Federal Tax Bulletin - Issue 86 - April 10, 2015

Couple Entitled to $1.4 Million in Gift Tax Exclusions for Transfers to Family Trust with "Crummey Power"

The Tax Court held that a husband and wife were each eligible for an annual gift tax exclusion of $720,000 for transfers of property to an irrevocable family trust. The court found the IRS's arguments that the provisions of the trust prevented the gifts from being excludable present interests in property were based on an unrealistic hypothesis and a misinterpretation of the trust's provisions. Mikel v. Comm'r, T.C. Memo. 2015-64.

Background

In 2007, Israel Mikel and his wife Erna established the IEM Family Trust, an irrevocable inter vivos trust, jointly transferring property to the trust with an asserted value of $3,262,000. The trust had 60 beneficiaries at the time, including the couple's children, grandchildren, and respective spouses.

After a contribution of property to the trust, the trustees were required to notify all beneficiaries that they had a demand right to withdraw trust funds, which was to be exercised within 30 days of such notice. The terms of the trust required the trustees to immediately distribute the requested trust funds upon receipt of a timely withdrawal demand. Apart from these mandatory distributions in response to withdrawal demands, the trust empowered the trustees to, within their sole discretion, make distributions for the health, education, maintenance, or general support of any beneficiary or family member.

Any disputes concerning the administration of the trust were to be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith, known in Hebrew as a "beth din." Additionally, the trust contained an "in terrorem" provision designed to discourage beneficiaries from challenging discretionary acts of the trustees, whereby a beneficiary would forfeit rights in the trust if he or she took part in proceedings opposing distributions, including filing actions in court.

On separate gift tax returns for 2007, the Mikels each claimed annual exclusions from the gift tax of $720,000 on the theory that both had made separate gifts of $12,000 to each of the trust's 60 beneficiaries. Following examination of these returns, the IRS sent the Mikels separate notices of deficiency determining that they were ineligible for the claimed annual exclusions.

Analysis

Code Sec. 2503(b)(1) provides an annual exclusion from gift tax for gifts of a present interest in property. In 2007, the annual exclusion amount was $12,000 per donee. Under Reg. Sec. 25.2503-3(b), a "present interest in property" is defined as an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.

The IRS argued that the beneficiaries did not receive a "present interest in property" because their rights of withdrawal were not legally enforceable in practical terms. The IRS hypothesized that the trustees might refuse to honor a timely withdrawal demand, requiring the beneficiary to submit the dispute to a beth din. If the beth din sustained the trustees' refusal to honor the demand, the IRS noted that the beneficiary could seek redress in a New York court, but claimed he or she would be extremely reluctant to go to court because in doing so the beneficiary would forfeit all rights under the trust by virtue of the in terrorem clause.

According to the IRS, a right of withdrawal was enforceable only if the beneficiary could go before a state court to enforce that right, but the in terrorem provision made this right illusory, as beneficiaries would never attempt to enforce their rights in court. The IRS claimed that because the beneficiaries' withdrawal rights were illusory, they did not have present interests in trust property, and therefore the Mikels were not entitled to the gift tax exclusions.

The Tax Court noted two fatal flaws in the IRS's argument. First, it was not obvious to the court why, as the IRS argued, the beneficiary must be able to go before a state court for the withdrawal right to be legally enforceable. The court noted that if the trustees were to breach their fiduciary duties by refusing a timely withdrawal demand, the beneficiary could seek justice from a beth din. A beneficiary would not suffer adverse consequences from submitting a claim to a beth din, and the court found the IRS had not explained why that was not enforcement enough.

Second, the court noted the IRS's argument was not that judicial enforcement was unavailable, but that the remedy was "illusory" because the in terrorem provision would deter beneficiaries from pursuing it. The court concluded the IRS had misunderstood the provision's meaning, stating the provision was designed to discourage legal challenges to discretionary distributions made by trustees, such as for a beneficiary's medical expenses. In contrast, a beneficiary who filed suit to compel the trustees to honor a timely withdrawal demand would not be opposing or challenging a distribution from the trust. The court found that because a beneficiary's challenge to compel mandatory distributions would not be covered by the in terrorem provision, that provision would not, as the IRS argued, dissuade a beneficiary from seeking judicial enforcement of his rights.

