SCOTUS Reports

Tag: assignment of income

  • Kenseth v. Commissioner, T.C. Memo. 2000-178: Tax Treatment of Attorney’s Fees in Contingent Fee Agreements

    Kenseth v. Commissioner, T. C. Memo. 2000-178

    Settlement proceeds paid directly to an attorney under a contingent fee agreement must be included in the client’s gross income, with attorney’s fees deductible subject to statutory limitations.

    Summary

    In Kenseth v. Commissioner, the Tax Court ruled that the full amount of a settlement from an age discrimination lawsuit, including the portion paid directly to the attorney under a contingent fee agreement, must be included in the client’s gross income. Eldon Kenseth received a settlement from his former employer, APV Crepaco, Inc. , for age discrimination, with a portion of the proceeds paid directly to his attorneys, Fox & Fox, as per their contingent fee agreement. The court held that Kenseth must report the entire settlement amount as income, with the attorney’s fees deductible as a miscellaneous itemized deduction, subject to the 2% adjusted gross income floor and the overall limitation on itemized deductions. The decision reaffirms the assignment of income doctrine and distinguishes the case from others where different state attorney lien statutes might affect the outcome.

    Facts

    Eldon Kenseth, a former employee of APV Crepaco, Inc. , filed a complaint with the Wisconsin Department of Industry, Labor, and Human Relations in October 1991, alleging age discrimination. Kenseth and other former employees retained Fox & Fox, S. C. , under a contingent fee agreement that provided for a 40% fee on any recovery before appeal and 46% after appeal. In February 1993, Kenseth settled his claim against APV for $229,501. 37. APV issued a check for $32,476. 61 directly to Kenseth for lost wages and another check for $197,024. 76 to Fox & Fox for the remainder of the settlement, which included the attorney’s fees. Kenseth reported only the lost wages portion on his 1993 tax return, leading to a dispute with the IRS over the tax treatment of the attorney’s fees.

    Procedural History

    The IRS issued a notice of deficiency to Kenseth, asserting that the full settlement amount should be included in his gross income, with the attorney’s fees deductible as a miscellaneous itemized deduction. Kenseth petitioned the Tax Court, arguing that the portion paid directly to Fox & Fox should be excluded from his gross income. The Tax Court heard the case and issued its opinion, affirming the IRS’s position and ruling against Kenseth.

    Issue(s)

    1. Whether the portion of the settlement proceeds paid directly to Fox & Fox under the contingent fee agreement is includable in Kenseth’s gross income.
    2. Whether the attorney’s fees paid to Fox & Fox are deductible as a miscellaneous itemized deduction subject to statutory limitations.

    Holding

    1. Yes, because the full settlement amount, including the portion paid to Fox & Fox, is considered income to Kenseth under the assignment of income doctrine.
    2. Yes, because the attorney’s fees are deductible as a miscellaneous itemized deduction, subject to the 2% adjusted gross income floor and the overall limitation on itemized deductions.

    Court’s Reasoning

    The Tax Court relied on the assignment of income doctrine, established by Lucas v. Earl, to hold that Kenseth must include the entire settlement amount in his gross income. The court rejected Kenseth’s argument that he lacked control over the settlement proceeds paid to Fox & Fox, noting that he retained ultimate control over the litigation and could have settled or changed attorneys at any time. The court distinguished the case from Cotnam v. Commissioner, where the Fifth Circuit had excluded attorney’s fees from gross income based on Alabama’s attorney lien statute, stating that Wisconsin’s attorney lien statute did not confer the same rights to attorneys. The court also addressed the potential inequities of the alternative minimum tax (AMT) on the deductibility of attorney’s fees but emphasized that such policy considerations are for Congress to address.

    Practical Implications

    This decision reinforces the principle that clients must include the full amount of settlement proceeds in their gross income, even if a portion is paid directly to attorneys under a contingent fee agreement. Attorneys and clients should be aware that such fees are deductible only as miscellaneous itemized deductions, subject to statutory limitations, which can significantly impact the client’s net recovery. The ruling may influence how attorneys structure fee agreements and advise clients on the tax implications of settlements. It also highlights the ongoing debate over the fairness of the AMT’s treatment of legal fees, potentially spurring further legislative action. Subsequent cases, such as those in the Fifth and Eleventh Circuits, may continue to grapple with the tax treatment of attorney’s fees based on different state lien statutes, but the assignment of income doctrine remains a key consideration in federal tax law.

