IRS Won't Follow Tax Court Decision on Deductibility of Forbearance Payments

Recently, a conflict erupted between the IRS and the Tax Court on the issue of whether or not payments made under a forbearance agreement are deductible. A forbearance agreement generally refers to an agreement to defer payment to a creditor. In Media Space v. Comm'r, 135 T.C. 424 (2010), a corporation entered into several consecutive forbearance agreements whereby the corporation's preferred shareholders agreed to forgo their redemption rights in exchange for payments (i.e., forbearance payments) from the corporation. The corporation deducted the payments as interest, or alternatively as business expenses, while the IRS took the position that none of the payments were deducible. The court rejected the IRS's arguments and allowed a partial deduction. On July 23, 2013, the IRS issued AOD-2012-08 in which it rejected the Tax Court's analysis and said that it would continue to pursue the positions it took against the taxpayer in Media Space.

Media Space Decision

In 2003, Media Space issued shares of preferred stock shortly after its incorporation. Media Space's charter granted its preferred shareholders redemption rights that, if exercised, triggered obligations by Media Space to pay the redemption amount. If Media Space was unable to pay the redemption amount, it was required to pay interest on the redemption amount. In 2004 and 2005, Media Space entered into several consecutive forbearance agreements whereby the preferred shareholders agreed to forgo their redemption rights in exchange for forbearance payments. The 2004 agreement covered 12 months or less. But, due to extensions, the 2005 agreement was found to cover more than 12 months.

Media Space reported the 2004 payments as interest expense and the 2005 payments as an ordinary and necessary business expense. The IRS disallowed both deductions. In the Tax Court, the IRS argued that Code Sec. 263(a) and Reg. Sec. 1.263(a)-4 required that the forbearance payments be capitalized as amounts paid to create an intangible asset. In the alternative, the IRS argued that the payments were nondeductible distributions made to shareholders with respect to their stock under Code Sec. 301, Code Sec. 162(k), and Code Sec. 361(c).

The Tax Court held that the payments were not interest and could not be deducted as interest expense. However, the court held that the forbearance payments satisfied the "ordinary and necessary" test of Code Sec. 162(a). The court also determined that Reg. Sec. 1.263(a)-4(d)(2)(i) required capitalization of the forbearance payments, but that the 12-month rule of Reg. Sec. 1.263(a)-4(f)(5) (i) removed the 2004 forbearance agreement from the purview of Reg. Sec. 1.263(a)-4(d)(2)(i).

The 12-month rule in Reg. Sec. 1.263(a)-4(f)(5)(i) provides that, unless otherwise provided, a taxpayer is not required to capitalize amounts paid to create (or to facilitate the creation of) any right or benefit for the taxpayer that does not extend beyond the earlier of (1) 12 months after the first date on which the taxpayer realizes the right or benefit, or (2) the end of the tax year following the tax year in which the payment is made. Thus, the court held that the forbearance payments relating to the 2004 agreements fell within the 12-month rule and were deductible as business expenses under Code Sec. 162.

However, the court ruled that the forbearance payments relating to the 2005 agreements did not fall within the 12-month rule, due to an extension of the agreement, and had to be capitalized under Reg. Sec. 1.263(a)-4(d)(2)(i).

The court further found that there was neither a reacquisition nor an exchange of stock to which either Code Sec. 162(k) or Code Sec. 361(c)(1) applied. The court also found that the payments were not distributions under Code Sec. 301. The IRS appealed to the Second Circuit, which subsequently dismissed the appeal after an agreement was reached between the IRS and Media Space.

In July 2013, the IRS issued AOD-2012-08, in which it formalized its disagreement with the Tax Court's findings and said it would nonacquiescence on the issues ruled on by the Tax Court.

