Incomplete Documents Didn't Preclude Establishment of Family Limited Partnership (FLP), Fifth Circuit Holds

In 2000, a wealthy taxpayer died leaving behind both a substantial fortune and incomplete estate-planning documents. At the time of her death, the decedent's accountants had been working on an estate plan that included the transfer of her assets to a family limited partnership (FLP). Originally believing the failure to complete the estate planning documents precluded the transfer of estate property to the FLP, the decedent's estate paid over $147 million in federal taxes. One of the decedent's accountants subsequently attended a continuing education seminar, which caused him to reconsider the estate's position. He concluded that state law supported the proposition that the decedent sufficiently capitalized the FLP before her death, entitling the estate to a substantial refund.

The estate filed a refund suit in which it claimed that the initial value of the estate's assets failed to discount appropriately the value of the partnership interest, and also claimed a substantial deduction for interest on the initial tax payment, which it retroactively characterized as a loan from the FLP to the estate for payment of estate taxes. A district court agreed with both of the estate's contentions and the IRS appealed. In Keller v. U.S., 2012 PTC 265 (5th Cir. 9/25/12), the Fifth Circuit upheld the lower court's ruling. In doing so, it refused to collapse the estate and FLP to functionally the same entity, as argued by the IRS, simply because they shared substantial (though not complete) common control. In the end, the estate was entitled to a $115 million refund.

Facts

Maude Williams was married to Roger Williams. The couple lived in Victoria, Texas, and had two children and six grandchildren. Following their daughter's divorce, the Williamses set about extensive estate planning to preserve family assets. They first settled a family trust in 1998 a revocable trust into which the couple placed approximately $300 million of cash, certificates of deposit, and bonds. The trust agreement provided that on either spouse's death, the family trust would terminate, split into two shares (Share A and Share M), and fund two respective trusts (Trust A and Trust M). The agreement further provided that on the surviving spouse's death, Trust A and Trust M would terminate to fund six family trusts for the Williamses' grandchildren.

After Roger's death in 1999, Maude became the trustee of both the shares and the trusts and began exploring further options for protecting her family's assets, including establishing a FLP. She consulted with the family's longtime CPA, Rayford Keller, and his son, Lane Keller, and ultimately decided to establish a FLP. The FLP was to consist of two limited partners Trust A and Trust M and a general partner, a limited liability company formed alongside the partnership. The limited partner trusts were each to hold 49.95 percent limited partnership interests, while the new general partner LLC was to hold a 0.1 percent general partnership interest. Maude would initially own all shares of the LLC. Trusts A and M were to fund the FLP. The Kellers organized a spreadsheet in September 1999 listing specific assets to be transferred to the FLP. Maude reviewed this spreadsheet in 1999, but neither signed it nor memorialized her agreement with the Kellers' plans in writing. Based on her implicit approval, Lane formalized these plans in January 2000 in a flowchart and a series of notes indicating how various trust accounts would fund the FLP principally with Community Property bonds and cash amounting to $250 million.

Maude was diagnosed with cancer that March and hospitalized several times in May. Her FLP advisers reduced Maude's FLP estate plans to a partnership agreement and LLC incorporation documents, which Lane took to Maude in her hospital room. In a meeting lasting two hours, Lane carefully went over with Maude the details of these documents. The court found that she was able to understand their legal ramifications. She signed the constitutive agreements multiple times, as required, and Lane notarized her signatures. Article VIII of the partnership agreement, entitled Capital Contributions, provided that [e]ach partner shall contribute to the Partnership, as his initial Capital Contribution, the property described in Schedule A as part of the Agreement. Lane left Schedule A blank; he testified at trial that he left the schedule blank because he did not have the firm market value of the bonds on hand. While the Kellers' extensive notes and spreadsheet indicated Maude's expected capital contribution to the FLP, the specific contributions meant for the blanks on Schedule A could not be discerned from anything else in the partnership agreement.

Additional sources, however, corroborated that Maude intended her initial capital contribution. Rayford made handwritten notes that substantiated that intention. Lane also drafted a check from one of the family trust accounts for Maude's initial capitalization of the LLC that day, which Maude never signed. Maude's advisers filed the Articles of Organization of the LLC and registered the limited partnership with the Texas Secretary of State on May 11. The Secretary of State issued both a Certificate of Organization and a Certificate of Limited Partnership. Lane intended to complete the outstanding requirements to finalize and fund the LLC and FLP within a week.

