Court Rejects Attempt to Use QSub Election to Increase S Corp Stock Basis

In a recent Tax Court case, a group of S corporation shareholders used a novel argument in attempting to justify an increase in the basis of their S stock before selling it. The shareholders in R Ball for R Ball III By Appt., Et Al v. Comm'r, T.C. Memo. 2013-39 (2/6/13), argued that they were entitled to increase the adjusted bases in their S stock after the S corporation made a qualified subchapter S subsidiary (QSub) election for a subsidiary. Where a parent S corporation elects to treat a wholly owned domestic corporation as a QSub, the subsidiary is no longer treated as a separate corporation. Instead, Code Sec. 1361(b)(3)(A) treats all assets, liabilities, items of income, deductions, and credits of the QSub as the assets, liabilities, items of income, deductions, and credits of the parent S corporation. The subsidiary for which the election is made is deemed to have liquidated into the parent S corporation.

According to the shareholders, the QSub election resulted in a gain derived from dealings in property and, therefore, created an item of income that justified their increasing the basis of their S stock. Unfortunately for the shareholders, the IRS and the Tax Court rejected this argument. As the Tax Court noted, the shareholders overlooked the role of realization and recognition of income in determining what constitutes gain from the sale or disposition of property.

Background

In June 1997, nine members of the Ball family and another person directly owned 100 percent of American Insurance Service, Inc. (AIS). The S shareholders had an aggregate adjusted basis of approximately $5.6 million in their shares of AIS.

In 1999, the S shareholders organized Wind River Investment Corp. (WRIC). They contributed 100 percent of their shares of AIS to WRIC in exchange for 100 percent of the stock in WRIC. After completing the transaction, the shareholders directly owned 100 percent of WRIC, and WRIC directly owned 100 percent of AIS. In 2003, the nine Ball family members owned 99.01 percent of WRIC.

Effective June 4, 1999, WRIC elected to be taxed as an S corporation. From June 4, 1999, through September 4, 2003, WRIC continued to own 100 percent of AIS. During WRIC's tax year ended September 4, 2003, WRIC made a QSub election under Code Sec. 1361(b)(3)(B) with respect to AIS, effective February 28, 2003.

About five months later, all the S shareholders sold their WRIC shares to an unaffiliated third party. Before transaction costs, they received over $230 million. The Ball family members claimed losses on the transaction as a result of having increased their S stock basis after the QSub election.

The IRS disallowed the claimed bases adjustments following the QSub election and assessed a deficiency.

Adjusting S Corporation Stock Basis

Under Code Sec. 1367(a)(1), the basis of each S shareholder's stock in an S corporation is increased for any period by the sum of certain items. Code Sec. 1367(a)(1)(A) provides that those items include items of income described in Code Sec. 1366(a)(1)(A). Code Sec. 1366(a)(1)(A) provides that, in determining an S shareholder's tax for the year, there is taken into account the shareholder's pro rata share of the corporation's items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder.

Taxpayers' Position

The S shareholders argued that they properly adjusted their bases in the WRIC shares after the QSub election pursuant to Code Sec. 1367(a)(1)(A) and that they properly claimed losses from the sale of WRIC on their 2003 income tax returns. According to the shareholders, the QSub election resulted in a gain derived from dealings in property and, therefore, created an item of income under Code Sec. 61(a). Code Sec. 61(a) defines gross income as all income from whatever source derived, which includes gains derived from dealings in property. The family members claimed that the exchange of the S corporation's shares of stock in the subsidiary for the subsidiary's assets resulted in gains derived from dealings in property.

Tax Court's Decision

The Tax Court held that the unrecognized gain resulting from the QSub election did not create an item of income or tax-exempt income pursuant to Code Sec. 1366(a)(1)(A). As a result, the court concluded that the shareholders improperly adjusted their bases in their WRIC stock following the QSub election.

According to the Tax Court, the shareholders' position would create noneconomic basis adjustments that would reduce or eliminate tax at the shareholder level. This would not only convert the single-level taxation of S corporations into a zero-level taxation of S corporations; it would also undermine the double-level taxation of C corporations, as preserved in Code Sec. 1374 (relating to the built-in gains tax), and circumvent the repeal of the General Utilities doctrine.

Observation: Before 1986, the General Utilities doctrine so named for the Supreme Court's decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935) permitted a C corporation to escape corporate-level tax on certain distributions of appreciated property to its shareholders. Congress repealed the General Utilities doctrine in the Tax Reform Act of 1986, thus ensuring a corporate-level tax on the distribution of appreciated property. Congress noted that the General Utilities doctrine undermined the corporate income tax. Congress further cemented the repeal of the General Utilities doctrine by enacting Code Sec. 1374 in the Tax Reform Act of 1986. Code Sec. 1374 prevents a C corporation from avoiding corporate-level taxation on the sale of appreciated assets by converting to an S corporation.

