IRS Removes No-oad Retirement Tax Applies to the Value of Stock Options; Estate Can't Recover Attorney's Fees After VictorRule Position for Certain Sec. 355 or Sec. 361 Transactions; IRS Issues 2018 Inflation Amounts for HSAs; Railry over IRS ...
Federal Circuit Vacates Claims Court Decision on Timing of Investment Scheme Loss; Couple Gets Second Shot at Arguing for Deduction
The Federal Circuit vacated a decision by the Federal Claims Court, which had held that a couple did not prove that their loss from an investment scheme occurred in 2004 and, thus, rejected their refund claim. The court rejected the lower court's interpretation of Reg. Sec. 1.165-1(d)(3) as setting forth two different standards that had to be met in order for a taxpayer to take a theft loss deduction. Adkins v. U.S., 2017 PTC 218 (Fed. Cir. 2017).
House Passes Health Care Bill by Slim Margin; Senate Hints That It Will Rewrite the Bill
On May 4, 2017, the House passed The American Health Care Act of 2017 (AHCA) by a vote of 217 - 213. The bill would repeal all of the Affordable Care Act's (ACA) tax provisions except for the "Cadillac tax" on high cost employer-sponsored health plans. Most of the tax changes would be effective beginning in 2017 or 2018, but the repeal of the individual and employer mandates would be retroactive to January 1, 2016. The bill would replace the ACA's means-tested premium tax credit with an age-based health insurance credit. H.R. 1628 (May 4, 2017).
The Eleventh Circuit affirmed the Tax Court's holding that an estate was not permitted to take an interest deduction on a loan it used to pay its tax liabilities where it had sufficient liquid assets to pay the taxes. The court also concluded that the Tax Court properly valued the estate by taking into account certain redemption agreements that had not yet been consummated. Estate of Koons v. Comm'r, 2017 PTC 201 (11th Cir. 2017).
Tax Court Has Jurisdiction over Penalty Relating to Inconsistent Partnership Reporting
The Tax Court rejected arguments by a partner in a partnership that it lacked jurisdiction over a penalty relating to the partner's inconsistent reporting of partnership items and thus deficiency procedures did not apply. According to the court, since there were no adjustments to partnership items, deficiency procedures applied to the penalties asserted by the IRS. Malone v. Comm'r, 146 T.C. No. 16 (2017).
Court Calls Taxpayer's Arguments "Heavy on Chutzpah"; Duty of Consistency Prevents Additional Deductions
The Tax Court held that a restaurant owner who underreported his employees' wages for years that were outside of the three-year assessment period could not later amend his returns to increase the amount of wages he paid in order to claim additional deductions. The duty of consistency prevented him from taking a contradictory position after the statute of limitations had run in order to change a previous representation to the detriment of the IRS. Musa v. Comm'r, 2017 PTC 200 (7th Cir. 2017).
The Seventh Circuit, in a case of first impression, held that a taxpayer could not challenge its liability for a reporting penalty in a collection due process (CDP) hearing after having unsuccessfully challenged the penalty in an administrative hearing before the IRS Office of Appeals. Because the taxpayer did not raise his issue in the CDP hearing, it could not be considered on appeal by the Tax Court, and the taxpayer's only recourse was to pay the penalty in full and sue for a refund. Our Country Home Enterprises, Inc. v. Comm'r, 2017 PTC 214 (7th Cir. 2017).
Tax Debts Were Not Dischargeable in Bankruptcy; Late Returns Were Not Returns for Bankruptcy Purposes
In a case of first impression, the Third Circuit held that an individual's late Form 1040s, filed after the IRS assessed deficiencies, were not an honest and reasonable effort to comply with the tax law and therefore did not constitute returns. The tax debts were for tax liabilities for which no return was filed, so they were not dischargeable in bankruptcy. Giacchi v. IRS, 2017 PTC 215 (3d Cir. 2017).
District Court Incorrectly Applied Factors in Considering If IRS Could Foreclose on Married Couple's Home
The Third Circuit vacated a district court's decision not to force the sale of a married couple's home to recover the husband's unpaid taxes and ordered the lower court to recalculate the couple's respective interests in the property and to reconsider the equitable factors set forth in U.S. v. Rodgers, 461 U.S. 677 (S. Ct. 1983). The court rejected the taxpayer's argument that the district court did not have the authority to order a sale of the property. U.S. v. Cardaci, 2017 PTC 217 (3d Cir. 2017).
Federal Circuit Vacates Claims Court Decision on Timing of Investment Scheme Loss; Couple Gets Second Shot at Arguing for Deduction
The Federal Circuit vacated a decision by the Federal Claims Court, which had held that a couple did not prove that their loss from an investment scheme occurred in 2004 and, thus, rejected their refund claim. The court rejected the lower court's interpretation of Reg. Sec. 1.165-1(d)(3) as setting forth two different standards that had to be met in order for a taxpayer to take a theft loss deduction. Adkins v. U.S., 2017 PTC 218 (Fed. Cir. 2017).
Background
Charles and Jane Adkins suffered investment losses resulting from a decline in the value of stock purchased in a pump-and-dump scheme. The scheme was run by brokers at Donald & Co., who would arrange to purchase large blocks of stock in various companies; encouraging its customers to purchase these stocks, artificially inflating the stocks' prices by, among other means, hyping the stock; and then, once the price of a particular stock was sufficiently inflated, selling the stock that it owned, resulting in gains for the company and, due to the subsequent decline in the stock price to a normal, uninflated level, losses for the company's customers.
By the beginning of 2002, the value of the Adkinses' investment with Donald & Co. had dropped dramatically. The Adkinses filed an arbitration claim against Donald & Co and several of its brokers, alleging that they had manipulated the value of the stock, causing the couple to incur substantial losses. In May of 2004, a federal grand jury indicted several principals and employees of Donald & Co (defendants). Mr. Adkins took the indictment to mean that the government intended to seize any documentation concerning the identity and ownership of the defendants' assets, foreclosing his ability to prove the existence of a theft loss and locate assets that could be used to reimburse him and his wife for their loss. Mr. Adkins further interpreted the indictment to mean that the government was going to seize all of the defendants' assets, preventing him from attaching those assets to recover their loss.
In September of 2004, several employees of Donald & Co. pled guilty to securities fraud and other charges. They received prison terms, fines, mandatory restitution in an amount to be determined, and forfeiture. By the end of 2004, no amounts had been paid to the victims of the fraud. In 2005, additional prosecutions were taking place. The broker who had sold stocks to the Adkinses pled guilty to securities fraud and was sentenced to prison, fines, and mandatory restitution. In 2008, the Adkinses formally withdrew their arbitration claim.
While the criminal proceedings were pending, the Adkinses attempted to recoup some of their losses by claiming a tax deduction under Code Sec. 165. They timely filed amended returns for 2001 through 2004 reflecting a total theft loss of approximately $2.6 million. Approximately $2.3 million of that loss came from the Donald & Co. pump-and-dump scheme and most of the rest was attributable to purchases made via the third-party brokers. The IRS disallowed the refund claims and the Adkinses protested to the IRS Office of Appeals.
