Complimentary Issue of Parker's Federal Tax Bulletin August 17, 2012

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Issue 17

August 17, 2012

Tax Briefs

Debtors Can Exclude EIC from Bankruptcy Estate; Extension Granted to File Form 8939; Postnuptial Agreement Didn't Show Present Intent to Convey Property; Failure to Include IRA Distribution in Income Results in Penalty ...

Proposed Regs Clarify Tax Treatment of Employer Reimbursement Arrangements

The IRS issued proposed regulations that clarify the definition of reimbursement or other expense allowance arrangements for purposes of determining how the deduction limitations apply to reimbursement arrangements between three parties.

Tractors and Trailers Are Separate Items for Purposes of Self-Rental Rules

Where two separate S corporations owned by the same taxpayer leased tractors and trailers, each individual tractor and trailer was an item of property, with the result that the losses from one company were passive but the income from the other company was not.

Taxpayer Can't Deduct Medical Marijuana Business Expense

The Tax Court applied Code Sec. 280E to deny a taxpayer a deduction for expenses related to his medical marijuana dispensary, which was legal in California. The court did, however, allow a much larger deduction for cost of goods sold than the IRS had originally allowed.]

Payment of S Shareholders' Liability Wasn't Fraudulent Conveyance

Even though a fully executed agreement in which an S corporation agreed to reimburse its shareholders for their pass-through liability could not be found, the fact that the shareholders operated in accordance with such an agreement and that the corporation received consideration for such an agreement precluded a finding that the corporation made a fraudulent conveyance. In re Kenrob Information Technology Solutions, Inc., 2012 PTC 214 (E.D. Va. 7/10/12).

Change from Expensing to Capitalization Is Accounting Method Change

A change in the time for deducting an item of expenditure and a change from deducting to capitalizing an item of expenditure are changes in accounting methods and a Code Sec. 481(a) adjustment is computed for relevant amounts in all tax years preceding the year of change, whether the tax years are open or closed. CCM 201231004.

IRS Issues Guidance on Contributions to Domestic Disregarded Entities

The IRS issued guidance on the deductibility of contributions to domestic single-member limited liability companies (SMLLC) that are wholly owned and controlled by U.S. charities and that, for federal tax purposes, are disregarded as entities separate from their owners. Notice 2012-52.

Gambling Expenses Based on Taxpayer Testimony Allowed

Based on the credible testimony of the taxpayers, the Tax Court allowed a married couple a $15,000 gambling loss deduction against gambling income that they initially failed to report. Gonzalez v. Comm'r, T.C. Summary 2012-78 (8/6/12).

Insurance Payments to Fund Buy-Sell Agreements Are Nondeductible

Contributions by partnerships to a welfare benefit plan were not normal, usual, or helpful for the development of the taxpayers' business and were not made in furtherance of a profit objective or for any viable business purpose; thus, they were not deductible. Curcio v. Comm'r, 2012 PTC 230 (2d Cir. 8/9/12).

No Abuse of Discretion in Denying Interest Abatement to Taxpayer

The IRS did not abuse its discretion by denying a taxpayer's request to abate the interest on an erroneous refund where the taxpayer contributed to the mistake resulting in the erroneous refund. Allcorn v. Comm'r, 139 T.C. No. 4 (8/9/12).

IRS Finalizes Regs on Deductions for Entertainment Use of Business Aircraft

The IRS issued final regulations relating to deductions for the use of business aircraft for entertainment. T.D. 9597 (8/1/12).

Bankruptcy

Debtors Can Exclude EIC from Bankruptcy Estate: In In re Lea, 2012 PTC 226 (D. Bankr. Kan. 8/2/12), a bankruptcy court concluded that trustees in three bankruptcy cases had not overcome the presumption of constitutionality that attached to Kansas's bankruptcy-only earned income credit exemption statute. The court overruled the trustees' objections to the debtors' exemptions of the right to receive the earned income credit portions of their income tax refunds. [Code Sec. 32].

Estate, Gifts, and Trusts

Extension Granted to File Form 8939: In PLR 201231003, the IRS granted the executrix of a decedent's estate an extension of time of 120 days from the date of the letter ruling to file the Form 8939 and make an election under Code Sec. 1022 for the decedent's estate. [Code Sec. 1022].

Liens and Levies

Postnuptial Agreement Didn't Show Present Intent to Convey Property: In Porath v. U.S., 2012 PTC 227 (6th Cir. 8/6/12), the Sixth Circuit affirmed a district court and held that (1) a 1987 postnuptial agreement between a husband and wife did not demonstrate a present intent to convey the husband's interest in the marital home to his wife, and (2) a 1991 transfer of the marital property from the husband to his wife via a quitclaim deed was carried out to hinder the collection of a trust fund recovery penalty. Under Michigan's Uniform Fraudulent Conveyance Act, the Sixth Circuit noted, a court can consider badges of fraud including: a lack of consideration for the conveyance; a close relationship between transferor and transferee; pending or threatened litigation; the transferor's financial difficulties; and the retention of the possession, control, or benefit of the property by the transferor. The Sixth Circuit found these badges of fraud to exist in this case. [Code Sec. 6321].

Penalties

Failure to Include IRA Distribution in Income Results in Penalty: In Abilheira v. Comm'r, T.C. Memo. 2012-221 (8/1/12), the Tax Court held that the taxpayers did not exercise reasonable diligence in preparing their 2007 return and thus were liable for negligence penalties for failing to include IRA distributions in income. Although the couple cited the husband's poor health, confusion, and memory loss as excuses for the errors on their return, the court said that their failure to seek competent help in preparing the return constituted negligence. According to the court, the length and severity of the health problems suggested that a reasonable person in the husband's position would have sought help rather than adopt his disability as an excuse for inaccurate reporting. And, the court noted, there was no indication that the taxpayer's wife, who the court characterized as well educated, had any disabling health condition. Thus, the court found her negligent in not taking steps to assure that the tax return was correct. [Code Sec. 6662].

Procedure

IRS Working on Streamlining Refund Process: In CC-2012-14, the IRS Office of Chief Counsel advised that it is actively working with the IRS and the Department of Justice to arrive at a more streamlined approach to process refunds in refund-litigation cases. As soon as the new procedures are in place, it will update the Chief Counsel Directives Manual (CCDM) to reflect them. The procedures currently outlined in the CCDM are not current. [Code Sec. 6402].

Retirement Plans

Retirement Distribution Was Taxable: In Clanton v. Comm'r, 2012 PTC 227 (6th Cir. 8/6/12), the Sixth Circuit affirmed the Tax Court and held that whether the taxpayer's account was an IRA or, as the IRS argued on appeal, a Code Sec. 457(b) account, the taxpayer did not establish that the Tax Court erred in concluding that the distribution was taxable. [Code Sec. 408].

