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Archive for October, 2011

Perhaps we’re looking into this a bit too much, but we found the Tax Court’s decision this Thursday in Kilker v. Commissioner, 2011-250 to be a bit curious.

In Kilker, the taxpayer (Kilker) was the owner and operator of Allegra Print and Imagining, a printing shop. Kilker was Allegra’s CEO during 2003 and 2004. In 2003, in exchange for providing Zap Corp. (Zap) with printing services, Kilker received 73,529 shares of Zap stock. The stock was restricted stock pursuant to SEC rule 144, meaning Kilker could not sell or transfer the stock for at least 1 year. In 2004, at the end of the 1-year holding period, Kilker sold 30,000 shares for a total of $90,290.

Kilker failed to file a tax return for 2004. The IRS recreated Kilker’s 2004 tax return, and reported the $90,290 as capital gain. The Tax Court agreed:

Section 61(a) defines gross income as all income from whatever source derived. Section 61(a)(3) specifically includes in income gains derived from dealings in property. Respondent argues that petitioner received $90,290 from the sale of 30,000 shares of Zap stock in 2004. To satisfy his initial burden of production with respect to petitioner’s capital gain income of $90,290, respondent provided the Court with a Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, and trade confirmations from Edward Jones confirming the information reported on the Form 1099-B. Petitioner has failed to present any evidence to dispute she received this amount or any evidence of her basis in the shares of stock. Accordingly, we sustain respondent’s determination with respect to the capital gain income.

Seems simple enough. But here’s what we’re wondering: Why didn’t the IRS and the Tax Court include the income related to the Zap stock in Kilker’s 2003 tax year,when it was received in 2003, rather than when it was sold in 2004?

When a taxpayer receives stock in exchange for services, the inclusion of the value of the stock in the income of the recipient is governed by Section 83. Generally, stock received in exchange for services is taxable upon receipt for an amount equal to its FMV less any amount paid by the taxpayer for the stock. However,  if the stock received is 1) subject to a substantial risk of forfeiture, and 2) not freely transferable, Section 83 defers the taxation of the stock until the stock is no longer subject to a substantial risk of forfeiture and is freely transferable.

In Kilker, the taxpayer received the Zap stock in 2003 subject to SEC Rule 144, which prohibits the sale of the unregistered stock on the public market for 1 year. Now, it may sound like this is a sufficient restriction on transferability to defer income recognition on the receipt of the Zap stock from 2003 (when the stock was granted) until 2004 (when the restriction lapsed under Rule 144 and the stock was sold). However, the District Court of California and the Ninth Circuit have recently held that the restriction on transferability under Rule 144 does not constitute a significant enough restriction to defer income under Section 83, echoing the position tax advisors have adhered to for years based on the general structure and language of Section 83.

In Gudmundsson v. U.S.,107 AFTR 2d 2011-852 (634 F.3d 212), 02/11/2011, the taxpayer (Gudmundsson) received stock options on July 1, 1999 that were subject to several constraints. The Ninth Circuit discussed the Rule 144 element of the constraints as follows:

First, these were “restricted securities” under Securities and Exchange Commission (“SEC”) Rule 144 meaning they were acquired directly from the issuer and not in a public offering, id. Under Rule 144, the Stock could not be sold on a public exchange until the expiration of a holding period that, in Gudmundsson’s case, ended on July 1, 2000. The Stock could, however, be disposed of in a private placement sale or pledged as security or loan collateral.

The Ninth Circuit ultimately concluded that the options were taxable on July 1, 1999, the date of receipt, despite the fact that Rule 144 barred the sale of the options on the public market until July 1, 2000:

The Stock was not subject to a substantial risk of forfeiture on July 1, 1999, and although this is enough for income recognition under  Section 83, we briefly address plaintiffs’ arguments regarding the transferability of the Stock, as well. Plaintiffs assert, however, that the Stock was not transferable because “in reality, … [t]he various restrictions imposed by law and agreement made [the Stock] impossible to sell.” Regardless of whether this is true, the argument misunderstands what Section 83 requires. Transferability is not just a question of marketability. In fact, even if sales are prohibited for a period of time, property may be transferable if it can be pledged or assigned.

