Tax Firm's Challenge to Limitation on Contingent Fee Arrangements Rejected

A tax services firm and its founder, as well as another firm employee, challenged Circular 230's limitation on contingent fees before the district court in Washington, D.C. In particular, they claimed that Circular 230's restrictions on the use of contingent fee arrangements for ordinary refund claims violated their First and Fifth Amendment rights and asked for a permanent injunction barring the enforcement of those restrictions.

The taxpayers may have thought they were in friendly territory since the same court recently invalidated the IRS's registered tax return preparer rules (see ¶271,127). However, while the court in Ryan, LLC v. Lew, 2013 PTC 43 (D. D.C. 3/29/13) concluded that the firm, but not its founder, had standing to take its arguments before the court, the court ultimately held that the tax services firm failed to state a plausible claim for relief. As a result, the court granted the IRS's motion to dismiss their claims.

OBSERVATION: A separate claim filed under the Administrative Procedure Act was not included in the IRS's motion to dismiss. As a result, the court allowed that claim to go forward.

Background

Ryan, LLC, is a global tax services firm. Along with its founder, G. Ryan, and Gerald Lee Ridgely, Ryan, LLC filed a suit in the U.S. District Court for the District of Columbia challenging certain provisions of Circular 230. In particular, they challenged the limitation on the use of contingent fee arrangements in connection with the preparation and filing of refund claims with the IRS. Their arguments against Circular 230 were as follows:

(1) Ryan, LLC and G. Ryan argued that Circular 230 violated taxpayers' rights under the Petition Clause of the First Amendment (Count I);

(2) G. Ryan argued that Circular 230 violated his Fifth Amendment Due Process Rights (Count II); and

(3) Gerald Lee Ridgely, in a suit under the Administrative Procedure Act, argued that the IRS had exceeded its statutory authority in promulgating Circular 230 (Count III).

OBSERVATION: The Petition Clause of the First Amendment allows a taxpayer to state a grievance and request relief from a court or other ruling authority. It provides a taxpayer with a means to institute a nonfrivolous lawsuit and mobilize popular support to change existing law. The Administrative Procedure Act governs the way in which administrative agencies of the federal government may propose and establish regulations.

The taxpayers were seeking a declaratory judgment that Circular 230's restrictions on contingent fee arrangements in the context of ordinary refund claims was unconstitutional and exceeded the scope of the IRS's authority. They asked for a permanent injunction barring the enforcement of Circular 230's restrictions on the use of contingent fee arrangements for ordinary refund claims. The IRS filed a motion to dismiss Counts I and II.

Contingent Fee Rules

Beginning in 1994, Circular 230 restricted the use of contingent fee arrangements for preparing original income tax returns. However, the regulations allowed the use of contingent fee arrangements for the preparation and filing of amended returns and/or refund claims, so long as the practitioner reasonably anticipated at the time the fee arrangement was entered into that the amended return or refund claim would receive substantive review by the IRS. In issuing the regulations, the IRS explained that a rule restricting contingent fees for preparing tax returns supports voluntary compliance with the tax laws by discouraging return positions that exploit the audit selection process.

In September 2007, however, the IRS issued final regulations expanding the Circular 230 limitations on the use of contingent fee arrangements. In response to public comments, the IRS repeated its prior stance that a rule restricting contingent fees for preparing tax returns supports voluntary compliance with the federal tax laws by discouraging return positions that exploit the audit selection process. Circular 230, Section 10.27(b)(1), now provides that, in most circumstances, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the IRS. However, Circular 230, Section 10.27(b)(3) and (4), does allow for some exceptions to this limitation for services rendered in connection with the IRS's examination of, or challenge to: (1) an original tax return; or (2) an amended return or claim for refund or credit where the amended return or claim for refund or credit is filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to, the original tax return. Additionally, a practitioner may properly charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the IRS or for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code.

The term contingent fee is defined as any fee that is based, in whole or in part, on whether or not a position taken on a tax return or other filing avoids challenge by the IRS or is sustained either by the IRS or in litigation, and also includes a fee that is based on a percentage of the refund reported on a return, that is based on a percentage of the taxes saved, or that otherwise depends on the specific result attained.

Ryan LLC's Argument

According to Ryan, LLC, an integral part of its business has historically been the representation of clients on a contingent fee basis in the preparing and filing of ordinary tax refund claims. The firm asserted that the ordinary refund claims it has prepared and filed on behalf of its clients typically have not involved complex legal issues, or in many cases, any legal disputes at all. Instead, these refund claims have usually been extremely fact intensive inquiries that required an enormous outlay of time, energy, and resources. The firm stated that its efforts in compiling, organizing, preparing, and analyzing the volumes of data necessary to establish the validity of such claims results in substantial expenses being incurred up front, in the preparation of the claim. Given this, Ryan, LLC alleged that its clients have preferred the use of contingent fee arrangements when pursuing these claims. Ryan, LLC argued that it has lost clients and substantial revenue due to the Circular 230 prohibition on the use of contingent fee arrangements for services rendered in connection with preparing and filing of ordinary refund claims. Through the suit, Ryan, LLC asserted that Circular 230's restrictions infringed upon the First Amendment right to petition the Government for a redress of grievances, through the filing of ordinary refund claims.

