I. Shareholders of Bankrupt S Corporation Failed to Abandon Their Stock; Yaguda v. Commissioner, TC Summary Opinion 2022-21.
Mr. and Mrs. Yaguda owned stock of EFI, Inc., an S Corporation. In 2008, a creditor forced EFI into involuntary bankruptcy. Later that year, EFI’s case was converted to a voluntary Chapter 11 bankruptcy proceeding. In addition, during 2008, Mr. Yaguda’s ownership interest in EFI was transferred to a receivership created by the California Superior Court as a result of criminal proceedings initiated by California against Mr. Yaguda.
During 2015, EFI began selling its assets to raise funds for payment to its creditors. EFI issued a Form K-1 for 2015 reporting Mr. and Mrs. Yaguda had over $97,000 of distributive pass-through income. However, when Mr. and Mrs. Yaguda filed their income tax return, they failed to include any pass-through amounts from EFI on the basis they did not derive any personal benefit from the business activities of EFI during the year, since all of the liquidating sales proceeds went to the payment of EFI’s creditors.
During the Tax Court proceedings, Mr. Yaguda contended he should not be taxable on any income attributable to EFI since all of his stock was transferred to a receivership. However, the receivership never exercised its authority to claim the EFI shares as property of the receivership. Instead, the receiver abandoned the shares, thus leaving them still owned by Mr. Yaguda.
Mr. and Mrs. Yaguda alternatively contended they had effectively abandoned their EFI stock before the liquidating sales took place. Past courts have held a partner can abandon partnership interests for federal tax purposes. Citron v. Commissioner, 97 TC 200 (1991). However, courts have required an affirmative action by the taxpayer to abandon the interest. The mere intention to abandon a partnership interest is insufficient to accomplish abandonment. See, Beus v.Commissioner, 261 F. 2d 176, 180 (9th Cir. 1958); United Cal. Bank v. Commissioner, 41 T.C. 437, 451 (1964), aff’d per curiam, 340 F. 2d 320 (9th Cir. 1965).
Mr. and Mrs. Yaguda, however, did not establish they had taken affirmative actions to transfer or abandon their stock in EFI. Therefore, Mr. and Mrs. Yaguda were taxable on their distributive share of pass-through income of EFI.
The court concluded the 20% negligence penalty under 6662(a) should not be assessed based on the reasonable, good faith defense. The court noted the appropriate tax treatment was not entirely clear from the proceedings in the California Superior Court and the bankruptcy court.
II. Special Income Allocation Fails the Substantial Economic Effects Test and Must be Reallocated in Accordance with the Partners Interests in the Partnership; Clark Raymond & Co. PLLC vs. Commissioner, TC Memo 2022-105.
In Clark Raymond & Company, the Tax Court rejected the IRS’s attempt to reallocate income away from LLC members withdrawing from the LLC. The court found the LLC’s attempt to specially allocate income to its withdrawing partners failed the substantial economic effect test and therefore had to be reallocated in accordance with their partnership interests pursuant to Section 704(b) and the 704(b) Regs. Nevertheless, because the LLC operating agreement contained a qualified income offset provision and because the withdrawing partners had negative capital accounts at the end of the year, ordinary income would have allocated to the withdrawing partners in an amount necessary to bring their negative capital accounts back to zero.
CRC was an accounting firm operating as an LLC. There were three single-member entities that were member/partners of CRC during 2013. For short, we will call the three members C, N and T. During 2013, the three members were in the process of negotiating the buyout of C. They executed a restated operating agreement that contained a qualified income offset (“QIO”) provision. The restated operating agreement contemplated certain withdrawing partners would receive a distribution of clients from the LLC.
After the restated operating agreement was executed, N and T withdrew from CRC and took a number of CRC clients. C, as the sole remaining partner, filed a 2013 tax return reporting T and N received deemed distributions from CRC equal to the value of the clients they took with them (at such values as determined under the operating agreement). C therefore decreased N’s and T’s capital accounts by the value of those client distributions, which caused N’s and T’s capital accounts to drop below zero. To restore their capital accounts to zero, C allocated all of CRC’s ordinary income to N and T pursuant to the QIO provision. As a result, C was allocated no income for 2013.
N and T filed a Form 8082 “Notice of Inconsistent Treatment or Administrative Adjustment Request” protesting the 2013 income allocations. The IRS audited CRC’s 2013 tax return and determined CRC’s purported client distributions to N and T had not been substantiated, and therefore CRC’s corresponding allocations of income to N and T lacked substantial economic effect.
