMorgan Chase loan were
instead nonrecourse--in that the bank's remedies were limited to the Gearhart
property--the unpaid loan would have been included in petitioners' amount
realized from the sale of the property. See sec. 1.1001-2(a), Income Tax Regs. In
that event, respondent accepts that the canceled loan would have reduced
petitioners' nondeductible loss without resulting in cancellation of indebtedness
income.9 (Even if the unpaid loan were included in petitioners’ amount realized
from the sale of the property, it is unlikely petitioners would have realized a gain
on the sale. The adjusted basis of a personal residence converted to business use
is stepped down to fair market value for purposes of determining a loss on a
subsequent sale of the property but not for purposes of determining gain on such
sale. See Simonsen v. Commissioner, 150 T.C. 201, 214 (2018).)
9
Respondent makes no argument that the discharge of part of the JPMorgan
Chase loan was not "a result of" petitioners' sale of the Gearhart property. See
Simonsen v. Commissioner, 150 T.C. 201, 209-211 (2018).
-24-
[*24] Before considering petitioners' claimed entitlement to the insolvency
exclusion of section 108(a)(1)(B), we must first address the scope of JPMorgan
Chase's remedies--in particular, whether the loan secured by the Gearhart property
was recourse or nonrecourse. Resolution of that question requires an
interpretation of Oregon's "antideficiency" statute.
Under Oregon law, when property subject to an obligation secured by a trust
deed is foreclosed upon, the lender's ability to bring a deficiency action against the
debtor to obtain repayment of any portion of the obligation not satisfied by the
proceeds of the foreclosure sale turns on the nature of both the property and the
foreclosure proceedings. See Or. Rev. Stat. sec. 86.770(2) (2011). The statute
bars deficiency actions after a judicial foreclosure of a residential trust deed and
after an administrative foreclosure on any type of property. Id. Respondent
contends that the JPMorgan Chase loan "was a recourse liability under Oregon law
because the property was not subject to a residential trust deed". If petitioners
sold the Gearhart property in an administrative foreclosure, however, without the
involvement of a court, the Oregon antideficiency statute limited JPMorgan
Chase's remedies regardless of whether the trust deed securing that loan was a
"[r]esidential trust deed" within the meaning of Or. Rev. Stat. sec. 86.705(5)
(2011).
-25-
[*25] Because the documents which the parties stipulated regarding petitioners'
sale of the Gearhart property do not include any judicial filings by JPMorgan
Chase and we find no reference to any judicial proceedings in the documents that
were stipulated, we infer that the sale was part of an administrative rather than a
judicial foreclosure. Therefore, Oregon's antideficiency statute prevented
JPMorgan Chase from seeking satisfaction from petitioners' other assets of that
part of its loan in excess of the proceeds it received from the sale of the Gearhart
property. Petitioners' amount realized from the sale of the Gearhart property is
thus determined under the general rule of section 1.1001-2(a)(1), Income Tax
Regs., rather than the exception for the cancellation of recourse liabilities provided
in section 1.1001-2(a)(2), Income Tax Regs. It follows that the amount of the
JPMorgan Chase loan from which petitioners were discharged is included in their
amount realized from their sale of the Gearhart property. Petitioners thus realized
no section 61(a)(12) discharge of indebtedness income from the cancellation of the
$626,046 principal amount of the JPMorgan Chase loan or $108,661 of accrued
but unpaid interest. We need not address the issue of petitioners' insolvency at the
time of discharge.
-26-
[*26] III. Losses From Rental of Gearhart Property
Understanding petitioners' reporting of their rental of the Gearhart property
requires an understanding of the passive activity loss rules of section 469.
Congress enacted that section in 1986 as part of its efforts to deter tax shelter
investments it viewed as abusive. Section 469 prohibits specified taxpayers,
including individuals, from deducting losses from passive activities against other
income. In general, passive activities are trade or business activities in which the
investor does not materially participate. See sec. 469(c)(1). Rental activities are
generally considered passive activities regardless of the extent of the investor's
participation. See sec. 469(c)(2). Nonetheless, an individual who actively
participates in the rental of real estate can deduct up to $25,000 of annual losses
from the activity. Sec. 469(i)(1) and (2). The exclusion provided by section
469(i) is phased out for a taxpayer whose adjusted gross income exceeds $100,000
and is eliminated entirely if the taxpayer's adjusted gross income exceeds
$150,000. See sec. 469(i)(3)(A). Losses disallowed under the passive activity
loss rules can be carried forward and used to offset income from passive activities
or when the taxpayer, in a taxable transaction, disposes of his interest in the
activity that generated the loss. See sec. 469(b), (g)(1)(A).
-27-
[*27] Because the return petitioners initially filed for each of 2009 and 2010
reported adjusted gross income exceeding $250,000, they were not eligible, on the
basis of those returns, for the section 469(i) exemption from the general passive
loss disallowance rule. Presumably for that reason, they reported their loss as
unallowable. But their sale of the Gearhart property in 2011 gave them reason
under section 469(g)(1)(A) to report the previously suspended losses on their
return for that year.
Petitioners' 2011 return also reflects the rules for NOLs provided in section
172. Under that section, when an individual taxpayer incurs a net loss for a year
from business activities, the loss is carried back to offset income of the taxpayer
for the two prior years. See generally sec. 172. Any NOL remaining after
carryback is then carried forward to offset the taxpayer's income in future years.
Sec. 172(b)(1)(A)(ii). Section 172(b)(3) allows the taxpayer to waive the
carryback and simply carry the NOL forward.
Because petitioners' carryback of the 2011 NOL under section 172 reduced
their adjusted gross income for each of 2009 and 2010 below $150,000, their
amended returns for those years claimed loss deductions from the rental of the
Gearhart property under section 469(i) of $25,000 and $13,972, respectively.
