Federal Tax Bulletin - Issue 48 - October 25, 2013

Expiring Deductions and New Capitalization Rules Take Center Stage in Year-End Tax Planning for Businesses

As the year winds to a close, practitioners will want to review with their business clients any last-minute strategies that can help reduce taxes for 2013 or 2014. In particular, several developments late in the year have provided multiple tax planning opportunities, not to mention pitfalls, if certain elections are missed.

Practice Aid: See our sample client letter dealing with 2013 year-end planning issues for businesses.

The following are some of the major areas that practitioners should be thinking about when addressing year-end planning issues with their business clients.

Amounts Eligible for Expensing Drop Significantly in 2014

One of the biggest deductions available to all businesses, and one that will be dramatically reduced in 2014, is the Code Sec. 179 expensing election. This is the last year for expensing up to $500,000 of Section 179 property. It is also the last year in which the maximum amount that may be expensed is reduced where the taxpayer places into service more than $2 million of Section 179 property. For tax years beginning after 2013, the maximum amount that may be expensed drops to $25,000, and this amount is reduced where the taxpayer places into service more than $200,000 of Section 179 property. [Note: Despite the higher overall expensing limit in 2013, a $25,000 limitation applies to sport utility vehicles (SUVs) and certain other vehicles.]  

Bonus Depreciation Generally Not Available after 2013

Another big deduction scheduled to expire at the end of the year for most taxpayers is the bonus depreciation deduction. Under the bonus depreciation provisions, taxpayers can elect to claim a special additional depreciation allowance to recover part of the cost of certain qualified property placed in service during the tax year. The allowance applies only for the first year the taxpayer places the property in service and is an additional deduction taken after any Code Sec. 179 deduction and before calculating regular depreciation under MACRS for the year.

Observation: Although the additional first year depreciation deduction is generally scheduled to disappear after 2013, the placed-in-service date is extended through 2014 for certain long-lived property and transportation property.

Expiration of Shorter Recovery Period for Certain Leasehold Improvements, Restaurant Buildings and Improvements, and Qualified Retail Improvements

For qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property placed in service in 2013, a 15-year recovery period applies rather than the normal 39-year recovery period used for nonresidential real property. That shorter recovery period is not available for property placed in service after 2013. Instead, the 39-year recovery period will apply.

New Capitalization Rules

In September, the IRS issued final capitalization regulations that affect all businesses that acquire, produce, or improve tangible property. Thus, there are few businesses that are not affected by these rules. The regulations apply to tax years beginning on or after January 1, 2014. However, taxpayers can adopt the final regulations for tax years beginning on or after January 1, 2012. Because the final regulations include more taxpayer-friendly provisions than the temporary regulations, early adoption of these rules could result in significant refunds for clients. Practitioners should review the client's current fixed asset policies and compare them to the final rules to evaluate whether early adoption of the final regulations is advisable.

Observation: The IRS said separate revenue procedures would be issued under which taxpayers can obtain automatic consent to change their method of accounting to use the final regulations for a tax year beginning on or after January 1, 2012. Until those procedures are issued, however, it is unclear how the final regulations apply to earlier years and how taxpayers should be making changes relating to prior years. The original goal was to have these procedures published by the end of October. However, the government shutdown will most likely delay the issuance of these procedures to November or December.

It's important to generally review with clients the correct book and tax treatment of the various types of costs under these new capitalization rules. For example, material and supply costs can make up a large portion of a business entity's expenditures. Materials and supplies are described under the final regulations as tangible property used or consumed in the taxpayer's operations that is not inventory and is either (1) a component acquired to maintain, repair, or improve a unit of tangible property; (2) fuel, lubricants, water, or similar items that are reasonably expected to be consumed in 12 months or less; (3) a unit of property that has an economic useful life of 12-months or less; and (4) a unit of property with an acquisition or production cost of less than $200. The tax treatment of these costs depends on whether the material or supply is considered incidental or non-incidental. Non-incidental materials and supplies are deducted in the year used or consumed. Incidental materials and supplies, which are those carried on hand and for which no record of consumption is kept or for which no physical count is taken, are deducted in the year paid or incurred.

Under the final regulations, amounts paid to acquire or produce tangible property must be capitalized. Practitioners should review with clients exactly which type of expenditures constitute amounts paid to acquire or produce so such amounts can be correctly categorized on the taxpayer's books. For example, such amounts do not include materials and supplies, nor do they include costs subject to a de minimis rule. Amounts paid to acquire or produce do include, however, amounts paid to (1) acquire or produce a unit of real or personal property; (2) defend or protect title to a unit of real or personal property; or (3) facilitate the acquisition or production of real or personal property.

One of the more favorable changes in the final regulations, which may require practitioners to work with their clients to obtain the best results, is the general de minimis rule under which items may be expensed. The maximum amount that may be expensed depends on whether the taxpayer has an applicable financial statement (AFS) and a written capitalization policy. If the taxpayer has an AFS and written capitalization policy, the maximum amount of an item that may be expensed per invoice amount is $5,000. An AFS can be an SEC financial statement, an audited financial statement, or any other financial statement, other than a tax return, that is filed with a government entity. The written capitalization policy must be in effect as of January 1, 2014, if a calendar-year business wants to use the de minimis rule for 2014. So practitioners will want to impress upon clients the importance of having such a policy in place before the beginning of the taxpayer's next tax year. It's also important to caution clients that they must follow this policy. Thus, if the policy says that everything under $1,000 is going to be expensed, the taxpayer's books should not show any items under $1,000 that are capitalized. For taxpayers without an AFS but with a written capitalization policy, the maximum per item amount that may be expensed is $500. In both cases, the item must be expensed in the financial statements according to the written capitalization policy.

The final regulations contain several elections that may be beneficial to a client and that should be reviewed with the client.

For example, taxpayers may elect to capitalize repair and maintenance costs that would otherwise be deductible. Some taxpayers may prefer to do this to have conformity between book and tax and just generally make accounting for costs easier. Once the item is capitalized, depreciation is taken when the asset is placed in service. Practitioners should stress that this is an all-or-none election and it is irrevocable. Taxpayers can't choose to capitalize some items for books and then expense those items for tax purposes.

Observation: A taxpayer that capitalizes repair and maintenance costs under this election is still eligible to apply certain safe harbor rules to repair and maintenance costs that are not treated as capital expenditures on its books and records.

There is a safe harbor for small taxpayers to avoid having to capitalize amounts paid for improvements to eligible building property. So practitioners will want to review with a client whether or not they qualify for this election and whether the taxpayer has property that might come within the election. A qualifying taxpayer is one with average annual gross receipts for the three preceding tax years of less than or equal to $10 million. Property qualifies if it has an unadjusted basis of $1 million or less. Certain leased property also qualifies. If the taxpayer meets the requirements, the lesser of 2 percent of the property's unadjusted basis or $10,000 of repairs, maintenance, and improvements and similar activities may be expensed.

