I am in receipt of your letter dated March 23, 2011, and the accompanying Reports of the examining agent. On behalf of the taxpayers, D, E, & F (hereinafter referred to as PC) protest the adjustments set forth herein. In accordance with the provisions of I.R.C 7502(a), this Protest is timely filed. My power of attorney is on file.
The following information is submitted in support of this Protest:
A conference relating to this appeal from the findings of the examining agent is requested
before an Appeals Officer of the Boston Appeals Office.
NAME AND ADDRESS OF TAXPAYERS
D, E & F
10 Main Street
Anywhere, MA 01234
DATE AND SYMBOL OF LETTERS OF TRANSMITTAL
March 23, 2007
Letter 950(DO) (Rev. 8-2005) and Letter 937 (Rev. 11-2004)
PERIODS INVOLVED AND AMOUNTS DISPUTED
TAXPAYER YEAR DEFICIENCY ADDITION
D, E, F 2010 $ 1,000,000 $ 1,000,000
(a) The examining agent erred in determining that PCs operation of the Estate of John Smith for the year 2010 which did not constitute an activity engaged in for profit.
(b)The examining agent erred in determining that PC is liable for the additions to the tax imposed by 6662(c)) and/or (d) for any of their 2003, 2004 or 2005 taxable years, respectively.
Statement of Facts
The PC, which is a professional corporation practicing law is owned by D, E and F in equal share. The three are also the principle officers and the directors. For the calendar year 1120, the PC files cash receipts and disbursement methods of accounting. In 2008, attorney D was engaged to represent the Estate of John Smith in a wrongful death action against the Inter-district Telephone Company. The parties entered settlement in August 2010; leading to the payment of an attorneys fee of $3 million paid to Attorney D. D received payment in September of the same year and retained $1 million, while disbursing $1 million to E and F each. D reported his receipt of $3 million on Schedule C of his form 1040 for the year 2010. He also claimed a deduction in the amount of $2 million, representing the amount distributed to E and F. D issues forms 1099-MISC to E and F, who confirmed the receipt of $ 1 million each from D in their respective form C. the IRS agent concluded the examination of PC returns for 2010 and determined that the lump sum $ 3 million would be considered as gross income for the PC, and therefore taxable by law. The taxable dividend would be $ 1 million.
The issues of contest are:
Whether D was acting in their official capacity as an agent of the PC or acting privately to secure business.
Whether disbursement of funds to E and F amounted to a presumption that D was acting as an officer of the PC.
Law and Arguments
Notably, the finding of a constructive dividend must include two processes: the finding that the dividend was conferred, then the computation of said dividend United Aniline Company v. Commissioner of Internal Revenue, 316 F.2d 701 (1st Cir. 1963). It is relatively easy to find a constructive dividend if the value of benefit conferred exceeds the payments in compensation. As a result, the IRS must have satisfied legal procedures that it has adequately considered the two steps of finding constructive dividend. Therefore, the IRS must determine whether the benefit was purely for shareholder benefit or for corporate benefit Sammons v. Commissioner of Internal Revenue, 472 F.2d 449 (5th Cir. 1972). This is because not every expenditure done for the benefit of the shareholder amounts to a constructive dividend that would be taxable.
Where the individual was not subject to paying the corporation for services offered, this would not amount to a constructive dividend Gibbs v. Tomlinson, 362 F.2d 394 (5th Cir. 1966). From the evidence given from the different stakeholders, the three were still in business before the formation of the PC and would still adequately execute their services to their client John Smith without necessarily engaging the PC as their vehicle. Furthermore, the matter appeared to be quite sensitive to the reputation of the PC. Therefore, D went to tackle the issue solely, regularly engaging the services of E and F in their respective specialties. As a result, it would be noted that at first, no benefit accrued to the three directors that was attributable to an agency relationship for the PC. Additionally, the PC did not finance any of the activities of D, E and F in the course of the estate case thereby not accruing any constructive dividend over the earnings that the three would accrue from the operations of the attorney D. it would then follow that the earnings from the settlement awards amount to personal income for D.
Moreover, the PC is a corporate entity that can engage in contracts with other parties, meaning that it could receive payments if indeed the PC was contracted to handle the case. This goes on to say that the assertion of the PC as the recipient of the funds is misplaced.
In determining whether the disbursement of equal amounts to the three directors presumes that they were acting for the PC is a question to determine the individual participation of each director and their relationship to the PC. Despite the disbursement of funds to the three directors of the company, there is strong evidence to point to the benefit of the stockholder rather than the benefit of the corporation. As outlined, the other directors were substantially engaged in the settlement process for the case, each contributing 150 hours to the John Smith Estate case. Furthermore, it was at their private capacity as lead attorneys in their area of expertise that the three engaged this case. At no instance was their presentation an amalgamation of the PC in presenting John Smiths case. It could thus be determined that the corporation obtained no benefit whatsoever from the transaction between the three attorneys and the John Smith Estate Case. Nonetheless, individual benefit was obtained from the case following individual participation in the case Benes v. Commissioner, 42 T.C. 358 (1964.
Pursuant to Treasury Regulations 183 adopted in 1972, the Treasury provides for activities done for profit:
The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the objective of making a profit.
With regards to making a profit, it is clear that the PC may not be taxed because of the simplicity that the directors distanced themselves with the PC while working on the estate of John Smith to avoid any adverse effects that would be accrued should the individuals lose the case. Furthermore, no financial benefit from the case was accrued for the benefit of the corporation having included other staff members of the PC. The conduct of the PC was such that there was no direct benefit accruing to it, whether financial or otherwise, thereby exempting it from tax with regards to the Estate of John Smith case.
Further considering other aspects of the regulation touching on profit:
The presence of personal motives in carrying on of an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. On the other hand, a profit motivation may be indicated where an activitylacks any appeal other than profit. It is not, however, necessary that an activity be engaged in with the exclusive intention of deriving a profit or with the intention of maximizing profits.
Having considered that this activity was engaged by the attorney D simply for the profit of it, it becomes a taxable dividend accruing to him as opposed to the corporation. This is because the remaining $2 million disbursed to the partners can be calculated as costs. Nonetheless, attorney D would need to show that the costs to his personal share were sufficient to reduce the taxable dividend further.
In his report, the IRS agent brings about a claim stating that the corporation was the beneficiary of the lump sum from the John Smith case. However, this complaint disqualifies the possibility that the firm accrued any benefit from the case and further states that individual directors handled this case while distancing themselves from the PC to reduce damage should they lose the case.
Additionally, the accrued financial benefit fell squarely within the bounds of the individual director D who then settled the costs of engaging the services of E and F through a disbursement of $2 million. If individual directors E and F were considered to have accrued costs worth $1 million each for putting 150 hours in services towards the settlement agreement, it follows that director D who put in 300 hours and personally handled the case would accrue at least costs in the tune of $1 million, thereby equally exempting him from tax deductions.
Respectfully submitted by
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