RIPPLE, Circuit Judge:
Albert and Lizzie Calloway seek review of a judgment of the Tax Court sustaining the Commissioner's determination of a deficiency, an accuracy-related penalty and a penalty for filing a delinquent tax return. For the following reasons, we affirm the judgment of the Tax Court.
Albert Calloway worked for IBM for a number of years and acquired IBM stock by exercising his employee stock options. During 2001, Bert Falls, the Calloways' financial adviser, introduced Mr. Calloway to a program operated by Derivium Capital, LLC ("Derivium"). Under that program, Derivium would "lend" a client ninety percent of the value of securities that the client pledged to Derivium as collateral. During the term of the non-recourse loan, Derivium had no restrictions on its use of the collateral. At the end of the loan's term, the client had three options: (1) He could reclaim the collateral by paying the principal and accrued interest; (2) He could surrender the collateral to Derivium; or (3) He could refinance. Mr. Calloway testified that the loan program was attractive to him because, had he sold his stock, he would have had to pay twenty percent in capital gains tax; under the Derivium program, however, he received ninety percent of the stock's fair market value.
Before entering Derivium's program, Mr. Calloway consulted Falls as well as a tax advisor, who provided Mr. Calloway with a copy of a memorandum from Robert J. Nagy to Charles D. Cathcart, president of Derivium. In the memo, Nagy, who identified himself as a certified public accountant, opined that, although there were no absolute guarantees, there was a "solid basis for the position that these transactions are, in fact, loans."
The details of Mr. Calloway's arrangement with Derivium are set forth in three documents: "Master Agreement to Provide Financing and Custodial Services" ("Master Agreement"), "Schedule D Disclosure Acknowledgment and Broker/Bank Indemnification" ("Schedule D") and "Schedule A-1 Proper Description and Loan Terms" ("Schedule A-1").
The Master Agreement provides:
Paragraph 3 of the Master Agreement relates to the "Funding Of [the] Loan" and provides in relevant part:
The Master Agreement also includes a provision that allowed either party to terminate the agreement "at any time prior to the funding of a loan."
Schedule A-1 details the terms of the loan. Specifically, the loan amount was ninety percent of the fair market value at the time of closing; the estimated value of the collateral at that time was $105,444.90. The interest rate to be charged was ten-and-one-half percent, compounded annually; the interest accrued until, and was due at, maturity. Any dividends on the pledged collateral were to "be received as cash payments against interest due."
Mr. Calloway executed the Master Agreement and attached schedules on August 8, 2001, and authorized the transfer of 990 shares of his IBM stock to Derivium's account with Morgan Keegan & Company, Inc., on the following day. Cathcart, as president of Derivium, signed the Master Agreement and schedules on August 10, 2001.
On August 17, 2001, Derivium's operations office sent Mr. Calloway two documents. The first was a valuation confirmation indicating that Derivium had received the stock, valued at $104,692.50, into its account. The second document, titled "Activity Confirmation," indicated that, as of August 17, 2001, Derivium had hedged the IBM stock for slightly less, $103,984.70, yielding an "Actual Loan Amount" of $93,586.23. On August 21, 2001, Derivium sent to Mr. Calloway a letter informing him that the proceeds of the loan were sent to him according to the wire transfer instructions he had provided a few days earlier. On the same date, $93,586.23 was credited to Mr.
During the period of time covered by the loan, Mr. Calloway received quarterly and year-end account statements. Each quarterly statement set forth the loan balance at the beginning of the quarter, indicated the interest accrued during the quarter and credited the account for the dividends paid during the quarter to yield the end-of-quarter loan balance. The statement also provided the end-of-quarter collateral value. Mr. Calloway did not receive any tax statements reflecting dividend income (Form 1099-DIV), nor did he report on his tax returns any dividend income earned from the 990 shares of IBM stock.
In a letter dated July 8, 2004, Derivium informed Mr. Calloway that the loan would mature on August 21, 2004. Consistent with the Master Agreement and accompanying schedules, the letter stated that Mr. Calloway could either (1) pay the maturity amount of $124,429.09 and recover his collateral, (2) renew or refinance the transaction for an additional term or (3) surrender the collateral. On July 27, 2004, Mr. Calloway returned the response form to Derivium indicating that he was "surrender[ing his] collateral in satisfaction of [his] entire debt obligation."
On February 11, 2004, Mr. Calloway and his wife filed their joint federal income tax return for the year 2001 — nearly two years past the original filing deadline. On the return, they did not report the money received from Derivium in exchange for the stock. From the time of the loan until the surrender of the collateral in August 2004, the Calloways did not declare on their tax returns any dividend income generated by the 990 shares of IBM stock. The Calloways also did not report on their 2004 return the surrender of their collateral to Derivium, either by declaring capital gains from the sale of securities or by declaring a forgiveness of indebtedness.