Finding the IRS's arguments unconvincing, the Tax Court concluded that the beneficiaries of the Mikel trust possessed a present interest in property because they had an unconditional right to withdraw property which could not be "legally resisted" by the trustees, and because the Mikels had gifted present interests in property to the trust, the court held they were entitled to the claimed gift tax exclusions.

Observation: The Mikel trust is a "demand trust," often called a "Crummey trust" because of the favorable treatment accorded such a trust in Crummey v. Comm'r, 397 F.2d 82 (9th Cir. 1968). The demand clause in Crummey, substantially similar to that in the Mikel trust, provided that whenever an addition was made to the trust, a beneficiary or guardian acting for a minor beneficiary could demand immediate withdrawal of an amount keyed to the maximum annual exclusion under Code Sec. 2503(b). The Ninth Circuit held this demand right to be a "present interest in property" and the IRS confirmed this conclusion in Rev. Rul. 85-24. The Tax Court adopted the Ninth Circuit's reasoning and result in Estate of Cristofani v. Comm'r, 97 T.C. 74 (1991), explaining that the proper focus of analysis was not the likelihood that the beneficiaries would actually receive present enjoyment of the property, but the legal right of the beneficiaries to demand payment from the trustee.

For a discussion of the gift tax annual exclusion, see Parker ¶221,310.

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Final Regs Clarify Deduction Limitation for Compensation in Excess of $1,000,000

The IRS has issued final regulations clarifying that a performance-based compensation plan will meet the requirements of Reg. Sec. 1.162-27(e) for granting option or stock appreciation rights if it specifies a maximum number of shares for which such rights may be granted to an employee within a specified period. The regulations also clarify the application of the compensation deduction limitation for corporations that become publicly held. T.D. 9716 (3/31/15).

Code Sec. 162(m)(1) precludes a publicly held corporation from deducting compensation paid to any covered employee (a CEO or the three other highest paid officers) in excess of $1,000,000. However, this limitation does not apply to qualified performance-based compensation that meets all of the requirements of Reg. Secs. 1.162-27(e)(2) through (e)(5).

Per-Employee Limitation Requirement

Proposed regulations issued in 2011 as REG-137125-08 clarified Reg. Sec. 1.162-27(e)(2)(vi)(A) by providing that plans granting option or stock appreciation rights must state "the maximum number of shares with respect to which options or rights may be granted during a specified period to any individual [emphasis added] employee" (per-employee limitation requirement).

In response to comments, the final regulations modify Reg. Sec. 1.162-27(e)(2)(vi)(A) to provide that a plan will satisfy the per-employee limitation requirement if it specifies an aggregate maximum number of shares with respect to which equity-based awards (such as stock options, stock appreciation rights, or restricted stock and restricted stock units) may be granted to any individual employee during a specified period under a plan approved by shareholders in accordance with Reg. Sec. 1.162-27(e)(4).

The final regulations provided that these clarifications apply to compensation attributable to stock options and stock appreciation rights that are granted on or after June 24, 2011.

Limitation Rules for Corporations that Become Publicly Held

In general, Reg. Sec. 1.162-27(f)(1) provides that when a corporation becomes publicly held, the

Code Sec. 162(m) deduction limitation does not apply to compensation based on a plan or agreement existing before the corporation became publicly held. Pursuant to Reg. Sec. 1.162-27(f)(2), a corporation may rely on that provision until the earliest of:

(1) the expiration of the plan or agreement;

(2) a material modification of the plan or agreement;

(3) the issuance of all employer stock and other compensation that has been allocated under the plan or agreement; or

(4) the first meeting of shareholders to elect directors that occurs three years after an initial public offering (IPO) or, if there was no IPO, the first year after the year in which the corporation becomes publicly held.

