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March 09, 2023 At Court

Practitioner (and Commissioner) Beware: Do Not Make the Palmarini Lack of Substantiation Mistake

Peter D. Randolph

Palmarini provides a veritable case study in what not to do when operating your closely held business. Much of the case details the variety of ways in which Palmarini Inc. (Palmarini) and its president Benito Palmarini failed to keep adequate records, commingled business and personal assets, failed to appropriately differentiate multiple businesses, and prepared and filed inaccurate business and individual tax returns.

Palmarini Inc’s disorganized recordkeeping (if it can be called recordkeeping) does not enable one to verify the business purpose and specific amounts paid for “other” expenses. His documents show a tangle of business and personal, of capital and ordinary, and of mixed lines of potential business. His information was in such disarray that he himself, preparing returns in the months after the close of the years at issue, was unable to determine with reasonable certainty his own deductible expenses, so he filed a series of amended returns claiming deductions inexplicably “not included” in a return filed days before, or stating “[m]ore deductions found in Line 26.”

While the details are instructive, and somewhat entertaining from a practitioner’s perspective, this is ultimately a case about substantiation. Although Palmarini, Benito and Benito’s wife Bernadette are ultimately determined to have underreported hundreds of thousands of dollars of income and were assessed accuracy-related penalties for the years in question, the court also removed substantial constructive dividends from the Commissioner’s determination due to the Commissioner’s own failure to connect certain payments to Benito or to meet the Commissioner’s burden of proof that payments were primarily for Benito’s benefit.

I. Background Facts

Palmarini, a cement construction business in southeast Pennsylvania originally established as a sole proprietorship, was incorporated in 1983. By 2013, following a series of share transfers, brothers Pacifico (49.75%), Benito (33.16%), and Manuel (16.58%) owned the business. The brothers were officers, though Pacifico was no longer involved in the relevant years when Benito served as president and managed the business operations. Palmarini’s principal place of business was a garage in Philadelphia, for which it paid rent to Manuel (the owner) until in March 2014 the property was transferred to Palmarini, renovated and placed in service in August 2014.

By 2013, Palmarini’s only cement work was uncompensated work performed on Benito’s personal rental properties; instead, Benito and Manuel began an affiliated online marketing business. Although Benito set up an LLC for the marketing business, all business activity for 2013-14 was run through Palmarini and its existing accounts.

Benito self-prepared and timely filed (March 10, 2014 and March 6, 2015) Palmarini’s Form 1120 and the joint Form 1040 for himself and Bernadette for both 2013 and 2014. Palmarini filed 7 amendments to its 2013 Form 1120, the last of which was filed June 25, 2015. Palmarini filed 3 amendments to its 2014 Form 1120 between April 7 and June 27, 2015. On November 14, 2016, the Commissioner issued statutory notices of deficiency (NODs) to Palmarini, Benito and Bernadette finding deficiencies and section 6662(a) accuracy-related penalties for 2013 and 2014 as shown in Table I.

Table 1: Notice of Deficiency Amounts

Table 1: Notice of Deficiency Amounts
Taxpayer Year Deficiency §6662(a) Penalty
Palmarini 2013 $ 219,364 $ 43,873
  2014 $ 175,221 $ 35,044
B & B 2013 $ 118,955 $ 23,791
  2014 $ 106,550 $ 21,310

II. Key Issues in Dispute

Each taxpayer timely filed for redetermination of deficiencies and penalties under section 6213(a), and the parties stipulated to certain facts, leaving 8 remaining issues. This article will deal with the following: Palmarini’s gross receipts for 2013 and 2014; whether Palmarini is entitled to certain deductions for compensation/wages, bad debt, and other deductions in 2013 and 2014; and whether Benito received constructive dividends in those years.

A. Gross Receipts

Section 6001 mandates that taxpayers keep records, statements, and file returns. Forms 1099-MISC for Palmarini filed by third parties showed gross receipts for $628,149 (2013) and $672,362 (2014), but the amounts reported as gross income on the original 2013 and 2014 returns did not even agree with those third-party numbers.  Palmarini reported gross income of $866,986 (2013) and $659,789 (2014). Palmarini dug its own grave from which it could not climb out by failing to maintain anything resembling books and records. Rather than allowing Palmarini to “benefit from its own failure” by determining gross income to include only amounts reported by others, the court reviewed the various amended returns and found that on one of its amended 2013 returns, Palmarini reported just shy of $900,000 in gross receipts, while on an amended 2014 filing, Palmarini reported gross receipts just shy of $950,000. Palmarini provided no explanation for the source of those numbers nor why they disappeared in additional filings. The Commissioner’s bank deposit analysis (BDA) of $959,248 (2013) and $937,532 (2014) satisfied his evidence burden.

B. Deductions

Palmarini claimed a variety of deductible expenses: compensation of officers, salaries and wages; rent; repairs and maintenance; bad debt; and depreciation. Under INDOPCO, the taxpayer bears the burden of clearly showing “the right to the claimed deduction.”

