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Nonemployee Compensation in Tax Shelter Scheme was Not a Return of Capital.

(Parker Tax Publishing April 6, 2015)

The Tax Court rejected multiple arguments presented by a Harvard educated architect dabbling in the tax shelter business attempting to explain why $2 million of nonemployee compensation reported on Form 1099-MISC should be treated as a tax free return of capital.

Background

In 2003, Jason Chai made a small fortune doing work for a fellow Harvard graduate, Andrew Beer, very far afield from his professional architecture practice. Beer created and marketed tax shelters designed to reduce his wealthy clients' tax liabilities. In order to achieve the tax shelters' goals, Beer enlisted Chai to act as an accommodating party to whom noneconomic income would be allocated in order to offset equal amounts of noneconomic tax losses, which clients would use to reduce their tax liabilities.

Chai was an accommodating party for at least 131 entities, which involved executing numerous transactions to facilitate the strategy. Executing the transactions required signing binders of legal documents, which included articles of incorporation, loan agreements, wire transfers, and redemption request letters. At Beer's suggestion, Chai created JJC Trading, LLC (JJC), a disregarded entity, and gave signature authority to one of Beer's numerous companies, absolving him of the need to travel to sign documents.

Chai received significant compensation from Beer's companies in exchange for his participation in the tax shelters. In 2000, he received $1.2 million as a signing bonus, and in 2001, JJC received $1 million, ostensibly for use in investing in Beer's companies. These amounts were reported as nonemployee compensation on Forms 1099-MISC, and Chai reported them as income on his returns.

In 2003, Chai was notified that he would be receiving a $2 million payment from one of Beer's companies. Unsure of how the payment would be characterized, Chai contacted the company's CFO who informed him the payment would be reported on a 1099, just as his previous bonuses had been. Chai declined to tell his accountant about this conversation, and did not report the payment as taxable income.

The IRS determined a deficiency in Chai's 2003 return, and assessed an accuracy related penalty.

Analysis

The character of a payment for tax purposes is determined by the intent of the parties, particularly the intent of the payor, as disclosed by the surrounding facts and circumstances (Smith v. Comm'r, T.C. Memo. 1995-410).

Chai first asserted that the $2 million payment was a return of capital. However, aside from his blanket assertions, the court found no evidence establishing that Chai was a partner in any of Beer's companies or had invested capital in those entities. Simply stated, the court said, the payment could not have been a return of capital because Chai did not have any capital invested. Additionally, any investments he may have had were impossible to trace, given the complex structure of Beer's companies.

Chai alternatively argued that if the $2 million payment was not a return of capital, then it was a gift from Beer. The court disagreed with this characterization, citing a lack of any evidence suggesting that the payment met the requirement that a gift result from detached and disinterested generosity. Notably, the court stated, Beer testified that he viewed the $2 million payment as a discretionary bonus for services Chai provided.

Lastly, Chai argued that the $2 million payment could not have been compensation for services because after JJC was formed and he assigned his responsibilities, he no longer performed any services. However, the court emphasized that signing the formation and organizational documents was an integral component of creating entities for Beer's tax strategy, and Chai's subsequent delegation of his signature authority did not absolve him from liability for tax on the compensation he received.

The Tax Court found the treatment of the $2 million payment as nonemployee income was consistent with the treatment of the 2001 and 2002 "bonus" payments, both of which had been reported as nonemployee compensation, and Chai himself had reported them as self-employment income and paid tax accordingly. The court held the evidence established that the intent of the parties was to treat the $2 million payment as nonemployee income subject to tax, and Chai had no reasonable explanation as to why he treated the payment differently. The court upheld the IRS's $627,619 deficiency judgement, and imposed a $125,524 accuracy-related penalty under Code Sec. 6662(a). (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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