According to Ryan, LLC, its clients' interest in upending Circular 230 is to reduce the initial outlay of cost in pursuing ordinary refund claims by enabling them to share the expenses associated with the preparation and filing of these claims through contingency fee payments. Ryan, LLC stated that it wanted to set aside Circular 230's contingent fee prohibition so that it can resume contingent compensation agreements with its clients and can benefit from the renewed business opportunities and increased revenues that would result. According to Ryan, LLC, its clients' interest in upending Circular 230 is to reduce the initial outlay of cost in pursuing ordinary refund claims by enabling them to share the expenses associated with the preparation and filing of these claims through contingency fee payments.

G. Ryan's Arguments

G. Ryan, as founder and chairman of Ryan, LLC, argued that because of Circular 230's prohibition on the use of contingent fee arrangements, he was unable to retain a practitioner on a contingent fee basis to prepare and file an ordinary refund claim on his behalf. He alleged that Circular 230 violated his rights under the Petition Clause of the First Amendment, and also claimed that Circular 230 violated his Fifth Amendment due process rights by depriving him of the ability to obtain a refund for an overpayment of tax.

IRS Argument

According to the IRS, Circular 230's impact on taxpayers' ability to file refund claims with the IRS, if any, falls well within the permissible bounds of the government's ability to regulate potential First Amendment conduct. Under the revised regulations of Circular 230, the IRS said, taxpayers remain free to file ordinary refund claims with the IRS. The IRS stated that taxpayers remain free to retain a tax practitioner to assist them in the preparation and filing of such claims and taxpayers also remain free to compensate tax practitioners for such claims. The only limitation that Circular 230's revised regulations place on taxpayers, the IRS observed is if taxpayers choose to file an ordinary refund claim, and if taxpayers choose to retain a tax practitioner to assist them in the preparation and filing of such a claim, then they cannot compensate the practitioner on a contingency fee basis.

District Court's Opinion

The question before the district court was whether Ryan, LLC, or G. Ryan, individually, had standing to contest the Circular 230 limitation on contingent fee arrangements. The district court found that Ryan, LLC had standing to pursue its claim on behalf of its third-party taxpayer clients. However, with respect to G. Ryan, the court concluded that he failed to allege an injury consistent with this theory. Stated another way, the court said that, despite the supposedly complex and costly nature of ordinary refund claims, G. Ryan did not assert that his inability to retain a practitioner on a contingent fee basis had deprived him of the right or ability to pursue such a claim. In fact, the court pointed out, his allegations confirmed precisely the opposite because he stated that he had filed an ordinary refund claim since the effective date of the 2007 revisions to Circular 230. In sum, because G. Ryan failed to allege a sufficiently concrete and particularized injury that comported with his constitutional due process theory, the district court held that he lacked standing to pursue his claim.

The court then reviewed the crux of Ryan LLC's claim under the Petition Clause, which was that, given the technical complexities of the tax laws, the requirements imposed by the IRS on the content of refund claims and the enormous amount of time and effort necessary to prepare a proper refund claim, the prohibition on the use of contingent fee arrangements impairs and, in some cases, may extinguish, the ability of taxpayers to effectively petition the IRS for a refund of taxes that have been overpaid.

The court found dubious the IRS's argument that the Petition Clause does not protect a taxpayer's right to file an administrative claim for refund with the IRS. Not only has the Supreme Court explicitly held that Petition Clause guarantees citizens the ability to seek relief with courts, the district court noted, but it has also made clear that these protections extend to other forums established by the government for the resolution of legal disputes.

In the end, however, the district court agreed with the IRS that the minor limitation on proceedings before the IRS as put forth in Circular 230's limitation on contingent fee arrangements, does not run afoul of the Petition clause. The court concluded that, even accepting as true the well-pleaded allegations of Ryan LLC's complaint, the firm had failed to state a plausible claim for relief under the First Amendment's Petition Clause.

Finally, the court stated that Gerald Lee Ridgely's claim under the Administrative Procedure Act (Count III), which was not included in the IRS's motion to dismiss, would be allowed to proceed.

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Estate's Reliance on Expert's Wrong Advice Was Reasonable Up to a Point; Subsequent Delay Subject to Penalties

A number of estate tax cases recently have dealt with whether or not an estate had reasonable cause for missing a filing deadline and thus being excused from penalties assessed by the IRS. The courts generally rule against the estate, holding that reliance on an expert's advice does not negate the penalty because one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. However, in Est. of Liftin v. U.S., 2013 PTC 41 (Fed. Cl. 3/29/13), the court was faced with an interesting situation involving the marital deduction and a non-U.S. citizen spouse. No marital deduction is allowed if the spouse is not a U.S. citizen. Thus, on the advice of an estate tax legal expert, an estate put off filing the return until the spouse became a U.S. citizen and until all ancillary matters were resolved. It turns out that the advice was erroneous but the court found the estate had reasonable cause for the late filing up until the wife became a U.S. citizen. However, there was no reasonable cause for waiting to file nine months after the wife became a citizen and all ancillary matters were resolved.

OBSERVATION: The addition to tax for failure to file timely reaches the statutory maximum if the delinquency continues longer than four months. Therefore, the estate's nine-month delay without reasonable cause was sufficient to subject it to the maximum late-filing penalty.

