Tax Update Blog: August 2008 Archives

EUGENE A. FISHER, TRUSTEE,
SEYMOUR P. NAGAN IRREVOCABLE TRUST,
Plaintiff,
v.
THE UNITED STATES,
Defendant.

IN THE UNITED STATES COURT OF FEDERAL CLAIMS

(Filed: August 6, 2008)

Trial; Mutual insurance company -- participating policyholders;
Demutualization; Gain on sale of stock received in exchange for
ownership rights; Basis allocation rule -- Treas. Reg. §
1.61-6; "Open transaction" doctrine -- Burnet v. Logan;
Limited exception to Treas. Reg. § 1.61-6 where impossible
or impractical to value property; Pierce, Inaja Land and Warren
construed; Mutual ownership rights found not to be susceptible
of valuation; Expert reports on valuation; "Open transaction"
exception to Treas. Reg. § 1.61-6 applicable;
Refund entitled.

OPINION

Burgess J. W. Raby, Tempe, Arizona, for plaintiff.

Benjamin C. King, Jr., Tax Division, United States Department of Justice, Washington, D.C., with whom was Eileen J. O'Connor, Assistant Attorney General, for defendant.

ALLEGRA, Judge:

Since its infancy, the Federal income tax law has provided that gross income includes gains derived from dealings in property and that such gains generally equal the amount realized less the seller's cost basis in the property sold. Though clear in principle, these rules are not always easily applied -- particularly, where the property sold was first acquired, for a lump sum, as part of a larger assemblage, and, especially, where the values of the individual components of that grouping are not readily ascertainable. For generations, courts faced with the scenario just-described have grappled with two possibilities: to treat the property sold as having little or no cost basis, so that most or all the sale proceeds are taxable, or to treat the property as sharing the cost basis of the entire bundle, such that no gain is realized until all the capital represented by that basis is recovered. These are among the possible outcomes in this tax refund suit, which involves insurance policy rights that were acquired as an indivisible package, but then separated and sold as part of a demutualization of the insurance provider.

I. FINDINGS OF FACT

Trial in this case was conducted in Phoenix, Arizona. Based on the record at trial, including the parties' joint stipulations, the court finds as follows:

Prior to 2000, Sun Life Assurance Company (Sun Life) was a Canadian mutual life insurance and financial services company that conducted business in Canada, the United States and other countries. A mutual insurance company has no shareholders, but instead is owned by its participating policyholders, which possess both ownership rights, such as voting and distribution rights, as well as the more typical contractual insurance rights.1 Their voting rights differ from those possessed by traditional shareholders in that each policyholder has but a single vote, regardless of how many policies it owns or the amounts thereof. Once the mutual company pays its claims and operating expenses, the profits belong to the policyholders. Typically, some of those profits are returned to the policyholders as dividends, which reduce premium payments, while the remainder is retained as surplus, often accumulating from year to year. Payment of such policy dividends is largely at the discretion of the board elected by the participating policyholders. The ultimate goal of this arrangement is to provide insurance at the lowest possible cost.

On June 28, 1990, the Seymour P. Nagan Irrevocable Trust (the Trust) purchased a life insurance policy from Sun Life on Seymour Nagan and Gloria Hagan. The policy was for $500,000, with annual premiums at $19,763.76 per year. Under this "participating policy," plaintiff's ownership rights included the ability --

to vote on matters submitted to participating policy holders . . . to participate in the distribution of profits of Sun Life of Canada from all its businesses, to participate in any distribution of demutualization benefits, and in the unlikely event of a liquidation if Sun Life of Canada were ever to become insolvent, to participate in the distribution of any remaining surplus after satisfaction of all obligations.

Plaintiff's right to receive distribution of profits took the form of an annual dividend representing the amount, if any, of profits not retained in surplus. These ownership rights could not be sold separate from the policy and were terminated when the policy ended.

On January 27, 1998, the Sun Life Board (the Board) requested the insurer's management to develop a plan to convert the company into a publicly-traded stock company through a so-called "demutualization."2 On September 28, 1999, the Board voted to recommend that the policyholders approve the demutualization. It perceived that the conversion would permit the reorganized company to provide stock options to its employees, offer more diversified products and obtain, more readily, capital financing for its businesses, including those unrelated to providing insurance.

On October 29, 1999, Sun Life proposed a plan to its policyholders to demutualize. Under the plan, the policyholders would retain their insurance coverage at premiums that would be unaffected by the demutualization, but would receive shares of stock in a new holding company, Sun Life of Canada Holding Corp. (Financial Services), which would become the corporate parent of Sun Life. Those shares were to be exchanged for the ownership rights possessed by the participating policyholders, with approximately 20 percent of the shares being allocated to compensate for the loss of voting control and the remaining 80 percent of the shares being allocated to compensate for the loss of other ownership rights, including the right to receive a liquidating distribution.3 Under the plan, eligible policyholders -- those that had policies in force as of January 27, 1998 -- did not have to take stock in exchange for their shares. Those in the United States, for example, could elect to sell the shares issued in connection with a planned initial public offering, an option referred to as the "cash election." If the policyholder took this election, it would receive an amount determined "by multiplying the number of Financial Services Shares sold . . . by the Initial Share Price at which the number of Financial Services Shares are sold in connection with the initial public offering." Policyholders were informed as to how many shares they would be issued in a "share allocation statement."

On December 15, 1999, the Board certified that the demutualization plan had been approved by the eligible policyholders. In early March of 2000, Sun Life began its initial public offerings and received various regulatory approvals to proceed with the demutualization.4 On May 19, 2000, in response to a request from the company, the Internal Revenue Service (IRS) issued Private Letter Ruling 200020048, which dealt with various tax aspects of the demutualization. In that ruling, the IRS noted that the aforementioned ownership rights "cannot be obtained by any purchase separate from an insurance contract issued by [Sun Life]." It ruled that, under section 354(a)(1) of the Internal Revenue Code of 1986 (26 U.S.C.) (the Code), "[n]o gain or loss will be recognized by the Eligible Policyholders on the deemed exchange of their Ownership Rights solely for Company stock." It further opined that the "basis of the Company stock deemed received by the Eligible Policyholders in the exchange will be the same as the basis of the Ownership rights surrendered in exchange for such Company Stock," that is, "zero." The IRS did not rule on the tax treatment to be afforded the cash received in lieu of shares exchanged for ownership rights.

When the demutualization took effect, plaintiff received 3,892 shares of Financial Services stock in exchange for its voting and liquidation rights. Opting for the "cash election," plaintiff permitted Sun Life to sell those shares on the open market for $31,759.00. It reported this amount, unreduced by any basis adjustment, on its federal income tax return for 2000 and paid the resulting tax of $5,725.00. On February 11, 2004, plaintiff filed a timely claim seeking a refund of its money, and, upon the denial of that claim, filed the instant suit. On March 14, 2005, plaintiff filed a motion for partial summary judgment; on December 20, 2005, following the completion of discovery, defendant filed a cross-motion for summary judgment. On May 2, 2006, the case was reassigned to the undersigned. After a referral for alternative dispute resolution did not lead to a settlement, the court, on November 15, 2006, denied the pending dispositive motions. It found that the proceeds from the sale of the Financial Services stock could not be deemed a distribution by Sun Life of a policy dividend, or the equivalent thereof, so as to be excluded from gross income as a return of capital under the annuity rules of section 72 of the Code.5 The court then concluded that it could not resolve, as a matter of law, plaintiff's claim that no capital gain was realized on the sale of the Financial Services Stock because the proceeds were offset by plaintiff's basis in the stock, finding that the claim presented material questions of fact that required a trial.

Trial in this case began on June 18, 2007. At trial, the parties' expert witnesses assigned dramatically different values to the basis of the ownership rights. Plaintiff's expert, Eugene Cole, testified that he could not form an opinion as to the fair market value of the ownership rights because he found the ownership rights to be inextricably tied to the policy; in his view, the ownership rights added value to the policy but never had a separate value. Defendant's expert, Mark Penny, determined that the fair market value of the ownership rights was zero. He emphasized that none of the premiums were specifically dedicated to acquiring the ownership rights, that there was no available market for the ownership rights, and that it was highly unlikely, at the time the policy was acquired, that a demutualization would occur. The latter assertion was also made by defendant's expert on the insurance industry, James Reiskytl.

II. DISCUSSION

We begin with common ground. Section 61(a)(3) of the Code provides that gross income includes "[g]ains derived from dealings in property." Section 1001(a) indicates that "[t]he gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain." This "language provides a straightforward test for realization" of income, the Supreme Court has stated, to wit, "to realize a gain or loss in the value of property, the taxpayer must engage in a 'sale or other disposition of [the] property." Cottage Sav. Ass'n v. Comm'r of Internal Revenue, 499 U.S. 554, 559 (1991); see also Phil. Park Amusement Co. v. United States, 126 F. Supp. 184, 187-88 (Ct. Cl. 1954). Section 1011(a) states that "adjusted basis" is the basis determined under section 1012, with adjustments not herein relevant, which the latter section generally sets as "the cost of such property." See United States v. Hill, 506 U.S. 546, 554-55 (1993).