(Petitioners did not adjust the rental loss they claimed for 2011 to reflect the
-28-
[*28] deduction on their amended returns for 2009 and 2010 of part of the
previously suspended losses for those years.)
Respondent apparently bases his disallowance of the loss deductions
petitioners claimed from the rental of the Gearhart property on section 280A(a),
which provides as a general rule that no deduction is allowed to individuals or
specified corporations "with respect to the use of a dwelling unit which is used by
the taxpayer during the taxable year as a residence." (Respondent appears not to
have considered the special rules that apply to the rental of dwelling units. Among
other things, those rules allow the deduction of amounts, such as mortgage interest
and property taxes, that would be deductible without regard to the rental use of the
property. See sec. 280A(c)(3), (5), (e).)
Because their petition did not assign error to respondent's disallowance of
the loss deductions they claimed from the rental of the Gearhart property, we
would normally treat petitioners as having conceded the issue. A taxpayer's
petition to this Court must include "[c]lear and concise assignments of each and
every error which the * * * [taxpayer] alleges to have been committed by the
Commissioner in the determination of the deficiency or liability." Rule 34(b)(4).
If the taxpayer fails to raise an issue in his assignments of error, that issue is
"deemed to be conceded." Id.-29-
[*29] If an issue omitted from the parties' pleadings is tried by their express or
implied consent, however, we will treat the issue as having been raised in the
pleadings. Rule 41(b)(1). In the present case, respondent arguably consented to
try the issue of the deductibility of petitioners' losses from the rental of the
Gearhart property despite their failure to assign error to his disallowance of those
loss deductions. Respondent addressed the deductibility of those loss deductions
in the list of issues provided in his pretrial memorandum and his opening brief. In
each case, respondent did not identify the deductibility of the rental losses as a
separate issue but claimed that the disallowance of those loss deductions followed
from the disallowance of the deductions petitioners claimed from the rental of the
Gearhart property. In addition, respondent's opening brief advances the argument
petitioners were not entitled to deduct the reported rental losses because they used
the Gearhart property as a residence. See sec. 280A.
Even if we were to treat the issue of the deductibility of petitioners' reported
losses from their rental of the Gearhart property as having been tried by consent,
and thus raised in the pleadings, we would still conclude that petitioners have
conceded the issue. An issue raised by the pleadings may be conceded if a party
fails to advance on brief an argument regarding that issue. E.g., Bradley v.
Commissioner, 100 T.C. 367, 370 (1993); Ashkouri v. Commissioner, T.C. Memo.
-30-
[*30] 2019-95, at *24. Mrs. Duffy's brief neither included the deductibility of the
rental losses in her list of issues before the Court nor advanced any argument in
support of their deductibility. Because of their repeated failures to raise the issue,
we will treat petitioners as having conceded that they are not entitled to deduct the
losses they reported for 2009, 2010, and 2011 from their rental of the Gearhart
property.
IV. Cancellation of Wells Fargo Indebtedness
On brief, Mrs. Duffy admits that "[t]he debt discharged by Wells Fargo
Bank did not qualify as an exclusion from taxable income under Internal Revenue
Code Section 108(a)(1)(E)". That section excludes from income the discharge
before January 1, 2014, of "qualified principal residence indebtedness".
Indebtedness qualifies for the section 108(a)(1)(E) exclusion only if it was
incurred to acquire, construct, or improve a taxpayer's principal residence. See
secs. 108(h)(2), 163(h)(3)(B). Mrs. Duffy admits that the proceeds of the Wells
Fargo loan were "used for supporting * * * [her] family, rather than improving the
property" that secured the loan. But, she contends, "the discharge of the [Wells
Fargo] debt was not reported as taxable income on the Form 1040 for 2013 . . . for
the wrong reason!" She now avers that she and her husband "were insolvent when
that debt was forgiven." According to Mrs. Duffy: "The assets owned by the
-31-
[*31] Petitioners in October of 2013 would have been their * * * Portland
residence for the value of $750,000 and * * * [Mr. Duffy's] interest in Impact
Medical", which she claims "was worth at best less than $120,000." She adds:
"The Petitioners['] debts consisted of the debt to Oswego Bank of approximately
$200,000, the underlying mortgage on the * * * [Portland] residence * * * $65,000
of credit card debt; the line of credit debt forgiven by Wells Fargo Bank of
$391,532; as well as debts still owing on vehicles."
Respondent contends that petitioners have failed to meet their burden of
proving that they were insolvent immediately before the discharge of the Wells
Fargo loan. Respondent acknowledges petitioners' testimony regarding their
insolvency but dismisses that testimony as "vague and conclusory." Respondent
suggests that petitioners' claim of insolvency is undermined by evidence of their
lifestyle, such as their enrollment of their children in private schools that they
supported with donations and Mr. Duffy's membership in a country club.
Respondent also invokes the homeowners' insurance policy on the Portland
residence that covered personal property "valued at over $130,000.00". And
respondent argues that Mr. Duffy's testimony concerning the substantial
contributions he made to Impact Medical between 2011 and 2014 renders
"inconsistent and incredulous" petitioners' claim of insolvency. Finally,
-32-
[*32] respondent suggests that our caselaw establishes that taxpayers' testimony
cannot meet their burden of establishing insolvency when that testimony is
unsupported by documentary evidence.
We agree with respondent's characterization of Mr. Duffy's testimony. We
also agree that Mrs. Duffy's testimony was not as specific as it might have been.
Nonetheless, her testimony convinces us that petitioners were insolvent
immediately before the discharge of the Wells Fargo loan to an extent that, under
section 108(a)(1)(B) and (3), they are entitled to exclude from their gross income
some, but not all, of the amount that would otherwise be includible under section
61(a)(12).
