Court Rejects IRS Attempt to Use Obscure Provision to Deny Casualty Loss Deduction to Taxpayers

On December 25, 2002, a married couple's home was destroyed by fire. Their insurance company, because of a paperwork snafu, rejected their claim and refused to pay. The couple took the insurance company to court and lost. Then they filed suit against the contractors they felt were responsible for the fire. Again, they lost. Finally, after receiving not a dime for the destruction of their home by fire, the couple took a casualty loss deduction on their tax return, which resulted in a tax refund claim of a little over $16,000. Using a little known and never litigated provision of the Code that was enacted over 25 years ago, the IRS denied the claim. According to the IRS, the couple had failed to file a timely insurance claim as required by Code Sec. 165(h)(5)(E).

In Ambrose v. U.S., 2012 PTC 238 (Fed. Cl. 8/3/12), the Court of Federal Claims rejected the IRS position and held that the taxpayers were entitled to the casualty loss deduction. In its conclusion, the court noted that the IRS described this case as one of first impression. The court agreed saying an informed observer might ask why it took the IRS 25 years to happen upon a taxpayer claiming a casualty loss who had lost a dispute with his insurer. However, the court said the more perplexing question was not why the issue came up so late, but why it came at all.

Background

In August of 2002, Mark and Jennifer Ambrose took out a homeowners' insurance policy with Farm Family Casualty Insurance Company (Farm Family) on their home in Auburn, New York. That policy covered their home, other structures on the premises, personal property, and loss of use in the event of a fire or other peril insured against up to a limit of $216,000, subject to a $250 deductible. As is typical, this coverage was subject to a number of conditions.

In November 2002, the Ambroses' home was damaged by a dryer fire. In fulfillment of its obligations under the Ambroses' homeowners' policy, Farm Family contracted with Diamond's Air Clean and Construction (Diamond) to repair the fire, smoke, and water damage, while the Ambroses temporarily relocated to a nearby motel. In the early hours of December 25, 2002, a second, more serious fire occurred in the Ambrose home, totally destroying the house.

The Ambroses alleged that the second December fire was caused by Diamond's negligent workmanship. On January 29, 2003, Farm Family sent the Ambroses a letter, via both certified and regular mail, which noted that the insurance adjuster assigned to the case had requested that the Ambroses provide him with a Personal Property Inventory and such documentation had not been received. The letter said the Ambroses had 60 days in which to file a sworn statement regarding the fire. In February of 2003, the Ambroses hired an attorney, who contacted Farm Family inquiring whether anything else was required to process the Ambroses' claim beyond the information previously taken. On March 26 and April 7, 2003, a Farm Family representative conducted an examination under oath of each of the Ambroses. The Ambroses asserted that they never received either the certified or regular mail version of the January letter. They alleged that Farm Family did not request the sworn proof of loss until the April 7, 2003, examination, and that their attorney timely returned the sworn proof of loss on April 23, 2003. On June 12, 2003, Farm Family sent the Ambroses a letter denying coverage for the December 25th fire.

The Ambroses subsequently filed lawsuits against Farm Family and Diamond and lost. Following the final disposition of these lawsuits, the Ambroses filed an amended federal income tax return for 2007, in which they deducted a casualty loss of $167,619. The deduction eliminated their tax liability, leading them to claim a refund of $16,254. The IRS disallowed the claim saying it was fully disallowed because the Ambroses had failed to file a timely insurance claim as required by Code Sec. 165(h)(5)(E). According to the IRS, the Ambroses failed to file a timely insurance claim under Code Sec. 165(h)(5)(E) because they made a personal decision not to file the proof of loss on a timely basis.

History of Code Sec. 165(h)(5)(E)

Under Code Sec. 165(c)(3), an individual can generally deduct losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. To the extent such loss is covered by insurance, Code Sec. 165(h)(5)(E) provides that a casualty loss deduction is allowed only if the individual files a timely insurance claim with respect to the loss.

Before the enactment of Code Sec. 165(h)(5)(E), a number of courts considered whether, under Code Sec. 165(a), a taxpayer's election not to file an insurance claim for a loss precluded him from deducting the loss. In these cases, which involved casualty or theft losses, the IRS argued that the loss in question derived not from the casualty or theft itself, but from the taxpayer's intervening decision not to file an insurance claim. It contended that, as a result of the latter decision, the deduction did not correspond to a loss sustained . . . and not compensated for by insurance or otherwise, as required by Code Sec. 165(a). While this argument met some initial success, ultimately it was soundly rejected by the courts, first by the Tax Court, and then by various appellate decisions affirming the decisions of the Tax Court. In these cases, the taxpayers were allowed to deduct casualty losses under Code Sec. 165 even though they failed to file insurance claims.

