AM 2012-002
UIL No. 7701.02-00, 1001.00-00Split Eligible Entity Interests
FULL TEXT:
Number: AM2012-001
Release Date: 2/17/2012
CC:PSI:3:ASBERK
POSTU-141824-11
UILC: 7701.02-00, 1001.00-00
date: February 09, 2012
to: Cheryl Claybough
Director, Pre-Filing and Technical Guidance
(LB&I-Pre-Filing & Technical Guidance) LB&I:PFTG
from: Curt G. Wilson
Associate Chief Counsel
(Passthroughs & Special Industries) CC:PSI
subject:
Split Eligible Entity Interests
This advice may not be used or cited as precedent.
ISSUE
Whether a taxpayer (Owner) who owns one-hundred percent of the membership interest in an eligible entity, which is a disregarded entity for federal tax purposes, may split his eligible entity interest into separate classes of interests and then allocate income, loss, deduction, credit, and basis among those classes.
CONCLUSION
For federal tax purposes, unless Owner elects otherwise under § 301.7701-3, a wholly owned eligible entity is a disregarded entity, and Owner may not allocate tax items or basis among its different interests.
FACTS
We recently assisted with an audit involving a taxpayer in the Coordinated Exam Program. As part of that audit, the Service discovered that the taxpayer had engaged in a transaction similar to the one described herein. We suspect that other taxpayers may have engaged in similar transactions as well. Certain Owners owning one-hundred percent interests in eligible entities split their interests into separate classes of membership interests (Split Eligible Entity Interest Transaction), then allocate income, loss, deduction, credit, and basis among those classes for federal tax purposes according to the interests' preferences. Owner may own his various classes of interests through other disregarded entities. Owner uses this arrangement to create or manipulate an “outside basis” in parts of its disregarded entity interest for federal tax purposes. For example, Owner may attempt to control the recognition of income or loss on distributions from the eligible entity or on the disposition of a portion of its interest in that entity by manipulating the outside basis of the interests.
For example, in a Split Eligible Entity Interest Transaction, Owner creates a wholly owned state law entity, treated as a disregarded entity for federal tax purposes. The entity's governing documents state that Owner takes one-hundred percent of each class of interest in the entity. Based on the preferences contained in the governing documents, the entity allocates items of income, deduction, loss, and credit between the classes. Owner tracks and adjusts an outside basis in its various classes of interests accordingly. Owner drafts the governing documents to establish Owner's chosen class interest allocations. Thus, adjustments to Owner's bases in the various classes of interests will create disparities based on the entity's items of income, deduction, loss, or credit. Such disparities will exist in spite of the fact that the entity is a disregarded entity, and Owner should recognize all of the entity's items of income, deduction, loss, or credit directly regardless of any supposed “allocations” among artificially created classes of interests.
This artificial manipulation of the interests, if permitted, would allow Owner to control the recognition of income or loss on distributions from the entity or dispositions of its interests in the entity for federal tax purposes.
LAW & ANALYSIS
The “check the box” regulations generally provide for three types of entities— disregarded entities, associations, and partnerships. Section 301.7701-3(b)(1)(ii) of the Procedure and Administration regulations provides that unless the entity elects otherwise, a domestic eligible entity is disregarded as an entity separate from its owner if it has a single owner. Section 301.7701-3(a) provides that a business entity that is not classified as a corporation under , , , , , § 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (Eligible Entity) can elect its classification for federal tax purposes. An Eligible Entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. An entity whose classification is determined under the default classification, however, retains that classification until the entity makes an election to change that classification under Treas. Reg. § 301.7701-3(c)(1).
Rev. Rul. 99-5 governs the taxation of an Owner who sells a portion of its interest in a disregarded entity. The revenue ruling uses an example where a state law LLC has a single owner, A, and is treated as a disregarded entity for federal tax purposes. In the first situation, B purchases 50% of A's ownership interest, and A does not contribute any part of that purchase price to the LLC. Later A and B operate the LLC as co-owners. The revenue ruling provides that the LLC converts to a partnership when B purchases 50% of A's interest. Rev. Rul. 99-5 treats B's purchase as a purchase of a 50% interest in each of the LLC's assets, which A is treated as owning directly. The revenue ruling then treats A and B as contributing their interests in the LLC's assets to a partnership in exchange for ownership interests in the partnership. Rev. Rul. 99-5 does not ever mention a taxpayer's outside basis in his disregarded entity interest, because the owner of a disregarded entity has no outside basis in the entity for federal tax purposes. Therefore, outside basis has no relevance to a taxpayer's disposition of his interest in a disregarded entity.
Likewise, a disregarded entity cannot make distributions in a manner where the federal income tax consequences would turn on the member's nonexistent outside basis. Section 301.7701-2(a) provides that if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. For federal tax purposes, the member already owns all of the disregarded entity's property. Therefore, while a preferred interest in an eligible entity may entitle the owner of the preferred interest to preferential distribution or liquidation rights under state law, such preferences have no meaning for federal tax purposes while the same taxpayer owns one-hundred percent of all classes of interests.
In contrast, §§ 731 and 741 of the Internal Revenue Code, related to partnerships, both highlight why no authority exists allowing Owners to create or track an outside basis in a disregarded entity. Under § 731, a partner generally recognizes gain on partnership distributions to the extent money distributed exceeds the partner's outside basis in its partnership interest. Likewise, a partner that sells an interest in a partnership has sold an intangible asset that is its interest in the partnership itself—it has not sold its proportionate interest in each partnership asset. see e.g. Long v. Commissioner, 173 F.2d 471 (5th Cir. 1949) (cert. denied), Commissioner v. Smith , 173 F.2d 470 (5th Cir. 1949) (cert. denied); but see § 751(a), which in some cases overrides the principle that a partner sells its interest in the partnership and instead taxes the partner on its proportionate share of unrealized receivables and inventory items. Thus, tracking outside basis is critical to properly taxing a partner on partnership distributions or on the disposition of its partnership interest, because in both instances, the partner's federal tax consequences derive directly from its outside basis in its partnership interest. Conversely, tracking outside basis in its disregarded entity is irrelevant to Owner's taxation, and therefore, no authority provides for such tracking.
While state law may or may not allow for different classes of interests in eligible entities for federal tax purposes, such interests have no effect for federal tax purposes because a wholly owned eligible entity is a disregarded entity unless it elects otherwise. Therefore, for federal tax purposes Owner may not split its interest into separate classes of interests and may not allocate items of income, loss, deduction, credit, and basis among those classes.
The Service may disallow any tax benefit attributable to a Split Eligible Entity Interest Transaction, by asserting one or more arguments that may include, but are not limited to:
1) Rev. Rul. 99-5, 1999-6 C.B. 434, provides that a taxpayer who sells a portion of its interest in a disregarded entity is treated as selling a pro-rata share of each asset owned by the disregarded entity; and
2) a disregarded entity cannot make distributions, the taxation of which would affect outside basis because Treas. Reg. § 301.7701-2(a) treats a disregarded entity as a sole proprietorship, branch, or division of the owner.
Additionally, we do not believe that the federal tax laws provide any support for the Split Eligible Entity Interest Transaction, so the Service should consider the applicability of accuracy related penalties in these cases. Please contact Ari S. Berk at (202) 622-3070 if you have any further questions.
Curt G. Wilson
Associate Chief Counsel
(Passthroughs & Special Industries)
cc:
Thomas R. Thomas
Division Counsel (SB/SE)
Linda M. Kroening
Division Counsel (LB&I)
Sunday, February 26, 2012
Saturday, February 25, 2012
Alimony lump sum
Private Letter Ruling 201206005, 02/10/2012, IRC Sec(s). 71
UIL No. 71.00-00, 215.00-00, 1041.00-00, 2511.00-00, 2512.00-00, 2516.00-00, 2053.00-00, 2043.00-00
Alimony and separate maintenance payments—lump sum payments—qualification as alimony—deductions.
Headnote:
Lump-sum payment made by divorced taxpayer in return for extinguishment of his liability to pay alimony to wife isn't alimony or separate maintenance payment as defined in Code Sec. 71(b); , isn't includible in wife's income under Code Sec. 71; , and isn't deductible by taxpayer under Code Sec. 215; . But, stated month's alimony payments made under settlement agreement satisfy all Code Sec. 71(b)(1); factors and qualify as alimony taxable to wife under Code Sec. 71; and deductible to husband under Code Sec. 215; .
Reference(s): Code Sec. 71; Code Sec. 215;
Full Text:
Number: 201206005
Release Date: 2/10/2012
Index Number: 71.00-00, 215.00-00, 1041.00-00, 2511.00-00, 2512.00-00, 2516.00-00, 2053.00-00, 2043.00-00
Third Party Communication: None
Date of Communication: Not Applicable
Person To Contact: [Redacted Text]
[Redacted Text], ID No.
Telephone Number: [Redacted Text]
Refer Reply To:
CC:ITA:B03
PLR-126246-11
Date:
November 02, 2011
LEGEND
Husband =
Wife =
Date 1 =
Date 2 =
Date 3 =
Date 4 =
Date 5 =
Date 6 =
Date 7 =
Year 1 =
$A =
$B =
$C =
$D =
$E =
$F =
$G =
W =
X =
Y =
3Z =
State =
State Court =
Dear [Redacted Text]:
This ruling responds to a letter dated June 10, 2011 submitted by your authorized representatives, requesting a ruling regarding the income tax and gift tax consequences of a lump-sum payment in satisfaction of Husband's obligations to Wife to pay alimony and to leave one-third of his net estate to her under the divorce judgment and a settlement agreement incorporated into the divorce judgment.
STATEMENT OF FACTS
The facts submitted are as follows:
Husband and Wife were married on Date 1 and had four children, who are now fully emancipated. On Date 2, the parties entered into a separation agreement (the Separation Agreement) and obtained a divorce judgment (the Divorce Judgment), which was entered on Date 3 by the State Court. The Divorce Judgment incorporated, but did not merge, the Separation Agreement.
The Separation Agreement provides for alimony to be paid by Husband to Wife. The amount Husband must pay is based on a percentage of the first $A of his annual net income plus a smaller percentage of his annual net income exceeding $A but not more than $B, with a $C minimum annual payment. If Wife has annual net income exceeding $D, Husband receives a credit against his alimony obligation for that year. The term “annual net income” of Husband and Wife is generally defined in the Separation Agreement as his or her annual adjusted gross income for federal income tax purposes, disregarding certain types of income, for example, capital gains and losses, dividends and interest. Husband's obligation to pay alimony to Wife terminates on the earliest to occur of Husband's death, Wife's remarriage, or Wife's death.
Currently, Husband is age W and Wife is age X. Wife has not remarried and the parties anticipate that Wife will not remarry during Husband's lifetime. Wife has never had annual net income in excess of $D. At present, Husband is paying the minimum alimony amount of $C per year and the parties anticipate that Husband's alimony obligation will remain at the minimum amount for the duration of his obligation.
The Separation Agreement also requires Husband to leave not less than one-third of his net estate to Wife, if she survives him and has not remarried at his death. The term “net estate” is generally defined in the Separation Agreement as Husband's gross estate passing to others under his will less funeral and testamentary expenses, debts, inheritance and estate taxes, and death duties of every kind, but also includes certain additions to his net estate; however, limited to the extent that he has provided the corpus thereof.
The parties disagree on the proper method for computing Husband's net estate under the Separation Agreement. Specifically, the parties disagree on what comprises the net estate - whether gifts and inheritances are excluded and whether certain expenses and taxes are deductible. The parties recognize that resolving these issues will be costly to Husband's estate and will delay distributions to his beneficiaries and to Wife. Therefore, the parties agreed to settle the matter by entering into a settlement agreement (the Modification Agreement).
On Date 4, Husband and Wife entered into the Modification Agreement. The Modification Agreement requires Husband to pay Wife a lump-sum amount of $E in full settlement of his obligation under the Separation Agreement to pay alimony and to leave a portion of his net estate to Wife. The Modification Agreement also requires Husband to continue to pay alimony to Wife for a period of Y months as provided in the Separation Agreement after the entry of the amended Divorce Judgment and after he pays the sum of $E. The Modification Agreement further provides that § 71 of the Internal Revenue Code, as amended by the Tax Reform Act of 1984, shall apply to the Modification Agreement and that the lump-sum payment of $E shall not be taxable to Wife or deductible to Husband, but alimony payable for the Y months shall be taxable to Wife and deductible to Husband.
The lump-sum payment of $E was determined by a professional actuary who valued Wife's right to receive alimony for the term of her and Husband's life expectancy and Wife's right to receive one-third of Husband's net estate upon his death if she survives him. The amount of the lump-sum payment was determined using the RP-2000 mortality tables and the rate of investment return based on the current estimated yield-to-maturity on 30-year Treasury bonds. Of the lump-sum payment of $E, $F is attributable to the present value of Wife's right to lifetime payments for alimony as of Date 5. The balance of this payment, $G, represents the present value of Wife's right to receive one-third of Husband's net estate as of Date 6. The value of this testamentary transfer was computed using two alternative valuation methods, one that values the net estate without regard to the deductions or exclusions and another that values the net estate then reduces the net estate by the amount of the contested exclusions and deductions. The amount agreed upon by the parties was an amount in between the alternative values.
The Modification Agreement is contingent upon the parties obtaining (i) an opinion from the Internal Revenue Service (the Service) that the amount paid to Wife shall not be considered income to Wife or result in income tax liability to her, and shall not create any gift tax liability to Husband or Wife and (ii) an amended divorce judgment (the Amended Divorce Judgment) from the State Court which incorporates the Modification Agreement. The parties will seek amendment of the Divorce Judgment in the State Court after receiving a favorable private letter ruling from the Service. The parties anticipate that there will be no difficulty in obtaining the Amended Divorce Judgment on consent.
The Modification Agreement provides that if a favorable private letter ruling is not received from the Service on the tax consequences of the payment as designated in the Modification Agreement, the Modification Agreement will cease to be effective unless either or both of the parties waive the right to terminate the Modification Agreement. The Modification Agreement further provides that if the Amended Divorce Judgment is not obtained from the State Court by Date 7, the Modification Agreement will terminate and will be void.
The parties represent that each of Husband and Wife has fully performed his or her obligations under the Separation Agreement and no arrears or other breach of the Separation Agreement is outstanding as of the effective date of the Modification Agreement. Further, the parties represent that the Modification Agreement was negotiated in good faith and after extended arm's length negotiations. Throughout the negotiations, both sides were represented by independent counsel. The parties further represent that Wife's right to a share of Husband's estate constitutes a vested property interest under State law as does Wife's release and extinguishment of such right.
RULINGS REQUESTED
You have requested the following rulings:
1. The payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife will not be income to Wife or result in income tax liability to Wife.
2. The payment of $G in a lump sum by Husband to Wife in extinguishment of her claim to one third of his net estate will not constitute income to Wife or result in income tax liability to Wife.
3. The payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife will not constitute a gift which subjects Husband or Wife to a gift tax.
4. The payment of $G in a lump sum by Husband to Wife in extinguishment of her claim to one third of his net estate will not constitute a gift by Husband to Wife which subjects Husband to a gift tax.
5. The acceptance by Wife of the payment of $G in a lump sum in extinguishment of her claim to one third of Husband's net estate will not constitute a gift by Wife to Husband of the excess value, if any, of her entitlement to one third of Husband's net estate which subjects Wife to a gift tax.
LAW AND ANALYSIS
Ruling Request 1
Section 215(a) of the Internal Revenue Code (the Code) provides that an individual shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individual's taxable year. Section 215(b) defines “alimony or separate maintenance payments” as any alimony or separate maintenance payment (as defined in § 71(b)) which is includible in the gross income of the recipient under § 71.
Section 71(a) of the Code provides that gross income includes amounts received as alimony or separate maintenance payments. Section 71(b)(1) defines the term “alimony or separate maintenance payment” as any payment in cash if: (A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument; (B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under § 71 and not allowable as a deduction under § 215; (C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and (D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse. A payment must meet all of the factors to qualify as alimony.
Section 71(b)(2) of the Code defines a “divorce or separation instrument” as (A) a decree of divorce or separate maintenance or a written instrument incident to such decree, (B) a written separation agreement, or (C) a decree requiring a spouse to make payments for the support or maintenance of the other spouse.
Section 1.71-1T(b), Q&A-8, of the Temporary Income Tax Regulations (the Regulations) provides that spouses may designate that payments otherwise qualifying as alimony or separate maintenance payments shall be nondeductible by the payor and excludible from gross income by the payee by so providing in the divorce or separation instrument, as defined in § 71(b)(2) of the Code. See also H.R. Rep. No. 98-432 at 1496 (1984), reprinted in 1984 U.S.C.C.A.N. 697, 1138 (“The parties, by clearly designating in a written agreement, can provide that otherwise qualifying payments will not be treated as alimony for federal income tax purposes and therefore will not be deductible or includible in income.”). Section 1.71-1T(b), Q&A-8, further provides that a copy of the divorce or separation instrument containing the designation of payments as not alimony or separate maintenance payments must be attached to the payee's first filed federal tax return (Form 1040) for each year in which the designation applies.
Section 1.71-1T(e), Q&A-26 of the Regulations provides that § 71 of the Code, as amended by § 422 of the Tax Reform Act of 1984 (the Act), Division A of the Deficit Reduction Act of 1984, Pub. L. No. 98-369, 98 Stat. 494, 795-799, applies to any divorce or separation agreement instrument executed before January 1, 1985 that has been modified on or after January 1, 1985, if such modification expressly provides that § 71, as amended, shall apply to the instrument as modified.
Where a separate contractual instrument has been entered into by the parties modifying, changing or replacing the provisions of the initial agreement with respect to alimony, the deductibility of a payment made pursuant to the second agreement is governed by the provisions of the second instrument. Lehrer v. Comm'r, T.C. Memo. 1980-256 [¶80,256 PH Memo TC]. However, if a lump-sum payment is made in satisfaction of a mixture of alimony arrearages and future alimony obligations, the payment is treated for tax purposes as alimony to the extent of alimony arrearages unless there is an amount specifically allocated to the satisfaction of future alimony obligations. See Grant v. Comm'r, 18 T.C. 1013 (1952), aff'd, 209 F.2d 430 [45 AFTR 150] (2 Cir. 1953); see also Davis v. Comm'r, 41 T.C. 815 (1964); Holloway v. U.S., 428 F.2d 140 [26 AFTR 2d 70-5034] (9 Cir. 1970); Olster v. Comm'r, 79 T.C. 456 (1982), aff'd, 751 F.2d 1168 [55 AFTR 2d 85-919] (11 Cir. 1985).
In the instant case, the purpose of the Modification Agreement is to carry out the terms of the Separation Agreement and the Modification Agreement will be incorporated into the Amended Divorce Judgment. Thus, the Modification Agreement is “incident to” a decree of divorce despite the time span of Z years between the Divorce Judgment and the Modification Agreement. See Barnum v. Comm'r, 19 T.C. 401 (1952) (holding that the agreement entered into 19 years after divorce settling disputes in respect of previous agreements was “incident to” the decree of divorce). Under the rule recognized in Lehrer, the provisions of the latter agreement, the Modification Agreement, determine the tax consequences of the payment made pursuant to the modification.
The parties modified the Separation Agreement to change the period over which alimony payments will be paid. In doing so, the parties elected to apply § 71 of the Code, as amended by the Act, to the Modification Agreement by its terms. Accordingly, § 71, as amended by the Act, determines the characteristics of the lump-sum payment of $F made pursuant to the Modification Agreement with regard to whether it qualifies as alimony or not.
The Modification Agreement expressly designates the lump-sum payment provided under the agreement as excludible from Wife's income and non-deductible from Husband's income for federal income tax purposes. Therefore, the lump-sum payment does not meet one of the factors of § 71(b)(1) of the Code that requires no such designation of the payment in the divorce or separation instrument in order to meet the definition of alimony or separate maintenance payment for purposes of §§ 71 and 215. Further, there are no past-due alimony payments involved in this case. Accordingly, we conclude that the payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife is not alimony or separate maintenance payment as defined in § 71(b), and is not includible in Wife's income under § 71 and not deductible by Husband under § 215. However, the Y month's alimony payments made under the Modification Agreement satisfy all of the factors of § 71(b)(1) and qualify as alimony taxable to Wife under §71 and deductible to Husband under § 215.
Ruling Request 2
Section 1041(a) of the Code provides that no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce. Section 1041(b) provides that, in the case of any transfer of property described in § 1041(a), the property shall be treated as acquired by the transferee by gift, and the basis of the transferee in the property shall be the adjusted basis of the transferor. Section 1041(c) provides that for purposes of § 1041(a)(2), a transfer of property is incident to the divorce if the transfer occurs (1) within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.
Section 1.1041-1T(b), Q&A-7, of the Regulations addresses when a transfer of property is “related to the cessation of the marriage.” Q&A-7 provides that a transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in § 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument. Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one-and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.
In this case, although § 1041 of the Code had not yet been enacted when the parties' divorce became final in Year 1, the transfers contemplated under the Modification Agreement are pursuant to a post-1984 document. Accordingly, § 1041 and the regulations thereunder are now relevant. Section 1.1041-1T(b), Q&A-7, specifically discusses when a transfer of property is related to the cessation of the marriage for purposes of transfers under instruments executed after enactment of § 1041. In this case, any transfer of property under the Modification Agreement will occur more than Z years from the date the marriage ceased and thus is outside the one-year and six-year periods in the temporary regulations. The parties' reason for executing the Modification Agreement is to resolve differences that may arise at the time of Husband's death between Wife and the heirs or representatives of Husband's estate regarding the interpretation of the definition of “net estate.” These differences are not the product of disputes between Husband and Wife concerning the division of the marital property owned by them at the time of the divorce as addressed in Q&A-7. Further, there is no indication of any legal or business impediments to an earlier transfer of property or to the earlier resolution of the areas of concern noted in the submission.
Nevertheless, § 1.1041-1T(b), Q&A-7, of the Regulations also specifically recognizes that a divorce or separation instrument includes a modification or amendment to such decree or instrument. Consequently, any order from the divorce court that specifically modifies an original divorce or separation instrument must be considered related to the cessation of the marriage if that is what the parties intend, even if such order occurs many years after the divorce. In this case, the facts submitted and the representations made indicate that the parties will modify the Divorce Judgment and obtain the approval of the modifications by the State Court.