1. Officer Compensation; Salary & Wages

Under section 162(a)(1), a taxpayer may deduct reasonable salaries and other compensation for personal services that are ordinary and necessary business expenses. Deductibility of these expenses requires that payments be made only for services. The taxpayer bears the burden of proving that payments were intended as compensation. Palmarini claimed a deduction for officer compensation in 2013 for $92,400 that was not substantiated by the company’s bank records but claimed no salary payment in 2014. Palmarini filed no Form W-2, FUTA or Form 941 in either year. The court disallowed the entire officer compensation claim for lack of substantiation.

Palmarini also claimed additional wages for Benito’s labor in renovating the garage used as Palmarini’s principal place of business, with invoice evidence supporting payments of $58,100 (2013) and $76,500 (2014). Although the Commissioner had treated those payments as constructive dividends, the court found there was sufficient evidence to allow those wage deductions.

2. Bad Debts

Section 166 allows a deduction for a bad debt that becomes partially or wholly worthless during a tax year if the taxpayer can satisfy the following requirements:

  1. the debt is bona fide;
  2. the debt was incurred in a trade or business;
  3. the debt became worthless or partially worthless in the taxable year; and
  4. the taxpayer reports on the accrual basis.

There are various indicia of a bona fide debt, including “whether: (1) evidence of indebtedness exists; (2) any security is requested; (3) there has been a demand for repayment; (4) the parties’ records reflect the transaction as a loan; (5) any payments have been made; and (6) interest was charged.”

The bad debt deductions claimed by Palmarini for 2013 and 2014 are shown in Table 2.

Table 2: Bad Debt Deductions

Table 2: Bad Debt Deductions
Year Version Amount Explanation
2013 Original $ 80,541  
  3/12/15 $ 123,429 None
  4/25/15 $ 204,056 “Total deductions increased … due to underreporting”
  4/28/15 $ 237,458 None
2014 Original $ 81,900  
  4/7/15 $ 0 “Line 15 error on original return.”

The claimed bad debt was an alleged unpaid balance from 2011 of “approximately $240,000” due from Epic Media Group for affiliated marketing services. It is unclear from Palmarini’s unexplained changes in its various amended returns what the alleged debt equaled.

The Commissioner disallowed the bad debt deduction in full, finding the debt was not bona fide and lacked substantiation. The court agreed, ruling that there was a business-consumer relationship but no debt between Palmarini and Epic Media Group. The court considered whether a deduction could nonetheless be claimed by Palmarini for a debt arising out of an unpaid receivable but concluded that would only apply for an accrual method taxpayer that had previously included the income. Palmarini stated it was a cash-method taxpayer on its original returns for the relevant years, and there was no evidence that it had actually changed its method of accounting by 2011 (other than a checked box on its amended returns for 2013 and 2014). It did not enter its 2011 Form 1120 into evidence to prove that it had reported the alleged income or that it had become an accrual method taxpayer or provide evidence of securing the consent of the Commissioner to do so.

3. Other Deductions

The court appears to vent its full frustration with the company and its owner’s numerous amendments, lack of substantiation, and wild variations in deductible expenses with no credible explanation or evidence in considering the variable line 26 “other deductions” reported not on the company’s original 2013 or 2014 returns but on its multiple amended 2013 and 2014 returns.

Table 3: Line 26 other deductions

Table 3: Line 26 other deductions
Year Version Line 26 Explanation
2013 Original $ 0  
  2nd Amended $ 18,129 “On previous return $18,129 payable for rents …not included”
  4th Amended $ 16,159 statement attached (which the court found “illegible”)
  6th Amended $ 14,826 “1120 Line 26 Other Deduction 2013”
  7th Amended $ 38,290 “More deductions found in Line 26 –Form 1120”
2014 Original $ 0  
  3rd Amended $ 57,337 “More deductions found in Line 26 missed in earlier return”

At trial, Palmarini, somewhat brazenly it seems, claimed $165,122 (2013) and $128,550 (2014) in additional “other” expenses paid on a VIST bank account, as well as additional large expenses of $364,261 (2013) and $467,369 (2014) paid by the company for charges on an American Express card in Benito’s personal name.

If you are confused by these expenses, you’re in good company. The court had no more patience for the mental gymnastics Palmarini was asking it to perform to reach any conclusion that these “other” deductions were legitimate since they were claimed on various amended returns, inexplicably in and out of the same year returns at different amounts, in different amendments, at trial, and eventually in post-trial briefing. The court found Benito’s testimony not credible, issuing the blistering rebuke of his “record keeping” quoted at the beginning of this article. The court added more:

The best time to tally business expenses for 2013 and 2014 was when the returns were due, in 2014 and 2015; but Mr. Palmarini now unwittingly discredits his own contemporaneous reporting by years-late allegations of substantial additional expenses.

Suffice it to say that the court sustained the Commissioner’s disallowance of other expense deductions that were not conceded elsewhere.