Requirement to Capitalize Intangibles

Amounts paid or incurred to acquire an intangible from another party are generally capitalized under Reg. Sec. 1.263(a)-4(c)(1). Similarly, Reg. Sec. 1.263(a)-4(d)(2)(i) provides that a taxpayer must capitalize amounts paid or incurred to create certain intangibles, including certain financial interests. Financial interests covered by this capitalization rule include:

• an ownership interest in an entity;
• a debt instrument or other intangible treated as debt (such as a deposit, a stripped bond, a stripped coupon, or a regular interest in a REMIC or FASIT);
• a financial instrument (including a letter of credit, a credit card agreement, a notional principal contract, a foreign currency contract, a futures contract, a forward contract, an option, or any other financial derivative);
• an endowment contract, annuity contract, or insurance contract that has (or may have) cash value;
• nonfunctional currency; and
• an agreement providing either party with the right to use, possess, or sell any of the above intangibles.

Do Forbearance Payments Create a Financial Interest that Must Be Capitalized?

As noted above, a taxpayer must capitalize amounts paid to create an intangible described in Reg. Sec. 1.263(a)-4(d)(2). Stock in a corporation is among the financial interests described. The general rule requires capitalization of amounts paid to create, originate, enter into, renew or renegotiate such an interest. According to the IRS, the Tax Court correctly concluded that, as amounts paid to renegotiate a financial interest, the forbearance payments were subject to the general capitalization requirements applicable to created intangibles.

However, the IRS said the court erred in holding that the 12-month rule of Reg. Sec. 1.263(a)-4(f)(1) exempts the forbearance payments from the general capitalization requirement applicable to intangibles because the payments effected a modification rather than a creation. That rule, the IRS noted, provides that an expenditure that gives rise to a benefit that lasts no more than 12 months need not be capitalized. But the IRS noted, under Reg. Sec. 1.263(a)-4(f)(3), created financial interests are excepted from the 12-month rule. Consequently, the IRS said that the rule of capitalization should apply to the forbearance payments at issue. In the IRS's opinion, the Tax Court read the word create narrowly in Reg. Sec. 1.263(a)-4(f)(3), applying it inconsistently with the broader reading it gave the word in Reg. Sec. 1.263(a)-4(f)(1). Thus, the IRS said it will continue to litigate the issue, taking the position that payments that affect a financial interest are excepted from the 12-month rule and must be capitalized.

Observation: In Media Space, the Tax Court noted that Reg. Sec. 1.263(a)-4(f)(3) provides that the 12-month rule does not apply to amounts paid to create a Code Sec. 197 intangible or amounts paid to create an intangible described in Reg. Sec. 1.263(a)-4(d)(2). However, the court said that, while it had previously found that the terms of the investor's redemption rights were modified by the forbearance agreement, no intangible (i.e., stock) was created by the forbearance agreement. Therefore, the court concluded that Reg. Sec. 1.263(a)-4(f)(3) did not prevent the 12-month rule from applying.

Are the Forbearance Payments Like Those in Media Space Nondeductible Distributions to the Shareholders under Code Sec. 301?

In AOD-2012-08, the IRS states that, even if the forbearance payments are deductible under Reg. Sec. 1.263(a)-4(d)(2), the payments are nonetheless nondeductible distributions to the taxpayer's preferred shareholders under Code Sec. 301. According to the IRS, allowing the deduction of the forbearance payments would impermissibly allow a corporation a deduction for its payment to a shareholder of a return on the shareholder's investment. That Media Space received value for the forbearance payments, specifically the retention of equity capital, does not remove the forbearance payments from the scope of Code Sec. 301, the IRS said, because providing equity capital is a shareholders' function. The IRS concluded that compensation paid to a shareholder for providing equity capital is not deductible.

Are the Forbearance Payments Like Those in Media Space Nondeductible Distributions to the Shareholders under Code Sec. 162(k) or Code Sec. 361(c)?