Transfer of U.S. 403(b) Plan Is Taxable to U.K Resident: In CCM 201231010, the IRS Office of Chief Counsel advised that a U.K. resident, who taught at a university in the United States for several years, could not rely on the parenthetical language in Article 18(1) of the U.S. U.K Treaty to make a tax-deferred rollover distribution from a U.S. Code Sec. 403(b) annuity plan to a U.K. pension. The U.K. pension, the Chief Counsel's Office stated, was not an eligible retirement plan within the meaning of Code Sec. 402(c)(8)(B) and nothing in the treaty overrides the requirement that a tax-deferred rollover distribution can be made only to an eligible retirement plan. Thus, a lump-sum transfer from a U.S. 403(b) plan to a U.K. pension that is not an eligible retirement plan is taxable in the United States as a distribution pursuant to Article 17(2) of the U.S. U.K. Treaty. [Code Sec. 402].

IRS Issues Notice on Corporate Bond Weighted Average Interest Rate: In Notice 2012-53, the IRS provides guidance as to the corporate bond weighted average interest rate and the permissible range of interest rates specified under Code Sec. 412(b)(5)(B)(ii)(II) as in effect for plan years beginning before 2008. It also provides guidance on the corporate bond monthly yield curve (and the corresponding spot segment rates), and the 24-month average segment rates under Code Sec. 430(h)(2). In addition, Notice 2012-53 provides guidance as to the interest rate on 30-year Treasury securities under Code Sec. 417(e)(3)(A)(ii)(II) as in effect for plan years beginning before 2008, the 30-year Treasury weighted average rate under Code Sec. 431(c)(6)(E)(ii)(I), and the minimum present value segment rates under Code Sec. 417(e)(3)(D) as in effect for plan years beginning after 2007. These rates do not reflect any changes implemented by the Moving Ahead for Progress in the 21st Century Act (MAP-21). MAP-21 provides that for purposes of Code Sec. 430(h)(2), the segment rates are limited by the applicable maximum percentage or the applicable minimum percentage based on the average of segment rates over a 25-year period. According to the IRS, guidance related to the new legislation will be issued in the future. [Code Sec. 412].

Tax Accounting

Chief Counsel Issues Memo on Reporting Telephone Excise Tax: In CCM 201231011, the IRS Office of Chief Counsel advised that a business entity should report income from a telephone excise tax refund when all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy. In accordance with Section 5(f) of Notice 2006-50, a business entity should report income on the date the return making the request is filed if it makes a properly substantiated request for refund of the actual amount on an original 2006 return. Otherwise, a business entity generally should report income from a telephone excise tax refund when it receives payment or notice that the request for refund has been approved, whichever is earlier. [Code Sec. 451].

Tax Credits

Taxpayer Not Entitled to FTHBC: In Colca v. Comm'r, T.C. Summary 2012-77 (8/6/12), the Tax Court held that the taxpayer was not entitled to a first-time homebuyer credit (FTHBC) for the 2009 purchase of her brother's 50 percent ownership interest in their deceased parents' home. The home had been held in a trust and when the trust became irrevocable, the taxpayer acquired a vested one-third present ownership interest in all of the trust property. She subsequently acquired a 50 percent present ownership interest in the residence under a beneficiary agreement and these present ownership interests, the court stated, disqualified her from receiving the FTHBC. [Code Sec. 36].

IRS Issues Prop. Regs on Utility Allowances: In REG-136491-09 (8/7/12), the IRS issued proposed regulations that amend the utility allowance regulations concerning the low-income housing tax credit. [Code Sec. 42].

Tax Practice

Court Rules on Availability of Tax Practitioner Privilege: In Santander Holdings USA, Inc. & Subs. v. U.S., 2012 PTC 229 (D. Mass. 8/6/12), a district court held that certain contested documents were not protected by the work product doctrine because they either related to the assessment of the adequacy and propriety of tax reserves or their disclosure to an accounting firm effectively waived any work product protection. However, the court also held that the attorney-client and tax practitioner privileges and work product protection were not waived as to documents involving advice relating to changes in the law in both the United Kingdom and the United States and advice relating to the unwinding of the taxpayer's STARS transactions. Finally, the court concluded that the taxpayer waived its tax advice privilege when it voluntarily disclosed a memo that clearly fell within the scope of the privilege prior to the disclosure. [Code Sec. 7525].

Proposed Regs Clarify Tax Treatment of Employer Reimbursement Arrangements between Three Parties

In recent years, many small and medium-sized companies have sought to reduce their overall labor costs by contracting with a professional employer organization (PEO) to provide essential services such as administrating employee benefit plans and paying employees, employment taxes, and workers compensation premiums. Several tax issues have arisen as a result of using these organizations. One of the more complex issues deals with how the deduction limitation rules of Code Sec. 274 apply. The IRS has now issued proposed regulations (REG-101812-07 (7/31/12)) that clarify the definition of reimbursement or other expense allowance arrangement for purposes of determining how the deduction limitations apply to reimbursement arrangements between three parties.

Practice Tip: While the regulations are proposed to apply to expenses paid or incurred in tax years beginning on or after the date the regulations are finalized, the IRS is allowing taxpayers to apply the proposed regulations currently and to apply them to any tax years for which the statute of limitations is still open. Read more...

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Tractors and Trailers Are Separate Items of Property for Purposes of Self-Rental Recharacterization Rules

Generally, the passive activity loss rules under Code Sec. 469 characterize all rental activity as passive. However, Reg. Sec. 1.469-2(f)(6) requires net rental income received by the taxpayer for the use of an item of the taxpayer's property in a business in which the taxpayer materially participates to be treated as income not from a passive activity. In this case, that income is not available to offset passive losses of the taxpayer. The regulation explicitly recharacterizes as nonpassive the net rental activity income from an item of property rather than net income from the entire rental activity.

In Veriha v. Comm'r, 139 T.C. No. 3 (8/8/12), the taxpayers tried to argue that their entire collection of tractors and trailers held by two different companies was one big item of property such that the passive losses could offset the income. The IRS, however, argued that each individual tractor or trailer was an item of property with the result that the losses were passive but the income was not. The fact that the taxpayer held the tractors and trailers in separate companies and entered into separate lease agreements for each tractor and trailer belied the fact that it was one big item of property. Thus, the taxpayers did not prevail.

Facts

Joesph Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a Wisconsin S corporation. Joseph and his wife, Christina, worked for JVT during 2005, and Joseph materially participated in JVT's business. JVT is a trucking company that leases its trucking equipment from two different entities, Transportation Resources, Inc. (TRI), and JRV Leasing, LLC (JRV). The trucking equipment that JVT leases consists of two parts: a motorized vehicle (i.e., a tractor) and a towed storage trailer (i.e., a trailer). TRI is an S corporation in which Joseph owns 99 percent of the stock; his father owns the remaining 1 percent. TRI is an equipment leasing company with its principal place of business in Wisconsin. TRI owns only the tractors and trailers that it leases to JVT. During 2005, TRI and JVT entered into 125 separate lease agreements, one for each tractor or trailer leased. TRI's only source of income during 2005 was the leasing agreements with JVT.

