Federal Tax Bulletin - Issue 60 - April 10, 2014

Tax Court Holds That a Trust Can Qualify for Rental Real Estate Exception

While the Code Sec. 469 passive activity rules apply to trusts, there has been a dearth of guidance on how a trust can establish material participation for purposes of these rules. That is important because passive activity losses are limited where the taxpayer does not materially participate in an activity. Until recently, only one court opinion had addressed that issue. In Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003), a district court in Texas held that in determining whether a trust met the material participation rules, the activities of the trust's fiduciaries, employees, and agents should be taken into account. The court rejected the IRS's position that the determination should be made solely with reference to the activities of the trustee.

Recently, in Frank Aragona Trust v. Comm'r, 142 T.C. No. 9 (2014), the IRS took an even harder line, arguing that trusts are categorically barred from qualifying for the Code Sec. 469(c)(7) exception to the general rule that real estate rental activities are per se passive. For the Code Sec. 469(c)(7) exception to apply, there must be personal services performed by the taxpayer and, according to the IRS, a trust cannot perform personal services. However, the Tax Court rejected the IRS's position, holding that a trust can qualify for the Code Sec. 469(c)(7) exception. According to the Tax Court, a trust is capable of performing personal services within the meaning of Code Sec. 469(c)(7) because services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.

Facts

The Frank Aragona Trust owns rental real estate properties and is involved in other real estate business activities, such as holding and developing real estate. In 1979, Frank Aragona formed the trust with himself as grantor and trustee and with his five children as beneficiaries. Frank died in 1981. He was succeeded as trustee by six trustees. One of the six trustees was an independent trustee. The other five trustees were Frank's five children, one of whom served as the executive trustee. Although the trustees formally delegated their powers to the executive trustee to facilitate daily business operations, the trustees acted as a management board for the trust and made all major decisions regarding the trust's property. During 2005 and 2006, the board met every few months to discuss the trust's business. Each of the six trustees was paid a fee directly by the trust in part for the trustee's attending board meetings.

Three of the Aragona children worked full time for Holiday Enterprises, LLC (Holiday), a Michigan limited liability company wholly owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust's rental real estate properties. It employed several people in addition to three of the Aragona children, including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks. In addition to receiving a trustee fee, the three Aragona children who worked for Holiday received wages from Holiday.

The trust conducted some of its rental real estate activities directly, some through wholly owned entities, and the rest through entities in which it owned majority interests and in which two of the Aragona children owned minority interests. It conducted its real estate holding and real estate development operations through entities in which it owned majority or minority interests and in which two of the Aragona children owned minority interests.

During the 2005 and 2006 tax years, the trust incurred losses from its rental real estate properties. On its returns, the trust treated its rental real estate activities, in which it engaged both directly and through its ownership interests in a number of entities, as nonpassive activities. Thus, the losses from these activities contributed to net operating losses, which the trust carried back to its 2003 and 2004 tax years.

The IRS issued a deficiency notice in which it determined that the trust's rental real estate activities were passive activities, which increased the passive-activity losses for 2005 and 2006. The increase in the passive-activity losses resulted in a decrease in the allowable deductions from gross income for each of those years, which decreased the net-operating-loss carrybacks to the 2003 and 2004 years.

Passive Activity Losses and Rental Real Estate

Under Code Sec. 469(a)(1), a taxpayer's passive-activity loss is disallowed for the year if the taxpayer is described in Code Sec. 469(a)(2) - that is, if the taxpayer is an individual, estate, trust, closely held C corporation, or personal service corporation. Code Sec. 469(d)(1) defines a passive-activity loss as the excess of the aggregate losses from all the taxpayer's passive activities for the year over the aggregate income from all the taxpayer's passive activities for that year. Code Sec. 469(c)(1) in turn defines a passive activity as any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Under Code Sec. 469(c)(2), any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity. Thus, any rental activity is generally passive per se.

However, Code Sec. 469(c)(7) provides an exception - the per-se passive activity rule does not apply to the rental real estate activity of any taxpayer who meets both of the following two tests:  

(1) more than one-half of the "personal services" performed in trades or businesses by the taxpayer during the tax year is performed in real property trades or businesses in which the taxpayer materially participates; and  

(2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.  

In the case of a closely held C corporation, the exception applies for a tax year if more than 50 percent of the corporation's gross receipts for that tax year are derived from real property trades or businesses in which the corporation materially participates.

These requirements can be met only by a taxpayer who materially participates in a real property trade or business. This is because the one-half-of-personal-services test, the 750-hour test, and the special rule for closely held C corporations all presuppose that the taxpayer materially participates in real property trades or businesses. The term "real property trade or business" is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Under Reg. Sec. 1.469-9(b)(4), personal services mean any work performed by an individual in connection with a trade or business. This is an interpretation of the term "personal services" used in the first test of Code Sec. 469(c)(7)(B).

Code Sec. 469(h) provides that for the purposes of Code Sec. 469, a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis that is regular, continuous, and substantial. The test in Code Sec. 469(h) has two functions. First, it is used to determine whether a particular activity is a passive activity. Second, it is used to determine whether a taxpayer materially participates in real property trades or businesses.

IRS's Arguments

The IRS argued that, for the Code Sec. 469(c)(7) exception to apply, there must be personal services performed by the taxpayer and because the regulations define personal services as work performed by an individual in connection with a trade or business, a trust cannot perform personal services. Therefore, a trust cannot qualify for the Code Sec. 469(c)(7) exception.