There is also a safe harbor for routine maintenance of property other than a building. If a business client provides such maintenance, this should be reviewed. There are a number of exceptions for maintenance that may seem like routine maintenance but don't fall within the safe harbor and have to be capitalized.

After reviewing the client's records and discussing with the client the effects of the capitalization regulations on the client's business, practitioners will need to determine the optimal year, if any, to make any tax method changes and elections relating to the regulations and prepare amended returns for earlier years, if necessary.

Change in Disposition Rules for MACRS Assets

Also in September, the IRS issued proposed regulations on dispositions of MACRS property, which are expected to be finalized later this year and which will be effective for tax years beginning on or after January 1, 2014. Like the capitalization regulations, these rules affect almost all taxpayers. Once the proposed regulations are finalized, they will replace temporary regulations, which taxpayers may choose to apply to tax years beginning on or after January 1, 2012. The temporary regulations will not apply to tax years beginning on or after January 1, 2014. Taxpayers can adopt the proposed regulations for tax years beginning on or after January 1, 2012. So, to the extent a client is currently using provisions of the temporary regulations that are inconsistent with the proposed regulations, which presumably reflect what the final regulations will look like, practitioners will need to file a change in accounting method and work with clients to revise how dispositions of MACRS property are accounted for. The following are some of the more significant changes made by the proposed regulations.

(1) The proposed regulations also provide that the disposition rules apply to a partial disposition of an asset. This allows taxpayers to claim a loss upon the disposition of a structural component (or a portion thereof) of a building or upon the disposition of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposition event. This new rule helps minimize circumstances in which an original part and any subsequent replacements of the same part are required to be capitalized and depreciated simultaneously. While the partial disposition rule is generally elective, it must be applied to a disposition of a portion of an asset as a result of certain nonrecognition events.

(2) The partial disposition rules under the proposed regulations specify how taxpayers must treat the disposition of an asset's component. Thus, the rule in the temporary regulations allowing taxpayers to use any reasonable, consistent method to treat an asset's components as the asset for disposition purposes is no longer available in the proposed regulations.

(3) The proposed regulations change the rule in the temporary regulations that each structural component of a building, condominium, or cooperative is the asset for tax disposition purposes. Instead, the proposed regulations provide that a building (including its structural components), a condominium (including its structural components), or a cooperative (including its structural components) is the asset for disposition purposes. The change allows taxpayers to forgo a loss upon the disposition of a structural component of a building without making a general asset account election.

(4) Under a new rule in the proposed regulations, if a taxpayer disposes of a portion of an asset and the partial disposition rule applies to that disposition, the taxpayer must account for the disposed portion in a single asset account beginning in the tax year in which the disposition occurs.

Observation: The IRS is expected to issue a revenue procedure detailing how taxpayers are to apply the various changes in the proposed regulations. Practitioners with clients that are currently using general asset accounts (GAAs) should review with their clients whether they want to undo a prior GAA election based on changes in the proposed regulations. The procedure is also expected to advise how to implement the proposed regulations for prior years (i.e., years beginning on or after January 1, 2012).

Because the proposed regulations provide significant changes to the rules in the temporary regulations, and provide taxpayers with more simplified methods of accounting for dispositions of MACRS assets, it's important to review with clients the effect these changes will have on their particular business.

Affordable Care Act

Given the amount of confusion regarding the Affordable Care Act (i.e., Obamacare), practitioners may want to review with their clients how the law will impact their business.

(1) A qualified small employer may be eligible for a credit for contributions to purchase health insurance for its employees. The amount of the credit increases from 35 percent (25 percent for tax-exempt organizations) of eligible premium payments in 2013 to 50 percent (35 percent for tax-exempt organizations) in 2014.

(2) Employers must report the cost of employer-sponsored group health plan coverage on employee W-2s.

(3) The employer mandate that was suppose to take effect on January 1, 2014, has been delayed and will not take effect until January 1, 2015. Under the employer mandate, a penalty is imposed on certain large employers that do not offer health insurance coverage, offer health insurance coverage that is unaffordable, or offer health insurance coverage that consists of a plan under which the plan's share of the total allowed cost of benefits is less than 60 percent. The penalty is assessed for any month in which a full-time employee is certified to the employer as having purchased health insurance through a state exchange with respect to which a premium tax credit or cost-sharing reduction is allowed or paid to the employee.

Expiration of Work Opportunity Credit

For 2013, a business is eligible for a 40 percent credit for qualified first-year wages paid or incurred during the tax year to individuals who are members of a targeted group of employees. This credit is not available after 2013.

Generally, this credit is equal to 40 percent of the qualified first-year wages of members of a targeted group of employees who worked 400 or more hours during the year for the employer. The credit is reduced to 25 percent of the qualified first-year wages for employees who worked between 120 and 400 hours for the employer. No credit is available for the qualified first-year wages for employees who worked less than 120 hours.

The wages taken into account cannot be taken into account in computing the employer's compensation deduction. Practitioners should explore whether this in an option for any of their business clients.

Gain or Loss on Dispositions of Partnership and S Corporation Interests Are Subject to the Net Investment Income Tax

A new 3.8 percent tax on net investment income above a threshold amount took effect for 2013. The threshold amount is $200,000 ($250,000 if married filing jointly or $125,000 for married filing separately). For purposes of calculating the net investment income tax, net investment income includes net gain on the disposition of property, other than property held in a trade or business that is a passive activity or a trade or business of trading in financial instruments or commodities, over allowable deductions allocable to such net gain. In most cases, an interest in a partnership or S corporation is not property held in a trade or business. Therefore, gain or loss from the sale of a partnership interest or S corporation stock is subject to the net investment income tax. Similarly, distributions from a passive partnership interest will be subject to the tax.

Practitioners should review with S corporation owners and partners whether or not they will be subject to the 3.8 percent net investment income tax and, if so, the expected impact of these taxes.

Expiration of Reduced Recognition Period for S Corporation Built-in Gains

An S corporation may owe the built-in gains tax if it has net recognized built-in gain during the applicable recognition period. Generally, the applicable recognition period is 10 years. However, for purposes of determining the net recognized built-in gain for tax years beginning in 2012 or 2013, the recognition period was reduced from 10 years to five years. Thus, no tax is imposed on the net recognized built-in gain of an S corporation if the fifth tax year in the recognition period preceded 2012 or 2013. This rule applies separately with respect to any C corporation asset transferred in a carryover basis transaction to the S corporation.

After 2013, the recognition period returns to 10 years. Thus, after 2013, to escape gain recognition on property with built-in gain, the property will have to be held for more than 10 years.