Maude passed away on May 15. Her advisers initially believed they failed to fully create and fund the FLP before Maude's death and stopped attempts to activate the FLP and LLC. The estate paid over $147 million in estate taxes in February 2001. Lane reconsidered this position in May 2001 after he attended a continuing legal education seminar. He resumed activity with the FLP, including formally transferring the Community Property bonds to the FLP. The Kellers realized that having successfully established the FLP meant the estate had lacked liquid assets to issue a $147 million tax payment. Consequently, the estate's advisers retroactively restructured this transaction as a $114 million loan from the FLP, effective February 2001. The estate issued a promissory note to the FLP at the applicable federal interest rate effective February 2001.

Estate's Refund Claim

The estate filed a refund claim with the IRS in November 2001 on two grounds. First, the estate argued that under Texas law, Maude's intent to transfer bonds into the partnership transformed those bonds into partnership property, notwithstanding her failure to complete the partnership documents. As a result, the estate's initial fair-market value assessment of Maude's assets failed to discount appropriately the value of the partnership interests, thereby leading to an initial overpayment of estate taxes. Second, this transfer, the estate argued, necessarily rendered the estate tax payment a loan from the FLP, entitling the estate to an interest deduction as an actual and necessary expense of administrating the estate. After six months passed without IRS action, the estate filed suit in a district court on the same grounds.

The IRS raised several objections to the estate's arguments, including that Maude failed to create the FLP at all, that Texas law required Maude to have committed her transfer of assets to the partnership in writing, and that any purported loan between the estate and partnership was a sham transaction. According to the IRS, the loan could have as easily been retroactively characterized as a distribution, rendering it not actually and necessarily incurred in the meaning of the governing regulation.

District Court's Decision

The district court concluded that Maude's intent bound all the relevant entities the LLC as the general partner and Trusts A and M as limited partners. The court also found that the FLP was created for a limited, non-tax-related purpose, and that Trusts A and M received full and adequate consideration in the partnership interests they received in exchange for contributing the community property bonds.

Reviewing Texas law, the court held that Maude's intent to transfer the bonds to the FLP was sufficient under Texas law to transfer the bonds regardless of record title or the absence of a writing confirming that transfer. Moreover, because bonds sold to satisfy estate taxes were in fact FLP property, the court concluded that the transfer from the FLP to the estate was actually and necessarily incurred in the administration of the estate, entitling the estate to a corresponding deduction for the interest on the loan. The district court therefore granted the estate a refund of approximately $115 million.

Fifth Circuit's Analysis

Discounted Valuation of Estate

The Fifth Circuit first addressed the IRS's challenge to the discounted valuation of Maude's estate. The court noted that a decedent's partnership interest is not usually valued at the pro rata share of the property owned by the partnership. Instead, an estate can discount the value of that interest to reflect restrictions on the interest's transferability and other burdens on the partnership interest. According to the court, whether a substantial valuation discount was appropriate hinged on whether the community property bonds were transferred effectively to the FLP. The answer to that question, the court observed, depended on Texas state partnership law. The court agreed with the estate and the district court that Texas law is clear that the intent of an owner to make an asset partnership property causes the asset to be the property of the partnership. This is clearly true, the court stated, for acquisitions of property by already existing partnerships and for settling title to property where legal title rests with the partnership but the property is actually used by a partner in his personal capacity, or vice-versa. The Fifth Circuit noted that, in Logan v. Logan, 156 S.W.2d 507 (Tex. 1941), the Texas Supreme Court expressly relied on a purchasing partner's intent as controlling whether newly acquired property belonged to a partner or the partnership.

The court cited additional Texas case law for the proposition that, while mere use of property by the partnership does not make it an asset of the partnership, the question of actual ownership is one of intention. Under well established Texas law partnership principles, the court stated, ownership of property intended to be a partnership asset is not determined by legal title; the intention of the parties, as found by the jury and supported by the evidence, is controlling.

The Fifth Circuit noted that this case was different in that rather than addressing property acquired or used by an already-formed partnership, the question was whether title to property passed to the FLP contemporaneous with its formation.

The court also noted that the FLP was a limited partnership, formed under the then-applicable Texas Revised Limited Partnership Act (TRLPA) rather than general partnership laws.

The court addressed the IRS's argument that TRLPA Section 5.02(a), a statute of frauds provision, requires any promise by a limited partner to make a contribution to, or otherwise pay cash or transfer property to, a limited partnership is not enforceable unless set out in writing and signed by the limited partner. According to the court, the IRS's reliance on that provision ignored that, under Texas law, Maude transferred the community property bonds to the FLP immediately by forming the partnership and executing the partnership agreement with the intent that the community property bonds were partnership property. This intent on forming the partnership and transferring the bonds, the court stated, immediately conferred equitable title to the partnership. Thus, Section 5.02(a) was inapplicable.

