In episode 30 of How Tax Works, Matt Foreman continues his discussion of important and relevant tax cases, discussing gambling losses, whether something is a gift, whether an asset is inventory or a capital asset, and closing with a discussion of Broadway producer George M. Cohan’s contribution to tax law.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 30th episode of How Tax Works. I’m Matt Foreman. In this episode, I’m going to continue my discussion of famous, important, misunderstood, and frankly interesting, at least to tax professionals. Tax cases How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make. Before I get started, a few administrative things.

Matthew Foreman [00:00:45]:
New episodes in two weeks. The next episode will revisit the passive activity loss Rules under section 469 in the Real estate professional context. It’s gonna be a good one. I’m literally gonna record it after this, so I hope it’s good, right? If you have any questions, comments or constructive criticism, you can email me at my FRB email address. Upcoming webinars speaking engagements are on the How Tax Works landing page. All right, let’s do this. The next case is corn Products Refining Co. Vs.

Matthew Foreman [00:01:17]:
Commissioner 350 U.S. 46, 1955 case. And it is a companion case with Arkansas’s best score versus commissioner for 485 U.S. 212, 1988. They are 33 years apart, so they are very different, but they really deal with the same idea of hedging. So I, I put them into one a lot of times. You know, I’ve taken enough tax courses in my life that I’ve actually run into these, these cases twice. And the cases are basically always taught as one, one unit.

Matthew Foreman [00:01:48]:
I don’t know if the right word is. Anyway, so Corn Products. Corn products was a producer of products from corn, hence being called Corn Products Refining used futures contracts. So they had a time when the price, their input prices went up a lot. It’s very bad for the company. So they started engaging in the business of using futures contracts to protect itself from price fluctuations of inputs. Inputs being predominantly corn. But there were some others, I believe the question was, are futures contracts the same thing as the company’s raw materials? Ordinary as a hedge or insurance? Ordinary or capital.

Matthew Foreman [00:02:25]:
As if someone bought corn futures. Could be capital. If I bought corn futures, probably capital because I don’t make anything with corn corny jokes. That’s it. Thank you and you’re welcome. So the key to look at this is look at the taxpayers, the taxpayer’s business motives for acquiring the asset. And that’s the key. They said, look, hedges are used to manage risk.

Matthew Foreman [00:02:44]:
Right? Section Treasury Rank 1.12112 C4 1.1212 C4. You know this is. This is one where the regs really go on point. I think the tax work out this. Excuse me. The Supreme Court got this one right. Arkansas Best Corp. Despite the name it you know and being a companion case to a case about core and futures it has Arkansas’s Best was a diversified holding company.

Matthew Foreman [00:03:14]:
Arkansas’s Best bought shares stock of a bank. Then in the 70s and 80s it had a bank crisis. The value of the bank stop dropped significantly. The taxpayers sold and recognized the loss. It took the loss as ordinary under corn products because the motive for acquiring it were used to manage risk. They felt that owning a bank made it, you know, more risk tolerant. I don’t, I never really bought that. But whatever.

Matthew Foreman [00:03:43]:
Take these things as at their face value tax court agree with the taxpayer, the 8th Circuit and Supreme Court. Right. We’re in Arkansas agreed with the irs. Stock is a capital asset. The motivation for acquiring it is not relevant. It limited corn products to hedging transactions because the futures the ones in corn products were part of the business’s inventory purchase system. Since corn products again 1995 case was they’ve added section 1221 A7 to the code which says that hedging transactions are ordinary. So I think this is an interesting one.

Matthew Foreman [00:04:19]:
This is one where Congress looked at it and said, you know, I think that corn products was too broadly applied tax. The IRS disagreed, won the case and Supreme Court or the Congress changed law. Imagine that Congress changing a law based on a court decision they didn’t like. Didn’t know that was still allowed. All right, the next one’s a really interesting case. The case itself is not that interesting but I felt like discussing it because I find it a really interesting fact pattern and a Quirk. It is C.F. mueller.

Matthew Foreman [00:04:50]:
Mueller M u e l l e r Co. Vs. Commissioner 190 Fed 2nd 130 is a 3rd Circuit case. 1951 New York University Law School bought a pasta factory in New Jersey using the future profits from the pasta factory. Okay. It was considered under the law at the time tax free because it’s owned by a tax free entity tax A nonprofit tax free entity. Right. NYU School of Law 501 and so there’s no tax.

