Ferguson v. Comm’r, T.C. Summary Opinion 2007-30 (2007).

T.C. Summary Opinion 2007-30

UNITED STATES TAX COURT

MICHAEL FERGUSON, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21315-05S. Filed February 28, 2007.

Michael Ferguson, pro se.

Julie A. Jebe, for respondent.

ARMEN, Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect when the petition was filed.1 The decision to be entered

1 Unless otherwise indicated, all subsequent section references are to the Internal Revenue Code in effect for 2003, the taxable year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

is not reviewable by any other court, and this opinion should not be cited as authority.

Respondent determined a deficiency in petitioner’s Federal income tax for 2003 of $3,068. Petitioner timely filed a petition with the Court. The sole issue for decision is whether petitioner’s gambling activity constituted a trade or business under section 162 and, consequently, whether he was a professional gambler in 2003.

Background

Some of the facts have been stipulated, and they are so found. We incorporate by reference the parties’ stipulation of facts at trial and accompanying exhibits.

At the time the petition was filed, petitioner resided in Berwyn, Illinois.

During the taxable year in issue, petitioner was employed full-time as a building operating engineer in Chicago and earned approximately $51,840 from his employment in 2003.

In addition to his employment, petitioner spent a good deal of time playing video poker. It was his only form of gambling. Petitioner bet an average of $25 on each hand. He began playing video poker in 1997 and spent an increasing amount of time engaged in the activity.

Video poker is a “casino game based on five card draw poker.” Http://en.wikipedia.org/wiki/Video_poker. Players bet money or credits and then play poker against a computerized machine. See id. One does not play against other players but simply tries to obtain the best hand. After the player’s draw, “the machine evaluates the hand and offers a payout if the hand matches one of the winning hands in the posted pay schedule.” Id.

Some people, including petitioner, think that if one were to play video poker in a mathematically and theoretically perfect manner, eventually one would realize a profit. Petitioner testified that he tried to only play on machines with an expected payout value of a 100-percent return, meaning he thought he would never lose money;2 he also testified that the only way to get a return of more than 100 percent is to play on a “progressive” machine.3 He further testified that despite his hours of practice on a computer and diligent study of the perfect way to play the game, “it didn’t work”.4

2 A payout value or payback rate is the expected return a particular game will provide when played over a long enough period of time. See http://en.wikipedia.org/wiki/Expected_value.

3 A progressive machine is one which contributes to a progressive jackpot. A progressive jackpot, the highest payoff possible for a gaming machine, arises from a group of several gaming machines linked together. See http://en.wikipedia.org/wiki/Progressive_jackpot. A small amount from every game played on each of the machines increases the value of the jackpot, and the jackpot winner receives money pooled from the entire group of linked machines. See id.

4 The Court suspects that petitioner’s strategy did not (continued…)

Petitioner spent time traveling to and from the casinos, scouting machines, and studying strategy. He obtained a tutoring program to learn how to play and avoid mistakes. Sometimes he would observe other players and watch for a “positive” machine.5 He would be involved in video poker and related activities two or three times during the workweek and again on weekends.

Petitioner hit at least two big jackpots–approximately $60,000 each–but overall always lost money. Because he lost more money than he made in 2003, he used some of his savings to support himself.

Petitioner filed a Schedule C, Profit or Loss From Business, for the taxable year 2003. Reporting as a professional gambler,6 he claimed $1,311,200 in gross income from gambling, and a

4(…continued) work because, while some video poker games may have a payback rate at or in excess of 100 percent, assuming “error-free, perfect play”, most games offer a payback rate of less than 100 percent, even when played with perfect strategy. See, e.g., http://en.wikipedia.org/wiki/Video_poker. Of course, consistently error-free, perfect play is nearly impossible, and most players will lose a few cents or fractions thereof for each dollar bet over the long term. That said, short-term results do not always follow long-term statistical probabilities, which is why people still gamble.

5 A “positive” machine is a machine with a payout rate of 100 percent or better.

6 H&R Block, petitioner’s tax preparer, determined that petitioner was a professional gambler because he spent more than 20 hours per week on the activity.

corresponding $1,311,200 in gambling losses.7 For the year in issue, petitioner did not keep books and records of his win/loss activity and instead relied on the casinos’ yearly statements to track his activity for him.

Respondent determined that petitioner was not a professional gambler in 2003. Accordingly, his gambling winnings should have been reported on line 21 of the Form 1040, U.S. Individual Income Tax Return (Other income). Respondent also determined that the gambling losses should have been claimed on Schedule A, Itemized Deductions.

Discussion

The issue in this case is whether petitioner’s gambling activity in 2003 constituted a trade or business under section 162. If petitioner were engaged in the trade or business of gambling, his wagering losses, to the extent deductible under section 165(d),8 would be deducted in computing adjusted gross income. See sec. 62. On the other hand, if petitioner were not in the trade or business of gambling, wagering losses, to the

7 In addition to the $1,311,200 in income and losses from gambling, petitioner also reported $3,000 of “Other income” and $2,820 of “Car and truck expenses” on his Schedule C, neither of which is contested by respondent. Respondent did not raise any substantiation issues as to any of the amounts.

