IRS Issues July 2018 AFRs; Payments to Russian Subsidiary Aren't Deducible as Bad Debts or Ordinary Business Expenses; Taxpayer Can't Deduct Expenses Relating to Sale of Non-Marijuana Merchandise; Couple Can't Deduct Cost of Improvements to Home Allegedly Rented to Relatives ...
Supreme Court Rejects Precedents in State Sales Tax Case; Quill and Bellas Hess Overruled
The Supreme Court vacated a North Dakota Supreme Court decision in which that court held that a state law requiring out-of-state sellers to collect and remit sales tax as if the sellers had a physical presence in the state was unconstitutional. In so doing, the Supreme Court overruled its prior decisions in Quill Corp. v. North Dakota, 504 U. S. 298 (1992), and National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U. S. 753 (1967). South Dakota v. Wayfair, Inc., 2018 PTC 183 (S. Ct. 2018).
IRS Proposes Removal of Temp Regs on a Partner's Share of a Partnership Liability for Disguised Sale Purposes
The IRS issued proposed regulations relating to the way partnership liabilities are allocated for disguised sale purposes. The new proposed regulations, if finalized, would replace existing temporary regulations with final regulations that were in effect prior to the temporary regulations. REG-131186-17 (6/19/18).
The Supreme Court reversed the Seventh Circuit and held that the term "money," as used in Code Sec. 3231, unambiguously excludes "stock" and thus the railroad companies were entitled to refunds of taxes they paid on their employees' exercise of stock options. According to the Court, when Congress enacted Code Sec. 3231 in the Railroad Retirement Tax Act (RRTA) in 1937, the term "money" was understood to mean currency issued by a recognized authority and used as a medium of exchange and, while stock can be bought or sold for money, it isn't usually considered a medium of exchange. Wisconsin Central LTD v. U.S., 2018 PTC 182 (S. Ct. 2018).
Taxpayers Are Liable for Penalties After IRS Assurances That No Penalties Would be Assessed
A district court held that where (1) the IRS assessed but then waived an accuracy related penalty, (2) an IRS revenue agent told the taxpayer that all penalties had been waived, and (3) the taxpayer signed a Form 4549 which assessed no penalties, the IRS did not breach a closing agreement or other contract when it later assessed a penalty under Code Sec. 6707A because no closing agreement was ever executed and there was insufficient evidence that a contract existed. The court also found that the IRS was not equitably estopped from imposing the Code Sec. 6707A penalty because there was no evidence that it engaged in an affirmative misrepresentation or concealment constituting affirmative misconduct. Hinkle v. U.S., 2018 PTC 176 (D. N.M. 2018).
The Tax Court held that a shareholder of an S corporation that operated restaurants and whose employees' earnings came partly from customer tips could not elect on the S corporation's behalf to take the Code Sec. 45B credit for social security and Medicare taxes that the S corporation paid on its employees' tip wages by filing amended individual returns to claim flowthrough deductions from the credits. The Tax Court reasoned that the S corporation was considered the taxpayer for purposes of the Code Sec. 45B election and that permitting individual shareholders to unilaterally change an S corporation's tax election would affect the tax liabilities of shareholders who did not consent to the change. Caselli v. Comm'r, T.C. Memo. 2018-81.
Legal Fees Relating to Status of Investment Fund Distributions in Divorce Were Not Deductible Business Expenses
The Tax Court held legal fees that a taxpayer incurred in a divorce proceeding to defend his ownership of investment fund distributions, which he received after his former wife had filed for divorce but before the date the divorce was granted, were not deductible as expenses related to a business or income producing activity. The Tax Court applied the "origin of the claim" test under U.S. v. Gilmore, 372 U.S. 39 (1963) and found that the fees were personal and nondeductible because the former wife's claim to the distributions originated entirely from the marriage. Lucas v. Comm'r, T.C. Memo. 2018-80.
Fifth Circuit Vacates Lower Court Decision on Taxpayer's Liability for Section 6672 Penalty
The Fifth Circuit held that, in a case involving a taxpayer whose business failed to pay over to the IRS approximately $11 million in payroll taxes, a district court erred when it (1) granted summary judgment in the IRS's favor on the taxpayer's liability for the unpaid taxes and (2) denied the taxpayer's motion to reconsider on the basis that the amount of the taxpayer's liability was a genuine issue of material fact. The Fifth Circuit found that, under Code Sec. 6672, the taxpayer was liable only for the amount of available, unencumbered funds in the business's accounts after the taxpayer became aware of the unpaid withholding taxes and that the taxpayer presented competent evidence establishing an issue of material fact regarding whether the business's funds were sufficient to cover the tax obligation. McClendon v. U.S., 2018 PTC 173 (5th Cir. 2018).
Summary Judgment Denied in Tax Court Case Involving Split Dollar Life Insurance Arrangements
The Tax Court denied an estate's motion for partial summary judgment in a case where the estate argued that the cash surrender value of three split dollar life insurance arrangements should not be included in the decedent's gross estate. The court concluded that the decedent retained rights in the arrangements and that the transfers of the three split dollar life insurance agreements were not bona fide and were not for full and adequate consideration. Estate of Cahill v. Comm'r, T.C. Memo. 2018-84.
Supreme Court Rejects Precedents in State Sales Tax Case; Quill and Bellas Hess Overruled
The Supreme Court vacated a North Dakota Supreme Court decision in which that court held that a state law requiring out-of-state sellers to collect and remit sales tax as if the sellers had a physical presence in the state was unconstitutional. In so doing, the Supreme Court overruled its prior decisions in Quill Corp. v. North Dakota, 504 U. S. 298 (1992), and National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U. S. 753 (1967). South Dakota v. Wayfair, Inc., 2018 PTC 183 (S. Ct. 2018).
South Dakota, like many states, taxes the retail sales of goods and services in the state. Sellers are required to collect and remit the tax to the state, but if they do not, then in-state consumers are responsible for paying a use tax at the same rate. Under National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U. S. 753 (1967), and Quill Corp. v. North Dakota, 504 U. S. 298 (1992), South Dakota may not require a business that has no physical presence in the state to collect its sales tax. Consumer compliance rates are notoriously low, however, and it is estimated that Bellas Hess and Quill cause South Dakota to lose between $48 and $58 million annually.
Concerned about the erosion of its sales tax base and corresponding loss of critical funding for state and local services, the South Dakota Legislature enacted a law (the Act) requiring out-of-state sellers to collect and remit sales tax as if the seller had a physical presence in the state. The Act covers only sellers that, on an annual basis, deliver more than $100,000 of goods or services into the state or engage in 200 or more separate transactions for the delivery of goods or services into the state.
A group of top online retailers with no employees or real estate in South Dakota each meet the Act's minimum sales or transactions requirement, but do not collect the state's sales tax. South Dakota filed suit in state court, seeking a declaration that the Act's requirements are valid and applicable to the online retailers and an injunction requiring the retailers to register for licenses to collect and remit the sales tax. The retailers sought summary judgment, arguing that the Act is unconstitutional. A trial court granted their motion and the State Supreme Court affirmed on the ground that Quill is controlling precedent. North Dakota appealed to the Supreme Court.
