Unique, But Important Tax Issues – “Claim of Right”; Passive Loss Grouping; and Bankruptcy Taxation

Overview

It’s not unusual for a taxpayer to present the tax preparer with unique factual situations that aren’t commonplace and have very unique rules.  Today’s post digs into three of those areas that often generate many questions from practitioners, and also aren’t handled easily by tax software.

Unique, but important tax issues - the topic of today’s post.

“Claim of Right” Doctrine Denies Remedy for Stock Sale

Heiting v. United States, No. 19-cv-224-jdp, 2020 U.S. Dist. LEXIS 10967 (W.D. Wisc. Jan. 23, 2020)

In 1932, the U.S. Supreme Court created the “claim of right” doctrine.  American Oil Consolidated v. Burnet, 286 U.S. 417 (1932).  It applies when a taxpayer receives income, but the income is subject to a contingency or other significant restriction that might remove it from the taxpayer.  In that situation, the taxpayer need not recognize the income.  In essence, the doctrine applies when the taxpayer doesn’t have a fixed right to the income.  If the taxpayer ultimately has to return the income that has been recognized, the taxpayer might be entitled to receive an offsetting deduction or a tax credit.  I.R.C. §1341. 

The “claim of right” doctrine arose in a recent Wisconsin federal court case in a rather unique situation.  Under the facts of the case, the plaintiffs, a married couple, created a revocable living trust in 2004 and amended it in 2012. The trust was created under Wisconsin law and named a bank as trustee with a different bank as successor trustee. The trust language gave the trustee broad discretion to invest, reinvest, or retain trust assets. However, the trust barred the trustee from doing anything with the stock of two companies that the trust held. The trustee apparently did not know of the prohibition and sold all of the stock of both companies in late 2015, triggering a taxable gain of $5,643,067.50. The sale proceeds remained in the trust. Approximately three months later, in early 2016, the trustee learned of the trust provision barring the stock sale and repurchased the stock with the trust’s assets. The grantors then revoked the trust later in 2016.

On their 2015 return, the plaintiffs reported the gain on the stock sale and paid the resulting tax. On their 2016 return, the plaintiffs claimed a deduction under I.R.C. 1341 for the tax paid on the stock sale gain the prior year. The IRS denied the deduction and the plaintiffs challenged the denial.  The IRS motioned to dismiss the case. The plaintiffs relied on the “claim of right” doctrine of I.R.C. §1341– they reported the income and paid the tax.  Under I.R.C. §1341, the plaintiffs had to: (1) establish that they included the income from the stock sale in a prior tax year; (2) show that they were entitled to a deduction because they did not have an unrestricted right to the income as of the close of the earlier tax year; and (3) show that the amount of the deduction exceeds $3,000. If the requirements are satisfied, a taxpayer can claim the deduction in the current tax year or claim a credit for the taxes paid in the prior year.

The IRS claimed that the plaintiffs could not satisfy the second element because the plaintiffs were not actually required to relinquish the proceeds of the stock sale. The court agreed, noting that once the stocks were sold the plaintiffs had the unrestricted right to the proceeds as part of the revocable trust, as further evidenced by them revoking the trust in 2016. The court noted that neither the trustee nor the plaintiffs had any obligation to repurchase the stock. The court also noted that under Wisconsin trust law, the plaintiffs could have instructed the trustee to do anything with the proceeds of the stock sale, and that they had the power to consent to the trustee’s action of selling the stock. In other words, they were not duty-bound to require the trustee to buy the stock back. Accordingly, the court determined that I.R.C. §1341 did not provide a remedy to the plaintiffs, and that any remedy, if there was one, would be against the trustee. 

Grouping and the Passive Loss Rules

Eger v. United States, 405 F. Supp. 3d 850 (N.D. Cal. 2019)

 Under I.R.C. §469, the deduction of losses from a “passive activity” is limited to the amount of passive income from all passive activities of the taxpayer.  Stated another way, a passive activity loss is the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for that particular year.  For taxpayers with multiple activities, Treas. Reg. §1.469-4(c)(1) provides for a grouping of legal entities if the activities constitute an appropriate economic unit for the measurement of gain or loss. Also, rental activities can generally be grouped together.  Grouping can be helpful to satisfy the material participation tests of I.R.C. §469 to avoid the application of the passive loss rules.  This grouping issue came up in a recent federal case in Oklahoma involving rental activities. 

In the case, the plaintiff was a real estate professional within the meaning of I.R.C. §469(c)(7) that owned three properties (vacation properties) in different states that he offered for rent via management companies at various times during the year in issue. The plaintiff reserved the right for days of personal use of each rental property. The plaintiff sought to group the vacation rental properties with his other rental activities as a single activity for purposes of the material participation rules of I.R.C. §469. The IRS denied the grouping on the basis that the vacation rental properties were not rental properties on the basis that the average period of customer use for the vacation rentals was seven days or less as set forth in Treas. Reg. §1.469-1T(e)(3)(ii)(A), and that the petitioner was the “customer” rather than the management companies.

