Federal Tax Bulletin - Issue 27 - January 3, 2013

Last-Minute Fiscal Cliff Deal Produces Permanent Tax Relief for Many Taxpayers

In the waning hours of January 1, Congress passed the American Taxpayer Relief Act (ATRA) of 2012 as part of an effort to resolve the fiscal cliff dilemma. ATRA permanently extends the lower tax rates on individuals with income of $400,000 or less, heads of households with income of $425,000 or less, and married taxpayers with incomes of $450,000 or less. ATRA also increases the alternative minimum tax exemption amounts for 2012 to $50,600 (individuals), $78,750 (married filing jointly and surviving spouse), and $39,375 (married filing separately), and indexes the exemption and phaseout amounts thereafter. The following is a summary of the more important provisions of the new law. H.R. 8 (January 1, 2013)

GENERAL EXTENSIONS

Tax Rates

Under prior law, the 10 percent individual income tax bracket expired at the end of 2012. Beginning in 2013, the lowest tax rate was scheduled to increase to 15 percent. ATRA, Sec. 101, permanently extends the 10 percent individual income tax bracket for tax years beginning after December 31, 2012.

Prior to ATRA, the 25, 28, 33, and 35 percent individual income tax brackets were scheduled to expire at the end of 2012. Upon expiration, those rates were scheduled to increase to 28, 31, 36, and 39.6 percent, respectively. ATRA, Sec. 101, extends the 25, 28, 33 rates on income at or below $400,000 (individual filers), $425,000 (heads of households), and $450,000 (married filing jointly) for tax years beginning after December 31, 2012. Individuals with incomes above these amounts are subject, depending on their income, to tax rates of 35 and 39.6 percent.

See Parker Tax ¶19,100.

Permanent Extension of the Capital Gains and Dividend Rates

ATRA, Sec. 102(b), extends the current capital gains and dividends rates on income at or below $400,000 (individual filers), $425,000 (heads of households), and $450,000 (married filing jointly) for tax years beginning after December 31, 2012. For income in excess of $400,000 (individual filers), $425,000 (heads of households) and $450,000 (married filing jointly), the rate for both capital gains and dividends is 20 percent.

Also effective for tax years beginning after December 31, 2012, the accumulated earnings tax is 20 percent and the personal holding company tax is also 20 percent.

Permanent Repeal of Personal Exemption Phaseout for Most Taxpayers

Personal exemptions allow a certain amount per person to be exempt from tax. Due to the personal exemption phase-out (PEP), the exemptions are phased out for taxpayers with adjusted gross income (AGI) above a certain level. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repealed the PEP for 2010. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRUIRJCA) extended the repeal through 2012. ATRA, Sec. 101, permanently extends the repeal of the PEP on incomes at or below $250,000 (individual filers), $275,000 (heads of households) and $300,000 (married filing jointly) for tax years beginning after December 31, 2012.

See Parker Tax ¶10,705. Read more...

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Tax Court Weighs In on Ex-Spouse Battles Over Dependency Exemption

Often in a divorce, one parent gets custody of the children while the noncustodial parent pays child support, with the divorce court sometimes stipulating that the noncustodial parent gets a dependency exemption for the children involved. However, Code Sec. 152(e)(2)(A) provides that a noncustodial parent is not entitled to the dependency exemption unless, among other requirements, the custodial spouse signs Form 8332. Many noncustodial parents have tried to claim that a state court order allowing them a dependency exemption gives them the right to the exemption.

Late last month, two cases involving dependency exemption fights between ex-spouses reached the Tax Court. In Armstrong v. Comm'r, 139 T.C. No. 18 (12/19/12), the noncustodial parent argued that a state court order signed by the custodial parent agreeing to release the dependency exemption was enough to allow him the exemption. In George v. Comm'r, 139 T.C. No. 19 (12/19/12), a custodial parent claimed that the Form 8332 she was ordered to sign by the divorce court was invalid because the court failed to consider that her ex-spouse was in arrears in his child support payments. Thus, she claimed, she was entitled to the dependency exemption. In both cases, the taxpayers lost.

Dependency Exemption Rules

Under Code Sec. 151(c), an individual is allowed a deduction for exemption for each individual who is a dependent of the taxpayer for the tax year. Code Sec. 152(a) defines the term dependent to include a qualifying child. Generally, under Code Sec. 152(c)(1), a qualifying child must:

(1) bear a specified relationship to the taxpayer (e.g., be a child of the taxpayer);

(2) have the same principal home as the taxpayer for more than one-half of the tax year at issue;

(3) meet certain age requirements; and

(4) not have provided over one-half of such individual's support for the tax year at issue.

However, in the case of divorced parents, special rules determine which parent may claim a dependency exemption deduction for a child. Under Code Sec. 152(e), when certain criteria are met, a child may be treated as a qualifying child of the noncustodial parent rather than of the custodial parent. A child can be the qualifying child of a noncustodial parent under Code Sec. 152(e)(1) and (2), if:

(1) the child receives over one-half of the child's support during the calendar year from the child's parents who are divorced under a decree of divorce;

(2) the child was in the custody of one or both of the child's parents for more than one-half of the calendar year;

(3) the custodial parent signs a written declaration (in such a manner and form as IRS regulations prescribe) that such custodial parent will not claim such child as a dependent for any tax year beginning in such calendar year; and

(5) the noncustodial parent attaches the written declaration to his or her tax return for the appropriate tax year.