The Internal Revenue Service ("the IRS" or "the Service") issued a notice of deficiency to the Calloways for failing to include the income from the sale of the IBM stock on their 2001 income tax return. It also assessed two penalties for failure to timely file a return and for significant understatement of income.
The Calloways filed a petition for a redetermination of income tax deficiency and penalties with the Tax Court.
The Calloways framed the issues before the court in their pretrial memorandum. They argued that the mere fact that Mr. Calloway entered into the loan agreement with Derivium to avoid paying capital gains tax was not license for the Commissioner to recast the arrangement as a sale.
Finally, they maintained that "[a]ny plain reading of the Derivium loan contract demonstrates that the contract is clearly a loan agreement entered into by two independent, arms-length, unrelated parties, rather than an agreement to sell the stock pledged under the loan agreement."
For its part, the IRS argued that, because the Calloways received proceeds from the sale of the stock and Derivium, in exchange, received title and possession of the shares without any restrictions on the use of those shares, the transaction was a sale.
Considering those factors, the Commissioner submitted, the loan agreement between the Calloways and Derivium should be considered a sale:
The Commissioner also argued that the transaction did not meet the fundamental requirement of a loan: "a genuine intention on the part of the parties to create a debt," which is determined by looking at the facts and circumstances surrounding the purported debtor-creditor relationship.
After receiving the parties' briefs and exhibits, and after hearing Mr. Calloway's testimony, the Tax Court rendered its decision for the Commissioner, but was not unanimous in its reasoning.
Judge Ruwe, writing for the majority, characterized "[t]he primary issue" before the court as "whether the transaction ... was a sale or a loan."
Turning first to the question of whether the transaction should be considered a sale, the Tax Court noted that, under the tax laws, "`the term "sale" is given its ordinary meaning ... and is generally defined
Applying these factors to the transaction between Mr. Calloway and Derivium led the court to conclude that Mr. Calloway had sold his stock to Derivium in August 2001. The court first observed that legal title had passed from Mr. Calloway to Derivium: "The master agreement provide[d] that once Derivium received the IBM stock, Derivium was authorized to sell it without notice to the petitioner. Derivium immediately sold the stock. Thus, legal title ... passed to Derivium in 2001 when petitioner transferred the IBM stock pursuant to the terms of the master agreement."
Furthermore, the Tax Court continued, the parties treated the transaction as a sale. Derivium determined the amount of the "loan" only after it had determined the proceeds it would receive from the sale of the stock — a sale that, according to the terms of the Master Agreement, Mr. Calloway had authorized Derivium to make. Additionally, the Calloways did not report dividends from their purported ownership of the stock after it was surrendered to Derivium.
With respect to the equity inherent in the stock, the Tax Court believed that this factor weighed in favor of treating the transaction as a sale as well: "Derivium acquired all property interests in the IBM stock[].... Petitioner retained no property interest in the stock."
Finally, turning to other factors, the Tax Court determined that there was an obligation on the part of Mr. Calloway to deliver and on the part of Derivium to pay for the stock, that the right of possession passed entirely to Derivium and that Derivium had the right to profit from the property during the term of the transaction. All of these factors weighed in favor of finding that the transaction at issue was, in fact, a sale for tax purposes.
Considering these circumstances, the Tax Court held "that the transaction was not a loan and that petitioner sold his IBM stock for $93,586.23 in 2001."
The Tax Court noted that, although this was a case of first impression, two other district courts recently had held that Derivium "loans" were sales of securities.
Turning to the other issues raised by the Calloways, the Tax Court first rejected the Calloways' claim that, according to Revenue Ruling 57-451, they did not realize income from the transaction with Derivium until 2004 when they surrendered their rights to have Derivium return the stock. The Tax Court quoted the ruling, which addressed the following factual scenario:
With respect to these facts, the Commissioner had determined that no disposition of the stock occurs unless the broker satisfies his obligation either with stock of a different kind (or class) than originally was deposited, or with other property.
However, the 2001 transaction did not allow Mr. Calloway to retain the benefits and burdens of being the owner of the stock; he could not terminate the loan, and he could not repay the loan before the three-year period expired.
The Tax Court also observed that, "[i]n 1978[,] Congress codified and clarified the then-existing law represented by Rev. Rul. 57-451 by enacting [26 U.S.C. §] 1058."
Finally, turning to the penalties, the Tax Court held that the Calloways had not met their burden of establishing that the late filing of their 2001 return was due to either reasonable cause or the absence of willful neglect.
