Federal Taxation - Cecil M. Cheves and Russell E. Hinds

• Publication year: 2002

Federal Taxationby Cecil M. Cheves^* and

Russell E. Hinds^**

I. Introduction

In 2001 several tax cases were decided by the Eleventh Circuit Court of Appeals that are of interest to the private practitioner. Also, other tax cases were decided by federal district courts within the Eleventh Circuit that likewise are of interest to practitioners. Surveyed within this Article are Eleventh Circuit cases that: (1) determined whether one has standing to sue the IRS after paying another's tax obligation; (2) clarified when attorney fees paid out of a punitive damages award are included in a taxpayer's taxable income; (3) determined when a deduction claimed by an estate is valued—at date of death or date of distribution; (4) determined when a spinoff distribution by a parent corporation of its interest in a subsidiary corporation results in taxable gain; (5) determined that a beneficiary can sue for costs incurred in resolving a non-ascertainable standard problem in a will and a trust; (6) discussed the standards for sham transactions; (7) determined the dischargeability of income tax liability in bankruptcy; and (8) ruled on the anticipatory assignment of income from a covenant not to compete.

II. Standing to Sue the IRS

One of the details confronting a real estate attorney each time he or she closes a loan is paying off outstanding indebtedness secured by the real estate. The attorney must rely on the accuracy of staff preparing the closing documents and payoff information provided by creditors. St. Joe Title Services, Inc. v. United States¹ helped the title agent out of a difficult situation—specifically, a $30,000 error. In St Joe Title Services, Inc., the title company ("Sarasota Title") prepared a settlement statement that erroneously labeled the SunTrust Bank as entitled to receive only $45,384 for the payoff of the loan. However, the outstanding amount left on the mortgage in question was really $75,384. Sarasota Title then mistakenly paid the $30,000 discrepancy to the IRS in excess of what was owed.²

When SunTrust notified Sarasota Title that there was still a $30,000 deficiency in the mortgage's account, Sarastoa Title realized its mistake. It paid the amount owed to SunTrust out of its own pocket and then immediately notified the IRS of the overpayment, requesting a refund check. The IRS refused to refund the overpayment. Sarasota Title then filed suit in the Middle District of Florida. Both parties filed motions for summary judgment.³

Because Sarasota Title was only the closing agent and not the taxpayer in this debacle, the IRS maintained that Sarasota Title had no standing to sue pursuant to 28 U.S.C. Sec. 1346.⁴ The district court rejected this argument, citing to the United States Supreme Court case of United States v. Williams.⁵ In Williams the district court interpreted the Supreme Court to hold that a plaintiff who under protest had paid property taxes that were assessed against a third party in order to remove a cloud on the title of his or her own property does have standing to sue for a tax refund under 28 U.S.C. Sec. 1346 and 26 U.S.C. Sec. 744.⁶ The district court also noted that the Supreme Court's ruling in Williams "gives federal courts jurisdiction to hear 'any civil action against the United States for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected.'"⁷

The IRS attempted to distinguish the instant case from Williams by contrasting the source of monies used to pay the taxes in each case. In Williams the plaintiff herself paid the taxes out of her own pocket. However, in this case Sarasota Title transferred funds to the IRS directly from the equity in the property, which Sarasota Title did not own.⁸ The court was not persuaded by this argument, noting that Sarasota Title "is the party with an out-of-pocket loss of $30,000"⁹ and "is without a realistic remedy in the event that it cannot obtain a refund from the IRS."¹⁰

The court concluded that under the precedent of Williams, "28 U.S.C. Sec. 1346 clearly allows one from whom taxes are erroneously or illegally collected to sue for a refund of those taxes."¹¹ "Although Sarasota Title was not originally assessed the tax, the IRS, by accepting payment after being notified that the payment was sent in error and then refusing to issue a refund, certainly imposed a tax on Sarasota Title."¹² The court found the result to be unfair and that the IRS would obtain a windfall from Sarasota Title if standing to sue were not afforded Sarasota Title.¹³

