Parker's Federal Tax Bulletin - Issue 12 - June 8, 2012

Federal Circuit Invalidates Section 263A Avoided-Cost Reg Because It Leads to "Absurd" Results

In determining the amount of interest required to be capitalized under the uniform capitalization rules of Code Sec. 263A, Congress implemented an avoided-cost rule under Code Sec. 263A(f)(2). The general formula for determining interest that must be capitalized is the amount of production expenditures multiplied by the weighted-average interest rate on the debt during the time the production occurs. In other words, the production expenditures represent the base amount and some fraction of that amount represents the interest that must be capitalized. A larger base will lead to more interest capitalized.

In Dominion Resources, Inc. v. U.S., 2012 PTC 141 (Fed. Cir. 5/31/12), the Federal Circuit, in an issue of first impression, examined the regulation behind that rule. It declared that Reg. Sec. 1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service in order to make improvements, is not a reasonable interpretation of Code Sec. 263A because it unreasonably links the interest capitalized when making an improvement to the property's adjusted basis. The court concluded that the relevant statute that the regulation was interpreting was circular and the regulation itself was "absurd" and invalid.

Facts

Dominion Resources, Inc., provides electric power and natural gas to individuals and businesses. In 1996, it replaced coal burners in two of its plants. When making those improvements, it temporarily removed the units from service one unit for two months, the other for three months. During that time, Dominion incurred interest on debt unrelated to the improvements.

On its corporate tax returns, Dominion deducted some of that interest from its taxable income. The IRS disagreed with Dominion's computation under Reg. Sec. 1.263A-11(e)(1)(ii)(B). The IRS applied the regulation to capitalize $3.3 million of that interest. Under a settlement agreement, the IRS allowed Dominion to deduct 50 percent and capitalize 50 percent of the disputed amount.

Still asserting that the entire disputed amount was deductible, Dominion filed suit seeking a refund of $297,699 in corporate income tax. Dominion sought to invalidate Reg. Sec. 1.263A-11(e)(1)(ii)(B), which provides that a portion of interest expense relating to production expenditures must be capitalized. The Court of Federal Claims denied Dominion's claim and granted summary judgment to the United States. That court held that the regulation was a permissible construction of Code Sec. 263A and that the IRS issued the regulation with a reasoned explanation that satisfied the applicable standard. Dominion appealed to the Federal Circuit Court of Appeals.

Before the Federal Circuit, Dominion and the IRS agreed that a certain amount of construction-period interest should be capitalized instead of deducted, but could not agree on the extent of that capitalization requirement. They agreed that under Reg. Sec. 1.263A-11(e), production expenditures are defined to include not only the amount spent on the improvement, but also the adjusted basis of the entire unit being improved. The issue on appeal was whether that latter inclusion of the adjusted basis of the unit violates various statutory provisions. Because the regulation requires a larger base amount (by including the adjusted basis amount), it results in a larger amount of interest to be capitalized. Thus, the practical impact of the rule is that it determines how much interest Dominion is required to capitalize instead of deduct from its taxable income as a result of burner improvements in its power plants.

Interest Required to be Capitalized under Reg. Sec. 1.263A-11(e)

Reg. Sec. 1.263A-11(e) defines what constitutes production expenditures (the base amount) and therefore determines the amount of interest capitalized under Code Sec. 263A. The general rule of Reg. Sec. 1.263A-11(e)(1) provides that, if an improvement constitutes the production of designated property under Reg. Sec. 1.263A8(d)(3), accumulated production expenditures with respect to the improvement consist of (1) all direct and indirect costs required to be capitalized with respect to the improvement, and (2) in the case of an improvement to a unit of real property (a) an allocable portion of the cost of land, and (b) for any measurement period, the adjusted basis of any existing structure, common feature, or other property that is not placed in service or must be temporarily withdrawn from service to complete the improvement (associated property) during any part of the measurement period if the associated property directly benefits the property being improved, the associated property directly benefits from the improvement, or the improvement was incurred by reason of the associated property.

Statute on Interest Capitalization Is Circular

The Federal Circuit noted that the relevant statutory provisions in Code Sec. 263A relating to interest capitalization comprise five subsections: Code Sec. 263A(a)(1), Code Sec. 263A(a)(2), Code Sec. 263A(f)(1), Code Sec. 263A(f)(2), and Code Sec. 263A(f)(4)(C). Each subsection refers to the next. A careful reading of the five subsections, the court noted, shows that each rule or definition refers to another rule or definition in a circular progression that brings the law back to the place it began with little elucidation of legal standards and definitions. In simple words, the court observed, the statute is circular.

Court Applies Chevron Analysis to Find Regulation Invalid

The Federal Circuit noted that the challenge to Reg. Sec. 1.263A-11(e) was only as applied to property temporarily withdrawn from service and not as applied to property that is not placed in service. Citing the Supreme Court's decision in Chevron, U.S.A., Inc. v. NRDC, 467 U.S. 837 (1984), the Federal Circuit said that the validity of a Treasury regulation is analyzed under the Chevron two-step test. First, step one determines whether Congress has directly spoken to the precise question at issue. If the statute is silent or ambiguous, then step two determines whether the agency's answer is based on a permissible construction of the statute.