The court agreed with the IRS position on the basis that the plaintiff’s retained right to use each vacation property eliminated the management companies from having a continuous or recurring right to use the property when applying the test of Treas. Reg. §1.469-1(e)(3)(iii)(D) providing for measuring the period of customer use. As such, the facts of the case differed substantially from the contracts at issue in White v. Comr., T.C. Sum. Op. 2004-139 and Hairston v. Comr., T.C. Memo. 2000-386.  Thus, the management companies were not customers with a continuous right to use the properties, but merely provided marketing and rental services for the petitioner to rent out the properties. 

Prior Bankruptcy Filings Extends Non-Dischargeability Period

In re Nachimson v. United States, 606 B.R. 899 (Bankr. W.D. Okla. 2019)

The creation of the bankruptcy estate as a new taxpayer, separate from the debtor, highlights the five categories of taxes in a Chapter 7 or 11 case.  Category 1 taxes are taxes where the tax return was due more than three years before filing.  These taxes are dischargeable unless the debtor failed to file a return or filed a fraudulent return.  Category 2 taxes are the taxes due within the last three years.  These taxes are not dischargeable but are entitled to an eighth priority claim in the bankruptcy estate, ahead of the unsecured creditors.  Category 3 taxes are the taxes for the portion of the year of bankruptcy filing up to the day before the day of bankruptcy filing.  If the debtor's year is closed as of the date of filing, the taxes for the first year, while not dischargeable, are also entitled to an eighth priority claim in the bankruptcy estate.  If the debtor's year is not closed, the entire amount of taxes for the year of filing are the debtor's responsibility.  Category 4 taxes are the taxes triggered on or after the date of filing and are the responsibility of the bankruptcy estate.  Taxes due are paid by the bankruptcy estate as an administrative expense.  If the taxes exceed the available funds, the tax obligation remains against the bankruptcy estate but does not return to the debtor.  Category 5 taxes are for the portion of the year beginning with the date of bankruptcy filing (or for the entire year if the debtor's year is not closed) and are the responsibility of the debtor.

In a recent Oklahoma case, the debtor filed Chapter 7 in late 2018 after not filing his 2013 and 2014 returns. The 2013 return was due on October 15, 2014, and the 2014 return was due April 15, 2015. The debtor had previously filed bankruptcy in late 2014 (Chapter 13). That prior case was dismissed in early 2015. The debtor filed another bankruptcy petition in late 2015 (Chapter 11). Based on the facts, the debtor had been in bankruptcy proceedings during the relevant time period, (October 15, 2014, through October 25, 2018) for a total of 311 days. 11 U.S.C. § 523(a)(1)(A) provides, in general, that a discharge of debt in bankruptcy does not discharge an individual debtor from any debt for an income tax for the periods specified in 11 U.S.C. § 507(a)(8). One of the periods provided under 11 U.S.C. § 507(a)(8), contained in 11 U.S.C. § 507(a)(8)(A)(i), is the three years before filing a bankruptcy petition. Also, 11 U.S.C. § 507(a)(8) specifies that an otherwise applicable time period specified in 11 U.S.C. § 507(a)(8) is suspended for any time during which the stay of proceedings was in effect in a prior bankruptcy case or during which collection was precluded by the existence of one or more confirmed bankruptcy plans, plus 90 days.  When a debtor files multiple, successive bankruptcy cases, the ordinary operation of the automatic stay 11 U.S.C. § 507(a)(8) is altered by 11 U.S.C. § 362(c)(3)(A) which specifies that if a debtor had a case pending within the preceding one-year period that was dismissed, then the automatic stay with respect to any action taken with respect to a debt or property securing that debt terminates with respect to the debtor on the 30th day after the filing of the later case.

The debtor sought to have his 2013 and 2014 tax liabilities discharged in the present bankruptcy case under 11 U.S.C. §523(a)(1)(A) on the basis that the filing dates for those returns were outside the three-year look-back period. The IRS took the position that the three-year “look-back” period was extended due to the debtor's bankruptcy filings. The court agreed with the IRS, noting that the three-year look-back period began on October 25, 2015. However, the court concluded that an issue remained as to whether the look-back period extended back 401 days, or only for the first 30 days following each bankruptcy filing as provided by 11 U.S.C. § 362(c)(3)(A). Based on a review of applicable bankruptcy case law, the court concluded that the tolling provision of 11 U.S.C. § 507(a)(8) was not impacted by the automatic nature of 11 U.S.C. § 362(c)(3)(A). Instead, for purposes of the tolling provision, the stay of proceedings was in effect in each of debtor's three previous cases until each was dismissed. Therefore, the court found that the look-back period extended back three years plus 401 days. Since the debtor filed the bankruptcy petition in the present case on October 25, 2018, the three-year plus 401-day look-back period reached back to September 19, 2014. Because the debtor's 2013 and 2014 tax liabilities were due after that date (including the extension for the 2013 liability), neither was dischargeable in the current bankruptcy case. 

Conclusion

Some clients have standard, straightforward returns.  Others have very complicated returns that present very unique issues.  The cases discussed today point out just three of the ways that tax issues can be very unique and difficult to sort out.