Michael D. Brown and Mary M. Brown v. Commissioner

T.C. Memo. 2013-275
UNITED STATES TAX COURT
MICHAEL D. BROWN AND MARY M. BROWN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 1097-07, 2360-07, Filed December 3, 2013.
649-08, 721-09,
31012-09, 5108-11.
Michael Charles Cohen, Jonathan I. Reich, Judianne J. Jaffe, Russell M.
Ozawa, and David L. Rice, for petitioners.
Louis B. Jack and Jeri L. Acromite, for respondent.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: On December 30, 2003, an insurance salesman named
Michael Brown1 took ownership of a $22 million plane in Portland, Oregon. He
flew from there to Seattle to Chicago--he says for business meetings--and then
back to Portland. Brown says these flights put the plane in service in 2003, and
entitle him to a giant bonus-depreciation allowance. But a few days later he had
the plane flown to a plant in Illinois where it underwent additional modifications
that were completed about a month later. The Commissioner says these additional
modifications mean that Brown didn’t place the plane in service until 2004.
We have to figure out what exactly it means to put a plane “in service.”
FINDINGS OF FACT
I. Brown’s Insurance Business
Fitzgerald asserted that “the very rich * * * are different from you and me.”
F. Scott Fitzgerald, “The Rich Boy”, in All the Sad Young Men 1, 5 (1926).
Hemingway replied that “[t]he very rich are different from you and me. * * *
[T]hey have more money.” Ernest Hemingway, “The Snows of Kilimanjaro”, in
The Fifth Column and the First Forty-Nine Stories 58, 78 (1938). The facts of
1
Mary Brown is a party only because she and her husband filed a joint
return. All references to Brown are to Michael Brown.
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[*3] this case show that both statements are true: The very rich have much more
money and they can use it to do things with insurance that most people can’t.
Brown has built his career on figuring out how to help the very rich do these
things. He finds what Fitzgerald called the “compensations and refuges of life,”
Fitzgerald, supra, at 5--or at least of life insurance--for them to use in their estate
planning. And he’s been very successful--he doesn’t bother selling policies worth
less than $10 million, and has sold a handful in the range of $300 million. On
those larger ones, the premiums average between $10 and $15 million per year.
Since Brown’s commission on a policy often equals the first year’s premium, he’s
earned over $10 million on a single policy several times--and once even earned
$17 million on a single deal.
As one might imagine, individuals with the means to buy these policies are
not common, and Brown has to constantly prospect for new clients. Most of these
he gets through referrals, and most of his referrals come from a network of CPAs
and other insurance agents he has nurtured for years. When an agent or
accountant in his network identified a Forbes 400 member pursuing an insurance
program, that contact would often call Brown--an insurance genius often ahead of
the IRS in his understanding of the Code’s intricacies, or at least its apparent
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[*4] intricacies2--to explain and sell the insurance. If Brown closed the deal, he
would share the commission with the one who brought him the lead.
II. Need for an Aircraft
The very rich are also very demanding. Early in his career Brown realized
that relying on commercial flights to meet prospective clients at a moment’s whim
would limit his success, so he began to charter jets. The ability to get to
prospective clients quickly on their own schedules gave him a huge advantage
over his competitors. But eventually even chartering led to missed business
opportunities. Brown credibly testified that jet owners often reneged on their oral
commitment to supply a plane and, as Brown said, “[i]f they decide to use it
themselves, you’re just out of luck.” He recounted one such missed opportunity:
He had set up a meeting with the Koch brothers in Kansas and arranged for a
charter from Orange County to Wichita.3 But when he arrived at the airport, the
plane didn’t show up and the charter company told him that the owner had decided
2
In 2002, a New York Times article credited him and a nationally known
estate-planning attorney with inventing a split-dollar life-insurance arrangement
that enabled Brown’s clients to avoid $9 in estate taxes for every $1 of insurance
they bought. Within a mere three weeks after the article’s publication, the IRS
issued Notice 2002-59, 2002-2 C.B. 481, which disallowed the arrangement’s use.
3
The Koch brothers are part of the family that control Koch Industries, an
exceptionally large privately owned company.
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[*5] to use it for himself. Brown couldn’t fly commercially to Wichita to make the
meeting, and the Kochs didn’t reschedule. He later learned they ended up buying
a policy from another agent that resulted in an $8 million commission.
That missed opportunity in 2001 persuaded Brown to buy a plane for
himself. That plane was a Hawker jet managed by a company called PrivatAir--
and it helped Brown a good deal in meeting the needs of his upscale clientele. He
could even occasionally travel to four different states on the same day to meet with
prospective clients. Owning a plane also enabled him to establish a “certain
rapport” with the “extreme high end of the insurance buyers,” most of whom also
owned their own jets. The Hawker, however, wasn’t perfect. It was “only about a
four[-]hour airplane,” which meant that Brown couldn’t fly nonstop from Los
Angeles to New York--the two cities that he said had the most billionaires--unless
he had a jet stream behind him. Without one, he had to stop in Kansas to refuel,
which stretched a five-hour journey into a seven-hour one.
III. The Search for an Upgrade
This inefficiency wore on Brown, and he decided to upgrade his ride.
Recognizing the low interest rates prevalent in 2003 (compared to the 8% interest
he was paying on the money he borrowed to buy the Hawker), he began to shop
for a longer-range aircraft. His search intensified in May 2003 when Congress
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[*6] increased bonus depreciation from 30% to 50% for certain kinds of property
acquired and placed in service between May 6, 2003 and December 31, 2004. See
Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), Pub. L. No.
108-27, sec. 201, 117 Stat. at 756.
Upon learning of that “big benefit”--and in combination with his
“exceptionally good year”--Brown started his hunt for a better plane. But he
insisted that whatever was offered to him be available for delivery in 2003. After
unsuccessfully trying to buy an airplane on his own, Brown called Woody
McClendon. McClendon was working for a company named Private Jet Services,
Inc., but Brown had known him since his days at PrivatAir, the plane-management
company that Brown had used for years. McClendon directed Brown to a
Bombardier Challenger 604. And McClendon told him that the Challenger would
be available for delivery by the end of 2003--an absolute must for Brown whose
income, and thus whose ability to use very large depreciation allowances, could
vary greatly from year to year.
Brown quickly took off after this lead. He promised a $200,000
commission to Private Jet Services, and McClendon flew to Cahokia, Illinois, to
inspect the jet--then owned by a company called Jetcraft--to ensure a December
delivery. The jet was in Cahokia at the Midcoast Aviation Facility, a plant where
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[*7] owners could have their jets configured and equipped to their specifications.
(Jetcraft had a contract with Midcoast to configure jets that Jetcraft had bought on
speculation.) After confirming that the Challenger would be ready for a December
2003 delivery, McClendon put Brown in touch with Jetcraft and they began to bolt
together a deal. In early December 2003, Brown himself traveled to Cahokia to
check Midcoast’s progress, and took a test flight on a similar Challenger jet that
Midcoast had already finished work on.
Brown liked what he saw and so, on December 16, 2003, he signed a
contract to buy the Challenger for $22 million. He made sure that the contract
required delivery in Oregon by December 31, 2003;4 and if Jetcraft failed to do so,
the contract let Brown terminate the deal and receive a full refund of his entire
deposit. Brown made no secret to Jetcraft and Midcoast that he needed to close by
that date for tax reasons.
IV. Postcontract Modifications
The $22 million Brown promised to pay was not the entire purchase price.
While Brown was in Cahokia, Midcoast showed him some other planes, and one
in particular caught his eye. It had a conference table, in just about the same spot
4
Brown wanted the plane delivered to him in Oregon because that state,
unlike California, has no sales tax.
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[*8] where Brown’s plane had two barcaloungers. Brown was inspired--he “didn’t
want just comfort” from the jet, he “wanted to use it for business.” The
conference table was now a necessity.
McClendon tried to dissuade Brown. He advised him that adding a
conference table was not a good idea, and not just because of its cost and weight.
As McClendon put it, “it was a big job,” requiring a major rework of the airplane,
including rebuilding the floor and installing a separate subhydraulic system.5 But
because McClendon said that Brown told him that he “needed it for his mission,”
Brown insisted that his plane have a conference table.
