Federal Tax Bulletin - Issue 61 - April 24, 2014

Interpretation of At-Risk Rules on LLC Debt Guarantees Could Mean Recapture for Certain LLC Members

The at-risk rules under Code Sec. 465 are important in determining the tax effect of numerous transactions because they limit a taxpayer's loss from most activities to the amount at risk in the activity. In 1977 and 1979, the IRS issued a slew of proposed regulations under the at-risk rules, which are still in proposed form today. In 1985, 1998, and 2004, the IRS issued a limited number of final at-risk rules. Thus, most of the regulations that guide taxpayers on the consequences of the at-risk rules were issued more than 30 years ago. None of the at-risk rules address the effect of the rules on limited liability companies (LLCs) or their members.

Under the proposed regulations, a partner is not considered at risk for the guarantee of a partnership debt until the partner repays the debt and has no rights of reimbursement from anyone else. However, there is an exception to this rule. A partner's at-risk amount for an activity is increased by the partner's share of any qualified nonrecourse financing that is secured by real property used in the activity. A partner determines its share of qualified nonrecourse financing on the basis of that partner's share of partnership liabilities incurred in connection with such financing.

Earlier this month, the Office of Chief Counsel surprised practitioners by concluding that an LLC member is considered at risk with respect to LLC debts guaranteed by the member regardless of whether the member waives any right to reimbursement or indemnification from the LLC. The ruling in AM 2014-003 directly contradicts the proposed regulations. The Chief Counsel's Office also concluded that when an LLC member guarantees qualified nonrecourse financing of an LLC, the amount of the guaranteed debt no longer meets the definition of "qualified nonrecourse financing," and the amount of the guaranteed debt will no longer be includible in the at-risk amount of the other non-guarantor members of the LLC.

Practice Tip: While this is good news for the LLC member guaranteeing the debt, it can be detrimental to the other LLC members. Where the debt is no longer includible in the at-risk amount of the non-guarantor LLC members, at-risk recapture income could be triggered, thus leaving a substantial and unexpected tax liability.

At-Risk Rules Relating to Debt Guarantees

Generally, under Code Sec. 465(b)(1) and (2), a taxpayer is at-risk for amounts contributed to an activity and amounts borrowed for use in the activity, to the extent the taxpayer is personally liable for repayment of the debt or has pledged certain property as security for the debt. However, under Code Sec. 465(b)(4), a taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements.

Under Prop. Reg. Sec. 1.465-6(b), a partner is not at risk with respect to any partnership liability to the extent the partner would be entitled to contributions from other partners if the partner were called upon to pay the partnership's creditor, because to that extent, the partner is protected against loss.

Generally, a limited partner in a limited partnership organized under state law, who guarantees partnership debt is not at risk with respect to the guaranteed debt because the limited partner has a right to seek reimbursement from the partnership and the general partner for any amounts that the limited partner is called upon to pay under the guarantee. Thus, the limited partner is protected against loss within the meaning of Code Sec. 465(b)(4) unless and until the limited partner has no remaining rights against the partnership or general partner for reimbursement of any amounts paid by the limited partner.

Under Prop. Reg. Sec. 1.465-6(d), a taxpayer who guarantees repayment of an amount borrowed by another person (i.e., the primary obligor) for use in an activity, is not at risk with respect to the amount guaranteed. If the taxpayer repays to the creditor the amount borrowed by the primary obligor, the taxpayer's amount at risk is increased at such time as the taxpayer has no remaining legal rights against the primary obligor.

As previously noted, there are special rules for qualified nonrecourse financing. Under Code Sec. 465(b)(6), in the case of an activity of holding real property, a taxpayer's amount at risk includes the taxpayer's share of any qualified nonrecourse financing that is secured by real property used in that activity. Qualified nonrecourse financing is defined as any financing (1) that is borrowed by the taxpayer with respect to the activity of holding real property, (2) that is borrowed by the taxpayer from a qualified person or represents a loan from any federal, state, or local government or instrumentality thereof, or is guaranteed by any federal, state, or local government, (3) except to the extent provided in regulations, with respect to which no person is personally liable for repayment, and (4) that is not convertible debt. In the case of a partnership, a partner is required to determine its share of partnership qualified nonrecourse financing on the basis of that partner's share of partnership liabilities incurred in connection with such financing.

If at the close of any tax year a taxpayer's amount at risk in an activity is less than zero, Code Sec. 465(e) requires the taxpayer to include the amount of the excess in gross income. The amount required to be included in gross income, however, is limited to losses allowed in previous years that have not already been recaptured. The recaptured amount is treated as a deduction attributable to the activity in the following tax year.

LLC Member Guarantees of LLC Debt

In AM 2014-003, the Chief Counsel's Office noted that, unlike a partnership where a limited partner has a right to seek reimbursement from the partnership and the general partner when called upon to pay under a guarantee, an LLC member who guarantees LLC debt becomes personally liable for the guaranteed debt and is in a position akin to a general partner in a partnership who has no right of reimbursement. If called upon to pay under the guarantee, the guaranteeing LLC member may seek recourse only against the LLC's assets, if any. As in the case of a general partner, a right to subrogation, reimbursement, or indemnification from the LLC (and only the LLC) does not protect the guaranteeing LLC member against loss within the meaning of Code Sec. 465(b)(4).

Therefore, the Chief Counsel's Office concluded that, in the case of an LLC treated as a partnership or a disregarded entity for federal tax purposes, an LLC member is at risk with respect to LLC debt guaranteed by such member without regard to whether the LLC member waives any right to subrogation, reimbursement, or indemnification against the LLC, but only to the extent: (1) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC, (2) the guaranteeing member is not otherwise protected against loss within the meaning of Code Sec. 465(b)(4) with respect to the guaranteed amounts, and (3) the guarantee is bona fide and enforceable by creditors of the LLC under local law.

