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Federal Tax Research Bulletin - The Latest Tax and Accounting Articles


Parker's Federal Tax Bulletin
Issue 200     
July 2, 2019    

 

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 1. In This Issue ... 

 

Tax Briefs

Taxpayer Forfeited Right to Exempt IRA From Bankruptcy; Court Denies Summary Judgment for Taxpayer in FBAR Case; IRS Issues Final and Temp Regs on GILTI, Subpart F, and Foreign Tax Credit; Prop. Regs Address Tax Treatment of Domestic Partnerships with Foreign Partners ...

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Final Regs Address Employment Taxes for Disregarded Entities Owned by a Partnership

The IRS issued a final regulation clarifying that, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. Thus, taxpayers that are partners in a partnership that owns a disregarded entity cannot participate in certain tax-favored employee benefit plans of the disregarded entity. T.D. 9869.

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District Court Applied Wrong Definition of "Willful" in Return Preparer Penalty Case

The Ninth Circuit reversed and remanded a decision in which a district court held that, under Code Sec. 6694(b)(2)(A), a return preparer willfully understated tax on returns he prepared. According to the Ninth Circuit, the district court incorrectly included recklessness in the definition of "willful." Rodgers v. U.S., 2019 PTC 233 (9th Cir. 2019).

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Eleventh Circuit Reverses District Court, Upholds Taxpayer's Sec. 1341 Refund Claim

The Eleventh Circuit reversed a district court's judgment against a taxpayer and concluded that the taxpayer had a right to recover the taxes she paid on $300,000 of income, when she repaid that amount to her former husband as part of a $600,000 breach-of-fiduciary settlement he reached with his sister regarding a family owned business. The Eleventh Circuit held that the taxpayer met the requirements under Code Sec. 1341 and rejected the government's contention that the taxpayer was required to return the funds not to her ex-husband but to their "actual owner" in order to qualify for relief under Code Sec. 1341. Mihelick v. U.S., 2019 PTC 226 (11th Cir. 2019).

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Farm in Chapter 11 Bankruptcy Can't Convert to Chapter 12 to Obtain More Favorable Treatment of Capital Gains

A bankruptcy court rejected a farm's request to convert its Chapter 11 bankruptcy to Chapter 12 bankruptcy and to change its tax classification from a partnership to a corporation in order to allow the farm's capital gains tax liabilities to be discharged as a general unsecured claim. The court held that the farm was not eligible for Chapter 12 when it filed its petition and that changing its tax classification would violate the Bankruptcy Code and would be detrimental to the farm's creditors. In re Schroeder Brothers Farms of Camp Douglas LLP, 2019 PTC 210 (Bankr. W.D. Wis. 2019).

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Author's Royalty Income from Publishing Contracts Was Subject to Self-Employment Taxes

The Tax Court held that all of an author's royalty income derived from her contracts with publishing companies was allocable to her trade or business of writing and was therefore subject to self-employment tax under Code Sec. 1401. The court rejected the taxpayer's contention that a portion of the royalty payments represented a separate and distinct amount paid for her brand. Slaughter v. Comm'r, T.C. Memo. 2019-65.

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Tax Court Lacked Jurisdiction Because No Notice of Determination Was Issued

The Tax Court held that it lacked jurisdiction to consider whether the IRS should have given a taxpayer a collection due process (CDP) hearing because the taxpayer, after receiving a notice of federal tax lien filing, failed to timely request a CDP hearing and the IRS closed the case without conducting a hearing or issuing a notice of determination. The court rejected the taxpayer's argument that under Buffano v. Comm'r, T.C. Memo. 2007-32, the court should dismiss for lack of jurisdiction on the grounds that the IRS failed to satisfy the requirements for issuing a valid notice of federal tax lien filing, finding that this case was distinguishable because the taxpayer did not show that its last known address was one other than the address used by the IRS. Atlantic Pacific Management Group, LLC v. Comm'r, 152 T.C. No. 17 (2019).

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Early Withdrawal Did Not Render Debtor's Annuity Nonexempt in Chapter 7 Bankruptcy

A bankruptcy court held that a married couple's annuity account, which they formed 15 days before filing a Chapter 7 bankruptcy petition, was exempt from the bankruptcy estate under Wisconsin law because it was a tax-deferred account under Code Sec. 72 and was payable on death. The court found that the annuity contained the required death benefit language in Code Sec. 72(s), the annuity's early withdrawal provision did not render the principal non-tax-deferred, and that there was no evidence that the debtors transferred assets with the intention of defrauding creditors. In re Kluck, 2019 PTC 229 (Bankr. W.D. Wis. 2019).

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 2. Tax Briefs 

 

Bankruptcy

Taxpayer Forfeited Right to Exempt IRA From Bankruptcy: In In re Yerian, 2019 PTC 244 (11th Cir. 2019), the Eleventh Circuit affirmed decisions by a district court and a bankruptcy court and held that a taxpayer forfeited the right to exempt his individual retirement accounts (IRAs) from bankruptcy administration and shield his IRA from creditors when he engaged in self-dealing transactions prohibited by the IRA's governing instruments. The taxpayer, who titled IRA-owned cars in his own name and his wife's name and used IRA funds to purchase a condo which he used for personal purposes, had incurred over $100,000 in tax penalties for abusing his IRA.

 

International

Court Denies Summary Judgment for Taxpayer in FBAR Case: In U.S. v. Dadurian, 2019 PTC 247 (S.D. Fla. 2019), a district court held that, regardless of whether it used "recklessness," "willful blindness," or even "knowingly" to define the term "willfulness" in determining if a taxpayer willfully failed to file financial bank account reports (FBARs), circumstantial evidence existed that the taxpayer willfully failed to file FBARs for five financial accounts. Accordingly, the court denied the taxpayer's motion for partial summary judgment and found that there were genuine issues for trial as to whether the taxpayer may be penalized for failing to report such financial accounts.

