Phantom Stock Held by Partnership Receives Capital Gains Treatment

HURFORD INVESTMENTS NO. 2, LTD.,
HURFORD MANAGEMENT NO. 2, LLC, TAX
MATTERS PARTNER,
Petitioner(s),
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

Pursuant to Tax Court Rule 50(f), orders shall not be treated as precedent,
except as otherwise provided

UNITED STATES TAX COURT
WASHINGTON, DC 20217

ORDER

This partnership-tax case was on the Court's November 13, 2012 trial calendar for Dallas, Texas, but we moved it onto a summary-judgment track after some time on a pretrial-order track. The Court will assume the parties know the background facts (which they agree are not genuinely disputed); the usual rules about summary judgment apply.

Background

This unusually complicated pair of cross-motions have their ultimate origin in the aggressive estate planning undertaken by Thelma Hurford in 2000 after the sudden death of her husband Gary in 1999 and before her own death in 2001. This plan did not go well in design or execution, and we dissected it all in detail in Estate of Hurford v. Commissioner, 96 T.C.M. (CCH) 422 (2008); see also Dan W. Holbrook, Tax Court Has a Cow over Bad Estate Planning, 45 Tenn. B.J. 34 (2009).

These motions are about a part of that planning, a partnership called Hurford Investments No. 2, Ltd. (HI-2), whose tax matters partner is an LLC named Hurford Management No. 2, LLC. This partnership was created to hold one of Gary Hurford's most valuable assets — phantom stock in the Hunt Oil Company, the firm where he had spent most of his professional life. We described this asset in the opinion:

Estate of Hurford, 96 T.C.M. (CCH) at 425.

One of the most important terms in the phantom-stock agreement was what it called a "qualified termination of service." Gary's death was one such "qualified termination of service," and it triggered a five-year countdown. During these five years, the phantom shares would grow or decline with the value of the company and would also continue to earn any dividends. But at the end of the fifth year, the company would automatically "redeem" the stock. The agreement made clear that this redemption meant that Hunt Oil would create an interest-bearing "phantom account" on its books equal to the value of the shares. This account balance could also fluctuate with the company's value: If the company's stockholder equity fell, the account's value would fall by an equal percentage; if it rose, the account's value would rise by the lesser of the percentage rise in the company's stockholder equity or the 90-day Treasury rate. Whoever held the account — or Hunt Oil at its option — could cash it out at any time.

Who held the phantom stock is also important. Gary held it first until he died in 1999, and then Thelma inherited it. She then decided to transfer the phantom stock to HI-2 in 2000. She called Hunt Oil to ask it to recognize HI-2 as the phantom stock's holder, and after a bit of paperwork shuffling Hunt Oil wrote her at the start of 2001 to say that it formally recognized HI-2 as the holder of the phantom stock as of March 22, 2000.

At the time of transfer the value of the phantom stock was $6,411,000. Thelma had never reported her receipt of the phantom stock on her income-tax returns, but HI-2 reported this transfer on its 2000 Form 1065 as a $6,411,000 short-term capital gain.

Thelma died in February 2001. In the ensuing estate-tax case, we held the value of the phantom stock had to be included in her taxable estate. Estate of Hurford, 96 T.C.M. (CCH) at 442. This value, measured at the time of her death, was a little over $9.6 million, an increase in value of more than $3.2 million from when Hunt Oil recognized HI-2 as its owner.

The five-year clock on the phantom stock ended in 2004. Hunt Oil redeemed the stock as required. And in 2006 the company decided to liquidate the successor phantom account and distribute almost $13 million to HI-2.

This case is about the tax consequences to HI-2 of this distribution. We know how HI-2 originally reported it — its 2006 Form 1065 reported it as ordinary income of about $6.5 million, which was the difference between the value at the time of distribution minus the amount reported in 2000 as "short-term capital gain." The IRS audited HI-2's 2006 return, and during the audit HI-2 submitted a Form 8082 (Administrative Adjustment Request), in which it asserted that its initial reporting position was wrong. Its primary argument was that the reported income should've been reported as long-term capital gain, not ordinary income, and that the amount should have been only about $3.3 million — the difference between the value at the time of distribution minus the value at the time of Thelma's death that was added back to her gross estate. The IRS determined that HI-2's initial return position was correct and it issued a no-change Final Partnership Administrative Adjustment (FPAA). HI-2 filed its petition to challenge this determination.