Reg. Sec. 1.162-27(f)(3) provides that this transitional relief from the deduction limitations applies to any compensation received pursuant to the exercise of a stock option or stock appreciation right, or the substantial vesting of restricted property, if the rights were granted under a plan or agreement before the earliest of the events specified above.

The proposed regulations clarified that compensation payable under a restricted stock unit arrangement (RSU) or a phantom stock arrangement is generally ineligible for this transition relief. Instead, compensation payable under a RSU will be eligible for transition relief only if it is actually paid to an employee, rather than merely granted, before the earliest of one of the specified events. The final regulations adopt this clarification, and provide that it will apply to remuneration otherwise deductible under a RSU that is granted on or after March 31, 2015.

For a discussion of the deductibility of compensation, see Parker ¶91,101.

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Support Payments Contingent on Ex-Wife Homeschooling the Couple's Child Treated as Alimony

The Tax Court held that a provision in a separate maintenance agreement making support payments contingent upon the taxpayer's ex-wife homeschooling the couple's child did not disqualify the payments from being treated as alimony. Wish v. Comm'r, T.C. Summary 2015-25.

Background

Joshua Wish, who worked as a schoolteacher, and his wife decided to homeschool their child because of the child's learning disabilities. Because of their decision to homeschool, Wish's wife was not able to work. In January of 2009, Wish and his wife divorced and agreed that their child should continue to be homeschooled. They agreed that Wish would, in addition to paying $1,200 per month child support, pay alimony during a four-year transitional period to provide her with financial independence. In their separation agreement, Wish and his former wife agreed that she would receive $3,800 per month in alimony, but if she discontinued homeschooling their child, then her alimony would be reduced to $1,900 per month.

Wish's ex-wife continued homeschooling the child until September of 2009, at which point she enrolled him in a local school and returned to work. As a result, Wish reduced his support payments.

On his 2009 return, Wish reported alimony deductions of $38,000. The IRS audited his return, claiming that because the payments were conditional on the child's being homeschooled, they were non-deductible child support, not alimony, and disallowed the majority of Wish's claimed alimony deductions.

Analysis

In general, Code Sec. 215(a) allows deductions for alimony or separate maintenance payments. In contrast, child support payments are not deductible (Code Sec. 71(c)(1)). Under Code Sec. 71(c), if support payments agreed to in the divorce instrument will be reduced because of a contingency relating to a child, the amount of the reduction will be treated as child support, as opposed to alimony, and therefore will not be deductible.

The Tax Court analyzed the contingency to determine whether it related to the former wife, and therefore was properly characterized as alimony, or whether it was related to the child, and therefore was child support.

The IRS argued that the contingency in the alimony agreement related to the child. The IRS supported its argument by referencing Hammond v. Comm'r, T.C. Memo. 1998-53, where the alimony ended when the child turned 18, and Johnson v. Comm'r, T.C. Memo. 2014-67, where the alimony ended when the last child graduated from school. However, the court noted that in those cases, unlike in Wish's divorce agreement, the language clearly called for the cessation of the payments upon a specific event relating to a child.

In contrast to the IRS's cases, the court noted that Wish and his former wife entered into the agreement that she would homeschool their child with the explicit understanding that their decision would cause financial hardship for her because she would not be able to work while performing the schooling. Wish agreed to pay $3,800 of alimony with the understanding that his ex-wife would homeschool their child, and that the alimony was to be reduced to $1,900 if his ex-wife chose to return to work and no longer homeschooled their child.

The court reasoned that there was a clear and direct relationship between the amount of alimony and Wish's ex-wife's choice to work and there was no contingency under Code Sec. 71(c) that depended on the child, who continued to be educated, albeit at a public school rather than at home. Thus, the court concluded, the contingency did not rest on whether the child discontinued homeschooling, but on whether Wish's ex-wife was willing to make financial sacrifices. The court noted that it was her choice to go back to work and discontinue homeschooling after she was unable to obtain increased alimony payments.

Accordingly, the court found that the payments to Wish's ex-wife were properly treated as alimony, and allowed Wish's $38,000 alimony deduction for 2009.

