Proposed Regs Expand Guidance on Whistleblower Awards

Under Code Sec. 7623, also referred to as the whistleblower rule, the IRS is authorized to pay such sums as it deems necessary for detecting underpayments of tax, or detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws. Any amount payable under this rule is paid from the proceeds of amounts collected by reason of the information provided, and any amount so collected must be available for such payments.

The IRS has now issued proposed regulations (REG-141066-09 (12/18/12)) that provide comprehensive guidance for the whistleblower award program. The regulations provide guidance on submitting information regarding underpayments of tax or violations of the internal revenue laws and filing claims for an award for such information, as well as on the administrative proceedings applicable to claims for an award. The regulations also provide guidance on the determination and payment of awards, and provide definitions of key terms used in Code Sec. 7623. Finally, the regulations confirm that the Director, officers, and employees of the Whistleblower Office are authorized to disclose return information to the extent necessary to conduct whistleblower administrative proceedings.

When finalized, these regulations are proposed to apply to information submitted on or after the date these rules are adopted as final regulations in the Federal Register, and to claims for award under Code Sec. 7623(a) and Code Sec. 7623(b) that are open as of that date. Likewise, Prop. Reg. Sec. 301.7623-4 is proposed to apply to information submitted on or after that date, and to claims for award under Code Sec. 7623(b) that are open as of that date. Reg. Sec. 301.7623-4 is not proposed to apply to claims for award under Code Sec. 7623(a) that are open as of that date. This exception is intended to allow the IRS to continue to apply consistent rules to open claims for award under the discretionary award program of Code Sec. 7623(a).

Background

In 2006, the Tax Relief and Health Care Act of 2006 amended Code Sec. 7623. The law added Code Sec. 7623(b), which provides that qualifying individuals will receive an award of at least 15 percent, but not more than 30 percent, of the collected proceeds resulting from the action with which the IRS proceeded based on the information provided to the IRS by the individual.

In Notice 2008-4, the IRS provided guidance on filing claims for award under Code Sec. 7623, as amended. In the notice, the IRS recognized that the original award program authorized by Code Sec. 7623(a) had been previously implemented through Reg. Sec. 301.7623-1. The Internal Revenue Manual (IRM) provides additional guidance to IRS officers and employees on the award program under Code Sec. 7623(a). The notice provided that the IRS would generally continue to follow Reg. Sec. 301.7623-1 and the IRM provisions for award claims under Code Sec. 7623(a), subject to certain exceptions listed in the notice. Notice 2008-4 also provided, however, that the regulations would not apply to the new award program authorized under Code Sec. 7623(b). Instead, the notice provided interim guidance applicable to claims for award submitted under Code Sec. 7623(b).

In March 2008, the IRS issued Reg. Sec. 301.6103(n)-2T, and corresponding proposed regulations, describing the circumstances and process in and by which officers and employees of the Treasury may disclose return information to whistleblowers (and their legal representatives, if any) in connection with written contracts for services relating to the detection of violations of the internal revenue laws or related statutes. Under these regulations, whistleblowers and legal representatives who receive return information are subject to the civil and criminal penalty provisions of Code Secs. 7431, 7213, and 7213A for the unauthorized inspection or disclosure of return information. These regulations were finalized in 2011.

In December 2008, the IRS revised the IRM to update policies and procedures concerning the handling of information, processing of claims for awards, and payment of awards under Code Sec. 7623, as amended. The IRS also redelegated the authority to approve awards to the Director of the Whistleblower Office. In July 2010, the IRS further revised the IRM to provide detailed instructions to IRS officials and employees on the computation and payment of awards under Code Sec. 7623 and to describe the administrative procedures applicable to claims for award under Code Sec. 7623(b). The revised IRM introduced many guidance elements that the IRS has now developed in the proposed regulations, including definitions of key terms, the whistleblower administrative proceedings, the fixed percentage award framework and criteria for making award determinations, and rules on handling multiple and joint claimants.

In 2011, the IRS issued proposed regulations clarifying the definitions of the terms proceeds of amounts collected and collected proceeds for purposes of Code Sec. 7623 and providing that the provisions of Reg. Sec. 301.7623-1(a), concerning refund prevention claims, apply to claims under both Code Sec. 7623(a) and Code Sec. 7623(b). The proposed regulations further provided that the reduction of an overpayment credit balance constitutes proceeds of amounts collected and collected proceeds for purposes of Code Sec. 7623. Those proposed regulations were finalized in February 2012.

Key Provisions of the Proposed Regulations

The purpose of the proposed regulations is to provide comprehensive guidance for the whistleblower award program. The regulations provide guidance on issues relating to the award program from the filing of a claim to the payment of an award, focusing on three major elements of the program:

(1) the submission of information and filing of claims for award;

(2) the whistleblower administrative proceedings applicable to claims for award; and

(3) the computational determination and payment of awards.

The proposed regulations also provide definitions of key terms under Code Sec. 7623 and provide that the Director, officers, and employees of the Whistleblower Office are authorized to disclose return information to the extent necessary to conduct whistleblower administrative proceedings.