In 1986, Congress intervened, denying a loss deduction under Code Sec.163(c)(3) for any loss covered by insurance unless the individual files a timely insurance claim with respect to the loss. The accompanying House Committee Report described the impetus for the new provision as follows:

The deduction for personal casualty losses should be allowed only when a loss is attributable to damages to property that is caused by one of the specified types of casualties. Where the taxpayer has the right to receive insurance proceeds that would compensate for the loss, the loss suffered by the taxpayer is not damage to property caused by the casualty. Rather, the loss results from the taxpayer's personal decision to forego making a claim against the insurance company. The committee believes that losses resulting from a personal decision of the taxpayer should not be deductible as a casualty loss.

Court Rejects IRS Position

The Court of Federal Claims rejected the IRS's position and held that the Ambroses could take the casualty loss deduction. According to the court, requiring an insured taxpayer to file a timely claim does not mean that the taxpayer must file with his insurer anything more than what qualifies, under his policy, as a basic demand for compensation.

With respect to the IRS argument that the Ambroses failed to file a timely insurance claim under Code Sec. 165(h)(5)(E) because they made a personal decision not to file the proof of loss on a timely basis, the court noted that the statute does not use either of the quoted phrases. Nor, the court observed, does the statute define what is meant by the phrase it actually employs files a timely insurance claim. According to the court, it was unclear whether Congress intended to include within the concept of an insurance claim the necessity of providing timely proof of that claim.

According to the court, the IRS's interpretation of Code Sec. 165(h)(5)(E) did not hold up for many reasons. The key phrase in that statute, files a timely insurance claim, takes its meaning from its individual terms. Webster's Dictionary defines the phrase file in relevant part, as to deliver . . . after complying with any condition precedent . . . to the proper officer for keeping on file or among the records of his office. The same lexicon defines a claim as a demand for compensation, benefits or payment, using as an example thereof one made under an insurance policy. These and like definitions, the court observed, strongly suggest a distinction between the filing of a claim and the subsequent submission of proof of the validity of that claim.

The court further noted that Reg. Sec. 1.165-1(a) appears to recognize that there is a distinction between the claim requirement in Code Sec. 165(h)(5)(E) and the proof a policy might require as a precondition to recovery. Under Reg. Sec. 1.165-1(a), a deduction is allowed for any loss actually sustained during the tax year and not made good by insurance or some other form of compensation. Further, the court said, Reg. Sec. 1.165-1(d)(2)(i), which defines the year in which the loss deduction may be claimed, specifically alludes to a taxpayer's abandonment of a claim for reimbursement as marking the proper time for taking a deduction. Applying the statute in accordance with its actual terms, the court stated, there was little doubt that, with respect to the loss in question, the Ambroses filed a timely insurance claim and Code Sec. 165(h)(5)(E) did not bar them from receiving a casualty loss deduction.

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Sales Subsequent to Easement Donation Are Considered in Valuing Easement Contribution

It would seem counterintuitive to base the value of an easement contributed to charity on events subsequent to the donation. Yet, in Trout Ranch, LLC v. Comm'r, 2012 PTC 233 (10th Cir. 8/16/12), that's exactly what happened. The Tax Court rejected the expert appraisals introduced by both the taxpayer and the IRS in their entirety and, relying on data involving sales that took place after the easement was donated, came up with its own value of the taxpayer's easement donation. The taxpayer appealed, arguing, in part, that data from after the date of valuation is categorically inadmissible in determining fair market value. In upholding the Tax Court's decision, the Tenth Circuit concluded that the regulation fixing the fair market value of a donation at the time of contribution does not necessarily restrict the evidence to be considered in determining that fair market value.

Background

Gunnison Riverbanks Ranch sits on 453 acres in Gunnison County, Colorado. The property is located between the towns of Gunnison, six miles to the south, and Crested Butte, 20 miles to the north. The crown jewel of the property is two miles of frontage on the Gunnison River, a stream beloved by fisherman for its world-class rainbow and German brown trout.

Since Gunnison County has no zoning laws, land use is governed by Colorado law, under which developers may subdivide land into 35-acre parcels as a matter of right, with additional subdivision subject to the approval of county planning commissions. Gunnison County uses a system of transferable development rights called the Large Parcel Initiative Process (LPIP). The system promotes conservation by encouraging developers to permanently restrict development of large parcels of land (preserved tracts) in exchange for the right to develop unpreserved tracts more densely. Under the LPIP, a developer who preserves 75 percent of his property can subdivide the remainder into three lots for every 75 acres he owns (rounded down to the nearest multiple of 35). If a developer preserves 85 percent, he gets an additional lot for every 140 acres. So while Colorado law allows a property with Gunnison Riverbanks Ranch's dimensions to be divided into 12 35-acre lots, the LPIP would permit as many as 22 three-acre lots.