For a discussion of taxation of alimony and separate maintenance payments, see Parker ¶ 14,220.

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IRS Clarifies Limitations Period for Assessing Preparer Penalties for Amended Returns

The IRS's Office of Chief Counsel clarified that the IRS has three years from the time a return with an understatement is filed to assess a penalty against the return preparer, and the preparer has three years from when the penalty is paid to contest that penalty. CCA 201514008.

Background

An IRS examination group requested clarification of the limitation period for making an assessment of the Code Sec. 6694 return preparer penalty for preparing a return or claim for refund with an understatement of tax liability, and for the limitation period for when a preparer can request a refund for an overpayment of that penalty. The group noted that they often confronted situations where a return preparer had filed amended income tax returns that included an understatement of tax liability attributable to an unreasonable filing position.

For purposes of its memorandum, the IRS used a representative fact pattern wherein a tax return preparer prepared an amended return (Form 1040X) for 2011 and claimed a refund that was based on a meritless position. The 1040X was timely filed on April 15, 2015 (3 years following the filing of the original return).

Analysis

Code Sec. 6694(a) imposes a penalty on a tax return preparer for any return or claim for refund resulting in an understatement of liability due to an unreasonable position, about which the preparer knew or reasonably should have known. The penalty is the greater of $1,000 or 50 percent of the income derived by the preparer from the return or claim.

Reg. Sec. 1.6694-1(a)(1) divides the standards against which the return preparer's conduct is measured into two categories:

(1) for positions other than those relating to tax shelters and reportable transactions, the penalty applies when the understatement is due to an undisclosed position for which the return preparer did not have substantial authority on which to rely, or is due to a disclosed position for which there is no reasonable basis; and

(2) for positions with respect to tax shelters or reportable transactions, the preparer penalty applies if the return or claim includes an understatement of liability for which it is not reasonable to believe that the position has merit.

The IRS advised that the limitation periods under Code Sec. 6696(d) were controlling. As such, the penalty in Code Sec. 6694(a) must be assessed within three years after the refund claim was filed, and return preparers liable for the penalty have three years after the time the penalty was paid to file a claim for a refund of an overpayment of the penalty, if they believe the penalty was incorrectly assessed.

The IRS concluded that because the claim for refund in its representative fact pattern was based on a meritless position, the return preparer was subject to penalty under Code Sec. 6694(a). Because the amended 2011 return claiming a refund was filed April 15, 2015, the IRS advised its examination group that it would have until April 15, 2018 to assess the preparer penalty.

Assuming the penalty is paid, the IRS stated that the preparer would have 3 years from the date of payment to file a claim for refund for an overpayment of a penalty (Code Sec. 6696(b)). The IRS noted that the preparer's entitlement to a refund assumes that he can show the penalty was incorrectly determined or that he had reasonable cause and acted in good faith.

For a discussion of civil penalties against practitioners for understatements, see Parker ¶276,300.

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IRS Issues Temporary Regulations on Research Credit Allocation for Controlled Groups

The IRS has issued temporary and proposed regulations adopting the amendments made by the American Taxpayer Relief Act of 2012 (ATRA) to the allocation of the Code Sec. 41 research credit among controlled group members. The text of the temporary regulations also serves as the text of the proposed regulations. T.D. 9717 (4/3/15); REG-133489-13 (4/3/15).

Code Sec. 41 ATRA Amendments

For years beginning before January 1, 2012, Code Sec. 41 provides that the incremental tax credit for increasing research activities (research credit) allowable to a controlled group member is its proportionate shares of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums (collectively, QREs) giving rise to the credit. All members of a controlled group are treated as a single taxpayer for purposes of computing the research credit for the group and this group credit is computed by applying all of the Code Sec. 41 computational rules on an aggregate basis (Code Sec. 41(f)(1); Reg. Sec. 1.41-6(b)).

