Final Capitalization Regs Contain Significant Changes Favorable to Taxpayers

In December 2011, the IRS issued temporary regulations regarding the deduction and capitalization of expenditures related to tangible property. Initially, the temporary capitalization regulations were slated to apply to tax years beginning on or after January 1, 2012. Subsequently, the IRS reconsidered that effective date. On November 20, 2012, the IRS issued Notice 2012-73 which provided that, to assist taxpayers in their transitions to the temporary regulations and final regulations, the IRS was changing the applicability date of the 2011 temporary regulations to tax years beginning on or after January 1, 2014, while permitting taxpayers to choose to apply the 2011 temporary regulations to tax years beginning on or after January 1, 2012, and before the applicability date of the final regulations.

On September 19, 2013, the IRS issued final regulations (T.D. 9636) regarding the deduction and capitalization of expenditures related to tangible property. Generally, under the final regulations, a taxpayer must distinguish whether an amount paid is for a repair, in which case it may be currently deducted, or is for an improvement to a unit of property, in which case it must be capitalized. A unit of property is considered improved if the amounts paid for activities performed after the property is placed in service by the taxpayer:

(1) are for a betterment to the unit of property;

(2) restore the unit of property; or

(3) adapt the unit of property to a new or different use.

However, there are numerous safe harbor and de minimis rules under which a taxpayer can avoid capitalizing an item. For example, there is a safe harbor for routine maintenance on property. Under that safe harbor, amounts paid for routine maintenance on a unit of tangible property, or on a building (leased or owned), condo, or cooperative, are deemed not to improve that unit of property and may thus be expensed.

The final regulations made many changes to the temporary regulations that are favorable to taxpayers. The following discussion outlines some of the more significant ones.

Materials and Supplies

The final regulations expand the definition of materials and supplies to include property that has an acquisition or production cost of $200 or less (increased from $100 or less in the temporary regulations), clarify the application of the optional method of accounting for rotable and temporary spare parts, and simplify the application of the de minimis safe harbor to materials and supplies. Read more...

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IRS Explains How to File DOMA-Related Employment Tax Refund Claims

The Supreme Court's decision in U.S. v. Windsor, 2013 PTC 167 (S. Ct. 2013), has opened the door for a flood of amended returns and refund claims, as well as guidance on filing such amended returns and refund claims. It began with Rev. Rul. 2013-17 and continued this week with Notice 2013-61. In Notice 2013-61, the IRS provides procedures for filing claims for refunds or adjustments of overpayments of FICA and income tax withholding with respect to certain benefits provided to same-sex spouses, as well as remuneration paid to same-sex spouses.

Background

A number of income and employment tax provisions provide for exclusions from gross income and wages, respectively, for certain benefits provided to the spouse of an employee. In addition, services performed by an individual in the employ of the individual's spouse that are not in the course of the employer's trade or business or that are domestic services in the employer's private home are excepted from FICA tax under Code Sec. 3121(b)(3)(B). Until the Supreme Court's decision in Windsor, the IRS interpreted Section 3 of the Defense of Marriage Act (DOMA) as prohibiting the IRS from recognizing same-sex marriages for purposes of these provisions. As a result, employers withheld and paid employment taxes with respect to certain benefits provided to the same-sex spouse of an employee because the marriage was not recognized for purposes of the Code, and the benefits were not treated as excludable from gross income or wages for federal income or employment tax purposes. Employers may also have withheld and paid employment taxes on amounts paid for services performed by an individual in the employ of the individual's same-sex spouse without applying the employment tax exceptions for certain remuneration paid to spouses.

In Windsor, the Court held that Section 3 of DOMA is unconstitutional because it violates the principles of equal protection, and the IRS subsequently announced in Rev. Rul. 2013-17 that, for federal tax purposes, (1) the terms spouse, husband and wife, husband, and wife include an individual married to a person of the same sex if the individuals are lawfully married under state law, and the term marriage includes such a marriage between individuals of the same sex; (2) the IRS is adopting a general rule that recognizes a marriage of same-sex individuals that is validly entered into in a state whose laws authorize the marriage of two individuals of the same sex, even if the married couple is domiciled in a state that does not recognize the validity of same-sex marriages; and (3) the terms spouse, husband and wife, husband, and wife do not include 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, and the term marriage does not include such formal relationships.

Compliance Tip: The holdings of Rev. Rul. 2013-17 are applied prospectively as of September 16, 2013. Generally, taxpayers may rely on Rev. Rul. 2013-17 for the purpose of filing original returns, amended returns, adjusted returns, or claims for credit or refund for any overpayment of tax resulting from these holdings, provided the applicable limitations period for filing such claim is still open. Rev. Rul. 2013-17 also provides that if an affected taxpayer files an original return, amended return, adjusted return, or claim for credit or refund in reliance on Rev. Rul. 2013-17, all items required to be reported on the return or claim that are affected by the marital status of the taxpayer must be adjusted to be consistent with the marital status reported on the return or claim.

Rev. Rul. 2013-17 also provides that taxpayers may generally rely on Rev. Rul. 2013-17 retroactively with respect to any employee benefit plan or arrangement or any benefit provided thereunder only for purposes of filing original returns, amended returns, adjusted returns, or claims for credit or refund of an overpayment of tax for employment tax and income tax with respect to employer-provided health coverage benefits or fringe benefits that were provided by the employer and are excludable from income under Code Secs. 106, 117(d), 119, 129, or 132 based on an individual's marital status.

Practice Tip: Thus, if an employee made a pre-tax salary-reduction election for health coverage under a Code Sec. 125 cafeteria plan sponsored by an employer and also elected to provide health coverage for a same-sex spouse on an after-tax basis under a group health plan sponsored by that employer, an affected taxpayer may treat the amounts that were paid by the employee for the coverage of the same-sex spouse on an after-tax basis as pre-tax salary reduction amounts.