Facts

Morton Liftin died on March 2, 2003, and his son, John, was appointed as the executor of his estate. The decedent's will provided for direct bequests to, among others, his surviving spouse, Anna Liftin, who was a U.S. resident and a citizen of Bolivia at the time of the decedent's death.

Under Code Sec. 6075(a), the estate was required to file a federal estate tax return by December 2, 2003, nine months after the decedent's death. Code Sec. 6081(a) grants an extension of time of up to six months for the filing of a return, and Reg. Sec. 20.6081-1 provides that the total allowable time for filing, including extensions, is 15 months from the decedent's death. The executor hired his former law partner, John Dadakis, to assist with the estate's federal estate tax return and the administration of the estate's assets, including certain claims by Mrs. Liftin against the estate. At the time, Dadakis was a partner at the law firm of Morrison & Foerster LLP, and had expertise in private wealth services and estate and gift tax planning.

In discussions both before and after the decedent died, Dadakis advised the executor regarding the effect of Mrs. Liftin's citizenship status on the estate's federal tax return. In general, Code Sec. 2056(d)(1)(A) provides that the value of property that passes from a decedent to a surviving spouse may be deducted from the value of the estate that is subject to the federal estate tax. This so-called marital deduction is not available, however, if the surviving spouse is not a U.S. citizen. Nevertheless, Code Sec. 2056(d)(4) provides that, if the spouse becomes a citizen before the estate tax return is filed and has been a resident of the United States at all times after the decedent's death and before becoming a citizen, the estate may take the marital deduction. Thus, after the decedent's death, the estate could take the marital deduction only if Mrs. Liftin was a U.S. citizen when the estate filed its return.

On November 26, 2003, six days before the estate's return and taxes were due, the estate requested a six-month extension to file its return and pay the taxes due. The IRS granted the estate's request, setting a new deadline of June 2, 2004. On January 20, 2004, the estate made a tax payment of $877,300, an amount the estate estimated would be sufficient to satisfy the taxes due even if it were unable to claim the marital deduction.

Thereafter, the executor and Dadakis became aware that Mrs. Liftin intended to apply for U.S. citizenship. The executor knew, however, that Mrs. Liftin's naturalization process might not be completed before the June 2, 2004 deadline. Dadakis, based on his interpretation of Reg. Sec. 20.2056A-1(b), advised the estate, in substance, that its late filing in order to claim the marital deduction would not trigger a penalty as long as the return was filed within a reasonable time after Mrs. Liftin became a naturalized U.S. citizen and other ancillary matters were completed. The executor found this advice to be reasonable, particularly because the estate had already paid more than the amount of tax the executor believed would ultimately be due.

By June 2, 2004, Mrs. Liftin was not yet naturalized. Following Dadakis's advice, the estate did not file a return. On October 4, 2004, the IRS sent a letter to the estate inquiring why it had not filed a tax return. In response, Dadakis wrote the IRS on November 4, 2004, setting forth the estate's position, as well as his rationale for concluding that Reg. Sec. 20.2056A-1(b) allowed a late filing in order to claim the marital deduction. Dadakis's letter did not, however, reference his advice that the estate could wait to file its return until all ancillary matters were completed. Neither the estate nor Dadakis received a response from the IRS.

Mrs. Liftin became a U.S. citizen on August 3, 2005. Approximately seven months later, in February of 2006, the estate entered into an agreement settling Mrs. Liftin's claims against the estate. On May 9, 2006, the estate filed its tax return claiming the marital deduction in the amount of the value of the property passing to Mrs. Liftin and reflecting a tax due of approximately $679,000 and an overpayment of approximately $199,000.

The IRS did not contest the marital deduction, but did assess a penalty under Code Sec. 6651 of almost $170,000 for late filing and late payment. The estate filed a refund claim, which the IRS denied. After an administrative appeal, the IRS granted a partial refund in the amount of $34,000, leaving a claim of approximately $136,000.

In its administrative appeal, the estate argued that the statutes and regulations related to the marital deduction provided reasonable cause for the estate's late filing. The IRS rejected the appeal and the case headed to the Court of Federal Claims.

Federal Claims Court Decision

The Federal Claims court noted that, to avoid a penalty for a late-filed return, the estate had to prove that its failure to file timely was due to reasonable cause and not willful neglect. To prove reasonable cause, the court stated, the estate had to show that it exercised ordinary business care and prudence but nevertheless was unable to file the return within the prescribed time. Willful neglect, the court observed, requires a conscious, intentional failure or reckless indifference.

Citing the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), the court said that when an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. In short, tax returns imply deadlines. Thus, the Court of Federal Claims said, the Supreme Court distinguished advice from an attorney involving an interpretation of substantive tax law, which can constitute reasonable cause, from an attorney's assistance in meeting the requirements of unambiguous statutes, which cannot constitute reasonable cause.

The court looked at Dadakis's advice to the executor that a late-filed estate tax return would not trigger a late-filing penalty so long as the tax return was filed within a reasonable time after Mrs. Liftin became a naturalized United States citizen and after all ancillary matters were completed. This advice was subsequently recognized as erroneous.

