The Internal Revenue Code has relatively clear rules detailing the taxation of normal payments made on account of divorce. How these rules apply to pension plan distributions has been explained in several court cases. Recently, the Tax Court had to determine the taxation of a payment in divorce that was related to a pension plan in a community property state.

John Michael Dunkin was employed by the city of Los Angeles. On May 19, 1989, he became eligible to receive a pension, but decided not to retire. He was divorced on August 19, 1997. The divorce decree said John’s former spouse was entitled to half of his earned pension—at that point, $2,072. Since John did not retire on that date, the decree required him to pay his former spouse $2,072 monthly until he did retire. In 2000, he made the payments which totaled $25,511 and deducted this amount as alimony on his 2000 tax return. The IRS objected to the deduction.

Result. For the taxpayer. It has been long established that state law determines a person’s right to income and property and federal law determines the taxation of those rights. California law determined the $25,511 payment had to be made. The question, therefore, was the appropriate taxation of that payment.

In prior cases the Tax Court had ruled a former spouse was liable for the taxes due on her receipt of pension funds resulting from community property law. Likewise, she was liable if she received a lump-sum distribution from a pension plan. The IRS argued that these cases did not apply in this case because Dunkin had not started to receive his pension. The Tax Court rejected this argument. Prior cases had held the taxation of a former spouse was not determined based on the form of the payments. Dunkin’s former spouse received the payment from him because she was entitled to receive the pension regardless of the fact that he had not retired. Therefore the court was able to disregard the form of payment as meaningless.

The IRS then argued that taxing the former spouse would violate the assignment-of-income doctrine. The Tax Court rejected this argument on the grounds that under California community property law the former spouse earned the income and did not simply collect income earned by her former husband.

The government’s final argument was that the deduction was not allowed because the income was nontaxable to the former spouse since it had not come from the pension plan and had not, therefore, been covered by the rules governing such distributions. The fact that the code specifies how pension plan distributions should be taxed does not mean other payments related to pensions are nontaxable. Likewise, that a qualified domestic relations order directing the pension to pay the former spouse did not exist was immaterial. The former spouse had received a payment based on her share of a pension plan, and the court said it was taxable to her and deductible by her former husband if he had been ordered to make the payment.

The taxation of payment made on account of a divorce can be complicated. It is important, therefore, to carefully evaluate the true nature of the payment and not rely on the label or source of payment to determine the taxation.

John Michael Dunkin v. Commissioner, 124 TC no. 10.

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

A tax deduction is permitted for interest paid on business indebtedness. When a closely held corporation borrows money from its shareholders, the loans must be examined carefully to determine whether the transfer is a bona fide loan or a disguised capital contribution. The economics of the transfer must be examined to determine whether an unrelated lender would have entered into a similar agreement. When doubt exists, the taxpayer must prove the transfers represent debt by showing there is an unconditional obligation to repay the amounts transferred.
Indmar Products Co. is a closely held corporation whose shares are owned by members of the same family. From 1987 to 2000 the owners transferred money to the corporation, which treated the transfers as loans. Indmar made monthly payments to the shareholders equal to 10% of the amounts transferred, which it deducted as interest payments. The shareholders included the amounts received as interest income on their tax returns. The transfers were not immediately documented and never were secured. Repayments of “principal” were made when demanded by shareholders based on their financial needs rather than on a predetermined repayment schedule.

The shareholders treated the transfers as demand notes to avoid paying Tennessee income tax on the interest since interest on notes maturing within six months in that state is not subject to tax. Indmar, however, reported the demand notes as long-term liabilities on its financial statements to ensure its current ratio complied with the requirements of its loan agreements. To support the long-term liability classification, the company had its shareholders sign waivers stating they would not demand repayment of principal during the next 12-month period. Nonetheless, they demanded numerous repayments, and payments were made to them. The IRS disallowed the interest deductions for 1998 thru 2000, arguing that the transfers were capital contributions rather than loans. The taxpayer petitioned the Tax Court for relief.

Result. For the IRS. The Tax Court concluded the arrangement between Indmar and its shareholders would not occur between two unrelated parties in an arm’s-length transaction since the taxpayer and its shareholders altered the facts whenever it suited their needs. Furthermore, the 10% return paid to the shareholders was higher than the prime rate during the entire period in question.

The court also applied a list of 11 factors that the Sixth Circuit Court of Appeals had previously used ( Roth Steel Tube Company v. Commissioner, 800 F2d 625) to determine whether transfers made to a corporation represented debt or equity. The court determined the following factors showed debt treatment for the transfers in Indmar: (1) External financing was available to the corporation during the entire period; (2) Indmar was adequately capitalized; (3) the transfers were not subordinated to all creditors; (4) the transfers were not in proportion to the shareholders’ ownership interests; and (5) the transfers were reported as debt by the corporation, but the related monthly payments to the shareholders were reported by them as interest income.

