Lizzie W. Calloway v. Commissioner of IRS

Case: 11-10395 Date Filed: 08/23/2012 Page: 1 of 44
[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT
_______________________
No. 11-10395
_______________________
Agency No. 8438-07
LIZZIE W. CALLOWAY,
ALBERT CALLOWAY,
Petitioners-Appellants,
versus
COMMISSIONER OF IRS,
Respondent-Appellee.
____________________
Petition for Review of a Decision of the
U.S. Tax Court
____________________
(August 23, 2012)
Before CARNES, PRYOR and RIPPLE,* Circuit Judges.
RIPPLE, Circuit Judge:
*
Honorable Kenneth F. Ripple, United States Circuit Judge for the Seventh Circuit,
sitting by designation.
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Albert and Lizzie Calloway seek review of a judgment of the Tax Court
sustaining the Commissioner’s determination of a deficiency, an accuracy-related
penalty and a penalty for filing a delinquent tax return. For the following reasons,
we affirm the judgment of the Tax Court.
I
A. Facts
Albert Calloway worked for IBM for a number of years and acquired IBM
stock by exercising his employee stock options. During 2001, Bert Falls, the
Calloways’ financial adviser, introduced Mr. Calloway to a program operated by
Derivium Capital, LLC (“Derivium”). Under that program, Derivium would
“lend” a client ninety percent of the value of securities that the client pledged to
Derivium as collateral. During the term of the non-recourse loan, Derivium had
no restrictions on its use of the collateral. At the end of the loan’s term, the client
had three options: (1) He could reclaim the collateral by paying the principal and
accrued interest; (2) He could surrender the collateral to Derivium; or (3) He could
refinance. Mr. Calloway testified that the loan program was attractive to him
because, had he sold his stock, he would have had to pay twenty percent in capital
gains tax; under the Derivium program, however, he received ninety percent of the
2
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stock’s fair market value.
Before entering Derivium’s program, Mr. Calloway consulted Falls as well
as a tax advisor, who provided Mr. Calloway with a copy of a memorandum from
Robert J. Nagy to Charles D. Cathcart, president of Derivium. In the memo, Nagy,
who identified himself as a certified public accountant, opined that, although there
were no absolute guarantees, there was a “solid basis for the position that these
transactions are, in fact, loans.”1 Mr. Calloway later testified that “[i]t gave [him]
comfort to know that a decision had been considered and that this was in fact a
loan and not anything other, and it’s a nonrecourse loan.”2 Mr. Calloway
admitted, however, that he did not do any research to find out who Nagy was, that
he did not know whether Nagy was associated with Derivium and that he did not
“have any idea what [Nagy’s] training or background [wa]s.”3
The details of Mr. Calloway’s arrangment with Derivium are set forth in
three documents: “Master Agreement to Provide Financing and Custodial
Services” (“Master Agreement”), “Schedule D Disclosure Acknowledgment and
Broker/Bank Indemnification” (“Schedule D”) and “Schedule A-1 Proper
1
Ex. 27-P at 6.
2
Tr. 39.
3
Id. at 54.
3
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Description and Loan Terms” (“Schedule A-1”).
The Master Agreement provides:
This Agreement is made for the purpose of engaging [Derivium] to
provide or arrange financing(s) and to provide custodial services to
the Client, with respect to certain properties and assets (“Properties”)
to be pledged as security, the details of which financing and
Properties are to be set out in loan term sheets and attached hereto as
Schedule(s) A . . . .[4]
Paragraph 3 of the Master Agreement relates to the “Funding Of [the] Loan” and
provides in relevant part:
The Client understands that by transferring securities as collateral to
[Derivium] and under the terms of the Agreement, the Client gives
[Derivium] and/or its assigns the right, without requirement of notice
to or consent of the Client, to assign, transfer, pledge, repledge,
hypothecate, rehypothecate, lend, encumber, short sell, and/or sell
outright some or all of the securities during the period covered by the
loan. The Client understands that [Derivium] and/or its assigns have
the right to receive and retain the benefits from any such transactions
and that the Client is not entitled to these benefits during the term of a
loan. . . .[5]
The Master Agreement also includes a provision that allowed either party to
terminate the agreement “at any time prior to the funding of a loan.”6
Schedule A-1 details the terms of the loan. Specifically, the loan amount
4
Ex. 3-J at 1.
5
Id. (emphasis added).
6
Id. at 3.
4
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was ninety percent of the fair market value at the time of closing; the estimated
value of the collateral at that time was $105,444.90. The interest rate to be
charged was ten-and-one-half percent, compounded annually; the interest accrued
until, and was due at, maturity. Any dividends on the pledged collateral were to
“be received as cash payments against interest due.”7 The loan could not be pre-
paid, and the lender could not seek recourse against the borrower, only the
collateral. The closing date was “[u]pon receipt of securities and establishment of
[Derivium’s] hedging transactions.”[8]
Mr. Calloway executed the Master Agreement and attached schedules on
August 8, 2001, and authorized the transfer of 990 shares of his IBM stock to
Derivium’s account with Morgan Keegan & Company, Inc., on the following day.
Cathcart, as president of Derivium, signed the Master Agreement and schedules on
August 10, 2001.
On August 17, 2001, Derivium’s operations office sent Mr. Calloway two
documents. The first was a valuation confirmation indicating that Derivium had
received the stock, valued at $104,692.50, into its account. The second document,
titled “Activity Confirmation,” indicated that, as of August 17, 2001, Derivium
7
Ex. 4-J.
8
Id.
5
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had hedged the IBM stock for slightly less, $103,984.70, yielding an “Actual Loan
Amount” of $93,586.23. On August 21, 2001, Derivium sent to Mr. Calloway a
letter informing him that the proceeds of the loan were sent to him according to
the wire transfer instructions he had provided a few days earlier. On the same
date, $93,586.23 was credited to Mr. Calloway’s credit union account. Previously,
on August 17, Derivium had exercised its right to sell the stock without giving
notice to Mr. Calloway.9
During the period of time covered by the loan, Mr. Calloway received
quarterly and year-end account statements. Each quarterly statement set forth the
loan balance at the beginning of the quarter, indicated the interest accrued during
the quarter and credited the account for the dividends paid during the quarter to
yield the end-of-quarter loan balance. The statement also provided the
end-of-quarter collateral value. Mr. Calloway did not receive any tax statements
reflecting dividend income (Form 1099-DIV), nor did he report on his tax returns
any dividend income earned from the 990 shares of IBM stock.
In a letter dated July 8, 2004, Derivium informed Mr. Calloway that the loan
9
See, e.g., Ex. 3-J at 1 (“The Client understands that by transferring securities as
collateral to [Derivium]. . ., the Client gives [Derivium] and/or its assigns the right, without
requirement of notice to or consent of the client to . . . sell outright some or all of the securities . .
. .”).