To summarize, the district court was correct to recognize the Stock as income on July 1, 1999, as the Stock was transferable and not subject to a substantial risk of forfeiture on that day. This conclusion was correct under Section 83(a) and in general, as income in whatever form is taxable in the year in which it is received.

This begs the question: with authority like Gudmundsson out there, why didn’t the Tax Court in its decision in Kilker inlcude the income generated from the receipt of Zap stock in 2003 when it was received? Why did it wait until the stock was sold in 2004?

Clearly, under the principles established in earlier case law, the mere presence of the Rule 144 restriction on the sale of the Zap stock should not have prevented the IRS from including the FMV of the Zap stock in Kilker’s income in 2003. Perhaps there was some other substantial risk of forfeiture that was stipulated between the two parties and was not disclosed in the court documents. Or perhaps by the time the IRS caught wind of Kilker’s failure to file her 2004 tax return, the statute had run on the 2003 return, which apparently was filed. Otherwise, it would seem the IRS missed an opportunity to tax the income in 2003, and potentially increase the amount included in Kilker’s income if the stock price was higher upon receipt in 2003 that upon sale in 2004.

Any thoughts?

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Reaffirming my long-held belief that everything in life can be related back to The Simpsons, there’s an episode in which Homer is investigated by the IRS for tax fraud. In lieu of prosecution, Homer is told that he will “work for the IRS” to help the Service bring down Homer’s boss, Mr. Burns. Homer’s reply to the proposed arrangement?

“Sure, but can you pay me under the table?….I’ve got a little tax problem.”

As you might imagine, the government is not in the habit of showing sympathy for one’s self-imposed tax mess, a fact we were reminded of earlier this week with the Tax Court’s decision in May v. Commissioner, 137 T.C. 11 (2011). In May, the IRS refused to show leniency when an individual argued that his tax liability was created as a result of being ripped off. By himself.  

Mark May (May) was the CEO and sole shareholder of Marantha Financial Group (Marantha), a corporation with 100 employees. May controlled the finances of Maranatha; he had sole check signature authority on the corporate bank account and was the sole signatory on payroll checks issued by Paychex on Maranatha’s behalf.

During 1994 through 1996, Maranatha withheld all of the proper taxes from employee paychecks (including May’s) but failed to remit these withholdings to the Federal, State, or local governments. Though Marantha was the employer, May was the person responsible for remittance of these withholdings; a point driven home by the U.S. District Court, which had earlier convicted May on six counts of tax evasion charges related to Marantha’s payroll tax indiscretions.

The case in front of the Tax Court, however, focused on the individual income tax aspects of Marantha’s failure to remit employee withholdings. On May’s 1994, 1995, and 1996 tax returns, May attached his W-2 and claimed the full amount of federal withholding each year as an offset to his tax liability despite his knowledge that the government had never received the funds. Compounding his transgressions, May also claimed federal tax deductions each year for the “withheld” state income taxes that were never actually paid to the state.

The IRS denied both the federal credit for withholding and the federal deduction for the state withholding, assessing an underpayment of tax and fraud penalties averaging nearly $80,000 for each year from 1994 through 1996.

To May’s credit, he came up with a rather compelling argument to support his position that there could be no fraud penalty because there was no underpayment of tax. May contended that because taxes were actually withheld from his paychecks, he was entitled to the withholding credits even though the tax withholdings were never paid to the government. As support, May pointed to Treas. Reg. Section 1.31-1(a), which states in part that “If the tax has actually been withheld at the source, credit or refund shall be made to the recipient of the income even though such tax has not been paid over to the Government by the employer.”

Compelling as this argument may have been, for obvious reasons the Tax Court was not persuaded. The regulations cited under Section 31 contemplate a scenario where an employer fails to remit the withholdings of an employee without that employees knowledge; without some type of relief, the employee would unwittingly be subjected to underpayment penalties through no wrongdoing of their own.