The record establishes that, between them, petitioners owned, on October
28, 2013, the Portland residence, Mr. Duffy's interest in Impact Medical, two
automobiles, and other personal property such as jewelry, fine art, and silverware.
Mrs. Duffy testified that the Portland residence was worth "[p]robably around
750,000" when the Wells Fargo debt was canceled in October 2013, and
respondent offered no evidence to contradict her assessment.10
10
We reject respondent's suggestion that a taxpayer can establish insolvency
only by documentary evidence and that the taxpayer's testimony alone is
insufficient. Indeed, in Newman v. Commissioner, T.C. Memo. 2016-125, at *7,
one of the cases respondent cites in support of his position, we accepted that the
(continued...)
-33-
[*33] We also agree with Mrs. Duffy's claim on brief that her husband's interest in
Impact Medical "was worth at best less than $120,000." The $45,874 balance in
Mr. Duffy's capital account at the end of the year, as reported by the partnership,
indicates that, had the partnership then liquidated, in the absence of unrealized
appreciation in its assets, Mr. Duffy would have received no more than $45,874.
See sec. 1.704-1(b)(2)(ii)(b)(2), Income Tax Regs. (requiring that liquidating
distributions "be made in accordance with the positive capital account balances of
the partners"); see also sec. 1.704-1(b)(2)(iv)(f)(5)(ii), Income Tax Regs.
(allowing for adjustment of capital accounts to reflect a revaluation of partnership
property "[i]n connection with the liquidation of the partnership"). Given the
substantial losses Impact Medical had reported since its inception, we view it as
unlikely that the partnership had significant unrealized appreciation in its assets.
Consequently, we accept Mr. Duffy's capital account balance as of December 31,
2013, as a reasonable proxy for the value of his interest in the partnership as of
October 28, 2013.
While the record establishes that the Portland residence and Mr. Duffy's
interest in Impact Medical were the most valuable assets petitioners owned on
10
(...continued)
taxpayer had met his burden of establishing his insolvency by "provid[ing]
credible testimony that his assets and liabilities were what he claimed they were."
-34-
[*34] October 28, 2013, Mrs. Duffy's claim that those two properties were their
only assets obviously overstates the case. To begin with, her list of debts includes
"debts still owing on vehicles". We take that as an indication that, in October
2013, she and her husband still owned the Chevy Suburban and Jeep Commander
they had owned in March 2011 when they sold the Gearhart property and part of
the JPMorgan Chase loan was canceled. Although Mrs. Duffy testified to the
value of those vehicles in March 2011, petitioners presented no evidence of their
value in October 2013 when the Wells Fargo debt was forgiven. Nonetheless, we
assume that the vehicles did not increase in value between March 2011 and
October 2013.
When respondent dismisses "petitioners' insolvency claims * * * [as]
inconsistent and disingenuous when considered with some of the documents in the
record", he refers, among other things, to the list of personal property covered by
their homeowners' insurance policy. But Mrs. Duffy testified that, by October
2013, she had lost some of the items of jewelry on the list and sold the rest to raise
money after her husband lost his job. She explained why she had not been
scrupulous in keeping the itemized list up to date. According to Mrs. Duffy's
testimony, the only item of jewelry she continued to own in October 2013 was the
wedding ring that replaced the one she had lost. Given petitioners' financial
-35-
[*35] circumstances, we think it reasonable to assume that they did not spend
more on the new ring than the value of the ring it replaced. Therefore, we find that
the jewelry, fine art, and silverware petitioners owned on October 28, 2013, had a
fair market value of $27,003 (wedding ring worth $16,000, fine art worth $1,140,
and silverware worth $9,863).
Finally, although petitioners presumably had some liquid assets on October
28, 2013, we conclude that the value of those assets was insignificant. In
particular, we accept Mr. Duffy's testimony concerning the liquidation of his
retirement savings account and his use of the proceeds.
In short, we find, on the basis of the record before us that, immediately
before the discharge of the Wells Fargo debt, petitioners owned assets with fair
market value of $884,877: the Portland residence, worth $750,000; Mr. Duffy's
interest in Impact Medical, worth $45,874; automobiles worth $62,000 ($48,000 +
$14,000), and other personal property worth $27,003.
We also conclude that, immediately before the discharge of the Wells Fargo
debt, petitioners owed liabilities of $1,159,281. In her brief, Mrs. Duffy refers to
the largest of those liabilities, the mortgage on the Portland residence, but does not
provide the balance of the mortgage on October 28, 2013. She merely advises us
that the mortgage on the Portland residence is "referenced in" the application she
-36-
[*36] and her husband submitted to JPMorgan Chase for the $1.4 million loan on
the Gearhart property. That application, which is dated September 15, 2008,
includes the mortgage on the Portland residence in a list of petitioners' then-
existing liabilities and gives its unpaid balance, at that time, as $470,749. Mrs.
Duffy also claims in her brief that, in October 2013, she and her husband "still
ow[ed] * * * debts on [their] vehicles".
Petitioners have not presented specific evidence concerning the balances, as
of October 28, 2013, of their vehicle loans or the mortgage on the Portland
residence. But the record as a whole supports the inference that the balance of
petitioners' mortgage on the Portland residence did not change materially between
September 2008 and October 2013 and that they were unable to materially reduce
the balance of their car loans between March 2011 and October 2013. Similarly,
we accept Mrs. Duffy's testimony that, between 2011 and 2013, she and her
husband were unable to reduce the balances of their credit card debt or the
Oswego Bank home equity line of credit. We find that unsurprising given Mr.
Duffy's loss of employment.