The IRS's fallback position was that even if a trust can qualify for the Code Sec. 469(c)(7) exception, the Frank Aragona Trust did not qualify because it did not materially participate in real property trades or businesses. The IRS argued that in determining whether a trust is materially participating in an activity, only the activities of the trustees can be considered, and the activities of that trust's employees must be disregarded. In support of this position, the IRS cited a Senate report that stated that a trust is treated as materially participating in an activity if an executor or fiduciary, in his capacity as such, materially participates, and that the activities of employees are not attributed to the taxpayer. Thus, the IRS argued that the court should ignore the activities of the trust's non-trustee employees, as well as the activities of the three trustees who were employees of Holiday. The IRS reasoned that the activities of those three trustees should be considered the activities of employees and not fiduciaries because the trustees performed their activities as employees of Holiday, and it would be impossible to separate the activities they performed as employees of Holiday and the activities they performed as trustees. Disregarding all of these individuals would leave only the relatively insignificant activities of the three trustees who were not employees (one of whom was a dentist, one of whom was disabled and unable to work, and an outside attorney who served as the independent trustee).

A Trust Can Qualify for the Exception

The Tax Court first rejected the IRS's argument that a trust cannot qualify for the Code Sec. 469(c)(7) exception. A trust is an arrangement under which trustees manage assets for the trust's beneficiaries. According to the court, if the trustees are individuals, and they work on a trade or business as part of their trustee duties, their work can be considered work performed by an individual in connection with a trade or business. The court also found nothing in the legislative history of the Code Sec. 469(c)(7) exception that would compel the conclusion that only individuals and closely held C corporations can qualify for the exception. Thus, the court concluded that a trust is capable of performing personal services and therefore can qualify for the Code Sec. 469(c)(7) exception.

The Trust Did Qualify for the Exception

The court also rejected the IRS's fallback position, holding that the Frank Aragona Trust materially participated in a real property trade or business. The court found that even if the activities of the trust's non-trustee employees had to be disregarded, the activities of the three trustees who were employees of Holiday -- including their activities as employees of Holiday --should be considered in determining whether the trust materially participated in a real property trade or business. The trustees were required by Michigan law to administer the trust solely in the interests of the trust beneficiaries, because trustees have a duty to act as a prudent person would in dealing with the property of another, i.e., a beneficiary. Trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust. Therefore, the trustees' activities as employees of Holiday Enterprises should be considered in determining whether the trust materially participated in its real property operations.

The court noted that under Code Sec. 469(h), a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Considering the activities of all six trustees in their roles as trustees and as employees of Holiday, the court held that the trust materially participated in its real property operations. Three of the trustees participated in the trust's real estate operations full time. The trust's real estate operations were substantial, and the trust had practically no other types of operations. The trustees handled practically no other businesses on behalf of the trust.

The court also rejected the IRS's argument that because two of the trustees had minority ownership interests in all of the entities through which the trust operated real estate holding and real estate development projects, and because they had minority interests in some of the entities through which the trust operated its rental real estate business, some of these two trustees' efforts in managing the jointly held entities are attributable to their personal portions of the businesses, not the trust's portion. Despite two of the trustees' holding ownership interests, the court was convinced that the trust materially participated in the trust's real estate operations. First, the two trustees' combined ownership interest in each entity was not a majority interest. Second, their combined ownership interest in each entity was never greater than the trust's ownership interest. Third, their interests as owners were generally compatible with the trust's goals -- they and the trust wanted the jointly held enterprises to succeed. Fourth, they were were involved in managing the day-to-day operations of the trust's various real estate businesses.

Having held that the trust materially participated in a real property trade or business, the court said the next steps in ascertaining whether the trust was entitled to the benefits of the Code Sec. 469(c)(7) exception involved (1) determining whether more than one-half of the personal services performed in trades or businesses by the taxpayer during the year were performed in real property trades or businesses, and (2) determining whether the taxpayer performed more than 750 hours of services during the year in the real property trades or businesses. However, the IRS had limited its arguments to the two arguments discussed above, namely (1) that trusts were categorically barred from qualifying under the Code Sec. 469(c)(7) exception, and (2) that this particular trust did not materially participate in real property trades or businesses. Thus, in the context of the arguments raised in the case, the court held that the trust met the requirements for the Code Sec. 469(c)(7) exception for the years at issue.

Once the court determined that the trust qualified for the Code Sec. 469(c)(7) exception, and that therefore the trust's rental real estate activities were not per se passive activities, the next step would have been to determine whether the trust materially participated in its rental real estate activities. If the trust materially participated in its rental real estate activities, then its rental real estate activities would not be passive activities. If the trust did not materially participate in its rental real estate activities, then its rental real estate activities would be passive activities. Again, however, the IRS had argued only that the trust did not qualify for the Code Sec. 469(c)(7) exception it did not argue that, in the event the court determined that the trust did qualify for the exception, the trust did not materially participate in its rental real estate activities. Thus, the court concluded that, in the context of the arguments presented in the case, the trust's rental real estate activities were not passive activities.

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Virtual Currency Is Treated as Property, Resulting in Tax Consequences on Virtually Every Transaction

Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In other words, it's electronic money. Virtual currency may operate like "real" currency i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance. However, it is not backed by any government and does not have legal tender status in any jurisdiction. Read more...

Eleventh Circuit Rejects Tax Court's Reading of First-Time Homebuyer Credit

For a married couple to qualify for the first-time homebuyer tax credit, both spouses must meet the same statutory requirements, either as first-time homebuyers under Code Sec. 36(c)(1) or as long-time residents under Code Sec. 36(c)(6). Packard v. Comm'r, 2014 PTC 156 (11th Cir. 3/27/14).