As to Chevron step one, the Federal Circuit said that the lower court correctly recognized that the regulation does not contradict the text of the statute, but only because the statute is opaque. Code Sec. 263A(f)(2) states the amount of interest to be capitalized is that amount that could have been reduced if production expenditures had not been incurred. Then Code Sec. 263A(f)(4)(C) defines production expenditures as the amount required according to the general rules. Regardless of the definition of production expenditures, the Federal Circuit stated, the statute provides or assumes that sum would have been available to pay down the debt. Because the conclusion is assumed in the premises, the court concluded that the statute is circular. Thus, at Chevron step one, the Federal Circuit determined that the statute is ambiguous.

As to Chevron step two, the court found that Reg. Sec. 1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service, was not a reasonable interpretation of the avoided-cost rule set out in Code Sec. 263A(f)(2)(A)(ii). Specifically, the court concluded that the regulation was unreasonable in defining production expenditures to include the adjusted basis of the entire unit. According to the court, the regulation directly contradicts the avoided-cost rule that Congress intended the statute to implement. The avoided-cost rule recognizes that if the improvement had not been made, those funds (an amount X equal to the cost of the improvement) could have been used to pay down the debt and therefore reduce interest that accrued on the debt. Because the improvement was made, however, that amount X was not used to pay down the debt; therefore, interest accrued on that amount X.

To determine the accrued interest resulting from making the improvement instead of paying down the debt, the court said, one would multiply the interest rate by the amount X paid for the improvement. According to the court, one would not multiply the interest rate by the amount X paid for the improvement plus the adjusted basis of the entire unit. An amount equal to the adjusted basis of the unit would not have been available to pay down the debt had the improvement not been made. Those funds were expended at the time the property was acquired (before the decision to make the improvement) and are not made available to pay down debt by forgoing the improvement. The court used the following example to illustrate its point.

Example: An owner bought real property for $100,000 using a loan with a 3 percent interest rate. A few years later, the owner makes an improvement that costs $5,000. If the owner had used that $5,000 toward the debt instead of the improvement, the owner would have avoided accruing $150 in interest ($5,000 multiplied by 3 percent). The avoided-cost rule requires the owner to capitalize that $150 in interest. Reg. Sec. 1.263A-11(e)(1)(ii)(B), however, requires the owner to capitalize $3,150 in interest (($100,000 + $5,000) 3 percent).

The result in the above example, the court said, makes no sense, because there is no way that the owner could have avoided accruing $3,150 in interest by not making the improvement, as she did not expend or incur an amount equal to $105,000 when making the improvement.

The Federal Circuit noted that the House and Senate reports clarified the meaning of the statute and said that the regulation must implement the avoided-cost principle in particular that the interest to be capitalized is the amount that could have been avoided if funds had not been expended for construction. The adjusted basis, the court noted, does not represent such an avoided amount because a property owner does not expend funds in an amount equal to the adjusted basis when making the improvement. Instead, the owner expends funds in an amount equal to the cost of the improvement itself.

Indeed, the court observed, the statute uses the term production expenditures, the plain meaning of which is an amount actually expended or spent specifically, expended or spent on the improvement. Similarly, the statute states that the interest to be capitalized is an amount that could have been reduced if production expenditures had not been incurred. According to the court, a property owner would not expend or incur an amount equal to the adjusted basis when making the improvement. Thus, the regulation unreasonably links the interest capitalized when making an improvement to the adjusted basis.

Further, the court observed, the regulation leads to absurd results. Because the adjusted basis amount can have almost no relation to the improvement cost amount, the regulation can require capitalizing vastly different amounts of interest for the same improvements. In the instant case, Dominion's two improvements had similar costs of $5.3 million and $6.7 million. Yet, because the adjusted bases of the two units were drastically different, the regulations lead to production expenditures of $15 million and $138 million, respectively. The Federal Circuit concluded that there was no reasonable basis for requiring such wildly disproportionate results for similar improvements and the law did not intend such an absurd result.

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Court Rejects IRS Attempts to Transform Trust Beneficiaries into Transferees Liable for Estate Tax

When an estate defaulted on almost $2 million of estate tax liability, the IRS went after the beneficiaries of a trust that had received distributions from the estate. In U.S. v. Johnson, 2012 PTC 131 (D. Utah 5/23/12), the IRS used multiple arguments in an attempt to transform the beneficiaries of the trust into transferees liable for the estate tax under the provisions of Code Sec. 6324(a)(2). In a very taxpayer-favorable and well reasoned decision, a Utah district court rebuffed the IRS and held that, while the trustees of the trust might be liable, the trust beneficiaries were not.

Facts

Anna Smith died testate on September 2, 1991. She was survived by her four children, whom she named as her heirs. Before her death, Anna executed a will and established the Anna Smith Family Trust. Two of her children, Mary Johnson and James Smith, were named as the personal representatives of the Anna's estate and were also the trustees of the Anna Smith Trust. Read more...