JRV is a single-member limited liability company, and Joseph is its sole member. JRV is an equipment leasing company that owns only the tractors and trailers that it leases to JVT. During 2005, JRV and JVT entered into 66 separate lease agreements, one for each tractor or trailer leased. JRV's only source of income during 2005 was the leasing agreements with JVT. Each tractor was leased to JVT as one unit, and each trailer was leased to JVT as one unit. The monthly rate for leasing each tractor was determined by the tractor's age, and the monthly rate for leasing each trailer was determined by the type of trailer. During 2005, the tractors and trailers owned by TRI and JRV were all parked in the same lot and were intermingled. All the tractors were painted the same yellow color, and all received the same scheduled maintenance. JVT paid the expenses for all the tractors and trailers and insured all the tractors and trailers under the same blanket insurance policy. In determining which tractor or trailer to use on a route, JVT made no distinction between those TRI owned and those JRV owned. Similarly, when it assigned drivers, JVT did not make any distinction on the basis of the ownership of the tractor or trailer.

During 2005, TRI generated net income, which it reported to Joseph on a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. Joseph and Christina treated that net income as passive income on their return.

During 2005, JRV generated a net loss, which Joseph and Christina reported on their Schedule C, Profit or Loss From Business. They treated that loss as a passive loss on their return. The IRS issued a notice of deficiency in which it determined that the Verihas' income from TRI should be recharacterized as nonpassive income under Reg. Sec. 1.469-2(f)(6).

Recharacterization Rules for Self-Rented Property

Under Code Sec. 469(a) no deduction is allowed for the passive activity loss of an individual taxpayer. Passive activity losses are suspended until the taxpayer either has offsetting passive income or disposes of the taxpayer's entire interest in the passive activity. A passive activity is defined as an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. However, the term passive activity generally includes any rental activity, regardless of material participation.

While the general rule of Code Sec. 469(c)(2) characterizes all rental activity as passive, Reg. Sec. 1.469-2(f)(6) requires net rental income received by the taxpayer for use of an item of the taxpayer's property in a business in which the taxpayer materially participates to be treated as income not from a passive activity.

A taxpayer's activities include activities conducted through C corporations that are subject to Code Sec. 469. Reg. Sec. 1.469-2(f)(6) explicitly recharacterizes as nonpassive net rental activity income from an item of property rather than net income from the entire rental activity.

Code Sec. 469 and the related regulations distinguish between net income from an item of property and net income from the entire activity, which might include rental income from multiple items of property. Even when items of property are grouped together in one activity, Reg. Sec. 1.469-2(f)(6) still applies to recharacterize rental income from an item of property as nonpassive income.

Argument over What Constitutes a Single Item of Property

The Verihas and the IRS disagreed about the definition of the phrase item of property. In the notice of deficiency, the IRS determined that the income from TRI should be recharacterized as nonpassive income. The notice of deficiency did not explain the rationale for that recharacterization, and the Verhias contended that the notice of deficiency determined that each fleet of tractors and trailers TRI and JRV owned was a separate item of property and that the income from TRI should be recharacterized under Reg. Sec. 1.469-2(f)(6). In its Tax Court brief, the IRS contended that the notice of deficiency determined that each individual tractor or trailer is an item of property but that the IRS elected not to challenge the offsetting of income and losses with respect to each tractor or trailer within TRI or JRV.

In contrast, the Verihas argued that the entire collection of tractors and trailers, i.e., all the tractors and trailers whether owned by TRI or JRV, constitutes a single item of property. The Verihas further contended that, within the trucking industry, the phrase item of property typically refers to an entire fleet of trucks. However, they cited no authority for that proposition.

The Verihas also argued that the IRS's position was at odds with that taken by the IRS in Shaw v. Comm'r, T.C. Memo. 2002-35, in which the IRS reclassified as nonpassive the net rental income from various properties, including over-the-road trailers. In Shaw, for purposes of Reg. Sec. 1.469-2(f)(6), the IRS treated all the over the road trailers as one item of property.

Tax Court's Analysis

Because neither the Code nor the regulations define the phrase item of property, the Tax Court followed the established rule of construction that an undefined term is given its ordinary meaning. In this case, the court examined various dictionary definitions and found that they supported the IRS's contention that each separate tractor or trailer is an item of property.

Accordingly, the Tax Court concluded that the IRS was not bound to treat the Virahas' tractors and trailers as one item of property even though the IRS may have treated over-the-road trailers in Shaw v. Comm'r, as one item of property.

Citing Murphy v. Comm'r, 92 T.C. 12 (1989), the Tax Court noted that it has repeatedly held that, even with respect to the same taxpayer, the IRS is not bound in any given year to allow the same treatment as in prior years. Moreover, the court said, it was not even clear that, in Shaw, the IRS actually treated all the over-the-road trailers as one item of property. Indeed, the IRS's treatment of the trailers in Shaw was consistent with IRS's position in its brief that, although the IRS considered each individual tractor or trailer a separate item of property, the IRS was electing not to challenge the Verihas' offset of the income and losses from each item of property within TRI and JRV.

Indeed, the court noted, Joseph's decision to hold the entire fleet of tractors and trailers under the title of two different entities was inconsistent with the proposition that the entire fleet was viewed as a single item of property. Moreover, the court found that proposition also inconsistent with the fact that JVT entered into a separate lease agreement with TRI or JRV for each tractor and each trailer it leased. Indeed, those separate lease agreements strongly suggested to the court that JVT, TRI, and JRV viewed each of the tractors or trailers as a separate item of property.

Thus, the Tax Court concluded that each individual tractor and each trailer was a separate item of property within the meaning of Reg. Sec. 1.469-2(f)(6). However, because the IRS did not contest the Verihas' netting of gains and losses within TRI, only TRI's net income was recharacterized as nonpassive income.

Observation: This was a more favorable result than if the IRS had contended that it was necessary for the income from each tractor or trailer within TRI and JRV to be recharacterized as nonpassive.

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Taxpayer Can't Deduct Medical Marijuana Business Expenses; But Can Deduct COGS in Greater Amount than IRS Allowed

In 2004, Martin Olive quit college and opened a medical marijuana dispensary in California. Gross sales grew from over $1 million the first year to $3 million the second year. However, the amount of net income reported was small and when the IRS came to audit, the taxpayer initially could produce no records substantiating gross receipts or cost of goods sold. For expenses the taxpayer could substantiate, the IRS denied deductions. According to the IRS, Code Sec. 280E precluded any deductions. That provision states that a taxpayer cannot deduct any amount for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances that is prohibited by federal law. The IRS then assessed tax deficiencies and penalties.