Brown also wanted another change to the interior. He frequently used
PowerPoint to make presentations to potential clients or fellow insurance agents.
5
Adding a conference table would also increase the plane’s seating
capacity, and more seats meant that federal regulations would require the
installation of a digital flight-data recorder. The Commissioner focuses on the fact
that the flight-data recorder installation was necessary only because Brown wanted
to use the aircraft in a charter business in addition to his insurance business. And
because this modification was not made until 2004, the Commissioner argues that
Brown could not have placed the Challenger in service in 2003. Brown argues
that--even though he did sign a charter agreement for the Challenger beginning
January 1, 2004--he hadn’t decided in 2003 whether to charter it. Brown also
credibly testified that chartering is used only “to defray some of the cost, but it’s
not a business that will make enough money to pay for the airplane.” We make no
finding as to whether Brown intended to have a charter business in 2003, and
therefore we need not--and will not--decide whether the lack of a digital flight
recorder in 2003 prevented Brown from placing the Challenger in service that
year.
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[*9] This was important to the effectiveness of his sales pitch, so he wanted
Midcoast to replace the standard 17-inch display screens with 20-inch screens.
These seemingly minor touches about adding the conference table and upgrading
display screens were important to Brown’s business, and we find his testimony
credible when he stated that “[he] needed those two things done” for his business.
Midcoast hesitated to comply with these demands before delivering the
plane. According to Brown, these modifications were “too specific” and Midcoast
didn’t “like to make super specific adjustments until you’ve already bought the
airplane.” We find, however, that there was a reason Brown didn’t want the
changes made until after he took ownership of the plane: Midcoast estimated that
these modifications--along with a few other requested customizations--would take
at least six weeks. And that would prevent Brown from taking delivery in 2003.
So Brown and Midcoast agreed on an alternative. On December 23, 2003--
one week after Brown signed the contract to buy the plane--Midcoast sent him a
revised form, called an Aircraft Work Authorization, to reconfigure the Challenger
to include, among other things, the conference table and the larger display screens.
The proposal quoted a price for those modifications--along with a few others--of
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[*10] more than $500,000.6 The following day Brown agreed to Midcoast’s
proposal and paid an immediate 10% nonrefundable deposit.7 When Midcoast
received it five days later on December 29, 2003 (the delay allegedly due to a fax-
machine error), McClendon confirmed with a Midcoast representative that--after
Brown took delivery of the airplane before the end of the year--the plane would
return to Midcoast on January 5 or 6 to start the work.
V. Delivery
Brown and his family planned a vacation at the end of the year, but he
didn’t get much rest during those last few days of 2003. Although the parties had
first planned to transfer the Challenger on December 23, 2003, delays started to
creep in, and they rescheduled delivery for December 29 in Portland. Brown had
his personal pilot, Rick Duggan, fly him in his old plane from Cabo San Lucas,
6
Specifically, Midcoast estimated the installation of the conference table
would cost $220,000 and the display screen upgrade $20,000. (The other high-
dollar item in that proposal was the installation of a laser inertial-reference system
estimated to cost $225,000.) The proposal didn’t even include the installation of a
digital flight recorder, which ended up costing yet another $200,000.
7
The paperwork shows that Brown signed this authorization on behalf of
Zulu Equipment, LLC. Brown formed this company for the sole purpose of
buying and owning the Challenger. Because Zulu is a single-member LLC that
didn’t elect to be treated as a corporation, we disregard it as an entity separate
from Brown for tax purposes. See sec. 301.7701-2(c), Proced. & Admin. Regs.
(Jet owners apparently park ownership of their planes in LLCs to limit their
liability if something goes terribly wrong.)
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[*11] Mexico--where Brown had been at his vacation home with his family--to
Chino, California (the old plane’s home base). Then Brown learned that there
were problems with the loan he’d arranged to finance the deal. This meant more
delay.
On the morning of December 30, Brown and Duggan finally flew to
Portland so Brown could take delivery of the Challenger. Brown inspected the
plane, and pronounced it “perfect for some buyers.” He explained that “[i]t was
complete in every way except for two business requirements that [he] needed.”
We find this testimony credible. Brown reiterated that since he “wanted to use
[the plane] for business,” he “needed those two things done.” But, because of the
deal he had cut to have that work done in January 2004, Brown signed the closing
documents and accepted delivery of the Challenger.
Brown understood that taking delivery wasn’t enough to capture the bonus
depreciation he was hunting. So his eventful day had only just begun. In what the
Commissioner calls “tax flights,” Brown proceeded to take several trips in the
Challenger. After fueling the plane around noon,8 a pilot certified to fly the
8
See infra note 12 for discussion regarding the time discrepancy between
the Portland fuel receipt Brown provided at trial and the flight logs.
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[*12] Challenger flew Brown and Duggan9 --along with Brown’s aviation
attorney, Mark Schneider10--from Portland to Seattle, landing just before 1 p.m.
Brown testified that he flew there to have a business lunch with Michael Mastro, a
real-estate developer to whom he had sold a large insurance policy earlier in the
year, and a couple that Mastro wanted to introduce to him as potential clients.11
Brown said that he met them at a restaurant named Carmine’s for maybe an hour-
and-a-half or two. He added that it “turned out like most of the meetings, they
don’t buy.” In addition to his testimony, Brown introduced a letter dated
December 31, 2003 that Mastro wrote and signed. That letter read:
Dear Mike:
I just wanted to thank you for taking the time to fly up here to Seattle
and meet with me yesterday. As you know, it was critical that we
9
Since Duggan hadn’t received training specific to the Challenger--and thus
was not “type rated” for that aircraft--he was not yet able to fly it himself.
10
At trial Brown denied that Schneider was on board. Brown had, however,
previously told the Commissioner in response to an informal discovery request
that Schneider was on that flight “to review and discuss the purchase documents
signed in Portland and related legal matters associated with managing and
operating the aircraft.” Brown didn’t call Schneider to testify and didn’t
satisfactorily explain his earlier statement, which we now find more believable.
11
Brown testified he couldn’t remember the couple’s name. And neither
Mastro nor the unnamed couple testified at trial. (Mastro’s absence was easy to
explain since, according to the parties, he was a fugitive from money-laundering
and fraud charges at the time of trial.)
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[*13] meet before yearend to review the insurance policies that you
sold me earlier this year and discuss future opportunities.
Because of your extraordinary knowledge of insurance and related
matters, I was happy to introduce you to a business associate of mine
and his wife. I enjoyed watching their eyes light up as you discussed
how you could help them take advantage of various estate planning
alternatives. I trust you will be able to turn this introduction into a
win-win situation for both parties.
Again, thanks for all you have done for me and my family in the past
and I look forward to working with you in the future
Best regards,
/s/ Michael Mastro
Michael Mastro
Not only do our eyes not light up, but we sense something doesn’t smell
quite right with the whole Seattle visit. First, Brown’s testimony didn’t jibe with
the flight logs he submitted at audit. Although Brown said his lunch meeting
lasted between 90 minutes and two hours, the flight logs show that the Challenger
was on the ground in Seattle for only 66 minutes. With respect to the timeframe,
we find the flights logs submitted at audit more credible than Brown’s testimony.12
12
Brown introduced new records--a summary flight log and three gasoline
receipts--at trial that he hadn’t previously given to the Commissioner. These
records, however, not only contradict the original flight log that he had previously
turned over to the Commissioner but also aren’t consistent with each other. For
example, the new summary flight log (like the one he provided at audit) shows the
Challenger taking off at 11:50 a.m. local time in Portland, but one of the new--
(continued...)
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[*14] We also give zero credence to the letter. Brown acknowledged that the
letter was neither contemporaneous nor even prepared by Mastro. He admitted his
CFO/CPA, Gary Fitzgerald, drafted the letter sometime much later and had Mastro
sign it. Although at one point Brown said he thought he had told Fitzgerald to
write the letter “several months” after year end, we find more credible his later
testimony that one of Fitzgerald’s jobs is to write letters on behalf of Brown’s
business associates “to get the substantiation for deductions when the IRS requests
them.” (Emphasis added.) We therefore find that Fitzgerald didn’t write this letter
until at least 2006 when the IRS began auditing Brown’s return for the 2003 tax
year. We do not take it seriously as proof of anything but a reason to question
Brown’s credibility.
