Federal Tax Bulletin - Issue 31 - February 27, 2013

Court Allows Charitable Deduction Despite a Qualified Appraisal Not Being Attached to the Return

Earlier this month, the Tax Court handed taxpayers a big win in a case involving a charitable property donation. The Tax Court rejected all the IRS's arguments in determining that the taxpayers were entitled to the deduction. The case is particularly instructive for practitioners because it explains the factors the Tax Court looks at in determining whether a taxpayer has a reasonable cause defense for overlooking a major requirement associated with taking a large charitable contribution deduction. In Crimi v. Comm'r, T.C. Memo. 2013-51 (2/14/13), the IRS tried multiple arguments in its attempts to persuade the Tax Court that the taxpayers were not entitled to a charitable deduction. The most promising argument for the IRS was the fact that the taxpayers attached a 2000 appraisal report to substantiate a 2004 property donation. In the end, however, the Tax Court sided with the taxpayers and held that their reliance on their CPA constituted reasonable cause for any failure to adhere to the qualified appraisal requirements.

Facts

John Crimi was the president and majority shareholder of Concrete, an S corporation. The other shareholders were trusts set up for the benefit of his children. John, individually and through Concrete, has since before 2004 purchased and sold real estate in New Jersey, and he has pursued the development of certain properties into a residential subdivision. In July 2004, both Concrete and John and his family members, individually, transferred to Morris County, New Jersey more than 65 acres of undeveloped land for $1,550,000 in what was characterized as a part-sale, part-gift transaction. The transfer came after a decision had been made to forgo the pursuit of developing the land as a residential development project. Administrative officials of the town in which the land was located expressed their desire to acquire the property to preserve open space as a means of avoiding further development in the township. Previously, in 2000, John had obtained an appraisal of the property in the amount of $2,950,000. On August 16, 2004, the township's administrator wrote and signed a letter (August 16 letter) to the Crimis and Concrete acknowledging the contribution of block 101, lot 1, block 201, lot 1, and block 703, lot 12.

Michael LaForge was a CPA and a member of a reputable CPA firm. He had provided accounting, tax, and financial services to John and Concrete for over 24 years as their accountant. Since at least 1990, Mr. LaForge had been in charge of managing the client relationship with John and Concrete on behalf of the CPA firm, and on the basis of that engagement he was intimately familiar with the financial affairs of John and Concrete. Mr. LaForge, who had known about and been regularly updated on the contemplated part-gift, part-sale transaction since 1998, requested from John a copy of the 2000 appraisal for the 2004 tax return. John provided the 2000 appraisal, knowing only that an appraisal was necessary to claim a charitable contribution deduction. Mr. LaForge was aware when he prepared the returns at issue that the Code and the regulations specified detailed requirements for claiming a charitable contribution deduction. He also knew that the 2000 appraisal did not meet each of the rules to be considered a qualified appraisal even though the Code and the regulations required the Crimis to obtain a qualified appraisal before claiming a charitable contribution deduction. Knowing the 2000 appraisal did not meet the literal requirements to be a qualified appraisal, he consulted with and was advised by a member of the CPA firm's tax department, who determined the 2000 appraisal was a valid appraisal in substantial compliance with the regulations. Outside of explaining to John that an appraisal of the subject property was required in order to claim a charitable contribution deduction, Mr. LaForge did not explain to John or his family any other rules for claiming a charitable contribution deduction. Mr. LaForge did not say that the 2000 appraisal did not comply with the rules for a qualified appraisal. Nor did he advise John that there was at least a possibility that he would not prevail on the substantial compliance argument. Mr. LaForge did not advise John to obtain a new appraisal, and he did not give John reason to seek advice as to the value of the subject property as of the contribution date.

Concrete claimed a charitable deduction of $859,000. Because it was a flow-through entity, John, his wife, and their children claimed their share of the charitable contribution deduction, as well as deductions for their direct contributions of property. The total contribution deduction for 2004 was $1.4 million. This was the difference between the property's fair market value as stated in the 2000 appraisal ($2,950,000) and the 2004 sale price of $1,550,000.

The Crimis' 2004 return attached copies of (1) page 2 of Form 8283 for block 702, lot 12; (2) page 2 of Form 8283 for block 201, lot 1; (3) the August 16 letter; and (4) the 2000 appraisal. The Forms 8283 attached to the Crimis' 2004 return were signed by the individual who prepared the 2000 appraisal, and acknowledged by Mr. Lewis, the town administrator. The Forms 8283 described the donated property as Land - Block 201, Lot 1 and Land - Block 702, Lot 12 and each summarized the physical condition of the donated property as undeveloped land as described in the 2000 appraisal.

The IRS assessed deficiencies after disallowing the charitable deductions.

IRS Arguments

The IRS disallowed the deductions for three reasons. First, the IRS claimed that the Crimis failed to obtain from the county a contemporaneous written acknowledgment as required by Code Sec. 170(f)(8). According to the IRS, the August 16 letter did not satisfy the contemporaneous written acknowledgment requirement because it was not signed by the county that was the purported donee, the letter incorrectly described a part of the contributed property, and the letter did not include a statement as to whether the donee provided any goods or services in consideration, in whole or in part, for the property contributed.

Second, the IRS asserted that the Crimis failed to attach to their federal income tax returns a qualified appraisal as required by Code Sec. 170(f)(11) and Reg. Sec. 1.170A-13(c). According to the IRS, the 2000 appraisal was not a qualified appraisal because it (1) did not value the subject property as of the contribution date; (2) was prepared four years before the contribution date; (3) did not include the date or expected date of contribution; (4) did not contain a statement that the appraisal was prepared for income tax purposes; (5) incorrectly described the subject property as having more acreage than what was actually transferred; and (6) used market value instead of fair market value as its valuation standard.