Employers may also generally rely on the holdings in Rev. Rul. 2013-17 for purposes of recognizing same-sex spouses as spouses in applying exceptions from the definition of employment for employment tax purposes.

Adjustments and Claims for Refund for Employment Taxes

To reduce administrative burden, Notice 2013-16 provides special administrative procedures for adjustments and claims for refunds or credits for overpayments of employment taxes attributable to same-sex spouse benefits, including overpayments that result from a taxpayer's retroactive application of the holdings in Rev. Rul. 2013-17.

For purposes of Notice 2013-16, same-sex spouse benefits refers to the benefits specified in Rev. Rul. 2013-17 for which amended income tax returns and adjusted employment tax returns or claims for refund or credit may be filed. These benefits are same-sex spouse employer-provided health coverage and fringe benefits that were provided by an employer to a same-sex spouse and are excludable from income under Code Sec. 106, 117(d), 119, 129, or 132 based on an individual's marital status.

For purposes of Notice 2013-16, employment taxes paid on after-tax amounts that were used to purchase health coverage for an employee's same-sex spouse under these circumstances are treated as overpayments of employment taxes.

Employment Tax Returns for Third Quarter of 2013

If an employer withholds employment taxes with respect to same-sex spouse benefits paid to or on behalf of an employee in the third quarter of 2013, ascertains the amount withheld on such benefits, and repays or reimburses the employee for the amount of such taxes before filing the third quarter 2013 Form 941, the employer will not report the wages and withholding on the third quarter 2013 Form 941. If the employer does not repay or reimburse the employee for the amount of the over collection before filing the third quarter 2013 Form 941, the employer must report the amount of the over collection on that return and can use one of two special administrative procedures for 2013 (described in the next section) to make an adjustment or claim a refund for the overpayment.

Adjustments for 2013 on Fourth Quarter 2013 Form 941 or 941-X

Notice 2013-61 provides two alternative special administrative procedures for employers that treated the value of same-sex spouse benefits as wages on Forms 941 for the first three quarters of 2013 and that seek to correct overpayments of employment taxes attributable to the benefits.

First Special Administrative Procedure

Under the first alternative, an employer must repay or reimburse its employees for the amount of the overcollected FICA tax and the overcollected income tax withholding with respect to the same-sex spouse benefits for the first three quarters of 2013 on or before December 31, 2013. After repaying or reimbursing the employees, the employer, in reporting amounts on its fourth quarter 2013 Form 941, may reduce the fourth quarter wages, tips, and other compensation reported on line 2, taxable social security wages reported on line 5a (subject to the wage base limitation), and taxable Medicare wages and tips reported on line 5c, by the amount of the same-sex spouse benefits treated as wages for the first three quarters of 2013. Also, the income tax withheld from wages, tips, and other compensation reported on line 3 of Form 941 should be reduced by the amount of income tax withholding with respect to the same-sex spouse benefits that has been repaid or reimbursed to the employees by the end of the calendar year. In addition, if the value of any same-sex spouse benefits was included in taxable wages subject to additional Medicare tax withholding on line 5d, the amount of taxable wages subject to additional Medicare tax withholding on the fourth quarter 2013 Form 941 should be reduced.

Observation: By taking advantage of the special administrative procedure in Notice 2013-61, the employer will not have to file separate Forms 941-X to correct each of the first three quarters of 2013.

Under Notice 2013-16, the employer may only correct the employer share of FICA tax that corresponds to the employee share of FICA tax that has been repaid or reimbursed to the employees on or before December 31, 2013.

For the repayment or reimbursement of overwithheld social security tax and the corresponding reduction for taxable social security wages reported on Form 941, line 5a, the employer must take into account that adjustments of social security tax are limited to the tax paid on that portion of the value of the same-sex spouse benefits that, when added to other social security wages and tips for the year, does not exceed the social security wage base for 2013 ($113,700). Accordingly, if for a particular employee the value of same-sex spouse benefits was included in social security wages and, after the exclusion of the value of the same-sex spouse benefits from wages for 2013, the remaining social security wages of the employee are equal to or greater than $113,700, then no refund, credit, or adjustment of social security tax can be made for 2013 for that employee.

Observation: Notice 2013-61 provide procedures to ensure that use of the special administrative procedure for the 2013 fourth quarter Form 941 does not result in a mismatch between total taxes reported on line 10 (total taxes after adjustments) and total liability for the quarter reported on line 16 for a monthly schedule depositor or on Schedule B (Form 941) for a semiweekly schedule depositor, the employer should use the following procedures:

Second Special Administrative Procedure

Under the second alternative, an employer that does not repay or reimburse employees for the amount of withheld FICA and income taxes with respect to same-sex spouse benefits provided in 2013 on or before December 31, 2013, and thus, files the 2013 fourth quarter Form 941 without making the adjustment, may correct overpayments of FICA taxes with respect to same-sex spouse benefits paid in 2013 using Form 941-X. Under this option, an employer may file one Form 941-X for the fourth quarter of 2013 to make adjustments or claim refunds or credits of overpayments of FICA taxes with respect to same-sex spouse benefits paid in all quarters of 2013, provided the employer has satisfied the usual requirements for filing Form 941-X, including repaying or reimbursing the overcollected employee FICA tax to employees (or, for refund claims, securing consents from employees), and obtaining the required written statements from employees. The employer should write WINDSOR in dark, bold letters across the top margin of page 1 of Form 941-X. Only corrections made under this special administrative procedure may be shown on this Form 941-X. An employer may not make an adjustment for an overpayment of income tax withholding for a prior calendar year unless the overpayment is attributable to an administrative error. An employer may not claim a refund or credit for an overpayment of income tax withholding if the tax was deducted and withheld from the employee.

