Original Characterization by Taxpayers Matters, Even When Reporting Improperly

In an ongoing breach of contract case,[1] in which the parties contested the treatment of certain transfers as either gifts or as compensation under a contract, the U.S. District Court of Arizona dismissed the portion of the plaintiff’s motion for summary judgment related to “gift tax damages” due to the fact that gift tax labilities are the sole responsibility of the donor and the plaintiff characterized the amounts as gifts. Similar to holdings discussed by us in previous articles regarding the substance over form doctrine,[2] and how it is often used as a sword by the IRS while the taxpayer is stuck with the chosen form,[3] the Court held that the plaintiff was prevented from recovering damages relating to the amounts he paid in gift tax for gifts reported on his tax returns.

Facts

Plaintiff Ronald Pratte (“Pratte”) was a businessman who owned a construction business, which he ultimately sold in 2005. He hired Defendant, Jeffrey Bardwell (“Bardwell”), in 2001 to manage a lumberyard in Phoenix, Arizona. Over the next four years, the two became close friends. Pratte met with Bardwell and four other men at the Las Vegas Airport after selling his business. At the meeting, Pratte gave each of the men an envelope containing a two-million-dollar check and informed them that he would be transferring real property to them in the coming months. Pratte also expressed a wish that the men would start a home construction business with the funds and property. Pratte filed a gift tax return and paid over $3.3 million in gift taxes on the transfers.

Pratte alleged that, in exchange for the check and real property, Bardwell agreed to work for him for the rest of Pratte’s life. Bardwell, however, claimed that the transfers were gifts, and that he made no commitment to work for Pratte. Pratte brought suit against Bardwell alleging breach of contract, promissory estoppel, and unjust enrichment. As part of his showing of damages, Pratte alleged that he paid taxes on behalf of Bardwell related to the transfers, totaling the sum paid in gift taxes. Both parties then moved for summary judgement, Pratte on his breach of contract and unjust enrichments claims, Bardwell on all claims.

Analysis

A discussion of the legal standards surrounding motions for summary judgement are beyond the scope of this article, however the Court found that there was enough genuine issue of material fact for it to dismiss both sides’ motions for summary judgement except for Pratte’s claims related to his payment of gift tax liabilities. As related to the gift tax liability claim, the Court began by summarizing Section 2501, which imposes the gift tax calculated under Section 2502, and the accompanying regulations. The Court noted the language in the regulations which provides an exception from the gift tax for amounts which are transferred for full and adequate consideration.[4] Additionally, the Court cited 26 C.F.R. § 25.2511-2(a) in stating that the gift tax “is a primary and personal liability of the donor” as “an excise upon his act of making the transfer” and that it is not “imposed upon the receipt of the property by the donee, . . . determined by the measure of enrichment resulting to the donee from the transfer,” or “conditioned upon ability to identify the donee at the time of the transfer.”

The Court concluded that Pratte’s assertion of damages in excess of $3.3 million, that he paid, allegedly on behalf of Bardwell, were incompatible with his legal theory, due to the fact that 26 C.F.R. § 25.2511-2(a) clearly places the responsibility for paying gift taxes on him as donor. Furthermore, the Court criticized Pratte’s discrepancy between his original characterization of the transfers as gifts and his position in the suit that the transfers were in exchange for services. It stated that if the transfers were in exchange for services, the transfers should not have been subject to a gift tax at all, and the transfers were improperly reported.

Citing White v. Mattox,[5] which denied recovery related to a contract for illegal acts or contrary to public policy, and Gutierrez v. Carter Bros. Sec. Servs., LLC,[6] which refused to enforce an agreement where its apparent purpose was to avoid paying employment taxes and other benefits, the Court held that Pratte would not be permitted to assert damages from an agreement to improperly file his taxes and dismissed his claims for damages to the extent they were based on his payment of gift tax liabilities. While the court did not go into detail about the issue, based upon the White and Gutierrez citations and accompanying discussion, it would seem Pratte alleged that there was some side agreement whereby he would report the transfer as a gift, potentially to avoid Bardwell’s income tax, employment taxes, or payment of other benefits on the transfer. In effect, there was an agreement to misreport the transfers for some reason contrary to the law or public policy, and the Court was content to leave Pratte in the hole he dug for himself.

Conclusion

Similar to the substance over form doctrine, once a taxpayer has reported a taxable gift and paid the associated gift tax, the taxpayer is going to have a hard time recharacterizing such amounts as something other than a gift especially when the recharacterization satisfies a self-serving purpose. In this case, while the Court did not determine that Pratte was unable to recharacterize the transfers, it prevented him from including amounts associated with the payment of gift tax liabilities in his claim for damages. Certainly, Pratte has created an uphill battle for himself such that one has to wonder if he was provided with legal and/or tax advice regarding the original transfers.

Related to, and really a significant part of, holding taxpayers to the form over the substance of a transaction when they choose the form, is the role of proper documentation. This is something we have discussed often.[7] The Pratte ruling serves as a minor foil to our usual advice, illustrating that when the taxpayer has proper documentation, they’ll often be stuck with what it says, without the ability to go back later and change. Granted in this instance,

[1] Ronald H. Pratte v. Jeffrey Bardwell et al.; No. 2:19-cv-00239.

[2] Joshua W. Sage, “Sixth Circuit Clarifies Substance Over Form Doctrine in ‘Midco’ Case,” May 29, 2019, https://esapllc.com/hawk2019/ and Gray Edmondson, “Substance Over Form: No Friend of the Taxpayer,” Jan. 15, 2020, https://esapllc.com/messina9thcir/#easy-footnote-bottom-12-939.

[3] However note the recent article discussing a case in which the taxpayer was successful in using the doctrine as a shield, Gray Edmondson, “Substance over Form: Friend of the Taxpayer?,” Apr. 20, 2021, https://esapllc.com/complex-media-2021/#_ftnref6.

[4] 26 CFR § 25.2512-8.

[5] 127 Ariz. 181, 184, 619 P.2d 9, 12 (1980).

[6] 63 F. Supp. 3d 1206, 1215 (E.D. Cal. 2014).

[7] See Gray Edmondson, “Moore: What is a bona fide debt?,” August 29, 2019, https://esapllc.com/moore-debt2019/;  Charles J. Allen, “The Sale of a Business – Part 5: The Closing,” October 14, 2019, https://esapllc.com/business-sale-5/; Charles J. Allen, “Lessons to be Learned in Company Loans to Family Members,” August 26, 2019, https://esapllc.com/vhc-2020/; and Charles J. Allen, “Lack of Substantiation and Proof Results in Denial of Deductions and Addition of Penalties,” October 28, 2020, https://esapllc.com/langston-2020/.