VAUGHN v. US, Cite as 109 AFTR 2d 2012-XXXX, 12/28/2011
In re: JAMES CHARLES VAUGHN Debtor.
Case Information:
Code Sec(s):
Court Name: IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF COLORADO,
Docket No.: Case No. 06-18082 MER; Adversary No. 08-1095 MER,
Date Decided: 12/28/2011.
Disposition:
HEADNOTE
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Reference(s):
OPINION
IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF COLORADO,
ORDER
Judge: The Honorable Michael E. Romero
Chapter 11
This matter involves the rise and fall of James Vaughn, an obviously intelligent man who made an extremely unintelligent decision. Through hard work and entrepreneurial talent, he gained experience in the options trading, venture capital, and cable television industries, rising to executive positions in several companies. In 1995, he started a successful cable company and began acquiring small cable companies with an eye to selling to a larger entity. The venture was sold in 1999 for a gross sales price of $2.1 billion, of which Mr. Vaughn received approximately $34 million in cash and stock. Sadly, this inspiring business success story then took a very negative turn when Mr. Vaughn made the investment which forms the subject of this action.
JURISDICTION
The Court has jurisdiction over this matter pursuant to 28 U.S.C. §§ 1334(a) and (b) and 157(a) and (b). This is a core proceeding under 28 U.S.C. § 157(b)(2)(I) as it concerns the dischargeability of a particular debt.
BACKGROUND FACTS 1
The Plaintiff in this action, James Charles Vaughn (“Vaughn”), graduated from high school in 1962. He completed some college courses, but did not earn a degree. Vaughn gained significant experience in business by working with several companies, primarily in the cable television industry. During the 1980s and 1990s, he served as the senior vice president of Triax Communications, a cable company, and was involved in budgeting, financial review, capital raising, acquisitions, and complex negotiations. During the time Vaughn was with Triax, it grew from 30,000 subscribers to approximately 400,000 subscribers. In addition, early in his career, Vaughn began trading options and options futures. As he gained experience, he developed an understanding of the mechanics of investments.
In 1995, Vaughn started Frontier Vision Partners (“Frontier Vision”). He borrowed $500,000 from JP Morgan to start up the company. JP Morgan later invested an additional $25 million in the venture. Frontier Vision raised additional capital through Vaughn, JP Morgan agents, and from presentations to investors. Vaughn explained Frontier Vision's business model was to become a world cable television acquirer, with the intent to buy smaller companies and eventually sell them to a larger entity. To that end, Frontier Vision purchased rural cable television providers and consolidated them into a single provider.
When Frontier Vision began in 1995, it hired the international accounting firm KPMG, LLP (“KPMG”) to review acquisition agreements, handle tax preparation and audit activities, document public bond offerings, and perform related services. Vaughn hired Mr. Jack Koo (“Koo”), an experienced commercial banker, as Frontier Vision's chief financial officer. Mr. James McHose (“McHose”), a certified public accountant previously employed by KPMG as a senior tax manager, was also hired by Frontier Vision as vice president and treasurer.
In early 1999, Frontier Vision was sold to Adelphia Communications Corporation (“Adelphia”). From the sale, Vaughn received approximately $20 million in cash and $11 million in Adelphia stock. Koo also received significant cash and Adelphia stock from the sale.
Vaughn knew he would realize capital gains from the sale of Frontier Vision in excess of $30 million. Thus, after the sale was announced, McHose arranged meetings with financial advisors for Vaughn and Koo to suggest investment and tax strategies addressing their profits from the sale. In two meetings with KPMG partner Gary Powell (“Powell”), a product called Bond Linked Issue Premium Structure (“BLIPS”) was presented as an investment possibility. The BLIPS product was offered by a company known as Presidio Advisory Services, LLC (“Presidio”). In August 1999, Vaughn, as a potential investor, was issued a “Confidential Memorandum” which described the BLIPS program in detail.
A. The BLIPS Program
In the Confidential Memorandum, Presidio described BLIPS as a three-stage, seven-year program comprised of investment funds, or investment pools. The first stage, to last 60 days, involved relatively low risk strategies, while the second stage, lasting 120 days, and the third stage, lasting six and one-half years, increased the risk on the investment with the potential for higher returns. Investors, known as Class A members, could withdraw from the program after the first 60 days. 2 In general, this strategy focused on investing in foreign currencies, including currencies “pegged” to the United States dollar. 3 Specifically, these funds, in which a Class A member could invest through creation of a separate investment entity, would “invest in U.S. dollar and foreign currency denominated debt securities of corporate and governmental issuers and enter into forward foreign currency contracts, options on currencies and securities and other investments....” 4 Stated simply, this was an investment which could make money based on the volatility of foreign currencies.
What made BLIPS a “tax strategy” was how the investment was to be funded. Generally, an investor would contribute a relatively modest amount compared to the amount ultimately invested. The balance of the investment would be funded through a loan. The loan would be somewhat unconventional because it would charge a high rate of interest and also carry what was referred to as an “initial unamortized premium amount,” or loan premium. The loan premium created a lower, “market rate” of interest, by doing the following three things: 1) amortizing the loan premium; 2) paying interest on the loan amount; and 3) paying interest on the premium itself. Stated differently, while the aggregate of the loan and the loan premium was owed, the premium was being amortized as the loan went forward. 5
The more important aspect of the investment would be the basis claimed by the taxpayer for such an arrangement. Under the BLIPS program, the taxpayer would claim a basis of the total amount contributed to the investment less the stated principal amount of the loan. As a result, the loan premium is added to the initial investor contribution. Thus, gains are protected by the high basis or, alternatively, in a case where a tax loss may be attractive, for a relatively little actual cash outlay, a claimed basis could result in a high tax loss “even though the taxpayer has incurred no corresponding economic loss.” 6
B. The Investment
In July 1999, following their receipt of the Confidential Memorandum, Vaughn and Koo met with David Makov and Robert Pfaff of Presidio to discuss investments involving the Argentine Peso and the Hong Kong Dollar. The investments were to be accomplished through the creation of a fund called Sill Strategic Investment Fund (“Sill”), to which entities created by the individual investors would contribute funds through an account at Deutsche Bank AG (“Deutsch Bank”). Deutsche Bank would then provide loans for investments in the foreign currency markets through the BLIPS program.
Vaughn chose to invest in the BLIPS program, and in furtherance of this decision created an entity known as Pilchuck Ventures, LLC (“Pilchuck”). On October 7, 1999, pursuant to Presidio's instructions, Vaughn wired $2.8 million to the Pilchuck account at Deutsche Bank to commence the BLIPS transaction. 7 In Vaughn's case, the corresponding loan from Deutsche Bank would be $66 million, plus a $40 million “premium.” 8
Vaughn received closing documents to be reviewed, signed, and returned. 9 The credit documents with Deutsche Bank were dated October 13, 1999. Sill was set up on October 22, 1999. 10 Presidio's letter to Vaughn of October 26, 1999 indicated Sill received contributions from Pilchuck on October 22, 1999 in a total amount of $109.5 million, which included the $2.8 million supplied by Vaughn and the amount loaned by Deutsche Bank. 11 On October 22, 1999, Deutsche Bank sent confirmation notices showing transactions involving approximately $107 million, primarily purchases of Argentine Pesos and Hong Kong Dollars. 12 13
On December 9, 1999, Vaughn received a report from Presidio showing a Pilchuck loss, as of December 8, 1999, of approximately $280,000. 14 Thereafter, as planned, Vaughn “pulled out” of the investment after approximately 60 days. 15 After deduction of fees and interest, Vaughn received approximately $900,000 back from his initial $2.8 million investment, comprised of U. S. dollars, Euros, and Adelphia stock. 16
The large losses in the BLIPS transactions were generated because Pilchuck (and its sole owner, Vaughn) received only approximately $900,000 in returns on its investment, on a cost basis equal to the amount originally contributed by Vaughn, $2.8 million, plus the loan premium of $40 million, for a basis of approximately $43 million. Thus, a tax loss of approximately $42 million could potentially have been generated by this “investment.”
C. The Tax Problem
Thereafter, Lees prepared Vaughn's 1999 tax return. 17 This return reflected certain of the losses generated by the BLIPS investment. According to Lees, he relied on the opinions of KPMG and the law firm of Brown & Wood in taking a loss on that return. 18 While Vaughn acknowledged the purpose of BLIPS was to generate losses to him of approximately $40 million, he noted the loss taken on his 1999 tax return did not reflect any real hard dollar loss to anybody at the time the return was filed. In fact, he had no actual losses in the amount claimed when the deduction was taken. He admitted he did not take the full amount of the BLIPS losses on his 1999 tax return. He did take sufficient tax losses to result in his reporting only a $2.4 million capital gain from the sale of Frontier Vision. However, he denied Powell instructed him to take less than the full loss to avoid arousing any IRS suspicions.
On September 5, 2000, the IRS issued Internal Revenue Bulletin Notice 2000-44 addressing tax avoidance using artificially high basis. 19 That Notice stated in part:
Under the position advanced by the promoters of this arrangement, the taxpayer claims that only the stated principal amount of the indebtedness, $2,000X in this example, is considered liability assumed by the partnership that is treated as a distribution of money to the taxpayer that reduces the basis of the taxpayer's interest under § 752 of the Internal Revenue Code. Therefore, disregarding any additional amounts the taxpayer may contribute to the partnership, transaction costs, and any income realized or expenses incurred at the partnership level, the taxpayer purports to have a basis in the partnership interest equal to the excess of cash contributed over the stated principal amount of the indebtedness, even though the taxpayer's net economic outlay to acquire the partnership interest and the value of the partnership interest are nominal or zero. In this example, the taxpayer purports to have a basis of $1,000X (the excess of cash contributed ($3,000X) over the stated principal amount of the indebtedness ($2,000X)). On disposition of the partnership interest, the taxpayer claims a tax loss with respect to that basis amount, even though the taxpayer has incurred no corresponding economic loss. 20
KPMG determined BLIPS investors should be contacted regarding the Notice. Specifically, Mr. Jeffrey Eischeid, a KPMG employee, through an email to Powell dated October 3, 2000, provided a script to be used in conversations with such clients and specifically identified Vaughn and Koo as investors who should be contacted. 21 Vaughn did not recall attending a meeting with representatives of KPMG regarding Notice 2000-44, but Lees thought there may have been such a meeting on January 21, 2001, and remembered KPMG representatives continued to insist the transaction was legitimate and would back the transaction and fight the IRS on its interpretation. 22 It is not clear whether, in any such meeting, Vaughn was informed of the increased likelihood of audit or the increased possibility KPMG would be required to provide to the IRS the names of clients engaged in transactions similar to those described in the Notice. 23 On February 6, 2001, Lees sent a letter to Vaughn containing a copy of Notice 2000-44. Vaughn could not remember receiving this document.
On February 6, 2002, Victoria Sherlock (“Sherlock”), a KPMG in-house attorney, met with Koo and Vaughn to discuss an IRS settlement initiative, Notice 2002-2. Sherlock represented Koo, who had received an audit letter from the IRS in 2001 regarding his BLIPS investment. Koo stated he had not had much contact with Vaughn during 2001, and first informed him of his audit letter at the February 6, 2002 meeting. At this meeting, Sherlock, without making a representation about whether she believed BLIPS would ultimately result in additional taxes, informed Vaughn he should disclose his participation in BLIPS to the IRS. 24 Vaughn's disclosure was provided to the IRS on or about March 28, 2002. 25 Vaughn also provided other information requested by the IRS, and agreed to extensions of the statute of limitations to allow the IRS to continue its investigation concerning the losses on his 1999 tax return.
In May 2002, Vaughn and his then-wife Cindy Vaughn received letters from the IRS scheduling an appointment to examine their 1999 tax returns. 26 On March 18, 2004, Lees filed amended tax returns for the Vaughns for 1997, 1998 and 1999, adding a net operating loss carryback incurred by Vaughn in 2003. 27
On May 24, 2004, the IRS issued Announcement 2004-46, the so-called “Son of Boss Settlement Initiative.” 28 Vaughn asserts he was aware by this time of misrepresentations and omissions made by KPMG and Presidio, through conversations with his attorney, with Koo and through review of a widely-known Senate Subcommittee Report critical of investment vehicles such as BLIPS. 29 Specifically, Vaughn claims KPMG and Presidio hid information from their clients, made misrepresentations about the economic substance and leverage in investments, and misrepresentations about the validity of opinion letters. Vaughn mailed a Notice of Election to Participate in the Announcement 2004-46 Settlement Initiative on June 21, 2004. On June 24, 2004, Vaughn received a notice of deficiency showing taxes for the tax year ended December 31, 1999, in the sum of $8,617,902 (“the 2004 Assessment”). 30 He could not pay these taxes within thirty days, and so could not meet the eligibility requirements of the Settlement Initiative. 31
On November 3, 2006, Vaughn filed his Chapter 11 petition (the “Petition Date”). The IRS filed a proof of claim for $14,359,592 as a general unsecured claim, stating at that time the taxes were not entitled to priority under 11 U.S.C § 507(a)(8)(A) 32 because they were assessed more than 240 days before the Petition Date. Almost a year after the Petition Date, and three years after the 2004 Assessment, the IRS realized its error. On October 29, 2007, the IRS abated the 2004 Assessment as unlawful, and on April 10, 2008, the IRS filed its amended proof of claim, asserting the taxes were entitled to priority.
ISSUES AT TRIAL AND THE PARTIES' POSITIONS
Before the Court is the determination of the dischargeability of the 2005 assessments for the 1999 and 2000 taxes. 33 Critical to this determination is whether Vaughn 1) made a fraudulent return; or 2) willfully attempted in any manner to evade or defeat tax for years 1999 and 2000, pursuant to § 523(a)(1)(C).
Vaughn seeks a finding the taxes assessed against him prepetition, which were abated postpetition and which will be reassessed postpetition, are dischargeable under §§105, 523(a), and 507(a)(8). Specifically, Vaughn alleges KPMG and its agents abused their fiduciary relationship with Vaughn by approaching and pressuring him to invest in BLIPS. Vaughn further asserts because of Koo's financial expertise, he reasonably relied on Koo's advice and representations by KPMG, Koo, and attorneys engaged by KPMG. Vaughn thus did not perform much, if any, personal due diligence of the BLIPS program. 34 When Koo determined there was economic substance to the BLIPS investment, and based on KPMG's promises, Vaughn invested. Finally, he notes he was also distracted by his wife's serious medical problems at the time.
Vaughn contends KPMG committed fraud because it misrepresented the nature of the BLIPS transaction and did not timely provide promised opinion letters–not until after the investment was made. 35 In addition, Vaughn asserts KPMG knew the investments and that it was being investigated by the Senate for its involvement in the BLIPS program, but did not timely disclose this information to him. Vaughn therefore states he did not willfully evade taxes either through the filing of his tax return or his actions following the filing of the tax return because he was counseled by KPMG that the transaction was legitimate and would ultimately be approved by the IRS.
The IRS asserts the tax assessments are nondischargeable under § 523(a)(1)(C). According to the IRS, Vaughn willfully attempted to evade his tax obligations for 1999 and 2000, and filed fraudulent returns for those years. The IRS states Vaughn knew or should have known, and in reckless disregard of the information that would have informed him, that BLIPS provided him with no reasonable opportunity to earn a reasonable pre-tax profit. He also knew or should have known BLIPS would not survive IRS scrutiny. The IRS contends Vaughn and Koo were too sophisticated to believe BLIPS was legitimate.
Moreover, in contrast to Vaughn's arguments, the IRS points out on March 24, 2000, Vaughn signed off on the draft opinion letter to Pilchuck which KPMG planned to issue regarding BLIPS. 36 The cover letter to the draft, signed by Gary Powell, directed Vaughn to sign the last page of the draft indicating Vaughn had read the draft letter and agreed with its contents. The IRS states Vaughn's representations in this letter were false, and Vaughn knew the BLIPS investment had no reasonable prospect for earning a pre-tax profit, and, contrary to the letter, there was no economic reason for borrowing funds from Deutsche Bank at an excessive interest rate.
In addition, the IRS states Vaughn sought to conceal the BLIPS losses from the IRS by directing Presidio to cause Sill to purchase Euros and Adelphia stock in order to attach most of his tax losses to shares of Adelphia. 37 According to the IRS, the Euros and Adelphia stock were purchased in such a fashion that the tax basis of approximately $40 million could be allocated, once Pilchuck had withdrawn from Sill, 8% to Euros and 92% to a capital asset–the stock. 38 Moreover, the IRS states Vaughn evaded taxes associated with the sale of his company by transferring assets to family members and spending enough to reduce the value of his estate to far less than his taxes.
DISCUSSION
Section 523(a)(1) provides:
(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
((1)) for a tax or a customs duty--
((A)) of the kind and for the periods specified in section 507(a)(3) or 507(a)(8) of this title, whether or not a claim for such tax was filed or allowed;
((B)) with respect to which a return, or equivalent report or notice, if required--
((i)) was not filed or given; or
((ii)) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition; or
((C)) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax... 39
This subsection, to be read in the disjunctive, thus contains two separate exceptions to discharge: 1) for making a fraudulent return; and 2) for willfully attempting to defeat and evade tax. 40 The IRS admits it bears the burden of proving the tax debts should be excepted from discharge by a preponderance of the evidence. 41
A. Filing a Fraudulent Return
This Court can find no cases from the Tenth Circuit Court of Appeals discussing what constitutes a fraudulent return under § 523(a)(1)(C). The issue has been addressed, however, by other courts in this Circuit. These courts have focused on 1) knowledge of the falsehood of the return; 2) an intent to evade taxes; and 3) an underpayment of the taxes, items which have come to be referred to as the “Krause” factors. 42 These courts have also set forth additional “badges of fraud” signaling a fraudulent return, including: 1) consistent understatement of income; 2) failure to maintain adequate records; 3) failure to file tax returns; 4) implausible or inconsistent behavior by a debtor; 5) concealing assets; 6) failure to cooperate with taxing authorities; and 7) unreported income from an illegal activity. 43
The facts set forth above lead to the conclusion Vaughn knew or should have known the returns he filed in 1999 and 2000 contained false information. Specifically, after receiving approximately $34 million in cash and stock from the sale of his company, he invested, through creation of Pilchuk, in a risky and complex transaction promoted by KPMG. He did not conduct his own investigation regarding the nature of the investment nor its tax consequences. Rather, he asserts he relied on the representations of KPMG, of KPMG's attorneys, and of Koo after Koo had reviewed the information supplied by KPMG. Unfortunately for him, Vaughn signed several documents expressly representing he had made an independent investigation. Moreover, he knew, at least by the time he filed the 1999 and 2000 tax returns, the investment was considered suspect by the IRS, and was being investigated. He further acknowledges he now believes the investment had no economic basis.
The evidence makes clear Vaughn was, and is, a sophisticated businessman. What he may lack in formal education, he made up for with hard work, long experience, and intelligence, enabling him to build organizations and eventually create a business which he sold for $2.1 billion. He is a self-made, successful entrepreneur whose accomplishments merit admiration and respect. It is simply not credible such an individual would enter into a transaction like BLIPS without making an independent investigation. Nor it is credible a savvy businessman like Vaughn would not have identified the numerous red flags associated with the transaction–red flags suggesting the investment strategy was not sound and might be an abusive tax shelter. 44
As his defense, Vaughn seeks to convince this Court he relied on the misrepresentations of others. The Court recognizes KPMG, KPMG's attorneys, and others who may have made representations to Vaughn about BLIPS can certainly be argued to have committed malfeasance. However, it is simply not believable that a man of Vaughn's experience and business acumen would risk endangering what at that time must have been the financial culmination of his career, the $34 million from the sale of his company, without much more personal involvement and a true independent investigation. It is not credible Vaughn could have failed to recognize a representation by KPMG, the promoter of the BLIPS program, or a representation by the lawyers hired by KPMG, might not constitute a truly unbiased opinion or serve as independent investment advice. As the promoter of BLIPS, KPMG and anyone working for KPMG had an inherent conflict of interest when rendering an opinion on BLIPS. Further, even though it stood to gain fees, the attorneys hired by KPMG to issue “opinion letters” only felt comfortable issuing such a letter with the conclusion that BLIPS stood at least a 50% chance of being disallowed by the IRS. For these reasons, the Court finds Vaughn knew or should have known BLIPS-related losses were improper to claim as an offset against taxes he owed on his income from selling his company, thus meeting the first prong of theKrause test.
For these same reasons, the Court questions Vaughn's position he viewed BLIPS primarily as an investment versus a tax savings vehicle. According to DeRosa, the IRS's expert witness, BLIPS could not reasonably have generated any gains for investors. DeRosa analyzed the currency transactions engaged in by Sill, and pointed out they had no economic impact. For example, Sill initially bought Euros on a “spot” transaction with the dollars and simultaneously sold the Euros “forward” one month. 45 Such “short forward” transactions simply “washed out” at the U.S. dollar interest rate, and did not constitute meaningful economic transactions because there was no economic risk and the money never left Deutsche Bank. In DeRosa's opinion, there was no prospect of making any money other than interest on such transactions. 46 Sill also obtained “forward” positions with Hong Kong Dollars and Argentine Pesos. DeRosa stated these transactions were really a short-term bet the currencies would collapse and be worth much less in, for example, sixty days, when an investor would be able to buy back U.S. Dollars with significantly less valuable Hong Kong Dollars or Argentine Pesos.
DeRosa opined the problem with this strategy was the Hong Kong Dollar and the Argentine Peso in 1999 were extremely stable, with little to no chance of devaluation or collapse. He noted because the Hong Kong Dollar and the Argentine Peso are “hard pegged” to the U.S. Dollar, they are among the least volatile currencies. 47 They have traditionally been stable even when other currencies fell in value. Therefore, there was virtually no possibility of an economic return on this transaction. To obtain one, according to DeRosa, Vaughn would have had to realize an unrealistic return of 67% on his $2.8 million–in DeRosa's opinion, an impossible hurdle in 60 days.
DeRosa also noted the crippling restrictions placed on Sill by Deutsche Bank in their agreement. The investments Sill could make were extremely limited, and Deutsche Bank, according to DeRosa, could liquidate Sill's positions essentially at will. Deutsche Bank also reduced the possibility of gain by charging fees based on forecasts of Sill's portfolio fluctuation, the so-called “value at risk haircut.” Deutsche Bank further retained the right to call the loan if the value of the portfolio dropped below $108,033,750, or 101.25% of the $106.7 million funding amount, which, in DeRosa's opinion, meant Sill could not invest in anything that would make money because it was prevented from taking any risks. 48
Vaughn must have been aware of these “limitations” in light of his experience. Thus the Court finds Vaughn cannot have made the BLIPS investment because he thought it would be a way, even a risky way, to make money. He was simply too smart a businessman for that. Therefore, he must have had another motivation for placing approximately $2.8 million into BLIPS. Based upon the returns he filed, which showed significant tax losses, and based upon his testimony the returns were structured to show a small net capital gain rather than showing the entire amount of BLIPS losses, the Court concludes his motivation in making the BLIPS investment and filing tax returns using the losses from the BLIPS investment was designed to evade taxes on the income from the sale of his company. Accordingly, the secondKrause prong (intent) is met.
As to the third prong, it should be noted Vaughn himself testified he underpaid the taxes, and has repeatedly expressed his intention to pay them. His dispute is with the assertion he knew of the impropriety of the BLIPS investment at the time it was made, or at the time he filed his 2004 amendment to his 1999 return. He contends he did not know of the true nature of the investment until much later. Because the Court finds, as described above, he knew or should have known about the problems with BLIPS at the time of the investment, the Court concludes this argument lacks merit. In addition, when he filed his amended 1999 return in 2004, he was aware KPMG was under investigation, and Mr. Lees told him in early 2001 the BLIPS losses would be disallowed. Therefore, the taxes were clearly underpaid and the third prong of the Krause test has been met.
The Court notes the other “badges of fraud” signaling a fraudulent return set forth in Krause, such as failure to keep records and failure to file returns, are not present. However, the “badge” of implausible and inconsistent behavior exists. Vaughn's general investment manager, Robert Mueller, with whom he placed other investments, described Vaughn as a conservative investor who had never shown any interest in or knowledge of foreign currency based investments. 49 Thus, Vaughn's actions involving the BLIPS investment were inconsistent both with his other investment behaviors, and were both implausible and inconsistent with his business acumen and purported investment goals.
B. Willful Evasion
The most recent appellate decision addressing § 523(a)(1)(C) identified two components to a showing of willful evasion: 1) a conduct requirement; and 2) a mental state requirement. 50 The Court stated:
To satisfy the conduct requirement, the government must demonstrate that the debtor avoided or evaded payment or collection of taxes through acts of omission, such as failure to file returns and failure to pay taxes, or through acts of commission, such as affirmative acts of evasion. Non-payment of tax alone is not sufficient to bar discharge of a tax obligation, but it is a relevant consideration in the overall analysis.....
[In addition] non-dischargeability under 523(a)(1)(C) requires a “voluntary, conscious, and intentional evasion.” The government must prove that the debtor 1) had a duty to pay taxes, 2) knew she had a duty, and 3) voluntarily and intentionally violated that duty. 51
1. Conduct
A recent case observed when a debtor affirmatively acted to avoid payment or collection of taxes, whether through commission or omission, these actions satisfy the conduct requirement of willful evasion of tax. 52 TheHawkins court noted: “[L]arge discretionary expenditures, combined with nonpayment of a known tax, contribute to the conduct analysis. Moreover, nonpayment of a tax can satisfy the conduct requirement when paired with even a single additional culpable act or omission.” 53 The Hawkins court went on to affirm the bankruptcy court's finding a debtor met the conduct requirement of § 523(a)(1)(C) where he made “unreasonable and unnecessary discretionary expenditures at a time when he knew he owed taxes and knew he would be unable to pay those taxes.” 54
Here, Vaughn admitted as of June 2001, he knew Koo was subject to an IRS audit regarding the BLIPS transaction. In addition, by January 2001, he was informed of the IRS notice questioning the validity of BLIPS by receiving a copy of the Notice 2000-44. He was also in possession of the opinion letter indicating he could be subject to an audit on the same basis. He therefore knew he had a potential liability on the full amount of his gain from the Frontier Vision sale. Nonetheless, although he had transferred approximately one-half of his post-Frontier Vision sale assets to Cindy Vaughn as part of their divorce settlement, he failed to take any actions to preserve his remaining assets for the payment of additional taxes.