The court noted that the shareholders' position would produce absurd results and would open the door to a myriad of abusive transactions. Using these noneconomic basis adjustments, the court noted that the shareholders attempted to turn what should have been a $202 million aggregate taxable gain into a $12 million aggregate loss. Had WRIC sold any of AIS' appreciated assets at a gain after the QSub election, the shareholders would have increased their adjusted bases in WRIC a second time, thus reducing or eliminating more tax.

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Conflict in Easement Agreement Language Leads to Charitable Deduction Being Denied

Late last month, the Tax Court addressed for the first time what constitutes a qualified real property interest for purposes of taking a charitable deduction for a conservation easement. In Belk v. Comm'r, 140 T.C. No. 1 (1/28/13), the taxpayers contributed a conservation easement on 185 acres of a golf course to a qualified organization and took a deduction for the contribution. The conservation easement agreement allowed the parties, by agreement and subject to certain restrictions, to change what real property was subject to the conservation easement. The court found a conflict between a specific provision and a general provision in the conservation easement agreement. The court concluded that the specific provision, allowing the taxpayers to substitute property subject to the agreement, took precedence over the general provision saying substitutions were not permitted because they were not permitted under Code Sec. 170(h). As a result, the Tax Court disallowed the deduction because the taxpayers did not donate an interest in real property subject to a use restriction granted in perpetuity since the taxpayers were permitted to remove real property from the coverage of the conservation easement.

Facts

In 2004, B.V. Belk and his wife, Harriet, contributed 410 acres of land in North Carolina to their newly formed LLC, Old Sycamore. On that property, Old Sycamore, which is a partnership, developed a residential community that comprised 402 single-family home lots and built a golf course. Subsequently, Old Sycamore contributed a conservation easement on 184.627 acres of the golf course to Smoky Mountain National Land Trust (SMNLT), a qualified charitable organization. The conservation easement agreement states that the golf course possesses recreational, natural, scenic, open space, historic, and educational values. Except for the rights reserved, the conservation easement agreement prohibits the golf course from being used for residential, commercial, institutional, industrial, or agricultural purposes. The conservation easement agreement specifically provides that a golf course may be maintained on the easement property. The conservation easement agreement permits the Belks and SMNLT to change what property is subject to the conservation easement.

An appraisal report commissioned by the Belks stated that the value of the golf course before the easement was $10.8 million. The appraiser reached this amount after concluding the highest and best use of the property was a medium-and high-density residential development. After the easement, the appraiser determined the highest and best use of the property was use as a golf course and that its value was $277,000.

Olde Sycamore claimed a $10.5 million charitable contribution deduction on its 2004 Form 1065, U.S. Return of Partnership Income, for its contribution of the conservation easement to SMNLT. The Belks attached Form 8283, Noncash Charitable Contributions, to Olde Sycamore's partnership return. The Form 8283 listed the appraised fair market value of the conservation easement as $10.5 million. The Belks claimed a $10.5 million charitable contribution deduction on their Schedule A, Itemized Deductions, for 2004. They deducted $2,291,708 in 2004 and carried forward the remainder to 2005 and 2006.

The IRS disallowed the charitable deduction and assessed a deficiency.

Qualified Conservation Contributions and Qualified Real Property Interest

Code Sec. 170(h)(1) allows a charitable deduction for a qualified conservation contribution. A qualified conservation contribution requires a contribution of a qualified real property interest. Under Code Sec. 170(h)(2) a qualified real property interest is defined as any of the following interests in real property:

• the entire interest of the donor other than a qualified mineral interest;
• a remainder interest; and
• a restriction (granted in perpetuity) on the use that may be made of the real property.

With respect to (3), above, Reg. Sec. 1.170A-14(b)(2) provides that a perpetual conservation restriction is a qualified real property interest and defines a perpetual conservation restriction as a restriction granted in perpetuity on the use that may be made of real property, including an easement or other interest in real property that under state law has attributes similar to an easement (e.g., a restrictive covenant or equitable servitude).

Taxpayers' and IRS's Arguments

The IRS denied the Belks' charitable deduction. According to the IRS, the Belks did not donate their entire interest in real property or a remainder interest in real property and, therefore, had to satisfy the requirement in Code Sec. 170(h)(2)(C) that there be a restriction granted in perpetuity on the use that could be made of the donated property. The Belks did not satisfy this requirement, the IRS stated, because the interest in real property that they donated was not subject to a use restriction granted in perpetuity because it allowed the parties to change what real property was subject to the conservation easement. The IRS combined its Code Sec. 170(h)(2)(C) argument with an argument that the Belks also failed to satisfy the perpetuity requirement of Code Sec. 170(h)(5), which requires that the conservation purpose of the conservation easement be protected in perpetuity.

The Belks argued that it did not matter that the conservation easement agreement permits substitution because it permits only substitutions that will not harm the conservation purposes of the conservation easement and the substitutions must be approved by SMNLT.

Tax Court's Decision

The Tax Court held that the Belks did not satisfy Code Sec. 170(h)(2)(C) and, therefore, were not entitled to a deduction for a qualified conservation contribution.