8 While sec. 165(a) generally allows losses to be deducted from gross income, sec. 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.”

extent deductible under section 165(d), would be deductible as an itemized deduction in the computation of taxable income. See, e.g., Gajewski v. Commissioner, 84 T.C. 980, 982 (1985); Johnston

v. Commissioner, 25 T.C. 106, 108 (1955); see also secs. 67(a), 68(a), 151(d)(3).

In general, section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. The term “trade or business” is not defined in the Internal Revenue Code or the regulations. That said, it is well established that in order for an activity to be considered a trade or business for the purposes of section 162, the activity must be conducted with “continuity and regularity” and “the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).

Petitioner testified at trial that playing video poker totally consumed his free time and caused him to lose a lot of money. But simply spending all of one’s free time on an activity does not transform that activity into a trade or business, nor does it make the participant a professional. Occasionally, devoting all of one’s free time to a particular activity may be a sign of addiction.9 Further, the amount of time spent engaged in

9 At trial, petitioner testified that he had himself barred from his usual casinos for 5 years to prevent him from continuing to gamble there.

the activity is not the most significant aspect of the trade or business analysis. More important is the taxpayer’s actual or honest objective of making a profit. Keanini v. Commissioner, 94

T.C. 41, 46 (1990); Hulter v. Commissioner, 91 T.C. 371, 392 (1988); Dreicer v. Commissioner, 78 T.C. 642, 644-645 (1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs.

Although a reasonable expectation of a profit is not required, the taxpayer’s profit objective must be actual and honest. Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs. Whether a taxpayer has an actual and honest profit objective is a question of fact to be answered from all the relevant facts and circumstances. Hulter v. Commissioner, supra at 393; Hastings v. Commissioner, T.C. Memo. 2002-310; sec. 1.183-2(a), Income Tax Regs. Greater weight is given to objective facts than to a taxpayer’s mere statement of intent. Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs. The taxpayer bears the burden of establishing he or she had the requisite profit objective.10 Rule 142(a); Keanini

v. Commissioner, supra at 46; Hastings v. Commissioner, supra.

The regulations set forth a nonexhaustive list of factors that may be considered in deciding whether a profit objective exists. These factors include such matters as: The manner in which the taxpayer carries on the activity, the taxpayer’s history of income or losses with respect to the activity, and the financial status of the taxpayer. See sec. 1.183-2(b), Income Tax Regs.

No single factor, not even the existence of a majority of factors favoring or disfavoring the existence of a profit objective, is controlling. See id. In addition, not every factor is relevant in every case.11 Vandeyacht v. Commissioner,

T.C. Memo. 1994-148; Borsody v. Commissioner, T.C. Memo. 1993534, affd. per curiam 92 F.3d 1176 (4th Cir. 1996). Rather, the relevant facts and circumstances of the case are determinative.

10 Generally the Commissioner’s determinations are presumed correct, and the taxpayer bears the burden of proving those determinations wrong. Rule 142(a); INDOPCO, Inc. v Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under sec. 7491, the burden of proof may shift from the taxpayer to the Commissioner if the taxpayer produces credible evidence with respect to any factual issue relevant to ascertaining the taxpayer’s tax liability. Sec. 7491(a)(1). In this case there is no such shift because petitioner neither alleged that sec. 7491 was applicable nor established that he fully complied with the requirements of sec. 7491(a)(2). The burden of proof remains on petitioner.

11 Consequently, we do not analyze in depth all of the factors enumerated in the regulation but rather focus on some of the more important ones that lead to our decision.

See Golanty v. Commissioner, 72 T.C. 411, 426 (1979), affd. without published opinion 647 F.2d 170 (9th Cir. 1981). Given the facts and circumstances in this case, we find that petitioner’s gambling activity in 2003 was not a trade or business. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner did not carry on his video poker activity in a businesslike manner. See sec. 1.183-2(b)(1), Income Tax Regs. He did not maintain adequate books or records, instead relying on casino records to track his wins and losses from the activity, even though he was aware that there was a threshold amount below which amounts were not reported.

Although petitioner expended a great deal of time and effort engaged in his gambling activity, spending more than 1,000 hours gambling in 2003, see sec. 1.183-2(b)(3), Income Tax Regs., he did not seek additional assistance with or adjust his gaming strategy, even when it became apparent that he never had a winning year, see sec. 1.183-2(b)(2), (6), Income Tax Regs.

We are additionally unconvinced that petitioner’s gambling activity meets the standard for being a trade or business because we are not persuaded that an individual who gambles against a machine that is programmed by a casino can have, as his or her primary purpose, income or profit. After all, such a machine is on the floor to make money for the casino and is not there to provide income or profit for the casino’s patrons. For most individuals, gambling against a machine that is programmed to

make money for the casino constitutes what the Supreme Court in

Commissioner v. Groetzinger, 480 U.S. 23 (1987), characterized as

a sporadic activity, hobby, or amusement diversion.12 For other

individuals, gambling against such a machine may become a habit

or an addiction. In neither scenario is it a trade or business

with the participant’s primary purpose being income or profit.

The fact that petitioner did not have the requisite profit

objective to qualify his gambling activity as a trade or business

is by no means to say that petitioner did not wish to make money

gambling. But:

[N]ot every income-producing and profit-making

endeavor constitutes a trade or business. * * *

[T]o be engaged in a trade or business, the

taxpayer must be involved in the activity with

continuity and regularity and * * * the taxpayer’s

primary purpose for engaging in the activity must

be for income or profit. A sporadic activity, a

hobby, or an amusement diversion does not qualify.

