Federal Tax Bulletin - Issue 69 - August 15, 2014

Tax Court Rejects IRS's Excessive Valuation of Estate's Closely Held Stock

The valuation of closely held stock is often a contentious issue between an estate and the IRS, especially where the dollars at issue are large. Because there is no market for such stock, different methods may be used, and different factors considered, in determining stock value. This was the situation in Est. of Adell v. Comm'r, T.C. Memo. 2014-155 (8/4/14), where the IRS rejected an estate's $9.3 million valuation of its closely held stock and instead determined a date-of-death value of over $92 million. As a result, the IRS assessed an estate tax deficiency of almost $40 million and assessed millions more in penalties for substantial estate tax valuation understatements.

In a total defeat for the IRS, the Tax Court rejected the opinion of the IRS's valuation expert, noting that he did not factor in certain important details in his valuation for example, a key employee's goodwill that was personally owned independent of the corporation whose stock was being valued. Instead, the court held that the initial valuation of the stock on the estate's tax return (i.e., the $9.3 million) was the correct valuation. Additionally, since there was no estate tax deficiency, no penalties applied.

Background

In 1978, Franklin Adell decided to pursue an opportunity in television broadcasting. He applied for a television license, which he received 10 years later in 1988. At that time, he convinced his son, Kevin, to help him build a television station. With loans and money from his parents, Kevin built the television station WADL for his father.

In 1994, Mr. Adell formed STN Satellite Television Network, Inc. STN Satellite provided satellite uplinking services. Kevin hired a company to apply for an uplink license and the uplink license was issued to "STN." Kevin handled the day-to-day operations and began to learn about the uplinking business by providing satellite uplinking services on a contract basis for various customers. Subsequently, Kevin saw an opportunity to create STN.Com, a new entity to operate Mr. Adell's uplinking business.

Mr. Adell incorporated STN.Com in 1999, as a C corporation. He was STN.Com's sole shareholder until 2002, when he transferred his 100 percent interest in STN.Com consisting of 1,000 shares of common stock to the Adell Trust. From the date of incorporation through the date of Mr. Adell's death on August 13, 2006, STN.Com's board of directors included Mr. Adell, Kevin, and Ralph Lameti. Mr. Lameti, a CPA and a lawyer, did all of the accounting work for Mr. Adell and his family. Mr. Lameti's firm also provided accounting services for STN.Com. Kevin served as STN.Com's president, but he never had an employment agreement or a noncompete agreement with STN.Com. STN.Com's sole business purpose was to broadcast an urban religious program channel that Kevin named "The Word Network" (The Word).

To gain support for The Word, Kevin met with religious leaders in the Detroit area, including Bishop Charles Haywood Ellis, and Reverend Jesse Jackson, Sr., in Chicago. They agreed to help Kevin launch The Word. In October 1999, Mr. Adell, Kevin, Mr. Lameti, Rev. Jackson, and Bishop Ellis went to Los Angeles to meet with the president of DirecTV about The Word. Kevin presented his idea for a 24-hour urban religious program channel, and Rev. Jackson and Bishop Ellis explained the need for urban ministries to reach a national audience. The DirecTV representatives were interested in broadcasting The Word and asked Kevin to prepare a business plan.  

Shortly thereafter, Kevin and Mr. Adell incorporated World Religious Relief as a Michigan nonprofit to operate as The Word. The Word and STN.Com signed a Services and Facilities Agreement (services agreement) in which STN.Com agreed to provide executive, management, legal, technical, supervisory, administrative, accounting, clerical, and other services and such facilities as The Word might reasonably require in order to effectively run its operations, as requested from time to time by the Board of Directors or the President of The Word. In consideration, The Word agreed to pay STN.Com a monthly programming fee equal to the lesser of (1) actual cost, or (2) 95 percent of net programming revenue received by The Word in a one month period. The parties agreed that the programming fee would not exceed STN.Com's actual direct costs and allowable indirect costs.

The services agreement was scheduled to terminate upon the earliest of: (1) mutual written consent of the parties; (2) termination of The Word's right to use the DirecTV channel; (3) The Word's failure to pay the monthly programming fee within five business days after the due date; or (4) The Word's exercise of an option to terminate the agreement if STN.Com failed to transmit The Word's programming to the DirecTV channel for a specified length of time. Mr. Adell signed the services agreement as president of The Word, and Kevin signed the agreement as president of STN Satellite

Despite the limitation of STN.Com's programming fee, STN.Com was a profitable company on the date of Mr. Adell's death and there was no indication that it would not continue being profitable thereafter.

Estate's Valuation of Stock

Mr. Adell's estate filed its original Form 706 in 2007 with a valuation report of the estate's STN.Com stock that was prepared primarily by Stout Risius Ross, Inc. and certified by Jeffrey Risius, on a date that was 10 months after Mr. Adell's death. In the valuation report, Mr. Risius used the discounted cashflow analysis of the income approach to determine that the fair market value of STN.Com's stock was $9.3 million. On the basis of Mr. Risius' valuation, the estate reported that the date-of-death value of the STN.Com stock was $9.3 million.

The IRS rejected the estate's $9.3 million valuation and issued a deficiency notice based on its valuation of the stock of over $92 million. When it became clear that the case was headed to the Tax Court, Mr. Risius prepared a second valuation report for the STN.Com stock which the estate submitted to the Tax Court. In the second valuation report, Mr. Risius valued the STN.Com stock using the adjusted book value method reflecting the liquidation or sale of assets instead of a discounted cashflow method. Another expert for the estate, Mr. Howard, also prepared a report and both reports came to the same conclusion: the appropriate valuation approach for the STN.Com stock on Mr. Adell's date of death was the asset approach and under that approach the fair market value of the STN.Com stock was $4.3 million.

