Mandell v. Auditing Div. Of State Tax Com'n

• Decision Date: 23 May 2008
• Docket Number: No. 20060521.,20060521.
• Citation: 2008 UT 34,186 P.3d 335
• Parties: Dennis MANDELL and Kathy Mandell, Petitioners, v. AUDITING DIVISION OF the UTAH STATE TAX COMMISSION, Respondent.
• Court: Utah Supreme Court

186 P.3d 335

2008 UT 34

Dennis MANDELL and Kathy Mandell, Petitioners, v. AUDITING DIVISION OF the UTAH STATE TAX COMMISSION, Respondent.

No. 20060521.

Supreme Court of Utah.

May 23, 2008.

David W. Scofield, Thomas W. Peters, Salt Lake City, for petitioners.

Mark L. Shurtleff, Att'y Gen., Timothy A. Bodily, Asst. Att'y Gen., Salt Lake City, for respondent.

PARRISH, Justice:

INTRODUCTION

¶ 1 This petition for review asks us to determine whether the state of Utah has the authority to tax the proceeds of a settlement received by Dennis Mandell and his wife, Kathy (the "Mandells"). The settlement resolved a lawsuit that Dennis Mandell ("Mandell") filed in Nevada some two years after he and Kathy moved from Utah. The Auditing Division of the Utah State Tax Commission (the "Auditing Division") determined that the settlement proceeds were taxable because they related to the sale of assets of an S corporation doing business in Utah. As a result, the Auditing Division assessed a delinquency on the 2001 joint tax return filed by the Mandells. The Mandells unsuccessfully appealed that determination to the Utah State Tax Commission (the "Commission") and then filed a petition for review with this court. We affirm the Commission's determination. The settlement proceeds were paid in lieu of proceeds that Mandell should have received from the sale of assets of a Utah corporation. Because the proceeds of the original sale were taxable, the settlement is also taxable.

BACKGROUND

¶ 2 The Mandells were residents of Utah from 1995 to March 1999. During that time, Dennis Mandell was the manager and a 20% shareholder of Homes America of Utah, Inc. ("HAU"), a company that sold mobile homes in Utah. HAU filed as a subchapter S corporation for federal income tax purposes. In addition to Mandell, HAU had two other shareholders: Gerald Meyer owned 20% and Eugene Whitworth ("Whitworth") owned 60%.

¶ 3 Whitworth also controlled eight other corporations that were in the business of selling mobile homes. These other corporations operated in Nevada, Arizona, Idaho, Oklahoma, California, and Oregon. In 1998, Whitworth agreed to sell all nine corporations to Champion Homes, Inc. ("Champion") for an aggregate purchase price of $102.5 million. Of the aggregate purchase price, Champion paid $67.5 million in cash, with $5 million held in reserve for eighteen months to cover unknown liabilities. The remaining $30 million was payable contingent upon the combined future earnings of the corporations. Whitworth used his discretion to allocate the aggregate purchase price among the nine corporations. The sale was consummated on March 27, 1998, but the contingent component of the purchase price was never realized.

¶ 4 Mandell and the other shareholders of HAU elected to treat the sale as a "deemed asset sale" by filing an election under section 338(h)(10) of the Internal Revenue Code (the "section 338 election"). As a result, the transaction was treated for tax purposes as though HAU had sold assets and distributed the sale proceeds to its shareholders. See I.R.C. § 338(h)(10) (2000). The shareholders in the other eight Whitworth corporations similarly made section 338 elections. HAU reported the gain from the sale as business income apportioned 100% to Utah on its 1998 Utah income tax returns. It also identified Utah as its "commercial domicile."

¶ 5 In 1999, approximately one year after the sale of HAU, the Mandells moved to Nevada. Shortly thereafter, Mandell discovered that Whitworth had defrauded him in connection with the sale by characterizing the sale proceeds in a manner that disproportionately benefitted Whitworth. Whitworth allocated between 80% and 100% of the cash component to those corporations that he wholly owned, while allocating a higher percentage of the contingent payments to those corporations with minority shareholders. As a result of this disparate allocation, Whitworth was able to substantially underpay the minority shareholders.

¶ 6 For example, Whitworth allocated $8.105 million of the total $102.5 million purchase price to the sale of HAU. Of this allocation, however, only 38% (or $3.105 million) was paid through the cash component of the purchase price, with 62% (or $5 million) deferred as an unrealized contingency. This meant that Mandell received only $621,000, instead of approximately $1.67 million he would have received had the various components of the purchase price (i.e., cash, deferred, and contingent payments) been proportionately distributed among the various corporations.