With respect to the IRS's contention that Texas trust law supported its argument that Maude's death caused the limited partnership to terminate, the court noted that none of the authorities cited by the IRS were part of the IRS's opening brief. The court, therefore, declined to consider those arguments.

Deductibility of the Retroactively Structured Loan

With respect to the retroactively structured loans, the court began by noting that Reg. Sec. 20.2053-3(a) allows an estate to deduct those expenses actually and necessarily incurred in administration of the decedent's estate from the estate's value for tax purposes. This includes interest on loans taken to pay debts of an estate, such as estate taxes, if those loans are necessary to pay estate debts.

Citing Est. of Graegin v. Comm'r, T.C. Memo. 1988-477, the Fifth Circuit observed that the Tax Court has permitted deductions on loans between an estate and a closely related business entity several times. Typically, the loans were necessary because any obvious revenue-raising alternative to the loan threatened to diminish asset values of the estate. The Fifth Circuit also looked at Est. of Black v. Comm'r, 133 T.C. 340 (2009), which the IRS cited. In that case, the Tax Court denied a deduction for accrued interest on a loan between a family limited partnership and a decedent's estate. The Tax Court concluded that the indirect use of stock held by the limited partnership distinguished that case from Estate of Graegin in which loans from a related, family-owned corporation to the estate were found to be necessary to avoid forced sales of liquid assets or to retain an asset for future appreciation. Such was not the case in Est. of Black, the Fifth Circuit noted. In that case, the Black estate would eventually be required to sell stock held by the limited partnership or its partnership interest to satisfy the loan, and its financing structure merely constituted an indirect use of the stock to generate a tax deduction.

With respect to the IRS's argument that the loan between the FLP and the estate could have been characterized another way, e.g., as a distribution, rendering the loan (and its interest) unnecessary, the Fifth Circuit said that such a position took the decision in Est. of Black too far.

The Fifth Circuit also rejected the IRS's contention that the estate's and FLP's common control between related entities rendered any potential economic distinctions between the estate and FLP as well as the chosen financing structure little more than a legal pretense or an indirect use. What that position ignored, the court said, is that after the effective transfer of the community property bonds to the FLP, they were no longer property of the estate. The estate, having realized it improperly disposed of bonds belonging to another legal entity (the FLP was actually controlled by other family members), was forced to rectify its mistake using the assets it had available largely illiquid land and mineral holdings. In lieu of liquidating these holdings, it borrowed from the FLP. The Fifth Circuit refused to collapse the estate and FLP to functionally the same entity simply because they shared substantial (though not complete) common control.

The Fifth Circuit concluded that the district court correctly allowed a deduction for the interest on the resulting loan.

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S Corp Owner Liable for Tax on Entire Vested Accrued Benefit in ESOP

A special rule applies when an employees' trust, such as an S corporation employee stock ownership plan (ESOP) trust, does not qualify for exemption from tax due to the plan's failure to meet certain coverage or participation requirements. Under Code Sec. 402(b)(4)(A), a highly compensated employee that benefits from such a plan must include in income an amount equal to the employee's vested accrued benefit (other than the employee's investment in the contract). In Yarish v. Comm'r, 139 T.C. No. 11 (2012), the Tax Court was called upon to decide for the first time the meaning of that rule and whether it requires the employee to include in income only the annual increase in the vested benefit or the entire amount of the vested accrued benefit. Unfortunately for the taxpayer, the Tax Court sided with the IRS and held that the entire benefit was includible in the taxpayer's income.

Facts

Robert Yarish, a plastic surgeon, owned several medical practice entities. In 2000, he organized Yarish Consulting, Inc., an S corporation, to manage these entities. Yarish Consulting sponsored an ESOP, Yarish ESOP, and Robert participated in the ESOP. Robert was a highly compensated employee under Code Sec. 414(q) and was fully vested from the start of the Yarish ESOP until its termination. Multiple contributions were made to the Yarish ESOP during 2000 to 2004. Robert's account balance and vested accrued benefit was $2,440,000 at the end of 2004. None of that amount had been taxed to Robert and his wife before the 2004 plan year.

Robert terminated the Yarish ESOP on the last day of 2004. His entire account balance in the ESOP was transferred to an individual retirement account that same day. The IRS retroactively disqualified the Yarish ESOP through a revocation letter for the 2000 through 2004 period. The IRS determined in the revocation letter that the Yarish ESOP did not meet the requirements under Code Sec. 401(a) and was not exempt from tax under Code Sec. 501(a). In Yarish Consulting Inc. v. Comm'r, T.C. Memo. 2010-174, the Tax Court sustained that determination. With the exception of 2004, the statute of limitations period expired for all years for which the Yarish ESOP was disqualified.

