Federal Tax Bulletin - Issue 33 - March 27, 2013

Taxpayer Can Deduct Unallocated Support Payments in Full as Alimony

In Tax Court cases involving alimony, a recurrent theme is whether or not unallocated family support payments that are a combination of spousal support and child support constitute deductible alimony instead of nondeductible child support. This was exactly the situation in Delong v. Comm'r, T.C. Memo. 2013-70 (3/11/13), where the IRS rejected the taxpayer's contention that his family support payments were deductible in full as alimony. According to the IRS, because some of the unallocated payments were for child support, none of the payments were deductible. The Tax Court, however, disagreed, and allowed the taxpayer to deduct all the unallocated payment as alimony.

Observation: While this is a win for the taxpayer who made the payments, the opposite is true for the taxpayer receiving the payments because the payments, some of which represent child support, are taxable in full. Thus, if a practitioner has a client receiving such unallocated payments, the practitioner may want to review the separation papers to make sure such payments are excludible from income. In this case, the child support was not fixed and thus none of the payments were considered nontaxable child support to the payee. Alternatively, if the practitioner has a chance to advise the client ahead of time, the practitioner may want to review with the client the consequences of unallocated support payments and child support payments that are not fixed.

Background

Brendan DeLong was married to Tamsin DeLong before separating in 2006. Brendon and Ms. DeLong had two children, who lived with Ms. DeLong after the separation. Ms. DeLong filed for divorce in California Superior Court. While the divorce case was pending, Brendan and Ms. DeLong entered into a stipulated agreement that was incorporated into a temporary order of the Superior Court on December 6, 2007. The first support order required Brendan to pay Ms. DeLong $3,000 as family support for January 2008. The Superior Court issued a second support order two months after the first support order was issued. Brendan was obligated under the second support order to continue to pay Ms. DeLong family support payments of $3,000 per month until a trial in the divorce case was held. The Superior Court indicated in the second support order that the family support payments were for both spousal support and child support. It did not allocate, however, any specific portion of the family support payments as spousal support or child support in the second support order or the first support order. Neither the first support order nor the second support order included an explicit condition that would terminate Brendan's obligation to make the family support payments on Ms. DeLong's death.

Brendan made $24,491 in family support payments during 2008 under the support orders. On his individual income tax return for 2008, Brendan claimed an alimony deduction for the family support payments. The IRS issued a deficiency notice that disallowed the alimony deduction and also assessed a penalty. Brendan appealed to the Tax Court.

Alimony Deduction

Whether a payment constitutes deductible alimony is determined by reference to Code Sec. 71(b)(1), which defines an alimony or separate maintenance payment as any payment in cash if:

(1) the payment is received by (or on behalf of) a spouse under a divorce or separation instrument;

(2) the divorce or separation instrument does not designate the payment as a payment that is not includible in gross income under Code Sec. 71 and not allowable as a deduction under Code Sec. 215;

(3) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the payee spouse and the payor spouse are not members of the same household at the time such payment is made; and

(4) there is no liability to make any such payment for any period after the death of the payee spouse, and there is no liability to make any payment (in cash or property) as a substitute for such payments after the death of the payee spouse.

A payment satisfying the preceding criteria is nevertheless not includible in the recipient spouse's gross income under Code Sec. 71(a), and thus not deductible as alimony, if it qualifies as child support under Code Sec. 71(c).

IRS's Argument

The IRS did not dispute that the family support payments were made under a divorce or separation agreement or that Brendan and Ms. DeLong were members of different households when the family support payments were made. The IRS argued, however, that the family support payments failed to satisfy the general alimony requirements because they were designated as nonalimony and Brendan's liability to make them would have continued past Ms. DeLong's death. The IRS argument that the payments were designated as nonalimony was based, at least partly, on the fact that the support orders indicated the payments were partly for child support.

Tax Court's Analysis

The Tax Court began its analysis by considering whether Brendan's liability to continue making the family support payments ended after Ms. DeLong's death as required under Code Sec. 71(b)(1)(D). The court noted that the support orders did not expressly state that Brendan's liability for making the family support payments would end on Ms. DeLong's death. Accordingly, the court had to consider whether a termination would occur by operation of California law. The California Family Code, the court observed, defines family support as an unallocated combination of spousal support and child support. California law provides that a spousal support obligation terminates upon the death of the payee spouse. In contrast, a child support obligation survives the death of the payee spouse and continues as an obligation of the payor spouse under California law.