IRS Issues Final and Temp Regs on GILTI, Subpart F, and Foreign Tax Credit: In T.D. 9866, the IRS issued (1) final and temporary regulations that provide guidance to determine the amount of global intangible low-taxed income (GILTI) included in the gross income of certain U.S. shareholders of foreign corporations, including the U.S. shareholders that are members of a consolidated group, (2) final regulations relating to the determination of a U.S. shareholder's pro rata share of a controlled foreign corporation's subpart F income included in the shareholder's gross income, as well as certain reporting requirements relating to inclusions of subpart F income and global intangible low-taxed income, and (3) final regulations relating to certain foreign tax credit provisions applicable to persons that directly or indirectly own stock in foreign corporations. This guidance obsoletes Notice 2009-7 and Notice 2010-41.

Prop. Regs Address Tax Treatment of Domestic Partnerships with Foreign Partners: In REG-101828-19, the IRS issued proposed regulations on the treatment of domestic partnerships for purposes of determining amounts included in the gross income of their partners with respect to foreign corporations. The IRS also issued proposed regulations under the global intangible low-taxed income provisions regardi-g gross income that is subject to a high rate of foreign tax.

 

Penalties

No Reduction in Prison Sentence for Taxpayer Who Scammed Investors: In U.S. v. Rosen, 2019 PTC 245 (8th Cir. 2019), the Eighth Circuit upheld a more than five-year prison sentence handed down by a district court to a taxpayer who pled guilty to one count of engaging in monetary transactions involving property derived from unlawful activity and one count of tax fraud. The taxpayer had sold multiple investors on his business plans regarding the training and sale of highly-trained security dogs and the creation of a luxury dog-boarding facility, but used the investors' money instead to bankroll his daughter's wedding and his lifestyle, which included luxury vacations, designer handbags and watches, and diamond jewelry.

Company Should Have Disclosed Insurance Transaction Similar to a Listed Transaction: In Interior Glass Systems v. U.S., 2019 PTC 241 (9th Cir. 2019), the Ninth Circuit affirmed a district court and held that a company that joined a group life insurance term plan to fund a cash-value life insurance policy, which was owned by the company's sole shareholder and only employee, was liable for penalties for failing to disclose the existence of the transaction, which the court found to be substantially similar to a listed transaction. The court also held that the taxpayer's procedural due process rights were not violated when it was required to pay penalties for non-disclosure in full before seeking judicial review.

 

Procedure

Supreme Court Refuses to Overrule Deference Doctrine: In Kisor v. Wilkie, 2019 PTC 248 (S. Ct. 2019), the Supreme Court refused to overrule the decisions in Auer v. Robbins, 519 U.S. 452 (1997) and Bowles v. Seminole Rock & Sand Co., 325 U.S. 410 (1945) and thus rejected calls to discard the deference those decisions give to government agencies. However, the Court said the deference doctrine is not always appropriate and remanded the case to the Federal Circuit to decide whether that doctrine applies to a decision by the Board of Veterans' Appeals, which was based on its interpretation of a Department of Veterans Affairs rule governing the retroactivity of a veteran's claim for disability benefits.

Interest Is Allowable on Payment Incorrectly Applied by IRS: In CCA 201926001, the Office of Chief Counsel advised that interest was allowable on the refund of a remittance made by a non-liable spouse that the IRS incorrectly applied to the liable spouse's tax liability. The interest is allowable on the overpayment from the date the remittance was received and applied by the IRS to the date the overpayment is either credited or refunded.

 

Tax Return Preparer Penalties

Court Affirms Taxpayer's Prison Sentence for Aiding the Filing of False Returns: In Kadiri v. U.S., 2019 PTC 242 (4th Cir. 2019), the Fourth Circuit affirmed a district court's 48-month sentence imposed on a taxpayer after a jury convicted her of two counts of aiding or assisting in the filing of false tax returns in violation of Code Sec. 7206(2), and two counts of willfully failing to file tax returns in violation of Code Sec. 7203. The court rejected the taxpayer's challenges to the district court's application of an abuse-of-trust enhancement, as well as the court's reliance on the findings underlying the enhancement to justify an upward variance sentence.

 

Tax-Exempt Organizations

Prop. Regs Provide Guidance on Net Investment Excise Tax for Colleges and Universities: In REG-106877-18, the IRS issued proposed regulations for determining the Code Sec. 4968 excise tax applicable to the net investment income of certain private colleges and universities, as provided by the Tax Cuts and Jobs Act of 2017. The proposed regulations clarify a number of definitions related to the excise tax and make use of a number of existing statutory and regulatory provisions in defining students, tuition, exempt purpose, fair market value, net investment income and related organizations.

 

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 3. In-Depth Articles 

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Final Regs Address Employment Taxes for Disregarded Entities Owned by a Partnership

The IRS issued a final regulation clarifying that, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity. Thus, taxpayers that are partners in a partnership that owns a disregarded entity cannot participate in certain tax-favored employee benefit plans of the disregarded entity. T.D. 9869.

Background

Generally, under Reg. Sec. 301.7701-2(c)(2)(i), a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner (i.e., a disregarded entity). However, Reg. Sec. 301.7701-2(c)(2)(iv)(B) provides that an entity that is a disregarded entity is treated as a corporation for purposes of employment taxes. Therefore, the disregarded entity, rather than the owner, is considered to be the employer of the entity's employees for employment tax purposes and is required to file the appropriate employment tax returns. While Reg. Sec. 301.7701-2(c)(2)(iv)(B) treats a disregarded entity as a corporation for employment tax purposes, this rule does not apply for self-employment tax purposes.

In 2016, the IRS issued a temporary regulation (T.D. 9766) clarifying the employment tax treatment of partners in a partnership that owns a disregarded entity. Before that, the regulations did not explicitly address situations in which the owner of a disregarded entity is a partnership, and the IRS noted that some taxpayers were reading the regulations to permit the treatment of the individual partners in a partnership that owned a disregarded entity (either directly or through tiered partnerships) as employees of the disregarded entity. Taxpayers found their way to this interpretation, the IRS said, because the regulations did not include a specific example applying the general rule in the partnership context. Under this reading of the rules, which the IRS stressed was not intended, partners were participating in certain tax-favored employee benefit plans to which they were otherwise not entitled to participate.

