Estate's Attempt to Evade Code Sec. 642(g)'s Bar on Double Deductions Fails
(Parker's Federal Tax Bulletin: September 15, 2013)

A recent district court case involving refund claims by an estate for a decedent's personal income tax liability presented some interesting issues. The first issue involved the estate requesting a refund for the decedent's personal income tax obligation that allegedly arose out of the purchase of option assets during the sale of the decedent's aviation business. The estate argued that the IRS lost a court case on that issue and its subsequent assessment of tax, which was paid by the estate, was barred by res judicata. The second, and more interesting, issue was the refund request relating to lawsuit settlement payments made after the decedent's death for actions he allegedly took before his death. The estate had deducted the payments on the estate tax return and then sought to take a deduction on the decedent's prior-year income tax return on the theory that the deduction was allowed under Code Sec. 691(b). The IRS argued that Code Sec. 642(g) barred the double deduction.

The estate won on the first issue, but lost on the second. In Batchelor-Robjohns v. U.S., 2013 PTC 269 (S.D. Fla. 8/30/13), a district court analyzed the interaction of Code Sec. 1341, Code Sec. 691(b), Code Sec. 642(g), and Code Sec. 461(h), along with case law. The court found that the estate was attempting to deduct the settlement payments as ordinary and necessary business expenses, but the decedent's income that the estate said should be reduced as a result of the settlement payments, had been reported as capital gain. Thus, the settlement payments could only be treated as a capital loss an expense that is not covered by Code Sec. 691(b), which is an exception to the Code Sec. 642(g) bar on double deductions.

Facts

On February 10, 1999, George Batchelor sold his aviation business, IAL, to lnternational Air Leases of P.R., lnc. (IALPR) for $502 million. In exchange for nearly half his IAL stock, IALPR paid Batchelor almost $235 million in cash and marketable securities. To cover the remainder of the stock, IALPR offered Batchelor approximately $118 million in cash equivalents and a promissory note for $150 million. Additionally, IAL and IALPR negotiated an option for Batchelor to buy back some of the assets (i.e., option assets) transferred in the sale, thereby reducing the balance of the $150 million promissory note by a negotiated price for each asset that he bought back. These option assets included aircraft, engines, and IAL'S ownership interest in three joint ventures. On April 1, 1999, Batchelor exercised his option to buy back these assets for an agreed amount of almost $93 million, thus reducing the $150 million note by that amount. IALPR later caused the balance of the note to be paid off in August 2000. Batchelor subsequently declared his income from the sale as a capital gain and paid the appropriate capital gains tax on the proceeds.

As a result of the sale of these option assets, IAL itself realized a substantial capital gain. After an unsuccessful attempt by IAL to shelter its income via a currency swap, the IRS sought to collect IAL'S corporate income tax obligation from Batchelor under a theory of transferee liability. However, Batchelor died on July 29, 2002. The IRS then filed a lawsuit (Batchelor I) against Batchelor's estate. According to the IRS, the value of the transfer of the option assets constituted excess consideration that rendered IAL insolvent and, therefore, assigning liability to Batchelor as the transferee of those assets. In doing so, the IRS asserted that the real value of the option assets was higher than the amount Batchelor and IALPR agreed upon. The IRS assessed an income tax deficiency, and the estate paid the tax assessed. The estate then sued for a refund and the case went to court. The IRS could not prove its case and the court ruled in favor of the estate.

Several months later, the IRS filed a claim in the Batchelor probate case for unpaid personal income tax obligations, including liability arising from the 1999 transfer of the option assets. Although it originally contested the claim and was due to go to court over the issue, the estate subsequently opted to pay the tax. The IRS and estate filed a stipulation acknowledging that the estate had paid the contested tax liability but retained the right to assert a refund claim at a later time. The estate subsequently requested a refund, which the IRS denied.

Following the sale of Batchelor's ownership interest in IAL to IALPR, a number of parties filed suit challenging the transaction. In particular, IAL sued the estate seeking to set aside the sale as a fraudulent transfer. A week later, IALPR filed a claim in the estate's probate proceeding also seeking damages from Batchelor's allegedly fraudulent sale of his ownership interest. In addition, the estate inherited two ongoing lawsuits that had begun before Batchelor's death, both stemming from Batchelor's involvement with another aviation business.

