Source: Tony Nitti, a Forbes Contributor: view article on Forbes.com
As the town of Springfield’s resident oligarch, C. Montgomery Burns earned the ire of the townspeople through any number of misdeeds, including blocking out the sun, having the Rolling Stones killed, and stealing Christmas from 1981 through 1985.
But even the fictional Mr. Burns never sunk as low as his real-life namesake, who wound up in the Tax Court yesterday. That Mr. Burns, after bestowing nearly a million dollars worth of cash and cars on his girlfriend only to watch the union come to a quick and painful end, responded by issuing her a Form 1099.
Facts in Blagaich
Gather ’round, readers, and I’ll tell you a tale of a relationship built on the pillars of mutual trust and financial dependence that somehow went wildly astray.
Mr. Burns, then 71 years old, met Diane Blagaich, then 53, in 2009. Their relationship blossomed, but neither was determined to marry. Intent on solidifying their undying commitment to one another in a less formal but still legally binding manner, Burns and Blagaich entered into an agreement in 2010 whereby Burns would pay his girlfriend $400,000. In return, Blagaich would…accept the cash. Oh, and in addition, both Burns and Blagiach were required to “be faithful to each other and refrain from engaging in intimate or other romantic relations with any other individual.”
On top of the $400,000 he was contractually required to pay Blagaich, Mr. Burns handed another $273,000 and a $70,000 Corvette to his girlfriend in 2010. Early in 2011, however, Burns discovered that Blagaich had failed to live up to her obligation of fidelity by carrying on with another man throughout the duration of their relationship. In retaliation, Burns slapped a civil suit on Blagaich in 2011, and as one final kick-in-the-ass, filed a Form 1099 with the IRS stating that he had paid her income of nearly $750,000 in 2010. As you might imagine, however, Blagaich had reported no part of the amounts received as taxable income on her 2010 tax return.
The civil suit soon went to trial, and in late 2013 the state court found that Blagaich had fraudulently induced Mr. Burns to enter into the contract, and required her to repay the $400,000 she received pursuant to the agreement. The court further concluded that the remaining $273,000 of cash and the Corvette were gifts that Blagaich was entitled to keep.
IRS Responds
The IRS, having received a Form 1099 indicating that Blagaich had received income of nearly $775,000 in 2010, adjusted her tax return and assessed a tax deficiency and an accuracy related penalty.
Blagaich countered with two arguments. First, she maintained that the IRS was bound by the state court’s finding that $273,000 of the total payments were “gifts,” and were thus excludable from her taxable income under Section 102. The IRS countered by arguing that because it was not a party to the civil suit, it was not required to adhere to the court’s findings. The Tax Court sided with the IRS, noting that the Service had no active, participatory role in the litigation. Thus, the matter of whether the $273,000 of cash and cars constituted income or a gift for federal tax purposes is a question that must be answered in a subsequent trial.
Next , Blagaich argued that her 2010 income should not include the $400,000 she was required to repay to Mr. Burns, because her requirement to repay the amount permitted her to invoke the principle of “rescission.’
As a cash basis taxpayer, Section 451 requires Blagaich to include in her gross income amounts received under the so-called “claim-of-right doctrine.” A taxpayer receives income under a claim-of-right whenever she “acquires earnings, lawfully or unlawfully, without the consensual recognition…of an obligation to repay.” Stated in English, if you receive cash that you’re not immediately obligated to repay, you’ve got income.
The doctrine of rescission represents a minor exception to the claim-of-right doctrine. It provides that a taxpayer doesn’t need to report an amount as income if their right to the income is rescinded and they either 1) make repayment or 2) recognize a liability to repay within the year of receipt.
If you’re particularly astute, you’ve already noticed the problem with Blagaich’s argument. She received the $400,000 in 2010. She maintained until 2013, however, that the cash represented a tax-free gift. There was no evidence to indicate that Blagaich had any obligation to repay the $400,000 at the end of 2010 — the year of receipt — and thus, the Tax Court concluded, the principle of rescission did not apply.
Thus, Blagaich was left with $400,000 of income in 2010, with the possibility of another $273,000 to be tacked on soon.