The Court of Federal Claims held that the executor's reliance on Dadakis's erroneous advice was reasonable to the extent the advice was to wait until Mrs. Liftin became a U.S. citizen. That advice, the court noted, concerned a substantive question of tax law regarding the interaction between the statutes and regulations providing for the marital deduction and the statutes and regulations setting the deadline for filing the estate's return. The executor had no basis to question Dadakis's advice, the court stated. As the circumstances changed, the executor continued to ask whether the estate needed to file sooner, and Dadakis continued to reassure him that the estate could wait until Mrs. Liftin became a citizen. Moreover, the court said, there was no evidence to suggest that the executor was acting in bad faith. Therefore requiring the executor to challenge Dadakis would nullify the very purpose of seeking the expert's advice in the first place.

However, the court concluded that once Mrs. Liftin was naturalized, there was no reasonable cause for the estate to wait an additional nine months to file its estate tax return. Because Dadakis's advice that the estate could delay filing until it could submit an accurate return was not an interpretation of substantive tax law, it could not, as a matter of law, constitute reasonable cause for the delay in filing the estate tax return.

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D.C. Court of Appeals Rejects IRS Request to Stay Lower Court Order in Loving Case

The D.C. Court of Appeals rejected an IRS motion to stay a lower court order which held that the return preparer rules in Reg. Sec. 1.6109-2 are invalid. Loving v. IRS, 2013 PTC 37 (D.C. Cir. 3/27/13).

On January 18, 2013, in Loving v. IRS, 2013 PTC 10 (D.C. D.C. 2013), a district court agreed with three independent tax return preparers that the registered tax return preparer (RTRP) rules under Reg. Sec. 1.6109-2 were invalid - and that the IRS could not enforce them. The IRS subsequently said that, in accordance with the district court order, tax return preparers covered by the PTIN program would not be required to register with the IRS, complete competency testing, or secure continuing education. The IRS appealed the district court's decision to the D.C. Court of Appeals.

On January 23, the IRS filed a motion with the district court to suspend the district court's injunction pending its appeal of the court's decision. The IRS also shut down the RTRP exam testing system as of January 23, 2013, thus cancelling all exams from that date forward. On February 1, 2013, in Loving v. IRS, 2013 PTC 13 (D. D.C. 2/1/13), the D.C. district court rejected the IRS's request to stay the injunction but did modify the injunction to make clear that the IRS is not required to suspend its PTIN program, nor is it required to shut down all of its testing and continuing-education centers; instead, they may remain, but no tax-return preparer may be required to pay testing or continuing-education fees or to complete any testing or continuing education unless and until the injunction is stayed or vacated by the D.C. Circuit Court of Appeals.

The IRS then asked the D.C. Court of Appeals for a stay of the district court's order. On March 27, 2013, in Loving v. IRS, 2013 PTC 37 (3/27/13), the D.C. Court of Appeals rejected the IRS motion for a stay pending appeal, saying that the IRS did not satisfy the stringent requirements for a stay pending appeal.

For a discussion of the Loving case, see Parker Tax ¶271,127.

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IRS Halts Audits of Certain Issues Relating to Upcoming Capitalization Regs

For audits of tax years beginning before 2012, the IRS has directed auditors to discontinue the current audit activity and not begin any new audit activity with respect to certain capitalization issues that will be dealt with in upcoming regulations. LB&I Directive 04-0313-001 (3/22/13).

On December 27, 2011, the IRS issued temporary regulations that provide some bright-line tests for applying the capitalization standards in Code Sec. 162(a) and Code Sec. 263(a). The temporary regulations also amend the general asset account regulations and provide guidance regarding the accounting for, and dispositions of, property subject to Code Sec. 168. The temporary regulations affect all taxpayers that acquire, produce, or improve tangible property, and apply to tax years (or costs incurred in tax years, as appropriate) beginning on or after January 1, 2014. For tax years beginning on or after January 1, 2012, and before the applicability dates provided in forthcoming final regulations, taxpayers may choose to apply the temporary regulations.

In Large Business & International (LB&I) Directive 04-0313-001, the IRS said that it expects to publish final tangible property regulations in 2013 that may include changes to the rules provided in the temporary regulations. The IRS expects the final regulations to apply to tax years beginning on or after January 1, 2014, and to permit taxpayers to apply the provisions of the final regulations for tax years beginning during the period of January 1, 2012 thru the applicability dates in the forthcoming final regulations. Taxpayers choosing to apply the provisions of the temporary regulations to tax years beginning on or after January 1, 2012, may continue to rely on the procedures by which a taxpayer may obtain the automatic consent of the IRS to change its methods of accounting provided in Rev. Proc. 2012-19 and Rev. Proc. 2012-20. For taxpayers choosing to apply the provisions of the final regulations to tax years beginning on or after January 1, 2012, the IRS expects to publish procedures for obtaining automatic consent to change a method of accounting when the final regulations are published.

In Rev. Proc. 2012-19, the IRS provided the procedures for requesting a change for the following methods of accounting addressed in the temporary regulations:

(1) materials and supplies (Reg. Sec. 1.162-3T & 4T);

(2) capital expenditures in general (Reg. Sec. 1.263(a)-1T);

(3) transaction costs (Reg. Sec. 1.263(a)-2T); and

(4) improvements (Reg. Sec. 1.263(a)-3T).