In a closing agreement executed in 2011, HI-2 and the Commissioner agreed that $6,114,000 was the value of the phantom stock and it should be classified as income in respect of a decedent per section 691. They also agreed that HI-2 received basis in its phantom-stock interest of the same amount — $6,411,000.

Each party moved for summary judgment.

Analysis

The arguments. The Commissioner's position is simple — he wants us to leave things the way HI-2 first reported them. He argues

HI-2 disagrees.

It argues that the character of the distribution is long-term capital gain that should be recognized in 2006. It doesn't dispute that the value of the phantom stock in the hands of Thelma was income in respect of a decedent under section (and thus taxable as ordinary income to her if the IRS had chosen to do so back then). But it believes that the phantom stock became a capital asset in the hands of HI-2 after the transfer, meaning that it had long-term capital gain in 2006 when Hunt Oil liquidated the phantom account. This of course means it also has to assert that Thelma's transfer to HI-2 was valid for income-tax purposes.

HI-2 then argues even more aggressively that not only should it have long-term capital gain, but that it should also get a step-up in basis — measuring the gain as the difference between the phantom account's value at the time of distribution and the phantom stock's value at the date of Thelma's death in 2001. HI-2 contends that Thelma triggered section 691(a)(2) when she transferred the phantom stock before her death — which required it to be immediately recognized as income to Thelma. But it was HI-2, not Thelma, that recognized income then and got basis in the phantom stock. Our opinion in the estate-tax case held that the value of the phantom stock on the date of Thelma's death was part of her estate in 2001. This amount — just over $9.6 million — was higher than the $6.4 million value on the date of Thelma's transfer to HI-2. HI-2 argues that the inclusion of this $9.6 million in Thelma's estate in 2001 means that it should get a stepped-up basis in its phantom stock to equal that value.

We look at each.

Res Judicata

This is an easy issue. Res judicata is a doctrine that precludes a party from raising a claim that could have been brought in an earlier proceeding. See Allen v. McCurry, 449 U.S. 90, 94 (1980) ("Under res judicata, a final judgment on the merits of an action precludes the parties or their privies from relitigating issues that were or could have been raised in that action"). The Estate of Hurford case was about estate tax, and was limited to the claim that the notice of deficiency sent to the estate and adjusting the estate tax was wrong. No party to that proceeding could have brought a claim that the Commissioner erred in determining a deficiency in HI-2's income-tax from years later. Under res judicata one has to have the same claim in both cases and we don't have that here.

If by res judicata the Commissioner meant collateral estoppel, he still wouldn't win because — at a minimum — there was no actual litigation of the issue of whether HI-2 was a sham partnership that should be disregarded for tax purposes.

How the Distribution to HI-2 Should Be Taxed

We look first to the Code. The phantom stock was, as we've said, a form of deferred compensation to Gary. He hadn't yet received it when he died in 1999, which meant that it was — as to him — an item "of gross income in respect of a decedent which [is] not properly includible in respect of the taxable period in which falls the date of his death. . . ." I.R.C. § 691(a)(1).

That section then goes on to say that it should be included in the income of the person who inherited it — in this case, Thelma — when she received it because it is an item of income and "shall be included in the gross income for the taxable year when received, of . . . the person who, by reason of the death of the decedent, acquires the right to receive the amount. . . ." I.R.C. § 691(a)(1)(B).

But Thelma's death in 2001 meant that it wasn't includible in her gross income either. Except for one thing — she transferred the phantom stock to HI-2 in 2000 before she died. There's another sentence in section 691 that deals with this possibility: "If a right . . . to receive an amount is transferred by . . . a person who received such right by reason of the death of the decedent . . . there shall be included in the gross income of . . . such person . . . for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer. . . ." I.R.C. § 691(a)(2).

This is another good reason for Thelma's not doing what the estate planner who advised her back in 2000 told her to do: He seems to have been unaware of this section (as was, to be sure, the Commissioner and the Court during the estate-tax case). But the language is, as HI-2 now emphasizes, as clear as anything in the Code. Thelma got the phantom stock by reason of her husband's death. She transferred it to HI-2. This means that she should have reported the phantom stock's value at the time of the transfer. And section 691(a)(3) says that she should have reported it as ordinary income.