Submitting Information and Filing Claims for Award

With respect to submitting information to the IRS and filing claims for award with the Whistleblower Office, the proposed regulation are intended to clarify the process individuals should follow to be eligible to receive awards. The proposed rules, in large part, track the rules that the IRS has previously provided, as set forth in the existing regulations, Notice 2008-4, and the IRM. This includes, for example, the general information that individuals should submit to claim awards and the descriptions of the type of specific and credible information regarding taxpayers that should be submitted. Most notably, an individual submitting a claim should identify a person and describe and document the facts supporting the claimant's belief that the person owes taxes or violated the tax laws. The proposed rules clarify that the IRS will consider an individual who identifies a pass-through entity as having identified the taxpayers with direct or indirect interests in the entity. Further, the proposed rules provide that if an individual identifies a member of a firm who promoted another identified person's participation in an identified transaction, then the IRS will consider the individual as having identified both the firm and all the other members of the firm. These clarifying provisions complement the proposed rules' definition of related action.

The proposed rules also include eligibility requirements for filing claims for award and a list of ineligible claimants. The list of ineligible claimants restates the list published in Notice 2008-4 in its entirety. For example, the proposed rules provide that individuals who are or were required by federal law or regulation to disclose information are not eligible to file claims for award based on the information.

Whistleblower Administrative Proceedings

The proposed regulations describe the administrative proceedings applicable to claims for award under both Code Sec. 7623(a) and Code Sec. 7623(b). For purposes of applying these procedures, the IRS may rely on the claimant's description of the amount owed by the taxpayer(s). The IRS may, however, rely on other information as necessary (for example, when the alleged amount in dispute is below the $2 million threshold of Code Sec. 7623(b)(5)(B), but the actual amount in dispute is above the threshold).

Determining the Amount of Awards and Paying Awards

The proposed regulations provide the framework and criteria that the Whistleblower Office will use in exercising the discretion granted under Code Sec. 7623 to make awards. The proposed regulations are consistent with, and build on, the award determination provisions provided in the IRM. The rules are proposed to apply to claims for awards under both Code Sec. 7623(a) and Code Sec. 7623(b).

Generally, the proposed regulations adopt a fixed percentage approach under which the Whistleblower Office will assign claims for award to one of a number of fixed percentages within the applicable award percentage range. According to the IRS, the fixed percentage approach provides a structure that will promote consistency in the award determination process by enabling the Whistleblower Office to determine awards across the breadth of the applicable percentage range based on meaningful distinctions among cases. In general, the Whistleblower Office will determine awards at the uppermost end of the applicable percentage range, for example, 30 percent of collected proceeds under Code Sec. 7623(b)(1), only in extraordinary cases. The fixed percentage approach avoids having to draw fine distinctions that might seem unfair and arbitrary, given the differences among claims for award with respect to both the facts and law of the underlying actions and the nature and extent of the substantial contribution of the claimants.

Under these proposed regulations, the Whistleblower Office generally will assign the fixed percentages to claims for award by evaluating the substantial contribution of the claimant to the underlying action(s) based on the Whistleblower Office's review of the entire administrative claim file and the application of the positive factors and negative factors, listed in the proposed regulations, to the facts. After applying the positive and negative factors has been completed, the Whistleblower Office will review the planning and initiating factors, if applicable. The purpose of this criteria-based approach, the IRS stated, is to also promote consistency in the award determination process. In addition, this approach is intended to provide transparency in the process, and the publication of the criteria should provide helpful guidance to claimants when submitting their claims and in understanding the basis for award determinations. For claims involving multiple actions (regardless of the number of taxpayers involved), the proposed regulations enable the Whistleblower Office to determine and apply separate award percentages on an action-by-action basis in appropriate cases. The IRS said it recognizes that a multiple-action determination may result in a lengthier award process, but that it may be necessary in some cases.

Code Sec. 7623(b)(3) provides for an appropriate reduction of awards to claimants who planned and initiated the actions that led to the underpayment of tax or actions described in Code Sec. 7623(a)(2) (the underlying acts). Code Sec. 7623(b)(3), unlike Code Sec. 7623(b)(1) and Code Sec. 7623(b)(2), provides no direction to the Whistleblower Office on what to consider in exercising this grant of discretion. Accordingly, the proposed regulations provide slightly more flexibility to determine the amount of an appropriate reduction under this section than they provide under the respective frameworks for determining awards for substantial and less substantial contributions.

Under the proposed regulations, the Whistleblower Office will make a threshold determination of whether a claimant planned and initiated the underlying acts, but this determination will not result in an automatic or fixed reduction of the award percentage or award amount. A claimant will satisfy the threshold determination only if the claimant:

(1) designed, structured, drafted, arranged, formed the plan leading to, or otherwise planned an underlying act;

(2) took steps to start, introduce, originate, set into motion, promote or otherwise initiated an underlying act; and

(3) knew or had reason to know that there were tax implications to planning and initiating the underlying act.

If the Whistleblower Office determines that a claimant meets the threshold for planning and initiating, the Whistleblower Office will then categorize and evaluate the extent of the claimant's planning and initiating of the underlying acts, based on the application of factors listed in Prop. Reg. Sec. 301.7623-4(c)(3)(iv) to the facts contained in the administrative claim file, to determine the amount of the appropriate reduction, if any. The proposed regulations' use of the categories primary, significant, and moderate, like the use of the fixed percentage and criteria approach for determining awards in substantial contribution and less substantial contribution cases, is intended to promote consistency, fairness, and transparency in an award determination process that is inherently subjective.

