Romancing The Income

Let’s discuss Blagaich, an early 2016 decision from the Tax Court. This is a procedural decision within a larger case of whether cash and property transfers represent income. 

Blagaich was the girlfriend and in 2010 was 54 years old.

Burns was the boyfriend and in 2010 was 72 years old.

Their romance lasted from November 2009 until March 2011.

It appears that Burns was fairly well heeled, as he wired her $200,000, bought her a Corvette and wrote her several checks. These added up to $343,819.

He was sweet on her, and she on him. Neither wanted to marry, but Burns wanted some level of commitment. What to do …?

On November 29, 2010 they decided to enter into a written agreement. This would formalize their “respect, appreciation and affection for each other.” They would “respect each other and … continue to spend time with each other consistent with their past practice.” Both would “be faithful to each other and … refrain from engaging in intimate or other romantic relations with any other individual.”

The agreement required Burns to immediately pay Blagaich $400,000, because nothing says love like a check you can immediately take to the bank.

Surprisingly, the relationship went downhill soon after entering into the agreement.

On March 10, 2011 Blagaich moved out of Burn’s house.

The next day Burns sent her a notice of termination of the agreement.

That same month Burns also sued her for nullification of the agreement, as she had been involved with another man throughout the entire relationship. He wanted his Corvette, his diamond ring - all of it - returned.

Somewhere in here Burns must have met with his accountant, as he/she sent Blagaich a Form 1099-MISC for $743,819.

She did not report this amount as income. The IRS of course wanted to know why.

The IRS learned that she was being sued, so they decided to hold up until the Circuit Court heard the case.

The Circuit Court decided that:

·        The Corvette, ring and cash totaling $343,819 were gifts from him to her.

·        The $400,000 was different. She was paid that under a contract. Flubbing the contract, she now had to pay it back.

Burns had passed away by this time, but his estate sent Blagaich a revised Form 1099-MISC for $400,000.

With the Circuit Court case decided, the IRS moved in. They increased her income by $743,819, assessed taxes and a crate-load of penalties. She strongly disagreed, and the two are presently in Tax Court. Blagaich moved for summary adjudication, meaning she wanted the Tax Court to decide her way without going through a full trial.

QUESTION: Do you think she has income and, if so, in what amount?

Let’s begin with the $400,000.

The Circuit Court had decided that $400,000 was not a gift. It was paid pursuant to a contract for the performance of services, and the performance of services usually means income. Additionally, since the payment was set by contract and she violated the contract terms, she had to repay the $400,000.

She argued that she could not have income when she had to pay it back. In legal-speak, this is called “rescission.”

In the tax arena, rescission runs head-on into the “claim of right” doctrine. A claim of right means that you have income when you receive an increase in wealth without a corresponding obligation to repay or a restriction on your being able to spend. If it turns out later that you in fact have to repay, then tax law will allow you a deduction – but at that later date.

Within the claim of right doctrine there is a narrow exception IF you pay the money back by the end of the same year or enter into a binding contract by the end of the same year to repay. In that case you are allowed to exclude the income altogether.

Blagaich did not do this. She clearly did not pay the $400,000 back in the same year. She also did not enter in an agreement in 2010 to pay it back. In fact, she had no intention to pay it back until the Circuit Court told her to.

She did not meet that small exception to the claim-of-right doctrine. She had income. She will also have a deduction upon repayment.

OBSERVATION: This is a problem if one’s future income goes down. Say that she returns to a $40,000/year job. Sure, she can deduct $400,000, but she can only offset $40,000 of income and the taxes thereon. The balance is wasted. Practitioners sometimes see this result with athletes who retire, leaving their sport (and its outsized paychecks) behind. It may never be possible to get back all the taxes one paid in the earlier year.

Let’s go to the $343,819.

She argued that the Circuit Court already decided that the $343,819 was a gift. To go through this again is to relitigate – that is, a double jeopardy to her. In legal-speak this is called “collateral estoppel.”

The Court clarified that collateral estoppel precludes the same parties from relitigating issues previously decided in a court of competent jurisdiction.

It also pointed out that the IRS was not party to the Circuit Court case. The IRS is not relitigating. The IRS never litigated in the first place.

She argued that the IRS knew of the case, requested and received updates, pleadings and discovery documents. The IRS even held up the tax examination until the Circuit Court case was decided.

But that does not mean that the IRS was party to the case. The IRS was an observer, not a litigant. Collateral estoppel applies to the litigants. That said, collateral estoppel did not apply to the IRS.

Blagaich lost her request for summary, meaning that the case will now be heard by the Tax Court.

What does this tax guy think?

She has very much lost the argument on the $400,000. Most likely she will have to pay tax for 2010 and then take a deduction later when she repays the money. The problem – as we pointed out – is that unless she has at least $400,000 in income for that later year, she will never get back as much tax as she is going to pay for 2010. It is a flaw in the tax law, but that flaw has been there a long time.

On the other hand, she has a very good argument with the $343,819. The Court was correct that a technical issue disallowed it from granting summary. That does not however mean that the technical issue will carry the day in full trial. That Circuit Court decision will carry a great deal of evidentiary weight.

We will know the final answer when Blagaich v Commissioner goes to full trial.