Caution: This second special administrative procedure for 2013 cannot be used with regard to income tax withheld from employees with respect to same-sex spouse benefits in 2013 because an employer can use this Form 941-X procedure only if the employer did not repay or reimburse employees for the amount of withheld taxes with respect to same-sex spouse benefits provided in 2013 on or before December 31, 2013. In such case, employees will receive credit for the income tax withheld for purposes of determining any entitlement to a refund of income tax paid with respect to same-sex spouse benefits provided in 2013 when they file Form 1040, U.S. Individual Income Tax Return.

Adjustments or Claims for Refund for Years before 2013

Notice 2013-16 also provides a special administrative procedure for employers to make adjustments or claims for refund or credit of overpayments of FICA taxes paid with respect to same-sex spouse benefits for any year before 2013 for which the statute of limitations on credits or refunds has not expired. Under this procedure, the employer must take into account the applicable social security wage base in determining the overpayment of FICA taxes for the prior year being corrected. The employer may file one Form 941-X for the fourth quarter of the prior year. This fourth quarter Form 941-X would include the adjustments or refunds for all overpayments of employment taxes with respect to same-sex spouse benefits provided during such prior year, including overpayments reflected in the Forms 941 for the first three quarters of the year.

An employer may not make an adjustment for an overpayment of income tax withholding for a prior calendar year unless the overpayment is attributable to an administrative error. An employer may not claim a refund or credit for an overpayment of income tax withholding if the tax was deducted and withheld from the employee. Accordingly, this special administrative procedure for prior years cannot be used for income tax withheld from employees with respect to same-sex spouse benefits in prior years. Employees may receive refunds of income tax paid with respect to same-sex spouse benefits in prior years by filing Form 1040X, Amended U.S. Individual Income Tax Return. As indicated above, an employer filing a claim for refund or credit or making adjustments for prior years must file Forms W-2c for the prior years. Forms W-2c will assist employees in claiming a refund of income tax.

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Prop Regs Make Significant Changes to Rules on MACRS Property Dispositions

In 2011, the IRS released temporary and proposed regulations, both with the same text, on the accounting for, and dispositions of, MACRS property. Last week, in REG-110732-13 (9/19/13), the IRS withdrew those proposed regulations but left the temporary regulations in place. In place of the proposed regulations, the IRS issued new proposed regulations that provide significant changes to the rules for determining asset dispositions and qualifying dispositions of an asset in a general asset account.

The newly released proposed regulations are proposed to apply to tax years beginning on or after January 1, 2014. The regulations also permit taxpayers to rely on the provisions of the proposed regulations for tax years beginning on or after January 1, 2012, and before the applicability date of the final regulations. The proposed regulations provide that taxpayers may apply the provisions of the final regulations to tax years beginning on or after January 1, 2012. The temporary regulations allow taxpayers to apply the temporary regulations to tax years beginning on or after January 1, 2012, but the final regulations will provide that taxpayers may not apply the temporary regulations to tax years beginning on or after January 1, 2014.

Determining Assets Disposed of and Partial Dispositions

Temporary Regulations

The temporary regulations under Reg. Sec. 1.168(i)-8T provide rules for determining gain or loss upon the disposition of MACRS property that are generally consistent with the disposition rules for accelerated cost recovery system (ACRS) property (which have been generally applied to MACRS property). However, if an abandoned asset is subject to nonrecourse debt, the temporary regulations clarify that the asset is treated in the same manner as an asset disposed of by sale.

The temporary regulations under Sec. 1.168(i)-1T provide rules for establishing general asset accounts, for computing depreciation for general asset accounts, and for determining gain or loss upon the disposition of assets in general asset accounts. The temporary regulations provide that, in general, no loss is recognized upon the disposition of an asset from a general asset account. However, a taxpayer may elect to recognize gain or loss upon the disposition of an asset in a general asset account if there is a qualifying disposition. The temporary regulations define the term disposition to include the retirement of a structural component of a building and define the term qualifying disposition to allow the recognition of gain or loss upon most dispositions of assets in general asset accounts. Thus, a taxpayer has the option of recognizing a loss on most dispositions of assets in general asset accounts under the temporary regulations. Read more...

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IRS Clarifies Rules for Qualified Real Property Expensed Under Section 179; Amended Returns May Be in Order

The IRS issued guidance clarifying several issues that have arisen regarding the election to expense qualified real property under Code Sec. 179 and explaining procedures for filing amended returns, if necessary. Notice 2013-59.

For years 2010 through 2013, special rules allow for the expensing of qualified real property. Several issues have arisen as a result of these special rules. Originally, the election was only for tax years beginning in 2010 and 2011. However, the American Taxpayer Relief Act of 2012 (ATRA) retroactively extended the election to 2012 and 2013. In Notice 2013-59, the IRS gives practical guidance on how to prepare a tax return when certain issues relating to this election arise, such as recapture issues, as well as information on filing amended returns to take advantage of the special rules for expensing qualified real property.

If tax returns have already been filed for years 2010, 2011, and 2012, and a taxpayer could have taken advantage of the expensing provision for qualified real property in one of those years, the taxpayer can file an amended federal tax return for that tax year in accordance with procedures similar to those in Reg. Sec. 1.179-5(c)(2) and Rev. Proc. 2008-54, Section 7.

Alternatively, if the taxpayer filed prior returns and expensed amounts under Code Sec. 179(a) for property other than qualified real property, the taxpayer can increase the portion of the cost of such property expensed by filing an amended federal tax return for that tax year. According to Notice 2013-59, any such increase in the amount expensed under Code Sec. 179 is not deemed to be a revocation of the prior election for that tax year.

Under Code Sec. 179(b)(3)(A), a taxpayer's Code Sec. 179 deduction for any tax year is limited to the taxpayer's taxable income for that tax year that is derived from the taxpayer's active conduct of any trade or business during that tax year (i.e., the taxable income limitation). Code Sec. 179(b)(3)(B) provides that the amount of any cost of Section 179 property elected to be expensed in a tax year that is disallowed because of the taxable income limitation may be carried forward for an unlimited number of years and may be deducted under Code Sec. 179(a) in a future tax year, subject to the same limitations.