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The Tax Treatment of Repairs and Maintenance Expenditures: A Practical Guide to Mitigating Tax Compliance Issues while Maximizing Tax Consulting Opportunities Under New Capitalization Regs

By Julio Gonzalez, Peter J. Scalise, & Veronica Marino

Introduction

On December 23, 2011, the IRS issued temporary regulations that govern when costs are required to be capitalized or deducted as repair and maintenance costs. The new regulations replace the previously issued proposed regulations issued in March 2008.The proposed regulations were binding only on the IRS and not taxpayers.

Originally, the temporary regulations were binding on both the IRS and taxpayers and applied to tax years beginning on and after January 1, 2012. On December 17, 2012, in T.D. 9564, the IRS amended the applicability date for the temporary regulations. See related discussion in the Highlights section of this Bulletin. The temporary regulations now apply to tax years beginning on or after January 1, 2014. However, taxpayers may choose to apply the temporary regulations for tax years beginning on or after January 1, 2012. Practitioners should ascertain the impact of the regulations on sustaining strong tax return filing positions (i.e., "Will", "Should", "More-Likely-Than-Not" and "Substantial Authority").

As a reminder, the following standards for the applicable levels of opinion should be meticulously analyzed when assessing a client's tax return filing position:

"Will" Standard: Generally, a 95 percent or greater probability of success if challenged by the IRS. A "Will" opinion generally represents the highest level of assurance that can be provided by an opinion.

"Should" Standard: Generally, a 70 percent or greater probability of success if challenged by the IRS. A "Should" opinion provides a lower level of assurance than is provided by a "Will" opinion, but a higher level of assurance than is provided by a "More-Likely-Than- Not" opinion.

"More-Likely-Than-Not" Standard: A greater than 50 percent probability of success if challenged by the IRS. The "More-Likely-Than-Not" standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under Code Sec. 6662A.

"Substantial Authority" Standard: Typically, greater than the "Realistic Possibility of Success" standard and lower than the "More-Likely-Than-Not" standard (i.e., 40 percent probability of success).

"Realistic Possibility of Success" Standard: Approximately a one-in-three or greater possibility of success if challenged by the IRS.

"Reasonable Basis" Standard: Significantly higher than the "Non Frivolous" standard (i.e., not deliberately improper) and lower than the "Realistic Possibility of Success" standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority.

"Non-Frivolous" Standard: Approximately a 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstance should a tax professional ever render services with this level of comfort.

"Frivolous" Standard: Approximately less than a 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstances should a tax professional ever render services with this level of comfort.

It should be noted that each of the aforementioned standards has a relevant meaning to both the taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. Note that the percentages listed for "More-Likely-Than-Not" and "Realistic Possibility of Success" are specifically provided for and discussed in the treasury regulations. In contrast, the percentages for "Substantial Authority," "Reasonable Basis," "Non-Frivolous" and "Frivolous" have been developed based on their relative importance in the hierarchy of standards of opinion as primarily provided for in congressional committee reports. Moreover, while not intrinsically quantitatively calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

This article will focus on a practical engineering guide to mitigating tax compliance issues while maximizing tax consulting opportunities in connection with repair and maintenance expenditures.

Tangible Property Scope Synopsis

The line where deductible repairs under Code Sec. 162 ends and capitalized improvements under Code Sec. 263 begins has always been far from patently clear and has led to much controversy between taxpayers and the IRS.

The new regulations do little to clarify this matter (i.e., generally avoiding bright-line tests for facts-and-circumstances analysis). However, they do make substantive changes to the location of the linesome taxpayer favorable and some government favorable. Moreover, this line can be considerably clarified when taking an engineering approach resulting in a more sustainable tax return filing position. For example, having a structural engineer opine upon whether a repair to a building rooftop is a deductible repair or a repair that must be capitalized makes more business sense than having an accountant or attorney make this determination without consulting a qualified engineer. This is no different than having structural engineers render cost segregation services as opposed to accountants and attorneys who have not earned degrees in engineering and are not qualified to read and interpret blueprints and engineering concepts. It is always optimal to have a joint-collaborative effort between licensed engineers and accountants to ensure a sustainable tax return filing position, from both a qualitative and quantitative standpoint, when rendering any engineering-based tax advisory service offering (i.e., cost segregation, construction tax planning, energy tax incentives, research tax incentives, etc.).

The first step in rendering a repairs and maintenance analysis is to start with a complete review of the fixed asset schedule and a list of repairs and maintenance expenditures. Based on the sheer volume of capitalized assets and repairs and maintenance line items, one must decide on the sampling methodology to be used to identify which line items must be reviewed from a qualitative standpoint to get to the substance of the transaction. In addition, it is necessary to review why this capitalization or expenditure was incurred in order to identify if the expenditure was tantamount to an expense incurred to maintain the ordinary useful life of the asset, in which case the expense can deducted, or if the expense was incurred to appreciably prolong the useful life, in which case it is categorized as a betterment, restoration, and /or adaptation and must be capitalized.