Specifically, he purchased a $1.7 million home in Evergreen, Colorado, but put the title in the sole name of his then-fiancee, Kathy St. Onge (“St. Onge”). Moreover, shortly before disclosing his participation in BLIPS to the IRS, Vaughn created and funded a $1.5 million trust for his stepdaughter, Stephanie Frank (“Frank”). In addition, after Vaughn married St. Onge in October, 2001, St. Onge obtained funds of approximately $97,000 from the couple's accounts, spent funds to decorate the Evergreen home, and spent $42,000 on jewelry. 55 Between 2002 and 2003, Vaughn himself spent approximately $20,000 on jewelry. 56 Even if Vaughn himself did not retain access to the funds he spent after knowing of his large potential tax liability, his transfers ensured funds would not be available to satisfy his tax obligations.
2. Mental State
The Jacobs and Hawkins courts also summarize the case law interpreting the mental state component of willful evasion, noting the requirement is satisfied where the government shows the following three elements: 1) the debtor had a duty under the law; 2) the debtor knew he had the duty; and 3) the debtor voluntarily and intentionally violated the duty. 57 The government does not need to demonstrate fraudulent intent, but only that a debtor acted “knowingly and deliberately.” 58
Similarly, the Tenth Circuit has held a debtor's actions are willful under § 523(a)(1)(C) if they are done voluntarily, consciously, or knowingly and intentionally. 59 It agrees with other courts that more than non-payment of one's taxes is required to establish a willful evasion. 60 However, the Tenth Circuit also noted concealment of assets to avoid payment or collection of taxes may constitute a willful evasion. 61 Indeed, the Tenth Circuit recognized “Congress did not define or limit the methods by which a willful attempt to defeat and evade might be accomplished....” 62 The Court also stated:
By way of illustration, and not by way of limitation, we would think affirmative willful attempt may be inferred from conduct such as keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one's affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal. 63
In addition, the United States District Court for the District of Massachusetts observed:
Conduct that constitutes circumstantial evidence of a debtor's willful intent to evade taxes includes: 1) implausible or inconsistent explanations of behavior, 2) inadequate financial records, 3) transfers of assets that greatly reduce assets subject to IRS execution and 4) transfers made in the face of serious financial difficulties. 64
In this case, as noted above, Vaughn exhibited behavior which was inconsistent with his business acumen and was implausible based on that acumen when he participated in the BLIPS investment. Further, by purchasing expensive homes, automobiles, and jewelry, following a divorce which significantly depleted his assets, he further demonstrated such inconsistent and implausible behavior. That is, knowing, as he must have, the BLIPS investment constituted an improper abusive tax shelter with no economic basis and no reasonable expectation of profit, he nonetheless continued to spend as if there would be no additional tax to pay. This is simply not logical, unless he had another motive for such spending.
The evidence before the Court not only demonstrates he spent the funds and made the transfers in the face of serious financial difficulties, but also indicates his motive in doing so was to reduce assets subject to potential IRS execution. In short, by transferring funds and assets to St. Onge and Frank, he attempted to take those funds and assets out of the reach of the IRS. The Court does not deny Vaughn may have had some altruistic goals in setting up a trust for Frank, and may have had some good intentions for transferring real property to and purchasing real property for St. Onge, but any such motivations are overshadowed and outweighed by the fact Vaughn knew of the impending tax debt, and took no reasonable actions to preserve assets to pay it.
In order to meet the requirements of § 523(a)(1)(C), a debtor need not exhibit fraud or an evil motive. Rather, choosing to satisfy other obligations or pay for non-essentials, while not paying taxes, sufficiently demonstrates intent to evade tax. 65 The United States District Court for the Northern District of California, in affirming the Hawkins decision, stated:
This statement adequately places debtors on notice that their decision to prioritize other obligations or make non-essential purchases, rather than pay a known tax debt, can render their tax debts nondischargeable. Following the reasoning of other courts that have addressed the issue, the Court adopts this standard and affirms the bankruptcy court's conclusion that unnecessary expenditures combined with nonpayment of a known tax constitutes a willful attempt under Section 523(a)(1)(C). 66
This Court agrees with the reasoning set forth in these cases. Therefore, the Court finds Vaughn's actions meet the state of mind test to show intent to evade tax.
CONCLUSION
Throughout this case, Vaughn has argued he is an innocent victim of the machinations and misrepresentations of KPMG and persons in the employ of or hired by KPMG. This Court does not disagree that such machinations and misrepresentations took place. However, a taxpayer cannot reasonably rely on the advice of a professional who has an inherent conflict of interest, such as the promoter or marketer of a tax investment. 67 KPMG, its employees, and even the law firm employed by KPMG to issue “opinion letters” had such a conflict, because KPMG was the marketer of the BLIPS investment. It is simply not credible that an individual of Vaughn's extensive business background and demonstrated business skill would have reasonably relied on any such representations, and would not have, if he were seriously considering BLIPS as a legitimate investment, obtained a truly independent opinion as to its potential and its tax implications.
For these reasons,
IT IS ORDERED Vaughn's tax debts arising from the sale of Frontier Vision are not dischargeable under 11 U.S.C. § 523(a)(1)(C).
Dated December 28, 2011
BY THE COURT:
Michael E. Romero
U.S. Bankruptcy Judge
1
The background facts in this Order are taken from the testimony at trial, as well as exhibits and designated portions of depositions presented by the parties. In order to avoid a distracting number of footnotes, the Court will only insert a citation in reference to a specific document or where clarification is needed.
2
Joint Exhibit 3, Confidential Memorandum, pp. 7–8 and p. 15.
3
Joint Exhibit 3, Confidential Memorandum, pp. 8–9.
4
Joint Exhibit 3, Confidential Memorandum, p. 4 “Executive Summary.”
5
Testimony of Dr. David DeRosa (“DeRosa”). To show how this would work, DeRosa posited an investor who borrows $100 for a year at 6% simple interest, where the interest at the end of the loan term is thus $6, and the investor would owe $106 at the end of the year. If, on the other hand, the investor borrowed $60 for one year at 76.67% interest, and received a $40 premium, the interest at the end of the loan term would be $46, and the investor would owe $106. In each case, the investor receives $100 and owes $106 at the end of the year. According to DeRosa, the loan Vaughn received follows the same model as the second example, but over seven years rather than one year. See Internal Revenue Service (“IRS”) Exhibit NNNNN.
6
IRS Exhibit UUU, Internal Revenue Bulletin Notice 2000-44, p. 255.
7
Joint Exhibit 5.
8
See Joint Exhibit 7H, formation documents for Pilchuck, p. 9, approving credit agreement with Deutsche Bank; Joint Exhibit 7B, Credit Agreement between Pilchuck and Deutsche Bank; and IRS Exhibit C, noting a $1 million loan premium assigned for each $700,000 contributed by an investor.
9
See Joint Exhibits 7A–7L.
10
Joint Exhibit 8.
11
Joint Exhibit 12.
12
Joint Exhibits 9, 10, and 11.
13
Sill then proceeded to change the interest rate structure by engaging in a “swap” derivative transaction with Deutsche Bank, which lowered the rate to the more conventional London Interbank Offer Rate (“LIBOR”) common in financial markets. Thus, Sill received, at least on paper, the 17.694 % times $66.7 million, that is, the $66.7 million plus the $40 million. Since, following the swap, Sill had to pay LIBOR on the whole indebtedness, it becomes apparent the transaction is really a simple loan at LIBOR interest on $106.7 million. Because Sill was able to swap the 17.694 % interest rate for interest at LIBOR, DeRosa stated the only purpose for the initial 17.694 % interest rate was to amortize the $40 million and pay interest at market levels. Thus, after the contribution by Pilchuck, Sill now had a bargain rate, LIBOR, plus the $2.8 million put in by Vaughn, but the actual funds were still, and always were, physically held by Deutsche Bank.
14
Joint Exhibit 13.
15
See IRS Exhibit HH, consisting of a letter from KPMG employee Robert Lees (“Lees”) to Vaughn, dated December 16, 1999, confirming their discussion in which Vaughn directed KPMG to take steps to withdraw Pilchuck from Sill, and a withdrawal request signed by Vaughn and dated December 10, 1999.
16
Vaughn initially stated he did not authorize the purchase of Adelphia stock as part of the ending of the BLIPS transaction, but, upon review of his earlier deposition testimony, concluded he misspoke.
17
IRS Exhibit V.
18
As part of the promotion of BLIPS, KPMG provided a “more likely than not” opinion letter to investors, in which KPMG stated its belief it was more likely than not the IRS would accept the validity of the investment program. On March 23, 2000, Powell sent Vaughn ten pages of KPMG's opinion letter; after Vaughn had signed off on those pages, Powell provided the full opinion letter, dated December 31, 1999. Further, for an additional fee of approximately $50,000, Vaughn also received a similar opinion letter from the law firm of Brown & Wood, a firm engaged by KPMG, dated December 31, 1999. Joint Exhibit 19. However, Powell did not send Vaughn the Brown & Wood letter until May 24, 2000.
19
IRS Exhibit UUU.
20
Id., p. 255.
21
Vaughn Exhibit 24.
22
Joint Exhibit 20.
23
See also Vaughn Exhibit 27, Memorandum of Oral Advice, dated March 25, 2002, signed by Tracy Henderson, another KMPG employee, commemorating the January 2001 meeting with Powell, Koo and Vaughn. Vaughn could not remember this meeting; however, he points out the Memorandum does not contain the paragraph in the script provided to Powell on October 3, 2000, indicating such probabilities had been discussed.
24
Sherlock Deposition, pp. 54 and 67.
25
Joint Exhibit 25.
26
Joint Exhibit 26.
27
IRS Exhibit XX.
28
Vaughn Exhibit 47, IRS Announcement 2004-46, “Son of Boss Settlement Initiative.” The essence of this proposal by the IRS was to resolve the transactions described in IRS Notice 2000-44, like BLIPS, by allowing taxpayers to concede tax benefits from the transactions, including basis adjustments, and to treat their net out of pocket costs as either long term capital losses or ordinary losses. Taxpayers who participated in the initiative were required to make full payment of the liabilities under the initiative by the date the agreement with the IRS was executed.
29
Vaughn Exhibit 38, United States Senate Report entitled “U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals–Four KPMG Case Studies: FLIP, OPIS, BLIPS, and SC2”.
30
Joint Exhibit 29. The liability was the result of conclusion of the IRS that the claimed basis for Vaughn's BLIP investment was too high–the $40 million loan premium should not have been included because that obligation was taken over by Sill and never represented funds paid by Pilchuck or Vaughn. See IRS Exhibit UUU, p. 3, IRS Notice 2000-44, “Tax Avoidance Using Artificially High Basis.” As noted above, this Notice describes an example similar to the BLIPS transaction described here, and notes the taxpayer would claim a basis of the total amount contributed to the investment (in this case, $106.7 million) less the stated principal amount of the loan (in this case $66.7 million) for a basis (in this case $44 million) “even though the taxpayer has incurred no corresponding economic loss.” The Notice goes on to state the purported losses from such a transaction “do not represent bona fide losses reflecting actual economic consequences as required for purposes of [26 U.S.C.] § 165.”
31
Vaughn Exhibit 45, IRS Announcement 2004-46 p.2.
32
Unless otherwise noted, all future statutory references in the text are to Title 11 of the United States Code.
33
The Court's record reflects the IRS's tax claim arises from unpaid taxes for 1999 in the amount of $8,617,902, and for 2000 in the amount of $119,928.
34
Vaughn admitted the following key language in KPMG's engagement letter was incorrect: “Client [Vaughn] has independently determined that there is a reasonable opportunity for Client to earn a reasonable pre-tax profit from the [BLIPS] Investment Program in excess of all associated fees and costs.”
35
Specifically, Vaughn testified representatives from KPMG did not tell him KPMG's opinion letter was predicated on Vaughn's own representations about BLIPs, and that KPMG and Presidio representatives told him there was a reasonable possibility of a pre-tax profit from BLIPS. (However, as noted below, he did “sign off” on representations before receiving the final version of the KPMG opinion letter.) He further stated he did not receive the hundreds of pages of loan documents to be reviewed and signed until a few days before closing. With respect to KPMG's opinion letter, Vaughn stated he did not receive anything until March 23, 2000, when Powell sent him the first ten pages of the opinion letter and requested he “sign off” on them in order to receive the full opinion letter. See Joint Exhibit 17.
36
Joint Exhibit 17.
37
See IRS Exhibit HH, Annex A, signed by Vaughn, withdrawing Pilchuck's capital account balance from Sill and directing the purchase of Euros and shares of Adelphia stock.
38
Id., p.3, Information Sheet containing instructions for allocation of “total notional” of $40,000,000 after withdrawal of Pilchuck from Sill.
39
11 U.S.C. § 523(a)(1).
40
See In re Tudisco, 183 F.3d 133, 137 [84 AFTR 2d 99-5265] (2d Cir.1999); In re Epstein, 303 B.R. 280 [93 AFTR 2d 2004-450] (Bankr. E.D.N.Y. 2004).
41
Grogan v. Garner, 498 U.S. 279, 291 [70 AFTR 2d 92-5639] (1991).
42
Wilson v. United States, 394 B.R. 531, 540–541 [102 AFTR 2d 2008-5854] (Bankr. D. Colo. 2008), rev'd in part on other grounds, 407 B.R. 405 [103 AFTR 2d 2009-2526] (10th Cir. BAP 2009) (citing United States v. Krause (In re Krause), 386 B.R. 785, 825 [101 AFTR 2d 2008-1943] (Bankr. D. Kan. 2008) (collecting cases)). See also In reFliss , 339 B.R. 481, 486 (Bankr. N.D. Iowa 2006); In re Schlesinger, 290 B.R. 529, 536 [90 AFTR 2d 2002-7336] (Bankr. E.D. Pa. 2002).
43
Krause, 386 B.R. at 824 (citations omitted).
44
Such “warning signals” include the overly complex nature of the Deutsche Bank loan, the reliance on a “loan premium” not contributed by Vaughn to create a tax basis for the investment and KPMG's requirements for Vaughn to state, by signing a draft, that he agreed with KPMG's opinions, before KPMG would issue its actual opinion.
45
DeRosa explained a spot transaction is one which settles in two bank business days, with the last day, or “settlement day” as the day the currencies are valued. A forward transaction, by contrast, is one where the “settlement day” of the currency to be valued is beyond two days–anywhere from a week to any time in the future. A forward transaction is based on the difference of between one currency and the other, and because of differentials in interest rates, the forward rate cannot equal the spot except if the interest rates in both countries are equal to each other at that moment in time.
46
DeRosa stated eventually, however, even in this “zero sum” game, interest parity will cost money over time, eroding the original investment. Specifically, according to DeRosa, under John Maynard Keynes's theory of interest parity, there are no free transactions. The “forward” is the same as the “spot” adjusted for the interest rate differential during the term of the transaction. In other words, the “forward” amount will differ from the “spot” amount by the gap in the interest rate–otherwise, an investor could make money simply by switching investments to the highest interest currency. DeRosa stated if an investor is “shorting” a currency like the Hong Kong Dollar or the Argentine Peso, the investor will pay, implicit in the price of the “forward,” a higher interest rate than the U.S. Dollar rate, creating a “cost of carry” which eats away at the investor's position over time.
47
A “pegged” currency means the exchange rate with other currencies is fixed by a country's central bank. Some are called “soft pegs” because the government intends to keep the exchange rate fixed but could change the rate at any time. Some are “hard pegged,” which means the central bank of a country keeps on hand enough reserves of foreign currency, usually U.S. dollars, to exchange all of its currency in circulation at a fixed price, and promises to make a market continuously. Two hard pegged currencies, for purposes of this case, were the Hong Kong Dollar and the Argentine Peso.
48
Moreover, DeRosa noted the cost of leaving the investment after 60 days, even though that was what Vaughn anticipated, was high, due to breakage fees and other penalties. Further, he pointed out the other fees associated with the transaction, including $1.1 million to Presidio and $500,000 to KPMG, did not make sense because an investor who could establish an account with approximately $1 million could have made the same trades without the Sill investment scheme.
49
Mueller Deposition, p. 32, lines 19–20, and p. 36, lines 13–25.
50
United States v. Storey, 640 F.3d 739, 744 [107 AFTR 2d 2011-2267] (6th Cir. 2011). See also United States v. Jacobs, (In re Jacobs), 490 F.3d 913, 921 [100 AFTR 2d 2007-5013] (11th Cir. 2007); United States v. Fegeley (In re Fegeley), 118 F.3d 979, 983 [80 AFTR 2d 97-5268] (3rd Cir. 2000).
51
Storey, 640 F.3d at 744–745 (citations omitted).
52
Hawkins v. Franchise Tax Bd., 447 B.R. 291, 301 [107 AFTR 2d 2011-1439] (N.D. Cal. 2011) (citingJacobs , 490 F.3d at 921).
53
Id., at 301–302 (citing Jacobs, 490 F.3d at 926–27;Gardner , 360 F.3d at 560–61;Fegeley , 118 F.3d at 984; United States v. Fretz (In re Fretz), 244 F.3d 1323, 1329 [87 AFTR 2d 2001-1380]–30, Toti v. United States (In reToti) , 24 F.3d 806, 809 [73 AFTR 2d 94-2022] (6th Cir. 1994)).
54
Id., at 302.
55
IRS Exhibit KKK.
56
IRS Exhibit NNN.
57
Id., at 300; Jacobs, 490 F.3d at 921.
58
United States v Mitchell (In re Mitchell), 633 F.3d 1319, 1328 [107 AFTR 2d 2011-979] (6th Cir. 2011).
59
Dalton v. Internal Revenue Service, 77 F.3d 1297, 1302 [77 AFTR 2d 96-1487] (10th Cir. 1996) (citing Toti, 24 F.3d at 809).
60
Id., at 1307.
61
Id.
62
Id. at 1301.
63
Id., at 1301.
64
United States v. Beninati, 438 B.R. 755, 758 (D. Mass. 2010) (citations omitted). See also, Geiger v. Internal Revenue Service (In re Geiger), 408 B.R. 788, 791 [104 AFTR 2d 2009-5213] (C.D. Ill. 2009) (citations omitted).
65
Hawkins v. Franchise Tax Board (In re Hawkins), 430 B.R. 225, 235 (Bankr. N. D. Cal. 2010), aff'd., 447 B.R. 291 [107 AFTR 2d 2011-1439] (N.D. Cal. 2011) (citing Lynch v. U.S. (In re Lynch), 299 B.R. 62, 64 [92 AFTR 2d 2003-6263] (Bankr. S.D.N.Y. 2003); Jacobs, 490 F.3d at 925–27; Stamper v. United States, (In re Gardner), 360 F.3d 551, 560 [93 AFTR 2d 2004-1327]–61 (6th Cir. 2004); Wright v. United States (In re Wright), 191 B.R. 291, 293 (S.D.N.Y. 1995); Hamm v. United States (In reHamm) , 356 B.R. 263, 285–86 (Bankr. S.D. Fla. 2006)).
66
Hawkins, supra, 447 B.R. at 297.
67
See Goldman v. C.I.R., 39 F.3d 402, 408 [74 AFTR 2d 94-6923] (2nd Cir. 1994) (taxpayers “cannot reasonably rely for professional advice on someone they know to be burdened with an inherent conflict of interest.”).
Friday, December 30, 2011
Undivided interest
Estate of Axel O. Adler, et al. v. Commissioner, TC Memo 2011-28 , Code Sec(s) 2033; 2031; 2036.
ESTATE OF AXEL O. ADLER, DECEASED, ANNA AXINA ADLERBERT, ADMINISTRATOR, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: Code Sec(s): 2033; 2031; 2036
Docket: Dkt. No. 25113-08.
Date Issued: 01/31/2011.
Judge: Opinion by Morrison, J.
Tax Year(s): Date of death 6-20-2004.
Disposition: Decision for Commissioner.
HEADNOTE
1. Gross estate—valuation—fractional interest discounts—transfers with retained life estate—proof. Estate wasn't entitled to fractional interest discounts for, and instead was required to include in gross estate full fee simple value of, ranch land which decedent gratuitously deeded to children before death but in which he retained lifetime right to income and possession: given decedent's retained rights/life estate and in accord with Code Sec. 2036 , it was as if decedent retained entire interest during life and only made transfers to children at death for tax purposes. Thus, since property interests transferred to separate owners at death aren't valued separately for estate tax purposes, estate tax value of property was full/undiscounted death date FMV.
Reference(s): USTR Estate & Gift Taxes ¶20,335.11(20); 20,365.01(55) Code Sec. 2033; Code Sec. 2031; Code Sec. 2036
Syllabus
Official Tax Court Syllabus
Counsel
Benjamin Crispin Sanchez and Martin J. Tierney, for petitioner.
Trent D. Usitalo and Nicholas D. Doukas, for respondent.
MORRISON, Judge
MEMORANDUM OPINION
In a notice dated July 18, 2008, the respondent (the IRS) determined a deficiency in the federal estate tax of the Estate of Axel O. Adler (the estate). The estate and the IRS agreed to submit this case for decision under Rule 122. 1 The parties executed a stipulation of settled issues, leaving one issue to be resolved. The issue is whether the value of approximately 1,100 acres of land included in the value of the gross estate is subject to fractional-interest discounts. We find that it is not.
Background
We adopt the stipulation of facts as our findings of fact.
The decedent, Axel O. Adler (Adler), died on June 20, 2004. At the time of his death, Adler resided at 26446 Oliver Road, Carmel, California. Anna Axina Adlerbert is the administrator of the Estate of Axel O. Adler. At the time she filed the petition, Anna Axina Adlerbert resided at Jarkholmsvarden 616, 63656 Hovas, Sweden.
Before December 8, 1965, Adler owned property on Palo Colorado Road in Carmel, California. That property, known as the Rancho Aguila property, consisted of approximately 1,100 acres at the date of his death.
On December 8, 1965, Adler executed a grant deed transferring undivided one-fifth interests 2 in the Rancho Aguila property to his five children—Inna Maria Adler, Lena Kristina Bidegard, Dag Ivar Adler, Ruth Erikka Adlerbert, and Axel Jerker Adlerbert—as tenants in common. The deed, however, expressly stated that Adler “[reserved] unto himself the full use, control, income and possession of *** [the Rancho Aguila property] and every part thereof for and during *** [his] natural life”. The transfer was gratuitous; Adler received no consideration.
After the transfer, Adler continued to use the Rancho Aguila property. None of his children resided there. Nor did the children interfere with his use, possession, or enjoyment of the property. Adler paid all expenses associated with the property, including taxes, upkeep, and maintenance. Adler was not required to—and did not—pay rent to the children. Adler was not required to—and did not—seek the children's permission to alter or improve the property. [pg. 168] [pg. 168]
On August 16, 1991, daughter Inna executed a quitclaim deed 3 transferring her interest back to Adler, but neither she nor Adler recorded the deed. Adler died on June 20, 2004. The parties have stipulated that on that date, the fair market value of a fee simple interest in the entire Rancho Aguila property was $6,390,000. Because Adler and daughter Inna never recorded the 1991 quitclaim deed, litigation over her interest occurred during the probate of Adler's estate. As a result, daughter Inna executed a grant deed transferring her interest in the Rancho Aguila property to the estate in May 2005.
At issue is whether the value to include in the value of the gross estate is (i) the undiscounted value of a fee simple interest in the Rancho Aguila property or (ii) the value of several fractional interests in the Rancho Aguila property, which must be valued separately with appropriate fractional-interest discounts. As explained below, we find that no discount is appropriate.
Discussion
Section 2001(a) imposes the estate tax on the transfer of the taxable estate of a decedent. Section 2051 defines the value of the taxable estate as the value of the gross estate minus the estate-tax deductions. The value of the gross estate is “determined by including to the extent provided for in *** [sections 2031 through 2046], the value at the time of *** [the decedent's] death of all property, real or personal, tangible or intangible, wherever situated.” Sec. 2031(a).
Section 2033 includes “the value of all property to the extent of the interest therein of the decedent at the time of his death” in the value of the gross estate. Thus section 2033 includes the value of the decedent's interest in property at the time of death.
If a decedent owned a life estate, 4 section 2033 would not include its value in the value of the gross estate. A life estate has no value at the time of death. But if the decedent gratuitously transferred a remainder interest in property and retained a life estate, the value of the property would be included in the value of the gross estate by section 2036. Section 2036(a) provides:
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
Section 2036(a)(1) thus includes the value of transferred property in the value of the gross estate if three conditions 5 are met: (i) the decedent transferred an interest in the property during life, (ii) the transfer was not a sale, and (iii) the decedent retained possession or enjoyment of the property for life. 6 Sec. 20.2036-1(a), Estate Tax Regs.; see also Estate of Bongard v. Commissioner, 124 T.C. 95, 112 (2005). If a decedent gratuitously transferred a remainder interest in property and retained a life estate, the decedent transferred the property while retaining possession or enjoyment for life, and thus section 2036(a)(1) would apply.
The general purpose of section 2036 is to include the value of property in the value of the gross estate where the decedent transfers the property during life and the transfer is essentially testamentary in nature. United States v. Estate of Grace, [pg. 169] 395 U.S. 316, 320 [23 AFTR 2d 69-1954] (1969) (discussing statutory predecessor of section 2036). A testamentary transfer is a transfer made in a will. Black's Law Dictionary 1636 (9th ed. 2009). Transfers included under section 2036(a)(1) are essentially testamentary in nature because the transferor controls the disposition of the property at death but possesses and enjoys the property during life.
If section 2033 or section 2036 includes the value of property in the value of the gross estate, the amount included is the property's fair market value at the time of death (or on the alternate valuation date, if the executor so elects). Sec. 20.2031-1(b), Estate Tax Regs. Fair market value in the context of the estate tax is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Id. The standard is an objective standard, which determines fair market value by neither a forced sale price nor a price in a market “other than that in which *** [the type of property] is most commonly sold to the public”. Id.; see also Estate of Kahn v. Commissioner, 125 T.C. 227, 230-231 (2005) (discussing fair market value).
The owner of a fractional interest in property 7 often lacks the ability to control the property or to sell the interest freely. See, e.g., Estate of Amlie v. Commissioner, T.C. Memo. 2006-76 (applying fractional-interest discounts); Estate of Pillsbury v. Commissioner, T.C. Memo. 1992-425 [1992 RIA TC Memo ¶92,425] (same). To reflect the decrease in value the estate claims was caused by the fractional ownership of the Rancho Aguila property, the estate applied minority-interest and marketability discounts. 8 A minority-interest discount is due to lack of control; a marketability discount is due to lack of liquidity.