Increased Tax on Distributions to Owners

Another change that impacts business owners is the higher tax rate on dividend distributions (20 percent for taxpayers with income taxed at the 39.6 percent rate), as well as the 3.8 percent net investment income tax on such distributions, if certain thresholds are exceeded. The threshold amounts are $200,000, $250,000 if married filing jointly, or $125,000 for married filing separately.

Change for Food Service Employers

Beginning in 2014, automatic tips (e.g., 18 percent gratuity added to checks of six people or more) will be classified as service charges and treated as regular, non-tip wages for income tax and FICA tax withholding purposes, and are not subject to the special reporting and payment rules that apply to tips. Businesses that have been treating such amounts as tips may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges.

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Year-End Tax Planning for Individuals in Light of Changes Made by ATRA and Expiring Provisions

As year-end approaches, it's time for practitioners to pursue with their clients any last minute strategies that might lessen the impact of 2013 taxes. Last year, there was a lot of uncertainty over whether or not the Bush-era tax cuts would be extended. A last-minute deal was struck and, under the American Taxpayer Relief Act of 2012 (ATRA), the more favorable tax rates for lower income taxpayers were made permanent, while rates on the highest-earning taxpayers were increased to 39.6 percent. The Act also temporarily extended some of the more popular deductions.

Practice Aid: See our Sample Client Letter dealing with 2013 year-end planning issues for individuals.

The following are some of the major areas that practitioners should be thinking about when addressing year-end planning issues with their clients.

Increase in Top Tax Rate

As noted above, beginning in 2013, a new top tax rate of 39.6 percent takes effect. This rate applies to taxable income in excess of $450,000 (joint returns and surviving spouses), $425,000 (heads of household), $400,000 (unmarried other than head of household and surviving spouse), and $225,000 (married filing separately).

New Taxes Take Effect in 2013

There are two new high-profile taxes that take effect in 2013: the 3.8 percent tax on net investment income above a threshold amount and the .9 percent additional Medicare tax on wages and self-employment income above a threshold amount. The threshold amount is $200,000 ($250,000 if married filing jointly, or $125,000 for married filing separately). Income taken into consideration in calculating net investment income includes most rental income and net gain attributable to the disposition of property other than property held in a trade or business. Thus, this generally covers sales of interests in a partnership or S corporation.

Increased Tax Rate on Certain Capital Gains and Dividends

While the favorable tax rates in effect before 2013 for capital gains and dividend income were generally made permanent by the American Taxpayer Relief Act of 2012, a new 20-percent rate applies to amounts which would otherwise be taxed at the 39.6-percent rate. Thus, tax rates of 0, 15, and 20 percent apply to capital gain and dividend income, depending on the taxpayer's tax bracket. These rates apply for alternative minimum tax purposes also.

Reduction in Personal Exemptions and Itemized Deductions for High-Income Taxpayers

For 2013 and later years, ATRA resurrected the reduction in personal exemptions and itemized deductions for taxpayers with adjusted gross income over $250,000 (unmarried other than head of household and surviving spouse), $300,000 (joint returns), $275,000 (head of household), and $150,000 (married filing separately), which will have the effect of increasing taxes on those taxpayers. Year-end planning should consider the effect of these additional taxes on determining whether a client has paid a sufficient amount of tax so as to avoid any underpayment of estimated tax penalty.

Same-Sex Couples Filing Status

Also new for 2013, same-sex couples who are legally married can no longer file returns using the single filing status. They can either file a joint return or file as married filing separately. This could significantly increase the tax burden on some of these couples.

Observation: For purposes of computing the underpayment of estimated tax penalty for a taxpayer who files a joint return for 2013 but who filed a separate return for 2012, the tax shown on the 2012 return for the preceding tax year, for purposes of determining the applicability of the exception to the estimated tax penalty based on 100 percent of the tax shown on the individual's tax return for the preceding tax year, is the sum of both the tax shown on the 2012 return of the taxpayer and the tax shown on the 2012 return of the taxpayer's spouse.

Increased Threshold for Deducting Medical and Dental Expenses

Medical and dental expenses are only deductible if they exceed a certain percentage of the taxpayer's adjusted gross income for the year. For years before 2013, that percentage was 7.5 percent. For 2013 and later years, the percentage is 10 percent. However, for any tax year ending before January 1, 2017, the floor is 7.5 percent if the taxpayer or the taxpayer's spouse has reached age 65 before the end of that year.

Last Year for State and Local Sales Tax Deduction

One provision scheduled to expire at the end of 2013 is the election to deduct state and local sales taxes in lieu of state and local income taxes. Thus, if a taxpayer is thinking of purchasing a large ticket item that will generate a larger deduction than the state and local income tax deduction, purchasing the item in 2013 may be beneficial.

Deduction for Eligible Teacher Expenses

Another provision that expires this year is the deduction for eligible teacher expenses. For tax years beginning before 2014, eligible educators (i.e., teachers) can deduct from gross income up to $250 of qualified expenses they paid during the year. If spouses are filing jointly and both were eligible educators, the maximum deduction on the joint return is $500. However, neither spouse can deduct more than $250 of his or her qualified expenses.

Limited Reimbursements under Flexible Spending Arrangements

Beginning in 2013, for a health FSA to be a qualified benefit under a cafeteria plan, the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee's dependents, and any other eligible beneficiaries with respect to the employee, under the health FSA for a plan year (or other 12-month coverage period) cannot exceed $2,500. Thus, when an employee is given the option under a cafeteria plan maintained by an employer to reduce his or her current cash compensation and instead have the amount of the salary reduction be made available for use in reimbursing the employee for his or her medical expenses under a health FSA, the amount of the reduction in cash compensation pursuant to a salary reduction election must be limited to $2,500 for a plan year. The $2,500 limit is subject to indexing for years beginning after December 31, 2013

Qualified Principal Residence Debt Exclusion

Under a special rule that expires at the end of 2013, no income is recognized from the discharge of qualified principal residence debt (i.e., a mortgage on the taxpayer's home). The discharge of such debt is generally excludable from gross income for discharges through 2013. Qualified principal residence debt is debt that is incurred to buy, build, or substantially improve a principal residence and that is secured by that residence. It also includes debt secured by a principal residence that is used to refinance qualified principal residence debt, but not in excess of the outstanding principal amount of the debt that is refinanced.

Charitable Donations Using IRA Distributions

There is a special rule, not available after 2013, allowing taxpayers age 70-1/2 and older to make a qualified charitable distribution of up to $100,000 from the individual's IRA to a charity. The distribution is taken into account for purposes of determining if the taxpayer has met the minimum distribution requirements but is not included in the taxpayer's income. While no charitable deduction is allowed for any amount that was contributed to the IRA tax free, this can be a much more tax efficient way of donating for certain types of taxpayers. For example, donating this way reduces a taxpayer's adjusted gross income. This, in turn, potentially reduces the percentage of social security income that is taxed from 85 percent to 50 percent and increases certain deduction by reducing the effects of the limitations on personal exemptions, itemized deductions, and charitable contributions that are tied to higher adjusted gross income amounts.

