Written by Guy Schmitz J.D., LL.M.
The Code is comprised of over 3.8 million words. A sequence of some of these words gives us bright line tests: a 3-year statute of limitations (generally) for income tax returns; a 90-day letter from the IRS, which is the ticket to the Tax Court—if that ticket is not punched, the client pays the alleged tax owed and sues for a refund in a United States District Court or the United States Court of Federal Claims.
At the other end of the spectrum are sequences of words that are anything but bright lines, as the taxpayers discovered in SI Boo LLC, et al. v. Commissioner, TC Memo 2015-19. SI Boo and the other entities had a very expensive vocabulary lesson.
SI Boo LLC (and the other entities) were cash basis partnerships/limited liability companies (SI Boo) which secured ownership of various properties because the original owners did not pay real estate taxes. SI Boo properties were sold under contracts for deed, meaning, of course, that SI Boo held those deeds until all payments were made under the various contracts. When all the payments were made, SI Boo transferred the real property to the ultimate owners. SI Boo reported the payments made by the ultimate owners under the installment method of reporting and booked the gain as capital gain. The partners/members of the various SI Boo entities did not include the income from the sales as net income from self-employment income.
- Capital Gain: The court held that SI Boo was not entitled to capital gain treatment because the overall evidence indicated that the properties were held primarily for sale to customers in the ordinary course of business. The evidence showed that the sales were “frequent, regular and substantial” during the years in question. Result: ordinary income. SI Boo contended that the sales were not frequent in comparison to the number of purchases that SI Boo made for failure of the original owners to pay real estate taxes. The Commissioner contended that the sales were frequent. After an analysis of the numbers, the court, as said, held for the Commissioner.
- Installment Sales: The court denied installment sale treatment to SI Boo under the dealer disposition prohibition of Code section 453(b)(2)(A).
- Self-Employment Tax: Given that the court found that SI Boo earned income from the proceeds of sales of real property, which was an integral part of the businesses of the various SI Boo entities, the partners/members of the various SI Boo entities owed self-employment tax.
Practitioners know the rules and know that certain sequences of words are anything but bright lines—“sales to customers in the ordinary course of a trade or business,” “frequent, regular, and substantial,” “dealer.” The client, of course, only sees certainty. When you send a return to a client for signature, the client can tell to the penny what is owed or the amount of the refund. Be proactive and profile a new client. If a new client is the equivalent of SI Boo (somewhere between dealer and non-dealer), explain that some of the lines are not bright but fuzzy and that you will do anything to help to get the client on the correct side of the fuzzy line.