  • Schneer v. Commissioner, 97 T.C. 643 (1991): When Partnership Agreements Can Assign Income

    Schneer v. Commissioner, 97 T. C. 643 (1991)

    A partner’s income from services performed individually can be treated as partnership income if earned after joining the partnership and if the services are similar to the partnership’s business.

    Summary

    Stephen Schneer, a lawyer, received referral fees from his former employer, Ballon, Stoll & Itzler (BSI), after becoming a partner at Bandler & Kass (B&K) and later Sylvor, Schneer, Gold & Morelli (SSG&M). These fees were for clients Schneer referred to BSI while an associate there. The IRS argued Schneer earned the fees before joining B&K and SSG&M, making the subsequent assignment to these partnerships invalid under the assignment-of-income doctrine. The Tax Court, however, held that most of the fees were earned after Schneer joined B&K and SSG&M, and thus could be treated as partnership income under the partnerships’ agreements, provided the services were similar to those of the partnerships’ business.

    Facts

    Stephen Schneer was an associate at BSI, where he earned a salary plus a percentage of fees from clients he referred to the firm. Upon leaving BSI in February 1983, Schneer became a partner at B&K, and later at SSG&M in August 1985. Post-departure, BSI continued to pay Schneer his share of referral fees, which he turned over to B&K and SSG&M per partnership agreements. These agreements stipulated that all legal fees received by partners were to be treated as partnership income. Most of the fees in question were earned after Schneer’s departure from BSI, with Schneer consulting on these matters while a partner at B&K and SSG&M.

    Procedural History

    The IRS issued notices of deficiency for Schneer’s 1984 and 1985 tax years, asserting that the referral fees should be taxed to Schneer individually under the assignment-of-income doctrine. Schneer petitioned the U. S. Tax Court, which heard the case and ruled in favor of Schneer, except for $1,250 of fees earned in 1984 before his partnership with B&K.

    Issue(s)

    1. Whether the referral fees received by Schneer from BSI were taxable to Schneer individually or to the partners of B&K and SSG&M in their respective shares.

    Holding

    1. No, because most of the fees were earned after Schneer joined B&K and SSG&M, and the services were similar to those performed by the partnerships.

    Court’s Reasoning

    The court analyzed the case using the all-events test, determining that the fees were not earned until after Schneer left BSI, as they were contingent on the performance of services by BSI and Schneer’s potential consultation. The court rejected the IRS’s argument that the fees were earned prior to Schneer’s departure, citing the necessity of services being performed post-departure. The court also reconciled the assignment-of-income doctrine with the principle that partners can pool their income by treating the partnership as an entity for tax purposes when the income relates to services similar to the partnership’s business. The court emphasized that the partnership agreements allowed for the fees to be treated as partnership income, except for $1,250 in 1984, which was earned before Schneer joined B&K. The court also noted the absence of any intent to avoid taxation through the partnerships, supporting the treatment of the fees as partnership income.

    Practical Implications

    This decision clarifies that income from services performed by a partner individually can be treated as partnership income if those services are similar to the partnership’s business and are earned after the partner joins the partnership. Legal professionals should ensure that partnership agreements clearly stipulate the treatment of such income. This ruling impacts how partnerships structure their agreements and how attorneys manage income from prior engagements. It also influences how the IRS audits partnership income, focusing on the timing of when services are performed and the similarity of those services to the partnership’s business. Subsequent cases, such as Brandschain v. Commissioner, have applied this principle, affirming that income from services similar to the partnership’s business can be pooled and taxed at the partnership level.

  • Haag v. Commissioner, 88 T.C. 604 (1987): Allocating Income in Controlled Entities

    Haag v. Commissioner, 88 T. C. 604 (1987)

    A professional corporation’s income can be allocated to its controlling shareholder under section 482 if it does not reflect arm’s-length transactions.

    Summary

    Dr. Stanley Haag transferred his medical partnership interest and other businesses to his professional corporation (P. C. ). The IRS sought to allocate the P. C. ‘s income to Haag under section 61 and the assignment of income doctrine, and under section 482. The court held that the P. C. controlled the income from the medical partnership, rejecting the section 61 claim. However, it upheld the section 482 allocation for 1979 and 1980, finding that Haag’s compensation from the P. C. was not at arm’s length compared to what he would have earned without incorporation.