Third, citing a highest and best use of conservation, the IRS maintained that the subject property's fair market value was $660,000 on the contribution date. Along that line, the IRS argued that insofar as the value of the subject property did not exceed the consideration the paid, no deduction was allowed.

Taxpayer Arguments

At trial, the Crimis asserted that they were entitled to a larger charitable deduction because the value of the property had increased in 2004 from what the 2000 appraisal report stated. The purported increased fair market value of the property was based on a 2007 appraisal report the Crimis had prepared for the trial. Additionally, the Crimis asserted that they actually or substantially complied with the recordkeeping requirements, or alternatively, that the reasonable cause exception of Code Sec. 170(f)(11)(A)(ii)(II) precluded disallowance of the charitable contribution deductions.

Tax Court's Holding

Fair Market Value of Donated Property

The court rejected the IRS propositions that development of the property was highly speculative and that its highest and best use was for conservation purposes. The court said that New Jersey's smart growth policy supported the proposition that in 2004 development of the subject property was at least equally likely as its preservation. Nor did the court accept the IRS's uncorroborated allegation that an allegedly endangered wood turtle species inhabited the subject property, thus making development unlikely. After testimony from various experts, the court concluded that the property's fair market value at the date of the contribution was $2,966,000.

Contemporaneous Written Acknowledgment

With respect to the IRS argument that the August 16 letter was defective and did not satisfy the contemporaneous written requirements, the court said the IRS was wrong on all accounts. The court cited Rev. Rul. 2002-67 in noting that an agent of the donee may provide the contemporaneous written acknowledgment to the donor. The determination of whether a valid agency relationship exists is governed by state law and the court found ample evidence in the record to show that Mr. Lewis, in facilitating the bargain purchase, had acted as the agent of the preservation partnership with actual and apparent authority. Code Sec. 170(f)(8)(B)(i) requires the written acknowledgment to provide a description of the contributed property. Neither the statue nor the regulations, the court observed, states what may constitute a sufficient description. However, the court was satisfied that the August 16 letter provided a sufficient description of the contributed property to ensure the IRS would know the property described in the letter was the property contributed. What is essentially a small typographical error, the court stated, should not prevent the IRS from being able to recognize the property acknowledged to have been received by the county was actually Block 702 Lot 12, especially in the light of the fact that the 2000 appraisal and the Form 8283 attached to the Crimis' 2004 return provided the accurate description of the contributed property.

Code Sec. 170(f)(8)(B)(ii) and (iii) requires the written acknowledgment contain a statement whether the donee organization provided any goods or services in consideration, in whole or in part, for the contributed party, and if so a description and good faith estimate of the value of the consideration provided. If the donee did not provide any consideration for the contributed property, the written acknowledgment must say so. The August 16 letter, the court noted, stated that the donee received the contributed property valued at $2,950,000, in consideration for which the county provided cash consideration of $1,550,000, leaving a charitable contribution of $1.4 million. The court rejected the IRS suggestion that this was insufficient because it failed to say whether the done organization provided other goods, services, or valuable consideration. The court found the language in the letter to be sufficient and thus no other superfluous statement was required.

Qualified Appraisal Requirement Excused for Reasonable Cause

Congress enacted Code Sec. 170(f)(11), applicable to contributions of property made after June 3, 2004, to require a taxpayer claiming a deduction of more than $500,000 for a charitable gift of property to attach to the year's tax return a qualified appraisal of the property. The court did not address whether the 2000 appraisal was in substantial compliance with the qualified appraisal requirements; nor did it express an opinion as to whether an updated appraisal obtained at the audit stage would cure any defects in the 2000 appraisal. The court said discussions of these issues were moot because it agreed with the Crimis that any noncompliance should be excused for reasonable cause because they reasonably and in good faith relied on Mr. LaForge's advice that the 2000 appraisal met all legal requirements to claim the deduction.

Code Sec. 170(f)(11)(A)(ii)(II) provides that if a taxpayer donor claimed a deduction for a charitable gift of property worth more than $500,000 but failed to attach a qualified appraisal required by Code Sec. 170(f)(11)(D) to his return, the deduction will not be disallowed if the taxpayer can show the failure was due to reasonable cause and not willful neglect. The court noted that neither the statute nor the regulations explain what constitutes reasonable cause in the context of a failure to obtain a qualified appraisal.

However, the court stated, reasonable cause requires that the taxpayer to have exercised ordinary business care and prudence as to the challenged item. Thus, the court observed, the inquiry is inherently a fact-intensive one, and facts and circumstances must be judged on a case-by-case basis. Citing Reg. Sec. 1.6664-4(c)(1), the court said that a taxpayer's reliance on the advice of a professional, such as a CPA, constitutes reasonable cause and good faith if the taxpayer can prove by a preponderance of the evidence that: (1) the taxpayer reasonably believed the professional was a competent tax adviser with sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the advising professional; and (3) the taxpayer actually relied in good faith on the professional's advice.

John had relied on Mr. LaForge and the CPA firm that he worked for as competent tax advisers for over 20 years. Upon the filing of the returns at issue, Mr. LaForge had been a CPA for over 20 years and had expertise in preparing tax returns claiming deductions for charitable contributions. The accounting firm was an established regional accounting firm staffed with accountants, some of whom had law degrees. During the 24 years of engagement, Mr. LaForge had become intimately familiar with John's and Concrete's financial affairs, and there had been no history of mishaps. On these facts, the court concluded that John actually relied on Mr. LaForge's advice in good faith and found it reasonable for John to believe the 2000 appraisal was not stale in substance and thus was a good appraisal.

