Posts Tagged ‘litigation’


While F. Lee Bailey is widely considered one of the greatest defense attorneys to ever grace the inside of a courtroom, his body of work has more in common with that of  Lionel Hutz — the dimwitted lawyer from The Simpsons — than Bailey would ever care to admit. Think about it:

High profile victories:

Bailey: A successful defense of accused murderer Sam Sheppard, and of course, the O.J. debacle;

Hutz: Earned redemption for Homer in his false advertising suit against the all-you-can-eat seafood buffet, The Frying Dutchman.

Devastating defeats:

Bailey: Unable to free Patty Hearst from charges of armed robbery;

Hutz: Couldn’t garner justice for Marge in her sexual harassment suit against Mr. Burns.

 Questionable ethics:

 Bailey: Jailed for contempt (see below) and disbarred in Florida and Massachusetts;

Hutz: Set fire to all his records; changed his name to Miguel Sanchez.

Memorable quote:

Bailey: I use the rules to frustrate the law. But I didn’t set up the ground rules.

Hutz: Judge Snyder has had it in for me ever since I kinda ran over his dog… Well, replace the word ‘kinda’ with ‘repeatedly’ and the word ‘dog’ with ‘son’.

Despite this less than flattering comparison, it’s a must-read opinion when a lawyer of  Bailey’s caliber defends himself in front of the Tax Court, particularly when the transactions at issue are the very same that gave rise to Bailey’s incarceration and disbarment.

Facts in Bailey:

While there were other tax issues decided — the court held that Bailey’s yacht refurbishing activity was a “hobby” under the meaning of I.R.C. § 183, while his airplane manufacturing activity was a trade or business — the majority of the case was devoted to whether Bailey recognized taxable income during various stages of a rather unique relationship he entered into with a client at the behest of the government, so that’s where we’ll spend our time.

In 1994 Claude Duboc, who was accused of importing copious amounts of marijuana into the U.S., retained Bailey to negotiate a plea arrangement. As part of the agreement, Bailey would assist Duboc in cooperating with the federal government’s seizure of his many foreign assets, including multiple pieces of high-value residential real estate.

To facilitate restitution from Duboc, the government entered into a vague and unusual agreement with Bailey, under which Bailey would perform services to facilitate Duboc’s forfeiture of his assets, and Duboc would transfer 602,000 shares of Biochem stock to Bailey. This stock would provide funds that Bailey could use to maintain and transfer Duboc’s foreign assets, as well as to cover both Bailey’s fees and the other expenses generated by his work.

For receiving and holding the Biochem stock, Bailey did not open a new account. Rather, the government attorneys understood that Bailey possessed a Swiss bank account, and by agreement it was Bailey’s own account at Credit Suisse that was used. In 1994, 602,000 shares of Biochem stock, then worth $5,891,352, were transferred to Bailey’s Credit Suisse account. Bailey did not report income from his receipt of that stock on any income tax return for any year.

In 1994 and 1995, funds came into Bailey’s Credit Suisse account from three sources–(1) sales of Biochem stock for $2,400,855, (2) loans collateralized by Biochem stock of $3,013,463, and (3) sales of other stock owned by Duboc of $700,000.

From these proceeds, Bailey made further transfers to his personal money market account of stock sale and loan proceeds totaling $3,475,327, of which $425,056 represented stock sale proceeds and $3,013,463 constituted loan proceeds.

In late 1995 or early 1996, Duboc replaced Bailey with another lawyer. At the government’s request, the District Court ordered Bailey to transfer the 400,000 unsold Biochem shares to the federal government. At that time, however, Bailey owed $2,332,743 for loans that had been made against the unsold shares (and he had spent the proceeds); and Credit Suisse would not make any transfer of the shares until the loans were repaid. Bailey therefore did not immediately comply with the District Court’s order, and the court found him in contempt in March 1996 and ordered him incarcerated.

Bailey eventually repaid the full amount of the Credit Suisse loans.

Issue 1:Value of Biochem Stock Transferred to Bailey’s Credit Suisse Account Was Taxable Income:

Tax Court Position: The stock was not taxable income. The stock was not Baileys and was held merely in trust, and in light of the fact that the government persuaded the District Court to stick Bailey in jail until he lived up to the terms of that trust and turn the stock over, the value of the stock was not taxable income when received.

Issue 2: Stock Sale Proceeds and Loan Proceeds Received By Bailey’s Credit Suisse Account Represented Taxable Income:  

Tax Court Position: The stock sale and loan proceeds did not constitute taxable income:

Bailey’s agreement with the Government explicitly contemplated that he would use his existing Credit Suisse account for the Biochem stock. Consequently, the transfer of the shares to his Credit Suisse investment account and of the loan and sale proceeds to his Credit Suisse advance account did not constitute an appropriation of those proceeds.

Issue 3: Loan Proceeds Further Transferred From Bailey’s Credit Suisse Account to His Personal Money Market Represented Taxable Income:  

Tax Court Position: The loan proceeds were not income:

Bailey denied that the loans he received in his Credit Suisse account that were collateralized by the Biochem stock constituted income. He personally guaranteed the loans, and with great difficulty he borrowed from others and repaid the loans in 1996. He therefore invokes a basic tax principle: “[I]t is settled that receipt of a loan is not income to the borrower.” The receipt of a loan is not income to the borrower where the borrower uses another person’s property as collateral to obtain that loan–even where the collateral is obtained under false pretenses or is otherwise misappropriated–as long as there is a “consensual recognition” that the borrower will repay the loan.

Issue 4: Stock Sale Proceeds Further Transferred From Bailey’s Credit Suisse Account to His Personal Money Market Represented Taxable Income:  

Tax Court Position : Since Bailey was not required to repay the stock sale proceeds he appropriated, they represented taxable income.