When a person dies holding a fractional interest in property, it is often appropriate to discount the value of the interest because the lack of control and the lack of liquidity decrease the property's value. Whether property should be valued as a whole or as separate fractional interests—with appropriate discounts for split ownership—depends on when the interests are separated. If ownership is split during the decedent's lifetime, the interest the decedent retained is valued separately. If the split occurs only at death, the property is valued as a whole—without a discount for split ownership. Suppose, for example, that an owner of land gives a one-half interest in the land to a child. When the owner dies holding the remaining one-half interest, that interest should be valued separately from the child's: the interests were separated during the owner's life. See Propstra v. United States, 680 F.2d 1248 [50 AFTR 2d 82-6153] (9th Cir. 1982) (before he died, the husband held a one-half community-property interest in land and his wife held the other one-half interest; the husband's interest at death was valued separately from the wife's interest). On the other hand, suppose that an owner of land continued to own the land until death, and at his death, pursuant to his will, the land was transferred to his two children. Because the owner owned the land at death, no discount would be recognized to account for the fact that the land later had multiple owners. See Ahmanson Found. v. United States, 674 F.2d 761, 768 [48 AFTR 2d 81-6317] (9th Cir. 1981) (in valuing the assets of an estate, the property valued is not the property received, and thus no discount is made for the fact that the asset will “come to rest in several hands rather than one”; to do so would invite abuse). [pg. 170] [pg. 170]
For these purposes, the ownership of the Rancho Aguila property should be considered to have been split up at Adler's death. In 1965, Adler transferred a one-fifth remainder interest to each of his five children. He retained a life estate in the property. Thus, it was as if Adler had retained the entire interest in the land during his life and transferred the property to his children at death. The two transactions are not identical, but their similarity led Congress to enact section 2036, which treats the inter vivos transfer of a remainder interest with a retained life estate as a testamentary transfer of the entire property. Section 2036 is significant because it is the Code section that primarily includes the value of the property in the value of the gross estate. 9 It is consistent with section 2036 to value the Rancho Aguila property as if the children's interests were transferred only at Adler's death. A property interest transferred to separate owners at death is not valued separately for estate tax purposes.
Of the cases the estate cites for the idea that we must value multiple interests in the Rancho Aguila property separately, the closest to being on point is Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999). In Estate of Mellinger, a wife and husband owned a block of stock as community property. Id. at 27. The husband died first and left his interest to a qualified terminable interest property trust for the lifetime benefit of his wife. Id. When the wife died, she still owned her one-half interest in the stock, the value of which was included in the value of her gross estate under section 2033. The value of the husband's interest was also included in the value of the gross estate under section 2044. We held that the interests must be valued separately and that discounts were appropriate. One reason the interests were valued separately was that at no time did the wife “possess, control, or have any power of disposition” over the interest held in the trust. Id. at 36. Unlike the wife in Estate of Mellinger, Adler controlled the Rancho Aguila property. 10 He transferred remainder interests in the property in 1965, and he retained a life estate in the property from 1965 until his death in 2004.
The parties agree that the value of the entire Rancho Aguila property is included in the value of the gross estate. The parties stipulated that the fair market value of the Rancho Aguila property on the date Adler died was $6,390,000. As discussed above, we find that no discount is appropriate because Adler controlled the disposition of the entire Rancho Aguila property, and to apply a discount in this situation would value the property according to the number of recipients. Thus the value included in the value of the gross estate is $6,390,000, the Rancho Aguila property's fair market value as of June 20, 2004, the date Adler died.
To reflect the foregoing,
Decision will be entered under Rule 155.
1
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code (Code) as in effect for the date of Axel O. Adler's death.
2
The owner of an undivided interest does not have a claim on a specific portion of the property.
3
It is unclear whether daughter Inna received consideration for the transfer. The quitclaim deed states that the transfer was “for a valuable consideration”. In the petition, the estate claimed that the conveyance was in exchange for the cancellation of daughter Inna's debt to Adler of 150,000 Swedish kronor. In the answer, the IRS denied this for lack of sufficient knowledge. The stipulation of facts does not address whether the transfer was gratuitous or for consideration.
4
We use the term “life estate” here to refer to only a life estate measured by the life of the decedent; we do not include a life estate for the life of another in the term “life estate”.
5
See also sec. 2036(c) (limiting application of sec. 2036(a) for transfers made before Mar. 4, 1931 and for transfers made after Mar. 3, 1931, but before June 7, 1932).
6
Sec. 2036(a) also applies to other situations not relevant here.
7
A “fractional interest” in property is also known as an “undivided interest”. See Black's Law Dictionary 728, 885-886 (9th ed. 2009). An undivided interest is commonly understood to be “an interest held under the same title by two or more persons” and includes interests held as tenants in common. Id. at 886.
8
On Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, Schedule A, Real Estate, the estate reported a one-fifth interest in the Rancho Aguila property subject to a “32% marketability discount and a 16% minority-interest discount”. Exhibit 2-J at 15. On Form 706, Schedule G, Transfers During Decedent's Life, the estate reported four separate one-fifth interests in the Rancho Aguila property, each subject to a “22% marketability discount and a 16% minority-interest discount”. Id. at 21-22. Form 706, Schedule A, lists real property owned by the decedent, including property to which sec. 2033 applies. Form 706, Schedule G, lists certain inter vivos transfers, including transfers to which sec. 2036 applies.
9
The estate argues that it is sec. 2033—not sec. 2036—that includes the value of the one-fifth interest that was transferred from Adler to daughter Inna in 1965 and that daughter Inna transferred (or attempted to transfer) back to Adler in 1991. Even if this is true, the other four interests should be considered to have been split from the remaining interest only at Adler's death, and therefore no discount to the value of the remaining interest should be made to account for separate ownership of the other four interests.
10
In Estate of Fontana v. Commissioner, 118 T.C. 318 (2002), we declined to interpret Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), to require separate valuation of two interests in property where the decedent controlled both interests. In Estate of Fontana v. Commissioner, supra at 318-319, the estate sought to value two blocks of stock separately; the decedent owned one block outright and the other was subject to the decedent's testamentary general power of appointment. The value of both blocks of stock was included in the value of the gross estate. Id. at 319. The value of the stock the decedent owned outright was included under sec. 2033. Id. And the value of the stock that was subject to the decedent's power of appointment was included under sec. 2041. Id. Because the decedent in Estate of Fontana controlled the disposition of the stock that was subject to the general power of appointment (unlike the property in the qualified terminable interest property trust in Estate of Mellinger), we aggregated it with the stock the decedent owned outright for valuation purposes. Id. at 322.
ESTATE OF AXEL O. ADLER, DECEASED, ANNA AXINA ADLERBERT, ADMINISTRATOR, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: Code Sec(s): 2033; 2031; 2036
Docket: Dkt. No. 25113-08.
Date Issued: 01/31/2011.
Judge: Opinion by Morrison, J.
Tax Year(s): Date of death 6-20-2004.
Disposition: Decision for Commissioner.
HEADNOTE
1. Gross estate—valuation—fractional interest discounts—transfers with retained life estate—proof. Estate wasn't entitled to fractional interest discounts for, and instead was required to include in gross estate full fee simple value of, ranch land which decedent gratuitously deeded to children before death but in which he retained lifetime right to income and possession: given decedent's retained rights/life estate and in accord with Code Sec. 2036 , it was as if decedent retained entire interest during life and only made transfers to children at death for tax purposes. Thus, since property interests transferred to separate owners at death aren't valued separately for estate tax purposes, estate tax value of property was full/undiscounted death date FMV.
Reference(s): USTR Estate & Gift Taxes ¶20,335.11(20); 20,365.01(55) Code Sec. 2033; Code Sec. 2031; Code Sec. 2036
Syllabus
Official Tax Court Syllabus
Counsel
Benjamin Crispin Sanchez and Martin J. Tierney, for petitioner.
Trent D. Usitalo and Nicholas D. Doukas, for respondent.
MORRISON, Judge
MEMORANDUM OPINION
In a notice dated July 18, 2008, the respondent (the IRS) determined a deficiency in the federal estate tax of the Estate of Axel O. Adler (the estate). The estate and the IRS agreed to submit this case for decision under Rule 122. 1 The parties executed a stipulation of settled issues, leaving one issue to be resolved. The issue is whether the value of approximately 1,100 acres of land included in the value of the gross estate is subject to fractional-interest discounts. We find that it is not.
Background
We adopt the stipulation of facts as our findings of fact.
The decedent, Axel O. Adler (Adler), died on June 20, 2004. At the time of his death, Adler resided at 26446 Oliver Road, Carmel, California. Anna Axina Adlerbert is the administrator of the Estate of Axel O. Adler. At the time she filed the petition, Anna Axina Adlerbert resided at Jarkholmsvarden 616, 63656 Hovas, Sweden.
Before December 8, 1965, Adler owned property on Palo Colorado Road in Carmel, California. That property, known as the Rancho Aguila property, consisted of approximately 1,100 acres at the date of his death.
On December 8, 1965, Adler executed a grant deed transferring undivided one-fifth interests 2 in the Rancho Aguila property to his five children—Inna Maria Adler, Lena Kristina Bidegard, Dag Ivar Adler, Ruth Erikka Adlerbert, and Axel Jerker Adlerbert—as tenants in common. The deed, however, expressly stated that Adler “[reserved] unto himself the full use, control, income and possession of *** [the Rancho Aguila property] and every part thereof for and during *** [his] natural life”. The transfer was gratuitous; Adler received no consideration.
After the transfer, Adler continued to use the Rancho Aguila property. None of his children resided there. Nor did the children interfere with his use, possession, or enjoyment of the property. Adler paid all expenses associated with the property, including taxes, upkeep, and maintenance. Adler was not required to—and did not—pay rent to the children. Adler was not required to—and did not—seek the children's permission to alter or improve the property. [pg. 168] [pg. 168]
On August 16, 1991, daughter Inna executed a quitclaim deed 3 transferring her interest back to Adler, but neither she nor Adler recorded the deed. Adler died on June 20, 2004. The parties have stipulated that on that date, the fair market value of a fee simple interest in the entire Rancho Aguila property was $6,390,000. Because Adler and daughter Inna never recorded the 1991 quitclaim deed, litigation over her interest occurred during the probate of Adler's estate. As a result, daughter Inna executed a grant deed transferring her interest in the Rancho Aguila property to the estate in May 2005.
At issue is whether the value to include in the value of the gross estate is (i) the undiscounted value of a fee simple interest in the Rancho Aguila property or (ii) the value of several fractional interests in the Rancho Aguila property, which must be valued separately with appropriate fractional-interest discounts. As explained below, we find that no discount is appropriate.
Discussion
Section 2001(a) imposes the estate tax on the transfer of the taxable estate of a decedent. Section 2051 defines the value of the taxable estate as the value of the gross estate minus the estate-tax deductions. The value of the gross estate is “determined by including to the extent provided for in *** [sections 2031 through 2046], the value at the time of *** [the decedent's] death of all property, real or personal, tangible or intangible, wherever situated.” Sec. 2031(a).
Section 2033 includes “the value of all property to the extent of the interest therein of the decedent at the time of his death” in the value of the gross estate. Thus section 2033 includes the value of the decedent's interest in property at the time of death.
If a decedent owned a life estate, 4 section 2033 would not include its value in the value of the gross estate. A life estate has no value at the time of death. But if the decedent gratuitously transferred a remainder interest in property and retained a life estate, the value of the property would be included in the value of the gross estate by section 2036. Section 2036(a) provides:
The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death—
(1) the possession or enjoyment of, or the right to the income from, the property, or
(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
Section 2036(a)(1) thus includes the value of transferred property in the value of the gross estate if three conditions 5 are met: (i) the decedent transferred an interest in the property during life, (ii) the transfer was not a sale, and (iii) the decedent retained possession or enjoyment of the property for life. 6 Sec. 20.2036-1(a), Estate Tax Regs.; see also Estate of Bongard v. Commissioner, 124 T.C. 95, 112 (2005). If a decedent gratuitously transferred a remainder interest in property and retained a life estate, the decedent transferred the property while retaining possession or enjoyment for life, and thus section 2036(a)(1) would apply.
The general purpose of section 2036 is to include the value of property in the value of the gross estate where the decedent transfers the property during life and the transfer is essentially testamentary in nature. United States v. Estate of Grace, [pg. 169] 395 U.S. 316, 320 [23 AFTR 2d 69-1954] (1969) (discussing statutory predecessor of section 2036). A testamentary transfer is a transfer made in a will. Black's Law Dictionary 1636 (9th ed. 2009). Transfers included under section 2036(a)(1) are essentially testamentary in nature because the transferor controls the disposition of the property at death but possesses and enjoys the property during life.
If section 2033 or section 2036 includes the value of property in the value of the gross estate, the amount included is the property's fair market value at the time of death (or on the alternate valuation date, if the executor so elects). Sec. 20.2031-1(b), Estate Tax Regs. Fair market value in the context of the estate tax is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Id. The standard is an objective standard, which determines fair market value by neither a forced sale price nor a price in a market “other than that in which *** [the type of property] is most commonly sold to the public”. Id.; see also Estate of Kahn v. Commissioner, 125 T.C. 227, 230-231 (2005) (discussing fair market value).
The owner of a fractional interest in property 7 often lacks the ability to control the property or to sell the interest freely. See, e.g., Estate of Amlie v. Commissioner, T.C. Memo. 2006-76 (applying fractional-interest discounts); Estate of Pillsbury v. Commissioner, T.C. Memo. 1992-425 [1992 RIA TC Memo ¶92,425] (same). To reflect the decrease in value the estate claims was caused by the fractional ownership of the Rancho Aguila property, the estate applied minority-interest and marketability discounts. 8 A minority-interest discount is due to lack of control; a marketability discount is due to lack of liquidity.
When a person dies holding a fractional interest in property, it is often appropriate to discount the value of the interest because the lack of control and the lack of liquidity decrease the property's value. Whether property should be valued as a whole or as separate fractional interests—with appropriate discounts for split ownership—depends on when the interests are separated. If ownership is split during the decedent's lifetime, the interest the decedent retained is valued separately. If the split occurs only at death, the property is valued as a whole—without a discount for split ownership. Suppose, for example, that an owner of land gives a one-half interest in the land to a child. When the owner dies holding the remaining one-half interest, that interest should be valued separately from the child's: the interests were separated during the owner's life. See Propstra v. United States, 680 F.2d 1248 [50 AFTR 2d 82-6153] (9th Cir. 1982) (before he died, the husband held a one-half community-property interest in land and his wife held the other one-half interest; the husband's interest at death was valued separately from the wife's interest). On the other hand, suppose that an owner of land continued to own the land until death, and at his death, pursuant to his will, the land was transferred to his two children. Because the owner owned the land at death, no discount would be recognized to account for the fact that the land later had multiple owners. See Ahmanson Found. v. United States, 674 F.2d 761, 768 [48 AFTR 2d 81-6317] (9th Cir. 1981) (in valuing the assets of an estate, the property valued is not the property received, and thus no discount is made for the fact that the asset will “come to rest in several hands rather than one”; to do so would invite abuse). [pg. 170] [pg. 170]
For these purposes, the ownership of the Rancho Aguila property should be considered to have been split up at Adler's death. In 1965, Adler transferred a one-fifth remainder interest to each of his five children. He retained a life estate in the property. Thus, it was as if Adler had retained the entire interest in the land during his life and transferred the property to his children at death. The two transactions are not identical, but their similarity led Congress to enact section 2036, which treats the inter vivos transfer of a remainder interest with a retained life estate as a testamentary transfer of the entire property. Section 2036 is significant because it is the Code section that primarily includes the value of the property in the value of the gross estate. 9 It is consistent with section 2036 to value the Rancho Aguila property as if the children's interests were transferred only at Adler's death. A property interest transferred to separate owners at death is not valued separately for estate tax purposes.
Of the cases the estate cites for the idea that we must value multiple interests in the Rancho Aguila property separately, the closest to being on point is Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999). In Estate of Mellinger, a wife and husband owned a block of stock as community property. Id. at 27. The husband died first and left his interest to a qualified terminable interest property trust for the lifetime benefit of his wife. Id. When the wife died, she still owned her one-half interest in the stock, the value of which was included in the value of her gross estate under section 2033. The value of the husband's interest was also included in the value of the gross estate under section 2044. We held that the interests must be valued separately and that discounts were appropriate. One reason the interests were valued separately was that at no time did the wife “possess, control, or have any power of disposition” over the interest held in the trust. Id. at 36. Unlike the wife in Estate of Mellinger, Adler controlled the Rancho Aguila property. 10 He transferred remainder interests in the property in 1965, and he retained a life estate in the property from 1965 until his death in 2004.
The parties agree that the value of the entire Rancho Aguila property is included in the value of the gross estate. The parties stipulated that the fair market value of the Rancho Aguila property on the date Adler died was $6,390,000. As discussed above, we find that no discount is appropriate because Adler controlled the disposition of the entire Rancho Aguila property, and to apply a discount in this situation would value the property according to the number of recipients. Thus the value included in the value of the gross estate is $6,390,000, the Rancho Aguila property's fair market value as of June 20, 2004, the date Adler died.
To reflect the foregoing,
Decision will be entered under Rule 155.
1
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code (Code) as in effect for the date of Axel O. Adler's death.
2
The owner of an undivided interest does not have a claim on a specific portion of the property.
3
It is unclear whether daughter Inna received consideration for the transfer. The quitclaim deed states that the transfer was “for a valuable consideration”. In the petition, the estate claimed that the conveyance was in exchange for the cancellation of daughter Inna's debt to Adler of 150,000 Swedish kronor. In the answer, the IRS denied this for lack of sufficient knowledge. The stipulation of facts does not address whether the transfer was gratuitous or for consideration.
4
We use the term “life estate” here to refer to only a life estate measured by the life of the decedent; we do not include a life estate for the life of another in the term “life estate”.
5
See also sec. 2036(c) (limiting application of sec. 2036(a) for transfers made before Mar. 4, 1931 and for transfers made after Mar. 3, 1931, but before June 7, 1932).
6
Sec. 2036(a) also applies to other situations not relevant here.
7
A “fractional interest” in property is also known as an “undivided interest”. See Black's Law Dictionary 728, 885-886 (9th ed. 2009). An undivided interest is commonly understood to be “an interest held under the same title by two or more persons” and includes interests held as tenants in common. Id. at 886.
8
On Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, Schedule A, Real Estate, the estate reported a one-fifth interest in the Rancho Aguila property subject to a “32% marketability discount and a 16% minority-interest discount”. Exhibit 2-J at 15. On Form 706, Schedule G, Transfers During Decedent's Life, the estate reported four separate one-fifth interests in the Rancho Aguila property, each subject to a “22% marketability discount and a 16% minority-interest discount”. Id. at 21-22. Form 706, Schedule A, lists real property owned by the decedent, including property to which sec. 2033 applies. Form 706, Schedule G, lists certain inter vivos transfers, including transfers to which sec. 2036 applies.
9
The estate argues that it is sec. 2033—not sec. 2036—that includes the value of the one-fifth interest that was transferred from Adler to daughter Inna in 1965 and that daughter Inna transferred (or attempted to transfer) back to Adler in 1991. Even if this is true, the other four interests should be considered to have been split from the remaining interest only at Adler's death, and therefore no discount to the value of the remaining interest should be made to account for separate ownership of the other four interests.
10
In Estate of Fontana v. Commissioner, 118 T.C. 318 (2002), we declined to interpret Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), to require separate valuation of two interests in property where the decedent controlled both interests. In Estate of Fontana v. Commissioner, supra at 318-319, the estate sought to value two blocks of stock separately; the decedent owned one block outright and the other was subject to the decedent's testamentary general power of appointment. The value of both blocks of stock was included in the value of the gross estate. Id. at 319. The value of the stock the decedent owned outright was included under sec. 2033. Id. And the value of the stock that was subject to the decedent's power of appointment was included under sec. 2041. Id. Because the decedent in Estate of Fontana controlled the disposition of the stock that was subject to the general power of appointment (unlike the property in the qualified terminable interest property trust in Estate of Mellinger), we aggregated it with the stock the decedent owned outright for valuation purposes. Id. at 322.
Thursday, December 29, 2011
Mexican Innocent Spouse
Alavaro N. Gallego v. Commissioner, TC Summary Opinion 2011-139
ALVARO N. GALLEGO, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s):
Docket: Docket No. 12958-10S.
Date Issued: 12/28/2011
Judge: Opinion by PANUTHOS
Reference(s): Code Sec. 6015
Syllabus
Official Tax Court Syllabus
PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b),THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.
Brian C. Power, Marissa K. Rensen, and Thomas C. Durham, for petitioner.
Counsel
Erika B. Cormier, for respondent.
Opinion by PANUTHOS
This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect when the petition was filed. 1 Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.
This proceeding was commenced under section 6015 for review of respondent's determination that petitioner is not entitled to relief from joint and several liability with respect to underpayments of Federal income tax reported on his Form 1040, U.S. Individual Income Tax Return, filed for 2003, 2 2004, and 2005.
Background
Some of the facts have been stipulated and are so found. The stipulation of facts, the supplemental stipulation of facts, and the attached exhibits are incorporated herein by this reference. Petitioner resided in Massachusetts at the time the petition was filed.
Petitioner was born in Colombia and later moved to Mexico, where he studied and practiced medicine. Petitioner married Xochitl Lagunes Viveros Gallego (Viveros) in Mexico in 1989, and they had three daughters. Petitioner and Viveros moved to the United States with their children in 1996. Petitioner's medical credentials were not recognized, and he was unable to work as a doctor in the United States.
Petitioner worked at various jobs before starting a business as a sole proprietorship called Norman's Cleaning. Petitioner was primarily responsible for cleaning clients' properties, and Viveros was responsible for maintaining the business' financial records and office.
Petitioner and Viveros provided financial documents to a return preparer each February in order to have their Federal income tax return prepared. In years before 2003, petitioner and Viveros customarily signed the return at the preparer's office, and Viveros wrote a check and mailed the Federal income tax return and any payment due to the Internal Revenue Service (IRS). Petitioner and Viveros separated sometime after February 2006. Viveros remained in the marital home with the children, and petitioner lived with various family members.
During the summer of 2006 Viveros informed petitioner that she had not paid the Federal income tax liabilities for 2003 or 2004 and that she had not been paying other personal and business expenses since the separation. 3 At some point, petitioner and Viveros agreed to sell their house to pay debts. On August 28, 2006, they received $39,059 from the sale of the house. On the following day they deposited $41,228.55 into their joint checking account at Workers' Credit Union. Between August 29 and November 19, 2006, Viveros withdrew approximately $17,000 of the proceeds to pay various expenses, including clothing, food, entertainment, travel, and lodging. On November 20, 2006, Viveros withdrew $21,700 from the couple's joint checking account and moved to Mexico with the three children.
After Viveros left with the children, petitioner learned that a joint 2005 Federal income tax return had not been filed. Soon after learning this, petitioner took steps to have a 2005 return prepared and filed. 4 Petitioner did not communicate with Viveros about the preparation or filing of this return as a joint return, and Viveros did not sign the 2005 Federal income tax Viveros' 2005 income was not reported on the return. 5 return. On or about March 26, 2007, petitioner filed the 2005 Federal income tax return, reporting a balance due. 6
Petitioner filed for divorce from Viveros in October 2008. The divorce was finalized in 2009. The court in that proceeding found that Viveros withdrew $21,700 without petitioner's knowledge and ordered Viveros to repay petitioner $10,950.75. The judgment of divorce nisi stated that petitioner and Viveros share the tax debt equally. 7 Petitioner claims in his amended petition that he is entitled to a refund of the $11,679.29 he has paid toward the 2004 liability. 8
On June 9, 2009, petitioner filed Form 8857, Request for Innocent Spouse Relief, requesting relief from joint and several liability for taxable years 2003, 9 2004, and 2005. Attached to the Form 8857 was the complaint for divorce dated October 17, 2008, in which petitioner filed suit for divorce against Viveros in Massachusetts.
Discussion
Generally, married taxpayers may elect to file a joint Federal income tax return. Sec. 6013(a). After making the election, each spouse is jointly and severally liable for the entire tax due for that year. Sec. 6013(d)(3); Butler v. Commissioner, 114 T.C. 276, 282 (2000). In certain circumstances, however, a spouse who has filed a joint return may seek relief from joint and several liability under procedures set forth in section 6015. Sec. 6015(a).
Under section 6015(a) a spouse may seek relief from joint and several liability under section 6015(b) or, if eligible, may allocate liability according to provisions set forth in section 6015(c). If a taxpayer does not qualify for relief under either section 6015(b) or (c), 10 the taxpayer may seek equitable relief under section 6015(f). The Secretary has discretion to grant equitable relief to a spouse who filed a joint return with an unpaid tax liability or a deficiency. Sec. 6015(f)(1); sec. 1.6015-4(a), Income Tax Regs. Except as otherwise provided in section 6015, the taxpayer bears the burden of proving that he or she is entitled to section 6015 relief. Rule 142(a); Alt v. Commissioner, 119 T.C. 306, 311 (2002), affd. 101 Fed. Appx. 34 [93 AFTR 2d 2004-2561] (6th Cir. 2004). Both the scope and standard of our review in cases requesting equitable relief from joint and several income Porter v. Commissioner, 132 T.C. 203 tax liability are de novo. (2009).
As directed by section 6015(f), the Commissioner has prescribed procedures for determining whether a spouse qualifies for relief under subsection (f). The applicable provisions are found in Rev. Proc. 2003-61, 2003-2 C.B. 296.