The Tax Court noted that the Code Sec. 170(h)(5) requirement that the conservation purpose be protected in perpetuity is separate and distinct from the Code Sec. 170(h)(2)(C) requirement that there be real property subject to a use restriction in perpetuity. Satisfying Code Sec. 170(h)(5), the court stated, does not necessarily affect whether there is a qualified real property interest. According to the Tax Court, when defining what constitutes a real property interest, Code Sec. 170(h)(2), as well as the corresponding regulations and the legislative history, does not mention a conservation purpose. Thus, the court said, there is nothing to suggest that Code Sec. 170(h)(2)(C) should be read to mean that the restriction granted on the use that may be made of the real property does not need to be in perpetuity if the conservation purpose is protected.

According to the court, it was immaterial that SMNLT had to approve the substitutions of property. There is nothing in the Code, the regulations, or the legislative history, the court observed, to suggest that Code Sec. 170(h)(2)(C) must be read to require that the interest in property donated be a restriction on the use of the real property granted in perpetuity unless the parties agree otherwise. The requirements of Code Sec. 170(h) apply even if taxpayers and qualified organizations wish to agree otherwise.

The court found it immaterial that SMNLT could not agree to an amendment that would result in the conservation easement's failing to qualify as a qualified conservation contribution under Code Sec. 170(h). The substitution provision, the court noted, states that a substitution is not final or binding on SMNLT until the conservation easement agreement is amended to reflect the substitution. The court rejected the argument that, because substitution was effected by amendment and the conservation easement agreement seemingly prohibited amendments not permitted by Code Sec. 170(h), the conservation easement did not permit substitutions.

The court noted that there is a conflict between a specific provision and a general provision in the conservation easement agreement. The Belks' right to substitute property, the court said, is a specific provision one of the enumerated rights reserved in the agreement under Article III: Reserved Rights, and it contains several paragraphs with specific, detailed language. The amendment provision is a general provision, the court noted, and is included in Article VIII: Miscellaneous, and contains only one paragraph with broad, general language. Thus, the court observed, there is a specific contract provision stating that substitution is permitted and a general provision which seemingly says substitution cannot be permitted because it is not permitted under Code Sec. 170(h). It is a rule of law, the court said, that when general terms and specific statements are included in the same contract and there is a conflict, the general terms should give way to the specifics.

As a result, the court concluded that the Belks and SMNLT did not intend for the amendment provision to prohibit substitutions or to limit substitutions to where continued use was impossible or impractical. To find otherwise, the court said, would render the substitution provision meaningless, and such a result was contrary to the well-established rule of construction that each and every part of a contract must be given effect, if this can be done by any fair or reasonable interpretation.

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IRS Accepting Tax Returns with Education Credits and Depreciation; Should Begin Processing Forms Affected by ATRA the First Week of March

Taxpayers can now start filing two major tax forms covering education credits and depreciation, while other forms affected by the American Taxpayer Relief Act of 2012 should be ready for processing by the beginning of March. IR-2013-18 (2/8/13)

The IRS announced last week that it completed the reprogramming and testing of its systems, and taxpayers can start filing two major tax forms this week covering education credits and depreciation. Beginning Sunday, February 10, the IRS began processing tax returns that contain Form 4562, Depreciation and Amortization. And on Thursday, February 14, the IRS begins processing Form 8863, Education Credits.

The IRS stated that this step clears the way for almost all taxpayers to start filing their tax returns for 2012, as these forms affected the largest groups of taxpayers who weren't able to file following the January 30 opening of the 2013 tax season.

However, the IRS said it is still working on preparing IRS systems to accept the remaining tax forms affected by the American Taxpayer Relief Act (ATRA) enacted by Congress on January 2. The IRS said it would start accepting the remaining forms affected by the January legislation the first week of March. A specific date will be announced later. According to the IRS, most of those in this group file more complex tax returns and typically file closer to the deadline or obtain an extension.

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IRS Issues Annual Advice on Missing Form W-2's

Each year, the IRS issues annual advice on actions a taxpayer should take when the taxpayer has not received his or her Form W-2. IRS Website (2/8/13).

According to the IRS, if a taxpayer has not received his or her Form W-2, the taxpayer should:

(1) Contact the employer. Ask the employer or former employer to send the W-2 if it has not already been sent. Double check that the employer has the correct address.

(2) Contact the IRS. After February 14, a taxpayer can call the IRS at 800-829-1040 if the taxpayer has not yet received his or her W-2. The IRS will require the following information:

(i) the taxpayer's name, address, social security number and phone number;

(ii) the employer's name, address and phone number;

(iii) the dates the taxpayer worked for the employer; and

(iv) an estimate of the taxpayer's wages and federal income tax withheld in 2012, based on the taxpayer's final pay stub or leave-and-earnings statement, if available.

(3) The taxpayer must still file his or her tax return on or before April 15, 2013, even if no Form W-2 has been received. If the taxpayer has not received a Form W-2, the taxpayer should file Form 4852, Substitute for Form W-2, Wage and Tax Statement, in place of the W-2. This form is used to estimate the taxpayer's income and withholding taxes as accurately as possible. The IRS may delay processing of the return while it verifies the information.