On June 21, in a 5-4 decision, the Supreme Court vacated the lower court decisions and overruled the decisions in Quill and National Bellas Hess after concluding that the physical presence rule of Quill is unsound and incorrect. The Court began its analysis by reviewing the Court's Commerce Clause principles and their application to state taxes and noting that two primary principles mark the boundaries of a state's authority to regulate interstate commerce:
(1) state regulations may not discriminate against interstate commerce; and
(2) states may not impose undue burdens on interstate commerce.
Those principles, the Court said, also animate Commerce Clause precedents addressing the validity of state taxes, which will be sustained so long as they -
(1) apply to an activity with a substantial nexus with the taxing state;
(2) are fairly apportioned;
(3) do not discriminate against interstate commerce; and
(4) are fairly related to the services the state provides.
The Court noted that the physical presence rule has long been criticized as giving out-of-state sellers an advantage. Each year, the Court said, it becomes further removed from economic reality and results in significant revenue losses to the states. According to the Court, when the day-to-day functions of marketing and distribution in the modern economy are considered, it becomes evident that Quill's physical presence rule is artificial, not just at its edges, but in its entirety.
Modern e-commerce, the Court observed, does not align analytically with a test that relies on the sort of physical presence defined in Quill. As a result, the Court felt that it should not maintain a rule that ignores substantial virtual connections to the state.
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IRS Proposes Removal of Temp Regs on a Partner's Share of a Partnership Liability for Disguised Sale Purposes
The IRS issued proposed regulations relating to the way partnership liabilities are allocated for disguised sale purposes. The new proposed regulations, if finalized, would replace existing temporary regulations with final regulations that were in effect prior to the temporary regulations. REG-131186-17 (6/19/18).
Background
On January 30, 2014, the IRS amended partnership disguised sale regulations under Code Sec. 707, as well as regulations under Code Sec. 752 relating to the treatment of partnership liabilities (2014 Proposed Regulations). The 2014 Proposed Regulations provided certain technical rules intended to clarify the application of the disguised sale rules and also contained rules regarding the sharing of partnership recourse and nonrecourse liabilities under Code Sec. 752.
Based on a comment received on the 2014 Proposed Regulations requesting that guidance under Code Sec. 752 regarding a partner's share of partnership liabilities apply for disguised sale purposes, final and temporary regulations were issued in October of 2016 in T.D. 9788 and those regulations implemented a new rule on the allocation of liabilities for Code Sec. 707 purposes (the 707 Temporary Regulations). Those regulations also contained rules on the treatment of ''bottom dollar payment obligations'' (752 Temporary Regulations). Also in October of 2016, the IRS published final regulations under Code Sec. 707 and Reg. Sec. 1.752-3 in T.D. 9787 (707 Final Regulations).
The 707 Temporary Regulations adopted an approach that requires a partner to apply the same percentage used to determine the partner's share of excess nonrecourse liabilities under Reg. Sec. 1.752-3(a)(3) (with certain limitations) in determining the partner's share of all partnership liabilities for disguised sale purposes. The 707 Temporary Regulations also provide that a partner's share of a partnership liability for Code Sec. 707 purposes cannot exceed the partner's share of the partnership liability under Code Sec. 752 and applicable regulations. The 707 Temporary Regulations reserved on the treatment, for disguised sale purposes, of an obligation that would be treated as a recourse liability under Reg. Sec. 1.752-1(a)(1) or a nonrecourse liability under Reg. Sec. 1.752-1(a)(2) if the liability was treated as a partnership liability for purposes of Code Sec. 752.
Executive Order
On April 21, 2017, President Trump issued Executive Order (EO) 13789, a directive designed to reduce tax regulatory burdens. The order instructed the Secretary of the Treasury to review all "significant tax regulations" issued on or after January 1, 2016, and submit two reports, followed promptly by concrete action to alleviate the burdens of regulations that meet the criteria outlined in the order. Specifically, Section 2 of EO 13789 directed the Treasury Secretary to submit a report identifying regulations that meet the following criteria:
(1) they impose an undue financial burden on U.S. taxpayers;
(2) they add undue complexity to the federal tax laws; or
(3) they exceed the statutory authority of the IRS.
Subsequently, the Treasury Department issued a report which said that, while it believes that the 707 Temporary Regulations' novel approach to addressing disguised sale treatment merits further study, such a change should be studied systematically. In another report, the Treasury Department and the IRS proposed removing the 707 Proposed Regulations and 707 Temporary Regulations and reinstating the regulations under Reg. Sec. 1.707-5(a)(2) as in effect before the 707 Temporary Regulations (Prior 707 Regulations).
Proposed Regulations
On June 19, the IRS issued REG-131186-17. In that guidance, the IRS withdrew the 707 Proposed Regulations and proposed removing the 707 Temporary Regulations and reinstating the Prior 707 Regulations relating to the allocation of liabilities for disguised sale purposes.
In determining a partners' share of a partnership liability for disguised sale purposes, Reg. Sec. 1.707-5(a)(2) of the Prior 707 Regulations prescribed separate rules for a partnership's recourse liability and a partnership's nonrecourse liability. In REG-131186-17, the IRS adopts those same rules. Under Reg. Sec. 1.707-5(a)(2)(i) of the Prior 707 Regulations and, if finalized, the proposed regulations in REG-131186-17, a partner's share of a partnership's recourse liability equals the partner's share of the liability under Code Sec. 752 and the regulations thereunder. A partnership liability is a recourse liability to the extent that the obligation is a recourse liability under Reg. Sec. 1.752-1(a)(1). Under Reg. Sec. 1.707-5(a)(2)(ii) of the Prior 707 Regulations and, if finalized, the proposed regulations in REG-131186-17, a partner's share of a partnership's nonrecourse liability is determined by applying the same percentage used to determine the partner's share of the excess nonrecourse liability under Reg. Sec. 1.752-3(a)(3). A partnership liability is a nonrecourse liability of the partnership to the extent that the obligation is a nonrecourse liability under Reg. Sec. 1.752-1(a)(2).
The 707 Final Regulations limited the available methods for determining a partner's share of an excess nonrecourse liability under Reg. Sec. 1.752-3(a)(3) for disguised sale purposes. Under the 707 Final Regulations, a partner's share of an excess nonrecourse liability for disguised sale purposes is determined only in accordance with the partner's share of partnership profits and by taking into account all facts and circumstances relating to the economic arrangement of the partners. Thus, the significant item method, the alternative method, and the additional method as defined in Reg. Sec. 1.752-3(a)(3) do not apply for purposes of determining a partner's share of a partnership's nonrecourse liability for disguised sale purposes.
In addition, Reg. Sec. 1.707-5(a)(2)(i) and (ii) of the Prior 707 Regulations provided that a partnership liability is a recourse or nonrecourse liability to the extent that the obligation would be a recourse liability under Reg. Sec. 1.752-1(a)(1) or a nonrecourse liability under Reg. Sec. 1.752-1(a)(2), respectively, if the liability was treated as a partnership liability for purposes of Code Sec. 752 (Reg. Sec. 1.752 - 7 contingent liabilities). In the proposed regulations issued on June 19, the IRS reinstates the rules concerning Reg. Sec. 1.752-7 contingent liabilities.
