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Tax Court Modifies April Opinion to Deny "Inequitable" Windfall to IRS.
(Parker Tax Publishing July 12, 2014)

In a rare occurrence, the Tax Court modified a recent opinion, using the doctrine of equitable recoupment, to reduce the tax liability and penalty assessment previously imposed on a taxpayer. Frank Sawyer Trust of May 1992 v. Comm'r, T.C. Memo. 2014-128 (6/25/14).

Mildred Sawyer was the sole beneficiary of the Frank Sawyer Trust of May 1992. She died in 2000 and, for estate tax purposes, her gross estate included all the trust's property, including the stock of four C corporations. Later that year, the trust sold two of the corporations. The sale prices totaled over $32 million, although the fair market values of the shares of stock were considerably less. The estate filed its estate tax return in December of 2000, and valued the shares at their inflated sales prices.

The trust received a step-up in basis for the stock of each of the four C corporations when their stock was included in the gross estate. When it filed its estate tax return, the estate valued the stock of the corporations it had sold at their sale prices. Because the sale prices matched the trust's stepped-up bases, the trust did not recognize any gain on the sales. The trust then sold the other two corporations' shares of stock in 2001, again for prices exceeding their fair market values. The sale prices also exceeded the trust's bases in the shares, which had been stepped up to fair market value at the decedent's death. On the trust's 2001 fiduciary income tax return, it reported gains of approximately $14 million on the sales. The gains resulted in part from the inflated sale prices the purchaser of the corporations was willing to pay because it anticipated avoiding the corporations' income tax liabilities.

The IRS assessed penalties against the four corporations stemming from their 2000 and 2001 income tax returns. Before the IRS could collect against the corporations, the corporations rendered themselves insolvent by transferring all their assets to other entities. A dispute arose as to whether the trust was liable to the IRS, under Code Sec. 6901, for the corporations' unpaid taxes and penalties. The Tax Court concluded that the trust was not liable because the IRS failed to prove that the trust had knowledge of the new shareholders' asset-stripping scheme and because the IRS did not show that any of the corporation's assets were transferred directly to the trust.

The IRS appealed to the First Circuit which generally upheld the Tax Court. However, the First Circuit disagreed with the Tax Court insofar as the Tax Court construed Massachusetts fraudulent transfer law to require, as a prerequisite for the trust's liability, either (1) that the trust knew of the new shareholders' scheme; or (2) that the corporations transferred assets directly to the trust. The IRS, the court noted, had presented evidence of fraudulent transfers from the four companies to various acquisition vehicles, and the acquisition vehicles purchased the four companies from the trust. According to the First Circuit, if the Tax Court found that at the time of the purchases, the assets of these acquisition vehicles were unreasonably small in light of their liabilities and that the acquisition vehicles did not receive reasonably equivalent value in exchange for the purchase prices, then the trust could be held liable for taxes and penalties assessed upon the four corporations regardless of whether it had any knowledge of the new shareholders' asset-stripping scheme. The First Circuit remanded the case to the Tax Court to determine whether the conditions for liability were met in the instant situation.

In April, in Frank Sawyer Trust of 1992 v. Comm'r, T.C. Memo. 2014-59, the Tax Court held that the trust was liable under Code Sec. 6901 as a transferee of a transferee but that its liability was limited to the excess it received over the fair market value of the corporations it sold. After that decision, the trust returned to the Tax Court and asked the court to reconsider and modify the portion of its opinion that related to the amount of its liability. Specifically, the trust asked whether, under the equitable recoupment doctrine, its liability should be reduced for income tax it overpaid and estate tax the Estate of Mildred Sawyer overpaid, and whether the trust was liable for the accuracy-related penalties of almost $4 million that the IRS had assessed against the four C corporations.

While agreeing that the trust satisfied two of the four elements necessary for applying equitable recoupment, the IRS argued that the trust did not satisfy the following elements: (1) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the court, and (2) the transaction, item, or taxable event had been inconsistently subjected to two taxes. With respect to the first element, the IRS contended that the estate's estate tax liability and the C corporations' income tax liabilities arose out of different transactions. Thus, the IRS said that equitable recoupment did not apply.

The Tax Court agreed to modify its prior opinion and reduced the trust's tax liability by the amount of the estate tax overpayment resulting from the trusts' misevaluation of corporate stock. In so doing, the court held that the trust satisfied all the elements for equitable recoupment to apply. With respect to the IRS's argument that the estate's estate tax liability and the C corporations' income tax liabilities arose out of different transactions, the court noted that the overpayment arose from a single item: the stock of the corporations sold in 2000. That stock was overvalued, the court noted, and thus the estate overpaid its estate taxes. The overvaluation resulted from the inflated prices paid by the purchaser of the stock and that overpayment was directly tied to the income tax liabilities the trust was contending should be offset.

With respect to the IRS's argument about the other element necessary for equitable recoupment to apply, the Tax Court said that the trust had to show that the transaction, item, or taxable event had been inconsistently subjected to two taxes. The two taxes involved were the estate's estate tax and trust's (as transferee) income tax. The estate valued two of the corporations' shares of stock at their sale prices and paid estate tax on the basis of those amounts. The sale prices would have reflected fair market value only if the corporations could have avoided paying the full amounts of their tax liabilities. The IRS, the court said, assessed the full amounts of the liabilities against the corporations and was now attempting to assess them against the trust. The IRS did not offset the liabilities by the estate's overpayment of estate tax attributable to its overvaluation of the corporations' stock, the court observed. In other words, the IRS assessed the estate's estate tax as if the corporations would not have to pay their full income tax liabilities, but was subsequently attempting to collect the full income tax liabilities. On these facts, the court concluded, the equitable recoupment test was satisfied.

Finally, the court held that the conduct that gave rise to the accuracy-related penalties (i.e., substantially understating income tax) occurred many months after the transfers and the IRS did not prove that the transfer was made with the intent to defraud future creditors. As a result, the Tax Court declined to hold the trust liable as a transferee for the accuracy-related penalties.

For a discussion of equitable recoupment, see Parker Tax ¶261,180. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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