Id. at 35.

12 While we acknowledge that a taxpayer can be simultaneously engaged in more than one trade or business, the facts in the present case are different from those in Commissioner v. Groetzinger, 480 U.S. 23 (1987). There, the Supreme Court was heavily influenced by the fact that the taxpayer, following the termination of his 20-year employment in February of the taxable year in issue, spent the balance of the year engaged in parimutuel wagering and looked to such wagering for his livelihood. In contrast, petitioner was employed throughout the year on a full-time basis and relied on his wages to support himself; he did not make his living playing video poker.

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Conclusion

Because petitioner did not have the requisite profit objective, we decide that petitioner’s gambling activity in 2003 was not a trade or business, and consequently, that petitioner was not a professional gambler in the taxable year in issue.

Reviewed and adopted as the report of the Small Tax Case Division.

To reflect our disposition of the disputed issue,

Decision will be entered for respondent.

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February 28th, 2007 | 1 Comment »

Chief Counsel Notice 2007-008 (2007).

Notice

CC-2007-008 February 27, 2007

This Notice provides Chief Counsel attorneys direction in the handling of civil cases involving criminal restitution.

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What is Restitution?

Restitution is a legal remedy that may be ordered as an independent element of a criminal sentence by a United States district court. 18 U.S.C. §§ 3663(a)(1)(A) and 3663A(a)(1). A restitution order requires a defendant to pay money or render services to a victim of a crime to redress the victim’s loss. In criminal tax cases, the Internal Revenue Service is considered a victim. Restitution is often ordered in criminal tax cases pursuant to a plea agreement in which the defendant agrees to pay a specific sum. See 18 U.S.C. § 3663(a)(3) (authorizing restitution in any criminal case to the extent agreed to by the parties to the plea agreement); United States v. Thompson, 39 F.3d 1103, 1105 (10th Cir. 1994). Restitution can also be required of persons convicted of any offense as a condition of probation or supervised release. 18 U.S.C. §§ 3563(b)(2) and 3583(d); United States v. Butler, 297 F.3d 505, 518 (6th Cir. 2002), cert. denied, 538 U.S. 1032 (2003); United States v. Bok, 156 F.3d 157, 166 (2d Cir. 1998).

Restitution is calculated according to the “loss caused by the specific conduct that is the basis of the offense of conviction.” Hughey v. United States, 495 U.S. 411, 413 (1990); Weinberger v. United States, 268 F.3d 346, 357 (6th Cir. 2001); United States v. Baker, 25 F.3d 1452, 1456 (9th Cir. 1994); United States v. Trigg, 119 F.3d 493, 500 (7th Cir. 1997). In most criminal tax cases involving restitution, the probation office calculates the amount of tax loss from evidence admitted at trial or from the plea agreement and generally recommends this amount for restitution in the presentence investigation report. The sum fixed in a restitution order should include interest under Internal Revenue Code provisions to a specified date. Following entry of the restitution order, interest accrues as provided in 18 U.S.C. section 3612(f). Restitution generally does not include civil penalties. See United States v. Daniel, 956 F.2d 540, 543-544 (6th Cir. 1992).

Restitution is not assessable as a tax but payments of restitution for taxes owed should be credited against the civil liability for unpaid taxes, as provided in a plea agreement or court

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order. See United States v. Helmsley, 941 F.2d 71, 102 (2d Cir. 1991) (reducing judgment in civil proceeding for unpaid taxes by amount of restitution paid). Taxpayers responsible for paying restitution remain subject to tax return filing requirements. An assessment of the taxpayer’s civil liability should be made (subject to notice of deficiency procedures, if applicable) as soon as possible after the restitution order to ensure proper application of the payments to the relevant tax year.

Restitution may relate to, but is not the equivalent of, civil tax liability. An award of restitution does not bar the Service from determining civil liability in an amount greater than the amount awarded. Morse v. Commissioner, 419 F.3d 829, 833-35 (8th Cir. 2005); Hickman v. Commissioner, 183 F.3d 535, 537-38 (6th Cir. 1999); M.J. Wood Associates, Inc. v. Commissioner, T.C. Memo. 1998-375. An award of restitution also does not prevent a taxpayer from challenging the Service’s determination that the civil liability exceeds the amount of the restitution ordered. A restitution award may only be contested by direct appeal of the criminal case.

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Creel v. Commissioner

The Eleventh Circuit, in Creel v. Commissioner, 419 F.3d 1135 (2005), affirmed the Tax Court’s unpublished Order and Decision, in a collection due process case under section 6330. In Creel, No. 3037-01 (January 14, 2004), the Tax Court concluded that a taxpayer’s civil tax liabilities had been compromised previously by the United States Attorney in connection with that office’s acknowledgement that a criminal restitution order was satisfied. The Office of Chief Counsel disagrees with both courts’ conclusions.

Creel pleaded guilty in the district court to two counts of willfully failing to file income tax returns for 1987 and 1988. During the plea phase, Creel prepared and filed returns for various years. As part of his plea, he was ordered to pay restitution of $83,830 “plus any applicable penalties and interest” for taxable years 1986 through 1991. From 1994 to 1998, Creel paid $83,830 in restitution. The Service applied these payments first to satisfy Creel’s 1986 tax liability (including penalties and interest) and then to satisfy a portion of his 1987 tax liability.