In Rev. Proc. 2012-20, the IRS provided the procedures for requesting a change for the following methods of accounting addressed in the temporary regulations:

(1) leased property (Reg. Sec. 1.167(a)-4T);

(2) general asset accounts (Reg. Sec. 1.168(i)-1T);

(3) ACRS property (Reg. Sec. 1.168(i)-7T); and

(4) dispositions of MACRS property (Reg. Sec. 1.168(i)-8T).

LB&I Directive 04-0313-001 applies to audit activity relating to positions taken on original returns relating to:

(1) whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a) (see, e.g., Rev. Proc. 2011-14, Appendix section 3.06, Repair and maintenance costs (designated change number 144)); and,

(2) any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets (other than a building or its structural components) (see, e.g., Rev. Proc. 2011-14, Appendix sections 6.24 and 6.25 (designated change numbers 146 and 147, respectively)).

The directive does not apply to current audit activity relating to:

(1) costs for which the IRS provides specific guidance, separate from the temporary regulations, for determining whether expenditures incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a); or

(2) issues that do not pertain to whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a).

For audits of tax years beginning before 2012, the directive advises IRS auditors to discontinue the current audit activity and not begin any audit activity with respect to the issues mentioned above. In discontinuing the audit activity, the directive advises auditors to, among other things:

(1) withdraw Forms 4564, Information Document Request, or portions thereof, relating to the development of this issue for amounts paid to maintain, replace, or improve tangible property, and any correlative Issues involving the disposition of associated assets;

(2) withdraw all Forms 5701, Notice of Proposed Adjustment, that propose an adjustment to repair expenses related to whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Code Sec. 263(a), and any correlative adjustments involving the disposition of associated assets.

For a discussion of the rules relating to amounts paid to improve tangible property, see Parker Tax ¶99,535.

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Rent Expenses Denied where Taxpayers Did Not Put Forth Reasonable Effort to Find Paying Renters

The taxpayers could not take rent expense deductions where they made no effort to change their strategy after being unable to find a rent-paying tenant for over 30 years. Meinhardt v. Comm'r, T.C. Memo. 2013-85 (3/27/13).

Donald Meinhardt worked full time at an architectural firm. His wife, Arvilla, operated a day care center out of the couple's home. In 1976, the Meinhardts bought approximately 140 acres of land that was improved with a farmhouse and outbuildings and that also consisted of crop land and pasture land. The couple rented out the farmland separately from the farmhouse. Since buying the land, the Meinhardts have had numerous local farmers lease the crop land and the pasture land. The couple attempted to rent out the farmhouse but were unsuccessful in finding tenants to rent the house in exchange for cash.

From 1976 through 2007, various individuals lived in the farmhouse at different times, often exchanging services (such as repairs and maintenance on the farmhouse) for use of the house. Over the years, the occupants included Arvilla's brother, who lived in the farmhouse seasonally for 20 years; the Meinhardts' daughter and her husband, who lived in the farmhouse for four years; and the Meinhardts' son and his family, who lived in the farmhouse for three months. The Meinhardts never received rent for use of the farmhouse. At various other times, the farmhouse remained vacant. The Meinhardts did not keep or present any detailed records of the value of these barter exchanges or the fair market rental value of the farmhouse.

For 2005-2007, the Meinhardts reported on Schedule E approximately $32,000 in rental income from the rental of crop and pasture land and expenses of approximately $74,500. The expenses consisted of insurance, supplies, repairs, and other expenses associated with the farmhouse. According to the Meinhardts, the farmhouse was available for rent during the years at issue.

The Tax Court denied the rent expense deductions, concluding that because the taxpayers made no effort to change their strategy after being unable to find a rent-paying tenant for over 30 years, they had not put forth a reasonable effort to rent out the farmhouse. Additionally, the fact that the taxpayers allowed individuals to live in the house rent free connoted personal use to the court.

In reaching its conclusion, the Tax Court cited Ray v. Comm'r, T.C. Memo. 1989-623, in which the taxpayer deducted expenses in connection with a house inherited from her mother, which had never been offered for rent or for sale. The taxpayer in Ray claimed the expenses were ordinary and necessary expenses paid for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income within the meaning of Code Sec. 212(1) or (2). The Ray court concluded that, given the almost universal experience with appreciating residential property (which was the case at the time), something more was required than a taxpayer's mere statement that he or she held residential property for investment purposes. The totality of the facts and circumstances convinced the court in Ray that the taxpayer did not possess the requisite profit objective and found similarly in the case of the Meinhardts.

For a discussion of the deductibility of rental expenses, see Parker Tax ¶86,105.

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Debtor's Petition Filed with Tax Court Doesn't Invoke Automatic Stay

Agreeing with four other circuits, the Tenth Circuit held that a petition filed in the Tax Court is an independent judicial proceeding initiated by the debtor and not the continuation of an administrative proceeding against the debtor; thus, the automatic stay in Section 362(a)(1) of the Bankruptcy Code did not apply. Schoppe v. Comm'r, 2013 PTC 38 (10th Cir. 3/28/13).