Judge Halpern
Like Judge Halpern, Judge Holmes concurred in the result, but reached that result through a different route. He explained:
Although this rationale would have resolved the key substantive issue in the case, Judge Holmes continued, "[t]he majority... instead goes off on a frolic and detour through an inappropriate multifactor test, applies it in dubious ways, and ends up reaching an overly broad holding with potentially harmful effects on other areas of law."
After the Tax Court issued its decision, the Calloways moved for reconsideration. The Calloways took issue with the Tax Court's conclusion that "once Derivium received the IBM stock, Derivium was authorized to sell it without notice to petitioner."
The Calloways also argued that, because the court had concluded that "there was not a bona fide loan, then it is only fair and consistent that the Court should only apply those covenants of the master agreement which are effective prior to the loan period."
After considering the parties' proposed computations, the Tax Court entered its final decision as to the amount of the deficiency and penalties. The Calloways timely appealed.
"We review the Tax Court's application of the tax code de novo and its findings of fact for clear error." Campbell v. Comm'r, 658 F.3d 1255, 1258 (11th Cir. 2011).
The question presented here is whether Mr. Calloway's transaction with Derivium constituted a sale of property, the gain from which should have been included in his gross income for 2001. See 26 U.S.C. §§ 61(a)(3), 1001. When interpreting the Internal Revenue Code, "the term `sale' is given its ordinary meaning and is generally defined as a transfer of property for money or a promise to pay money." Anschutz Co. v. Comm'r, 664 F.3d 313, 324 (10th Cir.2011) (citing Comm'r v. Brown, 380 U.S. 563, 570-71, 85 S.Ct. 1162, 14 L.Ed.2d 75 (1965)).
To determine if a sale has occurred, we ask "whether, as a matter of historical fact, there has been a transfer of the benefits and burdens of ownership." Id. (citing Grodt & McKay Realty, 77 T.C. at 1237). Some of the factors that inform the benefits and burdens inquiry are:
Grodt & McKay Realty, 77 T.C. at 1237-38 (internal citations omitted); see also Anschutz, 664 F.3d at 324-25.
In addition to the Grodt & McKay Realty test, the Tax Court also has identified a number of factors to help determine whether a taxpayer has "transfer[red] the accoutrements of stock ownership." Anschutz v. Comm'r, 135 T.C. 78, 99 (2010), aff'd, 664 F.3d 313, 325 (10th Cir.2011). They are:
Dunne v. Comm'r, 95 T.C.M. (CCH) 1236, 1242 (2008), 2008 WL 656496, at *11 (T.C. 2008) (internal citations omitted). As with the Grodt & McKay Realty factors, "[n]one of these factors alone is determinative," rather "their weight in each case depends on the surrounding facts and circumstances." Dunne, 95 T.C.M. (CCH) at 1242, 2008 WL 656496, at *11.
For obvious reasons, there is significant overlap between the Grodt & McKay Realty factors that help determine whether a sale of an asset has taken place, and the Dunne factors that help determine whether, for tax purposes, an individual owns stock. Compare, e.g., Grodt & McKay Realty, 77 T.C. at 1237 (listing first factor as "[w]hether legal title passes"), with Dunne, 95 T.C.M. (CCH) at 1242, 2008 WL 656496 at *11 (listing first factor as "[w]hether the person has legal title or a contractual right to obtain legal title in the future"). Indeed, the Dunne factors address the same question as the Grodt & McKay Realty factors — who has assumed the benefits and burdens of ownership — but tailor the terminology more precisely to the attributes of stocks and stock ownership. For instance, in Grodt & McKay Realty, the tax court identified "how the parties treat the transaction," or, slightly rephrased, whether the parties act as if a
Applying the Grodt & McKay Realty factors, as further refined by Dunne, to the present case, we believe that the most relevant of those factors point firmly to the conclusion that the 2001 transaction was a sale of stock for the purposes of Federal income tax. First among those considerations is the way that the parties treated the transaction in the foundational documents. Although denominated an agreement "To Provide Financing and Custodial Services," the terms of the Master Agreement make it clear that, during the period of time covered by the "loan," Derivium was the owner of the stock. We previously have observed that "the characteristics typically associated with `stock' are that it grants `the right to receive dividends contingent upon an apportionment of profits'; is negotiable; grants `the ability to be pledged or hypothecated'; `confer[s][] voting rights in proportion to the number of shares owned'; and has `the capacity to appreciate in value.'" See Fin. Sec. Assur., Inc. v. Stephens, Inc., 500 F.3d 1276, 1285 (11th Cir.2007) (per curiam) (alteration in original) (quoting Landreth Timber Co. v. Landreth, 471 U.S. 681, 686, 105 S.Ct. 2297, 2302, 85 L.Ed.2d 692 (1985)). When Mr. Calloway transferred his securities to Derivium pursuant to the Master Agreement, he ceded these rights of stock ownership to Derivium. Mr. Calloway gave Derivium "the right, without requirement of notice to or consent of the Client, to assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber, short sell, and/or sell outright some or all of the securities during the period covered by the loan."