The IRS's Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, provides an effective and uniform way for a custodial parent to make the declaration required in (3) above. For tax years starting before July 3, 2008, Reg. Sec. 1.152-4T, Q&A-3, provides that a noncustodial parent can also rely on an alternative document, provided that it conforms to the substance of Form 8332. In particular, for such tax years, a court order that has been signed by the custodial parent may satisfy Code Sec. 152(e)(2)(A) as the noncustodial parent's declaration if the document conforms to the substance of Form 8332.

However, this regulation was amended and, for tax years beginning after July 2, 2008, a court order signed by the custodial parent does not satisfy Reg. Sec. 1.152-4(e)(1)(ii). The regulations now provide that a written declaration not on the form designated by the IRS (i.e., Form 8332) must conform to the substance of that form and must be a document executed for the sole purpose of serving as a written declaration under Code Sec. 152. A court order or decree or a separation agreement, the regulation states, cannot serve as a written declaration.

Armstrong Decision

Billy Armstrong was divorced, and his ex-wife, Ms. Delaney, had custody of their son. In 2003, an arbitration award and a state court order provided that Billy was entitled to a dependency exemption for his son. A March 2007 state court order provided the same and explicitly required Billy's ex-wife to execute in his favor a Form 8332 on the condition that Billy pay child support for his son. Billy paid the full amount of child support throughout 2007, but Ms. Delaney failed to provide the executed Form 8332. Billy remarried and claimed a dependency exemption and child tax credit for his son on a jointly filed return. He attached the May 2003 arbitration award. During an audit of that return, Billy also provided the IRS with the 2003 and 2007 child support orders, the latter signed by Billy's ex-wife.

The IRS rejected the Armstrongs' claim for a dependency exemption deduction and a child tax credit for Billy's son because the award and orders were conditional upon Billy staying current with his support obligations. The IRS also assessed an accuracy-related penalty. Billy took his case to the Tax Court.

The Tax Court began its analysis by assuming that Ms. Delaney's signature on the March 2007 court order constituted, in effect, her declaration that she would comply with the order. Therefore, the critical question before the court was whether, by declaring that she would comply with the March 2007 order, Ms. Delaney was also declaring that she would not claim her son as a dependent in 2007.

That March 2007 order, the court noted, did not provide unconditionally that Ms. Delaney would not claim a dependency exemption deduction for her son or that she had to sign Form 8332. Rather, the order unambiguously stated that her obligation to sign the release--and Billy's right to the exemption--was conditional upon Billy's payment of child support. By signing the order, the court stated, Ms. Delaney effectively declared circumstances under which she would not release her claim but would instead report herself to be entitled to the dependency exemption.

The court was quite sympathetic to Billy's situation. He was up to date on his child support; and under the state court order, Ms. Delaney was obliged to sign Form 8332 and release the exemption deduction to him. However, the court noted that it was obligated to follow the statute as written, whether the resulting disadvantage is suffered by a noncustodial parent who bore the burden of child support but did not receive an executed Form 8332, or whether the disadvantage is suffered by a custodial parent who executed a Form 8332 but then bore an undue and unintended burden of child support.

According to the court, in signing and assenting to the order, Ms. Delaney did not declare that she would not claim such child as a dependent. Instead, she declared that she would not claim her son as a dependent if Billy kept current with support payments; but she also thereby unambiguously declared that if he did not keep current, then she would claim their son as a dependent. According to the court, this made her declaration quite different from a declaration required by Code Sec. 152 that she would not claim the child as a dependent for the year at issue.

The court noted that, although the state court order was conditional, Billy fulfilled the condition. He did keep current with his support obligations, so that under the terms of the order, he was entitled to the exemption deduction and Ms. Delaney was obliged to execute the release. But, the Tax Court stated that the question was not what Billy was entitled to under the state court order but what he was entitled to under Code Sec. 152(e). The Tax Court concluded that, under Code Sec. 152(e), Billy's son was not his qualifying child in 2007, and Billy was not entitled to the dependency exemption or child tax credit for that year.

However, the court also concluded that Billy was not responsible for the accuracy-related penalty. To be liable for the penalty, the court noted, the IRS had to prove that Billy was negligent. The court did not believe that Billy, a truck driver, was sufficiently experienced in tax accounting and law such that he would realize that entitlement under the state court order to Ms. Delaney's release of the dependency exemption did not necessarily mean entitlement to that deduction under Code Sec. 152(e). In addition, the state court order and Billy's compliance with it constituted reasonable cause to someone in his circumstance, and nothing in the record of the case, the Tax Court stated, suggested anything other than that Billy acted in good faith.

