Court Rejects IRS Attempt to Recover Home Sale Proceeds from Debtor's Wife

(Parker Tax Publishing April 2017)

The First Circuit affirmed a district court holding that half of the proceeds from the sale of a couple's home, in order to pay a tax judgment against the husband, could be retained by the wife rather than turned over to the IRS. However, with respect to the 50/50 allocation of funds directly traceable to the husband's tax shelter which led to the judgment, the court vacated and remanded the lower court's decision so the lower court could specifically consider the 14 factors required under Massachusetts law when dividing up certain property. U.S. v. Baker, 2017 PTC 145 (1st Cir. 2017).

Background

In December 2002, Scott Baker and his business partner sold eight Planet Fitness gyms to Bally Fitness for approximately $15 million, including Bally Fitness stock that he later sold for $3.4 million. He used a Son-of-BOSS tax shelter to reduce his taxable income on gains from the Planet Fitness sale, and reported a $2.5 million loss on his 2002 return, which he filed separately from his wife, Robyn. Scott then amended his tax returns for 1997-2001 to carry back the loss, leading the IRS to refund virtually all of the taxes that Scott and his wife had paid in the years 1999-2001.

Scott deposited the proceeds from the sale of the Bally Fitness stock into a Cayman Islands family trust. He instructed the trustee to invest the corpus of the family trust into a hedge fund called International Management Associates (IMA). Late in 2005, the Bakers learned that IMA was in fact a Ponzi scheme and that all of the money had disappeared.

In August of 2005, the Bakers bought a house in Hingham, Massachusetts, which they owned as tenants by the entirety, for just over $1.6 million. In the same month, the IRS began an audit of Scott Baker's 2002 tax return.

In February 2007, the Bakers remortgaged their Hingham property with Scott as the sole mortgagor; on the same day, they established the S&R Realty Trust with Robyn as trustee and transferred the title of their Hingham property into the trust. They also established the C&S Realty Trust on the same day, with Robyn as sole trustee and their two children as primary beneficiaries, and transferred into it a beach house located in Scituate, Massachusetts. Scott did not receive any consideration for transferring his interests in the properties to the trusts. In November 2007, Robyn sold the Scituate property and deposited the $433,000 in proceeds into a South Shore Bank account owned by C&S Trust. She used the majority of the money to pay down loans secured by the Hingham property, and the remainder on living expenses.

On January 10, 2008, the Bakers signed a separation agreement, and the following day they filed for divorce. The agreement, which was incorporated into the final divorce judgment, gave most of the assets to Robyn, but most of the liabilities to Scott. The agreement stipulated that Scott could continue to live in the Hingham property, and he did so after the divorce became final in May of 2008. After the divorce, Robyn continued to refer to Scott as her husband, though she testified at trial that those references were mistakes or oversights.

Following an income tax judgment for over $5 million dollars against Scott in 2015, there was a dispute as to whether, and to what extent, the IRS's tax liens attached to certain assets. After a district court set aside the Bakers' separation agreement as a fraudulent transfer, it proceeded to re-divide and reallocate these assets applying Massachusetts law. The IRS's tax liens attached directly to any assets allocated to Scott. The IRS also argued that its tax liens attached indirectly to certain assets allocated to Robyn. The court determined the allocation of the following assets between Scott and Robyn: (1) funds that were directly traceable to Scott's tax shelter (i.e., the "Escrowed Funds"); and (2) a property the couple owned in Hingham, Massachusetts (i.e., the "Hingham property").

The district court divided both assets more or less evenly, reasoning that it was applying an equitable 50/50 division of the couple's assets consistent with the common-law community property system adopted by Massachusetts and recognized as valid by the IRS. In order to effectuate this division as to the Hingham property, the court ordered it to be sold and half the proceeds to be paid to the IRS and half to Robyn. The IRS had argued that it was entitled to Robyn's half of the proceeds from the sale of the Hingham property on a lien-tracing theory. The district court rejected this theory on the ground that the IRS had not submitted evidence sufficient to trace the liens with the required level of specificity. The IRS appealed to the First Circuit.

IRS's Arguments

Before the First Circuit, the IRS challenged the 50/50 division of the Escrowed Funds on the ground that Massachusetts is not a community property state. In fact, the IRS said, Massachusetts law requires a judge to consider, either explicitly or by clear implication, 14 factors in order to arrive at an equitable division of the parties' assets.

With respect to the Hingham property, the IRS again advanced it argument that it was entitled to Robyn's half of the proceeds from the sale of the Hingham property. The IRS argued that its tax liens attached to any property Scott possessed on or after May 14, 2009, the date of the first tax assessment. The IRS inferred from the Bakers' testimony that one of the Bakers made the mortgage payment on the Hingham property every month up to the time of trial, and that each payment was $6,200. The IRS noted that the district court found that Scott ultimately made the majority of the mortgage payments. Thus, reasoned the IRS, Scott must have paid at least half of the total mortgage payments made on the Hingham property between June 2009 and December 2014 (just before the start of trial) using money on which the IRS had a tax lien. By that logic, the IRS concluded, it had a lien on the property no smaller than $6,200 times 67 months divided by two, or $207,700. Dividing that lien between the two halves of the property, the IRS claimed that it had a lien of $103,850 on Robyn's half, which exceeded her share of the sale proceeds. Thus, the IRS argued, it was entitled to all the proceeds from the sale of the Hingham property.

First Circuit's Decision

Because it was not clear to the First Circuit that the district court considered the 14 factors required to be considered under Massachusetts law to arrive at an equitable division of the couple's assets, it vacated and remanded the determination of the allocation of the Escrowed Funds back to the district court. However, the First Circuit affirmed the district court's decision with respect to the IRS not being entitled to Robyn's half of the proceeds from the sale of the Hingham property.

According to the court, the IRS's argument suffered from a fatal flaw. The court noted that the district court found that "for the lien tracing theory to be viable the government has the burden of showing with particularity the sums transferred by [Scott] Baker to which the tax liens attach." However, the district court never made a finding as to the amount or the number of the mortgage payments. The IRS was relying, the court said, entirely on the testimony of the Bakers which the IRS itself conceded was contradictory for the proposition that the amount of the payment was $6,200 and then assumed that every payment during the relevant time period was made in full. The First Circuit noted that the district court found "neither of the Bakers to be credible witnesses, at least insofar as their financial interests are concerned." The court also noted that one of Robyn's former friends testified that Robyn had problems with honesty and that Robyn even admitted that she struggled with the truth.

The First Circuit agreed with the district court that "the equivocal testimony of the Bakers by itself [is not] sufficient to satisfy the government's burden in a lien tracing context." The IRS, the court said, had not met its burden of distinctly tracing its lien, because the evidence it presented was insufficient. The court did note, however, that its decision did not mean to hold that every time the IRS wishes to trace a lien it must be able to prove the amounts involved to the penny but, the court said, it should present the court with more than the testimony of witnesses who struggle with the truth.

For a discussion of tax liens, see Parker Tax ¶260,530.

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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