Expiring Tax Credits

Obviously, generating additional tax credits will help reduce taxes and there are two expiring tax credits that environmentally conscious taxpayers may want to take advantage of.

One such credit is the residential energy credit, which is available only through the end of 2013. Taxpayers contemplating energy improvements to their home may want to accelerate the improvements into 2013. The credit is 10 percent of the amounts paid or incurred for qualified energy efficiency improvements installed during the tax year and the amount of residential energy property expenditures paid or incurred during the tax year, up to a maximum credit of $500.

The other green credit due to expire at the end of the year is the credit for qualified two- or three-wheeled plug-in electric vehicles. The credit is equal to the lesser of 10 percent of the cost of such vehicle or $2,500.

Accelerating Income into 2013

It may be prudent to accelerate income into 2013 where the taxpayer will have more income in 2014, with the potential of being in a higher tax bracket and/or being subject to one or more of the additional taxes mentioned above. One common strategy is harvesting gains from the taxpayer's investment portfolio. However, in doing so, practitioners must take into account whether such acceleration will cause the taxpayer to be subject to the 3.8 percent net investment income tax.

Another option, which is new for 2013, is to have a taxpayer with a 401(k) plan that includes a qualified Roth contribution program to transfer an amount from his or her regular (preelective deferral account into a designated Roth account in the same plan. In 2012, this was allowed only for participants who were at least 59-1/2 years old. That age limitation does not apply in 2013 and, while the transfer is subject to regular income tax, no early distribution penalty applies.

Besides harvesting gains, other options to accelerate income into 2013 include:

1. if a taxpayer owns a traditional IRA or a SEP IRA, converting it into a Roth IRA and recognizing the conversion income this year;
2. taking IRA distributions this year rather than next year;
3. for self-employed individuals with receivables on hand, getting clients or customers to pay before year end, but being mindful of the .9 percent additional Medicare tax on self-employment income over $200,000 ($250,000 for joint returns); and
4. settling lawsuits or insurance claims that will generate income.

Deferring Income into 2014

For high-income taxpayers, especially those that may be subject to the 3.8 percent net investment income tax or the .9 percent Medicare tax, it may make sense to defer income into the 2014 tax year if the client expects a decrease in income in 2014 or to generally be in a more advantageous tax situation. Some options include:

1. if a client is due a year-end bonus, having the employer pay the bonus in January 2014;
2. if a client is considering selling assets that will generate a gain, postponing the sale until 2014;
3. delaying the exercise of any stock options;
4. considering an installment sale if property is being sold;
5. parking investments in deferred annuities;
6. establishing an IRA, if the applicable income requirements are met; and
7. putting the maximum salary allowed into a 401(k) before year end.

Deferring Deductions into 2014

If a client expects to move into a higher tax bracket in 2014, or anticipates a substantial increase in taxable income or net investment income next year, deferring deductions into 2014 might be the right approach. Two alternatives to consider are:

1. postponing year-end charitable contributions, property tax payments, and medical and dental expense payments until next year; and
2. postponing the sale of any loss-generating property.

With respect to postponing the payment of medical and dental expenses, it's important to consider that, for tax years ending before January 1, 2017, the increase in the threshold for deducting such expenses (from 7.5 percent of AGI to 10 percent of AGI) does not apply if the taxpayer or the taxpayer's spouse has attained age 65 before the close of the tax year.

Accelerating Deductions into 2013

Where a client's income is expected to decrease in 2014, accelerating deductions into 2013 may be prudent. Some options for accelerating deductions into the current year include:

1. prepaying property taxes in December;
2. prepaying a January mortgage payment in December;
3. prepaying any state income taxes due, but only if the client doesn't owe AMT since there is no state tax deduction for AMT purposes, so the deduction would be wasted;
4. since medical expenses are deductible only to the extent they exceed 10 percent of AGI for 2013 for taxpayers under age 65, bunching large medical bills not covered by insurance into one year may help overcome this threshold;
5. making any large charitable deductions in 2013, rather than 2014;
6. gifting appreciated stock to avoid paying tax on the appreciation but obtaining a deduction for the full value of the stock;
7. selling loss stocks; and
8. if the client qualifies for a health savings account, setting one up and making the maximum contribution allowable.

Miscellaneous Items

Finally, some additional miscellaneous items practitioners should consider when doing year-end planning:

(1) Encourage clients that have a health flexible spending account with a balance to spend it before year end (unless their employer allows them to go until March 15, 2014, in which case they'll have until then).

(2) For taxpayers with a vacation home that was rented out during the year, determine the number of days it was used for business versus pleasure to see if there is anything that can be done to maximize tax savings with respect to that property. For example, if the client spent less than 14 days at the home, it may make sense to spend a couple more days and have the house qualify as a second residence, with the interest being deductible. As a rental home, rental expenses, including interest, are limited to rental income.

(3) Consider having taxpayers shift income to a child so that the tax on the income is paid at the child's rate.

(4) Impress upon clients the importance of disclosing any foreign asset holdings so that the proper tax forms can be prepared and the onerous penalties for not disclosing such assets avoided.

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Obtaining Discharge of Tax Lien Under Wrong Code Section Costs Taxpayer $100,000

The rules relating to tax liens and the discharge of a tax lien are quite complicated and extremely procedural. As the taxpayer in McGinley v. U.S., 2013 PTC 297 (D. N.J. 9/30/13) found out, not following those procedures to the letter can be costly. In this case, the discharge of a tax lien on property sold by the taxpayer was requested under Code Sec. 6524(b)(2)(A) rather than Code Sec. 6524(b)(4). The result was that the taxpayer was without remedy to collect approximately $100,000 that the IRS had taken from her sale of the property as a result of a lien against her ex-husband and that the IRS had previously agreed she did not owe.

Facts

Beth McGinley and her then husband, Kevin Kops, filed a joint tax return for 2000. The amount due, exclusive of penalty and interest, was $76,744. Subsequently, Beth and Kevin divorced, and in June 2004, a New Jersey court entered a judgment against Kevin requiring him to pay Beth child support. The judgment was filed and attached as a lien against Kevin's half-interest in the former marital home where Beth lived with the couple's children. In August of 2004, the IRS filed a $91,000 tax lien against Beth and Kevin, which attached to the former marital home. In the divorce, Beth was awarded the previously jointly owned marital home and title to it was deeded solely to Beth in 2005. As such, the property was no longer held jointly by Kevin.

In March 2006, the IRS determined that Beth was an innocent spouse and granted her relief under Code Sec. 6015 for the entire tax liability for the 2000 tax year. Thus, the IRS effectively determined that Beth had no responsibility for that year's tax liability. Accordingly, in July, the IRS released the previously filed tax lien as to Beth, but did not release its lien with respect to Kevin.

