If you think the 20% and 40% “economic substance” penalties in the Obamacare legislation are just a threat for elaborate tax shelters from fancy-pants big city law and accounting firms, a Tax Court case yesterday out of Carroll, Iowa will make you think again.
A Carroll couple had operated a trucking business out of their home since 1967. They lawyered up in 2000 and set up three new entities — two C corporations and an LLC. One C corporation had the trucking operations, while the other was a “consulting” business that provided “management services” to the trucking business. Real estate was put into the LLC, which filed as a partnership.
The 87-page Tax Court opinion outlines a confusing series of payments between the controlled entities that resulted in no taxable income in the C corporations and reduced taxable income on the 1040. The taxpayers testified in their own defense, to no avail:

Before turning to the issues presented, we shall comment on the respective testimonies of [the couple], who were the only witnesses at the trial in these cases. We found those testimonies to be in certain material respects questionable, implausible, vague, inconsistent, unpersuasive and/or self-serving. We shall not rely on the respective testimonies…

The court said the arrangements amounted to a tax-avoidance scheme:

Based upon our examination of the entire record before us, we find that the only intended objective of the respective transactions between (1) (a) Transfer and Consulting and (b) Leasing and Consulting, under which Consulting purported to provide to each of those companies certain services, and (2) the [taxpayers] and Consulting, under which Consulting purported to agree to buy the [taxpayers'] residence, was the… tax-avoidance objective of having Consulting pay the [taxpayers'] personal living expenses with funds which Transfer and Leasing paid to Consulting and for which Transfer and Leasing claimed tax deductions for their respective taxable years at issue.

Here’s where the Obamacare penalty changes come in:

On that record, we find that the respective transactions at issue were not entered into for nontax business reasons, were entered into only for tax-avoidance reasons, and did not have economic substance.

New Section 6662(b)(6) provides a non-waivable penalty for tax understatements attributable to transactions that lack “economic substance.” The penalty is 40% (20% if there was “adequate disclosure”) of the understatement. The taxpayers in Carroll were hit with a 20% “accuracy related” penalties in the neighborhood of $20,000. If the new rules applied to the years at issue (they don’t), they might have faced a penalty twice as large, with no opportunity for a “reasonable cause” reduction (though the judge in this case rejected “reasonable cause” arguments for penalty reduction, despite the use of an attorney to set up the structure and prepare tax returns).
The Moral? The Tax Court doesn’t like it if they think you are trying to deduct personal expenses, and the new economic substance penalties will raise the stakes.
Cite: Sundrup, Et. Al, T.C. Memo 2010-249

Tags: Carroll, economic substance, Judge Kroupa

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