As proof that the reported value on the estate's original return was erroneous, the estate relied on the terms of the services agreement. Specifically, the estate cited the provision in the services agreement that limited STN.Com's programming fee to the lesser of its actual cost or 95 percent of The Word's revenue. The estate argued that this provision prevented STN.Com from being profitable and therefore any valuation of STN.Com had to be based on the liquidation of its assets, its highest and best use. Under the asset approach, Mr. Risius accounted for STN.Com's lack of ability to generate a profit from its sole customer and the fact that STN.Com did not have any other source of revenue or other customers from which STN.Com could generate income. Accordingly, Mr. Risius valued the STN.Com stock using the adjusted book value method of the asset approach. Using the adjusted book value, Mr. Risius determined the STN.Com stock was worth $4.3 million on Mr. Adell's date of death

The other expert, Mr. Howard, also found the income method was inappropriate because in addition to lacking a contractual guaranty of a specific return, STN.Com's projected cashflow streams from its only customer, The Word, were uncertain because Kevin did not have a noncompete agreement with STN.Com and could create a new company to replace STN.Com. Mr. Howard explained that the goodwill associated with the relationship between Kevin and The Word was personal to Kevin. Without an employment agreement with Kevin, Mr. Howard concluded that an income approach was not appropriate to determine the fair market value of the STN.Com stock. Instead, Mr. Howard said, the net asset value method was the appropriate valuation method because STN.Com had assets with values that could be determined. Using this valuation method, Mr. Howard determined that on Mr. Adell's date of death, the fair market value of 100 percent of the STN.Com stock was $4.3 million.

IRS's Valuation of Stock

Before the Tax Court, the IRS's expert witness, Mr. Burns, valued the STN.Com stock using the discounted cashflow method of the income approach. While the IRS initially proposed a value of over $92 million for the stock in its notice of deficiency to the estate, Mr. Burns determined that the value on Mr. Adell's date of death was approximately $26.3 million. In his valuation, Mr. Burns reviewed STN.Com's business operations, ownership structure, and financial performance. He also reviewed the services agreement and, like Mr. Risius and Mr. Howard, noted that the monthly program fee payable from The Word, STN.Com's only customer, to STN.Com was limited to the lesser of actual cost or 95 percent of net programming revenue received by The Word in a one month period. On this basis, Mr. Burns determined that the appropriate valuation method for the STN.Com stock on Mr. Adell's date of death in 2006 was the discounted cashflow method of the income approach. In support of his conclusion, Mr. Burns explained that STN.Com was a fairly young company as of the valuation date that had been profitable in each of the fiscal years preceding the valuation date.

Mr. Burns also addressed the importance of Kevin's relationship with The Word to STN.Com's continued business operations. Instead of applying an economic charge for Kevin's personal goodwill similar to one found in Mr. Risius' first valuation report, Mr. Burns concluded that a hypothetical investor would anticipate retaining Kevin as an officer of STN.Com and would need to compensate Kevin at an acceptable rate of 8.1 percent of sales. Mr. Burns noted that his assumed compensation level for Kevin of nearly $1.3 million in 2006 was significantly higher than Mr. Risius' estimate of $528,000 in his first valuation report.

Tax Court's Analysis

The Tax Court began by noting that, when considering expert testimony, it was not required to follow the opinion of any expert if that expert's opinion was contrary to the court's judgment. The court observed that the reported value on the estate's original return was an admission by the estate, and the lower value of $4.3 million could not be substituted without cogent proof that the reported value was erroneous. The court then reviewed the estate's arguments for the lower valuation and found them lacking.

Despite the limitation of STN.Com's programming fee, the court noted, STN.Com was a profitable company on the date of Mr. Adell's death and it was reasonable to conclude that it would continue to be profitable thereafter. The profitability of STN.Com was supported by five years of STN.Com's financial statements, which were prepared by Mr. Lameti's accounting firm, and by discussions with STN.Com's management during the year after Mr. Adell's date of death. Although The Word could have enforced the limitation on STN.Com's programming fee, the court said, it did not do so for the five years preceding Mr. Adell's date of death, or the four years thereafter. Moreover, management made no indication that The Word would enforce the limitation and, in fact, predicted that its sales would increase, resulting in expected capital expenditures that would enhance the value of STN.Com

The Tax Court concluded that a hypothetical willing seller and a hypothetical willing buyer could not ignore the historical performance of STN.Com's profits on Mr. Adell's date of death, and notwithstanding the programming fee limitation, STN.Com was indeed a profitable company. Thus, the court said, an income approach was the most appropriate method to determine the value of the STN.Com stock because the business' best value was as a going concern. Thus, it rejected the estate's valuation of the stock based on the liquidation value of the company's assets.

With respect to the IRS's valuation, the court noted that the most significant difference between Mr. Risius' first valuation report and Mr. Burns' valuation report was their treatment of the intangible value that Kevin provided STN.Com. While both Mr. Risius and Mr. Burns recognized that the success of STN.Com depended on Kevin's relationships with The Word and its customers, they accounted for that value differently. The court noted that, in his first report, Mr. Risius applied an economic charge for Kevin's personal goodwill that ranged from $8 million to $12 million over the projection period, thereby increasing STN.Com's projected operating expenses and decreasing its net cashflow. Mr. Burns, however, determined that a hypothetical willing investor would be able to retain Kevin for an acceptable salary, which he determined to be 8.1 percent of sales, or approximately $1.3 million in 2006. Mr. Burns' approach resulted in a higher estimate of STN.Com's projected net cashflow, and thus a higher valuation of the STN.Com stock.