    Facts

    Stanley Haag, a physician, formed a professional corporation (P. C. ) in 1976, transferring his medical partnership interest in Hilltop Medical Clinic, farms, a dog kennel operation, and other businesses to it. Haag became an employee of the P. C. , receiving minimal or no salary. The P. C. also operated a restaurant and provided medical services to other institutions. Haag made cash advances to the P. C. , which were repaid without formal loan agreements. The IRS sought to allocate the P. C. ‘s income to Haag under sections 61 and 482 of the Internal Revenue Code.

    Procedural History

    The IRS determined deficiencies in Haag’s federal income taxes for 1979, 1980, and 1981, leading Haag to petition the U. S. Tax Court. The court found that the P. C. was a validly organized and operated entity under Iowa law, and the case proceeded to address the tax allocation issues under sections 61 and 482.

    Issue(s)

    1. Whether the income reported by Haag’s P. C. from the medical partnership is taxable to Haag under section 61 and the assignment of income doctrine.
    2. Whether the P. C. ‘s income is allocable to Haag pursuant to section 482.

    Holding

    1. No, because the P. C. controlled the earning of income from the medical partnership.
    2. Yes, because Haag’s compensation from the P. C. in 1979 and 1980 was not at arm’s length compared to what he would have earned without incorporation.

    Court’s Reasoning

    The court applied the control test for the assignment of income doctrine, finding that the P. C. controlled the income from Hilltop because Haag was an employee subject to the P. C. ‘s direction, and the medical partnership recognized the P. C. as the partner. For section 482, the court analyzed whether Haag’s compensation from the P. C. reflected arm’s-length transactions. It found that Haag’s salary was significantly lower than what he would have earned without incorporation, especially in 1979 and 1980. The court upheld the section 482 allocation for those years but found that Haag’s 1981 compensation was comparable to what he would have earned without incorporation. The court also determined that Haag’s cash advances to the P. C. were not bona fide loans but disguised salary, further supporting the section 482 allocation.

    Practical Implications

    This decision underscores the importance of ensuring that transactions between a closely held corporation and its controlling shareholder reflect arm’s-length dealings to avoid section 482 allocations. It highlights the scrutiny the IRS may apply to the compensation arrangements of professional corporations, particularly when shareholders receive minimal or no salary. Practitioners should advise clients to document all transactions, including loans, and ensure that compensation levels are reasonable and comparable to industry standards. This case also influences how similar cases involving the assignment of income and section 482 are analyzed, emphasizing the need for clear evidence of corporate control and arm’s-length transactions.

  • Bagley v. Commissioner, 85 T.C. 663 (1985): Tax Treatment of Terminated Stock Options and Consulting Fees

    Bagley v. Commissioner, 85 T. C. 663 (1985)

    Payments received for the termination of stock options granted in connection with employment are treated as ordinary income, not capital gains, and consulting fees must be taxed to the individual who performed the services, not their corporation.

    Summary

    Hughes Bagley received $70,000 for terminating a stock option granted by his employer, Spencer Foods, and a $50,000 consulting fee. The Tax Court held that the $70,000 was taxable as ordinary income under Section 83 of the Internal Revenue Code, as it was compensation for services. The consulting fee was also taxable to Bagley personally, not to his wholly-owned corporation, under the assignment of income doctrine. The decision clarifies the tax treatment of terminated stock options and reinforces the principle that income from personal services cannot be shifted to a corporation without proper control and contractual recognition.

    Facts

    Hughes Bagley was employed by Spencer Foods and granted an option to purchase 10,000 shares of stock in 1975. In 1978, Spencer Foods was acquired, and Bagley’s option was terminated in exchange for $70,000. Concurrently, Bagley agreed to provide consulting services for one year and received $50,000, which he reported as income for his corporation, Hereford Trading. Bagley reported the $70,000 as a long-term capital gain on his personal tax return.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in Bagley’s 1978 tax return and asserted that the $70,000 should be treated as ordinary income and the $50,000 should be taxed to Bagley, not Hereford Trading. Bagley petitioned the U. S. Tax Court for a redetermination of the deficiency. The Tax Court held for the Commissioner on both issues.

    Issue(s)

    1. Whether the $70,000 received by Bagley in exchange for the termination of his stock option is taxable as capital gain or as ordinary income?
    2. Whether the $50,000 consulting fee received by Bagley is taxable to him or to his wholly-owned corporation, Hereford Trading?

