Horsing Around with the Fifth Amendment in Civil Cases - The Case of the NonParty Witness
In LiButti v. United States, 97 TNT 37-22 (2d Cir. 2/21/97), the IRS levied on a prize horse (named "Devil His Due") to pay a tax liability of a father who had been convicted of tax evasion and, from the same milieu, emerged with at $4MM+ tax liability. The taxpayer (really nontaxpayer) thereafter had ample reason to avoid owning assets in order to avoid paying the IRS Devil Its Due. Scouring for hidden assets, the IRS levied on the horse that the taxpayer's daughter alleged that she owned. The daughter sued under Section 7426 to recover the horse. The IRS urged that the horse was the taxpayer's and that the daughter was, in effect, simply a nominee. The IRS's case was built on circumstantial evidence. The district court rejected that circumstantial evidence, holding that the daughter had an ownership interest in the horse and that the Government had failed to meet its burden to show a nexus between the horse and the taxpayer. There was some confusion over the precise burden(s) (and shifting burdens) the parties faced in Section 7426 cases, but the Court of Appeals held that it did not have to refine the law on that subject because, under its view, the district court had to reconsider the case on remand. (Readers interested in the current confusion in the law on the burdens in such cases might want to review the opinion's discussion of the issue.) The issue we found most interesting was the Appeals Court's discussion of the propriety of drawing adverse interests from a nonparty witness's invocation of the Fifth Amendment privilege against self-incrimination. The Government had deposed the father -- the taxpayer (or nontaxpayer) in the case -- to inquire into whether he owned an interest in the horse. The father refused to answer, citing the Fifth Amendment privilege. The Court of Appeals concluded that his invocation of the Fifth Amendment was relevant to the issue before the Court, for if the father owned no interest in the horse, he could have simply denied such an interest without any concern regarding possible incrimination. An inference could therefore be drawn that the Fifth Amendment privilege to answering the question was proper only if the correct answer was affirmative and would show that he had hidden his ownership in order to defeat payment of the tax bill. Legally, that relevant evidence could be considered on the merits by drawing an adverse inference because there was a sufficient nexus between the plaintiff (the daughter) and the nonparty witness claiming the privilege under circumstances that the claim might assist the daughter. The inference is not conclusive, but a trier of fact could consider it in the overall context of the case to reach a decision on the merits. (Posted 2/25/97)
Danielson Rule and Its Variations - a Look at Litigation Settlements
There is a tax rule of general application that the IRS may rely upon and tax a taxpayer according to the form in which the taxpayer structured the transaction. In a negotiation resulting in an agreement, this means that the taxpayer is bound by the terms of the agreement. The IRS reserves the right to tax the transaction differently if the form is not consistent with the substance, but the taxpayer is generally limited in the right to do so because the taxpayer structured the form of the transaction. Some courts have adopted the Danielson rule, based on a case of the same name, that says just that. Other courts have adopted a "strong proof" rule permitting a taxpayer to avoid the form of the agreement only upon making strong showings of entitlement. There are sound policy reasons for the rule. But a recent case has illustrated how dramatically this can play out.
