Federal Taxation - Michael H. Plowgian, Svetoslav S. Minkov, and Mark S. Davis

• Publication year: 2007

Federal Taxationby Michael H. Plowgian^* Svetoslav S. Minkov^** and Mark S. Davis^***

I. Introduction

While the legal holdings of the tax cases decided in the Eleventh Circuit in 2006 do not appear remarkable at first blush, the cases present somewhat conflicting considerations of equity that make them noteworthy. The Eleventh Circuit held in Ellinger v. United States¹ that a taxpayer, who owned half of the stock in three S corporations, could not rely on language in a closing agreement between the Internal Revenue Service (the "Service") and one of the corporations to determine his tax liability with respect to transactions between the first corporation and the other two corporations.² Reversing a district court decision, the Eleventh Circuit held in Wachovia Bank, N.A. v. United States³ that the three-year statute of limitations on filing a tax refund claim applied to a trustee corporation that filed a return when it was not required to do so.⁴ In McGowan v. Commissioner,⁵ the Eleventh Circuit affirmed a Tax Court decision providing that the Service cannot rely solely on an individual's criminal tax conviction for filing false returns to establish that he had the specific intent to evade taxes.⁶ In Steffen v. United States,⁷ the U.S. District Court for the Middle District of Florida affirmed a bankruptcy court decision denying an individual's refund request pursuant to Sec. 1341⁸ of the Internal Revenue Code of 1986, as amended (the "Code"),⁹ for a failure to establish a nexus between income included in a prior taxable year and the individual's later disgorgement of property as a result of Securities and Exchange Commission ("SEC") litigation against the taxpayer's spouse.¹⁰ Finally, in Planes v. United States,¹¹ a magistrate judge in the U.S. District Court for the Middle District of Florida held that the Service did not abuse its discretion in finding that a CEO breached an offer in a compromise agreement with the Service when a corporation for which the CEo was a responsible person failed to pay its taxes, even though the notice of such breach never reached the CEo.¹²

II. Eleventh Circuit Cases

A. Closing Agreements Strictly Construed

In Ellinger v. United States,¹³ the Eleventh Circuit held that the taxpayer provided insufficient evidence of valid loans between three subchapter S corporations in which the taxpayer owned a fifty percent interest; therefore, the taxpayer was not entitled to a refund based on increased basis in the stock of two of the corporations.¹⁴ The Eleventh Circuit ruled that the taxpayer could not rely on language in a closing agreement, pursuant to Sec. 7121,¹⁵ between the Service and one such corporation to establish that the advances in question were bona fide loans with respect to the other corporations.¹⁶

Emery Ellinger, III ("Ellinger")¹⁷ was the owner of a fifty percent interest in three closely held corporations: Aberdeen Marketing, Inc. ("Aberdeen"), GlobalTel, Inc. ("GlobalTel"), and ProMail, Inc. ("Pro-Mail").¹⁸ Aberdeen, GlobalTel, and ProMail each elected to be treated as subchapter S corporations pursuant to Sec. 1361.¹⁹ In 1995 Aberdeen made monetary transfers of $78,659 to GlobalTel and $469,916 to ProMail. In its accounting records, Aberdeen initially characterized these transfers as debt obligations owed by GlobalTel and ProMail.²⁰

At the end of 1995, Aberdeen made adjustments to its books and recharacterized the transfers as though it had distributed cash to Ellinger and Ellinger had contributed the cash to GlobalTel and ProMail.²¹ This deemed distribution and contribution, if respected by the Service, would have increased Ellinger's basis in his stock of GlobalTel and ProMail, which would have enabled Ellinger to claim additional net operating losses allocable to Ellinger from such corpora-tions.²²

The Service audited Ellinger's 1995 federal income tax return and rejected Ellinger's characterization of the transfers as deemed distributions and contributions.²³ Ellinger settled the dispute with the Service, and each of the three corporations entered into a closing agreement with the Service under Sec. 7121²⁴ of the Code.²⁵ The closing agreement between the Service and Aberdeen stated that "advances made by the taxpayer [Aberdeen] to GlobalTel in the amount of $78,659 and to ProMail in the amount of $469,916 constitute[d] genuine indebtedness owed by GlobalTel and ProMail to the taxpayer [Aberdeen] as of December 31, 1995."²⁶ The Service entered into separate written agreements with GlobalTel and ProMail. In those agreements, however, the transfers were not explicitly characterized as debt.²⁷ Instead, the two closing agreements stated that "[n]one of the amount of [funds] advanced by Aberdeen to [either GlobalTel or ProMail] in 1995 is attributable to loans from, or paid in capital contributed by, [either GlobalTel or ProMail]'s shareholders for purposes of determining shareholder basis under I.R.C. Sec. 1367."²⁸