Finally, the proposed regulations reinstate Examples 2, 3, 7, and 8 under Reg. Sec. 1.707-5(f) of the Prior 707 Regulations. Example 2 relates to a partnership's assumption of recourse liability encumbering transferred property; Example 3 relates to a subsequent reduction of a transferring partner's share of liability; Example 7 relates to a partnership's assumptions of liabilities encumbering properties transferred pursuant to a plan; and Example 8 relates to a partnership's assumption of liability pursuant to a plan to avoid sale treatment of partnership assumption of another liability. However, the proposed regulations add language to Example 3 to reflect an amendment to Reg. Sec. 1.707-5(a)(3) in the 707 Final Regulations regarding an anticipated reduction in a partner's share of a liability that is not subject to the entrepreneurial risks of partnership operations.
Effective Date
The 707 Temporary Regulations are proposed to be removed 30 days following the date the regulations in REG-131186-17 are published as final regulations in the Federal Register. The amendments to Reg. Sec. 1.707-5 are proposed to apply to any transaction with respect to which all transfers occur on or after 30 days following the date the regulations in REG-131186-17 are published as final regulations in the Federal Register. However, a partnership and its partners may apply all the rules in these proposed regulations in lieu of the 707 Temporary Regulations to any transaction with respect to which all transfers occur on or after January 3, 2017.
For a discussion of the partnership disguised sale rules under Code Sec. 707, see Parker Tax ¶25,520.
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Supreme Court Reverses Seventh Circuit; No Railroad Tax on Stock Options
The Supreme Court reversed the Seventh Circuit and held that the term "money," as used in Code Sec. 3231, unambiguously excludes "stock" and thus the railroad companies were entitled to refunds of taxes they paid on their employees' exercise of stock options. According to the Court, when Congress enacted Code Sec. 3231 in the Railroad Retirement Tax Act (RRTA) in 1937, the term "money" was understood to mean currency issued by a recognized authority and used as a medium of exchange and, while stock can be bought or sold for money, it isn't usually considered a medium of exchange. Wisconsin Central LTD v. U.S., 2018 PTC 182 (S. Ct. 2018).
Background
In 1996, Wisconsin Central Ltd., Illinois Central Railroad Co., and Grand Trunk Western Railroad Co. ("the Railways"), all subsidiaries of the Canadian National Railway Company, began including stock options in the compensation plans of a number of employees. The options were nonqualified stock options, meaning that they were not incentive stock options as defined in Code Sec. 422(b) or part of an employee stock purchase plan as defined in Code Sec. 423(b), which in turn means that they were not "qualified stock options" as defined in Code Sec. 3231(e)(12).
Each option gave the employee the right to purchase one share of Canadian National stock at a fixed price equal to the stock's publicly traded price on the date of the option grant ("exercise price"). If an option was not exercised within a ten-year term, or possibly earlier if an employee retired or died, it expired. Twenty-seven percent of the options exercised from 2006-2013 were "performance" options, exercisable only if Canadian National attained certain financial performance benchmarks in a given year, while the remaining 73 percent were exercisable without regard to corporate financial performance or other constraints.
The Railroad Retirement Tax Act (RRTA) enacted Code Sec. 3201 through Code Sec. 3241. The RRTA was passed in 1937 and requires a railroad to pay an excise tax equal to a specified percentage of its employees' wages, and also to withhold a specified percentage of its employees' wages as their share of the tax. The RRTA is to the railroad industry what social security taxes paid by non-railroad employers and employees under the Federal Insurance Contributions Act (FICA) is to other industries: the imposition of an employment or payroll tax on both the employer and the employee, with the proceeds used to pay pensions and other benefits.
Under Code Sec. 3231(e)(1), the RRTA subjects to taxation "compensation," defined as "any form of money remuneration paid to an individual for services rendered as an employee to one or more employers." On the other hand, FICA, in Code Sec. 3121(a), taxes "wages," which are "all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash."
The railroad retirement tax rates are much higher than the social security tax rates. Unlike FICA, the RRTA imposes two tiers of taxes under Code Sec. 3201, with Tier 1 providing benefits and taxes in a manner almost identical to FICA, and Tier II functioning like a private pension plan, tying its benefits to any individual employee's earnings and career service.
In their initial tax payments for the years at issue, the Railways treated each exercised option as income for federal income tax purposes and compensation for the purposes of the RRTA, in the amount by which the publicly traded share price of Canadian National on the exercise date exceeded the exercise price for each option exercised, and paid taxes on those amounts. The Railways subsequently came to believe that paying the tax was a mistake and that no RRTA tax should have been paid on the exercised nonqualified stock options as the options did not qualify under the RRTA as "any form of money remuneration." The Railways filed for a tax refund, which the IRS rejected. The Railways then filed suit against the IRS in district court.
The Railways' Arguments
The Railways argued that the particular non-qualified stock options at issue were not compensation under the RRTA because the phrase "money remuneration" is a specific limitation in the RRTA that distinguishes RRTA compensation from FICA wages.
According to the Railways, the absence of a statutory definition for "money" in the RRTA and the Internal Revenue Code implies that the word must have a commonly understood meaning outside the context of the Internal Revenue Code, and that its common definition and usage should apply throughout the Code, in the absence of any specific modification for a particular provision. The common understanding of money, the Railways said, is that it has a constant amount or denomination representing a specific stored value that can be applied to a future transaction. They contrasted that with non-money property, which has no fixed value but is susceptible to varying valuations over time and subjectively in the hands of different holders. According to the Railways, income from the exercise of the nonstock options given to employees is not a form of "money remuneration" to them and is therefore not taxable to the railway as compensation under Code Sec. 3231(e)(1).
District Court and Seventh Circuit Agree with IRS
In Wisconsin Central Ltd v. U.S., 2016 PTC 248 (N.D. Ill. 2016), the district court sided with the IRS and denied the Railways refund claim after finding that the phrase "any form of money remuneration" included nonqualified stock options.
The Railways appealed to the Seventh Circuit which, in 2017 PTC 216 (7th Cir. 2017), affirmed the district court. The Seventh Circuit noted that the value of a company's stock is a function of the company's profitability, whereas the size of a cash bonus, once it is given, is unaffected by the company's future business successes or failures. Underscoring the point, the court noted that the railway's stock-option plans are performance-based: they can be exercised only if the company achieves specified goals. According to the court, the fact that cash and stock are not the same things doesn't make a stock-option plan any less a "form of money remuneration" than cash. Indeed, the court said, the Railway offers its employees a choice to have an agent exercise an employee's stock option, sell the shares of stock obtained by that exercise of the option, reserve part of the money received in the sale for taxes and administrative costs, and deposit the balance in the employee's bank account. An employee who uses this method, the court said, will thus experience the stock option as a cash deposit.
