Winter v. Comm'r Of Internal Revenue, T.C. Memo. 2010-287
| Decision Date | 30 December 2010 |
| Docket Number | T.C. Memo. 2010-287,Docket No. 5035-05 |
| Parties | MICHAEL C. WINTER AND LAUREN WINTER, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
John B. Beery, Joseph M. Laub, and John J. Scharkey III, for petitioners.
Kathleen C. Schlenzig, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Michael Winter owned stock in the bank where he worked. The bank paid him a large bonus in 2002, but then fired him and demanded part of the bonus back. On his 2002 return, Winter reported the full amount of his bonus, and his share of the bank's income and deductions--not as those items were reported by the bank, but from his own estimates.
The parties argued mostly about the consequences of Winter's failure to report his income from the bank consistently with its return, and about the taxability of his bonus in the year he received it. I would have held that the Court lacks jurisdiction over these questions, but my colleagues, in a reviewed opinion, assured me, the parties, and the rest of the audience for our opinions that we did have jurisdiction in Winter v. Commissioner, 135 T.C. __ (2010) (Winter I). Retreating back into my role as the trial judge in the case, and resuming our customary habit of using the first person plural, we now decide all the remaining issues in the case. Winter I laid out the facts in detail and we assume familiarity with them.
The key fact was that Winter failed to report his income from Builders Financial Corporation (BFC) consistently with the Schedule K-1, Shareholder's Share of Income, Credits, Deductions, that BFC prepared for him. Winter claims he never got the K-1, and instead used BFC's published regulatory statements to calculate his passthrough income. Using these numbers, Winter calculated his share of BFC's income to be a $1.2 million loss instead of the $820,031 gain BFC reported. Winter faults BFC's tax return for deducting only a portion of his prepaid bonus in 2002. The Commissioner also asserted that Winter failed toreport some dividend, interest, and gambling income. Winter has since conceded those adjustments.1
Yet another dispute arises from an issue not even mentioned in the notice of deficiency--the taxability of the bonus payment. Winter doesn't deny he received a W-2 showing 2002 compensation of $5,623, 559, and he did report this entire amount on his return. But now he claims that he didn't have to. Finally, the Commissioner questions the deductibility of Winter's pro-rata share of BFC's charitable contributions and says Winter should pay an accuracy-related penalty. There are thus four substantive issues:
Winter was a resident of Illinois when he filed his petition, and the parties submitted the case for decision under Rule 122.
Our first puzzle is whether it was wrong for Winter to report a passthrough loss on his return instead of reporting the passthrough income shown on his K-1.2 One large difference between Winter's and BFC's reporting--and the only one the parties focus on here--is the treatment of the $5.1 million prepayment of Winter's five-year, $5.5 million bonus that BFC made in 2002. Because BFC is a passthrough corporation, deciding how it should have treated the bonus will tell us how Winter should have reported it.
The major disputes are about the payment's proper characterization and the timing of its deduction. No one disputes that BFC properly deducted about $1.1 million of thebonus in 2002--the portion that Winter earned that year. See sec. 162(a)(1); sec. 1.162-9, Income Tax Regs. But Winter claims BFC, as a cash-basis taxpayer, should also have deducted another $4 million, the part of the bonus that BFC prepaid. Winter claims that BFC had authority to deduct this disputed portion in 2002 under either section 461(f), as a contested liability because the payment resembled severance, or under section 162 as an ordinary and necessary business expense. The Commissioner disagrees.
Unless the Code explicitly allows a taxpayer to make an election, each of his expenses has a proper year for its deduction. Crisp v. Commissioner, T.C. Memo. 1989-668 (); see also sec. 1.263(a)-3(b), Income Tax Regs, (listing Code sections that allow a taxpayer to elect timing of certain deductions). Section 461(a) states the general rule--a deduction is to be taken in the "proper taxable year under the method of accounting used in computing taxable income"--and the remaining subsections createvarious exceptions or qualifications. So we know at the outset that if any of the latter subsections applies, its specific rule will trump section 461(a)'s general one. See Pilaria v. Commissioner, T.C. Memo. 2002-230 (citing Bulova Watch Co. v. United States, 365 U.S. 753, 758 (1961)).
One of the exceptions is section 461(f), which applies to "contested liabilities." The Commissioner's main argument on this issue is that Winter's prepaid bonus wasn't contested, and therefore section 461(f) doesn't apply. So we must first decide if the disputed portion of the bonus was "contested". If it was, we have to follow section 461(f)'s timing rules. If not, we have to revert to section 461(a) and analyze the timing of the deduction under BFC's accounting method.
The Code doesn't say when we should look to see if a contest exists, but the Commissioner argues the right time to look to see if a contest exists is the time when the payment was made. Because BFC paid Winter when both parties were happy with each other, the Commissioner argues, there was no "contested liability" under section 461(f). Without more, this would be a plausible reading of the statute, but an example in the regulation points in exactly the opposite direction:
Example: * * * O [Corporation] receives a large shipment of typewriter ribbons from S Company on January 30, 1964, which O pays for in full on February 10, 1964. Subsequent to their receipt, several of the ribbons prove defective because of inferior materials used by the manufacturer. On August 9, 1964, O orallynotifies S and demands refund of the full purchase price of the ribbons. After negotiations prove futile and a written demand is rejected by S, O institutes an action for the full purchase price. For purposes of paragraph (a)(1)(i) of this section, S has asserted a liability against O which O contests on August 9, 1964. O deducts the contested amount for 1964.
Sec. 1.461-2(b)(3), Income Tax Regs. This example forces us to reject the Commissioner's contention that the contest had to exist when BFC paid Winter. We think instead that it makes more sense to look at whether a contest existed at the end of the tax year. We infer this from the regulation, which says a contest under section 461(f) means "[a]ny contest which would prevent accrual of a liability under section 461(a)." Sec. 1.461-2(b)(2), Income Tax Regs. If a liability isn't contested at the end of the tax year, then the taxpayer can use the ordinary deduction-timing rules of section 461(a); if it is, he cannot.
The relevant regulations also say there is a contest when "there is a bona fide dispute as to the proper evaluation of the law or the facts necessary to determine the existence or correctness of the amount of an asserted liability." Sec. 1.461-2(b)(2), Income Tax Regs. Although beginning a lawsuit is sufficient to establish a contest, it isn't necessary--an affirmative act denying the validity of the liability is sufficient. Id. It isn't even necessary that the objection be in writing. Id. Although BFC didn't sue Winter until 2003, we find that BFC's November 2002 "Notice of Termination for Cause"suffices to mark the start of a "contest". As in the regulation's example, BFC paid without complaint but later decided to demand partial repayment. From the example we know a contest begins on the date the payor notifies the payee of its discontent. BFC's letter was sent in November 2002, before the close of the tax year. We also find that BFC's later demand for repayment sent in January 2003 proves that the contest continued to exist at the end of the 2002 tax year. We therefore must look to section 461(f).
Section 461(f) allows a deduction for a contested liability in the year paid if the following conditions are met:
The Commissioner argues that not one of these elements is met. He says that because BFC paid Winter voluntarily and did not contest the amount at the time of the payment, BFC did not contest an asserted liability or transfer money to provide for the satisfaction of the asserted liability. He even reads thethird element to say the contest had to exist at the time BFC made the payment. The Commissioner finally says the deduction fails the fourth element because the deduction doesn't pass the economic-performance test of subsection (h). We'll look at the elements in order.
The first element requires us to decide if...
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