The court noted that Kevin did not transfer his goodwill to STN.Com through a covenant not to compete or other agreement and Kevin was free to leave STN.Com and use his relationships to directly compete against his previous employer. If Kevin quit, the court observed, STN.Com could not exclusively use the relationships that Kevin cultivated; thus, it was not appropriate to attribute the value of those relationships to STN.Com. Accordingly, the court concluded that Mr. Risius properly adjusted STN.Com's operating expenses to include an economic charge of $8 million to $12 million for Kevin's personal goodwill an amount high enough to account for the significant value of Kevin's relationships. On the other hand, the court stated, the IRS's expert not only failed to apply an economic charge for Kevin's personal goodwill but also gave too low an estimate of acceptable compensation for Kevin, i.e., $1.3 million in 2006. This was especially so, the court said, because Kevin had stepped into the position of Mr. Adell, who had previously been paid over $2 million and $7 million of compensation in each of the five years before his death.

Conclusion

In the end, the Tax Court gave no weight to the expert valuations that the estate submitted at trial, except for the consistent treatment of the underlying value of STN.Com's assets. The Tax Court also found that the IRS's expert was not persuasive because he did not reasonably account for Kevin's personal goodwill.

The Tax Court therefore found that the estate failed to introduce any evidence or present any arguments that would persuade it that the value reported on the estate's original tax return was incorrect. Thus, the court concluded that Mr. Risius' first valuation report on the STN.Com stock included with the original estate tax return was the most creditable because it properly accounted for Kevin's personal goodwill and appropriately used the discounted cashflow analysis of the income approach to value the STN.Com stock. The Tax Court thus concluded that the fair market value of the STN.Com stock owned by the estate on August 13, 2006, was $9.3 million. In addition, since there was no understatement of estate tax liability, the Tax Court held that no penalties applied.

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AICPA Lawsuit Challenges IRS's New Voluntary Tax Return Preparer Program

In late June, the IRS announced a new voluntary program, called the Annual Filing Season Program, which it designed to encourage education and filing season readiness for paid tax return preparers. The program is scheduled to be in place for the 2015 filing season. Shortly after the IRS announcement, the American Institute of Certified Public Accountants (AICPA) filed a lawsuit in D.C. district court challenging the new program.

Annual Filing Season Program

In 2011, the IRS issued regulations that mandated testing and continuing education (CE) for paid tax return preparers and created a Registered Tax Return Preparer (RTRP) credential. The RTRP designation was for preparers with valid preparer tax identification numbers PTINs, who passed an IRS competency test, and completed 15 hours of CE. However, in 2003, the D.C. Circuit Court of Appeals upheld a D.C. district court's holding in Loving v. IRS, 2013 PTC 10 (2013), that the IRS regulations mandating competency testing and CE for paid tax return preparers were invalid.

In the wake of the courts' rejection of the RTRP program, the IRS announced a new voluntary program, the Annual Filing Season Program. Under the Annual Filing Season Program, unenrolled return preparers can obtain a Record of Completion when they voluntarily complete a required amount of CE, including a course in basic tax filing issues and updates, ethics, and other federal tax law courses. Tax return preparers who elect to participate in the program and receive a Record of Completion from the IRS will be included in a database on IRS.gov that will be available by January 2015. In Rev. Proc. 2014-42, which is generally effective as of June 30, 2014, the IRS issued guidance on the Annual Filing Season Program requirements that practitioners must meet if they want to receive a Record of Completion and be included in the IRS.gov database.

Observation: The IRS submitted a proposal to Congress to explicitly authorize the IRS to regulate all paid tax return preparers. Before the 2013 court decision invalidating the RTRP program, over 62,000 return preparers passed an IRS-administered competency test and completed the requirements to become RTRPs. The Annual Filing Season Program will exempt RTRPs and others who have successfully completed certain recognized national or state tests from the filing season refresher course that will be required for other participants.

An Annual Filing Season Program Record of Completion is not required for an attorney, CPA, enrolled agent (EA), enrolled actuary, or enrolled retirement plan agent to represent taxpayers before the IRS. Further, the procedures in Rev. Proc. 2014-42 do not in any way affect or limit the ability of attorneys, CPAs, or EAs to represent taxpayers before the IRS.

AICPA Complaint

According to the AICPA, the Annual Filing Season Program is an unlawful exercise of government power. By implementing a purportedly "voluntary" program that is mandatory in effect, the AICPA called the program an end-run around Loving v. IRS. The IRS simply does not have the authority to proceed with the new rule, the AICPA charged.

The AICPA brought the lawsuit under the Administrative Procedure Act (APA), saying that in issuing Rev. Proc. 2014-42, the IRS ignored the notice and comment requirements of the APA. By circumventing the protections afforded by the APA, the AICPA said, the IRS avoided having to respond to comments that would have demonstrated that the new program is fatally flawed and arbitrary and capricious.

In its lawsuit, the AICPA argues that the Annual Filing Season Program will confuse consumers because it creates four new categories (for a total of eight) of tax return preparers among which consumers will have to distinguish (unenrolled tax return preparers, unenrolled tax return preparers who comply with the rule, enrolled agents, enrolled agents who comply with the rule, CPAs, CPAs who comply with the rule, attorneys, and attorneys who comply with the rule). In addition, the AICPA claims, although the IRS has cautioned tax return preparers that they are in no way permitted to imply an employer/employee relationship with the IRS or make representations that the IRS has endorsed the tax return preparer, most consumers will nonetheless conclude that the IRS has endorsed tax return preparers who have complied with the rules of the Annual Filing Season Program. The AICPA notes that IRS Commissioner Koskinen has emphasized that the Record of Completion and listing in the Directory of Federal Tax Return Preparers can be used as a means by which tax return preparers can market themselves.