Final Regulations

Reg. Sec. 301.7701-2(c)(2)(iv)(C)(2) clarifies that a disregarded entity that is treated as a corporation for purposes of employment taxes is not treated as a corporation for purposes of employing its individual owner, who is treated as a sole proprietor, or employing an individual who is a partner in a partnership that owns the disregarded entity. Rather, the entity is disregarded as an entity separate from its owner for this purpose. The IRS notes that existing regulations already provide that the entity is disregarded for self-employment tax purposes and specifically notes that the owner of an entity treated in the same manner as a sole proprietorship under Reg. Sec. 301.7701-2(a) is subject to tax on self-employment income. Accordingly, if a partnership is the owner of a disregarded entity, the partners in the partnership are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

Observation: In the preamble to the temporary regulation, the IRS requested comments on the appropriate application of the principles of Rev. Rul. 69-184 to tiered partnership situations, the circumstances in which it may be appropriate to permit partners to also be employees of the partnership, and the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if Rev. Rul. 69-184 were to be modified to permit partners to also be employees in certain circumstances. The holding in Rev. Rul. 69-184, which the IRS notes still applies, provides that: (1) bona fide members of a partnership are not employees of the partnership within the meaning of the employment tax provisions in the Code, and (2) a partner who devotes time and energy in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. One practitioner asked the IRS to consider an exception to the principles of Rev. Rul. 69-184 for publicly traded partnerships, but the IRS declined to make an exception at this time. In the final regulation, the IRS did not address the application of Rev. Rul. 69-184 in tiered partnership situations but said it is continuing to look at the application of Rev. Rul. 69-184.

For a discussion of the employment tax treatment of partners in a partnership that owns a disregarded entity, see Parker Tax ¶20,590.

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District Court Applied Wrong Definition of "Willful" in Return Preparer Penalty Case

The Ninth Circuit reversed and remanded a decision in which a district court held that, under Code Sec. 6694(b)(2)(A), a return preparer willfully understated tax on returns he prepared. According to the Ninth Circuit, the district court incorrectly included recklessness in the definition of "willful." Rodgers v. U.S., 2019 PTC 233 (9th Cir. 2019).

Background

John Q. Rodgers is a CPA and tax attorney who has worked in his own practice since 1986. During 2009 and 2010, the years at issue, Ramon Barbieri, also a CPA, was Rodgers' partner. For the years at issue, Rodgers' firm prepared personal tax returns for Joseph Ross and Scott Keller. Rodgers also prepared corporate tax returns for Rossmith Packaging, Inc., Ross Pac, Inc., and Freshtech Inc. (the companies), which were owned and operated by Ross and Keller. Dana Styck was the bookkeeper/controller of the companies.

The companies shared office space and expenses. Rossmith generally paid the companies' expenses. Ross Pac and Freshtech occasionally made payments to Rossmith, which Rossmith would allocate to various expenses. Funds not otherwise allocated went into a "suspense account." All of the companies had suspense accounts, although Barbieri directed Styck to rename Rossmith's suspense account "corporate operating expenses." In 2009, Ross Pac transferred $212,000 to Rossmith, which Rossmith entered in its corporate operating expense account. Styck entered the $212,000 payment in Ross Pac's cost of goods sold (COGS) account at the direction of Rodgers' firm. There was no evidence that Ross Pac purchased $212,000 of goods from Rossmith.

Rossmith's tax returns for 2009 and 2010, which Rodgers prepared, understated income by not including funds received from Ross Pac and Freshtech that were not reimbursements. Rossmith's 2009 return overstated deductions for salaries, taxes and other expenses by including amounts for which it did receive reimbursements. Rossmith's 2010 return claimed deductions for expenses related to Keller's condominium that were also claimed by Keller on his personal return and that were not, in any event, business-related expenses. Ross Pac's 2009 return overstated its deduction for salaries by including over $202,000 of expenses that were paid by Rossmith and were not reimbursed by Ross Pac. Ross Pac overstated its COGS by including the $212,000 transfer to Rossmith and by including payroll tax expenses it did not incur. Ross Pac's and Freshtech's 2010 returns overstated various expenses, including rental expenses and expenses for dues and subscriptions.

The IRS assessed nine penalties against Rodgers for willful or reckless understatements of tax on returns prepared for Keller, Ross, and their companies. Under Code Sec. 6694(b)(1), any tax return preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to willful or reckless conduct must pay a penalty with respect to each such return or claim in an amount equal to the greater of $5,000, or 75 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim. Code Sec. 6694(b)(2)(A) defines willful or reckless conduct to include a return preparer's willful attempt to understate tax liability on a return, while Code Sec. 6694(b)(2)(B) penalizes a return preparer's reckless or intentional disregard of rules or regulations. Rodgers paid the penalties and sued for a refund in a district court.

The district court upheld the penalty assessments, finding that understatements on the returns prepared by Rodgers were willful or done in reckless or intentional disregard of IRS rules or regulations. In reaching this conclusion, the district court determined that under Safeco Ins. Co. of Am. v. Burr, 551 U.S. 47 (2007), the definition of willfulness in Code Sec. 6694(b)(2)(A) includes reckless disregard.

The district court determined that Rodgers willfully understated tax based on several findings. The court noted that although Rodgers' standard practice was to have someone other than himself review the returns after their initial preparation, he did not require that reviewin the cases of Ross's, Keller's, or the companies' returns. The court found that Rodgers' firm directed Styck to classify the $212,000 payment from Ross Pac to Rossmith as COGS when Ross Pac did not purchase any goods from Rossmith. The district court found that Rodgers and his associates directed Styck to make other changes to the companies' general ledgers and profit and loss statements but never reviewed the general ledgers when preparing the tax returns. According to the district court, its finding of willfulness was supported by the fact that Rossmith's profit and loss statements had four iterations, which were necessary due to negative balances indicating that items were not adequately characterized. The district court said that the negative balances created a situation in which a tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. The district court concluded that Rodgers did not make reasonable inquiries in a situation which required him to do so.

In his appeal to the Ninth Circuit, Rodgers argued that there was insufficient evident to sustain the penalties against him and that the district court erred by defining willful in Code Sec. 6694(b)(2)(A) to include recklessness.