The rules become a bit more complicated when a taxpayer transfers only a portion of an asset previously-acquired. Then, the basis of the latter asset generally must be apportioned between the portions disposed of and retained. Treas. Reg. § 1.61-6(a) provides --

When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part. The sale of each part is treated as a separate transaction and gain or loss shall be computed separately on each part. Thus gain or loss shall be determined at the time of sale of each part and not deferred until the entire property has been disposed of.

Under this regulation, "where property is acquired for a lump sum and interests therein are subsequently disposed of separately, in order to compute the gain or loss from each disposition an allocation or apportionment of the cost or other basis to the several units must be made." Fasken v. Comm'r of Internal Revenue, 71 T.C. 650, 656-57 (1979), acq. 1979-2 C.B. 1; see also Gladden v. Comm'r of Internal Revenue, 262 F.3d 851, 853 (9th Cir. 2001) ("This regulation tells us that when property is acquired in a lump-sum purchase but then divided and sold off in parts, the cost basis of the property should generally be allocated over the several parts.").6 This apportionment is done by dividing the cost basis of the larger property among its components in proportion to their fair market values at the time they were acquired.7

Of course, for this formula to work, one must be able to derive the fair market values of the component parts of the larger property. The regulations presume these values are obtainable, stating that "only in rare and extraordinary cases will property be considered to have no fair market value." Treas. Reg. § 1.1001-1(a); see also Likins-Foster Honolulu Corp. v. Comm'r of Internal Revenue, 840 F.2d 642, 650 (9th Cir. 1988).8 But, what if, despite this regulatory bravado, it proves impractical or impossible to derive the values needed for the basis apportionment formula, at least without engaging in undue speculation? Does that mean that none of the basis of the originally-acquired property is allocable to the part disposed of or that all of it is allocable thereto until exhausted? These questions, of course, beg a deeper inquiry as to how, if at all, Treas. Reg. § 1.61-6 applies in such circumstances -- whether, for example, conditions not immediately apparent, perhaps those lying in the substructure of the income tax, serve to delimit the regulation? The parties vigorously dispute whether this is the case, with defendant arguing that the regulation, by its terms, is controlling, and plaintiff asseverating that the regulation, in the circumstances of this case, is inapposite. Deciding who is correct requires the court to study the evolution of the regulation, particularly with reference to the concepts of income realization and return of capital, as they have metamorphosed over time.

A.

While the earliest Revenue Acts defined income to include "gains from sales or dealings in property," see Revenue Act of 1916, ch. 463, § 2(a), 39 Stat. 756, 757 (1916); Tariff Act of 1913, ch. 16, § II(B), 38 Stat. 114, 167-68 (1913), neither they, nor the supporting Treasury Regulations, provided much guidance on how to calculate such gains. Revenue laws in 1918 and 1921 conditioned the realization of income on the receipt of property with a "fair market value, if any."9 Early regulations interpreted this statutory language as conditioning the occurrence of a taxable event on the receipt of property with a cash equivalency, stating that to "complete or close a transaction from which income may be realized," there must be a "change into the equivalent of cash."10 Shortly after these regulations were promulgated, the Treasury Department, in 1921, issued the progenitor of Treas. Reg. § 1.61-6. That regulation, Treas. Reg. 45, art. 43 (1921), dealt with the subdivision of real estate into lots and provided:

Where a tract of land is purchased with a view to dividing it into lots or parcels of ground to be sold . . . the cost . . . shall be equitably apportioned to the several lots or parcels . . . to the end that any gain derived from the sale of any such lots or parcels which constitute taxable income may be returned as income for the year in which the sale was made. This rule contemplates that there will be a measure of gain or loss on every lot or parcel sold, and not that the capital invested in the entire tract shall be extinguished before any taxable income shall be returned. . . .

See also Treas. Reg, 62, art. 43 (1922); Heiner v. Mellon, 304 U.S. 271, 275 (1938) (citing cases applying the early versions of the regulation).

Other regulations promulgated around this same time took a different tack, however. They recognized that apportioning a basis among assets acquired as a bundle might, in some situations, prove impractical, requiring income recognition to be deferred until the original cost of the whole bundle was recovered. One of these, Treas. Reg. 45, art. 39 (1921), applied to common stock "received as a bonus with the purchase of preferred stock or bonds." It provided, generally, for the apportionment of basis between the various securities purchased, but indicated that "if that should be impracticable in any case, no profit on any subsequent sale of any part of the stock or securities will be realized until out of the proceeds of sales shall have been recovered the total cost." See also Treas. Reg. 62, art. 39 (1922). Similarly, Treas. Reg. 45, art. 1567 (1921), which dealt with the non-taxable exchanges, provided that where a taxpayer received two kinds of property in such an exchange, the cost of the property originally-possessed had to be apportioned among the new properties. Id. But, "[i]f no fair apportionment is practicable," the regulation continued, "no profit on any subsequent sale of any part of the property received in exchange is realized until out of the proceeds of sale shall have been recovered the entire cost of the original property." Id.; see also Treas. Reg. 62, art. 1567 (1922); Green v. Comm'r of Internal Revenue, 33 B.T.A. 824, 828 (1935) (discussing the evolution of this regulation).

The use of "cash equivalency" principles to govern the realization of income soon proved unworkable. See 64 Cong. Rec. 2851 (1923) (stmt. of Rep. Green); Hearings Before the S. Finance Comm., 67th Cong. 199 (1921) (stmt. of Dr. T.S. Adams, Tax Advisor, Treas. Dept.). This led Congress, in 1924, largely to abandon these principles in favor of enacting the predecessor of section 1001(a) of the Code and, with it, the concept of "amount realized" -- defined, as it is today, to include the fair market value of property other than money or money equivalents received in a transaction. See Revenue Act of 1924, Pub. L. No. 68-176, § 202(c), 43 Stat. 253, 255 (1924); see also Campbell v. United States, 661 F.2d 209, 216 (Ct. Cl. 1981); Warren Jones Co. v. Comm'r of Internal Revenue, 524 F.2d 788, 791-92 (9th Cir. 1975). The accompanying Committee Reports criticized prior law as being "so indefinite that it can not be applied with accuracy, nor consistency," H.R. Rep. No. 68-179, at 13 (1924), reprinted in J.S. Seidman, Legislative History Of Federal Income Tax Laws 1938-1861, at 686 (1938), leading to "[g]reat difficulty . . . in administering" the law, S. Rep. No. 68-398, at 13-14 (1924), reprinted in Seidman, supra, at 686-87. See also Kwall, supra, at 994. The implication was clear -- Congress desired more certainty in determining the timing and amount of the gains realized upon sales or exchanges. See Bradley T. Borden, "Reverse Like-Kind Exchanges: A Principled Approach," 20 Va. Tax Rev. 659, 665-66 (2001).

Into this evolving legal environment was born the so-called "open transaction" doctrine, an accouchement traced to Burnet v. Logan, 283 U.S. 404 (1931). In that case, Mrs. Logan sold stock of a closely-held corporation which assets included stock in a second corporation that owned a mine lease. Id. at 409. She and the other shareholders, which included her mother, exchanged the stock for cash and a stream of annual payments corresponding to the amount of iron ore extracted from the mine. The IRS argued that, at the time of the sale, the right to receive the mining royalties could be estimated based upon the amount of reserves at the mine and that the transaction should be taxed based upon the value of that estimate. Id. at 412.11 The Supreme Court demurred, holding that Mrs. Logan was entitled to recoup her capital investment in the stock before paying income tax based on the supposed market value of the mineral payments. It reasoned:

As annual payments on account of extracted ore come in, they can be readily apportioned first as return of capital and later as profit. The liability for income tax ultimately can be fairly determined without resort to mere estimates, assumptions, and speculations. When the profit, if any, is actually realized, the taxpayer will be required to respond. The consideration for the sale was $2,200,000 in cash and the promise of future money payments wholly contingent upon facts and circumstances not possible to foretell with anything like fair certainty. The promise was in no proper sense equivalent to cash. It had no ascertainable fair market value. The transaction was not a closed one. . . . She properly demanded the return of her capital investment before assessment of any taxable profit based on conjecture.

Id. Notably, Mrs. Logan's mother owned stock in the same company and sold it on the same terms. She, however, died and her payments under the same sales agreement were valued for estate tax purposes. Id. at 413-14.12 The Supreme Court, however, summarily dismissed the notion that the valuation of the payment stream for estate tax purposes should be used for income tax purposes, stating "[s]ome valuation -- speculative or otherwise -- was necessary in order to close the estate. It may never yield as much, it may yield more." Id.; see also 1 Mertens Law of Fed. Income Tax'n § 5:15 (2008).