Matthew Foreman [00:05:18]:
So NYU Law at the time owned a number of businesses which kind of fascinates me because schools don’t tend to own businesses anymore. And what happened is Congress changed the law. There is a rumor that Columbia Law School was not Thrilled with this, this thing, thought it was uncouth to do. And instead of just getting behind it and doing what they wanted, they had the law changed and they said, okay, it’s only tax free if it’s related business to a non profit. This is the source. And this is why Congress. We don’t know if Columbia actually did this, but this is the case that drove Congress to create section 511 in sequence. Specifically 512, which is unrelated business taxable income.

Matthew Foreman [00:06:02]:
If your business, if the income is not a related business to the nonprofit, the nonprofit’s purpose, then income derived therefrom is taxable at corporate tax rates. Which is why non profits that own stock or own a business now own it through 3 Corp. Stock because that prevents you from having UBTI. And the truth is UBTI just creates C Corp. Level stock. C Corp. Level tax Anyway. All right, moving along, we had Grotzinger Commissioner v.

Matthew Foreman [00:06:28]:
Grozinger, 480 U.S. 23, 1987. I’ve discussed this one on the podcast. Talk about this one a lot. It is the definition, the closest we’re going to get the definition of a trader business for section 162 ordinary and necessary business expense purposes. Basically to be to duck, deduct things as an ordinary and necessary business expense. Robert P. Grotzinger, he worked 60 to 80 hours a week wagering on dog races after he got laid off from his job.

Matthew Foreman [00:06:55]:
He’s like, that’s it. I am. I am all in on the doggies. Okay. He had $70,000 in winnings and $72,000 in losses. His total losses, his net was $2,032. He litigated a case to the United States Supreme Court over $2032. Dude makes the Jarrett’s look like they’re big dollars, right? Anyway, Supreme Court citing Whipple v.

Matthew Foreman [00:07:20]:
Commissioner, 373 U.S. 197. To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity. And that the taxpayer’s primary purpose for engaging in the activity must be for income and profit. A sporadic activity, a hobby, or an amusement diversion does not qualify. Pretty good. Pretty good language there. I like that slight paraphrasing move.

Matthew Foreman [00:07:44]:
Some words, but that’s it. Next one. Commissioner v. Duberstein. I’ve heard Dubberstein. I think it’s Duberstein. 363 U.S. 278, 1960.

Matthew Foreman [00:07:53]:
The question is whether something is a gift for income tax purposes or where something is income for income tax purposes. The key is to look at the transfer’s intent. Gifts. To be a gift, it must have detached and disinterested generosity. And gifts are given out of an affection, respect, admiration, charity, or like impulses, income. Income has involved or intensely interested acts. So case by case basis, people always say, I want to thank my employee. They’re so wonderful.

Matthew Foreman [00:08:23]:
I want to give them a gift. Congratulations. That’s not a gift. Okay? That’s not detached or disinterested generosity. That is an interested act because you are so thankful for the money they made you as an employee that you want to, you want to reward them. Now, if they’re your employee and your child, that’s a different ball game. That’s a different question altogether. Case by case basis, Crane v.

Matthew Foreman [00:08:45]:
Commissioner, one of the really famous ones. Mrs. Crane inherited an apartment building from her husband’s estate. The apartment building was subject to non recourse debt. She sold the property for $3,000, subject to the debt. So the buyer still had to pay on the, on the mortgage. What’s the amount received? How much did she receive? It’s the cash plus the debt relief. So the debt relief on this, I, I don’t have it written down because I take notes on this was a couple hundred thousand dollars is my recollection.

Matthew Foreman [00:09:12]:
So it was a real number. She basically got probably attorney’s fees plus debt relief as well. What she ended up getting. Commissioner v. Tufts, 461 U.S. 300 1983. You can’t discuss Crane without discussing Tufts. In Tufts, the taxpayer sold the property for $0 plus debt relief.