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Increase in IRS Notices Leads to Loss in Productivity; Practitioners Need to Address Phenomenon in Engagement Letters

As most practitioners have noticed, there has been a significant increase in IRS notices. These are the result of increased IRS efforts focused on areas the IRS considers to be at high risk for inaccurate reporting, especially Forms 1099 and Form 1040 Schedules A, C, or E. At the same time, there has been a decrease in the ability to reach an IRS person that can effectively deal with inaccurate notices.

In 2011, the Internal Revenue Service Advisory Council (IRSAC), a federal advisory committee composed of members of the public, sounded the alarm in an annual report in which it stated:

Limited resources are forcing the IRS to continually streamline its services. An example of this approach is the limited ability of taxpayers to interface with a local IRS representative when responding to a notice, when seeking resolution of an issue, or during the process of tax collection or the processing of offers in compromise. Instead, taxpayers and representatives often encounter numerous erroneous notices and lengthy holding periods on the telephone followed by a non-discretionary approach that sometimes fails to comprehend the unique issues involved. Every taxpayer is not alike and the need for face-to-face interaction should not be overlooked or ignored in favor of budgetary concerns. . . .

In addition, before the AICPA Tax Conference in Washington, D.C. last November, IRS Commissioner Douglas H. Shulman noted that the IRS has begun sending letters to return preparers whose clients' returns contain traits commonly associated with highly questionable earned income tax credit (EITC) claims. In addition, the IRS intends to conduct in-person visits with EITC return preparers to discuss due diligence requirements, and will be assessing penalties against those who are found to be noncompliant.

As Tom Hood, Executive Director of the Maryland Association of CPAs, recently explained at a MACPA conference, what this means for practitioners is a loss of productivity resulting from time spent responding to these notices and in-person visits. Many of these notices and visits are no more than fishing expeditions, he says. But the time and effort it takes on the part of the practitioner to deal with these inquiries can significantly impact the practitioner's bottom line.

As a result, practitioners need to be proactive and explain to their clients ahead of time about the phenomena of increased IRS notices. Practitioners should explain that if there is an error on their part, they will fix it for free. But otherwise, the practitioner needs to charge the client for the time spent responding to such notices. And, as Tom Hood recommends, this should be clearly spelled out in the engagement letter.

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Prop. Regs Would Tighten Rules as to When a Substantial Risk of Forfeiture Exists

Under proposed regulations under Code Sec. 83, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered. REG-141075-09 (5/30/12).

Code Sec. 83(a) provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of the property (determined without regard to lapse restrictions) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, is included in the gross income of the service provider in the first tax year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture.

Code Sec. 83(c)(1) provides that the rights of a person in property are subject to a substantial risk of forfeiture if that person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual. Reg. Sec. 1.83-3(c)(1) provides that, whether or not a risk of forfeiture is substantial depends on the facts and circumstances. Reg. Sec. 1.83-3(c)(1) further provides that a substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon (1) the future performance (or refraining from performance) of substantial services by any person, or (2) the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if the condition is not satisfied.

According to the IRS, in addition to providing that a person's rights in property are subject to a substantial risk of forfeiture if conditioned upon the future performance of substantial services by any individual, the legislative history of Code Sec. 83 indicates that the drafters intended that in other cases the question of whether there is a substantial risk of forfeiture depends upon the facts and circumstances. The current regulations, the IRS said, adopt this approach by finding that a substantial risk of forfeiture may also arise if the rights to the property are subject to a condition related to the purpose of the transfer.

According to the IRS, some confusion has arisen as to whether other conditions may also give rise to a substantial risk of forfeiture. As a result, the IRS has issued proposed regulations that would clarify that a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer. The IRS also said that confusion has arisen as to whether, in determining whether a substantial risk of forfeiture exists, the likelihood that a condition related to the purpose of the transfer will occur must be considered. According to the IRS, a conclusion that such likelihood need not be considered would lead to anomalies not intended by the statute. For example, assume that stock transferred by an employer to an employee was made nontransferable and also subject to a condition that the stock be forfeited if the gross receipts of the employer falls by 90 percent over the next three years. Assume further that the employer is a longstanding seller of a product and that there is no indication that either there will be a fall in demand for the product or an inability of the employer to sell the product, so that it is extremely unlikely that the forfeiture condition will occur. Although, arguably, the condition is a condition related to the purpose of the transfer because it would, to some degree, give the employee incentive to prevent such a fall in gross receipts, the IRS does not believe that such a condition was intended to defer the tax on the stock transfer. Accordingly, the proposed regulations would clarify that, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered.

Finally, the proposed regulations would clarify that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.83-3(j) and (k), transfer restrictions do not create a substantial risk of forfeiture, including transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated. According to the IRS, this position is supported by the legislative history of Code Sec. 83. The IRS stated that the legislative history shows that Congress intended for Code Sec. 83 to be interpreted in such a way that precludes the use of transfer restrictions as a means of deferring the taxable event.