It is commonplace for lawyers settling tort or similar litigation to attempt the best tax spin on the settlement by allocating to tax favorable categories (principally Section 104 personal injury items). The IRS routinely insists upon going behind the allocations to determine the real deal, based upon the pleadings, the trial events, etc. For example, in Robinson v. Commissioner, 102 T.C. 116 (1994), aff'd on this issue 70 F.3d 34 (5th Cir. 1995), cert. denied 117 S. Ct. 83 (1996), after the jury returned a verdict that, on its face, allocated substantially less than 50% of the actual damages to personal injuries, the parties settled for a substantially reduced but allocated 95% of the reduced amount to personal injuries. The courts pierced the settlement agreement and reduced the amounts qualifying for the personal injury exclusion by looking to the jury verdict as containing the appropriate relative amounts. In Arrington v. United States, ___ F.3d ___ (Fed. Cir. 3/7/97), unofficially reported at 1997 DTR 46 d 57, the Court affirmed a decision of the Court of Federal Claims that taxed the taxpayer according to the settlement agreement. In that case, issue was whether certain settlement funds were includable in the estate of a deceased child. In the tort litigation giving rise to the settlement, both the child (since deceased) and the parents were plaintiffs. The jury returned a verdict in which the parents were entitled to 57.91 percent of the aggregate award. Nevertheless, in settling the case after the jury verdict, the settlement agreement allocated 100% to the child which then became includible in the child's gross estate when the child died. The taxpayer argued that the jury verdict reflected the "real deal," so that only 42.09 percent of the settlement proceeds really was owned by the child, with the balance being subject to a resulting trust in favor of the parents who were the real beneficial owners under the analysis exemplified in Robinson. The courts (trial and appellate) rejected the argument. The trial court rejected the argument because it found that the taxpayer had abandoned the argument. The appellate court considered the argument and rejected it, finding the break down in the jury verdict "inconsequential" because the settlement agreement superseded the jury verdict. The court of appeals thus required the estate to lay in the bed which it had made (i.e., the agreement it entered allocating the settlement all to the child). The Court did not cite Danielson or cases varying the same theme, but it is clear that the same policies impelled the result.
Bottom line, of course, tort lawyers have to be very careful in drafting settlement agreements. The parameters are, of course, that the IRS can stick the taxpayer to the tax consequences of the terms of the settlement agreement, even if the settlement agreement could have been drafted otherwise. Contrariwise, the IRS has the right to insist that the taxpayer be taxed on the real deal regardless of the actual terms of the settlement. Only the taxpayer loses the right to insist on the real deal if the settlement is inconsistent with the real deal. In drafting the settlement agreement, therefore the lawyers should be guided by what is the real deal, document the real deal, and not stray too far from the real deal, for otherwise they will be at the mercy of the IRS and the courts who may not understand the real deal.
Taxpayer's Reliance on Step Transaction Doctrine Rejected
In Norwest Corporation and Subsidiaries v. Commissioner, 108 T.C. No. 15 (4/28/97), the taxpayer had Brazilian blocked deposits at the Central Bank of Brazil. The blocked deposits arose from principal payments on dollar-denominated loans to Brazilian companies. Because of a debt crisis, Brazil prohibited the payment of these loans outside of Brazil. Instead, the payments were made into the blocked deposit accounts that were dollar-denominated accounts. These blocked deposits were bought and sold at significant discounts on a secondary market. Brazil allowed these deposits to be used in so-called "debt-equity conversions" whereby the lender’s dollar-denominated deposits would be exchanged into the Brazilian currency at the official exchange rate and the Brazilian currency would then be used to make the equity investment in a Brazilian currency. The taxpayer used its blocked deposits to acquire such an equity interest. The taxpayer took two tacks to obtain a significant tax loss on the transaction (which, of course, did reflect an economic loss in every practical sense of the term). First, it urged that the value of the Brazilian currency it received was the amount for which the blocked deposits would have traded on the secondary market (i.e., the heavily discounted amount). Second, it argued that the receipt of the Brazilian currency was just a step in a transaction whereby the dollar-denominated loans were converted to an equity investment, so that the measure of the tax loss is the difference between the amount of the loan deposits in question and the value of the stock investment. The IRS relied on this intermediate currency-conversion step, asserting that the taxpayer had no loss because it converted its dollar-denominated loan into Brazilian currency of equal value. The Tax Court judge (Judge Jacobs) first rejected the taxpayer’s step transaction argument and focused on the currency exchange as being the applicable taxable event. In valuing the Brazilian currency received, the Court rejected the taxpayer’s reference to the secondary market because the taxpayer chose for its own business reasons not to dispose of its loans in that market but to accept instead the Brazilian currency which it then used to make an equity investment in a Brazilian company. However, instead of valuing the exchange at par (in which case there would have been no loss), the Court gave the taxpayer a 15% discount on the Brazilian currency received, far less of a discount and resulting tax loss than the taxpayer sought. (Posted 4/29/97)