Bankruptcy Liquidating Trust Was Not Grantor Trust; Taxpayer Not Entitled to Associated NOLs

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1 Bankruptcy Liquidating Trust Was Not Grantor Trust; Taxpayer Not Entitled to Associated NOLs Gould, (2012) 139 TC No. 17 The Tax Court has held that a taxpayer was not the grantor of the liquidating trust established in association with his and his entities' bankruptcy estates, and he didn't acquire an interest in the trust from his bankruptcy estate upon its termination. Accordingly, he wasn't entitled to claim the trust's unused net operating losses (NOLs). However, the majority of IRS's determinations and adjustments made as a result of its disallowance of the NOL deductions were time-barred, and the extended limitations period under Code Sec. 6501(c) didn't apply because the taxpayer's returns for those years weren't fraudulent. Under Code Sec. 671, when the grantor or another person is treated as the owner of any portion of a trust, he shall compute his taxable income and credits by taking into account those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust. A grantor or another person is treated as the owner of a portion of a trust upon satisfaction of any one of five specified conditions. Deductions left unused by a trust upon its termination are generally not available to beneficiaries. The Code, however, mitigates this rule by allowing those beneficiaries who upon termination of the trust succeed to its property to take as their own certain deductions of which the fiduciary could make no use, including the carryover of an NOL under Code Sec In general, the amount of any tax can be assessed within three years after the tax return is filed. (Code Sec. 6501(a)) However, under Code Sec. 6501(c), the assessment period remains open indefinitely in the case of a false or fraudulent return with the intent to evade tax. 1

2 Theodore Gould formed and held interests in the following entities: Holywell Corp. (Holywell), the Miami Center Corp. (MCC), the Miami Center Limited Partnership (MCLP), Chopin Associates (Chopin), and the Miami Center Joint Venture (MCJV), a Florida general partnership. In '84, following Chopin's and MCLP's default on bank loans, Mr. Gould, Holywell, MCC, MCLP, and Chopin filed separate voluntary Chapter 11 bankruptcy petitions. In '85, the bankruptcy court confirmed an amended consolidated plan of reorganization providing, among other things, for the substantive consolidation of the debtors' bankruptcy estates and for the formation of a liquidating trust to which all estate assets would be transferred. The trust property would be liquidated and distributed to the bankruptcy estates' creditors, and after payment or resolution of all creditor claims, all remaining trust assets would revert to the debtors. The plan was silent as to the trustee's obligation to file Federal or State tax returns or to pay Federal and State income taxes on income attributable to the property it had received. The trustee later brought suit seeking a declaration of his obligation to file tax returns and pay taxes for the debtors, and the bankruptcy court held that he was not responsible for doing so on the basis that the liquidating trust was a grantor trust and thus not a taxable entity. However, on appeal, the Supreme Court held that the trustee had to file returns and pay taxes due on income attributable to the property that the trust had received from the debtors' estates. Despite the Court's ruling, the trustee didn't file returns for the taxpayers. IRS examined Holywell and its subsidiaries, the trust, and Mr. Gould's bankruptcy estate, and in a revenue agent's report (RAR) determined that there is no carryover to the debtor of any net operating loss from the [bankruptcy] estate. In early '92, the trustee made over $3 million in payments to IRS on behalf of the trust. IRS applied the excess amount as an overpayment of tax for the trust's '91 tax year. The trustee then made over $3 million in additional payments to IRS. 2

3 In '93, the bankruptcy court approved a Joint Motion which settled the tax liabilities of Holywell and its subsidiaries, the trust, and Mr. Gould's bankruptcy estate. The Joint Motion provided for an additional $10 million payment and stated that there would be no tax attribute carryovers available to Mr. Gould's bankruptcy estate. The trustee remitted the $10 million payment to IRS. The bankruptcy court later terminated the trust and closed each bankruptcy case. On joint income tax returns filed with his wife, Helen (who has since passed away), for '95 through '97 and ' , Mr. Gould reported NOL deductions, capital loss deductions, and estimated tax payments belonging to the liquidating trust and one of the debtor entities. Mr. Gould claimed that he succeeded to his bankruptcy estate's NOLs upon its termination under Code Sec. 1398(i). He also claimed losses attributable to his distributive share of losses from property held by the liquidating trust, including MCJV, but failed to report his share of MCJV's income generated during those years. The Goulds didn't remit any of the reported estimated tax payments claimed. They also reported self-employment tax liabilities, but didn't pay these amounts. IRS assessed the self-reported tax liabilities, including penalties and interest. In 2000 and 2001, Mr. Gould filed amended Forms 1041, U.S. Income Tax Return for Estates and Trusts, for the liquidating trust's tax years ending Dec. 31, '97, and Oct. 26, '98 (the short year). IRS assessed the amounts reported. IRS issued two levy notices to the Goulds in 2002 with regard to the assessed but unpaid self-employment taxes, penalties, and interest for '95-'96 and '99. The Goulds argued that the payments made by the liquidating trustee should be credited to Mr. Gould's account as the beneficial owner and sole beneficiary of the property transferred to the liquidating trust. The Appeals Officer rejected these arguments as groundless and sustained the levy. The Goulds then challenged the notices of determination (which, 3