Beth's attorney worked to get relief from the tax lien. The IRS advised the attorney to file a request for a certificate of nonattachment, which he did on October 29, 2008. The IRS denied the request. The IRS also advised the attorney to file a request for a certificate of discharge, which was done on June 22, 2009. This request was also denied. According to Beth's attorney, each of these requests was prepared after he engaged in long conversations with multiple IRS agents with whom he dealt with on the matter as to proper IRS procedure. Beth's attorney said he received conflicting advice from the IRS as to how to proceed from a procedural perspective and was engaged in protracted negotiations with the IRS to find suitable relief for Beth, but such negotiations allegedly lagged due to the IRS's confusion and conflicting advice on how to move forward.

In June 2010, Beth entered into a contract to sell her home. With respect to the sale, the IRS took the position that Kevin still had an interest in the property because the tax lien was filed before the property was transferred solely to Beth. Beth's attorney contacted the IRS in an attempt to come to a settlement on the amount owed so that amount could be escrowed at the closing. Initially, the IRS agreed to permit the escrow of an amount of just over $162,000 so that Beth could sell the home and continue to dispute the amount owed. On the eve of the closing, the IRS changed its position with respect to escrowing the funds and advised Beth that it would require payment of $103,000, not escrow, in exchange for a discharge of the lien. Beth sold the home and paid the IRS $103,000 in November of 2011. The IRS then issued a certificate of discharge on November 10, 2011, with respect to the entire tax lien.

Beth then appealed to the IRS Appeals Office. She was advised that the IRS could not provide any relief because the tax was paid as part of the sale of real estate. However, an appeals officer suggested that she file a claim for refund on Form 843, Claim for Refund and Request for Abatement. Consequently, Beth filed a claim for a refund with the IRS, asserting, among other things, that no monies should have been collected by the IRS with respect to the lien because the June 2004 child support judgment had priority over the August 2004 federal tax lien. The amount of child support owing by 2010 had become $553,000.

While her claim for refund was pending, Beth, believing that her claim was covered by the two-year statute of limitations under Code Sec. 6511(b), filed a lawsuit on August 30, 2012, in a New Jersey district court as a protective measure.

Beth's attorney continued his discussions with the IRS and, around the beginning of October 2012, reached an agreement with a member of the IRS Taxpayer Advocate's Office, who agreed that the full amount of the payment would be refunded because the tax lien did not have priority over the child support judgment lien. The IRS advised Beth's attorney that New Jersey's probation department would have to send a letter to the IRS requesting the payment of the funds to the department directly. Accordingly, in November 2012, Superior Court of New Jersey, Family Part, Somerset County, entered an order requiring the IRS to pay the funds into court pending a formal application by Beth for release of those funds. The IRS refused to pay the funds, and Beth's suit against the IRS was heard in a New Jersey district court in 2013.

IRS Arguments

The IRS argued that the district court lacked jurisdiction over the case because the United States did not waive sovereign immunity. The government's argument was essentially two-fold. First, it contended that if Beth purported to bring a refund action under 28 U.S.C. Section 1346(a)(1) (permitting a civil action against the United States for the recovery of any tax alleged to have been erroneously or illegally assessed or collected), there was no jurisdiction because Beth was not a proper party under Code Sec. 7422 (addressing requirements for refund actions) to file the action. According to the IRS, Beth was not the taxpayer (i.e., the person who had the tax obligation) and, further, even if she was the taxpayer, the tax liability had to be paid in full before filing suit.

Second, the IRS argued that, to the extent Beth's action was considered one pursuant to Code Sec. 7426 (providing certain remedies for third parties), Beth's claim was late because that statute required her to file her action in district court within 120 days of the issuance of the certificate of discharge by the IRS.

Beth's Arguments

Beth argued that 28 U.S.C. Section 1346(A)(1) authorized her suit under the doctrine of the Supreme Court's decision in U.S. v. Williams, 514 U.S. 527 (S. Ct. 1995). Similar to Beth's case, the plaintiff in Williams paid her ex-husband's federal tax under protest in order to remove a tax lien on the house formerly owned jointly by both. Rejecting the IRS's argument that no waiver of sovereign immunity existed, the Williams Court concluded that 28 U.S.C. Section 1346(a)(1) authorized a tax-refund claim by a third party whose property was subjected to an allegedly wrongful tax lien. The Court's holding was based on the fact that no other remedy would have existed for the plaintiff in that case.

District Court's Opinion

Turning first to the IRS's not-the-taxpayer argument, the district court noted that the IRS provided little in the way of an explanation for its argument. Instead, it simply cited Code Sec. 7422 and, the court presumed that it was to infer that, under Code Sec. 7422, a party may not bring a refund action without first exhausting administrative remedies that, under Code Sec. 6511, only a taxpayer may exhaust, and that under Code Sec. 7701(a)(14), Beth was not a taxpayer for purposes of the refund action. The court noted that this argument was rejected by the Supreme Court in Williams under facts similar to Beth's situation and that it has been generally held that the ultimate holding in Williams has been superseded by statute. In response to the William's decision, Congress created a remedy for individuals in Beth's shoes by adding Code Sec. 7426(a)(4) and Code Sec. 6325(b)(4).

Under Code Sec. 6325(b)(4), the owner of a property subject to the federal tax lien of a third party can obtain a certificate of discharge from the IRS by providing a cash deposit or bond sufficient to protect the government's lien interest in the property (i.e., a substitution of value). Code Sec. 7426(a)(4) provides that if a certificate of discharge is issued under Code Sec. 6325(b)(4) and a property owner is dissatisfied the IRS's determination of the lien value, the property owner may bring suit within 120 days after issuance of the certificate discharge for a determination of whether the value of the interest of the United States (if any) in such property is less than the value determined by the IRS. Code Sec. 7426(a)(4) expressly provides, the court stated, no other action may be brought by such person for such a determination. In the time since the enactment of those provisions, the court stated, the majority of courts addressing the question have found that the amendments have superseded the holding in Williams, and taxpayers in Beth's situation must use the procedures set forth in Code Sec. 6325(b)(4) and Code Sec. 7426(a)(4) before filing a claim in district court.

In finding that the holding in Williams did not apply to save Beth's claim, the district court rejected Beth's argument that her situation was identical to that of the Williams' plaintiff in that she was without a remedy. The court noted that Beth could have but failed to seek relief under Code Sec. 6325(b)(4) and Code Sec. 7426(a)(4). With respect to Beth's argument that her ability to enter into a substitution of value arrangement required by these statutes was foreclosed by the IRS's eleventh-hour rejection of the escrow agreement, the court found no evidence that Beth had sought a discharge under Code Sec. 6325(b)(4). To the contrary, the court said, documentary evidence predating the IRS's last-minute payment demand showed that Beth, through her attorney, sought a certificate of discharge expressly under Code Sec. 6325(b)(2)(A), and not Code Sec. 6325(b)(4). Consistent with Beth's initial request, the certificate of discharge, on its face, states that it was issued pursuant to Code Sec. 6325(b)(2)(A). In addition to explicitly referencing Code Sec. 6325(b)(2)(A), the court observed, the certificate of discharge was issued on Form 669-B, which is used when the discharge is pursuant to Code Sec. 6325(b)(2)(A).