LLC Member Guarantees of LLC Qualified Nonrecourse Financing

With respect to LLC member guarantees of LLC qualified nonrecourse financing, the Chief Counsel's Office concluded that, because the guarantor is personally liable for that debt, the debt is no longer qualified nonrecourse financing. Further, because the creditor may proceed against the property of the LLC securing the debt, or against any other property of the guarantor member, that debt also fails to satisfy the requirement that qualified nonrecourse financing must be secured only by real property used in the activity of holding real property.

Because the debt is no longer qualified nonrecourse financing, the Chief Counsel's Office stated, the nonguaranteeing members of the LLC who previously included that portion of the qualified nonrecourse financing in their amount at risk and who have not guaranteed any portion of that debt can no longer include that amount of the debt in determining their amount at risk. Any reduction that causes an LLC member's at-risk amount to fall below zero will trigger recapture of losses under Code Sec. 465(e). The at-risk amount of the LLC member that guarantees LLC debt is increased, but only to the extent (1) such debt was not previously taken into account by that member, (2) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC, (3) the guaranteeing member is not otherwise protected against loss with respect to the guaranteed amounts, and (4) the guarantee is bona fide and enforceable by creditors of the LLC under local law.

[Return to Table of Contents]

Foreclosure Is a Fully Taxable Transaction for Purposes of Passive Loss Rules

The passive loss rules under Code Sec. 469(g) provide that if a taxpayer disposes of his entire interest in a passive activity in a "fully taxable transaction" to an unrelated party, any suspended passive losses from that activity are "freed up" and become deductible against non-passive income of the taxpayer. But does a foreclosure on real property comprising a taxpayer's entire interest in a passive activity qualify as a fully taxable disposition and if so, does it make a difference if the foreclosed property is subject to recourse debt and the foreclosure triggers cancellation of indebtedness (COD) income which is excludible from gross income because the taxpayer is insolvent? This is an area of tax law in which little guidance exists; the statute does not provide any additional explanation on what constitutes a fully taxable disposition, and there are no regulations on the issue. Thus, a recent memorandum by the IRS Office of Chief Counsel which sheds some light on this area of the tax law is welcome news for practitioners.

In CCA 201415002, the Office of Chief Counsel concluded that a foreclosure on real property subject to recourse debt comprising the taxpayer's entire interest in a passive activity is a fully taxable transaction for purposes of Code Sec. 469(g), regardless of whether any COD income from the cancellation of recourse debt is excluded from the taxpayer's income. Thus, the losses from the activity are treated as not being from a passive activity and are deductible against non-passive income. Further, the losses are not reduced by any excluded COD income.

Facts

Under the facts in CCA 201415002, a taxpayer bought real property for $1 million and financed the purchase with a recourse mortgage of $1 million. The taxpayer then leased the property to a third party. This rental activity was a passive activity of the taxpayer and the real property constituted the taxpayer's entire interest in the passive activity. The taxpayer had no other passive activities. The rental property accumulated net losses of $100,000 over three years that were suspended and carried forward under Code Sec. 469(b).

Four years later, the taxpayer defaulted on the debt and the lender foreclosed the mortgage. The fair market value of the property at the time of foreclosure was $825,000. The taxpayer's adjusted basis in the property was $800,000, and the remaining balance on the debt at the time of the foreclosure was $900,000. At the time of the foreclosure, the taxpayer was insolvent, with liabilities exceeding assets by $200,000. The mortgagee canceled the remaining $75,000 debt after the foreclosure. As a result, the taxpayer had a $25,000 gain on the foreclosure ($825,000 fair market value -$800,000 adjusted basis). The taxpayer also had $75,000 of cancellation-of-debt (COD) income ($900,000 debt - $825,000 fair market value), which was excludable from gross income under Code Sec. 108(a)(1)(B).

Cancellation of Debt

Generally, under Reg. Sec. 1.1001-2(a)(1), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. However, Reg. Sec. 1.1001-2(a)(2) provides that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under Code Sec. 61(a)(12).

Under Code Sec. 61(a)(12), gross income generally includes income from the discharge of indebtedness. However, Code Sec. 108(a)(1)(B) excludes such amounts from income if the discharge occurs when the taxpayer is insolvent. The amount excluded is limited to the amount by which the taxpayer is insolvent. Generally, amounts excluded from gross income under Code Sec. 108(a)(1)(B) are applied to reduce certain tax attributes of the taxpayer. Code Sec. 108(b)(2)(F) provides that the taxpayer's passive activity loss or credit carryover under Code Sec. 469(b) from the tax year of the discharge is a tax attribute subject to reduction. However, reductions to tax attributes required by Code Sec. 108(b) are made after the tax is determined for the year of discharge.

Passive Activity Losses

Under Code Sec. 469(a)(1), no deduction is allowed for an individual's passive activity loss for the year. A passive-activity loss is 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(b) provides a carryover rule under which any loss or credit from an activity that is disallowed is treated as a deduction or credit allocable to that activity in the next tax year.

Code Sec. 469(g)(1)(A) provides a special rule if, during the tax year, a taxpayer disposes of his entire interest in any passive activity (or former passive activity). Under this rule, if a taxpayer disposes of his entire interest in a passive activity in a "fully taxable transaction" to an unrelated party, any disallowed (i.e., suspended) passive losses from that activity are freed up and become deductible against non-passive income of the taxpayer.

Chief Counsel's Analysis

In its analysis, the IRS Office of Chief Counsel noted that it is well established that a foreclosure is a sale or exchange for federal tax purposes from which a taxpayer realizes gain or loss. If a taxpayer will no longer have, after a foreclosure on rental real estate that generated passive losses, any remaining interest in the activity then, at the time of the foreclosure, the taxpayer will realize and recognize all the gains and losses from the activity. Therefore, according to the Chief Counsel's Office, a foreclosure on real property comprising the taxpayer's entire interest in a passive (or former passive) activity is a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A). According to the Chief Counsel's Office, this result is not affected by whether or not the taxpayer also has COD income excludable from income under Code Sec. 108(a)(1)(B).