6
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would mature on August 21, 2004. Consistent with the Master Agreement and
accompanying schedules, the letter stated that Mr. Calloway could either (1) pay
the maturity amount of $124,429.09 and recover his collateral, (2) renew or
refinance the transaction for an additional term or (3) surrender the collateral. On
July 27, 2004, Mr. Calloway returned the response form to Derivium indicating
that he was “surrender[ing his] collateral in satisfaction of [his] entire debt
obligation.”10
On February 11, 2004, Mr. Calloway and his wife filed their joint federal
income tax return for the year 2001--nearly two years past the original filing
deadline. On the return, they did not report the money received from Derivium in
exchange for the stock. From the time of the loan until the surrender of the
collateral in August 2004, the Calloways did not declare on their tax returns any
dividend income generated by the 990 shares of IBM stock. The Calloways also
did not report on their 2004 return the surrender of their collateral to Derivium,
either by declaring capital gains from the sale of securities or by declaring a
forgiveness of indebtedness.
The Internal Revenue Service (“the IRS” or “the Service”) issued a notice of
deficiency to the Calloways for failing to include the income from the sale of the
10
Ex. 13-J.
7
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IBM stock on their 2001 income tax return. It also assessed two penalties for
failure to timely file a return and for significant understatement of income.
The Calloways filed a petition for a redetermination of income tax
deficiency and penalties with the Tax Court.
B. Proceedings in the Tax Court
1.
The Calloways framed the issues before the court in their pretrial
memorandum. They argued that the mere fact that Mr. Calloway entered into the
loan agreement with Derivium to avoid paying capital gains tax was not license
for the Commissioner to recast the arrangement as a sale.11 “In this case,” the
Calloways maintained, they “chose to enter into a bona fide and actual loan
agreement with Derivium.”12
The Calloways also argued that “the Commissioner [could ]not rely upon a
series of events which were . . . outside of [the] Calloway[s’] control to recast the
loan as a sale.”13 According to the Calloways, the Commissioner’s efforts to
11
See Pretrial Mem. for Pet’rs at 12.
12
Id. at 13.
13
Id. at 14.
8
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characterize the 2001 transaction as a sale were based on Derivium’s actions. The
Calloways noted that they “did not discover that the shares of stock were
inappropriately sold by Der[i]vium until after 2004.”14 It therefore “would be
unfair,” they continued, “to expect [them] to include the proceeds of the stock sale
in their income taxes for the years that they did not, in good faith, realize such
income.”15
Finally, they maintained that “[a]ny plain reading of the Derivium loan
contract demonstrates that the contract is clearly a loan agreement entered into by
two independent, arms-length, unrelated parties, rather than an agreement to sell
the stock pledged under the loan agreement.”16 They claimed that this position
was “further fortified by the existence of a long-standing Internal Revenue Ruling
on point that was issued for the Wall Street brokerage industry,”17 specifically,
Revenue Ruling 57-451, 1957-2 C.B. 295.18
For its part, the IRS argued that, because the Calloways received proceeds
14
Id. at 15.
15
Id.
16
Id.
17
Id. at 19.
18
In their statement of issues, the Calloways raised questions about the basis used for the
capital gains tax calculation as well as the propriety of assessing penalties against them; however,
they made no specific arguments with respect to these issues in their pretrial submission.
9
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from the sale of the stock and Derivium, in exchange, received title and possession
of the shares without any restrictions on the use of those shares, the transaction
was a sale.19 The Commissioner noted that the Tax Court, in Grodt & McKay
Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237-38 (1981), had enumerated
several factors to consider in determining whether a transaction should be
considered a sale for purposes of the tax laws, namely:
(1) whether legal title passes; (2) how the parties treat the transaction;
(3) whether an equity was acquired in the property; (4) whether the
contract creates a present obligation on the seller to execute and
deliver a deed and present obligation on the purchaser to make
payments; (5) whether the right of possession is vested in the
purchaser; (6) which party pays the property taxes; (7) which party
bears the risk of loss or damage to the property; and, (8) which party
receives the profits from the operation and the sale of the property.[20]
Considering those factors, the Commissioner submitted, the loan agreement
between the Calloways and Derivium should be considered a sale:
Petitioner was required to deliver stock to Derivium Capital upon
which Derivium Capital was obligated to deliver 90% of the value of
the stock to petitioner. Petitioner transferred a set number of shares
of stock to Derivium Capital without restriction in use. Title to the
stock was transferred to Derivium Capital. The amount to be
transferred to petitioner was determined only after the stock was
transferred to Derivium Capital and sold. Petitioner bears no
19
See Pretrial Mem. for Resp’t at 5-6 (discussing, among other cases, Hope v. Comm’r,
55 T.C. 1020 (1971), aff’d 471 F.2d 738 (3d Cir. 1973), and Provost v. United States, 269 U.S.
442 (1926)).
20
Id. at 6.
10
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additional risk - he keeps all of the funds he received regardless of the
eventual value of the stock. Petitioner has had unrestricted use of the
proceeds. The petitioner gave up possession, legal title, right to
receive dividends and right to vote the shares. Both petitioner and
Derivium Capital treated the stock as if it belonged to Derivium
Capital.[21]
The Commissioner also argued that the transaction did not meet the
fundamental requirement of a loan: “a genuine intention on the part of the parties
to create a debt,” which is determined by looking at the facts and circumstances
surrounding the purported debtor-creditor relationship.22 Looking at the economic
realities of the transaction, the Commissioner submitted that the transaction was
not a loan:
Although the agreement between the parties to the transaction
is in writing, nowhere in the agreement does petitioner promise to
repay the loan. Petitioner was not required to make payments on the
non-recourse loan, and petitioner never did make any payment . . . .
In fact, petitioner was not allowed to make payments - principal or
interest - during the term of the loan. Repayment at maturity was
optional. Although the parties to the transaction refer to the
transferred stock as collateral, it bears little resemblance to collateral.
The transferred stock was not held to insure repayment or sold due to
default or a margin requirement rather Derivium Capital sold the
stock to fund the loan and to determine the amount of the loan.
The parties did not conduct themselves as if the transaction
21
Id. at 6-7 (citation omitted).
22
Id. at 7.
11
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w[ere] a loan. . . .[23]
2.
After receiving the parties’ briefs and exhibits, and after hearing
Mr. Calloway’s testimony, the Tax Court rendered its decision for the
Commissioner, but was not unanimous in its reasoning.
Judge Ruwe, writing for the majority, characterized “[t]he primary issue”
before the court as “whether the transaction . . . was a sale or a loan.”24 Although
Mr. Calloway and Derivium had characterized the transaction as a loan in their
documentation, the Tax Court observed that “‘Federal tax law is concerned with
the economic substance of the transaction under scrutiny and not the form by
which it is masked.’”25
Turning first to the question of whether the transaction should be considered
a sale, the Tax Court noted that, under the tax laws, “‘the term “sale” is given its
ordinary meaning . . . and is generally defined as a transfer of property for money
23
Id. at 8. The Commissioner also addressed issues with respect to the Calloways’
proper basis in the shares as well as the penalties the petitioners had been assessed.
24
Calloway v. Comm’r, 135 T.C. 26, 32 (2010).
25
Id. at 33 (quoting United States v. Heller, 866 F.2d 1336, 1341 (11th Cir. 1989)).