In Olive v. Comm'r, 139 T.C. No. 2 (8/2/12), the taxpayer tried to argue that his business did not consist of the illegal trafficking in a controlled substance because the business was legal under California law. Thus, Code Sec. 280E did not apply. The Tax Court did not agree, but did allow a deduction for cost of goods sold for which the taxpayer had little to no substantiation. And that deduction, which was based on various testimonies, was much larger than what the IRS had originally allowed. Further, some of the penalties assessed by the IRS were rejected because the issue before the court relating to Code Sec. 280E had not been settled by the court when the taxpayer had filed his return.

Facts

While pursuing a college degree in arts and education, Martin became involved in the medical marijuana industry by volunteering at a medical marijuana dispensary in San Francisco, California. The dispensary had a single business, the distribution of medical marijuana. Martin learned that an approximately 1,250-square-foot room in his low-income neighborhood of San Francisco was available to rent at a minimal cost and he decided to abandon his college studies during his second year and establish a medical marijuana dispensary in the room. He sought the help of local friends and marijuana suppliers and, on January 25, 2004, began operating an unlicensed medical marijuana dispensary as a sole proprietorship. He named his dispensary the Vapor Room. He established the Vapor Room as a place where its patrons, almost all of whom were recipients under the California Compassionate use Act of 1996 (CCUA) (including some with terminal diseases such as cancer or HIV/AIDs), could socialize and purchase and consume medical marijuana.

Martin designed the Vapor Room with a comfortable lounge-like, community center atmosphere, placing couches, chairs and tables throughout the premises. He placed vaporizers, games, books and art supplies on the premises for patrons to use at their desire. He set up a jewelry-store-like glass counter with a cash register on top and jars of the Vapor Room's medical marijuana inventory displayed underneath and behind the counter.

The Vapor Room was generally open for business (except on some holidays) on weekdays from 11 a.m. to 8:30 p.m., and on weekends from noon to 8 p.m. The Vapor Room sold nothing but medical marijuana (in three different forms) and its patrons went to the Vapor Room primarily to consume marijuana, knowing that it was readily available there. The marijuana was sold in three different forms: dried, food laced with marijuana, and a concentrated version of the principal active component. Patrons also frequented the Vapor Room to socialize with each other incident to consuming marijuana. Martin required that each patron possess either a doctor's recommendation to use medical marijuana or a similar certificate the San Francisco government issued. This documentation contained the person's picture and identification number, but not his or her name. Patrons came to know at least the first name of the other patrons who regularly frequented the Vapor Room.

The Vapor Room's staff members were Martin and a few other individuals (four working as employees and an undisclosed number working as volunteers), and all staff members qualified under the CCUA to receive and consume medical marijuana. Neither the staff members nor the other patrons paid Martin a stated fee to frequent the Vapor Room. Nor did Martin require that any patron buy medical marijuana from him to frequent the Vapor Room or to take part in its activities or services. Patrons had access to all the activities and services that the Vapor Room provided, and marijuana was routinely passed throughout the room for consumption without cost to patrons who wanted to partake.

The Vapor Room's sole source of revenue was its sale of medical marijuana, and patrons did not specifically pay for anything else connected with or offered by the Vapor Room. Martin bought for cash (or sometimes received for free) the Vapor Room's medical marijuana inventory from suppliers, each of whom was eligible under the CCUA to receive and consume marijuana.

Martin regularly took cash from the cash register to use personally, including paying for personal trips to New York, New York, to Barcelona, Spain, to Amsterdam, the Netherlands, to Venice, Italy, to Cabo San Lucas, Mexico, and to the British Virgin Islands.

IRS Audit and Tax Court Proceedings

The IRS audited Martin's 2004 and 2005 tax returns in which Martin reported the Vapor Room's net income for those years as approximately $65,000 and $34,000, respectively. Gross receipts for 2004 and 2005 were approximately $1,069,000 and $3,132,000, respectively, while cost of good sold was approximately, $993,000 and $2,812,000, respectively.

Neither Martin nor his accountant/tax preparer could provide any documentation to the IRS agent for the cost of goods sold. As a result, the IRS denied those deductions. After the IRS issued a deficiency notice, Martin provided receipts for approximately $26,000 and $27,000 of cost of goods sold for 2004 and 2005, respectively. While Martin had receipts for other reported expenses, the IRS denied those deductions, stating that Code Sec. 280E precluded any deduction for those expenses. Code Sec. 280E prohibits taxpayers from deducting any expense of a trade or business that consists of the trafficking of a controlled substance such as marijuana.

During the Tax Court trial, Martin produced several ledgers purporting to show the Vapor Room's cash receipts and disbursements. The ledgers showed categories of cash received and expenditures made during each business day in a total figure for each category and listed few (and in some cases no) specifics on the components of the categories. The ledgers sometimes contained no identification for an expenditure. Martin could not definitively identify some of the entries in the ledgers.

Originally, the IRS did not adjust the gross receipts Martin reported. However, the ledgers revealed that the Vapor Room's gross receipts were greater than the reported amounts. The IRS then computed the Vapor Room's gross receipts using the ledgers and concluded that the Vapor Room's gross receipts for 2004 and 2005 were approximately $1,968,000 and $3,302,000, respectively.

Tax Court's Opinion

The Tax Court was asked to decide whether the Vapor Room, a medical marijuana dispensary permitted by California law, could deduct any of its expenses. It was also asked to decide whether Martin underreported the Vapor Room's gross receipts, overreported the Vapor Room's cost of goods sold (COGS), and whether he was liable for an accuracy-related penalty.

With respect to testimony received from Martin and other witnesses, the Tax Court said that testimony was rehearsed, insincere, and unreliable. However, the court found Martin's reporting in the ledgers of the Vapor Room's sales reliable evidence of the amount of the Vapor Room's gross receipts for 2004 and 2005. The IRS calculated the Vapor Room's gross receipts using those ledgers and arrived at slightly different totals for each year than Martin. The court placed more weight on the IRS's calculations, as they were accompanied by more detail and accepted the IRS amounts as the gross receipts for 2004 and 2005.

With respect to the dispute as to the Vapor Room's COGS, the court rejected Martin's argument that the IRS's determination of the Vapor Room's COGS was arbitrary and thus shifted the burden of proof to the IRS. A cash method taxpayer like Martin, the court noted, may generally deduct all ordinary and necessary expenses of the business upon payment of those expenses. However, deductions are strictly a matter of legislative grace, and Martin was required to prove he was entitled to deduct the Vapor Room's claimed amounts of COGS (as well as the Vapor Room's claimed amounts of expenses).

