Cupid’s Arrow Strikes Lover in the Wallet

ThinkstockPhotos-505650276Revenge is a dish best served cold. In a recent case, a disenchanted suitor not only sued to recover gifts he made to his former lover but also reported those gifts to the IRS as income payments! See Diane Blagaich, TC Memo 2016–2.

Here’s what happened. Taxpayer and Boyfriend were in a romantic relationship from November 2009 until March 2011. In November 2010, they entered into a written agreement intended to formalize their “respect, appreciation and affection for each other” that required Boyfriend to make an immediate payment of $400,000 to Taxpayer.

Earlier that year, Boyfriend had given her $273,819 in cash, a $70,000 Corvette, and a diamond ring.

The relationship then went sour. In March 2011, Boyfriend sued Taxpayer in state court seeking nullification of the agreement, return of the Corvette and diamond ring, and an order directing disgorgement of cash and other gifts “totaling in excess of $700,000.”

But clearly the lawsuit wasn’t enough for Boyfriend. He then filed a Form 1099-MISC with the IRS reporting that he had paid Taxpayer $743,819 in 2010. The IRS determined a deficiency in that amount and Taxpayer filed a petition in Tax Court.

In November 2013, the state court found that Taxpayer had fraudulently induced Boyfriend to enter into the agreement and entered a $400,000 judgment against her. Taxpayer paid $400,000 to Boyfriend’s estate in compliance with the order. (Boyfriend died shortly after the trial).

Taxpayer asked the Tax Court to take judicial notice of the state court’s finding that all other cash amounts and property paid or given to her were “clearly gifts.” Under IRC §102, gifts and inheritances are excluded from taxable income. Taxpayer further argued that the return of $400,000 to the estate invoked the doctrine of rescission, eliminating all grounds for a deficiency in her 2010 income tax.

Her arguments didn’t go well. The Tax Court denied Taxpayer’s motion for summary judgment, holding that the IRS wasn’t collaterally estopped from litigating the state court’s gift finding because it wasn’t in privity with a party to the state court action. And the doctrine of rescission didn’t apply because Taxpayer didn’t repay the $400,000 in the year she received it.

Taxpayer could still show the other items were gifts, but she probably can’t avoid the taxes on $400,000 of income she later lost.

For more on the income tax gift exclusion in a trust distribution context, see CEB’s California Estate Planning §§13.48–13.51. Also check out CEB’s California Will Drafting §28.26 on devises in lieu of compensation for services.

Other CEBblog™ posts you may find interesting:

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4 Responses

  1. A timely reminder that emotions and large sums of cash seldom end well & that tax law is seldom boring, esp. to a tax attorney. 🙂

  2. This seems wrong. I’m not a tax expert (at all), and I don’t have time to read the courts’ decisions, but clearly, if this article is accurate, the “contract” was rescinded by the state court. So then on what theory should “Taxpayer” be taxed on the $400,000 that she returned? That it wasn’t returned in the same year it was received? So what? What difference does THAT make? A rescission puts the parties back in their original positions, as if the contract had never been executed. So no contract, and no $400,000. So there’s nothing to tax.

    • Unfortunately, when it was returned makes all the difference. In tax law, the doctrine of rescission is an exception to the annual accounting period principle. For cash method taxpayers (most of us), each taxable year is treated as a separate unit for tax accounting purposes. So if the taxpayer’s right to receive an item of gross income is rescinded in the same year, the income is extinguished. In this case, the taxpayer had $400,000 of income in one year and $400,000 of outgo in another. These do not offset. The question becomes whether the $400,000 return payment can be deducted as a loss in the second year (and if so whether it can be carried over to other years). But the answer appears to be no. This appears to be a nondeductible personal loss.

      • Wow. The fact that it’s all part of the same transaction means nothing? That’s bizarre. (Shaking my head in incredulity.) Thanks for the education, Robert.

        All I can say is, to paraphrase the words of Charles Dickens, if that’s the law, then the law is an ass, an idiot.

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