Taxpayer and IRS Arguments

Robert argued that the phrase investment in the contract is defined in Code Sec. 72 and that the court should apply that meaning in interpreting Code Sec. 402(b)(4)(A). Under Code Sec. 72, employer contributions are treated as part of the investment in the contract to the extent they were previously includible in income (i.e., could have been taxed). According to Robert, all of his vested benefit from 2000 to 2003 was previously includible in income due to the disqualification of the Yarish ESOP and therefore constituted his investment in the contract for 2004. Thus, Robert contended, he was required by Code Sec. 402(b)(4)(A) to include in income for 2004 only the annual increase in his vested accrued benefit for that same year.

The IRS argued that under Code Sec. 402(b)(4)(A) an employee's investment in the contract equals the portion of the employee's vested accrued benefit that has previously been taxed to the employee. Thus, the IRS maintained that Robert had to include in income for 2004 the entire amount of his vested accrued benefit in the Yarish ESOP, given that no portion of it was previously taxed.

Tax Court Analyzes Statutory Interpretation

The Tax Court began by reviewing the plain language of Code Sec. 402(b)(4)(A) which provides, in part, that [A] highly compensated employee shall * * * include in gross income for the taxable year with or within which the taxable year of the trust ends an amount equal to the vested accrued benefit of such employee (other than the employee's investment in the contract) as of the close of such taxable year of the trust.

The center of the dispute, the court observed, was the meaning of the parenthetical (other than the employee's investment in the contract) used to modify the phrase an amount equal to the vested accrued benefit of such employee. The court noted that the disputed parenthetical was not defined in whole or part in Code Sec. 402 or in the corresponding regulations, nor was any definition supplied by a cross reference to another section in the Code. Additionally, neither the disputed parenthetical nor any of its words or phrases are terms of art, the court stated. The Tax Court found the disputed parenthetical ambiguous in that it was susceptible of at least two different meanings. It could mean that only direct contributions by the employee constitute the employee's investment in the contract. Or it could also mean that the employee's investment in the contract includes other contributions made on the employee's behalf, i.e., employer contributions.

Accordingly, the court looked to the legislative history of Code Sec. 402(b)(4)(A) as an aid in discerning its meaning. The legislative history indicated that the general purpose of Code Sec. 402(b)(4)(A) was to penalize highly compensated individuals. The conference report also shed light on the portion of a highly compensated employee's vested accrued benefit that Congress intended to tax. According to the report, the law was designed to tax highly compensated employees on the value of their vested accrued benefit attributable to employer contributions and income on any contributions to the extent such amounts had not previously been taxed to the employee.

Based on the Tax Court's reading of Code Sec. 402(b)(4)(A) in the context of the statutory scheme as a whole, the court concluded that Congress' intent in using the disputed parenthetical was to exclude that portion of the vested accrued benefit from tax that had previously been taxed to the employee so as to avoid double taxation of it. Thus, the court held that, under Code Sec. 402(b)(4)(A), the vested accrued benefit of a highly compensated employee must be included in income to the extent it was not previously taxed to the employee.

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Supreme Court Declines to Review S Corp Reasonable Compensation Case

The Supreme Court denied certiorari in a case in which a district court and the Eighth Circuit held that an S shareholder did not receive reasonable compensation and thus underpaid his FICA employment taxes. David E. Watson, P.C. v. U.S., No. 12-174 (S. Ct. 10/1/12).

In 1996, David E. Watson, a CPA with a Masters in Tax Law, incorporated a business entity known as David E. Watson, P.C. (DEWPC). He transferred a 25 percent interest he owned in an accounting firm called Larson, Watson, Bartling & Juffer, LLP (LWBJ) to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed David, but David exclusively provided his accounting services to LWBJ for the relevant period. From its inception, DEWPC elected to be taxed as an S Corporation.

The IRS investigated DEWPC and determined that it underpaid its FICA employment taxes in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. DEWPC paid the delinquent tax, penalty, and interest for the relevant periods and sought a refund from the IRS. The IRS denied DEWPC's refund claim, and DEWPC took the case to a district court. The district court ruled in the IRS's favor and David appealed to the Eighth Circuit.

In Watson v. U.S., 2012 PTC 33 (8th Cir. 2012), the Eighth Circuit upheld the district court's decision. In doing so, the court listed the factors that may be relied upon to determine the amount of an S shareholder's reasonable compensation. Among the factors listed by the court in finding that David did not receive reasonable compensation were:

(1) the fact that David was an exceedingly qualified accountant with an advanced degree and nearly 20 year of experience in accounting and tax;

(2) the fact that David was one of the primary earners of a CPA firm that had earnings much greater than comparable firms;

(3) the salary of $24,000 that was reported was exceedingly low when compared to the amount distributed as profits;

(4) the gross earnings of the CPA firm; and

(5) the results of a Management of an Accounting Practice (MAP) study done by the AICPA, which set the fair market value of the shareholder's services at a much greater amount.

