Care in Drafting Tax Court Settlements Is Critical
A recent case illustrates what can go wrong when settling a Tax Court case. In Miller Tabak Hirsh & Co. v. Commissioner, 101 F.3d 7 (2d Cir. 11/21/96), a securities partnership was challenged by the IRS with respect to repurchase transactions ("repos") which the partnership entered into in the period 1982-1985. The repos gave rise to interest deductions in the years 1982-1984 and roughly corresponding amounts of interest income in the years 1983-1985. The IRS argued that the transactions were purely tax motivated and both the interest deductions and related interest income should be disallowed. The IRS also proposed to disallow $28 million of stock option ordinary losses from transactions which it also believed were not profit-motivated.
The partnership challenged the IRS by bringing suit in the Tax Court. Months later, at the call of the trial calendar, the parties informed the judge that they had reached a basis of settlement of the case and, thus, trial would be unnecessary. They described the settlement as reducing 1982 interest deductions by $1 million and recharacterizing $2 million of 1983 stock option losses from ordinary to capital. They also submitted to the judge a written statement setting out the settlement terms.
The judge then directed the parties to submit to him within 30 days a stipulated decision document embodying the tax liability which resulted from the settlement. However, the parties could not agree on the tax figures because the partnership believed that it was entitled to eliminate approximately $1 million of interest income from 1983 relating to the disallowed repo interest deductions in 1982.
The IRS contended that the settlement did not include any interest income elimination, although it conceded that if it had litigated the repo issues and won, both the interest expense and interest income would have been eliminated. The IRS argued that the settlement was based on no particular theory, but was simply a settlement of both the repo and stock option issues using agreed upon adjustments.
The Tax Court judge agreed with the partnership that inherent in the concept of the settlement was the elimination of 1983 repo income corresponding to the 1982 repo deductions disallowed. The Court of Appeals for the Second Circuit disagreed with the Tax Court and reversed. It agreed with the IRS' argument that a flat disallowance of $1 million was not an illogical settlement for a case involving many millions of dollars. The basis of settlement announced to the Tax Court was concededly unambiguous. The Second Circuit was unwilling to add terms to the settlement that the parties failed to include.
The lesson to be learned is that when entering into a stipulation of settled issues or announcing a basis of settlement to the Tax Court, a party should be careful to note all terms of the settlement, not merely the principal points.
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