An Appeals Officer issued a memorandum on April 5, 2011, which concluded that the Adkinses had sustained a theft loss of $2.5 million - the claimed theft loss minus the portion of the loss attributable to the stock purchased through third-party brokers - and were therefore entitled to the corresponding refunds. However, at the time the Appeals Officer issued his memorandum, the IRS Office of Appeals lacked jurisdiction to settle the case because the Adkinses had filed a refund suit in the U.S. Court of Federal Claims. That suit had been filed on December 10, 2010. In the suit, the Adkinses sought income tax refunds totaling almost $320,000 for investment losses in their Donald & Co. accounts. The couple determined that the loss occurred in 2004 and carried back losses not used up in that year to earlier years. In that case (Adkins v. U.S., 2013 PTC 386 (Fed. Cl. 2013)), the court disallowed refunds relating to losses the Adkinses suffered from stock purchased through third-party brokers because there was no privity between the Adkinses and Donald & Co. with respect to those purchases. With respect to the other losses, the court held that whether the Adkinses had a reasonable prospect of recovery in 2004 was a genuine issue of material fact and that neither the IRS nor the Adkinses was entitled to summary judgment.
The Adkinses filed suit again, arguing that they were entitled to a refund for investment theft losses sustained in 2004. According to the couple, they sustained the loss in 2004 because by the end of that year, they had no reasonable prospect of recovering on their arbitration claim.
Federal Claims Court Rejects Refund Claim
The Federal Claims Court held that the Akinses did not prove that their loss occurred in 2004 and, thus, rejected their refund claim. Under the factual circumstances presented, the court said, the test was not whether the Adkinses had a reasonable prospect of recovering on their arbitration claim in 2004, but was instead whether, in 2004, they could have ascertained with reasonable certainty that they would not recover on their arbitration claim. To satisfy their burden under the latter test, the court said, the Adkinses were required to produce objective evidence that they abandoned their arbitration claim in 2004. Because they failed to do so, the court concluded that they were not entitled to a theft loss deduction for the 2004 tax year.
In reaching its holding, the court cited Reg. Sec. 1.165-1(d)(3), which provides that if a taxpayer has a reasonable prospect for recovery in the year that he discovers his loss, then he cannot claim the theft loss deduction until the year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether or not such reimbursement will be received, the court noted, may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. And, the court observed, Reg. Sec. 1.165-1(d)(2)(i) requires that, when a taxpayer claims that the year he sustained his loss is fixed by his abandonment of the claim for reimbursement, he must be able to produce objective evidence of his having abandoned the claim, such as the execution of a release.
In interpreting and applying this regulation, the Claims Court reiterated the conclusion reached in Johnson v. U.S., 74 Fed. Cl. 360 (2006). That is, the court said, although other courts tend to combine the "reasonable prospect of recovery" inquiry and the "ascertain with reasonable certainty" inquiry, the Claims Court found the two inquiries are distinct and the standards to be applied are different.
According to the Claims Court, the objective evidence in the record supported two abandonment dates other than 2004: (1) 2003, when the Adkinses' arbitration attorneys requested that the NASD adjourn a scheduled hearing and when the Adkinses stopped paying their arbitration attorneys, or (2) 2008, when the Adkinses formally withdrew their arbitration claim. Accordingly, the court found that the Adkinses did not meet their burden of establishing that they sustained their theft loss in 2004. The Adkinses appealed to the Federal Circuit.
Arguments on Appeal
On appeal, the Adkinses made essentially four arguments: (1) the Claims Court failed to correctly apply Reg. Sec. 1.165-1(d)(3)'s test for determining the year in which a taxpayer can deduct a theft loss under Code Sec. 165; (2) even under the Claims Court's interpretation of Reg. Sec. 1.165-1(d)(3), it improperly required abandonment of their arbitration claim; (3) the Claims Court failed to apply Rev. Proc. 2009-20, which provides an optional safe harbor treatment for taxpayers that experienced losses in certain investment arrangements discovered to be criminally fraudulent; and (4) if 2004 was not the correct loss year, the Claims Court should have ruled in favor of the Adkinses under the mitigation provisions of Reg. Sec. 1.1311(c), using 2003 as the loss year instead.
The Adkinses argued that Reg. Sec. 1.165-1(d)(3), properly interpreted, does not set forth two different standards. Rather, it merely describes two sides of the same probabilistic coin: a "reasonable prospect for recovery" is the inverse of "reasonable certainty" that there will be no recovery. That is, the test in Reg. Sec. 1.165-1(d)(3) may be simplified as follows: the proper year in which to claim a loss is the first year in which no reasonable prospect of recovery exists anymore, starting with the year of discovery.
Federal Circuit's Decision
The Federal Circuit vacated the lower court decision and remanded the case for further proceedings consistent with the Federal Circuit's opinion.
At the outset, the Federal Circuit agreed with the Adkinses' interpretation of Reg. Sec. 1.165-1(d)(3) as not requiring two different standards. The court noted that, while few circuit courts have addressed this issue explicitly, their conclusions appear to be the same. The court cited Vincentini v. Comm'r, 429 F. App'x 560 (6th Cir. 2011), where the Sixth Circuit described Reg. Sec. 1.165-1(d)(3) as setting forth a single test, and describing that test as whether the claimant demonstrated with reasonable certainty that there was no reasonable prospect of recovery; Jeppsen v. Comm'r, 128 F.3d 1410 (10th Cir. 1997), where the Tenth Circuit used "reasonable prospect" and "reasonable certainty" language interchangeably; and Rainbow Inn, Inc. v. Comm'r, 433 F.2d 640 (3d Cir. 1970), where the Third Circuit described "the test" under Reg. Sec. 1.165-1(d)(3) as whether there was a reasonable prospect of recovery at the time the deduction was claimed. The Federal Circuit said it could find no basis in the language of Reg. Sec. 1.165-1(d)(3) to deviate from this straightforward and sensible approach.
The Federal Circuit then turned to the Adkinses' second argument whether, under either interpretation of Reg. Sec. 1.165-1(d)(3), the Claims Court additionally erred by treating abandonment of their arbitration claim as a prerequisite to a reasonable certainty of no recovery. The court found the Adkinses' argument persuasive, and held that the Claims Court so erred. The court disagreed with the lower court's holding that the Adkinses had not met their burden of establishing that they sustained their theft loss in 2004, saying that it read Reg. Sec. 1.165-1(d)(2)(i) as setting forth a general totality-of-the-circumstances standard, followed by an alternative method for a taxpayer to demonstrate that no reasonable prospect of recovery existed as of a certain date.
That is, the Federal Circuit said, rather than make their case under the general "all facts and circumstances" standard, a taxpayer may rely on the date that their arbitration or lawsuit for the loss was settled, abandoned, or adjudicated. In the case of abandonment, because no dated court order or settlement agreement exists, a taxpayer must be able to provide some other form of "objective evidence" as to when abandonment occurred. But even in cases where taxpayers do have a related arbitration or lawsuit, the Federal Circuit did not read Reg. Sec. 1.165-1(d)(2)(i) as precluding taxpayers from making their case under the more general standard, should they so choose.
Because the court agreed with the Adkinses' first two arguments, it did not address the other arguments presented.