[Return to Table of Contents]

Sequester Threatens IRS Taxpayer Services and Enforcement, Acting Treasury Secretary Says

On August 2, 2011, the Congress passed the Budget Control Act of 2011 (the Act). The Act raised the debt ceiling but also included the sequester an incentive for the Joint Select Committee on Deficit Reduction (the Super Committee) to cut at least $1.2 trillion in federal spending over the next decade. Under the sequester, if the Super Committee did not reach its goal, across-the-board reductions in spending in the amount of $1.2 trillion would have to be made.

The reductions in spending must be allocated 50 percent to defense spending and 50 percent to nondefense functions. The Super Committee was composed of 12 members of both the U.S. House of Representative and the U.S. Senate. Bipartisan majorities in both the House and Senate voted for the threat of sequestration as a mechanism to force Congress to act on further deficit reduction.

The specter of harmful across-the-board cuts to defense and nondefense programs was intended to drive both sides to compromise and was never intended to be implemented. However, the Super Committee failed to reach an agreement and, effective, March 1, 2013, the sequester is scheduled to take effect.

The Office of Management and Budgets recently released the OMB Report Pursuant to the Sequestration Transparency Act of 2012. The report provides estimates of the sequestration's impact on more than 1,200 budget accounts. With respect to the Treasury Department, the report lists the following services and functions of the IRS that are subject to the sequester:

(1) Taxpayer Services;

(2) IRS Enforcement; and

(3) Business Systems Modernization.

On February 7, 2013, acting Treasury Secretary, Neal Wolin, wrote a letter to Senator Barbara Mikulski outlining the effects the sequestration would have on operations at the Treasury Department, which includes the IRS. According to Wolin, the effects would be particularly painful at the IRS because it would mean reducing the agency's ability to provide quality services to taxpayers. For example, he said, the cuts to operating expenses and expected furloughs would prevent millions of taxpayers from getting answers from IRS call centers and taxpayer assistance centers and would delay IRS responses to taxpayer letters.

The IRS would be forced, he said, to complete fewer tax returns reviews and would experience a reduced capacity to detect and prevent fraud. He noted that this could result in billions of dollars in lost revenue and further complicate deficit reduction efforts. According to Wolin, in recent years, each dollar spent on the IRS has returned at least $4 in additional enforcement revenue. Thus, each dollar the sequester cuts from current IRS operations would cause a net increase to the deficit, as the lost and forgone revenue would exceed the spending reduction.

He also noted that, in addition to providing fewer services at lower quality, sequestration would require reductions in a number of important Treasury programs that would adversely affect economic growth. The Treasury would need to reduce payments that support certain state and municipal bond programs through lower levels of refundable tax credits and direct payments to issuers likely increasing the borrowing costs to improve infrastructure, schools, affordable housing, and other needs for these communities.

[Return to Table of Contents]

A Practical Guide to Identifying, Gathering, and Documenting a Sustainable Research Tax Credit Claim

By Peter J. Scalise, M.S.

Introduction

The research and experimentation tax credit or research tax credit (RTC) was added to the Internal Revenue Code in 1981 as a temporary provision at a time when research and development jobs were significantly declining in the United States. That decline was due to these jobs being moved overseas where labor rates and overall operating costs were considerably lower. The RTC was introduced into the Code to motivate business entity taxpayers to incur qualifying research and development expenditures with the high expectations that such an advantageous tax incentive would facilitate in stimulating job growth and investment in the United States and prevent further jobs from going overseas.

Although passed into law in 1981 as a temporary provision, the RTC has successfully been extended over the past 32 years with only one exception. For those historically familiar with the RTC, it should be duly recalled that since the RTC's inception, only once was there a gap -- July 1, 1995, through June 30, 1996 -- from when the RTC expired and when it was reinstated without being retroactively applied. The RTC was recently extended for a two-year period through The American Taxpayer Relief Act of 2012, resulting in the RTC being retroactively reinstated to cover calendar year 2012 and prospectively extended to cover calendar year 2013.

While the RTC serves as a highly valuable tax incentive for business entities conducting qualified research activities, it is imperative that the RTC be methodically documented from both a qualitative and quantitative perspective to ensure a sustainable result on IRS examination. It is critical that the design, implementation, and execution of the methodology for the RTC analysis be in full compliance with all applicable statutory, administrative, and judicial interpretations. This article will serve as a practical guide to identifying, gathering, and documenting a sustainable RTC claim.

Identifying Qualified Research Activities (QRAs)

To identify and qualify research and experimentation activities for purposes of the RTC, Code Sec. 41(d) and Reg. Sec. 1.41-4 require that the following four criteria must be satisfied and documented on a contemporaneous basis.

Technological in Nature Requirement

The research must be undertaken for the purposes of discovering information that is technological in nature. As provided in Reg. Sec. 1.41-4(a)(4), information is technological in nature if the process of experimentation used to discover the information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. Reg. Sec. 1.41-4(a)(3)(ii) further provides that a taxpayer need not seek to obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering, nor is the taxpayer required to succeed in developing a new or improved business component.

Process of Experimentation Requirement

Substantially all (i.e., meaning 80 percent or greater) of the activities must constitute, or be deemed to constitute, elements of a process of experimentation for a qualified purpose pursuant to Code Sec. 41(d)(1), (3). As clarified in Reg. Sec. 1.41-4(a)(5), a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving the result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities.

The so-called core elements of a process of experimentation require that the taxpayer (either directly or through another party acting on its behalf):

(1) fundamentally rely on principles of the physical or biological sciences, engineering, or computer science;

(2) identify uncertainty concerning the development or improvement of a business component;

(3) identify one or more alternatives intended to eliminate that uncertainty; and

(4) identify and conduct a process for evaluating the alternatives.