Robert and Marianna Packard were married on November 22, 2008, but they continued to live in separate homes until they bought a house together on December 1, 2009. Before buying the home, Marianna owned a principal residence where she lived for more than five consecutive years during the eight years before December 1, 2009. Robert had no present ownership interest in a principal residence during the three-year period ending on December 1, 2009.

For certain years, under Code Sec. 36(a), an individual who was a first-time homebuyer of a principal residence in the United States was entitled to a tax credit for the year the home was purchased. Code Sec. 36(c)(1) defines a first-time homebuyer as any individual if such individual (and if married, such individual's spouse) had no present ownership interest in a principal residence during the three-year period ending on the date of the purchase of the principal residence. In 2009, Code Sec. 36(c)(6) was added to the Code. That provision stated that, in the case of an individual (and, if married, such individual's spouse) who owned and used the same home as that individual's principal residence for any five-consecutive-year period during the eight-year period ending on the date of the purchase of a subsequent principal residence, the individual is treated as a first-time homebuyer for purposes of the credit with respect to the purchase of such subsequent home.

When they filed their 2009 income tax return, Robert and Marianna filed as married filing jointly and claimed a $6,500 first-time homebuyer credit on the basis of the exception provided in Code Sec. 36(c)(6).

The IRS rejected the Packards' claimed tax credit and issued a deficiency notice with respect to their 2009 federal income tax liability. The couple petitioned the Tax Court to redetermine the deficiency, claiming that because Marianna owned a prior residence for more than five consecutive years before the purchase of their home on December 1, 2006, the couple qualified for the credit. The IRS countered that under the plain language of Code Sec. 36(c)(6), both husband and wife must live in the same residence for the prescribed period of time to qualify for the credit, and that while Marianna owned and lived in a prior residence for five consecutive years before the purchase of the subject home, Robert did not.

The Tax Court, in Packard v. Comm'r, 139 T.C. 390 (2012), held that the couple was entitled to the $6,500 first-time homebuyer credit under Code Sec. 36(c)(6). In its opinion, the Tax Court acknowledged that under an application of the plain language of the statute, the Packards were not eligible for the credit. However, the court characterized the effects of a plain reading of the statutory sections as "absurd" and concluded that Congress could not have intended to deny the credit where individually one spouse would have qualified for the credit under Code Sec. 36(c)(1) and the other spouse would have qualified for the credit under Code Sec. 36(c)(6). The Tax Court concluded that, because Robert qualified as a first-time homebuyer under Code Sec. 36(c)(1) and Marianna qualified as a first-time homebuyer under Code Sec. 36(c)(6), the Packards were entitled to the first-time homebuyer credit.

On appeal, the IRS argued that the plain language and structure of Code Sec. 36 requires that spouses qualify under the same paragraph to be eligible for a first-time homebuyer credit.

The Eleventh Circuit reversed the Tax Court and held that Code Sec. 36(c) requires that, for a married couple to qualify for the first-time homebuyer tax credit, both spouses collectively must meet the same statutory requirements, either as first-time homebuyers under Code Sec. 36(c)(1) or as long-time residents under Code Sec. 36(c)(6).

In reviewing the legislative history of the first-time homebuyer credit, the court found that when Congress originally enacted Code Sec. 36(c)(1), it defined "first-time homebuyer" as an individual (and if married, that individual's spouse) who had no present ownership interest in a principal residence for the three years preceding the purchase. With that parenthetical phrase, said the court, Congress precluded a husband and wife from being eligible for the credit unless they both satisfied the requirements of Code Sec. 36(c)(1). When Congress later added the long-time resident exception in a separate subsection, it included the same parenthetical phrase to define a long-time resident as an individual (and if married, that individual's spouse) who met a five-year consecutive residency requirement. Thus, according to the court, Congress originally precluded a married couple from being eligible as first-time homebuyers unless both spouses satisfied the requirements of Code Sec. 36(c)(1), and when it added Code Sec. 36(c)(6), it also precluded a married couple from being eligible unless both satisfied the requirements of that subsection.

According to the Eleventh Circuit, a court must presume that in a statute, the legislature says what it means to say, and means what it says there. Thus, a court's inquiry begins with the statutory text, and ends there as well if the text is unambiguous. The Eleventh Circuit found that the unambiguous language of Code Sec. 36(c)(1) and Code Sec. 36(c)(6) requires that a married individual must be considered together with his or her spouse as a unit to qualify under either paragraph. The Eleventh Circuit noted that Tax Court had acknowledged that the language of Code Sec. 36(c) was unambiguous, yet it deviated from that plain language in allowing the Packards to claim the first-time homebuyer credit when they did not qualify under the same paragraph. According to the Eleventh Circuit, the Tax Court's observation that the Packards would have qualified for the tax credit individually had they not been married has no bearing on the application of Code Sec. 36(c) to the facts of the case. Further, the Eleventh Circuit found that the IRS's reading of Code Sec. 36(c) did not produce an absurd result, as the Tax Court suggested. The absurdity exception to the plain-meaning rule comes into play only where the absurdity is so gross as to shock the general moral or common sense. The Eleventh Circuit found that while the effect of enforcing the statute as written might seem inequitable in light of the facts of this case, it does not shock general moral or common sense.

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

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New Tax Laws Eliminate Taxpayer Financing of Political Party Conventions and Encourage Philippines Typhoon Relief

In late March and early April, President Obama signed the Philippines Charitable Giving Assistance Act and the Gabriella Miller Kids First Research Act. Pub. L. 113-92; Pub. L. 113-94.