Accordingly, assuming the parties receive an order issued by the State Court amending the Divorce Judgment to incorporate the terms and provisions of the Modification Agreement, we conclude that, based on the representations set forth in the submissions, the following transfers are related to the cessation of the marriage within the meaning of § 1041(c)(2) of the Code and § 1.1041-1T(b), Q&A-7, of the Regulations: (i) Husband's transfer of $G in cash to Wife, and (ii) Wife's relinquishment of her right to receive a lump-sum payment upon Husband's death equal to one-third of Husband's “net estate” pursuant to the Separation Agreement. Therefore, pursuant to § 1041(a), no gain or loss will be recognized on these transfers by Wife or Husband.
Ruling Requests 3, 4, and 5
Section 2511 of the Code provides that the gift tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.
Section 2512(b) of the Code provides that where property is transferred for less than an adequate and full consideration in money or money's worth, the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.
Section 2516 of the Code provides that where husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within the 3- year period beginning on the date one year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money's worth.
Prior to amendment by § 425(b) of the Act and effective before July 18, 1984, § 2516 of the Code provided that where a husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within two years thereafter (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money's worth. The Act changed § 2516 only insofar as to allow the parties an additional year before the divorce to enter into the written agreement. See § 425 of the Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 494, 804.
Section 25.2516-1 of the Regulations provides that transfers of property or interests in property made under the terms of a written agreement between spouses in settlement of their marital or property rights are deemed to be for an adequate and full consideration in money or money's worth (whether or not the agreement is approved by a divorce decree), if the spouses obtain a final decree of divorce from each other within two years after entering the agreement.
Section 2053(a)(3) of the Code provides that the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts for claims against the estate as shall be allowable by the laws of the jurisdiction under which the estate is being administered. Under § 2053(c)(1), the deduction allowed for claims against the estate, when founded on a promise or agreement, is limited to the extent the claim was contracted bona fide and for an adequate consideration in money or money's worth.
Section 2043(b)(1) of the Code provides a general rule that for estate tax purposes, a relinquishment or promised relinquishment of marital rights in a decedent's property or estate is not considered to any extent a consideration in “money or money's worth.” However, § 2043(b)(2) provides an exception for estates of decedents dying after July 18, 1984; that for purposes of § 2053, a transfer of property that satisfies the requirements of § 2516(1) shall be considered to be made for an adequate and full consideration in money or money's worth. See also Rev. Rul. 60-160, 1960-1 C.B. 374, regarding the deduction of amounts paid pursuant to a property settlement agreement to which § 2516 does not apply.
Husband and Wife executed the Separation Agreement relative to their marital and property rights. Less than a year later, the State Court entered the decree of divorce. Therefore, Husband's obligations to make the inter vivos and testamentary transfers under the Separation Agreement are within the purview of § 2516. The inter vivos transfers are deemed made for a full and adequate consideration, and are not subject to the gift tax.
Similarly, under § 2043(b)(2) of the Code, the lump-sum payment to be made to Wife at Husband's death pursuant to the Separation Agreement would be treated as made for adequate and full consideration in money or money's worth for purposes of § 2053(c)(1). Thus, the payment would be deductible under § 2053 for estate tax purposes.
As discussed above, under the terms of the Modification Agreement, Husband is to pay Wife a single lump-sum payment of $E as well as Y monthly alimony payments, in lieu of all future payments Husband (or Husband's estate) is obligated to make under the Separation Agreement. Of this $E payment, $F is intended to approximate the present value of the alimony and support payments Wife would otherwise receive under the Separation Agreement. As noted above, these alimony and support payments would not be subject to gift tax under § 2516(1) of the Code. Accordingly, we conclude that the $F lump-sum payment to be made by Husband and accepted by Wife will not be subject to gift tax. Therefore, neither Husband nor Wife will be considered to make a gift for the payment (in Husband's case) or acceptance (in Wife' case) of the lump-sum amount.
Of the $E payment, $G is intended to approximate the present value of the amount due on Husband's death. As noted above, under § 2043(b)(2) of the Code, the lump-sum amount payable by Husband's estate on Husband's death under the Separation Agreement would be treated as made for adequate and full consideration and, therefore, the payment would be deductible for estate tax purposes. A bona fide dispute was presented regarding the computation of the amount due on Husband's death. In addition, it is represented that the parties were dealing at arm's length. The $G amount, as well as the Y months of alimony, payable under the Modification Agreement in satisfaction of this obligation, is within the range of reasonable outcomes under the governing instrument and state law. Under these circumstances, we conclude that the $G lump-sum payment to be made by Husband under the Modification Agreement will not be subject to gift tax. Therefore, neither Husband nor Wife will be considered to make a gift for the payment (in Husband's case) or acceptance (in Wife' case) of the lump-sum amount. But cf. Rev. Rul. 79-118, 1979-1 C.B. 315 (concluding that additional amounts paid pursuant to the donor's voluntary agreement to increase support payments made under a separation agreement constituted taxable gifts by the donor).
This letter ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.
A copy of this letter ruling must be attached to any tax return to which it is relevant. Alternatively, taxpayers filing their returns electronically may satisfy this requirement by attaching a statement to their return that provides the date and control number of the letter ruling.
The information contained in the letter ruling is based on the information and representations submitted by the taxpayer and accompanied by a penalties of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for ruling, it is subject to verification on examination.
Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the proposed transaction under any other provision of the Code or regulations.
Enclosed is a copy of the letter ruling showing the deletions proposed to be made when the letter is disclosed under § 6110 of the Code.
In accordance with the power of attorney on file with this office, a copy of this letter is being sent to your authorized representatives.
Sincerely,
Christopher F. Kane
Branch Chief, Branch 3
(Income Tax & Accounting)
Enclosure (1): Copy for § 6110 purposes
cc: [Redacted Text]
UIL No. 71.00-00, 215.00-00, 1041.00-00, 2511.00-00, 2512.00-00, 2516.00-00, 2053.00-00, 2043.00-00
Alimony and separate maintenance payments—lump sum payments—qualification as alimony—deductions.
Headnote:
Lump-sum payment made by divorced taxpayer in return for extinguishment of his liability to pay alimony to wife isn't alimony or separate maintenance payment as defined in Code Sec. 71(b); , isn't includible in wife's income under Code Sec. 71; , and isn't deductible by taxpayer under Code Sec. 215; . But, stated month's alimony payments made under settlement agreement satisfy all Code Sec. 71(b)(1); factors and qualify as alimony taxable to wife under Code Sec. 71; and deductible to husband under Code Sec. 215; .
Reference(s): Code Sec. 71; Code Sec. 215;
Full Text:
Number: 201206005
Release Date: 2/10/2012
Index Number: 71.00-00, 215.00-00, 1041.00-00, 2511.00-00, 2512.00-00, 2516.00-00, 2053.00-00, 2043.00-00
Third Party Communication: None
Date of Communication: Not Applicable
Person To Contact: [Redacted Text]
[Redacted Text], ID No.
Telephone Number: [Redacted Text]
Refer Reply To:
CC:ITA:B03
PLR-126246-11
Date:
November 02, 2011
LEGEND
Husband =
Wife =
Date 1 =
Date 2 =
Date 3 =
Date 4 =
Date 5 =
Date 6 =
Date 7 =
Year 1 =
$A =
$B =
$C =
$D =
$E =
$F =
$G =
W =
X =
Y =
3Z =
State =
State Court =
Dear [Redacted Text]:
This ruling responds to a letter dated June 10, 2011 submitted by your authorized representatives, requesting a ruling regarding the income tax and gift tax consequences of a lump-sum payment in satisfaction of Husband's obligations to Wife to pay alimony and to leave one-third of his net estate to her under the divorce judgment and a settlement agreement incorporated into the divorce judgment.
STATEMENT OF FACTS
The facts submitted are as follows:
Husband and Wife were married on Date 1 and had four children, who are now fully emancipated. On Date 2, the parties entered into a separation agreement (the Separation Agreement) and obtained a divorce judgment (the Divorce Judgment), which was entered on Date 3 by the State Court. The Divorce Judgment incorporated, but did not merge, the Separation Agreement.
The Separation Agreement provides for alimony to be paid by Husband to Wife. The amount Husband must pay is based on a percentage of the first $A of his annual net income plus a smaller percentage of his annual net income exceeding $A but not more than $B, with a $C minimum annual payment. If Wife has annual net income exceeding $D, Husband receives a credit against his alimony obligation for that year. The term “annual net income” of Husband and Wife is generally defined in the Separation Agreement as his or her annual adjusted gross income for federal income tax purposes, disregarding certain types of income, for example, capital gains and losses, dividends and interest. Husband's obligation to pay alimony to Wife terminates on the earliest to occur of Husband's death, Wife's remarriage, or Wife's death.
Currently, Husband is age W and Wife is age X. Wife has not remarried and the parties anticipate that Wife will not remarry during Husband's lifetime. Wife has never had annual net income in excess of $D. At present, Husband is paying the minimum alimony amount of $C per year and the parties anticipate that Husband's alimony obligation will remain at the minimum amount for the duration of his obligation.
The Separation Agreement also requires Husband to leave not less than one-third of his net estate to Wife, if she survives him and has not remarried at his death. The term “net estate” is generally defined in the Separation Agreement as Husband's gross estate passing to others under his will less funeral and testamentary expenses, debts, inheritance and estate taxes, and death duties of every kind, but also includes certain additions to his net estate; however, limited to the extent that he has provided the corpus thereof.
The parties disagree on the proper method for computing Husband's net estate under the Separation Agreement. Specifically, the parties disagree on what comprises the net estate - whether gifts and inheritances are excluded and whether certain expenses and taxes are deductible. The parties recognize that resolving these issues will be costly to Husband's estate and will delay distributions to his beneficiaries and to Wife. Therefore, the parties agreed to settle the matter by entering into a settlement agreement (the Modification Agreement).
On Date 4, Husband and Wife entered into the Modification Agreement. The Modification Agreement requires Husband to pay Wife a lump-sum amount of $E in full settlement of his obligation under the Separation Agreement to pay alimony and to leave a portion of his net estate to Wife. The Modification Agreement also requires Husband to continue to pay alimony to Wife for a period of Y months as provided in the Separation Agreement after the entry of the amended Divorce Judgment and after he pays the sum of $E. The Modification Agreement further provides that § 71 of the Internal Revenue Code, as amended by the Tax Reform Act of 1984, shall apply to the Modification Agreement and that the lump-sum payment of $E shall not be taxable to Wife or deductible to Husband, but alimony payable for the Y months shall be taxable to Wife and deductible to Husband.
The lump-sum payment of $E was determined by a professional actuary who valued Wife's right to receive alimony for the term of her and Husband's life expectancy and Wife's right to receive one-third of Husband's net estate upon his death if she survives him. The amount of the lump-sum payment was determined using the RP-2000 mortality tables and the rate of investment return based on the current estimated yield-to-maturity on 30-year Treasury bonds. Of the lump-sum payment of $E, $F is attributable to the present value of Wife's right to lifetime payments for alimony as of Date 5. The balance of this payment, $G, represents the present value of Wife's right to receive one-third of Husband's net estate as of Date 6. The value of this testamentary transfer was computed using two alternative valuation methods, one that values the net estate without regard to the deductions or exclusions and another that values the net estate then reduces the net estate by the amount of the contested exclusions and deductions. The amount agreed upon by the parties was an amount in between the alternative values.
The Modification Agreement is contingent upon the parties obtaining (i) an opinion from the Internal Revenue Service (the Service) that the amount paid to Wife shall not be considered income to Wife or result in income tax liability to her, and shall not create any gift tax liability to Husband or Wife and (ii) an amended divorce judgment (the Amended Divorce Judgment) from the State Court which incorporates the Modification Agreement. The parties will seek amendment of the Divorce Judgment in the State Court after receiving a favorable private letter ruling from the Service. The parties anticipate that there will be no difficulty in obtaining the Amended Divorce Judgment on consent.
The Modification Agreement provides that if a favorable private letter ruling is not received from the Service on the tax consequences of the payment as designated in the Modification Agreement, the Modification Agreement will cease to be effective unless either or both of the parties waive the right to terminate the Modification Agreement. The Modification Agreement further provides that if the Amended Divorce Judgment is not obtained from the State Court by Date 7, the Modification Agreement will terminate and will be void.
The parties represent that each of Husband and Wife has fully performed his or her obligations under the Separation Agreement and no arrears or other breach of the Separation Agreement is outstanding as of the effective date of the Modification Agreement. Further, the parties represent that the Modification Agreement was negotiated in good faith and after extended arm's length negotiations. Throughout the negotiations, both sides were represented by independent counsel. The parties further represent that Wife's right to a share of Husband's estate constitutes a vested property interest under State law as does Wife's release and extinguishment of such right.
RULINGS REQUESTED
You have requested the following rulings:
1. The payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife will not be income to Wife or result in income tax liability to Wife.
2. The payment of $G in a lump sum by Husband to Wife in extinguishment of her claim to one third of his net estate will not constitute income to Wife or result in income tax liability to Wife.
3. The payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife will not constitute a gift which subjects Husband or Wife to a gift tax.
4. The payment of $G in a lump sum by Husband to Wife in extinguishment of her claim to one third of his net estate will not constitute a gift by Husband to Wife which subjects Husband to a gift tax.
5. The acceptance by Wife of the payment of $G in a lump sum in extinguishment of her claim to one third of Husband's net estate will not constitute a gift by Wife to Husband of the excess value, if any, of her entitlement to one third of Husband's net estate which subjects Wife to a gift tax.
LAW AND ANALYSIS
Ruling Request 1
Section 215(a) of the Internal Revenue Code (the Code) provides that an individual shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individual's taxable year. Section 215(b) defines “alimony or separate maintenance payments” as any alimony or separate maintenance payment (as defined in § 71(b)) which is includible in the gross income of the recipient under § 71.
Section 71(a) of the Code provides that gross income includes amounts received as alimony or separate maintenance payments. Section 71(b)(1) defines the term “alimony or separate maintenance payment” as any payment in cash if: (A) such payment is received by (or on behalf of) a spouse under a divorce or separation instrument; (B) the divorce or separation instrument does not designate such payment as a payment which is not includible in gross income under § 71 and not allowable as a deduction under § 215; (C) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and (D) there is no liability to make any such payment for any period after the death of the payee spouse and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse. A payment must meet all of the factors to qualify as alimony.
Section 71(b)(2) of the Code defines a “divorce or separation instrument” as (A) a decree of divorce or separate maintenance or a written instrument incident to such decree, (B) a written separation agreement, or (C) a decree requiring a spouse to make payments for the support or maintenance of the other spouse.
Section 1.71-1T(b), Q&A-8, of the Temporary Income Tax Regulations (the Regulations) provides that spouses may designate that payments otherwise qualifying as alimony or separate maintenance payments shall be nondeductible by the payor and excludible from gross income by the payee by so providing in the divorce or separation instrument, as defined in § 71(b)(2) of the Code. See also H.R. Rep. No. 98-432 at 1496 (1984), reprinted in 1984 U.S.C.C.A.N. 697, 1138 (“The parties, by clearly designating in a written agreement, can provide that otherwise qualifying payments will not be treated as alimony for federal income tax purposes and therefore will not be deductible or includible in income.”). Section 1.71-1T(b), Q&A-8, further provides that a copy of the divorce or separation instrument containing the designation of payments as not alimony or separate maintenance payments must be attached to the payee's first filed federal tax return (Form 1040) for each year in which the designation applies.
Section 1.71-1T(e), Q&A-26 of the Regulations provides that § 71 of the Code, as amended by § 422 of the Tax Reform Act of 1984 (the Act), Division A of the Deficit Reduction Act of 1984, Pub. L. No. 98-369, 98 Stat. 494, 795-799, applies to any divorce or separation agreement instrument executed before January 1, 1985 that has been modified on or after January 1, 1985, if such modification expressly provides that § 71, as amended, shall apply to the instrument as modified.
Where a separate contractual instrument has been entered into by the parties modifying, changing or replacing the provisions of the initial agreement with respect to alimony, the deductibility of a payment made pursuant to the second agreement is governed by the provisions of the second instrument. Lehrer v. Comm'r, T.C. Memo. 1980-256 [¶80,256 PH Memo TC]. However, if a lump-sum payment is made in satisfaction of a mixture of alimony arrearages and future alimony obligations, the payment is treated for tax purposes as alimony to the extent of alimony arrearages unless there is an amount specifically allocated to the satisfaction of future alimony obligations. See Grant v. Comm'r, 18 T.C. 1013 (1952), aff'd, 209 F.2d 430 [45 AFTR 150] (2 Cir. 1953); see also Davis v. Comm'r, 41 T.C. 815 (1964); Holloway v. U.S., 428 F.2d 140 [26 AFTR 2d 70-5034] (9 Cir. 1970); Olster v. Comm'r, 79 T.C. 456 (1982), aff'd, 751 F.2d 1168 [55 AFTR 2d 85-919] (11 Cir. 1985).
In the instant case, the purpose of the Modification Agreement is to carry out the terms of the Separation Agreement and the Modification Agreement will be incorporated into the Amended Divorce Judgment. Thus, the Modification Agreement is “incident to” a decree of divorce despite the time span of Z years between the Divorce Judgment and the Modification Agreement. See Barnum v. Comm'r, 19 T.C. 401 (1952) (holding that the agreement entered into 19 years after divorce settling disputes in respect of previous agreements was “incident to” the decree of divorce). Under the rule recognized in Lehrer, the provisions of the latter agreement, the Modification Agreement, determine the tax consequences of the payment made pursuant to the modification.
The parties modified the Separation Agreement to change the period over which alimony payments will be paid. In doing so, the parties elected to apply § 71 of the Code, as amended by the Act, to the Modification Agreement by its terms. Accordingly, § 71, as amended by the Act, determines the characteristics of the lump-sum payment of $F made pursuant to the Modification Agreement with regard to whether it qualifies as alimony or not.
The Modification Agreement expressly designates the lump-sum payment provided under the agreement as excludible from Wife's income and non-deductible from Husband's income for federal income tax purposes. Therefore, the lump-sum payment does not meet one of the factors of § 71(b)(1) of the Code that requires no such designation of the payment in the divorce or separation instrument in order to meet the definition of alimony or separate maintenance payment for purposes of §§ 71 and 215. Further, there are no past-due alimony payments involved in this case. Accordingly, we conclude that the payment of $F in a lump sum by Husband to Wife in return for the extinguishment of his liability to pay alimony to Wife is not alimony or separate maintenance payment as defined in § 71(b), and is not includible in Wife's income under § 71 and not deductible by Husband under § 215. However, the Y month's alimony payments made under the Modification Agreement satisfy all of the factors of § 71(b)(1) and qualify as alimony taxable to Wife under §71 and deductible to Husband under § 215.
Ruling Request 2
Section 1041(a) of the Code provides that no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce. Section 1041(b) provides that, in the case of any transfer of property described in § 1041(a), the property shall be treated as acquired by the transferee by gift, and the basis of the transferee in the property shall be the adjusted basis of the transferor. Section 1041(c) provides that for purposes of § 1041(a)(2), a transfer of property is incident to the divorce if the transfer occurs (1) within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage.
Section 1.1041-1T(b), Q&A-7, of the Regulations addresses when a transfer of property is “related to the cessation of the marriage.” Q&A-7 provides that a transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in § 71(b)(2), and the transfer occurs not more than 6 years after the date on which the marriage ceases. A divorce or separation instrument includes a modification or amendment to such decree or instrument. Any transfer not pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one-and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.
In this case, although § 1041 of the Code had not yet been enacted when the parties' divorce became final in Year 1, the transfers contemplated under the Modification Agreement are pursuant to a post-1984 document. Accordingly, § 1041 and the regulations thereunder are now relevant. Section 1.1041-1T(b), Q&A-7, specifically discusses when a transfer of property is related to the cessation of the marriage for purposes of transfers under instruments executed after enactment of § 1041. In this case, any transfer of property under the Modification Agreement will occur more than Z years from the date the marriage ceased and thus is outside the one-year and six-year periods in the temporary regulations. The parties' reason for executing the Modification Agreement is to resolve differences that may arise at the time of Husband's death between Wife and the heirs or representatives of Husband's estate regarding the interpretation of the definition of “net estate.” These differences are not the product of disputes between Husband and Wife concerning the division of the marital property owned by them at the time of the divorce as addressed in Q&A-7. Further, there is no indication of any legal or business impediments to an earlier transfer of property or to the earlier resolution of the areas of concern noted in the submission.
Nevertheless, § 1.1041-1T(b), Q&A-7, of the Regulations also specifically recognizes that a divorce or separation instrument includes a modification or amendment to such decree or instrument. Consequently, any order from the divorce court that specifically modifies an original divorce or separation instrument must be considered related to the cessation of the marriage if that is what the parties intend, even if such order occurs many years after the divorce. In this case, the facts submitted and the representations made indicate that the parties will modify the Divorce Judgment and obtain the approval of the modifications by the State Court.
Accordingly, assuming the parties receive an order issued by the State Court amending the Divorce Judgment to incorporate the terms and provisions of the Modification Agreement, we conclude that, based on the representations set forth in the submissions, the following transfers are related to the cessation of the marriage within the meaning of § 1041(c)(2) of the Code and § 1.1041-1T(b), Q&A-7, of the Regulations: (i) Husband's transfer of $G in cash to Wife, and (ii) Wife's relinquishment of her right to receive a lump-sum payment upon Husband's death equal to one-third of Husband's “net estate” pursuant to the Separation Agreement. Therefore, pursuant to § 1041(a), no gain or loss will be recognized on these transfers by Wife or Husband.
Ruling Requests 3, 4, and 5
Section 2511 of the Code provides that the gift tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible.
Section 2512(b) of the Code provides that where property is transferred for less than an adequate and full consideration in money or money's worth, the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift.
Section 2516 of the Code provides that where husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within the 3- year period beginning on the date one year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money's worth.
Prior to amendment by § 425(b) of the Act and effective before July 18, 1984, § 2516 of the Code provided that where a husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within two years thereafter (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money's worth. The Act changed § 2516 only insofar as to allow the parties an additional year before the divorce to enter into the written agreement. See § 425 of the Tax Reform Act of 1984, Pub. L. No. 98-369, 98 Stat. 494, 804.
