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Analysis of and reflections on recent cases and rulings.

Employee Benefits & Pensions


Self-help stock purchase not IRA distribution

The Seventh Circuit held that a taxpayer-initiated wire transfer of funds from the taxpayer's self-directed individual retirement account (IRA) to purchase stock to hold in the IRA, which the IRA custodian would not purchase directly, was not a taxable distribution of funds from the IRA.


Raymond McGaugh opened an IRA with Merrill Lynch in 2002. In 2011, he asked Merrill Lynch to use money from that IRA to purchase 7,500 shares of stock issued by First Personal Financial Corporation (FPFC), a privately held company. For unknown reasons, Merrill Lynch refused to purchase those shares on McGaugh's behalf. McGaugh then initiated a wire transfer of $50,000 from his IRA directly to FPFC on Oct. 7, 2011, to buy the shares.

On Nov. 28, 2011, FPFC issued a stock certificate titled "Raymond McGaugh IRA FBO Raymond McGaugh," which it mailed to Merrill Lynch. After receiving the certificate, Merrill Lynch, believing McGaugh's transaction to have impermissibly exceeded the 60-day window applicable to rollovers of IRA assets under Sec. 408(d)(3), tried to mail the certificate to McGaugh. The Post Office returned the certificate twice to Merrill Lynch as undeliverable, but the third time the company sent out the certificate (this time by FedEx), it did not return. McGaugh, however, claimed he never received it.

Merrill Lynch characterized the wire transfer as a taxable early distribution and issued a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to McGaugh, which he also claimed he never received. McGaugh did not report the distribution on his return for 2011. Based on the Form 1099-R, the IRS determined that he had received a taxable distribution from his IRA and in 2014 sent him a notice of deficiency listing a $13,538 tax deficiency and an accuracy-related penalty of $2,708.

McGaugh filed suit in the Tax Court to challenge the IRS's determination. The Tax Court held he did not take a taxable distribution from his IRA in 2011. The IRS appealed the decision to the Seventh Circuit.

Seventh Circuit's opinion

The Seventh Circuit affirmed the Tax Court's holding that McGaugh had not taken a taxable distribution from his IRA because he had not constructively received funds from it. The court looked at whether McGaugh had constructively received the stock when he received the certificate or when he directed Merrill Lynch to wire the funds to purchase the stock to FPFC.

Regs. Sec. 1.451-2(a) provides that a taxpayer constructively receives income when income:
is credited to [an individual's] account, set apart for him, or
otherwise made available so that he may draw upon it at any time, or
so that he could have drawn upon it during the taxable year if notice
of intention to withdraw had been given. However, income is not
constructively received if the taxpayer's control of its receipt is
subject to substantial limitations or restrictions.

The Seventh Circuit has held that under the constructive-receipt doctrine, a taxpayer receives income "not only when paid in hand but also when the economic value is within the taxpayer's control" (Fletcher, 562 F.3d 839, 843 (7th Cir. 2009)).

The Seventh Circuit first addressed the IRS's contention that McGaugh had constructively received the stock when he received the stock certificate. As had the Tax Court, the Seventh Circuit noted that FPFC issued the shares not in McGaugh's name but in the name of his IRA. Thus, McGaugh did not have any control over the shares or the rights associated with them that could give rise to a finding of constructive receipt.

The Seventh Circuit then considered the IRS's argument that McGaugh constructively received funds from his IRA when he directed Merrill Lynch to wire them at his discretion to FPFC. The IRS made this argument based on the general principle that a party cannot circumvent the rules on taxable income simply by directing a distribution to a third party. However, the court found that this principle was not implicated in this case. According to the court, McGaugh did not direct a distribution to a third party; instead, he simply bought stock, which "is a prototypical, permissible IRA transaction."The court further noted that a finding of constructive receipt was not appropriate because there was no indication that McGaugh purchased the stock to benefit FPFC or for any reason other than his wish to obtain the stock to hold in his IRA.


In Ancira, 119 T.C. 135 (2002), the Tax Court was even more lenient, allowing the taxpayer to receive a check made out to a non-public-issuing company and then send the check to the company to make the stock purchase. However, if the taxpayer were to receive a check made out to him or her from an IRA, deposit the money, and then use the funds to purchase stock issued in the name of the IRA, it is likely that the taxpayer would be held to have constructively received the funds distributed because there was no restriction on how the taxpayer could use the funds.