As a background, there are two basic categories of samples: statistical samples and professional judgment samples. Each category of sampling methodology is subject to different treatment in connection to tax matters. Statistical samples are based on mathematical principles and use the laws of probability to measure sampling risk. The prominent feature of statistical sampling is its ability to measure risk. The measurement instrument is the confidence interval, which gives a calculated range of values for the estimated amount of misstatement in a population. The measurability of statistical sampling distinguishes it from so-called professional judgment sampling, where the decision as to the items selected for examination is left to the professional judgment of the tax professional. Statistical sampling is a measurement tool. When applied in a substantive test of details, it measures misstatement in an account or class of transactions. Its ability to measure arises from the selection method used, which is similar to probability sampling. As a Best Practice Rule, for engagements with a large number of transactions to be reviewed (i.e., thousands of transactions vs. dozens of transactions), it is only practicable to utilize statistical sampling, as other methods would not be feasible due to the large-scale volume and time needed to vet the thousands of transactions. As a caveat, should the IRS take exception to how a statistical sample was prepared during the course of an examination, the IRS has the right to disallow both the statistical sample and the entire claim. Similar to transfer pricing analysis, statistical sampling should always be prepared by qualified professionals and, again, not prepared in a vacuum by accountants and attorneys. It is critical when designing and implementing methodologies for specialty tax incentives that only true subject matter experts be engaged with appropriate educational backgrounds and subject matter expertise as applicable (i.e., accountants working collaboratively with engineers, economists, and other professionals).

Once the sample of capitalized assets and repairs and maintenance expenditures has been identified to be interviewed on, it is imperative to have a truly joint collaborative effort between qualified and licensed engineers and accountants to vet each and every line item that has been selected for examination. The subsequent practical guide will enable a tax professional to understand the necessary inquires required to properly opine upon whether an expense should be deducted or capitalized under the new temporary regulations.

Deductible Expenses under the New Temporary Regulations

Materials and Supplies

The temporary regulations indicate that incidental materials and supplies may be deducted when purchased as long as no record of consumption is kept and expensing such items does not distort income. Non-incidental materials and supplies, however, are not expensed until they are used or consumed.

Items considered materials and supplies are:

(1) Components acquired to maintain or repair property;

(2) Fuel, lubricants, water and similar items;

(3) Property with an economically useful life of 12 months or less;

(4) Property with an acquisition or production cost of $100 or less; and

(5) Other property identified by the IRS.

De Minimis Rule

The de minimis rule provides another deduction opportunity for amounts paid to acquire or produce tangible property. To be eligible, however, a taxpayer must:

(1) Have an Applicable Financial Statement (AFS), which is generally an audited financial statement;

(2) Have a written accounting policy at the beginning of the tax year for deducting property costing less than a certain dollar amount for non-tax purposes; and

(3) Follow its written accounting policy.

The total amount of such expensed items cannot exceed the greater of 0.1 percent of the taxpayer's gross receipts for the tax year as determined for federal income tax purposes or 2 percent of the taxpayer's total depreciation and amortization expense for such year as determined in its AFS. As a caveat, many small to middle market privately held companies will not be able to take advantage of the de minimis rule because they don't have an AFS.

PRACTICE TIP: While many small businesses do not have an AFS and thus cannot avail themselves of the de minimis rule, the rule may subsequently be broadened to apply to smaller businesses. Alternatively, a business may grow to the point where it does have an AFS and can take advantage of the de minimis rule. In either case, to avail themselves of this rule, taxpayers must have in place written accounting procedures treating as an expense for nontax purposes the amounts paid for property costing less than a certain dollar amount. Thus, practitioners should advise clients to put into place, as soon as possible, the written accounting procedures necessary to take advantage of the de minimis rule should they otherwise be able to. For example, if a calendar-year business otherwise qualifies for the de minimis rule in 2013, it must have the written accounting procedures in place by the end of 2012. Often, these written policies will just be written clarification of procedures the taxpayer already has in place.

Repairs

The general rule is that a taxpayer may deduct amounts paid for repairs and maintenance to tangible property as long as the amounts are not otherwise required to be capitalized. Although the general rule is not very helpful, the regulations do allow a safe harbor deduction for routine maintenance.

Routine Maintenance Safe Harbor

Routine maintenance is the set of recurring activities that keep a unit of property in its ordinary operating condition. This includes the inspection, cleaning, testing, and replacing of parts. Activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the class life of the property. The routine maintenance safe harbor applies to all property other than buildings.

Expenditures Required to be Capitalized

Amounts paid for tangible property that need to be capitalized fall into two general buckets: (1) amounts paid to acquire or produce tangible property, and (2) amounts paid to improve it. Taxpayers must generally capitalize amounts paid to acquire or produce a unit of real or personal property, including leasehold improvement property. This includes the invoice price, transaction costs, and costs for work performed before the date the property is placed in service by the taxpayer. Additionally, a taxpayer must capitalize amounts paid to improve property. Property is improved if the amounts paid result in betterment to the property, restore the property, or adapt the property to a new or different use.

Betterments

A betterment is an amount paid to correct a material condition or defect of the property, which results in either a material addition to the property (physical enlargement, expansion, or extension) or a material increase in capacity, productivity, efficiency, strength or quality of the property or the output of the property.

Restorations

An amount is paid to restore property if:

(1) It is for the replacement of a component of the property and the taxpayer recognized gain or loss on the sale or exchange of the component or deducted a loss for the component;

(2) The taxpayer returns the property to its ordinary efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional;

(3) It results in the rebuilding of the property to a like-new condition after the end of its class life; or

(4) It replaces a part or a combination of parts that comprise a major component or substantial structural part of the unit of property.

Adaptations

An amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the property at the time the property was originally placed in service by the taxpayer.

The IRS included 19 examples in the regulations to illustrate what is and what is not a betterment, and 26 examples to illustrate what is and what is not a restoration. The number of examples demonstrates the difficulty in determining the fine line between a deductible expense and a capitalized item.

