The United States Legal system is as hard to learn as the English language. One of the more difficult aspects of the system is the existence and interplay of 51 sovereignties. The Tax Code is not immune from that difficulty. Even though federal tax is governed in the first instance by federal law, state law can still be quite important to the resolution of a federal tax controversy, whether the dispute is about the amount of tax owed or the collection of an undisputed amount. The recent case of Vincent C. Hamilton and Stephanie Hamilton v. Commissioner, T.C. Memo. 2018-62 (May 8, 2018) teaches a lesson about the role of state law in determining a federal tax liability.
2011 was the year at issue. That year, the Hamiltons received just over $300,000 in a nontaxable distribution from a limited liability company. Mr. Hamilton also received a discharge of about $160,000 in student loans. Mr. Hamilton had borrowed the money to pay for his son Andrew’s education. The loans were discharged because Mr. Hamilton had been injured some years before and by 2011 was permanently disabled and out of work.
The Hamiltons did not report the discharged debt as income. The IRS thought they should have. That was the dispute before (soon to be Chief) Judge Foley: did the Hamiltons have to include the $160k in discharged debt as gross income? Section 61 says that discharged debt constitutes gross income. My “Phantom of the Tax Code” blog earlier this year explains why that is so. Section 108, however, allows taxpayers to exclude reporting discharged debt under certain circumstances one of which is when “the discharge occurs when the taxpayer is insolvent.” §108(a)(1)(B).
The test for insolvency is a simple balance sheet test that compares a taxpayer’s assets to their liabilities. Taxpayers who are insolvent at the time of discharge do not need to report discharged debt as income, up to the amount of the insolvency. §108(a)(3).
The Hamiltons had a CPA prepare their return and they reported that their liabilities exceeded their assets by more than $165,000. Therefore, they excluded the student loan discharge (and presumably made any adjustments required by §180(b), but the operation of that provision is not today’s lesson).
The dispute was over whether the Hamiltons were really insolvent. Judge Foley described the factual wrinkle this way: “During the year in issue Mr. Hamilton engaged in erratic spending behavior which led Mrs. Hamilton to begin managing petitioners’ finances. On April 1, 2011, petitioners transferred $323,000 to Andrew’s Chase bank savings account. Andrew gave Mrs. Hamilton his electronic banking username and password and gave her permission to transfer funds from his savings account. Throughout 2011 Mrs. Hamilton regularly transferred money from Andrew’s savings account to the petitioners’ joint account, from which she paid a majority of the household bills.”
The parties agreed that if the money in Andrew’s bank account was an asset of the Hamiltons, they were not insolvent. But the if money was properly their asset, they were not insolvent. The Hamiltons argued that that the money was no longer theirs because it was Andrew’s account. They were no joint account-holders and they had no rights to withdraw money from the account.
The IRS argued that the money still belonged to the Hamiltons because their son Andrew was holding it in name only. This is called a nominiee theory. It looks to see whether a taxpayer ‘‘has engaged in a sort of legal fiction, for federal tax purposes, by placing legal title to property in the hands of another while, in actuality, retaining all or some of the benefits of being the true owner.’’ In re Richards, 231 B.R. 571, 578 (E.D. Pa. 1999).
The Tax Code “itself creates no property rights but merely attaches consequences, federally defined, to rights created under state law.” United States v. Craft, 535 U.S. 274, 278 (2002). Whether property is being held by one person as a nominee to another person is thus a question of state law. To be sure, if state law does not provide an answer, then courts can and do look to the federal common law for an answer. For example, in May v. United States, 2007-2 USTC ¶50,799 (11th Cir. 2007), the IRS was pursuing a nominee theory but Alabama law was not clear on what factors created a a nominee relationship. So the court used federal common law.
Judge Foley thus first looked to the law of Utah, the state where the Hamiltons lived. Utah has clear precedent that instructs courts to look at the following six factors: (i) the taxpayer exercises dominion and control over the property; (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.
Judge Foley went through the factors and found Andrew held the transferred money as the Hamiltons’ nominee, based on the close relationship between the Hamiltons and their son, the actual control exercised over the funds by Mrs. Hamilton to pay expenses, and the lack of consideration for the transfer.
The income tax is a federal law. But the law of property and of property rights is still very much state law. When tax law turns on the proper relationships between a taxpayers or between taxpayers and specified property, the rights and relationships created by state law will be the first step in figuring out the federal tax consequences. In this case, Utah law said that the money in Andrew’s bank account was really an asset of the Hamiltons. Therefore they were not insolvent within the meaning of §108 and could not exclude the discharged debt
Coda: The Hamiltons did escape the §6662 penalty here because the IRS did not provide documentation to show that the revenue agent’s supervisor had approved the penalty.
Bryan Camp is the George Mahon Professor of Law at Texas Tech University School of Law.