IRS Issues Final Regs on Health Insurance Mandate Penalty Effective in 2014

Under the Patient Protection and Affordable Health Care Act (PPACA), beginning after 2013, nonexempt U.S. citizens and legal residents of the United States must maintain minimum essential healthcare coverage. This is referred to as the "individual mandate." A penalty, referred to as a "shared-responsibility payment," is imposed upon individuals who do not have such healthcare coverage. The penalty is imposed under Code Sec. 5000A.

The constitutionality of this individual mandate was challenged in court. On June 28, 2012, the Supreme Court, in National Federation of Independent Business et al. v. Sebelius, Secretary of Health and Human Services, 2012 PTC 167 (S. Ct. 2012)), concluded that the penalty imposed by PPACA on individuals who do not buy health insurance functions more like a tax than a penalty. Thus, because Congress has the authority to tax, the Court held the law is constitutional

On February 1, 2013, the IRS issued proposed regulations on the shared responsibility payment. It received many suggested changes from practitioners. The IRS has now finalized those regulations in T.D. 9632 (8/30/13)).

According to the IRS, the principle in implementing the individual shared responsibility provision is that the shared responsibility payment should not apply to any taxpayer for whom coverage is unaffordable, who has other good cause for going without coverage, or who goes without coverage for only a short time.

The following is a summary of some of the more important aspects of the final regulations.

Partial-Month Coverage for the Month

The final regulations provide that an individual is treated as having coverage for a month so long as he or she has coverage for any one day of that month. For example, an individual who starts a new job on April 30 and is enrolled in employer-sponsored coverage on that day is treated as having coverage for the month of April. Similarly, an individual who is eligible for an exemption for any one day of a month is treated as exempt for the entire month.

The IRS rejected a practitioner's recommendation that an individual be considered as covered for a month only if the individual is enrolled in and entitled to receive benefits under a plan or program identified as minimum essential coverage for a majority of the days in the month. The IRS said it chose the one-day rule over the majority of the days in the month rule because it provides administrative convenience for both taxpayers and the IRS. Without the one-day rule, taxpayers and the IRS would need to determine the number of days each person in a shared responsibility family is covered in each month of a tax year. However, the IRS said it will reconsider this rule if future developments indicate that the rule is being abused, for example, if individuals obtain coverage for a single day in a month over the course of several months in a year.

A practitioner requested that the final regulations provide that an individual who has submitted an application for Medicaid but is awaiting approval for enrollment has minimum essential coverage while the application is pending approval. In general, Medicaid coverage is granted retroactively to the date the application is filed. Code Sec. 5000A(a) requires that an individual have minimum essential coverage for a month. If retroactive coverage is granted, an applicant has minimum essential coverage. If the application is denied, the applicant does not have minimum essential coverage. Thus, the IRS rejected this recommendation. However, an individual without coverage may be eligible for an exemption, such as a short coverage gap exemption.

Exemptions for Certain Gaps in Coverage

The statute provides an exemption for gaps in coverage of less than three months. It generally specifies that such gaps be measured without regard to the calendar years in which the gap occurs. For example, a gap lasting from November through February lasts four months and therefore generally would not qualify for the exemption. However, recognizing that many individuals file their tax returns as early as January, before the length of an ongoing gap may be known, the final regulations provide that if the part of a gap in the first tax year is less than three months and the individual had no prior short coverage gap within the first tax year, then no shared responsibility payment is due for the part of the gap that occurs during the first calendar year, regardless of the eventual length of the gap. For example, for a gap lasting from November through February, no payment would be due for November and December.

Liability for Dependents

Consistent with Code Sec. 5000A(b)(3), the final regulations provide that a taxpayer is liable for the shared responsibility payment imposed for any individual for a month in a tax year for which the individual is the taxpayer's dependent (as defined in Code Sec. 152) for that tax year.

Practice Tip: Whether the taxpayer actually claims the individual as a dependent for the tax year does not affect the taxpayer's liability for the shared responsibility payment for the individual.

Some practitioners recommended that a taxpayer's liability for the shared responsibility payment be limited to individuals eligible for the same minimum essential coverage for which the taxpayer is eligible. According to those practitioners, many taxpayers are unable to enroll their qualifying children in their employer-provided plans. Other practitioners recommended that a taxpayer's liability under Code Sec. 5000A extend solely to those dependents who meet the requirements to be a qualifying child under Code Sec. 152, so that a taxpayer's qualifying relatives would be disregarded. In addition, practitioners requested that Code Sec. 5000A liability extend only to those dependents who are actually claimed by the taxpayer. They felt that the complexity in identifying a potential dependent before the tax year begins, particularly a qualifying relative, would prevent them from making informed coverage decisions. The practitioners claimed that, unless the rule is revised, those taxpayers may unexpectedly be liable for shared responsibility payments for dependents for whom a deduction under Code Sec. 151 is not claimed. The IRS rejected these suggestions, and the final regulations retain the rule imposing liability on the taxpayer who may claim an individual as a dependent.

Other practitioners recommended that a noncustodial parent who must provide the health care of a child under a separation agreement, divorce decree, court order, or other similar legal obligation and who fails to provide that health care be liable for the shared responsibility payment attributable to that child even if the child is the custodial parent's dependent under Code Sec. 152.

As the IRS noted, Code Sec. 5000A places liability for a dependent's lack of minimum essential coverage on the taxpayer who may claim the individual as a dependent and it does not provide that this liability may be assigned to another taxpayer, even if the other taxpayer has a legal obligation to provide the child's health care. Accordingly, the IRS rejected these practitioners' suggestions. However, the IRS noted, HHS has addressed the situation described in these comments in recently issued guidance, permitting Exchanges to grant a hardship exemption to the custodial parent for a child in this situation if the child is ineligible for coverage under Medicaid or the Children's Health Insurance Program (CHIP).

Liability for Adopted Children

Like the proposed regulations, the final regulations provide special rules for determining liability for the shared responsibility payment attributable to children adopted or placed in foster care during a tax year. If a taxpayer legally adopts a child and is entitled to claim the child as a dependent for the tax year when the adoption occurs, the taxpayer is not liable for a shared responsibility payment attributable to the child for the month of the adoption and any preceding month. Conversely, if a taxpayer who is entitled to claim a child as a dependent for the tax year places the child for adoption during the year, the taxpayer is not liable for a shared responsibility payment attributable to the child for the month of the adoption and any following month. Similar to the comments on a custodial parent's liability, practitioners recommended that a taxpayer's liability for shared responsibility payment for an adopted child be based on the state law assigning responsibility for the child's health care, not when a child is adopted or placed for foster care. The IRS rejected this recommendation because, it said, determining when a taxpayer is liable for an adopted child's health care under numerous and varying state laws would introduce considerable administrative difficulty and uncertainty into the implementation and administration of Code Sec. 5000A.

Categories of Coverage That Comprise Minimum Essential Coverage

The regulations explain that minimum essential coverage includes, at a minimum, all of the following statutory categories:

(1) employer-sponsored coverage (including COBRA coverage and retiree coverage);

(2) coverage purchased in the individual market;

(3) Medicare Part A coverage;

(4) Medicaid coverage;

(5) Children's Health Insurance Program (CHIP) coverage;

(6) Certain types of Veterans health coverage; and

(7) TRICARE

Minimum essential coverage does not include certain specialized coverage, such as coverage only for vision care or dental care, workers' compensation, or coverage only for a specific disease or condition. Under the law, minimum essential coverage also includes any additional types of coverage that are designated by the Department of Health and Human Services (HHS) or, as detailed by the regulation, when the sponsor of the coverage follows a process outlined in the regulations to be recognized as minimum essential coverage.

Employer-Sponsored Coverage

In the proposed regulations, the IRS explained that a self-insured group health plan is an eligible employer-sponsored plan and thus is considered minimum essential coverage. Several practitioners requested additional clarification on the treatment of a self-insured group health plan because these plans are not offered in a large or small group market within a state. The IRS revised the final regulations to clarify that a self-insured group health plan is an eligible employer-sponsored plan, regardless of whether the plan could be offered in the large or small group market in a state.