These regulations under Code Sec. 83 are proposed to apply as of January 1, 2013, and would apply to property transferred on or after that date. Taxpayers may rely on the proposed regulations for property transferred after May 30, 2012.

For a discussion of what constitutes a substantial risk of forfeiture under Code Sec. 83, see Parker Tax ¶124,515.

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Since Taxpayer Met Nonpayment Testing Period in 1999, He Didn't Recognize COD Income in 2008 on Subsequent Collection Attempts

Because the taxpayer defaulted on his credit card account in 1994, and the credit card company charged off the debt in 1996, the 36-month nonpayment testing period expired in 1999 and he could not have had COD income in 2008; the issuance of a 1099-C for 2008 was irrelevant. Stewart v. Comm'r, T.C. Summary 2012-46 (5/21/12).

On October 22, 1994, David Stewart incurred a credit card obligation to Maryland Bank National Association (MBNA). David defaulted on his obligation to MBNA sometime between October 22, 1994, and September 6, 1996. David made no payments on the debt after the default. MBNA charged off the debt on September 12, 1996. At some point between September 12, 1996, and December 28, 2007, NCO Portfolio Management, Inc. (NCO), acquired David's defaulted account from MBNA. On December 28, 2007, Portfolio Recovery Associates, LLC (PRA), acquired David's defaulted account from NCO. Although aware that a state statute of limitations period for beginning collection activity in regard to the debt had expired on February 15, 2001, PRA began making automated attempts to collect payments from David.

In 2008, PRA received a letter from David that demanded PRA cease its automated collection activities. Once PRA received the 2008 letter, the company stopped its automated attempts at collection and took no other collection-related action. PRA subsequently issued to David a Form 1099-C, Cancellation of Debt, which reported $8,571 in COD income for the 2008 tax year. David timely filed a joint federal income tax return for 2008 but did not include the purported COD income on the return.

In a notice of deficiency, the IRS increased David's income by the amount reported on the Form 1099-C. David contested the deficiency, contending that the indebtedness at issue was actually discharged long before 2008. In response, the IRS provided account reports from PRA, which included the date PRA acquired David's defaulted account, the original account balance received by PRA, and a timeline of PRA's automated collection activity.

The Tax Court held that David did not recognize COD income in 2008. The court noted that the question as to the year for which a taxpayer realizes COD income is one of fact to be determined based on the evidence. Determining when that moment occurs, the court observed, requires a practical assessment of the facts and circumstances with respect to the likelihood of repayment. There can be a series of identifiable event, the court stated, and any identifiable event that fixes the loss with certainty may be considered.

The court looked to its decision in Kleber v. Comm'r, T.C. Memo. 2011-233, in which it concluded that a rebuttable presumption arises that an identifiable event occurred in a calendar year if, during a testing period ending at the close of that year, the creditor has received no payments from the debtor. The testing period for this rebuttable presumption is generally 36 months. The presumption that an identifiable event has occurred upon expiration of the 36-month nonpayment testing period may be rebutted in two specific ways. First, the presumption may be rebutted if the creditor (or a third-party collection agency on behalf of the creditor) has engaged in significant, bona fide collection activity at any time during the 12-month period ending at the close of the calendar year. According to the Tax Court, ministerial collection action, such as automated mailing, does not constitute significant, bona fide collection activity for purposes of rebutting the presumption that an identifiable event has occurred. Second, the presumption may be rebutted if facts and circumstances existing as of January 31 of the calendar year following expiration of the 36-month period indicate that the indebtedness has not been discharged. Citing Reg. Sec. 1.6050P-1(b)(2)(iv), the court noted that those facts and circumstances include the sale or packaging for sale of the indebtedness by the creditor.

The court was not persuaded that the decision by PRA to cease its automated collection activity and issue a Form 1099-C in 2008 was the first identifiable event indicating that David's debt would never have to be repaid. Since David defaulted on his credit card account sometime after October 22, 1994, and MBNA charged off the debt on September 12, 1996, and David made no payments on the defaulted account after the charge-off, the Tax Court found that the 36-month nonpayment testing period expired in 1999. Accordingly, a rebuttable presumption existed that an identifiable event indicating that the debt was discharged occurred in that year. The court found no evidence that MBNA, NCO, or PRA engaged in significant, bona fide collection activity at any time after MBNA charged off David's debt in 1996. Although PRA engaged in automated collection activity for approximately two months after the company acquired David's defaulted account, the court concluded that these ministerial actions did not constitute significant, bona fide collection.

Finally, the court noted that while the issuance of Form 1099-C is indeed an identifiable event, it is not dispositive of a discharged debt.

For a discussion of whether a debt has been discharged and the correct year of discharge, see Parker Tax ¶72,310.

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Part of Truck Driver's Business Expenses Allowed; Reliance on CPA's Inaccurate Worksheets Provided Reasonable Cause for Avoiding Penalties

A truck driver could deduct certain employee business expenses, including clothing and gravel for his driveway; his reliance on CPA-provided worksheets was reasonable, and thus penalties did not apply. Nolder v. Comm'r, T.C. Summary 2012-50 (5/29/12).

