District Court Slams IRS for Overreaching Its Authority; Declares Tax Return Preparer Regs Invalid

In 2011, the IRS began requiring all tax return preparers to have a preparer tax identification number (PTIN). Additionally, the IRS issued regulations requiring preparers to pass a qualifying exam, pay an annual application fee, and take 15 hours of continuing-education courses each year. Certain tax return preparers, such as attorneys, CPAs, and enrolled agents, are exempt from the testing requirements because they have their own testing requirements.

In 2012, three independent tax-return preparers brought suit against the IRS in the U.S. District Court for the District of Columbia, arguing that the IRS exceeded its authority in issuing the return-preparer regulations. On January 18, in Loving v. IRS, 2013 PTC 10 (D.C. D.C. 1/18/13), the district court agreed and held that the regulations were invalid and that the IRS could not enforce them. The IRS subsequently released a statement saying that, in accordance with the district court order, tax return preparers covered by the PTIN program are not currently required to register with the IRS, complete competency testing, or secure continuing education. On January 23, the IRS filed a motion to suspend the district court's injunction pending its appeal of the court's decision.

OBSERVATION: Many CPAs and enrolled agents have expressed disappointment at the holding, saying it places them at a clear disadvantage because they are required to comply with competency and quality control regulations under IRS Circular 230 while, if this court's decision holds, unlicensed tax return preparers would escape regulation.

Background

In January 2010, the IRS issued IRS Pub. 4832, Return Preparer Review. The publication discusses the results of an in-depth review of the tax return preparer industry. The IRS recommended increased oversight of tax return preparers through the issuance of regulations governing tax return preparers.

The IRS subsequently issued Reg. Sec. 1.6109-2, which provides that, after December 31, 2010, all individuals who prepare all, or substantially all, of a tax return or claim for refund for compensation must have an IRS-issued PTIN and must use that PTIN as their sole identifying number. A PTIN must be included on any tax return or claim for refund prepared for compensation. Under the regulations, attorneys, CPA, enrolled agents, registered tax return preparers, and individuals authorized under Reg. Sec. 1.6109-2(h) are eligible to receive a PTIN.

Reg. Sec. 1.6109-2(h) provides that the IRS, through forms, instructions, or other appropriate guidance, may prescribe exceptions to the requirements of Reg. Sec. 1.6109-2, including the requirement that an individual be authorized to practice before the IRS before receiving a PTIN or other prescribed identifying number. The IRS, through other appropriate guidance, may also specify specific returns, schedules, and other forms that qualify as tax returns or claims for refund for purposes of the regulations.

In Notice 2011-6, the IRS identified two additional groups of individuals who are eligible under Reg. Sec. 1.6109-2(h) to obtain a PTIN: (1) specified individuals who are supervised by the attorney, CPA, enrolled agent, enrolled retirement plan agent, or enrolled actuary who signs the tax return or claim for refund prepared by the individual; and (2) individuals who certify they do not prepare or assist in the preparation of all or substantially all of any tax return or claim for refund covered by a competency examination (Form 1040 series tax returns and accompanying schedules until further notice).

In IR-2011-89 (9/6/11), the IRS said that, to become a registered tax return preparer, an individual (other than a CPA, attorney, EA, etc.) must pass a one-time competency test, a tax compliance check, and a suitability check. Preparers who meet these requirements are then given the designation "registered tax return preparer." Additionally, the IRS said, preparers must complete 15 hours of continuing education each year, starting in 2012. The IRS issued specifications for the competency test, which was last updated in July 2012.

In 2012, three independent tax return preparers, including Sabina Loving, filed suit in the U.S. District Court for the District of Columbia, contesting the new return preparer requirements. All three previously were not subject to regulation by the IRS. They argued that, under 31 U.S.C. Section 330, which forms the basis for the IRS return-preparer requirements, the IRS has authority to regulate only those people who practice before the Treasury Department and that did not include them.

OBSERVATION: The Treasury Department publishes regulations governing practice before the IRS in Circular No. 230. The crux of Circular 230 is a long list of duties and restrictions relating to practice before the IRS. Circular 230 also lays out sanctions and sets the rules for disciplinary proceedings. The Circular 230 regulations have long applied to attorneys, CPAs, and a handful of other specified tax professionals.

District Court's Decision

The district court noted that 31 U.S.C. Section 330(a) authorizes the Treasury Secretary to regulate the practice of representatives of persons before the Department of the Treasury. The dispute in this case involved the IRS's interpretation that tax-return preparers are representatives who practice before the IRS.

According to the district court, the case centered on whether or not Section 330 is ambiguous as to whether tax return preparers are representatives who practice before the IRS. The court concluded that Section 330 unambiguously forecloses the IRS's interpretation for two reasons. First, the court stated, the text of Section 330(a)(2)(D) defines the practice of representatives in a way that does not cover tax-return preparers. The court concluded that the IRS cannot regulate return preparers pursuant to its inherent authority because 31 U.S.C. Section 330 governs only the IRS's authority to regulate those who practice before it. Second, the court stated, the IRS's interpretation would displace an existing statutory scheme that comprehensively regulates penalties on tax return preparers. Thus, the court enjoined the IRS from enforcing the regulatory requirements for registered tax return preparers.

The court's ruling does not affect the regulatory practice requirements for CPAs, attorneys, enrolled agents, enrolled retirement plan agents, or enrolled actuaries.

IRS's Motion

The IRS has filed a motion (January 23rd motion) asking that the district court's injunction be suspended while the IRS appeals the court's decision. According to the IRS (in a memorandum supporting the motion), the court's injunction has far-reaching negative implications not only for the IRS, but also for the public. The IRS said that it and the public would suffer irreparable harm if the injunction remains in place during the pendency of the appeal. At press time, a decision had not yet come down from the district court on the IRS's motion.

OBSERVATION: This is not the first time a preparer has challenged the IRS's return preparer regulations. In Jesse E. Brannen, III, P.C. v. U.S., 2012 PTC 150 (11th Cir. 2012), the taxpayer challenged the requirement that compensated tax return preparers obtain a PTIN and pay an annual fee for that number. The Eleventh Circuit held that, because in exchange for the tax preparer user fee the IRS assigns a PTIN and confers a special benefit upon tax return preparers, the IRS has the statutory authority to impose the fee.