The proposed regulations did not specifically address arrangements in which an employer provides subsidies or funds a pre-tax arrangement for employees to use to obtain coverage under plans offered in the individual market. At least one practitioner suggested that certain arrangements of this type be treated as eligible employer-sponsored plans, arguing that treating these arrangements as eligible employer-sponsored plans would increase flexibility for employers and employees in satisfying their respective shared responsibility requirements.

The IRS did not specifically address these arrangements in the final regulations. Instead, it anticipates that future guidance will address the application of Code Sec. 5000A and the Affordable Care Act's insurance market reforms to these types of arrangements.

The proposed regulations provide that the term employee includes former employees and, as a result, treat coverage provided by an employer to former employees as coverage under an eligible employer-sponsored plan. Practitioners noted that retiree coverage may be unlike coverage offered to current employees in terms of cost, scope of benefits, and enrollment opportunities and, therefore, should be treated differently from other employer-provided coverage. Employer-sponsored group health plans offered to former employees are treated similarly for purposes of the Public Health Service Act, the Employee Retirement Income Security Act, and other provisions of the Code, the IRS noted. Therefore, the IRS did not revise the final regulations to adopt this suggestion, and retiree coverage under a group health plan is minimum essential coverage. However, the final regulations provide that, for the lack of affordable coverage exemption, an individual will not be eligible for retiree coverage unless the individual enrolls. Therefore, an individual who is eligible for retiree coverage but does not enroll disregards that eligibility in determining qualification for the lack of affordable coverage exemption.

Individuals Exempt from the Shared Responsibility Payment

Consistent with the statute, the final regulations provide nine categories of individuals who are exempt from the shared responsibility payment. These categories are as follows:

(1) Religious conscience. This applies to a member of a religious sect that is recognized as conscientiously opposed to accepting any insurance benefits. The Social Security Administration administers the process for recognizing these sects according to the criteria in the law.

(2) Health care sharing ministry. This applies to a member of a recognized health care sharing ministry.

(3) Indian tribes. This applies to a member of a federally recognized Indian tribe.

(4) No filing requirement. This applies to an individual whose income is below the minimum threshold for filing a tax return. The requirement to file a federal tax return depends on the individual's filing status, age and types and amounts of income.

(5) Short coverage gap. This applies to an individual went without coverage for less than three consecutive months during the year.

(6) Hardship. The Health Insurance Marketplace, also known as the Affordable Insurance Exchange, has certified that an individual has suffered a hardship that makes the individual unable to obtain coverage.

(7) Unaffordable coverage options. An individual can't afford coverage because the minimum amount that the individual must pay for the premiums is more than 8 percent of the individual's household income.

(8) Incarceration. This applies to an individual in a jail, prison, or similar penal institution or correctional facility after the disposition of charges against the individual.

(9) Not lawfully present. The individual is not a U.S. citizen, a U.S. national or an alien lawfully present in the U.S.

The religious conscience exemption and the hardship exemption are available exclusively through a Health Insurance Marketplace or Exchange. Four categories of exemptions are available exclusively from the IRS through the filing process the exemptions for individuals who are not lawfully present, taxpayers with household income below the filing threshold, individuals who cannot afford coverage, and individuals who experience short coverage gaps.

Practice Tip: Starting in early 2015, individuals filing a tax return for 2014 will indicate which members of their family (including themselves) are exempt from the provision. For family members who are not exempt, the taxpayer will indicate whether they had insurance coverage. For each nonexempt family member who doesn't have coverage, the taxpayer will owe a shared responsibility payment.

A choice is available to individuals for the exemptions in the three remaining categories members of a health care sharing ministry, individuals who are incarcerated, and members of Indian tribes. These exemptions can be obtained either through a Health Insurance Marketplace or through the tax return filing process.

[Return to Table of Contents]

IRS Recognizes All Same-Sex Marriages for Federal Tax Purposes, Regardless of Domicile; Multiple Opportunities Exist for Amended Returns

In June 2013, in U.S. v. Windsor, 2013 PTC 167 (S. Ct. 2013), the Supreme Court struck down a provision in the Defense of Marriage Act (DOMA) that had prevented same-sex couples from receiving many federal benefits. However, the decision left many unanswered questions one of the biggest being what happens when a same-sex couple is married in a state that recognizes such marriages but then lives in a state that doesn't recognize the marriage?

In recently released guidance, Rev. Rul. 2013-17, the IRS ruled that if a same-sex couple is married in a state that recognizes such marriages, that marriage will be recognized for all federal purposes, no matter where the couple lives. However, the ruling goes on to say that there is no recognition for federal tax purposes of individuals, whether of the opposite sex or the same sex, who have entered into a registered domestic partnership, civil union, or other similar formal relationship recognized under state law that is not denominated as a marriage under the laws of that state.

Practice Aid: Parker Tax Publishing has prepared several new client letters that practitioners may use to update their clients about these new rules. These may be found in the Sample Client Letters database (¶320,142, ¶320,144, ¶320,146, and ¶320,148)

Practice Tip: The Supreme Court decision and Rev. Rul. 2013-17 present many opportunities for practitioners to file amended returns not only for the same-sex individuals, but also for businesses that paid social security taxes and Medicare taxes on benefits to a same-sex spouse of an employee.

The IRS also released the IRS FAQ on Same-Sex Married Couples on its website, which answers additional questions. In the FAQ, the IRS states that, beginning with the 2013 tax year, and for the 2012 tax year if the return has not been filed by September 16, 2013, a same-sex couple that is living together must file their federal income tax return using the filing status of either married filing jointly or married filing separately. Additionally, the FAQ provides guidelines that retirement plans must follow in order to retain their status as a qualified retirement plan, including the provision that a plan that only operates in a state that doesn't recognize same-sex marriages, must treat a participant who is married to a spouse of the same sex under the laws of a different jurisdiction as married for purposes of applying the qualification requirements that relate to spouses.

Filing Refund Claims

Same-sex couples that were married in years where the statute of limitations is still open should review prior-year tax returns to see if filing amended returns would be beneficial. Generally, a taxpayer may file a claim for refund for three years from the date the return was filed or two years from the date the tax was paid, whichever is later. If an employer provided health coverage for an employee's same-sex spouse, the employee may claim a refund of income taxes paid on the value of coverage that would have been excluded from income had the employee's spouse been recognized as the employee's legal spouse for tax purposes.

Example: ABC Corporation sponsors a group health plan covering eligible employees and their dependents and spouses (including same-sex spouses). Fifty percent of the cost of health coverage elected by employees is paid by ABC. Bob was married to Mike at all times during 2012. Bob elected coverage for Mike through ABC's group health plan beginning January 1, 2012. The value of the employer-funded portion of Mike's health coverage was $250 per month. The amount in Box 1, Wages, tips, other compensation, of the 2012 Form W-2 provided by ABC to Bob included $3,000 ($250 per month x 12 months) of income reflecting the value of employer-funded health coverage provided to Mike. Bob filed Form 1040 for 2012 reflecting the Box 1 amount reported on Form W-2. Bob may file an amended Form 1040 for 2012 excluding the value of Mike's employer-funded health coverage ($3,000) from gross income.

Amended returns could also be filed in situations where an employer sponsored a cafeteria plan that allowed employees to pay premiums for health coverage on a pre-tax basis. A participating employee can file an amended return to recover income taxes paid on premiums that the employee paid on an after-tax basis for the health coverage of the employee's same-sex spouse for all years for which the period of limitations for filing a claim for refund is open. If an employer sponsored a cafeteria plan under which an employee elected to pay for health coverage for the employee on a pre-tax basis, and if the employee purchased coverage on an after-tax basis for the employee's same-sex spouse under the employer's health plan, the employee may claim a refund of income taxes paid on the premiums for the coverage of the employee's spouse.

Example: ABC Corporation sponsors a group health plan as part of a cafeteria plan with a calendar year plan year. The full cost of spousal and dependent coverage is paid by the employees. In the open enrollment period for the 2012 plan year, Carl elected to purchase self-only health coverage through salary reduction under ABC's cafeteria plan. On March 1, 2012, Carl was married to David. Carl purchased health coverage for David through ABC's group health plan beginning March 1, 2012. The premium paid by Carl for David's health coverage was $500 per month. The amount in Box 1, Wages, tips, other compensation, of the 2012 Form W-2 provided by ABC to Carl included the $5,000 ($500 per month x 10 months) of premiums paid by Carl for David's health coverage. Carl filed Form 1040 for 2012 reflecting the Box 1 amount reported on Form W-2. Carl's salary reduction election is treated as including the value of the same-sex spousal coverage purchased for David. Carl may file an amended Form 1040 for 2012 excluding the premiums paid for David's health coverage ($5,000) from gross income.