The regulations provide that such a process may involve, for example, modeling, simulation, or a systematic trial-and-error methodology. Reg. Sec. 1.41-4(a)(5) further provides that a process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.

Technical Uncertainty Requirement

Expenditures attributable to research activities must be eligible to be treated as research expenses under Code Sec. 174. As described in Reg. Sec. 1.174-2(a), expenditures are costs incurred in connection with the taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense. Under Code Sec. 174(c), expenditures generally include all costs incident to the development or improvement of a product, but not expenditures for the acquisition or improvement of land or depreciable property.

Permitted Purpose Requirement

A process of experimentation is conducted for a qualified purpose if the research relates to:

(1) a new or improved function;

(2) increased performance;

(3) enhanced reliability; or

(4) enhanced quality.

Under Code Sec. 41(D)(3), research is not considered to be conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal deign factors commonly referred to as mere aesthetics.

Identifying, Gathering, and Documenting QRAs

The requirements described above are applied separately to each business component. Code Sec. 41(d)(2)(c) provides that any plant, process, machinery, or technique for commercial production of a business must be treated as a separate business component, and not as part of the business component (i.e., inventory) being produced. In cases involving development of both a product and a manufacturing process improvement for that product, research activities relating to the product are not qualified research unless the requirements described above are met for the research activities relating to the development of the product without taking into account the activities relating to the development of the manufacturing process improvement as discussed under Reg. Sec. 1.41-4(b).

Reg. Sec. 1.41-4(a)(6) provides that if 80 percent or more of a taxpayer's research activities with respect to a business component constitute elements of a process of experimentation for a qualified purpose, the substantially all requirement is satisfied even if the remaining 20 percent or less of a taxpayer's research activities with respect to that business component does not constitute elements of a process of experimentation for a qualified purpose. However, in no event may activities be treated as qualified research if such activities do not fall within the scope of Code Sec. 174 or if such activities are specifically excluded under Code Sec. 41-(d)(4).

If the requirement of qualified research cannot be satisfied when applied first at the level of the product or process that is to be held for sale, lease, or license, or used by the taxpayer in its own trade or business, then such requirements should be applied at the most significant subset of elements of the product or process. This shrinking back of the business component is continued until either a subset of elements of the business that satisfies the requirement of qualified research is reached, or the most basic element of the product is reached and the requirements of qualified research are not met as set forth under Reg. Sec. 1.41-4(b)(2). To that end, even though a taxpayer's research activities, viewed in their entirety, for a new or improved product (i.e., an aircraft) may not satisfy the substantially all test or other requirements for qualified research, activities related to developing or improving a portion of the product (i.e., the flight actuation system) may still be eligible for the RTC.

Statutorily Excluded Activities

Code Sec. 41(d)(4) specifically excludes the following activities from being treated as qualified research and therefore are ineligible for the RTC.

Research After Commercial Production

Activities conducted after the beginning of commercial production of a business component generally do not constitute qualified research if the activities are conducted after the component is developed to the point where it is ready for commercial sale or use. However, even after a product meets the taxpayer's basic functional requirements, activities relating to the manufacturing process still may constitute qualified research under Reg. Sec. 1.41-4(c)(2).

Adaptation of Existing Business Component

Activities related to adapting an existing business component to a particular customer's requirements are ineligible for the RTC. As set forth under Treas. Reg. Sec. 1.41-4(c)(3), this exclusion does not apply, however, merely because a business component is intended for a specific client.

Duplication of Existing Business Component

As illustrated under Treas. Reg. 1.41-4(c)(4), qualified research does not include activities relating to reproducing an existing business component (i.e., reverse engineering) from a physical examination of the component itself or from blueprints and / or detailed specifications drawings.

Surveys and Studies

Excluded from qualified research are activities in connection with:

(1) efficiency surveys;

(2) management functions or techniques;

(3) market research;

(4) routine data collections; and

(5) ordinary testing or inspections for quality control.

Foreign Research

Research conducted outside the United States or its possessions, such as Puerto Rico and Guam, may not be treated as qualified research.

Funded Research

To the extent research is funded by another person or government entity (by grant, contract, or otherwise), such research may not be treated as qualified research. There are limited exceptions to this rule in cases where overruns are incurred that are not funded. For example, if an aerospace company had a cost plus contract with a client and was funded up to $5 million to develop a flight actuation system and that aerospace company incurred $6 million to develop the flight actuation system, then the $1 million overrun could potentially be claimed as part of RTC assuming the aerospace company had substantially all of the rights to the research (i.e., not needing to make a royalty payment to use that technology in the future) and had the economic risk of loss.

Identifying, Gathering, and Documenting Qualified Research Expenditures (QREs)

Expenditures that qualify for the RTC generally include: (1) in-house research expenses for wages paid to employees for the performance of qualified services; (2) amounts paid for supplies used in the performance of qualified services; and (3) certain qualified research expenses paid to third parties. The term qualified services includes the services of employees who are actually engaged in qualified research and the services of employees who are engaged in direct support of the first level of research activities that constitute qualified research.

QRE Wages

Compensation for the performance of qualified research services should include only compensation treated as wages for income tax withholding purposes. Therefore, in addition to regular wages, the allocation of compensation to research projects should include bonuses and the compensation element recognized on the exercise of nonqualified stock options, but should not include payments to qualified pension and profit sharing plans, including employee Code Sec. 401(k) contributions and nontaxable fringe benefits. Practically speaking, employee wages as documented on Form W-2, Box 1, should be included and then multiplied by a direct qualifying labor wage percentage. This direct qualifying labor wage percentage, for each person, should be calculated as a numerator that is directly tied to qualifying research projects by hour and a fixed denominator of 2,080 hours, which can be further reduced for paid holidays and vacation and sick time. It is imperative to ensure proper and clear nexus between QRAs and QREs at this stage so that an IRS agent can see the link between qualified research hours by project to specific wage expenditures.