Trout Ranch purchased Gunnison Riverbanks Ranch in 2003 with plans to develop a residential subdivision under the LPIP and preserve the remainder with a conservation easement. The price was almost $4 million. According to the development plan, the land not encumbered by the easement would be subdivided into 21 residential lots, with an additional lot for a clubhouse. Lots would average approximately three acres, and owners would have access to a host of shared amenities, including a clubhouse, a boat house, riding stables, duck blinds, an archery range, and three ponds. In addition, the lot owners would enjoy preferred, if not exclusive, right to use the conserved lands, in particular the right of access to nearly two miles of frontage on the Gunnison River. The deal was completed in December 2003, when Trout Ranch conveyed an easement encumbering approximately 85 percent of the property384 of 453 acresto the Crested Butte Land Trust. The plan was approved by Gunnison County in April 2004.

Trout Ranch elected to be taxed as a partnership in 2003 and, on its tax return for that year, it claimed a charitable deduction for the easement, which it valued at approximately $2.2 million. The IRS determined the easement did not reduce the value of the property and reduced the charitable deduction to zero. Trout Ranch filed a petition with the Tax Court objecting to the adjustment and asserting that the IRS had substantially undervalued the conservation easement. The value of the easement was the only issue raised in the petition; both parties agreed that the easement was a qualified conservation contribution and therefore, to the extent allowed, properly deductible under Code Sec. 170(f)(3). Code Sec. 170(f)(3) creates an exception to the general rule that a taxpayer can't take a deduction for a charitable contribution of a partial interest in property.

Battle of the Appraisers

Before the Tax Court, both sides introduced the testimony of expert appraisers in support of their asserted valuations. The experts worked under the framework for valuing conservation easements set forth in Reg. Sec. 1.170A-14(h)(3)(i). Under this framework, the value of a conservation easement is the fair market value (FMV) of the easement at the time of the contribution. Under the regulations, there are two methods for ascertaining fair market value. First, if there is a substantial record of sales of easements comparable to the donated easement, then the FMV of the donated easement is based on the sales prices of such comparable easements. Second, if no substantial record of sales is available, then as a general rule (but not necessarily in all cases), the FMV is equal to the difference between the FMV of the property it encumbers before the granting of the restriction and the FMV of the encumbered property after the granting of the restriction. Finding the before and after values requires a determination of the property's income-producing potential. To this end, appraisers will generally construct discounted cash-flow models, which estimate the present value of a property by estimating future revenue (in this case, revenue from lot sales) and discounting it based on the cost of capital. The before-and-after approach is more common in remote areas like Gunnison County where records of comparable sales are scarce.

The Trout Ranch appraiser, Jonathan Lengel, was the only expert to perform a valuation based on the comparable-sales method. Lengel also provided a valuation using the before-and-after method, but the comparable sales figure is what ultimately formed the basis for his opinion. Lengel admitted that this was his first time using the comparable-sales method, and he admitted at trial that he probably would have stuck to the before-and-after approach had his client not urged him to consider an alternative method. Lengel based his comparable-sales valuation on four sales of conservation easements in Gunnison County, but, on cross-examination, it was apparent that he had not carefully vetted the comparisons. The sales had been recorded by a local conservation group and listed on a matrix that omitted most of the information necessary for a meaningful comparison, including the consideration exchanged, the relevant restrictions, and the profitability of the underlying land. Worse yet, Lengel admitted he had not examined the deeds or appraisals for any of the easements and all of the comparable transactions involved bargain sales to charities in which the purchaser paid less than the appraised price, making it difficult to determine the actual value of the easement.

In spite of these flaws, Lengel's comparable-sales analysis estimated the value of the easement between $1.59 million and $2.3 million, a figure in line with the before-and-after appraisal he submitted with Trout Ranch's tax return ($2.2 million), and not far from the before-and-after appraisal he had submitted in a supplemental report in anticipation of trial ($3 million). In the end, he placed the value of the easement at $2.2 million, an estimate based primarily on comparable sales.

