Who Are You?
“Who are you?” said the Caterpillar.
-- Alice’s Adventures in Wonderland
“Who are you?” is an often-asked question. We may hear it from philosophers, psychiatrists, psychologists, social scientists, Homeland Security, the FBI, the CIA, the NSA, and practitioners. But we will let them tend their gardens while we tend ours. A related question arose recently in Jason Chai v. Commissioner, T.C. Memo 2015-42. More specifically, the issue was whether the taxpayer had non-employment compensation, subject to self-employment tax.
Jason Chai v. Commissioner
The Facts: During all relevant times, the taxpayer (Chai) conducted a successful architectural business. While at university, Chai met Andrew Beer (Beer). Beer created and marketed several tax shelters (as called by the Tax Court), directed to wealthy individuals. The tax shelters did what tax shelters do -- offset clients’ large tax liabilities with tax losses.
Without going into unnecessary detail, we will summarize by stating that this tax shelter construct needed a transitory or accommodating party who received income from certain transactions while the rich folks received the losses. Chai acted as the accommodating party. The income to Chai? Easy. Again, simply put, offsetting losses. (One does wonder why these constructs are called “tax shelters.” Tax is sent out the door into the howling night. It is income that is sheltered.) In 2003, Chai received a $2,000,000 payment from Delta Currency Trading, LLC (Delta), one of the entities forming part of the tax shelter construct. Chai did not report the $2,000,000 as taxable income, contending that it was a return of capital from his investment in Delta. The Commissioner argued that the $2,000,000 payment was non-employee income, subject to the self-employment tax.
The Holding: The Tax Court held for the Commissioner. What makes the case interesting is not the holding but Chai’s spirited offense. Some of his arguments are set out below.
- Chai argued that he delegated real decision making to Beer through certain entities controlled by Beer, including Delta. The best the Tax Court could muster was that the “risky nature and large receipts of the tax shelters” justified that high compensation despite the low amount of Chai’s efforts (other than using a pen to sign documents).
- Chai apparently used his pen a lot because, as the accommodating party, he had to go to Beer’s office “a lot” and “regularly,” and he felt the burden because his architectural business required travel. The Tax Court cited the burden on Chai’s time as evidence of providing services but said no more.
- During the relevant years, Chai, at the suggestion of a representative of Delta, formed JJC Trading, LLC (JJC), which removed Chai from even the signing process (see above). Chai said, in effect, that he did nothing for the money. Here again, all the Tax Court could do was cite the significance of signing the formation and organizational documents necessary to assure the creation of the tax shelters. The Tax Court said that in removing himself from signing, Chai did not remove himself from tax liability for the compensation.
- Chai’s argument that the $2,000,000 was a return of capital failed because he could not prove that he was ever an investor in Delta.
There is no evidence in the record that Chai sought tax advice. Beer had assured Chai that the tax structures in question had been vetted by attorneys and accountants (what are friends for?). But given Chai’s spirited offense, how can we, as an exercise, reshape the construct to favor Chai more?
- We would certainly advise Chai to assure he had an investment in Delta. Code §61 is appallingly broad. In this case, if there were no investment in Delta, there is no argument that there was merely a return of income.
- Certainly the formation of JJC, whose manager was not Chai, gives serious support to Chai’s argument. The Tax Court dismissed Chai’s argument even though Chai did nothing after the formation of JJC. The Tax Court’s argument was that Chai’s “delegation of his signature authority does not absolve him from liability for tax on compensation that he received.” Really? There is no citation. Is the Tax Court suggesting that the powers of a general partner (who has the authority to sign documents) somehow infect limited partners? That in a limited liability company, passive investors in a non-service company are subject to self-employment tax just because they are members?
- There is nothing on the record which quantifies the hours which Chai spent as an accommodating party. Chai testified that he went to Delta’s offices “a lot” and “regularly” to sign documents. The Tax Court used such testimony to justify its conclusion but then went on to say how important Chai’s work was to the tax shelter business. The passive loss rules can be used as a reverse benchmark in determining what is employment or self-employment. Such rules are mostly quantitative, not qualitative. The Tax Court’s emphasis on the importance of Chai’s “signing” is suspect because Chai had no real decision-making power. In any event, keep your client’s participation in any activity of the limited liability company to a quantitative low (and certainly out of decision making).
Chai would probably have lost in all events. The Delta shelters and those of related entities were designated as “listed transactions” in 2002. There was just a taint there. That does not mean that you cannot, under more normal circumstances, help your client avoid the self-employment tax.