On March 25, President Obama signed the Philippines Charitable Giving Assistance Act (Pub. L. 113-92). The Philippines Charitable Giving Assistance Act treats cash contributions made after March 25 and before April 15, 2014, for the relief of victims in areas affected by Typhoon Haiyan as having been made on December 31, 2013, for purposes of the tax deduction for charitable contributions. Thus, rather than being deductible in 2014, such deductions may be taken on 2013 tax returns. The Act also deems such a contribution as meeting the recordkeeping requirements of Code Sec. 170(f)(17) if the taxpayer produces a telephone bill showing the name of the donee organization and the date and amount of the contribution.

On April 3, President Obama signed the Gabriella Miller Kids First Research Act (Pub. L. 113-94). The Gabriella Miller Kids First Research Act eliminates taxpayer financing of political party conventions and reprograms the savings to provide for a 10-year pediatric research initiative through the Common Fund administered by the National Institutes of Health, and for other purposes.

For a discussion of the general rules for deducting charitable contributions, see Parker Tax ¶84,105.

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Real Estate Pro Is Not Automatically Exempt from Having Rental Real Estate Losses Categorized as Passive Losses

A taxpayer who materially participated in a real estate trade or business as a real estate agent was not automatically exempt from having her rental real estate losses categorized as passive losses; rather, the taxpayer had to demonstrate her material participation in the rental real estate activities separately from her material participation in her primary occupation as a real estate agent. Gragg v. U.S., 2014 PTC 169 (N.D. Cal. 3/31/14).

During the tax years 2006 and 2007, Charles and Delores Gragg owned two real estate rental properties. During those years, Delores also was in the trade or business of being a full-time real estate agent. The Graggs' rental properties incurred losses, and the Graggs, on joint returns for 2006 and 2007, sought to deduct those losses from their otherwise taxable income. The Graggs did not elect to treat all interests in rental real estate as one activity under Code Sec. 469(c)(7)(A)(ii) for those years.

In 2009, the IRS conducted an audit of the Graggs' 2006 and 2007 tax returns. The IRS determined that the claimed losses were passive activity losses, disallowed the deductions for those losses, and issued a deficiency notice. The Graggs paid the deficiency and then filed a claim for refund for 2006 and 2007. The basis for their claim was that Delores is a real estate professional, and as such is not subject to the passive loss limitations. The IRS disallowed the claim, and the Graggs filed suit in district court for a refund.

Under Code Sec. 469, taxpayers cannot generally deduct passive activity losses. A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for the year. A passive activity is any trade or business in which the taxpayer does not materially participate.

Under Code Sec. 469(c)(2), rental activities are generally treated as per se passive, regardless of whether the taxpayer materially participates. However, Code Sec. 469(c)(7) provides a mechanism for removing one's rental real estate activities from the per se categorization of rental activity as a passive activity. Under Code Sec. 469(c)(7)(B), this mechanism is available to a taxpayer where: (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Thus, taxpayers who fall within the scope of Code Sec. 469(c)(7)(B) for a particular year can avoid having their rental activities treated as per se passive activities for that tax year, and instead have them tested under the material participation rules. In applying the material participation rules, Code Sec. 469(c)(7)(A) requires that each interest of the taxpayer in rental real estate must be treated as a separate activity, unless the taxpayer elects to treat all interests in rental real estate as one activity.

In the district court, the Graggs' argued that Delores's status as a full-time real estate agent establishes her material participation in a qualifying real estate trade or business, so that she did not need to demonstrate material participation in each of her separate real estate rental activities.

The district court rejected the Graggs' argument, holding that notwithstanding Delores's occupation, the Graggs had to separately establish material participation as to their two rental properties for 2006 and 2007. The court pointed out that Reg. Sec. 1.469-9(e)(3) provides that a qualifying taxpayer cannot group a rental real estate activity with any other activity of the taxpayer to determine if the taxpayer materially participates in the rental real estate activity. For example, if a qualifying taxpayer develops real property, constructs buildings, and owns an interest in rental real estate, the taxpayer's interest in rental real estate cannot be grouped with the taxpayer's development activity or construction activity. Thus, only the taxpayer's participation with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity.

Thus, in order to deduct losses from a rental real estate activity against the income declared in 2006 and 2007, the Graggs had to establish that they materially participated in each such rental real estate activity. Since they did not meet their burden of demonstrating material participation in each of their rental real estate activities during those years, they were not entitled to deduct their losses from those activities.

For a rental real estate losses under the passive activity loss rules, see Parker Tax ¶247,120.

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Stock Redemption Proceeds Constructively Received in Year Funds Made Available; Not in Years When Actually Received

A shareholder who took no action to surrender her stock certificates following a company's merger constructively received the redemption proceeds in the year the company made the redemption funds available to her; therefore the income was properly reported on her return in the year the funds were made available and not in the later years when the proceeds were actually received. Santangelo v. U.S., 2014 PTC 144 (S.D. Miss. 3/19/14).

Natalie Santangelo owned over 21,500 shares of common stock in HCA, Inc., divided into two certificates. Natalie kept the physical stock certificates rather than turning them over to a broker or bank. In 2006, HCA merged with another company. As part of the merger agreement, all common stock holders would receive $51 per share, and their stock would be cancelled. HCA deposited the required funds with a paying agent in November 2006. Natalie was eligible to receive over $1 million on the date the funds were deposited. To collect the funds, Natalie was required to surrender the physical stock certificates.