During 2007 and 2008, Thomas Nolder was an over-the-road truck driver. As such, he lived in the cab of his truck while away from home. He used the services of a tax preparer, John Devine, to prepare his returns for the years at issue, as well as prior years. Mr. Devine provided Tom with preprinted worksheets entitled, Trucker's Deductible Business Expenses, which listed various items and also included blank lines for him to complete. Mr. Devine told Tom that he did not need to retain receipts for any items under $75. The worksheets also included the statement, Over 30 Years experience in Trucker Taxation. The IRS examined Tom's tax returns for 2007 and 2008 and, for each year, disallowed a portion of the claimed employee business expense deduction.

In 2010, the IRS issued a notice of deficiency disallowing unreimbursed employee expense deductions of $6,939 for 2007 and $9,544 for 2008. The IRS also assessed accuracy-related penalties due to lack of substantiation for deductions taken.

While upholding the disallowance of some of the deductions, the Tax Court concluded that Tom was allowed to deduct a portion of the disallowed expenses. Tom could not deduct his cell phone expenses because his employer had a reimbursement policy in place that would have reimbursed Tom $45 per month for such expenses. Tom did not seek reimbursement because he was unaware of the policy. As the court noted, no deduction is allowed for such expenses where the taxpayer receives reimbursement for such expenses or had a right to obtain reimbursement for such expenses. The court also disallowed the remaining cell phone expenses over the employer-allowed reimbursement amount due to lack of substantiation.

With respect to Tom's clothing deduction, the court allowed deductions for purchases of specialized clothing and safety equipment. These included coveralls, insulated coveralls, lightweight coveralls, a hard hat liner, rain gear, safety glasses, steel-toed boots, winter work boots, and work gloves. Other deductions relating to clothing that could be used for general or personal purposes were disallowed.

The court allowed Tom's $25 monthly expense for parking his trailer and also allowed expenses incurred for putting gravel in his driveway to accommodate the cab of his truck. Because Tom parked his cab in the driveway, the driveway deteriorated and became muddy. The gravel, the court noted, slowed the rate of deterioration and also allowed Tom to continue to use the driveway to park his cab. Thus, the court concluded, the gravel was in the nature of a repair, and its cost was deductible as a business expense. However, the court disallowed expenses Tom paid to clean his cab and expenses incurred for identity theft insurance, saying such expenses were personal in nature.

Finally, with respect to the accuracy-related penalties, the court held that Tom exercised ordinary business care and prudence as to the disputed items. Despite the inclusion of personal items on the worksheet and the inaccurate advice of the preparer advising him that he need not retain any receipts for items under $75, the court concluded that Tom reasonably relied on his preparer and was not liable for the penalties.

For a discussion of the deductibility of unreimbursed employee expenses, see Parker Tax ¶85,105.

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Fourth Circuit Rejects IRS Attempt to Hold Former Shareholders Liable for Company's Taxes

The IRS could only collect a corporation's taxes from the corporation's former shareholders if, under North Carolina law, a creditor of the corporation could recover payments of the corporation's debts from the former shareholders; since creditors cannot collect such debts, the shareholders weren't liable for the taxes. Starnes v. Comm'r, 2012 PTC 138 (4th Cir. 5/31/12).

Albert Starnes, Ronald Morelli, Sr., Anthony Naples, and Sallie Stroupe worked at Tarcon, Inc., a trucking company, for over 40 years. Together they bought the company in 1972, each holding a 25 percent stake. In 2003, they decided to sell their interests and retire. After consulting with their real estate broker, accountant, and attorneys, they sold Tarcon's only remaining asset (a warehouse) to one company, ProLogis, Inc., and sold their Tarcon stock to another company, MidCoast Investments, Inc. MidCoast contractually agreed that it would operate Tarcon as a going concern and cause Tarcon to pay the approximately $880,000 in federal and state corporate income taxes Tarcon owed on the income the company received from selling the warehouse. Having become the sole shareholder of Tarcon, however, within a few weeks Mid-Coast sold Tarcon to another company, which transferred Tarcon's cash to an offshore account. Tarcon's 2003 tax returns claimed certain losses that purported to offset entirely the tax liability it incurred on the income from the sale of the warehouse. When the IRS audited the federal return, it disallowed those losses and assessed taxes, but Tarcon never paid the taxes.

Unable to obtain payment from Tarcon, the IRS turned its efforts to the former shareholders, asserting they were themselves liable, as transferees, for Tarcon's unpaid taxes. Starnes, Morelli, Naples and the Estate of Sallie Stroupe filed petitions in the Tax Court contesting the IRS's notices of transferee liability. The Tax Court ruled in favor of the former shareholders.