In 1998, the U.S. Attorney filed a Cancellation and Release stating that the lien of judgment was “fully released, satisfied, discharged and cancelled” because it was “paid in full.” The U.S. Attorney also filed a satisfaction that stated, “the . . . restitution imposed by the Court . . . having been paid or otherwise settled, the Clerk . . . is hereby authorized and empowered to satisfy the Judgment as to the monetary imposition only.”

The Service sent Creel a notice of intent to levy for his 1985 and 1987 through 1991 outstanding tax liabilities from which Creel requested a collection due process hearing with the Service’s Office of Appeals. Appeals issued a determination after the hearing sustaining the proposed levy action.

Creel argued in Tax Court that he did not owe any tax, penalty, or interest for the1987 through 1991 tax years because he believed his restitution payments and the satisfaction of judgment for restitution and release of the judgment lien meant that everything he owed to the Government was paid. The court inferred from petitioner’s testimony and from the inclusion of “applicable penalties and interest” in the restitution order that the civil tax liability was compromised by the satisfaction and release given by the U.S. Attorney for those tax years. The court drew negative inferences, citing Wichita Terminal Elevator Co. v. Commissioner, 6

T.C. 1158, 1165 (1946), from the Commissioner’s failure to call a witness on the restitution

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issue, e.g., from the Department of Justice or the U.S. Attorney’s Office. The court also dismissed the Commissioner’s legal arguments that the U.S. Attorney did not have authority to settle the tax liabilities.

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Construing the Creel Decision

The Eleventh Circuit acknowledged in Creel that the government was correct “in the abstract” when arguing that satisfaction of criminal tax liability does not generally include satisfaction of civil tax liability. The court noted the general rule that the government can seek restitution through criminal proceedings and pursue recovery of excess civil tax liability in subsequent civil proceedings. The court, nevertheless, found that the “unique facts and the nuances” of the case dictated a departure from this general rule. Specifically, the court held that ambiguous language in the restitution judgment and the actions of the U.S. Attorney permitted the conclusion that satisfaction of the criminal obligations of the defendant in this instance subsumed civil liability. The court misconstrued the facts of the case.

To reduce the chance that another court would reach a similar conclusion, the distinction between civil and criminal liabilities must also be well understood and clearly articulated in any collection due process case or other litigation in which the issue arises. If a taxpayer suggests, as Creel did, that he paid “everything he owed” related to his tax delinquency when he satisfied his restitution obligation, the taxpayer may be suggesting that unpaid penalties, interest, and tax were compromised in conjunction with resolution of the criminal case. Section 7122(a) vests compromise authority in the Secretary of the Treasury prior to the referral of a case to the Justice Department and reserves such authority to the Attorney General or his delegate following referral.

Post-referral compromises should be set forth in writing. The taxpayer has the burden of proving the existence of a compromise or settlement. See generally Parks v. Commissioner, 33

T.C. 298, 301 (1959) (placing burden on taxpayer to prove existence of settlement or compromise).

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Relevant Documentary Evidence

The taxpayer has the burden of presenting evidence to prove that, contrary to the normal course of events, civil tax liability was compromised by satisfaction of a restitution obligation. Relevant documentary evidence would include: (1) the plea agreement (if applicable); (2) related waivers or exceptions; (3) the criminal judgment; (4) the restitution order; (5) the satisfaction of judgment (if applicable); and (6) any certificate releasing the judgment lien. These documents can be obtained from the U.S. Attorney’s Office for the district where the criminal case was prosecuted by contacting the Criminal Investigation special agent assigned the case. The prosecuting attorney should have items (1) through (4), and the Financial Litigation Unit attorney in the U.S. Attorney’s Office should have items (5) and (6). If the special agent is unavailable or unable to assist, contact the IRS Criminal Tax Division, the prosecuting attorney or Financial Litigation Unit directly.

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Revised Restitution Procedures and Forms

The Department of Justice recently revised the U.S. Attorneys’ Manual to include standardized language for use by U.S. Attorneys in restitution orders and in the restitution portion of plea agreements. See United States Attorneys’ Manual § 6-4.360, Compromise of Criminal Liability/Civil Settlement (September 2006), citing Tax Resource Manual §§ 56-59 (September

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2006). The promulgation of these standards may increase the number of cases in which courts order defendants to pay restitution to the United States. The new standard language reflects the Tax Division’s long-standing policy of not compromising civil tax liability in conjunction with a plea agreement and is intended to ensure that Tax Division trial attorneys and Assistant U.S. Attorneys do not inadvertently compromise civil tax liabilities, penalties or interest for criminal prosecution years.1 It is expected that use of the standard language and forms should significantly reduce latent ambiguities concerning whether civil liabilities were compromised by satisfaction of the restitution obligation.

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Chief Counsel’s Litigating Position

It is Chief Counsel’s position that the Eleventh Circuit fundamentally misconstrued the facts of Creel in concluding that civil liability was compromised by satisfaction of a criminal restitution obligation. In future cases arising in the Eleventh Circuit, attorneys should strive to distinguish Creel on its facts. In factually similar cases arising in other circuits, attorneys should argue that Creel was wrongly decided. In factually dissimilar cases arising outside the Eleventh Circuit, Creel should also be distinguished on its facts.

