In the case of Gage v. Commissioner, TC Memo 2023-47[1], a taxpayer found that even though they believed they had paid an $875,000 settlement to the Department of Housing and Urban Development by the end of 2012, in fact the payment was rather treated as made in 2013 for income tax purposes.

Facts of the Case

The opinion begins discussing the general situation that led to this dispute between the IRS and the taxpayers:

The United States, on behalf of the Department of Housing and Urban Development (HUD), filed a complaint against Edwin and Elaine Gage. The Gages tentatively settled in December 2012 and gave their lawyer a cashier’s check for the agreed amount before the end of the year. The government sometimes works slowly, and the tentative settlement didn’t become final until March 2013. Shortly after, the Gages’ lawyer delivered the check.

When the Gages filed their return for 2012, they claimed a business-loss deduction for the amount of the settlement.[2]

More detail on the settlement is provided later in the opinion:

Negotiations ensued, and by August 2012 it looked like the case would settle. The Gages, RMG’s other owners, and counsel for the United States tentatively agreed to settle for $1.75 million, of which the Gages would pay $875,000. The deal was expressly conditioned on final approval by the Department of Justice, but it must have looked pretty likely that the deal would work out — the magistrate judge who supervised the settlement talks entered an order in which he noted that a settlement conference was held and that the settlement was contingent upon acceptance and approval by the DOJ. The district court then entered an administrative closing order, which terminated the suit without prejudice.[3]

The taxpayers took action to pay the settlement just before the end of 2012:

On December 27, 2012, the Gages purchased a cashier’s check in the amount of $875,000 and delivered it to their lawyer. Their lawyer emailed the Assistant U.S. Attorney who represented the government to inform him that the check would soon be delivered. The Assistant U.S. Attorney, however, explained that the United States did not have authority to receive the cashier’s check before the settlement was finally approved. The Gages’ lawyer held onto the check.[4]

In March of 2013 the Department of Justice approved the settlement and accepted the check:

The DOJ reviewed the settlement agreement and finally signed it in March 2013. …

The Gages’ attorney then finally delivered the cashier’s check, dated December 27, 2012, to the United States on March 18, 2013.[5]

Analysis and Opinion

The IRS objected both that the Gage’s payment was not made, for tax purposes in 2012 (and thus no deduction could be claimed in that year) and that the settlement itself wasn’t deductible.  The opinion only directly deals with the first issue, as the Court’s finding that it wasn’t properly paid for tax purposes in 2012 made the question of whether it would have been deductible moot, as the year 2013 was not before the Court.

The analysis begins by outlining the general rules for the timing of a payment made by a cash basis taxpayer:

The Gages are cash-method taxpayers. What this means is that they can take deductions only for expenses that they actually paid, not that they merely incurred, during a particular tax year. See Saviano v. Commissioner, 80 T.C. 955, 964 (1983) (“It is clear that a cash basis taxpayer cannot deduct an expense incurred unless it has been paid during the taxable year”) (citing Treas. Reg. § 1.461-1(a)(1)), aff’d, 765 F.2d 643 (7th Cir. 1985); see also §446(a); Treas. Reg. § 1.446-1(c)(1)(i) (“Expenditures [by cash-method taxpayers] are to be deducted for the taxable year in which actually made.”) There’s a rule for payments by check as well — tax law treats a payment by check as made when the check is delivered. See Guy v. Commissioner, 105 T.C.M. (CCH) 1626, 1628 (2013). If a check is dated in one year but cashed in the next year, the deduction will not be allowed absent proof of delivery in the year of the deduction. See Reynolds v. Commissioner, 79 T.C.M. (CCH) 1376, 1383 (2000), aff’d, 296 F.3d 607 (7th Cir. 2002).[6]

The analysis then notes that, in fact, the check was not delivered to the government in 2012:

The Gages did not themselves deliver the check to the government at the end of 2012. They instead gave it to their lawyer to deliver to the government when the settlement was finally approved. (And one might, though the parties don’t, question whether the Gages owed anything under the settlement at all before it was finally approved.) Their lawyer delivered the check to the United States only on March 18, 2013. A copy of the United States’s payment record confirms that this is the date that the check was received. That check was not cashed by the United States (i.e., actually paid) until March 22, 2013 — after the DOJ reviewed and approved the agreement. The record includes a copy of the check, dated December 27, 2012, and a copy of the United States’s payment record, showing that the United States received the Gages’ cashier’s check on March 18, 2013, and cashed it on March 22, 2013. The payment record proves that the delivery was made in 2013, not in 2012.[7]

But the taxpayers argued that, under the applicable state law, the tender of payment would qualify as payment:

That would seem to end the matter. But the Gages argue that under Oklahoma law a payment is made when there is a tender of payment. They purchased a cashier’s check and delivered it to their attorney in the case who then offered to give it to the Assistant U.S. Attorney who worked the case. He said that he could not hold the check since the settlement agreement had not been approved. The Gages argue that under Oklahoma law, this uncontested sequence of events is a tender of payment.[8]

However, the Court found that Oklahoma law wasn’t relevant in this case:

We don't need to review Oklahoma law because what constitutes delivery of a check made in settlement of a federal lawsuit brought by the federal government is, we hold, a matter of federal, not state, law.[9]

The opinion finds that there are two separate reasons why federal, and not state, law controls when this payment is deemed to be made:

The first is that the litigation here was between an agency of the federal government and a taxpayer. See Trout v. Commissioner, 131 T.C. 239, 251 (2008) (citing Boyle v. United Techs. Corp., 487 U.S. 500, 504 (1988)) (finding that litigation between the federal government agency and a taxpayer is a factor that weighs in favor of using federal common law). This may not be decisive, but it weighs in favor of using federal law. Id.

The second reason is that settlements are contracts, and this contract was entered into under federal law. It was between a federal government agency and the Gages, and it was brought under a federal statute to protect a federal financial interest by the DOJ under its own procedures for approval of settlements. The federal government settles cases all over this broad land, and caselaw tells us that this means there is a strong interest in nationwide uniformity and therefore a need to use federal common law to develop and maintain a uniform law of settlements. See id. at 251 (first citing Boyle, 487 U.S. at 504; and then citing United States v. Kimbell Foods, Inc., 440 U.S. 715, 726, 728 (1979)) (“[A] federal government agency as litigant, contracts entered into under federal law, and the need for nationwide uniformity in administration, all point us to the federal common law of contracts as our source of rules.”). All of these factors point toward using federal law to decide when the Gages paid the settlement.[10]

[1] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023,  https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/check-made-out-but-not-cashed-during-the-tax-year/7gh46 (retrieved April 25, 2023)

[2] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[3] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[4] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[5] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[6] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[7] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[8] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[9] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023

[10] Gage v. Commissioner, TC Memo 2023-47, April 12, 2023