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11th Circuit Rejects Estate's Attempt to Dodge Code Sec. 642(g)'s Bar on Double Deduction.
(Parker Tax Publishing June 23, 2015)
The Eleventh Circuit reversed a district court decision that res judicata applied to prevent the IRS from collecting certain taxes but affirmed the district court's holding preventing an estate from taking an estate tax deduction and an income tax deduction for settlement payments made in various lawsuits. Batchelor-Robjohns v. United States, 2015 PTC 179 (11th Cir. 2015).
Background
In 1999, George Batchelor sold the stock in his aviation business, International Air Leases, Inc. (IAL), to International Air Leases of Puerto Rico, Inc. (IALPR) for $502 million. As part of the transaction, IALPR gave Batchelor a promissory note for $150 million, which was secured by IAL assets that had been transferred in the sale. Additionally, IAL and IALPR negotiated an option for Batchelor to buy back some of the transferred assets ("Option Assets"). Later that year, Batchelor exercised his option to buy back these assets for almost $93 million, thus reducing the $150 million note by that amount. The following year, IALPR paid off the note. As a result of the transaction, Batchelor received capital gains and interest income, and IAL realized a capital gain through its sale of the Option Assets. Batchelor reported the income he received from the sale as capital gain, and paid capital gains tax on the proceeds
In 2002, IAL was placed into involuntary bankruptcy and later that year, Batchelor died. The IRS determined that IAL was liable for approximately $100 million in unpaid taxes, largely as a result of its attempt to use a tax shelter scheme after the stock sale. The IRS sought to collect IAL's corporate income tax obligation directly from Batchelor's estate under a transferee liability theory. In a district court, the IRS attempted to prove that the sale of the IAL stock rendered IAL insolvent because the transferring parties undervalued the Option Assets such that Batchelor received excess consideration relative to the actual fair market value of the IAL stock. The district court, however, struck the experts testimony on the value of the Option Assets based on the IRS's failure to comply with certain procedural rules and granted summary judgment in favor of Batchelor's estate (Batchelor I). Consequently, the value of the Option Assets was not decided in Batchelor I.
In 2004, the IRS sued Batchelor's estate based on its determination that Batchelor had underreported his capital gains in conjunction with the IAL sale on his personal income tax returns (Batchelor III). Batchelor's estate subsequently paid the $6.7 million deficiency and filed for a refund. The IRS denied the estate's refund request.
Following the sale of Batchelor's ownership interest in IAL to IALPR, a number of parties filed civil lawsuits challenging the transaction. From 2002 to 2004, the estate settled each of the pending claims against it and deducted settlement payments of $41 million from the gross estate under Code Sec. 2053(a)(3). The estate later sought a refund of $8.3 million on its 2005 income tax return for those payments pursuant to Code Sec. 1341. The IRS denied the refund request.
Batchelor's estate filed suit in district court seeking refunds for amounts it had paid the IRS. In Counts I and II, the estate sought refunds of tax payments relating to payments to the IRS in Batchelor III. Count III of the estate's complaint involved the settlement payments the estate made in connection with the civil lawsuits. The estate argued that after taking the estate tax deduction for the lawsuit settlement payments, it was also entitled under Code Sec. 1341 to an $8.3 million credit on its 2005 income tax return for the $41 million returned to the plaintiffs in the lawsuits as settlement payments.
With respect to Counts I and II, the district court held that the IRS was precluded by res judicata from defending against the estate's claim that the value of the Option Assets had been accurately reported in calculating Batchelor's 1999 and 2000 income tax obligations. With respect to Count III, the district court rejected the estate's claim, finding that Code Sec. 642(g) barred the estate from claiming both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment.
The case was appealed to the Eleventh Circuit.
Analysis
With respect to Counts I and II, the IRS argued that res judicata was not applicable because the personal income tax claims against Batchelor and the transferee liability claim against IAL in Batchelor I were not the same cause of action. Alternatively, even if the claims were part of the same cause of action, the IRS said it could not have asserted the instant claims in Batchelor I given that the it had not yet issued a Notice of Deficiency with respect to the income tax claims against Batchelor at the time the complaint in Batchelor I was filed.
With respect to Count III, the estate argued that Code Sec. 162 and Code Sec. 212 provided a basis for permitting a "double deduction" of the settlement payments at issue because the payments arose out of Batchelor's business activities and thus were ordinary and necessary business expenses.
The Eleventh Circuit reversed the district court's holdings on Counts I and II, finding that the district court erred in applying res judicata to bar the IRS's claims in Counts I and II.
The Eleventh Circuit affirmed the district court's holding on Count III. With respect to the estate's argument that Code Sec. 1341 applied to allow a double deduction, the court noted that Code Sec. 1341 does not, by itself, create an independent tax deduction and instead applies only if another code section would provide a deduction for the item in the current year. Thus, the Eleventh Circuit said, the dispute involved in Count III could not be resolved simply by reference to Code Sec. 1341. To determine whether another code section would provide a deduction for the item in the current year, the Eleventh Circuit agreed with the district court that the tax code provisions relating to overlapping estate and income tax deductions were relevant.
The court noted that Code Sec. 642(g) applied to prevent an estate from claiming both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment. However, the court observed, Code Sec. 642 contains an exception for income in respect of decedents and Code Sec. 642(g) does not apply to such income. Thus, a double deduction is permitted for taxes, interest, business expenses, and other items accrued at the date of a decedent's death that fall within Code Sec. 2053(a)(3) as claims against the estate, as long as they are also allowable under Code Sec. 691(b). Code Sec. 691(b), in turn, provides that a decedent's estate may claim both deductions if the expense falls within one of six statutes: Code Secs. 162, 163, 164, 212, 611, or 27. The district court in this case, the Eleventh Circuit said, properly required the estate to show that one of these statutes applied in order to claim both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment.
With respect to the estate's argument that Code Sec. 212 and Code Sec. 162 allowed a double deduction, the court cited the decision in Kimbell v. U.S., 490 F.2d 203 (5th Cir. 1974), in which the Fifth Circuit determined that a payment made by a taxpayer in satisfaction of a liability arising from an earlier transaction, on which that taxpayer reported capital gain, must be treated as a capital loss at least to the amount of the capital gain, rather than as a Code Sec. 162 business expense. It was undisputed, the Eleventh Circuit said, that Batchelor obtained the $41 million of income (that was used to pay the plaintiffs in the lawsuits) as a result of his sale of IAL stock.
The $41 million at issue, the Eleventh Circuit noted, derived from income Batchelor originally reported as capital gain through the sale of his IAL stock. Batchelor's treatment of this income as capital gain, the court said, determines the character of a subsequent repayment of that income pursuant to Kimbell. Thus, the Eleventh Circuit concluded, a payment made by a taxpayer in satisfaction of a liability arising from an earlier transaction on which that taxpayer reported capital gain, such as the payments at issue, must be treated as a capital loss at least to the amount of the capital gain, rather than as a Code Sec. 162 business expense.
Because the estate failed to identify an applicable deduction identified in Code Sec. 691(b), the Eleventh Circuit found no error in the district court's determination that the estate could not avoid Code Sec. 642(g)'s bar on double deductions, and therefore affirmed on Count III.
For a discussion of the rule disallowing double deductions for estate expenses, see Parker Tax ¶53,130.
(Staff Editor Parker Tax Publishing)
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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