12
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or a promise to pay money.’”26 Furthermore, the court continued, because the
economic substance of the transaction is controlling, “the key to deciding whether
the transaction was a sale or other disposition is to determine whether the benefits
and burdens of ownership of the IBM stock passed from petitioner to Derivium.”27
This factual question “is determined from the intention of the parties as
established by the written agreements read in the light of the attending facts and
circumstances.”28 The court then identified several factors that inform the
inquiry:
(1) Whether legal title passes; (2) how the parties treat the
transaction; (3) whether an equity interest in the property is acquired;
(4) whether the contract creates a present obligation on the seller to
execute and deliver a deed and a present obligation on the purchaser
to make payments; (5) whether the right of possession is vested in the
purchaser; (6) which party pays the property taxes; (7) which party
bears the risk of loss or damage to the property; and (8) which party
receives the profits from the operation and sale of the property.[29]
Applying these factors to the transaction between Mr. Calloway and
Derivium led the court to conclude that Mr. Calloway had sold his stock to
26
Id. (quoting Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237 (1981)).
27
Id.
28
Id.
29
Id. at 34 (citing Arevalo v. Comm’r, 124 T.C. 244, 252 (2005), and Grodt & McKay
Realty, 77 T.C. 1237-38).
13
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Derivium in August 2001. The court first observed that legal title had passed from
Mr. Calloway to Derivium: “The master agreement provide[d] that once Derivium
received the IBM stock, Derivium was authorized to sell it without notice to the
petitioner. Derivium immediately sold the stock. Thus, legal title . . . passed to
Derivium in 2001 when petitioner transferred the IBM stock pursuant to the terms
of the master agreement.”30
Furthermore, the Tax Court continued, the parties treated the transaction as
a sale. Derivium determined the amount of the “loan” only after it had determined
the proceeds it would receive from the sale of the stock--a sale that, according to
the terms of the Master Agreement, Mr. Calloway had authorized Derivium to
make. Additionally, the Calloways did not report dividends from their purported
ownership of the stock after it was surrendered to Derivium.
With respect to the equity inherent in the stock, the Tax Court believed that
this factor weighed in favor of treating the transaction as a sale as well:
“Derivium acquired all property interests in the IBM stock[] . . . . Petitioner
retained no property interest in the stock.”31
Finally, turning to other factors, the Tax Court determined that there was an
30
Id.
31
Id. at 35.
14
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obligation on the part of Mr. Calloway to deliver and on the part of Derivium to
pay for the stock, that the right of possession passed entirely to Derivium and that
Derivium had the right to profit from the property during the term of the
transaction. All of these factors weighed in favor of finding that the transaction at
issue was, in fact, a sale for tax purposes.
The court then turned to the separate inquiry of whether the transaction
could be classified as a “loan.” The Tax Court noted that, “[f]or a transaction to
be a bona fide loan[,] the parties must have actually intended to establish a debtor-
creditor relationship at the time the funds were advanced.”32 In determining
whether a transaction is a loan, the economic realities of the situation, not the
parties’ terminology, guide the inquiry. The Tax Court concluded that, under the
facts and circumstances presented to it, there was no intent on the part of
Mr. Calloway to repay the loan and no intent on the part of Derivium to secure
repayment. Specifically, the Tax Court observed:
The transaction was structured so that petitioner could receive
90 percent of the value of his IBM stock. Petitioner would have no
personal liability to pay principal or interest to Derivium, and it
would have made no sense to do so unless the value of the stock had
substantially appreciated. Petitioner transferred ownership of the
stock to Derivium, who received all rights and privileges of
ownership and was free to sell the stock. Derivium did immediately
32
Id. at 37 (citing Fisher v. Comm’r, 54 T.C. 905, 909-10 (1970)).
15
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sell the stock and immediately passed 90 percent of the proceeds to
petitioner. The only right petitioner retained regarding shares of IBM
stock was an option, exercisable 3 years later, in 2004, to require
Derivium to acquire 990 shares of IBM stock and deliver them to him
in 2004. Petitioner[s’] right to exercise this option in 2004 was
wholly contractual because he had already transferred all of the
incidents of ownership to Derivium, which had immediately sold the
990 shares. Petitioner engaged in the transaction because he thought
that the “loan” characterization would allow him to realize 90 percent
of the value of the stock, whereas a “sale” would have netted only 80
percent of the stock’s value after payment of tax on the gain. After
the transfer, petitioners did not conduct themselves as if the
transaction were a loan. Petitioners did not report dividends earned
on the 990 shares of IBM stock on their Federal income tax returns.
When petitioners decided not to “repay the loan” in 2004, they did
not report a sale of the stock on their 2004 Federal income tax return
and failed to report any discharge of indebtedness income. This
failure was totally inconsistent with petitioners’ “loan”
characterization.
. . . . In an ordinary lending transaction[,] the risk of loss to a
lender is that the borrower might not repay the loan. In contrast to the
ordinary risk assumed by a lender, Derivium’s only risk of loss would
have arisen if petitioner had actually repaid the “loan.”[33]
Considering these circumstances, the Tax Court held “that the transaction was not
a loan and that petitioner sold his IBM stock for $93,586.23 in 2001.”34
The Tax Court noted that, although this was a case of first impression, two
other district courts recently had held that Derivium “loans” were sales of
33
Id. at 38-39 (citations omitted).
34
Id. at 39.
16
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securities.35 In reaching this conclusion, these courts similarly had employed the
analysis set forth in Grodt & McKay Realty, 77 T.C. 1237-38, and Welch v.
Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000).36
Turning to the other issues raised by the Calloways, the Tax Court first
rejected the Calloways’ claim that, according to Revenue Ruling 57-451, they did
not realize income from the transaction with Derivium until 2004 when they
surrendered their rights to have Derivium return the stock. The Tax Court quoted
the ruling, which addressed the following factual scenario:
“(2) The stockholder deposits his stock with his broker in a
‘safekeeping’ account and, at the time of deposit, endorses the stock
certificates and then authorizes the broker to ‘lend’ such certificates
in the ordinary course of the broker’s business to other customers of
the broker. The broker has the certificates cancelled and new ones
reissued in his own name.”[37]
With respect to these facts, the Commissioner had determined that no disposition
of the stock occurs unless the broker satisfies his obligation either with stock of a
35
See id. at 39-40 (citing Nagy v. United States, Nos. 2:08-cv-2555-DCN &
2:08-cv-2755-DCN, 2009 WL 5194996 (D.S.C. Dec. 22, 2009), and United States v. Cathcart,
No. C 07-4762 PJH, 2009 WL 3103652 (N.D. Cal. Sept. 22, 2009)).
36
Since the Tax Court handed down its decision, the Court of Appeals for the Ninth
Circuit has employed the Grodt & McKay Realty factors to evaluate whether a “loan agreement,”
“essentially identical” to the one at issue in this case, constituted a sale. See Sollberger v.
Comm’r, No. 11-71883, 2012 WL 3517865, at *2-3 (9th Cir. Aug. 16, 2012). The Ninth Circuit
concluded that the transaction was, in fact, a sale. Id. at *6; see also infra at 33.
