Merrill Lynch’s board had approved the sale of a subsidiary, Merrill Lynch Capital Resources (MLCR). As a preliminary step to finding a buyer, MLCR sold a second-tier subsidiary to yet another subsidiary of Merrill Lynch. Because the sale was to a related party, IRC section 304 treated it as a stock redemption; Merrill Lynch reported the transaction as a dividend. The government reclassified the redemption as a sale under IRC section 302(b)(3), which deals with complete termination of interest, arguing there was a “firm-and-fixed” plan for MLCR to lose control of the second-tier subsidiary and, therefore, the sale fit the definition of a complete termination of interest. The Tax Court agreed with the government. Merrill Lynch appealed.

Result. For the IRS. The Second Circuit said any analysis of section 302(b)(3) must permit the integration of several transactions into the redemption transaction. In other words, the step transaction doctrine is available for use by the government and the courts to prevent the nullification of section 302(b)(3) when the transaction is broken into several pieces. The court then said applying the step-transaction doctrine based solely on the intent of the taxpayer would be too subjective and unmanageable. In the past the courts have used the “firm-and-fixed-plan” test to determine when to integrate multiple steps into one transaction. Since neither party presented an alternative test, the court used the firm-and-fixed-plan test to determine the taxation of the stock sale.

Both parties agreed the firm-and-fixed-plan test should be applied at the time of the sale of the lower-tiered subsidiary. They disagreed on the need for a binding contract to sell MLCR at that time to meet the test and so reviewed the history of the test. In the first case to use it by name, Niedermeyer (62 TC 380 (1974), aff’d 575 F2d 500 (CA-9, 1976)), the court refused to allow the taxpayer to combine steps under this test where there was no written plan and no binding requirements, and where the taxpayer could choose not to follow the plan. However, it did not make these prerequisites for applying the test. In Bleily (72 TC 751 (1979), aff’d 647 F2d 169 (CA-9, 1981)), a case in which the majority shareholder of a corporation wanted to buy out the minority shareholders, the Tax Court used the firm-and-fixed-plan test to determine the taxation of the transaction. The court stated that “a plan need not be in writing, absolutely binding, or communicated to others to be fixed and firm although these factors all tend to indicate that such is the case.” In other words it would consider multiple factors, with a binding contract being just one. Looking at all the factors, the Tax Court had adequate evidence that a plan existed.

Merrill Lynch argued that under Paparo (71 TC 692 (1979)), the test could not be applied without a fixed and binding plan. The Second Circuit acknowledged that individual sentences in the opinion could produce this conclusion. However, it was the control that an independent third party had on the transactions, rather than the absence of a binding agreement, that caused the court in Paparo to refuse to treat the multiple transactions as one transaction. Therefore, the Second Circuit dismissed Merrill Lynch’s argument that a binding agreement was necessary.

This case clearly supports the application of the firm-and-fixed-plan test even without a binding agreement. In those cases in which the agreement is missing, taxpayers will need to have sufficient other factors to prove the existence of a plan and the certainty of its completion. In the future, it is likely a taxpayer will be held to a higher standard of proof if an actual binding contract is absent.

There is one additional interesting note about this case. The Court of Appeals remanded the case to the Tax Court to consider a new argument by Merrill Lynch—that ownership should have been measured at the parent- and not the subsidiary-level. The decision on this issue will be of great interest to corporations that sell subsidiaries to related parties.

Merrill Lynch & Co. v. Commissioner, 2004 US App. Lexis 20382 (CA-2).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Ismat M. Abeid purchased a lottery ticket in 1992 for $1 while living in California. He was luckier than most and won twenty annual payments of $722,000 each. He was not given a choice of payment plans but was required to accept the prize as 20 payments. He subsequently moved to Israel, where he is a citizen.

During the tax years 1997, 1998 and 1999, Abeid filed U.S. income tax returns in which he took the position that the $722,000 payments each year were not taxable in the United States. The IRS disagreed and determined a deficiency of $216,600 for each of the three years.

Result. For the IRS. Abeid argued the lottery payments were an annuity under Article 20(2) of the treaty, which says “alimony and annuities paid to an individual who is a resident of one of the contracting states shall be taxable only in the contracting state.” If this clause applied, the lottery payments would have been taxable to Abeid only in Israel, where he resided during the years at issue. Abeid made several different arguments to support the position the lottery payments were an annuity under the treaty, but the court disagreed with each one.

Abeid’s first argument relied on a definition of the term annuity from outside the treaty in Estate of Gribauskas v. Commissioner . However, the language of the treaty implies that any term used and defined in the treaty should employ that definition. The term annuities is defined in the treaty as “a stated sum paid periodically at stated times during life, or during a specified number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered).”