The AICPA is asking the IRS to withdraw the new rule, consult with stakeholders, and use the tools and data already at its disposal to monitor unethical tax return preparers. At a minimum, the AICPA said, the IRS must conduct a legitimate notice and comment rulemaking before proceeding.

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Taxpayer Gets Rare Win on Conservation Easement Deduction; IRS Penalties Rejected

The correct value of a taxpayer's easement contribution was much higher than the amount determined by the IRS and, as a result, the taxpayer did not owe any of the accuracy-related penalties assessed by the IRS. Schmidt v. Comm'r, T.C. Memo. 2014-159 (8/6/14).

In 2000, Leroy Schmidt bought a 40-acre parcel of vacant land in northern El Paso County in Colorado for $525,000 with the intention of subdividing and developing it. The property, which was at the base of Raspberry Mountain, was raw land with no development entitlements. Leroy hired David Jones and Land Resource Associates (LRA) to provide land planning and consulting services. In a preliminary development cost analysis dated May 12, 2003, LRA estimated the development costs per lot for the proposed Raspberry Ridge subdivision. During the development process, Leroy hired W.D. Park of Park & Associates to value a proposed conservation easement. In a letter dated June 10, 2003, Mr. Park notified Leroy that his firm had concluded that the value of the proposed conservation easement would be $1.6 million.

Mr. Park used the before-and-after method to determine the value of the conservation easement. He determined that the highest and best use of the subject property before the granting of the conservation easement was a residential subdivision, and he used the subdivision development method to determine the before value of the subject property. As part of his calculation of the before value, Mr. Park used a discounted cash flow analysis and relied on the LRA May 12, 2003, cost estimate for the development cost input. He opined that the before value was $2 million. He determined that the highest and best use of the subject property after the granting of the conservation easement was a 40-acre homesite, and he used the market method to determine an after value for the subject property. Mr. Park opined that the after value of the subject property was $400,000, and he therefore opined that the value of the conservation easement was $1.6 million. On August 1, 2003, Leroy executed an easement deed, granting a conservation easement on the subject property to El Paso County.

On their Form 1040 for 2003, the Schmidts claimed a charitable contribution deduction of $1.6 million for the conservation easement. Because of limitations, the Schmidts claimed only $325,407 of the contribution on their 2003 return. They carried over the remainder of the charitable contribution deduction and claimed portions of it on their 2004, 2005, and 2006 returns.

The IRS issued notices of deficiency for the Schmidts' 2003, 2004, 2005, and 2006 tax returns. According to the IRS, the correct value of the conservation easement was $195,000, not $1.6 million. In addition, the IRS assessed accuracy-related penalties against the Schmidts under Code Sec. 6662(a) and Code Sec. 6662(b)(2) and (3) for substantially misstating the value of the conservation easement donation or for substantially understating their federal income tax liabilities for 2003 through 2006, respectively.

Code Sec. 6662(a) and (b)(2) and (3) authorize the IRS to impose a 20 percent penalty on an underpayment of tax that is attributable to, among other things, (1) any substantial understatement of income tax and (2) any substantial valuation misstatement. Only one Code Sec. 6662 accuracy-related penalty may be imposed with respect to any given portion of an underpayment. Generally, there is a substantial valuation misstatement if: (1) the value or adjusted basis of any property claimed on a return is 150 percent or more (200 percent or more for a gross valuation misstatement) of the amount determined to be the correct value or adjusted basis.

The Tax Court rejected the IRS's low appraisal value and several of the assumptions made by its expert witness. The court concluded that the value of the conservation easement, and the resulting deduction, was $1,152,445. Thus, while the Tax Court's valuation was lower than the value assigned by the Schmidts, it was much higher than the IRS's valuation. With respect to the testimony of the experts on both sides, the court said neither expert's report was complete and convincing. Thus, after giving appropriate weight to each expert's report, the court drew its own conclusions based on its examination of the evidence in the record. From that evidence, the Tax Court concluded that the before value of the property was $1,422,445 and that the after value of the property was $270,000.

With respect to the assessment of penalties by the IRS, the court noted that the Schmidts relied on Mr. Park's 2003 appraisal, that Mr. Park had the requisite credentials and experience to justify the Schmidts' reliance on his 2003 appraisal, and that the IRS conceded that Mr. Park's appraisal met the requirements to be considered a qualified appraisal. The court said that it sustained, in part, the IRS's deficiency determination because it did not find Mr. Park's report to be complete and convincing in certain respects. However, the court said, it did not think that the problems it found with Mr. Park's report, and by extension with his appraisal of the easement, called into question the reasonableness of the Schmidts' reliance on his appraisal. With respect to the IRS's argument that there were certain facts that supported an inference that Mr. Park intended to secure excessive tax benefits for the Schmidts with his 2003 appraisal, the court said that many of those facts were ambiguous and were also consistent with a good-faith attempt on the part of the Schmidts to reach the right result. The amount the Schmidts claimed on their 2003 return, the court noted, was less than 200 percent (and less than 150 percent) of the amount determined to be the correct amount of the easement donation. Accordingly, the court held that the Schmidts were not liable for a penalty for a substantial valuation misstatement under Code Sec. 6662(a) and (b)(3) for any of the years at issue.

For a discussion of the charitable deduction for conservation easements, see Parker Tax ¶84,155. For a discussion of the penalties for substantial valuation misstatement, see Parker Tax ¶262,120.

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Jones Day Seeks Expedited Appeal before Supreme Court on Obamacare Subsidies Issue

Attorneys for the losing party in King v. Burwell have petitioned the Supreme Court for an expedited review of whether the IRS can issue regulations extending tax-credit subsidies to coverage purchased through federally run insurance Exchanges (King v. Burwell Supreme Court Petition).