As viewed by the Logan Court, then, the income tax law did not resolve every doubt in favor of taxation -- irreducible values could exist in that world, with the effect of postponing the recognition of income. In the years that followed, the predecessor regulations to Treas. Reg. § 1.61-6 and the "open transaction" doctrine developed like a pavane -- intertwined in theory, but rarely touching in the decisional law. A dozen years after Logan, in Pierce v. United States, 49 F. Supp. 324 (Ct. Cl. 1943), it was not the taxpayer, but the United States, that claimed that a transaction was still open. In that case, the First National Bank of the City of New York, in order to give its stockholders the benefits of investments in securities that could not then be lawfully held by a bank, organized a separate company, First Security Company, to invest in such securities. Each of the certificates of stock in the bank was endorsed with a statement that the stockholder had an interest in the dividends or profits, and, in case of dissolution, in the distribution of capital of the Security Company, ratable with its interest in the bank. Id. at 329. Via this arrangement, the shareholders also had limited control over the Security Company, albeit control exercised through the votes of the holders of two-thirds of the bank stock. Neither the bank stock by itself, nor the interest represented by the endorsement, could be transferred separately from the other. Between 1928 and 1932, the plaintiffs' testator bought thirty-five shares of the bank stock with the endorsements. The Banking Act of 1933, however, banned the securities arrangement used by the bank, causing the Security Company to be dissolved; transferable interests in the proceeds of the dissolution were issued to the bank stockholders and the endorsements were removed from the stockholders' certificates of bank stock. The plaintiffs' testator received his interest in the proceeds of the dissolution on December 6, 1933, and promptly sold them on January 29, 1934, allegedly at a loss, on account of which they sought a refund of income taxes.

The United States contended that --

the sale by plaintiffs' testator of the declarations of interest in the dissolution of the Security Company may not be treated separately as showing a loss, since his interest in the Security Company was acquired in combination with his stock in the bank, and the answer to the question whether a loss or profit resulted from the transaction cannot be had until the bank stock is sold, so that it may be known how much the combined investment has sold for.

Id. at 330. While conceding that "in some instances apportionment of the amount of a single purchase price to several items purchased for that single total price may be had," defendant asseverated that the situation presented was "not a proper case for such an apportionment, since it would not be practicable here." Id. The court took the latter contention to mean that "no particular value could be assigned to the interest in the Security Company represented by the indorsement on the bank stock, as of the date of the purchase of the bank stock, with any degree of assurance that that assignment of value was correct, or even approximately so," requiring the "answer to the question of profit or loss" to wait "till the bank stock is sold." Id. Readily agreeing with this proposition, the court reasoned that "an attempt here to attribute a certain value to the interests in the Security Company acquired by plaintiffs' testator involves us largely in guess-work." Id. Rejecting plaintiffs' attempt to value the endorsement, the court found that "we do not think that the situation calls for such a rough estimate, when by patience the exact answer may be obtained." Id.13 The upshot, the court concluded, was that "the Commissioner acted within his powers in refusing to permit the deduction." Id.

The focus of our inquiry next shifts to Inaja Land Co., Ltd. v. Comm'r of Internal Revenue, 9 T.C. 727 (1947), acq. 1948-1 C.B. 2, an "open transaction" case much debated by the parties here. There, the taxpayer owned about 1,200 acres of land on the banks of a river that it had purchased for $61,000. The land was used for fishing and for grazing. In 1934, the City of Los Angeles began altering the flow of the water in the river; ultimately it paid the taxpayer $50,000 for a perpetual easement to allow water to flow over the land toward the city. A tax dispute arose over the treatment of this money. The Tax Court found that the amount received constituted proceeds from the disposition of an interest in real property, that is, the easement. It concluded, however, that it would be wholly impracticable and impossible to apportion a cost basis to the easement involved because the easement could not be described by metes and bounds as the flow of water was likely to change over time and was not predictable. Id. at 735. Citing Logan, the Tax Court reasoned that "[a]pportionment with reasonable accuracy of the amount received not being possible, and this amount being less than petitioner's cost basis for the property, it can not be determined that petitioner has, in fact, realized gain in any amount." 9 T.C. at 736. It concluded that "[a]pplying the rule . . ., no portion of the payment in question should be considered as income, but the full amount must be treated as a return of capital and applied in reduction of petitioner's cost basis." Id.

In Pierce and Inaja Land, then, the courts made short shrift of basis allocations that lacked a rational foundation. The First Circuit would reach the same result in Warren v. Comm'r of Internal Revenue, 193 F.2d 996 (1st Cir. 1952), another case involving hybrid securities. There, the taxpayer purchased preferred stock of a business trust and received, as an endorsement on the stock, a guaranty of the payment of a liquidating dividend. Upon the liquidation of the trust in 1939, the taxpayer exchanged his shares of stock for cash and a claim, evidenced by certificates, against the guarantor of the liquidating dividend. The Commissioner asserted that the latter certificates had a minimal basis and that considerable income was generated when they were sold in 1944. Id. at 999. The Tax Court agreed -- but, the First Circuit did not. Citing the regulations that would become Treas. Reg. § 1.61-6,14 the latter court stated that "[n]ormally when a taxpayer acquires an aggregate of assets for a single purchase price, on subsequent sale of any portion he must allocate a part of the price he originally paid to the portion being sold on the basis of its proportionate value at the time of purchase so that gain or loss on the partial sale can be determined. Id. at 1001. But, "[i]n some situations," the court noted, "where at the time of the acquisition of the aggregation there was no separate market for the different parts of the aggregate, rational apportionment of the purchase price between the several elements purchased cannot be made." Id. Recognizing that this principle derived from the bonus stock regulation which did not apply, by its terms, to the situation presented, the court, nonetheless, observed that "if the regulation enunciates a sound rule, as unquestionably it does, a similar principle ought to govern analogous situations where the price paid for a bundle of assets cannot be allocated among them on a rational basis." Id. Remanding the case to the Tax Court, the First Circuit concluded that if "[i]t is wholly impracticable to make such an allocation of the purchase price, proper tax treatment would be to treat the cash disbursement upon liquidation in 1939 as a return of capital going to reduced basis, and to recognize no loss until the last part of the package, the guaranty, was sold in 1944." Id.15

While all these cases were percolating through the system, the Treasury Department periodically reissued the regulations dealing with the sale of real property in lots and bonus stock. These iterations, however, were triggered by the passage of new revenue acts and reflected nothing new by way of substance. See Treas. Reg. 118, § 39.22(a)-8 (1953) (bonus stock); id. at § 39.22(a)-11 (sale of real property in lots); Treas. Reg. 111, § 29.22(a)-8 (1943) (bonus stock); id. at § 29.22(a)-11 (sale of real property in lots); Treas. Reg. 103, § 19.22(a)-8 (1940) (bonus stock); id. at § 19.22(a)-11 (sale of real property in lots); Treas. Reg. 94, art. 22(a)-8 (1936) (bonus stock); id. at art. 22(a)-11 (sale of real property in lots); Treas. Reg. 86, art. 22(a)-8 (1935) (bonus stock); id. at art. 22(a)-11 (sale of real property in lots).16 During the later 1940s and early 1950s, the Commissioner sometimes saw fit to argue that the apportionment principles reflected in the regulation dealing with real property lots ought to apply, by analogy, to other forms of real and personal property -- with varying levels of success. See, e.g., Comm'r of Internal Revenue v. Cedar Park Cemetery Ass'n, 183 F.2d 553, 557 (7th Cir. 1950); Atwell v. Comm'r of Internal Revenue, 17 T.C. 1374, 1379-80 (1952); W.D. Haden v. Comm'r of Internal Revenue, 5 T.C.M. (CCH) 250 (1946). In an apparent effort to lessen the need to make such extending analogies, the Treasury Department, in 1957, promulgated Treas. Reg. § 1.61-6 -- patterned after the provision previously applied to real property lots, but applicable now to most forms of property. See Computation of Taxable Income, 22 Fed. Reg. 9419, 9422 (Nov. 26, 1957).

Nevertheless, even after this new and broader regulation was promulgated, both taxpayers and the Commissioner continued to invoke the "open transaction" doctrine -- and, at times, did so successfully. Sometimes, as in Logan, the doctrine was pressed by taxpayers claiming that no gain should be realized upon the sale of a portion of a given property until the basis of the entire original property acquired was recovered.17 In other instances, defendant invoked the doctrine in seeking either to: (i) postpone income to years in which the statute of limitations on assessments was still open; or (ii) argue that no loss should be deducted upon the sale or exchange of a portion of a property until all the interests comprising the property have been sold or exchanged.18 So things remained until the scope of the "open transaction" doctrine was tapered by the passage of several amendments to the Code. Principal among these was section 453, enacted by the Installment Sales Revision Act of 1980, Pub. L. No. 96-471, 94 Stat. 2247, which provided a new method of reporting gains on an installment basis, to be applied, unless the taxpayer elects out. See 26 U.S.C. § 453(d). Yet, the legislative history of this section confirms that Congress envisioned that the "open transaction" doctrine would still be available, albeit, to use the words in one report, in "rare and extraordinary" circumstances.19 And it bears noting that none of these statutes directly addressed the impact of the doctrine on basis allocations -- the form of the doctrine pertinent here. Accordingly, while these statutes undoubtedly narrowed the scope of the doctrine,20 they did not defenestrate it -- the doctrine survives, albeit in more limited form, but with its basic rationale unscathed, leaving the courts to apply it as appropriate. See Gladden v. Comm'r of Internal Revenue, 262 F.3d 851, 855 (9th Cir. 2001) (recognizing the continuing viability of the doctrine); Davis, 210 F.3d at 1348 (same).21

B.