Bailey bore the burden to prove that in transferring the funds to his money market  account he did not depart from his fiduciary role, and he did not carry that burden. The record does not show that he regarded the funds in the money market account as subject to restrictions on their use. We therefore hold that Bailey wrongly appropriated Biochem stock sale proceeds when he made transfers thereof to his Barnett money market account in the amounts of $175,037 in 1994 and $250,019 in 1995 (totaling $425,056) and that he received income for those amounts in those years.

Joe Kristan at Roth & Company has much more on the hobby loss aspects of the case.

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Don’t be fooled: Tax Court judges are people too. They live and laugh and love, just like the rest of us. Their highfalutin position may require them to carry themselves with an excess of formality, but deep down, they all eagerly anticipate that rare moment when the court loosens the shackles and allows them to have a little fun.

And when it happens, as it did last week in  Willson v. Commissioner, the results can be both entertaining and educational. Because when formality is sacrificed for simplicity  — as Judge Holmes did in authoring his decision — the takeaway lessons of the case are often easier to absorb.

First, some background: the taxpayer (Willson) chose “S case” status, which allowed him to introduce evidence that would otherwise not be admissible, but more germane to this blog post, also permitted the Tax Court to conduct the trial as informally as possible. Which it most certainly did.

Willson was a bit of an entrepreneur, though not necessarily by choice. He built a bar in 1986 after a gunshot wound prematurely ended his career as an auto mechanic. Willson made considerable improvements to the bar and the surrounding parking lot, only to see the majority of the property burn down courtesy of some faulty hair-band pyrotechnics.

But perhaps we’re best served letting Judge Holmes explain the events leading up to the fire, as he does it quite eloquently; throwing in a brief history of the evolution of late 80’s rock for good measure. His words resemble those not of a reputable adjudicator, but rather those of a disillusioned codger ruminating on all that’s wrong with the world from the sanctity of his front porch, pausing just long enough to implore the neighborhood kids to get a haircut.

His words are, however, awesomely refreshing in their informality:  

With these new stages, the bar became a local mecca for a type of “rock and roll” called “glam metal.” We also took judicial notice that “hairbands” had lost much of their popularity with the coming of something called “grunge rock” (another type of “rock and roll” music) in the early nineties. This was important to Willson’s business because “hair bands,” with such unlikely names as Head East, Great White, and Saturn Cats could still draw large crowds to a bar on the outskirts of Des Moines but had become affordable providers of live entertainment. Willson even invited one of these “hair bands” to be a sort of artist-in-residence. One night in 1994, a few band members did something to a smoke machine that sparked an enormous fire. This fire engulfed everything except the parking lots, the shed, and the property’s original house.

And with that I give you the first — and almost certainly the last– mention of Great White you’ll ever find in a Tax Court decision.

Undeterred by his bad fortune, Willson rebuilt the bar and rented out a portion of it to a new business; one that employed the type of women who was once a  staple in the videos of the very 80’s music that caused the demise of the bar in the first place. Circle of life, I guess.

As Judge Holmes put it:

Willson rented out the old space to a tenant who installed minor improvements and opened an establishment felicitously–and paronomastically–called the “Landing Strip,” in which young lady ecdysiasts engaged in the deciduous calisthenics of perhaps unwitting First Amendment expression.

Now, we here at Double Taxation fancy ourselves as fairly bright individuals, but we’re not ashamed to admit that we only recognized about four words in that sentence. For those of you without a Word of The Day Calendar handy, here’s the best translation we could muster: Willson opened a strip bar with the clever name: The Landing Strip.

In 1999, the city of Des Moines began condemnation proceedings against Willson. Unfortunately for Willson, he wasn’t around to oversee the dealings with the city, as he was about to begin serving a federal prison term for, as Judge Holmes put it, “…something to do with money and drugs and possibly the bar.”

Willson eventually received $203,427 from the city in exchange for his property, leaving the Tax Court to determine the amount — if any — of the gain resulting from the condemnation.

Now typically, the Tax Court has a way of needlessly complicating even the most seemingly straight-forward of concepts through the required references to the statute, regulations, administrative procedures and a near-century of case law, all delivered in the standard legal mumbo jumbo.

And therein lies the beauty of an “S” case: Judge Holmes was permitted to explain the concepts of “amount realized” and “adjusted basis” for purposes of computing Willson’s gain or loss in layman’s terms, which can be a tremendous benefit to young CPAs struggling to grasp these intangible concepts.

 Someone who sells property is taxed on the gain, not the sale price. This gain basically depends on two other numbers: the amount the seller receives and what is called “adjusted basis.”

The amount the seller receives is not just how much cash he pockets. It also includes, for example, money that goes to pay off other debts tied to the property.  The amount that Willson received in this sense (called the“amount realized”) is $203,427.

That leaves us with the “adjusted basis.” To figure out Willson’s gain, we have to subtract the adjusted basis from the amount realized. Basis is pretty much what a property owner paid for the property plus what he later spent to improve it.

A taxpayer can’t generally deduct these payments right away because they provide a benefit that lasts longer than just one taxable year. But before calculating the capital gain the basis must be adjusted under section 1016. And depreciation is one of those adjustments we need to figure out in this case.

Most property doesn’t just fall apart one day, it suffers wear and tear over time. That’s why the Code allows a taxpayer yearly deductions for depreciation over the estimated useful life or recovery period of the property used in a trade or business.

When it was all said and done, the Tax Court held that Willson actually generated a loss on the condemnation, but not before also working through the implications of an involuntary conversion under § 1033 on Willson basis (upon recovering insurance proceeds after the hair-band fire.)

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