The court rejected Martin's argument that the ledgers alone were sufficient substantiation for taxpayers operating in the medical marijuana industry because the industry shun[s] formal substantiation' in the form of receipts. The ledgers did not specifically identify the marijuana vendors or reflect any marijuana that was received or given away, the court noted. The ledgers neither were independently prepared nor bore sufficient indicia of reliability or trustworthiness, the court stated, and the substantiation rules require a taxpayer to maintain sufficient reliable records to allow the IRS to verify the taxpayer's income and expenditures.

Neither Congress nor the IRS, the court noted, has issued a rule stating that a medical marijuana dispensary may meet that substantiation requirement merely by maintaining a self-prepared ledger listing the amounts and general categories of its expenditures. However, the court considered it unreasonable to conclude that the Vapor Room's COGS totaled the small amounts that the IRS calculated. The court also considered it unreasonable to conclude that the Vapor Room's COGS was the amount set forth in the ledgers. After considering various testimony, the court concluded that 75.16 percent of sales was a reasonable measure of the Vapor Room's COGS. It therefore adopted that percentage of sales as a measure of the Vapor Room's COGS for each year at issue. But the court also considered that Martin gave away some of the marijuana and thus adjusted the COGS by 6.5 percent.

With respect to the Vapor Room's expenses, the Tax Court turned to the provisions of Code Sec. 280E, which provide that a taxpayer may not deduct any amount for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances that is prohibited by federal law. The court cited its previous decision in Californians Helping to Alleviate Medical Problems, Inc. v. Comm'r, 128 T.C. 173 (2007), holding that medical marijuana was a controlled substance under Code Sec. 280E and thus related business expenses were not deductible.

The court rejected Martin's argument that he could deduct the Vapor Room's expenses notwithstanding Code Sec. 280E because the Vapor Room's business did not consist of the illegal trafficking in a controlled substance and the illegal trafficking in controlled substances was the only activity covered by Code Sec. 280E. According to the court, Code Sec. 280E was not that narrow. The court noted that in Code Sec. 280E, Congress set an illegality under federal law as one trigger to preclude a taxpayer from deducting expenses incurred in a medical marijuana dispensary business. This is true even if the business is legal under state law.

Finally, the court generally upheld the accuracy-related penalties. However, because the application of Code Sec. 280E to the expenses of a medical marijuana dispensary had not yet been decided when Martin filed his federal income tax returns for 2004 and 2005, the court concluded that the accuracy-related penalty did not apply to the portion of each underpayment that would not have resulted had Martin been allowed to deduct his substantiated expenses.

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Agreement to Reimburse S Shareholders' Tax Liability Was Not a Fraudulent Conveyance by S Corp

Kenrob Information Technology Solutions, Inc., an S corporation, had three shareholders: Kenneth and Sylvia Robinson and Mark Schuler. By agreement between the shareholders and Kenrob, the corporation was obligated to reimburse the shareholders for the income taxes attributable to the pass-through liability from the corporation. In April 2007, the corporation paid the personal income taxes attributable to the pass-through liability directly to the IRS. The tax payments were applied to the shareholder's personal tax returns. The corporation did this again in April 2008. According to Mark, he was not fully reimbursed for all the taxes for which he should have been reimbursed. However, he did not request reimbursement because he wanted to assist the corporation in its cash flow. Subsequently, Kenrob filed for bankruptcy. During the bankruptcy proceedings, the bankruptcy trustee asserted that Kenrob's payments of the shareholders' tax liabilities were fraudulent conveyances because they were made without consideration by the corporation.

The trustee disputed some of the facts asserted by the IRS to be undisputed, in particular, the existence of a shareholder agreement obligating the corporation to reimburse the shareholders for taxes attributable to the pass-through liability. The trustee pointed to deposition testimony of both Ken and Mark that they did not recall signing the shareholder agreement and the absence of a fully executed agreement. There was a copy of a redlined agreement, but not a final executed document. The IRS pointed to the unequivocal testimony of both Ken and Mark that there was an agreement, that all the parties acted in accordance with the agreement, and that the shareholders would not have agreed to a subchapter S election had there not been an agreement to reimburse them for the additional tax liability. The trustee asserted that a shareholders' agreement made years before the transaction was not sufficient.

A district court rejected the bankruptcy trustee's objections and held that the payment of the shareholders' associated tax liability did not constitute a constructively fraudulent transaction. The court concluded that the fact of the existence of the agreement was not generally in dispute and the mere absence of a copy of the executed document did not show that there was no such agreement, particularly where the agreement had been fully performed.

With respect to the issue of consideration, the court stated that consideration need not come directly from the party to whom the payment is made (i.e., in this case, the IRS). Consideration can be derived from a third party. Thus, according to the court, as long as the unsecured creditors are no worse off because the debtor, and consequently the estate, has received an amount reasonably equivalent to what it paid, no fraudulent transfer has occurred. Citing the Third Circuit's decision in Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981), the district court observed that indirect benefits may also be evaluated. In this instance, it was clear to the court that there was a benefit derived by the corporation from its arrangement with the shareholders. Court records showed a taxable income of $1,560,000, which was passed through to the shareholders. The IRS calculated the tax that would have been paid by the corporation had it been a chapter C corporation and not a chapter S corporation. The benefit to the corporation of the election, the court noted, was significant.

In addition to the reduction of taxes, the corporation also received the benefit of not distributing its income to the shareholders even though that income was passed through for tax purposes. The shareholders left the money in the corporation to be used for corporate purposes. Had they insisted upon distribution to themselves, the corporation would have been stripped of more than $1.2 million that it used as operating capital.

With respect to the trustee's assertion that a shareholders' agreement made years before the transaction is not sufficient, the court noted that there is no requirement that the consideration be contemporaneous with the agreement. The consideration was the election by the shareholders of the corporation to be taxed as a chapter S corporation as long as the corporation paid their additional personal taxes. There was a continuing benefit to the corporation over the years and a continuing obligation on the part of the corporation to reimburse the shareholders.

The trustee asserted that there was a dispute as to material fact in the computation of the value of the election. According to the trustee, the calculation by the IRS was incorrect because the corporation could have planned for its taxes in other manners that might have reduced the taxes as well and would have engaged in such tax planning had there been no chapter S election. The court rejected such speculation as to what alternative tax planning measures could have been taken only the facts as presented, the court said, should be considered. And those facts were that the corporation was a chapter S corporation and it did not engage in other tax planning. The mere prospect of hypothetical alternative tax planning without any supporting documentation in the court record as to what it would have been or the effect of it does not create a genuine dispute as to a material fact, the court said.