Matthew Foreman [00:09:29]:
Okay? The relief was $1.8 million. What’s different about Tufts is the fair market value of the property at the time was 1.4 million. It was underwater mortgage. The question was, is the amount received, the $1.8 million, the debt relief or. Or the $1.4 million to fair market value? Remember, the taxpayer got zero dollars for this, okay? The answer is it is the greater of the debt relief or fair market value, which is the $1.8 million. Really good one. Really good one. This is one I really like.

Matthew Foreman [00:10:02]:
It is a Fifth Circuit case. Bead Harn Realty Co. Vs. US 526 Fed. 2nd 409 again, Fifth Circuit, 1976. This is a question whether the sale of real estate, whether it’s inventory or capital asset, really, really interesting one because people get this, right? This is one that I deal with a fair amount because, well, here’s the situation, right? You buy a piece of property and a day later someone comes along and says, hey, I want to buy this from you. I’m going to offer you twice what you paid. What are you going to do? You’re going to sell it? Taxes.

Matthew Foreman [00:10:38]:
Taxes be darned. All right, so you’re going to sell that case. The capital asset does not include inventory and this is a code IRC 1221 A1. A capital asset does not include inventory or property held by the taxpayer primarily for the sale to customers in the ordinary course of the taxpayers trade or business. What does primarily. Right. Held by the taxpayer primarily for sale to customers. Customers in the ordinary course of the taxpayers business.

Matthew Foreman [00:11:09]:
There are a number of factors, right? The number of sales, the extent to which they sell, the continuity and the substantiality of sales. USG Winthrop 417 Fed. Second 905 again, Fifth Circuit case 1969. There’s a couple others that talk about that. That’s the one I’m going to cite though. While there is no factor or combination of factors that is controlling, the most important factors are the frequency and substantiality of the sales. The nature and the extent of the activities is very, very, very important. The way I end up usually coming across on this and the way I, you know, when talking to clients, this is a real question and a lot of times you get this question from people who either, you know, they buy, develop and rent and one time they just get a really good deal to sell or they buy and they’re going to do something with it and someone just comes along and they’re like, well, you know, that’s interesting.

Matthew Foreman [00:11:59]:
I have even had the fact pattern where someone is set to buy it and before they have closed, someone else comes along and offers 20% more. And so they assign their option to buy or they buy it and then immediately flip it. Heck of a fact pattern in my view. But anyway, you know, that’s it, right? Look at the nature, extent, look at what your intent was. What were you trying to do at the time? I think that’s a really important one. All right, before we bring it on home, let’s take a quick break, get some water and we’ll be back to talk about Grote McKay Realty. All right, we’re back with episode 30. This is, we’re going to talk about Groat McKay Realty Inc.

Matthew Foreman [00:12:50]:
77 Tax Court 1221. This is a 1981 case. We’re getting a little bit more recent. It involved the sale of cattle, but that’s not really relevant. The issue is whether something is a bona fide sale. Right. Again, I’m not going to get into the sale of cattle because it doesn’t do it. But the key to determine whether there’s a bona fide sale, and maybe I should have discussed this one earlier a couple cases ago, but here we are and the question, the key is whether the benefits and burdens of ownership have transferred.

Matthew Foreman [00:13:18]:
There are a number of factors to look at. This is where Grote McKay’s are really good, right? Whether legal title has in fact transferred, how parties treated the transaction, whether one party has acquired an equity interest, how that’s treated in legal documents such as a tax return. If a contract created the obligation to execute a deed or similar right deeds need to be recorded. I think that’s a really important point that’s often understated and you know, it’s kind of problematic in situations where there’s no deed, right? No real estate, you know, there is no deed for a bottle of water, right? Maybe a receipt, whatever. Whether property taxes are paid or there are sales or transfer taxes, you know, depending on the specifics, whether risk of loss has transferred, if there’s damage to the property and who would receive property, who’d receive money if it’s sold. I think that’s a really important one when looking at bonafide sales. You know, people talk about it, oh, you know, I’m selling 49% of my business, but all the profit goes to the 51. And in three years he has an option to buy me out for $6.