    Holding

    1. No, because the $70,000 is treated as compensation under Section 83 of the Internal Revenue Code and thus is taxable as ordinary income.
    2. No, because the $50,000 consulting fee is taxable to Bagley personally under the assignment of income doctrine, as there was no evidence that Hereford Trading controlled the earning of the income.

    Court’s Reasoning

    The court applied Section 83, which governs property transferred in connection with the performance of services, to the $70,000 payment. The option was granted to Bagley in connection with his employment, and its termination before exercise meant it was not subject to Section 421’s capital gain treatment. Since the option lacked a readily ascertainable fair market value at grant, the $70,000 received upon termination was treated as ordinary income. For the consulting fee, the court relied on the assignment of income doctrine, requiring that income be taxed to the earner. Bagley failed to show that Hereford Trading controlled his consulting services or that Spencer Foods recognized the corporation in any agreement. Thus, the fee was taxable to Bagley personally.

    Practical Implications

    This decision clarifies that payments for terminated stock options linked to employment are ordinary income, not capital gains, affecting how employers and employees structure such options and report their termination. It also reinforces the assignment of income doctrine, requiring careful structuring of service agreements with corporations to shift income tax liability. Practitioners must ensure clear contractual recognition and control by the corporation over services rendered to avoid personal tax liability for their clients. Subsequent cases have applied this ruling to similar situations, emphasizing the need for adherence to Section 83’s requirements and proper corporate structuring to achieve desired tax outcomes.

  • Schuster v. Commissioner, 84 T.C. 764 (1985): When Income Earned by Members of Religious Orders is Taxable

    Schuster v. Commissioner, 84 T. C. 764, 1985 U. S. Tax Ct. LEXIS 87, 84 T. C. No. 51 (1985)

    Income earned by members of religious orders is taxable to the individual if earned in their personal capacity, not as an agent of the order.

    Summary

    Francine Schuster, a nurse-practitioner and member of a Catholic religious order, worked for the National Health Services Corps (NHSC) at a clinic in Texas. She endorsed her paychecks to her order per her vow of poverty. The issue was whether her wages were taxable to her personally or to her order as an agent. The Tax Court held that her wages were taxable to her because she was employed by the NHSC in her individual capacity, not as an agent of her order. The decision was based on the lack of a contractual relationship between the NHSC and her order, and the fact that she was treated as an individual employee by the NHSC.

    Facts

    Francine Schuster, a member of the Order of the Adorers of the Blood of Christ, was a nurse-practitioner who accepted a position with the National Health Services Corps (NHSC) to work at Su Clinica Familiar in Texas. She received her salary directly from the NHSC, but endorsed all checks to her order in accordance with her vow of poverty. The order had approved her mission and requested that her wages be paid directly to it, but the NHSC issued checks in her name only. Schuster’s work at the clinic fulfilled her commitment to serve in a health manpower shortage area, a condition of her nursing education funding.

    Procedural History

    Schuster filed a timely tax return for 1980, claiming her wages were not taxable because they were earned as an agent of her religious order. The Commissioner of Internal Revenue issued a notice of deficiency, asserting that Schuster’s wages were taxable to her personally. Schuster petitioned the U. S. Tax Court, which held a trial and subsequently ruled in favor of the Commissioner.

    Issue(s)

    1. Whether compensation earned by Schuster while a member of a religious order is includable in her gross income.

    Holding

    1. Yes, because Schuster earned the income in her individual capacity as an employee of the NHSC, not as an agent of her religious order.

    Court’s Reasoning

    The court applied the fundamental principle that income must be taxed to the person who earns it, citing Lucas v. Earl. The court found that Schuster was employed by the NHSC under standard federal personnel policies, received federal benefits, and was paid directly by the U. S. Treasury. Despite her vow of poverty and the order’s request for direct payment, there was no contractual relationship between the NHSC and the order. The court rejected the argument that Schuster was an agent of her order, emphasizing that an agency relationship requires the principal to have a legal obligation to the third party, which was not present here. The court distinguished this case from others where members of religious orders worked directly for their orders or affiliated entities. A dissent argued that Schuster’s income should not be taxable to her because she acted strictly as an agent of her order, subject to its control and direction.