And that leaves us with only Brown’s uncorroborated testimony about his
lunch in Seattle. Brown didn’t produce a lunch bill, and neither Mastro nor the
12
(...continued)
signed--fuel receipts introduced at trial shows the Challenger being fueled in
Portland almost a half hour later. The new--unsigned--Seattle fuel receipt also
indicates that Brown spent almost four hours in Seattle--about double the time that
Brown himself said he was there. If Brown had been in Seattle for that long, the
Challenger couldn’t have landed at its next destination (Chicago) before 10 p.m.
local time--which is over an hour later than the Chicago fuel-service receipt
provided at trial indicates. We therefore don’t give any weight to the unsigned
Seattle fuel receipt or to the new summary flight log to the extent that it conflicts
with what Brown originally provided.
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[*15] unknown couple testified on his behalf. We also find noteworthy that
Schneider--who was on board the Challenger from Portland to Seattle (but not on
any of the other flights discussed below)--worked at a law firm just outside of
Seattle. We therefore find it more likely than not that there was no business lunch
in Seattle.
Brown, however, was not finished. Sometime between 1 and 2 p.m. local
time, Duggan and Brown flew the Challenger to Chicago, landing about three-and-
a-half hours later at Midway airport. Brown flew there for the sole purpose of
meeting a fellow insurance agent named Marc Pasquale.
There is no doubt that Brown was Pasquale’s mentor. In the late ‘90s
Pasquale--then only in his midtwenties--was a disillusioned CPA working for a
giant accounting firm. In 1998 his father, also a CPA, suggested to him that he
meet Brown. Pasquale grudgingly complied, but Brown quickly won him over--
and at a breakfast meeting in New York, Brown convinced him to leave public
accounting and begin selling insurance.
From “day one” Brown helped establish Pasquale’s insurance career.
Although Pasquale acknowledged that it “was kind of an odd arrangement”
because Brown was in southern California while he was in Chicago, Pasquale
followed Brown around the country to apprentice with him for nearly two years.
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[*16] The two often shared insurance commissions, and Pasquale credibly testified
that he made over a million dollars on the policies that he worked on with Brown
between 2000 and 2003. During that time they spoke several times a week.
So after Brown got off the plane in Chicago, he met with Pasquale at an
airport pizza restaurant. Although Brown at times suggested otherwise, we find--
as Pasquale testified--that Brown himself set this meeting up. The whole visit
lasted about an hour--Brown gave Pasquale a tour of the plane for about 10
minutes and then had a quick dinner for the other 50 or so minutes.
What exactly did they discuss? Brown introduced another letter, very
similar to the one supposedly from Mastro. This letter was signed by Pasquale,
dated December 31, 2003, and looks like it’s on Pasquale’s company letterhead. It
reads:
Dear Mike:
Thanks for coming through for me when I told you how vital it was
for us to meet before the books are closed on 2003.
As we discussed yesterday in Chicago, due to my efforts, we were
able to share insurance commissions on well over a million dollars of
policies in 2003. The list we reviewed, of prospective clients in the greater
Chicago area, should generate even greater commissions in 2004.
Our relationship has always been mutually rewarding in the past, and
based on yesterday’s meeting, looks like it will continue so well into the
future.
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[*17] Thanks again.
Sincerely,
OAK VENTURE ADVISORS, LLC
/s/ Marc A. Pasquale
Marc A. Pasquale
This is just not believable. Brown admitted that Fitzgerald had written the
letter at his direction--like the Mastro letter--and sent it to Pasquale to sign.
(Pasquale confirmed he signed a letter that had been written for him.) Pasquale
“couldn’t recall” exactly when he received it, saying he thought it was at some
point in 2004 but also that it was possible that it was given to him as late as 2006.
In light of that testimony, and Brown’s testimony that one of Fitzgerald’s jobs was
to get documentation for these events only “when the IRS requests [it],” we
find--as we did with the Mastro letter--that Fitzgerald didn’t send this letter to
Pasquale until after the IRS began auditing Brown’s return in 2006.
Now to the letter’s contents. As even Pasquale admitted, this letter was “a
little bit over the top.” Pasquale said he couldn’t stand by the letter’s statement
that he needed to meet with Brown before year end. But we do believe Pasquale’s
testimony that “any time spent with [Brown] face to face was valuable” to him.
So, although Pasquale admitted that he neither wrote nor reviewed the letter, we
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[*18] find that it was important for him in some general way to talk to Brown in
person about business.
What did they discuss? Brown said that they talked about two mutual
clients with whom they were having some difficulty. Pasquale couldn’t remember
any of those details, and we don’t credit Brown’s testimony. That said, Pasquale
credibly testified that of the hundreds of conversations he had with Brown over the
years, “[t]here was not one that didn’t involve business in some way.” Their
whole business is selling policies, Pasquale explained, and all they did was “talk
about who [they’re] going to see, who’s [their] prospects, what’s worth following
up with, what’s not worth following up with, [and] how to coordinate schedules.”
We believe Pasquale when he said that “there’s no doubt” they talked business
that night.
The Challenger remained grounded at Midway for about an hour and a half
before Brown and Duggan boarded it at about 9 p.m. Chicago time to return to
Portland. They returned there a little before midnight local time, and all said,
Brown logged nearly 4,000 miles during his flights that day. The following
morning--New Year’s Eve--Brown and Duggan got back into Brown’s old plane
and returned to Cabo San Lucas where Brown rejoined his family on vacation.
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[*19] The Challenger, however, stayed in Portland. It needed to return to
Midcoast so--in McClendon’s words-- it could be “finish[ed] up.” On January 3,
2004, McClendon flew it from Portland to Arizona (where he lived). The next
day, he took it to Cabo San Lucas to retrieve Brown and his family, dropping them
off in California. A different pilot then flew the plane back to Midcoast in
Cahokia to complete the modifications. Work began on January 5 and lasted
about three weeks.13 After a few additional days of working through an issue
related to obtaining replacement insurance, the completed Challenger was finally
ready to return to Brown on January 30.
VI. The Audit
The Browns claimed almost $11.2 million of bonus depreciation on the
Challenger as an expense for his insurance business on Brown’s 2003 Schedule C,
Profit or Loss from Business. That deduction, however, was far from the only
item on the Browns’ returns over a number of years that started the
Commissioner’s radar beeping loudly. Between 2006 and 2010, the
Commissioner issued six notices of deficiency to the Browns--one for each year
between 2001 and 2006--determining that they had underpaid their tax by over
13
Although Midcoast initially estimated in late December that the
modification would take six weeks, that estimate was reduced to four weeks after
Brown subsequently decided not to have some woodwork done.
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[*20] $30 million, not including penalties under sections 6662 and 6663 of
approximately $10 million.14 The Browns timely filed a petition for each of these
years and we consolidated the cases.
About two weeks before a scheduled two-week trial in Los Angeles (the
Browns were California residents when they filed their petitions), the parties still
hadn’t resolved many of the issues. According to the Commissioner’s 76-page
pretrial memo, Brown had failed to substantiate a litany of his expenses on
Schedule C, claimed fraudulent consulting-fee deductions, used nominees to
conceal ownership and control of entities from the IRS, and created many false
documents in an attempt to support illegitimate deductions. In the week leading
up to trial, however, the parties settled every issue except Brown’s entitlement to
bonus depreciation. We thus tried the case on the single issue of whether Brown
was entitled to deduct over $11 million in bonus depreciation on the Challenger
for 2003. (The parties later filed a stipulation of settled issues that adjusted the
Browns’ income upwards of over $50 million, approximately $10 million of which
was “subject to an addition to tax” for fraud under section 6663, resulting in taxes
and penalties of over $20 million.)
14
All section references are to the Internal Revenue Code in effect at all
relevant times, unless otherwise indicated. All Rule references are to the Tax
Court Rules of Practice and Procedure.