Finally, the court noted that case law and Rev. Rul. 2005-50 provide that if a third party obtains the discharge of a tax lien under Code Sec. 6325(b)(2)(A), there is no judicial review of the collection by the IRS in exchange for the certificate of discharge. Rev. Rul. 2005-50 specifically provides that persons who request a certificate of discharge under Code Sec. 6325(b)(2)(A) may not seek judicial review of the IRS's valuation determination through a refund action under 28 U.S.C. Section 1346(a)(1). As a result, Beth could not recover the $103,000 she paid to the IRS to discharge the tax lien.

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Government Can't Hide Behind Code Sec. 6103 to Deny Documents to Taxpayer

It seemed unlikely to the court that all of the materials confiscated by the IRS that were being sought by the taxpayer constituted returns such that Code Sec. 6103 prevented them from being turned over. Gourmet Express, LLC v. U.S., 2013 PTC 315 (N.D. Calif. 10/9/13).

Robert Scully was the chief executive officer of Gourmet Express from January 2008 until mid-2009. In May 2008, the IRS executed a search warrant and collected evidence at a home owned by Robert in California in connection with a criminal investigation of Robert in Texas. The warrant authorized the seizure of Records related to federal income tax returns filed by ROBERT SCULLY and KEVIN SCULLY and Gourmet Express, LLC, Records relating to Gourmet Express, LLC and its relationship with product suppliers and their representatives including . . . Groupwel1 International (HK) Limited, and Records pertaining to the business of Gourmet Express, LLC. Robert was indicted in Texas for, among other things, tax evasion. The indictment contended that Robert concealed income for tax purposes by creating four shell companies controlled by relatives, including Groupwell International Limited (Groupwell), using them to inflate the cost Gourmet Express paid for food products, and siphoning off those excess costs.

In September 2009, Groupwell filed a civil lawsuit against Gourmet Express in a Kentucky district court seeking payment for the goods they supplied to Gourmet Express. Gourmet Express filed counterclaims against Groupwell contending that they were involved in defrauding Gourmet Express. Gourmet Express asked the government to reproduce the documents it seized in the May 2008 search of Robert's home. The government opposed the request, primarily citing Code Sec. 6103.

Code Sec. 6103 provides that returns and return information are confidential, and except where authorized under the Internal Revenue Code, no officer or employee of the United States can disclose any return or return information obtained by him in any manner in connection with his service as an officer or an employee or otherwise. At the same time, the court noted, Congress realized tax information on file with the IRS was often important to other government agencies and revised Code Sec. 6103 to represent a legislative balancing of the right of taxpayers to the privacy of tax information in the hands of the IRS and the legitimate needs of others for access to that information. The statutory definitions of return and return information to which the entire statute relates, the court observed, confines the statute's coverage to information that is passed through the IRS, but that is as far as the statute goes.

The court ordered the government to reproduce the property requested within 14 days, unless the government filed a motion to stay enforcement of the order that is accompanied by authority supporting its arguments. It seemed unlikely to the court that all of the material at issue constituted returns because Code Sec. 6103(b)(1) provides that a return means any tax or information return, declaration of estimated tax, or claim for refund required by, or provided for or permitted under, the Internal Revenue Code, which was filed with the Secretary of Treasury by, on behalf of, or with respect to any person, and any amendment or supplement thereto, including supporting schedules, attachments, or lists that are supplemental to, or part of, the return so filed. The warrant sought Robert's returns, but it also sought Gourmet Express' tax returns, as well as documents other than tax returns that related to Gourmet Express' business. At least some of the information sought, the court stated, was probably not filed with the Secretary of Treasury by Robert, and in any case, the United States did not demonstrate that all of it was. The question of whether the material constituted a return, the court said, appeared to turn on the scope of the definition of return information of Code Sec. 6103(b)(2).

The court noted that the government had submitted no affidavits or competent evidence of any kind that demonstrated that the materials qualified as return information. If a document's status as return information is contingent on certain facts not known, the court stated, the government had to do more. It was not clear to the court that any IRS official had even reviewed the material and determined which documents qualified as return information, and why. The burden was similarly on the government to justify its decision not to disclose.

For a discussion of Code Sec. 6103, see Parker Tax ¶265,153.

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Film Producer Who Didn't Pay Employment Taxes Can't Avoid $43 Million Restitution Order

A film maker's conviction on charges of not paying employment taxes and interfering with the administration of the internal revenue laws that resulted in a 144-month prison sentence and a $43 million restitution order was upheld. U.S. v. Harrison, 2013 PTC 304 (4th Cir. 9/26/13).

Bruce Gregory Harrison, III, owned and operated several temporary staffing agencies from offices in Greensboro, North Carolina. Although Harrison employed a large workforce, he failed to file required IRS forms and failed to collect and withhold payroll taxes. Harrison also failed to file personal tax returns for 2004, 2005, and 2006. In late 2006, Harrison sold the staffing companies to two employees. While those employees operated the companies, the payroll taxes were paid and employment tax returns were filed.

In 2008, Bruce reacquired the companies and again stopped paying payroll taxes. He used these withheld payments to fund his lifestyle, including the purchase of a luxury beach house and the production of two motion pictures, National Lampoon's Pucked, featuring Jon Bon Jovi, and Home of the Giants.

For these actions, as well as efforts made to conceal his criminal activities, a federal grand jury indicted Bruce on one count of corruptly endeavoring to obstruct the administration of the internal revenue laws, in violation of Code Sec. 7212(a); 59 counts of failing to account for and pay payroll taxes, in violation of Code Sec. 7202; and three counts of willfully failing to file income tax returns, in violation of Code Sec. 7203. After a three-week trial, the jury convicted Bruce on all 63 counts. Following his conviction, a district court sentenced Bruce to 144 months in prison and three years of supervised release. The court also ordered Bruce to pay restitution of over $43 million as a condition of his release. Bruce appealed.

On appeal, Bruce argued that the government constructively amended his indictment by presenting evidence that he failed to pay federal unemployment tax (and which was not charged in the indictment). A constructive amendment, also known as a fatal variance, happens when the government, through its presentation of evidence or its argument, or the district court, through its instructions to the jury, or both, broadens the bases for conviction beyond those charged in an indictment. Additionally, Bruce said that offenses under the U.S. Tax Code (i.e., Title 26) do not authorize restitution and, even assuming otherwise, any restitution was capped at $15.9 million, the amount of unpaid taxes, rather than the $43 million in tax loss caused by his scheme.