In AOD-2012-08, the IRS states that forbearance payments of the type in Media Space are nondeductible distributions to the taxpayer's preferred shareholders under Code Sec. 162(k) (providing for nondeductibility of amounts paid or incurred in connection with reacquisitions of stock) and Code Sec. 361(c) (providing that a corporation a party to a reorganization in Media Space's case, a recapitalization under Code Sec. 368(a)(1)(E) does not recognize any gain or loss on its distribution to shareholders of property in pursuance of the plan of reorganization). The forbearance agreement is a significant enough modification, the IRS said, to constitute a deemed exchange of the original preferred stock for new preferred stock and money (i.e., the forbearance payments).

According to the IRS, this argument is in accord with the case law principle regarding debt, eventually drafted into Reg. Sec. 1.1001-3, that a significant modification of a debt instrument results in a deemed taxable exchange of the original debt instrument for a modified instrument. Before entering into the forbearance agreement, the preferred shareholders possessed the right at any time to force redemption and be paid in full if they, for instance, sensed that the corporation's finances might deteriorate. By entering into the forbearance agreement, however, the shareholders exchanged the right to demand redemption at any time for (1) the forbearance payment received (which is smaller than the redemption payment would be); and (2) only a postponed right to demand redemption. A right to demand redemption at any time, the IRS noted, is significantly different from a postponed right to demand redemption. The postponed right to demand redemption is less valuable because there is an additional risk that the corporation's finances will deteriorate and the corporation will be unable to pay at the postponed redemption date.

According to the IRS, where there is a deemed exchange of old preferred stock for new preferred stock, such a transaction leads to the conclusion that both Code Sec. 162(k) and Code Sec. 361(c)(1) preclude deduction of the forbearance payments.

Conclusion

While the Tax Court seems inclined to hold that forbearance payments are deductible as long as they relate to an agreement that falls within the 12-month rule, it will be interesting to see if other courts follow suit. For taxpayers, it's important that any agreement that will result in forbearance payments must not be seen as existing beyond 12 months. Otherwise, the payments must be capitalized. As the Tax Court noted, the duration of a right under an agreement includes any renewal period if all the facts and circumstances in existence during the tax year in which the right is created indicate a reasonable expectancy of renewal. Thus, if there is a reasonable expectancy of renewal or extension of a forbearance agreement that leads to an agreement of more than 12 months, the 12-month rule would not apply, and the taxpayer must capitalize the forbearance payments.

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IRS Expands Class of Taxpayers That Can Defer Advanced Payments for Gift Cards

A new revenue procedure allows a taxpayer to defer recognizing in gross income certain advance payments received from the sale of gift cards that are redeemable for goods or services by an unrelated entity. Rev. Proc. 2013-29.

Rev. Proc. 2004-34 allows taxpayers a limited deferral beyond the tax year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding tax year the inclusion in taxable income of advance payments to the extent they are not recognized in book income in the year received. Likewise, an accrual method taxpayer that receives an advance payment for goods or services must include the advance payment in gross income in the tax year of receipt to the extent recognized in revenues in the taxpayer's applicable financial statement for that tax year. For a taxpayer without an applicable financial statement, an advance payment must be included in gross income to the extent earned in the tax year of receipt. Rev. Proc. 2011-18 subsequently modified Rev. Proc. 2004-34 by allowing taxpayers to defer recognizing in gross income advance payments received from the sale of gift cards that are redeemable for goods or services of the taxpayer or a third party.

To qualify as an advance payment eligible for deferral, the payment must be recognized by the taxpayer (in whole or part) in revenues in its applicable financial statement for a subsequent tax year, or, for taxpayers without an applicable statement, the payment must be earned by the taxpayer (in whole or part) in a subsequent tax year. However, if a gift card is redeemed by an unrelated entity whose financial statement revenues are not consolidated with the taxpayer's revenues on the taxpayer's applicable financial statement, the taxpayer will never recognize any portion of the gift card sale proceeds in revenues in its applicable financial statement because that revenue is accounted for only by the unrelated redeeming entity upon the sale of goods or services. Similarly, for a taxpayer without an applicable financial statement, the payment is never earned by the taxpayer because the payment is earned by the unrelated redeeming entity.