For a discussion of when a theft loss is deductible, see Parker Tax ¶84,540.
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House Passes Health Care Bill by Slim Margin; Senate Hints That It Will Rewrite the Bill
On May 4, 2017, the House passed The American Health Care Act of 2017 (AHCA) by a vote of 217 - 213. The bill would repeal all of the Affordable Care Act's (ACA) tax provisions except for the "Cadillac tax" on high cost employer-sponsored health plans. Most of the tax changes would be effective beginning in 2017 or 2018, but the repeal of the individual and employer mandates would be retroactive to January 1, 2016. The bill would replace the ACA's means-tested premium tax credit with an age-based health insurance credit. H.R. 1628 (May 4, 2017).
Tax Provisions in Healthcare Bill
The following are the AHCA's tax changes:
- Repeals the penalties for individuals who are not covered by a health plan that provides at least minimum essential coverage ("the individual mandate"). The repeal is retroactive to January 1, 2016.
- Repeals the penalties for certain large employers who do not offer full-time employees and their dependents minimum essential health coverage under an employer-sponsored health plan ("the employer mandate"). The repeal is retroactive to January 1, 2016.
- Repeals the 3.8 percent net investment income tax (NIIT) in Code Sec. 1411, effective for tax years beginning on or after January 1, 2017.
- Repeals the 0.9 percent additional Medicare tax, effective for remuneration received on or after January 1, 2023.
- Reduces the income threshold for determining medical expense deductions under Code Sec. 213 from 10 percent to 5.8 percent, effective January 1, 2017.
- Makes several modifications to the premium assistance tax credit in Code Sec. 36B, effective in 2018 and 2019. Beginning in 2020, the mean-tested tax credit will be replaced with a new, age-based credit, ranging from $2,000 to $4,000. The new credits will be phased out for modified adjusted gross income between $75,000 and $115,000 ($150,000 and $190,000 for married filing jointly).
- Imposes liability on taxpayers for the full amount of excess advance payments of the premium assistance tax credit, beginning in 2018. Under current law, liability for certain low-income households was limited to an applicable dollar amount.
- Repeals the small business tax credit under Code Sec. 45R, which provides a credit to certain employers who provide health care to employees, effective January 1, 2020. The bill also modifies the credit to prohibit it from being used for health plans that include coverage for abortions (other than any abortion necessary to save the life of the mother or any abortion with respect to a pregnancy that is the result of an act of rape or incest) for tax years beginning on or after January 1, 2018.
- Delays the implementation of the excise tax on high cost employer-sponsored health coverage (commonly referred to as "the Cadillac tax") until 2025. Under current law, the tax goes into effect in 2020.
- Permits tax-favored health savings accounts (HSAs), Archer Medical Savings Accounts (MSAs), health flexible spending arrangements (FSAs), and health reimbursement arrangements to be used to purchase over-the-counter medicine that is not prescribed by a physician.
- Repeals the increase in the tax on distributions from HSAs and Archer MSAs that are not used for qualified medical expenses. The Bill reduces the tax on HSA distributions from 20 percent to 10 percent and reduces the tax on Archer MSA's from 20 percent to 15 percent, effective for distributions made on or after January 1, 2017.
- Repeals limitations on contributions to flexible spending accounts, effective January 1, 2017.
- Repeals the medical device excise tax in Code Sec. 4191, effective for sales after on or after January 1, 2017.
- Repeals the elimination of the deduction for expenses allocable to a Medicare Part D subsidy, effective for tax years beginning on or after January 1, 2017.
- Repeals the tax on prescription medications.
Repeals the tanning tax, effective for services performed after June 30, 2017.
Non-Tax Provisions
The following is a summary of some of the AHCA's other key provisions:
- Requires insurance companies to impose a 30% surcharge on the health insurance premiums of individuals who let their coverage lapse for at least 63 days.
- Allows children to stay on their parents' healthcare plans until age 26 (unchanged).
- Continues use of state healthcare exchanges.
- Relaxes the current-law requirement that prevents insurers from charging older people premiums that are more than three times larger than the premiums charged to younger people. Unless a state sets a different limit, the legislation would allow insurers to charge older people five times more than younger ones, beginning in 2018.
- Provides that states may opt-out of providing essential health benefits.
- Provides that states may opt-out of requiring premiums to be the same for all people of the same age, so while individuals with pre-existing conditions must be offered health insurance there is no limit on what insurance companies can charge. A new $8 billion fund (for five years) would help lower premiums for these individuals through use of high-risk pools.
- Provides that states may opt-out of limitations on premium differences based on age.
- Freezes the ACA's federally subsidized Medicaid expansion beginning in 2020 and capping the growth in per-enrollee payments for most Medicaid starting the same year.
- Creates a Patient and State Stability Fund for risk sharing to help states lower premiums ($15 per year for 2018-2019, $10 billion per year for 2020-2026).
CBO Estimates and Potential Senate Action
The Congressional Budget Office (CBO) and the staff of the Joint Committee on Taxation are in the process of preparing a cost estimate for the House-passed version of the AHCA. The CBO anticipates being able to release that estimate the week of May 22.
In the meantime, initial work on healthcare legislation has begun in the Senate. Some Senators have indicated that the Bill coming from the House will have to be substantially reworked. "I think it needs a lot of improvement," said Sen. Shelley Moore Capito (R-W.Va.). While Sen. John Cornyn (R-Texas) promised a Senate healthcare bill this year, Senate Majority Leader Mitch McConnell (R-Ky.) cautioned that getting healthcare legislation through the Senate would be "a big challenge."
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Estate Can't Deduct Interest on Loan Used to Pay Estate Taxes
The Eleventh Circuit affirmed the Tax Court's holding that an estate was not permitted to take an interest deduction on a loan it used to pay its tax liabilities where it had sufficient liquid assets to pay the taxes. The court also concluded that the Tax Court properly valued the estate by taking into account certain redemption agreements that had not yet been consummated. Estate of Koons v. Comm'r, 2017 PTC 201 (11th Cir. 2017).
Background
John Koons died in March 2005. Koons, his four children, and other family members owned Central Investment Corp. (CIC), which bottled and distributed soft drinks and also sold vending machine items. As the result of litigation and a subsequent settlement in 1997 with PepsiCo, Inc., CIC sold its soft drink and vending machine businesses to PepsiAmericas, Inc. (PAS). CIC received approximately $402 million in the settlement.
Koons intended to invest the proceeds in new businesses by putting the money into another entity, CI LLC. In January 2005, CI LLC obtained the $402 million plus the CIC assets not sold to PAS, which included four operating businesses. CI LLC sold three of these and kept only one, valued at approximately $3.8 million.
Koons' children disagreed with their father's plans for CI LLC and asked that their interests in CI LLC be redeemed after the sale to PAS. Around the time of the sale, CI LLC's operating agreement was amended to provide for a board of managers. The board of managers was permitted to make distributions at its sole discretion. It was required to consult with a board of advisors composed in part of Koons' children. Members were permitted to transfer membership interests only to Koons' children or grandchildren. In late January 2005, CI LLC made a pro rata distribution of $100 million to its members. The Koons children received about $29 million. Pursuant to the terms of their redemption offers, their redemption payments were to be reduced by the distribution amount.