The key question was whether the payments were “in return for adequate and full consideration.” Since this term was not defined in the treaty, the court used the meaning of the term in U.S. tax law. It determined that adequate and full consideration would require a bona fide and arm’s-length price and must be reasonably related to the value of the property acquired.

Abeid said the California lottery had received “adequate and full consideration.” First, he argued the treaty did not require the payor to receive such consideration from the recipient of the lottery payments and, in fact, that the lottery did receive it from the contributions of all lottery players.

Abeid then argued that if the consideration had to come from the recipient of the lottery payment, his $1 ticket purchase was “adequate and full consideration” because it was the full, undiscounted price for the ticket. He supported this claim by citing Estate of Shackleford. In this case, the estate tried to exclude the value of uncollected lottery payments (an annuity) because the decedent had paid only the $1 purchase price of the lottery ticket in exchange for the payments. Under IRC section 2039(b), the gross estate includes a proportionate share of an annuity if the purchase price was paid by more than one party. The court in Abeid’s case pointed out that the issue in Shackleford was whether anyone else had paid a portion of the cost of the annuity, not whether the amount paid for the annuity constituted “adequate and full consideration.”

The Tax Court disagreed with both of Abeid’s arguments without addressing who was required to provide the consideration. The court reasoned the purchase price of the ticket was not in exchange for the lottery winnings but in exchange for a chance—that is, a wager. Each ticket purchaser provided “adequate and full consideration” for his or her own chance or wager. Similarly, Abeid received a chance in exchange for his $1. He won the wager, which is a separate taxable event under U.S. law. This separate event produces gambling income, which is not excluded under the U.S./Israel treaty. In addition, the $1 purchase price was deemed to have had no “reasonable relationship” to the value of the lottery payments he won.

Nonresident aliens who choose to wager on U.S. lotteries should be aware the language in the U.S./Israel treaty, the U.S. Model Income Tax Treaty and most other treaties in force at this time does not exclude this income from taxation in the United States. Lottery authorities also may need to consider federal withholding obligations when making payments to nonresident alien recipients as a consequence of this ruling.

Ismat M. Abeid v. Commissioner, 122 TC 404.

Prepared by Cheryl Metrejean, CPA, PhD, assistant professor of accountancy, Texas State University, San Marcos.

John Okerson was granted a divorce in 1994. In 1995 a state court entered a final divorce decree requiring him to make 113 monthly alimony payments to his ex-wife totaling $117,000 from September 1994 through January 2004. The decree, agreed to by both parties, stated the payments were to be considered alimony. The decree also said that if the taxpayer’s ex-wife died before the entire $117,000 was paid, the payments should continue until either of their two children completed their first four years of college or until the entire $117,000 was paid, whichever occurred first. No payments would be required if the children did not attend college, and the payments would be cut in half if only one child attended.

Okerson deducted $21,600 on his 2000 federal income tax return for the payments made to his ex-wife. In 2003 the IRS sent him a notice of deficiency disallowing the deduction. He petitioned the Tax Court for relief in 2003. He then obtained a court order from the state court that had granted the original divorce decree: It said the court had “clearly stated more than one time” that it intended the alimony to be tax deductible to Okerson and taxable to his wife. He presented the court order to the Tax Court.

Result. For the IRS. Okerson had argued the payments should be deductible as alimony since the parties in the original decree and the state court clearly intended to treat them as such. The Tax Court disagreed, saying Congress had eliminated any consideration of intent by the parties or any court when it enacted IRC section 71 and that, therefore, such intent did not determine the tax treatment of those payments. The requirements of the statute had to be followed.

Okerson further argued the contingent payments for the children’s college education should not be considered substitute payments since he never actually made any of them. The Tax Court disagreed, saying the standard to be applied to substitute payments was not whether they actually were paid but whether they could have been paid if the payee spouse died. The court then referred to temporary regulations section 1.71-1T(b), Q&A-14, to determine whether any of the $21,600 might qualify as alimony. The temporary regulations do allow a portion of the predeath payments to qualify as alimony when the postdeath payments are less than scheduled predeath payments. For example, if the predeath payments were $30,000 and the substitute payments were $10,000, then $20,000 would be considered alimony. The court determined that no portion of the $21,600 payments was deductible as alimony since the amount of the contingent postdeath payments would have been the same as the payments made to the ex-wife under the divorce decree.

John R. and Patricia G. Okerson v. Commissioner, 123 TC no. 14.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

Generally the transfer of property from one spouse to another due to a divorce is a nontaxable exchange under IRC section 1041. IRC section 408(d)(6) further states that the transfer of an individual’s interest in an individual retirement account (IRA) to a former spouse also is a nontaxable event.

