or,  Never Suborn, But Consider to Subordinate

We all know that unless taxpayer is current with present taxes, IRS need not consider an installment agreement or other collection alternative as to past-due taxes. But when IRS, through its own mistake of law, creates the default in current payments, Tax Court’s abuse-of-discretion review puts taxpayer’s proposed collection agreement back on track.

That’s the moral of AlessioAzzari, Inc., 136 T.C. 9, 2/24/11.

Taxpayer was a New Jersey homebuilder torpedoed by the credit crunch of 2008. Taxpayer was behind on its quarterlies even before 2008, but caught up by factoring its receivables to raise cash. Then the tsunami hit, and IRS filed a lien.

Taxpayer had more factoring cash lined up, laid off half its employees and entered other lines of business, trying to stay in business. But the factor refused to lend with the tax lien in place. Taxpayer sought release of lien, but IRS denied it, saying the factor’s  filed lien (UCC financing statement) predated the tax lien filing,  and was therefore senior, so there was no reason to subordinate that which was already subordinated as a matter of law—“first in time is first in right.”

Except it isn’t. Reviewing tax lien learning for the last sixty years, Tax Court distinguishes, as the law does, between “choate” and “inchoate” liens (pronounced “ko-ate”; not to be confused, as one of my colleagues did, with Choate, pronounced “Chote”, a private school). The factor’s lien attached only to receivables existing at filing date of tax lien and those acquired by factor during 45 days following (“choate”). So the factor was subordinate to the tax lien from day 46 onward (“inchoate”).

IRS’ appeals officer first misapplied the law, then refused to consider an installment agreement because his refusal to consider subordination provoked taxpayer to fall further behind. Tax Court treats this conduct as it deserves (I cannot do better than quote Judge Wells’ decision):

“Respondent urges us to hold that the issue of subordination of the tax lien is irrelevant because even if the tax lien had been subordinated, petitioner still would have been ineligible for a collection alternative because it was not in compliance with its employment tax deposits. In his briefs respondent did not even address the relevant law governing the priority of tax liens, nor did he bother to respond to petitioner’s arguments that Mr. Lee [IRS appeals officer] erred in his interpretation of that law.

“Instead, respondent rests his entire argument on a previous case in which we upheld the Commissioner’s policy of rejecting collection alternatives when taxpayers have failed to pay their current taxes. See Giamelli v. Commissioner, 129 T.C. 107, 111 (2007). However, respondent’s reliance on Giamelli is misplaced.

“In Giamelli and other previous cases in which we have upheld the Commissioner’s rejection of collection alternatives because the taxpayers had failed to satisfy current tax obligations, the Commissioner had done nothing to contribute to the taxpayers’ failures to remain current with their tax liabilities.  In contrast, respondent’s abuse of discretion contributed to petitioner’s failure to make timely tax deposits.” 136 T.C. 9, at pp. 23-24.

Judge Wells went on to say:

“We do not accept respondent’s argument that Mr. Lee’s  decision regarding subordination of the tax lien is irrelevant.

“Indeed, accepting respondent’s contention would be tantamount to granting respondent the power to abuse his discretion at will as long as petitioner eventually misses a deposit on its employment taxes. In situations similar to the instant case, where petitioner’s business is in a dire position largely due to industry conditions beyond its control, the Commissioner’s decision not to subordinate an NFTL could exacerbate taxpayers’ cashflow problems and make it difficult, if not impossible, for taxpayers to remain current with their tax deposits while continuing to run their businesses. The Commissioner could hold off issuing a notice of determination indefinitely until the taxpayer missed a deposit, and the Commissioner could then refuse to grant an installment agreement on the basis of the taxpayer’s failure to remain current with its tax deposits. Because the taxpayer would have already fallen behind on current tax liabilities, we would be unable to meaningfully review the Commissioner’s decision not to subordinate the NFTL. We find such a scenario unacceptable.” 136 T.C. 9, at pp. 25-26.

In short, while IRS must never suborn, if they caused the problem they must at least consider to subordinate.

From the Tax Court website:  “The Tax Court’s Web site will be unavailable from 4:00 p.m. Friday, February 18 through 9:00 a.m. Tuesday, February 22 due to system upgrades. No documents may be eFiled during this time.” So no postings from me over Presidents’ Day weekend.

I recently discussed  WB Acquisitions, Inc. and Subsidiaries as an example of following the forms, and the penalties for not doing so. Now we have another example of form not followed, with grave consequences for the taxpayer. Again, while I don’t usually comment on 7463’s, this case is a good example of why taxpayers need competent advisers to help them follow the rules.