The IRS had two expert appraisers, Lou Garone and Michael Nash. Both Garone and Nash performed before-and-after appraisals using discounted cash-flow models to determine the most profitable use of the property before and after the easement. In evaluating the most profitable use before the easement, Garone considered configurations as sparse as 12 lots and as dense as 60, but concluded a 22-lot model, much like the one prepared by Trout Ranch, would be the most lucrative use of the land, with a projected value around $5 million. Since everyone agreed the same 22-lot configuration represented the best use of the property after the easement, Garone concluded the value of the easement was zero.

Because Nash agreed with Garonea 22-lot configuration was the best use of the land both before and after contributing the easementhe concluded the value of the easement was zero. In his view, Trout Ranch wisely availed itself of the LPIP process, which allowed it to avoid the costs and procedural risk of a prolonged approval process. Nash also constructed a discounted cash-flow model that yielded a $5,650,000 value for the property, to which he added $725,000 for improvements made by Trout Ranch, for a total value of $6,300,000.

Tax Court's Decision

The Tax Court refused to accept any of the expert appraisals in their entirety. Rather, it achieved a different result by borrowing bits of data from each report to construct its own value of the easement. As a preliminary matter, the Tax Court concluded the before-and-after approach was the appropriate valuation method because there was no substantial record of sales of easements comparable to the donated easement. The court agreed with the experts' consensus that the most profitable use of the land post contribution was a 22-lot residential subdivision.

Recognizing disagreement among the experts over the potential value of such a development, however, the court conducted its own analysis using sales data from a nearby subdivision, Hidden Valley, where similarly sized lots had been selling in a range between $320,000 and $430,000. This included sales data from after the date of valuation of Trout Ranch's easement. Since the court viewed the Hidden Valley property as comparable but less desirable than Gunnison Riverbanks Ranch, the court added a $60,000 premium to the top of the sales range to arrive at an estimated lot price of $490,000. That figure was then considered in conjunction with factors such as the number of lots, absorption rate, overhead, appreciation, and discount rate to reach a final post-contribution value of $3.89 million. With respect to the pre-contribution value, the court used a hypothetical 40-lot residential subdivision with an estimated value of $4.45 million. The court then subtracted from that figure the $3.89 million post-contribution value to arrive at a total before-and-after value of $560,000.

Trout Ranch challenged that figure on appeal and insisted the correct valuation was higher, closer to the $2.2 million estimate it originally offered. Trout Ranch argued that the Tax Court erred by relying on data involving sales that took place after the easement was donated.

Tenth Circuit's Analysis

The Tenth Circuit upheld the Tax Court's valuation. With respect to the argument that the Tax Court erred by relying on data involving sales that took place after the easement was donated, the Tenth Circuit said that assertion appeared to embrace two related arguments: first, a legal argument that data from after the date of valuation is categorically inadmissible in determining fair market value; and second, a factual argument that the post-valuation-date data used by the court in this case distorted its method. According to the Tenth Circuit, no authority supports the contention that land appraisals cannot take account of data released after the date of valuation. With respect to Trout Ranch's reliance on Reg. Sec. 1.170A-14(h)(3)(i), the court said that a regulation fixing the fair market value at the time of contribution does not necessarily restrict the evidence to be considered in determining fair market value. Reg. Sec. 1.170A-14(h)(3)(i), the court observed, is neutral on the question of relevant evidence; it sets no limitations on the information informing fair market value.

With respect to Trout Ranch's question of how a reasonable buyer at the time of contribution could be expected to account for land sales that had yet to occur, the court said that Trout Ranch was reading the reasonable buyer language too literally. The reasonable buyer, the court stated, is a conceptual device meant to illustrate the objective nature of the inquiry, not a limitation on the evidence that can inform it.

The question for the real estate appraiser and ultimately the Tax Court, the Tenth Circuit noted, is not what a reasonable buyer could say about a particular sale but what the particular sale could say about the reasonable buyer. According to the court, data unavailable to a reasonable buyer may still say something about the price such a hypothetical buyer would have been willing to pay at the time of the contribution. Fair market value is a question of fact, and questions of fact are governed by the rule of relevance. While evidence of subsequent sales may not always be probative of a prior fair market value, the court stated, whether such evidence should factor into an appraisal is not a categorical question of law but a simple question of relevance: Does unfair prejudice substantially outweigh the probative value of the evidence? Citing the Seventh Circuit's decision in First Nat'l Bank of Kenosha v. U.S., 763 F.2d 891 (7th Cir. 1985), the Tenth Circuit said the question to be asked in a valuation case is whether the admission of the evidence would make more or less probable the proposition that the property had a certain fair market value on a given date? To this end, the Tenth Circuit found that data from events after a donation can be just as informative (and just as distorting) as data from events before the donation. If there is a hard-and-fast rule governing the admission of subsequent events, the court said, it is that such events will be considered to the extent they were reasonably foreseeable on the date of donation valuation.

