Reversing a district court, the Eleventh Circuit held that a taxpayer was entitled to a deduction under Sec. 1341(a) based on her payment to her ex-husband, under the couple's separation agreement, of her share of the settlement of a lawsuit involving compensation her ex-husband earned while they were married.
Background
Nora Mihelick and Michael Bluso married in Ohio in 1978. From 1999 to 2004, Bluso was the CEO of Gotham Staple Co., a closely held company owned by his family, and received compensation for his work at Gotham.
In September 2004, Mihelick filed for divorce. While the divorce was pending, Pamela Barnes, one of Bluso's sisters and a minority shareholder in Gotham, sued Bluso, Gotham, and others, claiming, among other things, that Bluso had breached his fiduciary duties by excessively compensating himself at Gotham's expense.
Bluso thought that Mihelick should have to pay half of any liability from the lawsuit, but Mihelick did not. However, under pressure from Bluso, Mihelick signed a separation agreement that provided that any liability from the Barnes litigation would be considered a marital liability for which Bluso and Mihelick would be jointly and severally liable. In 2005, the couple's divorce was finalized.
In 2007, Bluso settled with Barnes. Under the terms of the settlement, Bluso disclaimed any wrongdoing but agreed to pay Barnes $600,000 to settle her excess-compensation claims. Bluso paid the full $600,000 to Barnes.
Bluso expected Mihelick to pay him $300,000 to cover her half of the settlement payment per their separation agreement, but, despite the terms of the agreement, Mihelick initially refused to do so. However, after her lawyer advised her that she was obliged to make the payment, Mihelick gave in and paid Bluso $300,000 in 2009.
Bluso took a tax deduction for $300,000, his share of the settlement payment to Barnes, and the IRS allowed the deduction. Mihelick, feeling that she was in the same position as Bluso, took a deduction for her payment to Bluso in 2009 and claimed a refund as a result of the deduction. She asserted that she was entitled to the deduction under Sec. 1341 because the payment to Bluso was a restoration of an amount she had previously included in income under a claim of right. The IRS denied the deduction and her claim for a refund. In response, Mihelick filed a refund suit in district court.
Under Eleventh Circuit precedent, Sec. 1341 does not, by itself, create an independent tax deduction and applies only if another Code section would provide a deduction for the item in the current year. Mihelick argued that she was entitled to deduct the $300,000 payment under Sec. 165(c)(1) as a loss incurred in a transaction entered into for profit not connected with a trade or business. She claimed that the repayment of income from prior years was clearly a loss and she entered into the transaction to repay past income to be released from further liability.
The court disagreed, finding that Mihelick made the payment under a private settlement agreement and not because of any personal obligation resulting from Barnes's lawsuit; consequently, she did not have a loss from a transaction entered into for profit. Thus, the court held that she was not entitled to a deduction in 2009 for the payment under Sec. 1341.
Mihelick appealed the decision to the Eleventh Circuit, again arguing that she was entitled to a deduction under Sec. 1341 and Sec. 165(c).
The Eleventh Circuit's decision
The Eleventh Circuit reversed the district court and held that Mihelick was entitled to a deduction in 2009 under Sec. 1341. Following its decision in Florida Progress Corp., 348 F.3d 954 (11th Cir. 2003), the court employed a four-part test to determine whether Sec. 1341 applied to Mihelick's payment to Bluso.
Under this test, first a taxpayer must show that the item of income was included in a prior year's gross income because it appeared that the taxpayer had an unrestricted right to the item of income. Second, the taxpayer must establish that, after the close of the tax year in which the income was reported as taxable income, he or she actually did not have an unrestricted right to that income. Third, the amount of income the taxpayer did not have an unrestricted right to must exceed $3,000, and, fourth, it must be deductible under another Code provision. If the taxpayer qualifies for relief under Sec. 1341, he or she can deduct the item from the current year's taxes or claim a tax credit for the amount his or her tax was increased in the prior year by including that item.
The IRS did not dispute that the amount of the deduction Mihelick claimed exceeded $3,000. Therefore, the court only addressed the remaining three elements of the test in making its decision.