¶ 7 After discovering Whitworth's underpayment, Mandell filed suit in a Nevada state court against Whitworth's estate.¹ Mandell's complaint alleged that Whitworth had inflated the values of the corporations of which he was the sole shareholder or in which he owned a relatively large percentage of shares, thereby artificially decreasing the value of Mandell's ownership in HAU. Mandell sought imposition of a constructive trust on the misallocated sales proceeds. He also requested general damages, attorney fees, and interest on the amounts due.

¶ 8 Whitworth and Mandell settled the Nevada lawsuit in 2001. In return for a settlement payment, Mandell and his wife, Kathy released and discharged all claims alleged in the complaint. The Mandells received $1,127,977 through the settlement, which increased the total amount that Mandell received from the sale of HAU to $1,748,077-approximately $78,000 more than the principal amount Mandell should have received originally. The parties documented their settlement in a "Confidential Settlement Agreement."

¶ 9 The way the parties characterized their settlement is important. On their federal income tax return, the Mandells reported the settlement proceeds as a long-term capital gain from the sale of Mandell's "20% stock interest of [HAU], sold on 9/15/01." The Mandells' accountant, Kenneth Stieha, explained that the settlement was reported as capital gain (not ordinary income) on the Mandells' 2001 federal income tax return because the proceeds related back to the initial sale of HAU and the section 338 election. Whitworth similarly treated the settlement as an adjustment to the HAU sale, seeking reimbursement under a claim of right credit on his 2001 federal income tax return by offsetting the settlement proceeds paid to the Mandells against the income reported from the sale in 1998. Whitworth also attempted to file an amended 1998 Utah state income tax return-reducing the gain recognized from the sale of his stock in HAU by the amount of the settlement paid to the Mandells in 2001. Although the Commission initially challenged Whitworth's position, the Commission and Whitworth eventually reached a settlement.

¶ 10 In 2003, the Auditing Division assessed a deficiency on the Mandells' 2001 tax return for $70,129.62, as well as penalties of $14,025.92 and interest amounting to $6,148.00. The Mandells appealed. On appeal, the Commission waived the penalties but upheld the deficiency, after finding that the settlement was paid in lieu of proceeds Mandell should have received from the original sale. The Mandells thereafter petitioned this court for review of the Commission's decision. We have jurisdiction pursuant to Utah Code section 78A-3-102(3)(e)(ii) (2008).

STANDARD OF REVIEW

¶ 11 When reviewing the Commission's formal adjudicative proceedings, we grant no deference to the Commission's conclusions of law, reviewing them for correctness. Utah Code Ann. § 59-1-610(1)(b) (2006); see also Kennecott Corp. v. State Tax Comm'n, 858 P.2d 1381, 1383 (Utah 1993). We do, however, grant deference to the Commission's written findings of fact, applying the "substantial evidence standard" on review. Utah Code Ann. § 59-1-610(1)(a).

¶ 12 Our standard of review for mixed questions of law and fact varies "according to the nature of the legal concept at issue." State v. Levin, 2006 UT 50, ¶ 21, 144 P.3d 1096. To determine the standard of review for a mixed question of law and fact, we apply a test that considers (1) the complexity of the facts; (2) the degree to which the lower court relied on observable facts that cannot be adequately reflected in the record, such as witness demeanor and appearance; and (3) any policy reasons favoring or disfavoring the exercise of discretion. Id. ¶ 25.

ANALYSIS

¶ 13 The Mandells characterize the 2000 lawsuit as a chose-in-action litigated entirely in Nevada, deriving from a fraud that occurred in California. Because they were not Utah residents at the time of the 2001 settlement, the Mandells contend that Utah lacks jurisdiction to tax the settlement proceeds.

¶ 14 The fact that the Mandells had no personal, commercial, or business presence in Utah in 2001 does not render them immune from taxation by the state of Utah. "[T]he power to promulgate and enforce income tax laws is an essential attribute of sovereignty." Franchise Tax Bd. v. Hyatt, 538 U.S. 488, 498, 123 S.Ct. 1683, 155 L.Ed.2d 702 (2003) (citing Franchise Tax Bd. v. U.S. Postal Serv., 467 U.S. 512, 523, 104 S.Ct. 2549, 81 L.Ed.2d 446 (1984)). In order to tax, a state must show only "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax." Miller Bros. Co. v. Maryland, 347 U.S. 340, 344-45, 74 S.Ct. 535, 98 L.Ed. 744 (1954). Among other things, "incorporation by a state or permission to do business there forms the basis for proportionate taxation of a company." Id. at 345, 74 S.Ct. 535 (footnotes omitted).

¶ 15 The Mandells' claim that Utah lacks authority to tax their settlement proceeds presents an issue of first impression in Utah. Other courts, however, have had ample opportunity to determine a state's authority to tax settlement proceeds or damages received through litigation. These courts uniformly look to the character and nature of the settlement proceeds or damages to determine their taxability, asking "in lieu of what were the damages...