McGaugh, T.C. Memo. 2016-28

Partners & Partnerships

Partner's bonus was not a partnership distribution

The Court of Federal Claims held that an $18 million bonus, paid to a hedge fund manager by a U.K. partnership in which she was a partner, was a payment made to her for services outside of her capacity as a partner rather than a partnership distribution and was taxable to her in the year she received it.


In January 2005, Mina Gerowin Herrmann joined Paulson & Co. as a senior analyst in its New York office. Paulson & Co. is an investment management firm organized as an S corporation under U.S. law and owned by John Paulson. Paulson & Co. managed about $10 billion in various hedge funds, including merger arbitrage funds, event arbitrage funds, and credit funds.

As a senior analyst, Gerowin's role was to analyze investment opportunities 4for the Paulson & Co. funds and propose viable opportunities to Paulson. She initially worked on the merger funds but later shifted her focus to include the event funds as well. In 2006, she was promoted to the position of senior vice president, and, as such, expanded her role to include meetings and presentations with investors. Gerowin received a salary and an annual bonus as compensation. In her first year, the bonus was fixed, but in her second year it was discretionary and determined by Paulson. In 2007, it was changed to a formulaic bonus, with the formula for calculating the bonus determined by Paulson.

Paulson considered members of Paulson & Co.'s senior management who received formulaic bonuses to be "partners" in the company. However, because Paulson & Co. was a corporation and not a partnership, they were not actually partners in the firm, and the firm reported their salaries and bonus payments to them and the IRS on Form W-2, Wage and Tax Statement.

In 2008, Gerowin transferred to Paulson Europe LLP (PELLP), and she moved to London. Upon transferring to PELLP, she became a member of the partnership by signing a deed of adherence and contributing [pounds sterling]30,000 to the partnership. The deed of adherence did not give her voting rights in the partnership.

Despite having technically joined the partnership, during her time at PELLP, Gerowin remained an at-will employee, performed the same duties, and received the same compensation as she had as an employee at Paulson &. Co., and she stated at trial that she "had nothing to do with the profits and losses of [PELLP]." It was her understanding that she had been made a member of PELLP so that the partnership could avoid certain U.K. employment tax obligations.

On Dec. 31, 2008, PELLP directed that the $18 million payment be made to Gerowin. Paulson & Co. wired the money for the payment to PELLP, which then had the money transferred to Gerowin's bank account. Her bank received the money on Jan. 5, 2009, and credited it to her account on the next day. The formula used to determine the $18 million payment was the same formula used to calculate her bonus in 2007, when she was still an employee of Paulson 8c Co.

Gerowin did not initially receive a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., from PELLP for 2008. For tax purposes, she reported her regular salary payments from PELLP as her share of the partnership's profits or losses on her 2008 U.K. tax return. She also reported this income on her 2008 U.S. income tax return and took a foreign tax credit based on the tax on the income that she paid to the U.K.

In September 2010, Gerowin received a 2009 Schedule K-1 from PELLP. On her 2009 U.K. return, she included her regular salary and the $18 million bonus payment income. On her 2009 U.S. return, Gerowin reported the income shown on the Schedule K-1 from PELLP on her return and took a foreign tax credit on the return based on the tax she had paid to the U.K. Gerowin and the accounting firm that prepared her return erroneously believed that the income shown on the 2009 Schedule K-1 included the $18 million bonus payment.

In 2011, the IRS began audits of both PELLP and Gerowin for the 2008 tax year. After the beginning of the IRS audits, PELLP issued a Schedule K-1 to Gerowin in August 2011, which showed that she had received a partnership distribution from PELLP that included the $18 million bonus payment but incorrectly listed her foreign-source income as $3.2 million. In July 2012, PELLP provided the IRS and Gerowin a corrected Schedule K-1 that changed her foreign-source income from PELLP from $3.2 million to $21.5 million. Based on the corrected Schedule K-1, the IRS took the position that the $18 million payment was a partnership distribution that was taxable to Gerowin and that she was not entitled to a foreign tax credit carryback from 2009 related to the U.K. tax she paid on the bonus payment. The IRS determined that in total she owed $7.86 million in tax and interest for 2008.