37
Id. at 42 (quoting Rev. Rul. 57-451, 1957-2 C.B. at 296).
17
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different kind (or class) than originally was deposited, or with other property.38
The Tax Court concluded, however, that the 2001 transaction at issue here
differ[ed] significantly from that described in the revenue ruling.
Derivium was not acting as a broker, and the arrangement between
petitioner and Derivium was not the type of securities lending
arrangement described in the revenue ruling. In the revenue ruling,
the stockholder authorized his broker, subject at all times to the
instructions of the stockholder, to “lend” his stock to others to satisfy
obligations in a short sale transaction. The “loan” in the revenue
ruling required the borrower, “on demand,” to restore the lender to
the same economic position that he had occupied before entering into
the “loan.”[39]
However, the 2001 transaction did not allow Mr. Calloway to retain the benefits
and burdens of being the owner of the stock; he could not terminate the loan, and
he could not repay the loan before the three-year period expired.40
The Tax Court also observed that, “[i]n 1978[,] Congress codified and
clarified the then-existing law represented by Rev. Rul. 57-451 by enacting [26
U.S.C. §] 1058.”41 As described by the Tax Court, § 1058 of Title 26 “provides
for nonrecognition of gain or loss when securities are transferred under certain
38
Id.
39
Id.
40
See id.
41
Id. at 43 (citations omitted).
18
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agreements.”42 The provision requires that “the agreement must give the person
who transfers stock ‘all of the benefits and burdens of ownership of the transferred
securities’ and the right to ‘be able to terminate the loan agreement upon
demand.’”43 The Calloways, concluded the Tax Court, could not meet these
requirements.
Finally, turning to the penalties, the Tax Court held that the Calloways had
not met their burden of establishing that the late filing of their 2001 return was due
to either reasonable cause or the absence of willful neglect.44 As well, the
Calloways had not shown that they acted with reasonable cause and in good faith
in understating their tax liability. The Tax Court noted that the Calloways’
failures both to pay taxes on the dividends reported to them by Derivium and to
pay taxes for forgiveness of indebtedness in 2004 “were inconsistent with
[Mr. Calloway’s] version of the transaction.”45 Furthermore, the Calloways had
not relied in good faith on the advice of their financial advisor or on the Nagy
memo because they had not confirmed credentials or independence with respect to
42
Id.
43
Id. at 44 (quoting Samueli v. Comm’r, 132 T.C. 37, 51 (2009)).
44
Id. at 45-46; see 26 U.S.C. § 6651(a)(1) (imposing a penalty for late filing “unless it is
shown that such failure is due to reasonable cause and not due to willful neglect”).
45
Id. at 48.
19
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either source. Thus, the Tax Court entered a decision in favor of the
Commissioner.
Judge Halpern46 and Judge Holmes filed separate opinions. Judge Halpern
concurred in the result, but differed with the majority on the rationale for ruling in
the Commissioner’s favor. Judge Halpern stated that the multifactor test set forth
in Grodt & McKay Realty is appropriate for non-fungible assets; “[f]or fungible
securities, however, a more focused inquiry--whether legal title to the assets and
the power to dispose of them are joined in the supposed owner”--is
determinative.47 Applying this rule to the Calloways, Judge Halpern opined:
It is enough for me that petitioner gave Derivium the right and
authority to sell the IBM common stock in question for its own
account, which Derivium in fact did. The nonrecourse nature of the
petitioner[s’] obligation to repay Derivium, and almost every other
factor considered by the majority to determine who bore the “benefits
and burdens of ownership”, is beside the point.[48]
Like Judge Halpern, Judge Holmes concurred in the result, but reached that
result through a different route. He explained:
Calloway and Derivium agreed to what Calloway claims was a
nonrecourse loan secured by his stock. In exchange for money,
Calloway transferred control of the stock to Derivium. Derivium sold
46
Judge Wherry agreed with Judge Halpern.
47
Id. at 49-50 (Halpern, J., concurring in result).
48
Id. at 51 (footnote omitted).
20
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the stock on the open market. The tax rules would seem to be easy to
apply. Section 1.1001–2(a)(4)(i), Income Tax Regs., provides that
“the sale . . . of property that secures a nonrecourse liability
discharges the transferor from the liability.” Commissioner v. Tufts,
461 U.S. 300, 308–09 (1983), and Crane v. Commissioner, 331 U.S.
1, 12–13 (1947), teach that the amount realized includes any
nonrecourse liability secured by the property sold. Calloway would
then have to recognize the difference between the discharged debt
(i.e., the amount of the loan proceeds plus one day’s accrued interest
minus his basis in the stock).[49]
Although this rationale would have resolved the key substantive issue in the
case, Judge Holmes continued, “[t]he majority . . . instead goes off on a frolic and
detour through an inappropriate multifactor test, applies it in dubious ways, and
ends up reaching an overly broad holding with potentially harmful effects on other
areas of law.”50 Judge Holmes then explained why he believes that the various
Grodt & McKay Realty factors are inapplicable to the sale of stock. For example,
Judge Holmes observed that the concepts of title and possession are largely
illusory with respect to publicly traded securities, a large proportion of which are
held in a limited purpose trust company for the purpose of acting as a depository
for its trading members. Furthermore, Judge Holmes articulated the fear that the
majority’s opinion could be read as holding that “this transaction was a sale
49
Id. at 53 (Holmes, J., concurring in result) (alteration in original) (parallel citations
omitted).
50
Id. at 53-54.
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because the advance of money was nonrecourse and Derivium had the authority to
sell after taking possession of the stock.”51 Judge Holmes opined that, “[g]iven
modern conditions in which a lender’s authority to sell stock is routine and even
necessary, the real effect of the holding would be to treat all nonrecourse lending
against stock collateral as sales.”52
3.
After the Tax Court issued its decision, the Calloways moved for
reconsideration. The Calloways took issue with the Tax Court’s conclusion that
“once Derivium received the IBM stock, Derivium was authorized to sell it
without notice to petitioner.”53 The Calloways argued that Derivium was
authorized to sell the stock only “during the period covered by the loan”; the loan
term was “3 years, starting from the date on which final loan proceeds are
delivered on the loan transaction.”54 According to the Calloways, when “[r]ead
51
Id. at 63.
52
Id. Judge Holmes also expressed his disagreement with the way the majority applied
the factors set forth in Welch v. Comm’r, 204 F.3d 1228, 1230 (9th Cir. 2000); in contrast to the
majority, he believed that these factors led, at least arguably, to the conclusion that the
transaction was a loan. See infra at 36-37.
53
Mot. for Reconsid. of Findings of Fact and Op. at 1.
54
Id. at 1-2 (emphasis omitted) (internal quotation marks omitted).
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together, these terms clearly state that Derivium’s right to sell Petitioners’ pledged
securities does not begin until the loan funding has been fully delivered to
Petitioners.”55 The Calloways concluded that, because Derivium sold the stock on
August 17, 2001, “but did not fund the loan . . . until August 21, 2001,”56 it had
breached the agreement.