Except that she didn't report it at all, much less as ordinary income, and now too much time has passed to fix this mistake.¹ And there's the added complication that HI-2 did report it on its own 2000 tax return, albeit as short-term capital gain. (How it came up with that characterization is another mystery.)

A. Was the Phantom Stock a Capital Asset?

Here we have two problems. The first is whether the phantom stock in the hands of HI-2 was a capital asset. The second is what the basis of that capital asset might be.

The Closing Agreement. On the first question, HI-2 has two arguments. The first is that HI-2 and the IRS reached a closing agreement back in 2011. Under its terms:

This is the kind of reporting mess that closing agreements are especially good at tidying up. Courts accept closing agreements as contracts between taxpayers and the Commissioner as to the matters specifically agreed upon. See Alexander v. United States, 44 F.3d 328, 332 (5th Cir. 1995); Estate of Magarian Commissioner, 97 T.C. 1, 6 (1991). The only way parties get out of them is with a showing of fraud, misrepresentation, or malfeasance, see I.R.C. § 7121(b); Zaentz v. Commissioner, 90 T.C. 753, 760 (1988), which no one alleges here. And, it is very important to emphasize that parties may premise a closing agreement on a mistake of law. See id. at 761-62.

That may be what happened here. The phantom stock in Thelma's hands was ordinary income — remember that it wasn't actual stock but a form of deferred compensation. And the Commissioner's acceptance in the closing agreement that HI-2 had "basis" in the phantom stock would seem to be premised on an assumption that the phantom stock was a capital asset in HI-2's hands. But the closing agreement doesn't specifically say that the phantom stock was a capital asset. That makes this case look like Zaentz, where a partnership reached a closing agreement with the Commissioner, but the Commissioner later claimed that the partnership was a sham, and litigation ensued. The taxpayer argued that the IRS must've agreed that the partnership was valid if it was willing to execute a closing agreement with it, but we held that a closing agreement "does not bind the parties as to the premises underlying their agreement; they are bound only as to the matters agreed upon." Zaentz, 90 T.C. at 761. We followed Zaentz in Estate of Magarian — even though the parties said in the closing agreeement in that case that they "wish[ed] to resolve with finality the disputes with respect to the partnership" and held the IRS could still go for additions to tax in a later proceeding because that particular item was not the subject of any provision in the closing agreement. Estate of Magarian, 97 T.C. at 5-6.

If HI-2 relied only on the closing agreement it might have a problem with this part of its motion.

But it doesn't. It also has section 1221.

Section 1221. Section 1221 defines the term "capital asset." It's a very broad section, and defines the term as all property that isn't specifically excluded by one of a list of exceptions. I.R.C. § 1221(a); 26 C.F.R. § 1.1221-1(a). Importantly, the character of property can change depending on who holds it. A car dealership's cars, for example, are inventory to the dealership, so the cars would fall into the category of non-capital assets in the hands of a car dealer. But a car becomes a capital asset in the hands of the usual car buyer because it no longer fits one of the non-capital asset definitions in section 1221. See, e.g., David Taylor Enters., Inc. v. Commissioner, 89 T.C.M. (CCH) 1369 (2005). The same holds true in more complicated cases, such as inventory of a sole proprietorship which become capital assets in the hands of the business owner's estate. Estate of Ferber v. Commissioner, 22 T.C. 26 1 ( 1954); see also Berry Petroleum Co. v. Commissioner, 104 T.C. 584, 650 n.48 (1995) (noting that the character of property for one company may be different for a successor company). HI-2's interest in the phantom stock doesn't fit into one of the exceptions listed in section 1221,² so it seems it's a capital asset.

But caselaw throws another exception at us that we must consider — the substitute-for-ordinary-income doctrine. Sometimes something must be taxed as ordinary income even if it doesn't fit one of the exceptions specifically listed in section 1221. The classic example of this doctrine is the sale of a winning lottery ticket. Lump-sum payments or annuity payments for winning the lottery are taxed as ordinary income. But what if a taxpayer sells his right to future annuity payments? The IRS always argues that a sale of such property doesn't produce a capital gain. See, e.g., Davis v. Commissioner, 119 T.C. 1, 5-6 (2002). The courts agree. We noted in Davis that the Supreme Court said "[w]hile a capital asset is defined . . . as 'property held by the taxpayer,' it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset." Id. at 7 (quoting Commissioner v. Gillette Motor Transp., Inc., 364 U.S. 130, 134 (1960)). Should the phantom stock receive similar treatment? If Gary had lived to see the liquidation of the phantom account it would've been deferred compensation, and taxed as ordinary income. Why should that change now?