Although the funds were available in November 2006, Natalie did not take any steps to obtain the proceeds before her death in March 2007. Her estate located one of the two stock certificates, redeemed the shares, and received the payment in January 2008. The second certificate was never found. However, the estate followed the procedure for lost certificates, and a second payment was received in October 2009. HCA issued a Form 1099 to Natalie, indicating that she received taxable proceeds in the full amount in 2006. Natalie's estate filed her 2006 tax return and claimed as income the full amount reflected on the Form 1099. Subsequently, the estate filed suit for a refund, on the ground that the income should not have been claimed in 2006 since it was not actually received in 2006.

Code Sec. 451 states that generally income is taxable when the funds are received. In addition, Reg. Sec. 1.451-2(a) provides for the reporting of income that is actually or constructively received during the tax year. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

Natalie's estate argued that substantial obstacles prevented her access to the funds and the three-year delay in obtaining the funds negated the constructive receipt theory. The IRS contended that the income was properly claimed on the 2006 return because it was constructively received, and thus no refund was due.

The district court held that the stock proceeds were constructively received by Natalie in 2006 and were properly reported on her 2006 tax return. The court cited Oliver v. U.S., 193 F. Supp. 93 (1961), which found that income which is unqualifiedly and without substantial limitation available to the taxpayer is considered to be constructively received even though it is not actually received. In this case, Natalie was on a cash basis. It was undisputed that HCA immediately deposited the funds in November 2006 and that the funds were available to Natalie as of that date. It was also undisputed that Natalie made no attempt to obtain the funds when they were first available. Moreover, to the extent the stock certificates were lost, the delay in redeeming the shares was a self-imposed event. The process for a lost certificate was not a substantial limitation or restriction on obtaining the funds. The court concluded that since the funds were unqualifiedly and without substantial limitation available to Natalie in 2006, her failure to actually receive the funds was due to her own volition, and the income should be considered as having been constructively received.

For a discussion of the cash method of accounting and the constructive receipt of income, see Parker Tax ¶241,515.

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Manager Liable for Increased Taxes and Penalties for Misusing Private Foundation

The manager of a private foundation was liable for over $460,000 of unpaid private foundation excise taxes and federal income taxes as a result of the foundation not operating for a charitable purpose and the manager using funds from the foundation to obtain personal benefits and pay personal expenses unrelated to the purported charitable purposes of the foundation. U.S. v. Ziegenhals, 2014 PTC 145 (S.D. Tex. 3/21/14).

The Le Tulle Foundation was formed in 1991 as a testamentary trust, under the will of Thomas Le Tull,with a stated purpose of operating exclusively for charitable purposes. The Foundation was incorporated as a nonprofit corporation and granted tax-exempt status by the IRS. The Foundation was made legal owner of 1,475 acres of ranch property. James Ziegenhals, Thomas's nephew, served as manager, director, trustee, and registered agent for the Foundation. As a result of an audit in 2005, the IRS discovered that the Foundation did not operate for a charitable purpose and revoked its tax-exempt status. During the audit, the IRS determined that James used Foundation funds to obtain personal benefits and pay his personal expenses. Specifically, the IRS found that he had engaged in self-dealing transactions in the amount of $46,266. The IRS also determined that James had complete decision-making authority for the Foundation's funds and expenditures.

James filed an individual income tax return for 2007, showing a tax due of over $9,600. His tax liability was only partially paid. In assessments in 2008 and 2009, the IRS gave notice to James of his unpaid private foundation excise taxes, unpaid federal income tax of $6,830, penalties, and interest. The IRS subsequently filed suit, seeking to reduce the federal tax assessments to judgment against both James and the Foundation, and to foreclose tax liens against real property owned by the Foundation.

The district court granted the IRS summary judgment, finding that James failed to offer any evidence to rebut the presumption that the IRS assessments were correct.

The district court noted that the amount James allegedly owed over $461,000 as of November 29, 2013 was based on the IRS's calculations of penalties, statutory additions, and interest that accrued from his unpaid private foundation excise taxes in 2003 and his unpaid federal income taxes in 2007. That amount was much larger than the original unpaid taxes of $46,266 from 2003 and $6,830 from 2007 because the IRS had assessed several additional taxes and penalties on James as both a self-dealer and foundation manager for each year until he was issued the notice of deficiency in 2009. Under Code Sec. 4941, James was liable for a first tier tax of 5 percent for each act of self-dealing and a second tier tax of 200 percent of the amount involved for each act of self-dealing that was not corrected within the taxable period. In addition, under Code Sec. 4945, James was liable for a first tier tax of 2.5 percent as the foundation manager, and a second tier tax of 50 percent of the amount involved for refusing to agree to corrections. In addition, the IRS determined that James's actions constituted willful and flagrant conduct, and thus imposed a penalty equal to the amount of the private foundation excise taxes under Code Sec. 6684.

Observation: James' story is a cautionary tale of what can happen when a private foundation is misused for noncharitable purposes. In James' case, he originally owed approximately $53,000; but after all the additional taxes and penalties were assessed, he owed over $461,000.

IRS tax assessments are presumed to be correct and the taxpayer bears the burden of overcoming this presumption. Since James failed to offer any evidence to rebut the presumption that the IRS assessments were correct, the district court found in the IRS's favor.

For a discussion of activities that jeopardize a private foundation's tax-exempt status, see Parker Tax ¶62,460.

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IRS Issues Guidance on Eligibility for Premium Tax Credit for Victims of Domestic Abuse

The IRS issued guidance on circumstances in which a victim of domestic abuse who is married within the meaning of Code Sec. 7703 and is unable to file a joint tax return may claim a health plan premium assistance tax credit under Code Sec. 36B. Notice 2014-23.