    Practical Implications

    This decision clarifies that members of religious orders who work for secular employers are generally taxable on their earnings, even if they transfer those earnings to their orders. Practitioners advising members of religious orders should ensure that any employment arrangement explicitly establishes an agency relationship between the order and the employer if the goal is to avoid individual taxation. This case may impact how religious orders structure missions for their members, potentially encouraging direct employment by the order or its affiliates. Later cases, such as Fogarty v. United States, have followed this ruling, reinforcing the principle that individual taxation applies unless a clear agency relationship exists.

  • Jones v. Commissioner, 82 T.C. 586 (1984): Tax Implications of Relinquishing Vested Pension Rights in Plea Bargains

    Jones v. Commissioner, 82 T. C. 586 (1984)

    A taxpayer must include in income the value of a fully vested interest in a qualified profit-sharing plan, even if relinquished as part of a plea bargain.

    Summary

    In Jones v. Commissioner, the Tax Court ruled that Kermit Jones must include in his income the value of his fully vested interest in his employer’s profit-sharing plan, which he relinquished as part of a plea bargain after being terminated for attempted embezzlement. The court found that Jones’s endorsement of the check back to his employer constituted actual receipt, and his assignment of the right to the funds was a taxable event under the Internal Revenue Code. This case underscores that income realization occurs when a taxpayer assigns an unconditional right to receive funds, even if the funds are never physically received.

    Facts

    Kermit Jones was employed by Magna Corp. and participated in their qualified profit-sharing plan, in which he had a fully vested interest. In June 1978, Jones was arrested and terminated for attempting to embezzle goods. During plea bargaining, Jones agreed to relinquish his interest in the profit-sharing plan in exchange for pleading guilty to a lesser charge. On July 28, 1978, Jones endorsed a check from the profit-sharing trust back to Magna without it leaving the hands of Magna’s counsel. Jones did not report this amount on his 1978 tax return, leading to a deficiency determination by the Commissioner.

    Procedural History

    The Commissioner determined a deficiency in Jones’s 1978 federal income tax return due to the unreported lump-sum distribution from the profit-sharing plan. Jones petitioned the U. S. Tax Court to contest the deficiency. The Tax Court upheld the Commissioner’s determination, ruling that the distribution must be included in Jones’s income.

    Issue(s)

    1. Whether Jones must include in income the value of his fully vested interest in Magna’s profit-sharing plan, which he relinquished in conjunction with his plea bargaining arrangement.

    Holding

    1. Yes, because Jones’s endorsement of the check back to Magna constituted actual receipt, and his assignment of his unconditional right to the funds was a taxable event under the Internal Revenue Code.

    Court’s Reasoning

    The court reasoned that Jones had an unconditional right to his vested interest in the profit-sharing plan. By endorsing the check back to Magna, Jones actually received the funds, requiring their inclusion in income under sections 402(a) and 451 of the Internal Revenue Code. The court also applied the principle from Helvering v. Horst that income is realized when a taxpayer assigns the right to receive income, even if it is never physically received. The court distinguished cases cited by Jones, noting that the lump-sum distribution was not repaid to the original distributor, and Jones did not qualify for any exclusion or deduction provisions that would offset the income realization.

    Practical Implications

    This decision clarifies that the relinquishment of a vested interest in a qualified plan as part of a plea bargain is a taxable event. Legal practitioners should advise clients that such actions will likely result in taxable income, even if the funds are never physically received. Businesses should be aware that allowing employees to forfeit vested benefits in exchange for leniency in criminal proceedings may have tax implications for the employee. Subsequent cases have followed this ruling, reinforcing the principle that the assignment of income rights is taxable.

  • Benningfield v. Commissioner, T.C. Memo. 1984-59: Sham Trusts and the Assignment of Income Doctrine

    T.C. Memo. 1984-59

    Income is taxed to the individual who earns it, and sham transactions designed to avoid taxation will be disregarded for federal income tax purposes.

    Summary

    Max Benningfield attempted to avoid income tax by assigning his wages to a purported trust, “Professional & Technical Services” (PTS), and claiming a deduction for a “factor discount on receivables sold.” He also claimed a deduction for “financial counseling” fees paid to “International Dynamics, Inc.” (IDI). The Tax Court disallowed both deductions and upheld a negligence penalty. The court found that Benningfield remained in control of earning his income and that the transactions lacked economic substance, constituting a sham designed solely to avoid taxes. The court emphasized the fundamental principle that income is taxed to the one who earns it and that deductions require actual expenditure for a legitimate purpose.

