I can’t find the source of this quotation. If some reader can supply it, I’d be grateful. “Every genius needs someone standing behind him with a hammer, to hit him over the head when he’s gone too far.”
In this case, the genius is Judge Mark V. Holmes, The Great Dissenter, a/k/a The Judge Who Writes Like A Human Being, and he goes too far in Alan R. Pinn and Toni A. Pinn, 2013 T. C. Memo. 45, filed 2/11/13.
This is a son-of-SDLIA (see my blogpost “The Split”, 8/29/12). Alan and Brother David were high school teachers who became homebuilders one summer vacation. Using sub-minimum-wage student labor, they made an outrageous profit, and turned pro, jettisoning the classroom for the great outdoors: that is, the great outdoors for their laboring types. Alan and Brother David sat at their desks and waxed stout in the bankroll.
Enticed by a SDLIA run through a dubious labor union, Alan and Brother David, though as management they couldn’t join the union, started an employee plan. And the plan provided that management could get death benefits through the plan, and get an unlimited deduction for payments made to the plan. This was a Section 419 plan (not to be confused with the Nigerian e-scams). That’s an employee welfare plan, for contributions to which employers get deductions.
This 419 buys life insurance for the beneficiaries. The beneficiaries can borrow against the cash surrender values of their policies, but must pay back the loans with interest; if they don’t, then the plan trustees can take the money out of the death benefit. But if the employee ceases to be employed while alive, or the plan is discontinued, or if the employer drops out, then the benefit goes away. And the employee can irrevocably designate the beneficiary of the life insurance.
Alan and Brother David borrow, sign promissory notes (and even amend them after the fact to correct an error) but make only a token payment. The plan doesn’t hold them in default or try to collect.
The story gets to the IRS when the plan trustee has to disclose Alan’s and Brother David’s loans in default on Schedule G of the Form 5500, but claims the loans are secured: “The Schedule G loans are not in default because the collateral for each Schedule G loan, the participant-borrower’s death benefit provided under the terms of the plan of benefits of the Fund, will provide a payment or distribution to pay the underlying Schedule G loan obligation upon maturity. For the same reasons, the Schedule G loans are not uncollectible since, each Schedule G loan is supported by collateral which is sufficient to repay the Schedule G loan upon maturity.” 2013 T. C. Memo. 45, at p.19.
IRS claims the loans were in default and uncollectible, so Alan and Brother David had COD. But IRS doesn’t raise COD until answer stage, so IRS has burden of proof.
Alan and Brother David are conjoined for trial, briefing and decision. And IRS stipulates the loans were bona fide loans.
The question of course, is when did the debt become uncollectible, and that’s our old friend facts and circumstances. But we need to fix a year, because taxes go by the year, and we can’t use remote possibilities.
“The Commissioner argues that the Trust had a collection policy requiring that a demand letter be mailed to a delinquent borrower and, if necessary, Forms 1099 would be issued to borrowers who failed to comply. The Commissioner correctly notes that the Trust sent no demand letter to either Pinn in 2002, from which he concludes the Trust must have intended to forgive the loans.
“Hmm. There’s something to this logic. A creditor’s decision not to try to collect a debt may be persuasive evidence of its cancellation, especially when the creditor has a policy or custom of trying to collect its debts in a particular way or at a particular time after default. But there is one problem here: The Trust didn’t have a settled policy for collecting on delinquent loans in 2002. The Trustees did discuss whether to adopt one, but never actually did. We are convinced by the credible testimony of X, and the Trust’s Board minutes which confirm that it just wasn’t the Trust’s policy in 2002 to send demand letters; therefore, we don’t think the failure to send them is as significant as the Commissioner argues.” 2013 T. C. Memo. 45, at p. 24. (Name omitted).
And while the right of Alan and Brother David to receive proceeds may be contingent, as IRS argues, these rights aren’t highly contingent in the year at issue, so no COD that year.
Here, I think, Judge Holmes has been overcome by his own cleverness. Alan and Brother David’s company could leave the plan, or one or both of them could leave their company, or the plan could cease. But to say that IRS must wait until one of those happens, or Alan or Brother David dies, to see if there’s a repayment or cancellation of debt, means Alan and Brother David have a long free ride. If I were IRS, I’d appeal.
And Judge Holmes finds the Form 5500 ambiguous as an indicium of uncollectibility in the year at issue. The loans may have been in default, but they weren’t uncollectible, as Judge Holmes finds the plan trustee could recoup the unpaid loan amounts out of the death benefit.
Judge Holmes’ conclusion: “We therefore find that the Commissioner has failed to prove that the Pinns had COD income in 2002. This may strike learned observers as unusual–there was some evidence in the record that the union associated with the Trust marketed similar plans widely, touting their benefits as including immediate deductions, tax-free loan proceeds, and a long-deferred recognition of income. When this is true, a decent respect for the opinions of informed mankind requires an explanation of why we believe our holding will not have a pernicious effect.
“The chief of these is that here the parties agreed that the loans were bona fide. Under very similar circumstances, we found… that a similar distribution did not create a loan but taxable income. Yet even if our reading and rereading and rerereading of the arguments actually made in these cases allowed us to call the loans income to the Pinns, the Commissioner would still be stuck. Alan received his loan in 1999, and David received his in 2000. These are not the tax years at issue in these cases. And the Pinns may well have to pay taxes on the loans if they become ineligible for their death benefits, or when their death benefits are used to satisfy their debts.
“All these possibilities we leave for different records and different years.” 2013 T. C. Memo. 45, at pp. 36-37. (Citations omitted).
Very clever, but Judge, you went too far.