For a discussion of the reasonable compensation issue as it relates to S corporations, see Parker Tax ¶31,927.

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District Court Rejects Theft Loss Claim of Investor in Bankrupt Investment Firm

Because there was no evidence that an investment firm that went into bankruptcy made any fraudulent misrepresentations on which the taxpayer relied or acted with criminal intent to deprive the taxpayer of his money, and because the taxpayer willfully invested with the firm, there was no support for a theft loss deduction. Labus v. U.S., 2012 PTC 269 (N.D. Ohio 9/27/12).

Around 2000, Ralph Labus became involved with American Business Financial Services (ABFS), a company that offered high interest notes to investors. Ralph decided to invest with ABFS in order to make some retirement money. His first investment was for $35,000 in December 2002 at a 9 percent interest rate. After receiving monthly interest checks on this initial investment, Ralph elected to invest more money. In July 2002, he made two additional separate investments with ABFS of $100,000 and $75,000. In August of 2003, Ralph invested an additional $50,000 with ABFS. He received monthly interest checks on each of his four investments.

In February of 2004, Ralph accepted an offer to be repaid on three of his unsecured investment notes totaling $185,000 and either reinvest or convert half of the principal amounts into senior subordinated collateralized notes. Three of Ralphs's notes were halved and he received $92,500 back after switching the other half of these notes into senior subordinated collateralized notes. Ralph kept his $75,000 investment note as an unsecured note. ABFS began defaulting on its obligations to investors sometime in 2004. On January 21, 2005, ABFS filed for Chapter 7 bankruptcy. Ralph joined a class action lawsuit that was filed against ABFS on behalf of allegedly defrauded investors. He initially claimed $264,036 in losses in the class action case, but this amount was adjusted to $171,036 in light of his decision to switch half of three unsecured notes ($92,000) into senior subordinated collateralized notes. In March 2010, Ralph received a check for $5,527 as a result of the class action lawsuit.

In 2008, Ralph filed amended tax returns for 2002, 2003, 2004, and 2005. According to Ralph, he suffered a theft loss in 2005 of $205,943, which resulted in a net operating loss that he could carry back to 2002-2004. He then filed a refund claim. The IRS rejected the refund claim alleging that no loss was deductible for 2005, and thus, no carrybacks were permitted. However, the IRS mistakenly issued Ralph's claimed refunds for 2005 (the loss year) and 2002 (the first carry back year).

A district court sided with the IRS and rejected Ralph's theft loss deduction. The court noted that, although ABFS was incorporated in Delaware, Ralph made his investments while he lived in Ohio and suffered his alleged loss while living in Ohio. Thus, to claim a theft loss deduction under Code Sec. 165(a) and (c), Ralph had to prove that the loss resulted from a theft (or larceny, embezzlement, or robbery) as defined by Ohio law. Under Ohio law, a theft is defined, in part, as an act depriving an owner of property or services by use of deception. To establish a theft by deception, it must be proven that the accused engaged in a deceptive act to deprive the owner of possession of property or services, and that the accused's misrepresentation actually caused the victim to transfer property to the accused.

The court said that there was no evidence that ABFS possessed the criminal intent to deprive Ralph of his investment money without any plan of paying back the principal investments. Instead, the record reflected that ABFS sent Ralph monthly interest checks from his four investments for some time before filing for Chapter 7 bankruptcy. That fact alone, the court noted, contradicted Ralphs's contention that ABFS acted with the criminal intent to deprive him of his investment money.

Moreover, the court said, there was no evidence to support Ralph's contention that ABFS made any fraudulent misrepresentations on which he relied in making his investment decisions, nor was there any evidence that ABFS acted with criminal intent to deprive Ralph of his money. Lastly, the court said, because Ralph willfully invested with ABFS, there was no support for an assertion that ABFS deprived him of his investment money without his consent.

For a discussion of the criteria for taking a theft loss deduction, see Parker Tax ¶84,510.

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Minimum Threshold of Decency Requires IRS to Pay Vietnam Vet's Court Costs

While the statute of limitations ran on four of six years for which a 75-year-old disabled vet was seeking a refund, the IRS should consider the vet's 100 percent disability rating as a factor when making its final determination as to his entitlement to litigation costs. Haas v. U.S., 2012 PTC 261 (Fed. Cl. 9/20/12).