The IRS assessed tax deficiencies against John Schoppe for the years 2002 through 2007. John then filed a petition in Tax Court seeking redetermination of the deficiencies. The Tax Court found him liable for the tax deficiencies, and John filed a petition for review in the Tenth Circuit. While the case was proceeding before the Tenth Circuit, John filed a voluntary bankruptcy petition. The Tenth Circuit then requested supplemental briefings as to whether the automatic bankruptcy stay in 11 U.S.C. Section 362(a)(1) should apply to John's appeal.

As a threshold matter, the Tenth Circuit held that Section 362(a)(1) did not stay John's appeal. The automatic stay provision, the court noted, provides that the filing of a bankruptcy petition operates as a stay of the beginning or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been started before the beginning of the case, or to recover a claim against the debtor that arose before the beginning of the case.

Citing its decision in TW Telecom Holdings Inc. v. Carolina Internet, Ltd., 661 F.3d 495 (10th Cir. 2011), the Tenth Circuit explained that Section 362 should be read to stay all appeals in proceedings that were originally brought against the debtor, regardless of whether the debtor is the appellant or appellee. Thus, whether a case is subject to the automatic stay must be determined at its inception.

The court noted that it was an open question in the Tenth Circuit as to whether a proceeding is initiated by the debtor when he files a petition in Tax Court or whether the Tax Court proceeding is a continuation of the proceeding initiated against the debtor when the IRS begins the administrative process of determining that there is a deficiency. The Tenth Circuit observed that the Fifth Circuit in Freeman v. Comm'r, 799 F.2d 1091 (5th Cir. 1986), and the Ninth Circuit in Delpit v. Comm'r, 18 F.3d 768 (9th Cir. 1994), have taken opposing views on this question.

In discussing the split, the Eleventh Circuit in Roberts v. Comm'r, 175 F.3d 889 (11th Cir. 1999), explained that in Freeman, the court found that the taxpayers had initiated the judicial proceeding by filing their petition with the Tax Court. Accordingly, neither the Tax Court proceeding nor the taxpayers' appeal therefrom was a proceeding against the debtor, and Section 362(a)(1) did not apply. In contrast, in Delpit, the Ninth Circuit concluded that a proceeding before the Tax Court and an appeal therefrom constituted continuations of the comprehensive income tax assessment procedure that was initiated by IRS administrative proceedings. The First and Third Circuits have adopted the reasoning of the Fifth and Eleventh Circuits and rejected the reasoning of the Ninth Circuit.

The Tenth Circuit agreed with the four circuits that have applied a bright-line rule that a petition filed in Tax Court is an independent judicial proceeding initiated by the debtor, not the continuation of an administrative proceeding against the debtor. Because the underlying case in the instant appeal originated with John beginning a judicial proceeding in Tax Court for a redetermination of his tax deficiencies, the Tenth Circuit concluded that the automatic stay in Section 362(a)(1) did not apply.

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Chief Counsel's Office Explains Mechanics of Calculating Section 911 Housing Exclusion

Noting that the exclusion or deduction under Code Sec. 911 for foreign housing is calculated differently on Forms 1040 and 2555 than deductions are normally calculated, the Chief Counsel's Office explained how the exclusion/deduction should be calculated. CCA 201313023.

In CCA 201313023, the IRS Office of Chief Counsel responded to an inquiry for information on how the Code Sec. 911 housing deduction should be calculated on Forms 1040 and 2555. In general, the housing exclusion and the housing deduction under Code Sec. 911 are calculated in such a way that two similarly situated taxpayers will pay the same amount of tax regardless of whether they take the exclusion or deduction. To achieve this, the deduction is calculated differently on Form 1040 and Form 2555 than deductions are normally calculated.

The Code Sec. 911 housing exclusion is the amount provided by the taxpayer's employer for housing expenses incurred while living and working in the foreign country. In contrast, the housing deduction is generally taken by self-employed individuals working abroad. The deduction is taken by taxpayers who do not receive a housing stipend from an employer (or whose employer-provided housing stipend is less than the actual cost of housing, subject to limitations), and their housing expenses are instead paid for out of their own income (at least partially). For purposes of calculating the Code Sec. 911 housing exclusion and deduction, a qualifying taxpayer who is paid foreign earned income in the amount of $x and a housing stipend in the amount of $y from an employer will be treated the same as a qualifying self-employed taxpayer with income in the amount of $x+y, where y is spent on housing. Assuming they are otherwise identically situated, they will owe the exact same amount of tax.

According to the Chief Counsel's Office, the mechanics of how the forms work are as follows. First, the housing exclusion, housing deduction, and foreign earned income exclusion are all subtracted from total gross income on the Form 1040 at lines 21 and/or 36 to arrive at adjusted gross income (AGI) on Form 1040, line 37. Next, exemptions and the itemized or standard deduction are subtracted from AGI at lines 40 and 42 to arrive at taxable income. The tax on this taxable income is determined on the Foreign Earned Income Tax Worksheet for Form 1040, line 44. The housing exclusion, housing deduction, and foreign earned income exclusion are all added to the taxable income amount; this ensures that the taxpayer's income that exceeds the amounts allowed under Code Sec. 911 will be stacked on top of the Code Sec. 911 amounts and thereby be taxed at the appropriate rates. The worksheet then calculates a total hypothetical tax that would apply to this grossed-up amount in the absence of Code Sec. 911. Finally, the worksheet calculates a hypothetical amount of tax for the Code Sec. 911 amounts. The difference between this amount and the hypothetical tax on the grossed-up amount is the taxpayer's actual tax liability.