Therefore, as noted above, we find that, immediately before the discharge of
the Wells Fargo debt, petitioners owed liabilities of $1,159,281: a mortgage on
the Portland residence of $470,749, the Wells Fargo home equity line of credit of
-37-
[*37] $391,532, the Oswego Bank home equity loan of $200,000, credit card debt
of $65,000, and auto loans of $32,000 ($22,000 + $10,000). Those liabilities
exceeded the fair market value of petitioners' assets, at that time, by $274,404
($1,159,281 ! $884,877). Because petitioners were insolvent, immediately before
the discharge of the Wells Fargo debt, by $274,404, the amount of their gross
income from the cancellation of the Wells Fargo debt is limited to $117,128
($391,532 ! $274,404). See sec. 108(a)(1)(B), (3).11
V. Deductibility of Impact Medical Losses
A partner can deduct his share of a partnership's loss for a taxable year only
to the extent of the adjusted basis of his partnership interest at the end of the year.
Sec. 704(d). (The partner's basis in his partnership interest is often referred to as
his "outside" basis, to distinguish it from the partnership's "inside" basis in its
assets.) Any excess of the loss allocated to the partner over his outside basis
carries forward to the following year. Id.11
We do not find the evidence respondent cites concerning petitioners'
lifestyle probative on the question of their insolvency. They may have largely
maintained their prior lifestyle for a time after Mr. Duffy's loss of employment in
the hope that Impact Medical would prove successful. But the evidence shows
that Mr. Duffy's investments in the partnership did not bear fruit. Any failure by
petitioners to adjust their living expenses to their changed financial circumstances
may have contributed to their insolvency.
-38-
[*38] When a partner acquires his interest in a partnership by contributing
property to the partnership, the partner's initial outside basis equals the amount of
any money and the adjusted basis of any other property contributed. Sec. 722. (If
the partner recognizes gain on the exchange, his initial outside basis is increased
by the amount of that gain. Id.) The partner's initial outside basis is adjusted over
time to reflect partnership activity. In particular, his outside basis is increased by
his share of partnership income and decreased by distributions made by the
partnership to the partner and by the partner's share of partnership losses and
nondeductible expenditures. See secs. 705, 733. A partner's outside basis also
includes the partner's share of partnership liabilities. Section 752 achieves that
result by treating increases in the partner's share of partnership liabilities as cash
contributions and decreases as cash distributions.
On brief, respondent acknowledges that Mr. Duffy made capital
contributions to Impact Medical of $50,000 and $450,000. He does not explain
why, even leaving aside Mr. Duffy's share of the partnership's liabilities,12 those
contributions did not provide Mr. Duffy sufficient outside basis to deduct at least
12
Respondent suggests that "a partner's outside basis is increased only when
the partnership's liabilities are recourse". That suggestion, however, is plainly
incorrect. See sec. 1.752-1(a)(4), Income Tax Regs. (defining "liability" for
purposes of sec. 752 without distinction between recourse and nonrecourse
obligations).
-39-
[*39] some of the ordinary losses the partnership allocated to him. Moreover, in
the course of his argument, he gets confused about the dates of the contributions.
Initially, he describes the $50,000 and $450,000 contributions as having been
made in December 2012 and January 2013, respectively. That description is
consistent with the parties' stipulations. Later in his brief, however, respondent
repeatedly describes the two contributions as having been made one year later, in
December 2013 and January 2014. Despite his confusion about when Mr. Duffy
made his capital contributions, respondent accepts that Mr. Duffy contributed
substantial capital to Impact Medical between 2012 and 2014. Nonetheless,
respondent concludes: "[P]etitioners have not established that petitioner Edward
Duffy had sufficient outside basis in Impact Medical LLC to take the reported
flow-through ordinary losses for taxable years 2012, 2013, and 2014."
Mrs. Duffy, by contrast, asserts in her brief that her husband "had basis in
Impact Medical for the years 2012, 2013, and 2014, as a result of capital
contributions he made in those years." In particular, she contends, her husband
"had capital contributions into Impact Medical in 2012 of $125,000, in 2013
capital contributions of $590,000 and in 2014 of $180,000." She fails, however,
to cite evidence in the record in support of that contention.
-40-
[*40] For the reasons explained below, we conclude that petitioners are not
entitled to deduct any ordinary loss from Impact Medical for 2012 but are entitled
to deduct the loss the partnership allocated to Mr. Duffy for 2013. As explained
infra part V.C., we need not decide whether Mr. Duffy had sufficient outside basis
in Impact Medical to allow him to deduct the entire ordinary loss the partnership
allocated to him for 2014. Even after the adjustments reflected in the notice of
deficiency for 2014, petitioners had no taxable income. The deductibility of Mr.
Duffy's loss from Impact Medical for 2014 is relevant to the case--if at all--only
because of its possible effect on Mr. Duffy's self-employment tax liability. We
conclude that, whatever Mr. Duffy's outside basis in Impact Medical at the end of
2014, it was sufficient to allow him to deduct a loss that would eliminate his net
earnings from self-employment.
A. 2012
We need not address the question of Mr. Duffy's outside basis in Impact
Medical at the end of 2012 because petitioners have not established that the
partnership allocated any loss to Mr. Duffy for that year. The return the
partnership originally filed for that year did allocate to Mr. Duffy an ordinary loss
of $250,051, equal to the amount petitioners took into account in computing the
nonpassive loss from the partnership that they reported on their return. But the
-41-
[*41] partnership's amended return allocated to Dr. Edelson all of the partnership's
$390,705 ordinary loss for the year.
Section 6222 requires a partner to report partnership items on an individual
return in a manner consistent with the partnership's reporting. If the partner
reports inconsistently and fails to notify the Commissioner of the inconsistency,
section 6222(c) authorizes the Commissioner to make a computational adjustment
to conform the partner's treatment of the relevant items to the partnership's
treatment of those items and collect any additional tax without deficiency
procedures.