The reason is that HI-2 isn't Gary Hurford and the phantom stock isn't the same as a winning lottery ticket. We've already said the character of property can change when it's transferred to another party, so the character in the hands of Gary or Thelma shouldn't automatically be applied to HI-2. In Davis we said that "[i]t is well established that the purpose for capital-gains treatment is 'to afford capital-gains treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year.'" 119 T.C. at 7 n.9 (quoting Gillette Motor Transp., 364 U.S. at 134). The winning lottery ticket doesn't fit this description because it represents the right to guaranteed future payments of a set amount. The phantom stock, on the other hand, could increase or decrease in value over time, similar to ordinary stock. Once HI-2 acquired it, its value was inextricably linked to the value of Hunt Oil, which was far from set in stone. Unlike Gary, HI-2 couldn't do anything to affect its value, but rather simply held it and hoped it would appreciate in value. This distinguishing characteristic is enough for us to conclude that it is a capital asset of HI-2's.

B. Was There a Sale or Exchange?

Winning capital-asset status is only half the battle for HI-2. To receive capital-gains rates, the income must be from a "sale or exchange" of that capital asset. I.R.C. § 1222. "The touchstone for sale or exchange treatment is consideration. If in return for assets any consideration is received, even if nominal in amount, the transaction will be classified as a sale or exchange." La Rue v. Commissioner, 90 T.C. 465, 483 (1988). The Commissioner argues that even if we find the phantom stock is a capital asset, HI-2 never sold or exchanged it. Instead, Hunt Oil simply fulfilled a contractual obligation. The Commissioner points us to Pounds v. United States, 372 F.2d 342 (5th Cir. 1967).

The taxpayer in Pounds was a real-estate broker. He and another broker brokered a real estate transaction and received an unusual form of compensation. Instead of a commission, the buyer — named Gilson — gave each broker a 12.5% interest in any profits he earned on future sales of the property. Although not commission, the court said this property right still clearly constituted compensation for services. Pounds, 372 F.2d at 346. The taxpayer, however, then bought Gilson's 12.5% interest, and the court held that this property right was different than the one the broker had earned for his own services. Id. at 348. The court never affirmatively concluded this other interest was capital property, but just assumed it was. Id. at 351 n.7. But even assuming the interest was capital, the court concluded that the taxpayer had ordinary income when he eventually realized some income from a future sale of the property. It reasoned that "[n]ot every gain growing out of a transaction concerning capital assets is allowed the benefits of the capital gain tax provision. Those are limited by definition to gains from 'the sale or exchange' of capital assets." Id. at 348 (quoting Dobson v. Commissioner, 321 U.S. 231-32 (1944)). The court concluded that the taxpayer never sold or exchanged his interest. Rather, when he realized income, it was the result of a sale or exchange of the underlying property, something he had no interest in. Ultimately, "courts have universally recognized that mere collection of an obligation, purchased or not, does not fit the ordinary meaning of 'sale or exchange.'" Id. at 349.

The court in Pounds recognized the difficulty of the question: "If Pounds' interest were considered a capital asset and if it had been sold to a third party shortly before Gilson disposed of the real estate, the income realized from the sale should be taxable at capital gains rates." Id. at 351. This thought still meshes with our language in La Rue, where we noted that even a nominal amount of consideration gets a taxpayer over the sale or exchange hump. La Rue, 90 T.C. at 482-83.

HI-2 doesn't dispute that under Pounds it would have a big problem. HI-2 argues instead that Pounds has been superseded by a new Code section — section 1234A. Section 1234A says that "[g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of . . . a right or obligation . . . with respect to property which is . . . a capital asset in the hands of the taxpayer . . . shall be treated as gain or loss from the sale of a capital asset." If a transaction meets the definition in section 1234A, it counts as capital gain or loss from a sale.

HI-2 argues that when its right to participate in the phantom-stock plan ended in 2006 and Hunt Oil paid out the value of the phantom account, HI-2's interest in the phantom stock was cancelled, lapsed, expired, or was otherwise terminated. HI-2 thinks this means that there was a sale or exchange in 2006, so it should received capital-gains treatment under section 1234A. This motion is thus affected by the Fifth Circuit's decision in Pilgrim's Pride Corp. v. Commissioner, 779 F.3d 311 (5th Cir. 2015), rev'g 141 T.C. 533 (2013).

