TAX COURT OPINION

Case: Otto F. & Sayoko Hinckelmann
Docket Number: 29433-09
Judge: Colvin
Opinion Type: bench
Filed: 12/23/2010
Pages: 12

UNITED STATES TAX COURT WASHINGTON, DC 20217 OTTO F. & SAYOKO HINCKELMANN, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent . ) ) ) ) ) ) ) ) ) ORDER Docket No. 29433-09. Pursuant to Rule 152 (b) , Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith the pages of the ' to petitioner and to respondent a copy of transcript of Holmes at San Francisco, California on Monday, December 6, 2010, containing his oral fact and opinion rendered after the conclusion of trial. the above case before Judge Mark V. the trial of findings of In accordance with the oral findings of fact and opinion, a decision will be entered pursuant to rule 155. (Signed) Mark V. Holmes Judge Dated: Washington, D.C. December 23, 2010 SERVED DEC 3 0 2010 3 Bench Opinion by Judge Mark V. Holmes December 6, 2010 Otto F. & Sayoko Hinckelmann v. Commissioner Docket 29433-09 THE COURT: In the case of Otto F. and Sayoko Hinckelmann, 29433-09, the Court has decided to render oral findings of fact and opinion in this case, and the following represents the Court's oral findings of fact and opinion. This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court's Rules of Practice & Procedure. The parties signed a bare-bones stipulation which constitutes the records or constitute, together with testimony in this case, the record on which I make my decision. The Hinckelmanns were California residents when they filed their petition. There were three items that gave rise to this case, all of which were misreported by the Hinckelmanns, in the IRS' s view. In all cases, in all three cases, the question is whether the dividends that were reported by the Hinckelmanns were qualifying dividends under section 1 of the Internal Revenue Code. In the case of the smallest item, $80 in dividends from General Motors Corporation, the well-known government subsidiary, the government has conceded that those dividends were qualifying dividends. The Hinckelmanns clearly win on 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 | Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 4 that one. The second and third categories of investment assets which gave rise to dividends were the Western Asset Money Market Fund and the Smith Barney Cash Portfolio A Series, together with the Wells Fargo Advantage Money Market Fund. As the names suggest in each of these three cases, a quick check of SEC records, as the Court warned that it would do and gave notice th partiesfÝaking judiciald/7 notice of the fact, suggests and indeed proves that these three companies were all investment companies regulated under the Investment Company Act of 1940, which is a fancy lawyerly way of saying that they were mutual funds. There's little doubt about this. What is at issue is how we characterize the Hinckelmanns' receipt of $24,730 in dividend income from those corporations, and more specifically, whether those dividends were qualifying dividends for purposes of the advantageous tax rate on qualified dividends. Now what Mr. Hinckelmann did -- are you Mr. Hinckelmann or Dr. Hinckelmann, by the way? MR. HINCKELMANN: Mister. THE COURT: -- Mr. Hinckelmann did was he did exactly what an intelligent person would do, and he's understandably annoyed at what the IRS did to him, he went to the IRS's own publications. He found in Publication 550, Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 5 which deals with this issue, a list of three criteria for whether dividends are qualified dividends or not. And if you Zook at 550, he's right. These dividends were paid by domestic corporations in all cases, as with most money market funds, these are Delaware corporations and they're certainly organized under the laws of one U.S. state or the other. And the dividends were not of the type listed in Publication 550 as dividends that are not qualified dividends. They weren't capital gains, they weren't from mutual savings banks, they weren't from tax-exempt organizations or ESOPs or payments in lieu of dividends or payments from foreign corporations or the exotic dividends on any share of stock to the extent that you were obligated to make related payments for positions and substantially some other related property, that refers to some exotic short sale opportunities not normally available to individual investors. And he concluded that if none of those things were true of his case, that his dividends must be qualifying dividends, and qualify for the advantageous tax rate. That's what he put on his return, that's what he explained over and over again to the IRS. Now if that was all that he had to do, he'd win this case, he'd be right. The problem, as he discovered, is that the IRS is Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 6 a vast bureaucracy set in motion according to certain rules that are administered by people who don't understand those rules. They can't give you an explanation, because that's not part of their portfolio. They just sort of blindly apply what they blindly apply. And as Mr. Hinckelmann discovered, that's true of the reporting bureaucracy even within the private sector mutual funds. They report what they report and they don't know how to answer questions about that. But let me try, because in the end, I'm not governed in my rulings by what's in the IRS publications, even Publication 550, 'but rather what's in the Internal Revenue Code. And here it's kind of useful, as an exercise for somebody who deals with this every day, to return to the fundamentals, because this is a question that actually raises some fundamental questions. Tax lawyers all kind of know what things are true, but sometimes we have a hard time explaining it through the actual language of the code. We begin with section 1 of the Internal Revenue Code, specifically section 1(h) (11), which talks about dividends that are qualified for purposes of that advantageous tax rate. And if you look at section 1(h) (11) (]B), there follow the three-part test that Mr. Hinckelmann applied in taking the position that his dividends were qualified dividends. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 7 The problem s, with so much of the Internal6 Revenue Code, is that it gets more convoluted. And if you go beyond Publication 550 into the actual language of the code itself, there is section 1(h) (11) (D), called special rules. And specifically 1(h) (11) (:D) (iii), a dividend received from a regulated investment company shall be subject to the limitations prescribed in sections 854 and 857. So the first thing to know is whether the three money market funds that Mr. Hinckelmann was invested in were regulated investment companies. So we can turn to Internal Revenue Code section 851(a) (1) (A), the term 'regulated investment company' means any domestic corporation which at all times during the taxable year is registered under the Investment Company Act of 1940, as amended, as a management company or unit investment trust. And money market funds uniformly qualify under this definition. So we know that the special rule, nowhere referred to in Publication 550, is what I have to look at. And that special rule then refers me from 1(h) (11) over to section 854. 