Opinion
6225-16 16847-16
09-21-2022
MICHAEL R. KELLY, ET AL Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Joseph Robert Goeke, Judge
On August 17, 2022, respondent filed a Motion to Modify Order dated July 27, 2022, in which we provided instructions for Rule 155 computations in these cases. Respondent seeks a modification with respect to the tax consequences of $19,329,039 of cancelation of debt (COD) income that is unrelated to transfers from NSI (non-NSI debt). Petitioner filed a Response to respondent's Motion on September 1, 2022.
Unless otherwise indicated, section references are to the Internal Revenue Code, title 26, U.S.C, in effect for the years at issue, and Rule references are to the Tax Court Rules of Practice and Procedure.
In his response, petitioner objects to respondent's proposed method of computation in his Motion on the basis that it applies § 108(a)(1)(B) first to exclude capital gain instead of ordinary income. Respondent has not presented a reasoned argument to support his approach.
In our July 27, 2022, Order, we treated respondent's failure to adequately address the non-NSI debt in his December 3, 2021, computation as a concession that the debt was excluded from gross income. In his Motion respondent explains that he had determined that the non-NSI debt was excluded from petitioner's gross income on the basis of petitioner's insolvency. He objects to our Order because it enables petitioner to exclude debt (NSI and non-NSI, collectively) that exceeds his insolvency. See § 108(a)(3) (limiting the insolvency exclusion to the amount by which the taxpayer is insolvent).
Our decision to treat the non-NSI debt as a concession was primarily based on our determination that respondent failed to include all or part of that debt as a liability in his insolvency computation, which was attached as an exhibit to his February 28, 2022, filing and which we adopted in our April 11, 2022 Order. Accordingly, to consider respondent's Motion, we must reconsider the insolvency computation.
Discharged Debt Counts As a Liability
Insolvency is defined in section 108(d)(3) as the excess of liabilities over the fair market value of assets as determined "immediately before the discharge". Liabilities include the debt for which discharge is imminent. Miller v. Commissioner, T.C. Memo. 2006-125, at 46. Thus, the cancelled non-NSI debt must be counted as a liability in the insolvency computation.
Before we rule on respondent's Motion, the parties must provide a revised insolvency computation that includes the non-NSI debt as a liability, or respondent must identify how the debt is accounted for in his insolvency computation. The $19.3 million COD income consists of debt with respect to Kelly Hospitality, IHSD, Lemen Road, JCE, and Home Savings. Kelly v. Commissioner, T.C. Memo. 2021-76, at 39-41. Respondent's computation lists the amount of liability attributable to the first four of these entities as zero and does not list any liability owed to Home Savings.
Pre-2008 NSI Debt
Upon further consideration, the NSI debt as of December 31, 2007 (pre-2008 NSI debt) is a discharged debt that must be counted as a liability in the insolvency computation under section 108(d)(3) and Miller, as explained further below. Accordingly, the parties must revise the insolvency computation to include the pre-2008 NSI debt, or respondent must identify how the debt, or any part thereof, is accounted for in his insolvency computation.
Procedural Background
On December 3, 2022, the parties each filed unagreed computations and on January 31, 2022, filed memoranda in support of their computations. Respondent did not provide an insolvency computation in either document; he calculated pre-2008 NSI debt as $35.5 million. Petitioner calculated his insolvency at $83,848,905 and pre-2008 NSI debt at approximately $60 million, which he included as a liability in his insolvency computation. In subsequent filings petitioner has agreed to pre-2008 NSI debt of $35.5 million.
In the Court's Order, dated February 4, 2022, we held that petitioner was insolvent but, without respondent's computation, did not set an amount of petitioner's negative net worth. We addressed respondent's argument, which we rejected, that the insolvency exclusion is not available where the discharged debt is shareholder debt treated as a corporate distribution under Treas. Reg. § 1.301-1(m). We did not address whether the discharged NSI debt is counted as a liability in the insolvency computation.
Thereafter, respondent provided an insolvency computation that petitioner was insolvent by $23,818,095, which did not include the $35.5 million pre-2008 NSI debt as a liability. Petitioner objected to the insolvency computation on that basis.
In the Court's Order dated April 11, 2022, the Court adopted respondent's insolvency computation and did not count pre-2008 NSI debt as a liability on the basis that petitioner was not liable for the debt. However, petitioner was liable for the pre-2008 NSI debt of $35.5 million as that amount was calculated and agreed to by the parties.
Pre-2008 NSI Debt Computation
Respondent calculated the amount of pre-2008 NSI debt as $35.5 million and included only transfers to and repayments by Kelly Capital occurred during 2007. Thus, the $35.5 million amount does not include any transfers made before 2007, which according to our holding were bona fide debt. Petitioner calculated pre-2008 NSI debt as approximately $60 million and appears to have counted pre-2007 transfers. However, he has agreed to the $35 million figure.