The Seventh Circuit concluded that the equivalence of stock to cash is actually signaled in the statutory exception for qualified stock options, explicitly divorced from "money remuneration" by Code Sec. 3231(e)(12). To the court, that exception, by virtue of its narrowness, supported an inference that non-qualified stock options are covered by the term "money remuneration" and are therefore taxable.
The Railways then appealed to the Supreme Court which granted certiorari.
Supreme Court Reverses Lower Courts
On June 21, in a 5-4 decision, the Supreme Court reversed the district court and Seventh Circuit decisions and held that employee stock options are not taxable "compensation" under the Railroad Retirement Tax Act because they are not "money remuneration." When Congress adopted the Act in 1937, the Court said, "money" was understood as currency issued by a recognized authority as a medium of exchange. It was obvious to the Court that stock options do not fall within that definition. While stock can be bought or sold for money, it isn't usually considered a medium of exchange. As the Court observed, few people value goods and services in terms of stock, or buy groceries and pay rent with stock. Adding the word "remuneration" also does not alter the meaning of the phrase, the Court said.
The Court found that, when the statute speaks of taxing "any form of money remuneration," it indicates Congress wanted to tax monetary compensation in any of the many forms an employer might choose. It does not prove, the Court said, that Congress wanted to tax things, like stock, that are not money at all. According to the Court, the broader statutory context pointed to this conclusion. For example, the 1939 Internal Revenue Code, adopted just two years after Code Sec. 3231, also treated "money" and "stock" as different things. And a companion statute enacted by the same Congress, the Federal Insurance Contributions Act (FICA), taxes "all remuneration," including benefits "paid in any medium other than cash." The Congress that enacted both of these pension schemes, the Court said, knew well the difference between "money" and "all" forms of remuneration and its choice to use the narrower term in the context of railroad pensions alone, the Court said, required respect, not disregard.
According to the Court, even the IRS seemed to have understood all this back in 1938 because shortly after the RRTA's enactment, the IRS issued a regulation explaining that the RRTA taxes "all remuneration in money, or in something which may be used in lieu of money (scrip and merchandise orders, for example)." The regulation said the RRTA covered things like salaries, wages, commissions, fees, and bonuses. But, the Court observed, the regulation nowhere suggested that stock was taxable. In light of these textual and structural clues and others, the majority of the Supreme Court thought it was clear enough that the term "money" unambiguously excludes "stock."
For a discussion of the RRTA taxes on compensation, see Parker Tax ¶213,160.
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Taxpayers Are Liable for Penalties After IRS Assurances That No Penalties Would be Assessed
A district court held that where (1) the IRS assessed but then waived an accuracy related penalty, (2) an IRS revenue agent told the taxpayer that all penalties had been waived, and (3) the taxpayer signed a Form 4549 which assessed no penalties, the IRS did not breach a closing agreement or other contract when it later assessed a penalty under Code Sec. 6707A because no closing agreement was ever executed and there was insufficient evidence that a contract existed. The court also found that the IRS was not equitably estopped from imposing the Code Sec. 6707A penalty because there was no evidence that it engaged in an affirmative misrepresentation or concealment constituting affirmative misconduct. Hinkle v. U.S., 2018 PTC 176 (D. N.M. 2018).
Bryan Hinkle and Matilda Garcia were notified in 2009 by IRS revenue agent Russell Gadway that their 2007 and 2008 tax returns had been selected for examination. Hinkle and Garcia each received a letter from Gadway asking if they would agree to an enclosed examination change report and stating that penalties would be waived if they agreed to resolve the issues at the revenue agent level. The letters included Forms 4549, Income Tax Examination Changes, which assessed an accuracy related penalty under Code Sec. 6662. However, in July 2010, Hinkle and Garcia signed Forms 4549 which assessed neither a Code Sec. 6662 penalty nor any other penalty.
Later that month, the IRS notified the taxpayers that it was considering assessing penalties under Code Sec. 6707A for failure to disclose a listed transaction. However, a September 2010 letter from an IRS Area Director stated that it would not make any additional changes to their returns unless they changed a return for a partnership or other entity in which the taxpayers had an interest in.
In March 2011, the taxpayers received Forms 4549-A, Income Tax Discrepancy Adjustments, assessing a penalty under Code Sec. 6707A. The taxpayers' accountant, Robert Bivins, sent a letter to Gadway protesting the penalty and noting that the taxpayers were assured no penalties would be assessed through acceptance and payment of the taxes due.
Over a year later, in September 2012, the taxpayers received a "Notice of Penalty Charge." Bivins responded with another letter protesting the imposition of the penalty. Bivins submitted a Form 843, Claim for Refund and Request for Abatement, requesting an abatement of the Code Sec. 6707A penalty. In December 2013, IRS manager Jeffrey Barrett sent a letter stating that all penalties had been waived as agreed by agent Gadway.
The taxpayers sued for a refund in a district court, asserting claims for breach of contract and, alternatively, equitable estoppel. The taxpayers argued that the December 2013 IRS letter was evidence of an offer that included the waiver of all penalties, and that they had accepted the offer by signing the Forms 4549 in July 2010. The taxpayers contended that, although no closing agreement was executed on a Form 866 or 906, a closing agreement form was not required under Haiduk v. Comm'r, T.C. Memo 1990-506 and other Tax Court cases, if the intent of the parties was otherwise ascertainable. Alternatively, the taxpayers asserted that they reasonably relied on Gadway's representations and did not know the falsity of the representations, which the court construed as an argument for equitable estoppel. The IRS filed a motion for summary judgment on both claims.
The district court granted summary judgment for the IRS. The court explained that under Code Sec. 7121(a), closing agreements must be executed on the forms prescribed by the IRS, and that the appropriate forms are Forms 866 or 906. The court found that Form 4549 documents do not create closing agreements because they are not the forms identified by the IRS and do not include the legal language indicating the IRS's intent to settle a disputed tax liability.
The court also disagreed with the taxpayers' contention that the IRS breached a contract. First, the court found that IRS manager Barrett's December 2013 letter was not an offer because there was no promise to take or forego some action. At most, the letter implied an agreement to waive penalties as defined by Gadway's 2010 letter accompanying the Form 4549 documents. The court found that the previous Form 4549 documents showed only a Code Sec. 6662 penalty but not a Code Sec. 6707A penalty and there was no evidence of a Form 4549 assessing a Code Sec. 6707A penalty before Gadway's June 2010 letter. Second, neither the Form 4549 documents nor the December 2013 letter were in a form required to create a binding closing agreement. Furthermore, the court found that the exception in Haiduk to the closing agreement standard applied only in the context of pending litigation.
The court rejected the taxpayers' equitable estoppel argument because it found that evidence of affirmative misconduct must be present when making such a claim against the government, and the taxpayers failed to present such evidence. The court found that while Gadway's letter stated that the Code Sec. 6662 penalty would be waived, the taxpayers failed to show that the Code Sec. 6707A penalty was ever included in a Form 4549 document prior to Gadway's letter. The court also found that Barrett's 2013 letter did not specifically mention the Code Sec. 6707A penalty but only referred to the penalties previously agreed to by Gadway. The court concluded that Barrett's letter therefore did not demonstrate the affirmative misrepresentation or concealment necessary to find that the IRS engaged in affirmative misconduct as required for a claim of equitable estoppel.
