I said “Wow!” when I read that clause in Hurford Investments No. 2, Ltd., Hurford Management No. 2, LLC, Tax Matters Partner, Docket No. 23017-11, filed 4/17/17. And read the opinion before commenting on what is “as clear as anything in the Code.”

Now if anyone objects that I blog a lot of Judge Holmes’ opinions, with or without honorifics, I can only reply that he gets some really good cases. So fans of other judges can complain to Ch J L. Paige (“Iron Fist”) Marvel or to the Office of the Clerk.

This tangled trail starts back in 2008 with Estate of Thelma G. Hurford, Deceased, Donor, G. Michael Hurford, Independent Executor, 2008 T. C. Memo.278, filed 12/11/08. I won’t digest this, except to say what Judge Holmes said: “This plan did not go well in design or execution….” Order, at p. 1.

So today’s episode moves from the late Thelma’s botched estate to the FLP set up by her attorney. The FLP wound up with the late Thelma’s late husband Gary’s phantom stock.

Gary worked for the legendary Hunt Brothers, who were what my daughter the Texan would call “awl kings.” Gary was the first non-Hunt president of Hunt Oil Corp. But he got no stock as compensation, and couldn’t buy any.

What he did get was a book entry in a notional amount, equivalent to the FMV of a number of Hunt Oil shares. This amount increased or decreased as the value of an equivalent number of shares as at 12/31 annually. When an employee reached qualified termination (which Gary did by dying), a five-year clock started ticking, at the end of which the non-stock was redeemed at book value. This non-stock is called “phantom stock.”

Well, Thelma got the phantom stock, but she died before the five-year clock ran out. She could have redeemed sooner, but didn’t. And she transferred the stock to the FLP while still alive.

Thelma never reported the phantom stock on her 1040, but the FLP did on its 1065, as a short-term capital gain, by which logic both Judge Holmes and I are confused.

Howbeit, in the case above-cited, relating to Thelma’s estate’s tax, the Court held that the phantom stock was includable in Thelma’s estate. Then the five-year clock ran, Hunt Oil gave the FLP much money, and IRS audited the FLP.

IRS and FLP made a closing agreement, whereby they agreed that the phantom stock proceeds were income in respect of a decedent, agreed on the amount, and that FLP got basis in the same amount.

IRS wants summary J. So does the FLP.

No issue preclusion or claim preclusion. The 2008 case only involved Thelma’s estate; nothing to do with the FLP.

Well the phantom stock was surely income in respect of a decedent (IRD). Gary was dead before he got it. Now Thelma, as the person who inherited the phantom stock from Gary, should have paid tax at ordinary rates, except she transferred the phantom stock to FLP before she died. And it’s too late to change that.

Now for the clear language.

“There’s another sentence in section 691 that deals with this possibility: ‘If a right . . . to receive an amount is transferred by . . . a person who received such right by reason of the death of the decedent . . . there shall be included in the gross income of. . . such person . . . for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer . . . .’ I.R.C. § 691(a)(2).

“This is another good reason for Thelma’s not doing what the estate planner who advised her back in 2000 told her to do: He seems to have been unaware of this section (as was, to be sure, the Commissioner and the Court during the estate tax case). But the language is, as [FLP] now emphasizes, as clear as anything in the Code. Thelma got the phantom stock by reason of her husband’s death. She transferred it to [FLP]. This means that she should have reported the phantom stock’s value at the time of the transfer. And section 691(a)(3) says that she should have reported it as ordinary income.

“Except that she didn’t report it at all, much less as ordinary income, and now too much time has passed to fix this mistake. And there’s the added complication that [FLP] did report it on its own 2000 tax return, albeit as short-term capital gain. (How it came up with that characterization is another mystery.).” Order, at pp. 5-6.

Even more interesting is whether the phantom stock is a capital asset. It’s not on the Section 1221 exclusion list. But the right to receive future income doesn’t make that right a capital asset. However, the right can change character with transfer. The original right was Gary’s. He died before he could get it. Thelma got it, but transferred it and at that point owed ordinary income tax. But the FLP reported and paid tax, not Thelma.

Most importantly, the phantom stock could go up or down in value, just like real stock. All the FLP could do was sit and suffer, or sit and gloat.

OK, so it’s a capital asset. But was there a sale or exchange by FLP?

Not in the traditional sense, bur remember Pilgrim’s Pride. What, you don’t? Well, see my blogpost “Just Walk Away – Part Deux,” 3/10/14, especially the reversal by 5th Cir.

“Remember that both parties to the phantom-stock arrangement had the right to liquidate the account at any time. When Hunt Oil liquidated the phantom stock and distributed the proceeds, it ended [FLP]’s right to sell the phantom stock when it chose. We think that means there was a termination of a right to buy or sell a capital asset, and not an abandonment of property, under the Fifth Circuit’s interpretation of 1234A(1). [FLP] still owned the rights to the phantom stock or, after the liquidation, to the cash proceeds. We therefore conclude that the transaction was a sale or exchange of a right to sell a capital asset under section 1234A(1) and [FLP] is entitled to capital-gains treatment.” Order, at p. 11.

OK, capital gain. But what basis? IRS said basis was stipulated on the closing agreement. No, says FLP, we get step-up in basis to FMV at DOD.

Hold on. The FLP didn’t die, and Thelma didn’t own the phantom stock when she died.

Judge Holmes to the rescue. “Yet section 1014(b)(9) tells us to consider property ‘to have been acquired from or to have passed from the decedent . . . if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate.’ That’s what happened here — in the estate-tax case we included the value of the phantom stock in Thelma’s gross estate.” Order, at p. 12.

So what? Section 1014(c) expressly excludes “property which constitutes a right to receive an item of income in respect of a decedent under section 691.”

But Judge Holmes already concluded that the phantom stock changed character when it went from Thelma to the FLP. So it was a capital asset in the FLP’s hands and not IRD.

A Taishoff “good job, first class” to J. L. Kennedy, Jr., Esq., and his team.