Whether a family support obligation terminates upon the death of the payee spouse, the Tax Court noted, is not specifically addressed in the California Family Code. Additionally, the IRS failed to cite, and the Tax Court was unaware of, any California case that had conclusively decided the question. The court did note that it had recently addressed the effect of a payee spouse's death on a family support obligation under California law in Berry v. Comm'r, T.C. Memo. 2005-91. The facts of Berry, the court said, were similar to the facts in DeLong. In Berry, the taxpayer was obligated to make California family support payments and claimed an alimony deduction for those payments. The IRS in Berry, as in DeLong, argued that the family support obligation did not terminate upon the death of the payee spouse as required by Code Sec. 71(b)(1)(D). In Berry, the Tax Court held that there was no continuing payment liability past the death of a payee spouse with respect to a family support obligation. The Tax Court stood by its reasoning and analysis in Berry. Moreover, it did not find any distinguishable facts in the DeLong situation that merited a different result. Thus, the court concluded that Brendan had no continuing liability for the family support payments past the death of Ms. DeLong and that the Code Sec. 71(b)(1)(D) requirement was met.

The court then considered whether the family support payments were designated as nonalimony. Under Code Sec. 71(b)(1)(B), the court noted, a payment is not treated as alimony if it is designated as nonalimony. Accordingly, the IRS's designation argument rested on whether any part of the family support payments constituted child support. Child support is defined under Code Sec. 71(c)(1) as any part of a payment that the terms of a divorce or separation instrument specifically fix (in terms of the amount of money or any part of the payment) as a sum that is payable for the support of the payor spouse's children. The statutory directive that child support payments be fixed is generally taken literally, and child support cannot be inferred from intent, surrounding circumstances, or other subjective criteria. An amount fixed as payable for the support of the payor spouse's children, nevertheless, includes any amount specified in the instrument if that amount will be reduced on the happening of a contingency specified in the instrument relating to a child (e.g., attaining a specified age, marrying, dying, leaving school, or a similar contingency) or at a time that can clearly be associated with such a contingency.

In the instant case, the court noted, the support orders made an unallocated award of spousal and child support. Consequently, they did not fix any portion of the family support payments as a sum that was payable for the support of Brendan's children for purposes of Code Sec. 71(c)(1). In sum, the Tax Court held that the family support payments made by Brendan constituted alimony, not child support, and were thus deductible in full.

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Court Objects to Reliance on State Law in Determining Deductible Theft Losses

The deduction for losses is one of the oldest provisions in the Code. The first section authorizing a loss deduction was included in the Revenue Act of 1867. Subsequently, language similar to the current Code Sec. 165(c), which provides for a tax deduction for theft and casualty losses, was added to the statute in the Revenue Act of 1916.

Under the regulations interpreting Code Sec. 165, the term theft is deemed to include, but is not necessarily limited to, larceny, embezzlement, and robbery. The regulations, however, stop there in terms of providing any further guidance on how to determine whether a particular conduct amounts to theft or any one of the other enumerated crimes. As a result, many cases have sought further guidance on this point from state law, often citing Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), for the proposition that whether a theft loss has occurred within the purview of Code Sec. 165(c)(3) depends on the criminal law of the jurisdiction where the loss was sustained. Read more...

IRS Grants Tax Penalty Relief for Delayed 2012 Forms

The IRS has provided relief from certain tax penalties due to the delayed publication of some 2012 tax forms. Notice 2013-24.

Generally, individuals, estates, and trusts are required to file income tax returns and pay any tax due by April 15; corporations and certain other entities must file returns and pay tax by March 15. Code Sec. 6081 provides that the IRS may grant a reasonable extension of time for filing any return, but, except in the case of taxpayers who are abroad, no such extension can be for more than six months. To qualify for an extension, taxpayers must properly estimate their tax liability using any available information and report that tax liability on the extension application. An extension of time to file a return, however, does not extend the time to pay the tax, and taxpayers generally must pay the tax by the original due date of the return.

Code Sec. 6651(a)(2) imposes an addition-to-tax penalty for payments made after the due date (determined with regard to any extension of time for payment) with respect to tax shown on a return. The Code Sec. 6651(a)(2) addition to tax is not imposed if the taxpayer shows that the failure was due to reasonable cause and not willful neglect.

On January 2, 2013, Congress enacted the American Taxpayer Relief Act of 2012 (ATRA). ATRA affected a number of tax forms. Revising those forms required extensive programming and testing of IRS systems, which delayed the IRS's ability to release, accept, and process those forms. Because these delays may affect, or may have affected, the ability of some taxpayers to timely estimate and pay their 2012 tax liability when requesting an extension to file, the IRS has issued tax penalty relief to such taxpayers.

Notice 2013-24 provides that, for each taxpayer who requests, or has requested, an extension to file a 2012 income tax return that includes one of the forms listed below, the IRS will deem the taxpayer to have demonstrated reasonable cause and lack of willful neglect, and will abate any Code Sec. 6651(a)(2) tax penalty, provided (1) a good faith effort was made to properly estimate the tax liability on the extension application, (2) the estimated amount is paid by the original due date of the return, and (3) any tax owed on the return is fully paid no later than the extended due date of the return. When responding to any assessment notice, a taxpayer should submit a letter describing the taxpayer's eligibility for this relief, identifying which of the form(s) listed below was included with the taxpayer's return as filed, and referencing Notice 2013-24 to the address listed in the assessment notice.