George Decision

In 1995, Rachael George and Johnson John were divorced in Maryland. Rachael got custody of their two children and Mr. John was ordered to pay child support. The divorce judgment did not expressly provide how or whether the dependent status of the children would be allocated between Mr. John and Rachael for tax purposes after the divorce. In December 1995, Rachael and her children moved to northern Virginia. By February 1996, Mr. John stopped fulfilling his support obligations and, as a result, Rachael initiated a child support action against him in Virginia. In October 1996, the Maryland court ordered that Mr. John could claim one of his children as an exemption for Federal and State income tax purposes, each year, commencing with 1996 taxes, provided that all support payments are current. Even though Rachael argued that Mr. John was in arrears on child care payments, she nonetheless complied with the court order. At the direction of the court, she signed in the courtroom on February 3, 1997, a Form 8332, thereby releasing her right to claim an exemption for the child for 1996. Rachael subsequently moved to dismiss the case from the Maryland court for lack of personal jurisdiction, since Mr. John had moved to Connecticut and Rachael and the children lived in Virginia. In May of 1997, the Maryland court dismissed the case.

In January 2007, a Virginia court ordered that Rachael execute Form 8332 releasing any tax exemption claim for one of the children for tax years 1996 to 2010 and amended Mr. John's child support obligation by releasing his obligation to support the other child. Mr. John was delinquent on his child support obligation at that time and continued to be in arrears thereafter.

Nonetheless, in January 2007, under court order and under threat of contempt, Rachael executed another Form 8332 relinquishing her claim to exemption for one of the children for the tax years 1996 to 2010. The form stated: I agree not to claim an exemption for the child. Rachael continued to battle the state court order.

Because Rachael believed the state court order to be improper, she claimed a dependency exemption and child tax credit for the child that was the subject of the Form 8332 on her returns for each of 2007 and 2008. Mr. John also claimed the same child as a dependent for those years and attached the executed Form 8332 to his tax returns. The IRS issued a deficiency notice to Rachael, finding that she was not entitled to a dependency exemption.

Before the Tax Court, Rachael argued that her Form 8332 should be disregarded for three related reasons--i.e., because she signed it under duress, because the order requiring her to sign it was erroneous, and because her former husband did not provide the child support that the court order required and presumed.

According to the Tax Court, the threat of judicial contempt if Rachael did not comply and sign Form 8332 cannot be considered duress that might make her signing void. Duress, the court noted, occurs when an unlawful act induces action. In Rachael's case, the court stated, it was Virginia law that required her to comply with the Virginia court's order. Thus, Rachael's obligation under the law to execute the Form 8332 was not duress, and the compulsion she felt provided no basis for invalidating her release on Form 8332.

The court declined to examine the propriety of the state court order that required Rachael to execute the Form 8332. Such an endeavor, the court stated, would undertake the administrative burden that the rule in Code Sec. 152(e) was designed to alleviate.

The court then addressed Rachael's contention that Mr. John was in arrears on his child support obligations. According to the court, even if this was true, it does not affect the validity of her Form 8332 under Code Sec. 152(e) once the form is executed. The only support requirement applicable to Mr. John's claim of the dependency exemption, the court stated, was one not disputed--i.e., the requirement in Code Sec. 152(e)(1)(A) that a child receives over one-half of the child's support during the calendar year from the child's parents. Code Sec. 152(e)(1)(A), the court noted, does not specify which of the child's parents must have provided that support. The statute thus does not require that a noncustodial parent who has the custodial parent's release on Form 8332 must also prove that he, and not the custodial parent, supported the child. Rather, the court stated, an obvious purpose of Code Sec. 152(e) is, where a release is executed, to eliminate any contest as to which parent provided how much support.

Conclusion

There are two lessons to be learned from the above cases. Where a noncustodial parent wants to claim a dependency exemption, that parent should require a signed Form 8332 as part of the final divorce agreement. Where a custodial parent has signed a Form 8332 but the noncustodial spouse is not living up to his or her end of the agreement, the custodial spouse can revoke the Form 8332 or written declaration giving the noncustodial spouse the exemption. Reg. Sec. 1.152-4(e)(3) provides that the revocation can be made on Form 8332, whether or not the written declaration was made on that form. A revocation not on that form must conform to the substance of the form and must be a document executed for the sole purpose of serving as a revocation. The revocation must specify the year or years for which the revocation is effective. The parent revoking the written declaration must make reasonable efforts to provide actual notice to the other parent and should keep documentation to that effect.

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CPA Entitled to Amortization Deductions Upon Repurchasing His Practice

A recent Tax Court case involved an unusual situation of a CPA selling his practice due to medical issues. However, when the buyer, a former worker at the CPA firm, also suffered medical issues, the CPA bought back the practice. While the CPA could not treat his practice as a Section 197 intangible subject to amortization before the sale, he did treat it as such after buying the practice back. The IRS cried foul, but the Tax Court, in Fitch v. Comm'r, T.C. Memo. 2012-358 (12/26/12), concluded that the transactions were legitimate and allowed the amortization deductions.

Background

Brenda Fitch has been a licensed California real estate agent since November 2001. She works full time as an independent contractor with Remax, performing duties typical of real estate agents and brokers, including reviewing buyer criteria, soliciting listings, going on caravans, and showing, leasing, and selling real property. She works six days a week, taking either Saturday or Sunday off.

Donald Fitch has been a licensed CPA in California since February 1993. Upon receiving his license, he started a CPA practice as a sole proprietor in San Francisco. He spent nearly a decade developing the CPA practice, until he suffered a brain aneurysm in May 2003. He was hospitalized for a week, underwent surgery, and slowly recuperated.