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Change from Expensing to Capitalization Is a Change in Accounting Method; Code Sec. 481 Adjustments to Closed Year Permissible

In CCM 201231004, a taxpayer took legal action against A and B. The litigation continued until the taxpayer and A executed a settlement agreement in Year 1, resolving all pending litigation and disputes. The litigation involved two major issues: (1) the defendants' failure to honor the taxpayer's right of first refusal to purchase land; and (2) the defendants' failure to maintain property under a management agreement. The settlement agreement awarded certain proceeds to the taxpayer. The proceeds consisted of a set amount through a line of credit to be used for a development plan, a set amount of cash due on the date the agreement closed of which a certain amount would be used to pay existing loan balances, an amount that could be used for immediate repairs and upgrades to existing facilities, and an amount that could be used for the development plan for proposed renovations, development, or redevelopment of the taxpayer's facilities.

Later that year, the taxpayer entered into a development agreement with A, under which A would manage, supervise, and complete a plan for major improvements of the taxpayer's facilities. The development agreement obligated the taxpayer to use part of the settlement proceeds toward the improvement plan.

The taxpayer reported the settlement proceeds as income on its tax return, and claimed an expense deduction of the same amount. Documents obtained by the IRS from the taxpayer did not show the extent to which services (for repairs or improvements) were performed as of December 31, of that tax year. However, the documents did show that as of December 31 of the subsequent tax year (Year 2), the taxpayer had spent a certain amount of the settlement proceeds on the improvements under the development plan. Moreover, according to the IRS, the documents indicated the expenditures under the development plan were capital in nature. The IRS said that taxpayer had not proven that any expenditures made pursuant to the settlement and development agreements were for deductible repairs.

Year 1, in which the taxpayer received the proceeds, is a closed year. For Year 2, the IRS proposed to place the taxpayer on the correct methods of accounting to capitalize expenditures and to deduct expenditures only when economic performance has occurred. Pursuant to the imposition of these changes in accounting method, the IRS proposed an adjustment under Code Sec. 481(a) attributable to the expense deduction taken in the closed year for the settlement proceeds.

The Office of Chief Counsel was asked to decide: (1) whether a change in the time for deducting an item of expenditure constitutes a change in method of accounting; (2) whether a change from deducting an item of expenditure to capitalizing the item of expenditure constitutes a change in method of accounting; and (3) if the foregoing do constitute changes in method of accounting, whether a Code Sec. 481(a) adjustment should be recognized in connection with such changes, and if so, whether the Code Sec. 481(a) adjustment may reflect amounts previously deducted in closed tax years.

The Office of Chief Counsel advised that (1) a change in the time for deducting an item of expenditure constitutes a change in method of accounting under Code Sec. 446; (2) a change from deducting to capitalizing an item of expenditure constitutes a change in method; and (3) an adjustment under Code Sec. 481(a) is appropriate when a taxpayer's method of accounting for an item of expenditure is changed from earlier deduction to later deduction or capitalization. The Code Sec. 481(a) adjustment is computed with respect to relevant amounts in all tax years preceding the year of change, whether the tax years are open or closed under the statute of limitations on assessment.

The Chief Counsel's Office noted that once the IRS has imposed a change in method of accounting, the application of Code Sec. 481(a) to the change is patent and mandatory. Further, an adjustment under Code Sec. 481(a) can include amounts attributable to tax years that are closed by the statute of limitations.

The Code Sec. 481(a) adjustment reflects relevant amounts from any tax years preceding the year of change, even if such years are closed by the statute of limitations. Citing Earthquake Sound Corp. v. Comm'r, T.C.Memo. 2000-112, the Chief Counsel's Office stated that if the taxpayer deducted certain amounts in Year 1 under its old method of accounting, and will be able to deduct or otherwise recover those same amounts again in the year of change or subsequent tax year(s), then positive amounts (increases to taxable income) must be recognized under Code Sec. 481(a) to eliminate the double deduction that would otherwise result, despite Year 1being closed under the statute of limitations.

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IRS Issues Guidance on Charitable Contributions to Domestic Disregarded Entities

Code Sec. 170(a) allows as a deduction any charitable contribution, as defined in Code Sec. 170(c). One of the requirements under that provision is that the organization to which the contribution is made is a domestic organization. Code Sec. 170(b) prescribes limitations on the maximum amount deductible as a charitable contribution.

Generally, Reg. Sec. 301.7701-2(c)(2)(i) provides that a business entity that has a single owner and is not a corporation under Reg. Sec. 301.7701-2(b) is disregarded for federal tax purposes as an entity separate from its owner (i.e., a disregarded entity). Reg. Sec. 301.7701-2(a) provides that if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. A business entity (including a disregarded entity) is domestic if it is created or organized within the United States, or under the law of the United States or of any state. A U.S. charity that wholly owns a disregarded entity must treat the operations and finances of the disregarded entity as its own for tax and information reporting purposes. However, for employment and certain excise tax purposes, an entity that is disregarded as separate from its owner for any purpose under Reg. Sec. 301.7701-2 is treated as an entity separate from its owner.

In Notice 2012-52, the IRS provides that, if all other requirements of Code Sec. 170 are met, the it will treat a contribution to a disregarded SMLLC that was created or organized in or under the law of the United States, a United States possession, a state, or the District of Columbia, and is wholly owned and controlled by a U.S. charity, as a charitable contribution to a branch or division of the U.S. charity. The U.S. charity is the donee organization for purposes of the substantiation and disclosure requirements.

Compliance Tip: To avoid unnecessary inquiries by the IRS, the charity should disclose, in the acknowledgment or another statement, that the SMLLC is wholly owned by the U.S. charity and treated by the U.S. charity as a disregarded entity. The limitations of Code Sec. 170(b) apply as though the gift were made to the U.S. charity.

While Notice 2012-52 is effective for charitable contributions made on or after July 31, 2012, taxpayers may rely on it for tax years for which the statute of limitations has not expired.

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Tax Court Allows Estimated Gambling Expenses Based on Taxpayer Testimony

Fortunato Gonzalez is president of Gonzalez Concrete Co. He and his wife, Maria, are recreational gamblers and, in 2009, played slot machines regularly on weekends at Cache Creek Casino Resort. The Gonzalezes did not keep formal records of their gambling activities. They did not use a casino members' club card because they did not trust it for accurate readings. While the Gonzalezes did not keep a diary, a log, or a regular record of their gambling activity, they did retain copies of canceled checks, totaling $29,700, which were negotiated near weekends or holidays. They cashed these checks to have funds available for gambling activities. The Gonzalezes received four Forms W-2G, Certain Gambling Winnings, representing winnings of $2,000, $10,000, $2,700, and $6,000, at the casino. On their Form 1040 for 2009, the Gonzalezes reported $34,359 of income earned from wages and $724 from rental activity. Upon an audit of their 2009 tax return, the IRS determined that Forms W-2G provided by the casino reflected gambling income which the Gonzalezes failed to report on their tax return.