Last month, two appellate courts reached opposite conclusions on the legality of health insurance subsidies in states with federally run insurance Exchanges. The issue before the courts involved Code Sec. 36B, which was enacted as part of the Patient Protection and Affordable Care Act (ACA). That provision authorizes federal tax credit subsidies for health insurance coverage that is purchased through an "Exchange established by the State under section 1311" of the ACA. Regulations under Code Sec. 36B say that the provision also applies to insurance purchased on federal Exchanges.

The D.C. Circuit Court, in Halbig v. Burwell, 2014 PTC 363 (D.C. Cir. 7/22/14), held that the ACA unambiguously restricts the insurance subsidy to insurance purchased on state Exchanges. Since only 16 states plus the District of Columbia have elected to set up their own Exchanges, with the rest using federal Exchanges, the decision has the potential to severely undermine the effectiveness of the ACA. Hours later, the Fourth Circuit, in King v. Burwell, 2014 PTC 364 (4th Cir. 7/22/14), held that, because the statutory language of Code Sec. 36B is ambiguous and subject to multiple interpretations, deference should be given to the IRS guidance under Code Sec. 36B as a permissible exercise of the agency's discretion. Both decisions came down along party lines. The D.C. Circuit opinion was approved by a 2-1 vote, with the dissenting vote cast by the lone Democrat. The Fourth Circuit opinion was approved 3-0, with all judges having been appointed by a Democratic President.

Commentators wondered what was next. Often, when circuit courts rule differently on an issue, that issue winds up before the Supreme Court. While the Supreme Court upheld the legality of the ACA in 2013, it's doubtful the Administration wants to take their chances with the Supreme Court again. Instead, the Administration said it would appeal the D.C. Circuit court's decision to the entire panel of judges sitting on the D.C. Circuit bench, by asking for an en banc review. Since more than a majority of the judges were appointed by Democratic presidents, it is assumed by many that the decision will be reversed; thus, no circuit split.

However, there's another option. The losing party in the Fourth Circuit decision can petition the Supreme Court to hear an expedited appeal. And that's exactly what Michael Carvin of Jones Day has done. Carvin, who represented David King and others in their challenge to the IRS guidance under Code Sec. 36B, filed a 43-page Petition for a Writ of Certiorari with the Supreme Court. The petition presents the court with the following question: Can the IRS issue regulations to extend tax-credit subsidies to coverage purchased through Exchanges established by the federal government under Section 1321 of the ACA?

According to the Carvin, the reasons for granting the petition are simple and compelling. Two federal Circuits have divided over whether the IRS has authority to spend tens of billions of dollars per year to subsidize health coverage in 36 states. According to the petition, if the ACA means what it says, as the D.C. Circuit held, the consequences are profound: It means millions of people are ineligible for subsidies and exempt from the ACA's individual mandate penalty. It means hundreds of thousands of employers are free of the Act's employer mandate. It means a fundamental change in the health insurance market in two-thirds of the country. And it means that the IRS is illegally spending billions of taxpayer dollars every month without congressional authority. Uncertainty over this issue, the petition states, is simply not tenable. Thus, the petition urges the Supreme Court to grant an expedited review of the case now and resolve the matter in its current term, regardless of whether the D.C. Circuit grants en banc review of Halbig.

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Taxpayer Entitled to Home Office Deduction for Portion of Studio Apt; Personal Use Deemed De Minimis

Where a taxpayer's studio apartment was her principal place of business and she was required to use the space as an office for the convenience and benefit of her employer, and her employer was not able or willing to reimburse her for any of her apartment-related expenses, she was entitled to a home office deduction for a portion of the apartment. Miller v. Comm'r, T.C. Summary 2014-74 (7/28/14).

Lauren Miller lives in New York City. In 2008, she was hired to work for Branding Iron Worldwide, Inc. (BIW), a company headquartered in Los Angeles. Lauren was responsible for managing existing client accounts, hosting press events, producing style guides, and assisting clients with product line development and communications. She was also expected to attempt to recruit new clients. At the time she was hired, Lauren was BIW's only employee in New York, and BIW did not have an office in New York. Instead, BIW listed Lauren's apartment address on its Web site as the address for its New York office. Lauren regularly used one-third of her efficiency apartment space as an office to conduct BIW business. She met with clients there, and she was expected to be available to work well into the evening. Although she used the office space primarily for business purposes, she occasionally used the space for personal purposes.

Lauren's studio apartment was a single room with a total living area of 700 square feet. For purposes of allocating business expenses to the apartment, she divided it into three equal sections: (1) an entryway, a bathroom, and a kitchen area; (2) office space, including a desk, two shelving units, a bookcase, and a sofa; and (3) a bedroom area including a platform bed and dressers. Lauren had to pass through the office space to get to the bedroom area.

BIW did not maintain a formal employee expense reimbursement policy. Lauren understood that BIW was struggling financially, that the company's business was not growing, particularly in New York, and that she would be reimbursed only for expenses that BIW could itemize and bill directly to its clients.

Lauren paid rent of $26,200 and cleaning service charges of $1,680 during 2009. She also paid $1,896 for a package of services that included cable television, a telephone line, and wireless Internet access. Lauren used the cable television exclusively for personal use, the telephone line exclusively for business purposes, and the wireless Internet access for both personal and business purposes. She estimated that approximately 70 percent of her wireless Internet use was business related.