For a discussion of closing agreements, see Parker Tax ¶263,160.
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S Shareholder Can't Unilaterally Elect FICA Tax Credit on S Corporation's Behalf
The Tax Court held that a shareholder of an S corporation that operated restaurants and whose employees' earnings came partly from customer tips could not elect on the S corporation's behalf to take the Code Sec. 45B credit for social security and Medicare taxes that the S corporation paid on its employees' tip wages by filing amended individual returns to claim flowthrough deductions from the credits. The Tax Court reasoned that the S corporation was considered the taxpayer for purposes of the Code Sec. 45B election and that permitting individual shareholders to unilaterally change an S corporation's tax election would affect the tax liabilities of shareholders who did not consent to the change. Caselli v. Comm'r, T.C. Memo. 2018-81.
Ronald Caselli was one of three shareholders of Apple Gilroy, Inc. (AGI), an S corporation operating multiple restaurants. AGI's restaurants hired employees whose wages came partly from customer tips, and AGI was required to pay Federal Insurance Contribution Act (FICA) taxes on the tips.
Under Code Sec. 45B, an employer in the food and beverage industry is allowed to claim a credit for a portion of the FICA taxes it pays on employee tips. On its 2006 and 2007 Forms 1120S, U.S. Income Tax Return for an S Corporation, AGI did not claim any FICA tax credits or file a Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips. Instead, it deducted its payments of the FICA tip taxes. AGI never amended its returns for either year.
Caselli claimed flowthrough deductions from AGI on his returns for 2006 and 2007. In 2010, the IRS sent Caselli a notice of deficiency for 2006 determining a deficiency of approximately $261,000. Caselli filed an amended return for 2007 on Form 1040X, Amended U.S. Individual Income Tax Return, claiming a refund of over $65,000 deriving from AGI's 2007 FICA tip credits. Caselli attached a Form 8846 to his Form 1040X showing himself as the taxpayer electing the FICA tip credit. His amended return did not include an amended Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc., from AGI. In 2011, the IRS sent a notice determining a deficiency of approximately $204,000 for 2007 and disallowing Caselli's refund claim. Caselli petitioned the Tax Court with respect to the 2007 deficiency in 2011. In 2014, he filed an amended petition for 2006, claiming that he was also entitled to flowthrough FICA tip credits for that year.
Code Sec. 45B allows an employer to elect a credit in the amount of the FICA taxes it paid on employee tips in excess of the minimum wage. To qualify, the employer must have employees who receive tips from customers for providing food or beverages for consumption. The employer cannot elect the credit if it has taken a deduction for the FICA tax payment. Form 8846 is the form for eligible employers to claim FICA tax credits.
Caselli argued that he was entitled to a proportionate flowthrough of AGI's FICA tax credits and that AGI could claim the credits by his unilaterally filing amended returns as a shareholder. Caselli recognized that the election could affect other shareholders, but argued that due to the special circumstances of the other AGI shareholders, any change to AGI's tax items for the years at issue would have no effect on them, and therefore no unfairness would result. The IRS argued that the Code Sec. 45B election had to be made by AGI directly, not by Caselli.
The Tax Court held that Caselli was not allowed to claim FICA tip credits from AGI because only AGI could elect to take the credits. First, the Tax Court noted that because AGI never filed amended returns, Caselli was essentially requesting an advisory opinion based on a future contingency, which ordinarily the court would decline. However, as there was little development of the law concerning Code Sec. 45B, the court determined it would be useful to discuss the provision and its application in this case.
The Tax Court found that under Code Sec. 1363, any election affecting the computation of items derived from an S corporation must be made by the corporation, and that Reg. Sec. 1.1363-1(c)(1) specifically states that shareholders are not permitted to make such elections. While this general rule is subject to exceptions (for example, elections under Code Sec. 617 to recapture mining expenditures and elections under Code Sec. 901 relating to foreign tax credits), the court found that the Code Sec. 45B election was not one of them.
Next, the court reasoned that under Code Sec. 45B(d), the FICA tax credit does not apply if the taxpayer elects to have the credit not apply. While S corporations are generally not considered taxpayers, the court found that employment taxes are liabilities of the employer, which was the S corporation taxpayer in this context. Thus, Caselli's position was foreclosed by the plain text of Code Sec. 1363 and Code Sec. 45B, in the view of the Tax Court.
The Tax Court explained that Caselli was essentially asking it to create a new precedent which would endow each individual shareholder with the power to unilaterally change an S corporation's tax election. If allowed, such a change would affect not only the tax liabilities of the requesting shareholder but could also affect the liabilities of shareholders who have not consented to such a change. The court noted that Caselli himself highlighted the danger of this approach by assuring the court that, due to special circumstances, the other shareholders of AGI would be unaffected by the change. The Tax Court declined to create a new precedent.
For a discussion of the credit for FICA taxes paid on employee tips, see Parker Tax ¶105,901.
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Legal Fees Relating to Status of Investment Fund Distributions in Divorce Were Not Deductible Business Expenses
The Tax Court held legal fees that a taxpayer incurred in a divorce proceeding to defend his ownership of investment fund distributions, which he received after his former wife had filed for divorce but before the date the divorce was granted, were not deductible as expenses related to a business or income producing activity. The Tax Court applied the "origin of the claim" test under U.S. v. Gilmore, 372 U.S. 39 (1963) and found that the fees were personal and nondeductible because the former wife's claim to the distributions originated entirely from the marriage. Lucas v. Comm'r, T.C. Memo. 2018-80.
Background
Sky Lucas formed Vicis Capital, LLC with two other partners in 2004. Vicis was an investment adviser for several funds including Vicis Capital International Fund (International Fund). The funds paid Vicis a management fee of 1.5 percent of assets under management (AUM) per year, as well as a performance fee equal to 20 percent of profits earned by the funds during the year. From 2005 to 2008, Vicis's AUM grew from approximately $290 million to $5.6 billion.
Under its agreement with International Fund, Vicis could elect to defer payment of the management and performance fees. If Vicis elect to defer the payments, they were invested in the International Fund portfolio. Vicis elected to defer a portion of its International Fund performance fees for 2006-2008.
Vicis began liquidating its portfolio in September 2009, after investors requested some $3 billion in redemptions as a result of the 2008 financial crisis. Vicis's deferred payment plan with the International Fund terminated in February 2010 and the deferred fees were distributed to Vicis. As of September 2010, the Vicis convertible portfolio was completely liquidated.
Lucas and his former wife, Margaret, were married in 1994. Ms. Lucas filed for divorce in January 2008. Between the date of the divorce filing and the date the divorce was granted, Mr. Lucas received approximately $47 million in distributions from Vicis. The largest issue in the divorce was the valuation and equitable distribution of Mr. Lucas's interest in Vicis, including the $47 million in distributions. Ms. Lucas argued that the distributions were part of the marital estate even though Mr. Lucas received them after she had filed for divorce. The divorce court determined that only around $4.7 million represented deferred compensation attributable to Mr. Lucas's predivorce earnings and was therefore a marital asset.