Based on this analysis, the Chief Counsel's Office concluded that the taxpayer in CCA 201415002 had disposed of his rental property in a fully taxable transaction under Code Sec. 1001 and realized and recognized $25,000 of gain on the foreclosure. Thus, the $100,000 of suspended passive losses are treated as losses that are not from a passive activity. In addition, the Chief Counsel's Office state, the taxpayer can exclude from income the $75,000 of COD income because he was insolvent to the extent of $200,000.

With respect to the $75,000 of COD income excludible under Code Sec. 108(a)(1)(B), the Chief Counsel's Office concluded that such income does not reduce the $100,000 of non-passive losses. Under Code Sec. 108(b)(2)(F), any COD income from the tax year of the discharge reduces any passive activity loss and credit carryover of the taxpayer under Code Sec. 469(b) from the year of the discharge. However, under Code Sec. 108(b)(4), reductions to tax attributes required by Code Sec. 108(b) are made after the tax is determined for the year of discharge. In determining the taxpayer's tax for the year of the discharge, all previously suspended losses under Code Sec. 469(b) are freed-up and fully allowable upon the taxable foreclosure. Thus, there are no remaining Code Sec. 469(b) suspended loss carryovers that are reduced under Code Sec. 108(b)(2)(F).

[Return to Table of Contents]

Total Fellowship Grant Is Taxable; Lab Research Income Is Subject to Self-Employment Tax

A Harvard doctoral student could not exclude part of a fellowship grant from income; nor could he avoid paying self-employment tax on income received from working in a laboratory performing research. Wang v. Comm'r, T.C. Summary 2014-39 (4/22/14).

Harris Wang received a bachelor's degree from the Massachusetts Institute of Technology in 2005. He then promptly enrolled as a full-time student pursuing a doctorate in biophysics at Harvard University. Harris completed the Harvard doctoral program in 2010.

In 2009, the American Society for Engineering Education (ASEE) awarded Harris the National Defense Science and Engineering Graduate Fellowship (i.e., fellowship grant). The fellowship grant paid all of Harris's tuition charges and mandatory fees in connection with his enrollment in Harvard University's doctoral program and provided him with an additional cash stipend of $18,375. For 2009, ASEE issued Harris a Form 1099-MISC, Miscellaneous Income, reporting that he had received other income of $18,375.

In 2010, 3W Consulting Co. paid $35,700 to Harris to perform research in connection with a nontaxable grant it was awarded to investigate therapies for cardiovascular disease. 3W Consulting issued Harris a Form 1099-MISC on which it reported the $35,700.

Harris timely filed Form 1040, U.S. Individual Income Tax Return, for 2009 and included $8,208 of the $18,375 ASEE stipend as an item of gross income. Harris excluded the $10,167 balance of the stipend because he allegedly used it to pay off student loans and other expenses related to his undergraduate and graduate studies. Harris did not provide any receipts, bank or credit card records, or similar documentation to substantiate these additional educational expenses.

On his 2010 tax return, Harris reported the $35,700 paid to him by 3W Consulting as other income, but did not report self-employment tax with respect to that income. Harris testified that he considered the payment to be similar to a graduate research grant and that he generally performed lab work and research that any graduate student would be doing as part of graduate study. Thus, Harris said, the payment was not subject to self-employment tax.

According to the IRS, Harris owed tax on the unreported $10,167 and also owed self-employment tax on the $35,700. At trial, Harris reported that he had received an ASEE stipend in 2007 that he did not include in gross income for that year and, when the IRS examined his 2007 return, it issued a "No Change" letter.

The Tax Court agreed with the IRS and held that the $10,167 was includible in Harris's 2009 taxable income and that Harris was subject to self-employment tax on the $35,700 received in 2010. The court noted that Code Sec. 117(a) and related provisions exempt from gross income any amount received as a qualified scholarship or fellowship grant by an individual who is a candidate for a degree at an educational organization.

The term "qualified scholarship" refers to any amount received by an individual as a scholarship or fellowship grant to the extent that such amount was used for qualified tuition and related expenses. Because Harris could not provide any documentation that he used the ASEE stipend for tuition and related expenses, the court concluded that the $10,167 was includible in Harris's gross income. Further, with respect to the fact that the IRS had examined a prior return and not made any change, the court said it is well settled that the acceptance of, or acquiescence in, returns previously filed by a taxpayer does not prevent the IRS from revisiting any item on the taxpayer's return and treating the item differently from prior years.

With respect to the medical research performed at 3W Consulting for which Harris was paid $35,700, the court noted there was no indication that 3W Consulting transferred the funds to Harris for a noncompensatory reason. The court recognized that some fellowship grants that are not excludable from gross income may nevertheless be exempt from self-employment tax. As an example, the court cited Spiegelman v. Comm'r, 102 T.C. 394 (1994), where a fellowship grant allowed the taxpayer to perform research and studies primarily to further his own education, training, and academic excellence and, thus, the grant was not compensation subject to self-employment tax. However, the court observed, 3W Consulting paid Harris to perform medical research in support of its pursuit of new therapies related to cardiovascular disease and thus, Harris's activities were easily distinguished from those of the taxpayer in the Spiegelman case.

For a discussion of the taxation of taxability of scholarships and fellowships, see Parker Tax ¶77,305.

[Return to Table of Contents]

Horse Owner Materially Participated in Horse Breeding and Racing Operation

Because an attorney/racehorse owner established through corroborating evidence that he materially participated in his operation of a thoroughbred horse breeding and racing activity, the activity was not a passive activity, and he could deduct losses from the thoroughbred activity for each of the years in issue. Tolin v. Comm'r, T.C. Memo. 2014-65 (4/9/14). Read more...