Section 25.2516-1 of the Regulations provides that transfers of property or interests in property made under the terms of a written agreement between spouses in settlement of their marital or property rights are deemed to be for an adequate and full consideration in money or money's worth (whether or not the agreement is approved by a divorce decree), if the spouses obtain a final decree of divorce from each other within two years after entering the agreement.
Section 2053(a)(3) of the Code provides that the value of the taxable estate shall be determined by deducting from the value of the gross estate such amounts for claims against the estate as shall be allowable by the laws of the jurisdiction under which the estate is being administered. Under § 2053(c)(1), the deduction allowed for claims against the estate, when founded on a promise or agreement, is limited to the extent the claim was contracted bona fide and for an adequate consideration in money or money's worth.
Section 2043(b)(1) of the Code provides a general rule that for estate tax purposes, a relinquishment or promised relinquishment of marital rights in a decedent's property or estate is not considered to any extent a consideration in “money or money's worth.” However, § 2043(b)(2) provides an exception for estates of decedents dying after July 18, 1984; that for purposes of § 2053, a transfer of property that satisfies the requirements of § 2516(1) shall be considered to be made for an adequate and full consideration in money or money's worth. See also Rev. Rul. 60-160, 1960-1 C.B. 374, regarding the deduction of amounts paid pursuant to a property settlement agreement to which § 2516 does not apply.
Husband and Wife executed the Separation Agreement relative to their marital and property rights. Less than a year later, the State Court entered the decree of divorce. Therefore, Husband's obligations to make the inter vivos and testamentary transfers under the Separation Agreement are within the purview of § 2516. The inter vivos transfers are deemed made for a full and adequate consideration, and are not subject to the gift tax.
Similarly, under § 2043(b)(2) of the Code, the lump-sum payment to be made to Wife at Husband's death pursuant to the Separation Agreement would be treated as made for adequate and full consideration in money or money's worth for purposes of § 2053(c)(1). Thus, the payment would be deductible under § 2053 for estate tax purposes.
As discussed above, under the terms of the Modification Agreement, Husband is to pay Wife a single lump-sum payment of $E as well as Y monthly alimony payments, in lieu of all future payments Husband (or Husband's estate) is obligated to make under the Separation Agreement. Of this $E payment, $F is intended to approximate the present value of the alimony and support payments Wife would otherwise receive under the Separation Agreement. As noted above, these alimony and support payments would not be subject to gift tax under § 2516(1) of the Code. Accordingly, we conclude that the $F lump-sum payment to be made by Husband and accepted by Wife will not be subject to gift tax. Therefore, neither Husband nor Wife will be considered to make a gift for the payment (in Husband's case) or acceptance (in Wife' case) of the lump-sum amount.
Of the $E payment, $G is intended to approximate the present value of the amount due on Husband's death. As noted above, under § 2043(b)(2) of the Code, the lump-sum amount payable by Husband's estate on Husband's death under the Separation Agreement would be treated as made for adequate and full consideration and, therefore, the payment would be deductible for estate tax purposes. A bona fide dispute was presented regarding the computation of the amount due on Husband's death. In addition, it is represented that the parties were dealing at arm's length. The $G amount, as well as the Y months of alimony, payable under the Modification Agreement in satisfaction of this obligation, is within the range of reasonable outcomes under the governing instrument and state law. Under these circumstances, we conclude that the $G lump-sum payment to be made by Husband under the Modification Agreement will not be subject to gift tax. Therefore, neither Husband nor Wife will be considered to make a gift for the payment (in Husband's case) or acceptance (in Wife' case) of the lump-sum amount. But cf. Rev. Rul. 79-118, 1979-1 C.B. 315 (concluding that additional amounts paid pursuant to the donor's voluntary agreement to increase support payments made under a separation agreement constituted taxable gifts by the donor).
This letter ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.
A copy of this letter ruling must be attached to any tax return to which it is relevant. Alternatively, taxpayers filing their returns electronically may satisfy this requirement by attaching a statement to their return that provides the date and control number of the letter ruling.
The information contained in the letter ruling is based on the information and representations submitted by the taxpayer and accompanied by a penalties of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for ruling, it is subject to verification on examination.
Except as specifically set forth above, no opinion is expressed or implied concerning the federal tax consequences of the proposed transaction under any other provision of the Code or regulations.
Enclosed is a copy of the letter ruling showing the deletions proposed to be made when the letter is disclosed under § 6110 of the Code.
In accordance with the power of attorney on file with this office, a copy of this letter is being sent to your authorized representatives.
Sincerely,
Christopher F. Kane
Branch Chief, Branch 3
(Income Tax & Accounting)
Enclosure (1): Copy for § 6110 purposes
cc: [Redacted Text]
Protester case
James R. Garber v. Commissioner, TC Memo 2012-47 , Code Sec(s) 6330; 6673.
JAMES R. GARBER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 6330; 6673
Docket: Docket No. 2863-11.
Date Issued: 02/22/2012
HEADNOTE
XX.
Reference(s): Code Sec. 6330; Code Sec. 6673
Syllabus
Official Tax Court Syllabus
Counsel
James R. Garber, pro se.
Nathan M. Swingley, for respondent.
MEMORANDUM OPINION
RUWE, Judge: This matter is before the Court on the parties' cross-motions for summary judgment pursuant to Rule 121. 1 In his motion, respondent moves that no genuine issue exists as to any material fact and that the Court should sustain his determination of petitioner's deficiencies in income tax and the related additions to tax. Respondent further moves that the Court award a penalty to the United States pursuant to section 6673 on the basis that petitioner instituted these proceedings primarily for the purpose of delay and/or petitioner's position in the present case is frivolous or groundless.
In his motion, petitioner contends that respondent has not been able to provide him with “any Section of the IRS code which makes the petitioner LIABLE for the tax imposed in Section 1 of the Code” and that "[i]f the respondent can locate any section of the code which makes the petitioner `liable' or `required' to file a return, the petitioner will immediately plead guilty thereby saving the court a great deal of time and money.”
Background
At the time the petition was filed, petitioner resided in Indiana.
On November 15, 2010, respondent mailed petitioner two separate notices of deficiency (notices) for the taxable years 2007 and 2008. Respondent determined a deficiency of $1,512 in petitioner's 2007 income tax, as well as additions to tax of $340.20 and $219.24 pursuant to section 6651(a)(1) and (2), 2 respectively. Respondent also determined a deficiency of $1,044 in petitioner's 2008 income tax, as well as additions to tax of $234.90 and $88.74 pursuant to section 6651(a)(1) and (2), respectively. Respondent made his determinations in the notices on the basis of substitutes for returns completed pursuant to section 6020(b) and in accordance with section 301.6020-1(b), Proced. & Admin. Regs.
Petitioner timely filed his petition with this Court. In his petition, petitioner does not dispute his receipt of income for the tax years 2007 and 2008 or the amounts of respondent's calculated deficiencies and additions to tax. Instead, petitioner contends that he never received an official assessment for 2007 or 2008 and, because he did not file a return for 2007 or 2008, respondent “had nothing” on which to base his “bogus assessments or Notices of Deficiency pursuant to "[sections] 6201(1) [and] 6211(1) (A)”.
Discussion
Summary judgment is intended to expedite litigation and to avoid unnecessary and expensive trials. Shiosaki v. Commissioner, 61 T.C. 861, 862 (1974). A motion for summary judgment is granted where the pleadings and other materials show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law. Rule 121(b); FPL Group, Inc. v. Commissioner 116 , T.C. 73, 74-75 (2001); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 [73 AFTR 2d 94-1198] (7th Cir. 1994).
Petitioner's response to respondent's motion fails to indicate that there is a genuine issue for trial. Consequently, we conclude that there is no issue as to any material fact and that a decision may be rendered as a matter of law.
In his motion and in his response to respondent's motion, petitioner makes many unfounded arguments which lead him to his conclusion that no statutes render him liable for Federal income taxes. For example, petitioner's claims include statements such as: (1) respondent has not been able to provide him with “any Section of the IRS code which makes the petitioner LIABLE for the tax imposed in Section 1 of the Code”; (2) “a resident of the fifty states may choose to file a return thereby assessing himself or he `may' choose not to do so. (A definition of `may' can be found in any dictionary.)”; and (3) “The only person in the Code required to file a tax return for income taxes is the withholding agent referred to in Section 1461 and, the only Persons referred to in Section 7203 (the Section used to erroneously send Persons to prison) are Withholding Agents (See Section 7343)” * * * [and] “Petitioner is not a Withholding Agent referred to in Section 7343.” Petitioner further argues that it “appears quite evident that the commissioner is trying to declare any law that might bolster a petitioner's case declared frivolous, thus attempting to rule by regulation in total disregard to the underlying LAWS and to THE CONSTITUTION.” Petitioner concludes by stating that if respondent cannot produce the Code sections upon which his tax liabilities are premised, then “all of the Notices of Deficiency, Proposed Assessments, 4340 forms and Substitutes for Returns are null and void and just a diabolical plot to manufacture a fake `Certificate of Assessment' of zero `0' in order to have a basis for illegal Notices of Deficiency. (You might say the IRS Position is `FRIVOLOUS and WITHOUT MERIT.)”.
As we have said of similar arguments on previous occasions, petitioner's arguments are frivolous and devoid of any basis in the law. We need not refute them with somber reasoning and copious citation of precedent; to do so might suggest that they have some colorable merit. See Crain v. Commissioner, 737 F.2d 1417, 1417 [54 AFTR 2d 84-5698] (5th Cir. 1984); Wnuck v. Commissioner, 136 T.C. 498 (2011); Guthrie v. Commissioner, T.C. Memo. 2006-81 [TC Memo 2006-81]. Petitioner has raised no issue in the pleadings to indicate that respondent's determinations in the notices were incorrectly computed, and there is no genuine issue of material fact surrounding whether respondent made any assessments regarding petitioner for 2007 or 2008. 3 Consequently, we find respondent's determinations in the notices for petitioner's 2007 and 2008 taxable years to be correct. Accordingly, we will grant respondent's motion for summary judgment. Section 6673 Penalty Respondent moved the Court to impose a penalty on petitioner under section 6673(a)(1). Section 6673(a)(1) authorizes the Court to impose a penalty not to exceed $25,000 if the taxpayer took frivolous positions in the proceeding or instituted the proceeding primarily for delay. A position “is frivolous if it is contrary to established law and unsupported by a reasoned, colorable argument for change in the law.” Coleman v. Commissioner, 791 F.2d 68, 71 [57 AFTR 2d 86-1420] (7th Cir. 1986). This Court has ruled that arguments such as those petitioner asserts here are frivolous and wholly without merit. See Williams v. Commissioner T.C. Memo. , 1999-277 (imposing section 6673 penalty for tax-protester arguments). Accordingly, we find that petitioner advanced frivolous arguments primarily for the purpose of delay and require that he pay a penalty of $1,000 to the United States pursuant to section 6673(a)(1). We also warn petitioner that we will consider imposing a larger penalty if he returns to the Court and advances frivolous or groundless arguments in the future.
To reflect the foregoing, An appropriate order will be issued granting respondent's motion and denying petitioner's motion, and decision will be entered for respondent.
2
The amount of any addition to tax pursuant to sec. 6651(a)(2) shall be determined pursuant to sec. 6651(a)(2), (b), and (c).
JAMES R. GARBER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 6330; 6673
Docket: Docket No. 2863-11.
Date Issued: 02/22/2012
HEADNOTE
XX.
Reference(s): Code Sec. 6330; Code Sec. 6673
Syllabus
Official Tax Court Syllabus
Counsel
James R. Garber, pro se.
Nathan M. Swingley, for respondent.
MEMORANDUM OPINION
RUWE, Judge: This matter is before the Court on the parties' cross-motions for summary judgment pursuant to Rule 121. 1 In his motion, respondent moves that no genuine issue exists as to any material fact and that the Court should sustain his determination of petitioner's deficiencies in income tax and the related additions to tax. Respondent further moves that the Court award a penalty to the United States pursuant to section 6673 on the basis that petitioner instituted these proceedings primarily for the purpose of delay and/or petitioner's position in the present case is frivolous or groundless.
In his motion, petitioner contends that respondent has not been able to provide him with “any Section of the IRS code which makes the petitioner LIABLE for the tax imposed in Section 1 of the Code” and that "[i]f the respondent can locate any section of the code which makes the petitioner `liable' or `required' to file a return, the petitioner will immediately plead guilty thereby saving the court a great deal of time and money.”
Background
At the time the petition was filed, petitioner resided in Indiana.
On November 15, 2010, respondent mailed petitioner two separate notices of deficiency (notices) for the taxable years 2007 and 2008. Respondent determined a deficiency of $1,512 in petitioner's 2007 income tax, as well as additions to tax of $340.20 and $219.24 pursuant to section 6651(a)(1) and (2), 2 respectively. Respondent also determined a deficiency of $1,044 in petitioner's 2008 income tax, as well as additions to tax of $234.90 and $88.74 pursuant to section 6651(a)(1) and (2), respectively. Respondent made his determinations in the notices on the basis of substitutes for returns completed pursuant to section 6020(b) and in accordance with section 301.6020-1(b), Proced. & Admin. Regs.
Petitioner timely filed his petition with this Court. In his petition, petitioner does not dispute his receipt of income for the tax years 2007 and 2008 or the amounts of respondent's calculated deficiencies and additions to tax. Instead, petitioner contends that he never received an official assessment for 2007 or 2008 and, because he did not file a return for 2007 or 2008, respondent “had nothing” on which to base his “bogus assessments or Notices of Deficiency pursuant to "[sections] 6201(1) [and] 6211(1) (A)”.
Discussion
Summary judgment is intended to expedite litigation and to avoid unnecessary and expensive trials. Shiosaki v. Commissioner, 61 T.C. 861, 862 (1974). A motion for summary judgment is granted where the pleadings and other materials show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law. Rule 121(b); FPL Group, Inc. v. Commissioner 116 , T.C. 73, 74-75 (2001); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 [73 AFTR 2d 94-1198] (7th Cir. 1994).
Petitioner's response to respondent's motion fails to indicate that there is a genuine issue for trial. Consequently, we conclude that there is no issue as to any material fact and that a decision may be rendered as a matter of law.
In his motion and in his response to respondent's motion, petitioner makes many unfounded arguments which lead him to his conclusion that no statutes render him liable for Federal income taxes. For example, petitioner's claims include statements such as: (1) respondent has not been able to provide him with “any Section of the IRS code which makes the petitioner LIABLE for the tax imposed in Section 1 of the Code”; (2) “a resident of the fifty states may choose to file a return thereby assessing himself or he `may' choose not to do so. (A definition of `may' can be found in any dictionary.)”; and (3) “The only person in the Code required to file a tax return for income taxes is the withholding agent referred to in Section 1461 and, the only Persons referred to in Section 7203 (the Section used to erroneously send Persons to prison) are Withholding Agents (See Section 7343)” * * * [and] “Petitioner is not a Withholding Agent referred to in Section 7343.” Petitioner further argues that it “appears quite evident that the commissioner is trying to declare any law that might bolster a petitioner's case declared frivolous, thus attempting to rule by regulation in total disregard to the underlying LAWS and to THE CONSTITUTION.” Petitioner concludes by stating that if respondent cannot produce the Code sections upon which his tax liabilities are premised, then “all of the Notices of Deficiency, Proposed Assessments, 4340 forms and Substitutes for Returns are null and void and just a diabolical plot to manufacture a fake `Certificate of Assessment' of zero `0' in order to have a basis for illegal Notices of Deficiency. (You might say the IRS Position is `FRIVOLOUS and WITHOUT MERIT.)”.
As we have said of similar arguments on previous occasions, petitioner's arguments are frivolous and devoid of any basis in the law. We need not refute them with somber reasoning and copious citation of precedent; to do so might suggest that they have some colorable merit. See Crain v. Commissioner, 737 F.2d 1417, 1417 [54 AFTR 2d 84-5698] (5th Cir. 1984); Wnuck v. Commissioner, 136 T.C. 498 (2011); Guthrie v. Commissioner, T.C. Memo. 2006-81 [TC Memo 2006-81]. Petitioner has raised no issue in the pleadings to indicate that respondent's determinations in the notices were incorrectly computed, and there is no genuine issue of material fact surrounding whether respondent made any assessments regarding petitioner for 2007 or 2008. 3 Consequently, we find respondent's determinations in the notices for petitioner's 2007 and 2008 taxable years to be correct. Accordingly, we will grant respondent's motion for summary judgment. Section 6673 Penalty Respondent moved the Court to impose a penalty on petitioner under section 6673(a)(1). Section 6673(a)(1) authorizes the Court to impose a penalty not to exceed $25,000 if the taxpayer took frivolous positions in the proceeding or instituted the proceeding primarily for delay. A position “is frivolous if it is contrary to established law and unsupported by a reasoned, colorable argument for change in the law.” Coleman v. Commissioner, 791 F.2d 68, 71 [57 AFTR 2d 86-1420] (7th Cir. 1986). This Court has ruled that arguments such as those petitioner asserts here are frivolous and wholly without merit. See Williams v. Commissioner T.C. Memo. , 1999-277 (imposing section 6673 penalty for tax-protester arguments). Accordingly, we find that petitioner advanced frivolous arguments primarily for the purpose of delay and require that he pay a penalty of $1,000 to the United States pursuant to section 6673(a)(1). We also warn petitioner that we will consider imposing a larger penalty if he returns to the Court and advances frivolous or groundless arguments in the future.
To reflect the foregoing, An appropriate order will be issued granting respondent's motion and denying petitioner's motion, and decision will be entered for respondent.
2
The amount of any addition to tax pursuant to sec. 6651(a)(2) shall be determined pursuant to sec. 6651(a)(2), (b), and (c).
FLP case
Estate of Joanne Harrison Stone, et al. v. Commissioner, TC Memo 2012-48 , Code Sec(s) 2036.
ESTATE OF JOANNE HARRISON STONE, DECEASED, COSBY A. STONE AND MICHAEL D. STONE, PERSONAL REPRESENTATIVES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Case Information: Code Sec(s): 2036
Docket: Dkt. No. 23290-09.
Date Issued: 02/22/2012.
Judge: Opinion by Goeke, J.
Tax Year(s):
Disposition:
HEADNOTE
1.
Reference(s): Code Sec. 2036
Syllabus
Official Tax Court Syllabus
Counsel
Dudley W. Taylor, for petitioner.
Caroline R. Krivacka, for respondent.
GOEKE, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined a $2,563,290 Federal estate tax deficiency against the Estate of Joanne Stone (estate). After settlement of certain issues, the sole issue remaining for decision is whether the value of real property transferred by Joanne Stone (decedent) to a family limited partnership should be included in the value of her gross estate pursuant to section 2036(a). 1 We hold that the value of the property transferred should not be included.
FINDINGS OF FACT
Decedent was a resident of Tennessee when she died on July 2, 2005, at the age of 81. Two of her sons, Cosby A. Stone and Michael D. Stone, are the personal representatives of the estate. Both reside in Tennessee. 1. Background of Decedent, Her Family, and Her Land Decedent was married to Roy A. Stone (Mr. Stone) and had six adult children and numerous grandchildren at the time of her death. Decedent and her family members were a very close-knit family in terms of living close together and working 1
Unless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the date of decedent's death, and all Rule references are to the Tax Court Rules of Practice and Procedure. together. Decedent, Mr. Stone, and at least four of their six children had worked at a publishing company started by the Stone family in the 1930s.
The Stones were a prominent family in their hometown of Crossville, Tennessee (which is in Cumberland County), and had held significant amounts of real estate in the area for several generations. Decedent owned, either wholly or in part, approximately 30 parcels of real property in Cumberland County in 1997. Nine parcels of decedent's land (totaling approximately 740 acres) were mostly undeveloped woodlands without utilities or roads (woodland parcels). The woodland parcels were jointly owned by decedent and Mr. Stone.
In the early 1990s Steve Stone, one of decedent's sons, acquired real estate near the woodland parcels. Steve Stone built a home on his property and desired to form a lake in the area through the construction of a dam on his property. He discussed the lake project with decedent and Mr. Stone, as well as his siblings, and entered into an agreement with Crab Orchard Water Utility District (Crab Orchard) by which Crab Orchard would construct the dam at a cost of approximately $1.5 to $2 million. In exchange, Crab Orchard would be entitled to use a portion of Steve Stone's property for construction of a water treatment plant and would be able to use the lake as a water reservoir for the county. Once the dam was completed in the mid-1990s, a portion of the woodland parcels fronted the newly formed lake.
Once the lake had been constructed, decedent and Mr. Stone concluded that they wanted the woodland parcels to become a family asset. They hoped that the family would one day be able to develop and sell homes near the lake, although there were long-term issues to be worked out. The first issue was that the shallow soil depth in the area makes it difficult to connect sewage systems to potential homes near the lake. The second issue is that the operations of Crab Orchard result in a significant drawdown of the water in the lake during the summer months. Potential solutions to these problems included construction of additional sewer lines closer to the lake and of a new primary reservoir for Cumberland County. 2 2. The Stone Family Limited Partnership of Cumberland County and Gifts of Partnership Interests To further their family planning regarding the woodland parcels, decedent and Mr. Stone sought the advice of their attorney, Joe Looney. Mr. Looney referred decedent and Mr. Stone to Harry Sabine, another attorney in the area. At their first 2
Cosby Stone testified that there have been "grumblings" of new sewer lines to be constructed near the lake. In addition, the rapid population growth in Cumberland County could spur the construction of a new primary reservoir. meeting with Mr. Sabine, decedent and Mr. Stone informed Mr. Sabine that they wanted to give gifts of real estate to various family members and were seeking the best way of doing so. Mr. Sabine discussed the use of a limited partnership and told decedent and Mr. Stone that it would simplify the gift-giving process by not requiring execution and recording of new deeds every year. Mr. Sabine also believed that using a limited partnership would help guard against partition suits, which could cause the land to be divided into smaller tracts.