The Tax Court concluded CRC failed to maintain capital accounts in accordance with the Section 704 regulations. Therefore, CRC’s purported special allocations of income to N and T lacked substantial economic effect and had to be reallocated in accordance with the partners’ interests in the partnership under Section 704(b) and Reg. 1.704-1(b)(3). However, the court agreed with the IRS that, because N and T had negative capital accounts at the end of 2013, they had to receive special allocations of ordinary income to bring their capital accounts up to zero.
The court scrutinized the capital account maintenance provisions in the operating agreement and concluded the agreement itself mandated that capital accounts be maintained in accordance with Reg. § 1.704-1(b)(2)(iv). The court found, however, that the LLC failed to maintain the members’ capital accounts in accordance with the provisions of Section 704(b) throughout the life of the partnership. For example, under the operating agreement and Section 704(b), when the LLC made deemed distributions of its clients to its withdrawing members, the capital accounts of N and T should have been grossed-up to reflect any unrealized appreciation in the value of the client accounts distributed to them. That gross-up should have been reflected as a positive adjustment to their capital accounts before the corresponding reduction in their capital accounts to reflect the fair market value of the deemed distribution of the client relationships to N and T.
In 2013 when the client relationships were distributed to N and T, the Forms K-1 reflected the fair market value of those distributions. However, the capital accounts of N and T were not grossed-up to reflect unrealized appreciation in the values of the client relationships. Since the LLC failed to adhere to the capital account maintenance provisions in the operating agreement and the Section 704(b) Regulations, any special income allocations arising from the QIO provision would necessary fail all three of the substantial economic effect tests. The court described the substantial economic effect test that determines whether the special allocations of income to N and T would be respected. The court reviewed the three tests for economic effect: the basic test, alternate test and economic equivalence test. Under all three of those tests, the partnership must follow the capital account maintenance rules in Section 704(b) and the 704(b) Regulations. Because the LLC did not strictly follow the capital account maintenance rules, the special allocations did not meet any of the substantial economic effect tests.
The court determined the LLC’s income held to be allocated among the partners in accordance with their interests in the partnership as required under Section 704(b). To accomplish that, the partners’ capital accounts had to be redetermined by first increasing N’s and T’s capital accounts to reflect how unrealized gain in the property distributed to them (the client relationships) would otherwise have been allocated among the partners if there were a taxable disposition of those client relationships for their fair market values. Reg. § 1.704-1(b)(2)(iv)(e)(1).
III. Conservation Easement Failed to Constitute a Contemporaneous Written Acknowledgement that Met the Section 170 Substantiation Requirements; Brooks vs. Commissioner, TC Memo 2022-122.
In Brooks, the taxpayers’ deduction of over $5 million for a conservation easement failed, in part, because the donation was not accompanied by a contemporaneous written acknowledgement (“CWA”) meeting the requirements of Section 170(f)(a). There was no typical donee acknowledgement letter. Instead, the taxpayers took the position that the deed conveying the conservation easement to the charitable organization met the CWA substantiation requirements.
Courts have held a deed of conveyance may meet the contemporaneous written acknowledgement substantiation requirements of Section 170(f)(8)(B)(ii) where the deed, taken as a whole, meets all of the requirements. French vs. Commissioner, TC Memo 2016-53. Usually, that means the deed must contain a merger or entire agreement clause, making it clear the deed itself constitutes the entire agreement between the parties. If the deed recites no consideration given to the grantor, other than the preservation of the donated property itself, the deed may serve as CWA that the donee provided no goods or services to the donor, but only where the deed confirms the terms of the deed are the entire agreement of the parties. Big River Day Dev., LP vs. Commissioner, TC Memo 2017-166; 310 Retail, LLC vs. Commissioner, TC Memo 2017-164.
The deed in Brooks did not contain any type of merger or entire agreement clause. Therefore, the entire $5.1 million charitable contribution deduction was denied.
IV. No Section 104(a)(2) Personal Injury Exclusion Even Where Alleged Physical Altercation Took Place; Tillman-Kelly vs. Commissioner, TC Memo 2022-111.
In Tillman-Kelly, the taxpayer brought a wrongful termination action against his employer claiming the employer retaliated against him for reporting the employer’s misuse of funds. After being fired, Mr. Tillman-Kelly sued his former employer alleging his termination violated protections for whistleblowers. The complaint filed by Mr. Tillman-Kelly requested “damages included but not limited to emotional distress and humiliation and lost income and benefits.” The complaint, however, did not allege Mr. Tillman-Kelly suffered any physical harm.
After the lawsuit settled, Mr. Tillman-Kelly received a payment of over $230,000. The agreement stated the payment was made for “alleged non-wage injuries as non-economic emotional distress damages.” Mr. Tillman-Kelly took the position that the settlement was nontaxable under Section 104(a)(2).