Ninth Circuit's Analysis

The Ninth Circuit reversed the district court and remanded because it agreed with Rodgers that the district court applied the wrong definition of "willful" for purposes of Code Sec. 6694(b)(2)(A). The Ninth Circuit found that willfulness requires a conscious act or omission made in the knowledge that a duty is therefore not being met. According to the Ninth Circuit, the definition of "willful" in Code Sec. 6694(b) is the same as the definition used in Code Sec. 7206, which criminalizes the making of false or fraudulent statements on tax returns. The Ninth Circuit noted that in U.S. v. Bishop, 412 U.S. 346 (1973), the Supreme Court explained that the definition of "willful" does not include recklessness.

Because it found that the district court applied the wrong definition of "willful" in Code Sec. 6694(b)(2)(A), the Ninth Circuit remanded to the district court to reconsider, in the first instance, whether the penalties predicated solely on violations of Code Sec. 6694(b)(2)(A) - the penalties assessed for the tax returns of Rossmith, Ross Pac, and Freshtech - remained justified in light of the evidence adduced at trial.

However, the Ninth Circuit affirmed the district court's findings concerning the penalties assessed under Code Sec. 6694(b)(2)(B) for the Keller and Ross personal returns. The Ninth Circuit found that the district court's conclusion that Rodgers recklessly or intentionally disregarded tax rules or regulations was based on an application of the correct statutory standard, and was not clearly erroneous.

For a discussion of tax return preparer understatement penalties, see Parker Tax ¶276,305.

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Eleventh Circuit Reverses District Court, Upholds Taxpayer's Sec. 1341 Refund Claim

The Eleventh Circuit reversed a district court's judgment against a taxpayer and concluded that the taxpayer had a right to recover the taxes she paid on $300,000 of income, when she repaid that amount to her former husband as part of a $600,000 breach-of-fiduciary settlement he reached with his sister regarding a family owned business. The Eleventh Circuit held that the taxpayer met the requirements under Code Sec. 1341 and rejected the government's contention that the taxpayer was required to return the funds not to her ex-husband but to their "actual owner" in order to qualify for relief under Code Sec. 1341. Mihelick v. U.S., 2019 PTC 226 (11th Cir. 2019).

Background

From 1999 to 2004, Nora Mihelick and her then-husband, Michael Bluso, lived in Ohio and worked at Gotham Staple Company, a closely held corporation owned by Bluso's family. Mihelick worked for the company, planning events, caring for and maintaining the homes of Bluso's parents, and handling administrative tasks. Bluso was the CEO of Gotham and the majority shareholder. Both Mihelick and Bluso earned income for their roles at Gotham, and the couple filed joint tax returns that included Bluso's income during those years.

In 2004, Mihelick filed for divorce. While the divorce was pending, Pamela Barnesone of Bluso's sisters, who was a minority shareholder at Gothamsued Bluso, Gotham, and others. Barnes claimed that Bluso had breached his fiduciary duties by excessively compensating himself at Gotham's expense. Mihelick was not a party to the litigation, but Bluso wanted her to share any resulting liability from Barnes's lawsuit. To Bluso, Mihelick had also reaped the benefits of his compensation, so she should share the burdens of his compensation as well. Bluso and Mihelick eventually agreed that they would be jointly and severally liable for any liability from the Barnes litigation. Specifically, the agreement clarified that the liability arose from the acquisition of marital assets, and since the marital assets had been equally divided, the liability was deemed to be a marital liability.

Mihelick and Bluso finalized their divorce in 2005, but the Barnes litigation continued. In 2007, Bluso settled with Barnes for $600,000. Bluso paid Barnes the $600,000 and took a tax deduction for his half of the payment, $300,000. Bluso looked to Mihelick to cover her half of the $600,000 liability, but Mihelick resisted paying. Bluso withheld alimony and threatened to deprive her of more support. After contentious negotiations, during which Mihelick's lawyer told her she had an obligation to pay, Mihelick paid Bluso $300,000 in 2009.

On her 2009 tax return, Mihelick claimed a refund of the taxes she had previously paid on the $300,000. However, unlike what it had done with Bluso, the IRS denied Mihelick's claim for a refund because she had paid the money to Bluso instead of returning the money directly herself. Mihelick sought relief in a district court, but the district court agreed with the government and granted summary judgment against Mihelick. Mihelick appealed to the Eleventh Circuit.

Code Section 1341

Under Code Sec. 1341, a taxpayer is entitled to either a deduction from current year's taxes or a credit for the amount that tax was increased in a prior year as a result of including an item in income that the taxpayer later returned if the following four requirements are met: (1) the income was included in a prior year's gross income because it appeared the taxpayer had an unrestricted right to the income; (2) the taxpayer actually did not have an unrestricted right to the income; (3) the amount to which the taxpayer did not have an unrestricted right exceeded $3,000; and (4) that amount is deductible under another provision of the Code. The first requirement is met if the taxpayer sincerely believed he or she had an unrestricted right to the income. To satisfy the second requirement, the taxpayer must demonstrate that the income was involuntarily given away because of some obligation and the obligation had a substantive nexus to the original receipt of the income.

Observation: Congress enacted Code Sec. 1341 in response to the Supreme Court's decision in U.S. v. Lewis, 340 U.S, 590 (1951), in which a taxpayer who paid tax on a $22,000 bonus in 1944 learned two years later that the bonus was improperly computed and had to return $11,000 of the bonus. The taxpayer tried to recalculate his 1944 taxes, but the Supreme Court ruled that he could deduct $11,000 from his 1946 return only, not the 1944 tax return. Lewis was seen as unfair because, since factors like tax rates and income brackets may change from year to year, the taxpayer still may have unnecessarily paid taxes on income that he turned out not to have.

The government argued that Mihelick did not appear to have an unrestricted right to the income in question because she had no presumptive right to Bluso's income and, even if she did, Bluso could not have claimed an unrestricted right to the income because he knowingly misappropriated it from Gotham. The government also said that Mihelick was not obligated to return the $300,000. The government's position was that a taxpayer lacks an unrestricted right to an item of income (i.e., the second requirement of Code Sec. 1341) only if he or she returned the income to its "actual owner" and Mihelick did not meet this requirement because she returned the income to Bluso, not to Barnes.