In February 2005, Koons removed his children as beneficiaries of his estate and replaced them with his grandchildren. Later that same month, Koons contributed his 50.5 percent interest in CI LLC to a trust. He restricted his children's control of CI LLC by eliminating its board of advisors. The children were also removed from the list of permitted transferees of membership interests. Limits were imposed on discretionary distributions. In late February, James Koons wrote his father to say that the redemption offer felt punitive. He raised various complaints and made suggestions regarding the operation of the business. While his letter threatened litigation if the board of managers made decisions that were detrimental to the family, it also expressed gratitude for the "exit vehicle" and said that the Koons children would "like to be gone."
Koons died in March 2005. The Koons children's redemption offers closed in April 2005. On the closing of the offers, the trust's interest in CI LLC increased from 50.5 percent to around 71 percent. At this time, most of the estate's assets were in the trust, and the trust's primary asset was its interest CI LLC.
The estate's remaining liquid assets were not enough to pay its estate tax liability. The trustees decided not to use the interest in CI LLC to pay the taxes because they feared that a distribution would hinder the company's plan to invest in operating businesses. Instead, the trustees borrowed approximately $10 million from CI LLC at a 9.5 percent interest rate. Repayment was not due to begin until 2024, and prepayment was not permitted. The projected interest payments would total approximately $71 million. At the time of the loan, CI LLC had over $200 million in liquid assets.
The estate filed its return in June 2006 and claimed a deduction for the approximately $71 million of interest as an administrative expense. The estate reported the market value of the revocable trust's interest in CI LLC at approximately $117 million as of the date of Koons' death. The IRS issued a notice of deficiency for approximately $42 million in estate tax.
The Tax Court agreed with the IRS's computation of the deficiency and with the IRS's valuation of the estate, which did not include a discount for lack of control. The estate appealed the Tax Court's decision to the Eleventh Circuit.
Estate Administration Expenses
Under Code Sec. 2053, an estate can deduct expenses that are actually and necessarily incurred in the administration of the estate. If the estate takes out a loan to pay its debts because it lacks enough liquid assets, the interest payments on the loan are generally deductible. A loan is necessary where an estate would have otherwise been forced to sell its assets at a loss to pay the estate's debts.
In Est. of Black v. Comm'r, 133 T.C. 340 (2009), the Tax Court held that interest payments are not deductible if an estate makes indirect use of its liquid assets by borrowing money from an entity it owns and then using distributions from that entity to repay the loan. In Est. of Black, the decedent contributed stock to a partnership, then after his death, his estate borrowed money from the partnership and claimed an interest deduction. The Tax Court disallowed the deduction because it found that the partnership distributions would be insufficient to repay the loan and that the estate could have ordered a pro rata distribution from the partnership. In either case, the estate would have to sell the stock; the only difference with the loan was that it resulted in a tax deduction.
Eleventh Circuit's Opinion
The Eleventh Circuit affirmed the Tax Court on both issues. The court cited Est. of Black for the rule that interest payments are not necessary expenses where:
(1) the entity lending money to the estate has sufficient liquid assets that the estate could use to pay the liability; and
(2) the estate lacks other assets and would eventually need to use the entity's liquid assets to repay the loan.
According to the Eleventh Circuit, the loan to the Koons estate was not a necessary expense. First, the court found that the estate had sufficient funds to pay its taxes. The trust owned around 70 percent of CI LLC, which had over $200 million in liquid assets. The trust could have ordered a pro rata distribution to obtain the funds to pay its taxes. The court rejected the estate's argument that a pro rata distribution would violate its fiduciary duty. The estate said that Koons had a long-term investment philosophy to retain liquid assets for investment purposes, and that a distribution would be to the detriment of this business model. The court found that under Ohio law, a majority interest holder has the right to take actions beneficial to that holder as long as minority holders benefit equally. A pro rata distribution by CI LLC would have benefitted all holders equally, so the trust would not have violated its fiduciary duty by ordering such a distribution to pay the estate taxes.
The court also found that, aside from the revocable trust and its interest in CI LLC, the estate did not have the funds to repay the loan from CI LLC. The estate acknowledged that the loan repayment schedule was designed so that the trust could repay the loan out of distributions from CI LLC. The court determined that distributions from CI LLC would be used to pay the estate taxes regardless of whether the estate ordered a pro rata distribution and paid its tax liability immediately or borrowed the money and then paid it back gradually. It also noted that the same entity would be on both sides of the transaction because CI LLC would be making payments to the trust only to have those payments returned to it in the form of principal and interest payments on the loan. The court concluded that there was no net economic benefit from the loan other than the tax deduction.
The court also did not agree with the estate's argument that the loan would be repaid using regular disbursements rather than an immediate, extraordinary distribution. The estate said that an immediate disbursement would have permanently depleted CI LLC, while the loan only temporary depleted it until a later date when it would be repaid using regular disbursements to the trust. The court found this to be a distinction without a difference, and determined that Est. of Black spoke only in terms of the source of the funds. It did not distinguish between a regular disbursement from liquid assets and an immediate disbursement from the same source of funds.
The estate's argument that the court should have deferred to the executor's business judgment was also rejected. The estate argued that the deduction should have been permitted based on the executor's decision that the loan was in the estate's best interests. The Eleventh Circuit distinguished the Tax Court decisions relied on by the estate because they dealt with an executor's decision between taking out a loan and selling illiquid assets, which did not apply in this case because of CI LLC's liquid assets. The court also rejected as a policy matter the idea that a loan is necessary (and that the interest is therefore deductible) whenever the executor acts in the best interests of the estate. In deciding whether to allow a deduction, a court is not considering the soundness of the executor's decision making, only whether the deduction should be allowed. If courts were required to defer to the executor's business judgment, the court said, then executors would in effect have blanket authority to establish that a deduction was proper with no judicial oversight.
The estate argued that the Tax Court should have discounted the value of the estate because the trust's interest in CI LLC was not a controlling interest at the time of Koons' death and the children's redemptions had not yet occurred. The Eleventh Circuit held that the Tax Court was correct in assuming that the redemptions would occur. Each child had signed a redemption agreement. The court also determined that there was enough testimony at trial to confirm that the children wanted to redeem their interests.
The estate also argued that the Tax Court erred in concluding that a hypothetical buyer of the trust's interest in CI LLC would be permitted to force a distribution of most of the LLC's assets. The Tax Court determined that a buyer of the trust's interest would have a majority interest in CI LLC and could therefore vote to distribute the majority of the LLC's assets. It then used this assumption in arriving at its fair market value of the interest. The estate said that a majority holder has a heightened fiduciary duty to minority interests which prevents it from frustrating the purpose for which the LLC was created. According to the estate, a majority holder must have a legitimate business purpose for its actions, and the inability to demonstrate such a purpose would be a breach of fiduciary duty. Koons' investment philosophy was to use CI LLC's funds to invest in businesses; minority holders, by the estate's reasoning, had a legitimate expectation that the LLC would be run according to Koons' wishes.