So what can we deduce from this tour d'horizon? One lesson taught, pure and simple, is that the "open transaction" doctrine first enunciated in Logan -- and the appurtenant method for recovering basis -- has long constituted an exception to the general rule requiring, upon the disposition of a portion of an asset, an allocation of basis. The regulation and the doctrine have coexisted for decades, and, despite defendant's claims, they continue to do so. Certainly, the notion, advanced by defendant, that the "open transaction" doctrine met its demise with the promulgation of Treas. Reg. § 1.61-6 in 1957 cannot be squared with the many decisions that have applied the doctrine since. Nor, incidentally, can it be reconciled with the IRS' own rulings. Thus, in Rev. Rul. 77-414, 1977-2 C.B. 299, the IRS described the general requirements of Treas. Reg. § 1.61-6, but then caveated that "when it is impractical or impossible to determine the cost or other basis of the portion of the property sold, the amount realized on such sales should be applied to reduce the basis of the entire property and only the excess over the basis of the entire property is recognized as gain."22 Indeed, over the last half century, defendant has periodically trotted the doctrine out in seeking to disallow deductions, arguing, as it did for decades prior, that the transactions upon which these deductions were predicated were not closed. See, e.g., Smith v. Comm'r of Internal Revenue, 78 T.C. 350, 377-78 (1982); Hutton v. Comm'r of Internal Revenue, 35 T.C.M. (CCH) 16 (1976); Grudberg v. Comm'r of Internal Revenue, 34 T.C.M. (CCH) 669 (1975). Accordingly, the court sees no reason to hesitate in concluding that the "open transaction" doctrine endures as a viable, albeit limited, exception to the general rule enunciated in Treas. Reg. § 1.61-6.

It remains to trace, more precisely, the contours of this exception -- a task complicated by the fact that the "open transaction" doctrine has "flowered into various rather disparate branches." Lykken, 42 Okla. L. Rev. at 581; see also Mertens, supra, at § 5:15; Bittker & Lokken, supra, at ¶ 41.6.1. Some decisions that rely on Logan premise "open transaction" treatment on contingencies that impact the value of the compensation received and focus on what amount, if any, should be realized in the year of the sale. The debate in these cases is over income realization. Other cases premise "open transaction" treatment on the inability to separate out the values corresponding to the portions of a previously-acquired asset being sold or retained, and focus on what amount, if any, should be viewed as the basis of the portion sold. The debate in these cases -- as here -- is on return of capital. Encompassed within this latter category are not only cases in which it is simply impractical or impossible to determine the value of a component of a larger whole, but also, as is illustrated by Pierce, a particular species in which the doctrine was triggered because the part disposed of was, when first acquired, inseparable or indivisible from the part retained. Nonetheless, despite the variety of scions that have been engrafted onto the stock of Logan, it bears repeating that the "open transaction" exception is still limited, "confined in its application to those situations that present elements of value so speculative in character as to prohibit any reasonably based projection of worth." Campbell, 661 F.2d at 215; see also Treas. Reg. § 1.1001-1(a).

C.

We return, at last, to the facts. The experts in this case had markedly divergent views not only as to the value of the ownership rights that were transferred under the demutualization, but even as to whether those rights were susceptible of valuation. Plaintiff's valuation expert, Mr. Cole opined that traditional methods could not be used to value the "ownership rights" associated with the policy because those rights were neither separable nor alienable. While convinced these rights added to the value of the policy, he concluded that, prior to the demutualization of Sun Life, their fair market value, separate from the policy itself, was "not determinable." One of defendant's experts, Mr. Reiskytl, previously worked at a mutual insurance company. He confirmed many of the premises underlying Mr. Cole's opinion. Contrasting the ownership rights of mutual policyholders to those of traditional shareholders, Mr. Reiskytl observed that "[u]nlike shareholder ownership rights that are separate from the contractual rights of the insurance policy, the mutual policyholder's ownership rights are inextricably tied to the underlying insurance contract." (Emphasis in original). He further noted that the policyholder ownership rights could not be "separately purchased, transferred or sold." and that "[t]here is no separately determinable or identifiable price for these ownership rights at the time of purchase of an insurance policy." Yet, in a somewhat self-contradictory fashion, Mr. Reiskytl proceeded to set a value for these rights, specifically concluding, based upon various factors, that they had "no" value.23 Defendant's other expert, Mr. Penny, also recognized that "the subject ownership rights could not be purchased nor [sic] sold separate from the purchase of an insurance policy." But, he essentially turned a blind eye to this fact in concluding that the value of the ownership rights was "best stated at zero during the 1990 calendar year." To derive this value, Mr. Penny purportedly used cost-and market-based approaches to valuation, based on his view of the cost of replacing asset and its market value, respectively.24 Yet, he did so, conspicuously, without considering any comparable properties, serving to highlight the fact that there were neither such comparables, nor, for that matter, any market in which the ownership rights or some derivative could be sold.

All the experts subscribed to the same, basic definition of "fair market value" -- essentially, the "price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or to sell and both having reasonable knowledge of the relevant facts." United States v. Cartwright, 411 U.S. 546, 551 (1973) (citing Treas. Reg. § 20. 2031-1(b)); see also Campbell, 661 F.2d at 221; Union Pacific R. Co., Inc. v. United States, 524 F.2d 1343, 1383 (Ct. Cl. 1975); Treas. Reg. § 1.170A-1(c)(2). Yet, in applying that definition, Mr. Cole believed that the circumstances prevented him from determining a value for the ownership rights, while Mr. Penny saw some of the same circumstances as reasons for setting that value at zero. So what caused those differences? It would appear that the experts parted company in deciding whether the nature of the ownership rights made them "impossible or impractical" to value or simply valueless. And that disagreement, in turn, undoubtedly stemmed from unstated differences as to what is meant by the phrase "impossible or impractical" -- a phrase that, despite dozens of "open transaction" cases, has received little in the way of direct definition. That the phrase "impossible or impractical" has largely been left undefined almost undoubtedly derives from the fact that most "open transaction" cases are heavily fact-driven. Nonetheless, a synthesis of the decisional law yields several factors that have proven pivotal in deciding whether a rational basis exists for determining fair market value.

The first of these focuses on the marketability of the asset -- both in terms of whether it is separately sellable or alienable and, if so, whether an established or private market exists in which to effectuate that sale. Several cases, among them the decisions in Pierce and Warren, have relied on the fact that an asset is not separately sellable to indicate that it lacks an ascertainable market value, particularly where that inalienability is inherent in the asset itself and not superimposed as a contractual limitation. See Pierce, 49 F. Supp. at 330; Warren, 193 F.2d at 1001.25 Likewise, courts frequently highlight the absence of any market in which to sell assets of the type at issue as suggesting that the targeted asset is not susceptible to valuation.26 A second factor focuses on whether there are any proxies that may be used to estimate the needed value -- for example, recent sales or exchanges of assets comparable to the one being valued. Because having such comparables is essential to using the comparable sales or market approach to valuation,27 the absence thereof not only deprives these methods of any utility, but also provides further indication that the value of the asset cannot rationally be ascertained. See Estate of Wiggins, 72 T.C. at 712. In similar vein, valuation methods that depend upon some bartering or exchange convention -- that the value of an item received in an arms-length transaction is equal to the value of the item given up28 -- are also unavailing if the taxpayer, via the barter, acquired a group of items of which the object to be valued is only part. Finally, an asset is more likely to be deemed insusceptible of valuation if its value is "contingent upon facts and circumstances not possible to foretell with anything like fair certainty." Logan, 283 U.S. at 413. Contingencies whose impact cannot be reasonably estimated, in particular, frustrate the use of methodologies that derive the value of an asset based upon the present value of an income stream, e.g., the income capitalization or discounted cash flow approaches.29 While not all contingencies prevent such present value calculations, it remains that "open transaction" treatment has been applied in "those situations that present elements of value so speculative in character as to prohibit any reasonably based projection of worth." Campbell, 661 F.2d at 215.30

Logic and experience suggest that the presence vel non of the above factors ought to be reflected in the ability (or inability) of an expert to value an asset reliably using accepted valuation methods. See McCormac, 424 F.2d at 620. The latter methods, of course, are not intended to produce results with talismanic precision, for it is well-accepted that fair market value is "incapable of mathematical precision and implicates methods of judgment." United States v. 1,378 Acres of Land, More or Less, Situate in Vernon County, State of Miss., 794 F.2d 1313, 1318-19 (8th Cir. 1986).31 Yet, empirically-speaking, if an expert lacks any rational basis upon which to value an asset, that ought to be strong indication that the asset is insusceptible of valuation. The burden of demonstrating this, of course, lies squarely upon the one invoking the exception -- here the plaintiff -- which must show that there was not "enough hard information in place from which willing buyers and willing sellers could construct soundly based equations of value." Campbell, 661 F.2d at 215; see also Bernice Patton Testament Trust, 2001 WL 429809, at * 2; Rosenberg v. United States, 3 Cl. Ct. 432, 437 (1983) (P. Miller, J.). Ultimately, it falls to the court to consider the record evidence bearing on the factors listed above, with particular focus given the expert opinions provided, and to determine, as a factual matter, whether plaintiff has proven that a rational basis for establishing the value of the asset in question is lacking.32

D.