Unit of Property

Determining the relevant unit of property also plays a large role in shaping whether an amount paid is properly deducted as a repairor must be capitalized as an improvement to the property. The larger the unit of property, the more likely the amount paid will be considered a deductible repair.

For real and personal property (except buildings), a unit of property is comprised of all components that are functionally interdependent (i.e., the placing in service of one component is dependent on the placing in service of the other component).

A new twist in these regulations is the unit of property determination for buildings. A building and its structural components are a single unit of property. For application of the improvement rules, however, "building systems" constitute separate units of property from the building structure. Consequently, for purposes of the improvement analysis, the units of a building property are the building structure (exterior walls, roof, windows, doors, etc.) and the building systems (HVAC, plumbing, electrical, escalators, elevators, fire-protection and alarm systems, security systems, gas distribution systems, and other structural components identified as building systems by the IRS).

This componentizing of a building into several units of property is a significant change from the prior proposed regulations. Accordingly, taxpayers that deducted repairs in prior years relating to any of these building systems will need to determine whether such treatment is still appropriate. If not, it may be necessary to request a change in accounting method.

Conclusion

The optimal way to mitigate or eliminate risk and render a precise tax return filing position under a Code Sec. 263(a) study would be to apply engineering-based analysis of the fixed assets and expenditures for repairs and maintenance. When rendering any engineering-based tax advisory service (the tax treatment of repairs and maintenance expenditures, cost segregation services, construction tax planning, energy tax incentives, research tax incentives, etc.) it is imperative to have a joint collaborative effort between highly qualified and licensed engineers and accountants to properly opine upon the tax return filing position from both a qualitative and quantitative perspective. Be sure to engage a true subject matter expert to best ensure sustainable tax return filing positions without any negative impacts on financial statement reporting in connection to both US GAAP and IFRS.

About the Authors

Julio P. Gonzalez is the Founding President and CEO of Engineered Tax Services. Julio is a noted thought leader amongst engineering based tax advisory services and a nationally renowned AICPA and AIA Keynote Speaker on specialty tax incentives.

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP. Peter is a nationally acclaimed AICPA, ABA, ASTP, TEI and AIA Keynote Speaker on specialty tax incentives.

Veronica Marino serves as a Senior Associate for Engineered Tax Services where she renders specialty tax incentives. Veronica joined Engineered Tax Services with approximately five years of leading public accounting experience and is a graduate of Florida State University where she earned her Bachelor of Science Degree in Accounting.

ETS Disclaimer

The article is designed to provide authoritative information on the subject matter covered. However, it is distributed with the understanding that the publisher, editors, and authors are not engaged in rendering legal, accounting, or other related professional services for your client base. Consequently, it is your responsibility to exercise all of the necessary measures to ensure proper tax preparation and tax advisory services for your client base.

Circular 230 Disclaimer

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

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IRS Hints at Simplification of Temp Capitalization Regs; Delays Effective Date to 2014

The temporary capitalization regulations may be revised in a manner that might affect, and in certain cases simplify, taxpayers' implementation of the rules when the regulations are issued in final form and, thus, the IRS delayed the effective date of the temporary regulations from 2012 to 2014. Notice 2012-73; T.D. 9564 (12/16/12).

On December 27, 2011, the IRS issued temporary regulations (T.D. 9564) for determining whether amounts paid to acquire, produce, or improve tangible property must be capitalized. The temporary regulations were generally effective for tax years beginning on or after January 1, 2012. After issuing the temporary capitalization rules, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20 to assist taxpayers in obtaining automatic IRS consent to change to methods of accounting provided in the capitalization rules.

Implementing the new rules requires a fair amount of work for both taxpayers and practitioners. For example, to implement the regulations for 2013, there are some things taxpayers must do in 2012. First, to obtain automatic IRS consent under Rev. Proc. 2012-19 or Rev. Proc. 2012-20 to change to one of the methods in the new capitalization rules, a taxpayer must currently be using a Code Sec. 263A methodology. If a taxpayer is not currently in compliance with Code Sec. 263A, the taxpayer must first file a Form 3115 requesting an accounting method change to bring the taxpayer into compliance with Code Sec. 263A before the taxpayer can file a Form 3115 to take advantage of the automatic accounting method changes in Rev. Proc. 2012-19 or Rev. Proc. 2012-20.

On December 17, 2012, the IRS revised the effective date of the temporary regulations. Rather than applying to tax years beginning on or after January 1, 2012, the temporary regulations apply to tax years beginning on or after January 1, 2014. However, taxpayers can choose to apply the provisions of the temporary regulations to tax years beginning on or after January 1, 2012, and can continue to rely on the procedures in Rev. Proc. 2012-19 and Rev. Proc. 2012-20.

Also on December 17, the IRS also issued Notice 2012-73, in which it said it recognized that taxpayers are expending resources to comply with the temporary regulations and it wants taxpayers to be aware that certain sections of the regulations may be revised in a manner that might affect, and in certain cases simplify, taxpayers' implementation of the rules when the regulations are issued in final form. Specifically, the IRS mentioned the de minimis rule under Reg. Sec. 1.263(a)-2T(g), the rules relating to dispositions in Reg. Sec. 1.168(i)-1T and Reg. Sec. 1.168(i)-8T, and the safe harbor rule for routine maintenance in Reg. Sec. 1.263(a)-3T(g), as rules that may be revised.

For a discussion of the temporary regulations as they apply to amounts paid to improve tangible property, see Parker Tax ¶99,535.

