Brandon Ridge Partners v. United States, 2007 TNT 148-14 (M.D. Fl. 2007); Estate of Hicks v. Commissioner, T.C. Memo. 2007-182 - One case is worth analyzing the other case is worth reversing.

In Brandon Ridge, the United States District Court in the Middle District of Florida jumped in the foray of TEFRA and the statue of limitation. The lesson from the case is clear- just because the Court cites to a case doesn’t mean the court has necessarily read the case. I would be shocked if Brandon Ridge is not appealed and reversed faster than one can say 11th Circuit.

In Hicks, Judge Holmes wrote an opinion that was not only a legal opinion but an educational treatise to Trust and Estate attorneys and all planners on how to protect one’s client by using the probate court without run afoul of Estate of Bosch.

In Brandon Ridge, the Court is facing a Son of Boss case and was confronted with the issue whether the statute of limitations was three years or six years. The Court cited to Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. No. 17 (2007) and to Colony, Inc. v. Commissioner, 357 U.S. 28 (1958) did not apply.

In Bakersfield, the Tax Court cited to Colony, Inc. v. Commissioner, 357 U.S. at 37 as follows:

We think that in enacting section 275(c) Congress manifested no broader purpose than to give the Commissioner an additional two years [now three] to investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors. In such instances the return on its face provides no clue to the existence of the omitted item. On the other hand, when, as here, the understatement of a tax arises from an error in reporting an item disclosed on the face of the return the Commissioner is at no such disadvantage. * * * [ Id. at 36.]

This language led the Tax Court to hold that “The precise holding of the Supreme Court in Colony, Inc. v. Commissioner, supra, was that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis.”

In Bakersfield, the Court relied on a rather unique statutory interpretation of § 6501. The Court accepted the Commissioner’s proposition that: "In the case of a trade or business, the term 'gross income' means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to diminution by the cost of such sales or services." See § 6501(e)(1)(A)(i). Thus Colony's gross receipts test only applies to situations described in § 6501(e)(1)(A)(i), which applies to trade or business sales of goods or services. To conclude otherwise would render § 6501(e)(1)(A)(i) superfluous. Since the transaction at issue in the instant case is the Partnership's sale of the FES stock, which is not a business sale of goods or services, the gross receipts test does not apply.

The Court then stated that the matter was not properly disclosed because:

"they show the sales price of the FES stock and the purported basis of the FES stock. However, what is not disclosed in any of the returns is the fact that the proceeds of the short sale, along with the obligation to cover the short sale, was contributed to the Partnership, and the Jeffersons did not reduce their basis in the Partnership by the value of the obligation to cover the short sale that was assumed by the Partnership. Additionally, the returns do not disclose that the basis of the FES stock was increased by $3,258,458.33 or that the FES stock was the only "Investment Asset" held by the Partnership.

In order to adequately disclose the gain on the sale of the FES stock, information regarding the contribution of the obligation to cover the short sale and its effect on the basis of the Jeffersons' interest in the Partnership (which was later transferred to Brandon Ridge, Inc.) was necessary so that the IRS could detect the error in the calculation of the net long-term capital gain on the sale of the FES stock. As presented in the returns and statements attached thereto, the substance of the transactions relating to the sale of the FES stock (which included the contribution to the Partnership of the obligation to cover the short sale of the Treasury Notes and the effect on the Jefferson's basis in the Partnership) was not disclosed in a manner that was adequate to apprise the IRS of the true amount of capital gain that resulted from the sale of the FES stock."

Simply stated it appears that the Court does not understand Bakersfield or Colony, Inc. as the Court readily admits that the transaction was reported on the returns. Rather it appears that the Court believed, mistakenly so, that the taxpayer had a duty to specifically tell the IRS that the item on the return was a son-of-boss transaction, In addition, the taxpayer had a duty to set forth in detail all the steps involved the transactions. Bakersfield nor Colony require such type of information to be set forth on the return for there to be adequate disclosure. Like I said appeal and reversal are in store for this case.

At the opposite extreme is Estate of Hicks v. Commissioner, T.C. Memo. 2007-182, the facts are rather complex but essential in understanding the case. The decedent at the age of 2 years and 9 months suffered a devastating injury that left her a quadriplegic. Her parents were concerned that if to their employment status with the state of Ohio, medical coverage would be insufficient to take of their child. Her parents retained the services of a specialist to structure the settlements that were to be received from the impending lawsuits. The specialist formed various trusts and used the local probate court (Ohio) to review and approve the settlement, allocation and distribution of damages.

