A taxpayer who was used as what might be termed a “partner of convenience” by a promoter in structuring tax shelters where a partnership entity was needed was found by the Tax Court to have self employment income on a payment of $2,000,000 in the case of Chai v. Commissioner, TC Memo 2015-42.

The taxpayer was approached by Andrew Beer, a person the taxpayer had met while attending Harvard and who later married Jason Chai’s cousin. Mr. Beer explained what he wanted Mr. Chai to do as follows:

After petitioner moved to New York, he lived in Beer’s home during the summer of 2002. That summer, Beer approached petitioner about participating in a new tax strategy Beer had developed to reduce tax liabilities of potential clients. Beer explained to petitioner that he intended to market the tax shelters to encourage wealthy individuals to become clients of Delta and its affiliated companies.

Beer also explained the tax strategy and the structure of the tax shelters to petitioner. Petitioner understood that the clients had large tax liabilities for a given year. Additionally, petitioner understood that the structure was a series of transactions designed to offset clients’ tax liabilities and that his role was to serve as a partner with the potential clients. These partnerships were integral to the overall structure. Furthermore, petitioner understood he would serve as a conduit and that the potential clients’ tax liabilities then would be transferred to him. Beer told petitioner the tax obligations transferred to petitioner would be eliminated by offsetting activities. Petitioner raised concerns about the transactions and asked Beer whether POPS and PICO were “pure tax shelters”. Beer assured petitioner these structures had been vetted by attorneys and accountants.

Mr. Chai became an accommodating party for at least 131 shelters that allocated to him over $3 billion of income on his 2000 and 2001 tax returns, receiving offsetting losses from other structures that he was assured eliminated his tax liabilities.

But that income and the deductions aren’t the issue in this case. Rather this case looks at the compensation Mr. Chai did or did not receive. Specifically at issue was a $2 million payment Mr. Chai received on March 2, 2003.

Mr. Chai had an exchange with the chief financial officer of a related organization, Helen Del Bove, regarding the tax status of the $2 million payment.

The court related that exchange as follows:

Before petitioner received the $2 million payment, however, he and Del Bove had exchanged several emails in February 2003 discussing the proper tax treatment of the $2 million payment. Del Bove notified petitioner that Delta was going to wire petitioner the $436,000 remaining in JJC, dissolve that entity, and pay petitioner an additional $2 million. In response, petitioner asked: “To this end, can you fill me in on how this money should be treated as far as my accountant is concerned? Will I be issued a 1099 for the whole amount?” Del Bove responded that the $2 million payment “will be reported on a 1099, so you should tax-plan accordingly.” Petitioner again asked for clarification on whether both the $2 million payment and the balance in the JJC account were going to be reported on his Forms 1099 for 2003. Del Bove responded that “[t]he amount you receive from JJC Trading is not income and, therefore, will not be reported on a 1099. That money is from what you had originally invested in JJC Trading. The 2mm we pay you will be reported on a 1099, as well as any other subsequent payments.”

The Court noted that Mr. Beer viewed the payment as a discretionary bonus to Mr. Chai and, consistent with past practice, reported the $2 million on Form 1099 as nonemployee compensation.

However, Mr. Chai did not report this as an item subject to either income tax or self-employment tax on his 2003 return. As the Court noted:

Petitioner did not report the $2 million payment from Delta as taxable income, contending that it was a return of capital from his investments. However, petitioner was not a partner of Delta and did not invest any capital in Delta. Neither petitioner nor JJC reported receiving a share of Delta’s income or loss. No Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc., was prepared by Delta for petitioner.

However, as the Court noted, there appeared to be a real problem about just what sort of return of capital this might be.

All of petitioner’s interests in the other tax shelter entities were either sold or redeemed before he received the $2 million payment in 2003. In closing agreements executed between petitioner and the Internal Revenue Service (IRS) with respect to POPS and PICO, petitioner agreed that he had disposed of all his interests in the tax shelter entities by the end of 2001. Petitioner reported the amounts he received before 2003 on Forms 1040 for 2000 and 2001. JJC reported amounts received in completed sales of its interests in 2001.

Mr. Chai did seek professional assistance in preparing his 2003 return, but he “edited” the information he provided to the CPA. And, as the Court noted, the CPA made certain assumptions (which arguably may have been reasonable based on a key fact Mr. Chai left out) based on the information he did receive that also proved to be in error.

As the Court summarized:

Petitioner reported zero total tax on his income tax return for 2003. Stephen Ellspermann, a certified public accountant, prepared petitioner’s income tax return for 2003. Petitioner and Ellspermann discussed the nature of the $2 million payment before filing petitioner’s return for 2003. Petitioner told Ellspermann that he did not know the nature of the $2 million payment. He indicated to Ellspermann that the $2 million was from activities managed by Bricolage and that Ellspermann should contact Bricolage to clarify its nature.