In Notice 2013-59, the IRS notes that a taxpayer that treated the amount of a 2010 disallowed Code Sec. 179 deduction or a 2011 disallowed Code Sec. 179 deduction as property placed in service on the first day of the taxpayer's last tax year beginning in 2011 may want to carry over that amount to any tax year beginning in 2012 or 2013 in accordance with Code Sec. 179(f)(4). Accordingly, a taxpayer that treated the amount of a 2010 disallowed Code Sec. 179 deduction or a 2011 disallowed Code Sec. 179 deduction as property placed in service on the first day of the taxpayer's last tax year beginning in 2011 may either (1) continue that treatment, or (2) if the statute of limitations is still open, amend its federal tax return for the last tax year beginning in 2011 to carry over the 2010 disallowed Code Sec. 179 deduction or the 2011 disallowed Code Sec. 179 deduction to any tax year beginning in 2012 or 2013. However, if the taxpayer's last tax year beginning in 2011 is open under the statute of limitations and an affected succeeding tax year is closed under the statute of limitations, the taxpayer must continue to treat the amount of a 2010 disallowed Code Sec. 179 deduction or a 2011 disallowed Code Sec. 179 deduction as property placed in service on the first day of the taxpayer's last tax year beginning in 2011.

Practice Tip: The amended federal tax return for the taxpayer's last tax year beginning in 2011 must include any collateral adjustments to taxable income or the tax liability (for example, the amount of depreciation allowed or allowable in the last tax year beginning in 2011 for the amount of the 2010 disallowed Code Sec. 179 deduction or the 2011 disallowed Code Sec. 179 deduction). Such collateral adjustments also must be made on amended federal tax returns for any affected succeeding tax years. The amended returns for the taxpayer's last tax year beginning in 2011 and for any affected succeeding tax years must be filed within the time prescribed by law for filing an amended return for such tax years.

When a taxpayer sells or otherwise disposes of qualified real property in a tax year beginning in 2010, 2011, 2012, or 2013, or a transfer of qualified real property in a tax year beginning in 2010, 2011, 2012, or 2013 in a transaction in which gain or loss is not recognized in whole or in part (including transfers at death), immediately before the disposition or transfer, the adjusted basis of the qualified real property is increased by the amount of any outstanding carryover of disallowed deduction attributable to that property. Thus, the carryover of any disallowed deduction cannot be deducted by the transferor or the transferee of the qualified real property. However, this does not apply to a sale or other disposition of qualified real property, or a transfer of qualified real property in a transaction in which gain or loss is not recognized in whole or in part (including transfers at death), in the taxpayer's last tax year beginning in 2013 or any subsequent tax year.

To the extent the unadjusted basis of the qualified real property is reduced by the Code Sec. 179 deduction after applying these rules, the amount of that reduction is treated as Section 1245 property. The remaining unadjusted basis of the qualified real property is treated as Section 1250 property.

In Notice 2013-59, the IRS provides that a taxpayer may use any reasonable allocation methodology for determining the portion of the gain that is attributable to Section 1245 property upon the sale or other disposition of qualified real property. Notice 2013-59 provides the two reasonable allocation methodologies: (1) the pro rata allocation methodology; and (2) the gain allocation methodology.

For a discussion of the expensing of qualified real property, see Parker Tax ¶94,710.

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IRS Expands Situations in Which Innocent Spouse Relief Will Be Granted

A new revenue procedure provides the new factors that the IRS will consider in determining whether to grant either equitable relief from joint and several liability under Code Sec. 6015(f) or equitable relief from income tax liability resulting from the operation of community property law under Code Sec. 66(c). Rev. Proc. 2013-34.

Code Sec. 6015 provides three types of relief from joint and several liability: (1) full or apportioned relief (i.e., innocent spouse relief) under Code Sec. 6015(b); (2) proportionate relief for divorced or separated taxpayers (i.e., separation of liability relief) under Code Sec. 6015(c); and (3) equitable relief under Code Sec. 6015(f) when relief is unavailable under either Code Sec. 6015(b) or Code Sec. 6015(c). In addition, Code Sec. 66(c) provides relief from income tax liability resulting from the operation of community property law to taxpayers domiciled in a community property state who do not file a joint return.

In 2012, the IRS released Notice 2012-8, which set forth a proposed revenue procedure to update and revise Rev. Proc. 2003-61. Notice 2012-8 also modified and clarified the criteria for equitable relief, and eliminated the two-year rule for filing a claim for relief. The IRS has now released Rev. Proc. 2013-34, which supersedes Rev. Proc. 2003-61 and, based on comments by practitioners, contains the following significant changes to Rev. Proc. 2003-61:

(1) Greater deference is given to the presence of spousal abuse than Rev. Proc. 2003-61. According to the IRS, the issue of abuse can be relevant with respect to the analysis of other factors and can negate the presence of certain factors. This change is intended to give greater weight to the presence of abuse when its presence impacts the analysis of other factors.

(2) The time for filing a relief request under Code Sec. 6015(f) or Code Sec. 66(c) is expanded. A request for equitable relief under either provision must be filed before the expiration of the limitations period for collection under Code Sec. 6502 to the extent the taxpayer seeks relief from an outstanding liability, or before the expiration of the limitations period for credit or refund under Code Sec. 6511 to the extent the taxpayer seeks a refund of taxes paid. Rev. Proc. 2003-61 had imposed a two-year filing requirement. Rev. Proc. 2013-34 refers to the period of limitation for collection as its commonly used IRS term Collection Statute Expiration Date or CSED.

(3) The attribution threshold condition adds a new exception to the requirement that the income tax liability must be attributable to an item of the nonrequesting spouse. Under this exception, relief would not be precluded for an item attributable to the requesting spouse if the nonrequesting spouse's fraud gave rise to the understatement of tax or deficiency.

(4) Streamlined determinations now apply to understatements of income tax instead of only underpayments, and also apply to claims for equitable relief under Code Sec. 66(c).

(5) No one factor or a majority of factors necessarily controls the determination of whether relief will be granted. Therefore, depending on the facts and circumstances of the case, relief may still be appropriate if the number of factors weighing against relief exceeds the number of factors weighing in favor of relief, or a denial of relief may still be appropriate if the number of factors weighing in favor of relief exceeds the number of factors weighing against relief.

(6) The economic hardship factor in Rev. Proc. 2013-34 now provides minimum standards based on income, expenses, and assets, for determining whether the requesting spouse would suffer economic hardship if relief is not granted. It also now provides that the lack of a finding of economic hardship does not weigh against relief, as it did under Rev. Proc. 2003-61, and instead will be neutral.

(7) Actual knowledge of the item giving rise to an understatement or deficiency is no longer more heavily weighed than other factors, as it was under Rev. Proc. 2003-61. Further, Rev. Proc. 2013-34 clarifies that, for purposes of this factor, if the nonrequesting spouse abused the requesting spouse or maintained control over the household finances by restricting the requesting spouse's access to financial information, and because of the abuse or financial control, the requesting spouse was not able to challenge the treatment of any items on the joint return for fear of the nonrequesting spouse's retaliation, then that abuse or financial control will result in this factor weighing in favor of relief even if the requesting spouse knew or had reason to know of the items giving rise to the understatement or deficiency.

(8) The knowledge factor for underpayment cases in Rev. Proc. 2013-34 now provides that, in determining whether the requesting spouse knew or had reason to know that the nonrequesting spouse would not pay the tax reported as due on the return, the IRS will consider whether the requesting spouse reasonably expected that the nonrequesting spouse would pay the tax liability at the time the return was filed or within a reasonable period of time after the filing of the return. A requesting spouse may be presumed to have reasonably expected that the nonrequesting spouse would pay the liability if a request for an installment agreement to pay the tax was filed by the later of 90 days after the due date for payment of the tax, or 90 days after the return was filed.

(9) Rev. Proc. 2013-34 clarifies that, with respect to the knowledge factor, if the nonrequesting spouse abused the requesting spouse or maintained control over the household finances by restricting the requesting spouse's access to financial information, and because of the abuse or financial control, the requesting spouse was not able to question the payment of the taxes reported as due on the return or challenge the nonrequesting spouse's assurance regarding payment of the taxes for fear of the nonrequesting spouse's retaliation, then that abuse or financial control will result in this factor weighing in favor of relief even if the requesting spouse knew or had reason to know that the nonrequesting spouse would not pay the tax liability.

(10) The legal obligation factor in Rev. Proc. 2013-34 clarifies that a requesting spouse's legal obligation to pay outstanding tax liabilities is a factor to consider in determining whether equitable relief should be granted, in addition to whether the nonrequesting spouse has a legal obligation to pay the tax liabilities.

(11) The significant benefit factor in Rev. Proc. 2013-34 provides that any significant benefit a requesting spouse may have received from the unpaid tax or understatement will not weigh against relief (i.e., will be neutral) if the nonrequesting spouse abused the requesting spouse or maintained financial control and made the decisions regarding living a more lavish lifestyle. Further, if only the nonrequesting spouse significantly benefitted from the unpaid tax or understatement, and the requesting spouse had little or no benefit, or the nonrequesting spouse enjoyed the benefit to the requesting spouse's detriment, this factor will weigh in favor of relief. Further, if the amount of unpaid tax or understatement of tax was small such that neither spouse received a significant benefit, then this factor is neutral. The determination that the tax liability was small such that neither spouse received a significant benefit will vary depending on the facts and circumstances of each case.

(12) The compliance with the income tax laws factor in Rev. Proc. 2013-34 now provides that a requesting spouse's subsequent compliance with all federal income tax laws is a factor that may weigh in favor of relief, instead of always being neutral as it was under Rev. Proc. 2003-61.

(13) Finally, Rev. Proc. 2013-34 broadens the availability of refunds in cases involving deficiencies by eliminating the rule in Rev. Proc. 2003-61 that limited refunds in cases involving deficiencies to payments made by the requesting spouse pursuant to an installment agreement.

For a discussion of equitable relief under Code Sec. 6015(f) and Code Sec. 66(c), see Parker Tax ¶260,560.

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IRS Required to Honor Designation of Employment Taxes; Subsequent Attempt to Levy Was an Abuse of Discretion

A company's designation of delinquent employment tax payments towards its owners' past income tax liabilities discharged those liabilities in full and the IRS's proposal to levy on the owners' assets to collect the tax a second time was an abuse of discretion. Dixon v. Comm'r, 141 T.C. No. 3 (9/3/13).

James and Sharon Dixon were criminally prosecuted for failure to file individual income tax returns for 1992-1995. At the time, the Dixons were owners, officers, and employees of Tryco Corporation, which failed to file employment tax returns and corporate income tax returns during this period. As part of a plea agreement with the Department of Justice, the Dixons agreed that their wrongdoing had inflicted a tax loss on the IRS of $61,021 and acknowledged that they could be required to make restitution of this amount.

On advice of their attorney, the Dixons transferred funds to Tryco with instructions that Tryco remit the funds to the IRS. In December 1999, Tryco sent $61,021 to the IRS with a cover letter from the Dixons' attorney designating the payment as payment of [Form] 941 taxes of the corporation that was to be applied to the withheld income taxes of the Dixons for specified calendar quarters of 1992-95.

In early 2000, the Dixons' accountants determined that the Dixons actually owed $30,202 more in individual income tax for 1992-1995 than Tryco had remitted to the IRS in December 1999. Accordingly, the Dixons transferred additional funds to Tryco, and in June 2000, Tryco remitted to the IRS an additional check for $30,202. The cover letter from the Dixons' attorney stated that the payment was submitted as a preassessment designated payment of [Form] 941 taxes of the corporation which represents the withheld income taxes of the Dixons for the fourth quarter of 1995. The Dixons argued for a downward adjustment to their sentence and for a probated sentence on the ground that they had remitted taxes to the IRS in excess of the tax loss determined in the plea agreements. They were sentenced to probation and a small fine.