The Calloways also argued that, because the court had concluded that “there
was not a bona fide loan, then it is only fair and consistent that the Court should
only apply those covenants of the master agreement which are effective prior to
the loan period.”57 Derivium did not have the authority to sell their stock prior to
the loan period, therefore, the Calloways believed that the Tax Court could not use
this fact to determine whether the transaction was a legitimate loan. The Tax
Court did not rule on the Calloways’ motion to reconsider.
After considering the parties’ proposed computations, the Tax Court entered
its final decision as to the amount of the deficiency and penalties. The Calloways
timely appealed.
55
Id. at 2.
56
Id.
57
Id. at 3-4.
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II
“We review the Tax Court’s application of the tax code de novo and its
findings of fact for clear error.” Campbell v. Comm’r, 658 F.3d 1255, 1258 (11th
Cir. 2011).
A. Characterization of the Transaction
1. The Grodt & McKay Realty factors
The question presented here is whether Mr. Calloway’s transaction with
Derivium constituted a sale of property, the gain from which should have been
included in his gross income for 2001. See 26 U.S.C. §§ 61(a)(3), 1001. When
interpreting the Internal Revenue Code, “the term ‘sale’ is given its ordinary
meaning and is generally defined as a transfer of property for money or a promise
to pay money.” Anschutz Co. v. Comm’r, 664 F.3d 313, 324 (10th Cir. 2011)
(citing Comm’r v. Brown, 380 U.S. 563, 570–71 (1965)).
To determine if a sale has occurred, we ask “whether, as a matter of
historical fact, there has been a transfer of the benefits and burdens of ownership.”
Id. (citing Grodt & McKay Realty, 77 T.C. 1237). Some of the factors that
inform the benefits and burdens inquiry are:
(1) Whether legal title passes; (2) how the parties treat the
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transaction; (3) whether an equity was acquired in the property; (4)
whether the contract creates a present obligation on the seller to
execute and deliver a deed and a present obligation on the purchaser
to make payments; (5) whether the right of possession is vested in the
purchaser; (6) which party pays the property taxes; (7) which party
bears the risk of loss or damage to the property; and (8) which party
receives the profits from the operation and sale of the property.
Grodt & McKay Realty, 77 T.C. 1237-38 (internal citations omitted); see also
Anschutz, 664 F.3d at 324-25.58 “[N]one of these factors is necessarily
controlling; the incidence of ownership, rather, depends upon all the facts and
circumstances.” H.J. Heinz Co. & Subsidiaries v. United States, 76 Fed. Cl. 570,
582 (2007). Some factors may be more pertinent in some situations than others,
and, indeed, some factors simply may be ill-suited or irrelevant to shed light on the
ownership of assets under specific circumstances. See Sollberger v. Comm’r, No.
11-71883, 2012 WL 3517865, at *4 (9th Cir. Aug. 16, 2012) (“[W]e agree that
[the Grodt & McKay Realty] criteria may be relevant in a particular case, [but] we
do not regard them as the only indicia of a sale that a court may consider.
Creating an exclusive list of factors risks over-formalizing the concept of a ‘sale,’
58
The factors are sometimes phrased accordingly: “(1) Whether legal title passes; (2) the
manner in which the parties treat the transaction; (3) whether the purchaser acquired any equity
in the property; (4) whether the purchaser has any control over the property and, if so, the extent
of such control; (5) whether the purchaser bears the risk of loss or damage to the property; and
(6) whether the purchaser will receive any benefit from the operation or disposition of the
property.” Upham v. Comm’r, 923 F.2d 1328, 1334 (8th Cir. 1991) (quoting Houchins v.
Comm’r, 79 T.C. 570, 591 (1982)); see also Arevalo v. Comm’r, 469 F.3d 436, 439 (5th Cir.
2006); Crooks v. Comm’r, 453 F.3d 653, 656 (6th Cir. 2006).
25
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hamstringing a court’s effort to discern a transaction’s substance and realities in
evaluating tax consequences.”).
In addition to the Grodt & McKay Realty test, the Tax Court also has
identified a number of factors to help determine whether a taxpayer has
“transfer[red] the accoutrements of stock ownership.” Anschutz v. Comm’r, 135
T.C. 78, 99 (2010), aff’d, 664 F.3d 325 (10th Cir. 2011). They are:
(1) [w]hether the person has legal title or a contractual right to obtain
legal title in the future;
(2) whether the person has the right to receive consideration from the
transferee of the stock;
(3) whether the person enjoys the economic benefits and burdens of
being a shareholder;
(4) whether the person has the power to control the company;
(5) whether the person has the right to attend shareholder meetings;
(6) whether the person has the ability to vote the shares;
(7) whether the stock certificates are in the person’s possession or are
being held in escrow for the benefit of that person;
(8) whether the corporation lists the person as a shareholder on its tax
returns;
(9) whether the person lists himself as a shareholder on his individual
tax return;
(10) whether the person has been compensated for the amount of
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income taxes due by reason of the person’s shareholder status;
(11) whether the person has access to the corporate books; and
(12) whether the person shows by his overt acts that he believes he is
the owner of the stock.
Dunne v. Comm’r, 95 T.C.M. 1236, 1242 (2008), 2008 WL 656496, at *11
(T.C. 2008) (internal citations omitted). As with the Grodt & McKay Realty
factors, “[n]one of these factors alone is determinative,” rather “their weight in
each case depends on the surrounding facts and circumstances.” Dunne, 95
T.C.M. at 1242, 2008 WL 656496, at *11.
For obvious reasons, there is significant overlap between the Grodt &
McKay Realty factors that help determine whether a sale of an asset has taken
place, and the Dunne factors that help determine whether, for tax purposes, an
individual owns stock. Compare, e.g., Grodt & McKay Realty, 77 T.C. 1237
(listing first factor as “[w]hether legal title passes”), with Dunne, 95 T.C.M.
(CCH) at 1242, 2008 WL 656496 at *11 (listing first factor as “[w]hether the
person has legal title or a contractual right to obtain legal title in the future”).
Indeed, the Dunne factors address the same question as the Grodt & McKay Realty
factors--who has assumed the benefits and burdens of ownership--but tailor the
terminology more precisely to the attributes of stocks and stock ownership. For
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instance, in Grodt & McKay Realty, the tax court identified “how the parties treat
the transaction,” or, slightly rephrased, whether the parties act as if a change in
ownership has occurred, as a factor to consider. 77 T.C. 1237. In Dunne, the
court specified the ways in which a party may exercise his ownership rights in
stock--whether the taxpayer has the ability to vote shares and whether the taxpayer
shows by his overt acts that he believes he is the owner of the stock. See Dunne,
95 T.C.M. at 1242, 2008 WL 656496, at *11.
Applying the Grodt & McKay Realty factors, as further refined by Dunne,
to the present case, we believe that the most relevant of those factors point firmly
to the conclusion that the 2001 transaction was a sale of stock for the purposes of
Federal income tax. First among those considerations is the way that the parties
treated the transaction in the foundational documents. Although denominated an
agreement “To Provide Financing and Custodial Services,” the terms of the Master
Agreement make it clear that, during the period of time covered by the “loan,”
Derivium was the owner of the stock. We previously have observed that “the
characteristics typically associated with ‘stock’ are that it grants ‘the right to
receive dividends contingent upon an apportionment of profits’; is negotiable;
grants ‘the ability to be pledged or hypothecated’; ‘confer[s][ ] voting rights in
proportion to the number of shares owned’; and has ‘the capacity to appreciate in
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value.’” See Fin. Sec. Assur., Inc. v. Stephens, Inc., 500 F.3d 1276, 1285 (11th
Cir. 2007) (per curiam) (alteration in original) (quoting Landreth Timber Co. v.