According to the IRS, a taxpayer should not be precluded from using the deferral method of accounting solely because the taxpayer never recognizes in revenues in its applicable financial statement payments from an eligible gift card sale, or, for taxpayers without an applicable financial statement, never earns payments from an eligible gift card sale.

As a result, the IRS issued Rev. Proc. 2013-29, in which it allows taxpayers to defer recognizing in gross income certain advance payments received from the sale of gift cards that are redeemable for goods or services by an unrelated entity. The new procedure modifies the term eligible gift card to provide that an eligible gift card sale is the sale of a gift card (or gift certificate) if: (1) the taxpayer is primarily liable to the customer (or holder of the gift card) for the value of the card until redemption or expiration, and (2) the gift card is redeemable by the taxpayer or by any other entity that is legally obligated to the taxpayer to accept the gift card from a customer as payment for items that qualify for deferral in Rev. Proc. 2004-34. If a gift card is redeemable by an entity whose financial results are not included in the taxpayer's applicable financial statement, a payment will be treated as recognized by the taxpayer in revenues in its applicable financial statement to the extent the gift card is redeemed by the entity during the tax year. For a taxpayer without an applicable financial statement, if a gift card is redeemable by an entity eligible for deferral treatment under Rev. Proc. 2004-34, including an entity whose financial results are not included in the taxpayer's financial statement, a payment will be treated as earned by the taxpayer to the extent the gift card is redeemed by the entity during the tax year.

Rev. Proc. 2013-29 is effective for tax years ending on or after December 31, 2010.

For a discussion of the deferral of income from advance payments to accrual taxpayers, see Parker Tax ¶241,520.

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CPA Can't Be Sued for Incorrect Form W-2

The former employee of a CPA firm's client could not sue the CPA firm and one of its accountants for damages for the filing of a false Form W-2; damages could be obtained only from the person responsible for filing the Form W-2. Swartwout v. Edgewater Grill LLC, et al., 2013 PTC 197 (D.C. Mich. 7/12/13).

In 2010, David Swartwout worked for Edgewater Grill from May through October. As a result of receiving what he said were fraudulent W-2 statements, David filed a civil action for damages against Edgewater Grill; Blanche Klaus, the sole member of Edgewater Grill LLC; H&S Companies, P.C., a CPA firm; and Ward A. Van Dam, C.P.A., the managing partner of H&S Companies. David claimed that they submitted a fraudulent Form W-2 covering his wages for 2010 and that, when he informed them of major discrepancies in his W-2, they failed to provide a corrected copy. David's complaint also included a claim of conspiracy against H&S Companies and Van Dam for filing a materially false W-2 and aiding and abetting in the preparation of a fraudulent W-2. H&S Companies and Van Dam moved for summary judgment.

Code Sec. 7434 provides that if any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, the other person may bring a civil action for damages against the person filing the return.

David argued that H&S and Van Dam created and caused the erroneous W-2 form to be filed. Thus, the court was faced with the question of whether liability under Code Sec. 7434(a) attaches to those who assist an employer in preparing and filing information returns.

A district court held that liability for filing a false information return was limited to the person responsible for filing the return, which was David's employer. The court rejected David's claims against H&S Corporation and Van Dam. The court cited Vandenheede v. Vecchio, 2013 PTC 198 (D.C. Mich. 2013), in which a district court held that, although accountants and attorneys assist in the preparation of returns, Reg. Sec. 301.6721-1 provides that only the person required to file the information return can be held liable under Code Sec. 7434. The court noted that in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), the Supreme Court held that common law claims of secondary liability cannot be used to expand the class of persons liable for statutory violations. Because no secondary liability was implied for claims under Code Sec. 7434, H&S Corporation and Van Dam were entitled to summary judgment.