The Fourth Circuit affirmed the district court's sentence. With respect to Bruce's argument that the government presented evidence that he also failed to pay an unemployment tax that was not charged in the indictment, the court noted that this evidence was admitted-without objection-simply to show that Bruce's staffing agencies were still in operation in the years he failed to submit payroll taxes. Further, the court observed, the instructions to the jury specified repeatedly that Bruce was charged with 59 counts of failing to pay over payroll taxes.

The Fourth Circuit also concluded that the restitution order was appropriate, noting that the district court was authorized under 18 U.S.C. Section 3583(d) to impose any condition of probation listed in 18 U.S.C. Section 3563(b). That section, the court noted, authorizes restitution to the victim of the offense. Thus, the court stated, it is well settled that federal courts are authorized to order restitution for any criminal offense, including one under the U.S. Tax Code. Harrison's alternative contention, that the restitution should be capped at $15.9 million, the identified tax loss, fared no better. While Bruce noted that restitution is limited to the offense of conviction and is not for other related offenses of which a defendant is not convicted, the court found that Bruce was overlooking his conviction for interference with the administration of the internal revenue laws, in violation of Code Sec. 7212(a). Bruce's conviction on this count, the court said, covered a broader swath of conduct and amply supported the full restitution award.

For a discussion of the rules relating to fines and penalties that may be assessed as a result of interfering with the administration of the internal revenue laws, see Parker Tax ¶265,148.

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Taxpayer Didn't Meet Partial Payment Rule for Requesting Refund of Sec. 6672 Penalty Tax

Evidence submitted by the taxpayer was insufficient for the court to conclude that the full-payment requirement for filing a refund claim for the Code Sec. 6672 penalty tax had been met, as the taxpayer's conclusion that he met the divisible tax threshold for at least one employee assumed a certain level of consistency in restaurant work schedules without any reasonable basis for such an assumption. Kaplan v. U.S., 2013 PTC 309 (Fed. Cl. 10/9/13).

In 2010, the IRS assessed almost $87,000 of trust fund recovery penalties against Jonathan Kaplan. The IRS assessed this tax liability under Code Sec. 6672 after finding that for the first, second, and third quarters of 2008, Jonathan had failed to remit federal income and Federal Insurance Contributions Act (FICA) withholding taxes for the employees of Merchants Restaurant, LLC. Jonathan was listed as one of the company's three managing members in the certificate of formation filed with the Texas Secretary of State.

In the first six months of 2011, Jonathan made three payments of $100 toward the penalties associated with each of the three tax quarters. With each payment, he submitted IRS Form 843 to claim a refund of the amount he had paid. The IRS denied his three claims for a refund and reaffirmed the full judgment against him. Jonathan then sought a refund of these amounts by filing suit in the Court of Federal Claims.

Generally, a taxpayer must satisfy a tax liability in full before filing a refund claim. There is an exception to the full-payment rule for taxpayers seeking the refund of a divisible tax assessment, one example of which is a Code Sec. 6672 penalty tax resulting from an employer's failure to remit withholding taxes for a group of employees. This exception, or adjustment, to the full-payment rule derives from the premise that a Code Sec. 6672 assessment is a culmination of separable assessments for each employee from whom taxes were withheld. Accordingly, under this partial payment rule, the payment of one employee's withholding tax satisfies the full-payment rule for that employee. This one employee essentially serves as a test case by enabling employers to seek resolution of an employment tax dispute without the necessity of paying up front the entire amount at issue. Thus, courts recognize the partial payment of a Code Sec. 6672 assessment as sufficient, as long as that payment constitutes at least the income and FICA taxes withheld from one employee, even where the sum is a very small amount.

In support of his position, Jonathan offered into evidence one payroll report for one week of one quarter. Of the 30 employees in the report, four had gross FICA and income tax withholding of $7.69 or less. From that $7.69 figure, Jonathan extrapolated a total of $99.97 for a full 13-week quarter. Thus, he concluded, his payments of $100 must be enough to meet the divisible tax threshold for at least one employee.

The Court of Federal Claims held that the evidence Jonathan submitted was insufficient for the court to conclude that Jonathan satisfied the full-payment requirement. The problem with Jonathan's conclusion that he met the divisible tax threshold for at least one employee, the court said, was that it assumed a certain level of consistency in work schedules without any reasonable basis for such an assumption. Indeed, the court noted, a comparison with payroll reports from the fourth quarter of 2008 revealed tremendous variation in the number of hours worked. Given these circumstances, the court concluded that it would be unreasonable to extrapolate an entire quarter's worth of information from just one week's payroll report. Accordingly, the court held that Jonathan could not meet his burden of showing that the court has jurisdiction to hear his case.

For a discussion of the exception to the full payment rule for filing a refund claim for the penalty tax under Code Sec. 6672, see Parker Tax ¶261,155.

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Drought-Stricken Farmers and Ranchers Have More Time to Replace Livestock; 38 States Affected

Certain U.S. counties qualify for an extended replacement period under Code Sec. 1033(e) for livestock sold on account of drought in specified counties. Notice 2013-62.

Code Sec. 1033(a) generally provides for nonrecognition of gain when property is involuntarily converted and replaced with property that is similar or related in service or use. A sale or exchange of livestock (other than poultry) held by a taxpayer for draft, breeding, or dairy purposes in excess of the number that would be sold following the taxpayer's usual business practices is treated as an involuntary conversion if the livestock is sold or exchanged solely on account of drought, flood, or other weather-related conditions.

Generally, gain from an involuntary conversion is recognized only to the extent the amount realized on the conversion exceeds the cost of replacement property purchased during the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion and is solely on account of drought, flood, or other weather-related conditions that result in the area being designated as eligible for assistance by the federal government, Code Sec. 1033(e)(2)(A) provides that the replacement period ends four years after the close of the first tax year in which any part of the gain from the conversion is realized. The IRS has the authority to extend this replacement period on a regional basis for such additional time as it deems appropriate if the weather-related conditions that resulted in the area being designated as eligible for assistance by the federal government continue for more than three years.

Notice 2006-82 provides for extensions of the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion on account of drought, the taxpayer's replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year for the applicable region. For this purpose, the first drought-free year for the applicable region is the first 12-month period that:

(1) ends August 31;

(2) ends in or after the last year of the taxpayer's four-year replacement period determined under Code Sec. 1033(e)(2)(A); and

(3) does not include any weekly period for which exceptional, extreme, or severe drought is reported for any location in the applicable region.

The applicable region is the county that experienced the drought conditions on account of which the livestock was sold or exchanged and all counties that are contiguous to that county. A taxpayer may determine whether exceptional, extreme, or severe drought is reported for any location in the applicable region by reference to U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center. In addition, Notice 2006-82 provides that the IRS will publish in September of each year a list of counties, districts, cities, or parishes for which exceptional, extreme, or severe drought was reported during the preceding 12 months. Taxpayers may use this list instead of U.S. Drought Monitor maps to determine whether exceptional, extreme, or severe drought has been reported for any location in the applicable region.