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[*21] OPINION
The dispute here is over timing. The Commissioner concedes that Brown
could properly claim bonus depreciation on the Challenger for 2004. The
Commissioner, however, asserts there are two independent barriers that prevent
Brown from claiming the deduction for 2003. First, he contends that the
Challenger was not placed in service in 2003. But even if it was, the
Commissioner argues that Brown still loses because he didn’t substantiate
qualified business use for that year. We begin with a few passes over the lush and
tangled landscape of bonus depreciation.
I. Bonus Depreciation
We start with depreciation: Since tax policy desires generally to match
income with the expenses of producing that income, see INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992), the Code allows a deduction for the
exhaustion and wear and tear of property used in a trade or business, sec. 167(a).
This allows taxes to more closely reflect economic profit. To determine the annual
wear-and-tear, the Code generally requires taxpayers to use the modified
accelerated cost recovery system (MACRS) set up in section 168.
Enacted as part of the Economic Recovery Tax Act of 1981, Pub. L. No. 97-
34, sec. 201(a), 95 Stat. At 203--and substantially amended by the Tax Reform Act
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[*22] of 1986, Pub. L. No. 99-514, secs. 201, 203, 100 Stat. at 2121, 2143 (which
ushered in the MACRS regime)--section 168 has been tinkered with by Congress
so often over the years that it has become, even by the standards of the Code,
unusually complex. The many layers of amendments to the section have been of
many different shapes and sizes, but they still often show some semblance of
connection to the section’s original purpose--economic stimulation.
And this was true immediately after September 11, 2001. Concerned
about the effects the terrorist attacks might have on the economy, Congress
enacted section 168(k). That subsection granted a “special allowance” for certain
property acquired after September 10, 2001 and before January 1, 2005. See Job
Creation and Worker Assistance Act of 2002, Pub. L. No. 107-147, sec. 101, 116
Stat. at 22. In the case of “qualified property,” the depreciation deduction under
section 167(a) “for the taxable year in which the property is placed in service shall
include an allowance equal to 30 percent of the adjusted basis of the qualified
property” in addition to depreciation otherwise allowable under MACRS. Sec.
168(k)(1)(A) (emphasis added). This special allowance became known
colloquially as bonus depreciation.
Less than two years later, Congress upped the bonus. See JGTRRA
sec.201. Under new paragraph (4) of subsection (k), Congress increased bonus
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[*23] depreciation for “qualified property” acquired and “placed in service” after
May 5, 2003 and before January 1, 2005 from 30% to 50%. Sec. 168(k)(4)(B).
For Brown to properly claim bonus depreciation for 2003, the Challenger must
thus have been both qualified property and qualified property that was acquired
and placed in service that year.
II. Qualified Property
What is “qualified property?” As relevant here, the Code defines “qualified
property” as property with “a recovery period of 20 years or less.” Sec.
168(k)(2)(A)(i)(I). Noncommercial airplanes have a recovery period of five years,
see Rev. Proc. 87-56, 1987-2 C.B. 674, so the Challenger flies past that test with
no problem.
There are, however, exceptions that can bring otherwise “qualified
property” to ground. See sec. 168(k)(2)(C). One of those is if the property is
subject to the alternative depreciation system under section 168(g).15 Sec.
168(k)(2)(C)(i). And to determine whether section 168(g) applies to property, we
must first apply section 280F(b)--a section that relates to “listed property” with
limited business use. See sec. 168(k)(2)(C)(i)(II).
15
Section 168(g) requires the use of an alternative (and less favorable)
depreciation system for five specified categories of property.
- 24 -
[*24] Section 280F(b) sends us down another runway. Under section
280F(b)(1), a taxpayer must use the alternative depreciation system under section
168(g) if “listed property” is not “predominantly used in a qualified business use”
for a certain taxable year. “Listed property” includes property that’s used as a
means of transportation, such as the Challenger. See sec. 280F(d)(4)(A)(ii). The
term “predominantly used in a qualified business use” means that the listed
property’s “business use percentage” must exceed 50%. Sec. 280F(b)(3). And
“business use percentage” means the percentage of use which is a “qualified
business use.” Sec. 280F(d)(6)(A). And generally, “qualified business use” is
“any use in a trade or business of the taxpayer.”16 Sec. 280F(d)(6)(B) (emphasis
added). Thus, if Brown proved that he “used” the Challenger in any way in his
business in 2003 more than 50% of the time he flew it (i.e., if the majority of his
flight miles on December 30 were used any way in his business), then the
alternative depreciation system under section 168(g) wouldn’t apply, and the
16
An exception is that “qualified business use” doesn’t include leasing
property to a 5-percent owner or related person. Sec. 280F(d)(6)(C)(i)(I).
Although Zulu Equipment leased the Challenger to Brown in 2003, it’s
disregarded as a separate entity for tax purposes because it’s an LLC wholly
owned by Brown. See supra note 7. Thus, the lease is also disregarded for tax
purposes. See sec. 301.7701-2(a), Proced. & Admin. Regs (“[I]f the entity is
disregarded, its activities are treated in the same manner as a sole proprietorship,
branch, or division of its owner”).
- 25 -
[*25] Challenger would be considered “qualified property” for bonus-depreciation
purposes.17
III. Placed in Service
That’s a hard question to answer, and we think it makes sense to keep it on
standby--and move to the question of whether Brown placed his new plane in
service within the meaning of the regulations.
Remember that section 168(k) says that for qualified property, “the
depreciation deduction provided by section 167(a) for the taxable year in which
such property is placed in service shall” be eligible for 50% bonus depreciation.
Sec. 168(k)(4)(A) (emphasis added). The regulation says that “[p]roperty is first
placed in service when first placed in a condition or state of readiness and
availability for a specifically assigned function.” Sec. 1.167(a)-11(e)(1)(1),
Income Tax Regs. (emphasis added). So the question comes down to whether in
17
We note again the standard is “any use in a trade or business,” sec.
280F(d)(6)(B), which isn’t the same as the “ordinary and necessary” standard
generally required of business deductions under section 162. We have also held
that “[n]owhere in the language of section 168 is there a suggestion that
availability of the depreciation deduction is dependent on the satisfaction of the
requirements of section 162. There simply is no requirement that the use of the
depreciable property be ‘ordinary’ or ‘necessary.’ The only requirement is that it
be used in the taxpayer’s trade or business.” Noyce v. Commissioner, 97 T.C.
670, 689-90 (1991).
- 26 -
[*26] 2003 the Challenger was “in a condition or state of readiness and
availability” for the “specifically assigned function” for which Brown purchased
it.
The Commissioner argues that the Challenger’s specifically assigned
function was to serve as an aircraft configured in the manner Brown deemed
necessary for his insurance business. And that configuration included a
conference table and enhanced display screens. The Commissioner says that since
those two modifications weren’t made until January 2004 the Challenger wasn’t
ready for its specifically assigned function until then.
Brown disagrees. And with neither Code nor regulation to guide us, we
must navigate using only caselaw. The earliest case the Commissioner relies on is
Noell v. Commissioner, 66 T.C. 718 (1976). The taxpayer in Noell built an airport
runway between late 1965 and late 1968, which required him to grade the land,
supply a rock base, lay down asphalt pavement, and plant sod. Id. at 721. After
he laid down the rock base in 1967--but before he completed the project--pilots
did occasionally use the runway to land and take off. The roughness of the
incomplete surface however, made it unsatisfactory for permanent use, and
available only in good weather. Id. The taxpayer wanted an investment credit for
- 27 -
[*27] the runway against his 1968 tax bill.18 The Commissioner argued, however,
that since airplanes began to use the runway in 1967, the taxpayer had placed it in
service--and thus had to take the credit--that year. Id. at 728.
We rejected the Commissioner’s position. We said that the “runway was
not in a condition or state of readiness” in 1967 because the rock surface was
“clearly only a stage in the construction of the facility” and it “was quite
unsatisfactory and pilots risked damaging their aircraft by landing on it.” We also
said that “the rock surface could not be used on a permanent basis, since the
landing area easily could be ruined by the weather.” We therefore held that since
the facility wasn’t available for full service until the runway was paved in 1968,
the taxpayer hadn’t placed the landing facility in service in 1967. Id. at 729.