When restitution related issues arise in the course of litigation or other aspects of Chief Counsel’s practice, attorneys should coordinate promptly with the office of Associate Chief Counsel (Procedure & Administration). General questions regarding restitution should be addressed to Branch 2, Administrative Provisions and Judicial Practice (Procedure & Administration) at (202) 622-4940. Questions concerning collection due process cases involving restitution, including assistance in preparing appropriate motions, should be addressed to Branch 1, Collection, Bankruptcy & Summonses Division, Office of Associate Chief Counsel (Procedure & Administration) at (202) 622-3610.

________/s/___________ Deborah A. Butler Associate Chief Counsel (Procedure & Administration)

1 Authority to compromise criminal or civil liability in settling a criminal case lies with “the Attorney General or his delegate.” Section 7122(a). The Attorney General has delegated this authority to the Assistant Attorney General for the Tax Division. 28 C.F.R. § 0.70. The Assistant Attorney General has not delegated this authority in criminal cases to U.S. Attorneys. The U.S. Attorneys’ Manual directs that “United States Attorneys may not make agreements which prejudice civil or tax liability without the express agreement of all affected Divisions and/or agencies.” United States Attorneys’ Manual §§ 9-16.300, 9-27.630. U.S. Attorneys do not have the authority to settle civil tax liabilities in criminal cases unless proper approval is obtained from the Tax Division.

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February 27th, 2007 | 1 Comment »

Chief Counsel Advice Memorandum 20070801F (2007).

Office of Chief Counsel

IRS

Office of Chief Counsel Internal Revenue Service

MemorandumRelease Number: 20070801F

Release Date: 2/23/07 CC:SB:7:SJ:2:CSHong POSTF-138911-06

UIL: 6324A.00-00

date: December 20, 2006

to: Denice Huber Advisor, Technical Services (San Jose) (Small Business/Self-Employed)

From: Jeffrey L. Heinkel Associate Area Counsel (San Jose, Group 2) (Small Business/Self-Employed)

subject:

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Disclosure Statement

This writing may contain privileged information. Any unauthorized disclosure of this writing may have an adverse effect on privileges, such as the attorney-client privilege. If disclosure becomes necessary, please contact this office for our views.

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Issues

I. What wording would need to be added to the Agreement to Special Lien (“ASL”) signed by the to secure the government’s interests in the four business entities offered as collateral under section 6324A of the Internal Revenue Code of 1986, as amended?

II. Would the partnership and LLC agreements require amendments in order to allow the to pledge the interests?

III. Would the partners and members that are not heirs of the

need to sign the security agreements and consent to the pledging their interest in the entities?

IV. Provide an agreement that would be enforceable as a contract to pledge the interests of the in the partnership and LLCs.

Conclusions

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I. The ASL does not require additional wording. However, please see our comments regarding question IV.

II. The agreements do not require amendment. However, documentation showing that the partnership and LLCs approved the security agreements should be obtained. Furthermore, in this instance, the appropriate agreement is a security agreement rather than a pledge agreement.

III. Other partners or members, as applicable, need not sign the security agreement, but may need to approve the security agreement due to provisions of the applicable organizational agreement.

IV. An agreement based on the ASL is attached as Exhibit A. However, if it is possible to revise the Collateral to be offered, an alternative agreement is attached as Exhibit B.

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Facts

The (“Taxpayer”) elected to defer its estate tax liability for ten (or more) years under section 6166.1 It also elected to grant the Internal Revenue Service (“IRS” or “Service”) a lien on specific property pursuant to section 6324A. The Taxpayer has consented to the imposition of a lien on certain partnership and LLC interests. Due to the nature of the property, Technical Services is concerned that, despite the filing of a notice of federal tax lien, that the value of the interests could be impaired or the assets could be transferred outright. You have asked us to advise regarding securing the Service’s interest in the partnership and LLC interests. The agreement that is the subject of this memorandum is in addition to, and not in lieu of, the lien agreement described under § 6324A.

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Law & Analysis

Section 6166 allows estates to defer payment of estate tax attributable to interests in a closely-held business for up to five years, provided that the interest on any unpaid portion of the tax is paid annually during that period. I.R.C. § 6166(a), (f). The estate must pay the balance of interest and tax due in as many as ten equal

1 Unless otherwise stated, “Code” or “section” shall refer to the Internal Revenue Code of 1986, as amended.

installments with no more than a year between installments. I.R.C. § 6166(a). For purposes of this memorandum, we assume that the Service properly granted the section 6166 election. See Rev. Proc. 79-55; I.R.M. §§ 4.25.1.4.9(4), (13).

Where the Service agrees to defer the estate tax, the Service may require a bond from the estate as security. I.R.C. § 6165. Alternatively, the Service may not require a bond if the Service obtains a section 6324A special lien pursuant to an agreement under section 6324A(c).2

Where the Service accepts Collateral, any person with an interest in the Collateral must sign an agreement with the Service. I.R.C. § 6324A(c) (hereinafter referred to as “6324A lien agreement”). The 6324A lien agreement is governed by Federal law, and perfection and priority rules can be found in section 6324A(d). The fair market value of the property required by the Service may not exceed the sum of the deferred amount and the required interest amount, as defined in Treas. Reg. § 20.6324A-1(e)(1) and (e)(2). I.R.C. § 6324A(b)(2); Treas. Reg. § 20.6324A-1(b)(2). However, the parties to the agreement referred to in section 6324A(c) may voluntarily designate property having a fair market value in excess of that sum. Treas. Reg. § 20-6324A-1(b)(2).