In response, on Oct. 11, 2012, Gerowin paid the tax and interest that the IRS claimed she owed and the next day filed a refund claim, which the IRS eventually disallowed in September 2013. In October 2014, Gerowin filed a refund suit in the Court of Federal Claims. Her primary argument for relief was that the $18 million payment was made to her in a nonpartner capacity pursuant to Sec. 707(a)(2)(A) and, because she was a cash-basis taxpayer, should be taxed in the year she received it, 2009, rather than in 2008.

Court of Federal Claims decision

The Court of Federal Claims held that the $18 million bonus payment was a payment to Gerowin for services performed outside her capacity as a partner under Sec. 707(a)(2) and thus was taxable to her in the year she received it. The court identified four factors regarding Gerowin's work for PELLP and the issuance of the payment that led it to this conclusion.

First, the court found that the services performed by Gerowin when she worked at PELLP in 2008 did not change when she transferred from Paulson & Co. in New York to PELLP in London and became a member of PELLP. The court noted that she worked on the same New York-based merger and event funds she had previously worked on for Paulson & Co., and the only reason for her being in London was to have better access to European investment opportunities for those funds. Furthermore, in her work at PELLP, Gerowin did not perform any services on behalf of the partnership itself, but rather the partnership served as a European conduit for her to perform the same services she performed as an employee of Paulson & Co.

Second, the court determined that the circumstances around the issuance and receipt of the bonus payment itself indicated it was not a partnership distribution. The court found that the payment she received for 2008 was under the same agreement as when she was an employee of Paulson & Co. and was based on the performance of the merger and event funds, not on the success or any profit of PELLP. In addition, PELLP made the payment from funds transferred to it from Paulson 8c Co. because the partnership did not have the cash available to make the payment. The court stated that "[t]he $18 million payment was entirely under the control of and therefore subject to the risks of Paulson 8c Co., not PELLP, indicating that the payment was not a distribution of partnership profits."

The third factor identified by the court was that the $18 million payment was not a partnership distribution because it was not issued in accordance with the terms of the partnership. The court observed, the PELLP partnership agreement specifically stated that PELLP was to make distributions of partnership profits to the members of the partnership after the close of PELLP's accounting year, which ended on March 31, but Gerowin's bonus payment was determined and paid at the end of the calendar year. Also, the court found that, while the partnership agreement states that partnership distributions were only to be made after profits were allocated to cover the expenses and liabilities of the partnership, no funds were "siphoned off" from the payment to cover expenses or liabilities of PELLP.

The final factor the court pointed to was that the $18 million payment was disproportionate to Gerowin's actual ownership share of the partnership. According to various documents produced at trial, Gerowin owned between 0.45% and 4% of PELLP. Her share of PELLP's distributions for 2008, however, was about 27% of PELLP's receipts for that year. The disparity between her ownership share in PELLP and the amount of her 2008 bonus payment indicated to the court that the $18 million payment was not a partnership distribution reflecting PELLP's financial results for that year, but rather a distribution for services performed outside her capacity as a member of PELLP.


As it did in Gerowin's case, the IRS has consistently taken the position, and courts generally have agreed, that an individual cannot be both an employee and a partner in a partnership, and, even when the individual only owns a nominal interest in a partnership, he or she is considered a partner.

The Court of Federal Claims avoided this rule in Gerowin's case by determining that Paulson 8c Co. rather than PELLP made the bonus payment and that it made the payment for work she did on behalf of Paulson 8c Co. However, in the typical case involving the dual-status issue, where an individual who is an existing employee of a partnership receives a small partnership interest in return for services provided, there is no question that the individual is being paid by and providing services for the partnership, and the receipt of the partnership interest will be treated as transforming the individual from an employee into a partner with respect to all the income he or she receives from the partnership.

Because of the negative effects that a change in status from employee to partner can cause, including the loss of certain employee benefits for the employee whose status changes, and the increasing number of partnerships that are providing employees with nominal partnership interests, the IRS has indicated that it is considering changes to the regulations that in certain circumstances would allow partners to be treated as employees.

Herrmann, No 14-941T (Fed. CI. 6/21/17)


James A. Beavers, CPA, CGMA, J.D., LL.M.
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Title Annotation:TAX TRENDS
Author:Beavers, James A.
Publication:The Tax Adviser
Date:Sep 1, 2017
Previous Article:Deducting startup and expansion costs.
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