According to the Chief Counsel's Office, by making the Code Sec. 911 housing deduction an above-the-line deduction, adding it to taxable income to create a grossed-up amount, and then subtracting the tax attributable to that amount from the tax that would be owed on the grossed-up amount, Forms 2555 and 1040 work together to ensure that the housing deduction and housing exclusion are effectively treated the same.

PRACTICE TIP: If the housing deduction were instead simply deducted once when first calculating taxable income, a taxpayer taking the housing exclusion could end up paying more tax than a taxpayer taking the deduction because the taxpayers might otherwise fall in different tax brackets. That was not the intent of the statute, and the slightly more complicated approach taken above protects parity.

For a discussion of the Section 911 housing exclusion, see ¶78,650.

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Tax Court Should Have Considered Evidence of Fraudulent Transfers to Acquisition Vehicles

While the Tax Court was not required to apply the federal substance-over-form doctrine to determine whether a trust that owned four corporations should be considered a "transferee" of the four corporations' assets, evidence of fraudulent transfers from the four companies to various acquisition vehicles should have been considered. Frank Sawyer Trust of May 1992 v. Comm'r, 2013 PTC 39 (1st Cir. 3/29/13).

Four corporations, which had been owned by the Frank Sawyer Trust of May 1992, acknowledged that they owed the federal government more than $24 million in taxes and penalties. However, before the IRS could collect against the corporations, the corporations rendered themselves insolvent by transferring all their assets to other entities.

A dispute arose as to whether the Frank Sawyer Trust of May 1992 was liable to the IRS, under Code Sec. 6901, for the corporations' unpaid taxes and penalties. The trust sold the corporations before the taxes came due and before the asset-stripping occurred. Following Supreme Court precedent, the Tax Court looked to state substantive law the Massachusetts Uniform Fraudulent Transfer Act to determine the trust's liability. The Tax Court concluded that the trust could not be held liable for the corporations' taxes and penalties because the IRS failed to prove that the trust had knowledge of the new shareholders' asset-stripping scheme and because the IRS did not show that any of the corporation's assets were transferred directly to the trust.

The IRS appealed to the First Circuit, arguing that the Tax Court should have applied the federal substance-over-form doctrine to determine, as a threshold matter, whether the trust should be considered a "transferee" of the four corporations' assets. The IRS also argued that the Tax Court clearly erred in finding that the trust lacked constructive knowledge of the new shareholders' scheme.

The First Circuit held that the Tax Court correctly looked to Massachusetts law to determine whether the trust could be held liable for the corporations' taxes and penalties, and rejected the IRS's argument that the Tax Court was obligated to consider the federal substance-over-form doctrine as a threshold matter. The court also declined to disturb the Tax Court's factual finding that the trust lacked knowledgeactual or constructiveof the new shareholders' tax avoidance intentions.

However, the First Circuit disagreed with the Tax Court insofar as the Tax Court construed Massachusetts fraudulent transfer law to require, as a prerequisite for the trust's liability, either (1) that the trust knew of the new shareholders' scheme; or (2) that the corporations transferred assets directly to the trust. The IRS, the court noted, had presented evidence of fraudulent transfers from the four companies to various acquisition vehicles, and the acquisition vehicles purchased the four companies from the trust. According to the First Circuit, if the Tax Court found that at the time of the purchases, the assets of these acquisition vehicles were unreasonably small in light of their liabilities and that the acquisition vehicles did not receive reasonably equivalent value in exchange for the purchase prices, then the trust could be held liable for taxes and penalties assessed upon the four corporations regardless of whether it had any knowledge of the new shareholders' asset-stripping scheme. The court recognized that these issues had not been clearly raised and fully briefed by the parties, and remanded the case to the Tax Court to determine whether the conditions for liability were met in the instant situation.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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Book Publisher's Activities Don't Qualify for Domestic Production Activities Deduction

The IRS rejected a taxpayer's claim that its design, development, creation, materials analysis and selection, and packaging of its books constituted a qualifying activity for purposes of the Code Sec. 199 deduction. CCM 201313020.

The taxpayer at the center of CCM 201313020 is a publisher of books and other printed materials. The taxpayer's activities with respect to its books include market research, resource planning, content and layout development, and editing. These activities allow the taxpayer to create an electronic version of a book that contains exact electronic displays of each page. The taxpayer also develops print specifications that include type of paper, page sizes, type of printing process, type of ink, and whether to use thread, staples, or glue for binding.

The taxpayer uses contract manufacturers to produce books in mass and provides a contract manufacturer with the electronic version of a book and its list of print specifications. The contract manufacturer uses the electronic version of the book to create printing plates, which the contract manufacturer then uses to print mass copies of the book. The contract manufacturer uses its employees, machinery, and plant to print and assemble books according to the taxpayer's print specifications. After the books have been printed and assembled, the contract manufacturer may ship the books directly to the taxpayer's customers, or may ship them to the taxpayer so that the taxpayer can package and distribute the books. According to the taxpayer, its design, development, creation, materials analysis and selection, and packaging of its books constitute the manufacture, production, growth, or extraction (MPGE) activities for purposes of Code Sec. 199(c)(4)(A)(i)(I).