We assume that section 6222 would not apply to petitioners' 2012 taxable
year (regardless of whether Impact Medical is covered by the small partnership
exception13) because petitioners' reporting of Mr. Duffy's partnership items from
Impact Medical was consistent with the return the partnership initially filed and
the partnership did not file its amended return until after petitioners had filed their
individual return for the year. The fact that respondent cannot disallow the
ordinary loss petitioners claimed from Impact Medical for 2012 by means of a
computational adjustment, however, does not mean that petitioners are entitled to
the reported loss.
13
See infra note 15.
-42-
[*42] Petitioners ignore the partnership's amended return.14 Implicitly, they ask us
to accept that the return the partnership originally filed was correct and the
amended return incorrect. But they advance no argument in support of that
treatment. Because petitioners' claim of an ordinary loss from Impact Medical for
2012 is inconsistent with the partnership's amended return for the year, they have
not met their burden of proving their entitlement to deduct any loss, without
regard to the adequacy of Mr. Duffy's outside basis to absorb a loss.
B. 2013
The record shows that Mr. Duffy's outside basis in Impact Medical at the
end of 2013 was sufficient that his entitlement to deduct the $328,168 loss the
partnership allocated to him for that year was not limited by section 704(d). As
noted above, respondent accepts that Mr. Duffy made capital contributions to the
partnership totaling $500,000 no later than January 2013. The Schedule K-1 for
Mr. Duffy included in the partnership's amended return for 2012 reports no losses,
nondeductible expenditures, or distributions that would have reduced Mr. Duffy's
outside basis. The Schedule K-1 for Mr. Duffy included with the partnership's
14
Respondent largely ignores the partnership's amended return as well. He
acknowledges the amended return in a footnote to his opening brief but does not
consider the effect of that return on his position that petitioners are not entitled to
deduct an ordinary loss from Impact Medical for 2012.
-43-
[*43] 2013 return reports the allocation to him of a $2 section 1231 loss and
nondeductible expenditures of $889. That Schedule K-1 also reports that Mr.
Duffy's share of partnership liabilities at the end of the year was $75,613 ($18,922
nonrecourse and $56,691 recourse). We do not understand respondent to question
the partnership's reporting.15 It follows that Mr. Duffy's outside basis at the end of
2013, before taking into account the ordinary loss the partnership allocated to him,
was at least $574,722 ($500,000 ! $2 ! $889 + $75,613). Section 704(d) thus did
not limit Mr. Duffy's ability to deduct the $328,168 ordinary loss that the
partnership allocated to him for 2013.
C. 2014
As noted above, the deductibility of the ordinary loss Impact Medical
allocated to Mr. Duffy for 2014 is not relevant to petitioners' income tax liability
for the year. Petitioners owe no income tax for the year regardless of whether Mr.
Duffy is entitled to deduct any portion of the partnership loss.
15
Whether respondent could challenge the partnership's reporting in this
partner-level proceeding depends on whether Impact Medical qualified for the
small partnership exception from the unified partnership audit and litigation rules
enacted by the Tax Equity and Fiscal Responsibility Act of 1982 and in effect
before 2018. See sec. 6231(a)(1)(B)(i). Because Impact Medical had only two
partners during the years in issue, both of whom were individuals, the partnership
would have been covered by the small partnership exception unless either Mr.
Duffy or Dr. Edelson was a nonresident alien. Id.-44-
[*44] Because petitioners' 2014 return includes an election under section
172(b)(3) to waive the carryback of the net operating loss reported on that return,
the deductibility of Mr. Duffy's loss from Impact Medical is not relevant to their
income tax liability for either 2012 or 2013. For income tax purposes, the
deductibility of that loss is relevant only for 2015 and subsequent years--years that
are not before us in this case.
The deficiency respondent determined for petitioners' 2014 taxable year is
entirely attributable to self-employment tax on Mr. Duffy's guaranteed payments
from the partnership of $25,082. As explained infra part VII, the deficiency
respondent determined rests on the premise that Mr. Duffy's net earnings from
self-employment for 2014 would be reduced by his distributive share of the
partnership's ordinary loss for that year only to the extent that the loss is
deductible in computing petitioners' 2014 taxable income. Even if that premise
were correct, we would need to determine only that Mr. Duffy's outside basis in
Impact Medical at the end of 2014 at least equaled the guaranteed payments of
$25,082 that he received from the partnership in that year.
Whatever the precise amount of Mr. Duffy's outside basis in Impact Medical
at the end of 2014, we can readily conclude that it was at least $25,082. The
Schedule K-1 that the partnership issued to Mr. Duffy for 2014 allocated to him--
-45-
[*45] in addition to the ordinary loss of $123,936--nondeductible expenditures of
$239,402 and $2 of interest income. That schedule also states his share of
partnership liabilities at the end of 2014 as $413,243 ($170,020 nonrecourse and
$243,223 recourse). His share of partnership liabilities thus increased during 2014
by $337,630 ($413,243 ! $75,613). No other items shown on Mr. Duffy's 2014
Schedule K-1 would affect his outside basis. The items other than the ordinary
loss increased his outside basis by $98,230 ($337,630 increase in allocated
liabilities + $2 interest income ! $239,402 nondeductible expenditures).
Because the items reported on Mr. Duffy's 2014 Schedule K-1 other than
the ordinary loss increased his outside basis by more than $25,082, we need not
decide the extent to which that basis was reduced, as of January 1, 2014, by reason
of petitioners' exclusion under section 108(a)(1)(B) and (3), of part of the income
they would otherwise have recognized from cancellation of the Wells Fargo
indebtedness. The exclusion of cancellation of indebtedness income from a
taxpayer's gross income under the insolvency exclusion is not always a permanent
exclusion. As a concomitant of the exclusion, the taxpayer must apply the
excluded income to reduce specified tax attributes, including the basis of property
held by the taxpayer at the beginning of the year following the year of discharge,
to the extent provided in sections 108(b) and 1017. The reduction of tax attributes
-46-
[*46] may require the taxpayer to recognize additional taxable income in the
future. To that extent, the insolvency exclusion effects merely a deferral of tax
rather than a permanent exemption.