From 2002 to 2004, the estate decided to settle each of the pending claims against it, settling with Harrington for $2 million in October 2002, with Feltman for $25 million in December 2002, with IALPR for $12 million in August 2003, and with IAL for $1 million in March 2004. On October 29, 2003, the estate filed a Form 706, Federal Estate Tax Return, in which it deducted approximately $40 million from the gross estate for the settlement payments.

The estate subsequently filed a claim for an income tax refund requesting a refund of $8.3 million pursuant to Code Sec. 1341 based on the settlement payments made in all four lawsuits. The IRS denied the claim.

A magistrate judge prepared a report for the district court in which she sided with the IRS on both issues.

Refund Relating to the Purchase of the Option Assets

With respect to the refund request for the tax paid that related to tax liability arising from the 1999 transfer of the option assets, the estate argued that res judicata precluded the IRS from contesting the refund because of the ruling in Batchelor I.

The district court noted that res judicata will bar a claim due to prior litigation if the following elements are established: (1) there is a final judgment on the merits; (2) the decision was rendered by a court of competent jurisdiction; (3) the parties, or those in privity with them, are identical in both suits; and (4) the same cause of action is involved in both cases. In addition to these four elements, the district court said, courts must also determine whether the claim in the new suit was, or could have been, raised in the prior action.

With respect to the fourth element, the magistrate judge concluded that the estate failed to establish that the same cause of action raised in Batchelor I was present in the instant situation. She asserted that Batchelor I involved a different tax claim in a different tax year. Specifically, she found that Batchelor I involved a claim for IAL's corporate income tax during the corporation's April 1, 1999, to March 31, 2000, tax year, while the instant case pertained to Batchelor's personal income tax for the calendar year 1999.

The estate objected to the magistrate's judge's finding that Batchelor I concerned a different cause of action. It asserted that since the two claims arose out of the same transaction, specifically the 1999 transfer of the option assets, the claims therefore arose out of the same nucleus of operative fact and were therefore the same cause of action. In fact, the estate argued, the IRS was trying in the instant case to prove the same thing that it tried to prove in Batchelor I namely, that the value of the option assets was higher than the value that Batchelor and IALPR agreed upon.

The estate further objected to the magistrate's holding that two different years were involved. According to the estate, the fact that the date of the transaction fell in the middle of Batchelor's 1999 tax year but on the first day of IAL's April 1, 1999 to March 31, 2000 tax year was not relevant. What was relevant, the estate said, was that Batchelor I involved the exact same transfer on the exact same date as the present case.

The district court rejected the magistrate judge's recommendation and agreed with the estate that the present case involved the same claim or cause of action as Batchelor I under the Eleventh Circuit's case law (i.e., the circuit that would hear any appeal of this case) regarding the doctrine of res judicata. The district court also did not concur with the government's assertion that Batchelor I and the present case involved claims from different tax years. The case focused on a single transaction that occurred on a specific date. Though the transaction technically fell on different tax years for IAL and Batchelor, that was only because their tax years were measured differently. This did not change the fact that the transaction occurred on the same calendar date for both IAL and Batchelor.

The claim in the instant case, the court said, could have been raised in Batchelor I, and the government had over two years between the filing of the return in 2000 and the filing of Batchelor I in January 2003 to pursue the claim. The court thus concluded that the estate had established that the present case and Batchelor I involved the same cause of action, as well as the fact that the personal income tax claim against Batchelor could have been brought in Batchelor I. Thus, res judicata barred the government from contesting the estate's request for a refund.

Refund Relating to Settlement Payments

Under Code Sec. 1341, a taxpayer is entitled to relief if in one year the taxpayer included an item as gross income and paid tax on that income, then in a subsequent year is compelled to return the item. In claiming such relief, the taxpayer bears the burden of demonstrating that (1) an item was included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the tax year because it was established after the close of such prior tax year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and (3) the amount of the deduction exceeds $3,000. The district court noted that Code Sec. 1341 does not independently create a deduction; a taxpayer must be entitled to the deduction under another provision of the Code.

The IRS argued that Code Sec. 642(g) precluded the estate from taking an income tax deduction for the settlement payments since it already took an estate tax deduction for the payments in 2003. In addition, the IRS asserted that, because Batchelor reported a capital gain from the IAL transaction, the estate could not satisfy the independent deduction requirement of Code Sec. 1341.

