Decisions — Staying Civil

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Image source: By Berdea (Own work based on: File:Handshake icon.svg) [CC BY-SA 3.0 (http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

Image source: By Berdea (Own work based on: File:Handshake icon.svg) [CC BY-SA 3.0
(http://creativecommons.org/licenses/by-sa/3.0)], via Wikimedia Commons

While it’s a given under current tax code that all income from whatever source is taxable unless specifically excluded under the law, what happens when what’s given is deemed a gift in a civil lawsuit? Can the IRS still claim the amounts received are taxable income?

In T.C. Memo 2016-2 (Blagaich), the taxpayer was involved in a romantic relationship during 2010 with a man who gave her cash and other property with a total value of approximately $743,819. Though they didn’t marry, the taxpayer and her beau entered into a written agreement intended in part to confirm their commitment to each other and to provide financial accommodation for her.

Prior to the signing of the agreement, the beau gave the taxpayer an automobile, wired money to her bank, and wrote various checks, all of which totaled $343,819. The agreement required the beau to make an immediate payment of $400,000 to the taxpayer, which he did.

When the relationship disintegrated, the beau filed a civil suit in state court against the taxpayer to recover the $743,819 that he had given her. He also filed Form 1099-MISC, Miscellaneous Income, with the IRS, reporting that he had paid the taxpayer $743,819 in 2010.

The IRS learned of the civil suit and requested that the taxpayer’s lawyer submit copies of any depositions taken in the case and filings and motions relating to the Form 1099-MISC.

In November 2013, the state court found that the taxpayer had fraudulently induced her beau to enter into the written agreement. The court entered a judgment against the taxpayer of $400,000, payable to her beau’s estate (he had passed away shortly after the trial). The court found that the other items were gifts, and that the taxpayer was entitled to keep them.

After the decision, one of the executors of the beau’s estate issued a revised 2010 Form 1099-MISC reducing the amount of compensation reported as paid to the taxpayer in that year to $400,000. In 2014, the executor mailed a letter to the IRS, with a copy of the revised Form 1099-MISC attached, confirming that the taxpayer had paid $400,000 in compliance with the state court order.

The IRS adjusted the taxpayer’s 2010 return upward by $743,819 to reflect the amount reported on the original Form 1099-MISC.

Question 1 – Collateral Estoppel

The taxpayer says the state court found that, other than the agreed payment to her of $400,000, all other cash amounts and property paid or given to her by her beau were “clearly gifts,” and that gifts are not income. She says the IRS cannot deny that the $343,819 is a gift, because the IRS cannot relitigate an issue that was decided in a final judgment by the state court (known as collateral estoppel).

The IRS says collateral estoppel does not apply to the $343,819 because the IRS was not a party, nor in privity with any party, to the state court action. By requesting the state court documents relating to the suit, the IRS was merely keeping abreast of the litigation.

WHAT WOULD YOU DECIDE?

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Question 2 – The Rescission Doctrine

The taxpayer says the remaining $400,000 was returned to her beau’s estate. That means both she and her beau were restored to the positions they would have occupied had the agreement not been made (known as the doctrine of rescission). Because she paid the $400,000 back, she had no income.

The IRS says the rescission doctrine doesn’t apply to the $400,000 because Revenue Ruling 80-58 says the parties to the rescinded agreement must be restored to their prior positions in the year of receipt. The taxpayer did not repay the $400,000 in 2010, which was the year of receipt.

WHAT WOULD YOU DECIDE?

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For the or for the

THE COURT’S DECISION

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!

For the IRS.

The taxpayer claims “the IRS knew of the state court matter and requested, and received, updates, pleadings, and discovery documents regarding the same.” While that may be true, the mere fact the IRS took steps to keep apprised of litigation to which the taxpayer was a party cannot, without more, lead us to conclude there existed any working relationship or coincidence of interests between the IRS and either the taxpayer or her beau.

The limited factual assertions the taxpayer makes in her argument fail to demonstrate any collaboration or genuine alignment of interests between the IRS and either party to the state court action. Because the taxpayer failed to carry her burden by providing undisputed facts sufficient to establish privity, she failed to establish an element necessary to the defense of collateral estoppel. She may not avail herself of that defense, as pleaded.

Sorry, wrong answer :(
Right answer!

For the IRS.

In general, the annual accounting period principle reflected in section 451, considered in the light of the judicially articulated claim-of-right doctrine, limits application of the rescission exception such that, without regard to subsequent events, income received by the taxpayer under a claim of right and retained by her at the close of the taxable year must be included in gross income for that year.

The facts show that, in 2010, the taxpayer took possession of the whole amount in question, $400,000, without any substantial limitations or restrictions as to its disposition. She recognized no liability and made no provision to repay that amount until nearly three years later. None of the cases the taxpayer cites as allowing a “relaxation” of the same-year requirement for rescission is factually comparable to her own, and they provide no rationale for departing from the general rule.

The doctrine of rescission does not save the taxpayer from the IRS adjustment including in her 2010 gross income the $400,000 she received from her beau in that year.

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