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Blank Spaces in Gift Documents Did Not Mean Decedent Retained Power to Alter Gifts

In Est. of Sommers v. Comm'r, T.C. Memo. 2013-8 (1/10/13), a physician gave artwork by way of interests in a limited liability company (LLC) to his nieces, then remarried his second wife, and then tried to get the artwork back. He died before the saga was over and his estate tried to argue that the existence of blank spaces in the gift documents, to be filled in at a later date, necessarily meant that the decedent retained the power to alter, amend, revoke, or terminate those gifts within the meaning of Code Sec. 2038. The estate's argument that the LLC units transferred by the decedent to the nieces were includible in his gross estate appeared to be motivated by a desire to minimize or eliminate the estate's gift tax liability and a belief that any resulting increase in the estate tax liability was unlikely to be significant.

The Tax Court rejected the estate's argument and instead interpreted the gift documents in the context of the overall agreement among the decedent and his nieces, which was for him to give his LLC units to them free of any obligation on his part to pay gift tax.

Facts

Sheldon Sommers was a successful physician in Indiana who owned a valuable art collection. Sheldon's wife of 45 years died in 1989 and he remarried in 1990. Sheldon divorced his second wife, Bernice, in 1997, but they remarried on June 23, 2002, and were still married when Sheldon died on November 1, 2002. Sheldon had no children from either marriage.

During his lifetime, Sheldon lived in both Indiana and New Jersey. At the time he divorced Bernice he was a resident of New Jersey. He moved back to Indiana in 1998 but returned to New Jersey in 2002 and was a New Jersey resident when he died. Sheldon had one sibling, a brother, Richard, who died in 2000. Richard had three daughters, who were Sheldon's closest living relatives.

In 2001, while living in Indiana, Sheldon hired Kristin Fruehwald, an attorney with Barnes & Thornburg (B&T), to advise him on the transfer of 12 works of art to his nieces. Sheldon arranged for the 12 art pieces to be moved from New Jersey to the nieces' respective homes in Indiana and Illinois. Sheldon and Ms. Fruehwald agreed that she would develop a plan whereby he could make the gifts of artwork to the nieces without incurring gift tax on the transactions. Sheldon told the nieces of his plans, and, at his request, they discussed the proposed gifts with Ms. Fruehwald, who told them to secure an appraisal of the 12 works of art. Ms. Fruehwald and the nieces also discussed having the nieces commit to pay any gift tax that might become due should the gifts exceed the then-applicable Code Sec. 2010(c)(3) basic exclusion amount of $675,000. The nieces had the art appraised and the appraisal report, dated September 10, 2001, reflected a combined value of $1,750,000, which was much higher than Ms. Fruehwald had anticipated.

Gift Plan

Having in mind Sheldon's goals of maintaining family control over, and preventing sales of, the 12 works of art and of avoiding gift tax on their transfer to the nieces, Ms. Fruehwald and another B&T tax attorney recommended the following giving plan to Sheldon. Sheldon and the nieces would form a limited liability company (LLC) to own the art. There would be an operating agreement that would include restrictions on member transfers of capital interests. Sheldon then would make gifts to the nieces, over a period of time, of his interests in the LLC. The attorneys explained to Sheldon that, if the artwork was owned by an LLC, subsequent gifts of minority interests in it would have a lower value than gifts of the artwork itself because the recipients could not freely resell the interests and would lack control of it.

B&T's proposed giving plan contemplated making gifts of LLC units to the nieces over more than one year so Sheldon could take advantage of both the increase, to $700,000, in the basic exclusion amount used in determining the unified credit that was scheduled to take place in 2002, and the multiple gift tax annual exclusions under Code Sec. 2503(b). The idea was for Sheldon to give the nieces, in 2001, LLC units in an amount not to exceed his "basic exclusion amount" ($675,000) plus the three $10,000 annual exclusions then available. He then would transfer any remaining value (in the form of LLC units) in 2002 or in a later year.

In December 2001, pursuant to the plan, (1) an Indiana LLC was established; (2) by bill of sale, Sheldon transferred the 12 works of art to the LLC, receiving in exchange voting and nonvoting capital units in it; and (3) Sheldon and the nieces signed an operating agreement governing the LLC, which placed restrictions on transfers of capital units, required unanimous member consent for many actions relating to management of the LLC and its assets (i.e., the art), and provided that all controversies among members had to be referred to mediation and, if that were not pursued or it failed to resolve the dispute, to arbitration. Sheldon owned 99 percent of the voting capital units and 98 percent of the nonvoting capital units in the LLC. The balance of both was acquired by the nieces, one-third each, for cash.

On December 27, 2001, Sheldon executed three documents entitled, "GIFT AND ACCEPTANCE OF CAPITAL UNITS," effective as of that date, each of which provided for the transfer of an unspecified number of voting and nonvoting capital units in the LLC to one of the nieces. Each niece also signed the document as "donee," accepting the units transferred to her. The documents left blank both the total number of voting and nonvoting capital units in the LLC and the number of such units transferred to each niece. Similarly, "Exhibit A" to each agreement, entitled, "Transfer Power," signed by Sheldon, left blank the number of voting and nonvoting capital units transferred by Sheldon to each niece.

On January 4, 2002, Sheldon and the nieces executed documents essentially identical to the December 27, 2001, documents, effective as of that date, except that there was no reference to the total number of voting and nonvoting capital units in the LLC. As in the case of the December 27, 2001, transfers, the documents left blank the actual number of such units transferred to each niece.

B&T lawyers explained to Sheldon that, until they received an appraisal valuing the interests in the LLC, the number of LLC capital units to be transferred to each niece had to be left blank and would be filled in on the basis of the appraisal report so as to avoid gift tax on the transfers.