Jonathan Haas, a 75-year-old veteran, was diagnosed with a variety of medical conditions that were ultimately determined to be attributable to his exposure to Agent Orange during the Vietnam War. In 2001, he sought a ruling from the Department of Veterans Affairs (VA) that these conditions resulted from his military service such that he was entitled to disability compensation from the government. At first, his claim was denied but, eventually, after many years and many court decisions, he successfully established that he had been exposed to Agent Orange. As a result, he was granted service connection for his disability on September 8, 2009. This ruling occurred eight years after his initial claim was filed and over five years after the original decision denying his claim. Based on that ruling, the VA issued a decision that found that Jonathan was 100 percent disabled from July 30, 2001, onward. Thus, once the VA made its determination, the military retirement pay Jonathan had been receiving from 2001 onward was retroactively converted to veterans' disability compensation.

While military retirement pay is taxable income, compensation for disabilities attributable to service in the armed forces is nontaxable under Code Sec. 104(a)(4). As a result, Jonathan's income for years 2001-2009 was retroactively exempted from tax. Because the income was retroactively deemed exempt, Jonathan filed amended federal income tax returns (Forms 1040X) in 2010, seeking a refund of all taxes he had paid for his 2001-2009 tax years. Jonathan filed Forms 1040X for his 2001-2006 tax years on July 28, 2010. He also filed refund claims for his 2007-2009 tax years on August 2, 2010. While the IRS granted refunds for 2007-2009, it denied as untimely Jonathan's refund claims for his 2001-2006 tax years. After an unsuccessful administrative appeal, Jonathan filed suit in the Court of Federal Claims, seeking a refund for the denied tax years 2001-2006.

The Court of Federal Claims denied Jonathan's refund request for years 2001-2004, but held that Jonathan was entitled to a refund for tax years 2005 and 2006. The court noted that, although the delay was not Jonathan's fault, and the fact that he could not amend his 2001-2004 tax returns was unfortunate, the court's hands were tied, and it could not extend the statute of limitations for the 2001-2004 tax years.

However, the court observed, there was no dispute that Jonathan was entitled to a refund for tax years 2005 and 2006 and the IRS eventually conceded this. Consequently, the court directed the IRS to consider Jonathan's 100 percent disability rating as a factor in its calculus when making its final determination as to Jonathan's entitlement to an award of costs in the litigation. According to the court, the IRS cannot ignore that Jonathan was forced to file a court suit to compel the government monies to which was entitled. The court noted that the payment of costs seemed abundantly fair in these circumstances given the fact that despite Jonathan's due diligence in pursuing his refund claims, he was unable to recoup the overpayment of taxes for four tax years (2001-2004) because the statute of limitations barred his recovery. In sum, the court said, the government's payment of Jonathan's costs seems to this court to meet the minimum threshold of decency.

For a discussion of the exclusion from income for payments relating to disabilities resulting from military service, see Parker Tax ¶75,920.

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House Equity Payments Received from Ex-Spouse's 401k Aren't Retirement Funds Exempt from Bankruptcy

Money received from an ex-husband's 401(k) account in payment for the debtor's equity in the marital home were not exempt from the debtor's bankruptcy estate as retirement funds. In re Ahmed, 2012 PTC 273 (E.D. Mich. 9/29/12).

During her divorce, a state court awarded Nehya Ahmed 50 percent of her husband's 401(k) account. Nehya received and deposited that money. In addition, the court ordered the husband to pay Nehya $43,553 of the equity in one of the couple's houses. The court's order warned that Nehya's marital share from the real estate would be paid from the husband's half of his 401(k) if he did not pay it within 90 days. The husband failed to pay, and the state court ordered the money's removed from the 401(k). The 401(k) administrator, after withholding tax, paid Nehya, who about four weeks later placed the money in a new individual retirement account (IRA). In May 2011, around a month after opening the IRA, Nehya declared Chapter 7 bankruptcy.

Under Bankruptcy Code Section 522(d)(12), a debtor may exempt from the bankruptcy estate money that both (1) constitutes retirement funds and (2) resides in a fund or account exempt from taxation under any of several Internal Revenue Code provisions. Nehya argued mainly that the house equity payment she received equaled retirement funds because the payment came from a 401(k) retirement account. A bankruptcy court allowed Nehya to exclude $5,000 from the bankruptcy estate but concluded that the remainder that Nehya wanted to exempt failed to qualify as retirement funds subject to exemption. Nehya appealed.

Citing Code Sec. 402(c)(2), Nehya argued that, whatever the house equity payment's purpose, she could treat the money as a tax-free rollover into her new IRA. She also cited In re Chilton, 2012 PTC 61 (5th Cir. 2012) and In re Nessa, 426 B.R. 312 (8th Cir. B.A.P. 2010), which conclude that retirement funds can mean money that someone other than the debtor saved for retirement. The defining characteristic of retirement funds, as one of the cases explained, is the purpose they are set apart for, not what happens after they are set apart.