Father Was Custodial Parent Despite Conciliation Agreement's Terms

Because a son lived with his father for a longer period of time during each year in issue than he did with his mother, the child's father was entitled to claim the dependency exemption deduction, the credit for child and dependent care expenses, the child tax credit, and the earned income credit for the child. Harris v. Comm'r, T.C. Memo. 2014-69 (4/16/14).

Rodney Harris and Alvanisha McFall, who never married and lived apart from each other, were parents to a minor child. The couple entered into a conciliation agreement in 2003 in which they agreed to share joint custody of their son. The agreement did not award the dependency exemption to either parent; however, it did set out detailed guidelines as to how the child's time should be split between the parents throughout the year. The conciliation agreement suggested, by its terms, that Alvanisha should be treated as the custodial parent, as the child was to spend the greater part of the calendar year with her. In 2010 and 2011, the child was in school and active in sports. Alvanisha, who was unemployed, did not own a car or have a driver's license. Rodney played a significant role in the child's life, driving his son to sports practice and serving as a coach of his basketball team. The child also spent school vacations and went to church with Rodney. On their separate 2010 and 2011 tax returns, Rodney and Alvanisha each claimed dependency exemption deductions for their son. The IRS disallowed Rodney's dependency exemption deduction, credit for child and dependent care expenses, child tax credit, and earned income credit.

Code Sec. 151 allows an exemption for each dependent of the taxpayer. Code Sec. 152 defines "dependent" to include that taxpayer's child who does not provide more than half of his or her own support and who has the same principal place of abode as the taxpayer for more than one-half of the calendar year (i.e., a "qualifying child"). If a child's parents do not file a joint return, that child is treated as the qualifying child of the parent with whom the child lived for the longer period of time during the tax year (i.e., the custodial parent). Under Reg. 1.152-4(d), the custodial parent is the parent with whom the child lives the greater number of nights during the calendar year. However, the noncustodial parent may claim the dependency exemption deduction for a child if the custodial parent executes a written declaration releasing the custodial parent's claim to the deduction and the noncustodial parent attaches that written declaration to the noncustodial parent's return for that tax year.

Rodney claimed that he was entitled to the dependency deduction for his son not on the basis of a written declaration, but because he was the custodial parent of his son. The IRS contended that the conciliation indicated that Alvanisha should have custody of the child for a greater part of the year.

The Tax Court found that Rodney was the custodial parent, and his son was a qualifying child of his for 2010 and 2011. Although the conciliation agreement suggested that Alvanisha should be treated as the custodial parent, the agreement did not reflect the time the child actually spent with each of his parents in 2010 and 2011. In determining whether the child was a qualifying child of Rodney, the court noted that Rodney's credible testimony showed that he played a significant role in his son's life. He demonstrated that, due to the child's involvement with sports, the child slept at either Rodney's or Rodney's relative's home a greater number of nights than he did at his mother's home during 2010 and 2011. Thus, Rodney was entitled to the dependency exemption deduction for those years.

For a discussion of exemptions for dependents, see Parker Tax ¶10,720.

[Return to Table of Contents]

President Signs into Law New Funding Rules for Certain Cooperative and Charity Plans

On April 7, 2014, President Obama signed into law the Cooperative and Small Employer Charity Pension Flexibility Act of 2013. Pub. L. 113-97 (4/7/14).

The Pension Protection Act of 2006 (PPA) changed the way most pension plans must be funded. However, Congress carved out a temporary exemption from PPA's funding rules for rural cooperative multiple employer defined benefit plans to give Congress more time determine whether the PPA rules are appropriate for such plans. The Pension Relief Act of 2010 expanded the exemption to include eligible charity plans. The temporary exemption was set to expire for plan years beginning on or after January 1, 2017.

The Cooperative and Small Employer Charity Pension Flexibility Act of 2013 implements pension funding rules that reflect the special circumstances of these so-called Cooperative and Small Employer Charity plans (CSEC plans). These rules generally apply to years beginning after December 31, 2013, and are similar to those that currently apply to CSEC plans. A CSEC plan may elect not to be treated as a CSEC plan, in which case the plan is subject to the PPA rules as of its first plan year beginning after December 31, 2013.

The Act also imposes additional transparency requirements on CSEC plans.

For a discussion of qualified plan funding requirements, see Parker Tax ¶130,545.

[Return to Table of Contents]

Estate Beneficiary Doesn't Qualify for First-Time Homebuyer Credit

Where a taxpayer acquired his mother's home as a result of being a beneficiary of her estate, he did not qualify as a first-time homebuyer and was not entitled to the first-time homebuyer credit because the home was acquired from a related person. Zampella v. Comm'r, 2014 PTC 175 (3d Cir. 4/4/14).

Marie Lee Zampella died in 2008 and left her entire estate to her two sons, Edward and Arthur, to be divided equally. She appointed Edward and Arthur as co-executors and beneficiaries of her estate. Her estate included a home, which Edward wanted to own. The estate had the home appraised at $430,000, and Edward deposited $215,000 into a trust account of his brother, Arthur Zapolski, identified as the "Settlement Agent." Subsequently, the trust issued a check for $215,000 to Arthur, and a deed for the home was issued to Edward. The deed listed the grantor as "Edward R. Zampella and Arthur F. Zampella individually and as Co-Executors of the Estate of Maria Lee Zampella," and listed the grantee as "Edward R. Zampella." Additionally, a HUD-1 Settlement Statement was executed and identified the seller as Edward and Arthur as co-executors and beneficiaries of the estate. Edward claimed a first-time homebuyer credit (FTHBC) of $8,000 on his 2008 federal income tax return. After the IRS denied the FTHBC, Edward appealed to the Tax Court, which sided with the IRS. Edward then appealed to the Third Circuit.