Decedent and Mr. Stone decided to form a limited partnership to hold the woodland parcels. Mr. Sabine prepared the Stone Family Limited Partnership of Cumberland County (SFLP) agreement and helped decedent and Mr. Stone file a certificate of limited partnership with the Tennessee secretary of state on December 29, 1997. Decedent and Mr. Stone signed the SFLP agreement as both general and limited partners. A revised partnership agreement was executed December 31, 1997. This revised agreement made no material changes but allowed decedent's children, children's spouses, and grandchildren who received interests in the partnership to sign as limited partners. Decedent and Mr. Stone also signed the revised agreement as both general and limited partners.
The SFLP agreement provided that SFLP's purpose was to hold and manage property for the family members. The agreement provided that "The family members desire to provide for the health, education, maintenance and welfare of each other and their children." The agreement listed various ways in which SFLP may be terminated, including by written agreement of partners owning 67% of SFLP or upon sale of all SFLP property and distribution of proceeds. The agreement placed various restrictions on a partner's ability to transfer their partnership interest and allowed SFLP to purchase the interest of any partner upon his or her death.
As general partners of SFLP, decedent and Mr. Stone had considerable powers, including the sole rights to: (1) determine whether properties would be sold; (2) manage the day-to-day business of SFLP; and (3) determine the amounts of any distributions to partners. The partnership agreement provided: "The limited partners will have the right to dismiss the general partner upon written agreement of those limited partners owning sixty-seven (67%) percent of percentage of ownership then held by all the limited partners." The partnership agreement also provided that upon the death, withdrawal, removal, or bankruptcy of a general partner a new general partner would be elected by the limited partners.
Upon its formation, decedent and Mr. Stone each obtained 1% general partnership interests and 49% limited partnership interests in SFLP. On December 30, 1997, decedent and Mr. Stone quitclaimed the woodland parcels to SFLP and the parcels became SFLP's only assets. Before quitclaiming the woodland parcels to SFLP, decedent and Mr. Stone had the combined parcels appraised. Decedent and Mr. Stone used the appraisal value of $1,575,600 as the basis for all computations of SFLP interest values and did not discount the value of SFLP interests for gift tax purposes. Accordingly, decedent and Mr. Stone valued each 1% interest in SFLP at $15,756 for gift tax purposes.
On December 31, 1997, decedent and Mr. Stone gave portions of their limited interests in SFLP as gifts to their 21 children, children's spouses, and grandchildren. Each of the 21 recipients received a .634% limited partnership interest in SFLP from both decedent and Mr. Stone, so that the 21 recipients held a combined 26.628% limited partnership interest in SFLP at the end of 1997. Similar gifts were made in 1998 and 1999. In 2000 the recipients received only a .477% limited partnership interest from both decedent and Mr. Stone and two of the children's spouses no longer received interests as a result of divorce proceedings. As a result of the gifts, by the end of 2000 decedent and Mr. Stone each owned a 1% general partnership interest in SFLP and the children, children's spouses, and grandchildren owned the remaining 98% in limited partnership interests.
Xavier Ironside and Margaret Stone Ironside (one of decedent's daughters) began divorce proceedings in 1999. In an attempt to keep SFLP interests in family hands, SFLP and Mr. Ironside reached a deal whereby Mr. Ironside would receive approximately four acres of SFLP property on the lake. The decision to transfer the four acres was made by decedent and Mr. Stone, who had discussed it with various limited partners. In exchange for the four acres of lake property, on December 9, 1999, Mr. Ironside quitclaimed to Margaret Stone Ironside his interest in the woodland parcels still held by SFLP. No mention was made of the SFLP limited partnership interest then owned by Mr. Ironside in the quitclaim deed although it was mentioned that the parcels involved were the same ones conveyed to SFLP by decedent and Mr. Stone.
Patricia Connelly Stone and Michael Stone began divorce proceedings in 2000. As part of a financial settlement between them, Patricia Connelly Stone quitclaimed to Michael Stone her interest in the woodland parcels still held by SFLP on October 18, 2000. In exchange for the quitclaimed interest, Michael Stone gave up valuable consideration in the financial settlement. Again, no mention was made of the SFLP limited partnership interest then owned by Patricia Connelly Stone in the quitclaim deed, but it was mentioned that the parcels involved were the same ones conveyed to SFLP by decedent and Mr. Stone. 3. Additional Information SFLP has yet to develop or otherwise improve the woodland parcels. SFLP initially had a bank account in its name but closed the account because SFLP earned no income, either from the property it held or otherwise. SFLP's only expenses were property taxes of approximately $700 per year due on the real property it held. Decedent and Mr. Stone paid these property taxes from their personal funds.
Documents labeled "Bill[s] of Sale" were used to transfer the SFLP limited partnership interests to decedent's children, children's spouses, and grandchildren. Although each document recites payment of $1.00 and other "good and valuable consideration", the recipients paid nothing to decedent and Mr. Smith and the transfers constituted gifts. Mr. Sabine testified that he used a bill of sale for each transfer because he thought it was the same thing as a document reflecting a gift of the SFLP interest.
Decedent and Mr. Stone made no particular use of the woodland parcels held by SFLP other than to fish and visit Steve Stone. Each of the limited partners had the same access to the land as decedent and Mr. Stone.
As of the time of trial in June 2011, Mr. Stone was age 95. Decedent taught Sunday school for 60 years, up to and including the last Sunday before she passed away.
The estate's estate tax return was filed September 26, 2006. An amended estate tax return was filed October 31, 2008. Respondent issued a notice of deficiency to the estate on August 27, 2009, in response to which the estate timely filed a petition for redetermination of the deficiency.
OPINION
I. Burden of Proof Generally, taxpayers bear the burden of proving, by a preponderance of the evidence, that the determinations of the Commissioner in a notice of deficiency are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 [12 AFTR 1456] (1933). The estate has not argued that respondent should bear the burden of proof.
II. Whether Section 2036(a) Applies to Decedent's Transfer of the Woodland Parcels to SFLP
The purpose of section 2036 is to include in a deceased taxpayer's gross estate the value of inter vivos transfers that were testamentary in nature. United States v. Estate of Grace, 395 U.S. 316 [23 AFTR 2d 69-1954] (1969). Section 2036(a) generally provides that if a decedent makes an inter vivos transfer of property other than a bona fide sale for adequate and full consideration and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the decedent's gross estate. Section 2036(a) is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.
Respondent argues that these three conditions were satisfied by decedent's transfer of the woodland parcels to SFLP, while the estate argues that the latter two conditions were not satisfied. The parties agree that decedent made an inter vivos transfer of property. We find that decedent's transfer of the woodland parcels to SFLP was a bona fide sale for adequate and full consideration. As a result, we conclude that section 2036(a) does not apply to decedent's transfer of the woodland parcels to SFLP.
A. Whether Decedent's Transfer of the Woodland Parcels to SFLP Was a Bona Fide Sale for Adequate and Full Consideration In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred. Estate of Bongard v. Commissioner 124 T.C. 95, 118 (2005). , The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership's creation. Id. A significant purpose must be an actual motivation, not a theoretical justification. Id. A list of factors to be considered when deciding whether a nontax reason existed includes: (1) the taxpayer standing on both sides of the transaction; (2) the taxpayer's financial dependence on distributions from the partnership; (3) the partners' commingling of partnership funds with their own; (4) the taxpayer's actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer's old age or poor health when the partnership was formed. Id. at 118-119; Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66 [TC Memo 2009-66], aff'd, 431 Fed. Appx. 544 [107 AFTR 2d 2011-2069] (9th Cir. 2011); Estate of Hurford v. Commissioner T.C. Memo. 2008-278 [TC Memo 2008-278]. We separate the bona , fide sale exception into two prongs: (1) whether the transaction qualifies as a bona fide sale; and (2) whether the decedent received adequate and full consideration. Estate of Bongard v. Commissioner 124 T.C. at 119, 122-125; see also Estate of , Jorgensen v. Commissioner, T.C. Memo. 2009-66 [TC Memo 2009-66]. 1. Whether Decedent's Transfer of the Woodland Parcels to SFLP
Was a Bona Fide Sale Whether a transfer is a bona fide sale is a question of motive. Estate of Liljestrand v. Commissioner T.C. Memo. 2011-259 [TC Memo 2011-259]. We must separate the true , nontax reasons for SFLP's formation from those that merely clothe transfer tax savings motives. See Estate of Bongard v. Commissioner 124 T.C. at 121. , The estate argues that decedent had two nontax motives for transferring the woodland parcels to SFLP: (1) to create a family asset which later may be developed and sold by the family; and (2) to protect the woodland parcels from division as a result of partition actions. Respondent argues that decedent was motivated only by a desire to simplify the gift-giving process by not having to execute deeds each time a gift of a portion of the woodland parcels was made. We consider each of the parties' arguments. a. Gift Giving One of the reasons decedent transferred the woodland parcels to SFLP was to simplify the process of making gifts of the woodland parcels to her children, her children's spouses, and her grandchildren. Respondent claims that gift giving was decedent's only motive in transferring the woodland parcels to SFLP and that no nontax motive existed because "gift giving is considered a testamentary purpose and cannot be justified as a legitimate, non-tax business justification." Estate of Bigelow v. Commissioner, 503 F.3d 955, 972 [100 AFTR 2d 2007-6016] (9th Cir. 2007), aff'g T.C. Memo. 2005-65 [TC Memo 2005-65]. While we agree with respondent that gift giving alone is not an acceptable nontax motive, we disagree that gift giving was decedent's only motive in transferring the woodland parcels to SFLP. b. Creation of a Family Asset Testimony at trial established that a significant purpose of decedent's transfer of the woodland parcels to SFLP was to create a family asset managed by decedent's family. Decedent and Mr. Stone desired that their children, their children's spouses, and their grandchildren work together to develop and sell homes near the lake. We have previously found that a desire by a decedent to have assets jointly managed by family members, even standing alone, is a sufficient nontax motive for purposes of section 2036(a). Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74 [TC Memo 2008-74].
We find that decedent's desire to have the woodland parcels held and managed as a family asset constituted a legitimate nontax motive for her transfer of the woodland parcels to SFLP. Although this transfer to SFLP was also made with testamentary purposes in mind, we have previously noted that "Legitimate nontax purposes are often inextricably interwoven with testamentary objectives." Estate of Bongard v. Commissioner, 124 T.C. at 121. c. Other Factors Respondent argues that other facts show a nontax purpose did not actually exist. Respondent first argues that decedent stood on both sides of the transaction, as both transferor of the woodland parcels and general manager of SFLP. Respondent points out that decedent and Mr. Stone had almost complete control over the woodland parcels until 1999, when the limited partners acquired enough interest in SFLP (67%) to remove decedent and Mr. Stone as general partners.
Where a taxpayer stands on both sides of a transaction, we have concluded that there is no arm's-length bargaining and thus the bona fide transfer exception does not apply. Estate of Liljestrand v. Commissioner , T.C. Memo. 2011-259 [TC Memo 2011-259]. However, we have also stated that an arm's-length transaction occurs when mutual legitimate and significant nontax reasons exist for the transaction and the transaction is carried out in a way in which unrelated parties to a business transaction would deal with each other. Estate of Bongard v. Commissioner , 124 T.C. at 123.
We have already found the existence of a legitimate nontax motive for the transaction between decedent and SFLP. See supra pp. 14-15. We also believe decedent received interests in SFLP proportional to the property she contributed. See Estate of Bongard v. Commissioner 124 T.C. at 123. Therefore, this factor , does not weigh against the estate.
Respondent next argues that the partners of SFLP failed to respect partnership formalities because: (1) in divorce proceedings, Mr. Ironside and Patricia Connelly Stone quitclaimed their interests in the woodland parcels to their former spouses but did not transfer actual SFLP interests; (2) some inadequate documentation was kept for the partnership, such as using bills of sale to make gifts of SFLP interests; and (3) decedent and Mr. Stone paid SFLP property taxes out of their personal funds. We agree with respondent that the partners of SFLP failed to respect some partnership formalities.
Other factors, however, support the estate's argument that a bona fide sale occurred. First, decedent and Mr. Stone did not depend on distributions from SFLP as no distributions were ever made. Second, decedent and Mr. Stone actually did transfer the woodland parcels to SFLP. Third, there was no commingling of partners' personal and partnership funds, as SFLP had no partnership funds. Fourth, no discounting of SFLP interests for gift tax purposes occurred; decedent and Mr. Stone had the woodland parcels appraised and valued the SFLP interests so that the total value of SFLP interests was equal to the appraised value of the woodland parcels. Finally, the evidence presented tended to show that decedent (and Mr. Stone) were in good health at the time the transfer of the woodland parcels was made to SFLP. Although decedent was over age 70 at the time of transfer in 1997, she lived until 2005 and was healthy enough to continue teaching Sunday school up to and including the last Sunday before she passed away. Although Mr. Stone was over age 80 at the time of transfer, he was still alive at the time of trial in June 2011. d. Conclusion on Bona Fide Sale Issue After considering all facts presented, we find that decedent had a legitimate and actual nontax motive in transferring the woodland parcels to SFLP. We therefore find that the bona fide sale prong is satisfied. 2. Whether Decedent Received Full and Adequate Consideration for Her Transfer of the Woodland Parcels to SFLP A taxpayer's receipt of a partnership interest is not part of a bona fide sale for full and adequate consideration where an intrafamily transaction merely attempts to change the form in which the decedent holds property. Estate of Gore v. Commissioner, T.C. Memo. 2007-169 [TC Memo 2007-169]. We have stated that--
Without any change whatsoever in the underlying pool of assets or prospect for profit, as, for example, where others make contributions of property or services in the interest of true joint ownership or enterprise, there exists nothing but a circuitous "recycling" of value. We are satisfied that such instances of pure recycling do not rise to the level of a payment of consideration. To hold otherwise would open section 2036 to a myriad of abuses engendered by unilateral paper transformations. Estate of Harper v. Commissioner, T.C. Memo. 2002-121 [TC Memo 2002-121]. With regard to recycling of value, we have stated that when a "decedent employ[s] his capital to achieve a legitimate nontax purpose, the Court cannot conclude that he merely recycled his shareholdings." Estate of Schutt v. Commissioner, T.C. Memo. 2005-126 [TC Memo 2005-126].
We have already found that decedent had a legitimate and actual nontax purpose in transferring the woodland parcels to SFLP. See supra pp. 13-17. We therefore find that the transaction was not merely an attempt to change the form in which decedent held the woodland parcels and that the full and adequate consideration prong is satisfied. B. Conclusion Regarding Section 2036(a) We have found that decedent's transfer of the woodland parcels to SFLP was a bona fide transfer and that decedent received full and adequate consideration from SFLP as a result of the transfer. Because decedent's transfer was bona fide and for adequate and full consideration, section 2036(a) is inapplicable to the transfer and does not operate to include the values of the woodland parcels in the value of decedent's gross estate.
In reaching our holding herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
ESTATE OF JOANNE HARRISON STONE, DECEASED, COSBY A. STONE AND MICHAEL D. STONE, PERSONAL REPRESENTATIVES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Case Information: Code Sec(s): 2036
Docket: Dkt. No. 23290-09.
Date Issued: 02/22/2012.
Judge: Opinion by Goeke, J.
Tax Year(s):
Disposition:
HEADNOTE
1.
Reference(s): Code Sec. 2036
Syllabus
Official Tax Court Syllabus
Counsel
Dudley W. Taylor, for petitioner.
Caroline R. Krivacka, for respondent.
GOEKE, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined a $2,563,290 Federal estate tax deficiency against the Estate of Joanne Stone (estate). After settlement of certain issues, the sole issue remaining for decision is whether the value of real property transferred by Joanne Stone (decedent) to a family limited partnership should be included in the value of her gross estate pursuant to section 2036(a). 1 We hold that the value of the property transferred should not be included.
FINDINGS OF FACT
Decedent was a resident of Tennessee when she died on July 2, 2005, at the age of 81. Two of her sons, Cosby A. Stone and Michael D. Stone, are the personal representatives of the estate. Both reside in Tennessee. 1. Background of Decedent, Her Family, and Her Land Decedent was married to Roy A. Stone (Mr. Stone) and had six adult children and numerous grandchildren at the time of her death. Decedent and her family members were a very close-knit family in terms of living close together and working 1
Unless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the date of decedent's death, and all Rule references are to the Tax Court Rules of Practice and Procedure. together. Decedent, Mr. Stone, and at least four of their six children had worked at a publishing company started by the Stone family in the 1930s.
The Stones were a prominent family in their hometown of Crossville, Tennessee (which is in Cumberland County), and had held significant amounts of real estate in the area for several generations. Decedent owned, either wholly or in part, approximately 30 parcels of real property in Cumberland County in 1997. Nine parcels of decedent's land (totaling approximately 740 acres) were mostly undeveloped woodlands without utilities or roads (woodland parcels). The woodland parcels were jointly owned by decedent and Mr. Stone.
In the early 1990s Steve Stone, one of decedent's sons, acquired real estate near the woodland parcels. Steve Stone built a home on his property and desired to form a lake in the area through the construction of a dam on his property. He discussed the lake project with decedent and Mr. Stone, as well as his siblings, and entered into an agreement with Crab Orchard Water Utility District (Crab Orchard) by which Crab Orchard would construct the dam at a cost of approximately $1.5 to $2 million. In exchange, Crab Orchard would be entitled to use a portion of Steve Stone's property for construction of a water treatment plant and would be able to use the lake as a water reservoir for the county. Once the dam was completed in the mid-1990s, a portion of the woodland parcels fronted the newly formed lake.
Once the lake had been constructed, decedent and Mr. Stone concluded that they wanted the woodland parcels to become a family asset. They hoped that the family would one day be able to develop and sell homes near the lake, although there were long-term issues to be worked out. The first issue was that the shallow soil depth in the area makes it difficult to connect sewage systems to potential homes near the lake. The second issue is that the operations of Crab Orchard result in a significant drawdown of the water in the lake during the summer months. Potential solutions to these problems included construction of additional sewer lines closer to the lake and of a new primary reservoir for Cumberland County. 2 2. The Stone Family Limited Partnership of Cumberland County and Gifts of Partnership Interests To further their family planning regarding the woodland parcels, decedent and Mr. Stone sought the advice of their attorney, Joe Looney. Mr. Looney referred decedent and Mr. Stone to Harry Sabine, another attorney in the area. At their first 2
Cosby Stone testified that there have been "grumblings" of new sewer lines to be constructed near the lake. In addition, the rapid population growth in Cumberland County could spur the construction of a new primary reservoir. meeting with Mr. Sabine, decedent and Mr. Stone informed Mr. Sabine that they wanted to give gifts of real estate to various family members and were seeking the best way of doing so. Mr. Sabine discussed the use of a limited partnership and told decedent and Mr. Stone that it would simplify the gift-giving process by not requiring execution and recording of new deeds every year. Mr. Sabine also believed that using a limited partnership would help guard against partition suits, which could cause the land to be divided into smaller tracts.
Decedent and Mr. Stone decided to form a limited partnership to hold the woodland parcels. Mr. Sabine prepared the Stone Family Limited Partnership of Cumberland County (SFLP) agreement and helped decedent and Mr. Stone file a certificate of limited partnership with the Tennessee secretary of state on December 29, 1997. Decedent and Mr. Stone signed the SFLP agreement as both general and limited partners. A revised partnership agreement was executed December 31, 1997. This revised agreement made no material changes but allowed decedent's children, children's spouses, and grandchildren who received interests in the partnership to sign as limited partners. Decedent and Mr. Stone also signed the revised agreement as both general and limited partners.
The SFLP agreement provided that SFLP's purpose was to hold and manage property for the family members. The agreement provided that "The family members desire to provide for the health, education, maintenance and welfare of each other and their children." The agreement listed various ways in which SFLP may be terminated, including by written agreement of partners owning 67% of SFLP or upon sale of all SFLP property and distribution of proceeds. The agreement placed various restrictions on a partner's ability to transfer their partnership interest and allowed SFLP to purchase the interest of any partner upon his or her death.
As general partners of SFLP, decedent and Mr. Stone had considerable powers, including the sole rights to: (1) determine whether properties would be sold; (2) manage the day-to-day business of SFLP; and (3) determine the amounts of any distributions to partners. The partnership agreement provided: "The limited partners will have the right to dismiss the general partner upon written agreement of those limited partners owning sixty-seven (67%) percent of percentage of ownership then held by all the limited partners." The partnership agreement also provided that upon the death, withdrawal, removal, or bankruptcy of a general partner a new general partner would be elected by the limited partners.
Upon its formation, decedent and Mr. Stone each obtained 1% general partnership interests and 49% limited partnership interests in SFLP. On December 30, 1997, decedent and Mr. Stone quitclaimed the woodland parcels to SFLP and the parcels became SFLP's only assets. Before quitclaiming the woodland parcels to SFLP, decedent and Mr. Stone had the combined parcels appraised. Decedent and Mr. Stone used the appraisal value of $1,575,600 as the basis for all computations of SFLP interest values and did not discount the value of SFLP interests for gift tax purposes. Accordingly, decedent and Mr. Stone valued each 1% interest in SFLP at $15,756 for gift tax purposes.
On December 31, 1997, decedent and Mr. Stone gave portions of their limited interests in SFLP as gifts to their 21 children, children's spouses, and grandchildren. Each of the 21 recipients received a .634% limited partnership interest in SFLP from both decedent and Mr. Stone, so that the 21 recipients held a combined 26.628% limited partnership interest in SFLP at the end of 1997. Similar gifts were made in 1998 and 1999. In 2000 the recipients received only a .477% limited partnership interest from both decedent and Mr. Stone and two of the children's spouses no longer received interests as a result of divorce proceedings. As a result of the gifts, by the end of 2000 decedent and Mr. Stone each owned a 1% general partnership interest in SFLP and the children, children's spouses, and grandchildren owned the remaining 98% in limited partnership interests.
Xavier Ironside and Margaret Stone Ironside (one of decedent's daughters) began divorce proceedings in 1999. In an attempt to keep SFLP interests in family hands, SFLP and Mr. Ironside reached a deal whereby Mr. Ironside would receive approximately four acres of SFLP property on the lake. The decision to transfer the four acres was made by decedent and Mr. Stone, who had discussed it with various limited partners. In exchange for the four acres of lake property, on December 9, 1999, Mr. Ironside quitclaimed to Margaret Stone Ironside his interest in the woodland parcels still held by SFLP. No mention was made of the SFLP limited partnership interest then owned by Mr. Ironside in the quitclaim deed although it was mentioned that the parcels involved were the same ones conveyed to SFLP by decedent and Mr. Stone.
