IRS Not Bound by State Court Decision Finding Transfer a Gift, Taxpayer Not Eligible to Exclude from Income Amount Ordered to Pay Back in Later Year

Neil Sadaka may have crooned that “breaking up is hard to do” but most often the IRS doesn’t get involved—but this case is an exception to that rule. In this breakup, the Tax Court determined that the IRS retained the right to determine whether amounts transferred from an individual’s former boyfriend represented gifts and that the taxpayer could not use the rescission doctrine to escape taxation on a $400,000 payment from said boyfriend she received that she later was order to return after a finding she obtained it by fraud.

The case in question is that of Blagaich v. Commissioner, TC Memo 2016-2 and involves matters taking place between Ms. Blagaich and her former boyfriend Mr. Burns in 2010, specifically transfers to Ms. Blagaich during that year, as well an agreement entered into during that year.

As the Court describes it:

Mr. Burns and petitioner were involved in a romantic relationship from November 2009 until March 2011. In 2010, petitioner was 54 years old; Mr. Burns was 72. Both resided in suburbs of Chicago, Illinois. In 2010, Mr. Burns provided petitioner with cash and other property totaling in value at least $743,819. Before November 29, 2010, he wired to her bank account $200,000, gave her a $70,000 Corvette automobile, and wrote her various checks totaling $73,819 (in all, $343,819). On November 29, 2010, petitioner and Mr. Burns entered into a written agreement (agreement) intended in part to confirm their commitment to each other and to provide financial accommodation for her. Neither petitioner nor Mr. Burns desired to marry, and the agreement was, at least in some respects, intended to formalize their "respect, appreciation and affection for each other" in the way a marriage otherwise would do. The agreement provides that the parties "shall respect each other and shall continue to spend time with each other consistent with their past practice", and that both "shall be faithful to each other and shall refrain from engaging in intimate or other romantic relations with any other individual". The agreement also requires Mr. Burns to make an immediate payment of $400,000 to petitioner, which he did do.

But things did not go well for the relationship after that.  Not only would the couple break up, but the matter would spill over into the state courts.  As the opinion continues:

Mr. Burns' relationship with petitioner quickly deteriorated in the months following execution of the agreement. On March 10, 2011, petitioner moved out of Mr. Burns' residence for the last time, and, the next day, Mr. Burns sent petitioner a notice of termination of the agreement. Shortly thereafter, Mr. Burns came to believe that, contrary to her assurances, petitioner had been involved in an ongoing romance with another man throughout their relationship.

Late in March 2011, Mr. Burns initiated a civil suit against petitioner in the Circuit Court for the Eighteenth Judicial District, DuPage County, Illinois (sometimes, State court action). The complaint sought, among other things, nullification of the agreement, petitioner's return of the Corvette automobile and a diamond "engagement ring", and a further order directing petitioner to "disgorge all cash and other accommodations that * * * [Mr. Burns] provided to her, totaling in excess of $700,000." On April 8, 2011, Mr. Burns caused to be filed with the Internal Revenue Service a Form 1099-MISC, Miscellaneous Income (original Form 1099-MISC), reporting that he had paid petitioner $743,819 in 2010. That amount reflected Mr. Burns' transfer to petitioner in 2010 of the $200,000 wired to her account, the Corvette automobile worth $70,000, the various checks totaling $73,819, and the $400,000 payment made pursuant to the agreement.

… A trial was held in the State court action, and, in November 2013, the State court issued an opinion and order. With respect to the agreement, the State court found that petitioner had fraudulently induced Mr. Burns to enter into it, and the court entered a judgment against petitioner of $400,000, payable to Mr. Burns' estate (he having passed away shortly after the trial). With respect to the Corvette automobile, the $200,000 wire transfer, and various checks that Mr. Burns had given petitioner, the State court found as follows. He had given her the Corvette automobile because he did not want her to ride her Harley Davidson motorcycle, which activity frightened him. He had wired the $200,000 to her account to entice her to leave her job and to travel with him, and he gave her the various checks, totaling $73,819, under similar circumstances. The State court's ultimate finding was that the Corvette, the $200,000 wire transfer, and the various checks were "clearly gifts" from Mr. Burns to petitioner and that she was entitled to keep them.[1] Subsequently, one of the executors of Mr. Burns' estate issued a revised 2010 Form 1099-MISC reducing the amount of compensation reported as paid to petitioner in that year to $400,000. On March 25, 2014, the executor mailed a letter to the Internal Revenue Service, a copy of the revised Form 1099-MISC attached, confirming that petitioner had paid $400,000 in compliance with the State court order.

The IRS had become involved prior to the state court action due to the Form 1099 MISC as Ms. Blagaich did not report that income.  The IRS asked the Tax Court to delay action on this case until the conclusion of the state court case, which the Tax Court did.