With this background, and after carefully weighing the evidence, the court finds that this case presents one of the "rare and extraordinary" situations in which the "open transaction" exception to Treas. Reg. § 1.61-6 should apply. Of the experts who testified, the court is persuaded that Mr. Cole most accurately considered the realities of the circumstances presented here and the limitations on valuation inherent therein. In particular, he focused on the fact that the ownership rights were, at the outset, inextricably tied to the underlying insurance policy and were not separately sellable. Both he and, to a certain extent, Mr. Reiskytl, viewed this fact as an important indication that the ownership rights lacked a determinable fair market value at the time the policy in question was first acquired. Mr. Penny also, of course, was aware of this fact, but he concluded -- wrongly, in the court's estimation -- that the presence of the limitation meant that the value of the ownership rights was "best set at zero." That conclusion is not only contradicted by many of the "open transaction" cases discussed above, but also clashes with the Supreme Court's observations in Helvering v. Tex-Penn Co., 300 U.S. 481 (1937), a case in which the taxpayers, in a corporate reorganizations, received stock that was restricted against sale for a defined period. The Court there held that "the shares of . . . stock, regard being had to their highly speculative quality and to the terms of a restrictive agreement making a sale thereof impossible, did not have a fair market value, capable of being ascertained with reasonable certainty, when they were acquired by the taxpayers." Id. at 499; see also State Street Trust Co., 124 F.2d 948, 951 (restricted stock with speculative value had no fair market value); Mailloux v. Comm'r of Internal Revenue, 320 F.2d 60, 62 (5th Cir. 1963). Unless the Code specifies otherwise,33 an appraiser must take an asset as he finds it -- the definition of "fair market value" anticipates a "hypothetical" sale not a "hypothetical" asset and does not permit an expert the expediency of squaring a circle that, indeed, is round. Here, one of the critical features that could not be ignored was the fact the ownership rights were indivisible from the insurance policy.

Notably, Mr. Penny readily admitted that there was neither a market upon which to gauge the value of the ownership rights nor any assets that could be deemed comparable to those rights, so as to allow for accurate application of the market method of valuation. Rather, he, and to a lesser extent, Mr. Reiskytl, set the value of the ownership rights at zero because Sun Life had not incurred any costs in establishing those rights -- that is, because prior to the demutualization, Sun Life had neither associated any cost with the ownership rights on its books nor accounted for the rights in pricing its policies. But, it is hard to see how either fact is relevant, let alone dispositive here. There is, to be sure, a cost replacement method for appraising the value of an asset -- but that method does not establish value based upon the historical costs incurred by the seller with respect to an asset, but rather relies on the cost to the purchaser of replacing or reproducing the asset.34 Indeed, various courts have rejected claims that an asset has a value of zero because the entity or individual creating it did not associate specific past costs or future liabilities with that asset. For example, in Piper, supra, the Tax Court considered common stock subscription warrants that were acquired by the taxpayer with other stock as part of a reorganization and later sold. The Tax Court viewed the fact that the corporation had not allocated any costs to the warrants as evidence that the warrants were insusceptible of valuation, noting that "[t]hey were not reflected in the capital account of the corporation and did not represent an absolute equitable ownership therein." 5 T.C. at 1110.35 This result is consistent with cases suggesting that "open transaction" principles apply where costs are not identifiable to a particular asset, but instead represent investment in the business as a whole -- indeed, that argument has been made by the IRS itself in seeking to disallow deductions. See, e.g., Capital Blue Cross v. Comm'r of Internal Revenue, 431 F.3d 117, 125-27 (3d Cir. 2005); see also Drybrough v. Comm'r of Internal Revenue, 45 T.C. 424, 434-35 (1966); Mertens, supra at § 5:16. It would seem, then, that the fact that no specific costs were allocated by Sun Life to the ownership rights merely reflects that those rights related to values associated with the business as a whole -- the rights to vote for the entire board, to receive proceeds from the company's liquidation and to receive distributions in the case of a demutualization. That no more specific accounting of these rights is available does not support defendant's case, but rather is further indication that the rights are not susceptible to valuation.36

Contrary to defendant's experts, that the future financial benefits associated with the ownership rights here were speculative does not mean that those rights should be valued at zero. If that were true then virtually all of the "open transaction" cases, beginning with Logan itself, should have been decided differently. Indeed, one of the reasons why the Supreme Court held that Mrs. Logan was not required to recognize gain was because "the promise of future money payments [was] wholly contingent upon facts and circumstances not possible to foretell with anything like fair certainty." Logan, 283 U.S. at 413; see also Campbell, 661 F.2d at 215. At all events, many of the economic assumptions made by defendant's experts in diminishing the value of the ownership rights to zero do not withstand scrutiny. Those experts, for example, ascribed no value to the voting rights associated with the policies, even though those rights allowed the participating policyholders to elect the Board, which, in turn, established the policies under which dividends were paid and initiated the demutualization process. Also part and parcel of the opinions expressed by those same experts was the illogical view that no value should be ascribed to the demutualization or liquidation distribution rights -- even though those rights entitled the policyholders to share potentially in a surplus that during the period in question exceeded $5.7 billion (Canadian). The notion, moreover, that any distribution of the value of the company could not have been anticipated here because demutualizations such as that conducted by Sun Life were unprecedented -- a view unhesitatingly offered by both of defendant's experts -- is flatly contradicted by Sun Life's own plan of demutualization. An actuarial report, dated September 28, 1999, that was attached to the plan of demutualization thus stated that "[i]n the last ten years, there have been several demutualizations in the U.S.A., the U.K. Australia, and, most recently, South Africa," adding that "they are precedents." Other sources also indicate that such demutualizations were commonplace by the time the policy in question was purchased.37 In short, the evidence supports plaintiff's claim that the ownership rights did have value, albeit one that was not derivable.38

If nothing else, these facts are antithetical to the claim that the stock distributions made with respect to the ownership rights were a "windfall." Defendant's repeated and pejorative use of that term seemingly proceeds from the notion that, as in Orphic hymns, the value associated with the ownership rights here sprung from the aether, somehow sparked by the demutualization itself. As characterized by Mr. Scanlon, one of defendant's witnesses, these rights were "embedded values" that were not "monetized" until the demutualization occurred. But, if there is any meaningful distinction to be made between "embedded values" that were not previously "monetized" and ownership rights that were "impossible or impractical" to value at the time they were first acquired, it is almost certainly one without a difference.39 Nor is there the slightest support for the suggestion, again made by one of defendant's witnesses, that the allocation of stock here was a "windfall" because it was mandated by Canadian and state regulatory agencies. A silent premise in this argument, of course, is that those agencies acted arbitrarily or at least with considerable largesse in requiring compensation to be paid for the loss of ownership rights that -- in defendant's view -- were valueless. But, the court is no more inclined to believe this charge, sans any shred of evidence to support it, than it would be to ascribe similar conduct to Congress and Federal agencies. Without any evidence to the contrary, the more logical conclusion is that such agencies, and the legislatures that empowered them, sincerely believed that the ownership rights had value and that the policyholders were entitled to be compensated for their loss.40 The "windfall" tag, therefore, lacks evidentiary adhesive and does not stick.

At all events, the assertion that the ownership rights here ever had a "zero" value is thoroughly rebuffed by the actuarial study provided by Sun Life to its policyholders with the plan for demutualization. That study focused on whether the stock to be provided in the demutualization adequately compensated those policyholders for the ownership rights that were being relinquished. It recognized, as a first principle, that the stock allocation "should fairly compensate for what policyholders lose in the demutualization; namely, voting control of the insurance company and the right to share in the insurance company's residual value if it is wound up." It noted that the demutualization plan "provided for a fixed allocation of 75 Financial Service Shares to each Eligible Policyholder, regardless of the number of policies held, and for a variable allocation to each Eligible Policy of a number of Financial Services Shares which depends on its Cash Value, the number of years it has been in force and its annual premium." The study stated that it --

regarded the fix allocation as compensation for loss of voting control and the variable allocation as compensation for loss of the right to share in residual value. It is appropriate that the fixed allocation be the same to each Eligible Policyholder, since each has one vote and all the votes should be treated as equal. It is appropriate that the variable allocation differ among Eligible Policyholders because they have different customer attachments to, different financial interest in, and different rights to receive surplus distributions from, Sun Life of Canada.

In concluding that the compensation for the lost ownership rights was "fair," "equitable," and "appropriate," the report cited several other facts that suggest that the ownership rights had value prior to the demutualization, including that: (i) value comparable to that being offered in the Sun Life demutualization had been allocated to voting rights in other prior demutualizations; (ii) the loss of voting control could indirectly impact policy dividends, the payment of which was "largely at the discretion of [Sun Life's] board of directors; and (iii) the "primary historical sources of surplus" for Sun Life had been its "individual participating policies." Finally, and importantly, the report recognized that the distribution of stock was a "zero-sum game," that is to say, that certain policyholders would be harmed if the plan struck the wrong balance between the value of the voting rights and the residual rights. Of course, there would be no such harm -- and, concomitantly, no need to strike such a careful balance -- if either right properly were characterized as a "windfall."41

In sum, based on the record, the court simply cannot credit defendant's "zero" valuation of the ownership rights. The opinions of its experts, "like any other judgment . . . can be no better than the soundness of the reasons that stand in support of them." Fehrs v. United States, 620 F.2d 255, 265 (Ct. Cl. 1980); Campbell, 661 F.2d at 222. And, the court finds that the premises upon which these opinions were based were faulty and contrary to the facts.42 The record here instead supports the opinion rendered by plaintiff's valuation expert that the value of the ownership rights was not discernible, leading the court to conclude that plaintiff has borne its burden of proof in this case. That the facts in this case parallel strikingly those in several "open transaction" cases involving stock and other forms of securities, among them Pierce (which remains binding precedent in this circuit) and Warren, serves only to confirm that this is an appropriate situation in which to apply the "open transaction" exception to Treas. Reg. § 1.61-6. That being the case, and the amount received by plaintiff being less than its cost basis in the insurance policy as a whole, the court finds that plaintiff, in fact, did not realize any income on the sale of the stock in question and, therefore, is entitled to the requested refund.