If a taxpayer receives the missing W-2 after the tax return has been filed and the information on the W-2 is different from what was reported using Form 4852, then Form 1040X, Amended U.S. Individual Income Tax Return, should be filed to amend the tax return.

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Proposed Regs Address Individual Health Insurance Mandate

Proposed regulations provide details on rules relating to the requirement to maintain minimum essential health care coverage. REG-148500-12 (2/1/13).

The Patient Protection and Affordable Care Act of 2010 enacted Code Sec. 5000A. Code Sec. 5000A(a) and Code Sec. 5000A(b) provide that nonexempt individuals must have minimum essential coverage for each month beginning after December 31, 2013, or make an additional payment (the shared-responsibility payment) with their federal income tax return for the tax year that includes that month. A taxpayer is liable for the shared-responsibility payment if any nonexempt individual who may be claimed by the taxpayer as a dependent for a tax year does not have minimum essential coverage in a month included in that tax year. Married taxpayers filing a joint return for any tax year are jointly liable for any shared-responsibility payment imposed for the year.

Compliance Tip: An individual liable for the shared-responsibility payment under Code Sec. 5000A must report the payment on the individual's federal income tax return for the tax year including the month or months for which the payment is owed.

Many individuals are exempt from the shared-responsibility payment, including some whose religious beliefs conflict with acceptance of the benefits of private or public insurance and those who do not have an affordable health insurance coverage option available. The Affordable Care Act directs health care exchanges to issue to qualified individuals certificates of exemption from the requirement to maintain minimum essential coverage or the shared-responsibility payment. Exempt individuals are eligible for health care through state or federal health care exchanges.

The IRS has now issued proposed regulations under Code Sec. 5000A. The proposed regulations provide that, for a month, a nonexempt individual must either have minimum essential coverage or pay the shared-responsibility payment. An individual is treated as having minimum essential coverage if the individual is enrolled in and entitled to receive benefits under a program or plan that is minimum essential coverage for at least one day during the month. Under Code Sec. 5000A(b)(3)(A), if an individual with respect to whom the shared responsibility payment is imposed for a month is another individual's dependent for the tax year including that month, the other individual is liable for the shared-responsibility payment for the dependent. The proposed regulations clarify that a taxpayer is liable for the shared-responsibility payment imposed with respect to any individual for a month in a tax year for which the taxpayer may claim a personal exemption deduction for the individual (that is, the dependent) for that tax year. Whether the taxpayer actually claims the individual as a dependent for the tax year does not affect the taxpayer's liability for the shared-responsibility payment for the individual.

Code Sec. 5000A(b)(3)(B) provides that, if an individual for whom the shared-responsibility payment is imposed for a month files a joint return for the tax year including that month, the individual and the individual's spouse are jointly liable for the shared-responsibility payment. The proposed regulations clarify that whether one spouse is an exempt individual does not affect the joint liability of the two spouses for the shared-responsibility payment.

Observation: The penalty for failure to maintain minimum coverage will be phased in between 2014 and 2016. For a discussion of the penalty for failing to maintain minimum essential health coverage, see Parker Tax ¶190,100.

An individual is exempt from the shared-responsibility payment for a month for which the individual does not have access to affordable minimum essential coverage. An individual is considered as not having access to affordable coverage for a month if the individual's required contribution (determined on an annual basis) for coverage for the month exceeds 8 percent of the taxpayer's household income for the tax year. For any plan year beginning after 2014, the 8 percent figure will be updated to reflect the excess of the rate of premium growth between the preceding calendar year and 2013 over the rate of income growth for the same period.

For purposes of determining affordability of coverage, the proposed regulations require that the taxpayer's household income be increased by the portion of the required contribution made through a salary-reduction arrangement and excluded from gross income.

If an individual is eligible for coverage under an eligible employer-sponsored plan, whether as an employee or as an individual related to an employee, the individual's qualification for the lack of affordable coverage exemption is determined solely by reference to the cost of coverage under the eligible employer-sponsored plan. The proposed regulations clarify that an employee or related individual is treated as eligible for coverage under an eligible employer-sponsored plan for each month included in the plan year if the employee or related individual could have enrolled in the plan for that month during an open or special enrollment period.

Example: Ellen is single with no dependents. In November 2015, Ellen is eligible to enroll in self-only coverage under a plan offered by her employer for calendar year 2016. If Ellen enrolls in the coverage, she is required to pay $5,000 of the total annual premium. In 2016, Ellen's household income is $60,000. Her required contribution is $5,000, the portion of the annual premium she pays for self-only coverage. In this case, Ellen lacks affordable coverage for 2016 because her required contribution ($5,000) is greater than 8 percent of her household income ($4,800).

