With a cash basis taxpayer, the general rule is that the taxpayer recognizes gross income when money is received. But what if the taxpayer holds money on account for others? This is a common practice.
These transfers may include deposits, advances, etc. It can even include funds held in trust for the benefit of a third party. There are times when these amounts are gross income for the recipient.
This begs the question as to when are funds held in trust subject to tax for the recipient. The court addresses this in Berry v. Commissioner, T.C. Memo. 2021-42, which affords an opportunity to consider this issue.
Facts & Procedural History
The taxpayer is an S corporation owned by a father and his son. The S corporation was formed to build houses and develop real estate.
The taxpayer learned of a project to redevelop an old nursery into condominiums. It advised its client to purchase the property, which they did. The client then paid $250K to the taxpayer. There was no contract between the taxpayer and the client. The only evidence of what the $250K was for was the note on the check, which read “Start-up 13th Street.”
The IRS audited the taxpayer and its owners’ tax returns. The parties did not respond to the IRS auditor’s requests for information. Eventually, a 90-Day Letter was issued and the owners filed suit in U.S. Tax Court.
The primary dispute was whether the $250K was gross income for the taxpayers. The taxpayers contended that the $250K was not gross income.
Gross Income, Generally
Our income tax laws start with the broad statement that all income counts as gross income. The Code also includes several provisions that specifically exclude certain items from gross income. The regulations also explain what counts and does not count as gross income. See Treas. Reg. §§ 1.61-2-1.61-22.
These rules generally cast a wide net and have very narrow exceptions. The result is that most amounts received are gross income. It is up to the taxpayer to fit within one of the exclusions.
Tax returns that under report income fall into the problem tax return category. The IRS auditors apply these rules by assuming all deposits, etc. are gross income. The IRS will usually do a bank deposit analysis and conclude that all non-transfer deposits are gross income. They then leave it to the taxpayer to prove that specific items are not gross income.
Amounts Held in Trust
These rules do not really address amounts received by a taxpayer in trust for a third party. There are court cases that say that amounts held in trust are not gross income for the recipient.
The court notes these general rules:
Funds that a taxpayer holds in trust, which the taxpayer is obliged to spend entirely for a specified purpose with no profit, gain, or other benefit to himself, are not includible in gross income. If a purported trustee has the right to use the funds for his own benefit—even if that right is limited—no trust exists, and the funds are includible in gross income.
The cases the court cites make it clear that an actual trust document is not needed. One can infer a trust from the contracts and course of conduct between the parties.
The prime example is an attorney who maintains a trust account for client funds. The client funds are not gross income for the attorney until they are earned. This typically means that they are not taxable until the attorney performs the service or meets the requirements in their contract and is able to withdraw the funds from the trust account.
The Right to Use the Funds
What exactly is the right to use the funds?
The Canatella v. Comm’r, T.C. Memo. 2017-124 case helps explain this concept. In Canatella, the court considered several payments received by an attorney and deposited into his attorney trust account. The court considered specific deposits to determine whether they were gross income to the attorney. The court concluded that some payments were not gross income and others were. The distinction turned in part on the attorney not keeping client funds segregated and he used the trust account to pay his personal expenses. Thus, the attorney had the right to use the funds as he did not strictly follow the attorney trust fund rules.
The court opinion in the present case does not cite the attorney trust cases. But the taxpayers made an argument that suggests that the facts are the same. They argued that the funds received from their client were deposited into a trust account for the benefit of their client. The court does not go for it:
the record shows that the 3396 account was opened under Phoenix’ name and was not designated as a trust account and that Ronald and Andrew had sole signature authority over it. The check notation states only the general purpose of the payment; it does not impose any limitations on Phoenix’ right to use the money or indicate the creation of a trust. Although Ronald testified that each transaction from the 3396 account was telephonically approved by Ms. Beckman, we find this claim implausible and not credible. Petitioners drew from the 3396 account to pay expenses clearly unrelated to the 13th Street Project, such as the purchase of race car parts and payment of Phoenix’ shop rent, thus demonstrating that Phoenix could and, in fact, did use the funds purportedly held in trust for its own benefit and/or for the benefit of its shareholders. Additionally, despite failing to include the money in the 3396 account in its income, Phoenix nonetheless claimed deductions for expenses paid from that account.
In this case, there was actual use of the funds for the taxpayer’s benefit. Actual use makes it pretty difficult to argue there was no “right” to use the funds personally. A closer case would be where there was no actual use, such as where the taxpayer was a mere conduit holding funds.
All May Not Be Lost
An increase in gross income may not be all that significant. Even a little tax planning can help mitigate the impact.
Even if the funds are found to be gross income, the payments made using the funds would then likely be deductible. The tax deduction could then offset the gross income.
For example, in this case, the taxpayer could either spend the remaining monies to hire contractors or for materials. These expenses would entitle the taxpayer to a deduction. The taxpayer could also refund the amount to the original payor. Then it would be deductible as a “refund or allowance.” The taxpayer can make these transfers in the same year.
If the taxpayer does not make these transfers in the same year, this issue may just be a timing issue. The IRS increases the taxpayer’s gross income in year one and the taxpayer gets a tax deduction in year two. When the amounts are significant, the real issue is penalties and interest in year one.