Norma Cohen received a divorce in 1997 under an agreement that postponed to a later date any resolution of the financial matters. In June 1999 the Superior Court of New Jersey ordered that an IRA previously established by her ex-husband in his name should be divided equally. The IRA had assets of about $120,000. In July 1999 Cohen opened an IRA in her own name, into which her ex-husband transferred $60,000 from his IRA. Late in 1999, Cohen requested the $60,000 be withdrawn from her IRA in a check payable to her. She endorsed the check over to her ex-spouse to purchase his remaining interest in the former marital home. She did not report the $60,000 distribution on her 1999 tax return. She believed the $60,000 transfer from her ex-husband’s IRA represented a distribution from his IRA that was taxable to him and a subsequent $60,000 cash transfer of marital assets to her IRA. She then had a $60,000 basis in her IRA, which made the $60,000 withdrawal from her IRA a tax-free distribution. The IRS disagreed. Cohen petitioned the Tax Court for relief.

Result. For the IRS. Cohen argued the $60,000 transfer did not satisfy the requirements of section 408(d)(6) since the court order had directed an equal division of the $120,000 IRA but had not required a new IRA be established to receive the rollover. Therefore the transfer should have been taxable to her ex-husband. The Tax Court disagreed, saying the court order clearly had instructed her ex-husband to transfer a 50% interest in his IRA to her; therefore the requirements of section 408(d)(6) were satisfied.

The taxpayer also argued the Tax Court should follow its decision in Czepiel v. Commissioner , TC Memo 1999-289, holding that an IRA transfer was taxable to the ex-husband. The Tax Court also rejected this argument. In Czepiel , the taxpayer was ordered under a divorce decree to pay his ex-wife $29,000 as a “further division of marital property.” Due to financial difficulties, he withdrew funds from his IRA and paid the amount to his ex-wife. No transfer from the IRA had been required by the divorce decree. The Tax Court held that the $29,000 was taxable to Mr. Czepiel since he had received the funds from his IRA.

However, in this case, the $60,000 transfer from the IRA of Cohen’s ex-husband was due to the division of the IRA ordered by the divorce decree. Therefore, the transfer was tax-free to Cohen’s ex-husband, and she had a zero basis in the IRA. Cohen also had to pay the 10% penalty tax for an early withdrawal from an IRA.

Norma A. Cohen v. Commissioner, TC Memo, 2004-227.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

EITC Assistant Available Online
The IRS has developed a new tool to help tax professionals determine the eligibility of their clients for the earned income tax credit (EITC) ( www.irs.gov/newsroom/article/0,,id=129991,00.html ). The EITC Assistant helps determine eligibility for the credit, filing status and whether the taxpayers’ children meet the definition of “qualifying children” for EITC purposes.

Deduction for Educators Reinstated
Teachers and other educators can deduct up to $250 of their expenses for books and other classroom supplies for 2004 and 2005 when figuring adjusted gross income ( www.irs.gov/newsroom/article/ ). The Working Families Tax Relief Act of 2004 restored the educator expense deduction, which had expired at the end of 2003. Out-of-pocket expenses incurred any time during 2004 and 2005 (not just since the act was signed on October 4, 2004) may qualify. The deduction is available to educators in public or private elementary or secondary schools who work at least 900 hours during a school year as a teacher, instructor, counselor, principal or aide, whether or not they itemize deductions.

Toyota Prius Owners Can Take Clean-Fuel Deduction
The IRS approved the 2005 Toyota Prius as eligible for the clean-burning fuel deduction. Taxpayers who purchase this vehicle new may claim a tax deduction of $2,000 on form 1040 under the Working Families Tax Relief Act of 2004 ( www.irs.gov/newsroom/article/0,,id=130146,00.html ). The one-time deduction must be taken by the original owner in the year the vehicle first is used. Individuals can take this benefit as an adjustment to income and do not have to itemize deductions to claim it.

IRS Revises OIC Form
A newly revised application for an offer in compromise, the form 656 package—which makes it easier for taxpayers to follow the instructions and correctly apply for an agreement—is now available at www.irs.gov/newsroom/article/0,,id=130491,00.html . It includes Form 656-A, Income Certification for OIC Application Fee, and a worksheet to help taxpayers determine whether they meet the income exception to the $150 fee; a checklist to help them determine whether they are eligible; a third-party designee section, which allows a person other than the taxpayer to discuss any additional information the IRS needs to process the offer; and a summary checklist that reduces the chance the IRS will return the application for omissions.