Eleventh Circuit's Analysis

The Eleventh Circuit reversed the district court and remanded for it to reconsider whether there was any dispute that Mihelick met the requirements of Code Sec. 1341. The Eleventh Circuit explained that the first requirement of Code Sec. 1341 was met because Mihelick sincerely believed she had a right to Bluso's income, and the government's challenge to the correctness of that belief made no difference. With respect to the second requirement of Code Sec. 1341, the court rejected the government's argument that Bluso did not appear to have an unrestricted right to the income, reasoning that there was no proof that he knowingly misappropriated the funds and that his settlement agreement expressly disclaimed any wrongdoing. The Eleventh Circuit also found that Mihelick did not have an unrestricted right to the $300,000. The court said that Mihelick involuntarily gave up the income because she reasonably anticipated litigation, and payments to settle a lawsuit may constitute an involuntary obligation for purposes of Code Sec. 1341. The court also found that there was a substantive nexus between Mihelick's obligation to pay and the receipt of the original income because the income was presumptively for Mihelick and Bluso's shared marital estate and Barnes sued to recover it on grounds that it was allegedly wrongfully dispensed to the couple as income. The court rejected the government's contention that Mihelick had to have returned the income to its "actual owner." In the court's view, the government was arguing for a new requirement that lacked a basis in the statutory text and was inconsistent with the purpose of Code Sec. 1341.

Finally, the Eleventh Circuit determined that the fourth requirement of Code Sec. 1341 was met because Mihelick could deduct the $300,000 under Code Sec. 165(c)(1), which allows a corporate officer to deduct the amount to settle a bona fide suit alleging mismanagement of corporate affairs, if the allegations are directly connected with the taxpayer's business activity. The court explained that since Mihelick was presumed to have contributed equally to the production and acquisition of the income, she also was presumed to have contributed equally to the $600,000 liability. Because she paid for half the liability that she helped create, and because that liability was deductible under Code Sec. 165(c)(1), Mihelick could take a deduction for her payment under Code Sec. 165(c)(1), the court concluded.

For a discussion of relief under Code Sec. 1341, see Parker Tax ¶70,110.

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Farm in Chapter 11 Bankruptcy Can't Convert to Chapter 12 to Obtain More Favorable Treatment of Capital Gains

A bankruptcy court rejected a farm's request to convert its Chapter 11 bankruptcy to Chapter 12 bankruptcy and to change its tax classification from a partnership to a corporation in order to allow the farm's capital gains tax liabilities to be discharged as a general unsecured claim. The court held that the farm was not eligible for Chapter 12 when it filed its petition and that changing its tax classification would violate the Bankruptcy Code and would be detrimental to the farm's creditors. In re Schroeder Brothers Farms of Camp Douglas LLP, 2019 PTC 210 (Bankr. W.D. Wis. 2019).

Background

Schroeder Brothers Farms of Camp Douglas LLP (Schroeder), a Wisconsin farm, filed a Chapter 11 bankruptcy petition in November of 2016. The bankruptcy court confirmed the plan in June of 2018. The plan contained a liquidation provision requiring Schroeder to verify each month that it made the required payments under the plan for the preceding month. If Schroeder defaulted and did not cure the default within 30 days, a committee of unsecured creditors could appoint a liquidating trustee.

In August of 2018, Schroeder notified the committee that it was unable to make the monthly payments under the plan. The committee informed Schroeder of its intent to move for the appointment of a liquidating trustee. The committee proposed a carveout provision providing that no less than 10 percent of aggregate gross proceeds of assets sold by the liquidating trustee would be allocated for the payment of allowed administrative expenses and unsecured claims. If gross sale proceeds equaled or exceeded the sum of secured claims and the carveout amount, then the carveout provision would not apply.

Schroeder objected to the motion for appointment of a liquidating trustee. It asserted that, since August of 2018, the value of its encumbered real property, equipment, and cattle had declined. Schroeder argued that a sale of its assets would result in capital gains taxes and would likely be insufficient to pay the resulting taxes and fees. Schroeder asked the court to convert the bankruptcy to a Chapter 12 bankruptcy and to allow it to file an IRS Form 8832, Entity Classification Election, to change its tax classification from a partnership to a corporation in order to take advantage of 11 U.S.C. Sec. 1232, which treats certain capital gains tax liabilities of a Chapter 12 debtor as a general unsecured claim.

Observation: Congress added 11 U.S.C. Sec. 1232 to the Bankruptcy Code to overrule Hall v. U.S., 2012 PTC 110 (2012). In Hall, the Supreme Court ruled that an individual debtor cannot treat post-petition taxes as an administrative expense of the bankruptcy estate and must pay the post-petition taxes as they become due. 11 U.S.C. Sec. 1232(a) provides that any unsecured claim of a governmental unit that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor's discharge, as a result of the sale of any property used in the debtor's farming operation (1) will be treated as an unsecured claim arising before the date on which the petition is filed, (2) will not be entitled to priority, (3) will be provided for under a plan, and (4) will be discharged.

Chapter 12 is generally available only to family farmers with debt under $4,411,400 when the case is filed. Schroeder conceded that it was ineligible to be a Chapter 12 debtor when it filed its petition but that, as its total debts were now below $4 million, it was now eligible. Schroeder asserted that it was eligible to elect to be taxed as a corporation and that, if an election were made, Chapter 12 would allow the corporation's taxes to be discharged as an unsecured claim. Schroeder argued that the best approach in the instant situation was to deny the committee's motion for the appointment of a liquidating trustee, allow the conversion to Chapter 12, and confirm a Chapter 12 plan incorporating liquidation provisions.

The committee responded that Schroeder could not convert to Chapter 12 because it was ineligible when it filed its petition and post-petition changes in the amount of debt do not affect eligibility. The committee also argued there was no equitable ground on which the court should convert the case. The committee noted that potential capital gains taxes were a non-issue because the debtor is an LLP, i.e., a pass-thru entity, and its the partners, not the partnership, that are liable for any taxes arising from the sale of assets. BMO Harris Bank N.A., the primary secured creditor, joined the committee's objection, contending that the proposed conversion was prohibited under the Bankruptcy Code and that, even if allowed, it would be inequitable because Schroeder had no realistic probability of successfully reorganizing and the creditors had negotiated the liquidation provision in the plan with this scenario in mind.