The court found that the heightened fiduciary duty under Ohio law is focused on preventing abuses of power at the expense of minority holders. It does not, according to the court, impose a general obligation for majority holders' actions to have a legitimate business purpose. A legitimate business purpose must be demonstrated, the court found, only if the action breaches a fiduciary duty. Where an action benefits all holders equally, it does not violate the fiduciary duty obligation and the majority shareholder is therefore not required to demonstrate a legitimate business purpose.
For a discussion of estate tax deductions for administration expenses, see Parker Tax ¶227,520. For a discussion of the valuation of an estate, see Parker Tax ¶224,701.
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Tax Court Has Jurisdiction over Penalty Relating to Inconsistent Partnership Reporting
The Tax Court rejected arguments by a partner in a partnership that it lacked jurisdiction over a penalty relating to the partner's inconsistent reporting of partnership items and thus deficiency procedures did not apply. According to the court, since there were no adjustments to partnership items, deficiency procedures applied to the penalties asserted by the IRS. Malone v. Comm'r, 146 T.C. No. 16 (2017).
Bernard Malone was a partner of MBJ Mortgage Services America, Ltd (MBJ), a partnership that is subject to the unified audit and litigation procedures of Code Sec. 6220 through Code Sec. 6234 (i.e., TEFRA provisions). On its 2005 Form 1065, U.S. Return of Partnership Income, MBJ reported installment sales of partnership assets and reported as Mr. Malone's distributive share from those sales $3,200,748 of ordinary income and $3,547,326 of net long-term capital gain.
On their joint 2005 Form 1040, Malone and his wife failed to report Mr. Malone's distributive share from those sales but reported $4,526,897 of long-term capital gain from the sale of Mr. Malone's partnership interest in MBJ. With respect to Mr. Malone's distributive share, the Malones did not file a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, or otherwise notify the IRS that they were taking a position inconsistent with that reported by MBJ. The Malones also claimed repairs and maintenance and bad debt deductions, both of which are unrelated to MBJ.
In the notice of deficiency, the IRS adjusted the Malones' return to include the partnership items reported by MBJ but omitted by the Malones, disallowed the reported net long-term capital gain because Mr. Malone did not sell his partnership interest in 2005, and disallowed the claimed repairs and maintenance and bad debt deductions. The IRS asserted a negligence penalty under Code Sec. 6662 relating to the Malones failure to report partnership items. The Malones disagreed with the IRS's assessment and took their case to the Tax Court.
Before the Tax Court, the Malones moved to dismiss the penalty from the case, asserting that the Tax Court lacked jurisdiction over a penalty relating to their inconsistent reporting of partnership items. Under Code Sec. 6230(a)(2)(A)(i), deficiency procedures do not apply to penalties, additions to tax, and additional amounts that relate to adjustments to partnership items.
The Malones argued that the inconsistently reported partnership items on their 2005 Form 1040 were "adjusted" within the meaning of Code Sec. 6230(a)(2)(A)(i). The Tax Court had to determine whether the deficiency procedures apply to a Code Sec. 6662 accuracy-related penalty for negligence imposed solely because of a partner's inconsistent reporting of partnership items.
The Tax Court held that, regardless of whether the Code Sec. 6662(a) and Code Sec. 6662(b)(1) negligence penalty is a nonpartnership item or a factual affected item unrelated to an adjustment to a partnership item, deficiency procedures apply to the determination of the penalty because there were no adjustments to partnership items. Accordingly, the Tax Court denied the Malones' motion to dismiss for lack of jurisdiction.
For a discussion of partnership audit procedures, see Parker Tax ¶28,505.
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Court Calls Taxpayer's Arguments "Heavy on Chutzpah"; Duty of Consistency Prevents Additional Deductions
The Tax Court held that a restaurant owner who underreported his employees' wages for years that were outside of the three-year assessment period could not later amend his returns to increase the amount of wages he paid in order to claim additional deductions. The duty of consistency prevented him from taking a contradictory position after the statute of limitations had run in order to change a previous representation to the detriment of the IRS. Musa v. Comm'r, 2017 PTC 200 (7th Cir. 2017).
Background
Alaa Musa owns and operates a restaurant in Milwaukee, Wisconsin. For the years 2006 to 2010, the IRS determined that Musa underreported his income taxes by more than $500,000 and made numerous other misrepresentations on his tax returns. Musa employed his family members and did not report their wages to the company he hired to assist with payroll. The payroll company's services included withholding the required taxes from employees' paychecks, issuing Forms W-2 to the employees and the IRS, and filing Musa's quarterly employment tax returns. Between 2006 and 2008, Musa did not include any of his family members' earnings when he reported his employees' information to the payroll company. For 2009 and 2010, he included only two family members' wages. He also underreported the restaurant's revenues on his individual tax returns by giving inaccurate information to his accountant.
In 2009, the IRS audited Musa starting with his 2007 return, then expanded the audit to include his returns from 2006 to 2008. The IRS reviewed the bank statements for Musa and the restaurant and found that the amount of credit card deposits in the restaurant's account exceeded what Musa had reported on his returns. The IRS decided to pursue Musa for civil tax fraud. While under audit, Musa hired a new accountant to prepare his 2009 and 2010 returns and to file amended employment tax returns for 2006 to 2008. He made these corrections, however, only after the statute of limitations had run on the IRS's ability to collect the correct amounts of employment taxes that Musa's amended returns admitted were due.
In 2012, the IRS sent Musa a notice of income tax deficiency for 2006 to 2010. Musa challenged the notice in the Tax Court. In 2013, Musa responded to a discovery request by providing a list of employees who he claimed had been paid additional wages. Musa claimed he was entitled to additional deductions for these wages in calculating his income tax liabilities.
The IRS argued that Musa's duty of consistency prevented him from claiming new expense deductions on his income tax returns for wages paid between 2006 and 2009 because the IRS had relied on representations made by Musa in his original reports of employee wages in the restaurant's quarterly tax returns and because the three-year period under Code Sec. 6501 for assessing employment taxes on those wages had expired. The Tax Court ruled in the IRS's favor and determined that Musa had understated his income, failed to keep adequate records, concealed income, failed to file Forms W-2 and 1099-MISC for all employees, filed false documents, and failed to make estimated tax payments. The Tax Court found him liable for over $500,000 in income tax for 2006 to 2010, and over $380,000 in fraud penalties.
Analysis
The duty of consistency is an equitable tax doctrine which prevents a party from prevailing in a court proceeding by taking one position and then taking a contradictory position in a later case. It applies when there has been a representation by the taxpayer on which the IRS has relied followed by an attempt after the statute of limitations has run to change the previous representation or to recharacterize the situation in a way that harms the IRS.
Musa appealed to the Seventh Circuit. On appeal, Musa conceded that he had filed fraudulent income and employment tax returns but said the Tax Court had erred in its ruling on the duty of consistency. Calling Musa's arguments "heavy on chutzpah but light on reasoning or any sense of basic fairness," the Seventh Circuit affirmed the Tax Court.
The Seventh Circuit agreed with the IRS that Musa violated the duty of consistency. First, Musa made representations on his employment tax filings for 2006 to 2009 that the restaurant paid its employees certain sums in non-tip wages. Then, in 2013, Musa amended his filings to add wages that he had paid to his employees but failed to report for those same years. The court found that the IRS had relied on Musa's original representations because it assessed employment taxes based on the original filings.
