We know Tax Court’s love affair with stipulations between parties. Rule 91(a) says it all: “The parties are required to stipulate, to the fullest extent to which complete or qualified agreement can or fairly should be reached, all matters not privileged which are relevant to the pending case, regardless of whether such matters involve fact or opinion or the application of law to fact.” And Tax Court may deem matters admitted against the recalcitrant or gameplayers. So it’s stipulation or flagellation, guys.
But suppose the parties do stipulate, and the stipulation is dead wrong on the law?
Judge Holmes, the Judge who writes like a human being, gives us an answer in Robert Jay and Elizabeth T. Brooks, 2012 T. C. Mem. 25, filed 1/26/12, while I was at the New York State Bar Association’s Annual Meeting soaking up wisdom and CLE credits.
RJ was a stockbroker with a golden handcuffs deal. His firm gave him $500K up front, for which he signed a promissory note in usual form, calling for annual payments of principal and interest. If RJ was still around at each anniversary, the brokerage was supposed to write RJ a check for the installment of p&i less withholding, and RJ was supposed to write the brokerage a check for the entire amount of that p&i installment, so RJ paid out more than he got. If RJ bailed before the note matured, he had to pay whatever he hadn’t paid or been forgiven to date. RJ stayed the course, but of course no one wrote checks or withheld anything.
RJ reported the principal as income in the last year of the deal, when the brokerage tore up the note, but not the interest. He claimed that the interest would be a deduction if he reported it, and so it would wash the income, claiming Section 108(e)(2) treatment. In this case it wouldn’t, finds Judge Holmes, because the deduction would arise from RJ’s stock market investments, and the investment interest rule of Section 163(d)(1) trumps Section 108(e) and torpedoes RJ, because his net investment income is laughably below the amount of forgiven interest.
Now what happened to the stipulation? “The parties both assume that figuring out whether Brooks’s forgiven interest is taxable income is an issue only for the 2003 tax year.” 2012 T.C. Mem. 25, at p. 4.
Except it might not be. “In form, the agreement between Brooks and Dain [the brokerage] appears to be a loan: There is a note evidencing indebtedness and a stated interest rate. In substance, however, the up-front payment looks a lot like the advance in . . .–one that we held was compensation for personal services subject to a conditional obligation to repay. Brooks received the payment from Dain as part of his compensation arrangement and only had to repay it–on a pro rata basis–if he didn’t stay employed.
“This is a potential problem for the Commissioner. If Brooks’s ‘loan’ was compensation for personal services subject to a conditional obligation to repay, then Brooks should have reported the income from the forgivable note agreement in 1998–the year he received the money–and not 2003. And 1998 is not the tax year before us.” 2012 T. C. Mem. 25, at pp. 5-6. (Citations and footnotes omitted.)
Parenthetically, it might be too late for IRS to issue a deficiency for 1998. And anyway, IRS and RJ stipulated that the issue was what RJ did in 2003, not in any other year. What to do?
Duck the issue, says Judge Holmes. Apparently because he is going to nail RJ for tax on the unreported forgiven interest, he finesses as follows: “There are limits to what parties can stipulate, and pure statements of law that are just plain wrong may well be out of bounds. But we read the stipulation in this case as an agreement that Brooks received at least $506,300–the principal of the loan–as income in 2003. Because neither party has argued that the stipulation on this mixed question of fact and law doesn’t bind us, we deem this issue waived. See Buchsbaum v. Commissioner, T.C. Memo. 2002-138; see also Bartel v. Commissioner, 54 T.C. 25 (1970) (applying ‘duty of consistency’ in similar circumstances even without stipulation).
“We will therefore, like the parties, avert our eyes from this problem, and turn to the proper treatment of the forgiven interest.” 2012 T. C. Mem. 25, at p. 6. (Footnotes omitted.) And he nails RJ.
Ya gotta like a Judge who takes the bull by the horns, doesn’t flinch from the tough choices when confronted by a blatant error of law, and makes it all go away, preserving the error by means of the sanctity of the plainly erroneous stipulation. My kind of Judge.