Analysis

The bankruptcy court denied Schroeder's motion to convert to Chapter 12 and held that permitting Schroeder to change its entity tax classification would violate the Bankruptcy Code. The court found that Schroeder had to qualify as a family farmer as of the original petition date in order to be allowed to convert to Chapter 12 and that Schroeder's debt exceeded the statutory limit when it filed its petition. The court noted that Schroeder had conceded as much and found that conversion did not change the date from which the court determines eligibility to convert.

The court also found that allowing Schroeder to elect to be taxed as a corporation in order to take advantage of 11 U.S.C. Sec. 1232 would violate the absolute priority rule in 11 U.S.C. Sec. 1129(b)(2)(B), which provides that the owners of a debtor will not receive or retain under a bankruptcy plan any property because of that interest unless all general unsecured claims are paid in full. The court explained that the absolute priority rule is a mainstay of Chapter 11. The fundamental principle, according to the court, is to ensure that the plan is fair and equitable by prohibiting a court from approving a plan that gives the holder of a claim anything at all unless all objecting classes senior to him have been paid in full.

In the court's view, Schroeder's proposed tax election would benefit the partners of the LLP to the detriment of creditors by shifting funds from creditors to taxing authorities. The court found that since filing the bankruptcy, Schroeder's partners had retained the benefit of favorable tax treatment through any depreciation or other losses, and the partners were seeking to effect a change in the tax treatment of the LLP, saddling Schroeder with substantial estimated capital gains taxes. The partners would receive a tax benefit through favorable tax treatment, the court said, and would shift the unfavorable treatment to the detriment of creditors. The court also reasoned that allowing the change in election would result in an unfair surprise to the creditors, who had relied on the disclosure statement and the plan, which did not include a change in tax treatment.

For a discussion of Chapter 12 bankruptcy, see Parker Tax ¶16,120. The tax classification election rules are discussed in Parker Tax ¶29,501.

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Author's Royalty Income from Publishing Contracts Was Subject to Self-Employment Taxes

The Tax Court held that all of an author's royalty income derived from her contracts with publishing companies was allocable to her trade or business of writing and was therefore subject to self-employment tax under Code Sec. 1401. The court rejected the taxpayer's contention that a portion of the royalty payments represented a separate and distinct amount paid for her brand. Slaughter v. Comm'r, T.C. Memo. 2019-65.

Background

Karin Slaughter is an author based in Georgia. Since the 1990s, Slaughter has worked to establish herself as a brand author. A brand author is one who provides prestige or reliable profits to a publishing house. When Slaughter decided to become a writer, she set out in a businesslike fashion to obtain stationery, a reputable agent, and a contract with a New York publishing house. She worked with a media coach and publishers to develop her name and likeness into a successful brand. As a result, during 2010 and 2011 (the years at issue), Slaughter spent time meeting with publishers, agents, media contacts, and others to protect and further her status as a brand author.

Under contracts with publishers, Slaughter received two types of payments: nonrefundable advances and royalty payments. The royalties were a portion of the revenue or profits generated by the sales of Slaughter's manuscripts. The contracts specified the royalty rates applied to the revenue or profits from the works. Only the amounts in excess of the advance amounts were paid as royalties. In addition to the rights to her writing, the contracts secured the right to use Slaughter's name and likeness in advertising, promotion, and publicity for the contracted works.

Slaughter was not a brand author when she signed her first contract in 1999. But by 2007, she had become a brand author and her typical advance had grown eightfold. Slaughter now spends the same amount of time writing a book as she did in 1999. The change in her income is due to her cachet as a brand author, i.e., her ability to attract and engage readers, speak in front of a crowd, and recommend other authors within her publishing house. Slaughter's name is valuable to her publisher because it is how book buyers identify her books. Publishers now pay more for Slaughter's work because of her brand.

Slaughter hired a tax preparation firm to prepare her 2010 and 2011 tax returns. Several people from the firm, including a CPA, worked together to prepare Slaughter's returns. The CPA determined that a portion of Slaughter's income was for her name and likeliness and treated these amounts as investment income, i.e. payment for an intangible asset beyond that of her trade or business as an author. The CPA concluded that Slaughter should pay self-employment (SE) tax only on the amount publishers paid her for writing, and not on amounts paid for her name and likeness. Slaughter's returns for 2010 and 2011 reported all of her advances and royalties on a Schedule E, Supplemental Income and Loss, from which the portion relating to the trade or business of writing was subtracted. That amount was reported on Schedule C, Profit or Loss From Business. No SE tax was calculated on the balance of the advances and royalties left on Schedule E. Slaughter also deducted as business expenses the cost of leasing a vehicle in NYC to attend media interviews and promotional events, as well as the cost of an apartment in NYC which she used when was in town to attend meetings, conduct media interviews, and participate in publishing industry events.

The IRS determined SE tax deficiencies of $155,931 for 2010 and $110,670 for 2011 and applied negligence penalties under Code Sec. 6662. Slaughter challenged the IRS's determinations in the Tax Court.

Under Code Sec. 1401(a), self-employment tax applies to net earnings from self-employment, which is defined in Code Sec. 1402(a) as the gross income derived by an individual from any trade or business carried on by the individual, less the deductions attributable to the trade or business. The Tax Court has held that the term "derived" in Code Sec. 1402(a) requires a nexus between the income received and the taxpayer's trade or business. To be engaged in a trade or business, the taxpayer must be involved in an activity with continuity and regularity with the primary purpose of producing income and profit.

Slaughter argued that a portion of her royalties was derived solely from her name and likeness, which she said are personal attributes that are not part of any trade or business. She contended that her publishers intended to pay one amount for her writing and another separate and distinct amount for her brand. Slaughter argued that the nexus test under Code Sec. 1402(a) was limited to cases where taxpayers receive payments in lieu of engaging in their trade or business - for example, termination payments or insurance payments for the taxpayer's inability to work. The IRS responded that there was a sufficient nexus between Slaughter's royalties and her trade or business of writing such that all of her income from publishing contracts was subject to SE tax. There was no separate and distinct payment, according to the IRS, because all of Slaughter's income was directly or indirectly tied to the selling of her books.

