In United States v. Estate of Shackleford, the Eastern District Court of California ruled a taxpayer’s estate did not have to use IRS valuation tables to calculate the value of lottery annuity payments. It said use of IRC section 7520 tables would result in unrealistic and unreasonable values because of restrictions on the assignment of payments under state law. Therefore, it allowed the Shackleford estate to apply an alternate valuation method for its tax return.

In 1987, Shackleford won a California lottery jackpot of more than $10,160,000. He was to receive his winnings in 20 annual payments of $508,000. Shackleford could not collect his prize in a lump sum, even at a discount. In addition, according to California law, he could not “assign, [pledge] or collateralize” his future payments.

Shackleford died in 1990 after receiving only three payments. At the time of his death, the compound value of the 17 remaining payments was $8,636,000.

When Shackleford’s estate filed a tax return, it reported the present value of these payments at slightly more than $4 million. However, in amended returns, the estate claimed the value of the payments was zero. The IRS disagreed with this claim, contending the $4 million valuation was accurate. The estate sued the IRS, and the case was tried in district court.

In its initial decision, the court ruled the estate had to include the value of the payments that remained unpaid at the time of Shackleford’s death. However, it did not find, as a matter of law, that the payments had to be valued as an annuity using the code tables.

Based on expert testimony, the court ruled that the payments had a value of $2,012,500. Using the IRS tables to value the payments, it said, produced an unrealistic and unreasonable value, because they did not take into account any discount for the prize’s lack of liquidity.

The court, however, refused to allow a zero valuation. It noted that, even though state law restricted assignment of prizes, at least 10 California lottery winners had tried to transfer all or part of their winnings in 1990. In each case the price the winner got for the payments was substantially discounted to take into account the validity of the transactions. Based on these “gray market” transactions, the court allowed a discount that resulted in a $2,012,500 value for the payments in the Shackleford case.

Observation. This ruling applies to situations in which estates include lottery payments and assignment of the payments is restricted. It also applies to other types of private annuities with similar restrictions. Practitioners should review the past and pending tax returns of lottery winners’ estates to see if this ruling warrants an amended return.

( United States v. Estate of Shackleford, 84 AFTR.2d 99-5902).

—James Ozello, Esq.,
Ozello Tax and Legal Consulting,
Ringwood, New Jersey.

In divorce situations, the custodial parent is generally entitled to take the dependency exemptions for the children (IRC section 152(e)). This applies as long as both parents provide more than half the children’s support and the children live with either or both parents for more than six months each year.

However, this can be changed if the custodial parent signs Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, and agrees not to claim a particular child as a dependent for a particular year—then the noncustodial parent may claim that child by attaching the signed form to his or her tax return.

Form 8332 allows the custodial parent to release a claim for the deduction in the current year, specified future years, or all future years. It contains no cancellation date. The custodial parent need only sign the form once, but the noncustodial parent must attach it to his or her return every year.

The IRS recently reported it had received a large number of calls on its toll-free telephone lines from taxpayers inquiring if form 8332 could be nullified. This question is not answered on the form itself or in any related publications, and the IRS acknowledged it has not published procedures for revoking the release.

According to IRS legal memorandum 200007031, the only way a custodial parent can void form 8332 and claim the child on his or her own tax return, is to get the noncustodial parent to forgo claiming that child as a dependent. If the two former spouses cannot agree and both claim the same child, then the IRS steps in and an audit results.

Observation. The IRS memorandum discussed above is of no help to a custodial parent who has waived claiming the child for several years and whose ex-spouse fails to make support payments but continues to claim the exemption. To avoid such situations, CPAs should advise their clients to sign off on the exemption only on an annual basis and not to sign long-term releases.

—Michael Lynch, CPA, Esq.,
professor of tax accounting at
Bryant College, Smithfield, Rhode Island.

When an insolvent S corporation negotiates a reduction in its liabilities, it recognizes cancellation of debt (COD) income. Because the corporation is insolvent, the income is nontaxable. Can shareholders in the S corporation increase the basis of their stock by the amount of their share of COD income?

In 1986, Harold Farley and his wife invested $200,000 and received 50% of the stock in two S corporations. The corporations had operating losses, which the Farleys deducted on their tax returns, reducing their basis in the stock to zero. The corporations continued to have operating losses, which the taxpayers carried forward because they did not have sufficient stock basis to permit a deduction.

In 1992 the corporations ceased operations at a time when they were insolvent. They negotiated a reduction in their liabilities, which gave rise to COD income. The Farleys excluded this income based on the insolvency exception in IRC section 108, increasing the basis of their stock by the amount of the excluded income. Because of the basis increase, the unused loss carryforwards became deductible. The Farleys filed tax refund claims, and the Treasury issued refund checks.

The IRS subsequently determined that the excluded COD income did not increase the stock basis. It claimed the Farleys, therefore, were not entitled to the refunds. The IRS sued, asking that the Farleys return the refunds. The case went to the district court, with both sides moving for summary judgment. The court granted summary judgment in favor of the IRS. The Farleys appealed.

Result. For the taxpayers. The question before the court was whether an S corporation shareholder could increase his or her stock basis by the amount of the excluded COD income. The Third Circuit Court of Appeals said the answer lay in the interplay among IRC sections 1366, 1367 and 108.