Controlled groups are required to allocate the group credit in proportion to each member's stand-alone entity credit (Reg. Sec. 1.41-6(c)(1)(i)). For these purposes, a controlled group member's stand-alone entity credit is the research credit that would be allowable to that member if the credit were computed as if the aggregation rule did not apply, and instead applying the rules provided in Reg. Sec. 1.41-6(d)(1) (relating to consolidated groups) and Reg. Sec. 1.41-6(i) (relating to intra-group transactions).

The American Taxpayer Relief Act of 2012 (ATRA) amended Code Sec. 41(f)(1)(A)(ii) and Code Sec. 41(f)(1)(B)(ii) to provide that the group credit is allocated to group members based on a member's share of QREs, without regard to whether the member would have a stand-alone entity credit or what the amount of any such credit would be. These amendments apply to tax years beginning after December 31, 2011.

Changes Made by the Temporary and Proposed Regulations

The temporary and proposed regulations in T.D. 9791 and REG-133489-13 implement ATRA's changes to the allocation of the controlled group research credit by revising the allocation methods in Reg Secs. 1.41-6(c), (d), and (e). Rec Sec. 1.41-6T(c) provides an allocation method that follows the approach taken in Notice 2013-20, which provided that the group credit is allocated to group members based on each member's share of QREs, without regard to whether the member would have a stand-alone entity credit or what the amount of any such credit would be. Reg. Sec. 1.41-6T(d) provides that the group credit is allocated to group members based on a member's proportionate share of the controlled group's aggregate QREs, and clarifies that members are no longer required to calculate a stand-alone entity credit.

The temporary regulations also provide new examples in Reg. Sec. 1.41-6T(e). The first example illustrates a general application of the allocation method provided in the temporary regulations:

Example: AlphaCo, BetaCo, and CharlieCo are a controlled group. AlphaCo had $100,000, BetaCo had $300,000, and CharlieCo had $500,000 of qualified research expenses for the year, totaling $900,000 for the group. AlphaCo, in the course of its trade or business, also made a payment of $100,000 to an energy research consortium for energy research. The group's QREs total $1,000,000 and the group calculated its total research credit to be $60,000 for the year. Based on each member's proportionate share of the controlled group's aggregate QREs, AlphaCo is allocated $12,000, BetaCo $18,000, and CharlieCo $30,000 of the credit.

The second example demonstrates an allocation under the temporary regulations where a consolidated group is treated as a single member of a controlled group pursuant to Reg. Sec. 1.41-6T(d):

Example: The controlled group's members are DeltaCo, EchoCo, FoxCo, GolfCo, and HotelCo. FoxCo, GolfCo, and HotelCo file a consolidated return and are treated as a single member (FGH) of the controlled group. DeltaCo had $240,000, EchoCo had $360,000, and FGH had $600,000 of qualified research expenses for the year ($1,200,000 aggregate). The group calculated its research credit to be $100,000 for the year. Based on the proportion of each member's share of QREs to the controlled group's aggregate QREs for the taxable year, DeltaCo is allocated $20,000, EchoCo $30,000, and FGH $50,000 of the credit. The $50,000 of credit allocated to FGH is then allocated to the consolidated group members based on the proportion of each consolidated group member's share of QREs to the consolidated group's aggregate QREs. FoxCo had $120,000, GolfCo had $240,000, and HotelCo had $240,000 of QREs for the year. Therefore, FoxCo is allocated $10,000, GolfCo is allocated $20,000, and HotelCo is allocated $20,000.

In addition, the temporary regulations add a new section to provide an allocation method for controlled groups eligible for the railroad track maintenance credit (RTMC) under Code Sec. 45G that is consistent with the changes made to the research credit allocation methods.

The regulations are effective as of April 3, 2015.

For a discussion of the computation of the research credit for controlled groups, see Parker ¶104,940.

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Construction Superintendent Cannot Deduct Long Commutes to Jobsites as Travel Expenses

The Tax Court held that a construction superintendent who frequently commuted directly to job sites far from home could not deduct travel expenses because the sites were not temporary assignments and his tax home was within the area of his employment. Bartley v. Comm'r, T.C. Summary 2015-23.