When evaluated according to other Grodt & McKay Realty factors, the terms of the Master Agreement and accompanying schedules also point to the conclusion that the transaction was a sale of Mr. Calloway's stock to Derivium. The Master Agreement granted Derivium the right to possess the stock,
Several aspects of the transaction, especially when assessed as a totality, distinguish this arrangement from a legitimate loan. For instance, a borrower may provide stock as collateral for a loan, and possession (or the equivalent) may be transferred to the lender. Typically, however, a lender does not have completely unfettered use of the collateral — as Derivium did here — but holds the collateral in the event of nonpayment or default. In short, in a loan transaction, the parties do not treat the lender as the absolute owner of the stock, and, concomitantly, the lender does not exercise the full complement of ownership rights.
Moreover, the lockout provision, in combination with the transfer of all rights of ownership, prevented Mr. Calloway from taking advantage of favorable market developments during the course of the "loan." The terms of the Master Agreement and addenda ensured that Derivium, not Mr. Calloway, benefitted from temporary upswings in stock price. Derivium's absolute right to receive the profits from disposition of the collateral for a three-year period further distinguishes the present circumstance from a legitimate lending scenario.
Finally, the nonrecourse provision not only ensured that any risk of market downturn was born by Derivium, but also made it unlikely that Mr. Calloway ever would repay the loan and reclaim his collateral. On the day Mr. Calloway entered the agreement with Derivium, the stock would have had to appreciate significantly before paying off the loan became an economically viable option. In other words, Mr. Calloway did not have an ex ante incentive to, or a strong expectation that he would, pay off the loan.
None of these factors, standing alone, necessarily would suffice to distinguish a sale from a loan or to establish that a sale of securities, as opposed to some other type of transaction, had occurred. Nevertheless, the combination of these factors — that the parties, through the terms of the Master Agreement and addenda, treated Derivium as the owner of the stock; that Derivium, for the three-year period of the loan, had the sole right to benefit from the increase in stock price; and that Derivium,
Furthermore, we note that the Court of Appeals for the Ninth Circuit took a similar approach in evaluating the tax consequences of an "essentially identical transaction[]" to the one at issue here. Sollberger, 691 F.3d at 1122, 2012 WL 3517865, at *2. Asking "whether the burdens and benefits of ownership have been transferred," and noting that the Grodt & McKay Realty factors "provide a useful starting point" for this inquiry, id. at 1124, 2012 WL 3517865 at *4, the court concluded that the taxpayers had sold their stock, thus triggering capital gains liability, id. at 1126-27, 2012 WL 3517865 at *6.
Three members of the Tax Court voiced their concern that the Grodt & McKay Realty factors were particularly ill-suited for determining whether Mr. Calloway's transfer of IBM stock to Derivium constituted a sale. Judge Holmes took the view in his concurring opinion that factors such as title, possession and obligation to deliver the deed may be important for determining whether cattle or land has changed hands, but were "inapt[]" for determining stock ownership due to the "rapid evolution of the indirect holding system."
In short, employed in a measured manner, with full awareness of its limitations, the multifactor approach employed by the Tax Court's majority included sufficient analysis of the factual circumstances to permit our colleagues on the Tax Court to conclude, correctly, that Mr. Calloway and Derivium had treated the transaction in the Master Agreement and schedules as conveying all stockholder rights and liabilities, all the benefits and burdens of ownership of the stock, to Derivium. The Calloways, in turn, realized taxable income upon consummation of the transaction.
Judge Holmes's alternative analysis, we believe, contains its own infirmities. As set forth above,
Characterizing the initial transaction between Mr. Calloway and Derivium as a loan, even as an assumption for the limited purpose of deciding this case, presents substantial analytical and practical difficulties. As discussed previously, we cannot square Mr. Calloway's wholesale transfer of ownership interests to Derivium with the idea that the transaction was a loan. Furthermore, even if we were to agree with this characterization, Judge Holmes's approach would cause significant difficulties for taxpayers whose assets were sold without their knowledge or permission: "Judge Holmes's test could result in understatements
Over time, it may be possible for the Tax Court to refine further its approach to analyzing the myriad of factual situations in which it must determine whether a transaction, such as the one at issue here, has resulted in the receipt of taxable income. Indeed, it appears that this dialogue is already underway among its judges. Nevertheless, given the wide variety of situations that the Tax Court must confront as financial arrangements become more complex and inventive, flexibility in the use of analytical tools undoubtedly will remain a necessary attribute of judicial decisionmaking. We certainly perceive no error of law in the flexible approach followed by the Tax Court in this case.
