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New Case Shows That K-1 Alone Won't Help to Prove S Corporation Basis

10 / 13 / 2015

Estate of Cape v. United States, 2015 U.S. Dist. LEXIS 134785 (E.D. Wisc. 10/2/2015)

This is a refund case in which the focus was on whether sufficient proof was submitted by the taxpayer estate.  At issue was what were the correct amount of pass-through claims adjustments flowing through to the deceased in years 2001 and 2002.  The taxpayer estate claimed that there was an overstatement of income that gave rise to an refund claim.  

The difficulty that arose was that the estate had to provide sufficient support for the refund claim, in a situation where the taxpayer shareholder in the S corporation has died, the S corporation went into receivership, a related company with respect to which the items relate, and the accounting firm doing the returns for the deceased (Arthur Andersen LLP) went out of business.  Plus, many years have passed, whereby memories can fade.  

For practitioners, a preliminary issue arose concerning the "evidence."  The United States took issue with the affidavits or declarations that were submitted in support of the refund claim and a motion for summary judgment.  FRCP 56(c)(4) makes it clear that any declaration submitted in support of a motion for summary judgment must be made on personal knowledge, set out facts that would be admissible in evidence, and show that the declarant is competent to testify on the matters stated.

Here, the declaration of one William Walther purported to "attest" to the percentage ownership of a related corporation and how accounting and financial information for the S corporation owned by the deceased was improperly reported, that it was properly to be reported on the related company, and attached that company's tax returns for 1999-2001.  That this company's returns accurately reflected the rental of equipment by this related company to the S corporation owned by the deceased, but the declaration was made "to the best of Walther's knowledge and belief.  The Federal Court noted that this is not sufficient; that this does not meet the personal knowledge standard.  Because Walther also stated that he worked at the S corporation owned by the deceased and not at the related company, and that he was merely "familiar" with the other related company, which provided payroll services and equipment rentals, this also meant that his declaration was not proper, because he was not competent to testify on the matters asserted.  Similar problems arose with regard to the declaration submitted by a former Arthur Andersen partner, where he could only claim that he "participated" in the preparation of tax returns for the deceased for the years 1996 through 2001, and recognized the signature on the returns of 1996, 1997, and 2001 as his.  He, too, stated that in preparing the tax returns, it was the practice of the Milwaukee office to gather information from the taxpayer and reflect such information on the taxpayer's return, and that to the best of his knowledge and belief, the tax returns were prepared in accordance with this process.  The signer of the 1996, 1997, and 2001 returns he was responsible for supervising employed this process, and to the best of his knowledge and belief, such returns were prepared in accordance with this process.  While the Court felt that this established SOME personal knowledge, it could be considered in part.  However, this declaration was viewed by the Court as lacking in detail to support the accuracy of the deceased's financial records.  Beyond that, the estate taxpayer attempted to use tax returns and K-1s for the truth of the matters asserted therein.  The Court was quick to note that the documents may be used as evidence of what is written on them, but they cannot be used for the truth of the matters asserted in them.  In other words, putting forth a K-1 from the S corporation to the deceased to show a charitable deduction amount cannot be used to prove that the company actually made a charitable deduction. The tax forms and schedule K-1 did not get presented to the Court by attestation by a custodian or qualified witness who could also adress that the records were made by someone with knowledge of underlying, supporting material.  The Court was also bothered by the fact that a 2003 income tax audit had uncovered errors in the S corporation return, suggesting that the returns might have a lack of trustworthiness under FRE Rule 803(6).  Nor did the Court view the tax returns and other schedules as retrieved from another firm's files as a "business record" qualifying for the business records exception for hearsay under FRE Rule 803(6) or the residual heresay exception under FRE Rule 807.  

In going through the undisputed facts, the Court did find that the deceased owned 50% of the company that rented equipment to the S corporation, and a 43 +/- % in the S corporation.  Noting that the IRS audited and adjusted the 1999, 2000 and 2001 returns in 2003, and pursuant to that audit, prepared a Form 4549, Income Tax Examination Changes,and it was the additional tax, interest, and peanlties assessed under this 2003 audit that also were paid.  The taxpayers timely filed a protective claim for refund for these years on or about April 14, 2005, and the IRS Appeals Officer who reviewed the same, did allow one small item of a contribution carryover.  

One of the issues that arose when looking at the returns and schedules was that the taxpayer estate was unable to determine the deceased's actual basis in the related company that rented the equipment to the S corporation the deceased owned.  The Court looked at the proposed computational adjustments and looked back at the 1998 charitable contributions suspended because of tax code limitations but which, in fact, should have been taken in 1999, those arising in 2000 which were suspended as deductions but which should have been taken in 2001, and alleged passive activity losses attributable to rental that were suspended as deductions from 1996 to 2001, but which should have been taken in 2002.at the death of the deceased.  These were the adjustments that gave rise to a refund.  The Court noted that if a S Corporation makes a contribution, it is required to substantiate that contribution with a contemporaneous acknwledgement and maintain that record, while the shareholder need not do so.  In 1998, the K-1 presented from the S corporation showed a pass-through charitable deduction at the corporate level of $4,251 allocated to the deceased, matching the % of ownership and the total amount appearing on the S corporation return. 

As the court put it, "(t)ax returns and K-1s are not evidence of the truth of the numbers stated in them.  Sparkman v. Comm'r of Internal Revenue, 509 F.3d 1149, 1157-58 (9th Cir. 2007),"  The key according to the court is that an evidentiary foundation be established, through deposition or other sworn testimony and verification that sufficiently rebuts a presumption of correctness favoring the IRS' position.  In other words, underlying documentation is always needed.  "That amounts on tax returns and K-1s match does not mean that the facts underlying those amounts are reliable or have been substantiated....The information behding the numbers in the tax returns and K-1s (assuming that the K-1s are true copies of the final versions, which is unknown) still must be substantiated.  That the plaintiffs' ability to obtain records confirming the bases for their refund claims is difficult does not support a judicial finding that IRS rules (on substantiation) should be relaxed to allow the refund sought in this case."

For practitioners out there, this is a case that will further support the need to substantiate basis with an evidentiary predicate, long after a tax return might not be subject to audit.