In the instant case, however, it was May who ripped off May.  The Tax Court explained it this way:

May was not only an employee of Maranatha; he was also president and CEO. He was the person responsible for Maranatha’s failure to remit tax withholdings(including his own) to the Government and knew that those withholdings were not being remitted. Mr. May had sole check signature authority on Maranatha’s corporate bank account, giving him full control of its finances.

Because Mr. May was responsible for the nonremittance and fully controlled the corporate finances, we conclude that the funds never left Mr. May’s functional control and were therefore  not “actually withheld at the source” from his wages for purposes of section 1.31-1(a), Income Tax Regs. Section 1.31-1(a), Income Tax Regs., is therefore inapplicable, and petitioners’ reliance on it is misplaced.

Thus, the Tax Court upheld the fraud penalties assessed by the IRS, and Mr. May will now be asked to cut several very large checks from the comfort of his jail cell.

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If you’ve never visited Moab, Utah, set your faces to “stunned.”  The place is a geological wonder; once covered by ocean, Moab is now a brilliant desert landscape dotted with spires, arches, fins, and other features so remarkable in their beauty, they’ll leave you convinced of a higher power at work. 

And, of course, the mountain biking is sublime.

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Straight from the IRS:

The Internal Revenue Service today announced that the nation’s 738,000 tax return preparers who have Preparer Tax Identification Numbers (PTINs) can now renew their PTINs for the 2012 filing season.

Preparers are required to renew their PTINs on an annual basis and need to do so before the next year begins. For example, a preparer’s PTIN for 2012 must be renewed by Dec. 31, 2011.

Anyone who for compensation prepares, or helps prepare, all or substantially all of tax returns or claims for refunds must have a PTIN. Paid return preparers must have valid, current PTINs to prepare tax returns in 2012.

The PTIN renewal fee for 2012 is $63. The initial application fee for a PTIN remains at $64.25. Return preparers who obtained their PTINs by creating an online account should renew their PTINs at www.irs.gov/ptin.

Preparers who used paper applications to receive their 2011 PTINs will receive an activation code in the mail from the IRS which they can use to create an online account and convert to an electronic renewal for 2012.  Individuals can also renew using a paper Form W-12, IRS Paid Preparer Tax Identification Number Application, but renewing electronically avoids a four to six week wait for processing the renewal request.

Return preparers who are applying for a PTIN for the first time must go through a strict authentication procedure and should follow directions carefully. Return preparers who prepared, or helped prepare, returns for compensation in 2011 without PTINs must obtain 2011 PTINs and then renew their PTINs for 2012, paying fees for each year if they intend to practice next year. Penalties may apply for paid tax return preparers who prepared, or helped prepare returns in 2011 without valid PTINs.

Some changes to the PTIN application and renewal process include:

  • Return preparers must self-identify if they are supervised preparers or non-1040 preparers.
  • Supervised preparers will need to provide a supervisor’s PTIN when applying for or renewing their PTINs.
  • Credentialed preparers (Certified Public Accountants, attorneys and Enrolled Agents) must provide the expiration date for their licenses when they apply for or renew their PTINs.

Supervised preparers are individuals who don’t sign the returns they prepare or help prepare; work at a firm at least 80 percent owned by a Certified Public Accountant, an attorney or an Enrolled Agent; and prepare returns that are signed by a supervisor who is a CPA, attorney or Enrolled Agent.  

Non-1040 preparers are people who do not prepare any individual income tax returns for compensation. For this purpose, preparers of Form 1040-PR and Form 1040-SS are considered non-1040 preparers.

Supervised preparers and non-1040 preparers must identify themselves when they apply for or renew their PTINs to be exempted from testing and continuing education requirements; Certified Public Accountants, attorneys and Enrolled Agents are also exempt from testing and continuing education requirements.