A district court affirmed the bankruptcy court and held that Nehya could only exclude the $5,000 from the bankruptcy estate. With respect to the logic of Nehya's arguments regarding the characteristic of retirement funds, the court observed that such reasoning had its limits. If a retiree withdraws money he saved for retirement and uses it to buy a car, the court said, the car dealer does not then hold retirement funds. Money set apart for retirement, the court concluded, cannot remain retirement money forever. A person receiving an inherited IRA gets what the term inherited IRA suggests; a retirement account passes, more or less intact, to a named beneficiary. The house equity payment is different, the court reasoned. The state court seized money from a 401k and used it to pay a debt the husband owed Nehya. The court concluded that the house equity payment Nehya received no longer constituted retirement funds. Regardless of tax status, the payment could receive no protection under Section 522(d)(12) unless and until Nehya converted the money back to retirement funds. And although Nehya accomplished this conversion by placing the money in a new IRA, the transfer to a new IRA affected the money's tax status, the court said. Code Sec. 408(a)(1) and Code Sec. 219(b) limit the amount of the IRA contribution that Nehya can exempt from tax to the lesser of either $5,000 or her taxable income for the year. Because Nehya in 2011 had income of nearly $20,000, all but $5,000 in the IRA remained subject to tax, the court said. Thus, the district court held that the bankruptcy court properly allowed Nehya to exempt the $5,000 and concluded she was not entitled to exempt any more than that.

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Special Needs Trust Set Up by Elder Law Attorney Doesn't Qualify as an Exempt Org

The manner in which a trust's founder and other members of the legal community went about connecting eligible individuals with a special needs trust's services suggested that those services were a commercial product in disguise; thus, the trust did not satisfy the operational test to be designated as a tax-exempt entity. Family Trust of Massachusetts, Inc. v. U.S., 2012 PTC 262 (D. D.C. 9/24/12).

The Family Trust of Massachusetts, Inc. (FTM) was founded by Peter Macy, a private Massachusetts attorney who specializes in elder law. Peter incorporated FTM as a special needs trust in 2003. He serves as President, Treasurer, and sole Executive Director, and his law office is listed as FTM's principal place of business. His duties include supervising the day-to-day business matters of the FTM, including financial matters, bookkeeping, and corresponding directly with outside parties. He works with the FTM daily, averaging 260 hours a year.

On November 21, 2005, FTM applied for a determination from the IRS that it is a Code Sec. 501(c)(3) organization and therefore tax exempt. Since 2005, FTM's clientele has increased from 20 beneficiaries to over 300. After the IRS failed to issue a notice of determination, FTM filed suit in district court, seeking the court to declare FTM exempt from federal income tax. The IRS argued that FTM acts as an adjunct to Peter's private elder law practice, reaching only a select group of the relatively affluent disabled to whom trustee services might be provided profitably.

The district court concluded that FTM did not demonstrate that it met all three requirements necessary to be a Code Sec. 501(c)(3) tax-exempt organization. The court noted that, under Code Sec. 501(a) and (c)(3), an organization must prove that: (1) it is organized and operated exclusively for an exempt purpose; (2) its net earnings do not inure to the benefit of any private shareholder or individual; and (3) its activities do not attempt to influence legislation. To determine if an organization is operated exclusively for an exempt purpose, the court said, the critical inquiry is whether FTM's primary purpose for engaging in its sole activity is an exempt purpose, or whether its primary purpose is the nonexempt one of operating a commercial business producing net profits for FTM. The court observed that, in applying the operational test, courts have relied on the commerciality doctrine. The major factors courts have considered in assessing commerciality are the particular manner in which an organization's activities are conducted, the commercial hue of those activities, and the existence and amount of annual or accumulated profits.

The court found it difficult to escape the obvious correlation between FTM's increasing profits and the Peter's increasing salary derived from those profits. When examining this fact in light of other factors, such as the absence of the solicitation of charitable contributions, the court said FTM's profit margin appeared to be more a product of a growing commercial enterprise than a tool for expanding the pooled investments that might enable beneficiaries to reap a greater return or enjoy reduced fees.

According to the court, the claim that Peter contributed about $100,000 of unpaid services to FTM was flawed because it ignored the requirement in Reg. Sec. 53.4958-4(b)(1)(ii)(A) that a comparison be made between the level of Peter's compensation and the amount that would ordinarily be paid for like services by like enterprises under like circumstances. The court cited the publication, Special Needs Trust: Administration Manual, which states that a special needs trust does not have to be administered by an attorney. Rather, laypersons, such as friends and family of a person with disabilities, and . . . professionals, including attorneys, financial planners, and social workers are capable of administering a special needs trust.