III. Contingency Fee from Punitive Damages Award and Fee from Post-Judgment Interest Not Taxable Income

When a plaintiff is awarded a large jury verdict that includes punitive damages, must the plaintiff include as taxable income that portion of the award paid in attorney fees? Foster v. United States^14,decided by the Eleventh Circuit in 2001, confirmed that the answer is "no" and that the taxpayer is not to include in his or her income the amount of attorney fees paid out of the jury's award.¹⁵ Following Cotnam v. Commissioner,¹⁶ the court of appeals reasoned that, under attorney lien law, the ownership of the portion of the award representing attorney fees vests in the attorney ab initio. In Foster the taxpayer agreed to pay her attorney a contingent fee of 50% for the trial. For the appeal, the contingent fee arrangement was amended to treat all post-judgment interest collected as an additional contingent fee.¹⁷ The District Court for the Northern District of Alabama held that under Cotnam the taxpayer could treat the originally agreed upon contingent fee as excluded from gross income and received directly by the attorney, but the post-judgment interest paid as the additional contingent fee was includable in the taxpayer's gross income and deductible under the Internal Revenue Code ("I.R.C.") Sec. 212.¹⁸ The district court reasoned that at the point that the contingent fee was negotiated, the taxpayer's claim, which had been upheld by the jury, had value, and the "uncertainties" of the appellate process were insufficient to displace the applicability of assignment of income principles.¹⁹ When the case was considered by the court of appeals, the court affirmed the district court as to the originally agreed upon contingent fee's exclusion from gross income.²⁰ However, the court of appeals differed from the district court with respect to the post-judgment interest paid as the original contingent fee.²¹ The court of appeals held that the post-judgment agreement was analogous to a pre-trial contingency fee agreement, and, thus, because the case arose in Alabama, under Cotnam, the interest retained by the attorney as the fee could not be included in the taxpayer's gross income.²²

IV. Deductions Claimed by Estate Valued at Date of Death

When does an executor value a deduction claimed by the estate under I.R.C. Sec. 2053(a)(3)? In O'Neal v. United States,²³ a case of first impression, the Eleventh Circuit determined that the deduction "must be valued as of the date of the decedent's death."²⁴ Thus, "[ejvents occurring after the decedent's death that alter the value must be disregarded."²⁵

This decision leads to interesting results. In 1987, Mrs. O'Neal made gifts of family company stock to nine of her children and grandchildren. Each of the recipients agreed that upon the transfer of the stock each would contribute on a pro rata basis toward the payment of donee gift tax liability, if any.²⁶ When Mrs. O'Neal died in 1994, her estate took a Schedule K deduction of $9,407,226 pursuant to I.R.C. Sec. 2053(a)(3) for "claims for reimbursement of transfer gift tax liability by donees of 1987 gifts."²⁷ The estate used the government's per share stock values at the time of the stock's transfer in 1987 in reaching the total deduction amount.²⁸ The IRS notfied the nine donees that it would "assert transferee gift tax liability against them based upon its pending revaluation of the family company stock."²⁹ The government appraiser later issued his opinion that resulted in a sevenfold increase in the value of the family company stock. As a result of this drastically increased appraisal value, the IRS assessed additional gift taxes against the donees totaling $9,407,226. After making partial payments totaling $4,244,994, the grandchildren donees filed suit in Tax Court, contesting the IRS revaluation. The Tax Court found that the grandchildren donees were liable for an undetermined amount of gift taxes.³⁰

Eventually, the IRS and the grandchildren donees settled for a significant reduction in the IRS' initial valuation of the family company stock. The children donees who had filed suit in district court soon after settled on likewise terms. Thereafter, the probate court entered an order holding that the claims of the nine heirs were now valid and enforceable and the nine heirs received $563,314 in reimbursement monies from the estate.³¹

Mrs. O'Neal's estate subsequently amended its tax return, reducing the Sec. 2053(a)(3) deduction from $9,407,226 to $563,314. This caused a drastic increase in the value of Mrs. O'Neal's taxable estate, which in turn forced the estate to pay $1.8 million in estate taxes. The estate then filed suit in the Northern District Court of Alabama to resolve whether it was entitled to a refund on the Sec. 2053(a)(3) issue. After the district court found against Mrs. O'Neal's estate, the estate appealed to the Eleventh Circuit Court of Appeals.³²

In considering the refund action, the court of appeals noted that Sec. 2053(a)(3) does not address when a claim against an estate must be valued. The court acknowledged that ordinarily only personal obligations of decedents present at the time of death may be deducted, regardless of whether the personal obligations are then matured.³³ However, the court also recognized that the Treasury Regulations accompanying Sec. 2053(a)(3) provide that such a deduction may be allowed even '"though its...