The revenue procedure sets forth seven threshold requirements before the Commissioner will consider a request for relief under section 6015(f): (i) The requesting spouse filed a joint return for the taxable year for which he or she seeks relief; (ii) relief is not available to the requesting spouse under section 6015(b) or (c); (iii) the requesting spouse applies for relief no later than 2 years after the date of the IRS' first collection activity after July 22, 1998, with respect to the requesting spouse; (iv) no assets were transferred between the spouses as part of a fraudulent scheme by the spouses; (v) the nonrequesting spouse did not transfer disqualified assets to the requesting spouse; (vi) the requesting spouse did not file or fail to file the return with fraudulent intent; and (vii) absent enumerated exceptions, the income tax liability from which the requesting spouse seeks relief is attributable to an item of the individual with whom the requesting spouse filed the joint return. Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297. We employ these factors when reviewing the Commissioner's denial. Washington v. Commissioner, 120 T.C. 137, 147-152 (2003); see also Schultz v. Commissioner, T.C. Memo. 2010-233 [TC Memo 2010-233]. Respondent asserts that petitioner fails requirements (iii) and (vii), above, for taxable year 2004 and that petitioner fails requirements (i), (iii), and (vii), above, for taxable year 2005. Two-Year Period of Limitations Respondent initially asserted that the claim for relief under section 6015(f) was untimely. After trial but before release of this opinion, respondent conceded that the 2-year period of limitations under section 6015(f) does not apply. See Notice 2011-70, 2011-32 I.R.B. 135. In Notice 2011-70, supra, the IRS stated that effective July 25, 2011, it would consider requests for equitable relief under section 6015(f) if the period of limitations on collection provided by section 6502 remained open. See Notice 2011-70, supra; see also sec. 6015(f). Because respondent conceded that the 2-year limitation no longer applies, we need not consider respondent's argument concerning that threshold requirement. Income Attributable to Requesting Spouse Respondent asserts that petitioner fails threshold requirement (vii) for taxable years 2004 and 2005. See Rev. Proc. 2003-61, sec. 4.01. Generally, a requesting spouse cannot satisfy this requirement where the income tax liability from which the requesting spouse seeks relief is attributable to income earned by the requesting spouse. There are exceptions to this general rule, and petitioner asserts that he qualifies for one of the exceptions.
Rev. Proc. 2003-61, sec. 4.01(7)(c), 2003-2 C.B. at 297, provides an exception to the seventh requirement:
If the requesting spouse did not know, and had no reason to know, that funds intended for the payment of tax were misappropriated by the nonrequesting spouse for the nonrequesting spouse's benefit, the Service will consider granting equitable relief although the underpayment may be attributable in part or in full to an item of the requesting spouse. *** Furthermore, the IRS will consider relief “only to the extent that the funds intended for the payment of tax were taken by the nonrequesting spouse.” Id. Taxable Year 2004
Petitioner alleges that Viveros misappropriated the funds from the sale of their house and that those funds were intended to pay the tax liabilities for 2003 and 2004 and to pay various unpaid personal and business expenses.
Petitioner and Viveros shared a joint checking account at Workers' Credit Union. A bank account consists of a promise to pay by the bank to the depositors. Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 21 (1995). Under Massachusetts law, “shares and deposits may be received and held in the name of a member [of the credit union] with one or more persons as joint tenants *** and any part or all of the shares or deposits and dividends or interest represented by joint accounts may be withdrawn, assigned or transferred by any of the individual parties.” Mass. Ann. Laws ch. 171, sec. 39 (LexisNexis 2009). Misappropriation is the “application of another's property or money dishonestly to one's own use.” Black's Law Dictionary 1013 (7th ed. 1999). Since each joint account holder may withdraw any or all of the funds held in the account, we do not conclude that Viveros' withdrawal of the funds from this account constituted a misappropriation.
The funds from the sale of the house were deposited by petitioner and Viveros in their joint account and remained in the account from August to November 2006. Petitioner had access to the funds in the joint account. The record reflects that petitioner did not pay or attempt to pay the tax liabilities for 2003 or 2004, even after the funds from the sale of the house were deposited into the joint account. 11 Petitioner has also failed to establish that the proceeds from the sale of the house were specifically earmarked for the payment of the 2003 and 2004 tax liabilities and not to pay marital debts generally. Also, it is not at all clear that any funds withdrawn by Viveros were for her benefit rather than the benefit of the three children.
Petitioner has failed to meet the exception for the seventh threshold requirement and is not eligible for innocent spouse relief with respect to taxable year 2004. Since petitioner has failed to satisfy the threshold requirements, we need not consider the terms of the divorce decree as a factor weighing for or against relief. Taxable Year 2005
Respondent asserts that petitioner fails to satisfy the threshold requirements for taxable year 2005 in that Viveros did not file a joint return. Petitioner asserts that because he and Viveros had initially prepared and signed a joint Federal income tax return for 2005, it was their intent to file jointly although the initially prepared joint Federal income tax return was not actually filed. Petitioner has not satisfied the Court that the parties intended to file a joint income tax return for 2005.
In general, a joint return must be signed by both spouses. Sec. 1.6013-1(a)(2), Income Tax Regs. In circumstances where both spouses intend to file a joint return, the failure of one spouse to sign the return will not preclude its treatment as a Estate of Campbell v. Commissioner, 56 T.C. 1, 12 joint return. (1971). Whether the nonsigning spouse intended to file a joint Id.; Federbush v. Commissioner, 34 return is a question of fact. T.C. 740, 755-758 (1960), affd. 325 F.2d 1 [12 AFTR 2d 6069] (2d Cir. 1963); Heim v. Commissioner, 27 T.C. 270, 273-274 (1956), affd. 251 F.2d 44 [1 AFTR 2d 660] (8th Cir. 1958).
The Court may look to whether the taxpayers customarily filed joint returns to determine whether a return was intended to Estate of Campbell v. Commissioner, supra at be a joint return. 12. Although not conclusive, the inclusion of a spouse's income on a return is regarded as a factor supporting a conclusion that the return was intended as a joint return. Federbush v. Commissioner, supra at 756.
Petitioner conceded that Viveros did not sign the 2005 Federal income tax return. Petitioner and Viveros customarily filed joint Federal income tax returns. The record reflects that Viveros was generally responsible for the family and business finances. Assuming that a 2005 return was prepared and executed by Viveros in February 2006, she apparently chose not to file a joint return. When petitioner had the 2005 return prepared, he was aware that Viveros was living in Mexico; and he could have contacted her via telephone or mail to ask her about filing the return jointly. 12 Petitioner, however, did not contact Viveros, nor is there anything in the record indicating she agreed or consented to file a joint return for taxable year 2005, and Viveros' income for 2005 was not included on the filed return.
We conclude that petitioner and Viveros did not file a joint Federal income tax return for 2005; and thus petitioner is not entitled to relief under section 6015. See Raymond v. Commissioner, 119 T.C. 191, 197 (2002).
Even if we were to conclude that the 2005 return was a joint return, petitioner would in any event be unsuccessful in his request for innocent spouse relief for taxable year 2005 because the tax he requests relief from is attributable to his income and he does not qualify for an exception (as previously discussed with respect to 2004). See Rev. Proc. 2003-61, sec. 4.01(a)(7). Additionally, petitioner does not assert, and we do not find, that Viveros misappropriated funds intended for the payment of the 2005 tax liability.
Conclusion
Petitioner is not entitled to relief from joint and several liability for 2004 because he has not shown Viveros misappropriated funds intended for the payment of the 2004 Federal income tax liability. Additionally, petitioner is not entitled to relief from joint and several liability for 2005 because petitioner did not file a joint Federal income tax return with Viveros.
To reflect the foregoing, Decision will be entered for respondent.
1
Unless otherwise indicated, subsequent section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2
The parties agree that petitioner's claim for relief for the 2003 taxable year is no longer in issue.
3
On May 29, 2006, the IRS began collection action against petitioner by issuing a Final Notice - Notice of Intent to Levy and Notice of Your Right to a Hearing for the 2003 and 2004 joint liability.
4
Petitioner testified that a 2005 Form 1040 was prepared and executed by both himself and Viveros in February 2006. The record is unclear regarding whether the 2005 return was actually prepared and executed as petitioner suggested. Petitioner testified that after Viveros left for Mexico he gathered some of the documents previously used to prepare the 2005 return and took them to the same individual who had prepared the couple's returns in prior years. There is no independent or documentary evidence to support the assertion that a 2005 return had been previously prepared and executed. If the 2005 return had been prepared in February 2006, it would seem likely that the preparer would have had a copy of the return or some data related to its preparation.
5
Although Viveros worked at Norman's Cleaning, there is no independent evidence such as a Form W-2, Wage and Tax Statement, or Form 1099-MISC, Miscellaneous Income, in the record which reflect that Viveros had income for the years in issue. Petitioner's counsel asserts that Viveros was paid a salary in 2005.
6
Petitioner paid this amount in installments beginning on June 9, 2007. Although petitioner acknowledged that Viveros did not sign the return, the IRS accepted and filed the return as a joint return. Executed returns for 2004 and 2005 are not a part of the record.
7
The judgment of divorce nisi listed the Federal and State tax debt at the time of divorce as $17,388.04.
8
The parties have agreed that if petitioner is entitled to sec. 6015(f) relief, he is entitled to a refund of $11,679.29.
9
As previously indicated, the parties have agreed that taxable year 2003 is not at issue.
10
Petitioner requested relief under sec. 6015(f). We are satisfied that he is ineligible for relief under sec. 6015(b) or (c). Petitioner does not qualify for relief under sec. 6015(b) because there is no understatement of tax for the years in issue. See sec. 6015(b)(1)(B). Petitioner does not qualify for relief under sec. 6015(c) for 2004 because he requested relief more than 2 years from the beginning of IRS collection activities. See sec. 6015(c)(3)(B). Petitioner is also ineligible for relief for 2005 for the reasons discussed more fully below.
11
As previously indicated, petitioner did not learn that the 2005 tax liability had not been paid until after Viveros moved to Mexico in November 2006.
12
Petitioner had Viveros' address and a family member's telephone number in Mexico that he could have used to communicate with her.
ALVARO N. GALLEGO, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s):
Docket: Docket No. 12958-10S.
Date Issued: 12/28/2011
Judge: Opinion by PANUTHOS
Reference(s): Code Sec. 6015
Syllabus
Official Tax Court Syllabus
PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b),THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.
Brian C. Power, Marissa K. Rensen, and Thomas C. Durham, for petitioner.
Counsel
Erika B. Cormier, for respondent.
Opinion by PANUTHOS
This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect when the petition was filed. 1 Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.
This proceeding was commenced under section 6015 for review of respondent's determination that petitioner is not entitled to relief from joint and several liability with respect to underpayments of Federal income tax reported on his Form 1040, U.S. Individual Income Tax Return, filed for 2003, 2 2004, and 2005.
Background
Some of the facts have been stipulated and are so found. The stipulation of facts, the supplemental stipulation of facts, and the attached exhibits are incorporated herein by this reference. Petitioner resided in Massachusetts at the time the petition was filed.
Petitioner was born in Colombia and later moved to Mexico, where he studied and practiced medicine. Petitioner married Xochitl Lagunes Viveros Gallego (Viveros) in Mexico in 1989, and they had three daughters. Petitioner and Viveros moved to the United States with their children in 1996. Petitioner's medical credentials were not recognized, and he was unable to work as a doctor in the United States.
Petitioner worked at various jobs before starting a business as a sole proprietorship called Norman's Cleaning. Petitioner was primarily responsible for cleaning clients' properties, and Viveros was responsible for maintaining the business' financial records and office.
Petitioner and Viveros provided financial documents to a return preparer each February in order to have their Federal income tax return prepared. In years before 2003, petitioner and Viveros customarily signed the return at the preparer's office, and Viveros wrote a check and mailed the Federal income tax return and any payment due to the Internal Revenue Service (IRS). Petitioner and Viveros separated sometime after February 2006. Viveros remained in the marital home with the children, and petitioner lived with various family members.
During the summer of 2006 Viveros informed petitioner that she had not paid the Federal income tax liabilities for 2003 or 2004 and that she had not been paying other personal and business expenses since the separation. 3 At some point, petitioner and Viveros agreed to sell their house to pay debts. On August 28, 2006, they received $39,059 from the sale of the house. On the following day they deposited $41,228.55 into their joint checking account at Workers' Credit Union. Between August 29 and November 19, 2006, Viveros withdrew approximately $17,000 of the proceeds to pay various expenses, including clothing, food, entertainment, travel, and lodging. On November 20, 2006, Viveros withdrew $21,700 from the couple's joint checking account and moved to Mexico with the three children.
After Viveros left with the children, petitioner learned that a joint 2005 Federal income tax return had not been filed. Soon after learning this, petitioner took steps to have a 2005 return prepared and filed. 4 Petitioner did not communicate with Viveros about the preparation or filing of this return as a joint return, and Viveros did not sign the 2005 Federal income tax Viveros' 2005 income was not reported on the return. 5 return. On or about March 26, 2007, petitioner filed the 2005 Federal income tax return, reporting a balance due. 6
Petitioner filed for divorce from Viveros in October 2008. The divorce was finalized in 2009. The court in that proceeding found that Viveros withdrew $21,700 without petitioner's knowledge and ordered Viveros to repay petitioner $10,950.75. The judgment of divorce nisi stated that petitioner and Viveros share the tax debt equally. 7 Petitioner claims in his amended petition that he is entitled to a refund of the $11,679.29 he has paid toward the 2004 liability. 8
On June 9, 2009, petitioner filed Form 8857, Request for Innocent Spouse Relief, requesting relief from joint and several liability for taxable years 2003, 9 2004, and 2005. Attached to the Form 8857 was the complaint for divorce dated October 17, 2008, in which petitioner filed suit for divorce against Viveros in Massachusetts.
Discussion
Generally, married taxpayers may elect to file a joint Federal income tax return. Sec. 6013(a). After making the election, each spouse is jointly and severally liable for the entire tax due for that year. Sec. 6013(d)(3); Butler v. Commissioner, 114 T.C. 276, 282 (2000). In certain circumstances, however, a spouse who has filed a joint return may seek relief from joint and several liability under procedures set forth in section 6015. Sec. 6015(a).
Under section 6015(a) a spouse may seek relief from joint and several liability under section 6015(b) or, if eligible, may allocate liability according to provisions set forth in section 6015(c). If a taxpayer does not qualify for relief under either section 6015(b) or (c), 10 the taxpayer may seek equitable relief under section 6015(f). The Secretary has discretion to grant equitable relief to a spouse who filed a joint return with an unpaid tax liability or a deficiency. Sec. 6015(f)(1); sec. 1.6015-4(a), Income Tax Regs. Except as otherwise provided in section 6015, the taxpayer bears the burden of proving that he or she is entitled to section 6015 relief. Rule 142(a); Alt v. Commissioner, 119 T.C. 306, 311 (2002), affd. 101 Fed. Appx. 34 [93 AFTR 2d 2004-2561] (6th Cir. 2004). Both the scope and standard of our review in cases requesting equitable relief from joint and several income Porter v. Commissioner, 132 T.C. 203 tax liability are de novo. (2009).
As directed by section 6015(f), the Commissioner has prescribed procedures for determining whether a spouse qualifies for relief under subsection (f). The applicable provisions are found in Rev. Proc. 2003-61, 2003-2 C.B. 296.
The revenue procedure sets forth seven threshold requirements before the Commissioner will consider a request for relief under section 6015(f): (i) The requesting spouse filed a joint return for the taxable year for which he or she seeks relief; (ii) relief is not available to the requesting spouse under section 6015(b) or (c); (iii) the requesting spouse applies for relief no later than 2 years after the date of the IRS' first collection activity after July 22, 1998, with respect to the requesting spouse; (iv) no assets were transferred between the spouses as part of a fraudulent scheme by the spouses; (v) the nonrequesting spouse did not transfer disqualified assets to the requesting spouse; (vi) the requesting spouse did not file or fail to file the return with fraudulent intent; and (vii) absent enumerated exceptions, the income tax liability from which the requesting spouse seeks relief is attributable to an item of the individual with whom the requesting spouse filed the joint return. Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297. We employ these factors when reviewing the Commissioner's denial. Washington v. Commissioner, 120 T.C. 137, 147-152 (2003); see also Schultz v. Commissioner, T.C. Memo. 2010-233 [TC Memo 2010-233]. Respondent asserts that petitioner fails requirements (iii) and (vii), above, for taxable year 2004 and that petitioner fails requirements (i), (iii), and (vii), above, for taxable year 2005. Two-Year Period of Limitations Respondent initially asserted that the claim for relief under section 6015(f) was untimely. After trial but before release of this opinion, respondent conceded that the 2-year period of limitations under section 6015(f) does not apply. See Notice 2011-70, 2011-32 I.R.B. 135. In Notice 2011-70, supra, the IRS stated that effective July 25, 2011, it would consider requests for equitable relief under section 6015(f) if the period of limitations on collection provided by section 6502 remained open. See Notice 2011-70, supra; see also sec. 6015(f). Because respondent conceded that the 2-year limitation no longer applies, we need not consider respondent's argument concerning that threshold requirement. Income Attributable to Requesting Spouse Respondent asserts that petitioner fails threshold requirement (vii) for taxable years 2004 and 2005. See Rev. Proc. 2003-61, sec. 4.01. Generally, a requesting spouse cannot satisfy this requirement where the income tax liability from which the requesting spouse seeks relief is attributable to income earned by the requesting spouse. There are exceptions to this general rule, and petitioner asserts that he qualifies for one of the exceptions.
Rev. Proc. 2003-61, sec. 4.01(7)(c), 2003-2 C.B. at 297, provides an exception to the seventh requirement:
If the requesting spouse did not know, and had no reason to know, that funds intended for the payment of tax were misappropriated by the nonrequesting spouse for the nonrequesting spouse's benefit, the Service will consider granting equitable relief although the underpayment may be attributable in part or in full to an item of the requesting spouse. *** Furthermore, the IRS will consider relief “only to the extent that the funds intended for the payment of tax were taken by the nonrequesting spouse.” Id. Taxable Year 2004
Petitioner alleges that Viveros misappropriated the funds from the sale of their house and that those funds were intended to pay the tax liabilities for 2003 and 2004 and to pay various unpaid personal and business expenses.
Petitioner and Viveros shared a joint checking account at Workers' Credit Union. A bank account consists of a promise to pay by the bank to the depositors. Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 21 (1995). Under Massachusetts law, “shares and deposits may be received and held in the name of a member [of the credit union] with one or more persons as joint tenants *** and any part or all of the shares or deposits and dividends or interest represented by joint accounts may be withdrawn, assigned or transferred by any of the individual parties.” Mass. Ann. Laws ch. 171, sec. 39 (LexisNexis 2009). Misappropriation is the “application of another's property or money dishonestly to one's own use.” Black's Law Dictionary 1013 (7th ed. 1999). Since each joint account holder may withdraw any or all of the funds held in the account, we do not conclude that Viveros' withdrawal of the funds from this account constituted a misappropriation.
The funds from the sale of the house were deposited by petitioner and Viveros in their joint account and remained in the account from August to November 2006. Petitioner had access to the funds in the joint account. The record reflects that petitioner did not pay or attempt to pay the tax liabilities for 2003 or 2004, even after the funds from the sale of the house were deposited into the joint account. 11 Petitioner has also failed to establish that the proceeds from the sale of the house were specifically earmarked for the payment of the 2003 and 2004 tax liabilities and not to pay marital debts generally. Also, it is not at all clear that any funds withdrawn by Viveros were for her benefit rather than the benefit of the three children.
Petitioner has failed to meet the exception for the seventh threshold requirement and is not eligible for innocent spouse relief with respect to taxable year 2004. Since petitioner has failed to satisfy the threshold requirements, we need not consider the terms of the divorce decree as a factor weighing for or against relief. Taxable Year 2005
Respondent asserts that petitioner fails to satisfy the threshold requirements for taxable year 2005 in that Viveros did not file a joint return. Petitioner asserts that because he and Viveros had initially prepared and signed a joint Federal income tax return for 2005, it was their intent to file jointly although the initially prepared joint Federal income tax return was not actually filed. Petitioner has not satisfied the Court that the parties intended to file a joint income tax return for 2005.
In general, a joint return must be signed by both spouses. Sec. 1.6013-1(a)(2), Income Tax Regs. In circumstances where both spouses intend to file a joint return, the failure of one spouse to sign the return will not preclude its treatment as a Estate of Campbell v. Commissioner, 56 T.C. 1, 12 joint return. (1971). Whether the nonsigning spouse intended to file a joint Id.; Federbush v. Commissioner, 34 return is a question of fact. T.C. 740, 755-758 (1960), affd. 325 F.2d 1 [12 AFTR 2d 6069] (2d Cir. 1963); Heim v. Commissioner, 27 T.C. 270, 273-274 (1956), affd. 251 F.2d 44 [1 AFTR 2d 660] (8th Cir. 1958).
The Court may look to whether the taxpayers customarily filed joint returns to determine whether a return was intended to Estate of Campbell v. Commissioner, supra at be a joint return. 12. Although not conclusive, the inclusion of a spouse's income on a return is regarded as a factor supporting a conclusion that the return was intended as a joint return. Federbush v. Commissioner, supra at 756.
Petitioner conceded that Viveros did not sign the 2005 Federal income tax return. Petitioner and Viveros customarily filed joint Federal income tax returns. The record reflects that Viveros was generally responsible for the family and business finances. Assuming that a 2005 return was prepared and executed by Viveros in February 2006, she apparently chose not to file a joint return. When petitioner had the 2005 return prepared, he was aware that Viveros was living in Mexico; and he could have contacted her via telephone or mail to ask her about filing the return jointly. 12 Petitioner, however, did not contact Viveros, nor is there anything in the record indicating she agreed or consented to file a joint return for taxable year 2005, and Viveros' income for 2005 was not included on the filed return.
We conclude that petitioner and Viveros did not file a joint Federal income tax return for 2005; and thus petitioner is not entitled to relief under section 6015. See Raymond v. Commissioner, 119 T.C. 191, 197 (2002).
Even if we were to conclude that the 2005 return was a joint return, petitioner would in any event be unsuccessful in his request for innocent spouse relief for taxable year 2005 because the tax he requests relief from is attributable to his income and he does not qualify for an exception (as previously discussed with respect to 2004). See Rev. Proc. 2003-61, sec. 4.01(a)(7). Additionally, petitioner does not assert, and we do not find, that Viveros misappropriated funds intended for the payment of the 2005 tax liability.
Conclusion
Petitioner is not entitled to relief from joint and several liability for 2004 because he has not shown Viveros misappropriated funds intended for the payment of the 2004 Federal income tax liability. Additionally, petitioner is not entitled to relief from joint and several liability for 2005 because petitioner did not file a joint Federal income tax return with Viveros.
To reflect the foregoing, Decision will be entered for respondent.
1
Unless otherwise indicated, subsequent section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2
The parties agree that petitioner's claim for relief for the 2003 taxable year is no longer in issue.
3
On May 29, 2006, the IRS began collection action against petitioner by issuing a Final Notice - Notice of Intent to Levy and Notice of Your Right to a Hearing for the 2003 and 2004 joint liability.
4
Petitioner testified that a 2005 Form 1040 was prepared and executed by both himself and Viveros in February 2006. The record is unclear regarding whether the 2005 return was actually prepared and executed as petitioner suggested. Petitioner testified that after Viveros left for Mexico he gathered some of the documents previously used to prepare the 2005 return and took them to the same individual who had prepared the couple's returns in prior years. There is no independent or documentary evidence to support the assertion that a 2005 return had been previously prepared and executed. If the 2005 return had been prepared in February 2006, it would seem likely that the preparer would have had a copy of the return or some data related to its preparation.
5
Although Viveros worked at Norman's Cleaning, there is no independent evidence such as a Form W-2, Wage and Tax Statement, or Form 1099-MISC, Miscellaneous Income, in the record which reflect that Viveros had income for the years in issue. Petitioner's counsel asserts that Viveros was paid a salary in 2005.
6
Petitioner paid this amount in installments beginning on June 9, 2007. Although petitioner acknowledged that Viveros did not sign the return, the IRS accepted and filed the return as a joint return. Executed returns for 2004 and 2005 are not a part of the record.
7
The judgment of divorce nisi listed the Federal and State tax debt at the time of divorce as $17,388.04.
8
The parties have agreed that if petitioner is entitled to sec. 6015(f) relief, he is entitled to a refund of $11,679.29.
9
As previously indicated, the parties have agreed that taxable year 2003 is not at issue.
10
Petitioner requested relief under sec. 6015(f). We are satisfied that he is ineligible for relief under sec. 6015(b) or (c). Petitioner does not qualify for relief under sec. 6015(b) because there is no understatement of tax for the years in issue. See sec. 6015(b)(1)(B). Petitioner does not qualify for relief under sec. 6015(c) for 2004 because he requested relief more than 2 years from the beginning of IRS collection activities. See sec. 6015(c)(3)(B). Petitioner is also ineligible for relief for 2005 for the reasons discussed more fully below.
11
As previously indicated, petitioner did not learn that the 2005 tax liability had not been paid until after Viveros moved to Mexico in November 2006.
12
Petitioner had Viveros' address and a family member's telephone number in Mexico that he could have used to communicate with her.
Wednesday, December 28, 2011
Dude Ranch
Ray Feldman, et al. v. Commissioner, TC Memo 2011-297 , Code Sec(s) 6901.
RAY FELDMAN, TRANSFEREE, ET AL., 1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 6901
Docket: Dkt. Nos. 26737-08, 27386-08, 27387-08, 27388-08, 27389-08, 27390-08, 27391-08, 27392-08, 27393-08.
Date Issued: 12/27/2011.
Judge: Opinion by SWIFT
HEADNOTE
XX.
Reference(s): Code Sec. 6901
Syllabus
Official Tax Court Syllabus
Docket Nos. 26737-08, 27386-08, Filed December 27, 2011. 27387-08, 27388-08, 27389-08, 27390-08, 27391-08, 27392-08, 27393-08.
Counsel
Robert Edward Dallman, for petitioners.
George W. Bezold, for respondent.
Opinion by SWIFT
MEMORANDUM FINDINGS OF FACT AND OPINION
In these consolidated cases respondent determined transferee liability against petitioners relating to an agreed and unpaid $593,979 Federal income tax liability of Woodside Ranch Resort, Inc. (Woodside Ranch), for 2002, plus an addition to tax, penalties, and interest relating to Woodside Ranch's unpaid 2002 Federal income tax liability. The amount of each petitioner's respective transferee liability as calculated by respondent is as follows: Ray Feldman—$542,514; Sharon L. Coklan—$117,013; Jill K. Reynolds—$42,550; Jan Reynolds— $212,751; Carrie Donahue—$95,738; Rhea Dugan—$41,274; Emma McClintock—$95,738; Robert Donahue—$21,275; and Richard Feldmann—$309,765.
The transferee liability determined against each petitioner is based largely on respondent's conclusion that a purported July 18, 2002, sale 2 by petitioners of shares of stock in Woodside Ranch constituted a sham transaction not dissimilar from the abusive tax-avoidance transaction described in Notice 2001-16, 2001-1 C.B. 730 (referred to as an intermediary transaction). “purchase”, and similar words generally is for convenience and is not intended to and does not constitute a finding that the referenced transactions constituted a valid transaction to be recognized for Federal income tax purposes.
