Kenfield v. U.S., 83-1968

• Decision Date: 10 February 1986
• Docket Number: No. 83-1968,83-1968
• Citation: 783 F.2d 966
• Parties: -792, 86-1 USTC P 9225 Allen F. KENFIELD, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 966

783 F.2d 966

57 A.F.T.R.2d 86-792, 86-1 USTC P 9225

Allen F. KENFIELD, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 83-1968.

United States Court of Appeals Tenth Circuit.

Feb. 10, 1986.

Frank M. Cavanaugh, Evergreen, Colo., for plaintiff-appellee.

Before HOLLOWAY, Chief Judge, LOGAN, Circuit Judge, and SEAY, District Judge. ^*

LOGAN, Circuit Judge.

This is a federal income tax case. At issue is whether an ex-husband may be taxed on all the income of a partnership interest divided in a Colorado divorce.

Plaintiff Allen Kenfield was a partner in a two-person partnership engaged in land sales. In November 1977, while still a partner, Kenfield was divorced from his wife. The Colorado court granting the divorce held that Kenfield's partnership interest was marital property, whose value was to be divided between the spouses. See Colo.Rev.Stat. Sec. 14-10-113(3) (1973).

The Colorado court found, however, that the value of the partnership interest was not capable of "realistic or reasonable" appraisal. It therefore awarded the wife fifty percent of all future "net proceeds received" by Kenfield from the partnership. ¹ Kenfield appealed this award to the Colorado Court of Appeals, complaining that it awarded his ex-wife a future interest in property Kenfield did not own. The appellate court affirmed the settlement, and in its opinion stated that the trial court had given Kenfield "full control over the asset, with the wife's only participation being the right to receive half of his net after stated deductions.... Decisions on retaining or selling, or investing or not investing additional capital, are exclusively his to make. He is in no position to complain." R. I, 62.

The partnership continued to function after the divorce in the same manner as it did before. In 1977 the partnership made substantial profits, but Kenfield did not withdraw any and therefore distributed nothing to his ex-wife. ² The partnership tax return listed Kenfield as a fifty percent partner, and he initially paid the income tax due on that full share of the 1977 partnership profits, according to normal "pass-through" partnership taxation rules. See I.R.C. Secs. 701-704. Kenfield, however, then filed an amended return and claimed a refund, asserting that he should have paid tax on only half of these profits. He contended the rest should have been taxed to his ex-wife.

The Internal Revenue Service (IRS) denied the refund, ³ and Kenfield sued in district court to obtain it. The district court granted Kenfield summary judgment on this issue. The government now appeals and we affirm.

The key to properly deciding this case is Imel v. United States, 523 F.2d 853 (10th Cir.1975). There a husband transferred half of his appreciated stock holdings in several close corporations to his wife, pursuant to a Colorado divorce settlement. The IRS claimed that the transfers were sales or exchanges under I.R.C. Sec. 1001(c) requiring the husband to pay a capital gains tax on the stocks' appreciation. The husband argued that the settlement was only a division of property between marital coowners, and thus nontaxable.

Colorado has never been a community property state. See In re Marriage of Ellis, 36 Colo.App. 234, 538 P.2d 1347, 1349 (1975), aff'd, 191 Colo. 317, 552 P.2d 506 (1976). But it does recognize rights of each spouse in "marital property" upon divorce. See Colo.Rev.Stat. Sec. 14-10-113(3) (1973). The federal district court, during the trial portion of Imel, was uncertain how to characterize a spouse's state law rights in such marital property, and it certified the question to the Colorado Supreme Court. That court responded that marital property was "a species of common ownership" which "vested" at the time of the filing of the divorce (and thus before the actual court-ordered or court-approved transfer). See In re Questions Submitted by the United States District Court, 184 Colo. 1, 517 P.2d 1331, 1334 (1974).

On appeal we applied this Colorado Supreme Court pronouncement to determine the income tax controversy. Imel, 523 F.2d at 855-57. We stated that state law created property rights and that federal law determined only how these rights would be taxed. Id. at 855. ⁴ We held that the Imels' property settlement must therefore be considered only a division of property between marital coowners, and not a taxable event. Id. at 857. ⁵

The instant case may appropriately be called "son of Imel." The transfer here to the ex-wife of a right to fifty percent of partnership "net proceeds" gave her ownership of (1) half of Kenfield's right to the 1977 pre-divorce partnership income and (2) half of Kenfield's partnership interest. Under Imel the first transfer is a division between marital coowners. The right to half of Kenfield's share of the 1977 pre-divorce partnership income therefore only formally assigned to his ex-wife what in theory she already had. ⁶ Kenfield thus did not own this income and is not taxable on it. ⁷

After the settlement, Kenfield did not own the asset that produced his ex-wife's share of the 1977 post-divorce income, i.e., his ex-wife's half of the partnership interest. Kenfield thus also is not taxable on the partnership income earned by that asset.