The Commissioner makes a similar argument here. He says the
configuration of the Challenger in 2003 was “clearly only a stage in the
construction” of the asset and that the delivery of the Challenger in Portland on
December 30 was “nothing more than an interruption in the completion of the
18
The regulation defining “placed in service” for purposes of the investment
tax credit is identical to the “placed in service” definition in the depreciation
regulations. Compare sec. 1.46-3(d)(1)(ii), Income Tax Regs., with sec. 1.167(a)-
11(e)(1)(i), Income Tax Regs.; see generally Shirley v. Commissioner, T.C.
Memo. 2004-188 (proper to use regulations of repealed section if new section
nearly identical).
- 28 -
[*28] aircraft.” While that characterization likely understates how much of the
aircraft had been completed by the end of 2003, we do agree with the
Commissioner that Noell is relevant here. That is so because in 2003 the plane,
like the runway in Noell, was “simply not available for full service” for its
intended function--serving Brown’s air transportation needs in his insurance
business. See id. at 728. And until an asset is available for full service, it hasn’t
been placed in service. See id.
Brown disagrees, and argues that his plane was “fully functional for air
transportation” and that, unlike planes landing on the runway described in Noell,
his plane neither suffered nor threatened “safety hazards from its use or weather
limitations when placed in service in 2003.” The 2004 modifications, Brown says,
“merely provided enhancing features that did not involve improvements necessary
to allow the Challenger to serve its specific function of providing air
transportation in connection with Brown’s insurance business.”
We agree with Brown that the Challenger “was fully functional for air
transportation.” But that’s not quite the right question. The regulation tells us to
decide when the plane was ready and available for a “specifically assigned
function.” Sec. 1.167(a)-11(e)(1)(1), Income Tax Regs.
- 29 -
[*29] What exactly was the specifically assigned function of Brown’s new
plane? Brown asserts in his brief that the 2004 modifications were merely
“enhancing features” which implies that the specifically assigned function was
simply to fly Brown to and from meetings with his clients or leads. But this would
contradict his testimony. According to that testimony, his insurance business
required that the airplane have a conference table and the larger screens so he
could make his Power Point presentations to clients and other agents--and those
presentations were not a peripheral part of his business. Without those two
requirements, the Challenger wasn’t fully functional for the very specific needs of
Brown’s insurance business.
The Commissioner cites two other cases that point us in the same direction--
Consumers Power Co. v. Commissioner, 89 T.C. 710 (1987), and Valley Natural
Fuels v. Commissioner, T.C. Memo. 1991-341, 1991 Tax Ct. Memo. LEXIS 390,
aff’d without published opinion, 990 F.2d 1266 (9th Cir. 1993). We’ll start with
Consumers Power. There, an electric utility began construction of a hydroelectric
plant in 1969. Id. at 716. Regulators approved the utility’s request to begin
operating the plant, subject to successful completion of preoperational testing on a
particular unit. Id. at 717. That unit--Unit 1--began pumping water and for about
a two-week period in late November and early December 1972 generated electrical
- 30 -
[*30] power, substantially all of which was sold to the taxpayer’s customers. Id. at
718-19. On December 7, however, a disruption in the unit’s electrical power
caused damage that led to a temporary shutdown for repairs. Id. at 719.
Preoperational testing didn’t resume until early in 1973. Id.
The taxpayer claimed a depreciation deduction on the plant for 1972, but the
Commissioner determined the plant wasn’t placed in service that year and thus
disallowed the deduction. Id. We agreed with the Commissioner, finding that
Unit 1 was not available to provide electrical power on a regular basis in 1972 and
that the amount of electrical power generated that year wasn’t sufficient to
establish that the plant was available for “full operation on a regular basis.” Id. at
725 (emphasis added). We found instead that the plant wasn’t available for use
until it had completed all preoperational testing in January 1973. Only after the
unit had demonstrated that “it was available for service on a regular basis was the
unit in a state of readiness and availability for its specifically assigned function.”
Id. (emphasis added).
The analogy to this case is close. Just as Unit 1 actually pumped water and
generated electrical power that was sold to customers in late 1972, so did Brown
actually fly in the Challenger halfway across the country in late 2003 to talk
business (with at least one of the people he said he did). But the fact that a
- 31 -
[*31] taxpayer uses an asset in his business sometime during the course of a year
doesn’t necessarily mean that he placed it in service that year. Consumers Power
tells us instead that the asset needs to be available on a regular basis for its
specifically assigned function. And like the unit in Consumers Power that
suffered an interruption in its use after it had generated electricity, the Challenger,
after Brown flew in it one day in 2003, was grounded for three weeks at the
beginning of 2004 so Midcoast could make the modifications that Brown required
for his new plane to serve him on a regular basis for its specifically assigned
function--not just moving Brown across country but enabling him to make his
pitches on big screens to executives sitting at a conference table and not sprawled
out in a lounge chair.
Brown would have us distinguish Consumers Power “on the simple grounds
that the Challenger had already completed and passed flight testing, was
flightworthy, and licensed for flight when” Brown used it “for the regular service
of air transportation in 2003.” This might be a good argument if precedent
focused, for example, on an asset’s having cleared any regulatory hurdles it
needed to clear. But there are a great many depreciable assets which, unlike
power plants and jet aircraft, don’t have these sorts of regulatory obstacles. For
these assets--and here we make the test a generally useful one--as well as assets
- 32 -
[*32] like power plants and planes, our caselaw tells us to look at whether the
asset involved is ready and available for full operation on a regular basis for its
specifically assigned function. See id. at 724. Brown himself testified that the
Challenger--as it was on December 30, 2003--wasn’t sufficient to meet his specific
business needs because the big screens and the conference table weren’t yet
installed.
We turn next to Valley Natural Fuels. That case arose from a partnership’s
acquisition of an ethanol-distillation plant. Since the partnership’s objective was
to produce and sell anhydrous ethanol (198.2+ proof ethyl alcohol), it bought the
facility on an understanding that the plant could produce at least 1,500 gallons of
199+ proof ethanol per day. Valley Natural Fuels, 1991 Tax Ct. Memo. LEXIS
390, at *18. The plant began operations in December 1983, but couldn’t at first
produce 198.2-proof ethanol without a molecular sieve, and actual ethanol
production was less than 1,500 gallons per day. Id. at *5. The partnership didn’t
have the molecular sieve installed until spring 1984 (and the plant needed still
more equipment installed in 1985 to make it run properly.) Id. On its 1983 return,
however, the partnership claimed a depreciation deduction on the ethanol-
distribution equipment. Id. at *9. The Commissioner argued that the plant wasn’t
- 33 -
[*33] placed in service or in a state of readiness to be placed in service by the end
of that year. Id. at *11.
We sided with the Commissioner. We ultimately found that the “assigned
function of the facility was to produce and sell 198.2 proof ethanol,” and
concluded that the “facility was not in a condition or state of readiness and
availability for its assigned function” in 1983. Id. at *11-*12. We rejected the
partnership’s argument that it “was improper to assume that the taxpayer’s
business objective must automatically equate to the assigned function of the
taxpayer’s equipment.” Id. at *18-*19. We also rejected its argument that
Consumers Power was distinguishable because the partnership in Valley Natural
Fuels formally accepted the facility in 1983 whereas the taxpayer in Consumers
Power didn’t formally accept the plant until a year later than the one at issue. Id.
at *23. We pointed out that this distinction was likely not “a fair characterization
of the facts,” but in any event that alleged difference was “not dispositive.” Id.
Instead, the dispositive question was whether the plant “‘was available for service
on a regular basis’ and hence in a state of readiness and availability for its
specifically assigned function.” Id. (quoting Consumers Power, 98 T.C. 724).
While we acknowledged that the regulation doesn’t “require that property
be free of all flaws and defects as of the time that it is first operated,” we
- 34 -
[*34] ultimately said “the property must be operating in the fulfillment of its
specifically assigned function.” Id. at *24 (citing Noell, 66 T.C. 728-29).
Because the facility wasn’t capable of performing its specifically assigned
function--the production of 198.2 proof ethanol--in 1983, we concluded that it
wasn’t placed in service that year. Id. at *26. Rather, “only after all of the[]
component assets were installed and functioning [in 1985] did the facility
constitute a complete unit that was operational and served the purpose intended
by” the partnership. Id. at *26.