The Service is interested in entering into the proposed Security Agreement in order to secure the Service’s interest in the property to supplement the 6324A lien agreement. The Security Agreement is not specifically authorized by the Code, a nd as such is governed by state law.

The Security Agreement, as a contract between the Service and the estate, is governed at least in part by state law. Under California law, the Service is receiving a security interest in property and the Service must take the proper steps under California law with regard to that security interest.

Under California law, a security interest becomes enforceable only if it has attached. A security interest attaches if: 1) The debtor has rights in the property being offered as security, Ca. Comm. Code § 9203(b)(2); 2) the secured party gives value for

An open question is whether a section 6324A lien extinguishes the general estate tax lien, created by § 6324(a). The Service’s position is that the general estate tax lien continues to attach all estate property except the property subject to the section 6324A lien. See I.R.C. § 6324A(d)(4); see also Treas. Reg. §§ 20.6324A-1, 301.6324A-1(e); I.R.M. § 5.5.8.1(4)(b). This issue has never been directly addressed by any court. In In re Roth, 301 B.R. 451, 454 (Bankr. W.D. Pa 2003), aff’d, 2004 WL 716743 (April 1, 2004,

W.D. Pa.), the Service argued on appeal to the district court that a section 6324A lien on shares of stock displaced the section 6324(a) lien only with respect to those shares of stock. The court held that it need not reach this issue, however, as the other assets the Service was seeking to collect were not assets of the gross estate ever subject to the section 6324A lien. See also Noble v. Soler, 98-1 U.S.T.C. ¶ 60,297

(S.D. Ohio 1997) (court does not reach issue of extent of displacement of section 6324(a) lien because section 6324A lien agreement was never filed). In a bankruptcy case involving section 6324B (which makes the language of section 6324A(d)(4) applicable pursuant to section 6324B(c)(1)), the court again does not directly address this issue, but notes that “[m]oreover, any property against which a Section 6324B lien is filed is divested of the Section 6324 lien regardless of whether the property was Section 2034 to 2042 property.” In re Druse, Sr., Ltd., 82 B.R. 1013, 1016 (Bankr. D. Neb. 1988).

the security interest, Ca. Comm. Code § 9203(b)(1); 3) the parties have a security agreement containing a description of the property being offered as security, Ca. Comm. Code § 9203(b)(3); and 4) the debtor authenticates (i.e., signs) the security agreement, Ca. Comm. Code § 9102(7).

Also, the secured party must take additional steps to make the security interest enforceable against third parties. Absent these additional steps, the security interest is only enforceable against the debtor. The process of making the security interest enforceable against third parties is called perfection. Perfection can occur by filing a financing statement against the Collateral, receiving a pledge on the Collateral (i.e., taking possession of the Collateral), or obtaining control over the Collateral. See Law & Practice of Secured Transactions: Working with Article 9 § 3.02.

The appropriate form of perfection varies depending on the Colla teral. Most security interests can be perfected by filing. See Ca. Comm. Code § 9310(a).3 Even though perfection by filing is adequate, where possible, a pledge is often the best form of perfection. “By depriving the debtor of dominion over the colla teral, the secured party has alerted the world to the possibility of an encumbrance.” Richard F. Duncan et al., Law & Practice of Secured Transactions: Working with Article 9 § 3.02 (2005). A pledge can only be used where the Collateral is in the form of paper, such as money, negotiable instruments, chattel paper, securities and negotiable title documents. See Working with Article 9, at § 3.03[1]. Further, security interests in accounts or general intangibles can be perfected only by filing, and security interests in money or instruments can be perfected only by pledge. Id. Finally, where the Collateral is investment securities, taking control (as well as filing a financing statement or receiving a pledge) is also an appropriate form of perfection. See Working with Article 9, at § 3.03A.

In this case, the Collateral is partnership and LLC interests. Partnership and LLC interests are general intangibles. Ca. Comm. Code § 9102(a)(42).4 General intangibles can only be perfected by filing. See Working with Article 9, at § 3.03[1]; Lynn A. Soukup, It’s a Matter of Collateral, 14 Business Law Today 53 (2005). Therefore, a security agreement, rather than a pledge agreement, is appropriate.

The terms of the security agreement should also be consistent with the law and published guidance dealing with section 6324A liens and section 6166 elections. The Security Agreement should not, in any way, affect the Service’s remedies under the § 6324A lien agreement, as provided for by various provisions of the Code, most notably § 6166(g).

Section 6166 explains the causes and consequences of a default of a section 6166 deferred payment election. Most generally, if fifty percent or more of the interest in the closely-held business is disposed of or withdrawn, the unpaid balance is due and payable upon notice and demand. I.R.C. § 6166(g)(1). Likewise, failure to make a

3 See also Law & Practice of Secured Transactions: Working with Article 9 § 3.03[1].4 See also, Lynn A. Soukup, “It’s a Matter of Collateral,” 14 Business Law Today 53.

payment (left uncured for more than six months) renders the unpaid balance due and payable. I.R.C. § 6166(g)(3). In addition, regulations, Revenue Rulings, and other published guidance issued over the years illustrate particular circumstances that either do or do not cause a default under section 6166. See, e.g., Rev. Rul. 89-4 (“The sale of a portion of the assets of a closely-held business to a llay impending foreclosure does not constitute a disposition of an interest in the business under § 6166(g), if the proceeds are applied to reduce mortgage debt.”).