In the situations above, the employer can also file an amended return and claim a refund for the social security taxes and Medicare taxes paid on the benefits if the period of limitations for filing a claim for refund is open. The employer should file the claim on Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund.

Observation: The IRS said it will provide a special administrative procedure for employers to file claims for refunds or make adjustments for excess social security taxes and Medicare taxes paid on same-sex spouse benefits in the near future.

Additionally, if an employer cannot locate a former employee with a same-sex spouse who received the benefits described above, the IRS said the employer can still claim a refund of the employer portion of the social security and Medicare taxes on the benefits. According to the IRS, if the employer makes reasonable attempts to locate an employee who received the benefits that were treated as wages but the employer is unable to locate the employee, the employer can claim a refund of the employer portion of social security and Medicare taxes, but not the employee portion. Also, if an employee is notified and given the opportunity to participate in the claim for refund of social security and Medicare taxes but declines in writing, the employer can claim a refund of the employer portion of the taxes, but not the employee portion. Employers can use the special administrative procedure that the IRS said it will issue shortly to file these claims.

Finally because services performed by an employee in the employ of his or her spouse are excluded from the definition of employment for purposes of social security, Medicare and FUTA taxes, a sole proprietor can claim a refund of the social security, Medicare, and FUTA taxes paid on the compensation paid to his or her same-sex spouse as an employee in the business.

Head of Household Filing Status

As noted above, a taxpayer who is married cannot file using head of household filing status. However, a married taxpayer may be considered unmarried and may use the head-of-household filing status if the taxpayer lives apart from his or her spouse for the last six months of the tax year and provides more than half the cost of maintaining a household that is the principal place of abode of the taxpayer's dependent child for more than half of the year.

Rules Relating to Dependents and Children

While a same-sex partner may have previously been able to qualify as a dependent, that is no longer the case. A taxpayer's spouse cannot be a dependent of the taxpayer.

If a child is a qualifying child of both parents who are spouses (who file using the married filing separate status), either parent, but not both, may claim a dependency deduction for the qualifying child. If both parents claim a dependency deduction for the child on their income tax returns, the IRS will treat the child as the qualifying child of the parent with whom the child lives for the longer period of time during the tax year. If the child lives with each parent for the same amount of time during the tax year, the IRS will treat the child as the qualifying child of the parent with the higher adjusted gross income.

Under Code Sec. 23(d)(1)(C), if a taxpayer adopts the child of his or her same-sex spouse as a second parent or co-parent, the adopting parent cannot claim the adoption credit for the qualifying adoption expenses he or she pays or incurs to adopt the child.

Rules Applicable to Retirement Plans

Under Rev. Rul. 2013-17, qualified retirement plans are required to comply with the following rules:

(1) A qualified retirement plan must treat a same-sex spouse as a spouse for purposes of satisfying the federal tax laws relating to qualified retirement plans.

(2) For purposes of satisfying the federal tax laws relating to qualified retirement plans, a qualified retirement plan must recognize a same-sex marriage that was validly entered into in a jurisdiction whose laws authorize the marriage, even if the married couple lives in a domestic or foreign jurisdiction that does not recognize the validity of same-sex marriages.

(3) A person who is in a registered domestic partnership or civil union is not considered to be a spouse for purposes of applying the federal tax law requirements relating to qualified retirement plans, regardless of whether that person's partner is of the opposite or same sex.

The following examples illustrate the qualified plan rules:

Example: Plan A, a qualified defined benefit plan, is maintained by ABC Corporation, which operates only in a state that does not recognize same-sex marriages. Nonetheless, Plan A must treat a participant who is married to a spouse of the same sex under the laws of a different jurisdiction as married for purposes of applying the qualification requirements that relate to spouses.

Example: Plan B is a qualified defined contribution plan and provides that the participant's account must be paid to the participant's spouse upon the participant's death unless the spouse consents to a different beneficiary. Plan B does not provide for any annuity forms of distribution. Plan B must pay this death benefit to the same-sex surviving spouse of any deceased participant. Plan B is not required to provide this death benefit to a surviving registered domestic partner of a deceased participant. However, Plan B is allowed to make a participant's registered domestic partner the default beneficiary who will receive the death benefit unless the participant chooses a different beneficiary.

Qualified retirement plans must comply with these rules as of September 16, 2013. Although Rev. Rul. 2013-17 allows taxpayers to file amended returns that relate to prior periods in reliance on the rules in Rev. Rul. 2013-17 with respect to many matters, this rule does not extend to matters relating to qualified retirement plans.

Observation: The IRS has not yet provided guidance regarding the application of Windsor and these rules to qualified retirement plans with respect to periods before September 16, 2013. It stated that it intends to issue further guidance on how qualified retirement plans and other tax-favored retirement arrangements must comply with Windsor and Rev. Rul. 2013-17. It is expected that future guidance will address the following, among other issues: (1) plan amendment requirements (including the timing of any required amendments); and (2) any necessary corrections relating to plan operations for periods before future guidance is issued.

[Return to Table of Contents]

Estate's Attempt to Evade Code Sec. 642(g)'s Bar on Double Deductions Fails

A recent district court case involving refund claims by an estate for a decedent's personal income tax liability presented some interesting issues. The first issue involved the estate requesting a refund for the decedent's personal income tax obligation that allegedly arose out of the purchase of option assets during the sale of the decedent's aviation business. The estate argued that the IRS lost a court case on that issue and its subsequent assessment of tax, which was paid by the estate, was barred by res judicata. The second, and more interesting, issue was the refund request relating to lawsuit settlement payments made after the decedent's death for actions he allegedly took before his death. The estate had deducted the payments on the estate tax return and then sought to take a deduction on the decedent's prior-year income tax return on the theory that the deduction was allowed under Code Sec. 691(b). The IRS argued that Code Sec. 642(g) barred the double deduction.

The estate won on the first issue, but lost on the second. In Batchelor-Robjohns v. U.S., 2013 PTC 269 (S.D. Fla. 8/30/13), a district court analyzed the interaction of Code Sec. 1341, Code Sec. 691(b), Code Sec. 642(g), and Code Sec. 461(h), along with case law. The court found that the estate was attempting to deduct the settlement payments as ordinary and necessary business expenses, but the decedent's income that the estate said should be reduced as a result of the settlement payments, had been reported as capital gain. Thus, the settlement payments could only be treated as a capital loss an expense that is not covered by Code Sec. 691(b), which is an exception to the Code Sec. 642(g) bar on double deductions.

Facts

On February 10, 1999, George Batchelor sold his aviation business, IAL, to lnternational Air Leases of P.R., lnc. (IALPR) for $502 million. In exchange for nearly half his IAL stock, IALPR paid Batchelor almost $235 million in cash and marketable securities. To cover the remainder of the stock, IALPR offered Batchelor approximately $118 million in cash equivalents and a promissory note for $150 million. Additionally, IAL and IALPR negotiated an option for Batchelor to buy back some of the assets (i.e., option assets) transferred in the sale, thereby reducing the balance of the $150 million promissory note by a negotiated price for each asset that he bought back. These option assets included aircraft, engines, and IAL'S ownership interest in three joint ventures. On April 1, 1999, Batchelor exercised his option to buy back these assets for an agreed amount of almost $93 million, thus reducing the $150 million note by that amount. IALPR later caused the balance of the note to be paid off in August 2000. Batchelor subsequently declared his income from the sale as a capital gain and paid the appropriate capital gains tax on the proceeds.

As a result of the sale of these option assets, IAL itself realized a substantial capital gain. After an unsuccessful attempt by IAL to shelter its income via a currency swap, the IRS sought to collect IAL'S corporate income tax obligation from Batchelor under a theory of transferee liability. However, Batchelor died on July 29, 2002. The IRS then filed a lawsuit (Batchelor I) against Batchelor's estate. According to the IRS, the value of the transfer of the option assets constituted excess consideration that rendered IAL insolvent and, therefore, assigning liability to Batchelor as the transferee of those assets. In doing so, the IRS asserted that the real value of the option assets was higher than the amount Batchelor and IALPR agreed upon. The IRS assessed an income tax deficiency, and the estate paid the tax assessed. The estate then sued for a refund and the case went to court. The IRS could not prove its case and the court ruled in favor of the estate.