The issue for decision is whether petitioners are liable under section 6901 as transferees for their respective shares of Woodside Ranch's $593,979 Federal income tax liability for 2002, plus the addition to tax, penalties, and interest. 3
FINDINGS OF FACT
Many of the facts have been stipulated and are so found. At the time of filing their separate petitions, petitioners resided in Wisconsin, Florida, and Arizona. Trial was held on November 17, 2010, in Milwaukee, Wisconsin.
In the 1920s Woodside Ranch was established and began business as a Wisconsin corporation with its place of business in Mauston, Wisconsin.
From its incorporation until May of 2002 Woodside Ranch owned and operated a dude ranch resort offering, among other activities, horseback riding, swimming, boating, hiking, fishing, snow skiing, and snowmobiling, along with accommodations.
The historic shareholders in Woodside Ranch were William Feldman and his five children. In 2002, at the time of the transactions before us, Woodside Ranch stock was owned by 10 shareholders, 9 of whom were grandchildren or great-grandchildren of William Feldman. They are petitioners herein. The 10th shareholder, Lucille Nichols, daughter of William Feldman, has died, and her estate is not involved in these consolidated cases.
Just before the 2002 transactions involved in these cases, the officers of Woodside Ranch were: President—decedent Lucille Nichols; vice president—Richard Feldmann; secretary—Ray Feldman; and treasurer—Carrie Donahue. These same individuals also were the directors of Woodside Ranch.
On average, each year 6 to 20 accidents resulting in injuries to customers occurred at Woodside Ranch. Only a few of these accidents resulted in formal claims against Woodside Ranch. The injuries that occurred at Woodside Ranch typically were not serious, and personal injury claims were satisfied by Woodside Ranch with in-kind compensation (e.g., free return visits to the ranch for the injured customers and their families) plus the payment by Woodside Ranch of medical expenses. After the transactions described below that occurred in the spring and summer of 2002, only one personal injury claim against Woodside Ranch resulted in a payment to an injured customer. That payment was for $50,000.
Although the sporting and other activities at Woodside Ranch involved some risk of personal injury for Woodside Ranch customers, over the years Woodside Ranch did not obtain comprehensive personal injury insurance covering potential injuries. Such comprehensive insurance was available but expensive, and management of Woodside Ranch chose not to purchase it. Woodside Ranch did carry several insurance policies that covered some activities at the ranch. 4 As stated, for many years including 2002 Woodside Ranch management was unwilling to pay the high cost of comprehensive liability insurance covering participant sports activities. Sale of Woodside Ranch's Assets In the late 1990s and early 2000s the owners and management of Woodside Ranch faced significant challenges to the continued operation of the ranch: Increased competition from Wisconsin casinos and water parks; aging of the Woodside Ranch shareholders and directors; and lack of interest on the part of the shareholders and the Feldman next generation in continued operation of the ranch. As a result, the shareholders of Woodside Ranch began a search for a buyer of either their stock in Woodside Ranch or of the assets of Woodside Ranch.
The shareholders were interested in minimizing the tax liabilities associated with a sale of their interests in Woodside Ranch. A corporate asset sale would trigger significant Federal and State corporate income tax liabilities. 5
In the fall of 2001 negotiations began with an individual named Damon Zumwalt (Zumwalt) for the sale of Woodside Ranch, with the expectation on both sides that commercial operation of the dude ranch would be continued by Zumwalt. A stock sale was proposed to Zumwalt, who “just laughed and chuckled and said, `not on your life, it's got to be an asset sale'.”
On May 17, 2002, after several months of negotiations, the operating assets and business of Woodside Ranch were sold to Woodside Ranch, LLC (WRLLC), for $2.6 million in cash (hereinafter often referred to as the asset sale or the Zumwalt asset sale). Zumwalt was the sole owner and sole member of WRLLC. On this asset sale, the net cash proceeds received by Woodside Ranch were $2,301,089.
In a June 5, 2002, memorandum to the Woodside Ranch shareholders, petitioner Ray Feldman referred to the above estimated taxes as posing a “dilemma” for the shareholders. Also, Woodside Ranch management and shareholders were aware that under Wisconsin law they might be able to limit their individual liability relating to potential personal injury claims of customers arising from ranch activities if the sale of Woodside Ranch took the form of a stock sale with the new owners of the Woodside Ranch stock assuming the liabilities of Woodside Ranch, including risks relating to potential personal injury claims. 6
The total combined Federal and State income tax liability that Woodside Ranch incurred on the asset sale was approximately $750,000, of which the officers, directors, and shareholders of Woodside Ranch at all relevant times were aware.
After the asset sale to Zumwalt, Woodside Ranch had no operating assets and ceased to engage in any meaningful business activity. Efforts To Avoid Payment of Tax Liabilities In the early spring of 2002 Fred Farris (Farris), an accountant and financial adviser to Woodside Ranch and to some of the individual shareholders, introduced the Woodside Ranch officers, directors, and shareholders to MidCoast Credit Corp. and to MidCoast Acquisition Corp. (collectively MidCoast). MidCoast was owned directly or indirectly 50 percent by Michael Bernstein and 50 percent by Honora Shapiro.
Representatives of MidCoast claimed to have expertise in tax matters and provided to the Woodside Ranch officers promotional materials which outlined a potential tax-avoidance transaction as an alternative to a liquidation of Woodside Ranch.
Under the transaction presented by the MidCoast representatives, the shareholders of Woodside Ranch allegedly would be relieved of a significant portion, if not all, of Woodside Ranch's combined Federal and State income tax liability of approximately $750,000 relating to the Zumwalt asset sale.
On June 11, 2002, in spite of the MidCoast promotional materials that had been received, the Woodside Ranch finance committee, consisting of petitioners Carrie Donahue, Ray Feldman and Richard Feldmann, met and adopted a resolution recommending that a plan of liquidation for Woodside Ranch be adopted.
However, the Woodside Ranch board of directors did not adopt the recommended plan of liquidation, and the Woodside Ranch directors chose instead to pursue the alternative tax-avoidance transaction proposed by MidCoast mentioned above and described more specifically below.
As reflected in written notations of petitioner Ray Feldman of a meeting that apparently occurred later in the day on June 11, 2002, the MidCoast representatives explained that under the MidCoast proposal MidCoast would purchase bad debts from entities unrelated to target corporations (such as Woodside Ranch) and would use the bad debts to offset or eliminate unpaid tax liabilities of the newly acquired target corporations. The MidCoast representatives explained that the “Income comes in tax free by using NOL”, and “So *** [you] create *** [a] loss— lower deferred tax liability”. (Emphasis added.) On June 17, 2002, MidCoast representatives explained over the phone to Woodside Ranch officers that if Woodside Ranch was not liquidated and if the cash Woodside Ranch received on the Zumwalt asset sale was not distributed directly to the shareholders, but instead the shareholders agreed to sell to MidCoast their Woodside Ranch stock, MidCoast would pay to the MidCoast shareholders a “premium' of approximately $200,000 to 250,000” for their stock (hereinafter sometimes referred to as the MidCoast premium).
The MidCoast premium that the Woodside Ranch shareholders would receive was to be calculated as a percentage (between 25 and 33 percent) of the approximate combined Federal and State corporate income tax liability Woodside Ranch had incurred as a result of the Zumwalt asset sale. Notations reflecting the MidCoast representations explain: “The exact figure for the premium would be set on a percentage formula based upon the amount of State and Federal tax owed as a result of sale of Woodside assets to Damon Zumwalt and Woodside Ranch, LLC.”
Representatives of MidCoast repeatedly explained to the Woodside Ranch officers that if the Woodside Ranch stock was sold to MidCoast or to a MidCoast-related entity, MidCoast or its related entity would obtain bad debt losses from other companies and use those losses to offset or eliminate the tax liabilities of Woodside Ranch.
The transaction proposed by the representatives of MidCoast was also referred to by the MidCoast representatives as a “no- cost liquidation”. (Emphasis added.) In other words, instead of directly liquidating Woodside Ranch and distributing to the Woodside Ranch shareholders the cash proceeds from the Zumwalt asset sale (less the combined Federal and State tax liability that would have been paid), the MidCoast proposal was designed so that the cash, in effect, still could be “liquidated” or transferred to the Woodside Ranch individual shareholders, but indirectly and via a few additional steps, as follows: A purported or nominal sale of the Woodside Ranch stock to MidCoast; a transfer by MidCoast to the Woodside Ranch individual shareholders of the cash that would have been distributed to the shareholders on a direct liquidation of Woodside Ranch (i.e., the net proceeds available from Woodside Ranch for a liquidating distribution plus a “premium”—one-third of the taxes owed); and MidCoast would avoid paying the tax liabilities the Woodside Ranch shareholders would have had to pay on a direct liquidation. All this allegedly was to be made possible by MidCoast's use of bad debt losses from other companies to offset the reportable Woodside Ranch gain on the Zumwalt asset sale.
On June 17, 2002, Woodside Ranch's finance committee met and adopted a resolution to pursue further with the shareholders the sale of Woodside Ranch's stock to MidCoast as proposed in the MidCoast promotional materials.
As reflected in minutes of a June 17, 2002, Woodside Ranch finance committee meeting, the amount MidCoast would pay the Woodside Ranch shareholders for 100 percent of the outstanding Woodside Ranch stock would not be based on the value of the Woodside Ranch stock. (Such a valuation would have included the approximate $1.8 million in cash that Woodside Ranch had on hand from the Zumwalt sale.) Rather, the minutes state that the amount to be paid would be based on the premium or a percentage (approximately 33 percent) of the taxes due on the Zumwalt sale. The minutes state as follows: [T]he sale of 100% of the stock of Woodside Ranch Resorts, Inc., shareholders to MidCoast Investments, Inc. in exchange for a “premium” of approximately $200,000 to $250,000. The exact figure or total amount of the payment for the premium would be set on a percentage formula based upon the amount of State and Federal tax owed as a result of sale of Woodside assets *** . As described in the above minutes, the proposal from MidCoast to pay approximately $250,000 for 100 percent of the Woodside Ranch stock was not tied to the value of Woodside Ranch stock or to the $1.8 million in cash that Woodside Ranch had on hand, but on a split of Woodside Ranch's tax liabilities intended to go unpaid or be offset via the use of net operating losses (NOLs). In the above minutes, no mention is made of the cash Woodside Ranch held from the Zumwalt asset sale.
The minutes of the June 17, 2002, finance committee meeting also state that, upon a purchase by MidCoast, Woodside Ranch would become part of *** [MidCoast's] staple of companies that they are supervising for the purpose of utilizing tax losses which they acquired by buying credit card companies bad debts and losses to offset against profitable “C Corps” who have a situation like Woodside's wherein a large tax *** [liability exists] *** .
The obvious and only benefit to MidCoast and its owners was that they would end up with cash in their pockets equal to two- thirds of the amount of Woodside Ranch's unpaid tax liabilities.
During the weeks that the Woodside Ranch representatives were in discussion with the MidCoast representatives, Woodside Ranch representatives made a number of phone calls and undertook to find out information about MidCoast. However, we are not convinced, and in our opinion the credible evidence in these cases does not establish, that the Woodside Ranch shareholders and their representatives undertook a sufficiently in-depth and thorough due diligence investigation of MidCoast.
On June 18, 2002, MidCoast sent a letter of intent to Woodside Ranch in which MidCoast represented that—on the basis of 30 percent of the Woodside Ranch estimated $750,000 combined Federal and State tax liability—the Woodside Ranch shareholders together would receive approximately $210,000 more if the nominal stock sale to MidCoast was used, thereby converting the liquidation into the referred-to “no-cost” liquidation. The following comparison chart was included in the letter of intent to estimate roughly the promised benefits of the MidCoast transaction:
Shareholders
Sell Stock of Company to Shareholders MidCoast [The Liquidate Company “No Cost”
Liquidation] w/out MidCoast Asset Sales Proceeds $2,600,000 $2,600,000 Less: Federal & State Income Taxes (747,704) (747,704) Less: RE Commission (117,000) (117,000) Less: Title Insurance (2,000) (2,000) Less: Notes Payable (318,400) (318,400) (8,000) Less: Misc. Adjustments (8,000) Net Proceeds Available to Shareholders 1,406,896 N/A
Plus: MidCoast Premium to Shareholders N/A 224,311
MidCoast Stock Purchase Price [or “Net Proceeds Available to Shareholders”] N/A 1,631,207
On June 19, 2002, petitioner Ray Feldman sent a letter to the other Woodside Ranch shareholders discussing, among other things, MidCoast's proposal. Specifically, petitioner Ray Feldman noted:
The assets *** [were] sold by the deed and bill of sale on May 17th to [WRLLC] which of course is owned by
Damon Zumwalt. Therefore, the corporation Woodside Ranch Resort, Inc. is basically an “empty shell” but which consists of the cash at the time of sale of Two Million Two Hundred Seventy Six Thousand eighty-eight Dollars and fifty-six cents. *** MidCoast promises *** to pay Woodside's taxes because the corporation would not be liquidated but instead be kept alive as a going concern as part of the MidCoast organization. This deal is profitable for MidCoast because MidCoast purchases large amounts of defaulted and delinquent credit card amounts from the major credit card companies *** and carries forward such losses to offset against the purchase of “profitable” corporations such as Woodside. On the basis of the above evidence we have summarized (and contrary to some testimony and documentary evidence in these cases), it is absolutely clear that all individuals involved with Woodside Ranch and MidCoast were aware that MidCoast and its representatives had no intention of ever paying the tax liabilities of Woodside Ranch and also that the source of the approximately $225,000 MidCoast premium to be received by the Woodside Ranch shareholders was to come from the unpaid tax liability.
On June 27, 2002, a limited liability company was formed under the name of Woodsedge, LLC (Woodsedge), with the Woodside Ranch shareholders as its sole members, each having the same ownership percentage in Woodsedge as they had in Woodside Ranch.
On July 11, 2002, petitioners Ray Feldman and Richard Feldmann met with MidCoast representatives and others to discuss further the terms of the proposed purchase of the Woodside Ranch stock by MidCoast, referred to as a share purchase agreement (SPA). During that meeting, petitioners raised a question about their exposure to transferee liability relating to Woodside Ranch's tax liabilities.
On July 18, 2002, for reasons not clear in the trial record, Woodside Ranch redeemed 154 of the outstanding shares of Woodside Ranch stock and distributed therefor to its shareholders $300,326 in cash and other assets (the redemption proceeds). The parties explain that the fair market value of the redemption proceeds was later reduced to $293,728, and the total redemption proceeds were assigned and transferred by the Woodside Ranch shareholders to Woodsedge.
After the above partial redemption and moments before the effective date of the stock sale to MidCoast, Woodside Ranch had $1,835,209 in cash on hand from the Zumwalt asset sale and an approximate combined Federal and State income tax liability of $750,000.
Also on July 18, 2002, the Woodside Ranch shareholders and MidCoast entered into the SPA. Under the SPA, the stated purchase price to MidCoast for the Woodside Ranch stock was “equal to (a) the amount of Cash-on-Hand, less (b) $492,139.20”. The $492,139.20 represented a percentage (roughly 70 percent) of the estimated “Deferred Tax Liabilities” of approximately $750,000.
Still on July 18, 2002, in anticipation of the closing of the SPA, two escrow agreements were executed: The first by MidCoast, Woodside Ranch, the Woodside Ranch shareholders, and the law firm of Foley & Lardner (Foley) (hereinafter referred to as the sellers' escrow agreement); the second by MidCoast, Honora Shapiro (Shapiro), Shapiro's attorney, and Foley (hereinafter referred to as purchasers' escrow agreement).
Under both escrow agreements Foley was to act as escrow agent and all funds involved in the stock sale were to be wired into and out of the same trust account of the Foley law firm (the trust account).
On July 18, 2002, the following steps were taken: (1) $1,835,209 (Woodside Ranch's remaining cash on hand from the Zumwalt asset sale and after the $300,326 cash redemption) was transferred into the trust account; (2) $1.4 million from Shapiro was transferred into the trust account purporting to represent a loan from Shapiro to MidCoast allegedly to fund the MidCoast stock purchase; 7
(3) the purported sale to MidCoast by the Woodside Ranch shareholders of their remaining Woodside Ranch stock closed; “loan” was evidenced by a promissory note, nor that Shapiro received any security or collateral relating thereto. (4) $1,344,452 (viz., the $1,835,209 cash less the $492,139 portion of the combined Federal and State tax liability to be retained by MidCoast) (hereinafter sometimes referred to as the Woodside Cash) 8 was transferred from the trust account into an account of Woodsedge in favor of petitioners and which amount included the approximate $225,000 MidCoast premium; (5) $1.4 million was transferred back to Shapiro in return of the purported loan Shapiro had made to MidCoast earlier that same day (see (2) above); and (6) $38,000 was transferred out of the trust account to Foley for legal and escrow fees. 9
Section 7.1 of the SPA states that the above cash transfers were to be treated as occurring simultaneously. The schedule below highlights the reality that the above cash transfers occurred on the same day and within minutes or hours of each other:
Event
July 18, 2002 12:09 p.m. $1,835,209 Woodside Ranch cash transferred into the Foley trust account; 1:34 p.m. $1.4 million cash purportedly lent from Shapiro to MidCoast transferred into the Foley trust account; 3:35 p.m. $1,344,451 cash transferred out of the Foley trust account into an account of Woodsedge in favor of petitioners; 3:36 p.m. $1.4 million cash transferred out of the trust account back to Shapiro.
Per the sellers' escrow agreement, both the $1,344,451 (which petitioners received out of escrow on the purported sale of their stock to MidCoast) and the $452,728.84 (which MidCoast received) were to be paid, and they were paid from the sellers' escrow fund into which was deposited the $1,835,209 proceeds from the asset sale. In the sellers' escrow agreement, no express mention is made of any other funds being deposited into escrow to be transferred to the sellers. We quote from the express language of the sellers' escrow agreement:
The Escrow Agent acknowledges receipt of the aggregate amount of *** $1,835,209.08 (such amount, less distributions therefrom in accordance with this Agreement, being referred to herein as the “Escrow Fund”) from *** [Woodside Ranch]. *** The Escrow Agent shall immediately on the Closing Date *** pay over to (A) Woodsedge on behalf of the *** [petitioners] from the Escrow Fund $1,344,451.52 by wire transfer of immediately available funds to a bank account of *** [petitioners'] designation set forth in the Instructions; (B) *** [Woodside Ranch] from the Escrow Fund $452,728.84 by wire transfer of immediately available funds to a bank account of
* * * [Woodside Ranch's] designation set forth in the Instructions.
Per the purchaser's escrow agreement, the purported $1.4 million loan from Shapiro was not to be disbursed until the $1,835,209 proceeds of the Woodside Ranch asset sale were placed into the escrow fund, and only then was: $1,344,351 to be disbursed to Woodsedge on behalf of the Woodside Ranch shareholders; $452,728.84 to be disbursed to Midcoast; and $1.4 million to be “immediately” returned to Shapiro without interest. The closing statement shows $1.4 million coming from Shapiro and going back to Shapiro as part of the very same closing transaction.
The $1.4 million from Shapiro came into escrow only momentarily and went right back to Shapiro without ever serving a legitimate, economic purpose in this transaction. Were it a legitimate loan, the $1.4 million would have been outstanding for a period of time and would have had some business purpose. Interest would have been charged. There would have been a written promissory note. The $1.4 million from Shapiro constitutes a ruse, a recycling, a sham.
Within 4 days after the SPA closed, the $452,729 balance in the trust account was transferred out of the trust account into a SunTrust bank account in the name of Woodside Ranch, which by that point in time was controlled by MidCoast.
On or about July 22, 2002, April 2003, and August 8, 2005, each of the individual Woodside Ranch shareholders received from Woodsedge his or her respective share of the $293,728 redemption proceeds and of the $1,344,451 cash that passed through the Foley trust account as described above.
Included in the SPA was a representation by the shareholders of Woodside Ranch that, as of the time of the SPA, Woodside Ranch had no liabilities, direct or contingent, other than the combined Federal and State tax liability.
Included in the SPA was a guarantee and release in favor of petitioners to the effect that, as between petitioners and MidCoast, the maximum amount MidCoast could seek from petitioners relating to personal injury claims made by customers of Woodside Ranch was equal to the $224,311 MidCoast premium (i.e., to the portion of the taxes that were to go unpaid and that were to be retained by petitioners). 10
Also, the SPA contained a provision prohibiting MidCoast from liquidating or dissolving Woodside Ranch within 4 years of the July 18, 2002, closing of the stock sale. 11
Woodside Ranch After the Closing of the Purported Stock Sale After the purported stock sale to MidCoast, MidCoast was the nominal sole shareholder of Woodside Ranch. Woodside Ranch had $452,729 cash on hand, a combined Federal and State tax liability of approximately $750,000, and no operating assets. Woodside Ranch was rendered insolvent as a result of the payment by it of the redemption proceeds, the payment of the Woodside cash to the Woodside Ranch shareholders, and the return to Shapiro of his $1.4 million.
After the above transactions with MidCoast, Woodside Ranch had no paid employees and no income (other than nominal interest income). However, MidCoast charged Woodside Ranch a “professional service fee” of $250,000, and from August to December 2002 MidCoast charged Woodside Ranch $30,000 per month as a management fee, even though there were essentially no assets to manage. Woodside Ranch's SunTrust account records show withdrawals of $300,000 and $142,000 on July 19 and 22, 2002, respectively. As a result of these withdrawals, Woodside Ranch was unable to pay the July or August 2002 management fees it nominally owed MidCoast.
An amount of $1,181,249 was entered on the books of Woodside Ranch as a loan due from MidCoast to Woodside Ranch. This purported loan receivable in favor of Woodside Ranch apparently was based on the treatment of the $1.4 million in cash that, on July 18, 2002, was returned out of the Foley trust account to Shapiro. Woodside Ranch and MidCoast treated part (i.e., $1,181,249) of the $1.4 million returned to Shapiro as if it had been returned to Shapiro not by MidCoast, but by Woodside Ranch and that MidCoast somehow owed Woodside Ranch $1,181,249.
In December of 2003 MidCoast purportedly sold all of the stock of Woodside Ranch to Wilder Capital Holdings, LLC (Wilder), for no cash and for the “assumption” by Wilder of MidCoast's purported $1,181,249 loan obligation to Woodside Ranch.
Wilder made no payment on this purported loan assumption, and within 1 month, by January 29, 2004, the purported $1,181,249 loan and a promissory note of Wilder's relating thereto were marked “paid”. 12
On September 12, 2003, Woodside Ranch's 2002 Federal corporate income tax return was filed showing a tax due of $454,292, all relating to the Zumwalt asset sale. By that time, Woodside Ranch, of course, had no funds, and Woodside Ranch's Federal income tax liability was not paid with the filing of the return.
On February 22, 2005, Woodside Ranch's 2003 Federal corporate income tax return was filed claiming a net operating loss (NOL). This claimed NOL was carried back to 2002 and thereby reduced Woodside Ranch's reported 2002 Federal income tax liability to zero.
Woodside Ranch was administratively dissolved on August 13, 2009.
On audit, respondent disallowed all but $5,432 of the 2003 NOL claimed by Woodside Ranch on the grounds that the NOL was based on sham loans and was part of an illegal distressed asset/debt (DAD) tax shelter. Petitioners have stipulated that this DAD tax shelter was illegal, that the claimed 2003 NOL was not allowable, and that respondent properly disallowed the NOL carryback to 2002. 13
On September 11, 2006, respondent sent to Woodside Ranch a notice of deficiency setting forth respondent's determination of Woodside Ranch's $594,000 Federal income tax deficiency for 2002 plus an estimated tax penalty under section 6654, delinquency additions to tax under section 6651(a)(2) and (3), and an accuracy-related penalty under section 6662(b)(1). Woodside Ranch did not file a petition in this Court challenging the notice of deficiency, nor did Woodside Ranch file a complaint in any other court relating to its 2002 Federal income tax liability.
Petitioners took no actions to ensure that the Woodside Ranch Federal income tax liability triggered by the Zumwalt asset sale would be paid 14 and, as stated, it remains unpaid. 15
Respondent investigated whether Woodside Ranch had any available assets from which to collect Woodside Ranch's unpaid 2002 Federal income tax liability and determined that it had none.
On September 15, 2008, respondent sent notices of transferee liability to petitioners, each notice identifying Woodside Ranch as the transferor with an unpaid Federal income tax liability of approximately $594,000 plus additions to tax, penalties, and 14
Sec. 2.11 of the SPA provided that All Taxes due and payable by the Company on or prior to the Closing Date, including without limitation those which are called for by the Tax Returns, or heretofore claimed to be due by any taxing authority from the Company, have been paid, except for the Deferred Tax Liability, which liability is assumed by the Purchasers hereunder. Sec. 2.9 of the SPA defines “Deferred Tax Liability” and apparently limits it to $703,056. 15
It should be noted that the Woodside Ranch $153,725 Wisconsin corporate income tax liability for 2002 was paid by MidCoast when MidCoast representatives learned (apparently to their surprise) that Wisconsin law did not permit NOL deductions to be carried back and to offset prior year State corporate income tax liabilities. interest for a total of $1,057,216. The transferee notices indicated the total amount each petitioner received in the stock redemption and purported stock sale and calculated each petitioner's individual transferee liability accordingly.
An attachment to each notice of transferee liability stated in relevant part:
It is determined that the transaction in which shareholders of Woodside Ranch Resort, Inc. purportedly *** sold stock of Woodside Ranch Resort, Inc. to MidCoast Acquisitions Corporation and MidCoast Credit Corporation on July 18, 2002 is not respected for tax purposes. This transaction is substantially similar to an Intermediary transaction shelter described in notice 2001-16, 2001-1 C.B. 730 and Notice 2008-20, 2008-6 I.R.B. 406. It is determined that, in substance, Woodside Ranch Resort, Inc. ceased business activity on July 18, 2002, and that the allocation set forth in Exhibit 1 [showing petitioners' share of the deemed transferred assets] is attributable to you in liquidation or distribution of assets of Woodside Ranch Resort, Inc. on that date. 16
OPINION
In determining whether petitioners are liable under section 6901 as transferees for Woodside Ranch's unpaid Federal income tax liability, we first consider whether the July 18, 2002, purported stock sale between petitioners and MidCoast is, for Federal income tax purposes, to be recognized as such or is to be treated as a sham. Economic Substance or Sham Taxpayers generally are free to structure their business transactions as they wish, even if motivated in part by tax Gregory v. Helvering, 293 U.S. 465 [14 AFTR 1191] reduction considerations. (1935); Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 196 (1983), affd. on this issue 752 F.2d 89 [55 AFTR 2d 85-580] (4th Cir. 1985).