Landreth, 471 U.S. 681, 686, 105 S. Ct. 2297, 2302 (1985)). When Mr. Calloway
transferred his securities to Derivium pursuant to the Master Agreement, he ceded
these rights of stock ownership to Derivium. Mr. Calloway gave Derivium “the
right, without requirement of notice to or consent of the Client, to assign, transfer,
pledge, repledge, hypothecate, rehypothecate, lend, encumber, short sell, and/or
sell outright some or all of the securities during the period covered by the loan.”59
Furthermore, Derivium was entitled “to receive and retain the benefits from any
such transactions,” but “the Client [wa]s not entitled to these benefits during the
term of [the] loan.”60 Finally, for the duration of the agreement, Derivium had the
right to vote Mr. Calloway’s shares and to receive any dividends paid on those
shares.61 Moreover, there was no opportunity for Mr. Calloway to pay the loan
early and demand the return of his stock: Schedule A-1 contained a “3 year
59
Ex. 3-J at 1.
60
Id.
61
See id. (listing “[v]oting shares and receiving dividends or interest on securities held as
collateral” among the “services to be provided by” Derivium).
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lockout” that prohibited prepayment of the loan before maturity.62 According to
the terms of the parties’ agreement, therefore, Derivium was treated as the owner
of the stock for the duration of the loan.
When evaluated according to other Grodt & McKay Realty factors, the
terms of the Master Agreement and accompanying schedules also point to the
conclusion that the transaction was a sale of Mr. Calloway’s stock to Derivium.
The Master Agreement granted Derivium the right to possess the stock,63 the
equity in the stock, and the right to receive the profits from either holding or
disposing of the stock. As well, the nonrecourse provision of the loan ensured
that, once the transaction was entered, the risk of loss passed entirely to
Derivium.64 Applying the benefits and burdens test, therefore, we believe that the
transaction between Mr. Calloway and Derivium constituted a sale of securities.
Several aspects of the transaction, especially when assessed as a totality,
distinguish this arrangement from a legitimate loan. For instance, a borrower may
provide stock as collateral for a loan, and possession (or the equivalent) may be
62
Ex. 4-J.
63
Whether Derivium ever took physical possession of the stock certificates is not the
relevant inquiry; it is “the right of possession” that informs the analysis. Grodt & McKay Realty,
77 T.C. 1237.
64
See Ex. 4-J (“Non-recourse to borrower, recourse against the collateral only.”).
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transferred to the lender. Typically, however, a lender does not have completely
unfettered use of the collateral--as Derivium did here--but holds the collateral in
the event of nonpayment or default. In short, in a loan transaction, the parties do
not treat the lender as the absolute owner of the stock, and, concomitantly, the
lender does not exercise the full complement of ownership rights.
Moreover, the lockout provision, in combination with the transfer of all
rights of ownership, prevented Mr. Calloway from taking advantage of favorable
market developments during the course of the “loan.” The terms of the Master
Agreement and addenda ensured that Derivium, not Mr. Calloway, benefitted from
temporary upswings in stock price. Derivium’s absolute right to receive the
profits from disposition of the collateral for a three-year period further
distinguishes the present circumstance from a legitimate lending scenario.
Finally, the nonrecourse provision not only ensured that any risk of market
downturn was born by Derivium, but also made it unlikely that Mr. Calloway ever
would repay the loan and reclaim his collateral. On the day Mr. Calloway entered
the agreement with Derivium, the stock would have had to appreciate significantly
before paying off the loan became an economically viable option. In other words,
Mr. Calloway did not have an ex ante incentive to, or a strong expectation that he
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would, pay off the loan.65 From his perspective, Mr. Calloway bore no risk of loss
from the surrender of his stock pursuant to the Master Agreement and, therefore,
was not motivated to pay back the loan as a legitimate borrower would have
been.66
None of these factors, standing alone, necessarily would suffice to
distinguish a sale from a loan or to establish that a sale of securities, as opposed to
some other type of transaction, had occurred. Nevertheless, the combination of
these factors--that the parties, through the terms of the Master Agreement and
addenda, treated Derivium as the owner of the stock; that Derivium, for the three-
year period of the loan, had the sole right to benefit from the increase in stock
price; and that Derivium, by virtue of the nonrecourse aspect of the loan and the
recent performance of IBM stock, bore the burden of any likely decrease in stock
price--points decidedly to the conclusion that Mr. Calloway disposed of his stock
by signing the Master Agreement and addenda and retained no real interest in his
65
Indeed, as the Tax Court found, Derivium “did not expect or want” Mr. Calloway to
repay the loan because, had he done so, “Derivium would have been required to acquire 990
shares of IBM stock at a cost exceeding the amount it would have received from
[Mr. Calloway].” Calloway, 135 T.C. 39.
66
That is not to say that a legitimate borrower would not simply surrender collateral, as
opposed to repay a loan, if that collateral had experienced a steady decline in value over the life
of the loan. However, a nonrecourse loan typically is not structured in such a way that, at the
outset, the borrower has little motivation to repay the loan.
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collateral or the “loan” after Derivium had transferred the proceeds to him.
Furthermore, we note that the Court of Appeals for the Ninth Circuit took a
similar approach in evaluating the tax consequences of an “essentially identical
transaction[]” to the one at issue here. Sollberger, 2012 WL 3517865, at *2.
Asking “whether the burdens and benefits of ownership have been transferred,”
and noting that the Grodt & McKay Realty factors “provide a useful starting
point” for this inquiry, id. at *4, the court concluded that the taxpayers had sold
their stock, thus triggering capital gains liability, id. at *6.67
2. Alternative Approaches
Three members of the Tax Court voiced their concern that the Grodt &
McKay Realty factors were particularly ill-suited for determining whether
Mr. Calloway’s transfer of IBM stock to Derivium constituted a sale. Judge
Holmes took the view in his concurring opinion that factors such as title,
possession and obligation to deliver the deed may be important for determining
whether cattle or land has changed hands, but were “inapt[]” for determining stock
67
See supra n. 36.
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ownership due to the “rapid evolution of the indirect holding system.”68 He
observed that “[t]he Grodt & McKay [Realty] test might be helpful if the majority
adapted it to match the actual facts of this case instead of applying it without
consideration of how shares of stock differ from livestock.”69 As our previous
discussion frankly acknowledges, and as the analysis the decision of the Tax Court
in Dunne demonstrates, the factors articulated in Grodt & McKay Realty, address
the “benefits and burdens” test at a high degree of generality and therefore require
refinement to serve as analytical tools for determining whether income has been
received by the taxpayer. More specific articulation, tailored to the peculiar
attributes of securities, no doubt would assist accurate analysis of this question.