Even if Mr. Duffy's outside basis in Impact Medical as of January 1, 2014,
had been reduced to zero under sections 108(b)(2)(E) and 1017(a), he would have
had a basis at the end of the year of $98,230 before taking into account his
distributive share of the partnership's ordinary loss. We therefore conclude that,
after applying the limitation imposed by section 704(d), petitioners were entitled
to deduct an ordinary loss from Impact Medical for 2014 of at least $25,082.
VI. Unreimbursed Partnership Expenses
Respondent's opening brief includes a proposed finding of fact that the
amounts identified as "UPE" on petitioners returns are unreimbursed partnership
expenses. Because petitioners did not object to that proposed finding--or, indeed,
any of respondent's proposed findings--and because we find nothing in the record
that contradicts it, we will accept respondent's proposed finding that the
nonpassive losses petitioners identified as UPE are unreimbursed partnership
expenses.
When a partner pays expenses of a partnership, an issue can arise regarding
the proportion of those expenses the paying partner is entitled to deduct. See, e.g.,
-47-
[*47] Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 294-297 (1980), aff'd
without published opinion, 665 F.2d 1050 (7th Cir. 1981); Klein v. Commissioner,
25 T.C. 1045, 1051-1052 (1956); McLauchlan v. Commissioner, T.C. Memo.
2011-289, 2011 WL 6378793, at *2-*3, aff'd and remanded, 558 F. App'x 374 (5th
Cir. 2014). A partner generally cannot deduct partnership expenses as such. But a
partner's payment of partnership expenses can be treated as a contribution to the
partnership, with the paying partner then entitled to deduct his allocable share of
the expense. By express agreement or course of conduct, however, the entire
expense can be specifically allocated to the partner who paid it.
In contesting respondent's disallowance of petitioners' claimed deduction of
unreimbursed expenses of Impact Medical, Mrs. Duffy claims that, because her
husband "was authorized, of necessity, to personally pay expenses * * * [t]o the
extent they were not reimbursed, they should be deductible." Conversely,
respondent argues that "petitioners have not established that there was a routine
practice equal to an agreement between himself and Dr. Edelson that required
petitioner Edward Duffy to use his or her [sic] own funds to pay a partnership
expense."
The question of the share of a partnership expense allocable to a partner
who paid the expense on behalf of the partnership does not arise unless the partner
-48-
[*48] substantiates the amount of the expense. In the present case, petitioners
provided no substantiation of the nonpassive losses reported on Schedules E of
their returns for 2012, 2013, and 2014 identified as UPE. Therefore, respondent
properly disallowed those losses.
VII. Self-Employment Tax
Section 1401(a) imposes a tax "on the self-employment income of every
individual". An individual's "net earnings from self-employment" are included in
his self-employment income unless specifically excluded. Sec. 1402(b). Subject,
again, to specified exceptions, section 1402(a) provides:
The term "net earnings from self-employment" means the gross
income derived by an individual from any trade or business carried on
by such individual, less the deductions allowed by this subtitle which
are attributable to such trade or business, plus his distributive share
(whether or not distributed) of income or loss described in section
702(a)(8) from any trade or business carried on by a partnership of
which he is a member * * *
On brief, respondent appears to take the position that petitioners conceded
in the stipulation of settled issues that Mr. Duffy had net earnings from self-
employment for each of the years 2012 through 2014 equal to his guaranteed
payments from the partnership for the year. Respondent thus reads the stipulation
that Mr. Duffy's guaranteed payments "are subject to income and self-employment
taxes" to reflect an agreement that petitioners must pay income tax on those
-49-
[*49] payments, and Mr. Duffy must pay self-employment tax on them. In other
circumstances, we might agree with respondent's reading of the phrase "subject
to". The circumstances of this case, however, make it clear that the stipulation that
the guaranteed payments are subject to the specified taxes does not mean that
those taxes must in all events be paid on the guaranteed payments. As noted supra
part V, the notice of deficiency reflects respondent's determination that petitioners
have no income tax liability for 2014. Therefore, petitioners do not have to pay
income tax on the guaranteed payments Mr. Duffy received from Impact Medical
in that year. We therefore read the parties' stipulation to mean only that Mr.
Duffy's guaranteed payments must be taken into account in computing petitioners'
taxable income and Mr. Duffy's net earnings from self-employment. The
stipulation thus leaves open the possibility that Mr. Duffy's guaranteed payments
may be offset by allowable deductions in determining the relevant tax base.
Respondent's determination that Mr. Duffy was liable for self-employment
tax on the guaranteed payments he received from Impact Medical in 2013 and
2014 thus rests on the implicit premise that, as a matter of law, the ordinary loss
the partnership allocated to Mr. Duffy for each of those years reduces Mr. Duffy's
net earnings from self-employment only to the extent it was deductible for
purposes of computing petitioners' "regular" tax liability under chapter 1 of
-50-
[*50] subtitle A of the Internal Revenue Code (sections 1 through 1400-U3) after
applying the section 704(d) limitation. Respondent does not address that legal
issue in either of his briefs or acknowledge that the validity of his position turns
on its resolution.16
Given the plain terms of section 1402(a) and its accompanying regulations,
it is far from apparent that a partner's distributive share of an ordinary loss
incurred by a partnership engaged in a trade or business reduces the partner's net
earnings from self-employment only to the extent that the loss is allowed as a
16
If Mr. Duffy could be viewed as a limited partner of Impact Medical, his
ordinary losses from the partnership would be excluded from his net earnings from
self-employment regardless of whether those losses were deductible under
sec. 704(d). See sec. 1402(a)(13). In that case, the guaranteed payments he
received would be included in his net earnings from self-employment without any
offsetting deduction if those payments were for services Mr. Duffy rendered to the
partnership. See id. Because Impact Medical was a limited liability company,
however, Mr. Duffy was a member and not a limited partner. Even so, he could be
treated as a limited partner if his relationship to the entity was akin to that of a
limited partner in a limited partnership. See generally Renkemeyer, Campbell &
Weaver, LLP v. Commissioner, 136 T.C. 137 (2011). In Renkemeyer, Campbell
& Weaver, LLP v. Commissioner, 136 T.C. at 147, however, we concluded that an
owner's protection from claims against an entity is not enough to qualify the owner
as a limited partner for purposes of sec. 1402(a)(13). Instead, we concluded that
an interest other than a limited partner interest could be treated as such for
purposes of that section only if the holder is merely a passive investor in the entity
who does not actively participate in the entity's business operations. Id. at 150.