We agree with the Commissioner that Brown’s case is similar to these two
precedents. Like the unit in Consumers Power that wasn’t quite fully ready and
available for regular service in 1972 for its specifically assigned function, the
Challenger wasn’t first available for full operation in Brown’s insurance business
on a regular basis in 2003. And, just as the ethanol plant in Valley Natural Fuels
needed to have all of its components in place and functioning in the right way to
fulfill its specifically assigned function before we could find that it was placed in
service, so too did the Challenger require installation of all of its necessary parts--
including the conference table and enlarged display screens--to fulfill its
specifically assigned function before it was placed in service. Valley Natural
Fuels is also helpful in its observation that there’s nothing wrong in equating a
- 35 -
[*35] taxpayer’s stated business objective for some feature (e.g., Brown’s
requirement that his plane have a conference table and larger screens to help him
sell insurance) with an asset’s “specifically assigned function.” Much of the Code
and regs is written in the passive voice, and it is sometimes hard to figure out who
the actor in any particular sentence is supposed to be. Not so here. Cases like
Consumers Power and Valley Natural Fuels tell us to look at the taxpayer--he’s the
one who gets to determine what an asset’s “specifically assigned function” is.
And here that asset’s function wasn’t just to fly Brown around; it was to be
configured in a particular way to meet his very particular business needs. Even
though an asset like the Challenger may be operational, it’s not placed in service
until it is operational for its intended use on a regular basis.
The Commissioner directs us next to 85 Gorgonio Wind Generating Co. v.
Commissioner, T.C. Memo. 1994-544, 1994 WL 591909. That case started with a
partnership that invested in two wind-turbine generators. Id. 1994 WL 591909 at
*5. It acquired them, mounted drivetrains on towers, and even connected them to
a grid by the end of 1985. Id. But they were fitted only with helicopter blades
significantly shorter than those called for in the design specifications, and neither
one had been equipped with a controller. Id. And although the turbines could
produce electricity under favorable wind conditions through manual operation
- 36 -
[*36] with those blades, the lack of instrumentation prevented continuous
ground-level monitoring of the wind turbines’ sensors in an efficient manner. Id.
(One of the turbines was fitted with an automatic controller in 1986, and the other
one wasn’t fitted until sometime after that. Id.) The partnership took depreciation
deductions with respect to the turbines for 1985, but the Commissioner disallowed
them for that year. Id. at *1, *6.
We found that the partnership acquired the generators “for the purpose of
producing electricity for sale to a utility.” Id. at *6. And we then found that
“[n]either wind turbine acquired by the partnership was capable of regular,
ongoing operation for the production of electricity during 1985.” Id. We
therefore found that in 1985 neither of the generators was placed in a condition of
readiness and availability for its assigned function--the ongoing production of
electricity. Id. Although we acknowledged that operation of the turbines without
the controllers “was theoretically possible,” it was “unlikely” that they could’ve
been “operated on a regular, ongoing basis for the production of electricity without
electronic controllers.” Id. at *9. In conclusion, relying on Noell, Consumers
Power, and Valley Natural Fuels, we held that since neither of the generators
“[was] available for full service” in 1985, neither was placed in service that year.
Id.
- 37 -
[*37] These cases teach us that not just any use of an asset will satisfy the
placed-in-service standard. An asset must instead be available for its intended use
on a regular, ongoing basis before we can find it “placed in service” in the tax
year in question. Brown argues, however, that in contrast to the wind turbines--
whose operation was “theoretically possible”--the Challenger’s operation on
December 30, 2003 “was not a question of theory, but a matter of plain fact. As
evidenced by the round trip flights halfway across the continent in 2003, there
were no impairments to its full, regular functionality as a business aircraft in
2003.”
But that’s not what the cases tell us to look for. The problem with the
Challenger was that, although it would have been, as Brown said, “perfect for
some buyers,” it wasn’t complete for him without the “two business requirements
that [he] needed.” And without those two post-2003 modifications, the Challenger
wasn’t “in a state of availability for the specific intended function in” Brown’s
insurance business in 2003.
We do agree with Brown that the caselaw does not require that an asset
actually be used before it’s regarded as “placed in service.” In Sears Oil v.
Commissioner, 359 F.2d 191 (2d Cir. 1966), aff’g in part, rev’g in part T.C.
Memo. 1965-39, a barge was ready for use in the taxpayer’s business by December
- 38 -
[*38] 1957, but couldn’t actually be used because it was locked in ice in a canal
until May 1958. Id. The Second Circuit held that because the barge was “ready
for use” and “subject to the weather elements all winter,” “[i]t seem[ed] only
proper, in order to reflect the gradual deterioration of the completed asset that was
taking place during this period, that part of the cost of the asset be allocated as a
depreciation deduction to December 1957 and the remaining months of the winter
of 1957-1958.” Id. at 198. What we can glean from that holding is that it’s
possible for a taxpayer to place an asset in service for a certain tax year even
without using it that year. See Consumers Power, 89 T.C. 725 (“[T]he assets in
question [in Sears Oil] were held to have been placed in service during the taxable
year because they were ready and available to perform their specifically assigned
functions, even though the taxpayers were precluded from using the assets during
the taxable year due to circumstances beyond their control”). Contrary to what
Brown contends, however, Sears Oil doesn’t stand for the different proposition
that as long as an asset has been “used” in a certain year, it has also been “placed
in service” that year.
Brown points us in his reply brief to one case--Hellings v. Commissioner,
T.C. Memo. 1994-24, 2004 WL 17916--that does support his position. In
Hellings, two taxpayers formed a partnership on December 21, 1983 to engage in
- 39 -
[*39] sailboat chartering, and their partnership bought a sailboat that same day.
Id., 2004 WL 17916 at *3. It quickly entered into a charter agreement for the final
ten days of 1983 with a third party--Bay Yacht Agency--that both sold and
managed boats. (It also entered into a separate charter agreement with Bay Yacht
for 1984.) Since Bay Yacht didn’t have a similar sailboat in stock, it wanted to
have the sailboat available as a demonstration model to show prospective buyers--
and the parties agreed on a discounted fee because the boat would not be subject to
the normal wear and tear of a regular charter. We found that, by the end of 1983,
“the boat was fully equipped and charter-ready, except for sails which could be
easily borrowed.” Id. (emphasis added). The taxpayers took a depreciation
deduction in 1983 for the sailboat, but the Commissioner disallowed it, because he
thought that the boat wasn’t placed in service until 1984. Id. at *1, *8.
We sided with the taxpayers. We found that the boat’s “specifically
assigned function * * * was use as a charter boat,” and at the time the taxpayers
purchased the boat “it was charter-ready.” Id. at *8. Although we acknowledged
that “additional equipment was added later, and the boat may not have been as
attractive to prospective charterers at that time as it was after the additional
equipment was added, the boat was sailable, and ready to be chartered” in 1983.
Id. Although the Commissioner emphasized “that the boat was not actually in the
- 40 -
[*40] water when [the taxpayers] purchased it and was not placed in the water
until April 1984,” we found those facts not “controlling”, noting that the boat was
in the water two months before the taxpayers purchased it. Id. We also found
persuasive the fact that the charter agreement between the partnership and Bay
Yacht didn’t restrict Bay Yacht from placing the boat in the water and sailing it.
Id.
Brown contends that “[i]f a sailboat without sails, and apparently without an
array of safety equipment, is ready for the assigned function of charter
transportation,” there’s “no doubt that the Challenger was fully ready for the
assigned function of transporting [him] when it was lacking only the conveniences
of a conference table and larger video screens.” Truly, if Hellings were the only
case on point, we’d have to agree with Brown. But where we have gaps in the
Code and regs that need to be welded or riveted together to keep like cases
decided alike, any one case’s persuasiveness often depends on how it treats earlier
ones. In Hellings, we did not mention, much less distinguish, Noell, Consumers
Power, or Valley Natural Fuels in concluding that the taxpayers placed the boat in
service in 1983. And though we did find that the boat was “fully equipped” even
without having sails, we also found that those sails “could be easily borrowed.”