C. Constructive Dividends

Under sections 301(c)(1) and 316(a), dividends are any distribution of property to shareholders paid out of a corporation’s earnings and profits and must be included in gross income. A constructive dividend may arise when economic benefits are provided to shareholders or related parties “even though neither the corporation nor the shareholder intended a dividend.” The test is whether the primary purpose of the distribution is to confer such benefit. The Palmarini court provides a good primer, laying out the parameters of the test to determine whether a constructive dividend has been conferred: (1) the expense must be non-deductible to the corporation, and (2) represent some economic gain to the shareholder. The standard, however, is actually more precise for the second prong of the test: “The crucial test of the existence of a constructive dividend is whether ‘the distribution was primarily for the benefit of the shareholder.’” The Commissioner bears the burden of producing evidence of a connection between the unreported income and taxpayer.

The Commissioner’s initial determination of constructive dividends to Benito for 2013 and 2014 assumed that any non-deductible expenditure by Palmarini was a dividend to Benito: he revised the determination, but not the method of calculation, after conceding certain deductible expenses. The court found that the Commissioner’s “shorthand” method was “problematic” because it failed to satisfy the burden of connecting the taxpayer with the unreported income. Because some of the non-deductible expenses that the Commissioner included in his calculation lacked any description, the court concluded they could not be treated as constructive dividends, since there was no showing that the payments were connected to—and primarily for—Benito’s benefit, or whether they were actually made. This holding allowed Benito to benefit from his own failures, despite specifically denying the same to the company in the gross receipts analysis.

The court also found a lack of connection in analyzing the Commissioner’s case for additional constructive dividends for the benefit of other family members, including Benito’s mother. As noted, the Commissioner had used a shorthand that attributed all of the difference between disbursements and allowed expenses to Benito, but the court found that numerous payments were labeled as payments to his brothers or mother. Those payments, regardless of whether authorized by Benito, could have been made to Pacifico and/or Manuel as shareholders in Palmarini, or to their mother on the brothers’ behalf. The court held that the Commissioner did not establish a connection primarily for Benito’s benefit where other family members were shareholders of the Corp and payments to Benito’s mother could be a benefit flowing to her other sons as well as to Benito. The court appears, however, to misread Loftin for the “primarily benefits” portion of the two-part constructive dividend test. The purpose of the primary benefit test is to analyze whether the benefit was primarily for the benefit of the company or the shareholder/member, not whether the benefit is primarily or solely for the benefit of the individual shareholder/member.

A final category determined to be constructive dividends by the Commissioner were personal and rental expenses, including maintenance of Benito’s rental properties, a personal vehicle, medical bills, and a family vacation. These types of personal benefits are not deductible to a corporation and are likely to be deemed a constructive dividend. Checks written for all of these expenses on Palmarini’s bank account satisfied the Commissioner’s burden of proving a connection between the payments and Benito, shifting the burden to Benito show why these expenses should not be treated as constructive dividends. Benito argued, inter alia, that use of his rental properties was for business purposes, but no rental agreement, recurring payments, or other indicia of agreement between Palmarini and Benito were offered into evidence. Benito argued that the medical expenses were covered by the company in accordance with its bylaws, but no bylaws were produced and even had they been, “bylaws do not overrule the federal income tax consequences of a corporation’s distributions to its shareholders.” The court was unconvinced, noting Benito may be able to deduct certain of those expenses in Schedule E of his individual tax return, but they would be constructive dividends to him when paid by the corporation. Benito received constructive dividends in 2013 of $116,741 and in 2014 of $62,798.

III. Conclusion

While the Palmarini court did not make new law, it gave us a primer on a variety of issues often seen together, including taxpayer failure to keep accurate books and records; expenses that are non-deductible due to lack of substantiation; and the burden of proof on both the Commissioner and the taxpayer to connect payments to the taxpayer and provide evidence that such payments were primarily for the taxpayer’s benefit. Benito’s failure to keep accurate records in this case was ultimately to his and Palmarini’s detriment. He prepared and filed 12 original and amended returns for 2013 and 2014, reducing his credibility with the court through multiple unsubstantiated values and contradictory positions and increasing his own risk of liability. Palmarini was unable to rebut the Commissioner’s BDA because there were no credible records produced in evidence, and Palmarini was unable to prove that any of the claimed officer compensation was paid. It was only through the Commissioner’s analysis that the wages paid for labor on the garage were deductible. Palmarini’s lack of substantiation for the bad debts and Line 26 other deductions made Benito’s testimony not credible to the court and resulted in the court excoriating Benito for his role in preparing the returns and running his business.

It was the same lack of records that hurt the Commissioner in the constructive dividend context, where the Commissioner’s shorthand calculation of constructive dividends failed to meet his burden to show a connection between non-deductible expenses and Benito or a clear benefit to Benito rather than to other shareholders for payments to family members. One of the lessons for practitioners to take from Palmarini is that substantiation goes both ways. The Commissioner is bound by the same rules of substantiation under the Code and the Tax Court Rules as the taxpayer.

    Peter D. Randolph

    Lawless, Randolph & Dale, LLC, Bethesda, MD

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