In the instant situation, the Tenth Circuit noted that the Tax Court was mindful of the risks associated with post-valuation data and had devoted an entire section of its opinion to addressing Trout Ranch's concerns about the effect post-contribution lot sales might have had on the IRS's valuation. Excluding post-valuation data, it seemed to the Tenth Circuit, would have left the Tax Court unequipped to make an informed finding as to value. While reasonable minds could differ about the weight to be assigned to such data, the Tenth Circuit concluded that it was a stretch to argue that the use of post-valuation data in this case amounted to an abuse of discretion.

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Vineyards Are Eligible for Section 179 Expensing; Prior IRS Ruling No Longer Applies

Because the vineyard at issue constituted Section 179 property, the taxpayers could expense the costs incurred in developing the vineyard under Code Sec. 179. CCM 201234024.

In 2005, the individual taxpayers in CCM 201234024 began planting a vineyard. The costs of the land preparation, labor, rootstock, and the planting were capitalized over three years. The land preparation costs claimed did not include any nondepreciable land costs. In 2009, when the plants became viable, the taxpayers placed the vineyard in service and elected, under Code Sec. 179, to expense the costs incurred in planting the vineyard. The question presented to the Office of Chief Counsel was whether these individuals were entitled to claim a Code Sec. 179 deduction with respect to a vineyard they planted in 2005 and placed in service in 2009.

The Office of Chief Counsel concluded that the vineyards were Section 179 property and the taxpayers were thus allowed to expense in 2009 the cost (including capital expenditures made by the taxpayers to develop the vineyard to an income-producing stage), or a portion of the cost of the vineyard, under Code Sec. 179.

The Chief Counsel's Office noted that there is some confusion about the application of Rev. Rul. 67-51 to vineyards. In that ruling, the IRS concluded that certain fruit-bearing trees were not Section 179 property because they did not qualify as tangible personal property within the meaning of Code Sec. 179. However, the Chief Counsel's Office noted that when Rev. Rul. 67-51 was issued, Code Sec. 179(d)(1) provided that the term Code Sec. 179 property meant tangible personal property of a character subject to the allowance for depreciation under Code Sec. 167, acquired by purchase after December 31, 1957, for use in a trade or business or for holding for production of income, and with a useful life (determined at the time of such acquisition) of six years or more. Former Reg. Section 1.179-3(b) provided that, for purposes of Code Sec. 179, the term tangible personal property included any tangible property except land, and improvements thereto, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures). Since the issuance of Rev. Rul. 67-51, the definition of Code Sec. 179 property has significantly changed, the Chief Counsel's Office noted. Currently, and for the year in issue, Code Sec. 179 property includes depreciable property that is tangible personal property or other tangible property under Code Sec. 1245(a)(3). Accordingly, the Chief Counsel's Office observed, because of the change in the definition of Section 179 property, Rev. Rul. 67-51 no longer applies for purposes of Code Sec. 179.

The Chief Counsel's Office concluded that the taxpayers' vineyard met all the requirements of Code Sec. 179(d)(1) and thus met the definition of Section 179 property for purposes of making the expensing election.

For a discussion of property eligible for the Section 179 expensing election, see Parker Tax ¶94,710.

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Ex-BDO Tax Partner Can't Escape Restitution Payment for Involvement in Tax Shelter Scheme

An ex-tax partner of a large accounting firm was ordered to pay $2 million in restitution for his participation in a tax shelter scheme. U.S. v. Kerekes, 2012 PTC 240 (S.D. N.Y. 8/15/12).

Michael Kerekes was a tax partner at BDO Seidman. In 2009, he pled guilty to one count of conspiracy to defraud the IRS and one count of tax evasion of a BDO Seidman client's taxes. The charges stemmed from his part in a decade-long tax shelter scheme involving several other BDO employees, including the former chairman and CEO of the accounting firm. Others involved included a Deutsche Bank broker and attorneys at the law firm of Jenkens & Gilchrist. On November 16, 2011, the court sentenced Kerekes to a one-year sentence, six months incarceration, and six months home confinement, a $50,000 fine and a $200 special assessment, both of which he paid. The court gave the parties 30 days to provide submissions on the restitution issue, and several rounds of supplemental submissions were provided in response. In one of the submissions, the government requested restitution of $84.3 million.