The Office of Chief Counsel advised that the taxpayer's activities did not constitute MPGE of qualifying production property (QPP) for purposes of the domestic production activities deduction under Code Sec. 199. According to the Chief Counsel's Office, the taxpayer's activities related to producing an electronic version of a book do not result in QPP. While the taxpayer's electronic version of a book has the same layout and design as the book would have if printed and bound, it is not tangible personal property or computer software. While the Chief Counsel's Office said it recognized that the taxpayer's activities create valuable assets, those assets are intangibles, and do not qualify as QPP for purposes of the domestic production activities deduction.

For a discussion of property that qualifies as QPP for purposes of the Code Sec. 199 deduction, see Parker Tax ¶96,120.

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Taxpayer Can Use Special Government Contract Rule to Take Domestic Production Activities Deduction

A taxpayer that had entered into two government contracts met all of the requirements under Code Sec. 199(c)(4)(C) to treat gross receipts derived from qualifying production property as DPGR, and an attempt by the IRS's LB&I branch to impose a delivery requirement was rejected. TAM 201314043.

In TAM 201314043, the taxpayer entered into two contracts with the U.S. government, both of which were part of system development and acquisition programs. Contract 1 was the prime contract and Contract 2 was a subcontract to the prime contract. The question arose as to whether the special rule for government contracts under Code Sec. 199(c)(4)(C) eliminated the requirement that domestic production gross receipts (DPGR) must be attributable to the disposition of qualifying production property (QPP) manufactured or produced by the taxpayer in whole or in significant part within the United States. A second question was whether any of the gross receipts derived by the taxpayer from the two contracts were non-DPGR because the gross receipts were attributable to services or non-qualified property.

Code Sec. 199(c)(4)(C) provides that gross receipts derived from the manufacture or production of any property described in Code Sec. 199(c)(4)(A)(i)(I) (i.e., qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States) is treated as meeting the requirements of Code Sec. 199(c)(4)(A)(i) (i.e., qualifying as domestic production gross receipts derived from any lease, rental, license, sale, exchange, or other disposition) if (1) such property is manufactured or produced by the taxpayer under a contract with the federal government, and (2) the Federal Acquisition Regulations (FAR) require that title or risk of loss with respect to such property be transferred to the federal government before the manufacture or production of the property is complete. Final regulations clarify that the special rule for government contracts also applies to gross receipts derived from certain subcontracts to manufacture or produce property for the federal government.

The Large Business & International (LB&I) branch of the IRS asserted that none of the gross receipts the taxpayer derived from Contract 1 qualified as DPGR because the taxpayer did not deliver any property produced to the government. In Contract 1, delivery of the tangible personal property produced was not required and title to the property produced reverted from the government back to the taxpayer after production and testing of the property. LB&I said the purpose of the rule in Code Sec. 199(c)(4)(C) was to allow for a disposition in cases where title or risk of loss to property produced for the government was never held by the manufacturer because of FAR requirements. LB&I argued that property must be delivered and title should remain with the government after the property is manufactured rather than revert directly to the taxpayer. According to LB&I, Congress did not intend to allow gross receipts derived from a contract like Contract 1 to qualify as DPGR when enacting Code Sec. 199(c)(4)(C).

The taxpayer argued that Code Sec. 199(c)(4)(C) applied to the tangible personal property produced under Contract 1, but admitted it did not satisfy Code Sec. 199(c)(4)(C) with respect to computer software because title or risk of loss was not transferred under FAR regulations.

The Office of Chief Counsel advised that the taxpayer is treated as making a disposition of QPP under Code Sec. 199(c)(4)(A)(i) because it met the requirements of the special rule for government contracts under Code Sec. 199(c)(4)(C). Thus, the taxpayer could treat gross receipts derived from the disposition as DPGR. However, some of the gross receipts were attributable to nonqualified property provided to the government and, thus, were non-DPGR.

The Chief Counsel's Office said it could not adopt LB&I's position because the plain language of Code Sec. 199(c)(4)(C) does not include the requirements that LB&I was seeking to impose. The plain language treats a taxpayer that meets the requirements of Code Sec. 199(c)(4)(C) as having derived gross receipts from a disposition under Code Sec. 199(c)(4)(A)(i). Delivery, to the extent required, would be an element of a disposition under Code Sec. 199(c)(4)(A)(i). Because the taxpayer was treated as having made a disposition, it seemed inconsistent to the Chief Counsel's Office to apply a delivery requirement in this case. Code Sec. 199(c)(4)(C) requires that FAR require title (or risk of loss) be transferred to the federal government before the manufacture or production process is complete. It does not address whether title can or cannot revert back to the taxpayer at any point in the future. Further, to qualify under Code Sec. 199(c)(4)(C) a taxpayer must have manufactured or produced property described in Code Sec. 199(c)(4)(A)(i)(I). By meeting the requirements of Code Sec. 199(c)(4)(C), the Chief Counsel's Office stated, the taxpayer had met all the requirements to treat gross receipts derived from the QPP as DPGR.

For a discussion of what qualifies as DPGR for purposed of the domestic production activities deduction, see Parker Tax ¶96,110.