    Facts

    Max Benningfield, a steamfitter, entered into contracts with PTS and IDI, entities associated with Trust Trends. Under an “Intrusted Personal Services Contract,” Benningfield purported to sell his future services to PTS for $1 per year and various “economic justifications.” He endorsed his paychecks from J.A. Jones Construction Co. to PTS and claimed a deduction for a “factor discount.” Simultaneously, he received back approximately 90% of the paycheck amount from IDI Credit Union as purported “gifts.” Benningfield also entered into a “Financial Management Consulting Services” contract with IDI, paying a fee of $3,550 and receiving back $3,195 as a “gift” from IDI Credit Union. He deducted the full $3,550 as “financial counseling” expenses. J.A. Jones Construction Co. was unaware of Benningfield’s arrangements with PTS and IDI.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Benningfield’s federal income taxes for the years 1975-1979 and assessed negligence penalties. Benningfield petitioned the Tax Court to contest these determinations.

    Issue(s)

    1. Whether the deduction claimed as a “factor discount on receivables sold,” representing wages assigned to PTS, is allowable.
    2. Whether the deduction of $3,550 for “financial counseling” is allowable.
    3. Whether Benningfield is liable for the negligence addition to tax under section 6653(a) of the Internal Revenue Code.

    Holding

    1. No, because the assignment of income to PTS was ineffective for federal income tax purposes, and Benningfield remained taxable on the wages he earned.
    2. No, because Benningfield did not actually expend $3,550 for financial counseling due to the near simultaneous return of $3,195, and the expense lacked substantiation and a valid deductible purpose.
    3. Yes, because Benningfield was negligent in participating in a flagrant tax-avoidance scheme, demonstrating an intentional disregard of tax rules and regulations.

    Court’s Reasoning

    The Tax Court reasoned that the “factor discount” deduction was based on an ineffective assignment of income. Citing Lucas v. Earl, 281 U.S. 111 (1930), the court reiterated the fundamental principle that “income must be taxed to the one who earns it.” The court found that PTS did not control Benningfield’s earning of income; he continued to work for J.A. Jones Construction Co., who was unaware of the PTS arrangement. The court deemed the services contract a sham, stating, “We will not sanction this flagrant and abusive tax-avoidance scheme.”

    Regarding the financial counseling deduction, the court noted that deductions are a matter of legislative grace and require actual expenditure for a deductible purpose. Citing Deputy v. du Pont, 308 U.S. 488 (1940), the court found that Benningfield effectively only expended $355 ($3,550 – $3,195). Furthermore, he failed to prove that even this amount was for a deductible purpose under sections 162 or 212 of the Internal Revenue Code. The court concluded the financial management contract also lacked economic substance.

    Finally, the court upheld the negligence penalty under section 6653(a), finding that Benningfield’s participation in the tax-avoidance scheme was negligent. Quoting Hanson v. Commissioner, 696 F.2d 1232, 1234 (9th Cir. 1983), the court stated, “No reasonable person would have trusted this scheme to work.” The court emphasized Benningfield’s failure to seek professional advice and the blatant nature of the tax avoidance attempt.

    Practical Implications

    Benningfield serves as a clear illustration of the assignment of income doctrine and the sham transaction doctrine in tax law. It reinforces that taxpayers cannot avoid tax liability by merely redirecting their income through contractual arrangements, especially when they retain control over the income-generating activities. The case cautions against participation in tax schemes that appear “too good to be true” and emphasizes the importance of economic substance for deductions. It highlights that deductions require actual, substantiated expenses incurred for legitimate business or personal purposes as defined by the tax code. The case also demonstrates the willingness of courts to impose negligence penalties in cases involving abusive tax avoidance schemes, particularly those lacking any semblance of economic reality.

  • Miedaner v. Commissioner, 81 T.C. 272 (1983): Taxation of Income and Charitable Deductions When a Church is Used for Tax Avoidance

    Miedaner v. Commissioner, 81 T. C. 272 (1983)

    An individual cannot avoid taxation by assigning income to a church they control, nor claim charitable deductions for personal expenses.

    Summary

    Terrel Miedaner assigned royalties from his book to a church he founded, the Church of Physical Theology, claiming the income was exempt and contributions to the church were deductible. The IRS challenged this, arguing Miedaner retained control over the income and used the church for personal benefit. The Tax Court held that Miedaner’s assignment was ineffective for tax purposes because he retained control over the income and the church was his alter ego. The court also disallowed charitable deductions, finding the church’s net earnings inured to Miedaner’s benefit.

