IRS lays siege to Knight of Malta

December 14th, 2010 by Joe Kristan

20101214-1.jpgAn attorney took his tax greivances to Tax Court Judge Holmes, and the result is a history lesson on the Knights of Malta — and disallowance of thousands of dollars of expenses.
The taxpayer in this case was an attorney, a Mr. Pace, who specializes in “qui tam” work — compensated whistleblowing is the way I understand it. He attracted IRS attention with a rookie mistake — he earned a million dollars but didn’t file a return. Somehow his status as a member of the Knights of Malta had something to do with it, leading the court to explain a little history:

The Sovereign Military Hospitaller Order of St. John of Jerusalem, of Rhodes, and of Malta was established in the mid-eleventh century, when merchants from Amalfi founded the Benedictine Abbey of St. Mary of the Latins in Jerusalem. By 1080 the abbey built St. John’s hospital — located on the traditional site of the angel’s announcement of John the Baptist’s conception — which provided a place of refuge for poor and sick pilgrims visiting the Holy Land. Under the leadership of Brother Gerard, the Hospital of St. John grew to include several ancillary hospices in Palestine along the pilgrimage route. Pope Paschal II officially recognized the hospital in 1113, establishing the Order of St. John.
As the twelfth century wore on, the Hospitallers of St. John expanded their medical mission to preventive care by providing armed escort to pilgrims traveling the hostile route to Jerusalem. Crusading knights who stayed in Jerusalem began to join the Order, and by 1148 — the time of the Second Crusade — the Hospitallers of St. John were recognized as an essential part of the Holy Land’s defense…
The next several centuries did not go as well.

Sort of like the taxpayer’s case. You know the taxpayer has a problem when the discussion starts (my emphasis):

We begin by reviewing some of the basics of substantiation. The most important rule is that taxpayers have to keep records. Section 60014 and its accompanying regulations tell taxpayers to hold onto records that would enable the IRS to verify their income and expenses. See sec. 1.6001-1(a), Income Tax Regs. Unsophisticated taxpayers unfamiliar with the substantiation requirements often get extra leeway in their good-faith attempts to comply. See, e.g., Larson v. Commissioner, T.C. Memo. 2008-187. But sophisticated attorneys like Pace should know better.

The court disallowed many of the deductions, often on account of lack of substantiation:

Pace attempts to substantiate $1,711 in office expenses with a list of expenses containing check numbers, dates, and descriptions. He did not, however, introduce into evidence the underlying canceled checks, and the only testimony supporting the deduction was conclusory statements by Pace and his secretary that the office expenses were “incurred in the ordinary course of business.” Therefore, we disallow in full these office expenses.
Evaluating the remaining $6,698 in contested office expenses led to some engaging reading — nearly 150 pages of credit-card statements. Pace provided annotated statements to back up these deductions. But the majority of these expenses aren’t business related.

I like this:

Pace deducted custom-made shirts and a tie as office expenses. He explained that he found it difficult to buy some of his clothes off the rack because of his unusual physique. Our own observation makes us suspect that Pace was being modest, but no inspection could affect our necessary conclusion: expenses in this category are not deductible because Pace failed to establish that the clothing was not suitable for everyday wear. See, e.g., Hamilton v. Commissioner, T.C. Memo. 1979-186; Rev. Rul. 70-474, 1970-2 C.B. 35. And he wore one of his bespoke shirts to trial-showing without any doubt its suitability for everyday use.

Our taxpayer gave it his best:

The Commissioner has moved to impose a penalty under section 6673(a)(1), which authorizes us to impose a penalty not in excess of $25,000 whenever it appears that proceedings have been instituted or maintained by the taxpayer primarily for delay or that the taxpayer’s position in such proceedings is frivolous or groundless. Pace vigorously contested the Commissioner’s determination, resulting in a weeklong trial, 760 pages of trial transcript, and thousands of pages of credit-card statements, canceled checks, and other documents. But Pace’s aggressive advocacy doesn’t rise to the level of sanctionable behavior. He may be long winded – as many lawyers and even some judges are — but delay and frivolous positions were not the crux of his case.

But it wasn’t good enough; the court upheld a 20% “accuracy-related penalty” for a substantial understatement of tax without reasonable casue:

Pace offers a novel defense to the accuracy-related penalty in his opening brief — that it’s the IRS’s fault because it didn’t settle. Review of the caselaw fails to find any support for this penalties-don’t-apply-when-the-IRS-won’t-settle argument. And Pace never argued any of the valid defenses to the penalty. See secs. 6662(d)(2)(B), 6664(c)(1). We therefore find that he is subject to this penalty.

We’ll let Judge Holmes explain what it all means:

In the best of all possible worlds, perhaps, Pace’s pursuit of the unified life would be recognized and rewarded. See, e.g., Pope Paul VI, Pastoral Constitution on the Church in the Modern World — Gaudium et Spes sec. 43 (December 7, 1965). But the Code imposes a more exact and less merciful accounting: business expenses, charitable contributions, and the costs of everyday life must be identified, segregated, and substantiated by reliable documents and credible testimony.

Cite: Pace: T.C. Memo. 2010-272
Flickr image courtesy bazylek100 under Creative Commons license
UPDATE: The TaxProf has more.

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