In addition, it should be noted that under a special safe-harbor rule, if at least 80 percent of the services performed by an employee during the tax year constitute qualified services, then 100 percent of the services performed by the employee during the tax year may be treated as qualified services. In all cases, each employee and title / rank within the company should also be documented so that an IRS agent can determine at a high level whether that employee was supervising the research (e.g., Oncology Practice Leader), conducting the research (e.g., Bio-Chemist Researcher), or supporting the research (e.g., Lab Technician supporting oncology experimentation). It should be noted, however, that employee titles are not exclusive indicators for determining whether the activities performed by that employee qualify for the RTC.

QRE Supplies

In general, QRE supply costs can be claimed if the supplies are consumed or destroyed in the research process. The term supplies is broadly defined to include any tangible property, other than land, improvements to land, and depreciable property. Expenditures for supplies that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses. For example, amounts paid for electricity used for general laboratory lighting are treated as general and administrative expenses, although amounts paid for electricity used in operating high-energy equipment for qualified research (e.g., a laser for nuclear research) may be treated as expenditures for supplies in the conduct of qualified research as illustrated under Reg. Sec. 1.41-2(b)(2)(ii).

QRE Contract Research

The amount of third-party contractor costs eligible for the RTC is computed at 65 percent, or 75 percent in cases for payments to select research consortia's, of amounts paid to persons other than employees for services that, if performed by an employee, would constitute qualified services under Code Sec. 41(b)(3) and Reg. Sec. 1.41-2(e)(1). Additionally, contract research performed on behalf of a taxpayer is qualified research only if incurred under an agreement (either oral or written) entered into before the performance of the research, and requiring the taxpayer to bear the expenses even if the research is not successful. Any payment made by the taxpayer to a third party that is contingent upon the success of the research is considered to be paid for the product or result rather than the performance of the research, and thus, may not be treated as qualified research expenses under Reg. Sec. 1.41-2(e)(2).

Gathering Contemporaneous Documentation to Support the RTC

Under Reg. Sec. 1.41-4(d), taxpayers must retain records in sufficiently usable form (i.e., in an audit friendly format per the IRS Audit Technique Guidelines for research tax credit claims) and detail to substantiate claimed QREs (i.e., wages, supplies, and contract research) and QRAs (i.e., at the project level). To that effect, it is critical that sufficient contemporaneous documentation be identified, gathered, properly compiled, and retained as forms of substantiation documentation to assist in ensuring that the IRS does not disallow the merits of the RTC claim should an examination come to fruition.

In cases in which a company is government regulated, such as with Life Science companies (i.e., Pharmaceuticals, Bio-Technology & Medical Devices), then the FDA record-keeping requirements can be leveraged to support research activities. As another example, with Aerospace & Defense companies, the FAA and DCAA record-keeping requirements can also be leveraged to support the research activities. In cases where companies apply for a patent or have a patent granted, these forms of contemporaneous documentation serve as the strongest forms of qualified research documentation due to the inherently arduous process to apply for a patent.

From a Best Practice Tax Controversy perspective, the following list of forms of contemporaneous documentation provides several examples of key documents that the IRS typically requests to review during the course of an examination:

(1) complete project lists identifying the full scope of research based projects vs. the actual claimed research projects after conducting systematic project based interviews;

(2) patents or patent applications;

(3) annual R&D or technology plans;

(4) research project authorization requests;

(5) internal and external correspondence on R&D;

(6) design requirements or functional specifications;

(7) testing scripts or testing logs;

(8) modifications reports or error logs;

(9) technical reports or plans;

(10) laboratory notebooks;

(11) ingredient consumption worksheets; and / or

(12) raw material usage records.

It is highly recommended that the more contemporaneous documentation from the aforementioned list that can be obtained should be obtained and meticulously compiled in an audit-ready format, as it will incontestably assist in strengthening the merits of the RTC claim and overall RTC filing position (i.e., always strive for More Likely Than Not or higher, but never file a claim unless you can get at least to Substantial Authority, as discussed below).

From a risk-management perspective, to mitigate or avoid income tax return paid preparer penalties pursuant to Code Sec. 6694 (i.e., penalties that are assessed on both paid tax return preparers and tax advisers that are deemed paid tax return preparers due to their consulting on matters that constitute a substantial portion of their client's tax returns even if they were not engaged to prepare nor review the tax return), a More-Likely-Than-Not standard should be satisfied. The subsequent standards of the applicable levels of opinions should be scrupulously analyzed when assessing an RTC filing position:

(1) 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.

(2) 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.

(3) 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 I.R.C. 6662A.

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

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

(6) Reasonable Basis Standard: Significantly higher than the Not Frivolous standard (that is, 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.

(7) 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.

(8) Frivolous Standard: Approximately a less than 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 standards above has a relevant meaning to both 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 regulations. In contrast, the percentages for Substantial Authority, Reasonable Basis, Non-Frivolous, 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 scientifically calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

Conclusion

When identifying, gathering, and documenting an RTC claim, both from a qualitative and quantitative perspective, taxpayers should be careful to adhere to all applicable statutory, administrative, and judicial interpretations and consult a true subject matter expert in this area to ensure a strong tax return filing position and a sustainable result upon IRS examination.

About the Author

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.

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.