On her 2009 Form 1040, Lauren reported wage income of $48,680, and she claimed a deduction of $34,933 on Schedule A for unreimbursed employee business expenses (before applying the 2-percent of adjusted gross income floor in Code Sec. 67(a)). She attached Form 2106, Employee Business Expenses, to her return listing the following: parking fees, tolls, and transportation expenses of $553, meals and entertainment expenses of $299 (before applying the 50 percent limitation of Code Sec. 274(n)), and unspecified expenses of $34,230.

The IRS disallowed Lauren's Schedule A deductions for unreimbursed employee business expenses on the ground that the expenses were not ordinary and necessary business expenses.

The Tax Court held that, while Lauren used portions of her office space for nonbusiness purposes, her personal use of the space was de minimis and wholly attributable to the practicalities of living in a studio apartment of modest dimensions. Thus, the court said she was entitled to deduct one-third of her rent and cleaning services. The court also concluded that Lauren used her apartment telephone exclusively for business purposes. Thus, maintaining the telephone line was an ordinary and necessary business expense. The court noted that, under Code Sec. 262(b), any charge for basic local telephone service with respect to the first telephone line provided to a taxpayer's residence is treated as a nondeductible personal expense. Although Lauren provided some information related to the breakdown of the charges for the telephone line, the record was silent regarding the exact charge, if any, for local telephone service. Under the circumstances, the court estimated the amount allowable as a deduction. Allocating one-half of the telephone charge to local telephone service, the court held that Lauren was entitled to a deduction of $316 for the telephone line.

For a discussion of the home office deduction and the deduction for unreimbursed employee expenses, see Parker Tax ¶85,500.

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Tax Court Rejects IRS Request to Rule that Actuarial Tables Don't Apply to a Value a Successor Member Interest

The Tax Court denied the IRS's motion for summary judgment that (1) the actuarial tables under Code Sec. 7520 do not apply to value a successor member interest in property contributed to a university, and (2) a partnership failed to substantiate the value of the successor member interest with a qualified appraisal. RERI Holdings I, LLC v. Comm'r, 143 T.C. No. 3 (8/11/14).

RERI Holdings I, LLC (RERI) was formed as a Delaware limited liability company on March 4, 2002, and was taxed as a partnership for federal tax purposes. It was dissolved on May 11, 2004. On its 2003 partnership tax return, RERI reported as a charitable property contribution its transfer to the University of Michigan of 100 percent of the remainder estate in the membership interest in H.W. Hawthorne Holdings, LLC (Holdings). The contribution amount was approximately $33 million. Holdings, RERI reported, owned all of the membership interest of RS Hawthorne, LLC, a single purpose, single member Delaware limited liability company. RS Hawthorne was described by RERI as owning "the fee simple absolute in a parcel of land improved as an AT&T web hosting facility" located in Hawthorne, California. Read more...

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Transfer of Royalty Interests Was Invalid Attempt to Assign Income

A partnership's transfer of certain royalty interests was an invalid attempt to assign income, and the income was thus taxable to the partnership. Salty Brine v. Comm'r, 2014 PTC 390 (5th Cir. 7/31/14).

Thomas & Kidd Oil Production, Ltd. (TKOP) is a partnership involved in the gas and oil business. TKOP is owned by John Thomas and Lee Kidd through a series of other entities, including grantor trusts and investment partnerships. In 2006, the partnership engaged in two complicated transactions that the IRS determined were attempts to avoid tax. Essentially, a group consisting of domestic and offshore insurance companies, a marketing company, and a trust company sold tax shelters involving business insurance policies and life insurance policies with the ultimate goal of allowing businesses like TKOP to deduct as business expenses the cost of the insurance premiums. The insurance premiums were then used to fund life insurance policies for estate planning purposes.

One transaction involved TKOP's purchase of business protection policies (BPPs) and its attempt to deduct the cost of the BPPs as business expenses. The idea behind the BPPs was to set up an offshore "asset protection trust," then purchase cash-value life insurance policies, whose cash values would be invested with the principal and interest allocated to separate asset accounts (or segregated accounts). The BPPs were issued by a group of insurance companies and an offshore trust company. Each BPP provided coverage only against remote and implausible risks, virtually guaranteeing that no claim could be made under the policy. Assuming no claim was made under the BPP, approximately 85 percent of the premium was deposited into segregated accounts as profit, including the cash value of the policy. The life insurance policy holder could then withdraw those funds as a tax-free policy loan. If successful, this plan would allow TKOP to deduct 100 percent of the insurance premiums from taxable income as reasonable and necessary business expenses, then the life insurance policy holder could withdraw approximately 85 percent of that amount as a tax-free loan from the life insurance policy account. A district court held that although the BPPs were apparently set up to protect John and Lee's businesses, in reality the policies were merely a conduit used to funnel income from the businesses to offshore entities in a scheme to avoid paying taxes due on that income.

The district court found that the BPP scheme was not the only method John and Lee used to avoid paying taxes. In another type of transaction, TKOP carved out royalty interests from its working interests in a number of oil and gas properties and then transferred these royalty interests, through intermediate entities controlled by John and Lee, into the segregated accounts associated with their life insurance policies. A small portion of the income was intended to flow back as annuity payments purchased with the royalty interests, which payments were deferred for three years and thus not taxable in 2006. The larger portion was held in the segregated accounts and was available at any time for tax-free policy loans.

The royalty transaction did not change anything about TKOP's operation of the underlying oil and gas interests. Following the transfer, approximately 31 percent of the royalty income that would have been taxable to TKOP before the transfer instead accrued to the life insurance segregated accounts and could be withdrawn as tax-free policy loans.

