Bruner v. Commissioner of Internal Revenue (T.C. Memo 2018-10)

By James E. Holland • February 16, 2018 • 0 Comments

It was a quiet Tuesday afternoon. The first State of the Union address from President Trump was to take place that evening. No one expected any interesting government releases before the speech. At 3:30 p.m., I made my routine check of the Tax Court website for opinions that were issued.[1] There was only one opinion; the case of David L. Bruner, Petitioner v. Commissioner of Internal Revenue, Respondent (hereafter referred to as Bruner). 

The issue before the Tax Court was a motion for award of litigation and administrative costs (pursuant to Internal Revenue Code (IRC) section 7430 and the Tax Court Rule of Practice and Procedure. To me, that meant the IRS had lost or conceded its position and the taxpayer wanted to recover attorneys’ fees. Therefore, I thought that Bruner would not be of much interest from a pension perspective. I was wrong!

Upon further reading, it turned out that Bruner is of great interest from a pension perspective. It revolves around who gets the deduction for defined benefit plan contributions in a limited liability company (LLC). This article will describe the case and the pension matters at issue.

Facts of the Case[2]

The tax years at issue were 2011 and 2012. David Bruner was a member of Circle Road Financial LLC (Circle Road), a two-member LLC formed in 2004. At all relevant times Circle Road has been treated as a partnership for federal income tax purposes. Circle Road’s original operating agreement, dated Dec. 1, 2004, provided that each member had a 50% “participation percentage” and that profits, losses and deductions would be allocated 50% to each member. From the opinion, the name of the other member of the LLC was Eneas Kane.

On Jan. 1, 2006, Circle Road established a defined benefit plan. Contributions for 2011 were $288,897 and contributions for 2012 were $650,454. Circle Road claimed deductions for those amounts. On Schedules K-1, Circle Road allocated to David Bruner about 92% of the 2011 contributions ($265,560) and 100% of the 2012 contributions ($650,454). On his Forms 1040, Bruner reported flow-through deductions of $265,560 for 2011 and $640,454 for 2012. The Court, in footnote 3, stated it was unclear why Bruner took a flow-through deduction of $640,454 on the Form 1040, or $10,000 less than the amount reported on the Schedule K-1.

No further information was provided with respect to the plan or the calculation of the deductible limit in the Court’s opinion. However, I found the Forms 5500-SF and Schedules SB for 2011 and 2012 (calendar plan year) on the Department of Labor (DOL) website. From the Schedules SB, the plan had three participants at the beginning of 2011 and the beginning of 2012. There were only two participants at the end of 2012.[3] The 2012 Schedule SB shows an Adjusted Funding Target Attainment Percentage (AFTAP) of 116.68% in line 15, and that the valuation date was the end of the plan year. Furthermore, the target normal cost for 2012 was reported as $224,626, and the funding target reported was $1,278,110. The discounted contribution of $650,454 was $640,878. It is clear from the 2012 Schedule SB that the contribution of $650,454 was much in excess of the amount needed to meet the minimum required contribution for that year.

Lastly, from the Forms 5500-SF, the address for Circle Road was in Scottsdale, AZ, and the Tax Court stated that Bruner resided in Arizona.

Audit and Beyond

The IRS selected Circle Road’s and Bruner’s 2011 and 2012 returns for examination. As a result of the examination, the IRS challenged the allocation to Bruner of amounts exceeding 50% of the plan contributions. Circle Road had amended its operating agreement five times between 2008 and 2012 to make exceptions to the 50-50 allocation for certain (unspecified) items, but none of the amendments addressed the allocation of plan contributions, and Bruner provided no documentation to substantiate that an amendment addressing the subject had been made.

Based upon the 50-50 split, the IRS allowed Bruner 50% of the amounts contributed for each year and disallowed the remaining amounts allocated to him. That produced income tax deficiencies of $46,473 and $110,330 for 2011 and 2012 respectively. Bruner filed with the Tax Court for redetermination. In his petition to the Tax Court, Bruner alleged that Circle Road’s members had modified the operating agreement to permit a special allocation of the deduction at issue. In its answer filed on July 13, 2016, the IRS denied Bruner’s allegation for lack of substantiation.[4]

On Dec. 6, 2016, Bruner provided a declaration of Eneas Kane to the IRS Appeals Office.[5] That declaration stated that Circle Road had specially allocated to Bruner both the cost and accompanying deduction attributable to the pension benefit. The declaration also averred that:

  • Circle Road’s special allocations were reflected in the respective member’s capital accounts;
  • Kane agreed to the special allocations and the way they were made;
  • the special allocations were consistent with their economic sharing agreements; and
  • Circle Road’s established course of dealing and performing was to specially allocate the pension deduction.[6]

The IRS Appeals Office accepted Kane’s declaration as establishing that he and Bruner had orally modified Circle Road’s operating agreement to allow a special deduction of the defined benefit plan contributions. The parties began discussing settlement of the tax issues.

The IRS then filed an amended answer to the petition. In the amended answer, the IRS claimed that Bruner’s deductions were subject to the earned income limitation of section 404(a)(8)(C). Subsequently, Bruner and the IRS agreed that there was no limitation for 2011 because adjusted earned income was $520,053 and exceeded the allocated contribution of $265,560. For 2012, Bruner and the IRS agreed section 404(a)(8)(C) limit applied because the adjusted earned income was $489,687, and was lower than the allocated amount of $640,454.[7]

On May 15, 2017, the parties filed a stipulation of settled issues in which they agreed that:

  • Bruner’s share of the deduction for Circle Road’s plan contributions is $265,560 for 2011 and $640,454 for 2012;
  • Bruner is entitled to flow-through deductions of $265,560 for 2011 and $489,687 for 2012;
  • there is no income tax deficiency for 2011; and
  • there is a deficiency of $52,769 for 2012 (presumably based upon the disallowance of the excess of $640,454 over $489,687).

In June 2017, Bruner filed a motion for reasonable litigation and administrative costs.

Tax Court’s Opinion

After much analysis, the Tax Court denied the request for reasonable litigation and administrative expenses. While a complete explanation of the law and legal reasoning can be found in the opinion (much of which is unrelated to pension issues), the question boiled down to whether the IRS was “substantially justified” in disallowing the deductions and asserting there were tax deficiencies. The Tax Court found the IRS was “substantially justified” in its actions. The court needed to consider both the date of the notice of deficiency (for administrative costs) and the date of the answer to the Tax Court (for litigation costs). In this case, the basis of the deficiency was the 50-50 operating agreement and was the same at both dates. The reasoning behind the Court’s opinion is instructive.

The Tax Court first referred to section 1.404(e)-1A(f) of the regulations that provides, for contributions to a defined benefit plan, a partner’s distributive share of contributions made on behalf of the self-employed individuals and deductions for such contributions is determined in the same manner as the distributive share of partnership income. Next the Court referred to section 702(a) that provides a partner (or member of an LLC treated as a partnership) shall take into account his or her distributive share of the partnership’s items of income and deductions. Section 704(a) came next as the Court noted that a partner’s distributive share generally shall be determined in accordance with the partnership agreement.

The Tax Court, citing section 1.761-1(c) of the regulations, noted that modifications to a partnership agreement generally may be made orally or in writing. The basis of the IRS adjustments was the written partnership agreement. It was five months after the IRS initially answered the Tax Court petition that counsel for Bruner provided the declaration from Kane. The IRS had previously asked for the operating agreement and any amendments, modifications, etc. (see footnote 4 of the opinion), and the declaration was the first evidence of any modification affecting retirement plan contributions. After reviewing the declaration, the IRS conceded the 2011 deficiency and reduced the 2012 deficiency, which the Tax Court found to be reasonable in fact and in law.

Prior to the Kane declaration, the position of the IRS had, according to the court, a reasonable basis both in law and in fact, and was justified to a degree that could satisfy a reasonable person. Therefore, the Court held the position taken by the IRS was substantially justified, and no litigation or administrative costs were awarded.

Comments and Takeaways

With proper documentation, this case would never have gone to court. The chain of law referred to by the Court pointed to the partnership agreement and Bruner and his tax advisors would be expected to be aware of the law and regulations. When the IRS commenced its examination, the declaration could have been furnished early on in the process thus forestalling the adjustments on the basis of the partnership agreement.

Obviously, the better practice may be to have prior written modification to the partnership agreement. However, that was not the situation in Bruner. Furnishing substantiation of the modification late in the process resulted in Bruner having to bear the costs of contesting the adjustment.

The IRS applied section 404(a)(8)(C) to both years and limited the 2012 deduction to earned income. That in itself resulted in some additional tax. Aside from accepting the settlement, the Tax Court’s only observation concerning section 404(a)(8)(C) (found on page 6 of the opinion) was this parenthetical statement: “(That section provides in part that certain retirement plan contribution deductions are limited to the earned income an individual derives from the trade or business with respect to which the plan is established.)” We can expect that the IRS will compare deductions against earned income in other partnership situations.[8]

So what should we take away from Bruner? I suggest the following points, which are not necessarily the responsibility of the actuary:

  • Make sure allocations of deductions are in accordance with the partnership agreement taking into account all modifications.
  • Expect that the IRS will ask for the agreement and all modifications.
  • Watch out for section 404(a)(8)(C) and check to see if the deduction exceeds earned income.
  • While tax advice is generally not the province of the actuary, the tax advisor may need to be warned of the pitfalls, particularly when there is a change from what was done in prior years.

Of course, others may have their own thoughts, but at the very least Bruner should be taken into account in providing advice.

Footnotes

[1] The Tax Court generally releases any opinions at 3:30 each day from Monday through Thursday.

[2] Unless otherwise stated, all facts are taken from the Tax Court’s opinion.

[3] There were no Forms 5500 for later years on the DOL website for Circle Road.

[4] In short, when the petition is filed with the court, the other side has to answer it and agree, or disagree with the specific claims made by the petitioner.

[5] Even after a petition to the Tax Court has been filed, there may be an opportunity to settle a case in Appeals.

[6] See the last paragraph of page 5 of the opinion.

[7] No details of the computation of adjusted earned income were given in the opinion.

[8] A complete analysis of section 404(a)(8)(C) is beyond the scope of this article.

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