The taxpayer in Pilgrim 's Pride had bought securities for $98.6 million in 1999, but was offered only $20 million to redeem them in 2004. Faced with a potentially very large capital loss, the taxpayer decided it would rather simply abandon the securities and take a $98.6 million ordinary loss. Id. at 313. We held that abandoning the capital asset itself constituted a lapse, cancellation, or other termination of the asset and section 1234A triggered capital-loss treatment. Pilgrim's Pride, 141 T.C. at 551.

The Fifth Circuit disagreed. It held that section 1234A(1) applies only to the termination of rights or obligations to buy or sell capital assets, not the termination of their ownership. Pilgrim's Pride, 779 F.3d at 315. So, a contractual right to buy or sell a capital asset would fall into section 1234A(1) under the Fifth Circuit's interpretation. The Fifth Circuit tells us that if there's no sale or exchange and there's no termination of a right or obligation to buy or sell, then there can't be capital-gains treatment. Id.

So which category are we dealing with here — the termination of a right to buy or sell or the termination of ownership? Remember that both parties to the phantom-stock arrangement had the right to liquidate the account at any time. When Hunt Oil liquidated the phantom stock and distributed the proceeds, it ended HI-2's right to sell the phantom stock when it chose. We think that means there was a termination of a right to buy or sell a capital asset, and not an abandonment of property, under the Fifth Circuit's interpretation of 1234A(1). HI-2 still owned the rights to the phantom stock or, after the liquidation, to the cash proceeds. We therefore conclude that the transaction was a sale or exchange of a right to sell a capital asset under section 1234A(1) and HI-2 is entitled to capital-gains treatment.

C. What's HI-2's Basis in the Phantom Stock?

The last dispute between HI-2 and the Commissioner is about basis. The closing agreement set the basis of HI-2's interest in the phantom stock at $6,411,000. HI-2 received $12,985,603 when Hunt Oil terminated the phantom-stock plan in 2006. To the simple-minded observer, this looks like a long-term capital gain of the difference between these two numbers.

But HI-2 has a final tax-minimizing argument. It says it's entitled to a step up in basis to $9,639,588, which was the phantom stock's value at the time of Thelma's death.

This might seem an argument too far. The Code section that creates the step up in basis generally limits that benefit to property acquired "from a decedent." I.R.C. § 1014(a). Thelma was not yet a "decedent" at the time she contributed the phantom stock to HI-2. Yet section 1014(b)(9) tells us to consider property "to have been acquired from or to have passed from the decedent . . . if by reason thereof the property is required to be included in determining the value of the decedent's gross estate." That's what happened here — in the estate-tax case we included the value of the phantom stock in Thelma's gross estate. See Estate of Hurford, 96 T.C.M. (CCH) at 442; see also Conn. Nat'l Bank v. United States, 937 F.2d 90, 92 (2d Cir. 1991); Schrader v. Commissioner, 420 F.2d 443, 445 (6th Cir. 1970) (retention of life estate drew value of property into estate but gives stepped-up basis); H.R. Rept. No. 94-1380, at 36 (1976), 1936-3 C.B. (Vol. 3) 770 ("For the purposes of determining what property is given a stepped-up basis, the test is generally whether the property was included in the gross estate of the decedent").

Section 1014(c), however, may create an exception to this exception. It specifically excludes from the step up in basis "property which constitutes a right to receive an item of income in respect of a decedent under section 691." For the reasons we've already given, however, we find that the phantom stock to have been transformed into a capital asset in the hands of HI-2, so it is no longer an item of income in respect of a decedent.³

Conclusion

HI-2 is entitled to consider the income it received on termination of the phantom-stock plan as long-term capital gain, and its basis is equal to the fair market value of the phantom stock on the date of Thelma's death. There is no dispute that this value was $9,639,588.

It is therefore

ORDERED that respondent's motion for summary judgment, dated February 12, 2013, is denied. It is also

ORDERED that petitioner's cross-motion for summary judgment (as supplemented), dated June 27, 2013, is granted. It is also

ORDERED that on or before June 19, 2017, the parties submit an agreed decision, file their own proposed decisions with explanations of any points of disagreement, or file a joint status report that describes their progress in doing so.

Mark V. Holmes
Judge

Dated: Washington, D.C.
April 17, 2017