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Moonlightling Police Officer Was Independent Contractor Subject to Self-Employment Taxes

A police officer who worked as a security guard off-duty did not satisfy the factors necessary to be considered an employee and, thus, was liable for self-employment taxes. Specks v. Comm'r, T.C. Memo. 2012-343 (12/11/12).

During 2008, Carnell Specks worked as a police officer for the Houston Police Department. He worked 2,171 hours that year for HPD. Carnell also provided security services to several businesses during his off-duty hours. While providing the security services, Carnell wore an HPD uniform and carried his personal firearm. The businesses for which Carnell provided the services did not train, supply, or equip him. He had an at-will relationship with each of the third parties.

One of the businesses paid Carnell almost $18,000 for 619 hours of security services. Another business paid him over $26,000 for approximately 1,000 hours of security services. All the businesses reported the amounts paid to him on Forms 1099-MISC. Carnell and his wife, Cheryl, owned and rented several properties during 2008. Carnell spent less than 750 hours on the rental activity and Cheryl, who had a full-time job, spent no time on the rental activity.

On their 2008 tax return, the Specks reported the income from Carnell's security services as other income. They also reported that they were engaged in rental real estate activities and claimed a loss of $52,000 from those activities.

The IRS determined that Carnell was subject to self-employment tax on his income from the security services and that the rental losses were not deductible because they were subject to the passive activity loss deduction rules. Carnell contended that he was an employee of the businesses and, thus, the amounts he received from the businesses were not subject to self-employment tax. He also argued that he was entitled to the real estate losses because he was a real estate professional.

The Tax Court held that Carnell was liable for self-employment tax and could not deduct the real estate losses. The court noted that whether an individual is an employee or an independent contractor depends on certain criteria determined by applying common law. The court examined the relevant criteria and found that the majority of the factors weighed in favor of Carnell being an independent contractor subject to self-employment tax. Specifically, the court found that the businesses did not have the requisite right to control Carnell in the performance of the security services, did not train or equip him, that he was not an essential part of the businesses, and that he did not receive benefits from the businesses.

With respect to the question of whether Carnell was a real estate professional, the court concluded that because Carnell worked less than 750 hours in the rental activity, he did not qualify as a real estate professional under Code Sec. 469. Thus, his real estate losses were denied.

Finally, the court concluded that the Specks were liable for the accuracy-related penalty. The court found that the Specks did not establish that the return preparer was a competent professional with significant expertise to justify reliance or that the Specks provided the return preparer all relevant information.

For a discussion of individuals subject to self-employment taxes, see Parker Tax ¶13,105.

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Failure to Get CPAs Advice on Conservation Easement Donation Leads to Penalties for Taxpayer

Because the mortgage on land for which a conservation easement was granted was not subordinated to the conservation easement when it was granted, no charitable deduction was allowed, and the taxpayer's failure to ask the CPA preparing the return for advice precludes reasonable cause defense for penalty assessment. Minnick v. Comm'r, T.C. Memo. 2012-345 (12/17/12).

On January 25, 2005, Walter Minnick and his wife obtained a mortgage from U.S. Bank on a 74-acre parcel of land they owned. On September 5, 2006, the county in which the land was located permitted Walter to subdivide the land into seven single-family residential lots. Two days later, Walter granted a conservation easement on the land to the charitable organization Land Trust of Treasure Valley, Inc. (i.e., the Land Trust). The terms of the easement prohibited Walter and any subsequent owner from building on or altering the portions of the land outside the areas designated as building envelopes for each lot. The portions of the land thus restricted by the easement constituted 80 percent of the 74-acre parcel. The conservation easement stated: Grantor [i.e. Walter] warrants that * * * [he] owns the Property in fee simple and has conveyed it to no other person, and that there are no outstanding mortgages, tax liens, encumbrances, or other interests in the Property that have not been expressly subordinated to the Easement. Contrary to this warranty provision, U.S. Bank's mortgage was not then subordinated to the conservation easement. The conservation easement also provided that Walter and the Land Trust could amend the terms of the easement if circumstances arose under which an amendment would be appropriate.

When Walter and his wife filed their original 2006 income-tax return, they did not claim a charitable-contribution deduction for the grant of the conservation easement. Walter had not yet received a written appraisal of the easement. On or about December 26, 2007, the Minnicks filed an amended income-tax return for 2006. On the amended return, the Minnicks took a charitable deduction for the grant of the easement of $389,500. They reported that the value of the easement was $941,000, based on an appraisal by G. Joseph Corlett, who had been hired by Walter. The amended return was prepared by a CPA. Both the CPA and Walter intended that Corlett's appraisal be attached to the 2006 tax return, but for some reason the return the IRS received did not have the appraisal attached to it. Minnick never asked the CPA whether he was entitled to the $941,000 deduction, and the CPA did not tell him that he was. Minnick had worked for a few months as a lawyer near the beginning of his career, spending some time in tax law. He later went into the building-supply business. Minnick's wife was uninvolved in determining whether the conservation easement gave rise to a charitable-contribution deduction.

On September 12, 2011, Walter and U.S. Bank executed an agreement under which U.S. Bank subordinated its mortgage to the conservation easement. The effect of this subordination agreement is that the conservation easement will remain in force if U.S. Bank becomes the owner of the land by foreclosure.