Although the Calloways take issue with the Tax Court's use of the Grodt & McKay Realty factors, the crux of their argument is that the Tax Court erred in making certain factual findings that undergird its analysis. Specifically, the Calloways take issue with two of the Tax Court's conclusions: (1) that Derivium had the right to dispose of their stock, and (2) that they were prohibited from demanding a return of their stock during the three-year lockout period. According to the Calloways, Derivium's rights to dispose of the stock and to maintain possession of the stock for a three-year period were conditioned on the existence of a legitimate loan for tax purposes. In the Calloways' view, because the Tax Court later determined that there was not a legitimate loan, this condition precedent was not met.
We cannot accept the Calloways' characterization of their agreement with Derivium. Nothing in the Master Agreement or addenda required that the transaction be characterized as a "loan" by the IRS before the obligations of the parties became operative. Furthermore, the Master Agreement contains an integration clause that states: "There are no other representations, warranties, collateral agreements or conditions, which affect this Agreement other than as expressed herein and in the attached schedules.
According to the Master Agreement, once Mr. Calloway transferred the securities to Derivium, Derivium had the right to sell his securities. Mr. Calloway could terminate the Agreement only up until the time that the loan was funded.
The Calloways also take issue with the Tax Court's assessment of accuracy-related and late-filing penalties. We shall consider each of these in turn.
Section 6662 of Title 26 imposes a penalty for an underpayment of taxes "attributable to 1 or more of the following:... (2) Any substantial understatement of income tax." 26 U.S.C. § 6662(b). The provision defines "a substantial understatement of income tax" as one that exceeds "the greater of — (i) 10 percent of the tax required to be shown on the return for the taxable year or (ii) $5,000." 26 U.S.C. § 6662(d)(1)(A). The Tax Court's assessment of an accuracy-related penalty is a factual determination that we review for clear error. See Patterson v. Comm'r, 740 F.2d 927, 930 (11th Cir.1984) (per curiam). The Commissioner has the burden of production with respect to establishing liability for a penalty. See 26 U.S.C. § 7491(c) ("Notwithstanding any other provision of this title, the Secretary shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title."). That is, he "must come forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty." Higbee v. Comm'r, 116 T.C. 438, 446 (2001).
The Calloways do not argue that the Commissioner has not met his burden of production with respect to the penalty;
The Calloways submit that they acted in good faith and had reasonable cause for
26 C.F.R. § 1.6664-4(b)(2), Ex. 3.
The Calloways' argument would have greater force if they, like the taxpayer in the example, had paid the taxes on the dividends that Derivium reported to them and that allegedly were being credited toward the interest on their "loan." The taxpayer in the hypothetical relied in good faith on what should have been, and what appeared to be, accurate information in calculating the tax owed. The Calloways, however, did not employ the information provided by Derivium to calculate their tax liability; they failed to declare any dividend income on their taxes during the time period of the "loan." The Calloways, therefore, cannot rely on the example to establish their own reasonable cause or good faith.
The Calloways have not shown that they acted with reasonable cause and in good faith when they failed to declare their income from the sale of IBM shares to Derivium. Consequently, we affirm the Tax Court's imposition of an accuracy-related penalty.
Finally, the Calloways believe that they should not have been assessed a late-filing penalty. Section 6012(a)(1)(A) of Title 26 requires an individual to file a tax return unless his gross income does not exceed a threshold amount. Furthermore, 26 U.S.C. § 6651(a)(1) imposes a penalty of up to twenty-five percent of the tax owed for failure to timely file a tax return "unless it is shown that such failure is due to reasonable cause and not due to willful neglect."
The Calloways maintain that they should not have been assessed a late-filing penalty "based upon [Mr. Calloway's] reliance upon the account statements that Derivium ha[d] possession of his shares through 2004."
Finally, the Calloways suggest that their failure to file was inconsequential "since [they] overpaid their taxes in 2001."
The Calloways have not carried their burden of establishing reasonable cause for failing to timely file their return. The Commissioner's assessment of a late-filing penalty was appropriate.
For the foregoing reasons, the judgment of the Tax Court is affirmed.
Id. at 57-58 (Holmes, J., concurring in result) (footnote omitted).