But Mr. Duffy served as Impact Medical's manager and, as such, was obliged to
run the company's day-to-day operations. Therefore, we see no grounds for
treating him as a limited partner of Impact Medical within the meaning of
sec. 1402(a)(13).
-51-
[*51] deduction in computing the partner's regular taxable income. Under the
plain terms of section 1402(a), income from a business an individual carries on
directly can be reduced by deductions only to the extent that those deductions are
"allowed by" subtitle A (sections 1 through 1563). But that limitation does not
apply to the individual's distributive share of partnership income or loss. Under
the statutory text, after allowable deductions are subtracted from the individual's
income from any directly conducted business, the individual's net earnings from
self-employment are increased or reduced by the individual's "distributive share
* * * of income or loss * * * from any trade or business carried on by a partnership
of which he is a member". The text of section 1402(a) gives no indication that the
individual's distributive share of a loss from a business conducted by a partnership
reduces the individual's net earnings from self-employment only to the extent that
the individual's outside basis in the partnership is sufficient to allow him to deduct
the loss in computing his regular income tax liability.
Moreover, the regulations interpreting section 1402(a) provide no apparent
grounds for distinguishing between deductible partnership losses and those limited
by section 704(d). Section 1.1402(a)-1(a)(2), Income Tax Regs., defines "net
earnings from self-employment" to include two components, the second of which
is an individual's "distributive share (whether or not distributed), as determined
-52-
[*52] under section 704, of the income (or minus the loss), described in section
702(a)( * * * [8]) and as computed under section 703, from any trade or business
carried on by any partnership of which is he a member." The mandate that the
individual's distributive share of a partnership loss be "determined under section
704" requires consideration of section 704(d). But section 704(d) does not reduce
a partner's distributive share of a partnership loss; it reduces only the portion of
that loss that is allowed as a deduction in computing the partner's regular taxable
income. Losses not allowed as a deduction by reason of the section 704(d)
limitation remain part of the partner's distributive share of the loss (and can be
deducted in future years if the partner has a sufficient outside basis).
Given the conclusions reached supra part V, however, we need not resolve
the question of whether a partner's distributive share of a loss incurred in a
partnership trade or business reduces the partner's net earnings from self-
employment only to the extent that the loss is deductible in determining the
partner's regular tax liability under chapter 1 of subtitle A. As explained supra
part V.A., we have concluded that petitioners have not established that Impact
Medical allocated to Mr. Duffy any distributive share of the partnership's loss for
2012. And we concluded supra part V.B. that petitioners are entitled to deduct all
of the $328,168 ordinary loss the partnership allocated to Mr. Duffy for 2013.
-53-
[*53] Because the deductible loss exceeds Mr. Duffy's guaranteed payments of
$218,182 for the year, we conclude that Mr. Duffy had no net earnings from self-
employment for 2013 regardless of whether his distributive share of the
partnership's loss can be taken into account only to the extent that it is deductible
under chapter 1. Finally, we concluded supra part V.C. that petitioners are entitled
to deduct a loss from Impact Medical for 2014 in an amount at least equal to
Mr. Duffy's guaranteed payments for the year. Therefore, even accepting the
premise underlying respondent's position, Mr. Duffy had no net earnings from
self-employment tax for 2014.17 We thus uphold respondent's determination of
Mr. Duffy's self-employment tax liability for 2012 but not for 2013 or 2014.
VIII. Penalties
Section 6662(a) and (b)(1) provides for an accuracy-related penalty of 20%
on the portion of an underpayment of tax attributable to negligence or disregard of
rules and regulations. Section 6662(a) and (b)(2) provides for the same penalty on
the portion of an underpayment of tax attributable to "[a]ny substantial
understatement of income tax." Section 6662(d)(2)(A) generally defines the term
"understatement" as the excess of the tax required to be shown on the return over
17
Because neither Mr. Duffy nor Mrs. Duffy had net earnings from self-
employment for 2014, they were not entitled to the $2,000 refundable child tax
credit respondent allowed. See secs. 24(d)(1), 32(c)(2).
-54-
[*54] the amount shown on the return as filed. In the case of an individual, an
understatement is "substantial" if it exceeds the greater of 10% of the tax required
to be shown on the return or $5,000. Sec. 6662(d)(1)(A). An understatement is
reduced, however, by the portion attributable to the treatment of an item for which
the taxpayer had "substantial authority" or, in the case of items adequately
disclosed, a "reasonable basis". Sec. 6662(d)(2)(B). Section 6664(c)(1) provides
an exception to the imposition of the section 6662(a) accuracy-related penalty if it
is shown that there was reasonable cause for the underpayment and the taxpayer
acted in good faith. Reliance on the advice of a professional tax adviser may
constitute reasonable cause and good faith "if, under all the circumstances, such
reliance was reasonable and the taxpayer acted in good faith." Sec. 1.6664-
4(b)(1), Income Tax Regs.