[Return to Table of Contents]

Taxpayer Can't Deduct Deferred Interest Capitalized into Mortgage

Floating rate interest capitalized into the taxpayer's mortgage payment is not deductible mortgage interest. Smoker v. Comm'r, T.C. Memo. 2013-56 (2/21/13).

In 2006 and 2007, Philip Smoker owned two properties: one in Michigan and the second in California. Each of the properties was highly leveraged. Phillip leveraged the Michigan property with a $450,000 adjustable rate note secured by the property. The note charged floating rate interest on the unpaid principal until the loan was fully repaid. The interest rate reset monthly on the basis of a specified index. The note was capped as to interest rate and limited as to payment fluctuations. Under the terms of the note, if the monthly payment in any month was less than the interest portion of an amount determined to be necessary to repay the unpaid principal balance then owed in substantially equal monthly payments by maturity, the excess interest would be added into the principal of the note. The note provided that any unpaid portion of principal or interest as of the maturity date would become due on that date as a balloon payment. Philip deducted almost $11,000 of mortgage interest in 2006 and $83,500 in 2007.

The IRS denied the mortgage interest expense and also concluded that Philip was liable for the accuracy-related penalty. Philip argued that he paid interest within the meaning of Code Sec. 163(a) by promising to pay outstanding interest that had accrued on a secured mortgage note and simultaneously surrendering additional property rights in the real estate under the mortgage to the same lender. According to Philip, he satisfied the literal requirements of Code Sec. 163(a) and therefore was entitled to deductions for accrued but unpaid interest that was capitalized into the principal of the note.

The Tax Court held that Philip could not deduct the capitalized interest. The court noted that it is well settled that a cash method taxpayer, such as Philip, can take a deduction for interest paid during the tax year in cash or its equivalent. The mere delivery of a promissory note to satisfy an interest obligation, without an accompanying discharge of the note, is only a promise to pay and not a payment in a cash equivalent. The reasoning for such a rule, the court stated, is that the note may never be paid, and if it is not paid, the taxpayer has parted with nothing more than his promise to pay.

It is equally well settled, the court said, that when a lender withholds a borrower's interest payments from the loan proceeds, the borrower is determined to have paid interest with a note, not cash or its equivalent, and is consequently not entitled to a deduction until the loan is repaid. Similarly, when a lender debits the required interest payment to a loan account (i.e., capitalizing the required interest payment by adding its amount to the loan's principal), the borrower is not entitled to a current interest deduction for the interest debited.

The court noted that whether interest is charged by way of an original issue discount (OID) (i.e., interest withheld from the loan proceeds) or as capitalized interest (i.e., periodic interest added to the loan's principal), the economic reality is the same: The borrower is able to postpone paying the interest due to sometime in the future, either over the life of the loan or as part of a balloon payment upon maturity. Because the loan agreement at issue allowed Philip to do just that, the court concluded that he could not deduct any accrued but unpaid interest until he actually discharged his obligation to pay the accrued interest by a cash or cash-equivalent payment or by a disposition or transfer of the Michigan property. The court also sustained the IRS's imposition of the accuracy-related penalty.

For a discussion of the rules relating to the mortgage interest deduction, see Parker Tax ¶83,515.

[Return to Table of Contents]

Abandoned Option on Real Estate Results in Ordinary Loss, Tax Court Holds

An option on real property abandoned as a result of the economic downturn was properly characterized as an ordinary loss because the underlying property was an ordinary income asset in the hands of the taxpayer. Sutton v. Comm'r, T.C. Summary 2013-6 (2/6/13).

Phillip Sutton worked for Jon Gibson Co., a real estate developer, managing the developer's existing properties. In 2005, Phillip formed Sutton Enterprises, LLC, with the intent to purchase and develop real property part time for his own account. That same year he purchased a dilapidated property that he intended to fix up and flip for a profit. He continued to work for Gibson but began receiving compensation in two separate capacities. He was compensated as an employee for managing Gibson's existing properties and as an independent contractor through Sutton LLC for purchasing and developing new properties for Gibson. Gibson provided him with a Form W-2 for work he performed as an employee and a Form 1099-MISC, Miscellaneous Income, for work he performed as an independent contractor.

In 2007, Phillip received a California real estate license. He subsequently entered into a Residential Purchase Agreement, which was an option to purchase a parcel of real property in El Dorado Hills for over $3 million. The option contract provided that Phillip would make an initial deposit of $30,000 into an escrow account, and make additional monthly deposits of $3,000 until the escrow closed. It further provided that the period of time up to the escrow closing was being given to Phillip in order to develop the property for its highest and best use as determined by Phillip. Phillip spent 20 hours a week working on the property, searching for partners and investors, and developing the property. However, because of the economic downturn, he was unsuccessful and, in 2008, abandoned the option and forfeited $48,000 in deposits. He also ended his employment with Gibson and, the following year, closed Sutton LLC. On his 2008 Schedule C, Phillip reported his principal business or profession as real estate investment and development, and deducted the loss from the forfeited option.

The IRS objected to the ordinary loss characterization and said that Phillip purchased the option as an investment and that neither Sutton LLC nor Phillip ever held real property for sale to customers in the ordinary course of their trade or business. The IRS did not dispute that Phillip was in a trade or business; instead, it took the position that Phillip was only in the trade or business of locating, developing, and selling real property for third parties, including Gibson. Thus, the IRS argued that the loss on the option was a capital loss. Phillip contended that he did not purchase the El Dorado Hills property with the hope that it would appreciate over time like an investment. Instead, he purchased the property with the intent to create value by actively improving it and selling to multiple buyers/builders for profit and income.