The IRS denied the charitable deduction for the following reasons: (1) the grant of the conservation easement was a condition of receiving permission from the county to subdivide the land; (2) the conservation easement was not protected in perpetuity because (a) the terms of the easement allowed Walter and the Land Trust to amend the easement by agreement, (b) U.S. Bank's mortgage on the land was not subordinated at the time of the grant, and (c) the easement failed to provide for the allocation of proceeds to the Land Trust in the event the easement was extinguished; (3) the Minnick's deduction for the contribution of the easement was limited to the basis allocated to the easement; and (4) the easement was overvalued.

The IRS also assessed a penalty, contending that the Minnicks were negligent because they should have known that no deduction would be allowed. The Minnicks argued that they followed a model conservation-easement form given to them by the Land Trust, that Walter discussed with his CPA the legal requirements for a conservation easement, and that he hired an expert appraiser to appraise the conservation easement. Walter also contended that he should not be held to the standard of an experienced tax attorney because he worked only for a few months as an attorney and that he spent only a fraction of his time practicing tax law.

The Tax Court held that, because U.S. Bank's mortgage was not subordinated to the conservation easement when it was granted, the Minnicks could not take a deduction for the grant of the conservation easement. The court rejected the Minnicks argument that the September 2011 subordination agreement with U.S. Bank satisfied the subordination requirement in Reg. Sec. 1.170A-14(g). Citing its decision in Mitchell v. Commissioner, 138 T.C. 324 (2012), the court stated that a subordination agreement must be in place at the time that the conservation easement is granted.

The Tax Court also upheld the penalty assessment. The court concluded that, in determining whether the grant of the conservation easement gave rise to a charitable-contribution deduction, Walter did not exercise reasonable care. The court noted that he did not seek to subordinate U.S. Bank's mortgage to the conservation easement until 2011, and his failure to comply with the subordination requirement found in the regulations appeared to stem from his failure to solicit advice from his CPA about the deductibility of the conservation easement and the failure of the CPA to give such advice. The court noted that while the CPA explained to Walter that the value of a conservation easement was deductible under the Code, he did not tell Walter that the particular conservation easement Walter granted to the Land Trust was deductible. In the absence of such advice, the court said, Walter could not have reasonably relied on the CPA when he claimed a deduction for the conservation easement contribution. According to the court, Walter should have been alerted by the warranty provision in the conservation easement, which stated that there was no unsubordinated mortgage on the land, that there might be a problem with the lack of subordination. While it was true that the form Minnick used to grant the easement was a model, the court said that didn't matter the model easement form was not suited to Minnick's particular parcel of land.

For a discussion of the deductibility of conservation easements, see Parker Tax ¶84,155.

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IRS Finalizes Regs on Deduction for Qualified Film and TV Production

Final regulations provide guidance on determining the owner of a production, the production costs, and the amount of costs for which an election under Code Sec. 181 may be made with respect to qualified film and television production costs. T.D. 9603 (12/7/12).

Code Sec. 181 was enacted to promote film and television production in the United States. For a qualified film or television production that began before January 1, 2008 (a pre-amendment production), Code Sec. 181 permits an owner to elect to deduct production costs paid or incurred by that owner in the tax year the costs are paid or incurred, in lieu of capitalizing the costs and recovering them through depreciation allowances, if the aggregate production costs do not exceed $15 million ($20 million if a significant amount of the aggregate production costs are paid or incurred in certain designated areas) for each qualifying production (i.e., the aggregate production costs limit). A film or television production is a qualified film or television production if 75 percent of the total compensation for the production is compensation for services performed in the United States by actors, directors, producers, and other production personnel.

For a qualified film or television production that began after December 31, 2007, Code Sec. 181 permits an owner to elect to deduct production costs paid or incurred by that owner in the tax year the costs are paid or incurred, in lieu of capitalizing the costs and recovering them through depreciation allowances, to the extent of $15 million ($20 million if a significant amount of the aggregate production costs are paid or incurred in certain designated areas) for each qualifying production.

OBSERVATION: Thus, for a qualified film or television production that began before 2008, there is no deduction allowable if the aggregate production costs exceed $15 million (or $20 million in certain cases) whereas, if the production began after 2007, the first $15 million (or $20 million in certain cases) is deductible and the rest is not. The final regulations use the term pre-amendment production to distinguish productions that are subject to the maximum aggregate production costs limit from productions that are subject to the maximum production costs deduction limit. Several provisions of the final regulations are specific to pre-amendment productions.

On December 7, the IRS issued final regulations under Code Sec. 181. The final regulations provide rules for determining the owner of a production, the production costs, the maximum amount of aggregate production costs, that may be paid or incurred for a pre-amendment production for which the owner makes an election under Code Sec. 181, and the maximum amount of aggregate production costs that may be claimed as a deduction for a post-amendment production for which the owner makes an election under Code Sec. 181.

The final regulations apply to qualified film and television productions to which Code Sec. 181 applies and for which the first day of principal photography or in-between animation occurs on or after December 7, 2012. The owner of a qualified film or television production may apply the final regulations to productions to which Code Sec. 181 applies and for which principal photography or, for an animated production, in-between animation begun before December 7, 2012.

For a discussion of the rules relating to the tax treatment of qualified film and television production costs, see Parker Tax ¶95,600.

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Debtor Can't Use Fraudulent Transfer Statutes to Avoid Tax Penalties or Recover Prepetition Payments on Such Penalties

The fraudulent-transfer statutes were not meant to provide debtors with either a means to avoid tax penalties legitimately imposed or a means to recover prepetition payments made in satisfaction of those penalties. In re Southeast Waffles, LLC v. I.R.S., 2012 PTC 302 (6th Cir. 12/6/12).