Patricia Connelly Stone and Michael Stone began divorce proceedings in 2000. As part of a financial settlement between them, Patricia Connelly Stone quitclaimed to Michael Stone her interest in the woodland parcels still held by SFLP on October 18, 2000. In exchange for the quitclaimed interest, Michael Stone gave up valuable consideration in the financial settlement. Again, no mention was made of the SFLP limited partnership interest then owned by Patricia Connelly Stone in the quitclaim deed, but it was mentioned that the parcels involved were the same ones conveyed to SFLP by decedent and Mr. Stone. 3. Additional Information SFLP has yet to develop or otherwise improve the woodland parcels. SFLP initially had a bank account in its name but closed the account because SFLP earned no income, either from the property it held or otherwise. SFLP's only expenses were property taxes of approximately $700 per year due on the real property it held. Decedent and Mr. Stone paid these property taxes from their personal funds.
Documents labeled "Bill[s] of Sale" were used to transfer the SFLP limited partnership interests to decedent's children, children's spouses, and grandchildren. Although each document recites payment of $1.00 and other "good and valuable consideration", the recipients paid nothing to decedent and Mr. Smith and the transfers constituted gifts. Mr. Sabine testified that he used a bill of sale for each transfer because he thought it was the same thing as a document reflecting a gift of the SFLP interest.
Decedent and Mr. Stone made no particular use of the woodland parcels held by SFLP other than to fish and visit Steve Stone. Each of the limited partners had the same access to the land as decedent and Mr. Stone.
As of the time of trial in June 2011, Mr. Stone was age 95. Decedent taught Sunday school for 60 years, up to and including the last Sunday before she passed away.
The estate's estate tax return was filed September 26, 2006. An amended estate tax return was filed October 31, 2008. Respondent issued a notice of deficiency to the estate on August 27, 2009, in response to which the estate timely filed a petition for redetermination of the deficiency.
OPINION
I. Burden of Proof Generally, taxpayers bear the burden of proving, by a preponderance of the evidence, that the determinations of the Commissioner in a notice of deficiency are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 [12 AFTR 1456] (1933). The estate has not argued that respondent should bear the burden of proof.
II. Whether Section 2036(a) Applies to Decedent's Transfer of the Woodland Parcels to SFLP
The purpose of section 2036 is to include in a deceased taxpayer's gross estate the value of inter vivos transfers that were testamentary in nature. United States v. Estate of Grace, 395 U.S. 316 [23 AFTR 2d 69-1954] (1969). Section 2036(a) generally provides that if a decedent makes an inter vivos transfer of property other than a bona fide sale for adequate and full consideration and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the decedent's gross estate. Section 2036(a) is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent's transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.
Respondent argues that these three conditions were satisfied by decedent's transfer of the woodland parcels to SFLP, while the estate argues that the latter two conditions were not satisfied. The parties agree that decedent made an inter vivos transfer of property. We find that decedent's transfer of the woodland parcels to SFLP was a bona fide sale for adequate and full consideration. As a result, we conclude that section 2036(a) does not apply to decedent's transfer of the woodland parcels to SFLP.
A. Whether Decedent's Transfer of the Woodland Parcels to SFLP Was a Bona Fide Sale for Adequate and Full Consideration In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant nontax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred. Estate of Bongard v. Commissioner 124 T.C. 95, 118 (2005). , The objective evidence must indicate that the nontax reason was a significant factor that motivated the partnership's creation. Id. A significant purpose must be an actual motivation, not a theoretical justification. Id. A list of factors to be considered when deciding whether a nontax reason existed includes: (1) the taxpayer standing on both sides of the transaction; (2) the taxpayer's financial dependence on distributions from the partnership; (3) the partners' commingling of partnership funds with their own; (4) the taxpayer's actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer's old age or poor health when the partnership was formed. Id. at 118-119; Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66 [TC Memo 2009-66], aff'd, 431 Fed. Appx. 544 [107 AFTR 2d 2011-2069] (9th Cir. 2011); Estate of Hurford v. Commissioner T.C. Memo. 2008-278 [TC Memo 2008-278]. We separate the bona , fide sale exception into two prongs: (1) whether the transaction qualifies as a bona fide sale; and (2) whether the decedent received adequate and full consideration. Estate of Bongard v. Commissioner 124 T.C. at 119, 122-125; see also Estate of , Jorgensen v. Commissioner, T.C. Memo. 2009-66 [TC Memo 2009-66]. 1. Whether Decedent's Transfer of the Woodland Parcels to SFLP
Was a Bona Fide Sale Whether a transfer is a bona fide sale is a question of motive. Estate of Liljestrand v. Commissioner T.C. Memo. 2011-259 [TC Memo 2011-259]. We must separate the true , nontax reasons for SFLP's formation from those that merely clothe transfer tax savings motives. See Estate of Bongard v. Commissioner 124 T.C. at 121. , The estate argues that decedent had two nontax motives for transferring the woodland parcels to SFLP: (1) to create a family asset which later may be developed and sold by the family; and (2) to protect the woodland parcels from division as a result of partition actions. Respondent argues that decedent was motivated only by a desire to simplify the gift-giving process by not having to execute deeds each time a gift of a portion of the woodland parcels was made. We consider each of the parties' arguments. a. Gift Giving One of the reasons decedent transferred the woodland parcels to SFLP was to simplify the process of making gifts of the woodland parcels to her children, her children's spouses, and her grandchildren. Respondent claims that gift giving was decedent's only motive in transferring the woodland parcels to SFLP and that no nontax motive existed because "gift giving is considered a testamentary purpose and cannot be justified as a legitimate, non-tax business justification." Estate of Bigelow v. Commissioner, 503 F.3d 955, 972 [100 AFTR 2d 2007-6016] (9th Cir. 2007), aff'g T.C. Memo. 2005-65 [TC Memo 2005-65]. While we agree with respondent that gift giving alone is not an acceptable nontax motive, we disagree that gift giving was decedent's only motive in transferring the woodland parcels to SFLP. b. Creation of a Family Asset Testimony at trial established that a significant purpose of decedent's transfer of the woodland parcels to SFLP was to create a family asset managed by decedent's family. Decedent and Mr. Stone desired that their children, their children's spouses, and their grandchildren work together to develop and sell homes near the lake. We have previously found that a desire by a decedent to have assets jointly managed by family members, even standing alone, is a sufficient nontax motive for purposes of section 2036(a). Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74 [TC Memo 2008-74].
We find that decedent's desire to have the woodland parcels held and managed as a family asset constituted a legitimate nontax motive for her transfer of the woodland parcels to SFLP. Although this transfer to SFLP was also made with testamentary purposes in mind, we have previously noted that "Legitimate nontax purposes are often inextricably interwoven with testamentary objectives." Estate of Bongard v. Commissioner, 124 T.C. at 121. c. Other Factors Respondent argues that other facts show a nontax purpose did not actually exist. Respondent first argues that decedent stood on both sides of the transaction, as both transferor of the woodland parcels and general manager of SFLP. Respondent points out that decedent and Mr. Stone had almost complete control over the woodland parcels until 1999, when the limited partners acquired enough interest in SFLP (67%) to remove decedent and Mr. Stone as general partners.
Where a taxpayer stands on both sides of a transaction, we have concluded that there is no arm's-length bargaining and thus the bona fide transfer exception does not apply. Estate of Liljestrand v. Commissioner , T.C. Memo. 2011-259 [TC Memo 2011-259]. However, we have also stated that an arm's-length transaction occurs when mutual legitimate and significant nontax reasons exist for the transaction and the transaction is carried out in a way in which unrelated parties to a business transaction would deal with each other. Estate of Bongard v. Commissioner , 124 T.C. at 123.
We have already found the existence of a legitimate nontax motive for the transaction between decedent and SFLP. See supra pp. 14-15. We also believe decedent received interests in SFLP proportional to the property she contributed. See Estate of Bongard v. Commissioner 124 T.C. at 123. Therefore, this factor , does not weigh against the estate.
Respondent next argues that the partners of SFLP failed to respect partnership formalities because: (1) in divorce proceedings, Mr. Ironside and Patricia Connelly Stone quitclaimed their interests in the woodland parcels to their former spouses but did not transfer actual SFLP interests; (2) some inadequate documentation was kept for the partnership, such as using bills of sale to make gifts of SFLP interests; and (3) decedent and Mr. Stone paid SFLP property taxes out of their personal funds. We agree with respondent that the partners of SFLP failed to respect some partnership formalities.
Other factors, however, support the estate's argument that a bona fide sale occurred. First, decedent and Mr. Stone did not depend on distributions from SFLP as no distributions were ever made. Second, decedent and Mr. Stone actually did transfer the woodland parcels to SFLP. Third, there was no commingling of partners' personal and partnership funds, as SFLP had no partnership funds. Fourth, no discounting of SFLP interests for gift tax purposes occurred; decedent and Mr. Stone had the woodland parcels appraised and valued the SFLP interests so that the total value of SFLP interests was equal to the appraised value of the woodland parcels. Finally, the evidence presented tended to show that decedent (and Mr. Stone) were in good health at the time the transfer of the woodland parcels was made to SFLP. Although decedent was over age 70 at the time of transfer in 1997, she lived until 2005 and was healthy enough to continue teaching Sunday school up to and including the last Sunday before she passed away. Although Mr. Stone was over age 80 at the time of transfer, he was still alive at the time of trial in June 2011. d. Conclusion on Bona Fide Sale Issue After considering all facts presented, we find that decedent had a legitimate and actual nontax motive in transferring the woodland parcels to SFLP. We therefore find that the bona fide sale prong is satisfied. 2. Whether Decedent Received Full and Adequate Consideration for Her Transfer of the Woodland Parcels to SFLP A taxpayer's receipt of a partnership interest is not part of a bona fide sale for full and adequate consideration where an intrafamily transaction merely attempts to change the form in which the decedent holds property. Estate of Gore v. Commissioner, T.C. Memo. 2007-169 [TC Memo 2007-169]. We have stated that--
Without any change whatsoever in the underlying pool of assets or prospect for profit, as, for example, where others make contributions of property or services in the interest of true joint ownership or enterprise, there exists nothing but a circuitous "recycling" of value. We are satisfied that such instances of pure recycling do not rise to the level of a payment of consideration. To hold otherwise would open section 2036 to a myriad of abuses engendered by unilateral paper transformations. Estate of Harper v. Commissioner, T.C. Memo. 2002-121 [TC Memo 2002-121]. With regard to recycling of value, we have stated that when a "decedent employ[s] his capital to achieve a legitimate nontax purpose, the Court cannot conclude that he merely recycled his shareholdings." Estate of Schutt v. Commissioner, T.C. Memo. 2005-126 [TC Memo 2005-126].
We have already found that decedent had a legitimate and actual nontax purpose in transferring the woodland parcels to SFLP. See supra pp. 13-17. We therefore find that the transaction was not merely an attempt to change the form in which decedent held the woodland parcels and that the full and adequate consideration prong is satisfied. B. Conclusion Regarding Section 2036(a) We have found that decedent's transfer of the woodland parcels to SFLP was a bona fide transfer and that decedent received full and adequate consideration from SFLP as a result of the transfer. Because decedent's transfer was bona fide and for adequate and full consideration, section 2036(a) is inapplicable to the transfer and does not operate to include the values of the woodland parcels in the value of decedent's gross estate.
In reaching our holding herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
Dependency
Luis Santana, et al. v. Commissioner, TC Memo 2012-49 , Code Sec(s) 32; 151; 152.
LUIS SANTANA AND FLOR E. VARGAS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: Code Sec(s): 32; 151; 152
Docket: Dkt. No. 12662-10.
Date Issued: 02/22/2012.
Judge: Opinion by Vasquez, J.
Tax Year(s):
Disposition:
HEADNOTE
1.
Reference(s): Code Sec. 32; Code Sec. 151; Code Sec. 152
Syllabus
Official Tax Court Syllabus
Counsel
Luis Santana and Flor E. Vargas, pro se.
Vivian N. Rodriguez, for respondent.
VASQUEZ, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined a $2,888 deficiency in petitioners' Federal income tax for 2008. The issues for decision are: (1) whether petitioners are entitled to a dependency exemption deduction for C.S.; 1 and (2) whether petitioners are entitled to an earned income credit.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts and the attached exhibits are incorporated herein by this reference. Petitioners resided in Florida when the petition was filed.
Petitioner Luis Santana was formerly married to Maria Rodriguez. They had two children, E.S. and C.S. Mr. Santana and Ms. Rodriguez were divorced on November 21, 2001. In connection with their divorce Mr. Santana and Ms. Rodriguez entered into a family mediation unit agreement (mediation agreement). The mediation agreement designates Ms. Rodriguez as the "primary residential parent". During 2008 C.S. resided with Ms. Rodriguez for more than one-half of the year.
The mediation agreement states that for the purposes of Federal income tax exemptions Ms. Rodriguez is allowed to claim C.S. and petitioner is allowed to claim E.S. as long as he is current on his child support obligation. Upon E.S.' 1
It is the policy of the Court to refer to a minor by his or her initials.See Rule 27(a)(3). Unless otherwise indicated, all 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. reaching the age of majority, Mr. Santana and Ms. Rodriguez are to claim C.S. in alternate years as long as Mr. Santana is current on his child support obligation. Although the mediation agreement does not specify who is entitled to claim C.S. first after E.S. reached the age of majority, Ms. Rodriguez did. Ms. Rodriguez claimed C.S. for an odd-numbered year, and Mr. Santana subsequently started claiming C.S. for even-numbered years. In 2008 Mr. Santana was current on his child support obligation.
Petitioners reported $17,433 of self-employment income and claimed an earned income credit on their Form 1040, U.S. Individual Income Tax Return, for 2008. They also claimed a dependency exemption deduction for C.S. Petitioners did not attach Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or any written declaration with respect to C.S. to their 2008 return. Petitioners did not ask Ms. Rodriguez to sign a Form 8332 or any other document declaring that she would not claim C.S. as a dependent.
OPINION
I. Burden of Proof Petitioners have neither claimed nor shown that they satisfied the requirements of section 7491(a) to shift the burden of proof to respondent with regard to any factual issue. Accordingly, petitioners bear the burden of proof. See Rule 142(a).
II. Dependency Exemption Deduction Section 151(a) and (c) allows taxpayers an annual exemption deduction for each "dependent" as defined in section 152. A dependent is either a qualifying child or a qualifying relative. Sec. 152(a). The requirement is disjunctive, and, accordingly, satisfaction of either the qualifying child requirement or the qualifying relative requirement allows the individual to be claimed as a dependent. A qualifying child must meet four requirements for the taxpayer to qualify for the deduction. See sec. 152(c)(1)(A)-(D). The pertinent factor here is the residence requirement: The individual must have the same principal place of abode as the taxpayer for more than one-half of the taxable year. 2 Sec. 152(c)(1)(B).
Mr. Santana has not demonstrated that C.S. lived with him for more than one- half of 2008. Thus, C.S. is not Mr. Santana's qualifying child under section 152(c). See sec. 152(c)(1)(B). A qualifying relative must satisfy four requirements for the taxpayer to qualify for the deduction. See sec. 152(d)(1)(A)-(D). The two pertinent requirements are 2
Respondent does not question that Mr. Santana meets the relationship requirement, the age requirement, or the support requirement. that the taxpayer provide over one-half of the individual's support for the taxable year and that the individual not be a qualifying child of the taxpayer or of any other taxpayer for the taxable year. Sec. 152(d)(1)(C) and (D).
Mr. Santana did not substantiate the amount of C.S.' support from all sources in 2008. Mr. Santana also did not establish that C.S. was not a qualifying child of any other taxpayer for 2008 (e.g., Ms. Rodriguez). Therefore, C.S. is not Mr. Santana's qualifying child under section 152(d).
Section 152(e)(1), however, provides a special rule whereby a noncustodial parent may be entitled to claim a dependency exemption deduction for a child notwithstanding the residency requirement of section 152(c)(1)(B), the support requirement of section 152(d)(1)(C), and the so-called tie-breaking rule of section 152(c)(4). A child will be treated as the noncustodial parent's qualifying child or qualifying relative if five requirements are met. See sec. 152(e)(1) and (2). The relevant requirements here are that the custodial parent sign a written declaration, in such manner and form as the Secretary may prescribe, that the custodial parent will not claim the child as a dependent and that the noncustodial parent attach that declaration to the noncustodial parent's return for the taxable year. Sec. 152(e)(2)(A) and (B).
The Internal Revenue Service issued Form 8332 in order to standardize the written declaration required by section 152(e). See, e.g., Chamberlain v. Commissioner, T.C. Memo. 2007-178 [TC Memo 2007-178]. Form 8332 requires a taxpayer to furnish: (1) the name of the child; (2) the name and Social Security number of the noncustodial parent claiming the dependency exemption deduction; (3) the Social Security number of the custodial parent; (4) the signature of the custodial parent; (5) the date of the custodial parent's signature; and (6) the year(s) for which the claims were released. See Miller v. Commissioner, 114 T.C. 184, 190 (2000), aff'd on another ground sub nom. Lovejoy v. Commissioner, 293 F.3d 1208 [89 AFTR 2d 2002-2989] (10th Cir. 2002). Although taxpayers are not required to use Form 8332, any other written declaration executed by the custodial parent must conform to the substance of Form 8332. 3 See id. at 189. Section 152(e) allows a noncustodial parent to claim the dependency exemption deduction only when that parent attaches a valid Form 8332 or its equivalent to a Federal income tax return for the taxable year for which he or she claims the dependency exemption deduction. See Paulson v. Commissioner, T.C. Memo. 1996-560 [1996 RIA TC Memo ¶96,560]. 3
For cases applying sec. 152(e), see King v. Commissioner 121 T.C. 245, , 252 (2003), Gessic v. Commissioner, T.C. Memo. 2010-88 [TC Memo 2010-88], Loffer v. Commissioner, T.C. Memo. 2002-298 [TC Memo 2002-298], and Bramante v. Commissioner, T.C. Memo. 2002-228 [TC Memo 2002-228].
Petitioners did not attach Form 8332 or its equivalent to their Form 1040. Even if petitioners had attached the mediation agreement, they still would not have satisfied the requirements of section 152(e)(2). The mediation agreement contains a provision for Mr. Santana to share the deduction with his ex-wife in alternating years once there is only one eligible child. This alternating years provision does not specify which parent--Mr. Santana or Ms. Rodriguez--claims C.S. first once E.S. reaches the age of majority. Because the mediation agreement does not specify which parent was entitled to claim C.S. first, we cannot determine whether it is Mr. Santana's or Ms. Rodriguez's year to claim C.S. under the mediation agreement. Because this alternating years provision is so ambiguous, there is no explicit declaration of Ms. Rodriguez releasing her right as the custodial parent to claim C.S. for the year in issue. See Boltinghouse v. Commissioner T.C. Memo. 2003- , 134 (separation agreement was not so ambiguous that it failed to actually disclaim custodial parent's right to exemption); White v. Commissioner, T.C. Memo. 1996- 438 [1996 RIA TC Memo ¶96,438] (letter did not substantively conform to Form 8332 because it failed to explicitly state that custodial parent would not claim minor children).
Accordingly, we find that C.S. is not treated as Mr. Santana's qualifying child or qualifying relative under section 152(e), and therefore petitioners are not entitled to the dependency exemption deduction for C.S. for 2008. 4
III. Earned Income Credit Section 32(a) provides an earned income credit for an eligible individual for so much of the taxpayer's earned income for the taxable year as does not exceed the earned income amount. To be entitled to an earned income credit for the 2008 tax year, married filing jointly taxpayers must have earned income and adjusted gross income for the taxable year each less than: (i) $41,646 with two or more qualifying children; (ii) $36,995 with one qualifying child; or (iii) $15,880 with no qualifying children. Sec. 32(b)(2), (j)(1); Rev. Proc. 2007-66, sec. 3.07, 2007-2 C.B. 970, 973. Earned income includes wages, salaries, tips, and other employee compensation plus net earnings from self-employment. Sec. 32(c)(2)(A). The term "qualifying child", for purposes of section 32, means a qualifying child as defined in section 152(c) without regard to section 152(c)(1)(D) and (e). Sec. 32(c)(3)(A). 4
Because the decree is fatally ambiguous, we do not need to reach respondent's arguments regarding the conditionality of the mediation agreement or lack of Social Security numbers.
As discussed above, C.S. is not a qualifying child of Mr. Santana. 5 Thus, for purposes of section 32, petitioners have no qualifying children. Petitioners reported $17,433 of net earnings from self-employment and $18,949 of adjusted gross income, making them ineligible for an earned income credit. Consequently, respondent's determination is sustained.
We are not unsympathetic to petitioners' position. We also realize that the statutory requirements may seem to work harsh results to taxpayers, such as Mr. Santana, who are current in their child support obligations and who are entitled to claim the dependency exemption deductions under the terms of a child support order. However, we are bound by the statute as it is written and the accompanying regulations when consistent therewith. Michaels v. Commissioner, 87 T.C. 1412, 1417 (1986); Brissett v. Commissioner, T.C. Memo. 2003-310 [TC Memo 2003-310].
To reflect the foregoing,
Decision will be entered for respondent. 5
This remains true even without regard to sec. 152(c)(1)(D) and
LUIS SANTANA AND FLOR E. VARGAS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: Code Sec(s): 32; 151; 152
Docket: Dkt. No. 12662-10.
Date Issued: 02/22/2012.
Judge: Opinion by Vasquez, J.
Tax Year(s):
Disposition:
HEADNOTE
1.
Reference(s): Code Sec. 32; Code Sec. 151; Code Sec. 152
Syllabus
Official Tax Court Syllabus
Counsel
Luis Santana and Flor E. Vargas, pro se.
Vivian N. Rodriguez, for respondent.
VASQUEZ, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined a $2,888 deficiency in petitioners' Federal income tax for 2008. The issues for decision are: (1) whether petitioners are entitled to a dependency exemption deduction for C.S.; 1 and (2) whether petitioners are entitled to an earned income credit.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts and the attached exhibits are incorporated herein by this reference. Petitioners resided in Florida when the petition was filed.