Kerekes opposed the imposition of any restitution on several grounds or in the alternative requested that any restitution amount be set at a fraction of the amount sought by the government to reflect what Kerekes characterized as his comparatively modest economic circumstances and low level of culpability.

With respect to Kerekes argument that restitution should not be ordered because Deutsche Bank already forfeited almost $554 million pursuant to a non-prosecution agreement and that payment was partially in lieu of restitution, the court said there was no problem with an award of restitution and forfeiture in the same case. According to the court, restitution was an essential part of Kerekes' sentence in this conspiracy that, according to the government, put approximately $2 million of bonuses in his pocket.

In the end, the judge concluded that it was appropriate to exercise his discretion and apportion liability individually, at least with respect to Kerekes. He took into account Kerekes relatively modest role in the conspiracy and felt that the fairest approach was to hold Kerekes responsible for the amount of his $2 million bonus.

For a discussion of the penalties relating to tax evasion, see Parker Tax ¶265,110.

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Transfer of Assets for Floating Rate Notes Was Really a Taxable Sale

A taxpayer's attempt to escape all tax liability on a large gain failed when the court recognized the transaction as nothing more than a sale cloaked as a loan. Sollberger v. Comm'r, 2012 PTC 231 (9th Cir. 8/16/12).

Kurt Sollberger is president of Swiss Micron, Inc. On June 1, 1999, Swiss Micron adopted the Swiss Micron, Inc. Employee Stock Ownership Plan (the ESOP). On January 1, 2000, Sollberger sold 340 shares of Swiss Micron stock to the ESOP for $1,032,240. Because his original basis in the stock was $47,749, he earned a profit of $984,491. Instead of recognizing the capital gain from the sale of Swiss Micron stock, Sollberger exercised his option under Code Sec. 1042(a) to defer paying taxes on the profit by using the stock sale proceeds to purchase floating rate notes (FRNs) issued by Bank of America, with a face value of $1 million. He transferred the FRNs to Optech Limited for a nonrecourse loan of 90 percent of the FRNs' value. The loan was nonrecourse to Sollberger and secured only by the FRNs. Optech was to receive the quarterly interest payments from the FRNs and apply them to the quarterly interest accruing on the loan, with Sollberger being responsible for paying the difference, if any. The loan term was seven years, and Sollberger was not allowed to prepay the principal before the maturity date. Optech agreed to return the FRNs to Sollberger at the end of the loan term if Sollberger had repaid the loan amount in full, in addition to any outstanding net interest, and late penalties due. However, Optech was given the right to sell or otherwise dispose of the FRNs during the loan term, without giving Sollberger notice, or receiving his consent. Instead of holding the FRNs as collateral for the loan, Optech immediately sold the FRNs and, based on the sale price, transferred 90 percent of the proceeds to Sollberger. Sollberger did not report that he had sold the FRNs in his 2004 federal income tax return.

The IRS assessed Sollberger $128,979 in additional taxes, plus interest. Sollberger appealed to the Tax Court but the court agreed with the IRS. In its opinion, the Tax Court cited prior decisions, including Calloway v. Comm'r, 135 T.C. 26 (2010), in which it had held that essentially identical transactions were sales triggering capital gains rather than loans. Applying these precedents, the Tax Court concluded that Sollberger sold his FRNs to Optech, triggering capital gains in 2004, on which Sollberger owed taxes. Sollberger appealed to the Ninth Circuit. The primary question was whether Sollberger's transaction with Optech should be treated as a sale for tax purposes.

Sollberger acknowledged that the transaction took the form of a loan, but argued that the transaction was neither a sale nor a loan, but a transfer of the FRNs as collateral for a loan, and a theft by Optech of 10 percent of their value. The IRS disagreed, arguing that the transaction was a sale artfully disguised as a loan.

The Ninth Circuit affirmed the Tax Court decision. The court noted that the Tax Court identified the following eight relevant criteria to determine whether a sale occurs for tax purposes: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.

While the Ninth Circuit agreed that these criteria may be relevant in a particular case, it did not regard them as the only indicia of a sale a court may consider. Creating an exclusive list of factors risks over-formalizing the concept of a sale, the court said, hamstrings a court's effort to discern a transaction's substance and realities in evaluating tax consequences. The Ninth Circuit said that to determine whether a sale occurs for tax purposes, it would continue to apply a flexible, case-by-case analysis of whether the burdens and benefits of ownership have been transferred.