The Tax Court agreed with Phillip and held that the loss on the option was an ordinary loss. Citing Code Sec. 1221(a)(1) and Code Sec. 1234(a)(1), the Tax Court stated that the character of Phillip's loss on the abandonment of the option is the same as the character the El Dorado Hills property, the underlying property to which the option related, would have had in Phillip's hands. Thus, the court focused on Phillip's intent and concluded that the property would have been ordinary income property in Phillip's hands and, thus, the loss was an ordinary loss.

For a discussion of the tax treatments of options to purchase property, see Parker Tax ¶111,105.

[Return to Table of Contents]

Tax Preparer Can't Change Filing Status to Increase Mortgage Interest Deduction

A CPA could not change her filing status to married filing jointly to claim a larger mortgage interest deduction and was liable for an accuracy-related penalty for originally overstating the deduction. Zdunek v. Comm'r, T.C. Summary 2013-13 (2/20/13).

Jane Zdunek is a CPA and worked for the IRS for 15 years. After she left the IRS, she prepared tax returns for a living. She attends continuing professional education (CPE) classes on tax law each year and took such classes in 2007. She attended at least one CPE class that covered the mortgage interest deduction.

In 2007, Jane worked full time as a financial controller for a construction company, but also prepared 20 to 25 individual income tax returns for compensation. She filed her 2007 income tax return listing her filing status as married filing separately (MFS). On that return, she took a $47,000 mortgage interest deduction related to a home in Virginia and a second home in West Virginia. The IRS disallowed the deduction because it exceeded the limitations for an MFS return. The IRS also assessed an accuracy-related penalty. Jane filed a petition with the Tax Court.

Under Code Sec. 163(h)(3)(C), the aggregate amount of debt upon which a mortgage interest deduction may be taken is limited to $500,000 in the case of a married individual filing a separate return. In addition, Code Sec. 163(h)(4)(A)(ii) provides that a taxpayer filing an MFS return is generally limited to claiming one home for purposes of the mortgage interest deduction unless the taxpayer obtains written consent from his or her spouse to claim another home.

Before the Tax Court, the IRS conceded that Jane was entitled to a mortgage interest deduction, albeit in a lesser amount than she originally claimed. Specifically, the parties agreed that Jane was entitled to a mortgage interest deduction of approximately $29,000 with respect to her 2007 MFS return. Jane then sought to change her filing status from MFS to married filing jointly so that she and her husband could claim a greater overall mortgage interest deduction. Jane argued that she should be permitted to change her filing status because she was not informed of the MFS limitations by the IRS until after she filed her petition with the Tax Court.

The Tax Court held that Jane could not change her filing status and, thus, could not deduct more than the $29,000 of mortgage interest previously agreed upon by her and the IRS. Code Sec. 6013(b)(2)(B), the court noted, precludes the filing of a joint return after a taxpayer files a separate return if the taxpayer filed a timely petition with the Tax Court in respect of a notice of deficiency for the year at issue.

In addition, the court held that Jane was liable for the accuracy-related penalty. Despite her substantial experience, knowledge, and education, the court found that Jane did not research the applicable law with respect to the MFS limitations when she prepared her 2007 return. The court noted that she testified that she did not review the worksheet published by the IRS as an aid in computing the proper mortgage interest deduction on her MFS return. Rather, she testified that she simply figured it out. Thus, the court concluded that, on the basis of the record before it, and particularly in view of Jane's education and experience as a tax professional, she did not establish that she acted with reasonable cause and in good faith when preparing her return.

For a discussion of the rules relating to the mortgage interest deduction, see Parker Tax ¶83,515.

[Return to Table of Contents]

S Shareholder Can't Exclude Disability Payments from Income Where Premiums Weren't Included in Income

Where a 2-percent S shareholder excluded insurance premiums paid for by the S corporation from income when he should have included them in income, the shareholder cannot later exclude from income benefits paid under that insurance. CCA 201308030.

The Office of Chief Counsel was presented with a question about a taxpayer's duty of consistency with regard to inclusion of insurance premiums (or the subsequent benefit) as income. In this case, the taxpayer was a 2-percent shareholder-employee in an S corporation that paid disability insurance premiums on the shareholder's behalf, which the shareholder did not include as income. Subsequently, the shareholder collected a disability benefit. He proposed to the IRS that, because he should have included the premium payments as income all along, the benefit should not be included as income. He also proposed to amend his one open return to include whatever premiums were paid in that year as income.

The Office of Chief Counsel determined that the taxpayer's position regarding the correct treatment of the premium payments was "technically correct. In other words, an S corporation is treated as a partnership and a 2-percent shareholder-employee is treated as a partner under Code Sec. 1372(a), and thus the shareholder is required to include the premiums as income in the years they are paid. Notice 2008-1, the Chief Counsel's Office noted, clarifies the treatment of certain insurance premiums with respect to a 2-percent shareholder-employee. Additionally, Rev. Rul. 2004-55 deals with the payment of insurance premiums by employers outside of the S corporation 2-percent shareholder context and provides that where an insured has made an irrevocable election before the plan year to treat employer-paid premiums as income, any resulting benefit may be excluded from income. The revenue ruling further provides that if an insured does not make such an election before the plan year, any potential benefit is includible in the insured's gross income. Consequently, the Chief Counsel's Office concluded that, on equitable grounds, a taxpayer should not be allowed to retroactively make this election. According to the Chief Counsel's Office, this would create a large loophole that everyone receiving such a benefit would employ namely, to exclude the premiums from income and then subsequently amend one return to then exclude the benefit from income. If the taxpayer excluded the premiums, the Chief Counsel's Office stated, he should not also be able to exclude the benefit.