In the court’s view, these sections provide unambiguous guidance. Under section 1366, all income, including COD income, passes through to shareholders. The income is then includible or excludible on a shareholder’s tax return based on the solvency or insolvency of the S corporation. In this case, since the COD income passed through to the shareholders, they could, according to section 1367, increase their stock basis for the COD income. On the first day of the next tax year, the S corporation would reduce tax attributes such as net operating and capital loss carryovers, as listed in section 108(b). As a general rule this requires the corporation to reduce its basis in its assets. Given the unambiguous wording of these sections, the Third Circuit rejected all the IRS arguments for not increasing the stock’s basis.

The Third Circuit issued this opinion 11 days after the Seventh Circuit Court of Appeals issued its opinion in Witzel (200 F.3d 486), another COD income/S corporation basis case. The Seventh Circuit concluded that excluded COD income reduces the shareholder’s S corporation loss carryforward. After reducing any loss carryforward, the shareholder is entitled to increase the basis of his or her stock. While both courts agree on the basis increase, they appear to disagree on what attributes must be reduced.

Yet another opinion was expressed by the Tenth Circuit Court of Appeals in Gitlitz, (182 F.3d 1143). The court ruled that a shareholder may not increase his or her basis in S corporation stock by the amount of excluded COD income. In December 1999, the Treasury issued final regulations under section 1366. The regulations provide that COD income excludible under section 108 is not permanently tax exempt in all cases and therefore does not pass through to shareholders. If the income does not pass through, no basis adjustment is possible. The regulations—effective for S corporation tax years beginning on or after August 18, 1998—do not apply to the tax year at issue in Farley. These developments have set the stage for continuing litigation. CPAs who have not claimed the basis increase for their clients following Gitlitz may want to consider filing protective amended returns.

United States v. Harold D. Farley, 85 AFTR.2d 2000-380.

—Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.

Divorce can be a very complex matter, both emotionally and financially. The financial complexity is illustrated by the many tax implications of divorce. People going through divorces often find themselves in disputes with the IRS. The Tax Court recently decided one such matter.

John and Louise Young were married in 1969 and divorced in 1988. (Note: The court combined two cases into one because they concerned the same transaction. This discussion follows the case from Louise’s perspective.) In October 1989 they entered into a property settlement whereby Louise received a promissory note for $1,500,000, previously held by John. The note was secured by property John received as part of the settlement. He was to pay the note to Louise in five annual installments, which included interest. The settlement also provided that John would pay legal and collection fees if he defaulted.

John defaulted on the note in 1990, and Louise filed suit to collect the amount he owed her. A judgment was entered in her favor. In 1991, John paid Louise only $160,000. Louise properly recognized this amount as interest income on her 1991 income tax return.

In 1992, Louise again filed suit to execute the rest of the 1991 judgment. In December 1992, John and Louise entered into another settlement whereby he transferred the land that secured the note to Louise in exchange for surrender and cancellation of the note. John’s basis in the land was $130,794. This settlement discharged all of his debts to Louise, which totaled $2,153,844 including the $1,500,000 principal amount, accrued interest of $344,938, legal expenses of $300,606 and collection expenses of $8,300. The settlement also gave John the option to repurchase the land for $2,265,000. John assigned this option to a third party, who exercised it and acquired the land from Louise in 1993. Louise’s attorneys collected $300,000 directly from the sale proceeds in settlement of Louise’s legal fees. Louise received the remainder.

The case does not give details about how Louise wanted to treat the transaction. Presumably, she wanted receipt of the land to be considered a settlement of the $1,500,000 promissory note from John. If that had been the case, she would have a capital gain equal to the excess of the value of the land she received over the face value of the promissory note. This treatment would have given Louise a $2,265,000 fair-market-value basis in the land when she sold it to the third party in 1993 instead of John’s $130,794 carryover basis. Such treatment would obviously have created for her an advantageous tax result.

The IRS claimed the transfer of the land to Louise fell under section 1041, which says that, in transfers of property from an individual to a former spouse, the transferor recognizes no gain or loss and the transferee’s basis is the same as the transferor’s adjusted basis if the transfer is “incident to the divorce”—that is, the transfer occurs within one year of the divorce or is “related to the cessation of the marriage.” Further, temporary regulations provide that certain transactions occurring within six years of a divorce may still be considered incident to divorce (temporary regulations section 1.1041-1T(b), Q&A-7).

Result. For the IRS. All parties agreed the 1989 settlement was incident to the divorce because its purpose was to divide marital property. Since the 1992 settlement was the result of legal action regarding the 1989 settlement, the Tax Court found this settlement was also incident to the divorce. Even if the regulations did not apply here, the transfer was related to the cessation of the marriage. Therefore, section 1041 applied.

The IRS also claimed that the money Louise received to pay her legal fees should be included in her gross income. Louise contended that, since John was obligated to pay the legal expenses under the 1989 settlement, the amount he paid should not be included in her income. The Tax Court found that the obligation to pay the legal fees was Louise’s and, thus, she should include the amount paid on her behalf in her gross income. The Tax Court cited Glenshaw Glass Co. (348 US no. 426 (1955)) and O’Malley (91 TC no. 352, 358 (1988)), in support of its position that taxpayers are treated as receiving taxable income when a third party pays an obligation on their behalf.

CPAs and their clients should be aware of section 1041 implications when transfers of property result from a divorce, including those that occur some time after, but are incident to, the divorce. Ignoring the provisions of this section could be disastrous for both the client and the practitioner.

John B. Young, et ux. et al. v. Commissioner, 113 TC no. 152 (1999).

—Prepared by Eddie Metrejean, CPA, instructor, University of Mississippi,
E. H. Patterson School of Accountancy, University, Mississippi.
His e-mail address is emetreje@olemiss.edu .