Example: Bob and Carol are married and file a joint return for 2016. They have two children. In November 2015, Bob is eligible to enroll in self-only coverage under a plan offered by Bob's employer for calendar year 2016 at a cost of $5,000 to Bob. Carol and the children are eligible to enroll in family coverage under the same plan for 2016 at a cost of $20,000 to Bob. The family's household income is $90,000. Bob's required contribution is his share of the cost for self-only coverage, $5,000. Thus, Bob has affordable coverage for 2016 because his required contribution ($5,000) does not exceed 8 percent of his household income ($7,200). The required contribution for Carol and the children is Bob's share of the cost for family coverage, $20,000. As a result, Carol and the children lack affordable coverage for 2016 because their required contribution ($20,000) exceeds 8 percent of their household income ($90,000 x 8% = $7,200).

Example: Chris is single with no dependents. In June 2015, Chris is eligible to enroll in self-only coverage under a plan offered by his employer for the period July 2015 through June 2016 at a cost to Chris of $4,750. In June 2016, Chris is eligible to enroll in self-only coverage under a plan offered by his employer for the period July 2016 through June 2017 at a cost of $5,000. In 2016, Chris's household income is $60,000. Chris's annualized required contribution for the period January 2016 through June 2016 is $4,750 ($2,375 paid for premiums in 2016 x 12/6). Thus, Chris has affordable coverage for January 2016 through June 2016 because his annualized required contribution ($4,750) does not exceed 8 percent of his household income ($4,800). Chris's annualized required contribution for the period July 2016 to December 2016 is $5,000 ($2,500 paid for premiums in 2016 x 12/6). As a result, Chris lacks affordable coverage for July 2016 through December 2016 because his annualized required contribution ($5,000) exceeds 8 percent of his household income ($60,000 x 8% = $4,800).

For a discussion of requirement to maintain minimum essential health care coverage, see Parker Tax ¶190,100  

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IRS Reopens Online PTIN Program; Court Rejects IRS Request for a Stay of the RTRP Injunction

A district court rejected the IRS's request to stay the injunction on its registered tax return preparer program 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. Loving v. IRS, 2013 PTC 13 (D. D.C. 2/1/13).

On Friday, January 18, 2013, the District Court for the District of Columbia in Loving v. IRS, 2012 PTC 10 (D. D.C. 2013), enjoined the IRS from enforcing the regulatory requirements for registered tax return preparers (RTRPs). In accordance with this order, RTRPs covered by the IRS program are not required to complete competency testing or secure continuing education. The ruling does not affect the regulatory practice requirements for CPAs, attorneys, enrolled agents, enrolled retirement plan agents or enrolled actuaries. On January 23, the IRS filed a motion 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.

The 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 preparer tax identification number (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 district court rejected the IRS's argument that no harm would be done if the court stayed the injunction. According to the court, the harm would be considerable because, if it stayed the injunction, then all preparers would be faced with a choice of either (1) skipping the registration requirements, gambling on an affirmance by the D.C. Court of Appeals or a reversal that would be issued early enough that they could still fulfill their requirements by the end of the year, or (2) satisfying the testing and continuing-education requirements, knowing that this might be wasted time, effort, and expense.

As a result of the court's ruling, the IRS has reopened the online PTIN system

For a discussion of the RTRP program, see Parker Tax ¶271,127.

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IRS Finalizes Regs on Noncompensatory Partnership Options

Final regulations (1) generally provide that the exercise of a noncompensatory option does not cause the recognition of immediate income or loss by either an issuing partnership or the option holder; (2) modify the regulations under Code Sec. 704(b) regarding the maintenance of the partners' capital accounts and the determination of the partners' distributive shares of partnership items; and (3) contain a characterization rule providing that the holder of a noncompensatory

option is treated as a partner under certain circumstances. T.D. 9612 (2/5/13).

In 2003, the IRS issued proposed regulations under Code Sec. 721 relating to the tax treatment of noncompensatory options and convertible instruments issued by a partnership. The IRS has now finalized these regulations.

Like the proposed regulations, the final regulations under Code Sec. 721 define a noncompensatory option as an option issued by a partnership, other than an option issued in connection with the performance of services. For this purpose, an option is defined as a call option or warrant to acquire an interest in the issuing partnership, the conversion feature of convertible debt, or the conversion feature of convertible equity.

The proposed regulations provided that Code Sec. 721 did not apply to a transfer of property to a partnership in exchange for a noncompensatory option. Several practitioners observed that the proposed regulations did not exclude options issued in satisfaction of interest or similar items, such as unpaid rent or royalties. Accordingly, the final regulations provide that Code Sec. 721 does not apply to the transfer of property to a partnership in exchange for a noncompensatory option, or to the satisfaction of a partnership obligation with a noncompensatory option. The final regulations contain an example illustrating that a transfer of appreciated or depreciated property to a partnership in exchange for a noncompensatory option generally will result in the recognition of gain or loss by the option recipient. Under open transaction principles applicable to noncompensatory options, the partnership will not recognize income for receipt of the property while the option is outstanding. Notwithstanding the general rule, the IRS believes it is appropriate to take into account the conversion right embedded in convertible equity as part of the underlying partnership interest. Accordingly, the final regulations provide that Code Sec. 721 does apply to a contribution of property to a partnership in exchange for convertible equity in a partnership.