For a discussion of information return penalties, see Parker Tax ¶262,130.

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Failure to Designate Parsonage Allowance Precludes Deduction; Penalties Upheld

Because a minister did not establish that the amounts at issue were properly designated as a rental allowance by official church action before payment, he was not entitled to a parsonage allowance. Williams v. Comm'r, T.C. Summary 2013-60 (7/22/13).

Ricky Williams is an ordained minister with a master's in divinity. He began working as a pastor for the St. John Missionary Baptist Church in September 2005. Under the employment agreement, Ricky received a starting salary of $80,000 per year. The agreement specified that the church would provide Ricky with a $500 housing allowance for six months from the date he signed the agreement. That six-month period could be extended with a majority vote of approval of the church's Deacon Ministry. The agreement was otherwise silent with respect to a housing allowance.

Ricky filed a joint federal income tax return with his wife for 2007. The couple reported Mrs. Williams' income from the Young Men's Christian Association as wages on their return. St. John's church paid Ricky as a contract worker. Consistent with this, Ricky reported his income on Schedule C. The couple reported approximately $85,000 in gross receipts on the Schedule C and deducted approximately $82,000 in expenses.

The IRS issued a notice of deficiency for the couple's 2007 tax return. The IRS determined that the couple had unreported Schedule C gross receipts or sales of approximately $18,000 and disallowed the following deductions for lack of substantiation: (1) Schedule C deductions of approximately $30,000 for business use of home, $14,500 for supplies, and $13,700 for car and truck expenses and (2) Schedule A deductions of approximately $2,300 for cash contributions. The notice of deficiency assessed an accuracy-related penalty of almost $5,000.

The couple filed a Tax Court petition, asserting that they had supporting documentation for the amounts reported on their 2007 return. At some point, they submitted to the IRS an amended Schedule C, which included a deduction of more than $33,000 for returns and allowances. Before the Tax Court, the couple did not dispute the adjustments in the notice of deficiency but instead asserted that the $33,000 they had claimed as returns and allowances on the amended Schedule C was a parsonage allowance.

Code Sec. 107(2) provides that the gross income of a minister does not include the rental allowance paid to him as part of his compensation, to the extent used by the minister to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities. As a prerequisite for this exclusion, the taxpayer must establish that there was a designation of the rental allowance pursuant to official church action before payment.

The IRS argued that the claimed parsonage allowances were not properly designated and, thus, the $33,000 was not deductible from income.

The employment agreement that Ricky entered into with St. John's in September 2005 provided that the church would assist Ricky with a $500 per month housing allowance for six months from the date he signed the agreement but did not designate any other amount as a rental allowance.

Ricky did not assert that the six-month period was extended. Instead Ricky provided a purported second employment agreement at trial. Although the second employment agreement was dated 2005, it was signed by Ricky and the church in 2012. Before the Tax Court, Ricky argued that the second agreement was intended to clarify the original employment agreement because the original agreement was a generic type layout contract between Ricky and the church in which certain issues had not been defined. The second employment agreement discussed a parsonage allowance and provided that such an allowance would include costs associated with facilitating proper living facilities, including utilities and maintenance.

The Tax Court held that Ricky was not entitled to exclude $33,000 from income as a parsonage allowance because his original employment agreement did not designate a rental allowance, and the second employment agreement was executed in 2012 and therefore could not designate a rental allowance for 2007. The court also held that the couple was liable for the accuracy-related penalty.

For a discussion of parsonage rental allowances, see Parker Tax ¶76,310.

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Real Estate Agent's Remax Fee Deductible as Professional Expense

A Remax sales agent could deduct the monthly fee she paid to Remax to maintain her affiliation with the real estate firm; but unsubstantiated vehicle expenses and loss deductions relating to her real estate activity were disallowed, and penalties were imposed. Hardnett v. Comm'r, T.C. Summary 2013-56 (7/15/13).