Id. Perhaps the sail in that case were like jet fuel in this one--essential to making
- 41 -
[*41] the asset move, but so readily available that its absence at a particular time
would not prevent the asset’s being placed in service. But we have to admit that
that’d be a stretch--so we think it best to confine Hellings to its peculiar facts.
Consumers Power is a T.C. Opinion, so we must follow it -- which means that we
should follow its reasoning as elaborated and illuminated by the facts of later cases
that discuss it, and not a possible outlier that doesn’t.
Brown understandably downplays the significance of the 2004
modifications. While acknowledging in his briefs that those modifications made
the Challenger “more valuable to him” and allowed him to “more comfortably
conduct business” as a passenger, he says they have “nothing to do with the
Challenger’s assigned function of transporting him for his business.” The problem
is that this posttrial framing just doesn’t square with the trial testimony, in which
Brown testified that those two modifications were “needed” and “required”. We
therefore find that the Challenger simply was not available for its intended use on
a regular basis until those modifications were installed in 2004. Brown thus didn’t
place the Challenger in service in 2003 and can’t take bonus depreciation on it that
year.
- 42 -
[*42] IV. Penalties
A. Fraud Penalty
Section 6663(a) imposes a penalty equal to 75% of the portion of the
underpayment that is attributable to fraud. The Commissioner asserted that the
fraud penalty applied to some of the adjustments in the notices of deficiency. He
has the burden of proving fraud and, to do so, must have clear and convincing
evidence that a taxpayer underpaid and that his underpayment was attributable to
fraud. Sec. 7454(a); Rule 142(b); Akland v. Commissioner, 767 F.2d 618, 621
(9th Cir. 1985), aff’g T.C. Memo. 1983-249.
However, that’s only the general rule. The burden can shift in some cases--
and it does so here because if the Commissioner proves that any part of the
underpayment for a taxable year is attributable to fraud, then “the entire
underpayment shall be treated as attributable to fraud, except with respect to any
portion of the underpayment which the taxpayer establishes (by a preponderance
of evidence) is not attributable to fraud.” Sec. 6663(b). In the stipulation of
settled issues, the Browns agreed that more than $1.8 million of the adjustments
made to their income for 2003 will be subject to the fraud penalty. This puts on
- 43 -
[*43] them the burden of showing that the bonus-depreciation deduction taken for
the Challenger in 2003 was not attributable to fraud.19
Fraud is the intentional wrongdoing with the specific purpose of avoiding a
tax believed to be owed. See DiLeo v. Commissioner, 96 T.C. 858, 874 (1991),
aff’d, 959 F.2d 16 (2d Cir. 1992). In other words, it’s the “willful attempt to evade
tax.” Beaver v. Commissioner, 55 T.C. 85, 92 (1970). Since direct proof of a
taxpayer’s fraudulent intent is rarely available, we usually look to circumstantial
evidence to determine whether it exists. DiLeo, 96 T.C. 874. Over the years,
courts have developed a nonexclusive list of factors--often referred to as badges of
fraud--that demonstrate fraudulent intent. Those badges include:
• understating income;
• maintaining inadequate records;
• failing to file tax returns;
• implausible or inconsistent explanations of behavior;
• concealing assets;
• failing to cooperate with tax authorities;
19
In the case of a joint return--as there is here--section 6663 doesn’t apply
with respect to both spouses unless some part of the underpayment is due to both
spouses’ fraud. Sec. 6663(c). Mary Brown stipulated to the adjustments made in
the stipulation of settled issues, so the burden also shifts with respect to her.
- 44 -
[*44] • filing false documents;
• engaging in illegal activity; and
• attempting to conceal illegal activity.
See Spies v. United States, 317 U.S. 492, 499 (1943); Bradford v. Commissioner,
796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Niedringhaus v.
Commissioner, 99 T.C. 202, 211 (1992). We also consider a taxpayer’s level of
sophistication in tax matters. See Laurins v. Commissioner, 889 F.2d 910, 913
(9th Cir. 1989), aff’g T.C. Memo. 1987-265.
The Browns point to several facts that they contend should negate the fraud
penalty with respect to the bonus-depreciation deduction. They say that it’s clear
that Brown bought the Challenger in 2003, didn’t misstate its cost, flew in it on
December 30 of that year, and used it on that day to meet with people with whom
he had a significant business connection.
The Commissioner would nevertheless focus us on three factors that he says
support imposition of the fraud penalty for any portion of the underpayment due to
the bonus-depreciation deduction:
• the false “thank you” letters;
• Brown’s level of sophistication; and
• Brown’s pattern of substantially overstating deductions.
- 45 -
[*45] The Commissioner first contends that the “thank you” letters--purportedly
from Mastro and Pasquale but really drafted by one of Brown’s employees years
later--were false documents. The Commissioner is correct that making false
documents is one of the factors that indicates fraud. See, e.g., Spies, 317 U.S. at
499. Still, while these letters weren’t actually written by Mastro or Pasquale, we
know at least Pasquale did sign the one with his name on it. Thus, while the
contents of Pasquale’s letter were--as Pasquale mildly put it--“a little bit over the
top,” it’s not clear that the contents of either letter were patently false.
But even if they were, we don’t find that they bear on the fraud analysis
here. It’s well established that fraudulent intent must exist at the time the taxpayer
files the return. See Gleis v. Commissioner, 24 T.C. 941, 952 (1995), aff’d, 245
F.2d 237 (6th Cir. 1957); Holmes v. Commissioner, T.C. Memo. 2012-251, at *37.
We found that Brown (via Fitzgerald) generated those letters during the audit
process; that is, actions that took place after the filing of the return. While we
have said that postfiling events can indicate fraudulent intent at the time of filing,
see Holmes, at *37, we don’t see any evidence that Brown formed the intent to
create those letters when he filed the 2003 return. Brown testified that his practice
was to have Fitzgerald write letters on behalf of business associates only “when
the IRS requests them”--that is, after a return has been filed. On the unusual facts
- 46 -
[*46] of this case, we do find this bit of Brown’s testimony credible, and it does
persuade us that the letters are not good proof that Brown intended to evade tax at
the time he filed his returns. See id. at *41 (finding that “[A]lthough petitioner
failed to cooperate with respondent’s agents by intentionally submitting a false
document, his failure does not compel the conclusion that he had a fraudulent
intent in filing his 2000-04 tax returns”); id. at *32 (“Although respondent has
proffered some evidence of fraud, that evidence relates exclusively to petitioner’s
postfiling actions and does not convince us of his intention to evade tax when he
filed his tax return for each year in issue”).
The Commissioner also argues that we should factor in Brown’s level of
sophistication. He would have us weigh two other incidents that he says show
Brown committed fraud--Brown’s signature on a false letter to the California
Board of Equalization to avoid California sales tax when he bought the Hawker
and Fitzgerald’s drafting of false letters for former employees to sign to
corroborate that position. At trial, however, we didn’t admit this extrinsic
evidence to prove specific instances of Brown’s conduct with respect to these
collateral matters, see Fed. R. Evid. 608(b), and thus we won’t let the
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[*47] Commissioner use it here to support a fraud finding through a backdoor
argument that Brown’s alleged bad acts show his sophistication.20
Lastly, the Commissioner argues that--by virtue of the stipulation of settled
issues--Brown has engaged in a “four-year pattern of fraud,” and that a “pattern of
substantially overstating deductions supports a finding of fraud.” Generally a
“pattern of underreporting in years not at issue does tend to show fraud,” Fiore v.
Commissioner, T.C. Memo. 2013-21, at *18, “particularly when accompanied by
other circumstances exhibiting an intent to conceal,” Holmes, T.C. Memo. 2012-
251, at *32. Indeed, the stipulation of settled issues reflects tens of millions of
dollars of increased adjustments to income made to the Browns’ returns between
2001 and 2006--including about $10 million resulting in underpayments subject to
the fraud penalty. That document does indicate a pattern of substantial
underreporting of income.