Background

Lonnie Bartley worked as a construction superintendent for Far West Contractors Corp. Bartley's employment required him to regularly work at jobsites away from Far West's main office. For the most part, he would drive upwards of sixty miles to the jobsites directly from his residence. During his employment, Bartley primarily supervised jobsites in the Los Angeles metropolitan area, specifically in Redondo Beach and El Segundo, California. Occasionally, he would visit a site in Rancho Bernardo, California. Far West did not provide Bartley with a company vehicle or reimburse him for driving to work. Far West also required Bartley to provide his own personal protection equipment, including protective footwear.

On his 2010 Form 1040, Bartley attached a Form 2106-EZ, Unreimbursed Employee Business Expenses on which he claimed a deduction for commuting expenses of $24,448 and other business expenses of $2,482, including expenses for work boots and an overnight stay at a hotel near one of the jobsites. To substantiate the business expenses, he provided credit card statements with purported expenses highlighted, along with a daily commuting log claiming to total the number of miles driven each day. The IRS disallowed the deductions and determined a deficiency of $3,373.

Analysis

While commuting expenses are generally nondeductible, taxpayers may deduct transportation expenses incurred in going between a taxpayer's residence and a temporary work location outside the metropolitan area where the taxpayer normally lives and works. A work location is temporary if it is realistically expected to last (and does in fact last) for one year or less (Bogue v. Comm'r, T.C. Memo. 2011-164).

The Tax Court concluded the Redondo Beach and El Segundo sites were not temporary, as Bartley worked well over a year at each of them and there were no facts to suggest that the work at the two sites would end within a short time. The Tax Court rejected Bartley's argument that, given the large size of those sites, each site contained temporary sites that he would commute between.

The court also found Bartley's commuting log did not properly substantiate the number of miles he traveled to the Rancho Bernardo site. The court questioned the reliability of the information recorded in the commuting log, and whether the log was created contemporaneously given that the entries appeared to have been written all at once with the same pen and included several mistakes.

Although Bartley did not claim a deduction for traveling expenses, the Court characterized his hotel expense as an attempt to deduct a travel expense. The court noted a travel expense is a deductible under Code Sec. 162(a) if the expense was (1) incurred away from home, (2) reasonable and necessary, and (3) incurred in pursuit of a trade or business (Strohmaier v. Comm'r, 1 13 T.C. 106 (1999)).

The court determined Bartley properly substantiated the expense, but it was not incurred "away from home," as his tax home for purposes of Code Sec. 162(a) was the entire Los Angeles metropolitan area and the hotel was located within that region. The Court reasoned Bartley was not required by the exigencies of his business to incur the hotel expense as it was his own decision to live far away from where he worked.

In evaluating the other claimed business expenses, the court found Bartley could deduct the cost of his work boots as work boots were essential to his labor intensive employment in the construction industry, were not suitable for general or personal wear, and were properly substantiated by a receipt and a credit card statement. However, the court ruled Bartley failed to substantiate the other expenses, as he never explained how the other purchases highlighted on his statements related to his business, and some of his reported business expenses appeared to be for personal "cash-back" withdrawals associated with using a credit card to purchase items at Home Depot.

For a discussion of commuting expenses and related deductions, see Parker ¶ 91,110

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IRS Fails to Follow 3-Step Process for Levying Retirement Account, Must Reconsider Collection Alternatives

The Tax Court determined a settlement officer did not follow IRS protocol in sustaining a proposed levy on taxpayers' retirement account, and sent the case back to the IRS Appeals Office for further review. The taxpayers were experiencing economic hardship and relying on loans from a 401(k) account, but the officer did not appear to take that in to consideration when denying collection alternatives. Gurule v. Comm'r, T.C. Memo 2015-61.

Background

The Gurule family has faced myriad medical and financial challenges. Mrs. Gurule suffers from a severe neurological condition that causes her to experience seizures and has prevented her from working. The taxpayers' middle son was in an accident as a child and suffered a brain injury. He had medical problems throughout his life as a result of the injury and passed away in August 2013 from these problems. The associated medical costs compounded the family's financial challenges.

