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Tax Court Finds Reliance On Advisor In Messy Small Business Setting

Posted on Sep. 15, 2014

There are complex jurisdictional issues relating to TEFRA partnerships. Earlier this month in VisionMonitor Software v Commissioner the Tax Court discussed the odd TEFRA penalty landscape and also blessed a reliance defense in far from pristine circumstance where members claimed outside basis for notes they contributed to an LLC to satisfy the demands of an outside funder. Goosing outside basis for contribution of your own notes ran afoul of the partnership rules. In Vision Monitor for good measure IRS socked a 20% accuracy related penalty the partners would ultimately have to pay and possibly fight in separate refund proceedings.

In this post, I will briefly review the penalty aspects of the opinion. While reliance cases are notoriously fact specific, VisionMonitor is a useful case for practitioners seeking a reliance defense even when advice does not come in the way of a formal opinion, and the advice and corporate formalities reflect less than perfect attention to detail. In other words, this case is representative of the way many small businesses operate.

Factual Background

As readers of the blog may know, one of my favorite writers on the Tax Court is Judge Holmes. His opinions are clear and straightforward. Here is the summary of the facts from the opinion:

Torgeir Mantor and his partner Alan Smith started VisionMonitor Software, LLC back in 2002. They contributed a good deal of their savings and labor, but VisionMonitor lost money for the first several years. Another partner, a deep-pocketed corporation, was willing to contribute nearly 2million dollars to keep the firm afloat, but it wanted Mantor and Smith to place themselves at greater risk. Mantor and Smith responded by contributing their own promissory notes to VisionMonitor in both 2007 and 2008. VisionMonitor recorded the notes on its books as additional capital and accrued interest on them–but neither Mantor nor Smith funded them during either year.

The opinion discusses how the members came to contribute the notes rather than cash and how they came to the decision to treat the notes as increasing their outside basis:

Mantor and Smith didn’t have the liquidity to contribute cash. So they called their longtime attorney, Rick Sympson, to discuss some ideas. Smith asked Sympson about the tax implications of contributing promissory notes to a partnership. Sympson did some cursory research to make sure that the notes “would get him basis,” but testified that he relied mainly on the fact that Mantor and Smith were required by the other investors to contribute something more to the company. He knew the notes were enforceable, and that the partnership would put them down as assets on its balance sheet. So he told Mantor and Smith that the notes were appropriate capital contributions and “would create partnership basis.”

The advice from Sympson did not come via written opinion, and he apparently did not look at any of the underlying corporate documents.

This was still good enough for Mantor and Smith, and Mantor and Smith agreed at the start of 2007 to a “Resolution of the Managing Members” of VisionMonitor. They agreed to freeze their salaries, to provide personal credit to the “Company vendors * * * to ensure continued uninterrupted operations,” and to “indebt themselves through notes payable to the Company to improve the Company’s financial position.” The resolution was the formal authorization for the issuance of the promissory notes from Mantor and Smith to VisionMonitor.

The two members contributed differing notes totaling about $200,000 in 2007 and 2008. The notes were full of drafting errors; some even reflected an incorrect corporate name for the borrower. Some were not notarized. The corporate books were hard to reconcile fully with the nominal loan amounts. The opinion details the sloppiness. Here is an example:

And the nominal amount [of a particular note] seems to be a carryover from a prior draft of the note that sloppy proofreading didn’t catch, but the amounts that the partners now claim as the face values of the notes are the values actually reported in VisionMonitor’s books, although neither the nominal amount nor the amount in the parentheses matches the amount that is identified on the VisionMonitor return as Smith’s 2007 and 2008 contributions.

The Law at Issue

The substantive advice Sympson gave to the members was wrong, and the partners should not have increased their outside basis from an unfunded promise to pay. For those who want some substantive partnership tax, the opinion goes through the black letter law on that point. Because of the error, IRS also argued that the 20% accuracy-related penalty should apply.