The following is a list of the delayed 2012 tax forms, which were not available until February 2013 or the first week of March 2013, to which the relief in Notice 2013-24 applies:

• Form 3800, General Business Credit
• Form 4136, Credit for Federal Tax Paid on Fuels
• Form 4562, Depreciation and Amortization (Including Information on Listed Property)
• Form 5074, Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands
• Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations
• Form 5695, Residential Energy Credits
• Form 5735, American Samoa Economic Development Credit
• Form 5884, Work Opportunity Credit
• Form 6478, Alcohol and Cellulosic Biofuels Credit
• Form 6765, Credit for Increasing Research Activities
• Form 8396, Mortgage Interest Credit
• Form 8582, Passive Activity Loss Limitations
• Form 8820, Orphan Drug Credit
• Form 8834, Qualified Plug-in Electric and Electric Vehicle Credit
• Form 8839, Qualified Adoption Expenses
• Form 8844, Empowerment Zone and Renewal Community Employment Credit
• Form 8845, Indian Employment Credit
• Form 8859, District of Columbia First-Time Homebuyer Credit
• Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits)
• Form 8864, Biodiesel and Renewable Diesel Fuels Credit
• Form 8874, New Markets Credits
• Form 8900, Qualified Railroad Track Maintenance Credit
• Form 8903, Domestic Production Activities Deduction
• Form 8908, Energy Efficient Home Credit
• Form 8909, Energy Efficient Appliance Credit
• Form 8910, Alternative Motor Vehicle Credit
• Form 8911, Alternative Fuel Vehicle Refueling Property Credit
• Form 8912, Credit to Holders of Tax Credit Bonds
• Form 8923, Mine Rescue Team Training Credit
• Form 8932, Credit for Employer Differential Wage Payments
• Form 8936, Qualified Plug-in Electric Drive Motor Vehicle Credit

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Eleventh Circuit Denies FTHBC to Minor for House Purchased from Parents

The Tax Court did not err in finding that a minor, in substance, purchased a home from related persons, thereby making him ineligible for the first-time homebuyer credit. Conner v. Comm'r, 2013 PTC 32 (11th Cir. 3/15/13).

When he was three years old, W.E.R. received $464,000 in settlement proceeds as a result of trauma he suffered at birth, leaving him mentally and physically handicapped. In 2004, the probate court appointed Steven Conner as guardian of the proceeds because W.E.R.'s parentsMr. and Mrs. Rodriguezwere not financially sophisticated.

In early 2009, when W.E.R. was seven years old, Mr. Conner learned that Mr. and Mrs. Rodriguez were experiencing financial difficulties and had missed several mortgage payments. Mr. Conner petitioned the probate court for permission to lend Mr. and Mrs. Rodriguez approximately $103,000 from W.E.R.'s funds so they could refinance their mortgage. After the court's approval, Mr. Conner contacted Bank of America, the mortgage holder, to pay the mortgage in full, butaccording to Mr. Conner's testimonyBank of America informed him that it would not accept payment from a guardianship.

Mr. Conner then sent a letter to Mr. and Mrs. Rodriguez stating that he would purchase the home for the outstanding balance of the mortgage, approximately $107,000, and transfer the necessary funds for the purchase from W.E.R.'s account into an escrow account of Mr. Conner's accounting firm. Subsequently, Mr. and Mrs. Rodriguez executed a warranty deed transferring the home to Mr. Conner in his individual capacity. Within a few days, Mr. Conner's accounting firm purchased a cashier's check in the amount of the mortgage balance payable to Bank of America, and paid off the mortgage. Mr. Conner then executed a warranty deed, in his individual capacity, transferring the home to himself, in his capacity as guardian for W.E.R. A separate purchase and sale agreement, executed by Mr. Conner on that same day, indicated that the home was sold to W.E.R. for exactly the amount of the payment to Bank of America. On May 28, 2009, Mr. Conner prepared W.E.R.'s federal income tax return and claimed a first-time homebuyer's credit (FTHBC) in the amount of $8,000 for his purchase of the home.

Under prior law, Code Sec. 36(a) and (b) allowed a credit of up to $8,000 to a first-time homebuyer of a principal residence in the United States. Under Code Sec. 36(g). The FTHBC for the purchase of a principal residence in 2009 could be claimed on either the taxpayer's 2008 or 2009 federal income tax return. However, Code Sec. 36(c)(3) provided that the FTHBC was not available to a taxpayer who purchased a home from a related person. Under Code Sec. 36(c)(5), related persons included direct ancestors, such as parents.