In holding for the former shareholders, the Tax Court relied on Comm'r v. Stern, 357 U.S. 39 (1958). In that case, the IRS sought to collect from a widow whose husband had died deficient in his payment of income taxes. The husband had held a life insurance policy from which he could draw down cash during his life, and that named his wife as the beneficiary. The question was whether the widow's "substantive liability" for her deceased husband's tax deficiency was to be determined by state or federal law. After closely examining the legislative history of Code Sec. 6901, the Supreme Court held that Congress intended Code Sec. 6901 to be "purely a procedural statute." To determine a transferee's substantive liability, the Court concluded it must look to sources other than Code Sec. 6901. Because no other federal statute defined transferees' substantive liability, the Court was required to choose between federal law and state law. The Court concluded that, until Congress spoke to the contrary, the existence and extent of transferee liability should be determined by state law specifically the law of the state where a particular transfer was made.

In Stern, the Supreme Court rejected the IRS's argument that federal common law should apply to a transferee's substantive liability, in part because the varying definitions of liability under state statutes resulted in an absence of uniformity of liability. According to the Court, Congress knew courts had been applying state law developed for the protection of private creditors to determine transferees' liability for a transferor's federal taxes. Yet Congress, the Court stated, with knowledge that this was existing law, refrained from disturbing the prevailing practice.

Applying the Stern decision, the Tax Court held that the IRS could collect from the former shareholders only if, under North Carolina law, a Tarcon creditor could recover payments of Tarcon's debts from the former shareholders. And applying North Carolina law to the evidence presented, the Tax Court held that the IRS had not made the required showing. The IRS appealed, arguing that the Tax Court committed legal error in its interpretation of federal law and its application of state law and clearly erred in making certain factual findings.

The Fourth Circuit affirmed the Tax Court's decision in favor of the former shareholders. The appeals court concluded that the IRS's contention lacked merit and that the Tax Court properly identified and applied the controlling legal framework as set forth by the Supreme Court and did not commit clear error in its factual findings.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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Trend Away from Using Paper Media Fare and Other Transit-Related Changes Requires Updated Guidance

Developments in technology, among other things, mean that past IRS guidance on transit passes may need to be updated, and the IRS is looking for comments from the public. Notice 2012-38.

Code Sec. 132(a)(5) provides that any fringe benefit that is a qualified transportation fringe is excluded from gross income. The term qualified transportation fringe means, when provided by an employer to an employee: (1) transportation in a commuter highway vehicle between home and work; (2) any transit pass; (3) qualified parking; or (4) any qualified bicycle commuting reimbursement.

With respect to transit passes, the IRS issued Rev. Rul. 2006-57, which provides guidance on the use of smartcards, debit or credit cards, or other electronic media to provide employees with transportation fringes. The ruling's effective date was delayed, and it eventually became effective January 1, 2012. Rev. Rul. 2006-57 includes four situations that illustrate the tax treatment of arrangements under which employers use electronic media to provide employees with transportation benefits.

According to the IRS, at the time Rev. Rul. 2006-57 was issued, the IRS lacked sufficient factual context to develop guidance regarding whether terminal-restricted debit cards were readily available. The ruling provides that in the meantime, employers can use bona fide cash reimbursement arrangements when the only available voucher or similar item is a terminal-restricted debit card.

In Notice 2012-38, the IRS notes that changes in fare media and in transit benefit administration may have created the need for guidance in addition to that provided in Rev. Rul. 2006-57. Developments in technology, an increase in the number of transit systems, third parties providing electronic media for transit use, and the trend away from use of paper fare media, mean that the four situations described in Rev. Rul. 2006-57 may not cover the full range of available electronic media for providing fare media. Thus, the IRS is requesting comments on how electronic media may meet the requirements under Code Sec. 132(f) for providing transit benefits, either as vouchers or transit passes or through bona fide cash reimbursement arrangements in a manner other than those described in situations one through four in Rev. Rul. 2006-57.

Also, the IRS is requesting comments on the availability of terminal-restricted cards and any other electronic media qualifying as vouchers or transit passes for purposes of determining whether such items are readily available so that cash reimbursement arrangements for providing transit benefits should be prohibited. Finally, the IRS is requesting comments on challenges employers encounter in transitioning from paper transit passes or vouchers to electronic media that qualify as vouchers or transit passes, or from cash reimbursement arrangements to electronic media qualifying as transit passes or vouchers. Specifically, the IRS is requesting comments on: (1) electronic media other than those described in Rev. Rul. 2006-57; (2) the definition of readily available; (3) transitions from paper transit system vouchers to electronic vouchers or to bona fide cash reimbursement systems; and (4) application of bona fide reimbursement arrangement requirements in the context of electronic media.

For a discussion of transit passes as an excludable transportation benefit, see Parker Tax ¶123,140.

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IRS Provides Additional Guidance on Rules Relating to FSAs

Health flexible spending arrangements are not subject to the $2,500 limit on salary reduction contributions for plan years beginning before 2013; IRS requests comments on potential modification of use-or-lose rule. Notice 2012-40.

In Notice 2012-40, the IRS provides guidance on the effective date of the $2,500 limit (as indexed for inflation) on salary reduction contributions to health flexible spending arrangements (health FSAs) under Code Sec. 125(i) and on the deadline for amending plans to comply with that limit. Notice 2012-40 also provides relief for certain contributions that mistakenly exceed the $2,500 limit and that are corrected in a timely manner.