The court then addressed the requirement that net earnings of a Code Sec. 501(c)(3) not inure to the benefit of any private shareholder or individual. Although control of financial decisions by individuals who appear to benefit personally from certain expenditures does not necessarily indicate inurement of benefit to private individuals, the court stated, those factors coupled with little or no facts in the administrative record to indicate the reasonableness and appropriateness of the expenses are sufficient to suggest that there is indeed prohibitive private inurement. Since the record clearly demonstrated Peter's overwhelming control of FTM, while at the same time revealing an absence of comparability data showing the reasonableness of his compensation, the court said it could not be assured that it was not sanctioning an abuse of the revenue laws by conferring tax-exempt status on FTM. According to the court, the manner in which Peter and other members of the legal community went about connecting eligible individuals with FTM's services suggested to the court that those services were a commercial product in disguise being touted by Peter and others who made referrals to the trust. The facts that Peter founded the program as a result of his law firm's specialization in advice regarding trusts, estate planning, guardianship, and probate matters for elderly clients, and his legal office remained listed as FTM's principal place of business, only reinforced for the court the idea that FTM's services provided a marketable product to offer potential clients. And though procurement of new clientele for Peter's law practice may not have been the sole purpose of FTM, the court viewed this inevitable benefit as amounting to more than just an incidental nonexempt purpose.

For a discussion of the tests that must be met for an organization to be classified as a Section 501(c)(3) organization, see Parker Tax ¶60,510.

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Court Upholds Rejection of Taxpayer's OIC; Communications Between IRS Divisions Was Appropriate

There was no abuse of discretion in rejecting a taxpayer's OIC where the IRS included in the taxpayer's reasonable collection potential amounts collectible from third parties through judicial action, such as a suit to set aside a fraudulent conveyance. Hinerfeld v. Comm'r, 139 T.C. No. 10 (9/27/12).

In 2006, Norman Hinerfeld received a Final Notice of Intent to Levy and Notice of Your Right to a Hearing with respect to unpaid trust fund penalties totaling $471,696. Norman submitted a timely Form 12153, Request for a Collection Due Process or Equivalent Hearing, indicating that he was preparing an offer-in-compromise (OIC). Subsequently, a CDP hearing was held. Norman did not dispute that he was liable for the trust fund penalties at issue as a responsible person of Thermacon Industries, Inc. Subsequently, Norman submitted to Appeals an offer-in-compromise (OIC) of $10,000, followed by an amended OIC of $74,857. The settlement officer assigned to the case recommended that the amended OIC be accepted and submitted the matter to the IRS's Area Counsel for review in accordance with Code Sec. 7122(b).

Upon review, the IRS Area Counsel discovered that Norman and his wife were named as defendants in a lawsuit alleging that Norman had fraudulently conveyed assets to his wife. The IRS Area Counsel recommended that Norman's amended OIC be rejected, and the Appeals Team Manager agreed. Appeals issued to Norman a final notice of determination rejecting his amended OIC and determining that it was appropriate to proceed with the proposed levy.

Norman argued that Appeals and Area Counsel engaged in prohibited ex parte communications during the CDP hearing. In 1998, Congress directed the IRS to develop a plan to restrict ex parte communications between Appeals employees and other IRS employees, as part of the Internal Revenue Service Restructuring and Reform Act of 1998.

The Tax Court held that, under Code Sec. 7122(b), Appeals and Area Counsel were obliged to communicate with regard to Norman's amended OIC and, consequently, their communications were not prohibited ex parte communications within the meaning of Rev. Proc. 2000-43. Further, the Tax Court held that Appeals did not abuse its discretion in deciding to accept Area Counsel's recommendation to reject Norman's amended OIC or in determining to proceed with the proposed levy. Amounts includible in a taxpayer's reasonable collection potential, the court noted, include amounts collectible from third parties through judicial action, such as a suit to set aside a fraudulent conveyance. The Thermacon assets for which there was substantial evidence of a fraudulent conveyance and about which Norman appeared to be dissembling were conceded by him to be worth $2.2 million at the time of transfer. In these circumstances, the court stated, the decision to reject an OIC to settle trust fund penalties totaling $471,696 for $74,857 was not an abuse of discretion. If anything, the court observed, the case illustrates the wisdom of requiring the Office of Chief Counsel's review of OICs for fraudulent conveyance issues.

For a discussion of offers in compromise, see Parker Tax ¶263,165.

*CIRCULAR 230 DISCLOSURE: Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.