Harmon v. Comm'r of Revenue

• Decision Date: 03 May 2017
• Docket Number: A16-0973
• Citation: 894 N.W.2d 155
• Parties: Germaine F. HARMON, Relator, v. COMMISSIONER OF REVENUE, Respondent.
• Court: Minnesota Supreme Court

894 N.W.2d 155

Germaine F. HARMON, Relator,

v.COMMISSIONER OF REVENUE, Respondent.

A16-0973

Supreme Court of Minnesota.

Filed: May 3, 2017

Eric Johnson, Saint Paul, Minnesota, for relator.

Lori Swanson, Attorney General, Kathryn M. Woodruff, Assistant Attorney General, Saint Paul, Minnesota, for respondent.

Considered and decided by the court without oral argument.

OPINION

ANDERSON, Justice.

After the foreclosure of mortgage debt on a real-estate investment property triggered taxable gains to the investors, respondent Commissioner of Revenue requested that appellant Germaine Harmon file a 2010 Minnesota income-tax return. Three years later, Harmon still had not filed a return. Accordingly, the Commissioner assessed Harmon's 2010 Minnesota income-tax liability based on a Schedule K-1 filed by the partnership in charge of the foreclosed real-estate investment. Harmon appealed to the tax court, challenging the Commissioner's assessment. On cross motions for summary judgment, the tax court granted summary judgment in favor of the Commissioner. We affirm.

FACTS

This tax dispute arises out of a failed real-estate investment that resulted in substantial tax consequences for the widow of one of the original investors. The trail leading to those consequences began in May 1984, when a group of general partners at Goldman Sachs formed City Center Investors (CCI), a real estate partnership. CCI's sole investment was a 49.475% proportional share in a parent partnership, City Center Associates (CCA). CCA's only asset was the City Center building (City Center), a mixed-use office and retail property in downtown Minneapolis. Because City Center was located in Minneapolis, all income flowing from the investment, and therefore from CCA, was generated in Minnesota. Harmon, the widow of one of the initial investors, acquired her husband's share of CCI upon his death in 1997.

City Center was encumbered by two mortgage loans. One was a purchase-money mortgage, used by CCA to purchase the building, and another was an underlying non-recourse first mortgage. By 2007, due to various factors including depreciation, interest, and anemic rental revenue, the principal balance of the mortgage loans exceeded the market value of City Center.

In January 2007, CCI issued a memorandum to its partners, including Harmon, outlining CCI's financial situation. The memorandum warned that because the amount of mortgage debt from the two mortgage loans encumbering City Center exceeded the value of the property, a foreclosure sale would "trigger a taxable gain to the partners of CCI."¹ Therefore, CCI warned its partners of a "significant ‘built-in’ tax gain to be realized upon foreclosure" of either mortgage loan, amounting to each partner's "allocable share of the outstanding balance of the [mortgage loan], including all accrued and unpaid interest over the years."

In December 2007, CCI issued another memorandum to its partners, including Harmon, indicating that after consulting with an attorney and accountant, no "fruitful" options were available for the City Center investment. The memorandum concluded that "the most likely outcome is that a triggering event ... will result in a taxable gain to you" upon foreclosure of either of the mortgage loans encumbering City Center. At that time, CCI offered its partners an option to resign from CCI for a $1 cash buyout from the partnership. A resignation from CCI would still trigger the taxable gain, but at a time controlled by the resigning partner. Harmon did not take advantage of this early triggering opportunity to resign from CCI. But, because various other partners took advantage of the opportunity to resign, Harmon's proportional share in CCI increased from 1.446% in 2007 to 9.3025% in 2010, the taxable year at issue.

In 2010, one of the mortgage loans encumbering City Center was foreclosed, triggering the predicted taxable gain for its investors. After the foreclosure sale of its sole asset, CCA issued its final Schedule K-1 to its partners, including CCI.² The Schedule K-1 issued by CCA reported that CCI's share of taxable gains included $512 million in section 1231 gains and $149 million in section 1250 gains.³ CCI, however, disputed the taxable gains listed on the Schedule K-1 from CCA. Instead, CCI determined that its section 1231 gains were $105 million and its section 1250 gains were $27.5 million. CCI listed its own calculations of the taxable gains in a report to the IRS⁴ and issued to its partners, including Harmon, a Schedule K-1 reflecting CCI's calculation of the gains.