 

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Starting with the understanding that expenses incurred for “research and development” are generally deductible under Section 174, lets expand a bit on what exactly constitutes R&D.

With some expenses, it’s quite obvious that they represent “research and development” as intended by the Code:

Costs incurred to perform clinical trials on a promising new anti-depressant drug? Clearly R&D.

Costs incurred to develop a fat-free yogurt that doesn’t let you down in the flavor department like so many others? R&D.

Costs incurred to house three semi-conscious transients in your basement in hopes of  creating your very own human centipede in time for Halloween? R&D, but most certainly in violation of several Federal and state statutes.  

But what about the costs to design and implement a complex tax shelter? Not quite as clear, is it?

One could certainly argue that a tax shelter is a “product,” no different than an electric car or the Shake Weight. Wouldn’t it follow that the hours spent researching tax strategies and potential law changes in hopes of finding a “legal shelter” constitute the type of research and development costs contemplated by Section 174 of the Code?

According to the Tax Court and its decision on Wednesday in  The Heritage Organization LLC,[1] the answer is no.

Facts of Heritage Organization LLC

I’ll spare you many of the facts, as they’re a bit lengthy and exceedingly convoluted. All that’s relevant is this: An LLC (Heritage) was in the business of selling tax shelters. A related entity did the necessary legwork: searching for opportunities in the Code, developing the products, and researching via public information those individuals who may be prospective candidates for the shelter. Heritage would then sell the shelter and be compensated accordingly.

In the late 1990′s, Heritage began to market and sell the “Son of Boss” transaction,  a complex tax shelter necessitating the establishment of trusts, corporations and partnerships, the end result of which was to allow wealthy clients to take advantage of certain “built-in losses.” When the dust settled on Heritage’s tax shelters, the LLC was required to pay $550,000 to each of 11 corporations it had created to implement the Son of Boss. Heritage then deducted the $6,050,000 on its 2001 tax return as “research and development expenses.”

Relevant Law

To review, Section 174 and the related regulations define “research or developmental expenditures” as:

…expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”[2] The term generally includes all such costs incident to the development or improvement of a product.

The term “product” includes “any pilot, model, process, formula, invention, technique, patent or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale”.[3]

The expenditures may qualify as research and development expenses in “the experimental or laboratory sense” if they are incurred for activities to “eliminate uncertainty concerning the development or improvement of a product.”[3] Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the design of the product.

Taxpayer Argument and Tax Court Decision

 Heritage argued that the $,00,000 constituted “research and development” expenses under the meaning of Section 174, as they were incurred by Heritage to develop a set of shelf corporations with embedded losses.

The Tax Court disagreed, holding that the expenses did not qualify as R&D expenses.[4] In reaching its decision, the court focused on the fact that tax shelters are neither scientific, nor developed in an experimental or laboratory sense. Perhaps more importantly, any problem inherent in a tax shelter could not be remedied by the “developer” of the shelter, but rather only by a change in the tax law. The Tax Court explained its position as follows:

The payoff amounts fail to meet the section 174 requirement that the expenditures be for research in the experimental or laboratory sense. The payments were not made for scientific activities.

Further, the payoff amounts do not qualify as research and development expenses as they were not incurred to eliminate uncertainty concerning the development of a product. The uncertainty Heritage wished to eliminate was whether the tax planning structure created would be useful in a tax system without the generation skipping transfer tax exemption. The uncertainty on Heritage’s part would be resolved by a change in the tax law, not by any actions undertaken by Heritage.

Moral of the Story?

In order for an expense to qualify as a research and development expense under Section 174, the expense: 

  • Should be incurred for scientific and laboratory based activities;
  • The costs should be incurred to develop a product, or eliminate uncertainty concerning the development or improvement of a product;
  • The activities of the taxpayer must be intended to discover information not otherwise available regarding the capability of the product.

[1] The Heritage Organization LLC  v. Commissioner, T.C. Memo 2011-246 (2011).

[2] Treas. Reg. § 1.174-2(a)(1).