4 among other things, disallowed the NOL deductions and imposed civil fraud or accuracy-related penalties) as contrary to the Supreme Court's Holywell opinion and the Code and regs, and barred by collateral estoppel. After the Goulds filed Tax Court petitions for the '95 to 2002 tax years, IRS issued them each a separate levy notice and also issued a lien notice informing them that a notice of federal tax lien (NFTL) was filed relating to their assessed self-employment taxes for those years. Following a collection due process (CDP) hearing, the lien and levy for and were sustained in full in a determination notice. Mr. Gould assigned error to the notice, claiming that IRS abused its discretion in not applying the liquidating trustee's $13 million payment to his account. With regard to the Goulds' '95 to 2002 tax liabilities, unless the returns for those years were made falsely or fraudulently with the intent to evade tax, the Tax Court observed that the limitations periods on assessment and collection have expired. The burden was on IRS to show that the Goulds underpaid their taxes for these years and that at least some portion of each underpayment was due to fraud. IRS argued that there were underpayments each year because of overstated NOL and capital loss carryover deductions. Mr. Gould, however, claimed that they were entitled to the claimed deductions because the liquidating trust was a grantor trust of which he was its grantor or substantial owner, that he succeeded to his bankruptcy estate's tax attributes (including NOLs) for the '85 tax year, and that he incurred capital losses in '91 which he carried over to later tax years. The Tax Court found that, although the bankruptcy court initially ruled that the liquidating trust was a grantor trust, the Goulds couldn't rely on that ruling because of the Supreme Court's later reversal, and collateral estoppel didn't apply in this case. The Court further found that the liquidating trust was not created and funded gratuitously on his behalf and that he didn't acquire an interest in it from his bankruptcy estate upon its termination. 4

5 Thus, the Tax Court held that Mr. Gould was not a grantor of the trust, the trust didn't constitute a grantor trust with respect to him, and the Goulds therefore weren't entitled to take into account the trust's NOLs in computing their taxable income. Also, Mr. Gould's argument that he was entitled to use the bankruptcy estate's NOLs upon its termination was foreclosed by the joint motion which expressly provided to the contrary and, the Court also held that Mr. Gould failed to prove that his bankruptcy estate even had any NOLs to which he could have succeeded and carried over to later years. The Tax Court also rejected the Goulds' claimed capital loss deductions, finding that there was no evidence or substantiation of same. Accordingly, the Tax Court found that IRS proved that there were underpayments for the '95 to 2002 tax years and upheld its adjustments resulting from the disallowance of the NOL and capital loss carryover deductions. However, the Court found that IRS failed to clearly prove that the Goulds filed fraudulent tax years for '95 to Although certain factors indicated fraud, others indicated otherwise, including Mr. Gould's cooperation with tax authorities and his disclosure of the reasons for his position. Thus, the extended limitations period under Code Sec. 6501(c) didn't apply, and IRS's determinations and adjustments for '95 to 2001 were barred. With respect to 2002, the Tax Court upheld IRS's adjustments disallowing the claimed NOL deduction and capital loss deduction, as noted above. Given the Tax Court's finding that the liquidating trust wasn't a grantor trust, and Mr. Gould's concession that he would not be entitled to a credit or refund of the $13 million in payments in the event of such a finding, the Court found that Mr. Gould wasn't entitled to a credit or refund for these payments made to IRS on behalf of either the liquidating trust or Holywell. For the 2002 tax year, given the disallowed NOL and capital loss deductions, the resulting understatement of income tax was a substantial understatement under Code Sec The Court rejected Mr. Gould's argument that he had a reasonable basis for his reporting position, and also 5

6 found that the reasonable cause exception in Code Sec. 6664(c)(1) didn't apply. In their challenges to the lien and levy notices, the Goulds claimed that they should receive a credit for the $13 million payment to offset their '95, ' , and self-employment tax liabilities. However, the Court found that, under Code Sec. 6402(a), this claim was time-barred. The Tax Court also found that the IRS settlement officer didn't abuse his discretion in failing to grant a face-to-face CDP hearing where, given that the Goulds' claims were largely groundless and that no collection alternatives were proposed, such wouldn't have been productive. 6