Taxpayers denied insolvency exclusion of COD income

Cash held by a couple's son as their nominee tipped their balance sheet to positive, the Tax Court holds.
By David Silversmith, CPA

The Tax Court held that a Utah married couple were not insolvent under Sec. 108(a)(1)(B). As a result, they owed taxes on $158,511 of cancellation-of-debt (COD) income that they had excluded from gross income on their tax return.

Facts: The taxpayer husband, Vincent Hamilton, obtained two student loans to finance the education of the couple's son, Andrew Hamilton. A back injury in 2008 left Vincent Hamilton permanently disabled. Because of his disability, Vincent Hamilton sought to have the student loans discharged. In 2011, $158,511 of the student loan balances was discharged. Also in 2011, Vincent Hamilton's wife, Stephanie Hamilton, took over managing the couple's finances because of her husband's "erratic spending behavior." To that end, they transferred $323,000 to Andrew Hamilton's savings account, to which Stephanie Hamilton had access, regularly transferring amounts to the couple's joint account to pay their household expenses. On their 2011 joint income tax return (which they filed late on March 14, 2014), the Hamiltons omitted the COD income under the Sec. 108(a)(1)(B) exclusion because, they claimed, their liabilities exceeded their assets. They did not include among their assets the money they had transferred to their son's bank account.

The IRS determined a deficiency resulting from including the COD income and assessed late-filing and accuracy-related penalties.

Issues: Sec. 108(a)(1)(B) states that COD income is excluded from gross income if "the discharge occurs when the taxpayer is insolvent." The Hamiltons stated on their return that their liabilities exceeded their assets by $165,871. Both parties stipulated that the Hamiltons would be insolvent if Andrew Hamilton's account were not taken into consideration.

The IRS argued that Andrew Hamilton was a nominee for his parents, and thus the savings account should be included in his parents' assets when determining insolvency. Thus, the only issues were whether to include Andrew Hamilton's bank account as part of the couple's assets and whether they were liable for late-filing and accuracy-related penalties. The court stated that the Hamiltons had the burden of proof because they did not meet the requirements of Sec. 7491(a)(2), which states that taxpayers must maintain required records and respond to IRS requests for information, neither of which they did.

Holding: The Tax Court based its determination on six state-law factors used by Utah courts. Of the six, the court found that four of the factors favored the IRS's position: (1) The Hamiltons exercised dominion and control over the bank account; (2) Andrew Hamilton did not pay any consideration for the transferred money; (3) there was a close relationship between the Hamiltons and their son; and (4) the Hamiltons continued to enjoy the benefits of the money in their son's bank account. The court did not make a determination regarding the remaining two factors that can indicate the existence of a nominee relationship: that a transfer is made in anticipation of a liability or lawsuit, and that the conveyance is not recorded.

Because the factors favored the IRS, the Tax Court held, it found that Andrew was indeed a nominee for his parents, and thus the savings account should be included in their assets. With this addition, the Hamiltons' assets exceeded their liabilities by at least $60,002. Thus, their $158,511 of COD income should be included in gross income on their 2011 tax return, the court held. The court also found that the Hamiltons did not have reasonable cause for filing late and were thus subject to late-filing penalties.

However, the court denied the accuracy-related penalty. Under Sec. 6751(b)(1), tax penalties may not be assessed unless the initial determination of the assessment is "personally approved (in writing) by the immediate supervisor of the individual making such determination." The IRS failed to provide evidence that this requirement was satisfied; thus, the penalty was abated.

  • Hamilton, T.C. Memo. 2018-62

— By David Silversmith, CPA, senior tax accountant at Fulvio & Associates, New York City.

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