Musa argued that the IRS did not rely on the employment returns because it should have known that the returns were inaccurate. Musa claimed that the IRS either had all the facts available to it or had the opportunity to gain such knowledge before the limitations period expired, so the IRS did not "rely" on Musa's false representations. In other words, Musa argued, after the IRS discovered his income tax fraud and he submitted amended income tax returns, the IRS should have induced from the amended income tax returns that the restaurant's quarterly employment tax returns had also been incorrect.
The Seventh Circuit found there was no merit to Musa's claim that the IRS lost its ability to rely on Musa's employment tax returns because Musa amended his income tax returns. The court reasoned that the tax system is based on self-reporting and the IRS must be able to rely on truthful reporting for the system to function. In the court's view, the IRS was permitted to take at face value the representations on Musa's original employment tax returns and the duty of consistency prevented Musa from claiming the additional deductions which Musa tried to use to offset the consequences of his own fraud.
For a discussion of the duty of consistency doctrine, see Parker Tax ¶241,525.
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Taxpayer Properly Barred from Challenging Penalty in CDP Hearing
The Seventh Circuit, in a case of first impression, held that a taxpayer could not challenge its liability for a reporting penalty in a collection due process (CDP) hearing after having unsuccessfully challenged the penalty in an administrative hearing before the IRS Office of Appeals. Because the taxpayer did not raise his issue in the CDP hearing, it could not be considered on appeal by the Tax Court, and the taxpayer's only recourse was to pay the penalty in full and sue for a refund. Our Country Home Enterprises, Inc. v. Comm'r, 2017 PTC 214 (7th Cir. 2017).
Our Country Home Enterprises, Inc. participated in an employee benefit plan from 2003 through 2007. Only one employee, Thomas Blake, was enrolled in the plan. The company took deductions for its payments into the plan, but Blake did not report income from the plan on his return. The IRS determined that Our Country Home's participation in the plan was a listed transaction. According to the IRS, Our Country Home should have filed a Form 8886, Reportable Transaction Disclosure Statement. The maximum penalty of $200,000 was imposed for Our Country Home's failure to report its participation in the plan.
Before the penalty was assessed, Our Country Home was offered an administrative hearing before the IRS Office of Appeals. In that hearing, Our Country Home challenged its liability for the penalty, arguing that the IRS incorrectly computed the penalty amount and improperly classified its participation in the plan as a listed transaction. After holding a conference with Our Country Home's counsel, an IRS appeals officer sustained the penalty in full.
The IRS assessed the penalty against Our Country Home in February 2013. A month later, the IRS issued a final notice of intent to levy under Code Sec. 6330 and informed Our Country Home of its right to a collection due process (CDP) hearing. Our Country Home requested a CDP hearing in June 2013 to contest again its liability for the penalty. An appeals officer determined that Appeals had already considered a liability challenge to the penalty and that Our Country Home was therefore precluded under Code Sec. 6330(c)(2)(B) from challenging it again. Our Country Home's challenge was dismissed and the levy against it was sustained.
Our Country Home petitioned the Tax Court to review the Appeals Office decision. The Tax Court granted the IRS's motion for summary judgment, holding that Our Country Home had a prior opportunity to dispute its liability in its conference with the Appeals Office. Our Country Home then appealed the Tax Court's decision. The issue was important to Our Country Home because, had it been able to challenge the penalty in the CDP hearing, the outcome of that hearing would be appealable to the Tax Court under Code Sec. 6330(d)(1), giving Our Country Home judicial review before having to pay the penalty. Our Country Home's only other option was to pay the penalty in full and sue for a refund.
The Court of Appeals affirmed the Tax Court. It held that Code Secs. 6330(c)(2)(B) and 6330(c)(4)(A) precluded Our Country Home's challenge of the penalty in the CDP hearing after having raised the issue in its initial conference with Appeals.
Under Code Sec. 6330(c)(2)(B), a taxpayer can raise any issue in a CDP hearing as long as the taxpayer either (1) did not receive a notice of deficiency for the liability, or (2) did not otherwise have an opportunity to dispute the liability. The reporting penalty imposed on Our Country Home was not subject to a notice of deficiency, so the issue was whether Our Country Home's challenge before the Appeals Office was a prior opportunity to dispute the liability. Our Country Home argued that a prior opportunity means a prior judicial opportunity. The IRS's reading of the statute was that a prior opportunity means any opportunity, whether judicial or administrative.
The Seventh Circuit sided with the IRS and found that under Reg. Sec. 301.6630-1(e)(3), an opportunity to dispute the underlying liability includes a prior opportunity for a conference with the Appeals Office that was offered either before or after the assessment of the liability. The court reviewed the regulation under the deferential standard provided in Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). It determined that Code Sec. 6330(c)(2)(B) is ambiguous and that the IRS's interpretation of it in the regulation was reasonable.
Our Country Home's argument was based on the language in the regulation, which permits a taxpayer to challenge a liability in a CDP hearing "if the taxpayer did not receive a statutory notice of deficiency for such liability or did not otherwise have an opportunity to dispute such liability." According to Our Country Home, this implied that if a notice of deficiency entitles a taxpayer to judicial review before paying the penalty, then "opportunity to dispute" must also refer to an opportunity for prepayment judicial review. The court rejected this argument. It noted that nothing suggests the phrases "notice of deficiency" and "opportunity to dispute" are linked in a way that indicates they share a common quality. The court reasoned that, just because a notice of deficiency can be reviewed by a court before payment did not mean that other opportunities to dispute a liability must also be reviewable in the same way.
Next, the Court of Appeals determined that Reg. Sec. 301.6330-1(e)(3), which defines "opportunity to dispute" to include prior conferences with the Appeals Office and to exclude conferences prior to the IRS's assessment of a tax subject to deficiency procedures, is a reasonable interpretation of the statute. The regulation does not, in the court's view, conflict with the statute. The court said that other provisions in the statute, including Code Sec. 6330(c)(4)(A), lend support to the IRS's interpretation; Code Sec. 6330(c)(4)(A) precludes a taxpayer from raising an issue at a CDP hearing if the issue was raised and considered at a previous administrative or judicial proceeding. Our Country Home had not, in the court's view, explained why Congress considered an administrative proceeding an adequate forum for purposes of Code Sec. 6330(c)(4)(A) but not for Code Sec. 6330(c)(2)(B). To the contrary, it was more likely in the court's view that Congress, by creating an independent appeals function within the IRS, considered an administrative proceeding to be an appropriate way to resolve most prepayment tax challenges.
The court was not persuaded by Our Country Home's argument that the regulation is unreasonable because it tries to limit the Tax Court's jurisdiction. It found that the regulation does not address jurisdiction, it only specifies the issues that can be raised in a CDP hearing. According to the court, the regulation was reasonable because it preserved Our Country Home's right to file a refund suit in court after paying the tax, so Our Country Home at all times had a judicial forum to challenge the liability.