The Tax Court, however, also determined other factors outlined in Roth Steel Tube meant the transfers represented equity. The notes had no fixed maturity date or obligation to repay; the transfers were unsecured; no sinking fund had been established by Indmar to repay the “loans”; and the source of repayment of the notes, based on the testimony of a major shareholder, was corporate profits.

The court also noted Indmar never had paid a dividend during the years in question. Thus it concluded the factors suggesting equity treatment outweighed those showing debt treatment. This finding, combined with the court’s previous determination that the transfers were unlikely to occur between unrelated parties, led the court to conclude that the transfers were equity. Therefore it denied the interest deductions.

Roth Steel Tube provides a clear delineation of the factors that determine whether transfers to corporations are debt or equity. When applying these to a particular factual situation, no one factor is controlling.

Indmar Products Co., Inc., TC Memo 2005-32.

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

Determining whether a debt has become worthless always is a question of fact which requires consideration of all pertinent evidence—including the debtor’s financial condition and the value of any security for the debt. A recent Tax Court decision focused on some key factors in making such a determination.

Maurice E. John Jr. was an eye surgeon and sole owner of John Eye Clinic Inc., a professional corporation. In 1987, the taxpayer hired John Evans to serve as the clinic’s business manager. Because of Evans’ outstanding performance, the clinic became significantly more successful and profitable.

In 1991, as shrinking Medicare reimbursements reduced the clinic’s income, Evans suggested to John they diversify by offering management services to other clinics for a fee. In addition to the U.S. market, Evans saw economic opportunities in Russia as the Soviet bloc began to collapse. John agreed to provide the necessary capital while Evans was to manage and develop the businesses. For this Evans was to receive a 50% ownership interest.

Between 1992 and 1995 John advanced about $2.5 million to the ventures, while Evans made no capital contributions. John determined that Evans owed him $491,054 for his share of the investment. Although John never entered into a promissory note with Evans, he had always expected Evans to “work off” his share of the capital contributions if the ventures ever failed.

In 1995, due to a lack of profitability, John instructed Evans to stop making investments in Russia. Evans, however, continued to do so. John fired him and filed suit to recover Evans’ share of capital in January 1996. Although the legal action was settled out of court, John claimed a bad debt deduction in the amount of $491,054 on his 1995 tax return. The IRS challenged the deduction.

Result. For the IRS. According to the Tax Court, the debt did not become wholly worthless in the year in which the taxpayer claimed the deduction. While a taxpayer need not be an “incorrigible optimist” with respect to the value of a debt, he or she may not substantiate the worthlessness of a debt with his or her pessimism. Thus, a taxpayer must provide sufficient evidence to demonstrate a debt is indeed worthless and not merely surmise any collection effort would be futile. Consequently, the Tax Court focused on three main issues: Can a job termination render a debt worthless? Does the loan have future value? Were reasonable steps taken to collect the debt?

There is no case law that shows job termination leads to loan worthlessness. In fact, the converse has been held true. In Southwestern Life Insurance, the Fifth Circuit Court of Appeals denied a bad debt deduction for unpaid loans to employees who simply left the company. There was no relationship between the termination and the worthlessness of the loans. Therefore, in the case at hand, because the repayment of the advances was not conditioned on Evans’ continued employment, the Tax Court held the termination was insufficient to render the debt worthless.

On the second question, John argued that because Evans was insolvent and owned no significant assets, the loan must be worthless. But the Tax Court, as well as the Seventh Circuit, has long held that insolvency does not, of itself, demonstrate worthlessness. Furthermore, it is incumbent upon the taxpayer to show that the worthless security lacks “future value.” In making this determination, the courts take into consideration several factors, such as the debtor’s age, educational status and future earnings potential. Because Evans was in his forties, had an MBA from Vanderbilt University and quickly found new employment after termination from the clinic, the court held the loan had, at the very least, some future value.

Finally, a taxpayer must exhaust all reasonable means of collecting the debt in order to prove its worthlessness. There was no evidence John ever took affirmative steps, other than filing the lawsuit, to enforce collection of the amounts owed him by Evans. Moreover, his lawsuit was filed primarily to compel Evans to cease activities and not to collect a debt. The court further rejected John’s rebuttal that he did not want to destroy Evans financially, just to prove the debt was worthless. Based on these considerations, the Tax Court held that reasonable steps were not taken to collect the debt.

Maurice E. John Jr. v. Commissioner, TC Memo 2004-257, November 9, 2004.

Prepared by Steven C. Thompson, CPA, PhD, associate professor of accounting, Texas State University, San Marcos, and David W. LaRue, PhD, associate professor of accounting, University of Virginia, Charlottesville.