Nevertheless, the basic inquiry--determining whether the taxpayer enjoyed the
benefits and burdens of ownership--remains the same. See Anschutz, 664 F.3d at
324.
In short, employed in a measured manner, with full awareness of its
limitations, the multifactor approach employed by the Tax Court’s majority
included sufficient analysis of the factual circumstances to permit our colleagues
on the Tax Court to conclude, correctly, that Mr. Calloway and Derivium had
68
Calloway, 135 T.C. 58, 56 (Holmes, J., concurring in result).
69
Id. at 56.
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treated the transaction in the Master Agreement and schedules as conveying all
stockholder rights and liabilities, all the benefits and burdens of ownership of the
stock, to Derivium. The Calloways, in turn, realized taxable income upon
consummation of the transaction.70
Moreover, we do not believe that the tests applied by the concurring judges
provide viable alternatives to the benefits and burdens test. Judge Halpern, joined
by Judge Wherry, stated that “a more focused inquiry--whether legal title to the
assets and the power to dispose of them are joined in the supposed owner--has
been determinative of ownership for more than 100 years.”71 Although attractive
in its simplicity, this test poses its own set of problems. As explained by Judge
Holmes, Judge Halpern’s approach risks transforming, for income tax purposes, all
interests secured by stock into sales of stock.72 Limiting the test of ownership to
70
In addition to the difficulties inherent in implementing the benefits and burdens test,
Judge Holmes believes that the majority’s discussion of whether the transaction constitutes a
loan calls into question whether any nonrecourse financing arrangements may be considered
loans, as opposed to sales, for purposes of the tax laws. See id. at 60-61 (Holmes, J., concurring
in result). We agree that the majority’s alternative analysis of whether the transaction might
constitute a loan, see id. at 36-38 (majority opinion), may be read in such a way. In our own
application of the benefits and burdens test, however, the nonrecourse aspect of the loan merely
bolsters the conclusion--founded on other bases--that the transaction at issue constituted a sale of
securities.
71
Id. at 49-50 (Halpern, J., concurring in result).
72
Judge Holmes stated accordingly:
(continued...)
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title and possession risks recharacterizing as sales commercially accepted secured
lending agreements.73
Judge Holmes’s alternative analysis, we believe, contains its own
infirmities. As set forth above,74 Judge Holmes believes that, even assuming
Mr. Calloway was correct that his transaction with Derivium was, in fact, a loan,
Derivium’s sale of the loan collateral, i.e., the securities, was a taxable event.
Characterizing the initial transaction between Mr. Calloway and Derivium
as a loan, even as an assumption for the limited purpose of deciding this case,
72
(...continued)
Consider a true loan secured by stock. In most cases, creation of a security
interest in stock is no longer delivering a physical certificate or noting the pledge
on the books of the issuing corporation; it’s a matter of contracting with a lender
who is (as a matter of contract) allowed to sell, repledge, relend, etc. the stock
involved. Under the U.C.C., in fact, a lender with a secured interest in shares of
stock must obtain effective “control” over them to maintain priority--that is, he
must take all steps so that he may sell the securities without further permission of
the borrower. [U.C.C. art. 8] sec. 8-106 cmt. 1. One accepted way to obtain
control is to have the borrower transfer his position to the lender on the books of
the securities issuer or broker. Id. sec. 8-106(d)(1). When this happens, so far as
the broker, the securities issuer, or the rest of the outside world is concerned, the
secured party is the registered owner entitled to all rights of ownership, but the
debtor remains the owner as between him and the secured party. See id. sec.
9-207 cmt. 6 (Example) (2000). This makes secured lending collateralized by
securities look very similar to a sale if measured by title and possession. See, e.g.,
id. sec. 8-106 cmt. 4.
Id. at 57-58 (Holmes, J., concurring in result) (footnote omitted).
73
Counsel for the Commissioner expressed the same concern at oral argument: Further
limitations on the number of factors that a court may consider could jeopardize bona fide loans.
74
See supra at n.49 and accompanying text.
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presents substantial analytical and practical difficulties. As discussed previously,
we cannot square Mr. Calloway’s wholesale transfer of ownership interests to
Derivium with the idea that the transaction was a loan. Furthermore, even if we
were to agree with this characterization, Judge Holmes’s approach would cause
significant difficulties for taxpayers whose assets were sold without their
knowledge or permission: “Judge Holmes’s test could result in understatements of
income when taxpayers have absolutely no way to determine that a taxable event
has occurred.”75
Over time, it may be possible for the Tax Court to refine further its approach
to analyzing the myriad of factual situations in which it must determine whether a
transaction, such as the one at issue here, has resulted in the receipt of taxable
income. Indeed, it appears that this dialogue is already underway among its
judges. Nevertheless, given the wide variety of situations that the Tax Court must
confront as financial arrangements become more complex and inventive,
flexibility in the use of analytical tools undoubtedly will remain a necessary
attribute of judicial decisionmaking. We certainly perceive no error of law in the
flexible approach followed by the Tax Court in this case.
75
Richard M. Lipton, A Divided Tax Court Treats A Stock ‘Loan’ As A Sale--Which
Theory Should Apply?, 113 Tax’n 205, 212 (2010).
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3. Arguments of the Calloways
Although the Calloways take issue with the Tax Court’s use of the Grodt &
McKay Realty factors, the crux of their argument is that the Tax Court erred in
making certain factual findings that undergird its analysis. Specifically, the
Calloways take issue with two of the Tax Court’s conclusions: (1) that Derivium
had the right to dispose of their stock, and (2) that they were prohibited from
demanding a return of their stock during the three-year lockout period. According
to the Calloways, Derivium’s rights to dispose of the stock and to maintain
possession of the stock for a three-year period were conditioned on the existence
of a legitimate loan for tax purposes. In the Calloways’ view, because the Tax
Court later determined that there was not a legitimate loan, this condition
precedent was not met.
We cannot accept the Calloways’ characterization of their agreement with
Derivium. Nothing in the Master Agreement or addenda required that the
transaction be characterized as a “loan” by the IRS before the obligations of the
parties became operative. Furthermore, the Master Agreement contains an
integration clause that states: “There are no other representations, warranties,
collateral agreements or conditions, which affect this Agreement other than as
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expressed herein and in the attached schedules.76 Consequently, the fact that the
Tax Court ultimately determined that the “loan” was a sale for purposes of the tax
laws did not negate the transaction or undermine the legal obligations of the
parties.
According to the Master Agreement, once Mr. Calloway transferred the
securities to Derivium, Derivium had the right to sell his securities. Mr. Calloway
could terminate the Agreement only up until the time that the loan was funded.77
After the loan was funded, he did not have the right to prepay or to demand the
return of the collateral until the expiration of the three-year loan period.78 It is
undisputed that Mr. Calloway authorized the transfer of securities to Derivium on
August 9, 2001, and that Derivium confirmed its receipt of those securities on
August 17, 2001. Thus, the Tax Court did not err in concluding that Derivium had
the right to dispose of the securities and that Mr. Calloway could not terminate the
arrangement once he had received the promised funds.79
76
Ex. 3-J at 3 (emphasis added).