In this case, the Ninth Circuit had no difficulty concluding that the economic reality of the Optech-Sollberger transaction was that Sollberger sold the FRNs to Optech in return for 90 percent of their face value. The rights given to Optech in the relevant agreements, the court stated, suggested that the transaction was a sale. According to the court, the transaction was more akin to an option contract, whereunder the FRNs were sold, but the seller retained a call option to reacquire them after seven years, if he elected to do so. Optech's risk of loss would have arisen, the court noted, only if Sollberger had actually repaid the loan. Sollberger's and Optech's conduct also confirmed to the Ninth Circuit that the transaction was, in substance, a sale. Although interest accrued on the loan, Sollberger stopped receiving account statements and making interest payments after the first quarter of 2005, less than one year into the seven-year loan term. Thus, neither Sollberger nor Optech, the court noted, maintained the appearance that a genuine debt existed for long. The total amount that Sollberger paid to Optech was de minimis compared to the size of the loan. The FRNs were also sold before Sollberger received the loan from Optech, which suggested to the Ninth Circuit that Optech funded the majority of the loan amount with the proceeds received from the sale of the FRNs. The apparent lack of any ability or intention by Optech to hold the FRNs as collateral to secure repayment of the loan, the court stated, further buttressed the conclusion that the transaction was merely a sale in the false garb of a loan.

Observation: A week after the Ninth Circuit reached its decision in Sollberger, the Eleventh Circuit affirmed the Tax Court's decision in Calloway, 2012 PTC 243 (11th Cir. 8/23/12), which involved a transaction similar to that in Sollberger.

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Failure to File Form 3520 Could Cost Doctor Almost $600K; Doctor Claims Accountant Dropped Ballin Failing to File Foreign Trust Documents

Further court proceedings are necessary because questions remained with respect to whether a physician's tax return preparer told him he did not need to file Form 3520 with respect to a foreign-owned trust and whether the physician reasonably relied upon that advice. James v. U.S., 2012 PTC 237 (M.D. Fla. 8/14/12).

Brian James is a Florida physician specializing in pain management. In 2001, looking to protect his assets from potential malpractice claims, Brian created an irrevocable foreign trust in Nevis, West Indies, with First Fidelity Trust Limited (FFT) as its trustee. Brian initially funded the trust in 2001 with a contribution of $192,000. He made additional contributions of $805,000 in 2002 and $607,000 in 2003. For all the relevant years, the trust timely filed Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. In addition, as owner of the trust, Brian was required to file IRS Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Brian failed to file the required Form 3520 for 2001, 2002, and 2003.

In 2006, the IRS assessed penalties of $67,200, $281,750, and $230,000, for Brian's failure to file Form 3520 in years 2001, 2002, and 2003, respectively. Brian paid those amounts and filed suit in a district court for a refund, arguing that his failure to file Form 3520 was due to reasonable cause and not willful neglect.

Under Code Sec. 6048, an owner of a foreign trust is required to file Form 3520. The form is due at the same time as the taxpayer's federal income tax return for that year. If the trust owner fails to timely file Form 3520, or submits an incomplete or incorrect form, he is subject to a penalty of $10,000 or 35 percent of the gross reportable amount, whichever is greater. No penalty is imposed, however, if the failure to file was due to reasonable cause and not due to willful neglect.

According to Brian, the failure to file Form 3520 was the fault of his former accountant, George Famiglio. Famiglio had prepared Brian's personal and business taxes for a number of years, and Brian relied on Famiglio to properly oversee and advise him about the tax requirements of the foreign trust. According to Brian, he or his agent timely provided Famiglio with all appropriate trust documents and information, for each year in question, yet Famiglio failed to timely file Form 3520, and/or advise Brian that it should be filed. According to Brian, he was personally unaware of the requirement to file Form 3520. Brian argued that he acted prudently and with sound business judgment in engaging Famiglio to handle all issues related to the foreign trust, and that his accountant simply dropped the ball. Although Brian did not remember the details of most conversations he had with Famiglio, or any specific advice he received, he recalled that they talked a pretty good bit about the trust, and he believed at the time that Famiglio had filed everything required with the IRS. In short, Brian argued that he had reasonable cause for failing to file Form 3520 by reasonably relying on his accountant.

The IRS on the other hand, argued that Brian was put on notice of the requirement to file Form 3520 and that his reliance on Famiglio did not constitute reasonable cause.