On March 31, 2002, an appraisal set the net asset value of the LLC at $1,763,500 as of the two gift dates (December 27, 2001 and January 4, 2002). A B&T attorney computed the maximum number of LLC units to be transferred to the nieces under the original 2001 and 2002 gift documents. The computations revealed that the maximum number of LLC units that Sheldon would be able to transfer to the nieces in 2001 and 2002 without incurring any gift tax liability would leave Sheldon with 15.19 percent of the nonvoting capital units. The B&T attorneys then completed the original 2001 and 2002 gift documents by eliminating the blanks and identifying the interests transferred. In addition, they modified the original 2001 and 2002 gift documents in several respects, but none of the modifications affected the signature page of each document, which remained unchanged.

Second Thoughts about Gift

On April 5, 2002, Sheldon executed a new will in which he left his entire estate to Bernice. On June 4, 2002, Sheldon filed suit against his nieces claiming that there had been no effective gift or donation of the artwork to either the LLC or the nieces. An arbitrator concluded that Sheldon "did know that he was in effect gifting the artwork to the nieces, and that he intended to do what is reflected in the gifting documents." Subsequently, courts in both Indiana and New Jersey agreed with the arbitrator that completed gifts had been made.

Sheldon died on November 1, 2002.

Estate Tax Return

The Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, filed on behalf of Sheldon's estate included as one of the assets in the gross estate "artwork" valued at $1,750,000, with a footnote stating that litigation might change that valuation.

Previously, a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return for 2001, signed by Sheldon, and a Form 709 for 2002, signed by Bernice as executrix of Sheldon's estate, had been filed, which reflected the December 27, 2001, and January 4, 2002, transfers of LLC units to the nieces as taxable gifts (2001 and 2002 gifts). However, Sheldon's estate argued that those transfers did not constitute completed gifts for federal gift tax purposes.

IRS Arguments

The IRS argued that Sheldon's estate was precluded from denying that he made taxable gifts of his LLC units to the nieces, in part, on December 27, 2001, and, in part, on January 4, 2002, when he and the nieces signed the original 2001 and 2002 gift documents. The IRS relied on the fact that appellate courts in both Indiana and New Jersey affirmed decisions holding that Sheldon made irrevocable transfers of his LLC units on those dates. With respect to the December 27, 2001, transfer of LLC units, the IRS also argued that Sheldon's signing of the 2001 gift tax return reporting that transfer as a 2001 taxable gift constituted an admission that he ceded dominion and control of those interests (i.e., that he made a taxable gift thereof) in 2001.

The IRS argued in the alternative, that, if the Tax Court agreed with Sheldon's estate that his transfers of LLC units to the nieces were not completed gifts for federal gift tax purposes until the blanks on the original 2001 and 2002 gift documents were filled in and the completed documents delivered to the nieces on April 11, 2002, then Sheldon made taxable gifts of those interests in 2002.

Estate's Arguments

Sheldon's estate argued that the 2001 and 2002 gift documents, because they were incomplete when signed, did not effect completed gifts of the LLC units for federal gift tax purposes. Rather, because the 2001 and 2002 gifts were made in blank, Sheldon necessarily retained the power to alter, amend, revoke, or terminate those transfers, a power that he relinquished on April 11, 2002, by permitting B&T to deliver the completed gift documents to the nieces.

The estate cited Code Sec. 2038(a)(1), which includes in a decedent's gross estate interests in property transferred after June 22, 1936, where the transfer on the date of death was subject to change through the decedent's exercise of a power to "alter, amend, revoke, or terminate" the transfer, and to Code Sec. 2035(a), which requires the inclusion in a decedent's gross estate of property interests with respect to which the decedent relinquished, within three years of death, a Code Sec. 2038 power to alter, amend, revoke, or terminate the transfer thereof. On the basis of those provisions, the estate argued that the LLC units transferred to the nieces remained part of Sheldon's gross estate and that no gift taxes should therefore be imposed. According to the estate, the determination of a decedent's gross estate for federal tax purposes is governed by federal, not state, law, and pursuant to federal law there were no completed gifts of LLC units to the nieces on December 27, 2001, or January 4, 2002.

The estate also argued that the Indiana and New Jersey decisions did not collaterally estop the estate from arguing for the application of Code Sec. 2035 and Code Sec. 2038 in the instant case.

OBSERVATION: As the Tax Court noted, the estate's argument that the LLC units transferred by Sheldon to the nieces are includible in Sheldon's gross estate under Code Sec. 2035(a) and Code Sec. 2038(a)(1) appeared to be motivated by a desire to minimize or eliminate the estate's gift tax liability and a belief that any resulting increase in its estate tax liability was unlikely to be significant. That is because the estate believed that estate tax attributable to the inclusion of the LLC units in Sheldon's gross estate, unlike any additional gift tax payable by the estate, would be apportioned to the nieces as the recipients of the LLC units under New Jersey's equitable apportionment statute, thereby increasing the marital deduction for the balance of Sheldon's estate, which went to Bernice. Presumably, the Tax Court said, the estate feared a significant gift tax liability because: (1) it was possible that the Tax Court would find that the appraisal substantially undervalued the LLC units and the underlying art, and (2) the New Jersey court specifically found that the completed 2001 and 2002 gift documents made the nieces responsible for only the 2002 gift tax, meaning that an enhanced valuation of the LLC units that Sheldon gave to the nieces in 2001 would generate a substantial gift tax payable from the estate rather than no gift tax, which would be the case if the Tax Court adopted the appraisal valuation of the LLC units.

Nieces' Arguments

As intervenors in the case, the nieces argued that, on the basis of the Indiana and New Jersey state court decisions, the IRS was collaterally estopped from arguing that Sheldon failed to make completed gifts to the nieces for federal gift tax purposes on December 27, 2001, and January 4, 2002.

Tax Court's Decision

The Tax Court found that the Indiana and New Jersey state courts resolved the issue of whether Sheldon made a gift of the art work to his nieces in favor of the nieces and against the estate by finding that the 2001 and 2002 gifts were absolute and irrevocable and, therefore, not subject to alteration, amendment, revocation, or termination by Sheldon.

The Tax Court also concluded that Sheldon's estate was collaterally estopped by both the Indiana and New Jersey decisions from arguing (1) that the 2001 and 2002 gifts were not gifts for federal gift tax purposes, and (2) that, in making those gifts, Sheldon retained a Code Sec. 2038(a)(1) power to "alter, amend, revoke, or terminate" those gifts until that power was relinquished on April 11, 2002.