Mr. Gurule worked for General Mills for 18 years, beginning as a technician and advancing within the company. His job required him to move his family several times, most recently from Minnesota to Missouri in 2009. When the family moved to Missouri, Mr. Gurule took distributions from his Code Sec. 401(k) plan account in order to pay for a down payment on a house. Three months later, Mr. Gurule lost his job, preventing the family from finalizing the Missouri house purchase and forcing them to move back to their unsold Minnesota home. After the Minnesota home came under foreclosure, the family was forced to move again.

Due to the family's financial struggles, Mr. Gurule took out several loans from his 401(k) plan to pay for foreclosure, moving, and rent expenses, as well as for his son's medical bills and funeral service expenses.

In 2011, the IRS assessed a tax deficiency of $36,516 and notified the taxpayers of its intent to levy their retirement account to pay the liability. Unable to pay, the taxpayers proposed an offer in compromise and an installment agreement. However, the settlement officer rejected the collection alternatives, concluding the family's reasonable collection potential (RCP) was sufficient to pay the liability in full.

Analysis

The Tax Court noted that Code Sec. 6343(a)(1)(D) requires the IRS to release a levy upon all, or part of, a taxpayer's property if a levy would cause economic hardship to the taxpayer. The tax court found, however, that despite the taxpayers' assertion that they needed the 401K to pay necessary living expenses and would be harmed by the levy, the settlement officer's case notes did not show that she ever considered, much less made a determination about, the economic hardship claim.

The court found that the settlement officer may have made a material error in calculating the family's RCP, which would affect whether their alternate collection offers were properly denied. The officer calculated as a monthly expense repayments of the loans from the 401(k) account, based on amounts taken out of Mr. Gurule's paychecks. However, the earning statements the officer relied on reflected biweekly, not monthly, earnings, so the taxpayers' actual loan expenses were twice what the officer reported.

Additionally, the court found that the settlement officer did not follow the IRM's three-step process for levying retirement accounts, which includes consideration of special circumstances such as extraordinary expenses. The court noted that this was the case even though the officer was aware that the family was using their 401(k) plan account to pay necessary living expenses and the taxpayers' medical costs were at the time significant and unpredictable.

Observation: Internal Revenue Manual pt. 5.11.6.2 has a three-step procedure for levying upon retirement accounts. Step 1 requires agents to determine if property other than retirement assets are available for collection. If other funds can be collected to pay the liability, agents should consider those before proceeding against a retirement account. Step 2 requires agents to determine whether a taxpayer's conduct has been flagrant, for example, by making voluntary contributions to a retirement account while asserting an inability to pay tax liabilities. If there is no flagrant conduct, agents should not levy the account. Step 3 requires agents to determine whether the taxpayer currently depends on the money in the retirement account for necessary living expenses, or will need to in the near future. If the taxpayer is dependent on the funds, agents should not levy the account.

In the light of the unclear reasons the officer rejected the Gurules' proposed collection alternatives, the Tax Court was unable to conclude whether proceeding with the collection action was an abuse of discretion and sent the case to the IRS Appeals Office for further consideration and clarification.

For a discussion of IRS collection procedures with respect to tax levies, see Parker ¶260,540

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Shareholders Benefitting from Asset Transfer Only Partially Liable for Unpaid Taxes

The Tax Court held that shareholders who transferred all of their corporation's cash to a third party, without first paying corporate taxes, were liable as transferees for the unpaid taxes. However, the court found that under state law the shareholders were only liable for the amount of the benefit they received from the transaction. Stuart v. Comm'r, 144 T.C. No. 12 (4/1/15).

Background

Little Salt Development Co. (Little Salt or company), a C corporation, owned 160 acres of saline wetlands on the outskirts of Lincoln, Nebraska. In 2003, it sold the land for $471,111 to the Nebraska Game and Parks Commission, who were interested in protecting the habitat of an endangered beetle species. During negotiations leading up to the land sale, Little Salt's shareholders were contacted by MidCoast Investments, Inc. (MidCoast). MidCoast represented that it would purchase the Little Salt shares and would pay the shareholders significantly more than they would otherwise receive if they dissolved the company and receive the land sale proceeds in redemption of their shares.