Of concern to the IRS was the following: In addressing the medical insurance concern of the parents, the lawyer created a trust that was to be funded in part from another settlement in the amount $450,000. This trust's assets, however, would be counted in determining decedent's Medicaid eligibility. This meant that if the insurance coverage she had through her parents lapsed, she would have to spend all or nearly all of the Management Trust's assets. The attorneys came up with the apparently novel idea of having decedent’s father fund a substantial part of this trust with a loan of $1 million to be allocated to him from the settlement. The loan would be evidenced by a promissory note from the Management Trust to him and would pay interest at 6% per annum, slightly less than Society National expected to earn from investing the Management Trust's corpus. The note was not amortizing, and was callable on demand in only two circumstances-decedent’s death or her failure “to have available at reasonable premium charges a commercial medical indemnity contract” once she turned eighteen.

The plan was forwarded to the probate court and it was approved by the court. In 1998, she passed away at the age of eleven. The estate reported the $1 million as an asset of the estate. It also claimed as a deductible debt under section 2053(a)(3) and (4) the $1 million owed to decedent’s father under the promissory note.

The Commissioner argued that $1 million loan was a sham. The Court disagreed. The Court found that Section 2053(c)(1)(A) allows a deduction from the value of an estate for any indebtedness, but only “to the extent that [it was] contracted bona fide and for an adequate and full consideration in money or money's worth * * *.” (Emphasis added.) The regulation required that the Court apply State law in deciding whether a debt was “payable out of property subject to claims and * * * allowable by the law of the jurisdiction * * *.” Sec. 20.2053-1(a)(1), Estate Tax Regs; see also Estate of Lazar v. Commissioner, 58 T.C. 543, 552 (1972).

The key to finding a bona fide loan was the Probate Court and its decision in deciding to whom the $1 million belonged. Under Ohio law the Probate Court's broad had discretionary authority as “superior guardian” of a minor. That status meant that the Probate Court had the power and authority to control the actions of the minor's guardian and act directly to ensure that the minor's best interests were being considered. It also meant that the Probate Court had to approve any settlement which the minor's guardian reached before it could take effect. Because of this essential role the Probate Court played under Ohio law, the Tax Court held that the $1 million didn't belong to anyone until the Probate Court said it did, i.e. the loan itself was not a sham.

The Commissioner then argued that the allocation of the $1 million to decedent’s father was a sham. Again the Tax Court looked to the Probate Court and held against the Commissioner. The Court stated:

Under Ohio law Probate courts' decisions in this area are discretionary. Unless there is an abuse of discretion, an Ohio appellate court “will not substitute its judgment for that of the trial court.” Ohio is, moreover, wonderfully blunt about why it gives Probate Courts this degree of deference: to “protect minors against others whose interests may be adverse to theirs, especially their parents.” This makes us especially disinclined to second-guess, in the guise of economic-substance review, their specialized expertise in the appropriate allocation under Ohio family law of the lump-sum settlement of a state tort claim. (Citations Omitted).

Thus the Tax Court rightfully respected the settlement approved by the Probate Court. The Tax Court ensured that the Probate Court was not a mere rubber stamp for the parties but a disinterested party which recognized the needs of the family in the most difficult of circumstances of all – the care and welfare of a young child in need. The Tax Court’s ruling was not only correct as a matter of law but reflected the wisdom and compassion of a seasoned tax litigator. 

RJT INVESTMENTS X, LLC Tax Court's quick visit to the Son-of Boss store

Last April it was noted that the Tax Court had ruled against a taxpayer involved in a Son-Of- Boss case. It turned out the ruling was a one page order issued by Judge Laro. Judge Laro is one of the most respected judges on the United States Tax Court. Thus, a one page dispositive order as to a Son-of Boss case caught everyone’s attention. As suspected the case is now on appeal and the Government’s brief has been posted on Tax Analysts. See 2007 TNT 8-37.

The Government’s brief sets forth the issues as follows:

  1. Whether the Tax Court had jurisdiction to determine the partnership item components of the partner’s basis in his partnership interest in RJT.
  2. Whether the Tax Court had jurisdiction to determine that RJT was a sham, that it lacked economic substance, and that it was formed and/or used for tax avoidance purposes.

The reason for the issues being framed in such a narrow manner is according to the Government, the taxpayer conceded that the transaction had no economic substance and admitted that it would present no evidence in challenging the notice. Rather, according to the Government, the only issue was jurisdictional as the Court lacked jurisdiction over the sham issue and the issue over outside basis.

As they there are two sides to a story and we do await taxpayer’s version of the facts and the law to determine whether this case was worthy of the headlines it received from the IRS.