Petitioner is liable for the entire amount of pre-2008 NSI debt as calculated by the parties as Kelly Capital was a single-member, disregarded entity and the $35.5 million pre-2008 NSI debt included only transfers by NSI to Kelly Capital during 2007. It does not include any intercompany transfers.
For the purposes of clarify, we reiterate that intercompany loans refer to petitioner's practice of transferring funds among his affiliated companies including Kelly Capital's transfer of the funds that it received from NSI to petitioner's other companies and pre-2008 NSI debt refers to NSI transfers to Kelly Capital. It appears that NSI did not transfer any funds to Kelly Investment before 2008.
Accordingly, pre-2008 NSI debt of $35.5 million must be included as a liability in the insolvency computation under the legal standards discussed above that discharged debt that produces the COD income is counted as a liability in the insolvency computation, except to the extent that the debt, or any part thereof, is separately accounted for elsewhere as a liability in the insolvency computation. It is our understanding that no part of the $35.5 million debt is separately counted.
Petitioner's calculation of pre-2008 NSI debt may result in double counting some debt. To the best our understanding, use of the $35.5 million amount eliminates any intercompany loans and ensures that there is no double counting of liabilities in the insolvency computation.
The April 11, 2022, Order addressed $23.5 million in transfers that were pre-2008 NSI debt. However, NSI had transferred this amount before 2007, and thus, it was not included in pre-2008 NSI debt of $35.5 million. Accordingly, it appears to have no bearing on the insolvency computation.
The April 11, 2022, Order misstates the amount as $25.5 million; the amount was $23.5 million. Kelly, at 23.
Accordingly, the parties are to provide a revised insolvency computation that includes the pre-2008 NSI debt in its entirety or respondent must identify the part of the insolvency computation where that debt has already been accounted for.
Court's Opinion
Petitioner's reported COD income of approximately $145 million, which we held was overstated because it double counted debt by counting intercompany transfers between petitioner's affiliated companies, i.e., it counted NSI's transfers to Kelly Capital and Kelly Capital's transfers of those funds to petitioner's affiliated companies. The Court's Opinion held that "Mr. Kelly's insolvency computation for 2010 requires the elimination of loans to him from his closely held companies" and petitioner overstated his COD income. Kelly, at 3-4. Similarly, the Court's Opinion stated that petitioner's reported COD income "was based largely on intercompany loans and was not calculated with precision to eliminate intercompany debt or to ensure that only his personal debt was actually forgiven." Id. at 60. We held that COD income included pre-2008 NSI debt and third-party loans and determined that third-party loans were at least $19.3 million. Id. at 62. Accordingly, we held that no intercompany transfers were to be included in the COD income (irrespective of when the transfers were made). Thus, no debt is double counted as a result of intercompany loans.
With respect to petitioner's insolvency, the Opinion stated:
His proposed calculation of his liabilities for purposes of the insolvency calculation includes some liabilities of his affiliated companies which should be eliminated and some alleged debt which will be treated as distributions on the basis of our prior holding. Debts due from Kelly Capital and Kelly Investments are not properly included in the insolvency calculation. Mr. Kelly inappropriately included $36,888,254 in secondary intercompany loans. Kelly, at 63-64.
The Court's April 11, 2022, Order misquotes the second sentence of the quoted text by substituting "owed by" for "due from" and inserts NSI in bracketed text. Further, this sentence may not clearly reflect our holding, when read in its entirety, which is that pre-2008 NSI debt and pre-2008 intercompany loans from Kelly Capital and Kelly Investment cannot both be included in COD income or the insolvency computation, i.e., double counting. Although it is improper to count both NSI and intercompany loans, it is proper to include pre-2008 NSI debt, and as explained therein, we understand the pre-2008 NSI debt amount of $35.5 million would not result in any double counting.
We further stated that "[r]espondent's insolvency calculation reflects liabilities of $88,460,849, which removed the NSI and intercompany debt … [and] should be used as the starting point for the computations". Id. at 64.
Respondent's insolvency computation his brief did not include any transfers from NSI or any intercompany transfers as liabilities based on his position that the transfers were not bona fide loans. On the basis of our holding that pre-2008 NSI transfers were bona fide loans, that amount of transfers must be counted as liabilities in the insolvency computation. However, the insolvency computation must ensure that no funds are double counted as a result of intercompany transfers by Kelly Capital of the $35.5 million pre-2008 NSI debt. Accordingly, it is incorrect to exclude pre-2008 NSI debt from the insolvency computation was incorrect as the Court had found those transfers were bona fide loans.
Upon due consideration, it is
ORDERED that the Court's Order dated April 11, 2022, is modified to delete the insolvency computation. It is further
ORDERED that the parties are to file a revised insolvency computation in accordance with this Order by October 21, 2022. It is further
ORDERED that the Court's Order served March 21, 2022, is amended in that the time in which the parties are to submit to the Court revised joint or separate Rule 155 computations or a status report is extended to October 21, 2022. It is further
ORDERED that respondent's Motion filed August 17, 2022, is held in abeyance.