77
See id. (“This Agreement may be terminated by either party at any time prior to the
funding of [the] loan . . . .”).
78
See Ex. 4-J.
79
The Calloways also claim that they fall within the safe harbors provided by 26 U.S.C.
§ 1058 and Revenue Ruling 57-451. The Calloways admit, however, that their arguments with
respect to these safe harbors require that we first conclude that the Tax Court’s factual findings--
(continued...)
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B. Assessment of Penalties
The Calloways also take issue with the Tax Court’s assessment of accuracy-
related and late-filing penalties. We shall consider each of these in turn.
1. Accuracy-related penalty
Section 6662 of Title 26 imposes a penalty for an underpayment of taxes
“attributable to 1 or more of the following: . . . (2) Any substantial understatement
of income tax.” 26 U.S.C. § 6662(b). The provision defines “a substantial
understatement of income tax” as one that exceeds “the greater of -- (i) 10 percent
of the tax required to be shown on the return for the taxable year or (ii) $5,000.”
26 U.S.C. § 6662(d)(1)(A). The Tax Court’s assessment of an accuracy-related
penalty is a factual determination that we review for clear error. See Patterson v.
Comm’r, 740 F.2d 927, 930 (11th Cir. 1984) (per curiam). The Commissioner has
the burden of production with respect to establishing liability for a penalty. See 26
U.S.C. § 7491(c) (“Notwithstanding any other provision of this title, the Secretary
shall have the burden of production in any court proceeding with respect to the
79
(...continued)
that Derivium had the right to sell the transferred securities and that Mr. Calloway could not
terminate the contract and demand the return of his stock--were erroneous. The Tax Court,
however, did not err in reaching these conclusions. Consequently, these arguments cannot carry
the day.
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liability of any individual for any penalty, addition to tax, or additional amount
imposed by this title.”). That is, he “must come forward with sufficient evidence
indicating that it is appropriate to impose the relevant penalty.” Higbee v.
Comm’r, 116 T.C. 438, 446 (2001).
The Calloways do not argue that the Commissioner has not met his burden
of production with respect to the penalty;80 instead, they maintain that they fall
within the “reasonable cause” exception for accuracy-related penalties set forth in
26 U.S.C. § 6664(c). Section 6664(c) provides: “No penalty shall be imposed
under section 6662 or 6663 with respect to any portion of an underpayment if it is
shown that there was a reasonable cause for such portion and that the taxpayer
acted in good faith with respect to such portion.” The burden falls on the taxpayer
to establish a reasonable cause or good faith defense. See Murfam Farms, LLC ex
rel. Murphy v. United States, 94 Fed. Cl. 235, 245 (2010).
The Calloways submit that they acted in good faith and had reasonable
80
The Calloways do argue that, based on Fisher v. Commissioner, 45 F.3d 396 (10th Cir.
1995), the Tax Court’s imposition of the penalty was in error because, during the administrative
process, the Commissioner failed to set forth his reason for imposing a penalty. Fisher has no
application here. Fisher concerned 26 U.S.C. § 6661(c), now repealed, which gave the Service
the discretion to “waive all or any part of the addition to tax.” 45 F.3d at 397 (“The sole issue in
this appeal is whether the Tax Court correctly held that the Commissioner of the Internal
Revenue Service did not abuse her discretion in declining to waive the penalty for substantial
understatement of tax against the Fishers.”). The Calloways’ penalty is premised on § 6664,
which replaced § 6661 and does not contain a waiver provision.
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cause for their underpayment because Derivium sent them quarterly updates
indicating that it still owned the stock. The Calloways believe that their
circumstances, therefore, are analogous to one of the examples of “reasonable
cause” and “good faith” set forth in the regulations. In the example,
E, an individual, worked for Company X doing odd jobs and filling in
for other employees when necessary. E worked irregular hours and
was paid by the hour. The amount of E’s pay check differed from
week to week. The Form W-2 furnished to E reflected wages for
1990 in the amount of $29,729. It did not, however, include
compensation of $1,467 paid for some hours E worked. Relying on
the Form W-2, E filed a return reporting wages of $29,729. E had no
reason to know that the amount reported on the Form W-2 was
incorrect. Under the circumstances, E is considered to have acted in
good faith in relying on the Form W-2 and to have reasonable cause
for the underpayment attributable to the unreported wages.
26 C.F.R. § 1.6664-4(b)(2), Ex. 3.
The Calloways’ argument would have greater force if they, like the taxpayer
in the example, had paid the taxes on the dividends that Derivium reported to them
and that allegedly were being credited toward the interest on their “loan.” The
taxpayer in the hypothetical relied in good faith on what should have been, and
what appeared to be, accurate information in calculating the tax owed. The
Calloways, however, did not employ the information provided by Derivium to
calculate their tax liability; they failed to declare any dividend income on their
taxes during the time period of the “loan.” The Calloways, therefore, cannot rely
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on the example to establish their own reasonable cause or good faith.
The Calloways have not shown that they acted with reasonable cause and in
good faith when they failed to declare their income from the sale of IBM shares to
Derivium. Consequently, we affirm the Tax Court’s imposition of an
accuracy-related penalty.
2. Late-filing penalty
Finally, the Calloways believe that they should not have been assessed a
late-filing penalty. Section 6012(a)(1)(A) of Title 26 requires an individual to file
a tax return unless his gross income does not exceed a threshold amount.
Furthermore, 26 U.S.C. § 6651(a)(1) imposes a penalty of up to twenty-five
percent of the tax owed for failure to timely file a tax return “unless it is shown
that such failure is due to reasonable cause and not due to willful neglect.”
The Calloways maintain that they should not have been assessed a late-
filing penalty “based upon [Mr. Calloway’s] reliance upon the account statements
that Derivium ha[d] possession of his shares through 2004.”81 They do not
explain, however, how Derivium’s deception with respect to the ownership of the
stock affects their duty to file a tax return. They do not point to any statement
81
Pet’rs’ Br. 28.
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from Derivium that suggests that they should not file, or were somehow absolved
from filing, their joint return. To the contrary, the fact that Derivium was sending
them statements that showed dividend income on the stock would suggest that the
income should be reported. Moreover, even if they could point to such statements
by Derivium, they do not suggest how relying on those statements would
constitute “reasonable cause” for purposes of § 6651.
Finally, the Calloways suggest that their failure to file was inconsequential
“since [they] overpaid their taxes in 2001.”82 Nevertheless, it is the taxpayers’
gross income, not their tax liability, that triggers the filing requirement under 26
U.S.C. § 6012(a)(1)(A).
The Calloways have not carried their burden of establishing reasonable
cause for failing to timely file their return. The Commissioner’s assessment of a
late-filing penalty was appropriate.
Conclusion
For the foregoing reasons, the judgment of the Tax Court is affirmed.
AFFIRMED.
82
Id.
44