The district court held that there was a genuine issue of material fact with respect to whether Famiglio provided Brian with advice upon which Brian reasonably relied. The record, viewed in a light most favorable to Brian, the court stated, showed, among other things, that: (1) Brian (or his agent) timely provided all required trust forms to Famiglio; (2) Brian relied on Famiglio to advise him on all matters related to the trust; (3) Famiglio advised him on at least some trust matters (for example, Famiglio advised him how to report loans from the trust for tax purposes and advised him that the trust loans did not result in taxable income); (4) Brian relied on Famiglio to advise him about making the appropriate filings for the trust; (5) Famiglio failed to so advise him; and (6) Brian, based on his conversations with Famiglio, believed that he had filed all required forms. In addition, the court noted, Famiglio prepared Brian's personal tax returns and, on Schedule B of his Form 1040 tax returns, it appeared that Famiglio answered no to the question did you [Brian] receive a distribution from, or were you the grantor of, or transferor to, a foreign trust? If yes,' you may have to file Form 3520. Answering no to this question, the court said, could be construed as Famiglio providing advice that Brian need not file Form 3520, advice upon which Brian could have potentially reasonably relied.

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Penalties Upheld on Taxpayer Who Relied on Partner to Take Care of Withholding Taxes

A taxpayer could not reasonably rely on his business partner to escape trust fund penalties for failing to pay employment taxes. Logan v. U.S., 2012 PTC 241 (W.D. Ohio 8/20/12).

Thomas Logan, Jr. and John Zam founded X-L Enterprises, Inc. in 1991. X-L was engaged in the heating, ventilation, and air conditioning (HVAC) business, installing HVAC systems in commercial properties, light industrial buildings, schools, and offices. X-L had two shareholders, Logan and Zam, who each held a one-half interest in the Company. In addition to being the only shareholders, Logan and Zam were also the only officers of X-L; Logan served as both Vice President and Treasurer and Zam served as President and Secretary. From X-L's inception, Logan and Zam had different day-to-day responsibilities: Logan was in charge of fabricating the material used in the HVAC units, his primary workspace being X-L's workshop. Zam was in charge of HVAC installation and transacting company business, spending most of his time in the office. Both parties had the ability to sign checks, co-sign or guarantee loans on behalf of X-L, access the company checkbook, and hire and fire employees.

Despite these shared abilities, Logan stated that it was Zam who had primary control of X-L's finances and financial policies, including payment and filing of payroll tax returns. Zam did not dispute this claim. During the years 2005 to 2008, X-L failed to pay federal withholding taxes on behalf of its employees.

In April 2008, an IRS agent visited Logan and Zam regarding the unpaid taxes. The officer informed both men of their potential personal liability if the debt remained unpaid. It was only after this meeting that Logan admitted to having knowledge of the full extent of X-L's tax liability. Both Logan and Zam were subsequently repeatedly notified via mail of X-L's failure to pay. The taxes remained unpaid.

Logan stated that he trusted Zam to correct the situation. Under Code Sec. 6672, both Logan and Zam were assessed personal liability in the balance amount of $219,000 and $213,000, respectively. Logan officially retired from X-L on June 27, 2008, but maintained his ownership in the company. Since January 2011, Logan has been making monthly payments to the IRS for the trust fund recovery penalty via deductions in his monthly social security check. Neither Logan nor Zam has made any additional payments to the IRS. Logan applied for a refund of the taxes paid, arguing that he was not a responsible person under the law.

A magistrate judge concluded that Logan was a responsible person who willfully failed to turn over payroll taxes for all periods at issue. According to the magistrate, Logan had ample opportunity to resolve X-L's unpaid taxes and avoid personal liability for those taxes after October 2007. Instead, he elected not to pay or voluntarily reduce X-L's tax liability, but to rather rely on Zam to take care of the problem. This was true despite the fact Zam never made any effort to resolve the debt from the moment it began accruing. According to the magistrate, Logan was personally liable for the entire amount of X-L's outstanding payroll tax liability of approximately $220,000 plus interest. Further, as a responsible person, Logan was not entitled to a refund of the payroll taxes he had already paid.

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Interest Rates Remain the Same for Last Quarter of 2012

The IRS announced that interest rates will remain the same for the calendar quarter beginning October 1, 2012. Rev. Rul. 2012-23.

With respect to interest on tax overpayments and underpayments, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus three percentage points. Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus three percentage points and the overpayment rate is the federal short-term rate plus two percentage points.

Under Code Sec. 6621, the rate for large corporate underpayments is the federal short-term rate plus five percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a tax period is the federal short-term rate plus one-half (0.5) of a percentage point.

For the quarter beginning October 1, 2012, the rates are:

3 percent for overpayments(2 percent in the case of a corporation);

3 percent for underpayments;5 percent for large corporate underpayments; and

0.5 percent for the portion of a corporate overpayment exceeding $10,000.

For a discussion of interest on tax overpayments and underpayments, see Parker Tax ¶261,500.

*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.