In Crandall and Dulin, T.C. Sum. Op. 2011-14, 2/15/11, taxpayers wanted to sell one piece of unimproved realty held for investment (on which they had a substantial gain) for another closer to home. They tried the usual forward-deferred 1031—sell the old, escrow the proceeds of sale with a Qualified Intermediary, locate and identify the new, and close, all within the 45-180 day timeframe of Section 1031. All this the taxpayers did–except the paperwork was defective.

The taxpayers took a few thousand dollars worth of proceeds out of escrow, but that in itself didn’t torpedo the 1031. Tax Court went off on the proposition that “(T)he … escrow agreements did not reference a like-kind exchange under section 1031, nor did they expressly limit petitioners’ right to receive, pledge, borrow, or otherwise obtain the benefits of the funds.” Crandall, at p. 4.

Tax Court went on to say “(T)he taxpayer’s own limitation of use of the funds does not convert the escrow account into a qualified escrow account. Klein v. Commissioner, T.C. Memo. 1993-491.” Crandall, at p. 7.

Although the properties were like-kind, although the timeframes of Section 1031 were adhered to, although the taxpayers clearly intended to do a 1031 exchange, the defective paperwork resulted in a deficiency.

IRS kindly conceded the accuracy-related penalty in a rare moment of mercy.

The takeaway—don’t use a boilerplate escrow agreement. Carefully put in the magic language of Regulation Section 1.1031(k)-1(g)(3)(ii)(B): “The escrow agreement expressly limits the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account.”

Leave out that language and it can get expensive.

But if you put the form in writing, you must abide by it.

While relaxing on South Beach (if you wondered where my blog went to the last ten days, it was behind a mojito on Ocean Drive), my fingers idly strayed across the keyboard looking for something interesting. And I found WB Acquisition, Inc., and Subsidiary, et al., TC. Memo. 2011-36, 2/8/11.

Barone and Watkins were asbestos removers and specialty contractors. Their work involved high-risk, high-reward projects, requiring them to provide personal guarantees to bonding companies. Short-cutting a lengthy explanation (which Judge Haines gives at great length), Barone and Watkins hired an attorney to create a multi-layered ownership structure for WCI, the operating company, which would be undertaking an ultra-high-risk, ultra-high-reward project for the U. S. Naval Base at San Jose, CA.

The corporate structure was elaborately documented, with employment agreements between the entities and Barone and Watkins. But the Navy project was much larger than any project Barone and Watkins had done before. Concerned about shielding the rewards from past creditors, and desiring to minimize any personal liability, Barone and Watkins entered into a joint venture agreement between WCI and an entity two layers up the ownership chain (but still controlled by Barone and Watkins).

The joint venture agreement insulated the upstream partner from loss, but left all responsibility for the work, from initial permit to sign-off at completion, with WCI. The profits were to be split 70-30, the upstream entity getting the larger share, as it had no previous indebtedness or complications.

WCI was the only entity that could obtain permits for the work, or that was recognized by the bonding companies. The joint venture filed no income tax return, claiming that under GAAP they were not required to. That argument did not fly with Tax Court.

Barone and Watkins sold WCI after completion of the project, and the complications arising from that sale are dealt with in the decision, but I am concentrating here on the disregard of the joint venture agreement by Barone and Watkins.

They reallocated the share of the profits between the joint venture entities without amending the joint venture agreement or establishing any business purpose for the reallocation, except stating “the profits were too large”. Tax Court treated this as a prohibited income-shifting device, and proceeded to deconstruct the joint venture.

Using the “distilled” principles enunciated in Luna v. Commissioner, 42 T.C. 1067 (1964), the so-called “Luna factors”, Tax Court examined:

“The agreement of the parties and their conduct in executing its terms; the contributions, if any, which each party has made to the venture; the parties’ control over income and capital and the right of each to make withdrawals; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; whether business was conducted in the joint names of the parties; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers; whether separate books of account were maintained for the venture; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.” WB Acquisitions, Inc., at p. 24.

Of course, Barone and Watkins were found to have violated the greater part of the Luna factors, and run all the various entities as extensions of themselves. Despite the carefully constructed documents and the elaborate rationalizations of the legal team, the “joint venture” was found to be a smoke screen, and a rather transparent one.

Chiefest among Tax Court’s objections were shifting of profits after the fact and without any basis in the joint venture agreement, the joint venture’s failure to file its own income tax returns, and the lack of any substantial role played by the upstream entity.

In short, “build it–they will come” means not only build it, but play it like it was built.  And the takeaway for tax advisers– it isn’t enough to create a beautiful structure, you have to warn the users of the structure to play by the rules.