Before filing petitioner's income tax return for 2003, Ellspermann asked Del Bove's replacement, Barney Taglialatela, about money transfers between petitioner, JJC, Mercato Global Opportunities Fund, LP (Mercato Global), and Bricolage. He did not ask Taglialatela about money transfers to petitioner from Delta. Ellspermann understood, on the basis of his conversation with Taglialatela, that everything pertaining to the partnerships was included on the Mercato Global Schedule K-1 issued to petitioner. Ellspermann believed that the $2 million payment was included on the Schedule K-1. He believed this, even though he did not specifically ask Taglialatela if the $2 million payment was included on the Schedule K-1. Taglialatela did not tell Ellspermann that the $2 million payment from Delta was not income or that it would not be reported on Form 1099 for 2003. Similarly, Taglialatela never told petitioner or Ellspermann that the $2 million would be reported on Schedule K-1. The $2 million payment was not reported as a withdrawal or distribution on any Schedule K-1 or any combination of Schedules K-1 that petitioner received for 2003.

Before filing his income tax return for 2003, petitioner did not tell Ellspermann about his email correspondence with Del Bove regarding the $2 million payment and that Delta intended it to be income reported on a Form 1099 for 2003. He also did not tell Ellspermann that Del Bove had notified petitioner that he would receive future fees for his consulting work with Delta. Ellspermann first learned of the Delta Form 1099 for 2003 in 2008 during the examination of petitioner’s income tax return for 2003. Had Ellspermann known of the Form 1099 for 2003, he would have discussed the tax treatment of the $2 million with Taglialatela.

So now we turn to the proper treatment of this payment. The Court concludes that this was not a return of capital for a number of reasons.

As the Court points out:

Aside from his blanket assertions, the evidence establishes that petitioner was not a partner in Delta and did not invest capital in Delta. The parties stipulated that petitioner received the $2 million payment from Delta and Delta’s characterization of that payment. Simply stated, the payment could not have been a return of capital because petitioner did not have any capital invested in Delta.

The evidence establishes that petitioner did not have a capital investment in any tax shelter entity after 2001. In closing agreements with the IRS, petitioner agreed that both he and JJC sold or redeemed all of their respective interests in the tax shelter entities by the end of 2001. He recorded amounts received in sales or redemptions of his interests in the tax shelter entities on his income tax returns for 2000 and 2001. Similarly, JJC recorded amounts received in sales or redemptions of its interests in the tax shelter entities on its income tax return for 2001.

In fact, the Court notes that Mr. Chai couldn’t really point to exactly which entities this would represent a return of investment from.

Petitioner did not know which, or how many, of the Bricolage entities’ partnerships he had invested in. He did not keep track of the partnerships, his investments in the partnerships, or the transactions they engaged in. He concedes that it is impossible to trace his investments in the Bricolage entities because the tax shelters’ structures were too complex and vast to unwind. Finally, he notes that tracing his investments is impossible because he has repeatedly been denied access to necessary financial records.

Well, if it wasn’t a return of capital then he argues this was a gift from Mr. Beer to him. The Court quickly dismisses that as well, noting:

Petitioner alternatively argues that if the $2 million payment is not a return of capital, then it was a gift from Beer. Petitioner notes that "[w]hile the Court may think the suggestion that the payment was part gift somewhat far-fetched, this case must be decided on the evidence presented." We agree with petitioner's characterization of his suggestion and the necessity of deciding the case on the evidence, but we reject his conclusion. A gift results from a detached and disinterested generosity motivated by affection, respect, admiration, charity, or the like. Commissioner v. Duberstein, 363 U.S. 278, 285 (1960). The record is devoid of any evidence suggesting that the payment resulted from detached and disinterested generosity. Rather, the evidence establishes that the payor, Delta, intended the payment as compensation. Notably, Beer testified that he viewed the $2 million payment as a discretionary bonus for services petitioner provided to Delta. The evidence compels the conclusion that the $2 million payment in question was received for services and was neither a gift nor a return of capital contributions that neither petitioner nor Beer could identify.

Mr. Chai claimed that even if this was income, it surely wasn’t self-employment income—after all he was “merely” an accommodating party that allowed himself to be a “partner” in various structures that Beer was marketing.

The Court disagreed. It noted that Mr. Chai’s participation was crucial to the structures that Beer was claiming would provide tax benefits to his clients. He had received payments in prior years that he knew had been treated as compensation by Delta, and he had been told point blank that Delta would treat the $2 million payment in the same fashion.

But, he argued, he was not regularly engaged in a trade or business, a key requirement for the self-employment tax to apply. But the Court decided that he clearly was regularly engaged in a trade or business, noting:

The record demonstrates that petitioner's activities were continuous and regular. Petitioner testified that he went to Bricolage's offices "a lot" and "regularly" to execute large volumes of legal documents consisting of formation and organization documents for the tax shelter entities. This fact remained even after petitioner formed JJC in 2001. By forming JJC, making Bricolage JJC's nonmember manager, and giving Bricolage power of attorney over JJC, petitioner's activities remained continuous and regular. Bricolage's actions with respect to JJC are imputed to petitioner as his agent. Petitioner established the legal machinery for others to act on his behalf and cannot now use that delegation of authority as a shield. The record also demonstrates petitioner's profit motive. Petitioner was paid for his services through large lump-sum payments that were reported by the payors as nonemployee compensation on Forms 1099, and petitioner reported the payments as self-employment income. In short, the record demonstrates that petitioner accommodated tax shelters with sufficient continuity, regularity, and a profit motive such that he was engaged in a trade or business as a tax shelter accommodating party.