I have been thinking about alter ego, nominee, and transferee issues recently. At the ABA Tax Section 2018 May Meeting I moderated a panel discussing these issues in the tax lien context. (Materials here, membership or meeting registration may be required.) Normally these topics come up with taxpayers while we are preparing for an offer in compromise, installment agreement, or innocent spouse request. The recent case of Hamilton v. Commissioner, T.C. Memo. 2018-62, reminds us that the nominee doctrine can also be relevant outside of the collection setting.
Mr. Hamilton took out student loans to finance his son Andrew’s education, as many parents do. Sadly Mr. Hamilton later injured his back and became permanently disabled. (We have little information about Andrew, so I like to think that he graduated and used his education to succeed in his chosen career.) Due to Mr. Hamilton’s disability, his lenders discharged his student loans in 2011.
Unfortunately Mr. Hamilton’s problems went beyond his physical disability, and he began spending money erratically. As a result, his wife took over managing their finances. Mr. Hamilton had a large amount of cash, which was placed in Andrew’s savings account on April 1, 2011. We do not know the thinking behind this move, but perhaps Mr. Hamilton felt better about placing his money with Andrew for safekeeping than about placing it with his wife. After April 1, Andrew allowed Mrs. Hamilton to use his online banking credentials and to freely transfer funds from his savings account back to the petitioners’ joint account. Mrs. Hamilton regularly did this, and she paid household bills from the joint account.
Next we come to the Hamiltons’ 2011 joint tax return. Canceled debt is normally gross income under Code section 61(a)(12). However, section 108 lists several exclusions including the insolvency exclusion in section 108(a)(1)(B). It is not always easy for taxpayers to win an exclusion. A recent Designated Order post by William Schmidt includes two cases in which the taxpayers failed to prove that canceled debt should not be income to them. William also discusses the mechanics of claiming the insolvency exclusion.
Insolvency is defined in section 108(d)(3) as “the excess of liabilities over the fair market value of assets,” determined just before the discharge. The amount of canceled debt excluded from income can’t exceed the amount of insolvency. IRC § 108(a)(3). So, a taxpayer with total assets worth $3,000 and total liabilities of $6,000 could exclude up to $3,000 of canceled debt from her income under section 108(a)(1)(B).
One question for the Hamiltons, then, was the fair market value of Mr. Hamilton’s assets immediately before the discharge. The Hamiltons must have transferred the cash to Andrew’s account before the student loans were discharged, because they excluded that cash from their insolvency calculations. On their 2011 tax return the Hamiltons claimed they were insolvent by more than the amount of discharged debt, and therefore they excluded all the canceled debt from their income. Mr. Hamilton would have been solvent if the cash placed in Andrew’s account had been included in the equation.
The IRS examined the return, disagreed with the insolvency conclusion in a notice of deficiency, and the Hamiltons appealed to the Tax Court.
On a side note – readers may be wondering if the 2017 Tax Act would change the analysis in this case. Student loans discharged in 2018 through 2025 due to the death or total and permanent disability of the student are not includable in gross income. See code section 108(f)(5). Unfortunately, Mr. Hamilton was not the student (Andrew was) so I do not think this case would come out any differently if it involved tax year 2018.
In the Tax Court, the IRS argued that the cash in question was still Mr. Hamilton’s property after he placed it into Andrew’s bank account and that Andrew merely owned the account as nominee for Mr. Hamilton. Therefore, the IRS argued that Mr. Hamilton was solvent immediately before the student loans were canceled and therefore he owed income tax on the canceled debt.
The nominee doctrine is really common sense. It applies where a transfer occurs in name only, and the transferor retains beneficial ownership of the property. (Keith previously discussed nominee liens here; guest blogger A. Lavar Taylor discussed purported nominees’ CDP rights in a two-part series here and here.) The Internal Revenue Manual has a summary of the doctrine and it details how the IRS will go about enforcement action when a delinquent taxpayer’s assets are held by a nominee. IRM section 18.104.22.168.4 explains the theory:
The nominee theory is based on the premise that the taxpayer ultimately retains the benefit, use, or control over property that was allegedly transferred to a third party. Thus, the nominee theory focuses on the relationship between the taxpayer and the transferred property. A transfer of legal title may or may not have occurred, but the government does not believe a substantive transfer of control over the property in fact occurred.
Courts generally look to state law to determine a taxpayer’s property rights, including whether property belongs to the taxpayer under the nominee doctrine. See Fourth Inv. LP v. United States, 720 F.3d 1058, 1066 (9th Cir. 2013). These factors vary somewhat in their wording from state to state but they are remarkably consistent.
In Mr. Hamilton’s case, the Tax Court looked at the nominee factors under Utah law:
(i) the taxpayer exercises dominion and control over the property while the property is in the nominee’s name; (ii) the nominee paid little or no consideration for the property; (iii) the taxpayer placed the property in the nominee’s name in anticipation of a liability or lawsuit; (iv) a close relationship exists between the taxpayer and the nominee; (v) the taxpayer continues to enjoy the benefits of the property while it is in the nominee’s name; and (vi) the conveyance to the nominee is not recorded.
(1) Whether the nominee paid no or inadequate consideration…; (2) Whether the property was placed in the name of the nominee in anticipation of litigation or liabilities; (3) Whether there is a close relationship between the transferor and the nominee; (4) Whether the parties to the transfer failed to record the conveyance; (5) Whether the transferor retained possession; and (6) Whether the transferor continues to enjoy the benefits of the transferred property.
The Utah and Washington nominee factors are quite similar to the nonexclusive factors listed in the IRM at 22.214.171.124.7.2 (3):
a. The taxpayer previously owned the property.
b. The nominee paid little or no consideration for the property.
c. The taxpayer retains possession or control of the property.
d. The taxpayer continues to use and enjoy the property conveyed just as the taxpayer had before such conveyance.
e. The taxpayer pays all or most of the expenses of the property.
f. The conveyance was for tax avoidance purposes.
From these examples one can appreciate the flexibility of the common law as well as its ultimate convergence with common sense (at least in this instance).
In Mr. Hamilton’s case, the Tax Court easily concluded that the transferred funds still belonged to Mr. Hamilton, as Andrew was only holding on to them as Mr. Hamilton’s nominee. The Hamiltons retained full use of the funds. I think this is cleary the right result. The April 1 transfer may have been for the legitimate purpose of protecting Mr. Hamilton’s cash from his erratic spending impulses, but the Hamiltons should not have pushed their luck by excluding the account as an asset in their insolvency calculations.
This case illustrates the importance of asking about potential nominee property in all contexts where a taxpayer’s assets are relevant to a tax issue. Also, it provides an example of a complicating situation that could be easily missed if a tax preparer does not take (or have) time to conduct a thorough interview.
Low-income taxpayer advocates have long complained that free tax assistance sites are not permitted to help taxpayers claim the insolvency exclusion. Taxpayers who have no money to pay a preparer are often forced to borrow to come up with the funds, or else try to self-prepare, which can result in a controversy case when they cannot figure out how to properly exclude the income. This issue was highlighted by the National Taxpayer Advocate in her 2017 Annual Report to Congress, in Most Serious Problem No. 11. The IRS could delineate appropriate boundaries and provide worksheets to facilitate the insolvency determination by VITA, TCE, and AARP assisters and it would be a significant help to many taxpayers. I do not think the Hamilton case detracts from that argument too much. Most taxpayers whose student loans are canceled due to disability do not have $300,000 in cash to worry about. Nevertheless, the Hamilton case illustrates how the insolvency determination is not always straightforward.