Mr. Tillman-Kelly alleged he suffered emotional trauma as a result of physical injuries he suffered. He alleged his retaliation lawsuit led to a heated altercation with his employer that resulted in physical injury to him from the slamming of a door. However, because neither the complaint nor the settlement agreement mentioned any type of physical injury, the settlement payment was fully taxable.
V. Passive Activity Loss Rules: Married Couples and Qualification as a Real Estate Professional; Sezonov vs. Commissioner, TC Memo 2022-40.
Sezonov involves the hurdles married couples encounter in attempting to establish that one of them qualifies as a real estate professional (“REP”) under Section 469(c)(7). To qualify as a real estate professional, a taxpayer must meet two requirements. First, more than one-half of the personal services performed by the taxpayer in the year must be “performed in real property trades or businesses in which the taxpayer materially participates” (the one-half test). Second, the taxpayer must perform “more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates” (the more than 750 hours test).
Where a joint return is filed, if either spouse qualifies as an REP for the year, all of the rental activities of the spouses are treated as non-passive activities. However, the qualifying REP spouse must separately meet the more than one-half test and the 750-hour test on his or her own. Hours of real property business activities performed by the spouse who is not a qualifying REP are not counted in favor of the spouse attempting to qualify as an REP.
VI. IRS Allowed to Foreclose on Property Held by a Nominee Even Though the Taxpayer Never Owned the Property; US vs. Hovnanian, 130 AFTR 2d. 2022-6796.
In Hovnanian, the District Court allowed the IRS to foreclose on real property under the nominee theory even though the taxpayer never held a direct ownership interest in it. Mr. Shant was subject to extensive tax liens for engaging in tax shelters. He had more than $16 million in unpaid federal taxes related to those illegal tax shelters. Mr. Shant’s mother-in-law transferred a personal residence located in Red Bank, New Jersey (the “Red Bank residence”) to a trust created by Mr. Shant for the benefit of his children. The trust paid $1 to purchase the Red Bank residence from Mr. Shant’s mother-in-law. She made the transfer after the tax assessments against Mr. Shant. Mr. Shant’s sister-in-law, Nina Hovnanian, was the trustee of the trust. Mr. Shant and his wife lived in the Red Bank residence and were responsible for paying all expenses associated with the home. Mr. Shant never paid any rent to the trust.
The IRS sought a determination that the trust was Mr. Shant’s “nominee,” so the tax liens assessed against Mr. Shant consequently attached to the Red Bank home. The District Court agreed with the IRS. The court held the trust merely held legal title to the Red Bank home. In reality, Mr. Shant had total control over the property as “evidenced by him paying the property’s bills, living on the property, and being the decision maker for anything that had to do with the property.” Case law confirms the government can enforce its liens against the taxpayer’s property, including property held by a nominee or alter ego. United States vs. Wunder, 124 AFTR 2d. 2019-5069, aff’d, 829 App’x 589, (3d. Cir. 2020).
The court relied primarily on United States vs. Patras, 544 F. App’x 137, 113 (3rd Circuit 2013), which held when “there is a tax lien on a taxpayer’s property, the Government may seek to satisfy by levying upon property the taxpayer controls.” In other words, if property is under the control of the third party but the third party is the nominee or alter ego of the delinquent taxpayer, the property can be subject to the taxpayer’s tax lien. Under Patras, the test for a nominee relationship, under both federal and New Jersey law, generally is based on the following six factors:
Whether the nominee paid adequate consideration for the property;
Whether the property was placed in the nominee’s name in anticipation of a suit or other liabilities while the taxpayer continued to control the property;
The relationship between the taxpayer and the nominee;
The failure to record the conveyance;
Whether the property remained in the taxpayer’s possession; and
The taxpayer’s continued enjoyment of the benefits of the property.
Mr. Shant argued the first and second tests of Patras could not be met because Mr. Shant never held legal title to the Red Bank residence. He argued the government should be barred from pursuing a nominee lien against the property since he was never in the chain of title to the home.
The court, however, ruled the focus in the first and second tests is not on the taxpayer, but instead is on the nominee. The question is not whether the taxpayer paid adequate consideration for the transfer, nor whether the taxpayer was ever in the chain of title. Instead, the sole focus is whether the nominee paid adequate consideration for the property transfer. The trust only paid $1 for the property. Mr. Shant exerted total control and dominion over the home after it was transferred to the trust. Thus, the tests of Patras were met. Interestingly, the court noted Mr. Shant was actually the settlor of the trust. The decision, however, does not offer any insight whether the court would have reached a different decision had someone else (such as Mr. Shant’s mother-in-law) been the settlor of the trust.
Keith A. Wood is an attorney with Carruthers & Roth in Greensboro.