In addition, the Chief Counsel's Office advised that the duty-of-consistency doctrine could also be invoked. The duty of consistency is based on the theory that the taxpayer owes the IRS the duty to be consistent with his tax treatment of items and is not permitted to benefit from the his own prior error or omission. The Chief Counsel's Office noted that the doctrine requires the presence of three elements: (1) the taxpayer represented a fact or reported an item for federal income tax purposes for a particular year; (2) the IRS acquiesced in or relied upon the representation of fact for the reported item for that year; and (3) the taxpayer attempted to change the representation or reporting in a subsequent year after the period of limitation bars adjustments for the initial year and the change is detrimental to the IRS.

While each duty-of-consistency case is evaluated on its own facts, the Chief Counsel's Office said that the situation presented by the S shareholder was similar to the one in Grayson v. U.S., 437 F.Supp. 58 (D.C. Ala. 1977). In that case, the district court opined that a pension beneficiary could not exclude employer pension contributions from income in the years in which they were made and then, after the statute of limitations for those years had run, claim inconsistently that the contributions should have been included in the closed years. Applying the doctrine in the instant situation, the Chief Counsel's Office noted, was a bit of a stretch given that there was one open year and the duty of consistency doctrine generally requires closed years. But, the Chief Counsel's Office stated, Rev. Rul. 2004-55 seemed to plug that gap in that an irrevocable election had to be made to include the premiums paid as income before the next succeeding year. That would mean that an election would have to have been made in the year before the last open year.

For a discussion of the tax treatment of amounts received through accident or health insurance, see Parker Tax ¶75,915.

[Return to Table of Contents]

Taxpayer's Appeal of Prison Sentence Results in Increased Prison Time

A taxpayer's prison sentence for violating employment tax laws was increased upon his appeal as a result of the taxpayer's post-sentencing conduct in prison. U.S. v. McLain, 2013 PTC 20 (8th Cir. 2/8/13).

Francis McLain was convicted for failing to account for and pay employment taxes. He was initially sentenced to 48 months in prison and fined $75,000. Francis appealed and the Eighth Circuit affirmed the conviction but vacated the sentence and remanded for resentencing. According to the court, additional findings were needed to support the loss amount under the U.S. Sentencing Guidelines that was used to calculate Francis's prison time.

On remand, the government conceded that the existing record did not support a finding that Francis's counseling of two persons had led to the actual preparation of a false return. As a result, the district court found no violation of Code Sec. 7206(2). The government argued, however, that the conduct at issue was still criminal conduct because it violated other criminal tax provisions. Francis argued that the government had waived such arguments by not raising them sooner. The district court accepted that waiver argument and did not include the contested amounts in the loss-amount determination and guidelines calculations. Therefore, the advisory sentencing guidelines range was 3341 months rather than 4151 months, as determined at the first sentencing.

The district court then received testimony concerning Francis's post-sentencing conduct while in prison. The district court concluded that the Eighth Circuit's instruction to rely on the existing record was applicable to the issues previously identified but did not restrict the ability to address new evidence regarding post-sentencing conduct. Francis testified at length regarding title to a ranch in Montana; his knowledge regarding title to the ranch at various points in time; his actions attempting to create a back-dated quitclaim deed alienating his interest in the ranch; and his use of the mails from prison in relation to these matters. The government cross-examined Francis, and the district court concluded that Francis's actions from prison concerning title to the ranch were merely a continuation of fraudulent conduct and a transparent effort to hide assets from the government. The district court ultimately imposed a 55-month sentence and Francis appealed.

The Eighth Circuit affirmed the increased prison sentence. According to the court, the record more than adequately supported the determination that Francis's post-sentencing conduct revealed ongoing efforts to conceal assets and cloud title to the ranch property. The district court did not abuse its discretion, the Eighth Circuit said, in viewing such conduct as shedding new and additional light on Francis's risk of recidivism, a clearly relevant sentencing factor.

[Return to Table of Contents]

Tax Court Denies Foreign Tax Credits and Other Deductions Relating to STARS Transactions

Because a transaction lacked economic substance, the taxpayer was not entitled to foreign tax credits and expense deductions taken as a result of the transaction. Bank of New York Mellon Corporation v. Comm'r, 140 T.C. No. 2 (2/11/13).

The Bank of New York Mellon Corporation and its subsidiaries (Mellon Bank) are an affiliated group. The Bank engaged in a Structured Trust Advantaged Repackaged Securities transaction (STARS transaction). The STARS transaction provided the Mellon Bank with purportedly below-market cost financing from a U.K. bank. As part of the STARS transaction, Mellon Bank transferred income-producing assets to a trust with a U.K. trustee and subject to U.K. tax on its income.

Mellon bank claimed expense deductions and foreign tax credits of approximately $199 million on its 2001 and 2002 federal consolidated returns in connection with the STARS transaction. Mellon Bank also reported income from the assets transferred to the trust as foreign source on the consolidated returns.

The IRS determined that the STARS transaction lacked economic substance and consequently disallowed the foreign tax credits, the expense deductions, and the reporting of the asset income as foreign source. Mellon Bank contended that the STARS transaction had economic substance and that Congress intended the foreign tax credit to apply to transactions like the STARS transaction.

The Tax Court held that the STARS transaction lacked economic substance and is disregarded for federal tax purposes. Because the STARS transaction lacked economic substance, the court concluded that Mellon Bank was not entitled to the foreign tax credits and the expense deductions taken as a result of the transaction. Nor was Mellon Bank entitled to report the income attributed to a trust with a U.K. trustee used to effect the STARS transaction as foreign source income. Instead, such income was U.S. source.

For a discussion of the denial of deductions and credits where a transaction lacks economic substance, see Parker Tax ¶99,700.