The letter specified that, in exchange for Little Salt's cash on hand, MidCoast would purchase the shares for the value of the cash less 64.92 percent of the outstanding tax liability. The letter also contained a covenant under which MidCoast would "cause" Little Salt to pay the outstanding tax liability. Little Salt's accountant calculated the unpaid 2003 tax liability to be $167,737. He determined that 64.92 percent of that amount was $108,895, which he subtracted from Little Salt's cash balance of $467,721, to arrive at the purchase price of $358,826. Little Salt transferred its cash balance to the trust account of a local lawyer retained by MidCoast, leaving Little Salt with no cash and no tangible assets. MidCoast then transferred the cash in the trust account to a bank account created in Little Salt's name, and the next day, the cash was transferred out of that account and to a MidCoast account and recorded on Little Salt's balance sheet as a shareholder loan.

Despite MidCoast's covenant, Little Salt paid no taxes on its 2003 return. The IRS subsequently determined a deficiency in Little Salt's 2003 federal income tax of $145,923 and sent letters to the shareholders informing them that they were considered liable as transferees for the unpaid taxes.

Analysis

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must first establish that the target for collection is a "transferee" of the delinquent taxpayer within the meaning of Code Sec. 6901 and then must show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

Under Nebraska state law, a transfer is fraudulent with respect to a creditor where (1) the creditor's claim arose before the transfer, (2) the transferor does not receive "a reasonably equivalent value in exchange for the transfer," and (3) the transferor was insolvent as a result of the transfer (Neb. Rev. Stat. Ann. sec. 36-706(a)).

The Tax Court observed that, for purposes of Nebraska law, the term "claim" means "a right to payment," and prior to the transfer, the IRS had a claim against Little Salt for the unpaid taxes stemming from the land sale.

The court then found that Little Salt did not receive value reasonably equivalent to the $467,721 that it transferred to MidCoast's lawyer's trust account because, under state law, a debtor (Little Salt) does not receive reasonably equivalent value if it makes a transfer in exchange for a benefit to a third party (the shareholders). Additionally, the court noted that whatever value might be assigned to MidCoast's covenant to "cause" Little Salt to pay the $167,737 tax liability could not exceed the value of the liability, which was far from being substantially equivalent to the $467,721 that Little Salt transferred to the trust account. Moreover, the court reasoned a covenant to "cause" a corporation to pay its liabilities was essentially meaningless and valueless since MidCoast did not promise to pay the liabilities itself, and Little Salt lacked the assets to pay.

Next, the court determined that because Little Salt transferred its entire cash balance, it was left with no assets with which to pay its outstanding tax liability, rendering it insolvent. As Little Salt had received no equivalent value for the transfer, and as it was insolvent because of the transfer, the court held the transfer was fraudulent, finding that the shareholders were liable under state law to the IRS as "persons for whose benefit" Little Salt made the transfer to MidCoast. Thus, the tax court held the shareholders were transferees within the meaning of Code Sec. 6901, and the IRS could recover from them.

However, the court found scant Nebraska state authority addressing the measure of recovery in cases where the transferees were "persons for whose benefit" the transfer was made, and instead relied on its decision in Sawyer Trust of May 1992 v. Comm'r, T.C. Memo. 2014-59 to determine that the shareholders were liable only for the benefit they received from the transfer, rather than the full amount of the unpaid taxes.

The court noted that the shareholders' benefit from the transaction with MidCoast was $58,842: the $358,826 that MidCoast paid for their shares, less the $299,984 that Little Salt would have distributed to the shareholders had it paid its tax liability and redeemed the shares. Although $58,842 was substantially less than the unpaid tax, the Tax Court held that was the amount the shareholders owed the IRS.

For a discussion of transferee liability, see Parker ¶262,530.