The Gonzalezes attempted to substantiate gambling losses by relying on (1) their general testimony that they lost more money than they won, (2) checks that were cashed regularly so that funds would be available at the casino, and (3) the theory that all gamblers lose money.

The Tax Court held that the Gonzalezes could deduct $15,000 of gambling losses against the $20,700 of gambling winnings reflected on the four separate Forms W-2G issued by the casino. According to the Tax Court, the Gonzalezes credibly testified that these winnings were used for further gambling activities during their weekend trips. The court noted that, under the Cohan rule, if the trial record provides sufficient evidence that a taxpayer has incurred a deductible expense, but the taxpayer is unable to substantiate adequately the precise amount of the deduction to which he or she is otherwise entitled, the Tax Court may estimate the amount of the deductible expense.

The court noted that the Gonzalezes wrote checks to cash at least once a month for most of the year in issue, and most of the checks were negotiated near weekends and holidays. The court was satisfied that at least some of these funds and some of the winnings were used to engage in gambling activities. Taking into account the credible testimony of the Gonzalezes, the fact that gambling winnings were used to engage in additional gambling activity, the cashing of checks on the weekends, and the fact that the Gonzalezes' disposable income from other sources was otherwise limited, and using its best judgment to reasonably estimate the amount of gambling losses, the court allowed the Gonzalezes a gambling loss of $15,000.

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Payments to Welfare Benefit Plan to Fund Passthrough Entities' Buy-Sell Agreements Are Nondeductible

Marc Curcio and Ronald Jelling are each 50 percent partners of three car dealerships treated as partnerships: Dodge of Paramus, Inc. (Dodge), Chrysler Plymouth of Paramus, Inc. (Chrysler Plymouth), and JELMAC LLC (JELMAC). Around 2001, Marc and Ronald decided to enter into a buy-sell agreement. The buy-sell agreement contemplated that if one partner died, the other would buy the deceased partner's 50 percent stake in the businesses. When the buy-sell agreement was executed, it set the value of the businesses at $12 million. To fund the purchase if it became necessary, each partner agreed to take out an insurance policy on the other's life. In other words, each partner would list the other as the beneficiary of his death benefit, and the death benefit would be used to buy the deceased partner's share of the businesses. Instead of buying life insurance policies directly, however, Marc and Ronald decided to insure themselves through a plan called the Benistar 419 Plan. This plan was designed to be a multiple-employer welfare benefit plan under Code Sec. 419A(f)(6). Marc and Ronald were the only covered employees. They did not choose to insure any of the other 75 people employed by Dodge. Neither Chrysler Plymouth nor JELMAC enrolled, nor were any of their employees, other than Marc and Ronald, covered. Marc and his insurance agent selected a whole life policy with a $9 million death benefit. Ronald and his insurance agent chose two policies one whole life policy and one universal (or adjustable) life policy totaling approximately $9 million in coverage. Marc paid a $200,000 annual policy premium to the Benistar plan. Ronald paid the same.

Although Dodge was the only entity to enroll in the Benistar plan, Dodge was not always the only entity to contribute to the Benistar plan. In fact, all three Marc/Ronald business entities contributed to the Benistar plan, with whichever entity having the highest cash balance at the end of the year doing so. Dodge contributed $400,000 in 2001 and 2002. JELMAC contributed $400,000 in 2003 and Chrysler Plymouth contributed $400,000 in 2004. Each business claimed a tax deduction for the entirety of its contribution. Ronald considered the contributions "as a funding for our buy sell agreement." Marc and Ronald had asked their accountant, Stuart Raskin, about the deductibility of the contributions. Raskin consulted with his partners and, based on a letter from the law firm Edwards & Angell, LLP, concluded that a deduction was proper. Raskin advised Marc and Ronald that the deduction was proper, but also communicated that this opinion was derived solely from the Edwards & Angell letter, and not from any independent research or investigation. Furthermore, Raskin did not offer Marc or Ronald any assurances that the IRS would approve the deductions. Neither Raskin, nor anyone at his firm, was an expert in welfare benefit plans.

The IRS disallowed the deductions the business entities had taken for contributions to the Benistar plan because it said the contributions were not ordinary and necessary business expenses. Accordingly, the IRS found that Marc and Ronald had additional pass-through income on which they had failed to pay income tax. In addition to the deficiencies, the IRS assessed a 20 percent accuracy-related penalty on each of them. The Tax Court held for the IRS, and Marc and Ronald appealed to the second circuit. Their cases were consolidated with other similarly situated taxpayers.

The Second Circuit upheld the Tax Court. Expenditures may be deducted under Code Sec. 162, the court noted, only if the facts and the circumstances indicate that the taxpayer made them primarily in furtherance of a bona fide profit objective independent of tax consequences. Purchasing or subsidizing benefits e.g., life insurance for employees might fall into this category, the court said, to the extent it incentivizes employees to remain loyal to the business and perform to the best of their abilities. According to the court, in determining the deductibility of a welfare benefit plan contribution (which, under Code Sec. 419(a)(1), are not deductible per se), the threshold question is whether the contribution is an ordinary and necessary business expense under Code Sec. 162(a).

The Second Circuit concluded that the contributions were not normal, usual, or helpful for the development of the taxpayers' business; they were not made in furtherance of a profit objective or for any viable business purpose. Rather, the evidence demonstrated to the court that the contributions were made solely for the personal benefit of the taxpayers. According to the court, the contributions were a mechanism by which the taxpayers could divert company profits, tax-free, to themselves, under the guise of cash-laden insurance policies that were purportedly for the benefit of the businesses, but were actually for the taxpayers' personal gain.

The court noted that it was not holding that purchasing a life insurance policy with a cash component can never be an ordinary and necessary business expense. Such a determination is fact intensive and must be made on a case-by-case basis. In this case, however, the Second Circuit said that where the taxpayers could withdraw from the Benistar plan at any time and obtain personal control over cash-laden policies, and where other evidence in the record demonstrated that the taxpayers contributed to the plan solely for their personal benefit, the Tax Court did not clearly err in finding that the contributions were not ordinary and necessary business expenses and in upholding the penalties.

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Where an Erroneous Refund Resulted from a Mutual Mistake, the IRS Did Not Abuse Its Discretion in Denying Interest Abatement

Luther Allcorn timely filed his 2008 Form 1040, U.S. Individual Income Tax Return, after previously filing a Form 1040-ES, Estimated Tax, and paying $4,000 in estimated taxes. On his Form 1040, Luther mistakenly added the $4,000 estimated tax payment to the income tax withheld reported on Line 62 instead of the estimated tax payments reported on Line 63. That mistake contributed to IRS issuing a refund to Luther on May 11, 2009. The IRS later realized that Luther had reported the $4,000 estimated tax payment on Line 62, and the IRS subsequently informed Luther that he owed $4,000 plus a penalty and interest. Luther filed a request for abatement, and the IRS granted his request to abate the penalty but denied his request to abate the interest. Luther took his case to the Tax Court.

