Sage v. Comm’r

November 22, 2020Case Summary, NOL, Real Estate, Tax, Trusts, US Tax Court, off
The Oregon state seal. Source: https://sos.oregon.gov/blue-book/Pages/explore/focus-seal.aspx

Abstract

Case Name: Sage v. Comm’r, 154 T.C. No. 12 (2020).
Jurisdiction: U.S.T.C.
Petitioner: Jason B. Sage
Respondent: Commissioner of the Internal Revenue Service.
Concepts: NOL; Real Estate; Trusts
Nature of Case: Whether the Petitioner’s transfer of land into liquidating trusts for the benefit of the parcels’ mortgage holders transferred ownership to the beneficiaries within the meaning of the “grantor” trust provisions?

Introduction

Jason B. Sage, an Oregon real estate developer, owned the three real estate parcels at issue in this case through his wholly owned S corporation, Integrity Development Group, Inc. (IDG).1[1] Facing financial headwinds, IDG decided to transfer the properties to liquidating trusts for the benefit of the creditors that lent against them. IDG and Mr. Sage treated the transfers as closed transactions giving rise to business losses. The Tax Court disagreed, finding that IDG remained owner of the liquidating trusts and therefore IDG’s transfer of property to the trusts did not create deductible losses.

Background

In 2007, IDG borrowed against each of the parcels at issue from two local banks.2 Mr. Sage personally guaranteed each of the three loans.3 By 2009, the recession had flipped the parcels’ values underwater relative to the debts they secured.4

Mr. Sage and his advisers, wary of involuntary bankruptcy and expecting a silver-lining tax benefit, decided to pursue a “liquidating trust” strategy.5 To effect the strategy, JLS Property Management LLC6 formed, and became trustee of, three Oregon trusts.7 Each trust was drafted to qualify as a “liquidating trust” for federal tax purposes.8

Formally, the trust instruments declared that, for federal tax purposes, the parties would treat IDG as transferring each parcel to the bank, and the bank immediately after contributing the parcel to its liquidating trust in exchange for the entire beneficial interest in the trust.9

Substantively, the strategy simply transferred each parcel from IDG to a trust for the benefit of that parcel’s secured creditor.10 IDG remained liable for the three loans11 and Mr. Sage continued to guarantee one of them.12 In fact, Mr. Sage did not tell the banks about the liquidating trust transfers until after he executed them.13 Both banks later responded that they did not see the transfers as “having any practical effect.”14

On its 2009 Form 1120-S, IDG reported ordinary losses on the transfers of the three parcels to their respective liquidating trusts.15 Mr. Sage claimed those flow-through losses on his 2009 Form 1040.16 The 2009 losses gave rise to a net operating loss that Mr. Sage carried back to 2006 and forward to future years.17

IDG eventually sold two of the parcels, and those proceeds were distributed to the creditor-beneficiary and applied against IDG’s loan balances.11 Mr. Sage agreed with the other bank that the liquidating trust would surrender the third parcel in partial satisfaction of that debt.18

Generally, a taxpayer is allowed a deduction for “any loss sustained during the taxable year” that is not otherwise compensated.19 Only bona fide losses “evidenced by closed and completed transactions” are deductible.20 Substance-over-form doctrine governs the deductibility analysis.5

The IRS disallowed IDG’s 2009 losses on the theory that “the 2009 trust transactions were not closed and completed transactions capable of producing realizable losses for that year.21 which consequently eliminated most of Mr. Sage’s 2009 NOL. Mr. Sage petitioned the Tax Court for redetermination of the deficiency.

Case Description

The question of whether IDG’s 2009 transfers were bona fide deductible losses turned on the nature of the relationship between IDG, the liquidating trusts, and the creditor-beneficiary banks under the grantor trust provisions of the Internal Revenue Code.22

IDG was a grantor of the liquidating trusts because it made “direct gratuitous transfer[s]” of property to them.23 A trust grantor is treated as an owner of the trust if the trust’s income (or corpus24) can be applied to discharge a legal obligation of the grantor.25 The corpus of each trust was eventually used in fact to satisfy IDG’s legal obligations to its respective creditors.26 If a grantor is treated as an owner of the trust, the trust is disregarded as a taxable entity separate from the grantor-owner.27

Mr. Sage asserted two alternative theories that would require the grantor trust rules to treat the creditor-beneficiaries as the owners of the trusts rather than IDG.28 First, he argued that forming a liquidating trust necessarily involves a two-step transfer of property from debtor to creditor to trust, the form of which must be respected when analyzing which party made the direct gratuitous transfer to the trust.29

For this theory, Mr. Sage relied on administrative guidance that treated creditors as grantors of liquidating trusts when the creditors had agreed to accept the assets in exchange for relief of debt30 or because they could not be liquidated before the end of a 12-month plan of liquidation.31 The Tax Court found that creditor participation was critical for the treatment Mr. Sage wanted.32 Because IDG’s creditors were not aware of the transfers, did not participate in them, and did not accept the parcels in exchange for relieving IDG’s debt, he erred in relying that administrative guidance.