Tax Court's Analysis

The Tax Court held that all of the payments to Slaughter under the publishing contracts were income derived from her trade or business as an author, and such income was subject to SE tax. In the court's view, Slaughter's brand was part of her trade or business because she was engaged in developing her brand with continuity and regularity for the primary purpose of income and profit. The court also noted that it is common in the publishing industry for writers to build brands and promote their work. In the court's view, the fact that Slaughter's brand involved personal traits such as her name and likeness did not mean that it could not be part of her trade or business. If Slaughter's brand had commercial value, it could form part of her trade or business, the court reasoned. The court also found it unnecessary to determine the publishers' intent, reasoning that an allocation within the contracts was beside the point if all elements were to be allocated to a trade or business.

The court also concluded that Slaughter misapplied the Code Sec. 1402(a) nexus test. The court explained that, to satisfy the nexus test, earnings must be tied to the quantity or quality of the taxpayer's labor. In the court's view, the question was not whether Slaughter's brand was tied to the quantity and quality of her writing, but rather whether the payments for her brand were tied to the quantity or quality of her efforts in developing her brand. The court noted that Slaughter herself admitted she worked to develop her brand, and the court found that royalties earned from her brand were not solely a result of her publishers' actions.

The court noted that Slaughter's treatment of her expenses was further evidence that payments for her brand derived from a trade or business. For example, Slaughter deducted the rent for the NYC apartment on her Schedule C even though most of her writing was done in Georgia. Slaughter also deducted advertising costs and other promotion and brand-related expenditures. According to the court, if these expenditures were Schedule C trade or business expenses, then the income derived from the brand to which those expenses related was also trade or business income.

Finally, with respect to the negligence penalties, the court held that Slaughter reasonably relied on the advice of her tax preparers and therefore was not liable for the penalties.

For a discussion of net earnings from self-employment, see Parker Tax ¶13,120.

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Tax Court Lacked Jurisdiction Because No Notice of Determination Was Issued

The Tax Court held that it lacked jurisdiction to consider whether the IRS should have given a taxpayer a collection due process (CDP) hearing because the taxpayer, after receiving a notice of federal tax lien filing, failed to timely request a CDP hearing and the IRS closed the case without conducting a hearing or issuing a notice of determination. The court rejected the taxpayer's argument that under Buffano v. Comm'r, T.C. Memo. 2007-32, the court should dismiss for lack of jurisdiction on the grounds that the IRS failed to satisfy the requirements for issuing a valid notice of federal tax lien filing, finding that this case was distinguishable because the taxpayer did not show that its last known address was one other than the address used by the IRS. Atlantic Pacific Management Group, LLC v. Comm'r, 152 T.C. No. 17 (2019).

Background

Atlantic Pacific Management Group, LLC (Atlantic) is a partnership whose principal place of business is outside the United States. The IRS assessed penalties against Atlantic under Code Sec. 6698(a) for late partnership information return filings for 2014 and 2015 and a penalty under Code Sec. 6038(b) for failing to file an information return with respect to certain foreign corporations and partnerships for 2014.

On June 13, 2017, the IRS mailed Letter 3172, Notice of Federal Tax Lien Filing and Your Right to a Hearing under Code Section 6320, to Atlantic's New York address with respect to the 2014 and 2015 assessments. The Letter 3172, delivered and signed for on June 16, 2017, notified Atlantic of its right to file a request for a collection due process (CDP) or equivalent hearing on or before July 20, 2017. Atlantic's tax matters partner and managing member, David Chu, was not in the United States at the time and did not sign for the Letter 3172.

On July 28, 2017, Atlantic mailed a Form 12153, Request for a Collection Due Process or Equivalent Hearing, to the IRS. The Form 12153 listed Atlantic's New York address as its current address, and that address was also the return address on the envelope in which the form was mailed. The IRS received the request on July 31, 2017. On August 28, 2017, the IRS sent a letter to Atlantic's New York address stating that Atlantic's CDP hearing request was being denied as untimely and giving Atlantic until September 1, 2017, to request an equivalent hearing. On September 7, 2017, the IRS's automated collection system support closed the case without a hearing. Atlantic updated its last known address in October of 2017.

On December 19, 2017, Atlantic's attorneys sent a follow up request for a CDP or equivalent hearing. The request included a Form 2848, Power of Attorney and Declaration of Representative, which listed Atlantic's New York address as the taxpayer's address. The IRS did not respond to the request. On May 2, 2018, Atlantic filed a petition seeking the Tax Court's review and attached the August 28, 2017, letter received from the IRS. No CDP or equivalent hearing was ever conducted.

Under Code Sec. 6321, a lien in favor of the United States is imposed on all property and rights to property of a person liable for tax when a demand for the payment of taxes has been made and the person fails to pay. Code Sec. 6323 requires the IRS to file a notice of federal tax lien (NFTL) if the lien is to be valid against certain creditors. Under Code Sec. 6320(a)(1), the IRS must notify in writing any person against whose property an NFTL is filed. The notice must include the right of the person to request a hearing within 30 days following the fifth business day after the lien is filed. If the taxpayer makes a timely request, he or she is entitled to a hearing with the IRS Office of Appeals, and the Appeals officer must make a "determination" following the hearing. The taxpayer may petition the Tax Court within 30 days of the determination, and the Tax Court has jurisdiction to review it under Code Sec. 6330(d)(1). If no written determination is issued, the absence of such a determination is grounds for the Tax Court's dismissal of the petition.

The Tax Court generally will not look behind a notice of determination, or lack of notice, to determine whether a hearing was fair or whether the taxpayer was given an appropriate hearing opportunity. However, in Buffano v. Comm'r, T.C. Memo. 2007-32, where a taxpayer failed to timely request a CDP hearing and did not appear at an equivalent hearing, resulting in no notice of determination being issued, the Tax Court examined the IRS's compliance with the requirement that a levy notice be mailed to the taxpayer's last known address and held that the levy notice on which a notice of determination would have been based was invalid since it was not mailed to an appropriate address. Accordingly, the Tax Court invalidated the underlying levy notice. But in Adolphson v. Comm'r, 2016 PTC 483 (7th Cir. 2016), a case with facts similar to those in Buffano, the Seventh Circuit held that a decision invalidating administrative action for not following statutory procedures is a quintessential merits analysis, not a jurisdictional ruling.