However, a transaction which lacks economic purpose and substance other than sought-after tax avoidance may be treated as a sham and disregarded for Federal income tax purposes. Frank Lyon Co. v. United States, 435 U.S. 561 [41 AFTR 2d 78-1142] (1978); Rice's Toyota World, Inc. v. Commissioner, supra at 196. The economic substance of a transaction, rather than its form, controls. Commissioner v. Court Holding Co., 324 U.S. 331 [33 AFTR 593] (1945); Gregory v. Helvering, supra; Amdahl Corp. v. Commissioner, 108 T.C. 507, 516-517 (1997).
The “labels, semantic technicalities, and formal written documents do not necessarily control the tax consequences of a given transaction.” Houchins v. Commissioner, 79 T.C. 570, 589 (1982); see also Ocmulgee Fields, Inc. v. Commissioner, 613 F.3d 1360, 1368 [106 AFTR 2d 2010-5820] (11th Cir. 2010), affg. 132 T.C. 105 (2009); Teruya Bros., Ltd. v. Commissioner, 580 F.3d 1038, 1043 [104 AFTR 2d 2009-6274] (9th Cir. 2009), affg. 124 T.C. 45 (2005); Yosha v. Commissioner, 861 F.2d 494, 499 [63 AFTR 2d 89-369] (7th Cir. 1988), affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
As we recently stated, for Federal income tax purposes a transaction may be disregarded if the transaction was entered into not for valid business purposes but rather for “tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations.” Palm Canyon X Invs., LLC v. Commissioner, T.C. Memo. 2009-288 [TC Memo 2009-288]. Even if a transaction is not treated as a sham, it still may be recast in order to Gaw v. Commissioner, T.C. Memo. 1995- reflect its true nature. 531 (citing Packard v. Commissioner, 85 T.C. 397, 419-422 (1985)), affd. without published opinion 111 F.3d 962 (D.C. Cir. 1997).
Courts often interpret the Supreme Court's holding in Frank Lyon Co. v. United States, supra, as establishing an economic substance doctrine with two prongs: Whether the taxpayer had a nontax business purpose or objective for entering into the disputed transaction (the subjective prong); and whether the transaction had economic substance beyond the anticipated tax benefits (the objective prong). See, e.g., Karr v. Commissioner, 924 F.2d 1018, 1023 [67 AFTR 2d 91-653] (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988); Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 [60 AFTR 2d 87-5272] (9th Cir. 1987), affg. T.C. Memo. 1986-23 [¶86,023 PH Memo TC]; Rice's Toyota World, Inc. v. Commissioner, 752 F.2d at 91-92; Palm Canyon X Invs., LLC v. Commissioner, supra .
Some courts use a disjunctive approach and treat a transaction as having economic substance if the transaction has either a business purpose or economic substance. See, e.g., Rice's Toyota World, Inc. v. Commissioner, 752 F.2d at 91-92. Some courts use a conjunctive approach and treat a transaction as having economic substance only if the transaction has both a business purpose and economic substance. See, e.g., Dow Chem. Co. v. United States, 435 F.3d 594, 599 [97 AFTR 2d 2006-671] (6th Cir. 2006). Yet other courts collapse the objective and subjective prongs into one comprehensive inquiry. See, e.g., Sacks v. Commissioner, 69 F.3d 982, 988 [76 AFTR 2d 95-7138] (9th Cir. 1995), revg. T.C. Memo. 1992-596 [1992 RIA TC Memo ¶92,596]; Kirchman v. Commissioner, 862 F.2d 1486, 1492 [63 AFTR 2d 89-588] (11th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
The Court of Appeals for the Seventh Circuit has stated generally that “It is well-established that the Commissioner is not required to recognize, for tax purposes, those transactions which lack economic substance.” Muhich v. Commissioner, 238 F.3d 860, 864 [87 AFTR 2d 2001-667] (7th Cir. 2001), affg. T.C. Memo. 1999-192 [1999 RIA TC Memo ¶99,192]. "[T]ransactions with no economic substance don't reduce people's taxes.” Cemco Investors, LLC v. United States, 515 F.3d 749, 752 [101 AFTR 2d 2008-768] (7th Cir. 2008); Grojean v. Commissioner, 248 F.3d 572 [87 AFTR 2d 2001-1673] (7th Cir. 2001), affg. T.C. Memo. 1999-425 [1999 RIA TC Memo ¶99,425]; Muhich v. Commissioner, supra at 864 (citing Gregory v. Helvering, supra); see also Coleman v. Commissioner, 16 F.3d 821 [73 AFTR 2d 94-1209] (7th Cir. 1994), affg. T.C. Memo. 1990- 99 [¶90,099 PH Memo TC] and T.C. Memo. 1987-195 [¶87,195 PH Memo TC].
The Court of Appeals for the Eleventh Circuit recently noted that “Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.” United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014, 1018 [87 AFTR 2d 2001-2565] (11th Cir. 2001); see also Kirchman v. Commissioner, supra at 1492 (”The focus of the inquiry under the sham transaction doctrine is whether a transaction has economic effects other than the creation of tax benefits.” (citing Knetsch v. United States, 364 U.S. 361 [6 AFTR 2d 5851] (1960))). In Kirchman v. Commissioner, supra at 1492, the Court of Appeals for the Eleventh Circuit noted further:
The analysis of whether a transaction is a substantive sham, however, addresses whether a transaction's substance is that which it form represents. That does not necessarily require an analysis of a taxpayer's subjective intent. Once a court determines a transaction is a sham, no further inquiry into intent is necessary. The Court of Appeals for the Ninth Circuit has recently discussed in an unpublished opinion the economic substance doctrine and its two prongs as follows: "`(1) whether *** [taxpayers] demonstrated that either of the principals directing their respective transactions had a business purpose for engaging in the transaction other than tax avoidance and (2) whether either transaction had economic substance beyond the creation of tax benefits.” Thomas Inv. Partners, Ltd. v. United States, 108 AFTR 2d 2011-5369 [108 AFTR 2d 2011-5369], at 2011-5371, 2011-2 USTC par. 50,517, at 86,287 (9th Cir. 2011) (quoting Casebeer v. Commissioner, 909 F.2d 1360, 1363 [66 AFTR 2d 90-5361] (9th Cir. 1990)).
The Court of Appeals in Thomas concluded that the transactions under scrutiny were unlikely to confer a nontax benefit and that the individuals who engaged in those Id. at 2011- transactions did so solely to create tax benefits. 5372, 2011-2 USTC par. 50,517, at 86,287. Further, the Court of Appeals has stated that “the consideration of business purpose and economic substance are simply more precise factors to consider in the application of this court's traditional sham analysis”. Sochin v. Commissioner, 843 F.2d 351, 354 [61 AFTR 2d 88-926] (9th Cir. 1988), affg. Brown v. Commissioner, 85 T.C. 968 (1985).
Before us in these cases is a purported stock sale between petitioners and MidCoast that lacks both business purpose and economic substance and that we conclude is to be disregarded for Federal income tax purposes. In substance, there was no sale of the stock of Woodside Ranch; rather, Woodside Ranch was liquidated, and the $1,835,209 cash that Woodside Ranch had on hand (after the partial redemption that occurred on July 18, 2002) was distributed to the Woodside Ranch shareholders less a fee of approximately $500,000 that MidCoast retained for facilitating the sham.
The “no-cost liquidation” terminology used by the MidCoast representatives is telling. In substance, it really was a liquidation, not a stock sale. The effort, assisted by MidCoast's sleight of hand, to reduce the tax cost of the Woodside Ranch liquidation by cloaking the liquidation in the trappings of a stock sale is to be ignored.
We emphasize that at the same time Shapiro transferred $1.4 million into the trust account, $1.4 was immediately returned to Shapiro. Inferentially, the approximately $1.3 million the Woodside Ranch shareholders received out of the trust account came to them from the $1.8 million in proceeds of the Zumwalt asset sale—as a corporate distribution. In substance, Woodside Ranch was liquidated, and petitioners received the $1.3 million as liquidation proceeds.
The $1,181,249 reported loan receivable in favor of Woodside Ranch from MidCoast obviously was a mere accounting device, devoid of substance. As we have emphasized, the $1.4 million Shapiro placed into the escrow on July 18, 2002, was returned to Shapiro 2 hours later, and thereafter no portion thereof was owed by anyone to anyone. Shapiro had his $1.4 million. MidCoast did not owe him anything. Woodside Ranch did not owe him anything, and MidCoast did not owe Woodside Ranch anything with regard thereto.
What was transferred by Woodside Ranch to MidCoast did not actually represent equity in Woodside Ranch. See Owens v. Commissioner, 568 F.2d 1233, 1238 [41 AFTR 2d 78-419] (6th Cir. 1977), affg. in part and revg. in part 64 T.C. 1 (1975). On July 18, 2002, Woodside Ranch's assets consisted only of cash. All of the operating assets and business of Woodside Ranch had been sold to Zumwalt. After the asset sale and partial redemption, but before the purported stock sale, Woodside Ranch had $1,835,209 cash on hand and a combined Federal and State corporate income tax liability of approximately $750,000.
From the time of the purported stock sale, Woodside Ranch carried on no business activity; there was no viable business to continue, and, on the basis of our evaluation of the evidence and testimony before us, representations from MidCoast that Woodside Ranch would be incorporated into MidCoast's “asset-recovery” business are preposterous.
After the July 18, 2002, transaction, Woodside Ranch was nothing more than a shell, with no employees, no real property, and no assets other than MidCoast's share of the unpaid taxes.
Petitioners argue emphatically that if Woodside Ranch had been liquidated, Woodside Ranch's management and shareholders might have ended up facing unexpected and unknown claims and lawsuits against them personally under Wisconsin law. Indeed, petitioners argue that the Woodside Ranch shareholders' concern over potential liability claims was dominant and that the shareholders' concern over taxes due on the Zumwalt asset sale was only secondary.
As we have found, however, whatever the level of perceived risk the Woodside Ranch management and shareholders actually had in operating Woodside Ranch, it was not enough of a risk to convince them to purchase anything more than spotty or discrete personal injury insurance.
Over the years, Woodside Ranch had relatively few personal injury claims brought against it relating to activities of the ranch and then only in amounts not disclosed in the record.
On the facts and credible evidence before us, we conclude that petitioners had little basis for being concerned for their potential personal liability on unknown claims and lawsuits arising out of the activities of Woodside Ranch. 17
The June 17, 2002, minutes of the Woodside Ranch finance committee meeting establish that both the MidCoast representatives and the Woodside Ranch shareholders knew and understood that the only real payment MidCoast was making to the Woodside Ranch shareholders was calculated as, and in fact constituted, nothing more than a split of the projected tax liabilities that no one intended to pay.
The real price to be paid by MidCoast for the stock had nothing to do with the value of Woodside Ranch; rather, the stock purchase by Midcoast was a sham, and MidCoast was simply splitting between itself and the Woodside Ranch shareholders the amount of the taxes that should have been paid.
The MidCoast representative said it correctly when he stated that the transaction before us was all about creating tax avoidance; it was not supported by underlying economic substance and business activity. The only entity that was to fund, or incur, the cost of the transaction before us was the Federal Government via unpaid taxes.
Petitioners argue that the SPA provision under which Woodside Ranch was not to be dissolved for 4 years confirms their good faith and intent that the tax liabilities would be paid, and confirms their concern over personal liability for personal injury claims against Woodside Ranch. We disagree. We regard the SPA provision as essentially meaningless. While under the control of MidCoast, Woodside Ranch failed to pay its taxes, claimed other illegal tax-avoidance tax shelters, and was effectively given away by MidCoast for nothing.
We conclude that in substance the transaction before us was not a bona fide sale of Woodside Ranch stock. The substance of the transaction was a liquidation to petitioners of Woodside Ranch's cash and a fee payment to MidCoast for its role in facilitating the sham. Transferee Liability Section 6901(a) provides a procedure through which respondent may collect from transferees of assets unpaid taxes owed by the transferors of the assets if a legal basis exists under State law or equity for holding the transferees liable for the unpaid taxes. Commissioner v. Stern, 357 U.S. 39, 42 [1 AFTR 2d 1899]-47 (1958); Hagaman v. Commissioner, 100 T.C. 180, 184-185 (1993). Transferee liability under section 6901 includes related additions to tax, penalties, and interest owed by the transferors. Kreps v. Commissioner, 42 T.C. 660, 670 (1964), affd. 351 F.2d 1 [16 AFTR 2d 5649] (2d Cir. 1965). Respondent bears the burden of proving that petitioners are liable as transferees of the property of Woodside Ranch. See sec. 6902(a); Rule 142(d).
We apply Wisconsin law in our analysis of whether petitioners should be held liable as transferees of Woodside Ranch.
Wisconsin shareholders of a dissolved corporation may be liable as transferees to creditors of the corporation (such as respondent) where the shareholders receive corporate assets as part of a dissolution. Wis. Stat. Ann. sec. 180.1408(2) (West 2002) provides:
If the dissolved corporation's assets have been distributed in liquidation, a claim not barred under sec. 180.1406 or 180.1407 may be enforced against a shareholder of the dissolved corporation to the extent of the shareholder's proportionate share of the claim or the corporate assets distributed to him or her in liquidation, whichever is less, but a shareholder's total liability for all claims under this section may not exceed the total amount of assets distributed to him or her. As computed for purposes of this subsection, the shareholder's proportionate share of the claim shall reflect the preferences, limitations and relative rights of the class or classes of shares owned by the shareholder as well as the number of shares owned, and shall be equal to the amount by which payment of the claim from the assets of the corporation before dissolution would have reduced the total amount of assets to be distributed to the shareholder upon dissolution. Income tax liabilities arising from the sale of corporate assets are “claims” existing at the time of the sale. See Kreps v. Commissioner, supra at 670-671. This Court has held that at the time of an intermediary transaction asset sale (not dissimilar from the transaction herein), the Commissioner qualified as a creditor of the seller for Federal taxes arising from the sale. LR Dev. Co., LLC v. Commissioner, T.C. Memo. 2010-203 [TC Memo 2010-203] (discussing Illinois definitions of the terms “debt” and “claim” which are the same as under Wisconsin's fraudulent transfer statute).
Having found that the transaction before us in substance and purpose was part of a liquidation and dissolution of Woodside Ranch and that the Woodside Ranch shareholders received, as a part of that liquidation and dissolution, approximately $1.3 million in cash as a distribution from Woodside Ranch, we conclude that petitioners are liable as transferees under the above provision of Wisconsin law for their proportionate shares of Woodside Ranch's unpaid 2002 Federal income tax liability.
Wisconsin also has adopted the Uniform Fraudulent Transfer Act, codified at Wis. Stat. Ann. secs. 242.01 to 242.12 (West 2009) (Wisconsin UFTA), which provides creditors with certain remedies where a debtor transfers property and thereby avoids creditor claims. If the elements of the Wisconsin UFTA are satisfied, creditors may obtain an attachment or other remedy against the property transferred and against the transferees and their property. Wisconsin UFTA sec. 242.07.
Respondent does not argue that petitioners should be liable as transferees under Wisconsin UFTA section 242.04(1)(a), a provision that requires a debtor's actual intent to defraud, hinder, or delay a creditor. However, respondent argues that under two closely related provisions of the Wisconsin UFTA petitioners should be treated as transferees and as liable for the unpaid Federal income tax liability of Woodside Ranch.
Wisconsin UFTA section 242.04(1)(b) is applicable where: [T]he debtor made the transfer or incurred the obligation: *** Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor: (1) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (2) Intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor's ability to pay as they became due. Wisconsin UFTA section 242.05(1) is applicable where: [T]he debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation. Wisconsin statutes do not define “reasonably equivalent value”. The Uniform Fraudulent Transfer Act is a uniform act deriving the phrase “reasonably equivalent value” from 11 U.S.C. section 548. Leibowitz v. Parkway Bank & Trust Co. (In re Image Worldwide, Ltd.), 139 F.3d 574, 577 (7th Cir. 1998); Bowers- Siemon Chems. Co. v. H.L. Blachford, Ltd., 139 Bankr. 436, 445 (Bankr. N.D. Ill. 1992) (”Illinois law on fraudulent conveyance parallels sec. 548 of the Bankruptcy Code.”). Whether reasonably equivalent value was received by the transferor is a question of fact. Leibowitz v. Parkway Bank & Trust Co. (In re Image Worldwide, Ltd.), supra at 576 (citing Heritage Bank Tinley Park v. Steinberg (In re Grabill), 121 Bankr. 983, 994 (Bankr. N.D. Ill. 1990)).
In the bankruptcy context, the Court of Appeals for the Seventh Circuit has stated that the “test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and to compare it to what was received.” Barber v. Golden Seed Co., 129 F.3d 382, 387 (7th Cir. 1997).
Under the Wisconsin UFTA, creditors, such as respondent, have the burden to prove the above elements of transferee liability by clear and convincing evidence. Kaiser v. Wood Cnty. Natl. Bank & Trust Co. (In re Loyal Cheese Co.), 969 F.2d 515, 518 (7th Cir. 1992); Mann v. Hanil Bank, 920 F. Supp. 944, 950 (E.D. Wis. 1996).
Petitioners do not dispute Woodside Ranch's liability for the Federal income taxes arising from the Zumwalt asset sale, nor the existence of respondent's claim therefor or respondent's creditor status at the time of the transfers in question.
On the evidence before us, it is clear that in exchange for the distribution of approximately $1.3 million in cash to petitioners Woodside Ranch received nothing of reasonably equivalent value.
After the Zumwalt asset sale, Woodside Ranch ceased to engage in any business activity. There was no viable business to continue, and regardless of how MidCoast chose to describe its post-sale intentions for Woodside Ranch, the only “business” left for Woodside Ranch was to pay its tax liabilities arising from the asset sale. The transfer of Woodside Ranch's $1.3 million to petitioners left Woodside Ranch with remaining assets of approximately $453,000 in cash, insufficient to pay Woodside Ranch's Federal and State income tax liabilities exceeding $700,000.
It is clear that as a result of Woodside Ranch's cash distribution to petitioners, Woodside Ranch was rendered insolvent. See Wisconsin UFTA sec. 242.02(b)(2) (”A debtor is insolvent if the sum of the debtor's debts is greater than all of the debtor's assets at a fair valuation.”).
Further, the Woodside Ranch shareholders should have known that the Federal income tax liability arising from the Zumwalt asset sale would not be paid. The credible evidence before us establishes that petitioners' interest in the MidCoast transaction relied almost entirely on the assumption and calculation that the Woodside Ranch tax liability would remain unpaid; the impetus for taking the cumbersome route of a nominal stock sale was the mutual understanding between petitioners and MidCoast that each party would pocket and retain a portion of the unpaid taxes.
MidCoast offered a “no-cost” liquidation as a solution to the tax “dilemma” in which petitioners found themselves. In spite of representations to the contrary in some of the transaction documents, the record is replete with notice to petitioners that MidCoast never intended to pay Woodside Ranch's Federal income tax liability.
On the credible evidence before us, we conclude that petitioners knew or should have known that, as a result of the transactions among Woodside Ranch, MidCoast, and petitioners, Woodside Ranch had debts beyond its ability to pay.
We conclude that petitioners herein are liable as transferees under both of the above provisions of the Wisconsin UFTA for their proportionate shares of Woodside Ranch's unpaid 2002 Federal income tax liability.
Lastly, under what respondent refers to as a common law “trust fund” doctrine relating to fiduciary duties of corporate directors and officers, petitioners should be treated as transferees and as liable for the unpaid Federal income tax liability of Woodside Ranch. Respondent cites Beloit Liquidating Trust v. Grade, 677 N.W.2d 298, 309 (Wis. 2004), which explained that when a corporation is insolvent and has ceased to be a going concern and its directors and officers know, or ought to know, that suspension of the corporation is pending, transfers of corporate property to the directors or officers in lieu of payments to creditors of the corporation may be held to constitute a fraud on the creditors and the directors and officers may be held personally liable to the injured creditors. See also Polsky v. Virnich, 779 N.W.2d 712, 714 (Wis. Ct. App. 2010).
Under the above alternate authority, respondent argues that all petitioners should be held liable under Wisconsin law and under section 6901 as transferees. As noted, however, this Wisconsin common law authority would apply only to petitioners who were directors and officers of Woodside Ranch (namely, to Ray Feldman, Richard Feldmann, and Carrie Donahue), not to petitioners who were neither directors nor officers of Woodside Ranch.
In light of our conclusion and holding herein that petitioners are liable under Wis. Stat. Ann. sec. 180.1407, the Wisconsin UFTA, and section 6901 for their respective shares of Woodside Ranch's 2002 unpaid Federal income tax liability, we need not, and we do not decide whether any petitioners also should be held liable under the above common law authority on which respondent relies.
In two recent Memorandum Opinions and in a Memorandum Opinion filed today, this Court has addressed transferee liability relating to other transactions promoted by Midcoast. See Frank Sawyer Trust of May 1992 v. Commissioner, T.C. Memo. 2011-298 (filed Dec. 27, 2011); Starnes v. Commissioner, T.C. Memo. 2011-63 [TC Memo 2011-63] (decision entered Mar. 24, 2011), on appeal (4th Cir., June 8, 2011); Griffin v. Commissioner, T.C. Memo. 2011-61 [TC Memo 2011-61] (decision entered Sept. 30, 2011). In the above three cases this Court held in favor of the taxpayers. Those cases involved differences from the instant cases.
Starnes and Frank Sawyer Trust were decided largely on the basis of insufficiency of and burden of proof.
In Griffin, after the transaction with MidCoast, the target corporation retained substantial assets and was not thereby rendered insolvent. Additionally, the taxpayer filed a lawsuit and obtained a State court judgment against MidCoast in an effort to get the taxes paid.
In Starnes, Griffin, and Frank Sawyer Trust, the facts as found did not establish that the taxpayers knew that MidCoast intended not to pay the taxes.
For the reasons stated, we sustain respondent's determination that petitioners are liable as transferees with respect to their respective shares of the 2002 unpaid Federal income tax liability of Woodside Ranch and the related additions to tax, penalties, and interest.
Decisions will be entered for respondent.
2
In our findings of fact, use of the words “sale”,
3
Unless otherwise indicated, all section references are to the Internal Revenue Code applicable to the year before us, and all Rule references are to the Tax Court Rules of Practice and Procedure.
4
For example, Woodside Ranch carried landlord/tenant-type insurance relating to the buildings and property.
5
In an opinion letter, Woodside Ranch's accountant estimated that a sale of Woodside Ranch assets would trigger Federal and State corporate income taxes of approximately $595,700 and $152,000, respectively.
6
If a liquidation of Woodside Ranch occurred, creditors would be able to bring claims directly against Woodside Ranch shareholders who received corporate assets on the liquidation. See Wis. Stat. Ann. sec. 180.1408(2) (West 2002).
7
The record does not indicate that the purported Shapiro
8
Cash of $1,835,209 less $492,139 equals $1,343,070. The record does not explain why an extra $1,382 was transferred from the Foley trust account into the Woodsedge account in favor of the Woodside Ranch shareholders.
9
Farris' accounting firm also received a $25,000 finder's fee for introducing MidCoast to the Woodside Ranch shareholders.
10
As stated earlier, after the above transactions with MidCoast, petitioners made only one payment relating to personal injury claims arising from activities of Woodside Ranch before July 18, 2002, which resulted in a payment by petitioners and others of $50,000.
11
Petitioners presumably wanted this provision both as added protection against potential personal injury claims arising from Woodside Ranch activities and to protect against petitioners' personal exposure to transferee liability for Woodside Ranch's unpaid income tax liabilities relating to the asset sale.
12
Wilder's obligation on the assumed purported Midcoast debt to Woodside Ranch should have been, were it legitimate, reflected in a promissory note running from Wilder in favor of Woodside Ranch. In fact, however, a promissory note of Wilder relating thereto was issued in favor of MidCoast.
13
Generally, in a DAD tax shelter a domestic partnership claims a loss relating to a purported contribution of a built-in loss asset. The partnership typically will contribute the asset to a lower tier partnership, which in turn will sell that asset to another (sometimes related) entity, thereby purportedly incurring a significant loss. The reported loss passes through to the upper tier partnership, which allocates and passes through the loss to the domestic partners; the domestic partners offset other income or gain with the purported loss. The overall effect is that the domestic partner-taxpayers reap the benefits of the built-in loss asset without ever having incurred the costs associated therewith. See IRS Coordinated Issue Paper, “Distressed Asset/Debt Tax Shelters”, LMSB-04-0407-031 (Apr. 18, 2007).
14
15
14
15
16
Petitioners do not contest their liability as transferees relating to the $293,729 redemption proceeds they received.
17
We also find it remarkable that the Woodside Ranch shareholders and MidCoast capped the liability of the Woodside Ranch shareholders for personal injury claims relating to ranch activities to the amount of the MidCoast premium (i.e., to the amount the shareholders were to receive from the unpaid taxes). Apparently, the individuals involved in the transactions before us thought the unpaid taxes (or a portion thereof) should be the measure not only of MidCoast's fee, but also the measure and limit of the shareholders' liability for personal injury claims. The unpaid taxes were to serve dual purposes.
RAY FELDMAN, TRANSFEREE, ET AL., 1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 6901
Docket: Dkt. Nos. 26737-08, 27386-08, 27387-08, 27388-08, 27389-08, 27390-08, 27391-08, 27392-08, 27393-08.
Date Issued: 12/27/2011.
Judge: Opinion by SWIFT
HEADNOTE
XX.
Reference(s): Code Sec. 6901
Syllabus
Official Tax Court Syllabus
Docket Nos. 26737-08, 27386-08, Filed December 27, 2011. 27387-08, 27388-08, 27389-08, 27390-08, 27391-08, 27392-08, 27393-08.
Counsel
Robert Edward Dallman, for petitioners.
George W. Bezold, for respondent.