[3] Treas. Reg. § 1.174-2(a)(1).

[4] Nor did they qualify as ordinary and necessary business expenses under Section 12, as the Tax Court held that Heritage was not in the trade or business of selling “off the shelf” tax shelters.

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As discussed in this article written by Jesse Drucker at Bloomberg, our internet overlords at Google have found themselves the subject of an IRS audit. It seems the Service is heavily scrutinizing the web giant’s offshore activities, particularly the manner in which Google values software rights and other intellectual property it licenses to its foreign subsidiaries, as well as the transfer-pricing agreements between those same foreign subsidiaries and Google’s domestic operations.

Google has long taken advantage of the relative ease of transferability of many of its key patents and copyrights, moving these income-producing assets to tax havens, thereby shifting much of the corresponding earnings away from the U.S. and into favorable jurisdictions. According to the article, Google has shaved nearly $1 billion per year off its worldwide tax bill by using strategies called the “Double Irish”  and “Dutch Sandwich,” which, according to a quick search of Urbandictionary.com, are not nearly as perverted as they sound.

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No, that’s not just  a line from your favorite song by Breathe — the band comprised of feathered hair Brits that embodied masculinity while ruling the 1980′s– it’s the reality of life in Aspen come October. We here at Double Taxation were greeted this morning with the first signs of winter coating legendary Highland Peak. Ski season draws nigh.

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Following up on our previous post, those squares at the IRS have once again killed the collective buzz of an otherwise law-abiding medicinal marijuana facility and its clients:

When is a valid business expense deduction not a valid business expense deduction?  When you are running one of the country’s largest, most successful medical marijuana dispensaries, that’s when.  You see, back in 1982, Code Sec. 280E was added to the Internal Revenue Code.  We all remember the “war on drugs”, right?  Well, Congress decided that one way to crack down on drug traffickers was to disallow them any deductions incurred in the process of drug trafficking.  Specifically, Code Sec. 280E provides:

 No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business  . . . consists of trafficking in controlled substances . . . which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

 Now, I don’t know how compliant your average, run of the mill drug trafficker is with his or her tax filing obligations, but this would be quite a bitter pill to swallow (pun intended).

Fast forward to 2011.  Many states have now passed legislation that makes the use of medical marijuana legal.  At the forefront of this movement was the State of California, home of the Harborside Health Center.  Recently, the IRS used Sec. 280E to deny Harborside a deduction for many general business deductions.  As you can imagine, this generated quite a tax obligation, one that may put the company (and likely many other dispensaries like them) out of business. 

Stay tuned for further developments, as this is likely to be an evolving issue as more and more states look at medical marijuana legislation.  The full article can be found here.

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Pop quiz, hotshot. Can a taxpayer deduct mortgage interest on a home that’s never actually built?

Well, if you’d bothered to read my title, you’d already know the answer. And that answer, according to the Tax Court’s decision today in Rose v. Commissioner, T.C. Summary Opinion, 2011-117, is a resounding “yes.”

Facts

  • In 2006, Mr. Rose (Rose) purchased land and a home on beachfront property in Florida for $1,575,000. Rose didn’t want the house; he wanted to build his own. Thus, as part of the contract, the existing house was torn down prior to Rose’s purchase.
  • To purchase the property, Rose took out a $1,260,000 mortgage.
  • Florida required a lengthy permit application process before Rose could build on beachfront property. Before an application could even be submitted, Rose was required to perform survey work and provide core samples to the State.
  • To further the application process, Rose put together a team of architects, engineers, and designers who prepared and submitted the construction and site plans.
  • In early 2008, a full two years after Rose purchased the land, his permit to build was approved. Unfortunately, by that time the local real estate and lending markets had crashed, and Rose couldn’t obtain the necessary financing.
  • As a result, the house was never built, and Rose sold the raw land in 2009, taking a $850,000 bath.

