Alioto v. Commissioner

Tax Court Rejects 'Zero-Basis' Note and Unreported Wages

A taxpayer's attempt to shield $142,000 in capital gains using a $500,000 promissory note issued to his own company has failed in Tax Court. The court sided with the IRS, determining that the note lacked economic substance and created no basis. David S. Alioto also faced deficiencies for the 2014 and 2015 tax years, as well as additions to tax for 2015, stemming from unreported wage income and constructive dividends. Critically, the court applied the 'duty of consistency' to the wage income issue.

Logistics Contracts and Stock Shuffles

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Wages, Dividends, and the Duty of Consistency

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The $500,000 Promissory Note Failure

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Corporate Lines and Final Judgment

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Logistics Contracts and Stock Shuffles

Following the Tax Court's determination that the $500,000 promissory note lacked economic substance and created no basis, David S. Alioto also faced deficiencies for the 2014 and 2015 tax years, as well as additions to tax for 2015, stemming from unreported wage income and constructive dividends. Critically, the court applied the 'duty of consistency' to the wage income issue.

Alioto, a businessman with experience in the freight transportation industry, incorporated Probity Enterprises, Inc., in Ohio in 2011. He was the sole initial director and held all 1,000 shares of the company's stock, which had a par value of $0.01 at the time. Probity's articles of incorporation stated that it would provide contract services focused on the transportation and logistics industry. The company later developed a process called the Transportation Network Solution Program (TNS Program) to integrate truckload orders.

On June 9, 2014, Probity entered into a contract services agreement with Transplace Texas, LP, a freight logistics company, related to the TNS Program. Under the agreement, Probity would market the TNS Program to shippers, manage the key elements for all participants, and use Transplace as the primary transportation network provider in the United States, Mexico, and Canada. Transplace agreed to pay a "program fee" of $5,000 per week for the first 22 weeks to support Probity’s initial expenses related to the TNS Program, totaling $105,000 in 2014. Transplace also contracted to pay Probity a monthly commission of 20% on net revenues from TNS Program shipments, which were to be reduced until the initial program fee had been repaid.

Just days after finalizing the Transplace contract, Alioto entered into an employment agreement with Probity (signed by his wife, Melanie Alioto, as Treasurer) to perform the duties of President and CEO. The employment agreement provided for compensation of $550,000, payable in one lump sum on January 31, 2018, as well as the reimbursement of all reasonable expenses arising out of employment. Alioto did not receive the compensation outlined in the employment agreement.

Several stock transactions occurred in 2014. On August 28, 2014, Alioto, who then owned all 1,000 shares of Probity stock, transferred 501 shares to his wife for $5.01, or $0.01 per share. A week later, on September 4, Melanie transferred 376 shares back to Alioto, again for a penny a share. The following day, she transferred the remaining 125 shares to Probity itself for the same price. Although these transfers left Alioto holding 875 shares and Probity holding 125 shares, Probity filed an amendment to its articles of incorporation with the Ohio secretary of state on January 14, 2015, stating that Melanie owned 501 shares and Alioto owned 499 shares of common stock, each with a par value of $0.01.

Despite the representations on the amended articles of incorporation, Alioto entered into a promissory note on February 3, 2015, to purchase 125 shares of stock from Probity for $500,000, with 3% annual interest, to be paid by February 5, 2018. Melanie signed on behalf of Probity, and Alioto valued the stock himself. Between March and November 2015, Alioto sold 298 shares of Probity stock to business associates and family members for a total of $142,720.

Alioto timely filed his 2014 federal income tax return, reporting a negative adjusted gross income of $12,773. He reported that Probity had gross income of $22,800 and total expenses of $35,573. Alioto did not timely file his 2015 federal income tax return. The IRS examined Alioto’s 2014 and 2015 tax returns and concluded that he had unreported income for both years based on a bank deposit analysis. The IRS prepared a substitute for return for 2015 and issued a notice of deficiency for both years.

Wages, Dividends, and the Duty of Consistency

As Alioto had not timely filed his 2015 federal income tax return, the IRS examined Alioto’s 2014 and 2015 tax returns based on a bank deposit analysis and concluded that he had unreported income for both years. The IRS prepared a substitute for return for 2015 and issued a notice of deficiency for both years. The Tax Court agreed with the IRS's assessment regarding unreported wages and constructive dividends.

The court addressed the unreported income, noting that Section 61(a) defines gross income as "all income from whatever source derived," including compensation for services like wages, income derived from business, and dividends. The court emphasized that where a taxpayer doesn't maintain adequate books and records, the IRS can reconstruct income through any reasonable method under Section 446(b).

Regarding the wage income, the IRS determined that Probity paid Alioto $89,900 in 2014 and $6,044 in 2015, supported by a bank deposit analysis. Alioto argued that the 2014 payments were advance expense reimbursements pursuant to an accountable plan. Treasury Regulations Section 1.62-2(c)(4) excludes amounts paid under an accountable plan from an employee's gross income, provided specific requirements for business purpose, substantiation, and return of excess amounts are met. The court found that Alioto failed to introduce evidence of such a plan. Alioto also argued that the 2015 payments were merely a return of money that he had provided as part of a test of Probity’s payment portal, but the court found this argument unpersuasive in the absence of supporting evidence.