Sale of CPA Business

On June 14, 2003, Donald sold his CPA practice for $900,000 to Mark Gronke, a CPA licensed in Massachusetts who worked for Donald as an independent contractor sporadically from 1996 through 2003. They duly executed an agreement providing that the $900,000 was due and payable in full within 1 year at the applicable federal interest rates. The agreement stated that Donald has incurred recent brain surgery, Donald understands the need to transfer the business based on health issues. The Fitches reported the $900,000 as a capital gain on their 2003 tax return.

Donald performed a small amount of work for the CPA practice after the sale transaction to help ensure a smooth transition. On October 31, 2003, approximately 4-1/2 months after the sale transaction, Mr. Gronke suffered a seizure and was rushed to the hospital. Five days later, on November 5, 2003, Mr. Gronke sold the CPA practice back to Donald for $900,000 (repurchase transaction). They duly executed another agreement (repurchase agreement) containing the same payment terms as the sale agreement. The repurchase agreement stated that Mark Gronke has incurred recent severe medical problems * * *. Mr. Gronke understands the need to sell the business based on his health issues.

Taxpayers' Tax Returns

Donald prepared joint tax returns for 2003 to 2007. For 2003, the Fitches claimed a $900,000 cost basis in the CPA practice as a result of the repurchase transaction, and they took amortization deductions of $45,000 in each of the years in issue on their tax return. The Fitches reported net operating losses (NOLs) for 2003 and 2004 and elected to carry the NOLs forward. They reported zero tax for each of the years at issue. Upon auditing the Fitches' tax returns for 2005 to 2007, the IRS disallowed the amortization of the CPA practice, as well as losses on rental real estate properties owned by the couple, certain business meal expenses, and the NOL carryovers from 2003 and 2004.

IRS Position

With respect to the amortization of the CPA practice, the IRS principally argued that the alleged sales agreements that were submitted were untrustworthy and the alleged sales did not take place. Alternatively, the IRS argued the sale and repurchase transactions were rescinded or that the Fitches reacquired self-created intangibles of the CPA practice in a series of related transactions. According to the IRS, the Fitches presented false testimony and fabricated documents in an attempt to prove that the transactions took place.

Tax Court's Analysis

The Tax Court held that the sale and repurchase agreements for the CPA practice were genuine and trustworthy. Further, it found the Fitches' testimony to be credible and persuasive. The court noted that a taxpayer is entitled to an amortization deduction with respect to any amortizable Section 197 intangible, the amount of which is determined by amortizing the adjusted basis of the intangible ratably over a 15-year period beginning with the month in which it was acquired. An amortizable Section 197 intangible is any Section 197 intangible acquired by a taxpayer after August 10, 1993, and held in connection with the conduct of a trade or business. For purposes of depreciation and amortization, the court observed, a taxpayer's basis in purchased property is the cost, including any valid liabilities incurred in acquiring the property.

The court rejected the IRS's arguments that the agreements were too brief and lacked details that should be present in an authentic sale contract of nearly $1 million. According to the court, the parties put the basic elements of their agreement into writing and left the details to be sorted out later. Likewise, when Mr. Gronke suffered a seizure, they signed a similar agreement to effect a quick repurchase. In these circumstances, the court found it hard to believe that a lack of details somehow suggested the agreements were fabricated. The court noted that the IRS did not argue that the sale and repurchase agreements are invalid or unenforceable under state law. Thus, the court found that the Fitches had proven that the sale and repurchase transactions actually took place.

With respect to the IRS's argument that the sale and repurchase transactions were rescinded, the court looked to Rev. Rul. 80-58, which defines a rescission as the abrogation, canceling, or voiding of a contract that has the effect of releasing the contracting parties from further obligations to each other and restoring the parties to the relative positions that they would have occupied had no contract been made. The court noted that, for a rescission to be effective, both the buyer and the seller must be put back in their original positions. A rescission may be effected, the court stated, by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other if sufficient grounds exist, or by applying to the court for a decree of rescission. According to the court, the repurchase agreement, by its own terms, effected a sale of the CPA practice from Mr. Gronke to Donald and was not, the court stated, an unwinding of the earlier sale. There was no evidence that Donald and Mr. Gronke intended to abrogate, cancel, or void the sale agreement. Further, the court did not believe that the repurchase agreement returned them to their original positions. The CPA practice continued as a dynamic, ongoing enterprise for approximately 4-1/2 months after the sale transaction, and the court could not say that Donald received the CPA practice back in the exact same condition in which he had sold it. Accordingly, the court concluded that the sale and repurchase transactions were not rescinded.

OBSERVATION: The IRS also questioned Donald's wisdom in repurchasing the CPA practice. However, the court said it was beyond its purview to second-guess Donald's business judgment or the manner of operations of his business.

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Withholding Tables Issued January 3 Supersede Tables Issued December 31

On January 3, the IRS released updated income-tax withholding tables for 2013 reflecting changes made by the American Taxpayer Relief Act (ATRA) of 2012. Notice 1036.

The IRS has released updated income tax withholding tables based on changes made by the American Tax Relief Act (ATRA) of 2012. The updated tables show the new rates in effect for 2013 and supersede the tables issued on December 31, 2012. The newly revised version of Notice 1036 contains the percentage method income tax withholding tables and related information that employers need to implement these changes.