The IRS argued that Luther's excess refund was caused by his own mistake and that it is not at fault in any way. In contrast, Luther contended that he was not at fault in any way and that the error is entirely the IRS's. Insofar as he erred by reporting his estimated tax payments on Line 62 instead of Line 63 of his Form 1040, Luther said that the Form 1040 is unclear. He further argued that the IRS should have been able to figure out that he reported his estimated tax payments on Line 62 because the sum of the federal income tax withheld on his Forms 1099-R and W-2 was $4,000 less than that reported on Line 62. Additionally, Luther contended that the IRS ignored a note he included with his Form W-2 that explained that the additional $4,000 had been paid with his Form 1040-ES. The IRS countered that Luther's note was ambiguous.

The Tax Court held that, even though the refund was recoverable by assessment and levy procedures, the refund also would have been recoverable by filing a civil suit under Code Sec. 7405 and was therefore an erroneous refund under Code Sec. 6602. Because the refund constituted an erroneous refund under Code Sec. 6602, the court stated, it was also an erroneous refund under Code Sec. 6404(e)(2). According to the court, even though interest abatement was not mandatory under Code Sec. 6404(e)(2) because Luther's mistake contributed to causing the erroneous refund, the IRS still had the authority to abate the interest with respect to the erroneous refund. However, the court concluded that the IRS did not abuse its discretion by denying Luther's request to abate the interest on the erroneous refund.

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IRS Finalizes Regs on Deductions for Entertainment Use of Business Aircraft

The IRS issued final regulations relating to deductions for the use of business aircraft for entertainment. T.D. 9597 (8/1/12).

Generally, Code Sec. 162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Under Code Sec. 274(a)(1)(A), no deduction is allowed for an activity generally considered to be entertainment, amusement, or recreation, unless the taxpayer establishes that the activity is directly related to or (in certain cases) associated with the active conduct of the taxpayer's trade or business.

In 2007, the IRS issued proposed regulations on the use of business aircraft for entertainment. Those regulations, with some changes, have now been finalized. Under the final regulations, expenses subject to disallowance under Code Sec. 274(a) include variable costs such as fuel and landing fees, and fixed costs such as depreciation, hangar fees, pilot salaries, and other items not directly related to an individual flight. The IRS rejected practitioner suggestions that the final regulations limit expenses subject to disallowance to the direct or variable costs of a flight and exclude fixed costs.

Compliance Tip: The regulations apply to tax years beginning after August 1, 2012.

In the preamble to the final regulations, the IRS discussed whether allowing taxpayers to determine the amount of expenses paid or incurred for entertainment flights by reference to charter rates was appropriate. The difficulty of determining accurate and reliable charter rates, the IRS stated, was an impediment to establishing a charter rate safe harbor. Accordingly, the final regulations do not include these rules but rather authorize the IRS to adopt charter rate or other safe harbors in future published guidance.

With respect to depreciation, a taxpayer may elect to compute depreciation expenses on a straight-line basis for all the taxpayer's aircraft and all tax years for purposes of calculating expenses subject to disallowance, even if the taxpayer uses another method to compute depreciation for other purposes. There is a transition rule for applying the straight-line election to aircraft placed in service in tax years preceding the election, which requires the taxpayer to apply the straight-line method as if it had been applied from the year the aircraft was placed in service. The IRS rejected a request to allow a separate election for each aircraft. Requiring taxpayers to make the election for all aircraft, the IRS said, appropriately balances the policies of promoting business investment through the allowance of additional first-year depreciation and denying a tax benefit for entertainment use of business aircraft. The final regulations clarify that, in any tax year, the depreciation disallowance does not exceed the amount of otherwise allowable depreciation. Thus, the sum of the allowable depreciation and the depreciation disallowed will not exceed 100 percent of basis, regardless of the tax year a taxpayer makes the straight-line election.

Example: ABC Company owns an aircraft that it uses for business and other purposes. The expenses of operating the aircraft in the current year are $1,000,000. This amount includes $250,000 for depreciation (25 percent of total expenses). In the same year, the aircraft entertainment use subject to disallowance is 20 percent of the total use and ABC treats $80,000 as compensation to specified individuals. Thus, the amount of the disallowance is $120,000 ($1,000,000 x 20 percent ($200,000) less $80,000). ABC may calculate the amount by which a category of expense, such as depreciation, is disallowed by multiplying the total disallowance of $120,000 by the ratio of the amount of the expense to total expenses. Thus, $30,000 of the $120,000 total disallowed expenses is depreciation ($250,000/$1,000,000 (25 percent) x $120,000). The result is the same if ABC separately calculates the amount of depreciation in total disallowed expenses and in the amount treated as compensation and nets the result. Depreciation is 25 percent of total expenses, thus, the amount of depreciation in disallowed expenses is $50,000 (25 percent x $200,000 total disallowed expenses) and the amount of depreciation treated as compensation is $20,000 (25 percent x $80,000). Disallowed depreciation is $50,000 less $20,000, or $30,000.

Under the final regulations, interest is subject to disallowance if the underlying debt is secured by or properly allocable to an aircraft used for entertainment.

The regulations also provide aircraft aggregation rules, which provide that a taxpayer may aggregate expenses for aircraft of similar cost profiles to calculate expenses subject to disallowance. The regulations require that aircraft have the same engine type and number and suggest other factors relevant to whether aircraft are of a similar cost profile. The regulations provide two alternative methods for allocating the costs associated with the use of an aircraft to provide entertainment to specified individuals. The occupied seat hours or miles allocation method divides the total expenses for the year by the number of occupied seat hours or occupied seat miles to determine a per seat or per mile rate, and it applies the rate to the number of hours or miles of entertainment use. The flight-by-flight method allocates expenses to a flight and then to the passengers on the flight according to the entertainment or non-entertainment character of the travel.

Like the proposed regulations, the final regulations do not exempt expenses for entertainment travel from disallowance under Code Sec. 274 when there is a business need to use the aircraft to provide security pursuant to Reg. Sec. 1.132-5(m). The IRS rejected a comment saying that the final regulations should provide that the excess cost of using a private aircraft for bona fide security concerns should not be subject to disallowance. Reg. Sec. 1.132-5(m), the IRS noted, reduces the amount of income inclusion for the fringe benefit under circumstances in which a bona fide security concern exists, but does not convert an entertainment flight into a business flight. Because Code Sec. 274(e) does not provide an exception to disallowance for expenses related to the use of a private aircraft for bona fide security concerns, the final regulations did not adopt this comment.

*CIRCULAR 230 DISCLOSURE: Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.

Federal Tax Bulletin - Issue 17 - August 17, 2012