Finally, the Tax Court concluded that Sheldon made taxable gifts to the nieces on December 27, 2001, and January 4, 2002, and did not retain the power to "alter, amend, revoke, or terminate" those gifts within the meaning of Code Sec. 2038. As a result, the LLC units were not includible in Sheldon's gross estate.

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Needed Modifications to Form 8863 Will Delay Processing of Returns with Education Credits

Processing of tax returns claiming education credits will be delayed until mid-February. IR-2013-10 (1/28/13).

In a news release issued this week, the IRS stated that it will not be able to process returns that include Form 8863, Education Credits, until mid-February. Form 8863 is used to claim two higher education credits the American Opportunity Tax Credit and the Lifetime Learning Credit. The IRS said it remains on track to open the tax season on January 30 for most other taxpayers.

The IRS emphasized that the delayed start will have no impact on taxpayers claiming other education-related tax benefits, such as the tuition and fees deduction and the student loan interest deduction. People otherwise able to file and to claim these benefits can start filing January 30. As it does every year, the IRS reviews and tests its systems in advance of the opening of the tax season in an effort to avoid processing errors and refund delays. During this period, the IRS discovered that programming modifications were needed to accurately process Forms 8863.

The IRS noted that, typically, through the mid-February period, about three million tax returns include Form 8863.

For a discussion of the education tax credits, see Parker Tax ¶101,100.

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IRS Announces Estimated Tax Penalty Relief for Farmers and Fishermen

The IRS is waiving the additions to tax penalty for underpayment of estimated taxes for certain farmers and fishermen due to the delayed start for filing 2012 tax year returns. Notice 2013-5.

Generally, individuals must pay federal income tax as they earn income. To the extent these taxes are not withheld from an individual's wages, an individual taxpayer must pay estimated taxes. In general, estimated taxes are required in four installments and the amount of any required installment is 25 percent of the required annual payment. There is a penalty under Code Sec. 6654(a) for an addition to tax where a taxpayer fails to make a sufficient and timely payment of estimated tax.

Code Sec. 6654(i) provides a special rule for farmers and fisherman -- only one installment payment is required to be made. Under Code Sec. 6654(i)(1)(B), the installment is due on January 15 of the following tax year. Qualifying farmers and fishermen who choose not to make the required estimated tax installment payment are not subject to an estimated tax addition to tax penalty if they file their returns and pay the full amount of tax due by March 1 of the following taxable year. A taxpayer qualifies as a farmer or fisherman for the 2012 tax year if at least two-thirds of the taxpayer's total gross income was from farming or fishing in either 2011 or 2012.

Code Sec. 6654(e)(3) authorizes the IRS to waive Code Sec. 6654 penalties for underpayments of estimated tax in unusual circumstances to the extent its imposition would be against equity and good conscience. On January 2, 2013, the American Taxpayer Relief Act of 2012 (ATRA) was enacted into law. The ATRA affected several tax forms that are often filed by farmers and fishermen, including the Form 4562, Depreciation and Amortization (Including Information on Listed Property). Revision of these forms will require extensive programming and testing of IRS systems, which will delay the IRS's ability to accept and process these forms. These delays may affect the ability of many farmers and fishermen to file their 2012 tax year return by March 1, 2013.

In Notice 2013-5, the IRS said that it will waive the Code Sec. 6654 addition to tax for the 2012 tax year for farmers and fishermen who miss the March 1 deadline if they file their return and pay in full any tax due by April 15, 2013.

COMPLIANCE TIP: Farmers and fishermen requesting this addition to tax waiver must attach Form 2210-F, Underpayment of Estimated Tax by Farmers and Fishermen, to their tax return. The form can be submitted electronically or on paper. The taxpayer's name and identifying number should be entered at the top of the form and the waiver box (Part I, Box A) should be checked. The rest of the form should be left blank. Forms, instructions, and other tax assistance are available on IRS.gov. The IRS toll-free number for general tax questions is 1-800-829-1040.

For a discussion of the special rules for farmers and fisherman with respect to installment tax payments, see Parker Tax ¶168,150.

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Proposed Regs Help Determine Employment Tax Obligations in Three-Party Arrangements

The IRS issued proposed regulations aimed at assisting taxpayers and the IRS in determining employment tax obligations in a three-party arrangement. REG-102966-10 (1/29/13).

For various reasons, an employer may choose to enter into an agreement with a third party, such as a payroll service provider or a professional employer organization (PEO) sometimes referred to as a third-party payor. Under the agreement, the third-party payor remits the wages to employees and takes steps to ensure the employer's employment tax withholding, reporting, and payment obligations are satisfied. However, employment tax liability cannot be altered by a private agreement between an employer and a third-party payor. Rather, the liability of the employer and/or the third-party payor for employment taxes is determined under the Code and depends on all the facts and circumstances, including the terms and substance of the arrangement between the employer and the third-party payor. There are limited circumstances in a three-party arrangement when the third-party payor may be considered the person responsible for the withholding and payment of employment taxes in addition to, or in lieu of, the common law employer.

Rev. Proc. 70-6 provides the general procedures for a payor to request authorization to act as an agent under Code Sec. 3504 for FICA, income tax withholding, and Railroad Retirement Tax Act (RRTA) purposes. Each employer for whom the agent is to act provides the payor with a signed IRS Form 2678, Employer/Payer Appointment of Agent. The payor then submits these Forms 2678 to the IRS. Effective for periods on or after January 1, 2010, an agent with an approved Form 2678 must also complete and attach to the aggregate Form 941 a Schedule R (Form 941), Allocation Schedule for Aggregate Form 941 Filers. If an agent with an approved Form 2678 is acting for employers under the RRTA, the agent must report for each employer the taxable compensation as determined under RRTA with respect to each employer on an aggregate Form CT-1.