In addition, employers should also begin withholding social security tax at the rate of 6.2 percent of wages paid following the expiration of the temporary two-percentage-point payroll tax cut in effect for 2011 and 2012. The payroll tax rates were not affected by the new tax legislation.

Employers should start using the revised withholding tables and correct the amount of social security tax withheld as soon as possible in 2013, but not later than February 15, 2013. For any social security tax under-withheld before that date, employers should make the appropriate adjustment in workers' pay as soon as possible, but not later than March 31, 2013.

Employers and payroll companies will handle the withholding changes, so workers typically won't need to take any additional action, such as filling out a new W-4 withholding form.

OBSERVATION: Employees should review their withholding every year and, if necessary, fill out a new W-4 and give it to their employer. For example, individuals and couples with multiple jobs, people who are having children, getting married, getting divorced or buying a home, and those who typically wind up with a balance due or large refund at the end of the year may want to consider submitting revised W-4 forms.

For a discussion of the 2013 tax rates, see Parker Tax ¶19,100.

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Final Regs Address Use of Tax Return Info by Return Preparers

Final regulations provide rules on the disclosure or use of tax return information by tax return preparers. T.D. 9608 (12/28/12).

In 2010, the IRS issued temporary regulations providing rules relating to the ability of a tax return preparer to use tax return information, without taxpayer consent, for the purposes of compiling, maintaining, and using lists for solicitation of tax return business; to disclose or use statistical compilations of data; and to disclose or use tax return information for the purpose of performing conflict reviews. Those regulations applied to disclosures or uses of tax return information occurring on or after January 4, 2010. The IRS has now finalized these regulations.

Under the final regulations, a tax return preparer may, without taxpayer consent, compile a list of certain taxpayer specific information that may be used to contact the taxpayers on the list for two purposes: (1) providing tax information and general business or economic information or analysis for educational purposes, and (2) soliciting additional tax return preparation services. A tax return preparer may not use the list to solicit non-tax return preparation services. The final regulations do not attempt to describe every scenario that may constitute either a permissible or prohibited use of the list. The final regulations retain the provisions in the temporary regulations that require written consent for all other purposes not expressly allowed by the regulations.

One practitioner recommended that the proposed regulations be clarified to state that Reg. Sec. 301.7216-2(n)(1) permits a tax return preparer to use any delivery method that employs or is based on the list information sanctioned by that regulation. The practitioner expressed a concern that the two examples provided in the temporary regulations limited the method of delivery to only email or U.S. mail. As a result, the IRS amended that regulation to authorize any delivery method that will facilitate direct contact with the taxpayers on the list through the use of only the information authorized for compilation of a list under Reg. Sec. 301.7216-2(n).

The final regulations apply to disclosures or uses of tax return information occurring on or after December 28, 2012.

For a discussion of the rules relating to the disclosure or use of tax return information by tax return preparers, see Parker Tax ¶277,105.

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IRS Modifies Mandatory Language for Taxpayer Consents Relating to Disclosure of Tax Return Info

The IRS clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services, but does need to complete a consent form to allow a tax return preparer to disclose or use tax return information in providing services other than tax return preparation. Rev. Proc. 2013-14.

Under Code Sec. 7216(a), a tax return preparer is subject to criminal penalties for knowingly or recklessly making unauthorized disclosures or uses of information furnished in connection with the preparation of an income tax return. A violation of Code Sec. 7216 is a misdemeanor, with a penalty of up to one year imprisonment or a fine of not more than $1,000, or both, together with the costs of prosecution. Code Sec. 7216(b) provides exceptions to the general rule in Code Sec. 7216(a) and also authorizes the IRS to issue regulations prescribing additional permitted disclosures or uses. Under Code Sec. 6713(a), a related civil penalty applies for unauthorized disclosures or uses of information furnished in connection with the preparation of an income tax return. The penalty for violating Code Sec. 6713 is $250 for each disclosure or use, not to exceed a total of $10,000 for a calendar year. Code Sec. 6713(b) provides that the exceptions in Code Sec. 7216(b) also apply to Code Sec. 6713.

Reg. Sec. 301.7216-3 provides that, unless Code Sec. 7216 or Reg. Sec. 301.7216-2 specifically permits the disclosure or use of tax return information, a tax return preparer may not disclose or use a taxpayer's tax return information without obtaining a consent from the taxpayer. The consent must be knowing and voluntary. In addition, the regulations place timing requirements and other limitations upon consents to disclose or consents to use tax return information.

According to the IRS, some taxpayers have expressed confusion regarding whether they need to complete consent forms to engage a tax return preparer to perform tax return preparation services. As a result, the IRS has issued Rev. Proc. 2013-14, which supersedes prior guidance issued in Rev. Proc. 2008-35. Rev. Proc. 2013-14 modifies the mandatory language required in consent forms and clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services. To allow a tax return preparer to disclose or use tax return information in providing services other than tax return preparation, however, a taxpayer must complete a consent form as described in Rev. Proc. 2013-14.

Rev. Proc. 2013-14 provides guidance to tax return preparers regarding the format and content of taxpayer consents to disclose and consents to use tax return information with respect to taxpayers filing a return in the Form 1040 series (e.g., Form 1040, Form 1040NR, Form 1040A, or Form 1040EZ) under Reg. Sec. 301.7216-3. Rev. Proc. 2013-14 also provides specific requirements for electronic signatures when a taxpayer executes an electronic consent to the disclosure or consent to the use of the taxpayer's tax return information.

