Eleventh Circuit Affirms Tax Court in Recharacterizing Loan as a Sale for Tax Purposes
On August 23, 2012, the U.S. Court of Appeals for the Eleventh Circuit affirmed the decision of the Tax Court and ruled in favor of the IRS in Calloway v. Commissioner of the IRS, case no. 11-10395, available here.
The facts of the case are as follows:
Albert Calloway worked for IBM for a number of years and acquired IBM stock by exercising his employee stock options. During 2001, Bert Falls, Mr. Calloway’s financial adviser, introduced Mr. Calloway to a program operated by Derivium Capital, LLC (“Derivium”). Under that program, Derivium would “lend” a client ninety percent of the value of securities that the client pledged to Derivium as collateral. During the term of the non-recourse loan, Derivium had no restrictions on its use of the collateral. At the end of the loan’s term, the client had three options: (1) He could reclaim the collateral by paying the principal and accrued interest; (2) He could surrender the collateral to Derivium; or (3) He could refinance. Mr. Calloway testified that the loan program was attractive to him because, had he sold his stock, he would have had to pay twenty percent in capital gains tax; under the Derivium program, however, he received ninety percent of the stock’s fair market value.
The details of Mr. Calloway’s arrangement with Derivium are set forth in three documents: “Master Agreement to Provide Financing and Custodial Services” (“Master Agreement”), “Schedule D Disclosure Acknowledgment and Broker/Bank Indemnification” (“Schedule D”) and “Schedule A-1 Proper Description and Loan Terms” (“Schedule A-1”). Schedule A-1 details the terms of the loan. Specifically, the loan amount was ninety percent of the fair market value at the time of closing; the estimated value of the collateral at that time was $105,444.90. The interest rate to be charged was ten-and-one-half percent, compounded annually; the interest accrued until, and was due at, maturity. Any dividends on the pledged collateral were to “be received as cash payments against interest due.” The loan could not be prepaid, and the lender could not seek recourse against the borrower, only the collateral. The closing date was “[u]pon receipt of securities and establishment of [Derivium’s] hedging transactions.” Mr. Calloway executed the Master Agreement and attached schedules on August 8, 2001, and authorized the transfer of 990 shares of his IBM stock to Derivium’s account with Morgan Keegan & Company, Inc., on the following day. Cathcart, as president of Derivium, signed the Master Agreement and schedules on August 10, 2001.
On August 17, 2001, Derivium’s operations office sent Mr. Calloway two documents. The first was a valuation confirmation indicating that Derivium had received the stock, valued at $104,692.50, into its account. The second document, titled “Activity Confirmation,” indicated that, as of August 17, 2001, Derivium had hedged the IBM stock for slightly less, $103,984.70, yielding an “Actual Loan Amount” of $93,586.23. On August 21, 2001, Derivium sent Mr. Calloway a letter informing him that the proceeds of the loan were sent to him according to the wire transfer instructions he had provided a few days earlier. On the same date, $93,586.23 was credited to Mr. Calloway’s credit union account. Previously, on August 17, Derivium had exercised its right to sell the stock without giving notice to Mr. Calloway.
During the period of time covered by the loan, Mr. Calloway received quarterly and year-end account statements. Each quarterly statement set forth the loan balance at the beginning of the quarter, indicated the interest accrued during the quarter and credited the account for the dividends paid during the quarter to yield the end-of-quarter loan balance. The statement also provided the end-of-quarter collateral value. Mr. Calloway did not receive any tax statements reflecting dividend income (Form 1099-DIV), nor did he report on his tax returns any dividend income earned from the 990 shares of IBM stock. In a letter dated July 8, 2004, Derivium informed Mr. Calloway that the loan would mature on August 21, 2004. Consistent with the Master Agreement and accompanying schedules, the letter stated that Mr. Calloway could either (1) pay the maturity amount of $124,429.09 and recover his collateral, (2) renew or refinance the transaction for an additional term, or (3) surrender the collateral. On July 27, 2004, Mr. Calloway returned the response form to Derivium indicating that he was “surrender[ing his] collateral in satisfaction of [his] entire debt obligation.”
The IRS issued a notice of deficiency to the Calloways for failing to include the income from the sale of the IBM stock on their 2001 income tax return. It also assessed two penalties for failure to timely file a return and for significant understatement of income.
The case before the Tax Court produced a majority opinion authored by Judge RUWE, and joined by Judges COLVIN, COHEN, WELLS, GALE, THORNTON, MARVEL, GOEKE, KROUPA, GUSTAFSON, and PARIS. Judge HALPERN, issued an opinion concurring in the result only, which was joined by Judge WHERRY. Judge HOLMES, also issued an opinion concurring in the result only.
The Eleventth Circuit adopted the reasoning of both Anschutz Co. v. Comm’r, 664 F.3d 313, 324 (10th Cir. 2011), available here, and the Ninth Circuit’s opinion Sollberger v. Comm’r, case no. 11-71883 (Aug. 16, 2012), available here, and distilled the analysis regarding whether the transaction was a sale down to the following factors:
(1) Whether legal title passes; (2) the manner in which the parties treat the transaction; (3) whether the purchaser acquired any equity in the property; (4) whether the purchaser has any control over the property and, if so, the extent of such control; (5) whether the purchaser bears the risk of loss or damage to the property; and (6) whether the purchaser will receive any benefit from the operation or disposition of the property. The Eleventh Circuit noted, however, that no one factor is controlling, nor is the list exhaustive.
The 11th Circuit then held as follows: “[W]e believe that the most relevant of those factors point firmly to the conclusion that the 2001 transaction was a sale of stock for the purposes of Federal income tax.” Slip op. at 28. But the 11th Circuit then rejected the alternative analytical framework advanced by either Judge HALPERN or Judge HOLMES (“Moreover, we do not believe that the tests applied by the concurring judges provide viable alternatives to the benefits and burdens test.”). Slip op. at 35-36.
The Calloway case demonstrates that federal courts of appeal tend to take a more holistic and flexible approach to viewing transactions for income tax purposes. However, given the obvious disagreement as to the appropriate analytic framework among the Tax Court judges, it appears that tax court litigants need to be cognizant of the fact that methods of proof may vary not only among judges, but among circuits as well.
The attorneys at Fuerst Ittleman David & Joseph, have extensive experience litigating before the U.S. Tax Court and the various U.S. Circuit Courts of Appeal. You can contact us by calling 305.350.5690, or by emailing us at firstname.lastname@example.org.