An agent with an approved Form 2678 is generally not authorized to perform the employment tax obligations of an employer with respect to the FUTA tax. Thus, an employer generally must continue to satisfy its FUTA tax obligations by filing a Form 940 using its own employer identification number (EIN). Prop. Reg. Sec. 31.3504-1(b), however, provides a limited exception to the general rule regarding FUTA, which employers may rely on for periods beginning on or after January 1, 2010. The proposed regulation allows agents acting on behalf of employers receiving home care services to perform the acts of an employer required with respect to FUTA tax. An agent that files an aggregate Form 940 under the limited exception must complete and attach to the Form 940 a Schedule R (Form 940).

An employer may enter into an agreement with a payroll service provider (PSP) to prepare employment tax returns (including Forms 940 and 941) using the EIN of the employer for the signature of the employer. A PSP may also process the withholding, deposit, and payment of the associated employment taxes for the employer. A PSP is not liable for the employer's employment taxes. An employer's use of a PSP does not relieve the employer of its employment tax obligations or liability for the taxes.

The IRS has now issued Prop. Reg. Sec. 31.3504-2, which is aimed at assisting taxpayers and the IRS in determining the parties' employment tax obligations in a three-party arrangement when a payor has represented to its client that it will pay the employment taxes with respect to wages or compensation it pays to employees for services performed by employees for the client. The proposed regulation applies to arrangements when the employer enters into an agreement with a third-party payor under which the payor performs the employment tax obligations of the client with respect to wages or compensation paid by the payor to individuals performing services for the client, but the payor does not meet the legal conditions necessary to be a Code Sec. 3401(d)(1) employer, does not obtain an approved Form 2678, and is not a PSP or reporting agent. Subject to certain exceptions, the proposed regulation provides that a payor is designated as an agent under Code Sec. 3504 to perform the acts of an employer in any case in which the payor enters into a service agreement with a client. For this purpose, the term service agreement means a written or oral agreement under which the payor (1) asserts that it is the employer (or co-employer) of individuals performing services for the client, (2) pays wages or compensation to the individuals for services the individuals performed for the client, and (3) assumes responsibility to collect, report, and pay, or assumes liability for, any employment taxes with respect to the wages or compensation paid by the payor to the individuals who performed services for the client.

EXAMPLE: Corporation P enters into an agreement with ABC Company, effective January 1, 2013. Under the agreement, Corporation P hires ABC's employees as its own employees and provides them back to ABC to perform services for ABC. Corporation P also assumes responsibility to make payment of the individuals' wages and for the collection, reporting, and payment of applicable taxes. For all pay periods in 2013, ABC provides Corporation P with an amount equal to the gross payroll (that is, wage and tax amounts) of the individuals, and Corporation P pays wages (less the applicable withholding) to the individuals performing services for ABC. Corporation P also reports the wage and tax amounts on Form 941, Employer's QUARTERLY Federal Tax Return, filed for each quarter of 2013 under Corporation P's EIN. Corporation P is not a common paymaster or the employer of the individuals. Corporation P is designated to perform the acts of an employer with respect to all of the wages Corporation P paid to the individuals performing services for ABC for all quarters of 2013. ABC and Corporation P are each subject to all provisions of law (including penalties) applicable in respect of employers for all quarters of 2013 with respect to such wages.

EXAMPLE: Same facts as the above example, except that Corporation P only reports the wage and tax amounts on Form 941, Employer's QUARTERLY Federal Tax Return, filed for the first and second quarters of 2013. Neither Corporation P nor ABC files returns for the third and fourth quarters of 2013. Corporation P is designated to perform the acts of an employer with respect to all the wages Corporation P paid to the individuals performing services for ABC for all quarters of 2013. ABC and Corporation P are each subject to all provisions of law (including penalties) applicable in respect of employers for all quarters of 2013 with respect to such wages.

For a discussion of who is an employer for employment tax reporting purposes, see Parker Tax ¶210,105.

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IRS Announces Guidance on the Principal Reduction Alternative Offered in the Home Affordable Modification Program

The IRS provides guidance to borrowers, mortgage loan holders, and loan servicers who are participating in the Principal Reduction AlternativeSM offered through the Department of the Treasury's and Department of Housing and Urban Development's Home Affordable Modification Program(HAMP-PRA). Rev. Proc. 2013-16.

To help financially distressed homeowners lower their monthly mortgage payments, the Treasury Department and the Department of Housing and Urban Development (HUD) established a program called the Principal Reduction Alternative, which is offered through the Department of the Treasury's and HUD's Home Affordable Modification Program (HAMP-PRA). The program is described in detail at {"www.makinghomeaffordable.gov"}}{www.makinghomeaffordable.gov}}}. Under HAMP-PRA, the principal of the borrower's mortgage may be reduced by a predetermined amount called the PRA Forbearance Amount if the borrower satisfies certain conditions during a trial period. The principal reduction occurs over three years.

More specifically, if the loan is in good standing on the first, second, and third annual anniversaries of the effective date of the trial period, the loan servicer reduces the unpaid principal balance of the loan by one-third of the initial PRA Forbearance Amount on each anniversary date. This means that if the borrower continues to make timely payments on the loan for three years, the entire PRA Forbearance Amount is forgiven. To encourage mortgage loan holders to participate in HAMPPRA, the HAMP program administrator will make an incentive payment to the loan holder (called a PRA investor incentive payment) for each of the three years in which the loan principal balance is reduced.

In Rev. Proc. 2013-16, the IRS provides guidance on the tax consequences to borrowers involved in the program. Under that guidance, the IRS provides that PRA investor incentive payments made by the HAMP program administrator to mortgage loan holders are treated as payments on the mortgage loans by the U.S. government on behalf of the borrowers. These payments are generally not taxable to the borrowers under the general welfare doctrine.

If the principal amount of a mortgage loan is reduced by an amount that exceeds the total amount of the PRA investor incentive payments made to the mortgage loan holder, the borrower may be required to include the excess amount in gross income as income from the discharge of indebtedness. However, many borrowers will qualify for an exclusion from gross income.

For example, a borrower may be eligible to exclude the discharge-of-indebtedness income from gross income if (1) the discharge of indebtedness occurs (i.e., the loan is modified) before January 1, 2014, and the mortgage loan is qualified principal residence indebtedness, or (2) the discharge of indebtedness occurs when the borrower is insolvent.

Borrowers receiving aid under the HAMPPRA program may report any discharge-of-indebtedness income whether included in, or excluded from, gross income either in the year of the permanent modification of the mortgage loan or ratably over the three years in which the mortgage loan principal is reduced on the servicer's books. Borrowers who exclude the discharge-of-indebtedness income must report both the amount of the income and any resulting reduction in basis or tax attributes on Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

COMPLIANCE TIP: Mortgage loan holders are required to file a Form 1099-C with respect to a borrower who realizes discharge-of-indebtedness income of $600 or more for the year in which the permanent modification of the mortgage loan occurs. This rule applies regardless of when the borrower chooses to report the income (that is, in the year of the permanent modification or one-third each year as the mortgage loan principal is reduced) and regardless of whether the borrower excludes some or all of the amount from gross income. Penalty relief is provided for mortgage loan holders that fail to timely file and furnish required Forms 1099-C, as long as certain requirements described in Rev. Proc. 2013-16 are satisfied.

For a discussion of the rules relating to the discharge of indebtedness on a mortgage, see Parker Tax ¶76,125.

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IRS Extends Safe Harbor for Computing Certain Home Mortgage Deductions

IRS extends through 2015 the safe-harbor method for computing a homeowner's deduction for payments made on a home mortgage. Notice 2013-7.

Notice 2011-14 provides guidance on the federal income tax consequences of, and information reporting obligations for, payments made to or on behalf of financially distressed homeowners under (1) programs designed by state HFAs (state programs) with funds allocated from the Treasury Department's Housing Finance Agency Innovation Fund for the Hardest-Hit Housing Markets (HFA Hardest Hit Fund), and (2) HUD's Emergency Homeowners' Loan Program (EHLP) and any existing state program that is substantially similar to the EHLP and is eligible to administer an allocation of funds from the EHLP (the substantially similar state programs, or SSSPs).

For tax years 2010, 2011, and 2012, Notice 2011-14 provides a safe-harbor method for determining the amount a homeowner may deduct on his or her federal income tax return. Under the safe-harbor method, a homeowner may deduct the sum of all payments the homeowner actually makes during a tax year to the mortgage servicer, HUD, or the state HFA on the home mortgage, but not in excess of the sum of the amounts shown on Form 1098 in box 1 (Mortgage interest received), box 4 (Mortgage insurance premiums) for years 2010 and 2011 only, and box 5 (real property taxes). This safe-harbor method of computing the homeowner's deduction applies for a tax year if (1) the homeowner meets the requirements of Code Sec. 163 and Code Sec. 164 to deduct all of the mortgage interest on the loan and all of the real property taxes on the principal residence, and (2) the homeowner participates in a state program described in the Appendix to Notice 2011-14 in which the program payments could be used to pay interest on the home mortgage, or in the EHLP or an SSSP.

The American Taxpayer Relief Act of 2012 amended Code Sec. 163(h)(3)(E)(iv)(I) by striking December 31, 2011, and inserting in its place December 31, 2013. The effect of this amendment is to extend the deduction for qualified mortgage insurance premiums paid or accrued in, or properly allocable to, years 2012 and 2013. Notice 2011-14 provides that the IRS will not assert penalties under Code Sec. 6721 and Code Sec. 6722 against a mortgage servicer that reports on Forms 1098, Mortgage Interest Statement, payments received under a state program, the EHLP, or an SSSP during calendar years 2011 or 2012 if the servicer notifies homeowners that the amounts reported on the Forms 1098 are overstated because they include government subsidy payments.

Notice 2011-14 also provides that the IRS will not assert penalties under Code Sec. 6721 and 6722 against any state HFA for failing to file and furnish Forms 1098 for calendar years 2011 and 2012 if the state HFA provides each homeowner and the IRS a statement setting forth (1) the homeowner's name and taxpayer identification number (TIN), and (2) the amount of payments the state HFA made to a mortgage servicer under the state program or the SSSP during that year (separately stating the amount the state HFA paid and the amount the homeowner paid). The statement the state HFA provides to the IRS must be a single statement that separately lists the names, TINs, and relevant payment amounts for each homeowner.

In Notice 2013-7, the IRS provides that for tax years 2010 through 2015, a homeowner may deduct on his or her federal income tax return the lesser of: (1) the sum of all payments on the home mortgage that the homeowner actually makes during a tax year to the mortgage servicer, HUD, or the state HFA; and (2) the sum of amounts shown on Form 1098 for mortgage interest received, real property taxes, and (for years 2010 through 2013 only) mortgage insurance premiums. On Form 1098 for 2012, Box 4 is unlabeled, but, pursuant to instructions, mortgage servicers should again report these amounts in Box 4.) This safe-harbor method of computing the homeowner's deduction applies for a tax year if (1) the homeowner meets the requirements of Code Sec. 163 and Code Sec. 164 to deduct all of the mortgage interest on the loan and all of the real property taxes on the principal residence, and (2) the homeowner participates in a state program in which the program payments could be used to pay interest on the home mortgage, or the EHLP or an SSSP.

For a discussion of mortgage interest deductions, see Parker Tax ¶83,515.

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Private School Run by IRS Agent and Wife Properly Deferred Advance Payments

A couple properly accounted for advance payments received by the private elementary school they operated; additionally, payments made by the couple to the school were capital contributions rather than nondeductible tuition. Cvancara v. Comm'r, T.C. Memo. 2013-20 (1/17/13).

Ryan Cvancara worked as a special agent in the IRS Criminal Investigation Division. In 2003, he and his wife, Aimee, formed Desert Academy to operate a private early-elementary school. The couple elected to treat Desert Academy as a partnership for federal tax purposes. Aimee managed the day-to-day activities of, and occasionally taught classes for, Desert Academy. She also maintained Desert Academy's records and prepared its returns.

Desert Academy did not indicate whether it was using an accrual or a cash method of accounting on its 2003 Form 1065, U.S. Return of Partnership Income, but it indicated that it was using an accrual method of accounting on its 2004-2006 Forms 1065. The school closed in 2008. During 2005-06, the Cvancaras had three minor children. Their two oldest children attended Desert Academy's school during 2005-2006.