Mr. Lucas paid several million dollars of legal and professional fees in the divorce. He hired a law firm to represent him as well as a consulting group as an expert witness on the Vicis valuation issue. On his 2010 Schedule A, Itemized Deductions, Mr. Lucas deducted approximately $1.3 million in legal fees. For 2011 he deducted $1.6 million in fees on his Schedule E, Supplemental Income and Loss. In 2016, the IRS sent Mr. Lucas a notice of deficiency disallowing the legal fee deductions. Mr. Lucas petitioned the Tax Court to review the notice of deficiency.
Analysis
Litigation costs may be deductible as a business expense under Code Sec. 162(a) or as costs incurred in producing income under Code Sec. 212. Under Code Sec. 262, no deduction is allowed for personal, living or family expenses.
Observation: Taxpayers generally prefer the Code Sec. 162(a) trade or business expense deduction over the Code Sec. 212 deduction. A trade or business expense is subtracted in full from gross income, while a deduction under Code Sec. 212 is subtracted from adjusted gross income and is subject to certain floor limitations in Code Sec. 67(a). A Code Sec. 212 deduction may also be limited if the alternative minimum tax applies. However, it should be noted that, for years beginning after 2017 and before 2026, no miscellaneous itemized deductions are available to individuals as a result of the Tax Cuts and Jobs Act of 2017.
Under U.S. v. Gilmore, 372 U.S. 39 (1963), the deductibility of legal fees depends on whether the underlying claim arose in connection with the taxpayer's profit seeking or personal activities. Under this "origin of the claim" test, the Supreme Court held that legal expenses paid to defeat claims arising from a marital relationship were personal and nondeductible. The Gilmore test has been described as a but-for test; if the claim could not have existed but for the marriage relationship, the expense of defending it is a personal expense and not deductible.
Legal expenses arising from a divorce are deductible in some cases. A limited exception in the regulations under Code Sec. 262 applies for divorce-related legal fees incurred in collecting taxable alimony income. The Tax Court in Hahn v. Comm'r, T.C. Memo 1976-113 allowed a deduction under Code Sec. 212 for legal fees a former spouse incurred to secure income from jointly owned property over which the other spouse had taken possession. In Liberty Vending, Inc. v. Comm'r, T.C. Memo. 1998-177 (1998), the Tax Court allowed a taxpayer to deduct legal fees incurred to resist actions by an ex-spouse that interfered with the taxpayer's business activities.
Mr. Lucas argued that he was entitled to deduct his legal and professional expenses under Code Sec. 162(a) or Code Sec. 212 because the fees were paid to defend a claim for profits earned in his business or income producing activity. He contended that the facts in his case were similar to those in Hahn, where the Tax Court found the expenses to be deductible. The IRS responded that the fees were nondeductible personal expenses under Code Sec. 262.
Tax Court's Decision
The Tax Court held that Mr. Lucas's legal and professional fees were nondeductible personal expenses. The court reasoned that but for the marriage, Ms. Lucas would have had no claim to Mr. Lucas's interest in Vicis. The court further found that Hahn did not apply because, while the fees in that case were business connected, Mr. Lucas's legal fees had no connection to Vicis's investment advisory business. Rather, they were incurred defending his ownership and distributions from equitable distribution in the divorce.
Mr. Lucas failed to demonstrate that the expenses were otherwise deductible, in the Tax Court's view. The court concluded that Mr. Lucas was neither pursuing alimony nor resisting an attempt to interfere with his ongoing business activities as in Liberty Vending. The court found that Mr. Lucas engaged in little trade or business activity in 2010 or 2011, as Vicis began liquidating in 2009 and thereafter he engaged in no business activity other than a limited management role with Vicis. Mr. Lucas did not, in the view of the Tax Court, establish that Ms. Lucas's claim related to the winding down of Vicis, or that the fees incurred to defeat her claim were ordinary and necessary to his trade or business.
For a discussion of the deductibility of legal fees, see Parker Tax ¶80,185.
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Fifth Circuit Vacates Lower Court Decision on Taxpayer's Liability for Section 6672 Penalty
The Fifth Circuit held that, in a case involving a taxpayer whose business failed to pay over to the IRS approximately $11 million in payroll taxes, a district court erred when it (1) granted summary judgment in the IRS's favor on the taxpayer's liability for the unpaid taxes and (2) denied the taxpayer's motion to reconsider on the basis that the amount of the taxpayer's liability was a genuine issue of material fact. The Fifth Circuit found that, under Code Sec. 6672, the taxpayer was liable only for the amount of available, unencumbered funds in the business's accounts after the taxpayer became aware of the unpaid withholding taxes and that the taxpayer presented competent evidence establishing an issue of material fact regarding whether the business's funds were sufficient to cover the tax obligation. McClendon v. U.S., 2018 PTC 173 (5th Cir. 2018).
Background
Dr. Robert McClendon founded Family Practice Associates of Houston (FPA), a professional medical association, in 1979. By 1995, FPA employed five doctors, numerous nurses, and related support staff. That year, FPA hired Richard Stephen, a certified public accountant, to serve as FPA's chief financial officer. From 1995 to 2009, Stephen informed FPA's board of directors that FPA was doing well financially and that all of FPA's tax obligations were being met.
In 2009, the IRS notified FPA that it had no record of any payroll tax deposits from FPA for several of the previous years. FPA discovered that Stephen had failed to remit FPA's withholding taxes from 2003 to 2008, and that he had been stealing money from the company for several years. FPA's unpaid withholding tax balance was over $11 million.
In response, FPA stopped paying its creditors and vendors. To ensure FPA's employees would continue receiving their paychecks in May 2009 without using any of FPA's funds, McClendon loaned FPA $100,000. FPA remitted all of its receivables directly to the IRS, totaling over $400,000. FPA also paid the IRS $250,000 in insurance proceeds it received on its claims for employee theft. In 2013, Stephen pleaded guilty to first-degree felony theft and was sentenced to 10 years in prison.
In 2012, the IRS assessed approximately $4.3 million in penalties against McClendon personally for FPA's unpaid withholding taxes. McClendon paid a nominal amount and then sued for a refund. The IRS filed for summary judgment, contending that McClendon was a responsible person for FPA's payroll taxes and willfully failed to pay the taxes to the IRS. According to the IRS, McClendon acted willfully by using company funds to pay non-IRS creditors. The IRS pointed out that McClendon loaned FPA $100,000, paid a doctor $1,840, and paid an insurance company $2,000. The IRS also argued that McClendon was grossly negligent in delegating, with no oversight, the responsibility of paying payroll taxes to Stephen for years and that such conduct constituted willfulness under Code Sec. 6672.
McClendon conceded that he was a responsible person but contested the willfulness element. He asserted that none of the subject payments were made using FPA funds. He also argued that the $100,000 loan was encumbered and could not have been paid to the IRS because he specified in the loan terms that the money be used only to pay FPA employees.