    Facts

    Terrel Miedaner wrote “The Soul of Anna Klane” and in 1976, granted exclusive publication rights to a publisher in exchange for royalties. He then assigned all rights to the book to the Church of Physical Theology, which he and his wife founded. Royalties were paid to the church, and Miedaner directed these funds for his personal use, including living expenses and asset purchases. The church’s income was primarily from the book royalties and contributions from Miedaner, with minimal external contributions. Miedaner claimed charitable deductions for these contributions on his tax returns.

    Procedural History

    The IRS issued a notice of deficiency for 1977-1979, asserting that royalties should be taxed to Miedaner and disallowing charitable deductions. Miedaner petitioned the U. S. Tax Court, which upheld the IRS’s determinations.

    Issue(s)

    1. Whether royalties from the book are taxable to Miedaner despite the assignment to the church.
    2. Whether Miedaner is entitled to charitable deductions for contributions made to the Church of Physical Theology.
    3. Whether the IRS is precluded by equitable estoppel from raising these issues.

    Holding

    1. Yes, because Miedaner retained control over the royalties and the church was his alter ego, used for personal benefit.
    2. No, because the church’s net earnings inured to Miedaner’s benefit, and the contributions were used for personal expenses.
    3. No, because the church operated differently from its representations to the IRS and Miedaner cannot claim estoppel as the church’s founder.

    Court’s Reasoning

    The court found that Miedaner’s assignment of royalties to the church was ineffective for tax purposes because he retained control over the income. The church was deemed Miedaner’s alter ego, serving his personal interests rather than a genuine religious or charitable purpose. The court cited cases like Corliss v. Bowers and Commissioner v. Sunnen to support its view that income subject to a person’s unfettered command is taxable to them. The charitable deductions were disallowed under Section 170(c)(2)(B) and (C) because the church’s earnings benefited Miedaner personally. The court also rejected the estoppel argument, noting the church’s operations deviated from its initial representations to the IRS.

    Practical Implications

    This decision reinforces that individuals cannot use a church they control to avoid taxes by assigning income to it. It highlights the importance of a clear separation between personal and church finances for tax purposes. The ruling also affects how charitable deductions are scrutinized, particularly when contributions fund personal expenses. Legal practitioners should advise clients that the IRS will closely examine arrangements where churches are used for tax avoidance, and such schemes are unlikely to withstand judicial scrutiny. This case has been cited in subsequent rulings to challenge similar tax avoidance strategies involving religious organizations.

  • Estate of Applestein v. Commissioner, 80 T.C. 331 (1983): Taxation on Anticipatory Assignments of Income and Control over Assets

    Estate of Margita Applestein, Deceased, Louis Applestein, Administrator, and Louis Applestein, Surviving Husband, Petitioners v. Commissioner of Internal Revenue, Respondent, 80 T. C. 331 (1983)

    An individual is taxable on income from an asset if they retain control over it and its proceeds, even if nominally transferred to another party.

    Summary

    Louis Applestein, an experienced stock trader, transferred National Realty stock to his children’s accounts just before a merger and engaged in extensive trading using these accounts. The Tax Court ruled that the gains from the merger and subsequent trades were taxable to Applestein because he retained control over the assets and their proceeds. The court applied the assignment of income doctrine, holding that the transfers were anticipatory assignments of income and that Applestein never relinquished the benefits and burdens of ownership over the securities.

    Facts

    Louis Applestein, a retired IRS manager and experienced stock trader, learned of a proposed merger between National Realty Corp. and United National Corp. in late December 1972. He bought additional shares of National Realty and transferred them to his minor children’s custodial accounts just before the merger’s effective date. Applestein also conducted extensive stock trading in these accounts, using funds from his and his relatives’ accounts, treating these as loans to his children. The children reported the income from these transactions on their tax returns.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in Applestein’s 1973 federal income tax. Applestein petitioned the U. S. Tax Court, which ruled in favor of the Commissioner, holding that Applestein was taxable on the gains from the merger and the subsequent stock trading.

    Issue(s)

    1. Whether Louis Applestein is taxable on the gain from the exchange of National Realty stock transferred to his children after the merger was approved but before its effective date?
    2. Whether Louis Applestein is taxable on income derived from securities trading in accounts set up for his children?

