The tax consequences of the repetition of ordinary business transactions, such as transfers of funds between affiliated entities recorded as loans, may change not because of either a change in the documentation of such transactions or a change in the applicable legal standards, but rather because a change in underlying circumstances causes the prior characterization of such transfers for tax purposes in accordance with their form no longer to be defensible. The recent Tax Court decision in Kelly v. Commissioner, TC Memo 2021-76, illustrates the unfortunate tax consequences that may ensue from a change in underlying circumstances. The taxpayer's disclosure of information to his accountants, however, and reliance on their advice, was helpful in causing assertion of certain penalties, including fraud penalties, to be rejected by the court.

Facts in 'Kelly'

Beginning in the 1990s, Michael Kelly engaged in numerous ventures involving the purchase of nonperforming loans and other troubled assets. In many instances he would foreclose on the collateral securing a loan, make improvements to the business and related real property, and then either operate the business or sell it. He frequently borrowed from entities under his control, as well as from unrelated lenders, to finance new acquisitions.