Appearance of an unrestricted right to income: The IRS argued that Mihelick did not appear to have an unrestricted right to the income in question because she had no presumptive right to Bluso's income. Further, it asserted that even if she did have a presumptive right to the income, she did not have an unrestricted right to the income because Bluso could not have claimed an unrestricted right to the income he allotted himself from Gotham if he misappropriated those funds.
The Eleventh Circuit found, after reviewing Ohio statutory law and case law on the point, that Mihelick presumptively had the same right to the income at issue as Bluso. Moreover, it made no difference whether Mihelick had a presumptive right to Bluso's income because she only needed to have a sincere belief that she had a right to the income. Based on the evidence in the record, the court found that she did sincerely believe she had a right to the income.
The Eleventh Circuit agreed with the IRS that Bluso would not have had an unrestricted right to the income if he had misappropriated it because he would not have had a sincere belief that he had an unrestricted right to the income. However, since the settlement agreement in the Barnes lawsuit expressly disclaimed any wrongdoing on Bluso's part, the court said there was no proof that he had misappropriated the income, so the IRS's argument that he did not believe he had an unrestricted right to the income failed.
Proof there was not an unrestricted right to income: To prove the second requirement was met, the Eleventh Circuit stated that, based on its precedent, the taxpayer must demonstrate that he or she involuntarily gave away the income in question because of some obligation, and the obligation had a substantive nexus to the original receipt of the income.
Because the record showed that Mihelick had reasonably anticipated litigation and settled in good faith in the shadow of litigation, the court concluded her payment to Bluso was involuntary for purposes of Sec. 1341.
The court also determined that the substantive nexus between Mihelick's obligation to pay and the receipt of the original income was straightforward. The court found that the $300,000 presumptively was marital property earned equally by Mihelick and Bluso. The fact that the couple took the $300,000 as income was also the reason Barnes brought her lawsuit — to recover money that was allegedly wrongfully paid to them. Because Bluso and Mihelick agreed to split the $600,000 liability from Barnes's lawsuit, Mihelick paid the $300,000 in settlement of the claim, and therefore Mihelick's payment ultimately stemmed from the original receipt of the income at issue.
Deductible under another provision of the Code: The Eleventh Circuit concluded that this element was satisfied because Mihelick was entitled to a deduction under Sec. 165(c)(1) for losses incurred in a trade or business. Under the Tax Court's decision in Butler, 17 T.C. 675 (1951), a corporate officer may deduct the amount to settle a bona fide suit alleging mismanagement of corporate affairs if the allegations are directly connected with the taxpayer's business activity. According to the court, the rule from Butler applied in this case because Bluso was in the trade or business of being a fiduciary and employee of Gotham, and Barnes's suit was a bona fide suit for breach of trust or mismanagement of funds by Bluso in his capacity as a fiduciary and an employee of the company. Thus, the $600,000 settlement in the case was a deductible loss for Bluso.
In the court's view, this characterization of Bluso's settlement payment to Barnes carried over to Mihelick's payment to Bluso, because, as the court had already determined, Mihelick was presumed under Ohio law to have contributed equally with Bluso to the production and acquisition of the income from Gotham, so she was presumed to have contributed equally to the liability from the lawsuit. The payment of the liability from the lawsuit was deductible under Sec. 165(c)(1), and she had helped create the liability, so she was entitled to a deduction under Sec. 165(c)(1) for her payment of half the liability.
Reflections
The district court and the Eleventh Circuit came to different conclusions in this case because the district court considered the payment to Bluso to be due to Mihelick and Bluso's execution of the separation agreement in their divorce, while the Eleventh Circuit considered it to be due to the settlement of the Barnes lawsuit. Given that Mihelick, who was not a party to the Barnes lawsuit, was not required to make any payment as a result of the lawsuit and was only required to make the payment under the property settlement provisions of the separation agreement, the district court would seem to at least facially have a better argument. Nonetheless, the Eleventh Circuit came up with a creative way to reach what can be considered an equitable result.
Mihelick, No. 17-14975 (11th Cir. 2019)