The court then invoked the "duty of consistency," a judicial doctrine preventing a taxpayer from benefiting in a later year from an error or omission in an earlier year that cannot be corrected because the assessment period has expired, citing Estate of Letts v. Commissioner. The duty applies when (1) the taxpayer has made a representation in one year, (2) the IRS has relied on that act, and (3) the taxpayer tries to change the representation in a later year after the statute of limitations has expired. The court found that the close relationship between Probity and Alioto triggered this duty. Probity had taken a deduction for officer compensation of $104,191 for 2014 and $24,004 for 2015. The court emphasized that Alioto was Probity's founder, president, majority shareholder, and the only signatory on Probity's tax returns. The court reasoned that Probity (controlled by Alioto) benefitted from deducting officer compensation, so Alioto was estopped from claiming the corresponding payments weren't income to him. Therefore, the amounts paid to Alioto, $89,900 for 2014 and $6,044 for 2015, were treated as wage income.

The court also addressed constructive dividends. Citing Magnon v. Commissioner, the Tax Court stated that if a corporation confers an economic benefit on a shareholder without expectation of repayment, it becomes a constructive dividend, taxable to the shareholder, regardless of intent. The court found that Probity paid Alioto's personal living expenses (primarily food and fuel) of $13,282 in 2014 and $1,377 in 2015. Alioto claimed these expenses were related to Probity's business, but he offered no substantiation. The court concluded that Alioto received constructive dividends in these amounts.

The $500,000 Promissory Note Failure

Continuing its examination of Alioto's tax liabilities, the court then addressed the contested capital gains stemming from the sale of Probity stock. As previously discussed, the IRS had determined a long-term capital gain of $142,170 from the disposition of shares in 2015.

Alioto argued that he held two tranches of Probity stock with differing basis amounts. He claimed 875 shares had a basis of $0.01 per share, while 125 shares (treasury stock) had a basis of $4,000 per share due to a $500,000 promissory note he gave to the corporation. Alioto contended that he sold 274 shares of the low-basis stock and 36 shares of the purportedly high-basis stock in 2015, resulting in a net capital loss of $1,283.

The Tax Court rejected Alioto's argument on multiple grounds. First, the court looked to Section 351(a), which dictates that no gain or loss is recognized if property is transferred to a corporation solely in exchange for stock, provided the transferor controls the corporation immediately after the exchange, generally defined in Section 368(c) as owning 80% of the voting stock. The court then cited Section 358(a)(1), which addresses the basis of property received in such a nonrecognition exchange. Section 358(a)(1) states that the basis of the stock received is the same as the basis of the property exchanged. In this case, Alioto exchanged a $500,000 promissory note for stock. The court, citing Alderman v. Commissioner, held that a taxpayer incurs no cost in making such a note, resulting in a zero basis. Therefore, Alioto's basis in the 125 shares of stock was zero.

Second, the court questioned the economic reality of the $500,000 promissory note. For a debt instrument exchanged for property to create basis, it must reflect a "genuine debt." To be considered a genuine debt, there must be "an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor’s income or lack thereof." Examining the facts, the court found that while the note had a fixed maturity date and interest rate, there was no payment schedule. Critically, Alioto had the unilateral right to offset the note with unpaid compensation from Probity, essentially giving him complete control over repayment. The court determined that Alioto and Probity (which he controlled) did not intend to create a genuine debtor-creditor relationship. The court distinguished this case from Peracchi v. Commissioner, where the Ninth Circuit found the taxpayer risked liability on a note because of the potential bankruptcy of his closely held corporation. Here, Alioto's ability to unilaterally extinguish the debt negated any real risk.

Consequently, the court concluded that Alioto failed to demonstrate any basis in the stock he sold, upholding the IRS's determination of a $142,170 capital gain.

Corporate Lines and Final Judgment

Having determined that Alioto had unreported capital gains, the Tax Court then addressed the Schedule C deductions he claimed. Section 162 allows a taxpayer to deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. However, the court emphasized a fundamental principle: the trade or business of a taxpayer is separate and distinct from that of a corporation they own. The court, implicitly referencing Moline Properties, Inc. v. Commissioner, stated that shareholders cannot deduct expenses that further the business of their corporation.

Alioto argued that the business expenses stemmed from his strategic consulting business, not from Probity. The court found this unpersuasive, noting that his testimony established that the expenses related to and furthered Probity's business. Because Probity was a separate taxable entity, any business expense deductions belonged to it.

Beyond this fundamental issue, the court also noted that Alioto provided insufficient substantiation for the deductions.

Finally, the court addressed the additions to tax determined by the Commissioner for failure to file and failure to pay under Section 6651, and for underpayment of estimated taxes under Section 6654. Section 6651 imposes penalties for failure to file a tax return or pay tax when due, while Section 6654 pertains to the underpayment of estimated taxes. Although Alioto initially challenged these additions in his petition, he did not contest them in his post-trial brief. The court deemed this abandonment, citing precedent that issues not argued on brief are considered abandoned.

Consequently, the Tax Court sustained the IRS's deficiency determination in full, including the additions to tax. A decision will be entered under Rule 155, which allows the Court to compute the exact amount of the deficiency and penalties based on its findings.