The government argues that the ex-wife's mere right to half of Kenfield's share of "net proceeds" of the partnership, enforceable only when the partnership actually distributed such proceeds, cannot properly be called an "ownership" interest at all. It asserts that Kenfield retained "ownership" of the partnership interest, and that only he can be taxed on the income that it generated. In answering, we start again with the rule that property rights are created by, and exist under, state law. See Morgan v. Commissioner, 309 U.S. at 80, 60 S.Ct. at 425; Imel, 523 F.2d at 855. Here the ex-wife received rights against the partnership interest under a Colorado divorce decree. What property rights did the state court intend to create?

The Colorado court held that Kenfield's partnership interest was marital property. Under Colorado law, such marital property is to be "divided." See Colo.Rev.Stat. Sec. 14-10-113 (1973); In re Marriage of Gehret, 41 Colo.App. 162, 580 P.2d 1275, 1277 (1978) (court must obey statutory command). In dividing the marital property, the court could have given equivalent value, however; it need not give half of the property itself. See, e.g., In re Marriage of Warrington, 44 Colo.App. 294, 616 P.2d 177, 179 (1980) (actual division is equitable and discretionary; example of court assigning values to assets and then dividing values). The Colorado court held here that the value of Kenfield's partnership interest was too indeterminate to calculate fairly and divide. Therefore the purpose of the court's actual decree was to adopt the apparent alternative--to divide the asset itself.

The Colorado court recognized that the success of the business was highly dependent on the skills and cooperation of Kenfield and the other partner. Evidently hoping to maximize the value of the asset to everyone, the court left Kenfield in charge of both his and his ex-wife's interest. This is all we can reasonably read into the "net proceeds" language of the court.

We do not think that the two limitations the court imposed on the wife's interest--control in Kenfield and deferred right to receive the proceeds--changed the state court's underlying purpose to give half of the partnership interest to the wife. The court's settlement decree provided that the ex-wife was entitled to a "full accounting" of the operation of the partnership and access to the partnership books and records. See supra note 1. These point to something more than a mere right to future income. We do not believe Kenfield had uncontrolled discretion to leave profits in the partnership and thereby deprive his ex-wife indefinitely of the money to which she was entitled. Kenfield had only the power to leave income in the partnership accounts to meet the capital needs of the partnership. This discretion surely would be subject to the requirement that it be exercised reasonably under a trustee-like responsibility to the coowner ex-wife. That the Colorado courts maintained supervisory control is evidenced by its ruling in 1982 ordering Kenfield to jail for contempt when he did not pay his ex-wife amounts due to her after she sold her rights to the partnership for cash and property.

The government also argues that federal statutes command that partnership income be taxed directly to "partners." See I.R.C. Secs. 701, 702. Perhaps under Colorado partnership law, Kenfield was a partner and his ex-wife was not. But it is federal tax law, not state partnership law, that determines who is a "partner" for federal taxation purposes. Commissioner v. Tower, 327 U.S. 280, 287, 66 S.Ct. 532, 535, 90 L.Ed. 670 (1946).

Under federal tax law, the basic question is who appropriately can be said to own the partnership interest, such that it is correct to attribute to that person the income earned on the partnership interest. This is not always the person who, under state law, holds the official status of partner. It is standard state partnership law, for example, that a person can receive and properly own a partnership interest without becoming an actual partner. See, e.g., Bynum v. Frisby, 73 Nev. 145, 311 P.2d 972, 975 (1957) (outside party receiving twenty percent interest in partnership as compensation for services held to own a partnership interest, but not, under express provisions in the transfer, to be a partner). In such a case, federal law will tax the true owner of the partnership interest on the income earned by that interest, and not the state law "partners." See, e.g., Julian L. Hamerslag, 15 B.T.A. 96, 101-02 (1929) (Acq.) (amounts payable to partners' sister out of partnership profits, under partners' father's will, held not taxable to partners).

Analytically, this result may...