Following the state court decision the IRS concluded that Ms. Blagaich should be taxable on the entire $743,819 in 2010.  The taxpayer countered that none of it should be taxable to her in 2010 as a matter of law and asked the Court to grant a ruling on that basis.

The taxpayer contended that the IRS was bound by the state court ruling that $343,819 of the amounts transferred represented a gift and not taxable pursuant to IRC §102.  As well, since she had to repay the entire $400,000 that was not held to be a gift in a later year under the doctrine of rescission she should not be required to include that amount in income.

The Tax Court did not agree with the taxpayer on either point.  The Court pointed out that the IRS was not a party to the litigation between the parties regarding the nature of the $343,819.  Thus, a trial looking at the nature of that transfer in the Tax Court did not amount to a prohibited re-litigation of a matter already decided in another matter involving the parties under the doctrine of collateral estoppel. The fact that the IRS asked for the Tax Court action to be suspended pending the state court action did not make the IRS a party to such action.

As well, the Tax Court also commented that it was completely possible for the transfer to be properly a gift under common law but not a gift for federal tax purposes.  As the Court commented in a footnote:

We note in passing that, while a voluntary transfer may constitute a "gift" in the common law sense, the transfer might not constitute a "gift" as the term is used in sec. 102(a), excluding from gross income "the value of property acquired by gift, bequest, devise, or inheritance." See Commissioner v. Duberstein, 363 U.S. 278, 285 (1960) (stating that the statute uses the term "gift" in a more colloquial sense: "the mere absence of a legal or moral obligation to make * * * a payment does not establish that it is a gift"); Farid-Es-Sultaneh v. Commissioner, 160 F.2d 812, 815 (2d Cir. 1947) (finding that title to stock was acquired by purchase and not by gift when shares were received in consideration of promise to marry coupled with promise to relinquish marital rights to fiance's property), rev'g 6 T.C. 652 (1946). We need not decide whether the State court found the elements of a sec. 102(a) gift since respondent is not barred by collateral estoppel from relitigating facts found by the State court.

As for the $400,000 that Ms. Blagaich was ordered to repay, the Tax Court noted that generally the tax law requires a view of years standing alone.  In order to deal with cases where a taxpayer may receive income in one year that later has to be repaid in a later year, the doctrine of claim of right exists as the Court explains:

The need for certainty in allocating items to the appropriate period gives rise to the claim-of-right doctrine. A taxpayer receives income under a claim of right whenever she "acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition". James v. United States, 366 U.S. 213, 219 (1961). Under the claim-of-right doctrine, laid out by the Supreme Court in N. : "If a taxpayer receives earnings under a claim of right * * *, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent."

A taxpayer will have the right to claim a deduction (or, if the amount exceeds $3,000, electively a credit) for the year in which the amount is later repaid—in this case 2013.

However there is a limited exception to the claim of right treatment found in the doctrine of rescission.  The Court explains this rule as follows:

Pursuant to the exception, a taxpayer need not report as an item of gross income an amount received under a claim of right if the recipient's right to the amount is rescinded and, within the year of receipt, the parties to the payment are restored "to the relative positions that they would have occupied had no contract been made." The rule is so stated in Rev. Rul. 80-58, 1980-1 C.B. 181.

The taxpayer pointed to case law that indicated that the doctrine can apply in cases where the amount is not actually repaid by year end.  As the Court cites:

Petitioner relies on Hope v. Commissioner, 55 T.C. 1020, 1030 (1971), aff'd, 471 F.2d 738 (3d Cir. 1973), which suggests that the rescission doctrine may apply even when repayment of a gain does not formally occur in the year of receipt, but only if, before the end of the year, "[the] taxpayer recognizes his liability under an existing and fixed obligation to repay the amount received and makes provisions for repayment." 

However, the Court notes that Ms. Blagaich’s facts are not those described above:

Nothing in the facts presented indicates petitioner recognized such a liability, much less made provision for repayment, in 2010, the year she received the $400,000. Indeed, the record shows petitioner maintained, at least until November 2013, that she was under no obligation whatsoever to return the money paid to her under the agreement. Putting aside petitioner's questionable analogy regarding "a lack of control over the rescission", the suggestion in Hope is inapplicable to the facts of this case.

Ms. Blagaich argued this result was simply inequitable and the Court should not allow such an unfair result.  Unfortunately for Ms. Blagaich the Tax Court does not generally have the power to apply equitable principles in such cases, noting:

With respect to the equitable concerns petitioner raised in her motion—"The equities in this case simply do not support strict adherence to the one-year guideline in the rescission doctrine."—we note only that our statutory mandate does not permit us to decide this case on the basis of general principles of equity. See Knapp v. Commissioner, 90 T.C. 430, 440 (1988) (citations omitted) ("The Tax Court is a court of limited jurisdiction. * * * We have only the powers expressly conferred on us by Congress, and may not apply equitable principles to expand our jurisdiction beyond the limits of section 7442."), aff'd, 867 F.2d 749 (2d Cir. 1989)