Code Sec. 36 allows a tax credit of up to $8,000 to qualified first-time homebuyers who purchased a principal residence after April 8, 2008, and before May 1, 2010. For purposes of the FTHBC, no credit is allowed for the purchase of a home from a related person. Siblings are excluded from the definition of "related person" for FTHBC purposes. However, generally, related persons include an executor and a beneficiary of an estate.

Before the Third Circuit, Edward argued that he acquired the property from his brother, who was not a related person. The IRS contended that Edward acquired his home from the executors of the estate and, thus, it was acquired from a related person and did not qualify for the FTHBC.

The Third Circuit affirmed the Tax Court decision and held that Edward was not entitled to the FTHBC. The court concluded that, based on the transfer documents, Edward acquired the property from the executors of his mother's estate. The court noted that the deed listed Edward and Arthur as the grantors in their representative capacities as co-executors. The brothers, the court observed, were also identified in the HUD-1 Settlement Statement under "Seller" as co-executors, and both signed as the seller. In rejecting Edward's argument that under state (New Jersey) law, upon his mother's death, actual ownership of one-half interest in the property passed to him and one-half interest passed to Arthur, the court noted that the state law relates to the vesting of an interest in property and not to ownership.

The court also rejected Edward's argument that the substance of the transaction, not the form, should control the transaction. According to the court, although Edward paid one-half the value of the property rather than the full value, the substance of the transaction was that he acquired the property from the estate.

For a discussion of the first-time homebuyer credit, see Parker Tax ¶102,701.

[Return to Table of Contents]

Court Rejects Attempt to Classify Adult Care Facility Worker As an Employee

A worker at an adult care facility was an employee rather than an independent contractor and thus was not liable for self-employment tax on the income he earned from working at the facility. Rahman v. Comm'r, T.C. Summary 2014-35 (4/15/14).

In March 2010, Atig Rahman began working for Ever Care Adult Care Services, a business that provides a home and other care services to adults with disabilities. Ever Care paid Atig $9,075 for his services in 2010. Ever Care hires both floor staff and group home managers. Ever Care originally hired Atig to be a member of the floor staff, but he was promoted to group home manager after working approximately two weeks. The group home he managed was staffed with approximately six other full-time workers, and the home always had at least one staff member present. Atig worked approximately 40 hours a week and was paid an hourly rate every two weeks. When Atig was not working, he was on call as the first point of contact should a problem arise at the home. Atig did not have any ownership interest in Ever Care or in any of the properties associated with Ever Care.

When Ever Care hired Atig, the employment agreement specified his duties and responsibilities, many of which were required by the State of Florida to maintain an adult care facility. A copy of those duties and responsibilities was posted in each of Ever Care's group homes. Ever Care specified not only Atig's particular job duties, but also specified when and where to perform them. Atig's duties included preparing a monthly forecast of finances; purchasing groceries for the home; meeting with officials from the Florida licensing agency; maintaining the home and making repairs; and scheduling, hiring, and firing staff. His duties also included assisting residents with personal grooming and facilitating transportation for them. Atig provided Ever Care's owner with financial projections each month and met with the owner weekly for an accounting of grocery purchases. He also reported to the owner daily regarding how the home was running. In addition, he would contact the owner in the event of any emergency. Ever Care paid for the weekly groceries for the residents as well as for upkeep and repairs to the home. Atig did not incur any out-of-pocket expenses related to his work at Ever Care.

Ever Care considered Atig to be an independent contractor and provided him with a Form 1099-MISC, Miscellaneous Income, for 2010. Atig hired a CPA to prepare his 2010 federal income tax return. Atig did not pay any self-employment tax on the return. The IRS mailed him a deficiency notice for 2010. In the notice, the IRS determined, among other things, that Atig was an independent contractor of Ever Care and therefore liable for self-employment tax. Atig filed a petition for redetermination, alleging that he was an employee of Ever Care and therefore not liable for self-employment tax.

Code Sec. 1401 imposes a tax on income earned from self- employment. Income from self-employment consists of gross income derived by an individual from any trade or business carried on by the individual. The self-employment tax, however, does not generally apply to compensation paid to an employee. "Employee" means any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.

Whether an individual is an employee or independent contractor is a factual question to which common law principles apply. Factors that are particularly relevant in determining the substance of an employment relationship include: (1) the degree of control exercised by the principal over the details of the work; (2) the taxpayer's investment in the facilities used in his or her work; (3) the taxpayer's opportunity for profit or loss; (4) the permanency of the relationship between the parties; (5) the principal's right of discharge; (6) whether the work performed is an integral part of the principal's regular business; and (7) the relationship that the parties think they are creating. All of the facts and circumstances of each case are considered, and no single factor is determinative. The factors are not necessarily weighted equally; rather, they are considered according to their significance in the particular case.

After considering these factors, the Tax Court concluded that Atig was an employee of Ever Care and not an independent contractor. Thus, he was not liable for self-employment tax on income he earned from Ever Care in 2010.

For a discussion of a worker's status as an employee or independent contractor, see Parker Tax ¶210,110.

[Return to Table of Contents]

No Bad Deduction Allowed for Repayment to Mother for Unauthorized Stock Purchases and Loans to Sons' Trusts

A businessman could not claim a nonbusiness bad debt deduction for funds transferred to two trusts established for the benefit of his children; nor was he entitled to business loss deductions for amounts paid pursuant to a purported indemnification agreement with his mother to compensate her for losses resulting from his unauthorized stock purchases on her behalf. Alpert v. Comm'r, T.C. Memo. 2014-70 (4/17/14).