Toraino Hardnett and Marvell Preston-Hardnett timely filed a joint Form 1040 for 2008. Toraino worked as a police officer. Marvell was a real estate agent who worked as an independent contractor for Remax Hometown, Inc. Marvel operated a sole proprietorship, JM Partners Realty. The business reported receipts of $11,100; various expenses, including $4,725 of professional fees paid to Remax and $10,300 for vehicle expenses; and a net loss of $9,480. Marvell, a licensed real estate agent, claimed that Remax required its sales agents to pay a monthly fee of $350 to maintain an affiliation with the firm. She had monthly statements from Remax showing that she paid $4,800 to the firm in 2008. The statements listed the balance due each month and the date and amount of each payment, but did not describe the nature or source of the charges. The statements showed that Remax routinely charged Marvell's credit card account each month for January through September and December in 2008. However, her October and November statements varied in both the amount and timing of the charges. On Schedule C, Marvell reported that she drove 20,450 miles while conducting real estate sales and supervising work on an investment property. She provided no records to support the reported vehicles expenses and instead used the optional standard mileage rate to compute the expenses.

Toraino and Marvell also attached to their return a Schedule E, Supplemental Income or Loss, for a residential property they bought as an investment in 2007. The couple reported that they received no rents for the property, but incurred expenses for insurance, management fees, mortgage interest, repairs, and supplies. As a result, they claimed a rental real estate loss of $25,000 on Schedule E and Form 8582, Passive Activity Loss Limitations. Although the couple had some receipts for hardware and plumbing supplies, they did not have invoices, receipts, or canceled checks to substantiate the insurance, management fees, repairs, and most of the supplies expenses. The couple's return was prepared by a paid tax return preparer. The preparer did not review the return with the couple, nor did the couple review their return for accuracy before signing and filing it. The IRS selected the couple's 2008 return for audit and issued a notice of deficiency disallowing the claimed business expense deductions for the professional fees, vehicle expenses, and the $25,000 rental real estate loss.

Code Sec. 162 generally allows a deduction for ordinary and necessary expenses paid during the tax year in carrying on a trade or business. No deduction is allowed for personal, living, or family expenses. Code Sec. 274 provides substantiation requirements before a taxpayer may deduct certain categories of expenses, including expenses related to the use of listed property. To satisfy the substantiation requirements, a taxpayer must generally maintain records and documents that are sufficient to establish the amount, date, and business purpose of the expense or business use of the listed property.

Observation: No deduction is allowed for an expense for any listed property unless the taxpayer can substantiate each element of the expense or use.

The IRS asserted that Marvell failed to prove that the charges listed on the Remax statements were professional fees because the statements did not describe the nature and source of the charges at issue.

Based on Marvell's credible testimony that she paid Remax monthly fees to maintain her affiliation with the firm and supporting Remax statements for 10 months in 2008, the Tax Court held that Toraino and Marvell could deduct $3,500 for the professional fees paid to Remax. The court disallowed the couple's claimed deductions for vehicle expenses since they failed to satisfy the substantiation requirements imposed by Code Sec. 274. The court rejected Marvell's claim that she maintained a notebook in which she contemporaneously recorded the mileage she drove for business purposes after she conceded that some of the notebook entries had been altered. The couple was also denied the loss deduction claim relating to the real estate property they purchased but did not rent during the year in issue. Marvell failed to show that she materially participated in supervising work on the investment property, did not produce any records to substantiate the claimed expenses and was unable to approximate the number of hours she spent with respect to her activities with the investment property.

Finally, the court imposed the accuracy-related penalty. Although Toraino and Marvell relied on a paid tax preparer, they provided no evidence regarding the preparer's experience or qualifications to show that they reasonably relied on him. The return was not reviewed by the preparer with the couple, nor did Toraino and Marvell review the return on their own. They did not provide necessary and accurate information to their return preparer; therefore, the court concluded that the couple did not act with reasonable cause and in good faith.