Specifically, this notice provides that:

(1) the $2,500 limit does not apply for plan years that begin before 2013;

(2) the term taxable year in Code Sec. 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made;

(3) plans may adopt the required amendments to reflect the $2,500 limit at any time through the end of calendar year 2014;

(4) in the case of a plan providing a grace period (which may be up to two months and 15 days), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year; and

(5) relief is provided for certain salary reduction contributions exceeding the $2,500 limit that are due to a reasonable mistake and not willful neglect and that are corrected by the employer.

The statutory $2,500 limit under Code Sec. 125(i) applies only to salary reduction contributions under a health FSA, and does not apply to certain employer non-elective contributions (sometimes called flex credits), to any types of contributions or amounts available for reimbursement under other types of FSAs, health savings accounts, or health reimbursement arrangements, or to salary reduction contributions to cafeteria plans that are used to pay an employee's share of health coverage premiums (or the corresponding employee share under a self-insured employer-sponsored health plan).

Finally, Notice 2012-40 requests comments on whether to modify the use-or-lose rule that is currently set forth in the proposed regulations with respect to health FSAs.

For a discussion of the rules relating to FSAs, see Parker Tax ¶122,555.

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Taxpayer's Social Security Payments Not Subject to 15 Percent Levy Cap; IRS Can Take More than 50 Percent of Monthly Payments

As a one-time levy, the 15 percent cap on continuing levies under Code Sec. 6331(h) did not apply to the taxpayer's monthly social security benefits, and the IRS was free to take more than 50 percent of the taxpayer's monthly benefit. Bowers v. U.S., 2012 PTC 133 (C.D. Ill. 5/22/12).

Gary Bowers receives monthly social security benefits. He owed the IRS back taxes. As a result, the IRS placed a levy against Gary's social security benefits to collect the overdue tax debt. The Social Security Administration sent $1,108 of each of the checks since June 2010 to the IRS. This left a $779 monthly benefit for Gary. Gary filed suit in district court, arguing that the levy exceeded the 15 percent maximum allowed under Code Sec. 6331(h) and that all efforts to remedy the situation through the administrative process had failed.

Under Code Sec. 6331(h), if a levy is approved, the effect of the levy on specified payments to or received by a taxpayer is continuous from the date the levy is first made until the levy is released. The continuous levy attaches to up to 15 percent of any specified payment due to the taxpayer. A specified payment for this purpose includes social security payments.

A district court dismissed Gary's suit for failure to state a claim upon which relief could be granted. According to the court, the IRS has discretion to approve continuous levies under Code Sec. 6331(h) rather than under Code Sec. 6331(a), but Code Sec. 6331(h) does not require the IRS to attach a continuous levy even where the type of property might be eligible for one. In other words, where a levy could be issued under both Code Sec. 6331(a) and Code Sec. 6331(h), the statute does not compel that the levy be issued under one section or the other. The court noted that Gary's social security payments represented a present, vested right to receive such benefits in fixed monthly payments for the rest of the Gary's life and the amount of the benefits are calculable (i.e., they are based on earnings averaged over the taxpayer's lifetime and determinable based upon a formula). Receipt of the social security benefits was not contingent on the performance of any additional services, and the tax lien and levy could therefore attach to the entire stream of payments as a one-time levy under Code Sec. 6331(a) and (b). Thus, the levy was considered a one-time levy. According to the court, this characterization is further supported by the fact that the levy was initiated by a paper Form 668-W rather than the electronic processes under the Federal Payment Levy Program, as would be the proper mechanism for a continuous levy. As a one-time levy, the 15 percent cap on continuing levies under Code Sec. 6331(h) did not apply.

For a discussion of the rules relating to continuous levies and the 15 percent cap, see Parker Tax ¶260,540.

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Taxpayer Not Entitled to Civil Damages for Disclosures of Return Information During Unlawful Levies

The validity of a lien or levy is immaterial to the issue of whether the disclosure of a taxpayer's return information contained in IRS notices is authorized under Code Sec. 6103; thus, the taxpayer cannot collect damages for the unauthorized disclosure of his return information. Hodges v. U.S., 2012 PTC 134 (E.D. Mich. 5/22/12).

As of March 1, 2010, Tom Hodges owed the IRS $69,414 in unpaid income taxes for 2006, 2007, and 2008. The IRS issued a Final Notice thereby affording Tom certain statutory avenues of appeal before any form of enforced collection activity. On March 25, 2010, Tom exercised his Collection Due Process (CDP) rights, asking for either an installment payment agreement or an offer-in-compromise.