Several months later, the IRS filed a claim in the Batchelor probate case for unpaid personal income tax obligations, including liability arising from the 1999 transfer of the option assets. Although it originally contested the claim and was due to go to court over the issue, the estate subsequently opted to pay the tax. The IRS and estate filed a stipulation acknowledging that the estate had paid the contested tax liability but retained the right to assert a refund claim at a later time. The estate subsequently requested a refund, which the IRS denied.

Following the sale of Batchelor's ownership interest in IAL to IALPR, a number of parties filed suit challenging the transaction. In particular, IAL sued the estate seeking to set aside the sale as a fraudulent transfer. A week later, IALPR filed a claim in the estate's probate proceeding also seeking damages from Batchelor's allegedly fraudulent sale of his ownership interest. In addition, the estate inherited two ongoing lawsuits that had begun before Batchelor's death, both stemming from Batchelor's involvement with another aviation business.

From 2002 to 2004, the estate decided to settle each of the pending claims against it, settling with Harrington for $2 million in October 2002, with Feltman for $25 million in December 2002, with IALPR for $12 million in August 2003, and with IAL for $1 million in March 2004. On October 29, 2003, the estate filed a Form 706, Federal Estate Tax Return, in which it deducted approximately $40 million from the gross estate for the settlement payments.

The estate subsequently filed a claim for an income tax refund requesting a refund of $8.3 million pursuant to Code Sec. 1341 based on the settlement payments made in all four lawsuits. The IRS denied the claim.

A magistrate judge prepared a report for the district court in which she sided with the IRS on both issues.

Refund Relating to the Purchase of the Option Assets

With respect to the refund request for the tax paid that related to tax liability arising from the 1999 transfer of the option assets, the estate argued that res judicata precluded the IRS from contesting the refund because of the ruling in Batchelor I.

The district court noted that res judicata will bar a claim due to prior litigation if the following elements are established: (1) there is a final judgment on the merits; (2) the decision was rendered by a court of competent jurisdiction; (3) the parties, or those in privity with them, are identical in both suits; and (4) the same cause of action is involved in both cases. In addition to these four elements, the district court said, courts must also determine whether the claim in the new suit was, or could have been, raised in the prior action.

With respect to the fourth element, the magistrate judge concluded that the estate failed to establish that the same cause of action raised in Batchelor I was present in the instant situation. She asserted that Batchelor I involved a different tax claim in a different tax year. Specifically, she found that Batchelor I involved a claim for IAL's corporate income tax during the corporation's April 1, 1999, to March 31, 2000, tax year, while the instant case pertained to Batchelor's personal income tax for the calendar year 1999.

The estate objected to the magistrate's judge's finding that Batchelor I concerned a different cause of action. It asserted that since the two claims arose out of the same transaction, specifically the 1999 transfer of the option assets, the claims therefore arose out of the same nucleus of operative fact and were therefore the same cause of action. In fact, the estate argued, the IRS was trying in the instant case to prove the same thing that it tried to prove in Batchelor I namely, that the value of the option assets was higher than the value that Batchelor and IALPR agreed upon.

The estate further objected to the magistrate's holding that two different years were involved. According to the estate, the fact that the date of the transaction fell in the middle of Batchelor's 1999 tax year but on the first day of IAL's April 1, 1999 to March 31, 2000 tax year was not relevant. What was relevant, the estate said, was that Batchelor I involved the exact same transfer on the exact same date as the present case.

The district court rejected the magistrate judge's recommendation and agreed with the estate that the present case involved the same claim or cause of action as Batchelor I under the Eleventh Circuit's case law (i.e., the circuit that would hear any appeal of this case) regarding the doctrine of res judicata. The district court also did not concur with the government's assertion that Batchelor I and the present case involved claims from different tax years. The case focused on a single transaction that occurred on a specific date. Though the transaction technically fell on different tax years for IAL and Batchelor, that was only because their tax years were measured differently. This did not change the fact that the transaction occurred on the same calendar date for both IAL and Batchelor.

The claim in the instant case, the court said, could have been raised in Batchelor I, and the government had over two years between the filing of the return in 2000 and the filing of Batchelor I in January 2003 to pursue the claim. The court thus concluded that the estate had established that the present case and Batchelor I involved the same cause of action, as well as the fact that the personal income tax claim against Batchelor could have been brought in Batchelor I. Thus, res judicata barred the government from contesting the estate's request for a refund.

Refund Relating to Settlement Payments

Under Code Sec. 1341, a taxpayer is entitled to relief if in one year the taxpayer included an item as gross income and paid tax on that income, then in a subsequent year is compelled to return the item. In claiming such relief, the taxpayer bears the burden of demonstrating that (1) an item was included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the tax year because it was established after the close of such prior tax year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and (3) the amount of the deduction exceeds $3,000. The district court noted that Code Sec. 1341 does not independently create a deduction; a taxpayer must be entitled to the deduction under another provision of the Code.

The IRS argued that Code Sec. 642(g) precluded the estate from taking an income tax deduction for the settlement payments since it already took an estate tax deduction for the payments in 2003. In addition, the IRS asserted that, because Batchelor reported a capital gain from the IAL transaction, the estate could not satisfy the independent deduction requirement of Code Sec. 1341.

The estate claimed that the settlement payments were independently deductible under either Code Sec. 162 or Code Sec. 212. To this end, the estate noted that Batchelor would have had a legal obligation to restore to IAL and its creditors any excess consideration received from the 1999 sale of his interest in IAL if it had been determined that the sale rendered IAL insolvent. The estate therefore maintained that the payment of the settlements was an ordinary and necessary business expense in connection with Batchelor's business and income-producing activity as an investor. In its brief, the estate said that "[t]he settlement expenses related to claims alleging that, in obtaining the income from the sale of his interests in IAL, Mr. Batchelor received too much money and assets. To resolve claims to recover the entire amount he received, the Estate paid back-refunded-a portion of his income. According to the estate, the settlement payments were deductions in respect of a decedent under Code Sec. 691(b) and thus not barred by Code Sec. 642(g).

The estate also argued that, because Batchelor declared this income as a capital gain, but did not get to keep it, his estate should be able to exclude the gain he returned and recalculate the tax. The estate said it was not seeking an unfair result and that it was seeking the refund of the capital gains tax, not ordinary income tax.

Code Sec. 642(g) generally prevents an estate from claiming both an estate tax deduction under Code Sec. 2053 or Code Sec. 2054 (i.e., the provisions allowing estate tax deductions for expenses, debts, taxes, and losses) and an income tax deduction for the same expense. Consequently, an estate normally must choose to deduct the amount from the gross estate for estate tax purposes or from the estate's gross income for income tax purposes, but not both.

However, Code Sec. 642(g) does not apply with respect to deductions allowed under Code Sec. 691(b). Reg. Sec. 1.642(g)-2 provides that Code Sec. 642(g) has no application to deductions for taxes, interest, business expenses, and other items accrued at the date of a decedent's death so that they are allowable as a deduction under Code Sec. 2053(a)(3) for estate tax purposes as claims against the estate, and are also allowable under Code Sec. 691(b) as deductions in respect of a decedent for income tax purposes. In contrast, the bar on double deductions listed in Code Sec. 642(g) does apply to deductions for interest, business expenses, and other items not accrued at the date of the decedent's death.

As an initial matter, the magistrate judge's report cited Reg. Sec. 1.691(b)-1(a) and concluded that the settlement payments were not deductions in respect of a decedent under Code Sec. 691(b) because Batchelor, as the decedent, was not "liable" for the payments at the time of his death or any time prior.

To determine whether Batchelor was "liable" for the payments, the magistrate judge looked to Code Sec. 461(h) and its definition of when a liability is incurred. That provision, the judge noted, states that in determining whether an amount has been incurred with respect to any item during any tax year, the all-events test is not treated as met any earlier than when economic performance with respect to that item occurs. Where the liability of the taxpayer requires a payment to another person and arises out of any tort, economic performance occurs as the payments to such person are made. Accordingly, the judge said that since the estate did not actually make the settlement payments until 2004, Batchelor himself never incurred this liability at the time of his death in 2002 or at any time prior as required by Code Sec. 691(b). Thus, as the payments were not covered by Code Sec. 691(b), the exception to Code Sec. 642(g) did not apply, and that provision prohibited the estate from claiming a second deduction from its income tax liability for the settlement payments.