On his 2006 and 2007 tax returns, Rose deducted the interest on the 2006 mortgage to purchase the raw land as “qualified residence interest.” The IRS disallowed the deductions, posing the logical argument that a home cannot qualify as a qualified residence — and thus mortgage interest can never be deducted — if it’s never built.  

 The Tax Court disagreed, siding with Rose and allowing the mortgage deductions.

 Relevant Law

Qualified residence interest is any interest that is paid or accrued during the taxable year on acquisition debt or home equity debt. Acquisition debt is any debt secured by the qualified residence of the taxpayer and incurred in acquiring, constructing, or substantially improving the qualified residence.

Section 163(h)(4)(A)(i) defines a qualified residence as the principal residence of the taxpayer and “one other residence of the taxpayer which is selected by the taxpayer.”

 Pursuant to section 1.163-10T(p)(5), a taxpayer may treat a residence that is “under construction” as his or her second residence for up to 24 months “commencing on or after the date that construction is begun”.

Tax Court Decision

To determine if Rose’s 2006 and 2007 mortgage interest was deductible, the Tax Court had to determine whether “construction” had begun with regards to Rose’s planned Florida home. In reaching its decision, the Tax Court held that Rose’s construction activity began even before he owned the land.

For all practical purposes, petitioners were responsible for the demolition work, and it came about as a direct result of their purchasing the property. The fact that petitioners did not hold legal title to the property at the time that the work occurred does not negate its relevance to our inquiry… Therefore, we find that by causing an entire house to be demolished and by clearing the lot so that it would be suitable for a new residence, petitioners undertook significant steps in the process of constructing their vacation house, as early as January 2006.

The court also determined that Rose’s two-year effort as part of the permit application process constituted continued “construction” on the home.

The work petitioners were required to complete before filing the application was extensive and required the labor of multiple building and design professionals. Petitioners undertook significant work in preparing to obtain a construction permit, and that work was a necessary component of the overall process of construction. We hold that the property was “under construction” as a residence during 2006 and 2007.

Lastly, the Tax Court was left to decide whether Rose’s failure to ever build the house negated the mortgage interest deductions in 2006 and 2007. Reaching the logical conclusion, the court held that it didn’t, as in 2006 and 2007, Rose would not be aware that the home would eventually fail to be built.

Section 1.163-10T(p)(5)(i) and (ii) allows qualified residence interest to be deducted for the 24-month period following the commencement of construction. In the event the residence under construction has not been completed and is not ready for occupancy by the end of the 24-month period, the residence under construction ceases to qualify after that 24-month period ends. If petitioners intended to claim the deduction for interest during the construction period, they had to claim it on their returns for the years immediately following the commencement of construction in January 2006…[in those years], it would be impossible for petitioners or the Internal Revenue Service to have known that the proposed residence would never become ready for occupancy.

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Oftentimes in life, we say things merely because they appear to reflect conventional wisdom, regardless of whether we’ve ever actually independently verified their validity. Things like:

“Meryl Streep is the greatest actress of her generation.”

“He may enjoy lukewarm commercial success, but Beck is an extraordinarily talented musician.” 

“Anything bigger than a handful, and you’re risking a sprained thumb.”   

It’s no different in the tax world. For example, tax advisors almost universally offer up the following advice to clients seeking guidance on how to characterize the gain from the sale of assets or payments received as a result of a legal settlement:

“As long as you’ve got a bargained for, arms-length agreement with an unrelated party, the IRS won’t attack your allocation.”

Unfortunately, as Healthpoint, LTD., DFB Pharmaceuticals, Inc. v Commissioner, T.C. Memo 2011-241 reminded us today, just because we say it, doesn’t make it true. 

In Healthpoint,the taxpayer was a pharmaceutical partnership that manufactured and marketed a very successful drug; Accuzyme. A competitor came along and introduced Ethezyme, a drug that was marketed as a generic form of Accuzyme. Unfortunately, Ethezyme also contained a potentially harmful chemical that sickened patients. Once word got out, the damage wasn’t limited to the manufacturer of Ethezyme, however, as their marketing strategy had been rather successful. As a result, when the reputation of Ethezyme suffered, so did the reputation of Accuzyme, as in the eyes of the public, the drugs were one and the same. 

In response, Healthpoint filed two separate suits against the competitor, alleging false advertising, unfair competition, and trademark dilution. Healthpoint won the first suit, with a jury awarding the company $16,100,000. The jury allocated the damages as follows:

Actual damages: $5,000,000      Lost profits: $1,640,00     Punitive damages: $3,1745,000      Damage to goodwill: $6,349,000

While the second suit was in deliberation, the competitor filed an appeal with regards to the first suit. Healthpoint decided the best course of action was to pursue a settlement of both suits at once.

After much negotiation, the two parties agreed to settle, with Healthpoint receiving $16,300,000 between the two suits. Both parties had a vested interest in refraining from calling the bulk of the settlement punitive or compensatory damages: the competitor because an admission of wrongdoing would only further damage their already sullied reputation, and Healthpoint because any punitive or compensatory damages would generate ordinary income.

In light of these facts, a final settlement agreement was executed allocating the $16,300,000 as follows:

Lost profits: $1,800,000   Damage to goodwill: $14,5oo,00o

On its Form 1065 for the year of settlement, Healthpoint reported the $14,500,000 as long-term capital gain, and the $1,800,000 of lost profits as ordinary income. The IRS challenged the characterization, arguing that the allocation of the settlement income should follow the allocation provided for by the jury upon Healthpoint’s victory in the initial suit. This would effectively recharacterize $9,000,000 of the settlement payment from capital gain to ordinary income.

Healthpoint disagreed, repeating the long-held belief that the IRS and the Tax Court should respect the allocations provided for in the final, executed settlement agreement.

The Tax Court, likely to the surprise of many CPAs, sided with the IRS, choosing to ignore the executed settlement agreement between two unrelated parties. In reaching its decision, the court stated:

Where there is an express allocation in the settlement agreement between the parties, it will generally be followed in determining the allocation for Federal income tax purposes if the settlement agreement is entered into by the parties in an adversarial context at arm’s length and in good faith.

The Tax Court then backtracked by adding:

However, general adversity between the parties to a lawsuit is to be expected. If the parties were generally adverse but ultimately allocated the funds in a way that did not represent the claims they actually intended to settle, then we need not respect the allocations made in the settlement agreement.

The court determined that while Healthpoint and its competitor may had been adverse parties, they both benefitted from characterizing the bulk of the settlement payment as harm to goodwill rather than punitive or compensatory damages: the competitor could salvage its reputation; Healthpoint could benefit from the long-term capital gain rates. Because both parties wanted to avoid calling the settlement payment damages, the court held that the allocation could not be respected.

Instead, the Tax Court required that Healthpoint characterize the income in the same manner as was handed down by the jury in the first suit. As a result, over $9,000,000 of the $16,200,000 payment was treated as ordinary income.

What Can We Learn? The decision in Healthpoint will prove difficult for a majority of CPAs to get their arms around. If we are presented with a signed, fully executed settlement agreement between two unrelated parties that has been negotiated at an arm’s length, we will rarely  – if ever — dig any deeper than the document itself. In many cases, we are not even privy or party to the negotiations; rather, we are merely presented with the final agreement and charged with accurately presenting it on a tax return.

Well, in Healthpoint, not only did the court dig deeper than a CPA may feel necessary, the taxpayer was also held liable for a substantial underpayment penalty. In refusing to apply the “reasonable cause” exception, the court noted that Healthpoint’s tax adviser was not asked to opine on the propriety of the allocations in the agreement, nor did he participate actively in the negotiations.

This should serve as an eye-opener to tax advisers everywhere.  To best protect our clients from exposure to additional assessments of tax and the associated underpayment penalties, we may need to insist on being an active part of any negotiation that ultimately dictates the characterization of income on a client’s tax return.

In closing, Beck sucks.

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