The district court concluded that the BPP transaction and the royalty transaction were similar in that both transactions accomplished a transfer of assets into cash-value life insurance policies. Both transactions represented an internal shifting of assets from one set of entities owned and controlled by John and Lee to another set of entities owned and controlled by John and Lee. The tax benefits John and Lee were seeking, the court said, required arm's-length transfers to third parties, but no third parties existed on either end of the BPP or royalty transactions.

As a result, the district court held that the royalty interest transfer was an anticipatory assignment of income, and the income should be assigned to TKOP. The economic benefits of the royalty interests did not change with the alleged assignment, the court concluded, and thus the transaction should not be allowed to transfer taxable income away from TKOP. John and Lee, the court said, owned and controlled the assets at issue before and after the transactions. In substance, the BPP premium payments and royalty transfers were distributions from John and Lee's businesses to them and their families. These distributions, the court said, were not tax deductible business expenses or valid transfers of income to third parties.

TKOP appealed to the Fifth Circuit. With respect to the assignment-of-income doctrine, TKOP argued that the district court improperly conflated TKOP and the various other entities in finding that TKOP retained control or benefit from the royalty monies. TKOP argued that it was actually hurt by the overriding royalty interest transfer because it lost that royalty income. TKOP also argued that the royalty interest transfer was a property transfer under IRS regulations and thus could not be an assignment of income.

The Fifth Circuit affirmed the district court, saying that while it was true that TKOP lost royalty income on paper, the money ended up with TKOP's owners, bypassing income tax in the process. The court noted that John and Lee controlled TKOP and every part of the royalty scheme, which is a hallmark of unlawful assignment of income.

With respect to the argument that the royalty interest transfer was a property transfer under the regulations, the Fifth Circuit said that KTOP was ignoring the Fifth Circuit's decision in C.M. Thibodaux Co., Ltd. v. U.S. 915 F.2d 992 (1990), in which it held that a purported transfer of a royalty interest may still qualify as an assignment of income when the transferor retains control. The transfer in this case, the court said, was not a true transfer because the district court found that TKOP (or, more precisely, John and Lee), retained beneficial ownership of the mineral interests and ultimately received the proceeds after a circuitous route through several intermediaries.

The Fifth Circuit also agreed with the district court that the royalty interest transaction lacked economic substance because the orchestrated deal was designed primarily for tax avoidance reasons without any true business or profit motive. Furthermore, the Fifth Circuit found that money did not meaningfully change hands as, at all times, the funds moved through and settled in entitles controlled by John and Lee.

Observation: This case demonstrates the importance of ensuring that any insurance investment transaction has economic substance. Moreover, it illustrates that the importance of having independent third-party auditors and attorneys review the transaction. The Fifth Circuit and the district court noted that TKOP had contacted numerous attorneys to write opinions on the transactions, but the attorneys either withdrew their opinions or refused to write opinions once the true nature of the transactions became clear.

For a discussion of the assignment of income doctrine, see Parker Tax ¶70,105.

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Taxpayer Wrongfully Deducted Property Settlement Payment as Alimony

A taxpayer's payment to his former spouse pursuant to a separation agreement was improperly deducted as alimony as the payment was explicitly earmarked as a property settlement, and taxpayer was liable for accuracy-related penalties on the underpayment of taxes due to the erroneous deduction. Peery v. Comm'r, T.C. Memo. 2014-151 (7/29/14).

Joseph and Katrina Peery were divorced in 2008. The divorce decree incorporated a separation agreement addressing numerous issues, including how to divide marital assets and the amount of spousal support to be paid by Joseph to Katrina. The agreement set forth certain property rights granted to Katrina, including a property settlement of $63,500 to be paid within 30 days of June 6, 2008 (the date of the separation agreement). In addition to this amount, Joseph was to provide "spousal support" equal to 40 percent of all his income to Katrina until she remarried. Throughout 2008, Joseph made periodic payments to Katrina, with each check noting that the payments were for spousal support. On July 23, 2008, Joseph wrote a check for $63,500 payable to Katrina, including a handwritten note with the notation "Spousal Support" crossed out. On his 2008 tax return, Joseph included the $63,500 check in his deductions for alimony payments. On October 12, 2011, the IRS issued to Joseph a notice of deficiency, claiming that the $63,500 check was a property settlement, not an alimony payment, and thus was improperly deducted from Joseph's gross income in 2008. The IRS also assessed an accuracy-related penalty for substantial underpayment of tax.

Code Sec. 215(a) allows a taxpayer a deduction for alimony or separate maintenance payments paid during the tax year. Under Code Sec. 215(b), alimony or separate maintenance payments are defined by reference to Code Sec. 71. In turn, Code Sec. 71(b)(1) sets forth a four-pronged test to determine if a payment is alimony:  

(1) the payment must be received pursuant to a divorce instrument;  

(2) the divorce instrument must not designate the payment as one that is not includible in income;  

(3) the payor and payee must not still live together; and  

(4) there must not be a liability to continue making payments after the payor's death. All four of the requirements must be met for the payment to be considered deductible alimony.

The primary issue before the court was whether Joseph's payment of $63,500 to Katrina on July 23, 2008, was an alimony payment or a property settlement. The IRS argued that as the payment did not meet the statutory definition of alimony, it was a property settlement and was improperly deducted. Joseph claimed the payment was alimony.

Joseph argued that the $63,500 payment represented an alimony payment resulting from the sale of certain stock. The $63,500 payment in contention, he said, arose from his obligation to provide Katrina with 40 percent of his income as spousal support.