Matthew Foreman [00:14:20]:
Congratulations, you sold 100% of the property. That’s really important. Sometimes you see ones who’s like, oh, I’ve sold 49% but I’m keeping all rights to the income for 30 years. And then after that he gets it, you know, but he gets an 8% coupon during that years. During those years, that’s not the sale of property. That is debt financing. Pretty easy. Another one’s a really interesting one, little more esoteric.

Matthew Foreman [00:14:44]:
I use it just because I think it’s a really interesting sourcing case to talk about is Toby vs Commissioner 60 T.C. 227, 1973. The IRS acquiesced in 1979. 1 CB 1 Mark Toby is a fate is. Excuse me. Mark Toby was a famous artist. He was a US citizen who was resident of Basel, Switzerland, if I recall correctly. And you know, his domicile was Seattle, Washington.

Matthew Foreman [00:15:11]:
Not totally relevant where his domicile was because the US has worldwide taxation and this is a sourcing case anyway. He was predominantly a painter, but as is the case with relatively well known artists, they often go between different media, different times in their career. Anyway, the question is, where is the art sourced? Art is sold worldwide. His art was sold through art galleries. Pretty. Pretty big name ones, pretty important ones, I guess. I don’t really know what it means to be an important art gallery. I have been assured that they do in fact exist.

Matthew Foreman [00:15:44]:
But anyway, he was sold worldwide to collectors throughout the world through art galleries. He sold to museums, his art at a lot of museums where I’ve been throughout the world anyway, so art is sourced where it is created, not where it’s sold because it is attributable to services. And for art, capital assets are not a material income producing factor. This is maybe different if you need some sort of capital assets to produce, produce the art, a large printing press or something. But you know, the printing press example, as I use it, is probably one for Andy Warhol. That’s an easy one. A lot of his art was made in Pittsburgh. Or was it New York? Wherever his factory was.

Matthew Foreman [00:16:20]:
Actually I think that was in New York, even though he was from Pittsburgh. And I think it’s really important to know where it’s sourced. So what this did with this case did was says that Mark Toby’s art was sourced to where? Basel, Switzerland. Because that’s where he made his art, despite the fact he was a US citizen and and legally domiciled in Seattle, Washington. Big fan of the Rain, I suppose. All right, we’re bringing it on home. We are up to the very, very, very last case that I will discuss in this and one of my favorite ones, Cohan v. Commissioner.

Matthew Foreman [00:16:52]:
All right, 39 Fed, Second 542nd Circuit Case, 1930, George M. Cohan. He wrote, composed, produced and appeared. I took this from Wikipedia, but it’s true. He wrote, composed, produced and appeared in more than 30 Broadway musicals. You know his stuff, you really do. Okay, he wrote over there, Give my regards to Broadway, Yankee Doodle boy and you’re a grand old flag. If you know none of those, particularly over there and you’re a grand old flag, then I don’t know what to do with you because you should know those things.

Matthew Foreman [00:17:25]:
I think those are the kind of Americana that everyone should know. I will admit to my own biases, but I think I’m right on this one. There is a biopic about him. It won an Oscar. He was portrayed by James Cagney. There’s a statue of him in Times Square and it is generally covered by pigeon poop. That part was not in my notes, but it’s True. If you find it.

Matthew Foreman [00:17:46]:
It’s actually a pretty nice statue of him, but the pigeons love it. And it’s always covered in poop, unless it’s recently rained pretty hard or snowed or something. But they come back to it. They like to sit on it and they like to poop. Such is life, right? Anyway, this decision was written by Billings Learned Hand, who also wrote the majority opinion. Who. Who wrote majority opinion in Gregory? The very first case. Bringing it back, circling it back.

Matthew Foreman [00:18:09]:
We’re in the Second Circuit, as was the. As is the case in Gregory. So I think it’s really important to note that these are two cases. This one I totally. Well, actually, in the results, I agree with both of them. This one’s a little more linear in terms of how it’s done. The issue is whether Cohan could deduct his business travel and his business entertainment expenses. Cohan was not great with regard to keeping records.

Matthew Foreman [00:18:34]:
I am being borderline fatuous with that statement. He kept literally no receipts or records whatsoever. Nothing. Literally nothing. Cohan would lose today. Treasury regulation 1.2745 C2 Romanet 3 cap A2. Say that two times fast. I’m gonna say it again.

