In a recent case involving a motion for summary judgment, the Tax Court drew some interesting conclusions about a phantom stock plan. Phantom stock is not real stock. It is a form of deferred compensation paid to an employee and its value tracks the performance of the company stock. If the stock increases in value, the employee’s phantom stock account becomes more valuable. If the stock’s value declines, the employee’s account becomes less valuable. Gary Hurford worked for the Hunt Oil Company, which had a phantom stock deferred compensation program. When Gary died in 1999, his account was worth $6,411,000, which was reported on his estate tax return. He left the account to his wife, Thelma. Reporting the phantom stock on Gary’s estate tax return did not result in a tax basis increase because phantom stock is treated as “income in respect of a decedent,” which does not get the benefit of a basis increase at death.
Upon inheriting the account, in 2000 Thelma transferred it to a partnership called Hurford Investments No. 2, Ltd. (“HI-2”) which had been created to hold this asset. This is where the first mistake occurred. Thelma should have reported the value of the phantom stock account at the time of the transfer to HI-2 as ordinary income under IRC Section 691(a)(2). She did not report any income; however, HI-2 reported short term capital gain in the amount of $6,411,000. This was also not correct but at least the government got its tax money. The IRS later agreed that HI-2 obtained a tax basis of $6,411,000 by virtue of having reported the short term capital gain.
Thelma died in 2001. In a prior Tax Court case, it was determined that the value of the phantom stock account was included in Thelma’s estate for estate tax purposes because of certain interests she was found to have retained. The value of the account on the date of her death was $9,600,000.
In 2004, which was five years after Gary’s death, the phantom stock holding was terminated under the plan. This means that an account was created in the name of HI-2 that had an initial value equal to the value of the phantom stock account in 2004. This account could still grow or decline with the value of Hunt Oil Stock though not as much. Any growth could not exceed the 90 day Treasury rate. In 2006, Hunt Oil elected to cash out this account and paid HI-2 the sum of $13,000,000, the account’s value at the time.
Two questions had to be addressed that ended up back in the Tax Court. How much gain resulted and was the gain ordinary income or capital gain? The court addressed these questions in Hurford Investments No. 2, Ltd., v. Commissioner (Docket No 23017-11, 4-17-17). The IRS had previously agreed that HI-2 had a tax basis in the account of $6,411,000 as a result of having paid tax on that amount in 2000. HI-2, however, argued that its basis should be increased to the fair market value at Thelma’s death in 2001, which was $9,600,000. The court held that because the account had been included in Thelma’s estate for estate tax purposes, its basis was the fair market value at Thelma’s death, so HI-2 benefited from a basis increase of over $3,000,000.
The court’s resolution of the capital gain vs. ordinary income question was interesting. Everyone agreed that at Gary’s death in 1999, the account represented ordinary income under IRC Section 691 and continued such characterization under Thelma’s ownership. The court pointed out, however, that the character of property can change. When Thelma transferred the account to the partnership, Section 691 ceased to apply. Thelma should have recognized the value of the account as ordinary income at that time and thereafter the account was no longer governed by Section 691. The court then turned to Section 1221 to review the definition of a capital asset. A capital asset is defined as property other than certain specific types of property that are excluded. Because the account did not fall under any of the exclusions, the court concluded that in the hands of HI-2 it was a capital asset.
HI-2 had one more hurdle to clear to obtain capital gain treatment. It had to demonstrate that the account was disposed of in a “sale or exchange” transaction in order for capital gain income to result. The IRS argued that Hunt Oil closing the account in 2006 and paying HI-2 its balance did not amount to a sale or exchange transaction. HI-2 even agreed that the closing of the account was not a sale or exchange transaction but argued that IRC Section 1234A afforded it capital gain treatment nonetheless. This section provides that gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is a capital asset shall be treated as gain or loss from the sale of capital asset. The Code itself provides the necessary sale or exchange treatment.
The court agreed that Section 1234A applied. HI-2 had the right to liquidate the account at any time after 2004 and prior to 2006 when Hunt chose to liquidate the account. Hunt’s action amounted to the termination of HI-2’s right to sell the account back to Hunt, and therefore Section 1234A applied and capital gain resulted from an asset that started life as ordinary income.