The Tax Court held that the payment was a property settlement, not alimony, and found Joseph liable for underpayment of tax and associated penalties. The court noted that, under the plain language of the separation agreement, Joseph was obligated to make a $63,500 payment to Katrina as a property settlement. The agreement was split in two categories division of assets as a property settlement and ongoing spousal support payments and the $63,500 payment was included in the first category. The agreement even explicitly stated that "[an] award of property settlement in the sum of $63,500.00" was to be paid to Katrina within 30 days of the execution of the separation agreement. And in fact, Joseph did make a payment of that exact amount to Katrina within the 30-day limit, providing further evidence to the court that this payment was a property settlement and not alimony. Despite his insistence that the amount in dispute was due to his spousal support obligation, a review of Joseph's bank records provided no support to this claim. Accordingly, the court found that the $63,500 payment was a property settlement, not deductible alimony. As such, the court concluded that Joseph improperly deducted this amount on his 2008 tax return and was liable for the accuracy-related penalty imposed by the IRS.

For a discussion of alimony payments and related deductions, see Parker Tax ¶14,220.

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Amazon Must Prove That Cost Centers Contained Mixed Costs for Purposes of Allocating IDCs

A corporation was required to show that certain of its cost centers constituted mixed costs (intangible development activity costs and costs benefiting other business activities) before it could justifiably use an allocation method to determine intangible development costs under Reg. Sec. 1.482-7. Amazon, Inc. v. Comm'r, T.C. Memo. 2014-149 (7/28/14).

Amazon.Com, Inc. and its U.S. affiliates executed with Amazon Europe Holdings Technologies SCS, a Luxembourg affiliate, a cost sharing arrangement (CSA) that was intended to comply with the U.S. transfer pricing rules in Code Sec. 482 and Reg. Sec. 1.482-7(b). Reg. Sec. 1.482-7(b) provides that a CSA participant must calculate its share of intangible development costs (IDCs) on the basis of factors that can reasonably be expected to reflect that participant's share of anticipated benefits. In entering into the CSA, the parties agreed to share IDCs. Amazon's cost accounting system during 2005-06 did not specifically segregate IDCs from other operating costs. Amazon therefore developed a formula and applied it to allocate to IDCs a portion of the costs accumulated in various "cost centers" under its method of accounting. "Cost centers" are accounting classifications that enabled Amazon to manage and measure operating expenses.

Amazon tracked expenses in six broad categories: (1) Cost of Sales, (2) Fulfillment, (3) Marketing, (4) Technology and Content (T&C), (5) General and Administrative (G&A), and (6) Other. The T&C category expenses consisted principally of payroll and related expenses for employees involved in research and development, including application development, editorial content, merchandising selection, systems and telecommunications support, and costs associated with the systems and telecommunications infrastructure. Each of the six expense categories, including the T&C category, was a "rollup" of numerous individual cost centers. For some calendar quarters, more than 200 individual cost centers, each recording a specific type of expense, "rolled up" into intermediate cost centers and ultimately into the T&C category.

Amazon took the position that none of the costs accumulated in Cost of Sales and Other were allocable to IDCs, and the IRS accepted that position. With few exceptions, Amazon's operating costs rolled up into the Fulfillment, Marketing, T&C, and G&A categories. Amazon treated portions of the costs accumulated in Fulfillment, Marketing, and T&C categories as IDCs, using an allocation formula it developed. It treated a portion of the costs accumulated in the G&A category as IDCs, on the basis of the IDC outcomes for the other categories.

The IRS did not challenge Amazon's use of its allocation method, or the amounts of IDCs that it determined, for the Fulfillment and Marketing categories. However, the IRS did dispute Amazon's allocation to IDCs of costs accumulated in the T&C category. In a notice of deficiency, the IRS determined that 100 percent of T&C category costs constituted IDCs. As a corollary of that determination, the IRS adjusted the percentage of G&A costs that Amazon had allocated to IDCs.

The IRS filed a court motion to compel the production of documents relating to Amazon's cost allocations under Reg. Sec. 1.482-7(d)(1). Amazon objected to the request, arguing that it was unduly burdensome, and the Tax Court subsequently denied the IRS's request in its then-current form. The Tax Court's order stated, however, that the IRS was entitled to knowledge of the facts underlying Amazon's cost allocations, as to whether costs within the T&C category were mixed as Amazon contended, and as to the appropriateness of the formula Amazon used to allocate T&C category costs to IDC.

Observation: Reg. Sec. 1.482-7 was redesignated Reg. Sec. 1.482-7A when the IRS issued new regulations in T.D. 9441, effective January 5, 2009.

Amazon argued that the IRS's determination to allocate to IDCs 100 percent of the costs in the T&C cost centers was inconsistent with Reg. Sec. 1.482-7 and was an abuse of discretion. According to Amazon, Reg. Sec. 1.482-7(d)(1) requires that the IRS specifically identify costs related to the intangible development area or reasonably allocate mixed costs. By simply taking all of the T&C cost centers and including 100 percent of those costs, Amazon said, the IRS was violating the regulatory command that costs that do not contribute to the intangible development area should not be taken into account.

The IRS argued that Amazon had not provided sufficient information to substantiate that the costs in question were mixed, i.e., that any of the T&C category costs contributed to business activities or areas other than the intangible development area. That being so, the IRS contended, Amazon had not laid the necessary predicate for applying an allocation formula.

Amazon contended that it was not required by the regulations to show that its T&C costs were mixed before applying an allocation formula. According to Amazon, it only needed prove that the allocation formula it developed and applied was reasonable. If that formula is reasonable, Amazon contended, the formula necessarily allocates costs correctly between the intangible development activity and other business activities.

The Tax Court sided with the IRS and held that Amazon had yet to demonstrate that the T&C category contained nontrivial costs that were properly characterized as something other than IDCs. The court explained that the allocation formula provision of Reg. Sec. 1.482-7(b) must only be applied if first there is evidence that there are mixed costs; mixed costs are a prerequisite to applying the formula. