Contract Allocations and Judicial Doctrines
District Court Case Applies Strong Proof Test to Boxing Contracts to Address Puerto Rico Source Income
- Miguel Ángel Cotto-Vázquez (Cotto), the former four-time Puerto Rican boxing champion, recently has been involved in a different kind of fight – this time against the IRS.
- As a result of his pugilistic endeavors, Cotto was faced with the issue of income sourcing vis-à-vis the boxing contracts he entered into with Top Rank Inc. – i.e., the allocation of his compensation between U.S. source income and Puerto Rico source income.
- In Cotto-Vázquez v. United States, the U.S. District Court for the District of Puerto Rico applied the First Circuit's strong proof test, which is a doctrine based on the parties' intent.
In Cotto-Vázquez v. United States, CIV. NO.: 16-2807 (SCC) (D.P.R. March 11, 2021), Miguel Ángel Cotto-Vázquez (Cotto),1 the former four-time Puerto Rican boxing champion, became involved in another fight. This time he faced an opponent – the IRS – in an unfamiliar arena: tax refund litigation.
This is a follow-up to Holland & Knight's previous alert (see "When Is a Tax Return 'Filed'?," March 10, 2021) that discussed Coffey v. Comm'r, 987 F.3d 808 (8th Cir. 2021) and the ramifications of the case in regard to the IRS Large Business and International (LB&I) compliance campaign involving Puerto Rico Act 22, known as the "Individual Investors Act," and I.R.C. § 937.2
This Holland & Knight alert focuses on the issue of allocation of a Puerto Rico resident's income when there is a contract requiring services to be performed both in the United States and Puerto Rico.
District Court: Cotto-Vázquez v. United States
Facts: Cotto, a highly decorated professional boxer, entered into eight contracts with Top Rank Inc. for eight boxing matches with varying purses for each match. The revenues from the boxing matches were generated as follows: 1) gate revenues, 2) foreign television, 3) domestic television fees and 4) advertising and sponsorship revenues. In general, Cotto was to be compensated for training for the boxing matches, the matches themselves, and for current rights to his likeness and image as to the matches and future rights to rebroadcast the matches. Per the contracts, if any of the boxing matches were canceled, Top Rank was under no obligation to pay Cotto. Complicating the issue for tax purposes was the fact that, although the boxing matches were fought in the United States, Cotto trained for and promoted the matches in Puerto Rico.
Between 2005 and 2008, Cotto relied on his CPAs to file his income tax returns. The CPAs classified all of Cotto's income for the eight boxing matches as Puerto Rico source income and prepared Forms 1040-PR.3 At the time Cotto's 2005 through 2008 Forms 1040-PR were filed with the Puerto Rican tax authorities, his CPAs did not prepare, and therefore he did not file, Form 1040, U.S. Individual Income Tax Return, for any of those years with the IRS.
In or around 2009, the IRS commenced an income tax audit of Cotto for the 2005 through 2008 tax years. At the close of the audit, the IRS concluded that the income from the boxing matches was all U.S. source income. The agent prepared a Form 4549, Income Tax Examination Changes (Form 4549), and Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment. Cotto conceded to the adjustments and signed the Forms 4549.
On Feb. 8, 2010, the IRS assessed and notified Cotto of the tax deficiencies in connection with the income tax audit. Following the assessments, on or around March 26, 2010, Cotto requested an audit reconsideration regarding the assessment, therefore prompting the IRS to reopen the matter. On March 22, 2011, the IRS issued a determination in the audit reconsideration upholding the IRS' assessments. Cotto subsequently appealed the contested portions of the IRS' assessments.
On or around Jan. 25, 2012, Cotto paid to the IRS the portions of the assessment that were uncontested. On April 16, 2012, while Cotto's appeal remained pending, the IRS sent Cotto a Notice of Intent to Levy, and the amount stated therein was subsequently revised and paid by Cotto.
On Jan. 21, 2014, Cotto filed a Form 1040X, Amended U.S. Individual Income Tax Return, for each of the relevant tax years and Forms 843, Claim for Refund and Request for Abatement. On Oct. 23, 2014, the IRS rejected the refund claims on the grounds that the income earned from the boxing matches were entirely U.S. source income and that no cause existed for the penalties to be abated. On Oct. 7, 2016, Cotto filed the action requesting a refund of overpaid taxes, penalties and interest.
Issues: Before the Court were three issues, two of which are discussed in this alert: 1) whether the income from the boxing match purses was U.S. source income, i.e., that the income derived from eight professional boxing agreements, which Cotto entered into with Top Rank, was adequately characterized as entirely U.S. source income, and 2) whether a portion of the boxing match purses included the sale of Cotto's intangible property.4
As to the first issue, on which only the government moved for summary judgment, Cotto claimed that since he rendered certain personal services in Puerto Rico, the income earned for such services should not have been categorized as U.S. source income, but rather, it should have been deemed as Puerto Rico source income. As to the second issue, Cotto claimed that the contract sold certain rights such as his name, image and likeness in Puerto Rico. Therefore, this income was Puerto Rico source income and not U.S. source income.5
The government's position was straightforward: The contracts with Top Rank paid Cotto solely for boxing. According to the government, if there was no boxing match, then there was no payment of any kind. Therefore, since the contract language was clear and all of the boxing matches took place in the United States, all income earned in connection with the matches were correctly characterized as U.S. source income. The government pointed to Muskat v. United States, 554 F.3d 183 (1st Cir. 2009)6 and the judicial doctrine of strong proof. "[T]o constitute "strong proof" a taxpayer's evidence must have persuasive power closely resembling the 'clear and convincing' evidence required to reform a written contract on the ground of mutual mistake." Muskat, 554 F.3d at 191. The District Court in contrast viewed the strong proof rule as "a rule that drives at the contracting parties' intentions." Based on the language of the contract and the depositions taken in the case, the District Court determined that the factual issue of intent was present and denied the government's motion for summary judgment as to this particular issue.