The proposed regulations provided that Code Sec. 721 applied to the holder and the partnership upon the exercise of a noncompensatory option issued by the partnership. The final regulations generally adopt this rule. However, in response to comments, the final regulations also provide that Code Sec. 721 generally applies to the exercise of a noncompensatory option when the exercise price is satisfied with property or cash contributed to the partnership, regardless of whether the terms of the option require or permit a cash payment.

The proposed regulations did not specify whether, upon conversion of convertible debt in the partnership, the partnership was treated as satisfying its obligation for unpaid interest with a fractional interest in each partnership property. Under this ``vertical slice'' approach, the partnership could recognize gain or loss equal to the difference between the fair market value of each partial property deemed transferred to the creditor and the partnership's adjusted basis in that partial property. The IRS believes that approach would be difficult to administer and may inappropriately accelerate gain or loss recognition. Therefore, the final regulations provide that the partnership will not recognize gain or loss upon the transfer of a partnership interest to a noncompensatory option holder upon conversion of convertible debt in the partnership to the extent that the transfer is in satisfaction of the partnership's indebtedness for unpaid interest (including accrued original issue discount) on convertible debt that accrued on or after the beginning of the convertible debt holder's holding period for the indebtedness. Additionally, the final regulations also provide that the issuing partnership will not recognize gain or loss upon the transfer of a partnership interest to an exercising option holder in satisfaction of the partnership's obligation to the option holder for unpaid rent, royalties, or interest (including accrued original issue discount) that accrued on or after the beginning of the option holder's holding period for the obligation. This treatment is consistent with the rules under Sec. 1.721-1(d)(2).

Several practitioners requested guidance on the treatment of cash settled options, particularly regarding whether the cash settlement of an option is treated as a sale or exchange of the option or as an exercise of the option followed by an immediate redemption of the newly-issued partnership interest. According to the IRS, the cash settlement of a noncompensatory option should be treated as a sale or exchange of the option and taxed under the rules of Code Sec. 1234, rather than as a contribution to the partnership under Code Sec. 721, followed by an immediate redemption (although the latter may, in certain instances, be treated as a sale of the option under the disguised sale rules). The final regulations provide that the settlement of a noncompensatory option in cash or property other than an interest in the issuing partnership is not a transaction to which Code Sec. 721 applies.

Practitioners noted that the proposed regulations did not address the character of the gain or loss recognized upon lapse, repurchase, sale, or exchange of a noncompensatory option. While Code Sec. 1234(b) provides that gain or loss from any closing transaction generally is treated as short term capital gain or loss to the grantor of an option, practitioners were uncertain whether Code Sec. 1234(b) applied to partnership interests because it was unclear whether partnership interests qualified as ``securities'' for purposes of Code Sec. 1234(b). To eliminate this uncertainty, the IRS issued proposed regulations under Code Sec. 1234(b) which treat partnership interests as securities for this purpose.

Under the proposed regulations, issuance of a noncompensatory option was not a permissive or mandatory revaluation event under Reg. Sec. 1.704-1(b)(2)(iv). One practitioner noted that, as a result, unrealized gain in partnership property arising prior to the issuance of the option could be inappropriately shifted to the option holder upon exercise. As a result of this comment, the final regulations provide that the issuance by a partnership of a noncompensatory option (other than an option for a de minimis partnership interest) is a permissible revaluation event.

For a discussion of the rules relating to contributions of property to a partnership, see Parker Tax ¶22,700.

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IRS Finalizes Regs on Health Insurance Premium Tax Credit

Final regulations, relating to the health insurance premium tax credit and the determination of the affordability of employer-sponsored coverage for related individuals, have been issued. T.D. 9611 (2/1/13).

On February 1, 2013, the IRS issued final regulations that amend the regulations under Code Sec. 36B. Code Sec. 36B, which was enacted by the Patient Protection and Affordable Care Act (PPACA) and is effective for tax years ending after December 31, 2013, creates a refundable tax credit, called the premium assistance credit, for eligible individuals and families who buy health insurance through an insurance exchange. The premium assistance credit, which is refundable and payable in advance directly to the insurer, subsidizes the purchase of certain health insurance plans through an exchange.

The IRS had previously issued final regulations under Code Sec. 36B in 2012. However, those regulations reserved a rule in Reg. Sec. 1.36B-2(c)(3)(v)(A)(2)) for determining affordability of employer-sponsored coverage for related individuals. Instead, proposed regulations were issued, which provided that, for tax years beginning before January 1, 2015, an eligible employer-sponsored plan is affordable for related individuals if the portion of the annual premium the employee must pay for self-only coverage (the required contribution percentage) does not exceed 9.5 percent of the taxpayer's household income.