III. CONCLUSION

The court need go no further. Some might see this case as a revivification of the "open transaction" doctrine. It is not. It represents, rather, an unusual and unique result -- one based on long-standing, though not often-invoked, legal principles, to be sure, but ultimately driven by relatively unique facts. Be that as it may, the court finds that plaintiff has met its burden and is entitled to the refund requested. The Clerk will enter judgment for plaintiff in the amount of

IT IS SO ORDERED.

Francis M. Allegra
Judge

FOOTNOTES

1 Mutual insurance companies have a long provenance in this country, with one of the first established by Benjamin Franklin. See generally, Gregory N. Racz, "No Longer Your Piece of the Rock: The Silent Reorganization of Mutual Life Insurance Firms," 73 N.Y.U. L. Rev. 999 (1998); Edward X. Clinton, "The Rights of Policyholders in an Insurance Demutualization," 41 Drake L. Rev. 657 (1992) (hereinafter "Clinton").

2 As an alternative to the demutualization, the Board considered paying policyholders a greater percentage of the company's then-existing surplus. As of June 1999, that surplus amounted to approximately $5.7 billion (Canadian).

3 The plan provided for a fixed allocation of seventy-five Financial Services shares for the loss of voting control. A "time-weighted" variable allocation of shares was provided in exchange for the policyholders' rights to receive surplus distributions. This variable allocation was determined under a formula that considered the cash value of the policy or policies held, the number of years the policy or policies had been in force, and the annual premiums.

4 The cash surrender value of plaintiff's policy as of this time was $185,172.79. Total policy premiums paid through this time were $194,343.64.

5 Section 72 of the Code provides rules governing the reporting of income corresponding to annuities received under annuity, endowment or life insurance contracts. Section 72(e)(2) excludes from gross income certain amounts not received as annuities, among them "any amount received which is in the nature of a dividend or similar distribution," as defined in section 72(e)(1)(B). In its November 15, 2006, opinion, the court held that the amounts received by plaintiff did not qualify for exclusion under these provisions, finding that plaintiff "received those proceeds upon an entirely unrelated sale of the stock it received in the demutualization." In its post-trial brief, plaintiff asks the court to reconsider this ruling. The court sees no basis for doing so.

6 The regulation offers the following example:

B purchases for $25,000 property consisting of a used car lot and adjoining filling station. At the time, the fair market value of the filling station is $15,000 and the fair market value of the used car lot is $10,000. Five years later B sells the filling station for $20,000 at a time when $2,000 has been properly allowed as depreciation thereon. B's gain on this sale is $7,000, since $7,000 is the amount by which the selling price of the filling station exceeds the portion of the cost equitably allocable to the filling station at the time of purchase reduced by the depreciation properly allowed.

Treas. Reg. § 1.61-6(a) (Example (2)).

7 See Beaver Dam Coal Co. v. United States, 370 F.2d 414, 416-17 (6th Cir. 1966); Fairfield Plaza, Inc. v. Comm'r of Internal Revenue, 39 T.C. 706, 712 (1963), acq. 1963-2 C.B. 3; Ayling v. Comm'r of Internal Revenue, 32 T.C. 704, 711 (1959), acq. 1959-2 C.B. 3; Cleveland-Sandusky Brewing Corp. v. Comm'r of Internal Revenue, 30 T.C. 539, 545 (1958), acq. 1958-2 C.B. 3; John D. Byram v. Comm'r of Internal Revenue, 34 T.C.M. (CCH) 626, 626 (1975); see also Am. Smelting & Refining Co. v. United States, 423 F.2d 277, 289 (Ct. Cl. 1970).

8 In 1934, Judge Learned Hand took issue with the predecessor of this regulation, stating "'fair market value' is not nearly so universal a phenomenon as to justify such a comment, and the implication is misleading." Helvering v. Walbridge, 70 F.2d 683, 684 (2d Cir. 1934).

9 See Revenue Act of 1921, Pub. L. No. 98, § 202(c), 42 Stat. 227 (1921); Revenue Act of 1918, Pub. L. No. 254, § 202(b), 40 Stat. 1057, 1060 (1919) ("[w]hen property is exchanged for other property, the property received in exchange shall for the purposes of determining gain or loss be treated as the equivalent of cash to the amount of its fair market value, if any"); see also Jeffrey L. Kwall, "Out of the Open-Transaction Doctrine: A New Theory for Taxing Contingent Payment Sales," 81 N.C. L. Rev. 977, 992 (2003) (hereinafter "Kwall").

10 Treas. Reg. No. 45, art. 1563 (1919); see also Loren D. Prescott, Jr., "Cottage Saving Association v. Commissioner: Refining the Concept of Realization," 60 Fordham L. Rev. 437, 445-46 (1991).

11 As to 1916, the year of sale, the Commissioner acknowledged that "no taxable income had been derived from the sale when made" because that consideration had not exceeded Mrs. Logan's basis of her stock. Logan v. Comm'r of Internal Revenue, 42 F.2d 193, 194 (2d Cir. 1930, aff'd sub nom., Burnet v. Logan, 283 U.S. 404 (1931). As to later years (1917-1920), however, the Commissioner claimed that a "a portion of each payment under the contract was a return of capital and a portion represented gain." Logan v. Comm'r of Internal Revenue, 12 B.T.A. 586, 599-600 (1928), rev'd, 42 F.2d 193 (2d Cir. 1930), aff'd sub nom., Burnet v. Logan, 283 U.S. 404 (1931).

12 In making this estimate, the Commissioner projected the amount of contingent payments the shareholders would receive by examining the mine's capacity, a projected price for the mine's product, and the mine's projected useful life. Id. at 411 n.1.

13 The court particularly focused on the fact that the endorsement was not separately sellable from the shares, noting that "the locking device increases the practical difficulty of attributing a correct valuation to either piece of property as of the time of purchase, since the very fact of the restraint usually affects the value of the combination and each of its components in amounts difficult to measure." Pierce, 49 F. Supp. at 330.

14 The opinion, indeed, quoted, at length, from Reg. 111, § 29.22(a)-8, dealing with bonus stock, and Reg. 111 § 29.22(a)-11, dealing with the sale of real property in lots.

15 Further instructive in this regard is Piper v. Comm'r of Internal Revenue, 5 T.C. 1104, 1109 (1945), in which the Tax Court held that there was no practical basis upon which to allocate a cost basis between common stock subscription warrants that were acquired by the taxpayer along with shares of common stock. In so concluding, the court stated that "[w]here there is no market value, as in the situation with respect to the warrants, there is no practical basis upon which an allocation can be made and the taxpayer is entitled to recover his entire original basis before gain or loss will be recognized." For other earlier cases applying the "open transaction" exception in cases involving proposed basis allocation, see United Mercantile Agencies, Inc. v. Comm'r of Internal Revenue, 23 T.C. 1105, 1116-17 (1955), acq. 1955-2 C.B. 3 (acquired claims from the liquidators of four banks held to be too speculative to have ascertainable market value); Axton v. Comm'r of Internal Revenue, 32 B.T.A. 613, 615 (1935) (types of stock received in exchange for other stock were not susceptible to valuation so as to allow allocation of old basis).

16 Subsequent regulations did not contain provisions corresponding to ar

Rev. Rul. 87-41, 1987-1 C.B. 296.

Internal Revenue Service
Revenue Ruling

EMPLOYMENT STATUS UNDER SECTION 530(D) OF THE REVENUE ACT OF 1978

Published: 1987

Section 3121.-Definitions, 26 CFR 31.3121(d)-1: Who are employees.

(Also Sections 3306, 3401; 31.3306(i)-1, 31.3401(c)-1.)

Employment status under section 530(d) of the Revenue Act of 1978. Guidelines are set forth for determining the employment status of a taxpayer (technical service specialist) affected by section 530(d) of the Revenue Act of 1978, as added by section 1706 of the Tax Reform Act of 1986. The specialists are to be classified as employees under generally applicable common law standards.

Click here to go directly to legal analysis of ruling

ISSUE

In the situations described below, are the individuals employees under the common law rules for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24 respectively, subtitle C, Internal Revenue Code)? These situations illustrate the application of section 530(d) of the Revenue Act of 1978, 1978-3 (Vol. 1) C.B. xi, 119 (the 1978 Act), which was added by section 1706(a) of the Tax Reform Act of 1986, 1986-3 (Vol. 1) C.B. ___ (the 1986 Act) (generally effective for services performed and remuneration paid after December 31, 1986).

FACTS

In each factual situation, an individual worker (Individual), pursuant to an arrangement between one person (Firm) and another person (Client), provides services for the Client as an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work.

SITUATION 1

The Firm is engaged in the business of providing temporary technical services to its clients. The Firm maintains a roster of workers who are available to provide technical services to prospective clients. The Firm does not train the workers but determines the services that the workers are qualified to perform based on information submitted by the workers.