The district court granted the IRS's motion for summary judgment. It determined that McClendon acted willfully because, after learning of the unpaid taxes, he loaned money to FPA which for payroll rather than to pay the IRS. The district court found that the loan funds were not encumbered, reasoning that a responsible person cannot avoid liability by entering into a lending agreement in which creditors are paid before the government. The district court ruled in favor of the IRS for the total amount of penalties assessed against McClendon, approximately $4.3 million.
McClendon filed a motion for reconsideration. He argued that even if he were a responsible person who acted willfully, his liability was limited to the amount of unencumbered funds FPA had available after he learned of the unpaid taxes. He asserted that all of FPA's available unencumbered funds were paid over to the IRS and that the only evidence of funds not paid over was the $100,000 loan. McClendon asserted that, therefore, he could be liable to the government for, at most, $100,000.
The IRS responded that McClendon was not entitled to this limitation on his liability because he failed to prove the total amount of FPA's available funds, whether they were unencumbered, and if so, whether they were paid to the IRS. The IRS argued that applying the limitation on his liability necessarily required a full accounting of all of FPA's available funds after the date he became aware of the unpaid taxes. The IRS asserted that McClendon had not introduced any of FPA's bank records to show how much was deposited after his discovery of the unpaid taxes. The IRS also argued that McClendon would not be entitled to the liability limit if he was found to be grossly negligent.
In response, McClendon provided a copy of a check showing that FPA's closing balance in July 2009 of approximately $297,000 had all been turned over to the IRS. McClendon further contended that the gross negligence determination was an issue of material fact that could not be decided by summary judgment.
The district court denied McClendon's motion for reconsideration, finding that McClendon failed to raise the limitation of liability argument in response to the IRS's motion for summary judgment and could not raise it for the first time in his motion to reconsider. The district court also found that, even if the argument were properly before it, it failed on the merits because McClendon had the burden of proof as to the availability of the funds and had failed to demonstrate that FPA's funds were insufficient to cover the tax obligation. McClendon appealed to the Fifth Circuit.
Analysis
Employers are required to withhold taxes and social security contributions from their employees' paychecks and hold them in trust for the government. Under Code Sec. 6672, a penalty applies to officers or employees who are responsible for collecting and paying over the taxes but who willfully fail to do so. Such individuals are personally liable for a penalty equal to the amount of the delinquent taxes. Willfulness is established if a responsible person knew the taxes were delinquent but used company funds to pay non-IRS creditors. The responsible person's liability is limited to the amount of available, unencumbered funds deposited in the business's bank accounts after the responsible person became aware that the taxes were due.
On appeal, McClendon reasserted that $100,000 was the upper limit of his liability because that was the amount of available, unencumbered funds paid to non-IRS creditors after he learned of the unpaid taxes. McClendon also argued again that his loan to FPA was encumbered because its use was restricted to payroll.
The Fifth Circuit affirmed the district court's determination that McClendon's $100,000 loan was unencumbered because McClendon failed to identify any error in the district court's analysis on that issue. However, the Fifth Circuit vacated the remainder of the summary judgment because it found that there was a genuine issue of material fact as to whether FPA had $4.3 million in available, unencumbered funds after McClendon learned of the unpaid taxes.
The court recounted McClendon's testimony that as soon as FPA's board learned of the unpaid taxes, FPA stopped paying its creditors and vendors, that he and his wife loaned money to the company, and that FPA remitted its receivables and insurance proceeds to the IRS. The court also noted that McClendon submitted to the district court copies of checks made out to the IRS. One check was dated July 2009 and was for approximately $135,000. Another was dated February 2010 for $297,000, which the court noted was just under FPA's closing bank balance at the end of July 2009. McClendon also submitted a copy of an August 2010 check to the IRS for approximately $275,000.
The Fifth Circuit found that the district court believed McClendon had to provide an accounting of FPA's funds in order to satisfy his burden on summary judgment. The court looked to the decision in U.S. v. Stein, 2018 PTC 130 (11th Cir. 2018), in which the Eleventh Circuit held that a taxpayer's self-serving and uncorroborated statements could create an issue of material fact with respect to the correctness of the IRS's assessments, and that if a corroboration requirement existed, it had to come from a source other than the procedural rule governing summary judgment. The Fifth Circuit found that, while Code Sec. 6672 imposes a harsh remedy against taxpayers such as McClendon, who was in the court's view as much a victim of Stephen's criminality as the government, the statute did not supplant the evidentiary burdens applicable to a summary judgment proceeding.
Observation: In a concurring opinion, one judge opined that it was irresponsible for the IRS to claim McClendon failed to raise an issue of fact when it had access to FPA's financial records. In a dissenting opinion, one judge argued that the court could not vacate the district court's holding based on an argument McClendon never raised in the original summary judgment briefing.
For a discussion of the Code Sec. 6672 trust fund recovery penalty, see Parker Tax ¶210,108.
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Summary Judgment Denied in Tax Court Case Involving Split Dollar Life Insurance Arrangements
The Tax Court denied an estate's motion for partial summary judgment in a case where the estate argued that the cash surrender value of three split dollar life insurance arrangements should not be included in the decedent's gross estate. The court concluded that the decedent retained rights in the arrangements and that the transfers of the three split dollar life insurance agreements were not bona fide and were not for full and adequate consideration. Estate of Cahill v. Comm'r, T.C. Memo. 2018-84.
Background
Richard Cahill died in December 2011. Cahill was the settlor of the Richard F. Cahill Survivor Trust (Survivor Trust), a revocable trust of which Richard Cahill's son, Patrick, was the trustee and attorney in fact. Richard Cahill was also the settlor of an irrevocable trust, the Morrison Brown Trust (MB Trust). Patrick Cahill created MB Trust as Richard Cahill's attorney in fact in September 2010, when Richard Cahill was age 90 and unable to manage his affairs. Patrick Cahill's cousin, William Cahill, was the trustee of MB Trust and the beneficiaries were Patrick Cahill and his issue. MB Trust was formed to take legal ownership of three life insurance policies, one for Patrick Cahill and two for his wife, Shannon. The premiums on the three insurance policies totaled $10 million. Each policy guaranteed an investment return on the premiums of at least 3 percent.
To fund the policies, three split dollar agreements were executed by Patrick Cahill as trustee of Survivor Trust and William Cahill as trustee of MB Trust. Survivor Trust funded the premiums, paid in lump sums, using a $10 million loan from Northern Trust, N.A., with Richard and Patrick Cahill as the obligors. The loan had a five year term and a variable interest rate. No principal payments were required during the life of the loan.
Through Survivor Trust, Richard Cahill received death benefit rights and termination rights under the split dollar agreements. On the death of the insured, Richard Cahill was entitled to the greatest of (1) any remaining balance on the loan relating to the relevant policy, (2) the total premiums paid on that policy, or (3) the policy's cash surrender value. MB Trust would retain any excess of the death benefit over the amount paid to Survivor Trust. Richard Cahill also had right to terminate the agreements in conjunction with the trustee of MB Trust. On termination, MB Trust could opt to retain the policy, in which case Richard Cahill would receive the greater of the premiums paid or the cash surrender value. If MB Trust declined to retain the policy, it would be transferred to Northern Trust to satisfy Richard Cahill's loan liability. In 2010, Richard Cahill reported gifts to MB Trust of approximately $7,500 as determined under the economic benefit rules in Reg. Sec. 1.61-22.