Atlantic argued that under Buffano, the Tax Court should dismiss the case for lack of jurisdiction on the grounds that that the IRS failed to satisfy the requirements for issuance of a valid NFTL filing. Atlantic also contended that Code Sec. 7803(a)(3), which gives taxpayers a right to be heard and to appeal IRS decisions in an independent forum, conferred jurisdiction on the Tax Court. The IRS contended that the Tax Court should overrule Buffano and adopt the Seventh Circuit's approach in Adolphson.

Analysis

The Tax Court determined that it did not need to resolve the conflict between Buffano and Adolphson because it could clearly distinguish the instant case from Buffano. The court explained that, in Buffano, there was information showing the address appearing on the taxpayer's most recently filed federal income tax, which the court noted is the starting point for establishing a taxpayer's last known address. In addition, the taxpayer in Buffano did not even become aware of the IRS's levy filing until the IRS served a notice of levy on the taxpayer's employer. The Tax Court said that, by contrast, Atlantic did not show that its last known address was one other than the New York address used by the IRS. The court found that Atlantic in fact admitted that it received the notice at its New York address and filed a request, albeit untimely, for a CDP hearing based on the notice. The court also noted that Atlantic listed its New York address as its current address on Form 12153 and that Atlantic's attorneys listed the New York address as Atlantic's address on the Form 2848. Consequently, the court concluded that the IRS was not required to provide Atlantic with a hearing and, absent a determination letter, the Tax Court lacked jurisdiction over Atlantic's petition.

The Tax Court also rejected Atlantic's argument that Code Sec. 7803(a)(3) gave the court jurisdiction. The court found that that Code Sec. 7803(a)(3) provides no independent relief or additional rights to taxpayers but applies only to rights already guaranteed. In the court's view, Atlantic failed to explain how Code Sec. 7803(a)(3) would confer jurisdiction on the Tax Court when the taxpayer failed to timely request such a hearing.

For a discussion of the rules for IRS levies, see Parker Tax ¶260,540.

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Early Withdrawal Did Not Render Debtor's Annuity Nonexempt in Chapter 7 Bankruptcy

A bankruptcy court held that a married couple's annuity account, which they formed 15 days before filing a Chapter 7 bankruptcy petition, was exempt from the bankruptcy estate under Wisconsin law because it was a tax-deferred account under Code Sec. 72 and was payable on death. The court found that the annuity contained the required death benefit language in Code Sec. 72(s), the annuity's early withdrawal provision did not render the principal non-tax-deferred, and that there was no evidence that the debtors transferred assets with the intention of defrauding creditors. In re Kluck, 2019 PTC 229 (Bankr. W.D. Wis. 2019).

Lydell and Margaret Kluck filed a voluntary joint Chapter 7 petition. Before filing their petition, Mr. Kluck owned, among other assets, a 1974 Plymouth and several parcels of real estate in Wisconsin. In the months before filing bankruptcy, the Klucks sold those assets and deposited the proceeds of $181,780 into a bank account. The Klucks transferred $177,000 of the proceeds into an annuity account formed 15 days before they filed bankruptcy. They later withdrew funds from the annuity to pay attorney's fees. The Klucks stipulated that before the sales, the assets were not their homestead or exempt (1) from execution by judgment creditors under Wisconsin law, (2) under bankruptcy law, or (3) from federal or Wisconsin income tax.

When a bankruptcy case begins, most of the debtor's assets become property of the bankruptcy estate. However, to help give the debtor a fresh start, the Bankruptcy Code permits a debtor to exempt from the estate certain interests in property. Under Wisconsin law, a debtor may choose between the exemption scheme in the Bankruptcy Code or the Wisconsin exemption provisions. The Wisconsin retirement benefits exemption allows a debtor to claim property as exempt if it meets the following requirements: (1) it is tax deferred under Code Sec. 72, and (2) it provides benefits by reason of age, illness, disability, death or length of service. However, a bankruptcy court can deny an exemption if, in the court's discretion, the debtor procured, concealed or transferred assets with the intention of defrauding creditors.

The Klucks elected to claim their annuity as exempt under Wisconsin law. The trustee argued that the claimed exemption should be disallowed. According to the trustee, the account did not satisfy Wisconsin law because it was not tax deferred and because distributions under the account were not conditioned upon any particular event and thus also failed to satisfy Wisconsin law.

The bankruptcy court held in favor of the Klucks and overruled the trustee's objection. The court found that the annuity was exempt under Code Sec. 72 in part because it complied with the distribution requirement in Code Sec. 72(s) in the event the holder dies before the entire interest is distributed. The court noted that under the annuity contract, payment was to be made within five years if the death occurred before the annuity starting date or as soon after the death as proof of death or payment instructions are received. The annuity therefore contained the death benefit language required under Code Sec. 72(s), in the court's view. The court rejected the trustee's argument that the annuity was not tax-deferred because of the Klucks' early withdrawal. According to the court, early withdrawals do not render the principal non-tax-deferred, and funds in the account are tax-deferred until distribution. The court also concluded that the second requirement for exemption under Wisconsin law was met because the annuity provided for distribution by reason of age or death.

The bankruptcy court also concluded that there was insufficient evidence on which to find that the Klucks transferred assets with the intention of defrauding creditors. The court noted that exemption planning, where debtors seek to convert non-exempt assets into exempt assets shortly before filing bankruptcy, is commonplace and does not necessarily justify disallowance of a claimed exemption. The court said that exemption planning rises to the level of fraudulent conduct only if there is evidence the debtor committed an act extrinsic to the conversion which hinders, delays, or defrauds creditors. Such additional factors include any misleading contacts with creditors while converting non-exempt assets into exempt assets, the purpose of the conversion of assets, and conveyance for less than fair market value. The court found that none of these factors applied in the instant case.

For a discussion of individuals in Chapter 7 bankruptcy, see Parker Tax ¶16,130.

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