Rather than create new default terms in the security agreement, the agreement should incorporate the section 6166 default terms. This would allow the Service and the affected taxpayers to refer to the substantial published guidance surrounding section 6166 defaults in order to deal with peculiar fact situations that may develop. As stated recently regarding a related subject, “since the law in this area is not well settled, we recommend that the Service take a conservative approach.” CCA 200027046, 2000 WL 33116163.

For some time, we have encouraged the Service to disclose and agree upon all terms and conditions of the section 6166 installment agreement with the estate and other interested persons before approving the election. “We believe, as in any legally enforceable agreement, that all terms and conditions of the section 6166 installment agreement should be disclosed and agreed upon by all interested parties prior to granting the election.” CCA 200027046, 2000 WL 33116163.

The following addresses the specific questions posed by the Service.

I. What wording would need to be added to the ASL signed by the

to secure the government’s interests in the four business entities offered as collateral under section 6324A of the Internal Revenue Code of 1986, as amended (“Code” or “Section”)?

The ASL is sufficient as drafted. The Security Agreement attached to this memorandum provides additional terms that secure the Service’s interest in the property offered as collateral. However, please see our comments regarding question IV below.

II. Would the partnership and LLC agreements require amendments in order to allow the to pledge the interests?

Per the partnership and LLC agreements, the following provisions must be followed regarding creation of the Service’s security interests:

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III. Would the partners and members that are not heirs of the

need to sign the agreements and consent to the pledging their interest in the entities?

As with the § 6324A lien agreement, any parties who have an interest in the Collateral should sign the security agreement. See I.R.C. § 6324A(c). In this case, the Collateral is certain partnership and LLC interests. Therefore, the owners (or agents of the owners) of those particular interests that constitute the Collateral should sign the Agreement. This could include executors, trustees or beneficiaries.

Other partners or members not a party to the section 6324A agreement, as applicable, need not sign the security agreement, but may need to approve the security agreement due to provisions of the applicable organizational agreement (as stated in the previous section).

IV. Provide an agreement that would be enforceable as a contract to pledge the interests of the in the partnership and LLCs.

As previously explained, the appropriate document is a security agreement; and where the Collateral is intangible property, a pledge agreement is not applicable. Therefore, as requested, a security agreement that offers the partnership and LLC interests as collateral is attached as Exhibit A.

In addition, an alternative agreement is attached as Exhibit B. This alternative agreement has the offer the assets of the partnership and LLC interests as Collateral. If the Service can alter the ASL so that the assets of the partnership or LLC interests are the Collateral this would be preferable. See Roth v. U.S., 93 A.F.T.R.2d 2004-1663 (wherein the Service received security in the form corporate shares, but had no recourse where the shareholder disposed of all of the assets of the corporation and caused the shares to have no value).

The following are the differences between the two agreements:

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*****

If you have any questions, please call attorney Chong S. Hong at (408) 8174682.

JEFFREY J. HEINKEL Associate Area Counsel

By: ____________________ CHONG S. HONG General Attorney, Tax (Small Business/Self-Employed)

Encl: Exhibit A – Draft Security Agreement Exhibit B – Alternative Draft Security Agreement

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February 23rd, 2007 | No Comments »

PLR 200708006 (2007).

Refer Reply To: CC:TEGE:EB:HW PLR-125738-06

Date: November 17, 2006

Legend

Employer =

Trust = Plan =

Dear :

This responds to your letter of May 11, 2006 and subsequent correspondence of November 5, 2006 and November 16, 2006, requesting rulings concerning the proper Federal income tax treatment under section 106 of the Internal Revenue Code (Code) of retiree health benefits provided to eligible employees, their spouses and dependents.

Employer proposes to establish a Trust for the benefit of eligible retiring employees, their spouses and dependents. The Trust funds will be used to pay for retiree health benefits payable under the Plan. Under the Plan, retiree health benefits are limited to employees who regularly work 20 hours or more per week and who meet a 30 day waiting period. Coverage under the Plan will be automatic for eligible employees and an eligible employee cannot elect in or out of coverage.

Employer will contribute to the Trust amounts as specified in the Plan or by resolution of the Employer. No other person will be permitted to make contributions. The Employer’s contribution will include the following: discretionary contributions to be made by the Employer on behalf of all participating employees; contributions of all or a portion of employees’ accumulated and unused vacation and sick leave upon retirement; and contributions of all or a portion of employees’ annual excess vacation and sick leave that would otherwise be forfeited or paid out at year end. In accordance with the Plan’s procedures and prior to the beginning of each Plan year, the Employer will designate PLR-125738-06 2

the amounts for the discretionary Employer contributions to be contributed to the Trust and the percentage or fixed amount of the vacation and sick leave to be contributed to the Trust. Also, the Employer will, in its sole discretion, establish a contribution amount applicable to vacation and sick leave accrued prior to the effective date of the plan. All contribution amounts will be determined in the sole discretion of the Employer and under no circumstances will employees be permitted to decide the discretionary Employer contributions to be contributed to the Trust or the amount or percentage of their vacation and sick leave to be contributed to the Trust.