VisionMonitor reminds us of the TEFRA penalty landscape following Woods last year, where the Supreme Court attempted to navigate the murky jurisdictional waters surrounding TEFRA partnerships and accuracy-related penalties:

TEFRA gives courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non-partnership items such as outside basis.” Woods, 571 U.S. at ___,134 S. Ct. at 564. Therefore, the actual assessment of a penalty relating to an adjustment of a partnership item is done at the partner level but is based on partnership-level determinations. Partnership-penalty law gets even more complicated when one looks at defenses because jurisdiction over them can exist at both the partnership and partner levels. The partnership itself may have a defense to a penalty that would shield all its partners; one partner may have a defense to the penalty that’s all his own. Our Court has jurisdiction to rule on any partnership-level defense, but partners have to take their partner-level defenses to a refund forum. [citations omitted]

This case concerned a partnership level defense. As a defense to the penalty, the partnership argued good faith reliance on the advisor, Sympson. Citing the Neonatology case, the opinion implicated the three factors that courts have looked to under Section 6664 to determine if the reliance amounts to reasonable cause/good faith:

  1. Was the adviser a competent professional who had sufficient expertise to justify reliance?
  2. Did the taxpayer provide necessary and accurate information to the adviser?
  3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

In analyzing the first and third factors, the court found that the facts supported the taxpayer. As to competence, Sympson was a longtime attorney and tax preparer for the LLC and Mantor, who was the tax matters partner. As to reliance and good faith, the court also found in favor of the taxpayer:

We have little problem in finding that VisionMonitor actually relied on Sympson’s advice–his conclusion that the notes were additions to VisionMonitor’s capital (and the capital accounts of Smith and Mantor) was set out on the company’s returns. And we have little trouble in finding that this reliance was in good faith. In a case like this one–where VisionMonitor secured Smith [the other member] and Mantor’s promises to increase their personal risk alongside their promise to extend their personal credit to the firm’s vendors–advice from a longtime tax adviser that this increased Smith’s and Mantor’s bases would seem reasonable to Mantor.

What makes this a taxpayer friendly case is the opinion’s discussion of the second Neonatology factor. The requirement that the taxpayers provide necessary and accurate information to the advisor seems to be inconsistent with the sloppiness of the notes themselves and the way that the LLC reflected the debt on its books. The opinion notes the many drafting errors and found that the tax advisor Sympson himself did not look at any documents in connection with the advice he gave. Holmes is frank in addressing this part of the test, noting that “[t]hese problems may push Neonatology’s second prong to poke at VisionMonitor’s defense, but we don’t think they push hard enough to puncture it.”

Here is where the opinion parses the second prong in a taxpayer friendly way:

The test tells us to look at whether VisionMonitor provided necessary and accurate information to Sympson. Because a penalty is applicable as a result of a position taken on a return, we look to see if VisionMonitor provided what information it had before it filed its returns and not just when Sympson was giving his oral advice to Mantor. We think accuracy here means holding nothing back and letting the professional give his opinion on the notes and associated records in all their confusing messiness. And on this point we find both Mantor and Sympson credible in saying that Sympson had access to all the records he needed when he prepared the returns, as he had for many years in the past. We also believe Sympson’s testimony that Mantor discussed the factual background with him. (emphasis added)

Some Thoughts on the Case’s Implications

The opinion distinguishes some cases where the taxpayer did not establish the advisor had access to all the information, including the Ohana case I wrote about earlier this year where the Tax Court held that the taxpayer did not receive advice when the taxpayer mostly was dealing with a receptionist rather than the advisor himself. What makes the VisionMonitor case helpful for taxpayers is that it does not condemn taxpayers when they may fail to dot the i’s and cross the t’s, but who are not really in a position to second guess tax advice. That the advisor had access to the corporate records and was someone who had a longstanding relationship with the parties was key. Through Sympson’s return preparation and prior relationship he had detailed information about the business. What he lacked was the time or inclination to do the research on the specific question but the individuals did not and should not have been held to know that his off the top response was wrong, even though the individuals were fairly sophisticated. Tax law is complicated, and partnership tax is especially complicated. Moreover, unlike some of the recent cases where the Tax Court has been skeptical of advice, there was no conflict of interest, and the LLC was a real business that in later years actually turned a profit.

This result seems fair. As a practical matter, it does not penalize small business taxpayers. Given TEFRA’s odd rules, it also did not force the individual partners to have to raise accuracy-related defenses in a separate proceeding that would not likely have been made in a pre-payment forum.

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