Harmon received a Schedule K-1 from CCI that listed her proportional share in the partnership at 9.3025% in 2010. Based on CCI's calculations of its taxable gains, its Schedule K-1 listed Harmon's share as $9,781,486 in section 1231 gains and $2,559,468 in section 1250 gains. Harmon did not file a Minnesota income-tax return for 2010, despite having received the Schedule K-1 from CCI listing taxable gains from the foreclosure sale of City Center. Harmon believed that her carryover passive-activity losses from prior years would offset any taxable gains from the foreclosure. See Billion v. Comm'r of Revenue , 827 N.W.2d 773, 775 (Minn. 2013) ("[A] taxpayer may carry over a ‘passive activity loss' to offset income earned from passive activities in future tax years.").

The Commissioner became aware of the City Center foreclosure and the taxable gains to Harmon when CCI filed its Minnesota returns. In December 2011, the Commissioner first requested that Harmon file a 2010 Minnesota income-tax return. Harmon, through her accountant, indicated to the Commissioner that she was processing the 2010 tax return and that she intended to provide federal returns to establish that her passive-activity losses from prior years offset the taxable gains from the City Center foreclosure. The Commissioner requested five additional times that Harmon file a 2010 Minnesota income-tax return but received no response.

By 2013, the Commissioner had not received Harmon's 2010 Minnesota income-tax return. In August 2013, the Commissioner issued an order assessing Harmon's tax liability based on CCI's returns, including its Form 8082 and Form 1065, which was consistent with the Schedule K-1 provided to Harmon by CCI. See Minn. Stat. § 270C.33, subd. 4(a)(2) (2016) ("The commissioner may issue an order of assessment ... [when] no return has been filed and the commissioner determines the amount of tax that should have been assessed."). In the Commissioner's assessment of Harmon's income-tax liability, the Commissioner did not factor in all of Harmon's alleged passive-activity losses that may have offset her taxable gain in 2010 because Harmon had not filed a federal tax return since 2008 from which those passive-activity losses could be reliably calculated. The Commissioner calculated Harmon's 2010 Minnesota income-tax liability as $1,058,601.21, which included the tax on the 2010 gain, as well as a late fee and penalties.

Harmon administratively appealed the Commissioner's assessment, and the Commissioner amended the calculation of Harmon's income-tax liability to include the offsetting passive-activity losses from 2008, 2009, and 2010, based on the CCI-issued Schedule K-1s from those years. Further, the Commissioner eliminated one of the penalties that had been originally assessed. The amendment reduced Harmon's income-tax liability to $591,581.57, including interest and penalties.

Harmon appealed to the tax court, asking it to "overturn" the Commissioner's assessment of income-tax liability. On appeal, she asserted two central claims. First, she claimed that the conflicting calculations in the CCA-issued Schedule K-1 and the CCI-issued Schedule K-1 created a dispute that needed to be settled at the federal level before the Commissioner could assess Harmon's 2010 Minnesota income-tax liability. Second, Harmon argued that the CCI-issued Schedule K-1 for 2010 was not accurate evidence of her taxable income allowing the Commissioner to reliably assess her income-tax liability. During discovery, Harmon provided no documentation to show a different calculation of the taxable gains or her income-tax liability. She did provide, however, the following documentation: her federal income-tax returns, the memoranda issued to her by CCI warning of a potential taxable gain, documentation of the testamentary trust through which she inherited her husband's interest in CCI, income-tax returns filed on behalf of the testamentary trust, her husband's estate tax return, and most notably, the Schedule K-1s issued to her by CCI for 1996, 2000, and 2002 through 2010.

Following discovery, the parties filed cross-motions for summary judgment. Two days before filing for summary judgment, in 2015, Harmon filed her 2010 federal tax return with the IRS and provided copies to the tax court and Commissioner.

The tax court granted the Commissioner's motion for summary judgment and denied Harmon's, affirming the Commissioner's assessment in its entirety. Harmon v. Comm'r of Revenue , No. 8760-R, 2016 WL 1730731, at *7 (Minn. T.C. Apr. 21, 2016). The tax court reasoned that the dispute between the Schedule K-1s from CCA and CCI had been settled in CCI's favor when the IRS did not take action on the inconsistency within the 3-year time period provided by statute. Id. at *5. Therefore, the tax court found that there was no existing federal dispute requiring it to vacate the Commissioner's assessment, as Harmon had requested.

Regarding Harmon's direct challenge to the assessment, the tax court applied Minnesota's presumption of validity to the Commissioner's assessment and declined to shift the burden to the Commissioner to prove the validity of the assessment, as Harmon contended is required in federal courts. Id. at *6. After declining to shift the burden, the tax court determined that Harmon had not overcome the presumption or identified a genuine issue of material fact regarding the accuracy of the...