The IRS subsequently filed a notice of intent to levy on the Dixons' assets in satisfaction of their assertedly unpaid 1992-95 income tax liabilities. The Dixons were granted a collection due process (CDP) hearing in which they challenged the levy on the ground that Tryco's 1999-2000 remittances had discharged their 1992-95 income tax liabilities in full. The Appeals officer upheld the levy, concluding that Tryco's 1999-2000 payments were not withheld at the source and could not be designated to the withholding of a specific employee. The Dixons filed a petition under Code Sec. 6330(d)(1) asking for a review of this determination.

Code Sec. 31(a)(1) sets forth the consequences for the employee of the employer's withholding at the source. It provides that the amount withheld by the employer as tax from an employee's wages is allowed to the recipient of the income as a credit against his or her income tax liability for that year. Under Reg. Sec. 1.31-1(a), this credit is available only if the tax has actually been withheld at the source.

The Tax Court held that the Dixons were not entitled to a credit under Code Sec. 31(a) for the $91,223 Tryco remitted to the IRS in 1999-2000 because that amount was not actually withheld at the source by Tryco from the Dixons' wages during 1992-95. However, the court also held that the IRS was required to honor Tryco's designation of its 1999-2000 delinquent employment tax payments towards the Dixons' income tax liabilities for 1992-95. Because those payments discharged the Dixons' 1992-95 income tax liabilities in full, the Tax Court held that the IRS's proposal to levy on the Dixons' assets to collect this tax a second time was an abuse of discretion.

Observation: Code Sec. 31(a)(1) and Reg. Sec. 1.31-1(a) provide a credit to employees against their income tax obligation with respect to their wages if that tax is deducted and withheld at the source, even if their employer failed to remit it to the government. Under Code Sec. 31(a)(2), that amount so withheld during any calendar year is allowed as a credit for the tax year beginning in such calendar year. Thus, the effect of the Dixons' position would let the corporation's late payment of the withholding tax not only satisfy their income-tax debt, but also cancel the portion of that debt that consisted of compounded interest.

For a discussion of the credit for federal tax withheld on wages, see Parker Tax ¶103,301.

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Closing Agreement Doesn't Preclude Reduction of Taxpayer's Dividends-Received Deduction

A corporation's dividends-received deduction was reduced as a result of increased related-party indebtedness between the corporation and its controlled foreign corporation. BMC Software Inc. v. Comm'r, 141 T.C. No. 5 (9/18/13).

BMC Software, Inc. is a U.S. corporation that develops and licenses computer software. It is the common parent of a group of subsidiaries that file consolidated federal income tax returns. It is also the parent of nonconsolidated foreign affiliates. BMC's wholly owned BMC Software European Holding (BSEH) was a controlled foreign corporation (CFC) under Code Sec. 956 for its tax year ending March 31, 2006.

After auditing BMC, the IRS determined that royalty payments from BMC to BSEH were not arm's length under Code Sec. 482. The IRS and BMC then entered into a closing agreement under Code Sec. 7121 making primary adjustments regarding the royalty payments. The primary adjustments increased BMC's income and required it to conform its accounts with secondary adjustments. BMC accomplished the secondary adjustments by electing to establish accounts receivable under Rev. Proc. 99-32 rather than treat the secondary adjustments as deemed capital contributions. BMC had previously repatriated funds from its BSEH in transactions unrelated to the royalty payments or adjustments. BMC claimed a corresponding one-time dividends-received deduction under Code Sec. 965. The deduction was subject to certain limitations, including a reduction for an increased related-party indebtedness between BMC and its CFC. BMC claimed the deduction before agreeing to the primary adjustments or establishing the accounts receivable. The IRS determined that the accounts receivable that were deemed established during the testing period constituted an increase in related-party indebtedness and disallowed a corresponding amount of the deduction. The IRS issued a deficiency notice and BMC filed a petition for redetermination with the Tax Court.

According to BMC, the reduction for related-party indebtedness applies only to transactions intended to finance dividends. BMC also asserted that the parties agreed in a closing agreement that BMC avoids any federal income tax consequences from establishing the accounts receivable. BMC also argued that the accounts receivable did not constitute related-party indebtedness.

The Tax Court sided with the IRS, holding that the related-party debt rule under Code Sec. 965(b)(3) does not apply only to increased indebtedness resulting from intentionally abusive transactions. Further, the court stated, the election under Rev. Proc. 99-32 allowed BMC to avoid the federal income tax consequences of a deemed capital contribution. The repayment is treated as a return of principal and interest for all federal income tax purposes. Finally, the court concluded that the accounts receivable are deemed established during the testing period and qualify as increased related-party indebtedness.

For a discussion of the Code Sec. 482 rules for allocating income and deductions among related corporations, see Parker Tax ¶241,597.

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New Guidance Addresses Application of ACA Provisions to HRAs, Health FSAs, and Other Arrangements

IRS provides guidance on the effect of certain provisions of the Affordable Care Act to the following types of arrangements: (1) health reimbursement arrangements (HRAs); (2) certain group health plans; and (3) certain health flexible spending arrangements (health FSAs). Notice 2013-54.