Southeast Waffles, LLC (SEW), a limited liability corporation, was formed in 1999 for the purpose of purchasing, and operating as a franchisee, Waffle House restaurants. When SEW filed for Chapter 11 bankruptcy on August 25, 2008, it operated approximately 113 Waffle House restaurants located in Tennessee, Alabama, Mississippi, and Kentucky. Throughout the period from January 1, 2005, to August 25, 2008, SEW failed to pay all of the federal income tax withholding, social security (FICA), and unemployment (FUTA) taxes that were due to the IRS.

SEW also failed to timely file all returns relating to these taxes. Because SEW hired many hundreds of individuals in the restaurants it operated, the payments due to the IRS for federal income tax withholding, FICA, and FUTA taxes were sizable.

During the four years before August 25, 2008, the IRS assessed penalties well in excess of $1,500,000 for SEW's failure to timely file its tax returns and to fully and timely pay the taxes due. Throughout this time period, SEW was insolvent and owed unsecured debts to one or more creditors. After filing its voluntary Chapter 11 petition in a bankruptcy court, SEW operated its business and managed its properties as debtor-in-possession until it sold substantially all of its assets effective October 1, 2009.

SEW filed an avoidance action on August 24, 2010, seeking recovery from the IRS of prepetition tax penalty payments in the amount of approximately $638,000 or, in the alternative, an offset in the amount of the penalty payments against the tax amounts still owed to the IRS. SEW alleged a number of issues but did not allege that the penalty obligationsthose already paid as well as those then unpaidwere themselves avoidable under the fraudulent-transfer statutes. The IRS filed a motion to dismiss SEW's complaint for failure to state a claim, arguing that SEW's prepetition tax-penalty payments did not and could not constitute fraudulent transfers because, as a matter of law, the dollar-for-dollar reduction in SEW's antecedent tax-penalty liabilities constituted reasonably equivalent value for the penalty payments. SEW having failed to allege that the penalty obligations were themselves avoidable, the IRS focused its motion to dismiss exclusively on SEW's claims that the penalty payments were avoidable. In response to the IRS's motion, SEW continued to assert that each of the penalty payments was a fraudulent transfer.

While still maintaining that each penalty payment was a fraudulent transfer, SEW added that, by failing to give anything of value to SEW when the penalties were first assessed, the IRS received a fraudulent conveyance when the debt or obligation arose.

The bankruptcy court held that the imposition of penaltiesi.e., the incurrence of the obligationwas not itself a fraudulent conveyance subject to avoidance. Acknowledging that the fraudulent-transfer statutes do not expressly insulate prepetition noncompensatory penaltiesor payments in satisfaction thereoffrom recovery, the bankruptcy court nonetheless concluded that Congress never intended that such penalties be avoidable as fraudulent transfers. It thus dismissed SEW's suit.

SEW's case was then heard by the Bankruptcy Appellate Panel, which summarized the issue as whether SEW received less than reasonably equivalent value when the IRS applied prepetition payments made by SEW to the penalty portion of the tax liability. SEW argued that it received zero value for the payment when the IRS applied SEW's payments to the penalty portion of the liability rather than applying the payment to the tax or interest portion of the liability. SEW then argued that because it received zero value for the payment, the transfer (payment) must be avoided as a fraudulent transfer.

Citing Code Sec. 6671(a), the BAP explained that the penalty portion of a taxpayer's liability to the IRS is an integral part of the taxpayer's total tax debt. Whenever a payment of the penalty portion is made, the taxpayer's total tax debt is reduced dollar for dollar. Finding considerable case law holding that a dollar-for-dollar reduction in debt is sufficient to establish equivalent value for purposes of the fraudulent-transfer statutes, the BAP concluded that SEW's payment of penalties did not constitute a fraudulent transfer because those payments reduced SEW's total tax debt dollar for dollar, thereby providing SEW with reasonably equivalent value for its payments. The BAP thus affirmed the bankruptcy court. SEW then appealed to the Sixth Circuit.

Before the Sixth Circuit, SEW argued that the lower courts committed reversible error because they failed to consider SEW's argument that the penalties imposed by the IRS were fraudulent obligations subject to avoidance. According to SEW, the bankruptcy court and the BAP had the timing wrongi.e., they should have determined whether or not SEW received reasonably equivalent value as of the time the penalty obligations were incurred and not when the payments were made.

The Sixth Circuit noted that SEW cited no case, and the court could find none, in which prepetition tax penaltiesor prepetition payments in satisfaction thereofhave ever been avoided under the fraudulent-transfer statutes. The court observed that the impact of a decision to allow avoidance of noncompensatory penalties as fraudulent transfers would be enormous. Such a decision, the court stated, could open a Pandora's box of litigation by debtors seeking not only to avoid all sorts of noncompensatory fines and penalties that are commonly encountered in bankruptcy cases, but also to recover any prepetition payments made in satisfaction of those fines and penalties. The court found the fact that Congress would be silent about such a matter throughout 10 years of careful consideration and investigation to be utterly inexplicable unless Congress did not intend to change the landscape by making noncompensatory penalties and fines avoidable as fraudulent transfers. Thus, the Sixth Circuit concluded that the fraudulent-transfer statutes were not meant to provide debtors with either a means to avoid tax penalties legitimately imposed or a means to recover prepetition payments made in satisfaction of those penalties.