Robert Alpert, an entrepreneur and philanthropist, operated numerous business enterprises under the name "The Alpert Companies." In 1990, Robert established two irrevocable trusts to benefit his sons, Roman and Daniel. The trust agreements for the two trusts were substantially the same and allowed the trustee to appoint a successor trustee. Each trustee was either Robert's friend, relative, or employee. From 1995 to 2000, Robert transferred over $4 million to the two trusts. During the same time period, the trusts transferred almost $4 million to Robert to expend on behalf of the trusts. In 1996, the trustee for the trusts signed two promissory notes claiming to document loans from Robert to the trusts, which provided an interest rate, payment terms, and collateral for the notes. No funds were actually transferred to either trust in connection with the promissory notes. Rather, the amounts stated as transferred approximated the net funds Robert had previously advanced to each trust. At that time, Robert created a third trust for the benefit of his sons. In 1999, the trustee filed suit against Robert for interference with his duties as trustee. A probate court entered judgments in favor of the trusts.

In 1997, Robert, who had trading authority over his mother's brokerage accounts, acquired on her behalf thousands of shares in one of his companies, Aviation Sales Company (AVS). Gladys sold all the shares for a loss. In 2000, acting without her knowledge, Robert acquired additional AVS shares for Gladys. After Gladys threatened litigation when she learned of the unauthorized purchases, Robert agreed orally, and confirmed in a letter, that he would indemnify her for any losses incurred if the shares were sold at a loss. Gladys agreed to equally share any profits if the shares were sold at a gain. When the remaining shares were sold at loss in 2006, Robert sent Gladys a series of letters claiming he had fulfilled his obligation under their agreement to indemnify her for her losses.

On Schedules D, Capital Gains and Losses, of his 2006 tax return, Robert reported short-term capital losses for worthless debts he said were owed to him by the two trusts. He also claimed short-term capital losses in connection with the indemnification agreement with his mother, characterizing such losses as trade or business losses The IRS disallowed the deductions and determined that Robert was liable for an accuracy-related penalty. The IRS contended that Robert did not show that the transfers were bona fide debts and, even if they were bona fide debts, Robert did not show that he was a debt holder and the debts became worthless.

Code Sec. 166 allows a deduction for any debt that becomes worthless within the tax year. In the case of an individual, a nonbusiness bad debt that becomes worthless during the year may be deducted, but only as a short-term capital loss. A bona fide debt is a debt that arises from debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed sum of money under Reg. Sec. 1.166-1(c). Code Sec. 165 allows a deduction for losses sustained within the tax year that are not compensated for insurance. For individuals, the deduction is limited to losses incurred in a trade or business.

The Tax Court held that Robert's transfers to the two trusts were not bona fide loans. The court noted that the only evidence of the claimed loans were the two promissory notes executed by the trustee. No actual transfers of funds occurred in conjunction with the notes; rather, the notes merely reflected cumulative funds Robert had transferred to the trusts as of the date of the notes. With respect to funds transferred after that date, there was no documentation at all, and no provision for security, interest rate, repayment schedule or evidence of a demand for repayment.

The court also concluded that Robert's losses from the indemnification agreement with his mother were not in connection with his trade or business. Robert failed to show that his efforts to protect himself from liability for engaging in unauthorized transactions or that his management of his mother's assets constituted part of his trade or business.

Finally, the court upheld the IRS's imposition of an accuracy-related penalty. Although Robert's return was prepared by a professional tax preparer, he failed to show that he provided the necessary and accurate information to properly prepare his return or that he relied on his preparer's advice in good faith.

For a discussion of the general rules for a bad debt deduction, see Parker Tax ¶98,401.

[Return to Table of Contents]

Partnerships Waived Attorney-Client Privilege by Asserting State-of-Mind Defenses

Where two partnerships put their legal knowledge and understanding of the transactions at issue before a court, they forfeited the right to exclude certain documents as being protected by the attorney-client privilege. AD Investment 2000 Fund LLC v. Comm'r, 142 T.C. No. 13 (4/16/14).

The attorney-client privilege exists to encourage full and frank communication between attorneys and their clients. However, when a person puts into issue his subjective intent or state of mind in deciding how to comply with the tax law, he may forfeit the privilege afforded attorney-client communications that are relevant to his intent and state of mind.

In AD Investment 2000 Fund LLC v. Comm'r, 142 T.C. No. 13 (4/16/14), a case involving two partnerships' participation in alleged tax shelter transactions, the partnerships put their legal knowledge and understanding of the transactions into issue in order to establish good-faith and state-of-mind defenses. As a result, the Tax Court held that they forfeited the privilege protecting attorney-client communications relevant to their legal knowledge, understanding, and beliefs regarding those transactions.

Facts

Two partnerships, AD Investment 2000 Fund LLC and AD Global 2000 Fund LLC, were involved in transactions that the IRS described as a son-of-BOSS tax shelter. Generally, the purpose of a son-of-BOSS tax shelter is to create artificial tax losses designed to offset income from other transactions. Based on that characterization of the transactions, the IRS adjusted partnership items of the two partnerships and determined that Code Sec. 6662 accuracy-related penalties should apply to any resulting tax underpayments. In connection with its penalty determinations, the IRS claimed that its adjustments of partnership items were attributable to a tax shelter, and that the underpayments of tax resulting from these adjustments of partnership items were attributable to (1) a substantial understatement of income tax, (2) a gross valuation misstatement, or (3) negligence or disregard of rules and regulations. The partnerships claimed that the IRS's adjustments and penalty determinations were erroneous.

In defense to the IRS's determinations of an accuracy-related penalty based on a substantial understatement of income tax (the partnerships' first defense), the partnerships claimed that that there was substantial authority for their tax treatment of any items that resulted in an underpayment of tax, and that the partnerships and their partners reasonably believed that their tax treatment of those items was more likely than not the proper tax treatment. Further, in defense to the IRS's determination of accuracy-related penalties generally (the partnerships' second defense), the partnerships argued that any underpayment of tax was due to reasonable cause and that the partnerships and their partners acted in good faith.