As of the date of Richard Cahill's death, the aggregate cash surrender value of the insurance policies was approximately $9.6 million. Cahill's estate tax return reported the value of Cahill's interests in the split dollar agreements as $183,700. The estate contended that (1) because Cahill's right to terminate was held in conjunction with the trustee of MB Trust, and (2) because it would never make economic sense for MB Trust to allow termination, the termination rights had no value. The estate therefore argued that the value of the split dollar agreements was limited to the death benefit rights, which the estate said were worth relatively little given that Patrick and Shannon Cahill were projected to live for many years.
The IRS issued a notice of deficiency adjusting the total value of the rights in the split dollar agreements from $183,700 to $9.6 million, the aggregate cash surrender value. In support of this adjustment, the IRS presented alternative theories applying Code Sec. 2036(a)(2), Code Sec. 2038(a)(1), and Code Sec. 2703(a)(1) and (2). The notice determined a deficiency of approximately $6.2 million and imposed a gross valuation misstatement penalty. The estate challenged the notice in the Tax Court and sought a partial summary judgment that Code Secs. 2036, 2038, and 2703 were inapplicable and that Reg. Sec. 1.61-22 applied in valuing Cahill's interests in the arrangements.
Analysis
The estate tax applies to the transfer of a decedent's taxable estate. The taxable estate consists of the value of the gross estate after deductions. The gross estate includes the fair market value of the property owned by the decedent on the date of death, or included in the estate under the Code.
Code Sec. 2036 includes the value of property in the gross estate if it was transferred before death but the decedent retained the right to designate who will possess or receive income from the property. Code Sec. 2038 similarly provides that a decedent's estate includes transferred property if the decedent kept the power to alter or terminate the transferee's enjoyment of the property. An exception applies to Code Secs. 2036 and 2038 for bona fide transfers for adequate and full consideration. Code Sec. 2703 disregards, in calculating the value of an estate, certain rights to acquire or use property for less than fair market value and restrictions on the right to sell or use the property.
Reg. Sec. 1.61-22 provides rules for split-dollar life insurance arrangements for purposes of income, gift, and employment taxes. A split dollar insurance arrangement is any arrangement between an owner and a nonowner of a life insurance contract, where either party pays a portion of the premiums and at least one of the parties is entitled to recover some or all of the premiums from the insurance proceeds. Split dollar arrangements are taxed under either an economic benefit regime or a loan regime. Under the economic benefit regime, if the only economic benefit provided to the donee is current life insurance protection, then the donor is deemed the owner, irrespective of formal policy ownership. The cost of current life insurance protection is then treated as a transfer each year from the donor/owner to the donee/nonowner.
Cahill's estate asked for summary judgment that Code Secs. 2036 and 2038 did not apply to include the cash surrender value in the gross estate. The estate argued that Richard Cahill's termination rights were valueless because MB Trust could prevent him from terminating the split dollar agreements. The estate asserted that the $10 million transfer was bona fide and for adequate and full consideration. Patrick Cahill argued that his father would have wanted to ensure sufficient liquidity for his grandchildren when Patrick and Shannon died. The estate further contended that Code Sec. 2703 did not apply to the split dollar arrangements because the arrangements were similar to promissory notes and partnership interests, to which Code Sec. 2703 was inapplicable.
The estate argued that the difference between the $10 million Richard Cahill paid and the $183,700 that he allegedly received in return should be accounted for as gifts, and that to count the difference as part of the estate would essentially double count that amount. The estate therefore asked that the application of Code Secs. 2036, 2038 and 2703 be modified so as to avoid inconsistency with Reg. Sec. 1.61-22.
The IRS argued that the transactions were not bona fide sales because Patrick Cahill stood on both sides of the transactions. The IRS also questioned whether what MB Trust gave, if anything, constituted adequate and full consideration. Alternatively, the IRS argued that under Code Sec. 2703, MB Trust's ability to veto the termination of the agreements should be disregarded, and that the agreements should be valued as if Richard Cahill had been able to unilaterally terminate them. With respect to Reg. Sec. 1.61-22, the IRS argued that the regulation did not apply for estate tax purposes.
The Tax Court denied the estate's motion for summary judgment. First, the court found that Code Secs. 2036 and 2038 applied because Richard Cahill's right to terminate and recover at least the cash surrender value was clearly a right, held in conjunction with MB Trust, both to designate the persons who would possess or enjoy the transferred property and to alter or terminate the transfer. The court also found that the bona fide sale exception did not apply because the value of what Richard Cahill received was not even close to what he paid. The court noted that by the estate's own theory, the $10 million transfer could not have been in exchange for property worth that amount because the rights received in return were worth only $183,700.
The Tax Court found that summary judgment on Code Sec. 2703 was also inappropriate because the provisions in the split dollar agreements preventing Richard Cahill from immediately withdrawing his investment were agreements to acquire or use property at a price less than fair market value. The court reasoned that MB Trust paid nothing and received death benefit rights which the estate appeared to argue were worth at least the cash surrender value ($9.6 million) minus the value of Richard Cahill's death benefit rights ($183,700). The split dollar arrangements also clearly restricted Richard Cahill's right to terminate and withdraw his investment under Code Sec. 2703(a)(2). The court also rejected the estate's argument that the arrangements were like promissory notes or partnership interests.
The court was unconvinced that the difference between the $10 million paid and the $183,700 Cahill allegedly received in return would be double counted in the estate and as gifts. Cahill did not report any of that amount as a gift to MB Trust, and the parties agreed nothing other than the cost of current life insurance protection was a gift under Reg. Sec. 1.61-22. The cost of current life insurance was deducted from the cash surrender value of each policy, and the cash surrender value remaining as of Cahill's death was therefore composed of funds that had not yet been used to pay for the insurance. Accordingly, the court found that no part of the cash surrender value was a gift, and counting the difference in the gross estate would not double count any amount.
While the Tax Court acknowledged that Reg. Sec. 1.61-22 did not apply for estate tax purposes, it found the regulation relevant because the gift and estate tax provisions had to be construed together. The court found no inconsistency because none of the cash surrender value was treated as a gift, and if any of the cash surrender value might be treated as gifts after the estate was distributed to Richard Cahill's heirs, those gifts would not be attributable to Richard Cahill. The court concluded that because Cahill was clearly the owner of the cash surrender value under the economic benefit regime, consistency between the regulations and estate tax Code sections required including that value in the gross estate.
For a discussion of inclusions in a gross estate of transfers with a retained life interest, see Parker Tax ¶225,510. For a discussion of inclusion of revocable transfers in a gross estate, see Parker Tax ¶225,910. For a discussion of the valuation of property subject to restrictive arrangements, see Parker Tax ¶223,530.