The IRS noted that several comments supported this rule, while other comments asserted that the affordability of coverage for related individuals should be based on the portion of the annual premium the employee must pay for family coverage. The language of Code Sec. 36B, through a cross-reference to Code Sec. 5000A(e)(1)(B), the IRS said, specifies that the affordability test for related individuals is based on the cost of self-only coverage. By contrast, Code Sec. 5000A, which establishes the shared responsibility payment applicable to individuals for failure to maintain minimum essential coverage, addresses affordability for employees in Code Sec. 5000A(e)(1)(B) and, separately, for related individuals in Code Sec. 5000A(e)(1)(C). Thus, proposed regulations under Code Sec. 5000A, which were also released on February 1 (see discussion below) provide that, for purposes of applying the affordability exemption from the shared-responsibility payment in the case of related individuals, the required contribution is based on the premium the employee would pay for employer-sponsored family coverage.

The final regulations thus adopted the proposed rule without change.

For a discussion of the premium assistance credit under Code Sec. 36B, see Parker Tax ¶102,600.

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IRS Intensifies National Crackdown on Identity Theft Relating to Tax Refunds

The IRS announced the results of a massive national sweep targeting identity theft suspects fraudulently claiming tax refunds in 32 states and Puerto Rico, which involved 215 cities and surrounding areas. IR-2013-17 (2/7/13).

To stop identity thieves up front, the IRS has made a significant increase for the 2013 tax season in the number and quality of identity theft screening filters that spot fraudulent tax returns before refunds are issued. The IRS has dozens of identity theft screens now in place to protect tax refunds.

As of late 2012, the IRS assigned more than 3,000 IRS employees over double from 2011 to work on identity theft-related issues. IRS employees are working to prevent refund fraud, investigate identity theft-related crimes, and help taxpayers who have been victimized by identity thieves. In addition, the IRS has trained 35,000 employees who work with taxpayers to recognize identity theft indicators and help people victimized by identity theft.

In early February, the IRS announced the results of a massive national sweep targeting identity theft suspects in 32 states and Puerto Rico, which involved 215 cities and surrounding areas. According to the IRS, the coast-to-coast effort against 389 identity theft suspects led to 734 enforcement actions in January, including indictments, informations, complaints, and arrests. The effort comes on top of a growing identity theft effort that led to 2,400 other enforcement actions against identity thieves during fiscal year 2012.

The crackdown on identity theft, which was a joint effort with the Department of Justice and local U.S. Attorneys offices, unfolded as the IRS opened the 2013 tax season. IRS Criminal Investigation expanded its efforts during January, pushing the total number of identity theft investigations to more than 1,460 since the start of the federal 2012 fiscal year on October 1, 2011.

A map of the locations and additional details on the January enforcement actions and compliance visits are available on IRS.gov. The identity theft push over the last several weeks reflects a wider effort underway at the IRS. Among the highlights:

(1) The number of IRS criminal investigations into identity theft issues more than tripled in fiscal year 2012. The IRS started 276 investigations in fiscal year 2011, a number that jumped to 898 in fiscal year 2012. So far in fiscal year 2013, more than 560 criminal identity theft investigations have been opened.

(2) Total enforcement actions continue to rapidly increase against identity thieves. This category covers actions ranging from indictments and arrests to search warrants. In fiscal year 2012, enforcement actions totaled 2,400 against 1,310 suspects. After just four months in fiscal 2013, enforcement actions totaled 1,703 against 907 suspects.

(3) Sentencings of convicted identity thieves continue to increase. There were 80 sentencings in fiscal year 2011, which increased to 223 in fiscal year 2012.

(4) Jail time is increasing for identity thieves. The average sentence in fiscal year 2012 was four years or 48 months a four-month increase from the average in fiscal year 2011. So far this fiscal year, sentences have ranged from 4 to 300 months.

For a discussion of identity theft with respect to tax returns, see Parker Tax ¶250,170.

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IRS Extends Deadlines to April 1 for Hurricane Sandy Victims in Certain NY and NJ Counties

The IRS is extending tax deadlines to April 1, 2013, for certain individuals and businesses affected by Hurricane Sandy. IR-2013-16 (2/1/13).

In the aftermath of Hurricane Sandy, the IRS announced additional tax relief to affected individuals and businesses. The IRS is further extending tax deadlines of that relief until April 1 for the following localities:

• New Jersey (starting Oct. 26): Monmouth and Ocean counties.
• In New York (starting Oct. 27): Nassau, Queens, Richmond and Suffolk counties.

The tax relief postpones various tax filing and payment deadlines that occurred starting in late October. As a result, affected individuals and businesses will have until April 1, 2013, to file these returns and pay any taxes due. This includes the fourth quarter individual estimated tax payment, normally due Jan. 15, 2013. It also includes payroll and excise tax returns and accompanying payments for the third and fourth quarters, normally due on October 31, 2012, and January 31, 2013, respectively, and calendar year corporate income tax returns due March 15. It also applies to tax-exempt organizations required to file Form 990 series returns with an original or extended deadline falling during this period.

The IRS said it will abate any interest, late-payment, or late-filing penalty that would otherwise apply. This relief is automatic to any taxpayer located in the disaster area. Taxpayers need not contact the IRS to get this relief.

Beyond the relief provided by law to taxpayers in the FEMA-designated counties, the IRS said it will work with any taxpayer who lives outside the disaster area but whose books, records, or tax professional are located in the areas affected by Hurricane Sandy. All workers assisting the relief activities in the covered disaster areas who are affiliated with a recognized government or philanthropic organization are eligible for relief. Taxpayers who live outside of the impacted area and think they may qualify for this relief need to contact the IRS at 866-562-5227.

The IRS also announced that Taxpayer Assistance Centers in several New York and New Jersey locations will be open additional hours to provide help to taxpayers affected by Hurricane Sandy. There will also be special assistance available at several New Jersey and New York locations on Saturday, February 23 from 9 a.m. until 2 p.m. More information will be available on irs.gov.

For a discussion of Hurricane Sandy tax relief, see Parker Tax ¶79,320.

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Transfers of Partnership Interests in Exchange for Annuities Were Not Disguised Gifts

The transfer of family partnership interests to the decedent's children in exchange for annuity agreements was not a disguised gift; but portions of the annuities traceable to the ownership interest of QTIP trusts in the family partnership, less the value of the decedent's qualifying income interests in those trusts, were subject to gift tax. Est. of Kite v. Comm'r, T.C. Memo. 2013-43 (2/7/13).

Mrs. Kite was the current income beneficiary of four trusts two qualified terminable interest property (QTIP) trusts, one marital deduction trust, and one revocable trust. In 2001, the QTIP trusts and the marital deduction trust were liquidated, and the trusts' assets, which consisted entirely of family partnership interests in the Kite Family Investment Co. (KIC), were transferred to Mrs. Kite's lifetime revocable trust. The family partnership interests held by the lifetime revocable trust were then transferred to Mrs. Kite's children in exchange for 10-year deferred private annuity agreements. In addition to consulting her family and business advisers, Mrs. Kite, who was 74 years old at the time, contacted her physician. Her physician sent Mrs. Kite a letter attesting to her longevity and health. Each of the Kite children promised to pay $1,900,679 to Mrs. Kite's lifetime revocable trust on March 30 of every year beginning in 2011 and ending on Mrs. Kite's death. The Kite children did not make any annuity payments to Mrs. Kite before she died on April 28, 2004.

The IRS assessed a deficiency because, it argued, the transfer of the KIC partnership interests to Mrs. Kite's children in exchange for the annuity agreements was not made for adequate and full consideration. According to the IRS, the transfer was a disguised gift subject to gift tax. The IRS contended that the annuity agreements did not constitute adequate consideration because they were structured to ensure that no annuity payment would be made and there was no real expectation of payment. The IRS did not challenge the physician's letter or present evidence contradicting the physician. Instead, it relied on Mrs. Kite's 24-hour medical care at home, which began in 2001, and her increased medical costs from 2001 through 2003 to conclude that her death within the next 10 years was foreseeable.

Alternatively, the IRS argued that the annuity transaction, and the events leading up to it, should be disregarded and, as a result, Mrs. Kite's $10.6 million of KIC interests was includible in her gross estate under Code Sec. 2033. According to the IRS, the annuity transaction constituted a disposition of the qualifying income interests for life, as described in Code Sec. 2056(b)(7), which Mrs. Kite held in the corpuses of the QTIP trusts such that the dispositions constituted taxable gifts under Code Sec. 2519. The IRS also argued that Mrs. Kite made a taxable transfer under Code Sec. 2514 when she effectively released her general power of appointment over the corpus of the marital deduction trust.

The estate relied on the decision in Est. of McLendon v. Comm'r, 135 F.3d 1017 (5th Cir. 1998), in arguing that the annuity transaction was for adequate and full consideration because the parties used IRS actuarial tables to properly value the annuities. The estate further contended that the parties intended to comply with the terms of the annuity agreements, which were legally enforceable under state law, and that this intent was supported by the Kite children's ability to make payments under the annuity agreements and Mrs. Kite's profit motive.

The Tax Court held that, based on Mrs. Kite's position of independent wealth and sophisticated business acumen, the annuity transaction was a bona fide sale for adequate and full consideration.

Although the QTIP trust agreements authorized the Kite children, as trustees, to terminate the QTIP trusts in their discretion, the court noted that the estate had presented no explanation of why the QTIP trusts were terminated immediately before the transfer of the QTIP trust assets. According to the court, by creating an intermediary step in the annuity transaction, i.e., terminating the QTIP trusts before selling the QTIP trust assets to the Kite children, Mrs. Kite's transfer of her ownership interests in KIC would circumvent the QTIP regime and avoid any transfer tax imposed by Code Sec. 2519. Accordingly, the Tax Court found that the termination of the QTIP trusts and the following immediate transfer of the QTIP trust assets to the Kite children was a single transaction for purposes of Code Sec. 2519. Thus, the Tax Court concluded that the portions of the annuity value originally traceable to the ownership interest of QTIP trusts in KIC, less the value of Mrs. Kite's qualifying income interests in those trusts, were subject to federal gift tax as of the simultaneous termination of the marital trusts and the transfer of the marital trust assets in 2001.

For a discussion of the gift tax treatment of dispositions of certain life estates, see Parker Tax ¶222,300.