Petitioner Luis Santana was formerly married to Maria Rodriguez. They had two children, E.S. and C.S. Mr. Santana and Ms. Rodriguez were divorced on November 21, 2001. In connection with their divorce Mr. Santana and Ms. Rodriguez entered into a family mediation unit agreement (mediation agreement). The mediation agreement designates Ms. Rodriguez as the "primary residential parent". During 2008 C.S. resided with Ms. Rodriguez for more than one-half of the year.
The mediation agreement states that for the purposes of Federal income tax exemptions Ms. Rodriguez is allowed to claim C.S. and petitioner is allowed to claim E.S. as long as he is current on his child support obligation. Upon E.S.' 1
It is the policy of the Court to refer to a minor by his or her initials.See Rule 27(a)(3). Unless otherwise indicated, all 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. reaching the age of majority, Mr. Santana and Ms. Rodriguez are to claim C.S. in alternate years as long as Mr. Santana is current on his child support obligation. Although the mediation agreement does not specify who is entitled to claim C.S. first after E.S. reached the age of majority, Ms. Rodriguez did. Ms. Rodriguez claimed C.S. for an odd-numbered year, and Mr. Santana subsequently started claiming C.S. for even-numbered years. In 2008 Mr. Santana was current on his child support obligation.
Petitioners reported $17,433 of self-employment income and claimed an earned income credit on their Form 1040, U.S. Individual Income Tax Return, for 2008. They also claimed a dependency exemption deduction for C.S. Petitioners did not attach Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or any written declaration with respect to C.S. to their 2008 return. Petitioners did not ask Ms. Rodriguez to sign a Form 8332 or any other document declaring that she would not claim C.S. as a dependent.
OPINION
I. Burden of Proof Petitioners have neither claimed nor shown that they satisfied the requirements of section 7491(a) to shift the burden of proof to respondent with regard to any factual issue. Accordingly, petitioners bear the burden of proof. See Rule 142(a).
II. Dependency Exemption Deduction Section 151(a) and (c) allows taxpayers an annual exemption deduction for each "dependent" as defined in section 152. A dependent is either a qualifying child or a qualifying relative. Sec. 152(a). The requirement is disjunctive, and, accordingly, satisfaction of either the qualifying child requirement or the qualifying relative requirement allows the individual to be claimed as a dependent. A qualifying child must meet four requirements for the taxpayer to qualify for the deduction. See sec. 152(c)(1)(A)-(D). The pertinent factor here is the residence requirement: The individual must have the same principal place of abode as the taxpayer for more than one-half of the taxable year. 2 Sec. 152(c)(1)(B).
Mr. Santana has not demonstrated that C.S. lived with him for more than one- half of 2008. Thus, C.S. is not Mr. Santana's qualifying child under section 152(c). See sec. 152(c)(1)(B). A qualifying relative must satisfy four requirements for the taxpayer to qualify for the deduction. See sec. 152(d)(1)(A)-(D). The two pertinent requirements are 2
Respondent does not question that Mr. Santana meets the relationship requirement, the age requirement, or the support requirement. that the taxpayer provide over one-half of the individual's support for the taxable year and that the individual not be a qualifying child of the taxpayer or of any other taxpayer for the taxable year. Sec. 152(d)(1)(C) and (D).
Mr. Santana did not substantiate the amount of C.S.' support from all sources in 2008. Mr. Santana also did not establish that C.S. was not a qualifying child of any other taxpayer for 2008 (e.g., Ms. Rodriguez). Therefore, C.S. is not Mr. Santana's qualifying child under section 152(d).
Section 152(e)(1), however, provides a special rule whereby a noncustodial parent may be entitled to claim a dependency exemption deduction for a child notwithstanding the residency requirement of section 152(c)(1)(B), the support requirement of section 152(d)(1)(C), and the so-called tie-breaking rule of section 152(c)(4). A child will be treated as the noncustodial parent's qualifying child or qualifying relative if five requirements are met. See sec. 152(e)(1) and (2). The relevant requirements here are that the custodial parent sign a written declaration, in such manner and form as the Secretary may prescribe, that the custodial parent will not claim the child as a dependent and that the noncustodial parent attach that declaration to the noncustodial parent's return for the taxable year. Sec. 152(e)(2)(A) and (B).
The Internal Revenue Service issued Form 8332 in order to standardize the written declaration required by section 152(e). See, e.g., Chamberlain v. Commissioner, T.C. Memo. 2007-178 [TC Memo 2007-178]. Form 8332 requires a taxpayer to furnish: (1) the name of the child; (2) the name and Social Security number of the noncustodial parent claiming the dependency exemption deduction; (3) the Social Security number of the custodial parent; (4) the signature of the custodial parent; (5) the date of the custodial parent's signature; and (6) the year(s) for which the claims were released. See Miller v. Commissioner, 114 T.C. 184, 190 (2000), aff'd on another ground sub nom. Lovejoy v. Commissioner, 293 F.3d 1208 [89 AFTR 2d 2002-2989] (10th Cir. 2002). Although taxpayers are not required to use Form 8332, any other written declaration executed by the custodial parent must conform to the substance of Form 8332. 3 See id. at 189. Section 152(e) allows a noncustodial parent to claim the dependency exemption deduction only when that parent attaches a valid Form 8332 or its equivalent to a Federal income tax return for the taxable year for which he or she claims the dependency exemption deduction. See Paulson v. Commissioner, T.C. Memo. 1996-560 [1996 RIA TC Memo ¶96,560]. 3
For cases applying sec. 152(e), see King v. Commissioner 121 T.C. 245, , 252 (2003), Gessic v. Commissioner, T.C. Memo. 2010-88 [TC Memo 2010-88], Loffer v. Commissioner, T.C. Memo. 2002-298 [TC Memo 2002-298], and Bramante v. Commissioner, T.C. Memo. 2002-228 [TC Memo 2002-228].
Petitioners did not attach Form 8332 or its equivalent to their Form 1040. Even if petitioners had attached the mediation agreement, they still would not have satisfied the requirements of section 152(e)(2). The mediation agreement contains a provision for Mr. Santana to share the deduction with his ex-wife in alternating years once there is only one eligible child. This alternating years provision does not specify which parent--Mr. Santana or Ms. Rodriguez--claims C.S. first once E.S. reaches the age of majority. Because the mediation agreement does not specify which parent was entitled to claim C.S. first, we cannot determine whether it is Mr. Santana's or Ms. Rodriguez's year to claim C.S. under the mediation agreement. Because this alternating years provision is so ambiguous, there is no explicit declaration of Ms. Rodriguez releasing her right as the custodial parent to claim C.S. for the year in issue. See Boltinghouse v. Commissioner T.C. Memo. 2003- , 134 (separation agreement was not so ambiguous that it failed to actually disclaim custodial parent's right to exemption); White v. Commissioner, T.C. Memo. 1996- 438 [1996 RIA TC Memo ¶96,438] (letter did not substantively conform to Form 8332 because it failed to explicitly state that custodial parent would not claim minor children).
Accordingly, we find that C.S. is not treated as Mr. Santana's qualifying child or qualifying relative under section 152(e), and therefore petitioners are not entitled to the dependency exemption deduction for C.S. for 2008. 4
III. Earned Income Credit Section 32(a) provides an earned income credit for an eligible individual for so much of the taxpayer's earned income for the taxable year as does not exceed the earned income amount. To be entitled to an earned income credit for the 2008 tax year, married filing jointly taxpayers must have earned income and adjusted gross income for the taxable year each less than: (i) $41,646 with two or more qualifying children; (ii) $36,995 with one qualifying child; or (iii) $15,880 with no qualifying children. Sec. 32(b)(2), (j)(1); Rev. Proc. 2007-66, sec. 3.07, 2007-2 C.B. 970, 973. Earned income includes wages, salaries, tips, and other employee compensation plus net earnings from self-employment. Sec. 32(c)(2)(A). The term "qualifying child", for purposes of section 32, means a qualifying child as defined in section 152(c) without regard to section 152(c)(1)(D) and (e). Sec. 32(c)(3)(A). 4
Because the decree is fatally ambiguous, we do not need to reach respondent's arguments regarding the conditionality of the mediation agreement or lack of Social Security numbers.
As discussed above, C.S. is not a qualifying child of Mr. Santana. 5 Thus, for purposes of section 32, petitioners have no qualifying children. Petitioners reported $17,433 of net earnings from self-employment and $18,949 of adjusted gross income, making them ineligible for an earned income credit. Consequently, respondent's determination is sustained.
We are not unsympathetic to petitioners' position. We also realize that the statutory requirements may seem to work harsh results to taxpayers, such as Mr. Santana, who are current in their child support obligations and who are entitled to claim the dependency exemption deductions under the terms of a child support order. However, we are bound by the statute as it is written and the accompanying regulations when consistent therewith. Michaels v. Commissioner, 87 T.C. 1412, 1417 (1986); Brissett v. Commissioner, T.C. Memo. 2003-310 [TC Memo 2003-310].
To reflect the foregoing,
Decision will be entered for respondent. 5
This remains true even without regard to sec. 152(c)(1)(D) and
No w-2
Qunnia S. Hatch v. Commissioner, TC Memo 2012-50 , Code Sec(s) 61; 102; 6673.
QUNNIA SHANTEL HATCH, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 61; 102; 6673
Docket: Docket No. 19685-09.
Date Issued: 02/23/2012
HEADNOTE
XX.
Reference(s): Code Sec. 61; Code Sec. 102; Code Sec. 6673
Syllabus
Official Tax Court Syllabus
Counsel
Qunnia Shantel Hatch, pro se.
Joel D. McMahan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: On May 18, 2009, respondent sent to petitioner a notice of deficiency determining a deficiency in Federal income tax for taxable year 2007 of $1,966. The issues for decision are whether petitioner is liable for the deficiency in Federal income tax relating to $4,451 of unreported income for the tax year at issue and whether petitioner is liable for a penalty under section 6673 1 for instituting or maintaining proceedings primarily for delay and for maintaining a frivolous position.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At the time the petition was filed, petitioner lived in Florida.
During 2007 petitioner worked part time for North South Florida Rehab, Inc. (North South), in addition to her full-time job. North South hired petitioner on an as-needed basis. There was no written contract signed between the parties. Petitioner believed that she was an employee on the basis of documents representing the relationship between herself and North South. However, North South considered her an independent contractor.
Petitioner typically performed clerical duties, including inputting of data, filing, and billing. North South paid petitioner using corporate checks and provided her a Form 1099-MISC, Miscellaneous Income, for tax purposes. No income tax was withheld from the payments, and North South did not extend to her benefits that it offered its employees.
Petitioner timely filed her 2007 Federal income tax return and did not include the payments from North South in her income. Respondent sent to petitioner a notice of deficiency determining that petitioner failed to include in income the nonemployee compensation paid to her by North South. The notice of deficiency also determined that petitioner failed to pay self-employment tax on the nonemployee compensation; however, respondent has conceded this issue.
OPINION
Petitioner concedes that she received $4,451 of income from North South. She argues that the income she received was not taxable income within the meaning of the law, as she was an employee of North South, and that North South should not have issued her a Form 1099-MISC. 2 Alternatively, petitioner argues that the amounts paid by North South were a tax-free contribution to her.
Section 61 provides that gross income includes all income from whatever source derived, specifically including compensation for services. Sec. 61(a)(1). Compensation is further defined to include wages, salaries, and bonuses. Sec. 1.61- 2(a)(1), Income Tax Regs. Exclusions from income exist if the taxpayer can establish a specific legislative authorization to exclude income from taxation and are a matter of legislative grace. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 [13 AFTR 1180] (1934).
Petitioner argued that she was an employee and should not have been issued a Form 1099-MISC. However, given that respondent conceded the self-employment tax issue, it makes no difference whether the wages were earned in the context of being an employee or a contractor. Petitioner conceded that she received the amounts at issue from North South in exchange for her services; therefore, she has gross income from compensation.
Petitioner also argues that because she was an employee, the amount should be excluded from income as a nontaxable contribution to her from North South. Petitioner has not demonstrated that she was an employee for 2007. Additionally, even if she was an employee, the amounts are still taxable. Section 102(a) provides that gross income does not include the value of property acquired by gift, bequest, or inheritance. However, amounts “transferred by or for an employer to, or for the benefit of, an employee” are not excludible from income. Sec. 102(c). Only in “exceptional” circumstances is a transfer between an employer and an employee considered a gift. Commissioner v. Duberstein, 363 U.S. 278, 287 [5 AFTR 2d 1626] (1960). The legislative history of section 102 indicates that a gift may be made by an employer to an employee if it is exclusively for personal reasons, if it is entirely unrelated to the employment relationship, and if it reflects no anticipation of business benefit. See S. Rept. No. 99-313, at 47-49 (1986), 1986-3 C.B. (Vol. 3) 1, 47-49. There is no evidence that the amounts paid to petitioner are anything other than wages paid for the clerical services she performed and thus are not excludible from income.
Section 6673(a) authorizes the Tax Court to impose a penalty not in excess of $25,000 on a taxpayer for proceedings instituted primarily for delay or in which the taxpayer's position is frivolous or groundless. Respondent has moved for imposition of such a penalty because of petitioner's lack of cooperation and numerous filings with the Court. Petitioner submitted a large number of documents in efforts to explain her position to the Court. While a section 6673 penalty is not appropriate at this time, the Court warns petitioner that continuing to advance groundless arguments or accusations may result in penalties in the future.
In reaching these holdings, the Court has considered all arguments made and, to the extent not mentioned, concludes that they are moot, irrelevant, or without merit.
To reflect the foregoing and the concessions of the parties,
Decision will be entered under Rule 155.
2
Sec. 31(a)(1) provides to an employee a credit against the employee's income tax obligation with respect to her wages for "[t]he amount withheld as tax under chapter 24”. Sec. 1.31-1(a), Income Tax Regs., limits the credit to "[t]he tax deducted and withheld at the source upon wages under chapter 24”. Further, the credit is provided to the employee if the tax has been actually withheld at the source even if the tax has not been paid by employer to the Government. Id. The sec. 31(a)(1) credit is not available to petitioner as she was not treated as an employee by North South and North South never actually withheld any amounts from her wages.
QUNNIA SHANTEL HATCH, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information: Code Sec(s): 61; 102; 6673
Docket: Docket No. 19685-09.
Date Issued: 02/23/2012
HEADNOTE
XX.
Reference(s): Code Sec. 61; Code Sec. 102; Code Sec. 6673
Syllabus
Official Tax Court Syllabus
Counsel
Qunnia Shantel Hatch, pro se.
Joel D. McMahan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: On May 18, 2009, respondent sent to petitioner a notice of deficiency determining a deficiency in Federal income tax for taxable year 2007 of $1,966. The issues for decision are whether petitioner is liable for the deficiency in Federal income tax relating to $4,451 of unreported income for the tax year at issue and whether petitioner is liable for a penalty under section 6673 1 for instituting or maintaining proceedings primarily for delay and for maintaining a frivolous position.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. At the time the petition was filed, petitioner lived in Florida.
During 2007 petitioner worked part time for North South Florida Rehab, Inc. (North South), in addition to her full-time job. North South hired petitioner on an as-needed basis. There was no written contract signed between the parties. Petitioner believed that she was an employee on the basis of documents representing the relationship between herself and North South. However, North South considered her an independent contractor.
Petitioner typically performed clerical duties, including inputting of data, filing, and billing. North South paid petitioner using corporate checks and provided her a Form 1099-MISC, Miscellaneous Income, for tax purposes. No income tax was withheld from the payments, and North South did not extend to her benefits that it offered its employees.
Petitioner timely filed her 2007 Federal income tax return and did not include the payments from North South in her income. Respondent sent to petitioner a notice of deficiency determining that petitioner failed to include in income the nonemployee compensation paid to her by North South. The notice of deficiency also determined that petitioner failed to pay self-employment tax on the nonemployee compensation; however, respondent has conceded this issue.
OPINION
Petitioner concedes that she received $4,451 of income from North South. She argues that the income she received was not taxable income within the meaning of the law, as she was an employee of North South, and that North South should not have issued her a Form 1099-MISC. 2 Alternatively, petitioner argues that the amounts paid by North South were a tax-free contribution to her.
Section 61 provides that gross income includes all income from whatever source derived, specifically including compensation for services. Sec. 61(a)(1). Compensation is further defined to include wages, salaries, and bonuses. Sec. 1.61- 2(a)(1), Income Tax Regs. Exclusions from income exist if the taxpayer can establish a specific legislative authorization to exclude income from taxation and are a matter of legislative grace. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 [13 AFTR 1180] (1934).
Petitioner argued that she was an employee and should not have been issued a Form 1099-MISC. However, given that respondent conceded the self-employment tax issue, it makes no difference whether the wages were earned in the context of being an employee or a contractor. Petitioner conceded that she received the amounts at issue from North South in exchange for her services; therefore, she has gross income from compensation.
Petitioner also argues that because she was an employee, the amount should be excluded from income as a nontaxable contribution to her from North South. Petitioner has not demonstrated that she was an employee for 2007. Additionally, even if she was an employee, the amounts are still taxable. Section 102(a) provides that gross income does not include the value of property acquired by gift, bequest, or inheritance. However, amounts “transferred by or for an employer to, or for the benefit of, an employee” are not excludible from income. Sec. 102(c). Only in “exceptional” circumstances is a transfer between an employer and an employee considered a gift. Commissioner v. Duberstein, 363 U.S. 278, 287 [5 AFTR 2d 1626] (1960). The legislative history of section 102 indicates that a gift may be made by an employer to an employee if it is exclusively for personal reasons, if it is entirely unrelated to the employment relationship, and if it reflects no anticipation of business benefit. See S. Rept. No. 99-313, at 47-49 (1986), 1986-3 C.B. (Vol. 3) 1, 47-49. There is no evidence that the amounts paid to petitioner are anything other than wages paid for the clerical services she performed and thus are not excludible from income.
Section 6673(a) authorizes the Tax Court to impose a penalty not in excess of $25,000 on a taxpayer for proceedings instituted primarily for delay or in which the taxpayer's position is frivolous or groundless. Respondent has moved for imposition of such a penalty because of petitioner's lack of cooperation and numerous filings with the Court. Petitioner submitted a large number of documents in efforts to explain her position to the Court. While a section 6673 penalty is not appropriate at this time, the Court warns petitioner that continuing to advance groundless arguments or accusations may result in penalties in the future.
In reaching these holdings, the Court has considered all arguments made and, to the extent not mentioned, concludes that they are moot, irrelevant, or without merit.
To reflect the foregoing and the concessions of the parties,
Decision will be entered under Rule 155.
2
Sec. 31(a)(1) provides to an employee a credit against the employee's income tax obligation with respect to her wages for "[t]he amount withheld as tax under chapter 24”. Sec. 1.31-1(a), Income Tax Regs., limits the credit to "[t]he tax deducted and withheld at the source upon wages under chapter 24”. Further, the credit is provided to the employee if the tax has been actually withheld at the source even if the tax has not been paid by employer to the Government. Id. The sec. 31(a)(1) credit is not available to petitioner as she was not treated as an employee by North South and North South never actually withheld any amounts from her wages.
Friday, February 24, 2012
S corp fica case
WATSON, P.C. v. U.S., Cite as 109 AFTR 2d 2012-XXXX, 02/21/2012
David E. Watson, P.C., Plaintiff/Appellant, v. UNITED STATES of America, Defendant/Appellee.
Case Information:
Code Sec(s):
Court Name: United States Court of Appeals FOR THE EIGHTH CIRCUIT,
Docket No.: No. 11-1589,
Date Decided: 02/21/2012Submitted: November 15, 2011.
Prior History:
Disposition:
HEADNOTE
.
Reference(s):
OPINION
United States Court of Appeals FOR THE EIGHTH CIRCUIT,
Appeal from the United States District Court for the Southern District of Iowa.
Before RILEY, Chief Judge, BEAM, and BYE, Circuit Judges.
Judge: BEAM, Circuit Judge.
This case concerns the Federal Insurance Contribution Act (FICA), 26 U.S.C. (I.R.C.) § 3101 et seq., and certain employment taxes FICA imposes upon employers. After a bench trial on the merits, the district court 1 rendered a tax deficiency judgment against David E. Watson, P.C. (DEWPC) for unpaid FICA tax. DEWPC appeals, and we affirm.
I. BACKGROUND
In 1982, David Watson (Watson) graduated from college with a bachelor's degree in business administration and a specialization in accounting. In 1983, Watson became a Certified Public Accountant (CPA) and later obtained a master's degree in taxation. In his first ten years of practice, Watson worked at two accounting firms, one of which was Ernst & Young. While at Ernst & Young, Watson began specializing in partnership taxation.
After leaving Ernst & Young, Watson obtained a 25% interest in an accounting firm located in West Des Moines, Iowa, known as Larson, Watson, Bartling & Eastman. At trial, Watson testified that he received no salary when the firm first began operations because the entity did not have money to pay him. Eventually, one partner exited and the firm added a new partner, reemerging as Larson, Watson, Bartling & Juffer, LLP (LWBJ 2).
In 1996, Watson incorporated a business entity known as David E. Watson, P.C. Watson transferred his individual 25% interest in LWBJ to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed Watson, but Watson exclusively provided his accounting services to LWBJ for the period relevant to this dispute. From its inception, DEWPC elected to be taxed as an S Corporation.
In both 2002 and 2003, DEWPC distributed $24,000 to Watson as employment compensation. Watson testified that the LWBJ partners made the determination that LWBJ had sufficient cash flow where it could distribute $2,000 a month to each partner, regardless of the seasonality of the business. There were no documents reflecting these salary discussions, and no other LWBJ partner testified at trial. Ultimately, DEWPC is the entity that authorized and paid Watson's salary. In addition to salary, Watson, through DEWPC, received $203,651 from LWBJ as profit distributions for 2002. In 2003, Watson, through DEWPC, received $175,470 as profit distributions from LWBJ. Thus, in 2002 and 2003, after DEWPC paid Watson's salary and other expenses, it distributed all remaining cash to Watson as dividends.