The court considered the IRS's alternative argument that Our Country Home was precluded under Code Sec. 6330(c)(4)(A) from challenging its liability at the CDP hearing. That provision says that if an issue was raised and considered at a previous administrative or judicial proceeding and the taxpayer participated meaningfully in that proceeding, the taxpayer cannot raise that issue again in a CDP hearing. Our Country Home argued that the word "issue" in Code Sec. 6330(c)(4)(A) does not include a liability challenge, so that statute did not apply. It said that because Code Sec. 6330(c)(2)(B) explicitly deals with liability, "issue" as used in Code Sec. 6330(c)(4)(A) does not include liability. The court disagreed and found that the word "issue" encompasses liability challenges in Code Sec. 6330(c)(2)(B) and Code Sec. 6330(c)(3)(B), so it should have the same meaning in Code Sec. 6330(c)(4)(A).
Our Country Home next argued that reading Code Sec. 6330(c)(4)(A) to include liability challenges was inconsistent with Reg. Sec. 301.6330-1(e)(3), which says that a conference with the Appeals Office before the assessment of a tax subject to deficiency procedures is not a prior opportunity. The court saw some merit to Our Country Home's argument. It noted that on the one hand, the regulation assures the taxpayer that a preassessment administrative hearing before the Appeals Office would not preclude a future liability challenge in a CDP hearing. On the other hand, a taxpayer who did challenge a liability in a hearing before Appeals would then be prohibited under Code Sec. 6330(c)(4)((A) from raising the issue in a later CDP hearing. In resolving this apparent inconsistency, the noted a planning opportunity for the savvy taxpayer.
Planning Tip: According to the court, a taxpayer given an opportunity to challenge its liability before the Appeals Office could decline that invitation in order to preserve the ability to raise the challenge later in a CDP hearing. Having challenged the liability in the CDP hearing, the taxpayer could then appeal that decision to the Tax Court and thus have access to a prepayment judicial review of the liability, which would not be available if the issue was not considered in the CDP hearing.
The court ultimately held that under the plain language of Code Sec. 6330(c)(4)(A), Our Country Home raised the issue of its liability in a prior hearing before the Appeals Office and participated meaningfully in that hearing, so it could therefore not contest its liability again in its CDP hearing.
For a discussion of collection due process hearings, see Parker Tax ¶260,540.20.
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Tax Debts Were Not Dischargeable in Bankruptcy; Late Returns Were Not Returns for Bankruptcy Purposes
In a case of first impression, the Third Circuit held that an individual's late Form 1040s, filed after the IRS assessed deficiencies, were not an honest and reasonable effort to comply
with the tax law and therefore did not constitute returns. The tax debts were for tax liabilities for which no return was filed, so they were not dischargeable in bankruptcy. Giacchi v. IRS, 2017 PTC 215 (3d Cir. 2017).
Thomas Giacchi failed to timely file his Forms 1040 for 2000 through 2002. The IRS assessed a liability against Giacchi in 2004 for his 2000 and 2001 taxes. About a month after the assessment, Giacchi filed Forms 1040 for 2000 and 2001. In 2005, the IRS assessed his 2002 liability. Giacchi filed a Form 1040 for 2002 in 2006. The IRS partially reduced its assessments based on Giacchi's late returns.
Giacchi filed a Chapter 7 bankruptcy petition in 2010. In 2012, Giacchi sued for a judgment that his assessed tax liabilities for 2000 through 2002 had been discharged in the bankruptcy. The bankruptcy court concluded that Giacchi's debt to the IRS was nondischargeable under 11 U.S.C. Sec. 523(a)(1)(B) because Giacchi had failed to file returns for those years. It found that his late filings were not returns for bankruptcy purposes. A district court affirmed the bankruptcy court's decision and Giacchi appealed to the Third Circuit.
In general, a debtor who files a Chapter 7 bankruptcy petition is discharged from liability for all debts incurred before the petition was filed. An exception applies under 11 U.S.C. Sec. 523(a)(1)(B) to debts for taxes if no return was filed. If Giacchi's late Forms 1040 were not returns, then the exception applied and his tax debts were not dischargeable in bankruptcy. Under 11 U.S.C. Sec. 727(b), a return is defined for bankruptcy purposes as a return that satisfies the requirements of the applicable nonbankruptcy law, including any filing requirements.
The issue before the Third Circuit was whether belatedly filed forms constitute "returns." If they do, Giacchi's tax debts are not subject to 11 U.S.C. Sec. 523(a)(1)(B)(i)'s exception from discharge; if the forms do not, Giacchi's tax debts are excepted from discharge.
Giacchi made two arguments for why his late filings should be treated as returns. First, he said that the fact that they were late did not make them any less of an honest and reasonable attempt to comply. For this proposition, he cited the Eighth Circuit's decision in In re Colsen, 446 F.3d 836 (8th Cir. 2006), in which the court held that the "honest and reasonable attempt" inquiry focuses on the content of the return, not the circumstances of its filing. Second, Giacchi asserted that because his late filings showed less tax liability, and the IRS reduced its assessment based on those filings, the late filings served a tax purpose and thus were returns.
Noting that this was an issue of first impression in its court, the Third Circuit held that Giacchi's belatedly filed forms did not constitute "returns" and thus, his tax debts were not dischargeable in bankruptcy. The court noted that several other circuits have interpreted "applicable filing requirements" to include filing deadlines. In those jurisdictions, late filings therefore cannot be returns. The court also considered the decision in Beard v. Comm'r, 82 T.C. 766 (1984), which held that a document must meet four requirements to be a tax return: (1) it must purport to be a return, (2) it must be executed under penalty of perjury, (3) it must contain sufficient data to allow calculation of tax, and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law. The Third Circuit determined that the issue was whether Giacchi's late Forms 1040 were an honest and reasonable effort to comply with the tax law.
Giacchi's late returns were not, in the court's view, an honest and reasonable attempt to comply with the law. The court reasoned that the purpose of a tax return is to provide information to the government regarding the amount of tax due. When a taxpayer fails to file a return, the IRS must independently determine the tax liability; a return filed after the IRS has done so, the court said, can no longer serve the purpose of a tax return and thus cannot be an honest and reasonable attempt to comply with the tax law.
The court declined to adopt the Eight Circuit's approach in In re Colsen. It said the weight of authority supported the view that the timing of a filing is relevant to determining whether it is an honest and reasonable attempt to comply with the law. With respect to Giacchi's second argument that his taxes went down after filing the late Form 1040s, the court said that because the IRS had to determine Giacchi's tax liability without his assistance when he failed to file his returns, he could not now try to benefit from the IRS's imprecise estimate. In the court's view, Giacchi's late filings were merely self-serving bids to reduce his tax liabilities rather than attempts to comply with the requirements and objectives of prompt self-reporting and self-assessment.
For a discussion on the discharge of tax liabilities in a bankruptcy proceeding, see Parker Tax ¶16,160.
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District Court Incorrectly Applied Factors in Considering If IRS Could Foreclose on Married Couple's Home
The Third Circuit vacated a district court's decision not to force the sale of a married couple's home to recover the husband's unpaid taxes and ordered the lower court to recalculate the couple's respective interests in the property and to reconsider the equitable factors set forth in U.S. v. Rodgers, 461 U.S. 677 (S. Ct. 1983). The court rejected the taxpayer's argument that the district court did not have the authority to order a sale of the property. U.S. v. Cardaci, 2017 PTC 217 (3d Cir. 2017).