The estate claimed that the settlement payments were independently deductible under either Code Sec. 162 or Code Sec. 212. To this end, the estate noted that Batchelor would have had a legal obligation to restore to IAL and its creditors any excess consideration received from the 1999 sale of his interest in IAL if it had been determined that the sale rendered IAL insolvent. The estate therefore maintained that the payment of the settlements was an ordinary and necessary business expense in connection with Batchelor's business and income-producing activity as an investor. In its brief, the estate said that "[t]he settlement expenses related to claims alleging that, in obtaining the income from the sale of his interests in IAL, Mr. Batchelor received too much money and assets. To resolve claims to recover the entire amount he received, the Estate paid back-refunded-a portion of his income. According to the estate, the settlement payments were deductions in respect of a decedent under Code Sec. 691(b) and thus not barred by Code Sec. 642(g).

The estate also argued that, because Batchelor declared this income as a capital gain, but did not get to keep it, his estate should be able to exclude the gain he returned and recalculate the tax. The estate said it was not seeking an unfair result and that it was seeking the refund of the capital gains tax, not ordinary income tax.

Code Sec. 642(g) generally prevents an estate from claiming both an estate tax deduction under Code Sec. 2053 or Code Sec. 2054 (i.e., the provisions allowing estate tax deductions for expenses, debts, taxes, and losses) and an income tax deduction for the same expense. Consequently, an estate normally must choose to deduct the amount from the gross estate for estate tax purposes or from the estate's gross income for income tax purposes, but not both.

However, Code Sec. 642(g) does not apply with respect to deductions allowed under Code Sec. 691(b). Reg. Sec. 1.642(g)-2 provides that Code Sec. 642(g) has no application to deductions for taxes, interest, business expenses, and other items accrued at the date of a decedent's death so that they are allowable as a deduction under Code Sec. 2053(a)(3) for estate tax purposes as claims against the estate, and are also allowable under Code Sec. 691(b) as deductions in respect of a decedent for income tax purposes. In contrast, the bar on double deductions listed in Code Sec. 642(g) does apply to deductions for interest, business expenses, and other items not accrued at the date of the decedent's death.

As an initial matter, the magistrate judge's report cited Reg. Sec. 1.691(b)-1(a) and concluded that the settlement payments were not deductions in respect of a decedent under Code Sec. 691(b) because Batchelor, as the decedent, was not "liable" for the payments at the time of his death or any time prior.

To determine whether Batchelor was "liable" for the payments, the magistrate judge looked to Code Sec. 461(h) and its definition of when a liability is incurred. That provision, the judge noted, states that in determining whether an amount has been incurred with respect to any item during any tax year, the all-events test is not treated as met any earlier than when economic performance with respect to that item occurs. Where the liability of the taxpayer requires a payment to another person and arises out of any tort, economic performance occurs as the payments to such person are made. Accordingly, the judge said that since the estate did not actually make the settlement payments until 2004, Batchelor himself never incurred this liability at the time of his death in 2002 or at any time prior as required by Code Sec. 691(b). Thus, as the payments were not covered by Code Sec. 691(b), the exception to Code Sec. 642(g) did not apply, and that provision prohibited the estate from claiming a second deduction from its income tax liability for the settlement payments.

In reaching this determination, the magistrate found that "liability" does not mean the accrual of a cause of action. Rather, she pointed to Reg. Sec. 1.446-1(c)(1)(ii)(B) which defines "liability" as including any item allowable as a deduction, cost, or expense for federal income tax purposes. From this regulation, she concluded that "liability" pertains to the actual payment of the settlement amounts as opposed to the initiation of the suits from which the settlements derived.

The district court agreed with the magistrate judge and concluded that, based on the Eleventh Circuit's precedent, the estate failed to identify a suitable deduction provision that satisfied Code Sec. 691(b)'s exception to Code Sec. 642(g). Further, the court said, since the proceeds of the IAL sale constituted a capital gain, the holding in Kimbell v. U.S., 490 F.2d 203 (5th Cir. 1974) precluded treating the disgorgement of those proceeds via the settlement payments as a deductible business expense under Code Sec. 162. Like the taxpayer in Kimbell, the court said, Batchelor reported the income from the IAL sale as a capital gain and paid a capital gains tax on the proceeds. The settlement payments were made in satisfaction of liabilities arising from the IAL transaction. The court found that while the estate was now attempting to deduct those payments as ordinary and necessary business expenses, Kimbell barred such a deduction. Instead, the court concluded, the payments may only be treated as a capital loss an expense that is not covered by Code Sec. 691(b).

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