The IRS determined that W.E.R. was not eligible for the credit and asserted a tax deficiency in the amount of $8,000. Mr. Conner petitioned the Tax Court for a redetermination of the deficiency. The Tax Court held that Mr. Conner was a mere conduit through which to pass title from Mr. and Mrs. Rodriguez to W.E.R., disregarded the intermediate transfer of title from the parents to Mr. Conner in his individual capacity, and compressed the various steps into a single economic transactiona purchase of the home by W.E.R. from his parents.

On appeal, W.E.R. argued that the Tax Court erred in finding that Mr. Conner acted as a conduit. Relying on Frank Lyon Co. v. U.S., 435 U.S. 561 (1978), W.E.R. asserted that the transaction was not structured for tax-avoidance purposes, but instead (1) economic realities (i.e., Bank of America's refusal to accept payoff directly from W.E.R.) prevented him from buying the home from his parents, and (2) regulatory realities (i.e., Florida laws regarding the fiduciary duties of guardians) required Mr. Conner to sell the home. Additionally, Mr. Conner testified at the Tax Court trial that he purchased the home as an investment. At that trial, the Tax Court noted that, before taking title to the home, Mr. Conner did not have the home inspected, nor did he obtain an independent appraisal of the fair market value of the home or even know the fair market value of the home at the time of the transfer.

The Eleventh Circuit held that the Tax Court did not clearly err in finding that W.E.R., in substance, purchased the home from related persons, thereby making him ineligible for the first-time homebuyer credit. Although W.E.R. nominally purchased the home from Mr. Conner in Mr. Conner's individual capacity, the court said, the Tax Court did not clearly err in finding that, in substance, W.E.R. purchased the home from his parents.

As for Mr. Conner's assertion that he purchased the home as an investment, the Tax Court noted that (1) W.E.R.'s parents did not receive any money from Mr. Conner for the purported sale of the home, and (2) Mr. Conner had transferred the exact payoff amount from W.E.R.'s bank account into his accounting firm's escrow account before both the transfer of title from W.E.R.'s parents to Mr. Conner and the purchase of the cashier's check by Mr. Conner. Thus, the Eleventh Circuit stated, Mr. Conner used W.E.R.'s funds, and not his own, to pay off the mortgage. Thus, the court concluded, the transaction lacked economic substance.

For a discussion of the FTHBC and the taxpayers who were eligible for the credit, see Parker Tax ¶102,705.

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Tax Court Increases Professional Golfer's Allocation of Income to U.S.; Royalty Income Exempt under Swiss Tax Treaty

Payments made by a sponsor to a professional golfer were allocable 65 percent to royalties and 35 percent to personal services; however, the royalty income was exempt from tax in the United States under the Swiss Tax Treaty. Garcia v. Comm'r, 140 T.C. No. 6 (3/14/13).

Sergio Garcia is a professional golfer and a resident of Switzerland. He entered into an endorsement agreement with a sponsor, TaylorMade Golf Co. Sergio agreed to allow TaylorMade to use his image, name, and voice (image rights) in advertising and marketing campaigns worldwide. Sergio also agreed to perform personal services for TaylorMade, including using TaylorMade's products in all his golf play, posing and acting for advertisements, and making personal appearances for the company. In return for his services and use of his image rights, TaylorMade agreed to pay Sergio certain compensation.

Sergio and TaylorMade allocated 85 percent of Sergio's compensation to royalties (for use of his image rights) and 15 percent to personal services. Sergio established EP, LLC, in Delaware, which would receive the royalty payments and then pay a portion of the royalty payments (attributable to use of the image rights in the United States) to a second LLC, LD, which Sergio established in Switzerland. The result was that Sergio paid no U.S. tax on the royalty payments, but did pay U.S. tax on the U.S. source personal service payments.

The IRS assessed tax deficiencies, disputing the 85 percent - 15 percent allocation between royalty and personal service payments and arguing for a larger portion attributable to Sergio's personal services. The IRS also claimed that the U.S. source royalty payments were made directly to Sergio and that the form of the transaction involving EP and LD should be disregarded. The IRS additionally claimed that such royalty income (as well as all U.S. source personal service income) should be taxable to Sergio in the United States and not exempted from U.S. taxation under the Convention between the United States of America and the Swiss Confederation for the Avoidance of Double Taxation with Respect to Taxes on Income (i.e., the Swiss Tax Treaty).

Sergio argued that the 85 percent 15 percent allocation between royalty and personal service payments understated, if anything, the royalty allocation. Sergio disputed the IRS's claims regarding the EP/LD transaction and further claimed that even if that transaction is disregarded (and the payments are considered to have been made directly to Sergio), all of Sergio's royalty income, as well as a portion of his U.S. source personal service income, is exempt from tax in the United States under the Swiss Tax Treaty.

The Tax Court held that the payments made by TaylorMade were allocable 65 percent to royalties and 35 percent to personal services and that any royalty income to Sergio was exempt from tax in the United States under the Swiss Tax Treaty. In finding that Sergio was exempt from tax under the Swiss Tax Treaty, the court found an example in the treaty involving a sale of live recordings to be highly illustrative of the intent of the Swiss Tax Treaty. Even given the relationship between a live performance and a recording of that performance, the court noted that a Treasury Technical Explanation of the treaty stated that proceeds from the sale of such a recording may be royalties not taxable in the source country under treaty provisions. In a similar vein, the Tax Court said it believed that even though Sergio's golf play and personal services performed in the United States has some connection to his U.S. image rights, income from the sale of such image rights was not predominantly attributable to his performance in the United States. Rather, the image rights were a separate intangible that generated royalties for Sergio when TaylorMade paid him for their use.

However, the Tax Court also concluded that none of Sergio's U.S. source personal service income for services other than wearing TaylorMade products while golfing was exempt from tax in the United States.

For a discussion of how to allocate the source of a nonresident alien's income between foreign and U.S. income, see Parker Tax ¶200,540.

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Decedent's Gross Estate Includes Value of Disclaimed Artwork

In valuing certain fractional interests in artwork, a decedent's agreement by which he waived his right to institute a partition action with respect to some of the works of art and thereby relinquished an important use of his fractional interests in those works, was disregarded. Est. of Elkins, 140 T.C. No. 5 (3/11/13).

James Elkins and his wife purchased 64 works of art between 1970 and 1999. All 64 works were purchased during their marriage and the art thus became community property under Texas law. James died on February 21, 2006. On July 13, 1990, James and his wife each created a grantor retained income trust (GRIT) funded by each's undivided 50 percent interests in three of the works in the collection: a large Henry Moore sculpture, a Pablo Picasso drawing, and a Jackson Pollock painting (i.e., the GRIT art). Each trust was for a 10-year period, during which the grantor retained the "use" of the transferred interests in the art. At the conclusion of the 10-year period, each grantor's interests were to go to the Elkins's three children, which, in effect, would give them 100 percent ownership of the GRIT art, one-third each.

Mrs. Elkins died on May 19, 1999, before the expiration of the 10-year period of her GRIT. Pursuant to the terms of her GRIT, her 50 percent undivided interests in the GRIT art passed to James. Because James survived the 10-year term of his GRIT, his original 50 percent undivided interests in the GRIT art passed to his three children in equal shares so that each received 16.667 percent interests in the GRIT art. James retained the 50 percent interests in the GRIT art that he received upon his wife's death, which then constituted part of his gross estate. The Elkins children leased their combined 50 percent interests in the two works to James, in effect allowing him to retain year round possession of those works. There was an initial lease term, with automatic extensions, unless James opted out of an extension, which he never did.

Under Mrs. Elkins's will, her 50 percent community property interests in the other 61 works of art passed outright to James. James decided, however, to disclaim a portion of those interests equal in value to the unused unified credit against estate tax available to Mrs. Elkins's estate so that the disclaimed portion could pass to the Elkins children free of estate tax. On the basis of appraisals obtained by Mrs. Elkins's estate, James disclaimed a 26.945 percent interest in each of the 61 works (disclaimer art). Pursuant to Mrs. Elkins's will, those fractional interests passed to the Elkins children, one-third each. As a result, each child received an 8.98167 percent interest in each item of the disclaimer art, and the balance, a 23.055 percent interest in each item, passed to James. Thus, James retained a 73.055 percent interest in each item of the disclaimer art (his original 50 percent interest plus the additional 23.055 percent interest received from Mrs. Elkins that he did not disclaim). On February 14, 2000, shortly after James executed his partial disclaimer, he and the Elkins children entered into a "Cotenants' Agreement" relating to the disclaimer art. One provision of that agreement provided that unanimous consent of the co-owners was required for the sale of any art.

James's will provided that his descendants would inherit his personal and household effects, which included his undivided fractional ownership interests in the art. James's residuary estate passed to the James A. Elkins, Jr. and Margaret W. Elkins Family Foundation (Elkins Foundation), a bequest that entitled the estate to a charitable contribution deduction under Code Sec. 2055. The will provided that all estate taxes, plus any interest and penalties, due by reason of James's death (but not including taxes due with respect to the assets in Mrs. Elkins' marital trust includable in James's gross estate under Code Sec. 2044) should be charged against his residuary estate. Thus, any additional estate taxes payable by the estate would correspondingly reduce the distribution to the Elkins Foundation and the charitable contribution deduction with respect thereto.

James' estate timely filed a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return (estate tax return), in which it reported a federal estate tax liability of approximately $102 million. Schedule F, Other Miscellaneous Property Not Reportable Under Any Other Schedule, included in James's gross estate his 73.055 percent interests in the 61 works of disclaimer art that were subject to the original cotenants' agreement, valued at approximately $9.5 million and his 50 percent interests in the three works of GRIT art (two of which remained subject to the art lease on the valuation date), valued at approximately $2.7 million. Those amounts were derived by, first, determining James's pro rata share of the fair market value of the art as determined by Sotheby's, Inc., and, then, applying a 44.75 percent combined fractional LLP, to those pro rata share amounts. The parties stipulated a total (undiscounted) fair market value, as of the valuation date, of approximately $24.6 million for the disclaimer art and $10.6 million for the GRIT art.

The IRS assessed a deficiency after determining that James's gross estate included his 73.055 percent interests in the disclaimer art at an undiscounted fair market value of approximately $18.5 million and his 50 percent interests in the GRIT art at an undiscounted fair market value of $5.3 million. As alternative bases for using undiscounted values of James's fractional interests in the art in computing James's taxable estate, the IRS determined that (1) the restrictions on the sale of art subject to the cotenants' agreement and fractional interests in art subject to the art lease constituted "an option, agreement, or other right to acquire or use such artwork at a price less than the fair market value" and, alternatively, "a restriction on the right to sell or use the James's interest in such artwork" so that, pursuant to Code Sec. 2703(a)(1) and (2), respectively, James's interests in the art covered by those agreements should be valued without regard to those restrictions; and (2) the discounts used in calculating the fair market value of James's fractional interests in the art were overstated and no discount was appropriate. In addition, because James's will provided that all estate taxes were to be paid out of his residuary estate passing to the Elkins Foundation, the IRS notice reduced the deduction for the charitable bequest to that foundation by the amount of the proposed estate tax deficiency.

In support of the application of Code Sec. 2703(a)(2), the IRS said that, in view of the irrefutable evidence that the only way to sell a fractional interest in artwork is by selling the entire art by agreement or through a partition action filed with the court, the only apparent reason for including the restriction on sale language in the Cotenants' Agreement and the Art Lease Agreement * * * was to reduce the value of Decedent's retained fractional interests in the Artwork as part of a plan to make a testamentary transfer of his remaining interests in the Artwork to his children at a reduced transfer tax rate--a purpose which Section 2703 was specifically intended to prevent.

The Tax Court held that, in valuing certain of the fractional interests in the art owned by James, under Code Sec. 2703(a)(2), the agreement by which James waived his right to institute a partition action with respect to some of the works of art (i.e., the cotenants agreement) and thereby relinquished an important use of his fractional interests in those works should be disregarded. In reaching this conclusion, the court noted that (1) Code Sec. 2703(a)(2) provides that, for estate and gift tax purposes, the value of any property is determined without regard to any restriction on the right to sell or use such property, (2) that Code Sec. 2703(b) provides that Code Sec. 2703(a) does not apply to disregard a right or restriction if it meets certain requirements, and (3) the estate conceded that neither the cotenants' agreement nor the art lease satisfied the Code Sec. 2703(b) exception. Thus, the Code Sec. 2703 issue was whether the restrictions on transferability in the cotenants' agreement and the art lease were restrictions on the right to sell or use property within the meaning of Code Sec. 2703(a)(2), and the court concluded they were. Thus, the restrictions were disregarded in valuing the art for estate tax purposes.

For a discussion Code Sec. 2703 restrictions on valuation discounts, see Parker Tax ¶225,220.

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Flight Time Percentages Also Apply to International Flight Attendant's Nonflight Time

For purposes of determining the foreign earned income exclusion, an international flight attendant's flight time percentages apply to any of her wages that were allocable to nonflight time, such as vacation and sick leave. Rogers v. Comm'r, T.C. Memo. 2013-77.

Yen-Ling K. Rogers is a U.S. citizen and a bona fide resident of Hong Kong. She worked as a flight attendant for United Airlines on international flights based out of Hong Kong International Airport. The scope of her employment and compensation was determined under an agreement that provided that (1) Yen-Ling accrued nonflight time, such as sick and vacation hours, based on the period of her flight attendant service; and (2) United compensated Yen-Ling for additional categories, such as required training and meetings and the performance incentive program.

United required Yen-Ling to perform pre-boarding and post-arrival services on every flight on which she worked. She was required to report to work one hour and 45 minutes before flight departure and to perform approximately 30 minutes of post-arrival services. The flight time began at out time when the plane's brake was released and the plane pushed back from the airport. The flight time ended at in time when the plane's parking brake was set after landing. Yen-Ling was not separately compensated for the time spent performing pre-boarding and post-arrival services.

Yen-Ling worked the following flights in 2007: 16 flights between Hong Kong (HK) and San Francisco (SFO); 16 flights between SFO and HK; 14 flights between HK and Chicago (CHI); 14 flights between CHI and HK; 5 flights between HK and Ho Chi Minh City; 5 flights between Ho Chi Minh City and HK; 2 flights between SFO and Nagoya; and 2 flights between Nagoya and SFO. The percentage of Yen-Ling's flight time as a percentage within or over foreign countries during 2007 was as follows: HK-SFO-HK 63.38; HK-CHI-HK 86.05; HK-Ho Chi Minh City-HK 100; SFO-Nagoya-SFO 29.19.

United reported $41,762 of wages to Yen-Ling for 2007. Her pay statements from United allocated her 2007 wages between U.S. taxable income and Hong Kong taxable income. United provided Yen-Ling a duty time apportionment for her flights during 2007 that apportioned the minutes of her flight times within or over the United States, international waters, and foreign countries.

The Rogers excluded 100 percent of Yen-Ling's United wages as other income on a jointly filed 2007 Form 1040, which specified the other income by reference to an attached Form 2555-EZ, Foreign Earned Income Exclusion. On the Form 2555-EZ, the Rogers reported $41,762 as the total amount of foreign earned income and the total amount excluded from income as their foreign earned income exclusion.

The IRS sent the Rogers a deficiency notice determining that: (1) they were not entitled to exclude the 100 percent of compensation Yen-Ling received for flight time over international waters and the United States; (2) Yen-Ling's HK-CHI-HK exclusion percentage was 73 percent and her HK-SFO-HK exclusion percentage was 22 percent; (3) flight times were based on the duty time apportionment for Yen-Ling's flight routes and other information using the average time over foreign countries during 2007; and (4) the percentages were average approximate percentage minutes of Yen-Ling's flight times over foreign countries over Yen-Ling's total minutes.

The Rogers argued that wages allocable to Yen-Ling's nonflight time, such as vacation and training pay, were 100 percent foreign earned income. The IRS countered that all of Yen-Ling's 2007 United wages should be allocated in proportion to her flight time because her earnings were inextricably based on her flight time services. Code Sec. 911(d)(2) provides that the term earned income means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered.

The Tax Court held that only a percentage of Yen-Ling's United wages qualified for the Code Sec. 911(a) exclusion. The court noted that, although the Rogers excluded 100 percent of Yen-Lings 2007 United wages as foreign earned income, they stipulated that only a percentage of Yen-Lings's flight time occurred within or over foreign countries. In general, the court said, the place where the taxpayer's services are performed and not the place the compensation was paid or the location of the taxpayer at the time of payment is what determines whether compensation is treated as income from sources within a foreign country and eligible for the foreign earned income exclusion.

Because United required Yen-Ling to perform pre-boarding and post-arrival services on every flight she worked and did not specifically compensate her for those services, the court said those services were inextricably linked to each of her completed international flights regardless of whether she performed pre-boarding and post-arrival services within the United States or within a foreign country. Thus, the court concluded that Yen-Ling's stipulated flight time percentages applied to any of her wages that were allocable to nonflight time that was based on international flight attendant services she performed for United. In addition, because there was no rational basis for allocating these forms of compensation 100 percent to foreign earned income, the court upheld the IRS assessment of the accuracy related penalty under Code Sec. 6662.

For a discussion of the foreign earned income exclusion, see Parker Tax ¶200,120.

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Famous Deceased Tax Protester Found Guilty of Evading Taxes

A deceased lawyer, who had previously avoided being convicted of failing to file tax returns, was not so lucky the second time around. Cryer v. Comm'r, T.C. Memo. 2013-69 (3/11/13).

Tom Cryer was an attorney in Shreveport, Louisiana. In 2006, Tom was indicted under Code Sec. 7201 on two counts of tax evasion. In March 2007, two counts of willful failure to timely file tax returns under Code Sec. 7203 were added to the charges. Tom was alleged to have evaded over $73,000 in taxes in 2000 and 2001 by using a trust to receive payments of dividends, interest, and stock income. The two counts of tax evasion were subsequently dropped, and Tom was acquitted of the two counts of willful failure to timely file tax returns because he convinced the jury that he genuinely believed he was not liable for the $73,000 in taxes. Tom then filed a suit against the IRS under Code Sec. 6103, alleging that the IRS disclosed confidential information and injured his reputation during their criminal investigation of him. In 2008, that case was dismissed. As a result of escaping conviction of not paying his taxes, Tom became a poster child for the tax protestor movement.

From 1993 through 2001, Tom operated a sole proprietorship law practice but did not file federal income tax returns. No payments of federal income tax were made for any of those years. The IRS issued deficiency notices for income tax liabilities for the tax years 1994 through 2001. After an audit using a bank deposits analysis, the IRS determined Tom had significant income and was liable for various additions to tax for each of the years. Tom failed to maintain, and during the audit for his tax years 1994 through 2001 failed to submit for examination by the IRS, complete and accurate books and records of his income-producing activities for those tax years.

After Tom petitioned the Tax Court, he died. On July 19, 2012, pleadings were filed opening the Succession of Tommy K. Cryer in the First Judicial District Court, Parish of Caddo, State of Louisiana. In those proceedings, the court denied probate of a purported will belonging to the decedent. At the time of the Tax Court trial, the state court had not yet appointed anyone as the executor, the administrator, or the independent administrator of the succession, nor had it appointed anyone to act as curator for any missing heir. While there was no party to litigate the Tax Court case for the decedent, the case went on because the Tax Court concluded that the IRS had to present evidence in order to sustain the additions to tax penalty against the decedent.

The Tax Court upheld the deficiencies against the decedent and concluded that the facts supported the IRS's determination that the decedent fraudulently and with intent to evade taxes failed to file federal income tax returns reporting his taxable income and income tax liabilities for the tax years 1994 through 2001. Thus, under Code Sec. 6651 and Code Sec. 6652, the court also upheld penalty assessments for failing to file returns and failing to make estimated tax payments.

For a discussion of the penalties for failing to file returns and failing to make estimated tax payments, see Parker Tax ¶262,105 and ¶262,110.

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Incorrect Form of Written Acknowledgements Precludes Certain Charitable Deductions

Deductions for charitable contributions of $250 or more were denied to the founder of a ferret rescue because there was no contemporaneous written acknowledgement of those contributions. Villareale v. Comm'r, T.C. Memo. 2013-74 (3/12/13).

In 2000, Jolene Villareale cofounded NDM Ferret Rescue and Sanctuary, Inc. (NDM). NDM is an animal rescue organization that specializes in rescuing ferrets. During 2006, Jolene was NDM's president. She was responsible for managing NDM's finances, including paying bills and managing its bank accounts. Jolene had physical and electronic access to NDM's checking account. During 2006, Jolene made 44 contributions to NDM totaling $10,022. The contributions were made in varying amounts; 27 contributions were for less than $250 (totaling $2,393) and 17 were for $250 or more (totaling $7,629). She made the contributions by electronically transferring the funds from her personal bank account to NDM's bank account or by instructing the bank manager via telephone to make the transfer. After making the transfers, she logged into both her personal bank account and NDM's bank account to ensure the transfer took effect. The dates and amounts of the transfers are reflected in Jolene's and NDM's bank statements.

Jolene timely filed her 2006 federal income tax return and claimed a $12,386 charitable contribution deduction. The IRS subsequently issued a deficiency notice disallowing Jolene's claimed charitable contribution deduction for 2006.

A cash contribution of less than $250 may be substantiated with a canceled check, a receipt, or other reliable evidence showing the name of the donee, the date of the contribution, and the amount of the contribution. However, Code Sec. 170(f)(8)(A) provides that contributions of cash or property of $250 or more require the donor to obtain contemporaneous written acknowledgment of the donation from the donee. At a minimum, the contemporaneous written acknowledgment must contain a description of any property contributed, a statement as to whether any goods or services were provided in consideration, and a description and good-faith estimate of the value of any goods or services provided in consideration.

The IRS did not dispute that Jolene made the contributions of $10,022 to NDM, nor did it question the legitimacy of NDM as a valid Code Sec. 170(c) exempt organization. Further, the IRS conceded that Jolene was entitled to deduct the contributions she made to NDM in amounts smaller than $250 (totaling $2,393). However, the IRS argued that Jolene was not entitled to deduct the contributions of $250 or more because none were substantiated by a contemporaneous written acknowledgment. Jolene argued that her and NDM's bank statements are sufficient to substantiate her contributions and that she did not need a contemporaneous written acknowledgment to assist her in determining the deductible amounts of her charitable contributions. She also argued that she should be entitled to deduct the full amount of her contributions to NDM because she substantially complied with the requirements of Code Sec. 170.

The Tax Court agreed with the IRS and denied the deduction for Jolene's contributions of $250 or more. The court said it was immaterial that Jolene was on both sides of the transaction and rejected her contention that as the president of NDM it would have been futile to issue herself a statement that expressly provided that no goods or services were provided in exchange for her contributions. The essential statutory purpose of the contemporaneous written acknowledgment required by Code Sec. 170(f)(8), the court noted, is to assist taxpayers in determining the deductible amounts of their charitable contributions and to assist the IRS in processing tax returns on which charitable contribution deductions are claimed. Although Jolene may not have needed a contemporaneous written acknowledgment to assist her in determining the deductible amounts of her charitable contributions, the court stated that the IRS still needed it to assist in determining whether Jolene was entitled to the charitable contribution deduction she claimed. The court also concluded that the doctrine of substantial compliance did not apply to excuse compliance with the substantiation requirements of Code Sec. 170(f)(8)(B). The court also concluded that Jolene's bank statements did not qualify as contemporaneous written acknowledgments because they do not state whether Jolene received any goods or services in exchange for her contributions.

For a discussion of the contemporaneous written acknowledgment requirement for charitable deductions of $250 or more, see Parker Tax ¶84,190.