Beginning in 2014, eligible individuals who buy coverage under a qualified health plan through an Affordable Insurance Exchange may claim a premium tax credit under Code Sec. 36B. To be eligible for this credit, an individual must be an "applicable taxpayer" that is, a taxpayer (1) who has household income for the tax year between 100 percent and 400 percent of the federal poverty line for the taxpayer's family size, (2) who may not be claimed as a dependent by another taxpayer, and (3) who files a joint tax return if married within the meaning of Code Sec. 7703.

For victims of domestic abuse, contacting a spouse for purposes of filing a joint return may pose a risk of injury or trauma or, if the spouse is subject to a restraining order, may be legally prohibited. Code Sec. 7703(b) allows certain married individuals to be considered not married for tax purposes. Under Code Sec. 7703(b), a married taxpayer who lives apart from the taxpayer's spouse for the last six months of the tax year is considered unmarried if he or she files a separate return, maintains as the taxpayer's home a household that is also the principal place of abode of a dependent child for more than half the year, and furnishes over half the cost of the household during the tax year. However, Code Sec. 7703(b) does not apply to many individuals who are victims of domestic abuse. For example, the abuse may have occurred in the last six months of the tax year, the victim may not have the financial means to furnish over half the cost of a household, or the victim may not have a dependent child. Thus, the preamble to final regulations under Code Sec. 36B, issued in June 2012, provided that the IRS would propose regulations addressing domestic abuse and similar circumstances that create obstacles to filing a joint return. The IRS intends to release proposed regulations addressing this issue.

In the meantime, Notice 2014-23 provides that for 2014, a married taxpayer will satisfy the joint filing requirement if the taxpayer files a 2014 tax return using a filing status of married filing separately and the taxpayer (1) is living apart from the individual's spouse at the time the taxpayer files his or her tax return, (2) is unable to file a joint return because the taxpayer is a victim of domestic abuse, and (3) indicates on his or her 2014 income tax return in accordance with the relevant instructions that the taxpayer meets the criteria under (1) and (2). The proposed regulations will incorporate this rule for 2014.

For a discussion of eligibility for the health plan premium assistance tax credit, see Parker Tax ¶102,610.

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Final Regs Help Determine Employment Tax Obligations in Certain Three-Party Arrangements

The IRS issued final regulations aimed at assisting taxpayers and the IRS in determining employment tax obligations in a three-party arrangement. T.D. 9662 (3/31/14).

For various reasons, an employer may choose to enter into an agreement with a third party, such as a payroll service provider or a professional employer organization (PEO) sometimes referred to as a third-party payor. Under the agreement, the third-party payor remits the wages to employees and takes steps to ensure the employer's employment tax withholding, reporting, and payment obligations are satisfied. However, employment tax liability cannot be altered by a private agreement between an employer and a third-party payor. Rather, the liability of the employer and/or the third-party payor for employment taxes is determined under the Code and depends on all the facts and circumstances, including the terms and substance of the arrangement between the employer and the third-party payor. There are limited circumstances in a three-party arrangement when the third-party payor may be considered the person responsible for the withholding and payment of employment taxes in addition to, or in lieu of, the common law employer.

In T.D. 9662, the IRS issued final regulations aimed at assisting taxpayers and the IRS in determining the parties' employment tax obligations in a three-party arrangement when a payor has represented to its client that it will pay the employment taxes with respect to wages or compensation it pays to employees for services performed by employees for the client. The regulation applies to arrangements when the employer enters into an agreement with a third-party payor under which the payor performs the employment tax obligations of the client with respect to wages or compensation paid by the payor to individuals performing services for the client, but the payor does not meet the legal conditions necessary to be a Code Sec. 3401(d)(1) statutory employer, does not obtain an approved Form 2678, Employer/Payer Appointment of Agent, and is not a payroll service provider (PSP) or reporting agent.

Subject to certain exceptions, the final regulations provide that a payor is designated under Code Sec. 3504 to perform the acts of an employer in any case in which the payor enters into a service agreement with a client. For this purpose, the term "service agreement" means a written or oral agreement under which the payor (1) asserts that it is the employer (or co-employer) of individuals performing services for the client, (2) pays wages or compensation to the individuals for services the individuals performed for the client, and (3) assumes responsibility to collect, report, and pay, or assumes liability for, any employment taxes with respect to the wages or compensation paid by the payor to the individuals who performed services for the client.

The final regulations provide exceptions to when a payor is designated under Code Sec. 3504 to perform the acts of an employer even if the payor has entered into an agreement that includes the components of a service agreement. First, the final regulations do not apply to the extent the payor files employment tax returns under the client's employer identification number (EIN), reporting the wages or compensation paid to individuals performing services for the client. Thus, a reporting agent or a PSP that prepares returns using the employer's EIN is not designated under Code Sec. 3504 to perform the acts of an employer.

Second, the final regulations do not affect the application of the common paymaster rules under Code Sec. 3121(s) and Code Sec. 3231(i). Therefore, a second exception provides that a common paymaster is not designated under Code Sec. 3504 to perform the acts of an employer for wages or compensation it pays within the context of the concurrent employment arrangement described in Code Sec. 3121(s) or Code Sec. 3231(i) and the related regulations.