The Internal Revenue Service (IRS) investigated DEWPC and determined that it underpaid certain employment taxes pursuant to FICA, see I.R.C. § 3111(a), (b), in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. On April 14, 2007, DEWPC paid the delinquent tax, penalty, and interest for the fourth quarter of 2002 and sought a refund from the IRS. 3 The IRS denied DEWPC's refund claim, and DEWPC sued the United States in district court. The United States counterclaimed, seeking to recover employment taxes, penalties, and interest that remained unpaid for 2002 and 2003.
After denying DEWPC's motion for summary judgment, the district court held a bench trial on the merits. At trial, the government's expert, Igor Ostrovsky, opined that the market value of Watson's accounting services was approximately $91,044 per year for 2002 and 2003. Ostrovsky is a general engineer with the IRS and has worked on approximately 20 to 30 cases involving reasonable compensation issues. In forming his opinion as to Watson's salary, Ostrovsky relied on several compensation surveys and studies particular to accountants. Primarily, Ostrovsky focused on the Management of an Accounting Practice (MAP) survey conducted by the American Institute of Certified Public Accountants, which contained adjustments for specific regions. Ostrovsky discovered that an owner–defined as an investor and an employee–in a firm the size of LWBJ would receive approximately $176,000 annually, which reflected both compensation and return on investment. Ostrovsky also discovered that a director–an employee with no investment interest–would receive approximately $70,000 in compensation alone. Because owners billed at rates 33% higher than directors, and because Ostrovsky viewed Watson as a de facto partner of LWBJ, Ostrovsky increased the director compensation by 33% to arrive at owner compensation or $93,000. Ostrovsky then made a downward adjustment to $91,044, accounting for untaxable fringe benefits. In reaching his conclusion, Ostrovsky used average billing rates rather than Watson's actual billing rates.
Ultimately, the district court adopted Ostrovsky's opinion and determined that the reasonable amount of Watson's remuneration for services performed totaled $91,044. Therefore, the district court rendered a tax deficiency judgment against DEWPC, which included unpaid employment taxes, penalties, and interest in the amount of $23,431.23. DEWPC now appeals.
II. DISCUSSION
This case presents two issues for our review. First, we must decide whether the district court erred in allowing Ostrovsky to testify as an expert witness on the issue of compensation. Second, we must determine whether the district court properly characterized $91,044 as “wages” for the purposes of assessing FICA tax in 2002 and 2003.
We apply the same standard of review in tax refund cases as we do in other bench trials. Townsend Indus., Inc. v. United States, 342 F.3d 890, 891 [92 AFTR 2d 2003-6096] (8th Cir. 2003). That is, we review the district court's findings of fact for clear error and its conclusions of law de novo. Id. We review the district court's decision to admit expert testimony for abuse of discretion, giving substantial deference to the district court. United States v. Roach, 644 F.3d 763, 763 (8th Cir. 2011) (per curiam).
A. Ostrovsky's Expert Testimony
DEWPC argues that the district court erred in allowing Ostrovksy to testify as an expert witness on the issue of reasonable compensation because Ostrovsky was not competent to testify on that issue. Specifically, DEWPC asserts that Ostrovsky was not qualified, changed his opinion, relied on insufficient underlying facts, and used flawed methods in rendering his opinion.
Ostrovsky is a certified business valuation analyst, but because compensation is only one component of business valuation, DEWPC deems Ostrovsky incompetent to testify as to compensation. Federal Rule of Evidence 702 governs the admission of expert testimony in this case. A witness may qualify as an expert “by knowledge, skill, experience, training, or education.” Fed. R. Evid. 702. “Rule 702 does not rank academic training over demonstrated practical experience.” Roach, 644 F.3d at 764. Here, the record reveals that Ostrovsky, as a general engineer for the IRS, spends about 40% of his time dealing with compensation issues and has worked on about 20 to 30 reasonable compensation cases. Therefore, even if Ostrovksy's education and training was not specifically tailored to compensation issues, he certainly has “demonstrated practical experience” qualifying him as an expert in the field. See id. Accordingly, the district court did not abuse its discretion in determining Ostrovsky was qualified to render an expert opinion on Watson's compensation.
In addition to challenging his qualifications, DEWPC asserts that Ostrovsky was not a competent expert witness because his opinion as to the value of Watson's services changed over the course of the proceedings. It is true that Ostrovsky's opinion changed as the proceedings progressed. Before Watson's deposition, Ostrovsky's initial assessment was that Watson's salary in the disputed years should have been no less than $184,876. After discovering errors in his initial assessment and learning additional facts through Watson's deposition, Ostrovsky eventually revised his report and arrived at his final estimate. The district court made a specific finding on this point and found Ostrovsky competent. DEWPC fails to cite any authority supporting its contention that Ostrovky's revised opinion rendered his testimony incompetent. In fact, it appears Ostrovsky properly updated his expert report, giving DEWPC ample notice of his revised opinions. See Fed. R. Civ. P. 26(a)(2)(B), (e)(2). Under these circumstances, we see no reason why Ostrovsky's revised opinion would be incompetent. Thus, we see no abuse of discretion.
DEWPC also argues that Ostrovsky failed to consider certain facts in rendering his opinion. Generally, “the factual basis of an expert opinion goes to the credibility of the testimony, not the admissibility, and it is up to the opposing party to examine the factual basis for the opinion in cross-examination.” Nebraska Plastics, Inc. v. Holland Colors Am., Inc., 408 F.3d 410, 416 (8th Cir. 2005). However, “if the expert's opinion is so fundamentally unsupported that it can offer no assistance to the [fact-finder], it must be excluded.” Id. Previously, we have determined that when an expert “fail[s] to take into account a plethora of specific facts” his or her testimony is properly excluded. Id. at 417.
Here, DEWPC cross-examined Ostrovsky and questioned the factual basis for his opinion. The district court could take this into account when assessing Ostrovky's credibility. Based on the record, however, Ostrovsky did not fail to consider “a plethora of facts” rendering his opinion “fundamentally unsupported.” Id. at 416–17. To be sure, Ostrovsky even revised his opinion to reflect a lower salary after he considered new facts revealed at Watson's deposition. Therefore, after reviewing the factual basis for Ostrovky's opinion, we conclude the district court did not abuse its discretion in admitting the testimony.
Finally, according to DEWPC, the district court should have excluded Ostrovky's testimony because his conclusions were the product of flawed methods. In determining whether expert testimony should be admitted, the district court must decide if “the expert's methodology is reliable and can be reasonably applied to the facts of the case.” Eckelkamp v. Beste, 315 F.3d 863, 868 (8th Cir. 2002). Pursuant to Daubert, 4 the district court must conduct this initial inquiry as part of its gatekeeping function. Glastetter v. Novartis Pharm. Corp., 252 F.3d 986, 988 (8th Cir. 2001) (per curiam). However, Daubert is meant to “protectjuries from being swayed by dubious scientific testimony.” In re Zurn Pex Plumbing Prods. Liab. Litig. (In re Zurn), 644 F.3d 604, 613 (8th Cir. 2011) (emphasis added). When the district court sits as the finder of fact, ““[t]here is less need for the gatekeeper to keep the gate when the gatekeeper is keeping the gate only for himself.”” Id. (alteration in original) (quoting United States v. Brown, 415 F.3d 1257, 1269 (11th Cir. 2005)). Thus, we relax Daubert's application for bench trials. Id.
In the present case, although DEWPC objected to Ostrovsky's qualifications, the record does not show that DEWPC ever raised an objection to the methods or underlying science Ostrovsky employed to arrive at his conclusions. See McKnight ex rel. Ludwig v. Johnson Controls, Inc., 36 F.3d 1396, 1407 (8th Cir. 1994) (rejecting argument that district court must exercise gatekeeping function without an objection). Nevertheless, even if DEWPC did raise a proper Daubert challenge before the district court, we conclude the court acted within its discretion. At most, DEWPC has expressed a disagreement with the underlying assumptions Ostrovsky made in his calculations. This “mere disagreement with the assumptions and methodology used does not warrant exclusion of expert testimony.” Synergetics, Inc. v. Hurst, 477 F.3d 949, 956 (8th Cir. 2007). Rather, if DEWPC thought other assumptions and methods were more appropriate, it had the opportunity to make this apparent “through cross-examination and by presenting [its] own expert witness.” Id. Finally, with a relaxed Daubert standard in this bench trial, see In re Zurn, 644 F.3d at 613, we conclude the district court did not abuse its discretion in admitting Ostrovksy's expert testimony.
B. FICA Tax
FICA imposes “on every employer an excise tax, with respect to having individuals in [its] employ,” calculated as a certain percentage of wages the employer pays “with respect to employment.” 5 I.R.C. §§ 3111(a), (b). The term “wages” is defined as “all remuneration for employment,” with exceptions that do not apply to this case. Id. § 3121(a). Although the term “wages” is defined broadly, an employer need not pay FICA taxes on “other types of employee income, such as dividends.” HB & R, Inc. v. United States, 229 F.3d 688, 690 [86 AFTR 2d 2000-6426] (8th Cir. 2000). In characterizing employer payments, “[t]he name by which the remuneration for employment is designated is immaterial.” Treas. Reg. § 31.3121(a)-1(c). Similarly, the medium in which remuneration is paid is immaterial. Id. § 31.3121(a)-1(e).
When the IRS determines that a taxpayer owes the Federal Government unpaid taxes, the “assessment is entitled to a legal presumption of correctness.” United States v. Fior D'Italia, Inc., 536 U.S. 238, 242 [89 AFTR 2d 2002-2883] (2002). Because DEWPC sought a FICA tax refund in this case, “the ultimate question for our determination is whether [DEWPC] has overpaid its tax.” Iowa 80 Group, Inc. v. IRS, 406 F.3d 950, 952 [95 AFTR 2d 2005-2190] (8th Cir. 2005). The taxpayer bears the burden of proving that it overpaid its taxes, and the IRS's initial assessment was wrong. Id. To meet this burden, the taxpayer must prove “the amount he is entitled to recover[,] [and] [i]t is not enough for him to demonstrate that the assessment of the tax for which refund is sought was erroneous in some respects.” United States v. Janis, 428 U.S. 433, 440 [38 AFTR 2d 76-5378] (1976) (internal citation omitted).
In resolving this FICA tax dispute, the inquiry is “whether, based on the statutes and unusual facts involved, the payments at issue were made to [Watson] as remuneration for services performed.” Joseph Radtke, S.C. v. United States, 895 F.2d 1196, 1197 [65 AFTR 2d 90-1155] (7th Cir. 1990) (per curiam). Where, as here, “the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm's length bargaining.” Charles Schneider & Co. v. Comm'r, 500 F.2d 148, 152 [34 AFTR 2d 74-5422] (8th Cir. 1974). Ultimately, whether payments to a shareholder “represent compensation for services or constitute a distribution of profits is essentially the determination of a matter purely of fact.” Standard Asbestos Mfg. & Insulating Co. v. Comm'r, 276 F.2d 289, 294 [5 AFTR 2d 1164] (8th Cir. 1960) (internal quotation omitted).
When it determined the amount that constituted remuneration for employment, the district court required DEWPC to prove it paid Watson reasonable compensation, which DEWPC claims was error. According to DEWPC, because the district court applied an incorrect legal standard, it incorrectly found that $91,044 constituted Watson's wages in 2002 and 2003. To buttress this argument, DEWPC repeatedly asserts that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.
1. Reasonable Compensation
The concept of “reasonable compensation” is generally an issue found in the realm of income taxation. See, e.g., Charles Schneider & Co., 500 F.2d at 151. Under I.R.C. § 162(a)(1), a business may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered” as ordinary and necessary business expenses. Historically, we have applied a factors test to determine the reasonableness of compensation in the context of a business expense deduction. See Charles Schneider & Co., 500 F.2d at 151–52 (discussing factors). Here, the district court considered these factors, among other things, in finding that the value of Watson's services was $91,044 for 2002 and 2003.
Although reasonable compensation is usually an issue found in the context of an income tax deduction, the IRS finds the concept equally applicable to FICA tax cases. In Revenue Ruling 74-44, 1974-1 C.B. 287, an S corporation distributed dividends to its two sole shareholder-employees but did not pay any wages for their services. The IRS took the position that it could recharacterize the nature of “dividend” payments for FICA tax purposes because “the “dividends” paid to the shareholders ... were in lieu of reasonable compensation for their services.” Id. (emphasis added). Notwithstanding Revenue Ruling 74-44, 6 we have not had the opportunity to decide whether a reasonableness analysis is appropriate in determining if certain payments are in fact remuneration for employment subject to FICA tax. Other jurisdictions provide guidance.
In Joseph Radtke, S.C. v. United States, 712 F. Supp. 143, 144 [63 AFTR 2d 89-1469], (E.D. Wis. 1989), aff'd per curiam, 895 F.2d 1196 [65 AFTR 2d 90-1155] (7th Cir. 1990), the taxpayer-S corporation made dividend distributions to its only shareholder-employee but did not pay him any salary. Because the shareholder-employee also served as the corporation's only director, who authorized the dividend payment, the district court applied a substance-over-form analysis and determined the employee's ““dividends” were in fact “wages” subject to FICA ... taxation.” Id. at 145. On appeal, the Seventh Circuit affirmed, concluding that the payments “were clearly remuneration for services performed by [the shareholder-employee].” Joseph Radtke, S.C., 895 F.2d at 1197.
Drawing upon Radtke's reasoning, other courts addressing similar FICA characterization issues have evaluated the economic substance of the transaction rather than the form chosen by the taxpayer. See, e.g., Veterinary Surgical Consultants, P.C. v. Comm'r, 117 T.C. 141, 145–46 (2001) (noting that the characterization of payments as corporate distribution of net income “is but a subterfuge for reality”), aff'd sub nom., Yeagle Drywall Co. v. Comm'r, 54 F. App'x 100 [90 AFTR 2d 2002-7744] (3d Cir. 2002); Spicer Accounting, Inc. v. United States, 918 F.2d 90, 93 [66 AFTR 2d 90-5806] (9th Cir. 1990) (finding that “intention of receiving the payments as dividends has no bearing on the tax treatment of these wages”). Indeed, looking at the substance of a transaction instead of its form is a hallmark principle in resolving tax disputes, see Boulware v. United States, 552 U.S. 421, 430 [101 AFTR 2d 2008-1065] (2008), and one the applicable Treasury Regulations seem to compel in this case, see Treas. Reg. § 31.3121(a)-1(c) to (e). Therefore, in discovering all remuneration for employment, “the substance of the transaction as revealed by the evidence as a whole controls over the form employed; i.e., the veil of form is pierced and the entire transaction is carefully scrutinized.” Haag v. Comm'r, 334 F.2d 351, 355 [14 AFTR 2d 5211] (8th Cir. 1964). And, in light of all the facts and circumstances of the case, scrutinizing compensation for its reasonableness may guide a court in characterizing payments for FICA tax purposes. See Joly v. Comm'r, 76 T.C.M. (CCH) 633, 1998 [1998 RIA TC Memo ¶98,361] WL 712528, at 4 (1998) (rejecting claim that compensation was reasonable and finding that amount did “not reflect the true character of such payments”), aff'd, 211 F.3d 1269 [85 AFTR 2d 2000-1234] (6th Cir. 2000) (unpublished table decision).
Turning to the present case, we conclude the district court properly determined “that the characterization of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments at issue were made as remuneration for services performed.” See Joseph Radtke, S.C., 895 F.2d at 1197. This fact-intensive inquiry “is a matter to be determined in view of all the evidence.” Joseph Radtke, S.C., 712 F. Supp. at 145. Here, the district court found that DEWPC understated wage payments to Watson by $67,044 based on the following evidence: (1) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (2) he worked 35–45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (3) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (4) $24,000 is unreasonably low compared to other similarly situated accountants; (5) given the financial position of LWBJ, Watson's experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (6) the fair market value of Watson's services was $91,044. Based on the record, the district court did not clearly err.
2. Taxpayer Intent
Although we think reasonableness is pertinent to the analysis, DEWPC urges that instead of focusing on reasonableness, the district court should have focused on DEWPC's intent. Taxpayer intent, like reasonableness, is usually part of a § 162(a)(1) compensation deduction analysis, although less commonly employed. See O.S.C. & Assocs. v. Comm'r, 187 F.3d 1116, 1120 [84 AFTR 2d 99-5735] (9th Cir. 1999). As the language of § 162(a)(1) suggests, a deduction may be made if salary is both (1) “reasonable” and (2) “in fact payments purely for services.” Treas. Reg. § 1.162-7(a). The Ninth Circuit views this as a two-pronged test, the second prong of which requires proof of a “compensatory purpose.” Elliotts, Inc. v. Comm'r, 716 F.2d 1241, 1243 [52 AFTR 2d 83-5976] (9th Cir. 1983). Usually, courts only need to examine the first prong, i.e., whether compensation was reasonable. Id. Indeed, “[t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases.” Id. at 1245. However “[i]n the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.” Id. at 1244. This “intent is subjective and difficult to prove.” O.S.C. & Assocs., 187 F.3d at 1120.
DEWPC turns our attention to Pediatric Surgical Assocs., P.C. v. Comm'r, 81 T.C.M. (CCH) 1474, 2001 [TC Memo 2001-81] WL 314335 (2001), to illustrate that intent is the determining factor for characterization purposes. Pediatric Surgical Assocs., P.C., involved a § 162(a)(1) compensation deduction where reasonableness was not at issue. Id. at 7. After reviewing Pediatric Surgical Assocs., P.C., we are not convinced it stands for the proposition that taxpayer intent controls in FICA tax characterization cases. 7 This is especially true because Pediatric Surgical Assocs., P.C., was a “rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend.” Elliotts, Inc., 716 F.2d at 1243. However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson's assertion that DEWPC “intended” to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” We will not disturb this finding on appeal. See United States v. Bowie, 618 F.3d 802, 814 (8th Cir. 2010) (recognizing “credibility findings are virtually unreviewable on appeal” (quotation omitted)). Therefore, the district court's finding as to DEWPC's intent was not clearly erroneous.
DEWPC further argues that if the district court applied the principles of Pediatric Surgical Assocs., P.C., it would have limited the amount it characterized as wages to the amount of revenue each shareholder-employee personally generated, less expenses. In this case, like Pediatric Surgical Assocs., P.C., non-shareholder-employees also contributed to LWBJ's earnings. Thus, determining Watson's compensation is more complicated than if Watson had served as the only employee generating income for LWBJ. See Veterinary Surgical Consultants, P.C., 117 T.C. at 145 (determining that distributions of corporate net income to sole shareholder-employee were wages); see also Walter D. Schwidetzky, Integrating Subchapters K and S–Just Do It, 62 Tax Law. 749, 799 (2009) (opining that in a pure services S corporation with a sole practitioner, nearly all of the corporation's income may likely be treated as remuneration for employment under FICA). Nevertheless, although we think evidence of shareholder-employee billings and collections may be probative on the issue of compensation, in view of all the evidence presented to the district court in this case, we see no error. Therefore, as noted earlier, because the district court applied the correct legal standard, we affirm its determination on Watson's FICA wages.
III. CONCLUSION
The judgment of the district court is affirmed.
1
The Honorable Robert W. Pratt, United States District Judge for the Southern District of Iowa.
2
For the sake of simplicity, we will use “LWBJ” to refer to the accounting firm both before and after it took on a new partner.
3
Although DEWPC designated that its payment applied to the fourth quarter of 2002, the IRS erroneously applied it to the first quarter of 2002. The parties stipulated, and we agree, that this misapplication did not deprive the district court of jurisdiction. See I.R.C. § 7422(a); 28 U.S.C. §§ 1340, 1346(a)(1).
4
Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993).
5
The parties do not dispute that Watson was an employee of DEWPC.
6
DEWPC attempts to limit the effect of Revenue Ruling 74-44 by noting that Revenue Rulings do not have the same force and effect as Treasury Regulations and do not bind the court. The Supreme Court has never articulated the exact deference given to Revenue Rulings. Nelson v. Comm'r, 568 F.3d 662, 665 [103 AFTR 2d 2009-2621] (8th Cir. 2009). However, when a Revenue Ruling reflects a longstanding and reasonable interpretation of the agency's regulations, the Ruling “attracts substantial judicial deference.” United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 [87 AFTR 2d 2001-1706] (2001).
7
Notably, DEWPC has not cited a single FICA tax characterization case where a court looked solely to the taxpayer's intent. Also, we do not find persuasive DEWPC's attempt to distinguish more applicable FICA characterization cases on the basis that the employer-taxpayer paid no salary in those cases. For the purposes of determining FICA wages, there is little difference if the employer pays no salary or pays a low salary that does not accurately reflect all remuneration for employment. See, e.g., JD & Assocs. v. United States, No. 3:04-cv-59, slip op. at 4, 10 (D.N.D. May 19, 2006) (determining that paying accountant-shareholder $19,000, $30,000, and $30,000 as annual compensation for three consecutive years did not reflect real wages for FICA purposes).
David E. Watson, P.C., Plaintiff/Appellant, v. UNITED STATES of America, Defendant/Appellee.
Case Information:
Code Sec(s):
Court Name: United States Court of Appeals FOR THE EIGHTH CIRCUIT,
Docket No.: No. 11-1589,
Date Decided: 02/21/2012Submitted: November 15, 2011.
Prior History:
Disposition:
HEADNOTE
.
Reference(s):
OPINION
United States Court of Appeals FOR THE EIGHTH CIRCUIT,
Appeal from the United States District Court for the Southern District of Iowa.
Before RILEY, Chief Judge, BEAM, and BYE, Circuit Judges.
Judge: BEAM, Circuit Judge.
This case concerns the Federal Insurance Contribution Act (FICA), 26 U.S.C. (I.R.C.) § 3101 et seq., and certain employment taxes FICA imposes upon employers. After a bench trial on the merits, the district court 1 rendered a tax deficiency judgment against David E. Watson, P.C. (DEWPC) for unpaid FICA tax. DEWPC appeals, and we affirm.
I. BACKGROUND
In 1982, David Watson (Watson) graduated from college with a bachelor's degree in business administration and a specialization in accounting. In 1983, Watson became a Certified Public Accountant (CPA) and later obtained a master's degree in taxation. In his first ten years of practice, Watson worked at two accounting firms, one of which was Ernst & Young. While at Ernst & Young, Watson began specializing in partnership taxation.
After leaving Ernst & Young, Watson obtained a 25% interest in an accounting firm located in West Des Moines, Iowa, known as Larson, Watson, Bartling & Eastman. At trial, Watson testified that he received no salary when the firm first began operations because the entity did not have money to pay him. Eventually, one partner exited and the firm added a new partner, reemerging as Larson, Watson, Bartling & Juffer, LLP (LWBJ 2).
In 1996, Watson incorporated a business entity known as David E. Watson, P.C. Watson transferred his individual 25% interest in LWBJ to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed Watson, but Watson exclusively provided his accounting services to LWBJ for the period relevant to this dispute. From its inception, DEWPC elected to be taxed as an S Corporation.
In both 2002 and 2003, DEWPC distributed $24,000 to Watson as employment compensation. Watson testified that the LWBJ partners made the determination that LWBJ had sufficient cash flow where it could distribute $2,000 a month to each partner, regardless of the seasonality of the business. There were no documents reflecting these salary discussions, and no other LWBJ partner testified at trial. Ultimately, DEWPC is the entity that authorized and paid Watson's salary. In addition to salary, Watson, through DEWPC, received $203,651 from LWBJ as profit distributions for 2002. In 2003, Watson, through DEWPC, received $175,470 as profit distributions from LWBJ. Thus, in 2002 and 2003, after DEWPC paid Watson's salary and other expenses, it distributed all remaining cash to Watson as dividends.
The Internal Revenue Service (IRS) investigated DEWPC and determined that it underpaid certain employment taxes pursuant to FICA, see I.R.C. § 3111(a), (b), in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. On April 14, 2007, DEWPC paid the delinquent tax, penalty, and interest for the fourth quarter of 2002 and sought a refund from the IRS. 3 The IRS denied DEWPC's refund claim, and DEWPC sued the United States in district court. The United States counterclaimed, seeking to recover employment taxes, penalties, and interest that remained unpaid for 2002 and 2003.
After denying DEWPC's motion for summary judgment, the district court held a bench trial on the merits. At trial, the government's expert, Igor Ostrovsky, opined that the market value of Watson's accounting services was approximately $91,044 per year for 2002 and 2003. Ostrovsky is a general engineer with the IRS and has worked on approximately 20 to 30 cases involving reasonable compensation issues. In forming his opinion as to Watson's salary, Ostrovsky relied on several compensation surveys and studies particular to accountants. Primarily, Ostrovsky focused on the Management of an Accounting Practice (MAP) survey conducted by the American Institute of Certified Public Accountants, which contained adjustments for specific regions. Ostrovsky discovered that an owner–defined as an investor and an employee–in a firm the size of LWBJ would receive approximately $176,000 annually, which reflected both compensation and return on investment. Ostrovsky also discovered that a director–an employee with no investment interest–would receive approximately $70,000 in compensation alone. Because owners billed at rates 33% higher than directors, and because Ostrovsky viewed Watson as a de facto partner of LWBJ, Ostrovsky increased the director compensation by 33% to arrive at owner compensation or $93,000. Ostrovsky then made a downward adjustment to $91,044, accounting for untaxable fringe benefits. In reaching his conclusion, Ostrovsky used average billing rates rather than Watson's actual billing rates.
Ultimately, the district court adopted Ostrovsky's opinion and determined that the reasonable amount of Watson's remuneration for services performed totaled $91,044. Therefore, the district court rendered a tax deficiency judgment against DEWPC, which included unpaid employment taxes, penalties, and interest in the amount of $23,431.23. DEWPC now appeals.
II. DISCUSSION
This case presents two issues for our review. First, we must decide whether the district court erred in allowing Ostrovsky to testify as an expert witness on the issue of compensation. Second, we must determine whether the district court properly characterized $91,044 as “wages” for the purposes of assessing FICA tax in 2002 and 2003.
We apply the same standard of review in tax refund cases as we do in other bench trials. Townsend Indus., Inc. v. United States, 342 F.3d 890, 891 [92 AFTR 2d 2003-6096] (8th Cir. 2003). That is, we review the district court's findings of fact for clear error and its conclusions of law de novo. Id. We review the district court's decision to admit expert testimony for abuse of discretion, giving substantial deference to the district court. United States v. Roach, 644 F.3d 763, 763 (8th Cir. 2011) (per curiam).
A. Ostrovsky's Expert Testimony
DEWPC argues that the district court erred in allowing Ostrovksy to testify as an expert witness on the issue of reasonable compensation because Ostrovsky was not competent to testify on that issue. Specifically, DEWPC asserts that Ostrovsky was not qualified, changed his opinion, relied on insufficient underlying facts, and used flawed methods in rendering his opinion.
Ostrovsky is a certified business valuation analyst, but because compensation is only one component of business valuation, DEWPC deems Ostrovsky incompetent to testify as to compensation. Federal Rule of Evidence 702 governs the admission of expert testimony in this case. A witness may qualify as an expert “by knowledge, skill, experience, training, or education.” Fed. R. Evid. 702. “Rule 702 does not rank academic training over demonstrated practical experience.” Roach, 644 F.3d at 764. Here, the record reveals that Ostrovsky, as a general engineer for the IRS, spends about 40% of his time dealing with compensation issues and has worked on about 20 to 30 reasonable compensation cases. Therefore, even if Ostrovksy's education and training was not specifically tailored to compensation issues, he certainly has “demonstrated practical experience” qualifying him as an expert in the field. See id. Accordingly, the district court did not abuse its discretion in determining Ostrovsky was qualified to render an expert opinion on Watson's compensation.
In addition to challenging his qualifications, DEWPC asserts that Ostrovsky was not a competent expert witness because his opinion as to the value of Watson's services changed over the course of the proceedings. It is true that Ostrovsky's opinion changed as the proceedings progressed. Before Watson's deposition, Ostrovsky's initial assessment was that Watson's salary in the disputed years should have been no less than $184,876. After discovering errors in his initial assessment and learning additional facts through Watson's deposition, Ostrovsky eventually revised his report and arrived at his final estimate. The district court made a specific finding on this point and found Ostrovsky competent. DEWPC fails to cite any authority supporting its contention that Ostrovky's revised opinion rendered his testimony incompetent. In fact, it appears Ostrovsky properly updated his expert report, giving DEWPC ample notice of his revised opinions. See Fed. R. Civ. P. 26(a)(2)(B), (e)(2). Under these circumstances, we see no reason why Ostrovsky's revised opinion would be incompetent. Thus, we see no abuse of discretion.
DEWPC also argues that Ostrovsky failed to consider certain facts in rendering his opinion. Generally, “the factual basis of an expert opinion goes to the credibility of the testimony, not the admissibility, and it is up to the opposing party to examine the factual basis for the opinion in cross-examination.” Nebraska Plastics, Inc. v. Holland Colors Am., Inc., 408 F.3d 410, 416 (8th Cir. 2005). However, “if the expert's opinion is so fundamentally unsupported that it can offer no assistance to the [fact-finder], it must be excluded.” Id. Previously, we have determined that when an expert “fail[s] to take into account a plethora of specific facts” his or her testimony is properly excluded. Id. at 417.
Here, DEWPC cross-examined Ostrovsky and questioned the factual basis for his opinion. The district court could take this into account when assessing Ostrovky's credibility. Based on the record, however, Ostrovsky did not fail to consider “a plethora of facts” rendering his opinion “fundamentally unsupported.” Id. at 416–17. To be sure, Ostrovsky even revised his opinion to reflect a lower salary after he considered new facts revealed at Watson's deposition. Therefore, after reviewing the factual basis for Ostrovky's opinion, we conclude the district court did not abuse its discretion in admitting the testimony.
Finally, according to DEWPC, the district court should have excluded Ostrovky's testimony because his conclusions were the product of flawed methods. In determining whether expert testimony should be admitted, the district court must decide if “the expert's methodology is reliable and can be reasonably applied to the facts of the case.” Eckelkamp v. Beste, 315 F.3d 863, 868 (8th Cir. 2002). Pursuant to Daubert, 4 the district court must conduct this initial inquiry as part of its gatekeeping function. Glastetter v. Novartis Pharm. Corp., 252 F.3d 986, 988 (8th Cir. 2001) (per curiam). However, Daubert is meant to “protectjuries from being swayed by dubious scientific testimony.” In re Zurn Pex Plumbing Prods. Liab. Litig. (In re Zurn), 644 F.3d 604, 613 (8th Cir. 2011) (emphasis added). When the district court sits as the finder of fact, ““[t]here is less need for the gatekeeper to keep the gate when the gatekeeper is keeping the gate only for himself.”” Id. (alteration in original) (quoting United States v. Brown, 415 F.3d 1257, 1269 (11th Cir. 2005)). Thus, we relax Daubert's application for bench trials. Id.
In the present case, although DEWPC objected to Ostrovsky's qualifications, the record does not show that DEWPC ever raised an objection to the methods or underlying science Ostrovsky employed to arrive at his conclusions. See McKnight ex rel. Ludwig v. Johnson Controls, Inc., 36 F.3d 1396, 1407 (8th Cir. 1994) (rejecting argument that district court must exercise gatekeeping function without an objection). Nevertheless, even if DEWPC did raise a proper Daubert challenge before the district court, we conclude the court acted within its discretion. At most, DEWPC has expressed a disagreement with the underlying assumptions Ostrovsky made in his calculations. This “mere disagreement with the assumptions and methodology used does not warrant exclusion of expert testimony.” Synergetics, Inc. v. Hurst, 477 F.3d 949, 956 (8th Cir. 2007). Rather, if DEWPC thought other assumptions and methods were more appropriate, it had the opportunity to make this apparent “through cross-examination and by presenting [its] own expert witness.” Id. Finally, with a relaxed Daubert standard in this bench trial, see In re Zurn, 644 F.3d at 613, we conclude the district court did not abuse its discretion in admitting Ostrovksy's expert testimony.
B. FICA Tax
FICA imposes “on every employer an excise tax, with respect to having individuals in [its] employ,” calculated as a certain percentage of wages the employer pays “with respect to employment.” 5 I.R.C. §§ 3111(a), (b). The term “wages” is defined as “all remuneration for employment,” with exceptions that do not apply to this case. Id. § 3121(a). Although the term “wages” is defined broadly, an employer need not pay FICA taxes on “other types of employee income, such as dividends.” HB & R, Inc. v. United States, 229 F.3d 688, 690 [86 AFTR 2d 2000-6426] (8th Cir. 2000). In characterizing employer payments, “[t]he name by which the remuneration for employment is designated is immaterial.” Treas. Reg. § 31.3121(a)-1(c). Similarly, the medium in which remuneration is paid is immaterial. Id. § 31.3121(a)-1(e).
When the IRS determines that a taxpayer owes the Federal Government unpaid taxes, the “assessment is entitled to a legal presumption of correctness.” United States v. Fior D'Italia, Inc., 536 U.S. 238, 242 [89 AFTR 2d 2002-2883] (2002). Because DEWPC sought a FICA tax refund in this case, “the ultimate question for our determination is whether [DEWPC] has overpaid its tax.” Iowa 80 Group, Inc. v. IRS, 406 F.3d 950, 952 [95 AFTR 2d 2005-2190] (8th Cir. 2005). The taxpayer bears the burden of proving that it overpaid its taxes, and the IRS's initial assessment was wrong. Id. To meet this burden, the taxpayer must prove “the amount he is entitled to recover[,] [and] [i]t is not enough for him to demonstrate that the assessment of the tax for which refund is sought was erroneous in some respects.” United States v. Janis, 428 U.S. 433, 440 [38 AFTR 2d 76-5378] (1976) (internal citation omitted).
In resolving this FICA tax dispute, the inquiry is “whether, based on the statutes and unusual facts involved, the payments at issue were made to [Watson] as remuneration for services performed.” Joseph Radtke, S.C. v. United States, 895 F.2d 1196, 1197 [65 AFTR 2d 90-1155] (7th Cir. 1990) (per curiam). Where, as here, “the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm's length bargaining.” Charles Schneider & Co. v. Comm'r, 500 F.2d 148, 152 [34 AFTR 2d 74-5422] (8th Cir. 1974). Ultimately, whether payments to a shareholder “represent compensation for services or constitute a distribution of profits is essentially the determination of a matter purely of fact.” Standard Asbestos Mfg. & Insulating Co. v. Comm'r, 276 F.2d 289, 294 [5 AFTR 2d 1164] (8th Cir. 1960) (internal quotation omitted).
When it determined the amount that constituted remuneration for employment, the district court required DEWPC to prove it paid Watson reasonable compensation, which DEWPC claims was error. According to DEWPC, because the district court applied an incorrect legal standard, it incorrectly found that $91,044 constituted Watson's wages in 2002 and 2003. To buttress this argument, DEWPC repeatedly asserts that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.
1. Reasonable Compensation
The concept of “reasonable compensation” is generally an issue found in the realm of income taxation. See, e.g., Charles Schneider & Co., 500 F.2d at 151. Under I.R.C. § 162(a)(1), a business may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered” as ordinary and necessary business expenses. Historically, we have applied a factors test to determine the reasonableness of compensation in the context of a business expense deduction. See Charles Schneider & Co., 500 F.2d at 151–52 (discussing factors). Here, the district court considered these factors, among other things, in finding that the value of Watson's services was $91,044 for 2002 and 2003.
Although reasonable compensation is usually an issue found in the context of an income tax deduction, the IRS finds the concept equally applicable to FICA tax cases. In Revenue Ruling 74-44, 1974-1 C.B. 287, an S corporation distributed dividends to its two sole shareholder-employees but did not pay any wages for their services. The IRS took the position that it could recharacterize the nature of “dividend” payments for FICA tax purposes because “the “dividends” paid to the shareholders ... were in lieu of reasonable compensation for their services.” Id. (emphasis added). Notwithstanding Revenue Ruling 74-44, 6 we have not had the opportunity to decide whether a reasonableness analysis is appropriate in determining if certain payments are in fact remuneration for employment subject to FICA tax. Other jurisdictions provide guidance.
In Joseph Radtke, S.C. v. United States, 712 F. Supp. 143, 144 [63 AFTR 2d 89-1469], (E.D. Wis. 1989), aff'd per curiam, 895 F.2d 1196 [65 AFTR 2d 90-1155] (7th Cir. 1990), the taxpayer-S corporation made dividend distributions to its only shareholder-employee but did not pay him any salary. Because the shareholder-employee also served as the corporation's only director, who authorized the dividend payment, the district court applied a substance-over-form analysis and determined the employee's ““dividends” were in fact “wages” subject to FICA ... taxation.” Id. at 145. On appeal, the Seventh Circuit affirmed, concluding that the payments “were clearly remuneration for services performed by [the shareholder-employee].” Joseph Radtke, S.C., 895 F.2d at 1197.
Drawing upon Radtke's reasoning, other courts addressing similar FICA characterization issues have evaluated the economic substance of the transaction rather than the form chosen by the taxpayer. See, e.g., Veterinary Surgical Consultants, P.C. v. Comm'r, 117 T.C. 141, 145–46 (2001) (noting that the characterization of payments as corporate distribution of net income “is but a subterfuge for reality”), aff'd sub nom., Yeagle Drywall Co. v. Comm'r, 54 F. App'x 100 [90 AFTR 2d 2002-7744] (3d Cir. 2002); Spicer Accounting, Inc. v. United States, 918 F.2d 90, 93 [66 AFTR 2d 90-5806] (9th Cir. 1990) (finding that “intention of receiving the payments as dividends has no bearing on the tax treatment of these wages”). Indeed, looking at the substance of a transaction instead of its form is a hallmark principle in resolving tax disputes, see Boulware v. United States, 552 U.S. 421, 430 [101 AFTR 2d 2008-1065] (2008), and one the applicable Treasury Regulations seem to compel in this case, see Treas. Reg. § 31.3121(a)-1(c) to (e). Therefore, in discovering all remuneration for employment, “the substance of the transaction as revealed by the evidence as a whole controls over the form employed; i.e., the veil of form is pierced and the entire transaction is carefully scrutinized.” Haag v. Comm'r, 334 F.2d 351, 355 [14 AFTR 2d 5211] (8th Cir. 1964). And, in light of all the facts and circumstances of the case, scrutinizing compensation for its reasonableness may guide a court in characterizing payments for FICA tax purposes. See Joly v. Comm'r, 76 T.C.M. (CCH) 633, 1998 [1998 RIA TC Memo ¶98,361] WL 712528, at 4 (1998) (rejecting claim that compensation was reasonable and finding that amount did “not reflect the true character of such payments”), aff'd, 211 F.3d 1269 [85 AFTR 2d 2000-1234] (6th Cir. 2000) (unpublished table decision).
Turning to the present case, we conclude the district court properly determined “that the characterization of funds disbursed by an S corporation to its employees or shareholders turns on an analysis of whether the payments at issue were made as remuneration for services performed.” See Joseph Radtke, S.C., 895 F.2d at 1197. This fact-intensive inquiry “is a matter to be determined in view of all the evidence.” Joseph Radtke, S.C., 712 F. Supp. at 145. Here, the district court found that DEWPC understated wage payments to Watson by $67,044 based on the following evidence: (1) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (2) he worked 35–45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (3) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (4) $24,000 is unreasonably low compared to other similarly situated accountants; (5) given the financial position of LWBJ, Watson's experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (6) the fair market value of Watson's services was $91,044. Based on the record, the district court did not clearly err.
2. Taxpayer Intent
Although we think reasonableness is pertinent to the analysis, DEWPC urges that instead of focusing on reasonableness, the district court should have focused on DEWPC's intent. Taxpayer intent, like reasonableness, is usually part of a § 162(a)(1) compensation deduction analysis, although less commonly employed. See O.S.C. & Assocs. v. Comm'r, 187 F.3d 1116, 1120 [84 AFTR 2d 99-5735] (9th Cir. 1999). As the language of § 162(a)(1) suggests, a deduction may be made if salary is both (1) “reasonable” and (2) “in fact payments purely for services.” Treas. Reg. § 1.162-7(a). The Ninth Circuit views this as a two-pronged test, the second prong of which requires proof of a “compensatory purpose.” Elliotts, Inc. v. Comm'r, 716 F.2d 1241, 1243 [52 AFTR 2d 83-5976] (9th Cir. 1983). Usually, courts only need to examine the first prong, i.e., whether compensation was reasonable. Id. Indeed, “[t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases.” Id. at 1245. However “[i]n the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.” Id. at 1244. This “intent is subjective and difficult to prove.” O.S.C. & Assocs., 187 F.3d at 1120.
DEWPC turns our attention to Pediatric Surgical Assocs., P.C. v. Comm'r, 81 T.C.M. (CCH) 1474, 2001 [TC Memo 2001-81] WL 314335 (2001), to illustrate that intent is the determining factor for characterization purposes. Pediatric Surgical Assocs., P.C., involved a § 162(a)(1) compensation deduction where reasonableness was not at issue. Id. at 7. After reviewing Pediatric Surgical Assocs., P.C., we are not convinced it stands for the proposition that taxpayer intent controls in FICA tax characterization cases. 7 This is especially true because Pediatric Surgical Assocs., P.C., was a “rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend.” Elliotts, Inc., 716 F.2d at 1243. However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson's assertion that DEWPC “intended” to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” We will not disturb this finding on appeal. See United States v. Bowie, 618 F.3d 802, 814 (8th Cir. 2010) (recognizing “credibility findings are virtually unreviewable on appeal” (quotation omitted)). Therefore, the district court's finding as to DEWPC's intent was not clearly erroneous.
DEWPC further argues that if the district court applied the principles of Pediatric Surgical Assocs., P.C., it would have limited the amount it characterized as wages to the amount of revenue each shareholder-employee personally generated, less expenses. In this case, like Pediatric Surgical Assocs., P.C., non-shareholder-employees also contributed to LWBJ's earnings. Thus, determining Watson's compensation is more complicated than if Watson had served as the only employee generating income for LWBJ. See Veterinary Surgical Consultants, P.C., 117 T.C. at 145 (determining that distributions of corporate net income to sole shareholder-employee were wages); see also Walter D. Schwidetzky, Integrating Subchapters K and S–Just Do It, 62 Tax Law. 749, 799 (2009) (opining that in a pure services S corporation with a sole practitioner, nearly all of the corporation's income may likely be treated as remuneration for employment under FICA). Nevertheless, although we think evidence of shareholder-employee billings and collections may be probative on the issue of compensation, in view of all the evidence presented to the district court in this case, we see no error. Therefore, as noted earlier, because the district court applied the correct legal standard, we affirm its determination on Watson's FICA wages.
III. CONCLUSION
The judgment of the district court is affirmed.
1
The Honorable Robert W. Pratt, United States District Judge for the Southern District of Iowa.
2
For the sake of simplicity, we will use “LWBJ” to refer to the accounting firm both before and after it took on a new partner.
3
Although DEWPC designated that its payment applied to the fourth quarter of 2002, the IRS erroneously applied it to the first quarter of 2002. The parties stipulated, and we agree, that this misapplication did not deprive the district court of jurisdiction. See I.R.C. § 7422(a); 28 U.S.C. §§ 1340, 1346(a)(1).
4
Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993).
5
The parties do not dispute that Watson was an employee of DEWPC.
6
DEWPC attempts to limit the effect of Revenue Ruling 74-44 by noting that Revenue Rulings do not have the same force and effect as Treasury Regulations and do not bind the court. The Supreme Court has never articulated the exact deference given to Revenue Rulings. Nelson v. Comm'r, 568 F.3d 662, 665 [103 AFTR 2d 2009-2621] (8th Cir. 2009). However, when a Revenue Ruling reflects a longstanding and reasonable interpretation of the agency's regulations, the Ruling “attracts substantial judicial deference.” United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 [87 AFTR 2d 2001-1706] (2001).
7
Notably, DEWPC has not cited a single FICA tax characterization case where a court looked solely to the taxpayer's intent. Also, we do not find persuasive DEWPC's attempt to distinguish more applicable FICA characterization cases on the basis that the employer-taxpayer paid no salary in those cases. For the purposes of determining FICA wages, there is little difference if the employer pays no salary or pays a low salary that does not accurately reflect all remuneration for employment. See, e.g., JD & Assocs. v. United States, No. 3:04-cv-59, slip op. at 4, 10 (D.N.D. May 19, 2006) (determining that paying accountant-shareholder $19,000, $30,000, and $30,000 as annual compensation for three consecutive years did not reflect real wages for FICA purposes).
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