For a discussion of tax return preparer penalties for disclosing or using tax return information without the taxpayer's consent, see Parker Tax ¶277,105.

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IRS Expands Program Allowing Employers to Reclassify Workers and Receive Relief from Employment Taxes

A temporary expansion of eligibility for the Voluntary Classification Settlement Program (VCSP) is now available to taxpayers through June 30, 2013. Announcement 2012-45, Announcement 2012-46.

The IRS has developed a new, temporary initiative to permit taxpayers who are otherwise eligible for the Voluntary Classification Settlement Program (VCSP), but have not filed all required Forms 1099 for the previous three years with respect to the workers to be reclassified, to apply for a modified version of the VCSP. The VCSP Temporary Eligibility Expansion is available through June 30, 2013.

The VCSP has been modified to: (1) permit a taxpayer under IRS audit, other than an employment tax audit, to be eligible to participate in the VCSP; (2) clarify the current eligibility requirement that a taxpayer that is a member of an affiliated group is not eligible to participate in the VCSP if any member of the affiliated group is under employment tax audit; (3) clarify that a taxpayer is not eligible to participate in the VCSP if the taxpayer is contesting in court the classification of the class or classes of workers from a previous audit by the IRS or the Department of Labor; and (4) eliminate the requirement that a taxpayer agree to extend the period of limitations on assessment of employment taxes as part of the VCSP closing agreement with the IRS.

Like the VCSP, the VCSP Temporary Eligibility Expansion permits eligible taxpayers to voluntarily reclassify their workers as employees for federal employment tax purposes and obtain relief similar to that obtained through the current Classification Settlement Program (CSP). The VCSP Temporary Eligibility Expansion is optional and provides taxpayers with an opportunity to voluntarily reclassify their workers as employees for future tax periods with limited federal employment tax liability for the past nonemployee treatment. Payment under the VCSP Temporary Eligibility Expansion is higher than the payment under the VCSP, but the benefits are otherwise the same for taxpayers that want to voluntarily reclassify their workers but have not filed all required Forms 1099 for those workers. To participate, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP Temporary Eligibility Expansion, and enter into a closing agreement with the IRS.

For a discussion of the rules relating to the VCSP Temporary Eligibility Expansion, see Parker Tax ¶210,130.

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IRS Reminds Practitioners to Renew PTINs

The IRS reminded professional tax return preparers to renew their Preparer Tax Identification Numbers (PTINs) if they plan to prepare returns in 2013. Current PTINs expire Dec. 31, 2012. IR-2012-103 (12/20/12).

Anyone who prepares or helps prepare all or substantially all of a federal tax return, claim for refund, or other federal forms for compensation must have a valid PTIN. All enrolled agents also must have a PTIN. Tax professionals can obtain or renew their PTINs at {"www.irs.gov/ptin"}}{www.irs.gov/ptin}}}.

Preparers who need to take a competency test are encouraged to schedule an appointment while they are renewing their PTIN. The registered tax return preparer (RTRP) test can be scheduled up to six months in advance, depending on the location. Select next steps and additional requirements within your online PTIN account to schedule the RTRP test.

The other option available to those required to test is the Special Enrollment Exam, which is a three-part test to become an enrolled agent (EA). Enrolled agent status is the highest credential the IRS awards. More information is available at {"www.irs.gov/taxpros/agents"}}{www.irs.gov/taxpros/agents}}}.

The online PTIN system has been substantially upgraded. Those renewing their PTINs can complete the process in about 15 minutes. The renewal fee is $63. Tools are available to assist any preparers who have forgotten their user name, password, or email address.

New tax return preparers who are obtaining a first-time PTIN must create an online PTIN account as a first step and then follow directions to obtain a PTIN. Their fee is $64.25.

All preparers are encouraged to ensure entry of accurate information so the IRS can properly determine test requirements. Enrolled agents, certified public accountants, and attorneys should carefully enter information about their professional credentials. Preparers who do not prepare any Form 1040 series returns or who are supervised in certain firms must self-certify that they are exempt from the testing requirement. A supervised preparer is one who is employed by a law or accounting firm at least 80 percent owned by attorneys, CPAs or EAs who is supervised by an attorney, CPA, or EA who reviews and signs the returns they prepare.

RTRPs and RTRP candidates also must self-certify that they have completed or will complete the required 15 hours of continuing education courses.

The annual registration and renewal requirement is part of the IRS's ongoing effort to enhance the tax preparer profession and improve services to taxpayers.

Enrolled agents, certified public accountants, and attorneys already have passed exams and maintain professional education requirements. Tax return preparers who are not enrolled agents, certified public accountants or attorneys must pass the RTRP test or the Special Enrollment Exam by Dec. 31, 2013.

The IRS recently created the new credential registered tax return preparer. Individuals in this category must meet the RTRP testing and CE requirements. So far, there are more than 48,000 preparers who have earned RTRP certificates. There also has been an increase in the number of people taking the enrolled agent exam.