Opinion by SWIFT
MEMORANDUM FINDINGS OF FACT AND OPINION
In these consolidated cases respondent determined transferee liability against petitioners relating to an agreed and unpaid $593,979 Federal income tax liability of Woodside Ranch Resort, Inc. (Woodside Ranch), for 2002, plus an addition to tax, penalties, and interest relating to Woodside Ranch's unpaid 2002 Federal income tax liability. The amount of each petitioner's respective transferee liability as calculated by respondent is as follows: Ray Feldman—$542,514; Sharon L. Coklan—$117,013; Jill K. Reynolds—$42,550; Jan Reynolds— $212,751; Carrie Donahue—$95,738; Rhea Dugan—$41,274; Emma McClintock—$95,738; Robert Donahue—$21,275; and Richard Feldmann—$309,765.
The transferee liability determined against each petitioner is based largely on respondent's conclusion that a purported July 18, 2002, sale 2 by petitioners of shares of stock in Woodside Ranch constituted a sham transaction not dissimilar from the abusive tax-avoidance transaction described in Notice 2001-16, 2001-1 C.B. 730 (referred to as an intermediary transaction). “purchase”, and similar words generally is for convenience and is not intended to and does not constitute a finding that the referenced transactions constituted a valid transaction to be recognized for Federal income tax purposes.
The issue for decision is whether petitioners are liable under section 6901 as transferees for their respective shares of Woodside Ranch's $593,979 Federal income tax liability for 2002, plus the addition to tax, penalties, and interest. 3
FINDINGS OF FACT
Many of the facts have been stipulated and are so found. At the time of filing their separate petitions, petitioners resided in Wisconsin, Florida, and Arizona. Trial was held on November 17, 2010, in Milwaukee, Wisconsin.
In the 1920s Woodside Ranch was established and began business as a Wisconsin corporation with its place of business in Mauston, Wisconsin.
From its incorporation until May of 2002 Woodside Ranch owned and operated a dude ranch resort offering, among other activities, horseback riding, swimming, boating, hiking, fishing, snow skiing, and snowmobiling, along with accommodations.
The historic shareholders in Woodside Ranch were William Feldman and his five children. In 2002, at the time of the transactions before us, Woodside Ranch stock was owned by 10 shareholders, 9 of whom were grandchildren or great-grandchildren of William Feldman. They are petitioners herein. The 10th shareholder, Lucille Nichols, daughter of William Feldman, has died, and her estate is not involved in these consolidated cases.
Just before the 2002 transactions involved in these cases, the officers of Woodside Ranch were: President—decedent Lucille Nichols; vice president—Richard Feldmann; secretary—Ray Feldman; and treasurer—Carrie Donahue. These same individuals also were the directors of Woodside Ranch.
On average, each year 6 to 20 accidents resulting in injuries to customers occurred at Woodside Ranch. Only a few of these accidents resulted in formal claims against Woodside Ranch. The injuries that occurred at Woodside Ranch typically were not serious, and personal injury claims were satisfied by Woodside Ranch with in-kind compensation (e.g., free return visits to the ranch for the injured customers and their families) plus the payment by Woodside Ranch of medical expenses. After the transactions described below that occurred in the spring and summer of 2002, only one personal injury claim against Woodside Ranch resulted in a payment to an injured customer. That payment was for $50,000.
Although the sporting and other activities at Woodside Ranch involved some risk of personal injury for Woodside Ranch customers, over the years Woodside Ranch did not obtain comprehensive personal injury insurance covering potential injuries. Such comprehensive insurance was available but expensive, and management of Woodside Ranch chose not to purchase it. Woodside Ranch did carry several insurance policies that covered some activities at the ranch. 4 As stated, for many years including 2002 Woodside Ranch management was unwilling to pay the high cost of comprehensive liability insurance covering participant sports activities. Sale of Woodside Ranch's Assets In the late 1990s and early 2000s the owners and management of Woodside Ranch faced significant challenges to the continued operation of the ranch: Increased competition from Wisconsin casinos and water parks; aging of the Woodside Ranch shareholders and directors; and lack of interest on the part of the shareholders and the Feldman next generation in continued operation of the ranch. As a result, the shareholders of Woodside Ranch began a search for a buyer of either their stock in Woodside Ranch or of the assets of Woodside Ranch.
The shareholders were interested in minimizing the tax liabilities associated with a sale of their interests in Woodside Ranch. A corporate asset sale would trigger significant Federal and State corporate income tax liabilities. 5
In the fall of 2001 negotiations began with an individual named Damon Zumwalt (Zumwalt) for the sale of Woodside Ranch, with the expectation on both sides that commercial operation of the dude ranch would be continued by Zumwalt. A stock sale was proposed to Zumwalt, who “just laughed and chuckled and said, `not on your life, it's got to be an asset sale'.”
On May 17, 2002, after several months of negotiations, the operating assets and business of Woodside Ranch were sold to Woodside Ranch, LLC (WRLLC), for $2.6 million in cash (hereinafter often referred to as the asset sale or the Zumwalt asset sale). Zumwalt was the sole owner and sole member of WRLLC. On this asset sale, the net cash proceeds received by Woodside Ranch were $2,301,089.
In a June 5, 2002, memorandum to the Woodside Ranch shareholders, petitioner Ray Feldman referred to the above estimated taxes as posing a “dilemma” for the shareholders. Also, Woodside Ranch management and shareholders were aware that under Wisconsin law they might be able to limit their individual liability relating to potential personal injury claims of customers arising from ranch activities if the sale of Woodside Ranch took the form of a stock sale with the new owners of the Woodside Ranch stock assuming the liabilities of Woodside Ranch, including risks relating to potential personal injury claims. 6
The total combined Federal and State income tax liability that Woodside Ranch incurred on the asset sale was approximately $750,000, of which the officers, directors, and shareholders of Woodside Ranch at all relevant times were aware.
After the asset sale to Zumwalt, Woodside Ranch had no operating assets and ceased to engage in any meaningful business activity. Efforts To Avoid Payment of Tax Liabilities In the early spring of 2002 Fred Farris (Farris), an accountant and financial adviser to Woodside Ranch and to some of the individual shareholders, introduced the Woodside Ranch officers, directors, and shareholders to MidCoast Credit Corp. and to MidCoast Acquisition Corp. (collectively MidCoast). MidCoast was owned directly or indirectly 50 percent by Michael Bernstein and 50 percent by Honora Shapiro.
Representatives of MidCoast claimed to have expertise in tax matters and provided to the Woodside Ranch officers promotional materials which outlined a potential tax-avoidance transaction as an alternative to a liquidation of Woodside Ranch.
Under the transaction presented by the MidCoast representatives, the shareholders of Woodside Ranch allegedly would be relieved of a significant portion, if not all, of Woodside Ranch's combined Federal and State income tax liability of approximately $750,000 relating to the Zumwalt asset sale.
On June 11, 2002, in spite of the MidCoast promotional materials that had been received, the Woodside Ranch finance committee, consisting of petitioners Carrie Donahue, Ray Feldman and Richard Feldmann, met and adopted a resolution recommending that a plan of liquidation for Woodside Ranch be adopted.
However, the Woodside Ranch board of directors did not adopt the recommended plan of liquidation, and the Woodside Ranch directors chose instead to pursue the alternative tax-avoidance transaction proposed by MidCoast mentioned above and described more specifically below.
As reflected in written notations of petitioner Ray Feldman of a meeting that apparently occurred later in the day on June 11, 2002, the MidCoast representatives explained that under the MidCoast proposal MidCoast would purchase bad debts from entities unrelated to target corporations (such as Woodside Ranch) and would use the bad debts to offset or eliminate unpaid tax liabilities of the newly acquired target corporations. The MidCoast representatives explained that the “Income comes in tax free by using NOL”, and “So *** [you] create *** [a] loss— lower deferred tax liability”. (Emphasis added.) On June 17, 2002, MidCoast representatives explained over the phone to Woodside Ranch officers that if Woodside Ranch was not liquidated and if the cash Woodside Ranch received on the Zumwalt asset sale was not distributed directly to the shareholders, but instead the shareholders agreed to sell to MidCoast their Woodside Ranch stock, MidCoast would pay to the MidCoast shareholders a “premium' of approximately $200,000 to 250,000” for their stock (hereinafter sometimes referred to as the MidCoast premium).
The MidCoast premium that the Woodside Ranch shareholders would receive was to be calculated as a percentage (between 25 and 33 percent) of the approximate combined Federal and State corporate income tax liability Woodside Ranch had incurred as a result of the Zumwalt asset sale. Notations reflecting the MidCoast representations explain: “The exact figure for the premium would be set on a percentage formula based upon the amount of State and Federal tax owed as a result of sale of Woodside assets to Damon Zumwalt and Woodside Ranch, LLC.”
Representatives of MidCoast repeatedly explained to the Woodside Ranch officers that if the Woodside Ranch stock was sold to MidCoast or to a MidCoast-related entity, MidCoast or its related entity would obtain bad debt losses from other companies and use those losses to offset or eliminate the tax liabilities of Woodside Ranch.
The transaction proposed by the representatives of MidCoast was also referred to by the MidCoast representatives as a “no- cost liquidation”. (Emphasis added.) In other words, instead of directly liquidating Woodside Ranch and distributing to the Woodside Ranch shareholders the cash proceeds from the Zumwalt asset sale (less the combined Federal and State tax liability that would have been paid), the MidCoast proposal was designed so that the cash, in effect, still could be “liquidated” or transferred to the Woodside Ranch individual shareholders, but indirectly and via a few additional steps, as follows: A purported or nominal sale of the Woodside Ranch stock to MidCoast; a transfer by MidCoast to the Woodside Ranch individual shareholders of the cash that would have been distributed to the shareholders on a direct liquidation of Woodside Ranch (i.e., the net proceeds available from Woodside Ranch for a liquidating distribution plus a “premium”—one-third of the taxes owed); and MidCoast would avoid paying the tax liabilities the Woodside Ranch shareholders would have had to pay on a direct liquidation. All this allegedly was to be made possible by MidCoast's use of bad debt losses from other companies to offset the reportable Woodside Ranch gain on the Zumwalt asset sale.
On June 17, 2002, Woodside Ranch's finance committee met and adopted a resolution to pursue further with the shareholders the sale of Woodside Ranch's stock to MidCoast as proposed in the MidCoast promotional materials.
As reflected in minutes of a June 17, 2002, Woodside Ranch finance committee meeting, the amount MidCoast would pay the Woodside Ranch shareholders for 100 percent of the outstanding Woodside Ranch stock would not be based on the value of the Woodside Ranch stock. (Such a valuation would have included the approximate $1.8 million in cash that Woodside Ranch had on hand from the Zumwalt sale.) Rather, the minutes state that the amount to be paid would be based on the premium or a percentage (approximately 33 percent) of the taxes due on the Zumwalt sale. The minutes state as follows: [T]he sale of 100% of the stock of Woodside Ranch Resorts, Inc., shareholders to MidCoast Investments, Inc. in exchange for a “premium” of approximately $200,000 to $250,000. The exact figure or total amount of the payment for the premium would be set on a percentage formula based upon the amount of State and Federal tax owed as a result of sale of Woodside assets *** . As described in the above minutes, the proposal from MidCoast to pay approximately $250,000 for 100 percent of the Woodside Ranch stock was not tied to the value of Woodside Ranch stock or to the $1.8 million in cash that Woodside Ranch had on hand, but on a split of Woodside Ranch's tax liabilities intended to go unpaid or be offset via the use of net operating losses (NOLs). In the above minutes, no mention is made of the cash Woodside Ranch held from the Zumwalt asset sale.
The minutes of the June 17, 2002, finance committee meeting also state that, upon a purchase by MidCoast, Woodside Ranch would become part of *** [MidCoast's] staple of companies that they are supervising for the purpose of utilizing tax losses which they acquired by buying credit card companies bad debts and losses to offset against profitable “C Corps” who have a situation like Woodside's wherein a large tax *** [liability exists] *** .
The obvious and only benefit to MidCoast and its owners was that they would end up with cash in their pockets equal to two- thirds of the amount of Woodside Ranch's unpaid tax liabilities.
During the weeks that the Woodside Ranch representatives were in discussion with the MidCoast representatives, Woodside Ranch representatives made a number of phone calls and undertook to find out information about MidCoast. However, we are not convinced, and in our opinion the credible evidence in these cases does not establish, that the Woodside Ranch shareholders and their representatives undertook a sufficiently in-depth and thorough due diligence investigation of MidCoast.
On June 18, 2002, MidCoast sent a letter of intent to Woodside Ranch in which MidCoast represented that—on the basis of 30 percent of the Woodside Ranch estimated $750,000 combined Federal and State tax liability—the Woodside Ranch shareholders together would receive approximately $210,000 more if the nominal stock sale to MidCoast was used, thereby converting the liquidation into the referred-to “no-cost” liquidation. The following comparison chart was included in the letter of intent to estimate roughly the promised benefits of the MidCoast transaction:
Shareholders
Sell Stock of Company to Shareholders MidCoast [The Liquidate Company “No Cost”
Liquidation] w/out MidCoast Asset Sales Proceeds $2,600,000 $2,600,000 Less: Federal & State Income Taxes (747,704) (747,704) Less: RE Commission (117,000) (117,000) Less: Title Insurance (2,000) (2,000) Less: Notes Payable (318,400) (318,400) (8,000) Less: Misc. Adjustments (8,000) Net Proceeds Available to Shareholders 1,406,896 N/A
Plus: MidCoast Premium to Shareholders N/A 224,311
MidCoast Stock Purchase Price [or “Net Proceeds Available to Shareholders”] N/A 1,631,207
On June 19, 2002, petitioner Ray Feldman sent a letter to the other Woodside Ranch shareholders discussing, among other things, MidCoast's proposal. Specifically, petitioner Ray Feldman noted:
The assets *** [were] sold by the deed and bill of sale on May 17th to [WRLLC] which of course is owned by
Damon Zumwalt. Therefore, the corporation Woodside Ranch Resort, Inc. is basically an “empty shell” but which consists of the cash at the time of sale of Two Million Two Hundred Seventy Six Thousand eighty-eight Dollars and fifty-six cents. *** MidCoast promises *** to pay Woodside's taxes because the corporation would not be liquidated but instead be kept alive as a going concern as part of the MidCoast organization. This deal is profitable for MidCoast because MidCoast purchases large amounts of defaulted and delinquent credit card amounts from the major credit card companies *** and carries forward such losses to offset against the purchase of “profitable” corporations such as Woodside. On the basis of the above evidence we have summarized (and contrary to some testimony and documentary evidence in these cases), it is absolutely clear that all individuals involved with Woodside Ranch and MidCoast were aware that MidCoast and its representatives had no intention of ever paying the tax liabilities of Woodside Ranch and also that the source of the approximately $225,000 MidCoast premium to be received by the Woodside Ranch shareholders was to come from the unpaid tax liability.
On June 27, 2002, a limited liability company was formed under the name of Woodsedge, LLC (Woodsedge), with the Woodside Ranch shareholders as its sole members, each having the same ownership percentage in Woodsedge as they had in Woodside Ranch.
On July 11, 2002, petitioners Ray Feldman and Richard Feldmann met with MidCoast representatives and others to discuss further the terms of the proposed purchase of the Woodside Ranch stock by MidCoast, referred to as a share purchase agreement (SPA). During that meeting, petitioners raised a question about their exposure to transferee liability relating to Woodside Ranch's tax liabilities.
On July 18, 2002, for reasons not clear in the trial record, Woodside Ranch redeemed 154 of the outstanding shares of Woodside Ranch stock and distributed therefor to its shareholders $300,326 in cash and other assets (the redemption proceeds). The parties explain that the fair market value of the redemption proceeds was later reduced to $293,728, and the total redemption proceeds were assigned and transferred by the Woodside Ranch shareholders to Woodsedge.
After the above partial redemption and moments before the effective date of the stock sale to MidCoast, Woodside Ranch had $1,835,209 in cash on hand from the Zumwalt asset sale and an approximate combined Federal and State income tax liability of $750,000.
Also on July 18, 2002, the Woodside Ranch shareholders and MidCoast entered into the SPA. Under the SPA, the stated purchase price to MidCoast for the Woodside Ranch stock was “equal to (a) the amount of Cash-on-Hand, less (b) $492,139.20”. The $492,139.20 represented a percentage (roughly 70 percent) of the estimated “Deferred Tax Liabilities” of approximately $750,000.
Still on July 18, 2002, in anticipation of the closing of the SPA, two escrow agreements were executed: The first by MidCoast, Woodside Ranch, the Woodside Ranch shareholders, and the law firm of Foley & Lardner (Foley) (hereinafter referred to as the sellers' escrow agreement); the second by MidCoast, Honora Shapiro (Shapiro), Shapiro's attorney, and Foley (hereinafter referred to as purchasers' escrow agreement).
Under both escrow agreements Foley was to act as escrow agent and all funds involved in the stock sale were to be wired into and out of the same trust account of the Foley law firm (the trust account).
On July 18, 2002, the following steps were taken: (1) $1,835,209 (Woodside Ranch's remaining cash on hand from the Zumwalt asset sale and after the $300,326 cash redemption) was transferred into the trust account; (2) $1.4 million from Shapiro was transferred into the trust account purporting to represent a loan from Shapiro to MidCoast allegedly to fund the MidCoast stock purchase; 7
(3) the purported sale to MidCoast by the Woodside Ranch shareholders of their remaining Woodside Ranch stock closed; “loan” was evidenced by a promissory note, nor that Shapiro received any security or collateral relating thereto. (4) $1,344,452 (viz., the $1,835,209 cash less the $492,139 portion of the combined Federal and State tax liability to be retained by MidCoast) (hereinafter sometimes referred to as the Woodside Cash) 8 was transferred from the trust account into an account of Woodsedge in favor of petitioners and which amount included the approximate $225,000 MidCoast premium; (5) $1.4 million was transferred back to Shapiro in return of the purported loan Shapiro had made to MidCoast earlier that same day (see (2) above); and (6) $38,000 was transferred out of the trust account to Foley for legal and escrow fees. 9
Section 7.1 of the SPA states that the above cash transfers were to be treated as occurring simultaneously. The schedule below highlights the reality that the above cash transfers occurred on the same day and within minutes or hours of each other:
Event
July 18, 2002 12:09 p.m. $1,835,209 Woodside Ranch cash transferred into the Foley trust account; 1:34 p.m. $1.4 million cash purportedly lent from Shapiro to MidCoast transferred into the Foley trust account; 3:35 p.m. $1,344,451 cash transferred out of the Foley trust account into an account of Woodsedge in favor of petitioners; 3:36 p.m. $1.4 million cash transferred out of the trust account back to Shapiro.
Per the sellers' escrow agreement, both the $1,344,451 (which petitioners received out of escrow on the purported sale of their stock to MidCoast) and the $452,728.84 (which MidCoast received) were to be paid, and they were paid from the sellers' escrow fund into which was deposited the $1,835,209 proceeds from the asset sale. In the sellers' escrow agreement, no express mention is made of any other funds being deposited into escrow to be transferred to the sellers. We quote from the express language of the sellers' escrow agreement:
The Escrow Agent acknowledges receipt of the aggregate amount of *** $1,835,209.08 (such amount, less distributions therefrom in accordance with this Agreement, being referred to herein as the “Escrow Fund”) from *** [Woodside Ranch]. *** The Escrow Agent shall immediately on the Closing Date *** pay over to (A) Woodsedge on behalf of the *** [petitioners] from the Escrow Fund $1,344,451.52 by wire transfer of immediately available funds to a bank account of *** [petitioners'] designation set forth in the Instructions; (B) *** [Woodside Ranch] from the Escrow Fund $452,728.84 by wire transfer of immediately available funds to a bank account of
* * * [Woodside Ranch's] designation set forth in the Instructions.
Per the purchaser's escrow agreement, the purported $1.4 million loan from Shapiro was not to be disbursed until the $1,835,209 proceeds of the Woodside Ranch asset sale were placed into the escrow fund, and only then was: $1,344,351 to be disbursed to Woodsedge on behalf of the Woodside Ranch shareholders; $452,728.84 to be disbursed to Midcoast; and $1.4 million to be “immediately” returned to Shapiro without interest. The closing statement shows $1.4 million coming from Shapiro and going back to Shapiro as part of the very same closing transaction.
The $1.4 million from Shapiro came into escrow only momentarily and went right back to Shapiro without ever serving a legitimate, economic purpose in this transaction. Were it a legitimate loan, the $1.4 million would have been outstanding for a period of time and would have had some business purpose. Interest would have been charged. There would have been a written promissory note. The $1.4 million from Shapiro constitutes a ruse, a recycling, a sham.
Within 4 days after the SPA closed, the $452,729 balance in the trust account was transferred out of the trust account into a SunTrust bank account in the name of Woodside Ranch, which by that point in time was controlled by MidCoast.
On or about July 22, 2002, April 2003, and August 8, 2005, each of the individual Woodside Ranch shareholders received from Woodsedge his or her respective share of the $293,728 redemption proceeds and of the $1,344,451 cash that passed through the Foley trust account as described above.
Included in the SPA was a representation by the shareholders of Woodside Ranch that, as of the time of the SPA, Woodside Ranch had no liabilities, direct or contingent, other than the combined Federal and State tax liability.
Included in the SPA was a guarantee and release in favor of petitioners to the effect that, as between petitioners and MidCoast, the maximum amount MidCoast could seek from petitioners relating to personal injury claims made by customers of Woodside Ranch was equal to the $224,311 MidCoast premium (i.e., to the portion of the taxes that were to go unpaid and that were to be retained by petitioners). 10
Also, the SPA contained a provision prohibiting MidCoast from liquidating or dissolving Woodside Ranch within 4 years of the July 18, 2002, closing of the stock sale. 11
Woodside Ranch After the Closing of the Purported Stock Sale After the purported stock sale to MidCoast, MidCoast was the nominal sole shareholder of Woodside Ranch. Woodside Ranch had $452,729 cash on hand, a combined Federal and State tax liability of approximately $750,000, and no operating assets. Woodside Ranch was rendered insolvent as a result of the payment by it of the redemption proceeds, the payment of the Woodside cash to the Woodside Ranch shareholders, and the return to Shapiro of his $1.4 million.
After the above transactions with MidCoast, Woodside Ranch had no paid employees and no income (other than nominal interest income). However, MidCoast charged Woodside Ranch a “professional service fee” of $250,000, and from August to December 2002 MidCoast charged Woodside Ranch $30,000 per month as a management fee, even though there were essentially no assets to manage. Woodside Ranch's SunTrust account records show withdrawals of $300,000 and $142,000 on July 19 and 22, 2002, respectively. As a result of these withdrawals, Woodside Ranch was unable to pay the July or August 2002 management fees it nominally owed MidCoast.
An amount of $1,181,249 was entered on the books of Woodside Ranch as a loan due from MidCoast to Woodside Ranch. This purported loan receivable in favor of Woodside Ranch apparently was based on the treatment of the $1.4 million in cash that, on July 18, 2002, was returned out of the Foley trust account to Shapiro. Woodside Ranch and MidCoast treated part (i.e., $1,181,249) of the $1.4 million returned to Shapiro as if it had been returned to Shapiro not by MidCoast, but by Woodside Ranch and that MidCoast somehow owed Woodside Ranch $1,181,249.
In December of 2003 MidCoast purportedly sold all of the stock of Woodside Ranch to Wilder Capital Holdings, LLC (Wilder), for no cash and for the “assumption” by Wilder of MidCoast's purported $1,181,249 loan obligation to Woodside Ranch.
Wilder made no payment on this purported loan assumption, and within 1 month, by January 29, 2004, the purported $1,181,249 loan and a promissory note of Wilder's relating thereto were marked “paid”. 12
On September 12, 2003, Woodside Ranch's 2002 Federal corporate income tax return was filed showing a tax due of $454,292, all relating to the Zumwalt asset sale. By that time, Woodside Ranch, of course, had no funds, and Woodside Ranch's Federal income tax liability was not paid with the filing of the return.
On February 22, 2005, Woodside Ranch's 2003 Federal corporate income tax return was filed claiming a net operating loss (NOL). This claimed NOL was carried back to 2002 and thereby reduced Woodside Ranch's reported 2002 Federal income tax liability to zero.
Woodside Ranch was administratively dissolved on August 13, 2009.
On audit, respondent disallowed all but $5,432 of the 2003 NOL claimed by Woodside Ranch on the grounds that the NOL was based on sham loans and was part of an illegal distressed asset/debt (DAD) tax shelter. Petitioners have stipulated that this DAD tax shelter was illegal, that the claimed 2003 NOL was not allowable, and that respondent properly disallowed the NOL carryback to 2002. 13
On September 11, 2006, respondent sent to Woodside Ranch a notice of deficiency setting forth respondent's determination of Woodside Ranch's $594,000 Federal income tax deficiency for 2002 plus an estimated tax penalty under section 6654, delinquency additions to tax under section 6651(a)(2) and (3), and an accuracy-related penalty under section 6662(b)(1). Woodside Ranch did not file a petition in this Court challenging the notice of deficiency, nor did Woodside Ranch file a complaint in any other court relating to its 2002 Federal income tax liability.
Petitioners took no actions to ensure that the Woodside Ranch Federal income tax liability triggered by the Zumwalt asset sale would be paid 14 and, as stated, it remains unpaid. 15
Respondent investigated whether Woodside Ranch had any available assets from which to collect Woodside Ranch's unpaid 2002 Federal income tax liability and determined that it had none.
On September 15, 2008, respondent sent notices of transferee liability to petitioners, each notice identifying Woodside Ranch as the transferor with an unpaid Federal income tax liability of approximately $594,000 plus additions to tax, penalties, and 14
Sec. 2.11 of the SPA provided that All Taxes due and payable by the Company on or prior to the Closing Date, including without limitation those which are called for by the Tax Returns, or heretofore claimed to be due by any taxing authority from the Company, have been paid, except for the Deferred Tax Liability, which liability is assumed by the Purchasers hereunder. Sec. 2.9 of the SPA defines “Deferred Tax Liability” and apparently limits it to $703,056. 15
It should be noted that the Woodside Ranch $153,725 Wisconsin corporate income tax liability for 2002 was paid by MidCoast when MidCoast representatives learned (apparently to their surprise) that Wisconsin law did not permit NOL deductions to be carried back and to offset prior year State corporate income tax liabilities. interest for a total of $1,057,216. The transferee notices indicated the total amount each petitioner received in the stock redemption and purported stock sale and calculated each petitioner's individual transferee liability accordingly.