In recently issued Notice 2013-54, the IRS explains how the Affordable Care Act's (ACA) market reforms apply to certain types of group health plans, including health reimbursement arrangements (HRAs), health flexible spending arrangements (health FSAs), and certain other employer healthcare arrangements, including arrangements under which an employer reimburses an employee for some or all of the premium expenses incurred for an individual health insurance policy. These market reforms do not apply to a group health plan that has fewer than two participants who are current employees on the first day of the plan year, and the market reforms also do not apply to a group health plan in relation to its provision of excepted benefits. Excepted benefits include, among other things, accident-only coverage, disability income, certain limited-scope dental and vision benefits, certain long-term care benefits, and certain health FSAs. Notice 2013-54 also provides guidance on employee assistance programs or EAPs and on Code Sec. 125(f)(3), which prohibits the use of pre-tax employee contributions to cafeteria plans to purchase coverage on an Affordable Insurance Exchange (also called a Marketplace). The notice applies for plan years beginning on and after January 1, 2014, but taxpayers may apply the guidance provided in the notice for all prior periods.

The market reforms specifically addressed in Notice 2013-54 are:

• Public Health Service (PHS) Act, Section 2711, which provides that a group health plan (or a health insurance issuer offering group health insurance coverage) may not establish any annual limit on the dollar amount of benefits for any individualthis rule does not prevent a group health plan, or a health insurance issuer offering group health insurance coverage, from placing an annual limit, with respect to any individual, on specific covered benefits that are not essential health benefits to the extent such limits are otherwise permitted under applicable law (the annual dollar limit prohibition); and
• PHS Act, Section 2713, which requires non-grandfathered group health plans (or health insurance issuers offering group health insurance plans) to provide certain preventive services without imposing any cost-sharing requirements for these services (the preventive services requirements).

In prior guidance, the IRS provided that an employer-sponsored HRA could not be integrated with individual market coverage, and, therefore, an HRA used to purchase coverage on the individual market will fail to comply with the annual dollar limit prohibition. In Notice 2013-54, the IRS states that no other types of group health plans used to purchase coverage on the individual market be integrated with that individual market coverage for purposes of the annual dollar limit prohibition. For example, a group health plan, such as an employer payment plan, that reimburses employees for an employee's substantiated individual insurance policy premiums must satisfy the market reforms for group health plans. However the employer payment plan will fail to comply with the annual dollar limit prohibition because (1) an employer payment plan is considered to impose an annual limit up to the cost of the individual market coverage purchased through the arrangement, and (2) an employer payment plan cannot be integrated with any individual health insurance policy purchased under the arrangement.

With respect to the question of how the preventive services requirements apply to an HRA that is integrated with a group health plan, Notice 2013-54 provides that, similar to the analysis of the annual dollar limit prohibition, an HRA that is integrated with a group health plan will comply with the preventive services requirements if the group health plan with which the HRA is integrated complies with the preventive services requirements. Notice 2013-54 also provides that a group health plan, including an HRA, used to purchase coverage on the individual market may not be integrated with that individual market coverage for purposes of the preventive services requirements.

Notice 2013-54 also provides that an HRA will be integrated with a group health plan for purposes of the annual dollar limit prohibition and the preventive services requirements if it meets the requirements under either of the integration methods described in the notice. Pursuant to Notice 2013-54, under both methods, integration does not require that the HRA and the coverage with which it is integrated share the same plan sponsor, the same plan document or governing instruments, or file a single Form 5500, if applicable.

The notice also explains the criteria that must be met for an HRA to be considered integrated with another group health plan for purposes of the annual dollar limit prohibition and the preventive services requirements.

For a discussion of HRAs and flexible spending arrangements, see Parker Tax ¶120,125 and ¶122,555.

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Fifth Circuit Partially Reverses Lower Court; Partners Win on Penalty Interest Refund Claim

Because no determination was made that transactions a partnership engaged in were tax-motivated transactions, three partners in that partnership were entitled to receive a refund of penalty interest paid after settlements had been reached; however, with respect to taxes paid, the statute had expired and they were not entitled to a refund of those taxes. Irvine v. U.S., 2013 PTC 270 (5th Cir. 9/5/13).

In 1980, American Agri-Corp (AMCOR) organized limited partnerships for which it acted as general partner. The partnerships acquired agricultural land, invested in agricultural ventures and grew crops. AMCOR solicited investments in these partnerships from high-income individuals. Each partner in an AMCOR partnership received a projected tax loss from crops planted in the first years of twice the partner's investment. In 1987, the IRS audited the AMCOR partnerships to determine if they were impermissible tax shelters.

John Irvine, Billy White, and Kenneth Kraemer invested as partners in AMCOR limited partnerships from 1984 through 1986 and reported their proportionate share of their respective partnership losses in the relevant tax years. In 1990 and 1991, the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) for the tax years in issue to the tax matters partner (TMP) for each of the partnerships and disallowed 100 percent of the partnerships' expenses and other deductions. All the partners filed suit in the Tax Court contesting the FPAA and in July 2001, a settlement was reached. In 1999 and 2000, before the partnership-level settlements were entered, John, Billy, and Kenneth individually settled with the IRS. After accepting the individual settlements, the IRS assessed additional tax liability and penalty interest under Code Sec. 6621 against each of them. John, Billy, and Kenneth paid the additional taxes and filed an administrative claim for refund in a district court. They argued that the IRS had no authority to assess additional taxes and interest because the statute of limitations had expired and that Code Sec. 7422(h) did not bar jurisdiction since the statute of limitations related to a nonpartnership item based on the facts of each partner's situation.

The question before the court was whether the claim that the additional tax assessments were time-barred was a claim for a refund attributable to partnership or nonpartnership items. If the refund claim is attributable to partnership items, Code Sec. 7422(h) would apply to deprive the district court of jurisdiction. If, on the other hand, the refund is attributable to nonpartnership items, then Code Sec. 7422(h) is irrelevant, and the general grant of jurisdiction would be effective. The claim also involved the significant interplay between the statute of limitations provision in Code Sec. 6501(a) and Code Sec. 6229(a), a separate provision that can extend the statute of limitations period for partnership items. The district court concluded that, because the Code Sec. 6501 statute of limitations period applicable to an individual partner cannot be determined without reference to the asserted bases for extensions of the statute under Code Sec. 6229, which is a partnership item, it lacked jurisdiction over the statute of limitations claim under Code Sec. 7422(h) and granted summary judgment to the IRS. Because the taxpayers claims were untimely, the district court also granted summary judgment on the issue of refunding the penalty interest. John, Billy, and Kenneth appealed.