Starting Jan. 1, 2014, only registered tax return preparers, enrolled agents, CPAs, and attorneys will be authorized to prepare and sign federal individual returns.

There are currently 739,000 tax preparers with 2012 PTINs. Approximately 350,000 of them are subject to the new testing and CE requirements.

For a discussion of the PTIN requirement, see Parker Tax ¶275,100.

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IRS Increase in S Shareholder's Wages Excessive; Tax Court Uses Average of Prior Years Instead

To estimate what portion of the funds paid by an S corporation to its shareholder should be treated as wages, the court averaged the shareholder's prior four years of wages. Herbert v. Comm'r, T.C. Summary 2012-124 (12/26/12).

For the last six months of 2002 and in 2003 Patrick Herbert worked as a salesman and a manager for Gopher Delivery Systems. For the second half of 2002 and for 2003, Patrick received total wages from Gopher Delivery of approximately $14,000 and $46,000, respectively. In 2004, Patrick and his wife purchased the courier business and they continued to operate it through 2009. They operated the business as an S corporation under the name H&H Transportation, Inc. (H&H). Patrick owned 49 percent of H&H and his wife owned the rest. Patrick was president and general manager and a full-time employee. His wife was not employed by H&H and was not involved in the day-to-day operations. In years 2004-2006, Patrick received wages of approximately, $25,100, $24,500, and $28,500.

In 2007, H&H had gross receipts of approximately $580,000. H&H paid truck drivers over $300,000. In addition, Patrick would also make supplemental payments to the driver to compensate them for making repairs to the delivery vehicles. With regard to the cash payments to the truck drivers, Patrick and H&H did not receive receipts from the truck drivers, and Patrick's records were not complete as to the amount of cash actually paid to the truck drivers in 2007. During the Herberts' operation of H&H up to some point in 2009, H&H either lost money every year or earned little income. In 2009, the Herberts finally closed the business down, after losing their home on account of losses incurred in the business and their inability to make payments on a home equity loan obtained in 2004 to finance their purchase of the business.

During 2007, Patrick received from H&H approximately $60,000 that was deposited into Patricks' bank account. H&H and Patrick treated only $2,400 thereof as wages subject to employment taxes. Patrick's used a portion of the H&H funds transferred into his bank account to pay with cash expenses of H&H, such as the supplemental payments to the truck drivers for truck repairs.

On audit, the IRS determined that the $2,400 that H&H and Patrick reported as 2007 wages was unreasonably low and that $55,000 (of H&H's funds transferred into Patrick's bank account in 2007) should be treated as wages subject to employment taxes.

In spite of the evidence before it, the Tax Court found it improper and excessive to charge Patrick with receiving wages in 2007 of $52,600. However, it also believed Patrick's reported H&H wages of $2,400 to be unreasonably low. To estimate what portion of the funds Patrick received from H&H in 2007 should be treated as wages, the court found it appropriate to average Patrick's wages for 2002 through 2006 and to use the average wage amount as the total for Patrick's 2007 H&H wages subject to employment taxes. As a result, the court concluded that Patrick had wages of $30,445 subject to employment taxes for 2007.

For a discussion of reasonable compensation for S shareholders, see Parker Tax ¶31,927.

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Romantic Relationship Led Taxpayer to Lose $181K in Fraudulent Scheme; Attorney's Investigation Fixes Year of Theft Loss

An attorney's investigation, which concluded in 2009 that the taxpayer could not obtain reimbursement of money invested in 2006 in an apparent fraudulent scheme, fixed the taxpayer's theft loss as occurring in 2009. Halata v. Comm'r, T.C. Memo. 2012-351 (12/19/12).

Around 2000, Paula Halata began a romantic relationship with Dominique Ojeda. In late 2000, Dominique and her eight-year-old daughter moved in with Paula. Two years later, Dominique lost her job as an optometrist's assistant. Paula began paying all the living expenses of Dominique and her daughter. Dominique began researching business opportunities on the internet. In late 2006, Dominique told Paula that she had learned of a way of making money through bank-guaranty transactions. Dominique found this supposed opportunity through a member of the California bar named Dwight Montgomery. Montgomery persuaded Dominique to participate in a bank-guaranty transaction. Because Dominique did not have any money, Paula supplied the money for the purported transaction. Paula was given to understand that if she made a payment of about $180,000, Dominique would receive $2.5 million; that the first installment of the $2.5 million would be paid to Dominique two weeks after the payment of the $180,000; and that the $180,000 would be returned at any time upon request.

Paula and Dominique agreed that Paula would take the risk of loss on the purported transaction. In late 2006, Paula authorized a wire transfer of $181,000 to Credit Suisse to facilitate the transaction but never personally spoke with Montgomery. Two weeks after the wire transfer, Paula had not received any money. Dominique contacted Montgomery and then told Paula that Montgomery had given her some flimsy excuses for why there was no payment. There were many subsequent emails between Dominique and Montgomery, but no money was ever received by Paula. As part of Dominique's attempts to recover the transferred money, she contacted a state prosecutor in California. She also contacted the SEC. Dominique never recovered the lost money. In the aftermath of the purported bank-guaranty transaction, her relationship with Paula dissolved.