Third, a payor is not designated to perform the acts of an employer if the person is the employer of the employees under the common law test (because the person has the right to control and direct the individual with regard to the details and means of performing services for the client) or under one of the other Code Sec. 3121(d) provisions, or is a statutory employer under Code Sec. 3401(d)(1). Thus, a third exception provides that if the payor is the employer of the individuals performing services for a client, it is not designated to perform the acts of an employer. The payor remains liable for payment of employment taxes, however, as the employer. For example, if a consulting firm contracts to provide consulting services to a client and the consulting firm directs and controls the employees providing the consulting services under the contract with regard to how to perform those services, the consulting firm is liable for employment taxes as the common law employer of the employees, not as a payor designated under the regulations.

Fourth, Reg. Sec. 32.1 provides specific rules for reporting employment taxes with respect to payments made by a third party on account of sickness or accident disability (often called ``sick pay''). Those rules are unaffected by Code Sec. 3504 or the final regulations. Thus, a fourth exception provides that a third-party payor of sick pay that is treated as an employer under Code Sec. 3121(a)(2)(A) and Reg. Sec. 32.1 will not be designated to perform the acts of an employer with regard to the sick pay.

Example: ElmCorp enters into an agreement with MapleCo, effective January 1, 2015. Under the agreement, ElmCorp hires MapleCo's employees as its own employees and provides them back to MapleCo to perform services for MapleCo. ElmCorp also assumes responsibility for paying the individuals' wages and for the collection, reporting, and payment of applicable taxes. For all pay periods in 2015, MapleCo provides ElmCorp with an amount equal to the gross payroll (that is, wage and tax amounts) of the individuals, and ElmCorp pays wages (less the applicable withholding) to the individuals performing services for MapleCo. ElmCorp also reports the wage and tax amounts on Form 941, Employer's QUARTERLY Federal Tax Return, filed for each quarter of 2015 under ElmCorp 's EIN. ElmCorp is not a common paymaster, the employer of the individuals (including a statutory employer within the meaning of Code Sec. 3401(d)(1)), or treated as the employer of the individual under Code Sec. 3121(a)(2)(A) (relating to a third-party payor of sick pay that is treated as an employer under Reg. Sec. Sec. 32.1). ElmCorp is designated to perform the acts of an employer with respect to all the wages ElmCorp paid to the individuals performing services for MapleCo for all quarters of 2015. MapleCo and ElmCorp are each subject to all provisions of law (including penalties) applicable in respect of employers for all quarters of 2015 with respect to those wages.

Example: The facts are the same as the preceding example, except that ElmCorp only reports the wage and tax amounts on Form 941, Employer's QUARTERLY Federal Tax Return, filed for the first and second quarters of 2015. Neither ElmCorp nor MapleCo files returns for the third and fourth quarters of 2015. ElmCorp is designated to perform the acts of an employer with respect to all the wages ElmCorp paid to the individuals performing services for MapleCo for all quarters of 2015. MapleCo and ElmCorp are each subject to all provisions of law (including penalties) applicable in respect of employers for all quarters of 2015 with respect to those wages.

The final regulations are effective for wages or compensation paid by a payor in quarters beginning on or after March 31, 2014.

For a discussion of who is an employer for employment tax reporting purposes, see Parker Tax ¶210,105.

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Tax Court Affirmed: Employees Can't Challenge IRS Favorable Plan Determination in Subsequent Suit

Employees of an industrial steel product manufacturer could not challenge, in subsequent litigation, a favorable IRS determination that their employer's defined benefit pension plan had not been terminated and continued to qualify for favorable tax treatment; therefore, the employees were not entitled to an immediate distribution of plan benefits. Carter v. Comm'r, 2014 PTC 160 (7th Cir. 3/25/14).

A Finkl & Sons, Co. is a corporation that produces industrial steel products. In 2006, Finkl initiated the process of terminating its defined benefit pension plan in anticipation of merging with another company. As part of the termination process, in January 2008, the plan was amended to provide for distributions to participants who had not begun receiving benefits. In May 2008, Finkl decided not to terminate the plan and notified the IRS that the plan was not going to terminate. Finkl also deleted the provision in the plan providing for distributions in connection with the contemplated termination. Finkl subsequently received a favorable determination letter from the IRS stating that the plan had retained its tax-qualified status. In December 2008, employees of Finkl filed suit in district court, alleging that they were entitled to an immediate distribution of benefits while they continued to work for Finkl and that Finkl's repeal of the plan amendment violated the anti-cutback terms of the plan.

Under Code Sec. 411, a qualified plan must comply with the rules on benefit accruals and separately account for employee benefits in certain circumstances. Plan amendments cannot reduce the accrued protected benefits of any participant, except as permitted by the law. The employees argued that the pre-retirement distribution of plan benefits, as contemplated by the deleted amendment, was an accrued benefit.

Finkl argued that the deletion of the amendment was not a prohibited cutback because it deleted a provision that was superfluous, since the plan did not terminate. A district court granted summary judgment to Finkl and, in August 2011, the Seventh Circuit affirmed the district court's decision in Carter v. Pension Plan of A. Finkl & Sons Co., 654 F.3d 719 (7th Cir. 2011). According to the Seventh Circuit, the pre-retirement distribution of pension benefits was not an accrued benefit under Code Sec. 411 since the plan did not terminate. The appellate court also found that the anti-cutback clause of the plan applied only to benefits already accrued and there were no accrued benefits under the plan amendment since the plan did not terminate.