For a discussion of the substantiation requirements for business expenses, see Parker Tax ¶91,130.

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Mitigation Provisions Don't Apply to Allow Taxpayers' NOL Carryforwards/Carrybacks

A couple's claims for refunds based on net operating loss carryforwards and carrybacks were dismissed because the refund claims were untimely and the mitigation provisions did not apply to extend the statute of limitations for filing the refund claims. Hall v. U.S., 2013 PTC 201 (Fed. Cl. 7/12/13).

Raleigh Hall and Margaret Hall were the sole shareholders of R.W. Hall General Contractors, Inc., an S corporation. In 2007, they filed amended returns and sought to apply several years of accumulated net operating losses (NOLs) from years 1988 through 2001 forward to reduce their 2003 taxable income. The IRS denied their refund claim and the couple filed suit in 2010. The IRS told the Halls that when deducting the NOLs, the couple was required to apply the losses first as a carryback unless a timely waiver was elected. In finding that Raleigh and Margaret did not timely elect to waive the carryback periods for the NOLs, a court granted an IRS motion for summary judgment and dismissed the couple's complaint. In 2011, Raleigh and Margaret filed new refund claims for 1992, 1995 and 1997.

After those claims were denied, the couple filed suit and maintained they were entitled to refunds under the statute of limitations mitigation provisions of Code Sec. 1311 through Code Sec. 1314. The IRS asked the court to dismiss the complaint.

Under Code Sec. 6511(a), the statute of limitations for filing a tax refund claim is the later of (1) three years from the time the return is filed, or (2) two years from the time the tax was paid. For net operating loss carrybacks, Code Sec. 6511(d)(2)(A) provides that a refund claim must be filed within three years of the date on which the return was due to be filed, including extensions, for the tax year of the NOL that resulted in the carryback.

The IRS argued that the 1997 NOL carrybacks were time-barred because the refund was claimed more than six years after the return for the year at issue was required to be filed. The 1992 and 1995 NOL carryforwards, the IRS said, were time-barred because the refund claims were filed more than three years from the date the returns were required to be filed.

The Court of Federal Claims held that Raleigh and Margaret's claims for refund based on the NOL carryforwards and carryback were time-barred because they were filed after the applicable statute of limitations period had expired. The court noted that, for the mitigation provisions to apply, three threshold requirements must be met: (1) There must be a determination; (2) the determination must fall within one of the circumstances of adjustment in Code Sec. 1312(1) through (7); and (3) either an inconsistent position must have been maintained by the party against whom the mitigation will operate, or the correction of the error must not have been barred at the time the party for whom mitigation will operate first maintained its position. The court agreed that a final determination was made in the couple's 2010 suit, and the first requirement was met. However, in rejecting the couple's argument that their inability to carry back the NOLs operated as a double tax to engage the mitigation provisions, the court found that there was no circumstance of adjustment, and the couple first maintained their position regarding the NOLs after the 1992, 1995 and 1997 tax years were closed. Therefore, the couple did not meet all three requirements of the mitigation provisions and were not eligible to reopen the statute of limitations.

For a discussion of the statute of limitations period for net operating loss carrybacks, see Parker Tax ¶261,180.

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Taxpayer Had No Exclusion Ratio and Thus Could Not Exclude Any of His Pension from Income

A court rejected a taxpayer's argument that pre-tax contributions made by his employer to a qualified plan satisfied the "exclusion rule" of Code Sec. 401, and thus exempted such payments from federal income tax. Blue v. U.S., 2013 PTC 209 (Fed. Cl. 7/22/13).

From 1973 to 1998, Gregory Blue worked for King Kullen Grocery Co., Inc., as an inventory control checker. During this time, Gregory was a member of a union, the Local 282 of the International Brotherhood of Teamsters. The union administered a pension trust fund that required Gregory's employer to make weekly contributions on behalf of the union employees, including Gregory.