Background
Gary Cardaci was the owner of Holly Beach Construction Company. In 2000 and 2001, the business began to fail and, in an effort to shore it up, Mr. Cardaci used approximately $49,000 in taxes withheld from his employees' wages to pay suppliers and make payroll instead of paying the payroll taxes. Cardaci's salary during that time was approximately $20,000. He used that income to support his family, including making mortgage payments and paying one of his sons' private school tuition. The company eventually folded and Cardaci tried unsuccessfully to start other businesses. Cardaci had medical problems that limited his employment options. Beginning in 2005, Cardaci's wife, Beverly, was the primary wage earner in the family, earning about $62,000 a year as a public school teacher.
The Cardacis owned a home in New Jersey that they purchased in 1978. Two of their adult children lived in the house with them at least part of each year. Their son, Garrett, lived there full time with his wife and three children. Garrett earned approximately $37,000 a year. He emerged from bankruptcy a year and a half before the trial in this case. He and his wife did not pay rent. Another son, Robert, lived in the house during the summer. He earned just under $4,000 a year doing seasonal work.
The Cardacis' house had been their marital domicile continuously since they bought it. The mortgage was paid in full in 2009. Mr. Cardaci made the majority of the monthly mortgage payments from 1978 through 2005. After that, Mrs. Cardaci made the mortgage payments.
In 2012, the IRS sued the Cardacis for a judgment on tax assessments against Mr. Cardaci and to force a sale of their home. The IRS asked for half the proceeds to go to Mr. Cardaci's tax liability and to distribute the rest to Mrs. Cardaci. Mr. Cardaci owed the IRS approximately $80,000 plus interest. The district court granted partial summary judgment on the assessments against Mr. Cardaci. With respect to the foreclosure on the house, the district court determined that it had limited discretion to order an alternative remedy and decided against a forced sale.
In considering whether to order a sale of the Cardaci home, the district court applied the equitable factors set out in U.S. v. Rodgers, 461 U.S. 677 (S. Ct. 1983). The district court examined (1) whether the IRS's interests would be prejudiced if the court ordered a sale of Mr. Carduci's interest in the house, since he was the one liable for the taxes; (2) whether Mrs. Cardaci had a legally recognized expectation that her interest in the property would not be subject to a forced sale; (3) the likely prejudice to Mrs. Cardaci in personal dislocation costs and practical undercompensation; and (4) the relative character and value of the Cardacis' interests in the property. The district court also considered other factors, including the impact of a forced sale on other nonliable parties.
The district court determined that it would be inequitable to force the sale of the property. Its conclusion was based in part on the court's method of valuing Mr. and Mrs. Cardacis' respective interests in the home. It determined that Mrs. Cardaci's interest in the event of a forced sale would be 86 percent of the property, because she owned an undivided one-half interest in the whole property plus a right of survivorship. That meant that the IRS could recover only 14 percent of the value of the proceeds from a forced sale. The court considered that calculation plus the Rodgers equitable factors and found that the equities warranted the exercise of the court's limited discretion not to order a sale. Instead, it fixed a monthly rental value of $1,500 and ordered Mr. Cardaci to pay half of that value to the IRS every month. Mr. Cardaci defaulted on his monthly payment, failed to set up an automatic debit payment, and failed to provide proof of homeowner's insurance up to the balance of the tax liability. He made no payments and did not seek a stay while his appeal was pending.
The IRS appealed the district court's decision to the Third Circuit. The Cardacis also appealed, challenging the order to pay rent, the monthly rental amount, and the district court's authority to order a sale (even though no sale was ordered). The Cardacis also argued that the district court could not even consider ordering a sale of their home because it was protected by a New Jersey statute.
Third Circuit's Decision
The Third Circuit confirmed the district court's authority to order a sale of the property. However, it vacated the district court's calculation of the Cardacis' respective interests in the property and remanded the case for a recalculation of those interests and for reconsideration of the equitable factors weighing for and against a sale.
The court found two flaws with the argument that the sale of the Cardacis' home was protected by New Jersey law. First, the court said, the statute did not apply to their home because it was enacted after they purchased the property. Second, even the state statute applied, the court determined that it would have been preempted by the federal tax lien provision in Code Sec. 6321.
The court also concluded that the IRS was authorized under Code Sec. 7403(c) to dispose of the Cardacis' home by forced sale. The court noted that under the statute, a court "may" decree a sale of property, implying that the court has discretion. That reading of the statute was adopted by the Supreme Court in Rodgers, which held that courts must order a sale of property to satisfy a tax lien unless, in light of common sense or special circumstances, it determines that a sale would be inequitable. That determination is to be guided by four non-exhaustive factors.
The Third Circuit found that the district court abused its discretion in analyzing the Rodgers factors and erred in concluding that the Cardacis' home should not be sold. In remanding the case, the court gave an explanation of the Rodgers factors to assist the district court.
The first factor is whether the government's financial interests would be adversely affected by a partial sale of the property. The district court determined that a sale of Mr. Cardaci's interest in the home would be of little value, while rental payments would be likely to produce much greater collection of the taxes owed. On this factor, the Third Circuit agreed that there would be no real market for one spouse's interest in a marital home. However, the court said that rental payments were not relevant. In the court's view, the only consideration was whether the government would be adequately compensated by a partial sale. According to the court, the lack of a market for a partial interest in the property weighed heavily in favor of a forced sale of the entire property.
The second factor directs a court to consider whether a nonliable third party would have a legally recognized expectation that the separate property interest would not be subject to a forced sale. The court directed the district court to consider applicable New Jersey law in deciding the strength of Mrs. Cardaci's legally recognized expectations.
The third factor under Rodgers is the likely prejudice to Mrs. Cardaci, both in personal dislocation costs and in practical undercompensation. The Third Circuit agreed with the district court that Mrs. Cardaci's dislocation costs would be no greater than in any other foreclosure sale. However, it found that the district court should have also addressed the practical undercompensation Mrs. Cardaci might suffer in a forced sale. The court said that under Rodgers, if a forced sale would undercompensate a nonliable spouse, this factor should weigh against a forced sale. The court determined that a fair approach to valuing Mrs. Cardaci's interest would be to rely on joint-life actuarial tables to reflect the interests of both spouses. Once the spouses' respective interests were determined, the district court could then take into account whether Mrs. Cardaci would be undercompensated as a separate consideration.
Under the fourth factor, the district court had to consider the relative character and value of the nonliable and liable interests in the property. The Third Circuit said that this factor was more likely to come into play where the liable party owns a relatively small fraction of the property and found that it was neutral when applied to the Cardacis' approximately equal interests. This factor, the court said, could be applied more precisely by the district court once it calculated the relative interests in the property using a joint-life actuarial table.
The Third Circuit concluded by noting that the four Rodgers factors were not to be applied mechanically, and that the district court should also consider special circumstances. The IRS argued that the district court should not have taken into account the Cardacis' son, Garrett, who was living in the house with his wife and three children. The Third Circuit left it to the district court to decide how, if at all, the interests of Garrett's family should weigh in the mix.
For a discussion of foreclosures and forced sales in the enforcement of tax liens, see Parker Tax ¶260,530.