We’re not focusing here, however, on whether Brown committed fraud on
the returns generally; rather we’re looking at whether he has shown by a
preponderance of evidence that he didn’t commit fraud with respect to one specific
20
The Commissioner also points out that even though Brown--as an
experienced businessmen--was well aware of the need for contemporaneous
substantiation, he failed to keep such records and instead resorted to create false,
backdated letters. As we stated above, those letters don’t help support a finding of
fraud because they were created after the filing of the returns.
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[*48] deduction. The Commissioner concedes that the bonus-depreciation
deduction at issue is a legitimate business expense (albeit for 2004, not 2003).
While that concession alone certainly doesn’t shield Brown from fraud, we also
find persuasive that Brown actually bought the plane and took ownership of it in
2003. And we also find noteworthy that Pasquale credibly testified that Brown
flew to Chicago that year to talk business with him.
We do acknowledge that the absence of one of those facts would make it a
closer call. Cf. Hicks v. Commissioner, T.C. Memo. 2011-180, 2011 WL
3240843, at *3 (finding fraud when taxpayer improperly took depreciation
deduction in 1998 on unfinished airplane that he flew once that year because
neither did the taxpayer take delivery of it that year nor was there any evidence
that he used it for any business purpose); Smith v. Commissioner, T.C. Memo.
1992-353, 1992 WL 137448 (finding fraud when taxpayers improperly took
depreciation deduction on charter boat for 1982 instead of 1983 based on finding
that taxpayers had no reasonable belief that boat was even delivered to its port of
final destination--much less actually chartered--in 1982), aff’d without published
opinion, 993 F.2d 1539 (4th Cir. 1993). The facts here--although insufficient to
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[*49] satisfy the placed-in-service standard21--taken together do show that Brown
actually tried to meet the Code’s requirements for bonus depreciation by the end of
2003, and we conclude that he has shown that he actually believed that he
completed all of the steps necessary to use the plane in his business in 2003 which
would allow him to properly claim the bonus-depreciation deduction for that year.
We therefore find that Brown didn’t intend to willfully evade tax when he claimed
the bonus-depreciation deduction for 2003.22
B. Accuracy-Related Penalty
But that doesn’t necessarily mean that the Browns escape penalty free. As
an alternative to the fraud penalty, the Commissioner seeks a 20% accuracy-
related penalty under section 6662(a) on the underpayment of tax attributable to
the disallowance of the bonus-depreciation deduction. The Commissioner, who
21
We again note that we make no determination here whether Brown met
his burden to substantiate qualified business use for the Challenger in 2003.
22
This may have an unusual effect: The disallowance of the bonus-
depreciation deduction may well be the only adjustment that causes an
underpayment for 2003. And the parties stipulated not that a part of Brown’s
underpayment for 2003 was due to fraud but rather, that a portion of the
adjustment to income “shall be subject to an addition to tax under [section] 6663.”
Section 6663(b) doesn’t kick in unless the Commissioner proves that part of an
underpayment is attributable to fraud. We will fly over, but note, the strangeness
of section 6663’s shifting the burden of proof when one can’t tell until the end of a
case whether there’s actually been an underpayment.
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[*50] bears the burden of production as to the imposition of this penalty, see sec.
7491(c), argues for it on two separate grounds: “negligence” and “substantial
understatement of income tax,” see sec. 6662(b). We focus on the latter.
By definition, an understatement of income tax is “substantial” if it exceeds
the greater of $5,000 or “10 percent of the tax required to be shown on the return.”
Sec. 6662(d)(1)(A). Here, Brown reported a tax liability of a mere $48 (arising
solely from an additional tax on a tax-favored account) for 2003. After we add to
income both the agreed adjustments from the stipulation of settled issues and the
disallowed bonus-deprecation deduction, the understatement of the Browns’
income tax is greater than $5,000--it’s around $100,000. Because the Browns
reported that they owed only $48, the total tax required to be shown on the return
is around $100,000. Thus, the Commissioner has met his burden of production
with respect to the substantial understatement.
Since the Commissioner has met that burden, to avoid the penalty the
Browns must come forward with persuasive evidence that the Commissioner’s
penalty determination is incorrect. See Rule 142(a); Higbee v. Commissioner, 116
T.C. 438, 446-47 (2001). They can meet this burden by showing that the penalty
isn’t appropriate because their return position was based on “substantial authority”
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[*51] under section 6662(d)(2) or reasonable cause under section 6664(c). See
Higbee, 116 T.C. 446.
The Browns focus on substantial authority. If taxpayers have shown “there
is or was substantial authority” for the tax treatment of an item, the amount of an
understatement subject to the penalty shall be reduced by the portion of the
understatement attributable to that item. Sec. 6662(d)(2)(B). The Browns contend
that they “relied on the express language of the Internal Revenue Code to support
their claim for bonus depreciation,” and that “reliance was explicit” because
Brown told all of the other transaction participants “that he needed to use the
Challenger in his business before the end of the year to claim bonus depreciation.”
And that reliance, they say, “is clearly reliance on ‘substantial authority,’ which
makes the penalty for substantial understatement of tax inapplicable.”
That chain of reasoning doesn’t persuade us. First, the Browns don’t cite to
the “express language” of the Code they allegedly relied on. Assuming they’re
referring to the term “placed in service” in section 168(k), we previously noted
that the discussion in their opening brief of that term was limited to one footnote
that didn’t even discuss the regulation or any pertinent caselaw interpreting it.
Second, we’re not sure why the Browns believe they can meet the substantial
authority standard on the basis that Brown told people he needed the plane by year
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[*52] end to use in his business. Unlike applying the fraud standard, its irrelevant
what Brown subjectively believed for purposes of determining substantial
authority. See sec. 1.6662-4(d)(3), Income Tax. Regs. Rather, the “substantial
authority standard is an objective standard involving an analysis of the law and
application of the law to the relevant facts.” Sec. 1.6662-4(d)(2), Income Tax
Regs. And we will find the existence of substantial authority only “if the weight
of the authorities”--which include the Code, regulations, and caselaw--“supporting
the treatment is substantial in relation to the weight of authorities supporting
contrary treatment.” Sec. 1.6662-4(d)(3), Income Tax Regs. Not until their reply
brief did the Browns even discuss the key regulation that required the Challenger
be “in a condition or state of readiness and availability for [its] specifically
assigned function.” See sec. 1.167(a)-11(e)(1), Income Tax Regs. Even then they
were able to cite only one case favorable to their position (Hellings, T.C. Memo.
1994-24), and that case--which we have determined is materially distinguishable
on its facts, see sec. 1.6662-4(d)(3)(ii), Income Tax Regs.--was substantially
outweighed by other cases that compel us to a contrary treatment. And because
the Browns didn’t even attempt to construe the term “placed in service” in a
manner favorable to themselves, we cannot say that they have established
substantial authority by providing “a well-reasoned construction of the applicable
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[*53] statutory provision.” See id. Thus, we find that the Browns haven’t
established there is or was substantial authority to claim the bonus-depreciation
deduction for 2003. See sec. 1.6662-4(d)(3)(iv)(C), Income Tax Regs.
Taxpayers can also except themselves from the section 6662 penalty with
respect to any portion of an underpayment if they can establish that, under all the
facts and circumstances, they acted with reasonable cause and in good faith. Sec.
6664(c)(1); sec. 1.6664-4(b)(1), Income Tax Regs. This determination turns on
the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
“Circumstances that may indicate reasonable cause and good faith include an
honest misunderstanding of fact or law that is reasonable in light of all of the facts
and circumstances, including the experience, knowledge, and education of the
taxpayer.” Id. The most important factor generally is the taxpayers’ efforts to
assess their proper tax liability. Id. However, other than relying solely on their
substantial-authority argument to show they also acted with reasonable cause and
in good faith, the Browns don’t bring forth any evidence--for example, reliance on
their CPA’s advice or some credible proof that they were aware of Hellings and
the other cases when they filed their returns--showing how they did so.
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[*54] The Browns therefore have not met their burden, and we sustain the
Commissioner’s determination that they are liable for an accuracy-related penalty
based on a substantial understatement.23
Decisions will be entered
under Rule 155.
23
Our finding of a section 6662 penalty based on a substantial
understatement means that we don’t need to address the Commissioner’s argument
that the Browns are also subject to that penalty on account of negligence.