The 'Interest-ed Broker' Case

http://www.ustaxcourt.gov/InOpHistoric/BrooksMemo.TCM.WPD.pdf

1/26/2012

Taxpayer received a $500k sum of money from his employer, in 1998. The employer deemed this a loan which would be forgiven if taxpayer stayed employed with the company for five years. Taxpayer included the forgiven loan and accrued interest on his tax return in the year forgiven (since it was in his W2) however sought to exclude the accrued interest portion from income upon being audited and assessed taxes related to other, unrelated tax positions he had adopted on his return.

Take aways:

• The courts noted that the facts agreed to by both the taxpayer and the IRSwere in just plain wrong with respect to the law because payments such as this (forgiveness taking place in part for each year of services as an employee) have been deemed to be recognizable each year and not all at the end, however, since the IRS didn’t try to make that case they let it slide.

• The court took administrative notice that the taxpayer and his employer executed a legal agreement but didn’t follow it’s provisions. The agreement didn’t weigh for or against taxpayer but if it had supported his argument that would have been nullified by the fact that TP himself had disregarded it.

• The law does not require realization in income of discharge from indebtedness to the extent such liability would give rise to a tax deduction so if the TP could prove that he would have been able to deduct the interest he would not have to recognize it.

• TP was a stockbroker and argued that the loan was to allow him to acquire a securities portfolio with which he could showcase his skills. He claimed that the money was used for this purpose and therefore should be deductible as an ordinary and necessary cost incurred in the production of income. Unfortunately all he did was point to all the stocks he purchased right after receiving the money and did not enter into evidence any bank statments or other proof that they were purchased with the loan money specifically.

• The court found that even if TP had offered proof that the money was used for the purchase of the portfolio, such interest would be deemed investment interest and therefore only deductible to the extent of invest income. As luck would have it, TP had no investment income in that year. (It does carry forward for deduction in future years but the court did not seem to think that caused the interest to be called deductible. I would tend to disagree but the TP did not argue this point.)

• Investment interest is interest on monies use to acquire property held for investment. Property is held for investment if it produces income in the form of interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business (i.e., portfolio income).

• I wonder if the IRS would have questioned it if he had reported the interest as investment interest to begin with, enabling its use in future years? Taxpayers may elect to offset dividends and capital gains with investment interest expense carry-forwards even though those types of income are currently taxes at lower rates. He would likely have obtained the benefits at some point, given his large stock portfolio and career.