    Holding

    1. Yes, because the transfer of the stock constituted an anticipatory assignment of income, as the merger was virtually certain to occur after shareholder approval, and Applestein retained control over the stock until the merger’s effective date.
    2. Yes, because Applestein never relinquished the benefits and burdens of ownership over the securities, treating the accounts as his own and controlling the use of proceeds.

    Court’s Reasoning

    The court applied the assignment of income doctrine, emphasizing that the substance of the transaction, not its form, determines tax liability. For the National Realty stock, the court found that the merger was virtually certain to occur after shareholder approval on February 7, 1973, making the stock merely a vehicle for the merger proceeds. The transfer to the children’s accounts shortly before the merger’s effective date was an anticipatory assignment of income. Regarding the stock trading, the court noted that Applestein retained control over the accounts, using his funds and discretion in trading, and treated the proceeds as reducing debts owed to him by his children. The court cited Helvering v. Horst and Lucas v. Earl to support its conclusion that income from property is taxable to the party who retains control over it.

    Practical Implications

    This decision reinforces the principle that tax liability follows control over assets and their income. It warns against using family members or other entities to shift income for tax purposes without relinquishing control. Practitioners should advise clients to avoid arrangements where they retain control over assets nominally transferred to others, as such arrangements may be treated as anticipatory assignments of income. This case has been cited in subsequent rulings to uphold the taxation of income to the party who retains control over the asset producing it, emphasizing the importance of substance over form in tax law.

  • Johnson v. Commissioner, 78 T.C. 882 (1982): Assignment of Income and Control in Professional Services

    Johnson v. Commissioner, 78 T. C. 882 (1982)

    Income must be taxed to the party who controls its earning, not merely to whom it is assigned.

    Summary

    Charles Johnson, a professional basketball player, attempted to assign his income to a corporation, Presentaciones Musicales, S. A. (PMSA), and later EST International Ltd. (EST), under an agreement where he was to receive a monthly stipend in exchange for his services. The Tax Court held that the income from his NBA contracts was taxable to Johnson, not PMSA or EST, because he retained control over the earning of that income. The court distinguished this from cases where the corporation had a direct contract with the employer, emphasizing that the absence of such a contract between PMSA/EST and the NBA teams meant Johnson controlled the earnings.

    Facts

    Charles Johnson, a professional basketball player, signed an agreement with PMSA granting them rights to his services in exchange for a monthly payment. PMSA licensed these rights to EST, which received payments directly from the San Francisco Warriors and later the Washington Bullets via assignments executed by Johnson. Despite these arrangements, Johnson continued to sign NBA Uniform Player Contracts directly with the teams, and there was no contract between the teams and PMSA or EST. Johnson reported the payments from EST as business income on his tax returns.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Johnson’s federal income tax for the years 1975, 1976, and 1977, asserting that the amounts paid by the NBA teams should be taxed to Johnson. Johnson petitioned the U. S. Tax Court, which consolidated the cases for trial, briefing, and opinion. The Tax Court ultimately ruled in favor of the Commissioner.

    Issue(s)

    1. Whether the amounts paid by the NBA teams to EST for Johnson’s services are taxable to Johnson or to EST under the assignment of income doctrine.

    Holding

    1. Yes, because Johnson, rather than EST, controlled the earning of the income from his services as a basketball player.

    Court’s Reasoning

    The Tax Court applied the principle from Lucas v. Earl that income must be taxed to the person who earns it. The court found that Johnson controlled the earning of his income because he had direct employment contracts with the NBA teams, and there was no contract between the teams and PMSA/EST. The court distinguished this case from Fox v. Commissioner and Laughton v. Commissioner, where the corporations had direct contracts with the entities using the services. The court emphasized that the absence of such a contract between PMSA/EST and the NBA teams was crucial. The court also noted that the assignments of income to EST did not change the fact that Johnson controlled the earnings, as these assignments were akin to ordinary wage assignments.

    Practical Implications

    This decision underscores the importance of the control element in the assignment of income doctrine, particularly in professional services contexts. It suggests that for income to be taxed to a corporation rather than an individual, the corporation must have a direct contractual relationship with the entity paying for the services. This ruling impacts how professional athletes and other service providers structure their income assignments and may influence tax planning strategies. It also highlights the need for clear contractual arrangements to establish control over income, as subsequent cases have continued to apply this principle in determining tax liability.