In 1996 Aberdeen acquired all of the assets of GlobalTel and ProMail, and both companies ceased to exist as independent entities. Apparently no written document governed this acquisition.²⁹ In connection with the acquisition, Aberdeen made adjustments to its accounting records to write off the advances owed to it by GlobalTel and ProMail.³⁰

Five years later, the U.S. Supreme Court decided Gitlitz v. Commis-sioner.³¹ In Gitlitz the Supreme Court held that cancellation of debt ("CoD") income constitutes an "item of income" under Sec. 1366³² of the Code, even if it is excluded from gross income for tax purposes under Sec. 108(a)³³ of the Code.³⁴ As such, CoD income recognized by a sub-chapter S corporation passes through to the shareholders of the corporation and increases the shareholders' basis in the stock of the subchapter S corporation.³⁵ The increased basis can then be used by the shareholders to claim previously suspended losses.

In the wake of Gitlitz, Ellinger filed an amended tax return for the tax year 1996, wherein he claimed additional net operating losses attributable to GlobalTel and ProMail. Ellinger claimed that GlobalTel and ProMail recognized CoD income when Aberdeen acquired their assets and wrote off the debts owed to Aberdeen. Thus, Ellinger claimed that his basis in the stock of GlobalTel and ProMail was increased by his proportionate share of such income, thereby allowing him to claim additional suspended losses and carry them back.³⁶ Accordingly, Ellinger filed amended returns for 1994 and 1995 and sought refunds in the amount of $1,146 and $111,596, respectively. The Service denied Ellinger's claim for a refund, and Ellinger filed suit.³⁷

Ellinger contended that the language in the Aberdeen closing agreement, in which the transfers from Aberdeen to GlobalTel and ProMail were characterized as "'genuine indebtedness,'" established that the transfers were debt as between the three corporations and that the write-off of the advances by Aberdeen gave rise to COD income.³⁸ The Service disagreed, arguing that the advances were not genuine indebtedness and the closing agreement with Aberdeen did not make the advances debt with respect to GlobalTel and ProMail.³⁹

The magistrate judge who heard the case first determined whether the advances were debt or equity by applying the multi-factor analysis established in Lane v. United States.⁴⁰ Under this analysis, the magistrate judge found that the advances lacked the characteristics of bona fide indebtedness and that the advances were more likely capital contributions by Aberdeen to GlobalTel and ProMail.⁴¹ Additionally, the magistrate judge agreed with the Service that the closing agreements with the three corporations must be read as separate contracts and that there was nothing in the GlobalTel or ProMail agreements to suggest that the advances were debt with respect to those corpora- tions.⁴² Because there was no debt to be cancelled, there was no COD income to pass through to Ellinger, and thus Ellinger was not entitled to the claimed losses. The district court adopted the report of the magistrate judge and granted summary judgment in favor of the Service.⁴³

The Eleventh Circuit affirmed the district court, essentially reiterating the analysis of the magistrate judge.⁴⁴ The court applied the multi-factor test from Lane to determine whether the advances were debt for income tax purposes and concluded that they were not.⁴⁵ The court noted, in particular, that (1) there were no promissory notes executed in connection with the advances, (2) there was no evidence to show that the purported loan had a fixed maturity date (which the court considered highly probative), (3) no interest was charged in connection with the advances, and (4) Aberdeen apparently expected to collect on the advances only if GlobalTel and ProMail became profitable.⁴⁶

The court then turned to Ellinger's argument that the closing agreement between Aberdeen and the Service conclusively established that the advances were debt.⁴⁷ The court first noted that a closing agreement is to be strictly construed and that premises not specifically addressed in the agreement are not binding on the parties.⁴⁸ Because this case involved Ellinger in his capacity as a shareholder of GlobalTel and ProMail, the closing agreement with Aberdeen was irrelevant to the issue in the case. Thus, the court looked solely to the closing agreements with GlobalTel and ProMail.⁴⁹

The court concluded that the closing agreements with GlobalTel and ProMail did not state that the advances were loans but instead left considerable uncertainty concerning how the advances should be treated for tax purposes.⁵⁰ Indeed, in footnote 11, the court discussed the characterization difficulties noted supra in footnote 41 of this Article.⁵¹ The court noted that the advances could be one of only three things: gifts, capital contributions, or loans.⁵² The parties agreed that the transfers were not gifts, and the closing agreements appeared to suggest that the advances...