The IRS audited Desert Academy's tax return and assessed tax deficiencies based on two principal disputes: (1) whether Desert Academy properly accounted for advance payments it received in 2005 and 2006; and (2) whether amounts the Cvancaras paid to Desert Academy in 2005 and 2006 were tuition for their children.

According to the IRS, advance payments of $26,922 and $37,620 received by Desert Academy in 2005 and 2006, respectively, were includible in Desert Academy's income for the years of receipt. The Cvancaras contended that these payments were instead properly included in income for 2006 and 2007 under the accrual method. The IRS countered that it was entitled to compute Desert Academy's gross receipts using the bank deposits method because (1) Desert Academy's records were unreliable, inaccurate, and incomplete; (2) Desert Academy accounted for its expenses on a cash basis; and (3) Desert Academy was ineligible to use the deferral method provided for in Rev. Proc. 2004-34 since the advance payments were subject to a condition subsequent because parents that prepaid their children's tuition were entitled to a refund if they withdrew their children from the school. According to the IRS, this meant the payments were earned in the year of receipt.

The Tax Court held that Desert Academy (1) elected to use an accrual method of accounting; (2) elected, under Rev. Proc. 2004-34, to use the deferral method with respect to any advance payments it received; and (3) maintained its record of income, and calculated its income for income tax purposes, using an accrual method of accounting. As a result, the court rejected the IRS's contention that Desert Academy did not use an accrual method because its records were unreliable, inaccurate, and incomplete. Citing Rev. Proc. 71-21, the Tax Court concluded that, although far from perfect, Desert Academy's records were sufficient to allow the IRS to verify the amounts deferred.

The court also found that Aimee credibly testified that she intended from the beginning for Desert Academy to use an accrual method of accounting because the school year spanned two calendar years. The court noted that while Desert Academy did not check the box indicating whether it was using an accrual or a cash method of accounting on its 2003 Form 1065, it affirmatively stated on its 2004-06 Forms 1065 that the information reported on those forms was calculated using an accrual method of accounting.

The court also rejected the IRS's argument that, under Rev. Proc. 2004-34, the advance payments were subject to a condition subsequent because parents that prepaid their children's tuition were entitled to a refund if they withdrew their children from the school. The court said this argument was flawed and appeared to be based on a misreading of Rev. Proc. 2004-34. That procedure, the court stated, does not make the existence of a condition subsequent controlling. Rather, it provides that the determination of whether an amount is earned in a subsequent year must be made without regard to whether the taxpayer may be required to refund the advance payment upon the occurrence of a condition subsequent. In this case, because Desert Academy was entitled to retain the advance payments only if it provided the services that it agreed to provide, the court concluded that Desert Academy earned the advance payments in the year the services were provided without regard to any condition subsequent. Accordingly, the court found that Desert Academy was entitled to use the deferral method for those payments.

The court then addressed the IRS's argument that payments to Desert Academy labeled as capital contributions by the Cvancaras should be recast as tuition because Desert Academy should be required to charge the Cvancaras tuition. The court noted that Aimee credibly testified that she and her husband never intended for Desert Academy to charge tuition for their children and that all of their payments to Desert Academy were intended to be capital contributions. The court found the cases the IRS relied upon for its tuition argument to be inapplicable in this situation and concluded that the Cvancaras' payments to Desert Academy in 2005 and 2006 were capital contributions and not tuition.

For a discussion of the treatment of advance payments by an accrual method taxpayer, see Parker Tax ¶241,520.

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Litigation Expenses Advanced to Law Firm Clients Were Nondeductible Loans

Litigation expenses a law firm advanced to contingent-fee clients were loans and thus not deductible, and the change in treatment was an accounting method change subject to Code Sec. 481 adjustments. Humphrey, Farrington & McClain, P.C. v. Comm'r, T.C. Memo. 2013-23 (1/17/13).

Humphrey, Farrington & McClain, P.C. (HFM) is a law firm that primarily conducts plaintiff-side litigation in areas such as tobacco, toxic substance exposure, products liability, false advertising, consumer antitrust, securities fraud, medical malpractice, and ERISA benefits. It also has a smaller transactional practice that handles probate, trust-and-estate, business, and real estate matters. HFM is a cash-method, calendar-year taxpayer and is a qualified personal service corporation under Code Sec. 448(b)(2).

HFM initially pays the expenses of pursuing all litigation matters. These expenses include the costs of court-filing fees, court reporters, expert witnesses, depositions, medical records, medical examinations, travel, phone calls, faxes, and photocopying, but not charges for the time of HFM's professionals. Whether HFM is reimbursed by a client for the advanced expenses depends on the type of fee arrangement, and, in some instances, the result of the litigation. HFM has four kinds of fee arrangements with its litigation clients: (1) fully reimbursable, (2) net fee, (3) gross fee, and (4) class action.

For matters for which HFM has a fully reimbursable fee arrangement, clients pays an hourly or a flat fee and reimburse the firm for all advanced expenses incurred, regardless of the outcome. All other matters (net-fee, gross-fee, and class-action arrangements) operate on a contingent-fee basis. In all contingent-fee matters, clients pay a legal fee to HFM only if there was a favorable outcome; likewise clients reimburse the advanced expenses to HFM only if there is a favorable outcome. For matters for which HFM has a net-fee arrangement, clients first use the proceeds to reimburse the advanced expenses; then they pay the firm a set percentage of the remaining amount as legal fees. For matters for which HFM has a gross-fee arrangement, clients first pay the firm a set percentage of the proceeds as legal fees; then they reimburse the firm for advanced expenses out of the remaining amount. In class-action matters, clients pay legal fees and reimburse advanced expenses according to the terms of any eventual settlement or court award. The terms replicate the fee structure of either a net-fee or a gross-fee arrangement. Generally, each class member contributes an amount proportional to his or her share of the recovery. HFM handles most of its litigation matters on a contingent-fee basis.