After the Seventh Circuit denied the employees' petition for rehearing en banc, the employees advised the IRS and Finkl that they intended to pursue their position in Tax Court. Finkl and the IRS argued that collateral estoppel precluded the employees from re-litigating the anti-cutback issue. In Carter v. Comm'r, T.C. Memo. 2013-124, the Tax Court held that the employees were collaterally estopped by the Seventh Circuit's prior decision from relitigating the issues. The employees appealed again to the Seventh Circuit.

The Seventh Circuit affirmed the Tax Court and held that the employees were collaterally estopped by its prior holding from challenging the IRS's determination that the plan had not terminated and that the plan continued to qualify for favorable tax treatment. The court noted that the employees had a full and fair opportunity to litigate the issue of the plan's termination in the prior suit, a final judgment was entered, and they had an opportunity to appeal, which they exercised.

For a discussion of qualified plan accrued benefit requirements, see Parker Tax ¶130,525.

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Bankruptcy Trustee Failed to Show Constructive Fraud to Avoid Debtor Company's Payments to IRS

A bankruptcy trustee for the bankruptcy estate of an S corporation could not avoid transfers made by the debtor company to the IRS as payment for the income tax liability of the debtor's principal because the trustee failed to prove that the debtor was operating under unreasonably small capital at the time of the transfers. Menotte v. U.S., 2014 PTC 163(11th Cir. 3/26/14).

Brian Denson formed Custom Contractors, LLC, structured as a Florida S corporation, to operate a commercial construction business. In 2007 and 2008, Brian paid the estimated taxes on his pass-through income by having Custom Contractors send checks directly to the IRS using funds from the company operational account. In total, eight payments were made to the IRS and the payments were listed in the company records as distributions to Brian. In 2008, Custom Contractors operated at a loss, leaving Brian with no tax liability, allowing him to request a refund of the estimated tax payments made on his behalf. The payments were refunded to Brian and he did not return the funds to the company.

In 2009, Custom Contractors filed a Chapter 7 bankruptcy petition. Deborah Menotte was appointed as the bankruptcy trustee. Menotte filed an adversary proceeding in the bankruptcy court, alleging that the eight payments Custom Contractors made to the IRS for Brian's personal tax liability were fraudulent transfers.

Menotte sought to avoid the transfers under Bankruptcy Code Sections 544(b)(1) and 548(a)(1)(B), as well as under the Florida Uniform Fraudulent Transfer Act (FUFTA). Bankruptcy Code Section 544(b)(1) allows a trustee to avoid any transfer of an interest of the debtor that is voidable under applicable law by a creditor holding an unsecured claim. Under FUFTA, a transfer is fraudulent when a debtor engaged in a transaction for which the remaining assets of the debtor were unreasonably small and failed to receive reasonably equivalent value. Similarly, Bankruptcy Code Section 548(a)(1)(B) allows a trustee to avoid a transfer when the debtor was engaged in a transaction for which any property remaining with the debtor was an unreasonably small capital and for which the debtor failed to receive reasonably equivalent value. The IRS argued that the court did not have jurisdiction over Menotte's Section 544 claims because they did not fall within the scope of the waiver of sovereign immunity set forth in Bankruptcy Code Section 106(a).

The bankruptcy court found that the first seven transfers were not fraudulent because Menotte failed to prove that Custom Contractors was insolvent or had unreasonably small capital at the time of the payments. However, the court found that the eighth payment was a constructively fraudulent transfer because it was made while Custom Contractors was insolvent. A district court affirmed the bankruptcy court decision regarding the first seven transfers. However, the court reversed the ruling on the eighth transfer, holding that the IRS was not an initial transferee and, under the Eleventh Circuit's decision in In re Harwell, 628 F.3d 1312 (11th Cir. 2010), qualified for the mere conduit exception. Menotte appealed to the Eleventh Circuit.

On appeal, Menotte argued that, in view of the impending deterioration of the housing market, Custom Contractors was operating with unreasonably small capital, and the bankruptcy court disregarded evidence that the economic downturn in the construction industry was foreseeable. As to the eighth payment, Menotte argued that the IRS qualified as an initial transferee from whom she can recover under Bankruptcy Code Section 550(a)(1). The IRS contended that it was not an initial transferee because it lacked control over the fraudulently transferred funds, making it eligible for the mere conduit exception.

The Eleventh Circuit affirmed the district court's holding that Custom Contractors was not left with unreasonably small capital after the first seven transfers to the IRS of Brian's estimated tax payments. The Eleventh Circuit found that the bankruptcy court properly discounted Menotte's argument that the impending deterioration of the housing market required Custom Contractors to keep a greater amount of capital as "hindsight bias." As such, the bankruptcy court did not err in finding that Custom Contractors was not operating with unreasonably small capital.

The court also found that the IRS could not be held liable as an initial transferee. The court noted that, in its prior decision in In re Harwell, 628 F.3d 1312 (2010), it found that, to meet the mere conduit exception and avoid liability as an initial transferee, the initial recipient must show that (1) it did not have control over the assets received; and (2) it acted in good faith and as an innocent participant in the fraudulent transfer. The refund to Brian was granted under Code Sec. 6402, which obligated the IRS to refund the overpayments of his tax liability, the court noted. At no time did Brian actually owe income taxes for 2008. When the transfers were made, it was likely expected that Brian would accrue tax liability. As such, Custom Contractors and Brian had no rights to the funds until Brian's tax liability was determined. At the time the transfer was made, the IRS gained an asset increased cash on hand and a liability to refund the transfer if no liability accrued. Thus, the IRS was a mere conduit of the transfers that received the benefits of the funds from when they were received until they were returned, the court concluded.

For a discussion of taxpayer's claim for damages from unauthorized collection, see Parker Tax ¶260,550.