The Firm has entered into a contract with the Client. The contract states that the Firm is to provide the Client with workers to perform computer programming services meeting specified qualifications for a particular project. The Individual, a computer programmer, enters into a contract with the Firm to perform services as a computer programmer for the Client's project, which is expected to last less than one year. The Individual is one of several programmers provided by the Firm to the Client. The Individual has not been an employee of or performed services for the Client (or any predecessor or affiliated corporation of the Client) at any time preceding the time at which the Individual begins performing services for the Client. Also, the Individual has not been an employee of or performed services for or on behalf of the Firm at any time preceding the time at which the Individual begins performing services for the Client. The Individual's contract with the Firm states that the Individual is an independent contractor with respect to services performed on behalf of the Firm for the Client.

The Individual and the other programmers perform the services under the Firm's contract with the Client. During the time the Individual is performing services for the Client, even though the Individual retains the right to perform services for other persons, substantially all of the Individual's working time is devoted to performing services for the Client. A significant portion of the services are performed on the Client's premises. The Individual reports to the Firm by accounting for time worked and describing the progress of the work. The Firm pays the Individual and regularly charges the Client for the services performed by the Individual. The Firm generally does not pay individuals who perform services for the Client unless the Firm provided such individuals to the Client.

The work of the Individual and other programmers is regularly reviewed by the Firm. The review is based primarily on reports by the Client about the performance of these workers. Under the contract between the Individual and the Firm, the Firm may terminate its relationship with the Individual if the review shows that he or she is failing to perform the services contracted for by the Client. Also, the Firm will replace the Individual with another worker if the Individual's services are unacceptable to the Client. In such a case, however, the Individual will nevertheless receive his or her hourly pay for the work completed.

Finally, under the contract between the Individual and the Firm, the Individual is prohibited from performing services directly for the Client and, under the contract between the Firm and the Client, the Client is prohibited from receiving services from the Individual for a period of three months following the termination or services by the Individual for the Client on behalf of the Firm.

SITUATION 2

The Firm is a technical services firm that supplies clients with technical personnel. The Client requires the services of a systems analyst to complete a project and contacts the Firm to obtain such an analyst. The Firm maintains a roster of analysts and refers such an analyst, the Individual, to the Client. The Individual is not restricted by the Client or the Firm from providing services to the general public while performing services for the Client and in fact does perform substantial services for other persons during the period the Individual is working for the Client. Neither the Firm nor the Client has priority on the services of the Individual. The Individual does not report, directly or indirectly, to the Firm after the beginning of the assignment to the Client concerning (1) hours worked by the Individual, (2) progress on the job, or (3) expenses incurred by the Individual in performing services for the Client. No reports (including reports of time worked or progress on the job) made by the Individual to the Client are provided by the Client to the Firm.

If the Individual ceases providing services for the Client prior to completion of the project or if the Individual's work product is otherwise unsatisfactory, the Client may seek damages from the Individual. However, in such circumstances, the Client may not seek damages from the Firm, and the Firm is not required to replace the Individual. The Firm may not terminate the services of the Individual while he or she is performing services for the Client and may not otherwise affect the relationship between the Client and the Individual. Neither the Individual nor the Client is prohibited for any period after termination of the Individual's services on this job from contracting directly with the other. For referring the Individual to the Client, the Firm receives a flat fee that is fixed prior to the Individual's commencement of services for the Client and is unrelated to the number of hours and quality of work performed by the Individual. The Individual is not paid by the Firm either directly or indirectly. No payment made by the Client to the Individual reduces the amount of the fee that the Client is otherwise required to pay the Firm. The Individual is performing services that can be accomplished without the Individual's receiving direction or control as to hours, place of work, sequence, or details of work.

SITUATION 3

The Firm, a company engaged in furnishing client firms with technical personnel, is contacted by the Client, who is in need of the services of a drafter for a particular project, which is expected to last less than one year. The Firm recruits the Individual to perform the drafting services for the Client. The Individual performs substantially all of the services for the Client at the office of the Client, using materials and equipment of the Client. The services are performed under the supervision of employees of the Client. The Individual reports to the Client on a regular basis. The Individual is paid by the Firm based on the number of hours the Individual has worked for the Client, as reported to the Firm by the Client or as reported by the Individual and confirmed by the Client. The Firm has no obligation to pay the Individual if the Firm does not receive payment for the Individual's services from the Client. For recruiting the Individual for the Client, the Firm receives a flat fee that is fixed prior to the Individual's commencement of services for the Client and is unrelated to the number of hours and quality of work performed by the Individual. However, the Firm does receive a reasonable fee for performing the payroll function. The Firm may not direct the work of the Individual and has no responsibility for the work performed by the Individual. The Firm may not terminate the services of the Individual. The Client may terminate the services of the Individual without liability to either the Individual or the Firm. The Individual is permitted to work for another firm while performing services for the Client, but does in fact work for the Client on a substantially full-time basis.

LAW AND ANALYSIS

This ruling provides guidance concerning the factors that are used to determine whether an employment relationship exists between the Individual and the Firm for federal employment tax purposes and applies those factors to the given factual situations to determine whether the Individual is an employee of the Firm for such purposes. The ruling does not reach any conclusions concerning whether an employment relationship for federal employment tax purposes exists between the Individual and the Client in any of the factual situations.

Analysis of the preceding three fact situations requires an examination of the common law rules for determining whether the Individual is an employee with respect to either the Firm or the Client, a determination of whether the Firm or the Client qualifies for employment tax relief under section 530(a) of the 1978 Act, and a determination of whether any such relief is denied the Firm under section 530(d) of the 1978 Act (added by Section 1706 of the 1986 Act).

An individual is an employee for federal employment tax purposes if the individual has the status of an employee under the usual common law rules applicable in determining the employer-employee relationship. Guides for determining that status are found in the following three substantially similar sections of the Employment Tax Regulations: sections 31.3121(d)-1(c); 31.3306(i)-1; and 31.3401(c)-1.

These sections provide that generally the relationship of employer and employee exists when the person or persons for whom the services are performed have the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but as to how it shall be done. In this connection, it is not necessary that the employer actually direct or control the manner in which the services are performed; it is sufficient if the employer has the right to do so.

Conversely, these sections provide, in part, that individuals (such as physicians, lawyers, dentists, contractors, and subcontractors) who follow an independent trade, business, or profession, in which they offer their services to the public, generally are not employees.

Finally, if the relationship of employer and employee exists, the designation or description of the relationship by the parties as anything other than that of employer and employee is immaterial. Thus, if such a relationship exists, it is of no consequence that the employee is designated as a partner, coadventurer, agent, independent contractor, or the like.