For tax purposes, HFM capitalized some of the advanced expenses and deducted the rest. On its tax returns, HFM reported all capitalized expenses as Other current assets on Schedule L, Balance Sheets per Books. It did not report the capitalized expenses as deductions. If a previously capitalized expense was reimbursed (i.e., repaid to it by a client), HFM did not include the reimbursement in income on its tax return. If a previously deducted expense was reimbursed, HFM included the reimbursement in income on its tax return for the year the reimbursement was received. On its 2005 tax return, HFM reported a total of $675,713 of advanced expenses, of which it capitalized $73,220. A small portion of the $73,220 was attributable to matters in the fully reimbursable category. The rest of the $73,220 was attributable to matters in the net-fee category that were considered to have a high likelihood of expense reimbursement. HFM deducted the remaining $602,493 of advanced expenses. The $602,493 was attributable to matters in the gross fee, high risk & difficult category, matters in the class-action category, and matters in the net-fee category that were considered to have a low likelihood of expense reimbursement.

The IRS audited HFM's return, assessed a deficiency, and made adjustments to income based on Code Sec. 446 and Code Sec. 481. The IRS also assessed a penalty for substantial understatement of income tax. Overall, the Code Sec. 446 and Code Sec. 481 adjustments reflected the IRS's view that HFM should have treated all its advanced expenses as loans rather than as business expenses and that, therefore, HFM was entitled only to bad-debt deductions for unreimbursed expenses once cases were closed. The Code Sec. 446 adjustment disallowed HFM's deductions for advanced expenses that were incurred in 2005. The Code Sec. 481 adjustment effectively disallowed HFM's deductions for advanced expenses that were incurred in all years before 2005 by requiring HFM to include these previously deducted expenses in its 2005 income.

HFM argued that the advanced expenses for which it claimed deductions were not virtually certain of being reimbursed and that thus they were deductible as ordinary-and-necessary business expenses under Code Sec. 162(a) in the year paid. HFM claimed that its treatment of the advanced expenses did not produce undue tax benefits because, when previously deducted expenses were reimbursed, it included the reimbursed expenses in income on its tax return for the year the reimbursements were received. Additionally, HFM argued that its advanced expenses in class-action cases in particular were deductible because: (1) expense awards required court approval, and (2) there was no identifiable obligor for the advanced expenses. The IRS argued that advanced expenses are not deductible if the law firm's contingent-fee arrangements provide for reimbursement upon a favorable litigation outcome. According to the IRS, the expectation of reimbursement is irrelevant as long as the law firm has this contingent right of reimbursement.

The Tax Court held that HFM was not entitled to deduct its advanced expenses as business expenses. The advanced expenses were in the nature of loans to contingent-fee clients, and HFM was entitled only to claim a bad-debt deduction for the unreimbursed expenses of a case after the case had closed. The court also held that the change in tax treatment of HFM's advanced expenses was a change in method of accounting, and thus the IRS's Code Sec. 481 adjustment was proper. The court noted that HFM conducted preliminary investigations of clients and carefully selected the cases it would pursue. It also consistently reevaluated ongoing cases and reserved the right to withdraw if it felt it could no longer pursue a case. That it may have taken HFM a long time to recover its expenses, the court stated, was not dispositive. The relevant question, according to the court, was the possibility of reimbursement, not how long reimbursement was expected to take. The reimbursement rates for HFM's advanced expenses failed to demonstrate to the court that the possibility of reimbursement was insignificant.

With respect to HFM's argument regarding the deductibility of expenses related to class action suits, the Tax Court rejected HFM characterization that the requirement of court approval for expense awards was a barrier that lowered the probability of reimbursement. It is true, the court noted, that the attorney's fees and expenses in a class action must be approved by the court. However, it is a basic legal principle that class counsel is entitled to reimbursement of all reasonable out-of-pocket expenses of prosecuting claims and obtaining settlement and that the court will generally award such expenses to class counsel.

Finally, the Tax Court concluded that HFM qualified for the reasonable cause-and-good-faith exception to the Code Sec. 6662(a) penalty to the extent its understatement is attributable to its advanced expenses.

For a discussion of the tax treatment of expenses to which there is a right to reimbursement, see Parker Tax ¶90,120.

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IRS Denies Tax-Exempt Status to Farmer's Market

Although a farmer's market included some benefits for low-income individuals and occasional educational events, more than an insubstantial part of the activities were in furtherance of the non-exempt purpose of being a profitable outlet for local farmers and for-profit vendors and thus the market was denied tax-exempt status. PLR 201304011.

A farmer's market applied to the IRS for tax-exempt status under Code Sec. 501(c)(3). Its Articles of Incorporation stated that it was organized to (1) create a gathering spot and opportunity for social interactions for area residents; (2) be a profitable outlet for local farmers and craft vendors, and (3) provide a predictable, ample selection and variety of high quality, fresh, locally grown produce and crafts for customers.

The IRS rejected the market's request for tax-exempt status. According to the IRS, the market was similar to the organization described in Rev. Rul. 73-127. In that ruling, the IRS held that an organization that operated a cut-price retail grocery outlet and allocated a small portion of its earnings to provide on-the-job training to hard-core unemployed did not qualify for exemption from tax. The corporation was formed to operate a retail grocery store to sell food to residents of a poverty area at prices substantially lower than those charged by competing grocery stores, to provide free grocery delivery service to residents who needed it, to participate in the federal food stamp program, and to provide job training for unemployed residents. While the organization's purpose of providing job training was charitable and educational, the IRS found that its purpose of operating a retail grocery store, where food was sold to residents of a poverty area at low prices, was not recognized as a charitable purpose under the basic common law concept of charity. In Rev. Rul. 73-127, the IRS went on to say the operation of the store and the operation of the training program were two distinct purposes. Since the former purpose was not a recognized charitable purpose, the organization was not organized and operated exclusively for charitable purposes.

With respect to the request for tax-exempt status by the farm market, the IRS concluded that the farm market's operations were similar to the organization in Rev. Rul. 73-127 because the operation of the market and the operation of the food donation, as well as any education programs, were two distinct purposes. Since the operation of the farm market is the main part of the farm market's activities and is not a recognized charitable or educational purpose, the IRS concluded that the market was not eligible for tax-exempt status.

For a discussion of the tests that must be met for an organization to obtain tax-exempt status under Code Sec. 501(c)(3), see Parker Tax ¶60,510.