Taxpayer Not Allowed to Use Open Transaction Doctrine to Avoid Reporting Interest Income, Penalties Applied

The open transaction doctrine, if applicable to a case (and that’s a really big if), provides that a taxpayer generally treats amounts received as a return of capital until the taxpayer’s basis has been entirely recovered.  Unfortunately for the taxpayers in the case of Friedman v. Commissioner, TC Memo 2015-177, the Tax Court did not find their situation to be one where that doctrine applied.

The Tax Court outlines some of the basics of the application of this doctrine in describing the taxpayer’s justification for invoking it:

Petitioners rely heavily on the Supreme Court’s formulation of the open transaction doctrine in Burnet v. Logan, 283 U.S. 404  (1931), which applied the open transaction doctrine to deferred payment transactions where the realization of income is uncertain or contingent. This Court has applied the open transaction doctrine “only in rare and extraordinary circumstances” where property is considered not to have an ascertainable fair market value. See, e.g., Estate of Wiggins v. Commissioner, 72 T.C. 701, 708 (1979) (“In the event that fair market  value of property received cannot be determined, the transaction remains open for Federal income tax purposes and the taxpayer is entitled to report his gain under the cost recovery method.” (citing Burnet v. Logan, 283 U.S. 404, and McShain v. Commissioner, 71 T.C. 998 (1979))). Most cases in which this Court has applied the open transaction doctrine involve property other than cash or interests in property that are highly speculative. See Weigl v. Commissioner, 84 T.C. 1192 (1985); McShain v. Commissioner, 71 T.C. 998; Westphal v. Commissioner, T.C. Memo. 1984-363.

In this case the taxpayers had loaned to their daughter’s S corporation (referred to in the opinion as “Distinct”) over $4.8 million in two loans, one in 2003 and the other in 2007.  In 2010 (the year before the Court) the S corporation had written monthly interest checks to the taxpayers and claimed an interest deduction of $197,521 for the amounts paid.  Those amounts were deposited into the taxpayer’s bank accounts.

However the taxpayers claimed that, in fact,  most of this should be properly treated as a return of capital.  They justified this as follows:

Petitioners claim that Distinct was defrauded by two separate insurance agents from 2008 to 2011 and that, as a result of the fraud, they were certain that they would never recover the full amounts of their loans to Distinct. Petitioners did not provide any corroborating documentation as to the dates and dollar amounts of the purported fraud. Kayla Friedman testified that Douglas Terry Dean defrauded Distinct of approximately $1 million in 2008 and 2009 and that James A. Mecha defrauded Distinct of approximately $2 million in 2010 and 2011. Petitioners provided the Court with a grand jury indictment of Mr. Mecha from the Circuit Court of DuPage County, Illinois. The grand jury indictment does not specify the exact dollar amount attributable to Mr. Mecha’s fraud on Distinct but charges him with theft by deception of more than $1 million. Petitioners did not provide the Court with any information regarding attempts by Distinct to collect any amounts from Mr. Dean or Mr. Mecha. In sum, petitioners have not provided an adequate basis for the Court to find that fraud upon Distinct occurred, or if it did, that Distinct would not have had adequate funds with which to repay petitioners. [*5] Of the $197,521 petitioners received from Distinct in 2010, they reported $73,371 as interest income. Petitioners did not report the remaining $124,150 as interest income. Petitioners also claimed a capital loss deduction of $3,000 on their 2010 Federal income tax return.

However, as was noted earlier, the open transaction doctrine applies only “very rare” cases.  Generally the Courts only allow it in extreme or highly unusual circumstances and this was not found to be one of them.

The transactions in the aforementioned cases have virtually no similarities to the facts at hand. The loan transaction entered into with Distinct was not of the type where the property to be received did not have an ascertainable fair market value. In contrast petitioners received regular payments of defined dollar amounts in accordance with the terms of the underlying loans and promissory notes. See Underhill v. Commissioner, 45 T.C. 489 (1966) (finding the open transaction doctrine did not apply where the amounts required to be paid were fixed and the obligation to pay was not subject to a prior condition). Payments were made in the same exact amount, were almost always made on the first of each month, and bore roughly the same proportion to each other as did the original principal amounts of the two loans. These factors weigh in favor of finding a debtor-creditor [*9] relationship with petitioners’ receiving regular payments of interest income. See, e.g., Clark v. Commissioner, 18 T.C. 780, 783 (1952), aff’d per curiam, 205 F.2d 353 (2d Cir. 1953); Meier v. Commissioner, T.C. Memo. 2003-94.

Accordingly, we agree with respondent that the payments from Distinct to petitioners in 2010 were interest income. Our decision is in accord with Distinct’s treatment of the payments as interest and with petitioners’ treatment of a portion of the payments as interest income on their 2010 Federal income tax return, which directly contradicts their argument that they should be allowed to treat the payments as a return of capital.

So, despite the fact that the taxpayers claimed they knew by 2010 they would never be paid, that did not allow the use of the open transaction doctrine to report their receipts.

Some might think that this “novel” theory was at least worth a try.  After all, the theory would go, it seems unfair to tax them and there is this “open transaction” concept.  Maybe it could be used to avoid paying tax?  Given that the taxpayer doesn’t want to pay tax on what they see a “not real income” shouldn’t the adviser, being an advocate for the taxpayer, go along with taking this position on the tax return?

That brings to the next item in line.  Since the understatement in tax was in excess of 10% of the tax that should have been shown on the return or $5,000 (whichever is greater), the understatement is automatically subject to the 20% accuracy related penalty at IRC §6662 unless the taxpayer can show an exception is met.  The main exception is to show that the position had “substantial authority” as defined in Reg. §1.6662-4(d)(2).  The opinion notes that “[s]ubstantial authority exists only when the weight of the authorities supporting the treatment of the tax item is substantial in relation to the weight of the authorities supporting contrary treatment.”

The taxpayers did cite various sources of authority recognized in Reg. §1.6662-4 that they argued supported their position.  However merely citing authorities is not enough.  As the Court pointed in critiquing what was offered:

Petitioners direct us to the caselaw and Internal Revenue Service pronouncements—including a field service advice memorandum, chief counsel advice memoranda, and revenue rulings—cited in their briefs as support for their argument that substantial authority supports their exclusion of $124,150 in interest income from their 2010 tax return. Petitioners do not actually cite any authority in the section of their answering brief addressing the section 6662(a) penalty, but we assume they would have us rely on the authorities cited elsewhere in their briefs as being substantial authority sufficient to excuse them from the penalty. To that end, petitioners do not meet their burden of proving that substantial authority supports the position taken on their 2010 tax return because most, if not all, of the cases they cite in their briefs are inapposite to the receipt of interest payments on a loan agreement. The weight of the authorities definitely does not support their tax treatment of the payments received in 2010. Accordingly, petitioners have not shown that substantial authority exists, and we agree that imposition of the section 6662(a) penalty is appropriate.