Paula filed a Form 1040 for 2007 but did not report a theft loss on the return. She did not file a return for 2008. In 2009, the IRS conducted an audit of Paula's 2007 and 2008 tax years. Paula hired a lawyer to represent her before the IRS. The lawyer assigned another attorney to investigate Paula's legal remedies regarding the loss of the $181,000. That attorney contacted Dominique, who said she felt bad and thought the transaction was legitimate. The attorney also contacted Montgomery who insisted that the purported bank-guaranty transaction was a legitimate business transaction. He also claimed that he was merely a facilitator of bank-guaranty transactions and that he received no money from them. He said he had no information about how the purported bank-guaranty transaction worked or the identities and roles of the parties to the purported transaction. He said he did not know where Paula's money went. The attorneys told Paula that it would be risky to sue Montgomery, as it would cost $30-40,000 and she most likely would not recover anything.

The IRS assessed a deficiency based on what it calculated Paula's tax liability to be. The notice of deficiency did not reflect any deduction for the $181,000. The IRS contended that no theft occurred because Paula did not prove that any person appropriated the $181,000 with the intent to deprive her of the money using deception. The IRS asserted that Paula's payment of the $181,000 was part of a bona fide transaction and that it was just a bad investment or that the funds were still available to Paula.

Before the Tax Court, Paula argued that she had lost the $181,104 on account of theft in 2007, that she had no reasonable prospect of recovering the $181,000 that year, and therefore that there was a theft-loss deduction of $181,000 for 2007. In her post-trial brief, however, Paula contended that the theft loss was sustained (1) in 2008, which, according to her brief, was the year she realized that the purported bank-guaranty transaction was a fraudulent scheme, or alternatively, (2) in 2009, when the attorneys advised her that it was too costly to take legal action against Montgomery. She also contended that net operating losses resulting from her theft loss could be carried back and applied in 2007 and 2008 under Code Sec. 172(b)(1)(F).

The Tax Court held that Paula was entitled to a theft loss of $181,000 for 2009. However, because she presented no evidence regarding her gross income for 2009 and her deductions for 2009, other than the $181,000 theft-loss deduction, her net-operating loss could not be calculated and, thus, her deficiencies for 2007 and 2008 were unaffected by any net operating loss carryback.

The court noted that, under Texas law, a theft of Paula's $181,000 took place if someone appropriated the money by deceiving Paula and intended to deprive Paula of the money. In evaluating whether there was a theft, the court had to resolve a factual dispute between the parties regarding the nature of the purported bank guaranty transaction. Paula contended that the transaction was fictitious; the IRS contended it was not fictitious. The question of whether the transaction was fictitious, the court stated, was relevant to whether Paula's money was appropriated, whether there was a deception, and whether someone intended to deprive Paula of her money.

While the IRS posited several alternative ways to reach the conclusion that the purported bank-guaranty transaction was not fictitious, the court rejected those theories, saying the evidence did not support them. Paula, the court noted, transferred money to a mysterious Swiss bank account and received no contract documents in exchange evidencing her legal rights. This is more consistent with a scam, the court concluded, than with an investment account of some kind. Thus, the court found that Paula's money was appropriated and that she was deceived by someone into transferring the money thus qualifying the loss of the money as a theft loss.

For a discussion of when to deduct a theft loss, see Parker Tax ¶84,525.

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Final Regs Eliminate Partnership Substantiality De Minimis Rule

The IRS eliminated the de minimis partner rule in Reg. Sec. 1.704-1(b)(2)(iii)(e) and, as a result, the substantiality of all partnership allocations, regardless of when they became part of the partnership agreement, must be retested without the benefit of the de minimis partner rule. T.D. 9607 (12/28/12).

On December 28, the IRS issued final regulations that eliminate the application of the substantiality de minimis partner rule. The rule was part of final regulations issued in May 2008. The de minimis partner rule was incorporated in Reg. Sec. 1.704-1(b)(2)(iii)(e) and applied with respect to partners that were look-through entities. It provided that, for purposes of applying the substantiality rules, the tax attributes of de minimis partners need not be taken into account and defined a de minimis partner as any partner, including a look-through entity that owned, directly or indirectly, less than 10 percent of the capital and profits of a partnership, and that was allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit.

According to the IRS, the intent of the de minimis partner rule was to allow partnerships to avoid the complexity of testing the substantiality of insignificant allocations to partners owning very small interests in the partnership. It was not intended to allow partnerships to entirely avoid the application of the substantiality regulations if the partnership was owned by partners each of whom owned less than 10 percent of the capital or profits, and who were allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit. The IRS determined that the de minimis partner rule should be removed in order to prevent unintended tax consequences. The IRS is requesting comments on how to reduce the burden of complying with the substantial economic effect rules, with respect to look-through partners, without diminishing the safeguards the rules provide.

The final regulations are effective, and therefore the de minimis partner rule of Sec. 1.704-1(b)(2)(iii)(e) no longer applies, for all partnership tax years beginning on or after December 28, 2012, regardless of when the allocation became part of the partnership agreement. Thus, the substantiality of all partnership allocations, regardless of when they became part of the partnership agreement, must be retested without the benefit of the de minimis partner rule. For allocations in existing partnership agreements, the retest has to be as of the first day of the first partnership tax year beginning on or after December 28, 2012.

For a discussion of the substantiality of partnership allocations, see Parker Tax ¶20,535.