With respect to the second issue regarding the refund in connection with Cotto's intangible property rights, Cotto requested that 25 percent of the compensation identified as the "Purse" provision in the contracts be allocated to the sale of his intangible property rights, i.e., his name and likeness.
The government again countered with Muskat for the proposition that the contract provided for payment to occur only for the boxing matches and nothing more. In addition, the government argued that Cotto was unable to prove the boxing match agreements included the sale of Cotto's intangible property rights to TR. Lastly, the government argued that if there was compensation in exchange for the grant of Cotto's intangible property rights, the conveyance would be a license and, therefore, any income from the license would be characterized as royalties and should be deemed as exclusively U.S. source income.
The District Court dispatched the matter, finding that the second issue was not ripe for disposition as the record needed to be developed. That is, the contract did not read as the parties contended and the intent of the contractual parties needed to be further developed.
As is evident in Cotto, the question as to allocation of income may not be resolved solely by compliance with the statute.7 Allocation of income based on the contract's language will be based on judicial doctrines. Judicial doctrines may vary depending on the taxpayer's residency or place of business or where the return was filed or if the return was filed at all.8
The U.S. Circuit Courts of Appeal that do not follow the "strong proof rule" follow either 1) the mutual intent test, i.e., whether the parties mutually intended that an allocation of the purchase price be made to the matter at issue9; 2) the "Danielson rule," i.e., "[A] party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc."10; or 3) a more vigorous standard of the strong proof rule.11
In Cotto, there was no dispute that the plaintiff was a resident of Puerto Rico. Thus, as to the allocation of contractual income, the applicable test was the strong proof rule as set forth in Muskat.
However, what if, as in Coffey, residency is in dispute and, as in Cotto, the contract does not specifically set forth a tax allocation? If a taxpayer attempts to dispose of the Puerto Rico residency issue via a motion for summary judgment and the IRS disputes the residency, then for purposes of the contested motion, the taxpayer will be treated as a nonresident of Puerto Rico. Under such a scenario, the government may alternatively argue both the Danielson rule and the mutual intent test in opposition to the taxpayer's motion for summary judgment. Thus, the taxpayer's motion may be denied while disclosing the taxpayer's litigation strategy without the IRS expending any effort in discovery.
When a Puerto Rico residency issue arises and judicial concepts are mentioned, the reaction is to spew the sham, economic substance or step-transaction doctrines. Practitioners should be cognizant of the judicial concepts that will govern issues concerning contract allocation and the impact that those principles may have in formulating trial strategy.
For additional information, please contact the authors.
1 As these were joint income tax returns, Cotto's wife was also a named party, although the dispute centered around his income.
2 As stated in the previous alert:
In 2019, Act 60-2019 (the Act) amended the island's tax incentives regime. The provisions of the Act provide for a full exemption from Puerto Rican income taxes on interest and dividends from local sources, as well as a more limited exemption for capital gains accrued and realized after an individual becomes a resident. Those individuals who become residents of Puerto Rico and establish qualifying businesses must be paid reasonable compensation for services they provide to those companies; if so, those individuals will be exempt from local tax on any dividends they receive.
The Act requires that the individual benefiting from the incentives be physically present on the island for at least 183 days of a tax year, the payment of an annual fee of $5,000 and annual contributions to nonprofits of $10,000. Qualifying companies are subject to a 4 percent tax rate on revenues from export services. A bona fide resident of Puerto Rico would not have to pay federal taxes on his or her locally sourced income under I.R.C. §§ 933 and 937.
3 Form 1040-PR is generally used by self-employed persons in Puerto Rico to compute self-employment tax.
4 The third issue concerned whether Cotto was subject to additions to tax.
5 As to this issue, Cotto sought a refund in the amount of $1,084,875.
6 The U.S. Court of Appeals for the First Circuit includes the Districts of Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island.
7 See I.R.C. § 1060.
8 Under the Golsen rule, the U.S. Tax Court follows the precedent of the U.S. Circuit Court of Appeal to which an appeal would follow. Golsen v. Comm'r, 54 T.C. 742, 757 (1970), aff'd without discussion of this issue, 445 F.2d 985 (10th Cir. 1971), cert. denied, 404 US 940 (1971).
9 See, e.g., Better Beverages, Inc. v. United States, 619 F.2d 424, 430 (5th Cir. 1980).
10 See Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967).
11 See, e.g., Molasky v. Comm'r, 897 F.2d 334 (8th Cir. 1990).
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.