The Plan provides that under no circumstance may the retired eligible employee or the retired eligible employee’s spouse or dependents receive any unused amounts at any time in cash or other benefits. Following the participant’s death, unused amounts shall continue to carryover for the benefit of the participant’s spouse and dependents. After the death of the surviving spouse and dependents, any amounts not applied to reimburse medical expenses will be forfeited.

Section 61(a)(1) of the Code and section 1.61-21(a)(3) of the Income Tax Regulations provide that, except as otherwise provided in Subtitle A, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.

Section 106(a) of the Code provides that the gross income of an employee does not include employer-provided coverage under an accident or health plan. Section 1.106-1 of the regulations states that the gross income of an employee does not include contributions which his employer makes to an accident or health plan for compensation (through insurance or otherwise) to the employee for personal injuries or sickness incurred by the employee, the employee’s spouse, or the employee’s dependents as defined in section 152 of the Code. The employer may contribute to an accident or health plan either by paying the premium on a policy of accident or health insurance covering one or more of the employees, or by contributing to a separate trust or fund which provides accident or health benefits directly or through insurance to one or more of the employees. However, if the insurance policy, trust or fund provides other benefits in addition to accident or health, section 106 applies only to the portion of the contributions allocable to accident or health benefits.

Section 105(a) provides that, except as otherwise provided in section 105, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.

Section 105(b) states that except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) PLR-125738-06 3

if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the medical care (as defined in section 213(d)) of the taxpayer or the taxpayer’s spouse or dependents (as defined in section 152). Section 1.105-2 of the regulations provides that only amounts that are paid specifically to reimburse the taxpayer for expenses incurred by the taxpayer for the prescribed medical care are excludable from gross income. Thus, section 105(b) does not apply to amounts that the taxpayer would be entitled to receive irrespective of whether or not the taxpayer incurs expenses for medical care.

Part I of Notice 2002-45, 2002-2 C.B. 93, describes the tax treatment of health reimbursement arrangements (HRAs). The notice explains that a tax-favored HRA is an arrangement that (1) is paid for solely by the employer and not pursuant to a salary reduction election or otherwise under a section 125 cafeteria plan; (2) reimburses the employee for medical care expenses (as defined in section 213(d)) incurred by the employee or by the employee’s spouse or dependents; and (3) provides reimbursements up to a maximum dollar amount with any unused portion of that amount at the end of the coverage period carried forward to subsequent coverage periods.

Part IV of Notice 2002-45 emphasizes that employer contributions to an HRA may not be attributable to salary reduction or otherwise provided under a section 125 cafeteria plan. An accident and health plan funded pursuant to salary reduction is not an HRA and is subject to the rules under section 125. See also, Rev. Rul. 2002-41, 2002-2 C.B. 75; Rev. Rul. 2005-24, 2005-1 C.B. 892; Rev. Rul. 2006-36, 2006-36 I.R.B. 353. Under section 125, unused contributions at the end of a coverage period may generally not be carried forward and used in subsequent coverage periods.

Rev. Rul. 75-539, 1975-2 C.B. 45, describes two labor contracts. Contract A provides that upon retirement, an employee will receive a portion of accumulated unused sick leave credits as a cash payment or, at the election of the employee, the payment may be applied to continue the employee’s participation in the employer’s health plan. Contract B provides that the value of a portion of the accumulated unused sick leave credits will be used to pay for continued participation in the employer’s health plan.

Rev. Rul. 75-539 holds that, under Contract A, the value of unused accumulated sick leave credits used to continue health coverage is constructively received by the retired employee under section 451 of the Code, and therefore is includible in the retired employee’s gross income. Under Contract A, the amount of the premium payments is considered an employee contribution out of salary and not a contribution by the employer under section 106 of the Code. However, under Contract B, the value of unused accumulated sick leave credits, which may not be received in cash, is not constructively received by the retired employee, but is a contribution by the employer to the employer’s health plan that is excludable from the retired employee’s gross income under section 106 of the Code.

PLR-125738-06 4

Rev. Rul 2005-24 describes a health reimbursement arrangement. Situation 1 of the ruling states that when an employee retires, the employer automatically and on a mandatory basis (as determined under the Plan) contributes an amount to the reimbursement plan equal to the value of all or a portion of the retired employee’s accumulated unused vacation and sick leave. Relying on Rev. Rul. 75-539, the ruling concludes that the reimbursement plan described in Situation 1 is an HRA that meets the requirements for tax-favored treatment.

Based on the Trust and Plan as submitted on May 11, 2006, and as subsequently amended by submissions dated November 5, 2006 and November 16, 2006, and on the authorities cited above, we conclude that Employer contributions paid to Trust and payments made from Trust which are used exclusively to pay for eligible medical care expenses of retired employees, their spouses and dependents are excludable from the gross income of retired employees and retired employees’ spouses and dependents under sections 106 and 105 of the Code.

No opinion is expressed as to the federal tax consequences of the transaction under any other section of the Code or statute other than those specifically stated above.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

Sincerely,

Harry Beker Chief, Health and Welfare Branch Office of Division Counsel/Associate Chief Counsel (Tax Exempt & Government Entities)

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