As an aid to determining whether an individual is an employee under the common law rules, twenty factors or elements have been identified as indicating whether sufficient control is present to establish an employer-employee relationship. The twenty factors have been developed based on an examination of cases and rulings considering whether an individual is an employee. The degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed. The twenty factors are designed only as guides for determining whether an individual is an employee; special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee). The twenty factors are described below:
1. INSTRUCTIONS. A worker who is required to comply with other persons' instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the person or persons for whom the services are performed have the RIGHT to require compliance with instructions. See, for example, Rev. Rul. 68-598, 1968-2 C.B. 464, and Rev. Rul. 66-381, 1966-2 C.B. 449.
2. TRAINING. Training a worker by requiring an experienced employee to work with the worker, by corresponding with the worker, by requiring the worker to attend meetings, or by using other methods, indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner. See Rev. Rul. 70-630, 1970-2 C.B. 229.
3. INTEGRATION. Integration of the worker's services into the business operations generally shows that the worker is subject to direction and control. When the success or continuation of a business depends to an appreciable degree upon the performance of certain services, the workers who perform those services must necessarily be subject to a certain amount of control by the owner of the business. See United States v. Silk, 331 U.S. 704 (1947), 1947-2 C.B. 167.
4. SERVICES RENDERED PERSONALLY. If the Services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results. See Rev. Rul. 55-695, 1955-2 C.B. 410.
5. HIRING, SUPERVISING, AND PAYING ASSISTANTS. If the person or persons for whom the services are performed hire, supervise, and pay assistants, that factor generally shows control over the workers on the job. However, if one worker hires, supervises, and pays the other assistants pursuant to a contract under which the worker agrees to provide materials and labor and under which the worker is responsible only for the attainment of a result, this factor indicates an independent contractor status. Compare Rev. Rul. 63-115, 1963-1 C.B. 178, with Rev. Rul. 55-593 1955-2 C.B. 610.
6. CONTINUING RELATIONSHIP. A continuing relationship between the worker and the person or persons for whom the services are performed indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals. See United States v. Silk.
7. SET HOURS OF WORK. The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control. See Rev. Rul. 73-591, 1973-2 C.B. 337.
8. FULL TIME REQUIRED. If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work. An independent contractor on the other hand, is free to work when and for whom he or she chooses. See Rev. Rul. 56-694, 1956-2 C.B. 694.
9. DOING WORK ON EMPLOYER'S PREMISES. If the work is performed on the premises of the person or persons for whom the services are performed, that factor suggests control over the worker, especially if the work could be done elsewhere. Rev. Rul. 56-660, 1956-2 C.B. 693. Work done off the premises of the person or persons receiving the services, such as at the office of the worker, indicates some freedom from control. However, this fact by itself does not mean that the worker is not an employee. The importance of this factor depends on the nature of the service involved and the extent to which an employer generally would require that employees perform such services on the employer's premises. Control over the place of work is indicated when the person or persons for whom the services are performed have the right to compel the worker to travel a designated route, to canvass a territory within a certain time, or to work at specific places as required. See Rev. Rul. 56-694.
10. ORDER OR SEQUENCE SET. If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker's own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed. Often, because of the nature of an occupation, the person or persons for whom the services are performed do not set the order of the services or set the order infrequently. It is sufficient to show control, however, if such person or persons retain the right to do so. See Rev. Rul. 56-694.
11. ORAL OR WRITTEN REPORTS. A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control. See Rev. Rul. 70-309, 1970-1 C.B. 199, and Rev. Rul. 68-248, 1968-1 C.B. 431.
12. PAYMENT BY HOUR, WEEK, MONTH. Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on § straight commission generally indicates that the worker is an independent contractor. See Rev. Rul. 74-389, 1974-2 C.B. 330.
13. PAYMENT OF BUSINESS AND/OR TRAVELING EXPENSES. If the person or persons for whom the services are performed ordinarily pay the worker's business and/or traveling expenses, the worker is ordinarily an employee. An employer, to be able to control expenses, generally retains the right to regulate and direct the worker's business activities. See Rev. Rul. 55-144, 1955-1 C.B. 483.
14. FURNISHING OF TOOLS AND MATERIALS. The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship. See Rev. Rul. 71-524, 1971-2 C.B. 346.
15. SIGNIFICANT INVESTMENT. If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value from an unrelated party), that factor tends to indicate that the worker is an independent contractor. On the other hand, lack of investment in facilities indicates dependence on the person or persons for whom the services are performed for such facilities and, accordingly, the existence of an employer- employee relationship. See Rev. Rul. 71-524. Special scrutiny is required with respect to certain types of facilities, such as home offices.
16. REALIZATION OF PROFIT OR LOSS. A worker who can realize a profit or suffer a loss as a result of the worker's services (in addition to the profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee. See Rev. Rul. 70-309. For example, if the worker is subject to a real risk of economic loss due to significant investments or a bona fide liability for expenses, such as salary payments to unrelated employees, that factor indicates that the worker is an independent contractor. The risk that a worker will not receive payment for his or her services, however, is common to both independent contractors and employees and thus does not constitute a sufficient economic risK to support treatment as an independent contractor.
17. WORKING FOR MORE THAN ONE FIRM AT A TIME. If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. See Rev. Rul. 70-572, 1970-2 C.B. 221. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.
18. MAKING SERVICE AVAILABLE TO GENERAL PUBLIC. The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship. See Rev. Rul. 56-660.
19. RIGHT TO DISCHARGE. The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right is an employer. An employer exercises control through the threat of dismissal, which causes the worker to obey the employer's instructions. An independent contractor, on the other hand, cannot be fired so long as the independent contractor produces a result that meets the contract specifications. Rev. Rul. 75-41, 1975-1 C.B. 323.
20. RIGHT TO TERMINATE. If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer- employee relationship. See Rev. Rul. 70-309.

Rev. Rul. 75-41 considers the employment tax status of individuals performing services for a physician's professional service corporation. The corporation is in the business of providing a variety of services to professional people and firms (subscribers), including the services of secretaries, nurses, dental hygienists, and other similarly trained personnel. The individuals who are to perform the services are recruited by the corporation, paid by the corporation, assigned to jobs, and provided with employee benefits by the corporation. Individuals who enter into contracts with the corporation agree they will not contract directly with any subscriber to which they are assigned for at least three months after cessation of their contracts with the corporation. The corporation assigns the individual to the subscriber to work on the subscriber's premises with the subscriber's equipment. Subscribers have the right to require that an individual furnished by the corporation cease providing services to them, and they have the further right to have such individual replaced by the corporation within a reasonable period of time, but the subscribers have no right to affect the contract between the individual and the corporation. The corporation retains the right to discharge the individuals at any time. Rev. Rul. 75-41 concludes that the individuals are employees of the corporation for federal employment tax purposes.

Rev. Rul. 70-309 considers the employment tax status of certain individuals who perform services as oil well pumpers for a corporation under contracts that characterize such individuals as independent contractors. Even though the pumpers perform their services away from the headquarters of the corporation and are not given day-to-day directions and instructions, the ruling concludes that the pumpers are employees of the corporation because the pumpers perform their services pursuant to an arrangement that gives the corporation the right to exercise whatever control is necessary to assure proper performance of the services; the pumpers' services are both necessary and incident to the business conducted by the corporation; and the pumpers are not engaged in an independent enterprise in which they assume the usual business risks, but rather work in the course of the corporation's trade or business. See also Rev. Rul. 70-630, 1970-2 C.B. 229, which considers the employment tax status of sales clerks furnished by an employee service company to a retail store to perform temporary services for the store.

Section 530(a) of the 1978 Act, as amended by section 269(c) of the Tax Equity and Fiscal Responsibility Act of 1982, 1982-2 C.B. 462, 536, provides, for purposes of the employment taxes under subtitle C of the Code, that if a taxpayer did not treat an individual as an employee for any period, then the individual shall be deemed not to be an employee, unless the taxpayer had no reasonable basis for not treating the individual as an employee. For any period after December 31, 1978, this relief applies only if both of the following consistency rules are satisfied: (1) all federal tax returns (including information returns) required to be filed by the taxpayer with respect to the individual for the period are filed on a basis consistent with the taxpayer's treatment of the individual as not being an employee ('reporting consistency rule'), and (2) the taxpayer (and any predecessor) has not treated any individual holding a substantially similar position as an employee for purposes of the employment taxes for periods beginning after December 31, 1977 ('substantive consistency rule').

The determination of whether any individual who is treated as an employee holds a position substantially similar to the position held by an individual whom the taxpayer would otherwise be permitted to treat as other than an employee for employment tax purposes under section 530(a) of the 1978 Act requires an examination of all the facts and circumstances, including particularly the activities and functions performed by the individuals. Differences in the positions held by the respective individuals that result from the taxpayer's treatment of one individual as an employee and the other individual as other than an employee (for example, that the former individual is a participant in the taxpayer's qualified pension plan or health plan and the latter individual is not a participant in either) are to be disregarded in determining whether the individuals hold substantially similar positions.

Section 1706(a) of the 1986 Act added to section 530 of the 1978 Act a new subsection (d), which provides an exception with respect to the treatment of certain workers. Section 530(d) provides that section 530 shall not apply in the case of an individual who, pursuant to an arrangement between the taxpayer and another person, provides services for such other person as an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work. Section 530(d) of the 1978 Act does not affect the determination of whether such workers are employees under the common law rules. Rather, it merely eliminates the employment tax relief under section 530(a) of the 1978 Act that would otherwise be available to a taxpayer with respect to those workers who are determined to be employees of the taxpayer under the usual common law rules. Section 530(d) applies to remuneration paid and services rendered after December 31, 1986.

The Conference Report on the 1986 Act discusses the effect of section 530(d) as follows:

The Senate amendment applies whether the services of [technical service workers] are provided by the firm to only one client during the year or to more than one client, and whether or not such individuals have been designated or treated by the technical services firm as independent contractors, sole proprietors, partners, or employees of a personal service corporation controlled by such individual. The effect of the provision cannot be avoided by claims that such technical service personnel are employees of personal service corporations controlled by such personnel. For example, an engineer retained by a technical services firm to provide services to a manufacturer cannot avoid the effect of this provision by organizing a corporation that he or she controls and then claiming to provide services as an employee of that corporation.

* * * [T]he provision does not apply with respect to individuals who are classified, under the generally applicable common law standards, as employees of a business that is a client of the technical services firm.

2 H. R. Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-834 to 835 (1986).

Under the facts of Situation 1 the legal relationship is between the Firm and the Individual, and the Firm retains the right of control to insure that the services are performed in a satisfactory fashion. The fact that the Client may also exercise some degree of control over the Individual does not indicate that the Individual is not an employee. Therefore, in Situation 1, the Individual is an employee of the Firm under the common law rules. The facts in Situation 1 involve an arrangement among the Individual, Firm, and Client, and the services provided by the Individual are technical services. Accordingly, the Firm is denied section 530 relief under section 530(d) of the 1978 Act (as added by section 1706 of the 1986 Act), and no relief is available with respect to any employment tax liability incurred in Situation 1. The analysis would not differ if the acts of Situation 1 were changed to state that the Individual provided the technical services through a personal service corporation owned by the Individual.

In Situation 2, the Firm does not retain any right to control the performance of the services by the Individual and, thus, no employment relationship exists between the Individual and the Firm.

In Situation 3, the Firm does not control the performance of the services of the Individual, and the Firm has no right to affect the relationship between the Client and the Individual. Consequently, no employment relationship exists between the Firm and the Individual.

HOLDINGS

SITUATION 1. The Individual is an employee of the Firm under the common law rules. Relief under section 530 of the 1978 Act is not available to the Firm because of the provisions of section 530(d).

SITUATION 2. The Individual is not an employee of the Firm under the common law rules.

SITUATION 3. The Individual is not an employee of the Firm under the common law rules.

Because of the application of section 530(b) of the 1978 Act, no inference should be drawn with respect to whether the Individual in Situations 2 and 3 is an employee of the Client for federal employment tax purposes.