By Kate Alexander
WASHINGTON – A federal appeals court has slapped a former Bethesda couple with more than $600,000 in back taxes, in a ruling that some tax attorneys fear could adversely affect many small business owners in Maryland.
The 4th U.S. Circuit Court of Appeals reversed the U.S. Tax Court when it ruled Tuesday that David H. and Suzanne Hillman, who own a large real estate management company that operates in Maryland and Virginia, could not deduct certain management fees paid to them by their company in 1993 and 1994.
The Hillmans operate Southern Management Corp., which at the time owned about 90 commercial and residential rental real estate properties throughout the Baltimore-Washington region. Court records show that the Hillmans were not actively involved in the management of those properties during the time period in question, but that as active partners in Southern Management they collected fees for services from those properties.
Rather than claiming those fees as income, the Hillmans ultimately claimed the “self-charged management fees” as deductions — $294,556 in 1993 and $309,696 in 1994.
Their attorney likened it to “wearing one pair of pants and .shifting income from one pocket to another.” In that sense, said attorney Stefan F. Tucker, the fees were not income and the Hillmans should not be taxed on it as such.
But a three-judge panel of the appeals court disagreed in a published opinion, saying the plain meaning of the tax law in question required that the money be treated as income. The judges rejected the Hillmans’ argument that the legislative history of the law showed that Congress intended for such income to be exempted.
Tucker said the circuit court completely disregarded the Tax Court’s reasoning, something he has not seen in decades of practice.
He added that the appellate court’s ruling could adversely affect many small business owners who are also service providers, like accountants or attorneys.
In this case, the Hillmans were taxed for certain income they paid themselves even though they enjoyed no net gain from the transfer of income, said Stephen Owen, head of the business tax practice group for the law firm of Piper Marbury Rudnick and Wolfe. Owen was not involved in the Hillman case.
Owen agreed that, under this precedent, many small business owners might have an unanticipated tax liability.
A spokesman for the Department of Justice, which argued the case on behalf of the Internal Revenue Service, said it could not comment on the ruling.
The Tax Court will have to adhere to the appellate court’s ruling in cases that are filed in the 4th Circuit, which includes Maryland, North Carolina, South Carolina, West Virginia and Virginia. But it could rule otherwise in a case arising from another circuit, setting up a conflict between the circuits.
Even if the Hillmans choose not to appeal to the Supreme Court, Owen said the issue is far from over.
“The Tax Court conclusion was the common-sense, correct conclusion,” Owen said. “The 4th Circuit took a very narrow reading of the law. . .to the disadvantage of the taxpayer.”
The Hillmans lived in Bethesda at the time their suit was filed in 1997, but they have since moved to Fairfax County. Despite their current tax woes, a recent Washington Post analysis of county tax records found that David Hillman’s home was among the most expensive in one of the nation’s wealthiest counties.