Federal Cases: ESOP Fidiciuary Responsibility, Valuation Misstatement Penalties, More

Plus: Bishop v. Commissioner Rules on When and Whether a Bad Debt Loss Can Be a Claimed Deduction

In Schwab v. Commissioner, a case turns on when a variable universal life insurance policy is a taxable event.  In Boone Operations Co., LLC v. Commissioner, find out when contributing fill dirt to the city of Tucson is or isn’t a charitable or taxable event.

Schwab v. Commissioner
2013 U.S. App. LEXIS 8309
April 24, 2013
Judge Smith
Ninth Circuit Court of Appeals

Summary:

Appellant Commissioner of Internal Revenue appealed the partial grant by the United States Tax Court of a petition by appellee taxpayers that challenged the determination of a deficiency in their federal income tax. 

The taxpayers each purchased a variable universal life insurance policy that was subject to surrender charges, which were fees that they would incur if the policies were terminated prior to a contractually specified date. The distribution of the taxpayers’ policies to them was a taxable event, for which the commissioner contended that the full stated policy values had to be treated as income, even though the net cash surrender values were negative.

The court held that it agreed with the tax court that the “amount actually distributed” in 26 U.S.C.S. § 402(b)(2) when the taxpayers received ownership of the life insurance policies was the fair market value of what was actually distributed, and that surrender charges associated with a variable universal life insurance policy could be considered as part of the general inquiry into a policy’s fair market value.

The tax court properly determined that the surrender charges affected the fair market value of the polices and that they did not have significant value apart from the small amount of the insurance coverage that was attributable to the single premium that had been paid on each policy.  The court affirmed the partial grant of the taxpayers’ petition. 

White v. Marshall & Isley Corporation
2013 U.S. App. LEXIS 7831
April 19, 2013
Judge Hamilton
United States District Court for the Eastern District of Wisconsin

Summary:

Plaintiff employees appealed from the U.S. District Court for the Eastern District of Wisconsin, which granted the motion to dismiss of the defendants, comprising an employer and others.  In their action under 29 U.S.C.S. § 1132(a) of the Employee Retirement Income Security Act of 1974 (ERISA), 29 U.S.C.S. § 1001 et seq., the employees asserted that the ESOP’s fiduciaries violated their duty of prudence under 29 U.S.C.S. § 1104. 

The ESOP’s governing document required the fiduciaries to maintain the employer’s stock fund under all circumstances, “no matter how dire.”  The court continued to follow the reasoning of Moench v. Robertson and its progeny, noting that if ESOPs were to fulfill their purposes, fiduciaries who invested in employer stock, or who allowed employees to choose to invest in it—in compliance with the terms of the plan—needed substantial protection from liability for doing so. The court ruled that the employees’ allegations did not state a viable claim for breach of ERISA’s fiduciary duty of prudence during the proposed class period. 

The fiduciaries did not violate ERISA by complying with the terms of the plan by continuing to offer the employer’s stock fund as an investment option during the employer’s 54 percent decline in stock price, a decline that was not extraordinary, but was instead consistent with the rest of the stock market.

Offering the fund did not expose the participants to excessive risk, given the flexibility that the plan gave participants to direct their own investments among a variety of investment options.  The district court affirmed the trial court’s judgment. 

Kerman v. Commissioner
2013 U.S. App. LEXIS 7032
April 7, 2013
Judge Ludington
United States Court of Appeals for the Sixth Circuit

Summary:

Appellee Internal Revenue Service (IRS) disallowed a loss on appellant taxpayer’s income tax return and imposed a 26 U.S.C.S. § 6662(e) valuation misstatement penalty. The taxpayer petitioned for a redetermination of the deficiency. The U.S. Tax Court disallowed the loss deduction and imposed a § 6662(e) penalty, which was increased to 40 percent of the unpaid tax pursuant to § 6662(h).

The taxpayer sought review.  The taxpayer invested in a custom adjustable rate debt structure (hereinafter CARDS), whereby he personally guaranteed the repayment of a foreign currency loan that created a tax benefit by offsetting real taxable income against an artificial tax loss. The IRS and the tax court found that this transaction lacked economic substance because it had no purpose other than creating an income tax benefit. 

On appeal, the court found that the transaction had the hallmarks of a sham transaction: it made no economic sense as a source of financing; but for the claimed tax benefits, the transaction was a losing proposition; and it was expressly designed to create a tax loss even though there was no corresponding economic loss. Imposition of the § 6662(h) penalty was appropriate because the taxpayer failed to establish the § 6664(c)(1) reasonable cause exception; CARDS promotional materials warned that the IRS might challenge it and contained a copy of an IRS notice regarding CARDS transactions; the taxpayer did not reasonably investigate CARDS’ legitimacy; and the taxpayer did not reasonably rely on expert advice since such advice would have seemed to a reasonable person too good to be true.

The appellate court affirmed the tax court’s ruling. 

Boone Operations Co., LLC v. Commissioner
T.C. Memo 2013-101
April 11, 2013
Judge Marvel
United States Tax Court

Summary:

Respondent IRS issued notices of final partnership administrative adjustment (FPAAs) for 2003 and 2004 pursuant to I.R.C. § 6223 to petitioner partnership. In the FPAAs, the IRS disallowed the partnership’s claimed charitable contribution deductions for 2003 and 2004, and the partnership timely contested those determinations.  The partnership owned and operated a landfill in Tucson, Arizona. 

The partnership sold fill dirt to the City of Tucson and claimed charitable contribution deductions related to the alleged bargain sales. Specifically, the partnership claimed that the dirt had an appraised fair market value of $988,848 and the city paid $282,528 in the bargain sales. Thus, the partnership claimed a non-cash charitable contribution deduction of $706,320.

The court found that the partnership failed to satisfy the contemporaneous written acknowledgment requirement of I.R.C. § 170(f)(8).  None of the documents at the time of the sale showed either an acknowledgment of the consideration exchanged or a good-faith estimate of the fair market value of that consideration.

A 2003 settlement agreement between the partnership and the city showed only that the city provided some goods and services, as well as cash, in exchange for the fill. Even if the contemporaneous written acknowledgment requirement had been met, the court found that the partnership failed to prove that the charitable contribution deductions were proper.  The court sustained the IRS determination disallowing the claimed charitable contribution deductions. 

Bishop v. Commissioner
T.C. Memo 2013-98
April 10, 2013
Judge Laro
United States Tax Court

Summary:

Petitioner taxpayer brought an action challenging the determination of respondent Commissioner of Internal Revenue, which disallowed the taxpayer’s claimed deduction for a bad debt loss.  To facilitate a proposed business relationship, the taxpayer loaned money to a corporation, which was experiencing financial difficulties in a declining real estate market, and the taxpayer contended that the debt became worthless.

The court held that the bad debt deduction claimed by the taxpayer was properly disallowed since the taxpayer failed to show that the loan debt was worthless in the applicable tax year. While the taxpayer testified that the debt was worthless, the taxpayer failed to provide testimony from a disinterested party or any documentary evidence, such as the corporation’s balance sheet to corroborate the claim. Further, the corporation remained a going concern into the following tax year, and there was no evidence demonstrating the corporation’s ability or inability to improve its business and generate sufficient income to repay the loan to the taxpayer.  Also, the taxpayer made no attempt to collect the principal of the loan during the tax year and apparently believed the corporation could make interest payments and that the corporation’s financial health would improve.  Decision was entered in favor of the commissioner. 

Peter H. Agrapides, MBA, AVA, is a Principal at Western Valuation Advisors, which has offices in Salt Lake City, Utah, and Las Vegas, Nevada. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. He has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1billion.