An attachment to each notice of transferee liability stated in relevant part:
It is determined that the transaction in which shareholders of Woodside Ranch Resort, Inc. purportedly *** sold stock of Woodside Ranch Resort, Inc. to MidCoast Acquisitions Corporation and MidCoast Credit Corporation on July 18, 2002 is not respected for tax purposes. This transaction is substantially similar to an Intermediary transaction shelter described in notice 2001-16, 2001-1 C.B. 730 and Notice 2008-20, 2008-6 I.R.B. 406. It is determined that, in substance, Woodside Ranch Resort, Inc. ceased business activity on July 18, 2002, and that the allocation set forth in Exhibit 1 [showing petitioners' share of the deemed transferred assets] is attributable to you in liquidation or distribution of assets of Woodside Ranch Resort, Inc. on that date. 16
OPINION
In determining whether petitioners are liable under section 6901 as transferees for Woodside Ranch's unpaid Federal income tax liability, we first consider whether the July 18, 2002, purported stock sale between petitioners and MidCoast is, for Federal income tax purposes, to be recognized as such or is to be treated as a sham. Economic Substance or Sham Taxpayers generally are free to structure their business transactions as they wish, even if motivated in part by tax Gregory v. Helvering, 293 U.S. 465 [14 AFTR 1191] reduction considerations. (1935); Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 196 (1983), affd. on this issue 752 F.2d 89 [55 AFTR 2d 85-580] (4th Cir. 1985).
However, a transaction which lacks economic purpose and substance other than sought-after tax avoidance may be treated as a sham and disregarded for Federal income tax purposes. Frank Lyon Co. v. United States, 435 U.S. 561 [41 AFTR 2d 78-1142] (1978); Rice's Toyota World, Inc. v. Commissioner, supra at 196. The economic substance of a transaction, rather than its form, controls. Commissioner v. Court Holding Co., 324 U.S. 331 [33 AFTR 593] (1945); Gregory v. Helvering, supra; Amdahl Corp. v. Commissioner, 108 T.C. 507, 516-517 (1997).
The “labels, semantic technicalities, and formal written documents do not necessarily control the tax consequences of a given transaction.” Houchins v. Commissioner, 79 T.C. 570, 589 (1982); see also Ocmulgee Fields, Inc. v. Commissioner, 613 F.3d 1360, 1368 [106 AFTR 2d 2010-5820] (11th Cir. 2010), affg. 132 T.C. 105 (2009); Teruya Bros., Ltd. v. Commissioner, 580 F.3d 1038, 1043 [104 AFTR 2d 2009-6274] (9th Cir. 2009), affg. 124 T.C. 45 (2005); Yosha v. Commissioner, 861 F.2d 494, 499 [63 AFTR 2d 89-369] (7th Cir. 1988), affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
As we recently stated, for Federal income tax purposes a transaction may be disregarded if the transaction was entered into not for valid business purposes but rather for “tax benefits not contemplated by a reasonable application of the language and purpose of the Code or its regulations.” Palm Canyon X Invs., LLC v. Commissioner, T.C. Memo. 2009-288 [TC Memo 2009-288]. Even if a transaction is not treated as a sham, it still may be recast in order to Gaw v. Commissioner, T.C. Memo. 1995- reflect its true nature. 531 (citing Packard v. Commissioner, 85 T.C. 397, 419-422 (1985)), affd. without published opinion 111 F.3d 962 (D.C. Cir. 1997).
Courts often interpret the Supreme Court's holding in Frank Lyon Co. v. United States, supra, as establishing an economic substance doctrine with two prongs: Whether the taxpayer had a nontax business purpose or objective for entering into the disputed transaction (the subjective prong); and whether the transaction had economic substance beyond the anticipated tax benefits (the objective prong). See, e.g., Karr v. Commissioner, 924 F.2d 1018, 1023 [67 AFTR 2d 91-653] (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988); Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 [60 AFTR 2d 87-5272] (9th Cir. 1987), affg. T.C. Memo. 1986-23 [¶86,023 PH Memo TC]; Rice's Toyota World, Inc. v. Commissioner, 752 F.2d at 91-92; Palm Canyon X Invs., LLC v. Commissioner, supra .
Some courts use a disjunctive approach and treat a transaction as having economic substance if the transaction has either a business purpose or economic substance. See, e.g., Rice's Toyota World, Inc. v. Commissioner, 752 F.2d at 91-92. Some courts use a conjunctive approach and treat a transaction as having economic substance only if the transaction has both a business purpose and economic substance. See, e.g., Dow Chem. Co. v. United States, 435 F.3d 594, 599 [97 AFTR 2d 2006-671] (6th Cir. 2006). Yet other courts collapse the objective and subjective prongs into one comprehensive inquiry. See, e.g., Sacks v. Commissioner, 69 F.3d 982, 988 [76 AFTR 2d 95-7138] (9th Cir. 1995), revg. T.C. Memo. 1992-596 [1992 RIA TC Memo ¶92,596]; Kirchman v. Commissioner, 862 F.2d 1486, 1492 [63 AFTR 2d 89-588] (11th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986).
The Court of Appeals for the Seventh Circuit has stated generally that “It is well-established that the Commissioner is not required to recognize, for tax purposes, those transactions which lack economic substance.” Muhich v. Commissioner, 238 F.3d 860, 864 [87 AFTR 2d 2001-667] (7th Cir. 2001), affg. T.C. Memo. 1999-192 [1999 RIA TC Memo ¶99,192]. "[T]ransactions with no economic substance don't reduce people's taxes.” Cemco Investors, LLC v. United States, 515 F.3d 749, 752 [101 AFTR 2d 2008-768] (7th Cir. 2008); Grojean v. Commissioner, 248 F.3d 572 [87 AFTR 2d 2001-1673] (7th Cir. 2001), affg. T.C. Memo. 1999-425 [1999 RIA TC Memo ¶99,425]; Muhich v. Commissioner, supra at 864 (citing Gregory v. Helvering, supra); see also Coleman v. Commissioner, 16 F.3d 821 [73 AFTR 2d 94-1209] (7th Cir. 1994), affg. T.C. Memo. 1990- 99 [¶90,099 PH Memo TC] and T.C. Memo. 1987-195 [¶87,195 PH Memo TC].
The Court of Appeals for the Eleventh Circuit recently noted that “Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance.” United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014, 1018 [87 AFTR 2d 2001-2565] (11th Cir. 2001); see also Kirchman v. Commissioner, supra at 1492 (”The focus of the inquiry under the sham transaction doctrine is whether a transaction has economic effects other than the creation of tax benefits.” (citing Knetsch v. United States, 364 U.S. 361 [6 AFTR 2d 5851] (1960))). In Kirchman v. Commissioner, supra at 1492, the Court of Appeals for the Eleventh Circuit noted further:
The analysis of whether a transaction is a substantive sham, however, addresses whether a transaction's substance is that which it form represents. That does not necessarily require an analysis of a taxpayer's subjective intent. Once a court determines a transaction is a sham, no further inquiry into intent is necessary. The Court of Appeals for the Ninth Circuit has recently discussed in an unpublished opinion the economic substance doctrine and its two prongs as follows: "`(1) whether *** [taxpayers] demonstrated that either of the principals directing their respective transactions had a business purpose for engaging in the transaction other than tax avoidance and (2) whether either transaction had economic substance beyond the creation of tax benefits.” Thomas Inv. Partners, Ltd. v. United States, 108 AFTR 2d 2011-5369 [108 AFTR 2d 2011-5369], at 2011-5371, 2011-2 USTC par. 50,517, at 86,287 (9th Cir. 2011) (quoting Casebeer v. Commissioner, 909 F.2d 1360, 1363 [66 AFTR 2d 90-5361] (9th Cir. 1990)).
The Court of Appeals in Thomas concluded that the transactions under scrutiny were unlikely to confer a nontax benefit and that the individuals who engaged in those Id. at 2011- transactions did so solely to create tax benefits. 5372, 2011-2 USTC par. 50,517, at 86,287. Further, the Court of Appeals has stated that “the consideration of business purpose and economic substance are simply more precise factors to consider in the application of this court's traditional sham analysis”. Sochin v. Commissioner, 843 F.2d 351, 354 [61 AFTR 2d 88-926] (9th Cir. 1988), affg. Brown v. Commissioner, 85 T.C. 968 (1985).
Before us in these cases is a purported stock sale between petitioners and MidCoast that lacks both business purpose and economic substance and that we conclude is to be disregarded for Federal income tax purposes. In substance, there was no sale of the stock of Woodside Ranch; rather, Woodside Ranch was liquidated, and the $1,835,209 cash that Woodside Ranch had on hand (after the partial redemption that occurred on July 18, 2002) was distributed to the Woodside Ranch shareholders less a fee of approximately $500,000 that MidCoast retained for facilitating the sham.
The “no-cost liquidation” terminology used by the MidCoast representatives is telling. In substance, it really was a liquidation, not a stock sale. The effort, assisted by MidCoast's sleight of hand, to reduce the tax cost of the Woodside Ranch liquidation by cloaking the liquidation in the trappings of a stock sale is to be ignored.
We emphasize that at the same time Shapiro transferred $1.4 million into the trust account, $1.4 was immediately returned to Shapiro. Inferentially, the approximately $1.3 million the Woodside Ranch shareholders received out of the trust account came to them from the $1.8 million in proceeds of the Zumwalt asset sale—as a corporate distribution. In substance, Woodside Ranch was liquidated, and petitioners received the $1.3 million as liquidation proceeds.
The $1,181,249 reported loan receivable in favor of Woodside Ranch from MidCoast obviously was a mere accounting device, devoid of substance. As we have emphasized, the $1.4 million Shapiro placed into the escrow on July 18, 2002, was returned to Shapiro 2 hours later, and thereafter no portion thereof was owed by anyone to anyone. Shapiro had his $1.4 million. MidCoast did not owe him anything. Woodside Ranch did not owe him anything, and MidCoast did not owe Woodside Ranch anything with regard thereto.
What was transferred by Woodside Ranch to MidCoast did not actually represent equity in Woodside Ranch. See Owens v. Commissioner, 568 F.2d 1233, 1238 [41 AFTR 2d 78-419] (6th Cir. 1977), affg. in part and revg. in part 64 T.C. 1 (1975). On July 18, 2002, Woodside Ranch's assets consisted only of cash. All of the operating assets and business of Woodside Ranch had been sold to Zumwalt. After the asset sale and partial redemption, but before the purported stock sale, Woodside Ranch had $1,835,209 cash on hand and a combined Federal and State corporate income tax liability of approximately $750,000.
From the time of the purported stock sale, Woodside Ranch carried on no business activity; there was no viable business to continue, and, on the basis of our evaluation of the evidence and testimony before us, representations from MidCoast that Woodside Ranch would be incorporated into MidCoast's “asset-recovery” business are preposterous.
After the July 18, 2002, transaction, Woodside Ranch was nothing more than a shell, with no employees, no real property, and no assets other than MidCoast's share of the unpaid taxes.
Petitioners argue emphatically that if Woodside Ranch had been liquidated, Woodside Ranch's management and shareholders might have ended up facing unexpected and unknown claims and lawsuits against them personally under Wisconsin law. Indeed, petitioners argue that the Woodside Ranch shareholders' concern over potential liability claims was dominant and that the shareholders' concern over taxes due on the Zumwalt asset sale was only secondary.
As we have found, however, whatever the level of perceived risk the Woodside Ranch management and shareholders actually had in operating Woodside Ranch, it was not enough of a risk to convince them to purchase anything more than spotty or discrete personal injury insurance.
Over the years, Woodside Ranch had relatively few personal injury claims brought against it relating to activities of the ranch and then only in amounts not disclosed in the record.
On the facts and credible evidence before us, we conclude that petitioners had little basis for being concerned for their potential personal liability on unknown claims and lawsuits arising out of the activities of Woodside Ranch. 17
The June 17, 2002, minutes of the Woodside Ranch finance committee meeting establish that both the MidCoast representatives and the Woodside Ranch shareholders knew and understood that the only real payment MidCoast was making to the Woodside Ranch shareholders was calculated as, and in fact constituted, nothing more than a split of the projected tax liabilities that no one intended to pay.
The real price to be paid by MidCoast for the stock had nothing to do with the value of Woodside Ranch; rather, the stock purchase by Midcoast was a sham, and MidCoast was simply splitting between itself and the Woodside Ranch shareholders the amount of the taxes that should have been paid.
The MidCoast representative said it correctly when he stated that the transaction before us was all about creating tax avoidance; it was not supported by underlying economic substance and business activity. The only entity that was to fund, or incur, the cost of the transaction before us was the Federal Government via unpaid taxes.
Petitioners argue that the SPA provision under which Woodside Ranch was not to be dissolved for 4 years confirms their good faith and intent that the tax liabilities would be paid, and confirms their concern over personal liability for personal injury claims against Woodside Ranch. We disagree. We regard the SPA provision as essentially meaningless. While under the control of MidCoast, Woodside Ranch failed to pay its taxes, claimed other illegal tax-avoidance tax shelters, and was effectively given away by MidCoast for nothing.
We conclude that in substance the transaction before us was not a bona fide sale of Woodside Ranch stock. The substance of the transaction was a liquidation to petitioners of Woodside Ranch's cash and a fee payment to MidCoast for its role in facilitating the sham. Transferee Liability Section 6901(a) provides a procedure through which respondent may collect from transferees of assets unpaid taxes owed by the transferors of the assets if a legal basis exists under State law or equity for holding the transferees liable for the unpaid taxes. Commissioner v. Stern, 357 U.S. 39, 42 [1 AFTR 2d 1899]-47 (1958); Hagaman v. Commissioner, 100 T.C. 180, 184-185 (1993). Transferee liability under section 6901 includes related additions to tax, penalties, and interest owed by the transferors. Kreps v. Commissioner, 42 T.C. 660, 670 (1964), affd. 351 F.2d 1 [16 AFTR 2d 5649] (2d Cir. 1965). Respondent bears the burden of proving that petitioners are liable as transferees of the property of Woodside Ranch. See sec. 6902(a); Rule 142(d).
We apply Wisconsin law in our analysis of whether petitioners should be held liable as transferees of Woodside Ranch.
Wisconsin shareholders of a dissolved corporation may be liable as transferees to creditors of the corporation (such as respondent) where the shareholders receive corporate assets as part of a dissolution. Wis. Stat. Ann. sec. 180.1408(2) (West 2002) provides:
If the dissolved corporation's assets have been distributed in liquidation, a claim not barred under sec. 180.1406 or 180.1407 may be enforced against a shareholder of the dissolved corporation to the extent of the shareholder's proportionate share of the claim or the corporate assets distributed to him or her in liquidation, whichever is less, but a shareholder's total liability for all claims under this section may not exceed the total amount of assets distributed to him or her. As computed for purposes of this subsection, the shareholder's proportionate share of the claim shall reflect the preferences, limitations and relative rights of the class or classes of shares owned by the shareholder as well as the number of shares owned, and shall be equal to the amount by which payment of the claim from the assets of the corporation before dissolution would have reduced the total amount of assets to be distributed to the shareholder upon dissolution. Income tax liabilities arising from the sale of corporate assets are “claims” existing at the time of the sale. See Kreps v. Commissioner, supra at 670-671. This Court has held that at the time of an intermediary transaction asset sale (not dissimilar from the transaction herein), the Commissioner qualified as a creditor of the seller for Federal taxes arising from the sale. LR Dev. Co., LLC v. Commissioner, T.C. Memo. 2010-203 [TC Memo 2010-203] (discussing Illinois definitions of the terms “debt” and “claim” which are the same as under Wisconsin's fraudulent transfer statute).
Having found that the transaction before us in substance and purpose was part of a liquidation and dissolution of Woodside Ranch and that the Woodside Ranch shareholders received, as a part of that liquidation and dissolution, approximately $1.3 million in cash as a distribution from Woodside Ranch, we conclude that petitioners are liable as transferees under the above provision of Wisconsin law for their proportionate shares of Woodside Ranch's unpaid 2002 Federal income tax liability.
Wisconsin also has adopted the Uniform Fraudulent Transfer Act, codified at Wis. Stat. Ann. secs. 242.01 to 242.12 (West 2009) (Wisconsin UFTA), which provides creditors with certain remedies where a debtor transfers property and thereby avoids creditor claims. If the elements of the Wisconsin UFTA are satisfied, creditors may obtain an attachment or other remedy against the property transferred and against the transferees and their property. Wisconsin UFTA sec. 242.07.
Respondent does not argue that petitioners should be liable as transferees under Wisconsin UFTA section 242.04(1)(a), a provision that requires a debtor's actual intent to defraud, hinder, or delay a creditor. However, respondent argues that under two closely related provisions of the Wisconsin UFTA petitioners should be treated as transferees and as liable for the unpaid Federal income tax liability of Woodside Ranch.
Wisconsin UFTA section 242.04(1)(b) is applicable where: [T]he debtor made the transfer or incurred the obligation: *** Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor: (1) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (2) Intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor's ability to pay as they became due. Wisconsin UFTA section 242.05(1) is applicable where: [T]he debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation. Wisconsin statutes do not define “reasonably equivalent value”. The Uniform Fraudulent Transfer Act is a uniform act deriving the phrase “reasonably equivalent value” from 11 U.S.C. section 548. Leibowitz v. Parkway Bank & Trust Co. (In re Image Worldwide, Ltd.), 139 F.3d 574, 577 (7th Cir. 1998); Bowers- Siemon Chems. Co. v. H.L. Blachford, Ltd., 139 Bankr. 436, 445 (Bankr. N.D. Ill. 1992) (”Illinois law on fraudulent conveyance parallels sec. 548 of the Bankruptcy Code.”). Whether reasonably equivalent value was received by the transferor is a question of fact. Leibowitz v. Parkway Bank & Trust Co. (In re Image Worldwide, Ltd.), supra at 576 (citing Heritage Bank Tinley Park v. Steinberg (In re Grabill), 121 Bankr. 983, 994 (Bankr. N.D. Ill. 1990)).
In the bankruptcy context, the Court of Appeals for the Seventh Circuit has stated that the “test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and to compare it to what was received.” Barber v. Golden Seed Co., 129 F.3d 382, 387 (7th Cir. 1997).
Under the Wisconsin UFTA, creditors, such as respondent, have the burden to prove the above elements of transferee liability by clear and convincing evidence. Kaiser v. Wood Cnty. Natl. Bank & Trust Co. (In re Loyal Cheese Co.), 969 F.2d 515, 518 (7th Cir. 1992); Mann v. Hanil Bank, 920 F. Supp. 944, 950 (E.D. Wis. 1996).
Petitioners do not dispute Woodside Ranch's liability for the Federal income taxes arising from the Zumwalt asset sale, nor the existence of respondent's claim therefor or respondent's creditor status at the time of the transfers in question.
On the evidence before us, it is clear that in exchange for the distribution of approximately $1.3 million in cash to petitioners Woodside Ranch received nothing of reasonably equivalent value.
After the Zumwalt asset sale, Woodside Ranch ceased to engage in any business activity. There was no viable business to continue, and regardless of how MidCoast chose to describe its post-sale intentions for Woodside Ranch, the only “business” left for Woodside Ranch was to pay its tax liabilities arising from the asset sale. The transfer of Woodside Ranch's $1.3 million to petitioners left Woodside Ranch with remaining assets of approximately $453,000 in cash, insufficient to pay Woodside Ranch's Federal and State income tax liabilities exceeding $700,000.
It is clear that as a result of Woodside Ranch's cash distribution to petitioners, Woodside Ranch was rendered insolvent. See Wisconsin UFTA sec. 242.02(b)(2) (”A debtor is insolvent if the sum of the debtor's debts is greater than all of the debtor's assets at a fair valuation.”).
Further, the Woodside Ranch shareholders should have known that the Federal income tax liability arising from the Zumwalt asset sale would not be paid. The credible evidence before us establishes that petitioners' interest in the MidCoast transaction relied almost entirely on the assumption and calculation that the Woodside Ranch tax liability would remain unpaid; the impetus for taking the cumbersome route of a nominal stock sale was the mutual understanding between petitioners and MidCoast that each party would pocket and retain a portion of the unpaid taxes.
MidCoast offered a “no-cost” liquidation as a solution to the tax “dilemma” in which petitioners found themselves. In spite of representations to the contrary in some of the transaction documents, the record is replete with notice to petitioners that MidCoast never intended to pay Woodside Ranch's Federal income tax liability.
On the credible evidence before us, we conclude that petitioners knew or should have known that, as a result of the transactions among Woodside Ranch, MidCoast, and petitioners, Woodside Ranch had debts beyond its ability to pay.
We conclude that petitioners herein are liable as transferees under both of the above provisions of the Wisconsin UFTA for their proportionate shares of Woodside Ranch's unpaid 2002 Federal income tax liability.
Lastly, under what respondent refers to as a common law “trust fund” doctrine relating to fiduciary duties of corporate directors and officers, petitioners should be treated as transferees and as liable for the unpaid Federal income tax liability of Woodside Ranch. Respondent cites Beloit Liquidating Trust v. Grade, 677 N.W.2d 298, 309 (Wis. 2004), which explained that when a corporation is insolvent and has ceased to be a going concern and its directors and officers know, or ought to know, that suspension of the corporation is pending, transfers of corporate property to the directors or officers in lieu of payments to creditors of the corporation may be held to constitute a fraud on the creditors and the directors and officers may be held personally liable to the injured creditors. See also Polsky v. Virnich, 779 N.W.2d 712, 714 (Wis. Ct. App. 2010).
Under the above alternate authority, respondent argues that all petitioners should be held liable under Wisconsin law and under section 6901 as transferees. As noted, however, this Wisconsin common law authority would apply only to petitioners who were directors and officers of Woodside Ranch (namely, to Ray Feldman, Richard Feldmann, and Carrie Donahue), not to petitioners who were neither directors nor officers of Woodside Ranch.
In light of our conclusion and holding herein that petitioners are liable under Wis. Stat. Ann. sec. 180.1407, the Wisconsin UFTA, and section 6901 for their respective shares of Woodside Ranch's 2002 unpaid Federal income tax liability, we need not, and we do not decide whether any petitioners also should be held liable under the above common law authority on which respondent relies.
In two recent Memorandum Opinions and in a Memorandum Opinion filed today, this Court has addressed transferee liability relating to other transactions promoted by Midcoast. See Frank Sawyer Trust of May 1992 v. Commissioner, T.C. Memo. 2011-298 (filed Dec. 27, 2011); Starnes v. Commissioner, T.C. Memo. 2011-63 [TC Memo 2011-63] (decision entered Mar. 24, 2011), on appeal (4th Cir., June 8, 2011); Griffin v. Commissioner, T.C. Memo. 2011-61 [TC Memo 2011-61] (decision entered Sept. 30, 2011). In the above three cases this Court held in favor of the taxpayers. Those cases involved differences from the instant cases.
Starnes and Frank Sawyer Trust were decided largely on the basis of insufficiency of and burden of proof.
In Griffin, after the transaction with MidCoast, the target corporation retained substantial assets and was not thereby rendered insolvent. Additionally, the taxpayer filed a lawsuit and obtained a State court judgment against MidCoast in an effort to get the taxes paid.
In Starnes, Griffin, and Frank Sawyer Trust, the facts as found did not establish that the taxpayers knew that MidCoast intended not to pay the taxes.
For the reasons stated, we sustain respondent's determination that petitioners are liable as transferees with respect to their respective shares of the 2002 unpaid Federal income tax liability of Woodside Ranch and the related additions to tax, penalties, and interest.
Decisions will be entered for respondent.
2
In our findings of fact, use of the words “sale”,
3
Unless otherwise indicated, all section references are to the Internal Revenue Code applicable to the year before us, and all Rule references are to the Tax Court Rules of Practice and Procedure.
4
For example, Woodside Ranch carried landlord/tenant-type insurance relating to the buildings and property.
5
In an opinion letter, Woodside Ranch's accountant estimated that a sale of Woodside Ranch assets would trigger Federal and State corporate income taxes of approximately $595,700 and $152,000, respectively.
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If a liquidation of Woodside Ranch occurred, creditors would be able to bring claims directly against Woodside Ranch shareholders who received corporate assets on the liquidation. See Wis. Stat. Ann. sec. 180.1408(2) (West 2002).
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The record does not indicate that the purported Shapiro
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Cash of $1,835,209 less $492,139 equals $1,343,070. The record does not explain why an extra $1,382 was transferred from the Foley trust account into the Woodsedge account in favor of the Woodside Ranch shareholders.
9
Farris' accounting firm also received a $25,000 finder's fee for introducing MidCoast to the Woodside Ranch shareholders.
10
As stated earlier, after the above transactions with MidCoast, petitioners made only one payment relating to personal injury claims arising from activities of Woodside Ranch before July 18, 2002, which resulted in a payment by petitioners and others of $50,000.
11
Petitioners presumably wanted this provision both as added protection against potential personal injury claims arising from Woodside Ranch activities and to protect against petitioners' personal exposure to transferee liability for Woodside Ranch's unpaid income tax liabilities relating to the asset sale.
12
Wilder's obligation on the assumed purported Midcoast debt to Woodside Ranch should have been, were it legitimate, reflected in a promissory note running from Wilder in favor of Woodside Ranch. In fact, however, a promissory note of Wilder relating thereto was issued in favor of MidCoast.
13
Generally, in a DAD tax shelter a domestic partnership claims a loss relating to a purported contribution of a built-in loss asset. The partnership typically will contribute the asset to a lower tier partnership, which in turn will sell that asset to another (sometimes related) entity, thereby purportedly incurring a significant loss. The reported loss passes through to the upper tier partnership, which allocates and passes through the loss to the domestic partners; the domestic partners offset other income or gain with the purported loss. The overall effect is that the domestic partner-taxpayers reap the benefits of the built-in loss asset without ever having incurred the costs associated therewith. See IRS Coordinated Issue Paper, “Distressed Asset/Debt Tax Shelters”, LMSB-04-0407-031 (Apr. 18, 2007).
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Petitioners do not contest their liability as transferees relating to the $293,729 redemption proceeds they received.
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We also find it remarkable that the Woodside Ranch shareholders and MidCoast capped the liability of the Woodside Ranch shareholders for personal injury claims relating to ranch activities to the amount of the MidCoast premium (i.e., to the amount the shareholders were to receive from the unpaid taxes). Apparently, the individuals involved in the transactions before us thought the unpaid taxes (or a portion thereof) should be the measure not only of MidCoast's fee, but also the measure and limit of the shareholders' liability for personal injury claims. The unpaid taxes were to serve dual purposes.
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