Although taxpayers generally bear the burden of proof under Rule 142(a),
section 7491(c) provides that "the Secretary shall have the burden of production in
any court proceeding with respect to the liability of any individual for any penalty,
addition to tax, or additional amount imposed by this title." To meet his burden of
production under section 7491(c), the Commissioner must produce evidence
regarding the appropriateness of imposing the penalty. Higbee v. Commissioner,
116 T.C. 438, 446 (2001). Once the Commissioner carries his burden of
-55-
[*55] production, the taxpayer bears the burden of proving entitlement to relief
because of substantial authority, adequate disclosure, or reasonable cause. See id.
at 447.
The burden of production that section 7491(c) imposes on the
Commissioner requires him to establish compliance with the supervisory approval
requirement of section 6751(b). Graev v. Commissioner, 149 T.C. 485, 493
(2017), supplementing and overruling in part 147 T.C. 460 (2016). Section
6751(b)(1) provides: "No penalty under this title shall be assessed unless the
initial determination of such assessment is personally approved (in writing) by the
immediate supervisor of the individual making such determination or such higher
level official as the Secretary may designate."
In support of his determination that petitioners are liable for accuracy-
related penalties, respondent argues that petitioners demonstrated negligence in
claiming that the Gearhart property was a business asset and by "fail[ing] to
maintain records to establish their entitlement to claimed deductions and losses."
He also argues that, as an arithmetic matter, "he has met his burden of establishing
substantial understatements of taxes * * * for taxable years 2009 through 2013."
In claiming that he has met his burden of establishing compliance with
section 6751(b), respondent refers to the parties' stipulation that "Supervisory
-56-
[*56] Internal Revenue Agent, also known as Exam Group Manager, Patricia
Crespi, who was the manager or supervisor of one or more of the auditing revenue
agents, signed a Civil Penalty Approval Form * * * with respect to the IRS's audit
of petitioners' taxable years 2011 through 2014 inclusive." Respondent observes
that the civil penalty approval form "approved the assertion of the accuracy-related
penalty * * * on the grounds of negligence and substantial understatement of
income taxes for taxable years 2011 through 2014". He claims that Ms. Crespi's
approval was timely because she signed the civil penalty approval form "on
August 13, 2015, which was before the notice of deficiency for taxable year 2012
was issued on December 16, 2015."18
Respondent suggests that specific approval of the penalties determined for
2009 and 2010 was unnecessary because "[t]he understatements and deficiencies
for * * * [those] years * * * are computational adjustments due to the adjustments
for petitioners' 2011 taxable year, including the disallowance of the Form 4897
[sic] ordinary losses * * * and the net operating loss carryback adjustments."
Therefore, respondent claims, "the accuracy-related penalties for taxable years
18
Although respondent is correct that Ms. Crespi signed the penalty approval
form before the issuance of the notice of deficiency, he has his dates wrong. Ms.
Crespi signed the form on December 16, 2015. The notice of deficiency, which
covers all of the years in issue, not just 2012, is dated January 19, 2016.
-57-
[*57] 2009 and 2010 are also computational adjustments that were also approved
as a part of Ms. Crespi's approval of the accuracy-related penalty for 2011 taxable
year".
In her brief, Mrs. Duffy acknowledges that the returns she filed with her
husband include "several errors", but she blames those errors on the accountants
who prepared the returns. She contends that she and her husband "exercised
reasonable care in having complete and accurate records which they then provided
to * * * [their] CPA for the preparation of the returns in question." "This
conduct," she claims, "reflects a standard of reasonable care sufficient to avoid the
accuracy-related penalties provided for [sic] Internal Revenue Code Section
6662."
Respondent, in dismissing petitioners' reasonable cause argument, alleges
that they
did not establish that their tax return preparers were competent
professionals who had sufficient expertise to justify reliance, what
information and documents they provided to their tax return preparers
much less that they provided the necessary and accurate information
to the tax return preparers or advisors, they actually relied in good
faith on the advisors' judgment, and the incorrect returns * * * were
the result of the accountants' errors.
Consequently, respondent concludes, "petitioners could not have reasonably relied
upon their tax return preparers for taxable years 2009 through 2014, inclusive, and
-58-
[*58] they failed to establish that they acted with reasonable cause and good
faith."
We need not decide whether petitioners' reasonably relied on their return
preparers because we conclude that respondent failed to meet the burden of
production imposed on him by section 7491(c). In particular, respondent has not
established compliance with the supervisory approval requirement of section
6751(b)(1). The civil penalty approval form included in the record establishes that
Ms. Crespi approved the penalties for some of the years in issue, but respondent
has not established that Ms. Crespi is "the immediate supervisor of the individual"
who made the determination to assess penalties. See sec. 6751(b)(1). To establish
that Ms. Crespi's approval complied with section 6751(b)(1), respondent relies on
the parties' stipulation that she "was the manager or supervisor of one or more of
the auditing revenue agents". The stipulation thus does not establish that Ms.
Crespi was the immediate supervisor of the person who made the initial
determination to assess the penalties in issue (whether that person was Ms. Kelly
or someone else). According to the stipulation, Ms. Crespi supervised some of the
agents involved in the audit but not necessarily all of them. Thus, the record does
not demonstrate that Ms. Crespi was the immediate supervisor of the individual
-59-
[*59] who made the initial determination to assess the penalties respondent seeks
to impose.19
Because respondent has not met his burden of demonstrating compliance
with section 6751(b)(1), petitioners are not subject to an accuracy-related penalty
under section 6662 for any of the years in issue.
Decision will be entered under
Rule 155.
19
Because respondent has not established that Ms. Crespi was the
appropriate supervisor to approve the penalties in issue, we need not decide
whether her approval of penalties for 2011 necessarily approved penalties for 2009
and 2010 as well.