In 2007, Gregory began receiving monthly pension payments. The gross amount of his first pension payment was $1,613 and federal taxes of $68 were withheld. Shortly thereafter, Gregory filed Form W-4P, Withholding Certificate for Pension or Annuity Payment, with the union. Gregory indicated on the form that he did not want any federal income tax withheld from future pension payments. The Pension Trust Fund manager responded and explained that, if not enough tax was withheld from Gregory's benefits, he might have to pay estimated taxes during the year, or a tax penalty at the end of the year. Thereafter, for the rest of 2007, the Pension Trust Fund reported federal tax withholding as $0 per month. Subsequently, Gregory was provided with a 2007 Form 1099-R, which reported pension income in the amount of $19,365. Line 2a stated that $19,365 of that amount was taxable income. On his 2008 Form 1040, on Line l2a, Gregory reported $19,365 in pension payments, for which he claimed $0 as taxable on Line 12b. Gregory's employer reported that the amounts were taxable to Gregory. After an audit, the IRS assessed tax deficiencies.

Gregory and the IRS exchanged a series of letters regarding the tax assessment, but no agreement was reached. Gregory paid the deficiency and filed suit in Tax Court, seeking a refund of the $2,847 paid. The Tax Court dismissed Gregory's suit because the suit was filed 575 days after the IRS notice regarding the deficiency and beyond the 90-day limitations period for filing such claims. On March 23, 2012, Gregory filed suit in the Court of Federal Claims seeking a refund of $2,847 plus interest paid for the alleged overpayment of 2007 taxes.

Although Gregory recognized that pension income generally is taxable, Gregory argued that his pension payments qualified for exclusion. Gregory maintained that the pre-tax contributions made by his employer to the Pension Trust Fund satisfied an "exclusion rule" under Code Sec. 401, exempting such payments from federal income tax.

The IRS argued that Gregory's 2007 pension income was subject to federal income tax as gross income, unless it previously was taxed. The IRS cited Code Sec. 402, which provides that payments distributed from a Code Sec. 401 qualified employer plan are taxable to the distributee, in the tax year of the distributee in which distributed under Code Sec. 72. According to the IRS, Gregory was mistakenly maintaining that he was entitled to an exemption under the "general rule of exclusion income." Under that rule, an employer's contribution is nontaxable at the time it is made to a qualified plan. The amount of a distribution that may be excluded from income is calculated using the exclusion ratio under Code Sec. 72. In Gregory's case, the union allowed only employers to contribute to the Pension Trust Fund, not employees. Since Gregory never contributed to the Pension Trust Fund, his exclusion ratio was zero. Therefore, the IRS said, Gregory's receipt of 2007 pension income was taxable.

The Court of Federal Claims held that Gregory's pension was not excludible from income and that Gregory was liable for tax on his pension income. The Pension Trust Fund, the court noted, was qualified as an employer plan under Code Sec. 401(a). As such, all income received by Gregory under the Pension Trust Fund, either as a pension or annuity, is includible in his gross income and subject to ordinary federal income tax, unless that income previously was taxed or otherwise is exempt. The "exclusion ratio," the court noted, is the percentage amount that a taxpayer has invested in a pension or annuity. Since Gregory invested nothing, the exclusion ratio did not apply. Gregory elected, on Form W-4P, to opt out of withholding federal taxes from his monthly payments. However, the court noted, this only affected his monthly withholding, not the federal income tax due. The exclusion from income for annuities under Code Sec. 72(b) provides that gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract that bears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date). Gregory had no investment and, therefore, his exclusion ratio was zero.

For a discussion of the tax treatment of distributions from qualified plans, see Parker Tax ¶131,515. For a discussion of the exclusion ratio, see Parker Tax ¶71,915.