The IRS sought to compel the partnerships to turn over six opinion letters they had received from the law firm of Brown & Wood LLP, which, according to the IRS, set forth the law firm's opinion as to whether it was more likely than not that the anticipated tax benefits from the transactions in question would be upheld for federal income tax purposes. The partnerships argued that they were not required to produce the opinions, since each was a privileged communication between attorney and client. The IRS, though apparently accepting that the opinions were attorney-client communications, argued that, under the common law doctrine of implied waiver, the attorney-client privilege is waived when the client places otherwise privileged matters in controversy and that here, the partnerships had placed the opinions into controversy by relying on affirmative defenses to the penalties that depended on the partnerships' beliefs or state of mind.

General Rules on Privilege and Waiver

As construed under federal common law, the attorney-client privilege exists to encourage full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and administration of justice. In some circumstances, however, courts have ruled that it would be unfair for a party that is making arguments to a court to then rely on its privileges to deprive the opposing party of access to material that might disprove or undermine the party's arguments. Thus, where a party raises a claim that in fairness requires disclosure of the protected communication, the privilege may be implicitly waived. Whether fairness requires disclosure has been decided by the courts on a case-by-case basis, and depends primarily on the specific context in which the privilege is claimed.

Most courts considering the matter have concluded that a party waives the protection of the attorney-client privilege when the party voluntarily injects into the suit the question of his state of mind. The assertion of a good-faith defense involves an inquiry into state of mind, which typically calls forth the possibility of implied waiver of the attorney-client privilege.

Belief Requirement

With respect to the partnerships' first defense, the key point was whether each partnership (acting through its principals or its agents) reasonably believed that its tax treatment of partnership items was more likely than not the proper tax treatment. The belief requirement is found in Code Sec. 6662(d)(2)(C)(i)(II) and Reg. Sec. 1.6662-4(g)(4). The regulations provide that the belief requirement is satisfied if the taxpayer reasonably believed, at the time the return was filed, that its tax treatment of that item was more likely than not the proper treatment. A taxpayer may satisfy the belief requirement by either of two methods. Under the first method, the belief requirement is satisfied if the taxpayer analyzes the pertinent facts and authorities in the manner described in the regulations and, in reliance on that analysis, reasonably concludes in good faith that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the IRS. Under the second method, the belief requirement is satisfied if the taxpayer reasonably relies in good faith on the opinion of a professional tax adviser, if that opinion is based on the tax adviser's analysis of the pertinent facts and authorities and unambiguously states that the tax adviser concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the IRS.

The partnerships' claims raised only the first method (self-determination), and not the second method (reliance on professional advice), to show that they satisfied the belief requirement. Nevertheless, the IRS argued that the partnerships placed the law firm's tax opinions into controversy by relying on a reasonable cause, good-faith defense and by putting the partnerships' beliefs into issue. The IRS stated that under the first method, those tax opinions remain relevant to the subjective inquiries into reasonableness and good faith. According to the IRS, James Haber, the de facto manager of the partnership vehicles, received the tax opinions before taking the questioned positions and presumably before making his alleged self-determination of authorities. The opinions are relevant, the IRS argued, because, if they contradict Haber's claimed self-determination, they may show that his self-determination was not reasonable, and, if consistent with his self- determination, they may show that he made no self-determination. The IRS also argued that the tax opinions were relevant to the good-faith element of the penalty defenses. The facts contained in the tax opinions necessarily reflected communications made by Haber on behalf of the partnerships' partners for the purpose of securing tax advice. Evidence that Haber solicited advice on the basis of facts that were incomplete or false would indicate that he knew that the tax benefits claimed were not proper. This would show bad faith.

The partnerships responded that their Tax Court petitions did not assert any advice-of-counsel defense, nor did they mention (or even allude to) any advice from their attorneys. The petitions alleged that the partnerships and their partners reasonably believed the positions on the partnerships' tax returns were correct, and that such a defense need not rely on professional advice. They argued that a generalized good-faith defense, not specifically relying on the advice of counsel, is not a waiver of the attorney-client privilege. In response to the IRS's arguments that the opinions were relevant to factual questions presented by the partnerships' belief, reasonable cause, and good-faith defenses, the partnerships stated that the mere fact that attorney-client communications would be relevant was not a sufficient basis to waive the privilege.

Reasonable Cause Exception

Code Sec. 6664(c)(1) states that the accuracy-related penalty will not be imposed with respect to any portion of an underpayment if the taxpayer shows there was reasonable cause for, and that he acted in good faith with respect to, that portion. Reg. Sec. 1.6664-4(b)(1) states that the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, the most important factor is the extent of the taxpayer's effort to assess its proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.

Tax Court's Analysis

The Tax Court found that the partnerships' claims that they satisfied the belief requirement by the first method by analyzing the pertinent facts and authorities in the manner described in the regulations and then reasonably concluding that there was a greater than 50-percent likelihood that the tax treatment of the item would be upheld put into dispute their knowledge of the pertinent legal authorities.

The partnerships' claims also put into dispute their understanding of those legal authorities and their application of the legal authorities to the facts. Finally, their claims put into dispute the basis for the partnerships' belief that, if challenged, their tax positions would more likely than not succeed in the courts. Thus, according to the court, the partnerships had placed their legal knowledge, understanding, and beliefs into dispute, and those are topics upon which the law firm's tax opinions may bear. The court stated that if the partnerships are to rely on the legal knowledge and understanding of someone acting for the partnerships to establish that the partnerships reasonably and in good faith believed that their claimed tax treatment of the items in question was more likely than not the proper treatment, it was only fair that the IRS be allowed to inquire into the bases of that person's knowledge, understanding, and beliefs including the tax opinions, if they were considered.