Alternatively, Mr. Sage argued that IDG’s creditors were grantors of the trusts because the Treasury Regulations define “grantor” to include “any person who acquires an interest in [a liquidating trust] from a grantor of the trust.”33 The Tax Court reasoned by way of example that the regulations addressed the acquisition of a pre-existing grantor’s interest after—not during—the formation of the trust.34

Further, Mr. Sage’s interpretation would mean all liquidating trust beneficiaries are also grantors.5 Rejecting Mr. Sage’s position, the Tax Court followed its Bituminous35 line of cases for the proposition that if Treasury intended Treas. Reg. § 1.671-(e)(3) to cause such sweeping changes, “they would say so directly.”36

The Tax Court denied Mr. Sage’s petition, finding that IDG did not dispose of the properties in 2009 because, under the grantor trust rules, it continued to own the liquidating trusts to which it transferred the properties.37

Conclusion

As COVID-19 contracts the economy for the first time in a decade, distressed taxpayers might increasingly consider liquidating trust transactions. The Tax Court’s Sage opinion gives the IRS ground to challenge the deductibility of transfers to liquidating trusts where creditor-beneficiaries are not active participants and do not relieve the transferor of indebtedness in exchange for the property.

  1. Sage v. Comm’r, 154 T.C. No. 12, at *4 (2020). IDG owned two of the parcels directly; the third parcel was owned by Gales Creek LLC, a subsidiary of IDG that was disregarded for federal tax purposes. Id. For simplicity, the several disregarded entities involved in this case are omitted from the substantive discussion because they have no bearing on the analysis.
  2. Id. at *4–*5.
  3. Id. at *5.
  4. Id. at *6.
  5. Id.
  6. JLS Property Management LLC was a wholly owned subsidiary of JLS Custom Homes, Inc., which was another of Mr. Sage’s companies. Id. at *7 n. 4.
  7. Id. at *7–*8.
  8. Id. at *8. A liquidating trust is an organization that is “organized for the primary purpose of liquidating and distributing the assets transferred to it,” provided that “its activities are all reasonably necessary to, and consistent with, the accomplishment of that purpose.” Treas. Reg. § 301.7701-4(d). The Tax Court found that the trusts met these requirements. Id. at *25 n. 18.
  9. Id. at *9.
  10. Prior to the transfer, IDG created three wholly owned “project LLCs” to which it and Gale Creek contributed the parcels for no consideration. Id. at *7. The project LLCs were disregarded for federal tax purposes. Id. In form, IDG actually contributed its interest in the three project LLCs to their respective trusts. Id. at *9.
  11. Id. at *10.
  12. See Id. at *11.
  13. Id. at *8.
  14. Id. at *29 n. 20.
  15. Id. at *11. IDG computed the ordinary losses by subtracting its adjusted bases in the parcels from its estimate of their fair market values on the transfer date. Id. n. 8.
  16. Id. at *12. See generally I.R.C. § 1366 (S corporation’s items of income, loss, deduction, or credit flow through pro rata to shareholder’s return).
  17. Sage, 154 T.C. No. 12 at *12.
  18. Id. at *11.
  19. I.R.C. § 165(a).
  20. Treas. Reg. § 1.165-1(b).
  21. ”Sage, 154 T.C. No. 12 at *19. (internal quotation marks omitted). The IRS originally disallowed the losses as being “attributable solely to nonbusiness expenses,” but asserted the operative theory on brief and at trial. Id. at *14.
  22. See generally I.R.C. §§ 671–679.
  23. Sage, 154 T.C. No. 12 at *23 (citing Treas. Reg. § 1.671-2(e)(1)).
  24. Treas. Reg. § 1.671-2(b).
  25. Treas. Reg. § 1.677(a)-1(d).
  26. Sage, 154 T.C. No. 12 at *24.
  27. Id. at *22 (citing Gould v. Comm’r, 139 T.C. 418, 435).
  28. Id. at *25–*30.
  29. Id. at *26.
  30. d. at *27 (relying on CCA 200149006, 2001 WL 1559018 (Dec. 7, 2001)).
  31. Id. at *28–*29 (relying on Rev. Rul. 72-137, 1972-1 C.B. 101; Rev. Rul. 80-150, 1980-1 C.B. 316; Rev. Rul. 75-379, 1975-2 C.B. 505; Rev. Rul. 63-245, 1963-2 C.B. 144).
  32. Id. at *29.
  33. Id. at *29–*30 (citing Treas. Reg. § 1.671-2(e)(3)).
  34. Id. at *30 (citing Treas. Reg. § 1.671-2(e)(6), Example (2)).
  35. Bituminous Cas. Corp. v. Comm’r, 57 T.C. 58 (1971).
  36. Sage, 154 T.C. No. 12 at *30–*31 (citing Time Ins. Co. v. Comm’r, 86 T.C. 298, 320 (1986); Bituminous, 57 T.C. at 83).
  37. Id. at *31.