In the appendix of Notice 2013-62, the IRS lists the counties for which exceptional, extreme, or severe drought was reported during the 12-month period ending August 31, 2011. Under Notice 2006-82, the 12-month period ending on August 31, 2011, is not a drought-free year for an applicable region that includes any county on this list. Accordingly, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2011 (or, in the case of a fiscal year taxpayer, at the end of the tax year that includes August 31, 2011), the replacement period is extended under Code Sec. 1033(e)(2) and Notice 2006-82 if the applicable region includes any county on this list. This extension will continue until the end of the taxpayer's first tax year ending after a drought-free year for the applicable region.

For a discussion of the postponement of gain on livestock resulting from weather-related events, see Parker Tax ¶161,570.

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Couple Must Exhaust Administrative Remedies First When Pursuing IRS for Violating Discharge Order

A bankruptcy court did not err in ordering a couple to first exhaust their administrative remedies under Code Sec. 7433(d) instead of using the bankruptcy court as a remedy for suing the IRS for violating an order discharging their taxes in bankruptcy. In re McDonald, 2013 PTC 298 (D. Nev. 9/27/13).

On April 4, 2007, Richard and Paula McDonald filed a voluntary petition for relief under chapter 13 of the Bankruptcy Code. The IRS timely filed a proof of claim for its taxes, which had a priority tax amount of $11,200 for tax years 2003-05 and a secured portion in the amount of $1,105 with 7 percent interest. The McDonalds' plan was confirmed several months later and provided the IRS the priority amount of $12,700 for those tax years. Their plan paid the IRS its exact amount, through the bankruptcy trustee. The McDonalds received their discharge on September 23, 2011. Following their discharge, the IRS contacted the McDonalds at least three times to attempt to collect the tax debt from tax year 2005. The IRS subsequently withheld the McDonalds' 2011 tax refund of $998 and applied it towards the 2005 tax year. On June 27, 2012, the McDonalds served a motion on the IRS to reopen the chapter 13 case, hold the IRS in contempt, and for sanctions for violation of the discharge injunction.

On August 31, 2012, the a bankruptcy court (1) ordered the McDonalds' chapter 13 case reopened; (2) ordered the IRS to have no further contact with the McDonalds, including no collection letters, no legal process and no administrative action, with regard to their 2005 federal income tax; (3) ordered the IRS is to refund back to the McDonalds the $998 tax refund that was levied by the IRS within 45 days of the bankruptcy court hearing; (4) ordered the McDonalds to exhaust their administrative remedies before the court determined any further damages or attorneys' fees in the case; and (5) held that, for the purposes of the beginning of the six-month time period for administrative action under Code Sec. 7433, the date of service of the McDonalds' motion, i.e. June 27, 2012, started this time period.

Code Sec. 7433 provides for civil damages for certain unauthorized collection actions of the IRS. Under Code Sec. 7433(b), upon a finding of liability on the part of the IRS, the amount awarded is equal to the lesser of $1 million ($100,000, in the case of negligence) or the sum of (1) actual, direct economic damages sustained as a proximate result of the reckless or intentional or negligent actions of the officer or employee, and (2) the costs of the action.

Code Sec. 7433(d) provides limitations on the damages in any action brought under Code Sec. 7433(a) or Code Sec. 7433(e) that can be claimed for unauthorized collection. First, a judgment for damages is not awarded unless the court determines that the taxpayer has exhausted the administrative remedies available to the taxpayer within the IRS. Second, the amount of damages awarded must be reduced by the amount of such damages that could have reasonably been mitigated by the taxpayer.

Code Sec. 7433(e) provides, in part, that if the IRS willfully violates any provision of Bankruptcy Code Section 524 (relating to a discharge of taxes), the taxpayer may petition the bankruptcy court to recover damages against the United States and that this is the exclusive remedy for recovering such damages.

Reg. Sec. 301.7433-2 sets forth the administrative processes for seeking redress for violations of Bankruptcy Code Section 524 (relating to the discharge of a tax debt) and generally provides that no action relating to such violation can be maintained in any bankruptcy court before the earlier of (1) the date a decision is rendered on a claim filed in accordance with Reg. Sec. 1.7433-2(e); or (2) the date that is six months after the date an administrative claim is filed.

The McDonalds appealed to a district court, arguing that the bankruptcy court erred in ordering them to first exhaust their administrative remedies under Code Sec. 7433(d) instead of using the plain language of Code Sec. 7433(e), which states the bankruptcy court is the exclusive remedy for debtors when the IRS violates a bankruptcy discharge.

The IRS argued that the bankruptcy court erred in finding that, for purposes of an administrative action under Code Sec. 7433, the date of service of the McDonalds' motion, i.e., June 27, 2012, began the six-month period because the McDonald's motion did not contain the necessary information for the IRS to adequately consider their claim. The McDonalds claimed that their motion satisfied all the requirements of Reg. Sec. 301.7433-2(e)(1).

The district court upheld the bankruptcy court's holding that the McDonalds must first exhaust their administrative remedies. The court said that while the plain language of Code Sec. 7433 makes a petition under Code Sec. 7433(e) a debtor's exclusive remedy for recovering damages, Code Sec. 7433(b) places limitations on the damages that may be awarded by the bankruptcy court and explicitly states that it applies to petitions filed under Code Sec. 7433 (e).

Observation: A number of courts, including the Second and Seventh Circuits, have so applied the statute, determining that, before a judgment for damages can be awarded to a debtor under Code Sec. 7433(b) for violation of the discharge injunction or automatic stay, Code Sec. 7433(d) requires the debtor first to exhaust the administrative remedies available to the debtor within the IRS. However, at least one bankruptcy court, in In re Jha, 2011 PTC 129 (Bankr. N.D. Cal. 2011), has held that the debtors need not exhaust administrative remedies before seeking relief in bankruptcy court. In concluding that the administrative remedy requirement was not applicable to a petition brought under Code Sec. 7433(e)(1), the Jha court noted that Code Sec. 7433(e)(2) states that such a petition is the exclusive remedy for recovering damages for violations of the discharge injunction or the automatic stay. The court further reasoned that, because there is no express requirement in Code Sec. 7433(e)(1) that administrative remedies must first be exhausted, a petition filed in bankruptcy court under Code Sec. 7433(e)(1) is not subject to such a requirement. Thus, the court essentially concluded that the words exclusive remedy in Code Sec. 7433(e)(2) should be read to exclude any such exhaustion requirement with respect to a petition under Code Sec. 7433(e)(1).

For a discussion of taxpayer claims for damages from unauthorized IRS collections, see Parker Tax ¶260,550.