854 talks about qualified dividends received from an investment company as defined by the Investment Company Act of 1940. Now I want to pause here and give a brief general explanation. It might appear clearer on reading than it Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 8 might on hearing, Mr. Hinckelmann. As a general rule, mutual funds are corporations or companies. Some of them are organized as trusts. They aren't taxed like other corporations, however. They're a conduit, rather -- and here I'm out of my field -- like a superconductor that whisk electrons from one end to the other without losing the character of an electron or its origin. In this case, what happens is that a mutual fund is a corporation that receives income from its holdings in other companies that actually are operating companies. It can make money on stock sales, that takes the form of capital gains. As long as those capital gains are distributed every year, they are, even though they are in the form of a dividend, treated as capital gains to the individual shareholders of the mutual fund. Similarly, interest is earned by the corporation, distributed as a dividend, but it doesn't lose its character as interest for taxation reasons. This is grossly oversimplified, but it works,[it'll work well here.¢fff So what we're talking about is a mutual fund which does pay dividends and therefore looks like qualifying dividends because these mutual funds are domestic corporations paying dividends, but we have to look at the specific language of 854(b) to determine whether they are qualified dividends. And here the relevant section is Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 9 854 (b) (1) (B) (i) followed by large roman numerals - (I) , -(II), and -(III). This section is entitled Maximum Rate Under Section 1(h), and it states, 'In any case in which a dividend is received from a regulated investment company, such investment company meets the requirements of section 852(a) and the dividend and the qualified dividend income of such investment company for such taxable year is less than 95 percent of its gross income, then in computing qualified dividend income, there shall be taken into account only that portion of such dividend designated by the regulated inve s tment c ompany . ' Now this again establishes a three-part test, but a different three-part test from what Mr. Hinckelmann applied. First it says the dividends that the Hinckelmanns received from their mutual fund companies, were they dividends received from a regulated investment company. I've satisfied myself through judicial notice of the SEC's website that each of these three portfolios, money market companies, were regulated investment companies under the Investment Company Act of 1940, which then makes them investment companies under section 851 of the Internal Revenue Code. The second part of the test is were such, do such investment companies meet the requirements of section 852 (a) . What that means is when they get dividends or Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 10 interest, do they pass them on to their shareholders. The answer in all these cases is yes. I'll assume it's yes, but because they maintain a constant share price of a dollar, it is almost certainly the case that it is true, and the SEC website again confirms that. Admittedly, this is judicial notice rather than notice in the record. But the most important part is the third part, section 854(b) (1) (B) (i) (III), 'The qualified dividend income of such investment company for such taxable year is less than 95 percent of its gross income.' In other words, I have to know whether the mutual fund company was receiving itself qualified dividends from other companies. That's the phrase 'the qualified dividend income of such investment company for such taxable year.' A mutual fund company is not supposed to receive qualified dividends from other companies, it's supposed to receive in this case interest from other borrowers. And so the mutual find companies that were at issue here were receiving interest from their payors. They were paying dividends to their owners, to the Hinckelmanns. But they were ao receiving qualified dividend income that was less (sic) than 95 percent of its gross income. That means that the Hinckelmanns were entitled to take into account only that portion of such dividends that were designated by the regulated investment company, and Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 11 this is why, under the code, those mutual funds come out with their little boxes which they either leave blank or they fill in numbers. And so what was happening here, which is sort of known intuitively to tax lawyers but sometimes requires a little bit deeper explanation when we think about it, is that the mutual funds involved here that the Hinckelmanns owned were receiving interest, not dividends, from their investments. That interest is what they paid dividends out of. But under section 854(b)(1) (B) (i) (III), they were not receiving qualified dividends from the investments which those investment companies owned, they were receiving interest. That means that under the terms of section 854(b), the Hinckelmanns could take into account as qualified dividends only the portion of the distributions that they received from their mutual funds that were designated as qualifying dividends by the mutual fund. Because it's undisputed here that in each of these three cases, the mutual funds designated precisely zero as qualifying dividends, the Hinckelmanns aren't entitled to take as qualifying dividends the $24,730 that they received as dividends. This is, shall we say, obscure. It's not evident in this, in Publication 550, and it's clearly, as Mr. Hinckelmann discovered, not going to be told to him by Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 12 the revenue agents with whom he was corresponding. It required some digging, actually, and some thought, even on the part of my clerks and myself. So the idea of assessing the negligence penalty against the Hinckelmanns is a joke in this case. He explained everything, he revealed everything, there's no way I'm going to sustain the negligence penalty in this case, or, of course, any penalty at all, & the qualifying dividend income of $80 from General Motors. On the other hand, the government is right, even if obscurely right, that the remaining $24,730 in dividend income was not in fact a qualifying dividend. So this is a split decision; the computations under Rule 155 will be necessary. I will ask the government and the Hinckelmanns to get together and do those within 60 days. Ms. Schauff, what's 60 days from now? THE CLERK: Sixty days is February 4. THE COURT: February 4, and this concludes the Court's oral findings of fact and opinion in this case. I'll issue an order setting that deadline for the Rule 155 computations. A very interesting case, Mr. Hinckelmann, it required me to dig a little bit deeper myself, and you're right about.the publication, they should change it. So thank you very much. Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 MS . HALE : Thank you, Your Honor . THE COURT: We're off the record now. 13 (Whereupon, at 4:34 p.m., the bench opinion in the above-entitled matter was concluded.) // // // // // // // // // // // // // // // // // // // // // Heritage Reporting Corporation (202) 628-4888