On May 7, 2010, before the beginning of any CDP process, the IRS issued a wage levy to Tom's employer. After Tom notified the IRS of the procedural irregularity, it released the levy. On October 11, 2010, after the CDP process began, but before it was complete, the IRS issued a levy to TCF Bank, Tom's bank. Tom notified the IRS of this second untimely levy and the IRS could not explain why the levy was issued while the CDP process was on-going. When the IRS issued the above levies, it disclosed Tom's tax returns and other confidential information to Tom's employer and bank. Tom filed a claim for damages with the IRS. When he received no response, he filed a suit in district court arguing that Code Sec. 6330 prohibits the IRS from pursuing any form of levy activity while a CDP process remains pending, that the release of the tax information contained on each of the two levy documents constituted improper disclosure under Code Sec. 7431(c)(1)(A), and that he was due damages under Code Sec. 7433 based on an alleged violation of Code Sec. 6103. According to Tom, since the levies directed toward his employer and bank were prematurely issued, the disclosures made in connection with those levies were unauthorized under Code Sec. 6103.

A taxpayer can bring an action for damages under Code Sec. 7433 if the IRS discloses certain information without authorization. A disclosure is unauthorized if it violates the directives set forth in Code Sec. 6103. That section provides a general rule that a taxpayer's returns are confidential and should not be disclosed. This general rule is subject to a series of exceptions. One of these exceptions allows disclosures of information relating to enforcement of tax laws. The IRS has issued regulations under Reg. Sec. 301.6103(k)(6)-1 prescribing the circumstances in which disclosure may be made under Code Sec. 6103(k)(6). Under these regulations, the IRS is authorized to disclose return information of a taxpayer against whom a collection activity is directed in order to locate assets in which the taxpayer has an interest or otherwise to apply the provisions of the Code relating to establishment of liens against such assets, or levy on, or seizure, or sale of, the assets, to satisfy any such liability.

A Michigan district court dismissed Tom's claim. According to the district court, courts interpreting Reg. Sec. 301.6103(k)(6)-1 have explained that information disclosed in notices of levy are necessary to collection activity and fall squarely within the exemption under Code Sec. 6103(k)(6). An overwhelming majority of federal courts, the district court stated, have squarely rejected Tom's position by holding that the authority to disclose return information during the collection process is not premised on the procedural propriety of the underlying collection action. In other words, the validity of the lien and levies is immaterial to the issue of whether the disclosure contained in those notices is authorized under Code Sec. 6103. On the other hand, the district court observed, an isolated minority of cases have held that a disclosure made in connection with an unlawful levy violates Code Sec. 6103. After reviewing each side of the issue, the district court adopted the majority rule and dismissed Tom's claim to the extent it was based on an alleged violation of Code Sec. 6103.

For a discussion of damages under Code Sec. 7433, see Parker Tax ¶260,550.

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Interest Rates Remain the Same for Third Quarter of 2012

The IRS announced that interest rates will remain the same for the calendar quarter beginning July 1, 2012. Rev. Rul. 2012-16.

With respect to interest on tax overpayments and underpayments, the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus three percentage points. Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus three percentage points and the overpayment rate is the federal short-term rate plus two percentage points.

Under Code Sec. 6621, the rate for large corporate underpayments is the federal short-term rate plus five percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a tax period is the federal short-term rate plus one-half (0.5) of a percentage point.

For the quarter beginning July 1, 2012, the rates are:

(1) 3 percent for overpayments (2 percent in the case of a corporation);

(2) 3 percent for underpayments;

(3) 5 percent for large corporate underpayments; and

(4) 0.5 percent for the portion of a corporate overpayment exceeding $10,000.

For a discussion of interest on tax overpayments and underpayments, see Parker Tax ¶261,500.

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IRS Announces 43 Small Offices to Close; Agency Sheds More than One Million Square Feet of Office Space

The IRS announced a sweeping office space and rent reduction initiative that over the next two years will close 43 smaller offices and reduce space in many larger facilities. IR-2012-54 (5/22/12).

The IRS plans to close 43 smaller offices and reduce space in many larger facilities in order to save more than $40 million. Coupled with space reductions last year, the initiative will slash total IRS office space by more than one million square feet.

According to the IRS, to ensure that the agency uses rental space as efficiently and effectively as possible, the IRS will:

(1) Close 43 smaller offices. These are offices without taxpayer assistance centers and currently have fewer than 25 employees.

(2) Consolidate multiple offices within the same commuting area.

(3) Explore innovative ways to do more with existing space, such as desk sharing and increased telecommuting.

None of the offices being closed under this initiative are walk-in taxpayer assistance centers. Because of the nature of the work performed in these offices, the IRS anticipates minimal taxpayer impact as a result of these closures.

This cost-cutting initiative is projected to save $17.2 million in annual rental costs in fiscal 2012 and $23.5 million in fiscal 2013. These are permanent reductions in space and rent so these savings will be realized in future years as well.

The initiative will cut space by 715,000 square feet in fiscal 2012 and 230,000 square feet in fiscal 2013. This is on top of a 105,000-square-foot reduction in fiscal 2011.

The IRS has more than 650 offices around the country. According to the IRS, this most recent initiative supplements space saving projects over the past seven years that are now yielding $70 million annually in rental savings. This is part of a broader Administration effort that has cut government real estate costs by over $1.5 billion and is on track to exceed the President's directive to save $3 billion by the end of the year.