The Fifth Circuit affirmed the district court on the grant of summary judgment on the statute of limitations claim but reversed the district court on the penalty interest claim. The court looked to case law in Prati v. U.S., 603 F.3d 1301 (Fed.Cir. 2010), which found that when an assessment of tax involved a partnership item, Code Sec. 6229 extended the time period that the IRS had under Code Sec. 6501 to make an assessment. The court stated that the partners were required to raise the statute of limitations issue in the partnership-level proceeding before settlement and were barred from raising it in their refund suit. The court also looked to Weiner v. U.S., 389 F. 3d 152 (5th Cir. 2004), which held that the assessment period was not converted into a nonpartnership item by a taxpayer's settlement with the IRS when it is not specifically stated in the settlement. The settlement agreements made by John, Billy, and Kenneth with the IRS did not mention Code Sec. 6229 and, thus, did not convert the assessment period into a nonpartnership item.

With respect to the penalty interest claim, the Fifth Circuit found that there was no determination made in the partnership-level proceeding or individual settlements that any of the partnership transactions were tax motivated transactions and, therefore, the district court was not barred from considering the partners' claim that there was no tax-motivated determination to support the imposition of penalty interest under Code Sec. 6621(c). The court rejected the IRS's argument that the partners' claims for refund of the penalty interest were untimely. The court found that since their refund claims were dependent upon a sufficient tax-motivated determination, and that determination did not occur, the penalty interest is a substantive affected item rather than computational, and the refund claims were timely filed. The Fifth Circuit held in favor of the taxpayers on the penalty interest refund claim.

For a discussion of the rules for TEFRA audit procedures, see Parker Tax ¶28,505.

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Payroll Service Company's Claim for Refund of Employment Taxes Denied; Separate Wage Base Cap Applied to Each Individual Employer

A payroll service company was not entitled to a refund of employment taxes paid on behalf of individual motion picture and television production companies. Cencast Services, L.P. v. U.S., 2013 PTC 272 (Fed. Cir. 9/10/13).

Cencast Services, L.P., a payroll service company, contracted with independent motion picture and television production companies to provide payroll and related services, including computing and paying compensation to production workers, reporting and paying compensation to multi-employer pension and benefit funds, providing post-production financial reporting, and paying employment taxes to the IRS. The production companies hired and supervised the individual production workers. From 1991 through 1996, Cencast paid over $7 billion in wages, on behalf of production companies, to workers on numerous productions. Cencast also filed tax returns and remitted employment taxes under the Federal Unemployment Tax Act (FUTA) and Federal Insurance Contribution Act (FICA) with respect to these employees. For the six years at issue, Cencast filed its FUTA and FICA employment tax returns and treated each employee as being in an employment relationship with Cencast rather than with the individual production companies. This treatment reduced Cencast's overall tax payments due to the statutory caps on FUTA and FICA taxes because Cencast applied a single wage base cap in calculating each employee's taxable wages.

In 2001, the IRS assessed tax deficiencies totaling over $43 million for FUTA taxes and $15 million for FICA taxes and determined that Cencast was required to apply a separate wage cap to each production company that had an employment relationship with a production worker during each of the years in issue. Cencast paid a portion of the assessments and filed a claim for refund. The Court of Federal Claims found that the production companies were considered the employers of the production workers for purposes of calculating FUTA and FICA taxable wage bases. The Claims Court also rejected Cencast's claim that it erroneously overpaid taxes because certain workers were independent contractors. The court said the variance doctrine barred the independent contractor theory. Cencast appealed.

Code Sec. 3306(b) provides that each employer is only liable to pay FUTA taxes on wages on the first $7,000 of wages paid with respect to employment. Code Sec. 3121(a) states that each employer is only liable to pay FICA taxes on wages paid with respect to employment up to the contribution and benefit wage base.

Observation: An employer's use of a payroll service provider does not relieve the employer from its responsibility of ensuring that all of its federal employment tax obligations are met. The payroll service provider assumes no liability for its employer/client's employment tax withholding, reporting, payment and/or filing duties.

Cencast argued that FUTA and FICA tax liability is imposed only on the entities that control the payment of wages and that Cencast was the relevant employer for purposes of imposing liability and defining the wage cap calculation.

The Federal Circuit affirmed the Court of Federal Claims and held that, for purposes of calculating the FUTA and FICA wage base caps, the caps should be calculated as though the employees were in an employment relationship with each of the individual production companies, i.e., the common law employers, rather than with Cencast, which was the statutory employer. The court stated that both the common law employer and statutory employer are employers within the meaning of Code Sec. 3301. Under Code Sec. 3306(b)(1), the term employment refers to the common law employment relationship. It was undisputed that a common law employment relationship existed between the production companies and production workers, the court said. Thus, the common law employment rules governed the wage cap computation and not the relationship of the employees to Cencast. The court noted that the Code provision did not indicate a Congressional intent for having common law employers choose a different wage cap and reduce their tax liability depending on whether the employers administered payroll themselves or delegated that responsibility to another entity.

The court found that Cencast was barred from raising in its refund suit a claim for taxes erroneously paid to independent contractors. To allow Cencast to amend its arguments two years after filing its original complaint to include the independent contractor issue would be prejudicial to the government since the addition of the new claim would be overly burdensome and time consuming. Further, Cencast's filing of its original refund claim was insufficient to preserve its independent contractor claim because the new claim substantially varied from the legal theories and factual bases asserted in Cencast's original refund claim. There was no equitable recoupment since no new or inconsistent theories were raised by the IRS.

For a discussion of who is liable for FUTA and FICA wage bases, see Parker Tax ¶213,135 and ¶213,105, respectively.