The court noted that each partnership received the opinion letters well before its tax returns for the years in issue were due. The partnerships did not claim that those acting for the partnerships ignored the opinion letters. They claimed only that the regulations provide an alternative under which the partnerships may satisfy the belief requirement by self-determination (without relying on professional advice). That, said the court, is true but it is beside the point. According to the court, the point is that, by placing the partnerships' legal knowledge and understanding into issue in an attempt to establish the partnerships' reasonable legal beliefs arrived at in good faith (i.e., a good-faith and state-of-mind defense), the partnerships forfeited their privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs.

[Return to Table of Contents]

Eleventh Circuit Upholds 121-Month Sentence for Filing Fraudulent Returns Using Stolen Identities

An individual's 121-month sentence for filing as many as 2,000 fraudulent income tax returns using stolen identities was both procedurally and substantively reasonable. U.S. v. Clay, 2014 PTC 190 (11th Cir. 4/14/14).

From December 2010 to June 2012, Sonyini Clay, Chante Mozley, and Alci Bonannee, filed around 2,000 fraudulent income tax returns using stolen identities. They filed the returns using Mozley's electronic filing identification number and requested that the tax refunds be deposited into bank accounts they controlled. In total, Sonyini, Chante, and Alci applied for about $11 million in refunds. The IRS ultimately paid out over $4 million of the requested funds, a substantial portion of which was never recovered.

In August 2012, a federal grand jury returned an indictment charging Sonyini, Chante, and Alci with, among other things, conspiracy to defraud the United States by filing false income tax returns, filing and obtaining payments for false income tax returns, wire fraud, and, for Sonyini only, aggravated identity theft. After first pleading not guilty, Sonyini changed course on the first day of trial and, without a plea agreement, pleaded guilty to two counts. The district court dismissed the remaining counts against her. On Count 1, the conspiracy charge, the presentence investigation report (PSR) calculated a base offense level of six. The PSR increased that offense level by 20 because the intended loss amount for the offense was between $7 million and $20 million, and it added an additional six levels because the offense involved 250 or more victims. After subtracting two levels for acceptance of responsibility, the PSR calculated a total offense level of 30. That offense level, coupled with Sonyini's past criminal history, yielded a guideline range of 97 to 120 months imprisonment on the conspiracy charge. The aggravated identity theft charge carried a mandatory consecutive sentence of 24 months.

Sonyini did not object to the PSR; however, she did file a motion in which she argued that she should not be held responsible for the full intended loss amount. She pointed to the disparity between intended loss and actual loss and argued that she played a smaller role in the fraudulent scheme than Chante and Alci. She also asked the court to consider that she has a child with special needs. The district court denied her motion and sentenced her to, among other things, 97 months imprisonment on Count 1 and a consecutive 24-month term on Count 40. Sonyini appealed her sentence.

On appeal, Sonyini first contended that her sentence was procedurally unreasonable because the district court (1) failed to adequately explain her sentence as required, (2) imposed an unwarranted six-level enhancement for more than 250 victims, and (3) erroneously imposed a 20-level enhancement for a loss amount greater than $7 million but less than $20 million. She also argued that her 121-month sentence was substantively unreasonable because the district court ignored relevant factors such as her history, characteristics, and the role she played in the conspiracy. She also pointed out that she received a sentence three times longer than that of Chante, creating what she claimed to be an unwarranted sentencing disparity.

The Eleventh Circuit affirmed the district court's sentence, holding that Sonyini's sentence was both procedurally and substantively reasonable. A district court is required to state the reasons for imposing a particular sentence and, if the sentence is a guidelines sentence, its reason for imposing a sentence at a particular point within the range. According to the Eleventh Circuit, although the law requires district courts to state the reasons for choosing a particular sentence, a lengthy discussion is generally not required all that is required is that the sentencing judge set forth enough to satisfy the appellate court that he considered the parties' arguments and had a reasoned basis for exercising his own legal decision-making authority. The district court stated that it considered: (1) the parties' statements; (2) the PSR, which contained the advisory guidelines sentencing options; (3) each of the sentencing factors; and (4) Sonyini's motion for a downward departure or variance. The Eleventh Circuit found that the district court's explanation was sufficient to demonstrate that it had considered the parties' arguments and had a reasoned basis for exercising its own legal decision-making authority.

Regarding the enhancements for multiple victims and loss amount, the Eleventh Circuit noted that a defendant is responsible for the conduct of her co-conspirators if that conduct was both (1) in furtherance of the jointly undertaken criminal activity and (2) reasonably foreseeable in connection with that criminal activity. To determine a defendant's liability for the acts of others, the district court must first make individualized findings on the scope of criminal activity undertaken by a particular defendant. Sonyini argued that the district court committed reversible error by failing to make particularized findings about the scope of her involvement in the conspiracy. According to the Eleventh Circuit, although she characterized her challenge as a procedural one, she ultimately was seeking to retract facts she admitted at sentencing. Because Sonyini neglected to object to the statements in the PSR, she admitted them as facts for sentencing purposes. Thus, the district court was entitled to rely on the undisputed statements in the PSR that Sonyini was responsible for an intended loss between $7 million and $20 million and that her offense involved more than 250 victims.

Regarding Sonyini's substantive reasonableness claim, the Eleventh Circuit noted that the district court sentenced Sonyini at the bottom of her guidelines range. The court concluded that the district court did not commit an error in sentencing. Sonyini and her codefendants, the court stated, orchestrated a very serious and harmful scheme, and the sentence the district court imposed reflected the seriousness of the offense and would serve as a deterrent to others. The Eleventh Circuit held that the district court permissibly exercised its discretion to attach more weight to the aggravating factors than to any of the potential mitigating factors on which Sonyini was relying.

For a discussion of the penalties for filing fraudulent returns, statements, or other documents, see Parker Tax ¶265,128.