Matthew Foreman [00:18:57]:
Treasury regulation 1.27415 C Roman at 3 cap A2. Repeated it because it’s a long one. It’s a good one, which. It only exempts expenses less than $75 from having documented documentary evidence such as receipts, paid bills, or similar. So he would lose today. This is really important. He didn’t lose that. He had a trial and his friends, the ones who attended his parties, testified on his behalf.

Matthew Foreman [00:19:24]:
When I say that he was famous. He was famous. He was a New Yorker in the 1920s. You know who testified for him? Babe Ruth. Okay. You can like anything. You can be unaware of pop culture or sports or really anything. I suspect you probably, if you’re listening this, you know who Babe Ruth is.

Matthew Foreman [00:19:41]:
I should say who Babe Ruth was. He passed. Geez. Probably 80 years ago, give or take. I don’t know when, but that’s probably around that. Anyway, so. So Babe Ruth, right? The Babe. The Great Bambino.

Matthew Foreman [00:19:53]:
The Sultans of Swat. You can keep going on. Again, second reference for that movie, he testified in his behalf and he said, man, George M. Cohen. Dude through the best parties. Great, great first name, too, right? So. So he. He talked about it, and in it, he said it.

Matthew Foreman [00:20:08]:
So the holding was really important. It said, you can’t just disallow a deduction because there’s no direct. There’s no evidence, there’s no receipts. And this is still true to some extent. But you can’t come back and say, no, no, I’ll talk about it. Don’t worry about it. Right. You must make.

Matthew Foreman [00:20:23]:
Be able to make a close approximation of the taxpayer’s deductible expenses. The taxpayer must, must, must, must produce sufficient evidence that an expense was incurred and provide at least some information that will allow a court to make an informed estimate of the amount. I will tell you, the IRS and states, pretend, Cohen and all, there’s a bunch of similar cases. It. They pretend it doesn’t exist, that it never happened. I, I got to tell you, it’s really frustrating when this happens. I’ve had it happen a number of times. I cite, look, I cite Cohen with some level of regularity because we’re either saying we don’t have receipts for this or like 469 context, we don’t have perfect records.

Matthew Foreman [00:21:08]:
Or like I want is, you know, they’re like, I want all of your. I want a complete log of every second. And you send one over that’s broken down by an hour and has three tasks. Well, this isn’t an hour. They may have all taken an hour, but I need to know 6 minutes and 12 minutes and 14 minutes and 22 minutes and whatever. And. And that’s just, that’s not realistic. There is a lot of litigation on Cohan Rule.

Matthew Foreman [00:21:29]:
You’ll find a lot of it in the SEC in the context of things like section 41 R&D credit, because they often don’t have contemporaneous documentation. Show the R and D they did. Why? Because they were sitting there doing the R and D, not sitting there writing it down. Any business will tell you that if you spend too much time writing down everything you tried to do that didn’t work, and you don’t just write down what worked and the big things you did and the big things that didn’t work for later. You’re going to spend your entire life documenting and not your entire life actually doing R and D. So it’s inefficient. I have to fight on Cohan a lot in the R and D context in a substantiation of records, 469, 465, a variety of different things, charitable contributions. That one’s largely done because you have to have certain amounts.

Matthew Foreman [00:22:15]:
But if you give a $10 donation, you don’t need to have a receipt. Contemporaneous documentation is sufficient, and I think that’s important to know. So that’s it. That’s the Cohan rule. I really like the Cohan rule. I think it’s one of those ones that it’s a borderline judicial created exception, exemption rule, whatever you want to call it. Probably just a rule that really works and I think makes sense. But again, the IRS pretends it doesn’t exist.

Matthew Foreman [00:22:41]:
I have to fight on it all the time. And the states pretend, especially auditors in both states and IRS doesn’t exist. You have to get counsel involved because they need the risk of losing in litigation to be scared into making reasonable arguments. On that lovely note, that was the 30th episode of How Tax Works. I hope you learned something. I know I did. The next episode, two weeks we’re going to talk about section 469 of the internal Revenue Code pass activity losses relating to real estate professionals and rentals. Think that’s a really important one, really interesting one.

Matthew Foreman [00:23:17]:
And we’ll get there. And now for the best song of all time.