In reaching this determination, the magistrate found that "liability" does not mean the accrual of a cause of action. Rather, she pointed to Reg. Sec. 1.446-1(c)(1)(ii)(B) which defines "liability" as including any item allowable as a deduction, cost, or expense for federal income tax purposes. From this regulation, she concluded that "liability" pertains to the actual payment of the settlement amounts as opposed to the initiation of the suits from which the settlements derived.

The district court agreed with the magistrate judge and concluded that, based on the Eleventh Circuit's precedent, the estate failed to identify a suitable deduction provision that satisfied Code Sec. 691(b)'s exception to Code Sec. 642(g). Further, the court said, since the proceeds of the IAL sale constituted a capital gain, the holding in Kimbell v. U.S., 490 F.2d 203 (5th Cir. 1974) precluded treating the disgorgement of those proceeds via the settlement payments as a deductible business expense under Code Sec. 162. Like the taxpayer in Kimbell, the court said, Batchelor reported the income from the IAL sale as a capital gain and paid a capital gains tax on the proceeds. The settlement payments were made in satisfaction of liabilities arising from the IAL transaction. The court found that while the estate was now attempting to deduct those payments as ordinary and necessary business expenses, Kimbell barred such a deduction. Instead, the court concluded, the payments may only be treated as a capital loss an expense that is not covered by Code Sec. 691(b).

[Return to Table of Contents]

Proposed Section 174 Regs Would Broaden Definition of R&D

Proposed regulations provide that if expenditures qualify as research or experimental expenditures, it is irrelevant whether a resulting product is ultimately sold or used in the taxpayer's trade or business. REG-124148-05 (9/6/13).

Code Sec. 174 allows taxpayers to elect to take a current deduction for research and experimental expenditures in the tax year they are paid or incurred or to defer certain research and experimental expenditures and amortize them. Since its enactment in 1954, Code Sec. 174(c) has provided that Code Sec. 174 does not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character that is subject to depreciation or depletion. In 1957, the IRS issued Reg. Sec. 174-2(b)(1) and (b)(4) to implement this rule. This is referred to as the Depreciable Property Rule.

Practitioners have been questioning whether the sale of a product resulting from otherwise qualifying research or experimental expenditures should subsequently disqualify those expenditures from Code Sec. 174 treatment. The IRS had previously taken the position that Code Sec. 174(c) precluded Code Sec. 174 treatment in the case of a subsequent sale of a resulting product to a customer, because the sale gives rise to depreciable property in the hands of the customer. In T.G. Missouri Company v. Comm'r, 133 T.C. 278 (2009), the Tax Court rejected the IRS's argument that research or experimental expenditures were disqualified under Code Sec. 174 because the product resulting from research was sold to customers and was subject to depreciation in the customers' hands.

The IRS has now issued proposed regulations in which it proposes several substantive revisions to the current regulations and provides additional examples to further clarify how the rules work. First, to counter an interpretation that Code Sec. 174 eligibility can be reversed by a subsequent event, the proposed regulations provide that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation is not relevant to a determination of eligibility under Code Sec. 174. Second, the proposed regulations amend Reg. Sec. 1.174-2(b)(4) to provide that the Depreciable Property Rule is an application of the general definition of research or experimental expenditures provided for in Reg. Sec. 1.174-2(a)(1) and should not be applied to exclude otherwise eligible expenditures.

Third, the proposed regulations define the term ``pilot model'' as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully functional representation or model of the product or a component of a product (to the extent the shrinking-back provision described below applies). Fourth, the proposed regulations clarify the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under Code Sec. 174 because these costs are not for research or experimentation. Finally, the proposed regulations provide a shrinking-back provision to address situations in which the requirements of Reg. Sec. 1.174-2(a)(1) are met with respect to only a component part of a larger product and are not met with respect to the overall product itself. The proposed regulations provide new examples applying these provisions.

These regulations are proposed to apply to any tax year ending on or after the date the regulations are finalized. Notwithstanding the prospective effective date, the IRS will not challenge return positions consistent with these proposed regulations. Therefore, taxpayers may rely on these proposed regulations until the date that the final regulations are published in the Federal Register.

For a discussion of the rules for deducting research and experimental expenditures, see Parker Tax ¶95,505.

[Return to Table of Contents]

Investor's Trading Activities Weren't Frequent Enough to Constitute a Trade or Business; Longer Holding Period Showed He Wasn't Interested in Daily Market Swings

An investor was not a trader in securities because his trading activities did not have the frequency, continuity, and regularity to constitute a trade or business and the long holding periods showed that he was not seeking to profit from the swings in the daily market. Endicott v. Comm'r, T.C. Memo. 2013-199 (8/28/13).

Thomas Endicott was the president of a tool and stamping company before retiring in 2002. In 2006, Thomas began purchasing and selling stocks and call options. His strategy was to purchase shares of stock and then sell call options on the underlying stock with a goal of earning a profit from the premiums received from selling call options against a corresponding quantity of underlying stock he held. Thomas typically sold call options with a term of one to five months. During the years in issue, some of Thomas's call options expired, some were exercised by the option's purchaser, and for some options Thomas exited out of the position before the option expiration date.

In February 2006, Thomas purchased 20,000 shares of stock in SLM Corporation. From February 2006 through March 2007, Thomas sold call options on the SLM stock and exited out of the position before the expiration date. He earned net premiums of $166,000 from selling the call options and reported the amount as short-term capital gain. During this time period, Thomas received approximately $24,400 in dividends from the SLM stock. He sold the stock in July 2007 and reported a $212,700 long-term capital loss. From other stock in his portfolio, Thomas earned a total of over $120,200 in dividends in 2006, 2007 and 2008. During these years, the brokers allowed Thomas to use margin for his stock purchases. The process of using margin entailed the broker lending money to Thomas for him to purchase additional shares of stock. By using 100 percent margin, Thomas would double the number of shares of underlying stock that he could purchase, which allowed him to double the number of call options he sold, thereby doubling the amount of premiums he received. The brokers would charge Thomas interest on the amount he borrowed. The brokers charged him interest of more than $694,800 in 2006 2008. Although he did not execute trades every business day, Thomas monitored his portfolio and research new positions on a daily basis.

On each of his 2006, 2007, and 2008 federal income tax returns, Thomas attached two separate Schedules C, Profit or Loss From Business. On one Schedule C, Thomas listed his principal business as other financial investment activities and reported the expenses associated with his trading activities. On the second Schedule C, he listed his principal business as consulting. He reported the gains and losses from the sale of stock and options on Schedules D, Capital Gains and Losses. Thomas used the services of a tax return preparer for each of his returns. The IRS assessed deficiencies in Thomas's income tax of over $71,100 for 2006, 2007, and 2008 and assessed accuracy-related penalties.

Code Sec. 212 provides that nontrade or nonbusiness expenses incurred in the production of income are deductible as itemized deductions. Under Code Sec. 163, the deduction for investment interest expenses is limited to the amount of net investment income.

Thomas argued that he was a trader in securities. The IRS contended that Thomas was an investor during the years in issue. Traders can deduct their losses because they are in a trade or business; investors are subject to the $3,000 capital loss limitation on their losses.

The Tax Court held that Thomas was not a trader in securities and the investment expenses he claimed as business expenses on his Schedules C were disallowed. The court looked to case law in Kay v. Comm'r, T.C. Memo. 2011-159, which states that generally, for federal tax purposes, a person who purchases and sells securities is categorized as a dealer, trader, or investor. A trader is defined as engaged in the trade or business of selling securities for their own account and their profit is derived through acts of trading such as the direct management of purchasing and selling. Investors are defined as selling securities for their own account and are not engaged in the trade or business of selling securities. The court also cited Moller v. U.S., 721 F2d 810 (Fed. Cir. 1983), in which the Federal Circuit held that, in determining whether a taxpayer is a trader, the taxpayer's intent, nature of the income to be derived from the activity, and frequency, extent, and regularity of the taxpayer's transactions are to be considered. In Thomas's case, the court found that Thomas did not execute a substantial number of trades and the number of days that he executed trades did not have the requisite frequency, continuity, and regularity to constitute a trade or business.

The court rejected Thomas's argument that call options were unique and different from stocks, and in determining if he met the frequency requirement, the number of days he maintained an option position should be added to the number of days he executed trades. While the court agreed that options were different from stock, both were purchased and sold on a daily basis on exchanges. Thomas's inability to profit from frequent purchases and sales of options did not relieve him from the frequency requirement. In addition, the longer average holding periods during which Thomas held stock and maintained option positions showed that he was not seeking to profit from the swings in the daily market. The court noted that Thomas received a substantial amount of dividend and other income during the years at issue.

Finally, the court concluded that Thomas was liable for accuracy-related penalties. His understatements of income tax were substantial and he failed to show reasonable cause. Although his returns were prepared by a tax return preparer, Thomas did not show that the return preparer was a competent professional with sufficient expertise to justify his good-faith reliance. Thomas also did not have substantial authority to support his position that he was a trader.

For a discussion of the differences between investors and traders, see Parker Tax ¶242,350.

[Return to Table of Contents]

Purchasing Ex-Wife's Home Before Divorce Precluded First-Time Homebuyer Credit

The taxpayer could have qualified as a first-time homebuyer if he had waited to purchase his soon-to-be-ex-wife's house after their divorce was final; the settlement agreement the couple signed before the divorce was not recognized by the IRS or the court as evidence of a final divorce. Triggiani v. U.S., 2013 PTC 264 (Fed. Cl. 8/16/13).

Alfonso Triggiani bought a home July 20, 2009, and filed IRS Form 5405, First-time Homebuyer Credit and Repayment of the Credit, in that tax year to receive the $8,000 tax credit for first-time homebuyers. The home belonged to the wife from whom he was divorced under a final divorce decree in September of 2009. On July 9, 2009, Alfonso and his wife executed and signed a marital settlement agreement to memorialize their decisions regarding issues such as division of property and spousal support.

Observation: The first-time homebuyer credit (FTHBC) generally was available only for taxpayers who purchased a principal residence during 2008, 2009, or 2010.

The IRS disallowed the claim for the $8,000 credit. Under Code Sec. 36(c)(3)(A), the credit is not allowed for a home acquired from a person related to the person acquiring the home. Thus, the IRS explained, Alfonso did not qualify for the credit because his ex-wife had owned their home as a principal residence, and this interest was imputed to him.

Alfonso argued that the July 9 marital settlement agreement established the date of the divorce. The IRS argued that Alfonso was not entitled to the credit because his divorce decree was not final until September, well after he purchased his home. Alfonso appealed to the Court of Federal Claims.

The benefit for first-time homebuyers was a tax credit under Code Sec. 36 of 10 percent of the purchase price of a principal residence, up to $8000. Code Sec. 36 defines first-time homebuyer of a principal residence as an individual if such individual (and if married, such individual's spouse) had no present ownership interest in a principal residence during the three-year period ending on the date of the purchase of the principal residence to which Code Sec. 36 applies. The IRS said Alfonso did not qualify as a first-time homebuyer under the statute because he was married when he bought the new residence for which he sought the credit. His spouse had a present ownership interest in a principal residence during the three-year period before the purchase.

The Court of Federal Claims held that Alfonso was not entitled to the credit. The court noted that Alfonso could have qualified as a first-time homebuyer only by purchasing his new home after his divorce was final. The court concluded that the settlement agreement was not evidence of a final divorce. Thus, Alfonso was legally married when he purchased the property at issue. A beneficial interest in the home was imputed to him, the court said, and thus he did not qualify as a first-time homebuyer.

For a discussion of taxpayers eligible for the first-time homebuyer credit, see Parker Tax ¶102,705.

[Return to Table of Contents]

Experienced Tax Attorney Should Have Known He Had No Basis for Losses; 40 Percent Penalty Appropriate

Losses claimed by a partnership created as a tax shelter for the benefit of its investors were disallowed because the partnership lacked economic substance; penalties for gross valuation misstatements were upheld. Superior Trading, LLC v. Comm'r, 2013 PTC 263 (7th Cir. 8/26/13).

John Rogers, a tax attorney, created a partnership, Warwick Trading, LLC, for the purpose of selling tax shelter interests to U.S. investors. The partners in Warwick were a foreign consumer electronics retailer, Lojas Arapua S.A., and Jetstream Business Limited, another company owned by John. Superior Trading, LLC, a holding company, was a subsidiary of Warwick. Arapua contributed to Warwick largely uncollectible receivables of $30 million that were worth less than their face amount. Jetstream was designated managing partner and responsible for collecting the receivables. The net receipts collected by Jetstream would be Warwick's income to be divided between Jetstream and Arapua. With this arrangement, John intended to create a distressed asset/debt (DAD) tax shelter.

In a DAD tax shelter, when an asset is contributed to a partnership, the contributor receives a partnership interest in exchange. Although the partnership formally owns the asset, the contributor owns a partnership interest in recognition of the contribution and has actually parted with the asset. John's DAD tax shelter involved Arapua's contribution of receivables with built-in loss to Warwick, followed by the sale of Arapua's partnership interest to U.S. investors. The partnership losses generated when the receivables were sold would flow through to the U.S. investors. The investors would deduct the built-in loss up to the amount of their basis in the partnership. The basis of the partnership interest that investors acquired was the price at which Arapua sold the interest to the investors. The price for the interest was approximately 3 to 6 percent of the value of the losses obtained by buying into the shelter since the investors were only buying tax savings based on built-in loss. To increase their basis in the partnership to a level where the investors could deduct the entire built-in loss, investors contributed promissory notes to Warwick. The notes had no actual value, as John did not intend to collect on them.

Warwick claimed losses of the sale of the partnership interests to the U.S. investors. The IRS issued notices of final partnership administrative adjustment (FPAAs) for 2003 and 2004, denying the deductions, adjusting the partnership basis in the receivables to zero and imposing penalties for gross valuation misstatements under Code Sec. 6662(h). The Tax Court upheld the IRS's FPAAs and imposition of the 40 percent gross valuation misstatement penalty.

Code Sec. 723 provides that when an asset is contributed to a partnership, the asset's basis is the original basis of the contributor, which is the asset's original cost with adjustments. Recognition of gain or loss attributable to a change in the asset's value before the asset was contributed to the partnership is deferred until the partnership sells the asset. Code Sec. 704 states that if an asset is worth less than the contributor paid for it, then the loss in value, or built-in loss, will be recognized and used to reduce taxable income only when the partnership sells the asset.

The Seventh Circuit affirmed the Tax Court and held that Warwick lacked economic substance because there was no genuine business goal between Arapua and Jetstream to carry on a business and share in its profits and losses. The court looked to case law in Southgate Master Fund, LLC v. U.S., 659 F.3d 466 (5th Cir. 2011), which defined a genuine partnership as a business jointly owned by two or more persons and created for the purpose of earning money through business activities, and concluded that if the only purpose was to avoid taxes, then the partnership would be disregarded for tax purposes. Jetstream did not actively attempt to collect the receivables that Arapua contributed to the partnership, and the proceeds from the sale of the partnership interests was Warwick's only revenue, the court noted. Because the transaction did not make commercial sense, the court determined that the purpose of the partnership was not to earn money by collecting Arapua's receivables, but to sell interests to U.S. investors seeking tax savings. John's claim that Warwick was a valid LLC organized under state (Illinois) law and thus entitled to the tax benefits such as the deferral of losses in contributed property was rejected. The court found that Warwick was a sham partnership without economic substance and should be disregarded for federal tax purposes. The court concluded that, since Arapua's contribution of the receivables to Warwick was recharacterized as a sale to shelter investors, Arapua had to recognize any loss at the time of the sale and left no built-in loss for investors to claim when they entered the partnership.

Finally, the court determined that the 40 percent penalty for an understatement of tax attributable to any gross valuation misstatement was properly imposed. The valuation misstatement in this case was gross since the aggregate basis of the receivables transferred to Warwick was near zero and John valued them at $30 million. John failed to show that he had reasonable cause to deduct the built-in losses since he was an experienced tax attorney and knew or should have known that he had no reasonable basis to claim the partnership losses.

For a discussion of the 40 percent gross valuation misstatement penalty, see Parker Tax ¶262,120.

[Return to Table of Contents]

Proceeds from Sale of Tax Shelter Interests Were Income to S Corporation's Sole Shareholder

Income attributable to a wholly owned S corporation from the sale of tax shelter interests to investors was taxable income to its sole shareholder because the S corporation's income was personal income to its shareholder and was not held in trust for a third party. Rogers v. Comm'r, 2013 PTC 262 (7th Cir. 8/26/13).

John Rogers, a tax attorney, created a partnership, Warwick Trading, LLC, for the purpose of selling tax shelter interests to U.S. investors. The partners in Warwick were a foreign retailer, Lojas Arapua S.A., and Jetstream Business Limited, another company owned by John. Lojas Arapua contributed to Warwick largely uncollectible receivables that were worth less than their face amount. Jetstream was designated managing partner and responsible for collecting the receivables. Because the property contributed to Warwick retained its original basis even though its market value had fallen, the receivables had the potential to generate losses that would be deductible from the taxable income of U.S. taxpayers who later entered the partnership. John also created a wholly owned S corporation, Portfolio Properties, Inc. (PPI), to act as an intermediary between himself and Jetstream. The tax shelter interests were sold to U.S. investors for a total of $2.4 million. John directed the shelter investors to wire their funds to PPI's bank account, rather than Warwick's, stating that Warwick lacked adequate banking facilities. PPI forwarded $1.2 million of the funds to Lojas Arapua for the receivables. Of the $1.2 million PPI retained, $732,000 was distributed to John.

John filed his federal income tax return in 2003 and reported $513,000 of the distribution as personal income. The IRS assessed a deficiency, saying that John failed to report the income attributable to PPI and the distribution he received from PPI. John argued that the $1.2 million retained by PPI was held in trust for the benefit of Warwick and the tax deficiency was a partnership item that should be resolved at the partnership level.

The Tax Court held that the $1.2 million retained by PPI was taxable income to John. John appealed to the Seventh Circuit.

The Seventh Circuit affirmed the Tax Court and held that the amount retained by PPI from the sale of the shelter interests was income to John as the S corporation's sole shareholder rather than funds held in trust by PPI or John. The court stated that, although PPI kept the tax shelter interest sale proceeds in a segregated account, John did not claim that PPI wrongfully deprived Warwick of any money or property. The court rejected John's testimony that the proceeds PPI retained were held in trust for Warwick for pay for future expenses as not credible. John's argument that he held his $732,000 distribution from PPI in trust for Warwick was also rejected. He reported on his return a portion of the distribution as personal income for rendering legal services to PPI and paid income tax on the amount. Further, the court noted that if John had held the distribution in trust for Warwick and used it to reimburse himself for legal services, then he committed a grave breach of trust. Finally, with respect to the funds that PPI retained and did not distribute to John, the court presumed that they were intended to compensate John for organizing the tax shelter. Thus, the court concluded the distribution was income to John as PPI's sole shareholder.

For a discussion of S corporation distributions, see Parker Tax ¶84,515.

[Return to Table of Contents]

Pass-Through Losses Disallowed For Developer with Insufficient Debt Basis in S Corporation

Because a cellular network developer lacked sufficient debt basis in his S corporation, his deductions for its pass-through losses were properly disallowed; business expense and amortization deductions claimed for his other business entities were also properly disallowed, since the entities were never engaged in any active trade or business. Broz v. Comm'r, 2013 PTC 257 (6th Cir. 8/23/13).

Robert Broz invested in the development of cellular networks in rural statistical areas (RSAs) in the 1990s. He organized RFB Cellular, Inc. (RFB), a wholly owned S corporation, and purchased an RSA license for Northern Michigan in 1991. He later expanded his cellular telephone business by organizing additional entities. Alpine PCS, Inc., an S corporation, was created to construct and operate digital networks servicing new licensing areas. Several Alpine license-holding entities were also formed to hold and lease additional RSA licenses that Robert acquired. RFB operated the only on-air networks and used Alpine PCS's licenses on a limited basis. Only two Alpine license-holding entities reported income of approximately $68,000 from RFB's use of its licenses in 2001. Alpine did not report income during any of the other years in issue but claimed depreciation deductions, interest deduction on debt owed to the FCC, and interest deductions on debt owed to RFB, although Alpine never made any interest payments. Alpine also amortized and deducted expenses for startup costs. However, Alpine had not made a formal election under Code Sec. 195(b) to expense the startup costs. Alpine and the license holding entities stopped all business activities by the end of 2002.

CoBank was the main commercial lender to RFB and the Alpine entities during the years at issue. RFB used CoBank loan proceeds to expand its existing business through Alpine and the related entities. RFB advanced the CoBank loan proceeds to Alpine PCS. Using year-end accounting adjustments and post-dated promissory notes, Robert recharacterized the transaction so that it appeared that the loan proceeds were advanced from RFB to Robert and then loaned by Robert to Alpine PCS. The loan was secured by the assets of the Alpine license holding entities. Robert pledged his RFB stock as additional security but he never personally guaranteed the CoBank loan.

The IRS assessed an $18 million deficiency in Robert's federal income tax returns for 1996, 1998, 1999, 2000 and 2001. The IRS determined that Robert had insufficient debt basis in Alpine to claim pass-through losses and that he was not at risk with respect to his investments in the Alpine entities. Therefore, he was not entitled to claim the pass-through losses on his individual income tax return. The IRS also determined that the Alpine companies were not entitled to interest, depreciation, and startup expense deductions because they were not engaged in an active trade or business during the years at issue. Finally, the IRS disallowed the Alpine license holding entities amortization deductions for the FCC licenses because they were not engaged in an active trade or business at the relevant time. The Tax Court ruled in favor of the IRS and Robert appealed.

Code Sec. 1366(d) provides that the amount of pass-through loss deductions that an individual shareholder may claim cannot exceed the shareholder's basis in stock and debt. The debt-basis limitation is determined by examining the shareholder's adjusted basis in any indebtedness of the S corporation to the shareholder. An S corporation's indebtedness to another entity does not increase the amount of pass-through deductions the shareholder can claim.

Robert claimed that he was at risk and had sufficient debt basis in Alpine PCS to deduct its pass-through losses, business expense and amortization deductions.

The Sixth Circuit affirmed the Tax Court and held that purported back-to-back loan arrangement between FRB, Robert and Alpine did not establish a bona fide indebtedness between Robert and Alpine and Robert's pass-through loss deductions on his debt basis were properly disallowed. Robert was a mere conduit for the loans from RFB to Alpine PCS, and Alpine was never directly indebted to Robert. Robert's use of journal entries and promissory notes to guarantee the debt that already existed from Alpine to RFB and his pledge of stock did not establish indebtedness from the S corporation to the shareholder. Because Robert lacked sufficient debt basis in Alpine to allow him to deduct the pass-through losses under Code Sec. 1366(d), the at-risk rules under Code Sec. 465(c) did not apply.

The court also determined that the Alpine entities were not carrying on a trade or business during the years in issue, and Robert's claimed business expense deductions were properly disallowed. The court looked to case law in Bennett Paper Corp. v. Comm'r, 78 T.C. 458 (1983), which held that each entity must be evaluated individually and not in connection with any other entity. The court rejected Robert's argument that the Alpine entities were merely a business expansion and not a new business. Viewed individually, no Alpine entity was performing activity consistent with a business purpose.

Further, the FCC licenses were amortizable only upon the active beginning of a trade or business. The Alpine license-holding entities were formed solely to acquire and lease FCC licenses for use in Robert's cellular telephone business. Since the entities never leased the licenses for such use, the licenses were never held in connection with a trade or business that was being conducted. Thus, the court concluded that the licenses did not qualify as amortizable intangibles under Code Sec. 197 and were ineligible for amortization deductions.

For a discussion of calculating S corporation stock and debt basis, see Parker Tax ¶32,800.

[Return to Table of Contents]

Interest Rates Remain the Same for the Fourth Quarter of 2013

The IRS issued the interest rates for overpayments and underpayments of tax for the final quarter of 2013. Rev. Rul. 2013-16.

The IRS announced that interest rates will remain the same for the calendar quarter beginning October 1, 2013. The rates will be:

• three (3) percent for overpayments [two (2) percent in the case of a corporation];
• three (3) percent for underpayments;
• five (5) percent for large corporate underpayments; and
• one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.

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 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 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.

The interest rates announced today are computed from the federal short-term rate determined during July 2013 to take effect August 1, 2013, based on daily compounding.

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

[Return to Table of Contents]

IRS Extends Penalty Relief for Certain Form 1099-K Reporting Requirements

The IRS extends the penalty relief for reporting on Form 1099-K to certain errors on information returns and payee statements required to be filed and furnished in 2013 and 2014. Notice 2013-56.

Code Sec. 6050W requires that a payment settlement entity (payor) making payment to a participating payee (payee) in settlement of reportable payment transactions must make an information return for each calendar year to be filed with the IRS setting forth the gross amount of such reportable payment transactions, as well as the name, address, and TIN of the payee. A similar statement must be furnished to the payee setting forth the gross amount of such reportable payment transactions, as well as the name, address, and phone number of the information contact of the person required to make such return.

Code Sec. 6050W applies to two types of transactions: (1) payment card transactions; and (2) third-party network transactions. All payments made in settlement of payment card transactions must be reported in the manner described above. Payments made in settlement of third-party network transactions are reportable only if gross payments to a payee exceed $20,000 and the number of such transactions exceeds 200 with respect to the participating payee. The information is to be reported to the IRS on Form 1099-K, Payment Card and Third Party Network Payments.

Code Sec. 6721 imposes penalties on a person for, among other things, failing to include all required information or including incorrect information on an information return. Code Sec. 6722 imposes penalties on a person for, among other things, failing to include all required information or including incorrect information on a payee statement. In Notice 2011-89, the IRS provided transitional penalty relief from penalties for a Code Sec. 6050W filer reporting incorrect information on Form 1099-K and payee statements filed under Code Sec. 6050W. This relief was available for information returns and payee statements to be filed in 2012.

In Notice 2013-56, the IRS extends the penalty relief provided in Notice 2011-89 to certain errors on information returns and payee statements required to be filed and furnished in 2013 and 2014. Specifically, Notice 2013-56 provides relief from penalties under Code Secs. 6721 and 6722 for returns and statements required to be filed and furnished in 2013 based on payments made in calendar year 2012 if they have missing TINs, obviously incorrect TINs (as described in section 3406(h)(1))1, and incorrect name and TIN combinations. In addition, the notice provides relief from penalties for returns and statements required to be filed and furnished in 2014 based on payments made in 2013, but only in cases where the 2013 Form 1099-K contains an incorrect name and TIN combination. Limiting penalty relief for 2013 Forms 1099-K to incorrect name and TIN combinations, the IRS said, is warranted because more expansive penalty relief (i.e., relief from penalties for missing or obviously incorrect TINs) would be inconsistent with the payor's backup withholding obligations, which were first effective for payments made on or after January 1, 2013. Notice 2013-56 does not apply to a payor who erroneously fails to file an information return or payee statement.

In addition, the IRS said it will not issue CP2100/CP2100A Notices based on incorrect name and TIN combinations reported on Forms 1099-K due before 2014. The IRS will begin sending CP2100/CP2100A Notices with respect to Forms 1099-K in late 2014. These CP2100/CP2100A Notices will be based on incorrect name and TIN combinations reported on Forms 1099-K required to be filed in 2014 for calendar year 2013 payments. The IRS also said that CP2100/CP 2100A Notices are not necessary to trigger backup withholding if the payee either did not provide a TIN or provided an obviously incorrect TIN. Payors should continue to backup withhold on calendar year 2013 payments to payees who failed to provide a TIN or who provided an obviously incorrect TIN.

For a discussion of reporting of merchant card and third-party payments on Form 1099-K, see Parker Tax ¶252,557.

[Return to Table of Contents]

IRS Finalizes Regs on Nonrecognition Transfers of Loss Property to Corporations

Regulations under Code Sec. 362(e)(2) on certain nonrecognition transfers of loss property to corporations have been finalized. T.D. 9633 (9/3/13).

Code Sec. 362(e)(2) was enacted in 2004 to prevent the duplication of loss in certain corporate nonrecognition transfers. It applies to corporate acquisitions of property with a net built-in loss in transactions described in Code Sec. 362(a) (transactions to which Code Sec. 351 applies and acquisitions of property as paid-in surplus or contributions to capital), but only if the transaction is not described in Code Sec. 362(e)(1) (transactions in which there is an importation of built-in loss). When a transaction is subject to Code Sec. 362(e)(2), the acquiring corporation's basis in loss property is reduced by the property's allocable portion of the transferor's net built-in loss. However, under Code Sec. 362(e)(2)(C), the parties to the transaction can make an irrevocable election to apply the reduction to the transferor's basis in the stock received in the exchange instead of to the transferee's basis in the property received in the exchange.

The IRS subsequently issued Notice 2005-70 to provide interim guidance for making an election to apply Code Sec. 362(e)(2)(C). The IRS has now issued final regulations under Code Sec. 362(e)(2). The general operative rule set forth in the final regulations is that whenever a person (Transferor) transfers property to a corporation (Acquiring) in a loss duplication transaction, Acquiring's basis in each loss duplication property (as determined without regard to Code Sec. 362(e)(2)) is reduced by the property's allocable portion of Transferor's net built-in loss. The final regulations define the term loss duplication transaction as any Code Sec. 362(a) transfer in which Acquiring's aggregate basis in the property transferred by Transferor would exceed the aggregate value of such property immediately after the transaction.

The term loss duplication property refers to individual property transferred in the loss duplication transaction that Acquiring would take with a basis that would exceed value immediately after the transfer. The term transferor's net built-in loss is defined as the excess of Acquiring's aggregate basis in property received from Transferor over the aggregate value of such property immediately after the transaction. For purposes of applying each of these definitions, Acquiring's basis in property is determined immediately after the transfer, disregarding Code Sec. 362(e)(2), but taking into account all other applicable rules, including Code Sec. 362(e)(1). Transactions wholly outside the U.S. tax system are excepted from these rules.

The final regulations apply to transactions occurring after September 3, 2013, unless effected under a binding agreement that was in effect before September 3, 2013, and at all times thereafter. In addition, taxpayers may apply these regulations to transactions occurring after October 22, 2004.

[Return to Table of Contents]

Court Agrees with IRS Revocation of Tax-Exempt Status of Charity Set Up by Real Estate Developer

Where a tax-exempt organization allegedly set up to help required each home seller to pay to PIC the down-payment amount along with a fee, the IRS retroactively revoked PIC's tax-exempt status. Partners In Charity, Inc. v. Comm'r, 141 T.C. No. 2 (8/27/13).

Partners in Charity, Inc. (PIC) was established as a nonprofit corporation under the laws of Illinois. It was created by Charles Konkus, a real estate developer in the Chicago area who focused his business ventures on developments for medium- to high-income consumers. Charles observed that home ownership was becoming more difficult for low-income individuals, and he decided to create a means for helping homebuyers.

After establishing PIC, Charles served as PIC's executive director, devoting 40 hours a week to the job and receiving no direct compensation in return. While there were two other individuals on the PIC's Board of Directors, they devoted virtually no time to their positions with PIC. Thus, Charles exercised unchecked control over PIC's operations and finances.

PIC applied for recognition of tax-exempt status, explaining that its primary activity was to provide down-payment assistance grants to homebuyers. The IRS originally determined that PIC was a Code Sec. 501(c)(3) charitable organization. However, when the IRS learned that in actual operation, PIC required each home seller to pay to PIC the down-payment amount along with a fee, the IRS retroactively revoked PIC's tax-exempt status. Additionally, the IRS found that, apart from its down-payment assistance program, PIC paid over $500,000 for marketing to a firm wholly owned by Charles's wife. PIC appealed to the Tax Court.

The Tax Court held that PIC's down-payment assistance program was not operated for a charitable purpose, and PIC engaged in substantial commercial activities that did not further an exempt purpose. Therefore, the court concluded that PIC was not an organization described in Code Sec. 501(c)(3). Further, the court said, the IRS did not abuse his discretion in making its adverse determination retroactive to the date of PIC's incorporation.