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Sage v. Commissioner (154 T.C. No. 12)

On June 2, 2020, the Tax Court issued its opinion in Sage v. Commissioner, 154 T.C. No. 12. The issue presented in Sage was whether the petitioner, who wholly owned an S corporation and LLC, which in turn owned (indirectly) and transferred three encumbered properties to separate liquidating trusts that disposed of the parcels with the profits going to pay off the liabilities of the S corporation and LLC, was the owner/grantor of the liquidating trusts pursuant to the grantor trust provisions of IRC §§ 671-679.

Background

Petitioner, one Mr. Jason B. Sage (a distant cousin of Johnny B. Goode), found himself deeply underwater with respect to three parcels of Oregon real property, which Mr. Sage indirectly owned through wholly owned companies. He named his primary company Integrity Development Group, Inc. (Integrity), because he thought it would instill confidence in those who dealt with Integrity. In 2007, when Mr. Sage felt that real estate was the safest investment that could be made, Integrity took out two loans and a line of credit totaling $18.32m. For the loans, Mr. Sage executed indemnifications, and for the line of credit, a personal guaranty.

The financial crisis reached the Northwest soon after the ink dried on the indemnifications and guaranty. Cursing himself for going with his heart rather than his head, no doubt his mother’s influence over him, Mr. Sage, though deeply underwater on the loans and line of credit, bobbed about until 2009, when he knew the end was nigh. Instead of submitting to foreclosure, Mr. Sage had the bright idea to transfer the parcels from Integrity (and an LLC subsidiary of Integrity) into three separate liquidating trusts (as defined in Treas. Reg. § 301.7701-4(d)) established for the benefit of the respective lenders for each parcel. After all, as his father, the wizened old Irving B. Sage, instilled in young Jason, who better than a Sage to be able to think his way out of a tight spot.

The liquidating trust strategy was foolproof. Not only were the creditors offered protection from involuntary bankruptcy, Mr. Sage would reap significant tax benefits. Somewhere in his mind, his mother’s nagging voice told him it felt too good to be true. Nevertheless, Mr. Sage claimed ordinary losses from the transfers of the parcels to the trusts, which gave rise to significant NOLs in 2009. He carried-back part of the loss to 2006, and part he carried-forward to 2012.

Single member LLCs were set up to receive the properties, with Integrity as the sole member of each. Integrity and the LLC transferred the properties to the new LLCs on December 31, 2009. Another member of Mr. Sage’s business portfolio, JLS (an LLC, wholly owned by another S corporation, for which Mr. Sage was the sole shareholder) established trusts to receive the new LLCs, and ultimately named the creditors as beneficiaries.  Despite the whirlwind of activity (which all occurred on December 31, 2009), Integrity and the original LLC remained liable under the loans and line of credit respectively.

When the properties held by Integrity were sold (for pennies on the dollar) the bank turned around and credited the amounts distributed from the trusts to Integrity’s outstanding loans.  The third property failed to sell, and Mr. Sage transferred the property to the bank with a small amount of cash and a small promissory note.  Because Integrity and the LLC were flow-through companies, Mr. Sage claimed a total nonpassive loss of nearly $10.5m in 2009. The IRS, believing themselves to be wiser than the Sages (as they are wont to do), audited Mr. Sage and Identity’s returns, disallowed Integrity’s losses entirely, and determined a deficiency of $1.46m in 2009 and $7,700 in 2012. The IRS also determined an accuracy related penalty for 2012.

Burden of Proof When IRS Raises New Issue Subsequent to Notice of Deficiency on IRS

In general, a taxpayer seeking to challenge the IRS’s determinations in a notice of deficiency bears the burden of proving those determinations incorrect. Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The IRS, however, bears the burden of proof with respect to any “new matter” it raises subsequent to the notice of deficiency. See Tax Court Rule 142(a)(1).

The IRS will be considered to have raised a new matter when the basis or theory upon which he relies was not stated in the notice of deficiency and the new theory or basis requires the presentation of different evidence. Shea v. Commissioner, 112 T.C. 183, 197 (1999).

Application of Grantor Trust Rules to Liquidating Trust Owned by Petitioner’s S Corporation and LLC

The grantor of a trust is treated as the owner of that trust if certain conditions specified in IRC §§ 673-678 exist. Holman v. United States, 728 F.2d 462, 464 (10th Cir. 1984); see also Gould v. Commissioner, 139 T.C. 418, 435 (2012), aff’d, 552 F. App’x 250 (4th Cir. 2014). Because ownership under the grantor trust regime results in the attribution of income directly to the owner, the Code, in effect, disregards the trust entity.” Madorin v. Commissioner, 84 T.C. 667, 675 (1985).

Consequently, if a trust grantor is deemed an owner, the trust is not treated as a separate taxable entity for Federal income tax purposes to the extent of the grantor’s retained interest. Gould, 139 T.C. at 435. To put it another way, when the grantor trust provisions apply, they function to look through the trust and ignore the trust for Federal tax purposes as existing separately from the grantor. See Madorin, 84 T.C. at 671; Estate of O’Connor v. Commissioner, 69 T.C. 165, 174 (1977); see also Reddam v. Commissioner, 755 F.3d 1051, 1055, n.5 (9th Cir. 2014), aff’g T.C. Memo. 2012-106.

In the Sage case, the Integrity and the LLC made indirect gratuitous transfers of the properties to the liquidating trusts. See Treas. Reg. § 1.671-2(e)(1). The grantor of a trust is treated as an owner where trust income is applied in discharge of a legal obligation of the grantor. Treas. Reg. § 1.677(a)-1(d). Income, in this regard, includes the trust corpus. Treas. Reg. § 1.671-2(b).

As the corpus of each trust was used to satisfy the legal obligations of the Integrity and the LLC, the Tax Court concluded that the entities were owners of the respective trusts after the transfers, and the trusts therefore were not separate taxable entities as to them. See Treas. Reg. § 1.677(a)-1(d); see also Gould, 139 T.C. at 435; Madorin v. Commissioner, 84 T.C. at 671.

(154 T.C. No. 12) Sage v. Commissioner

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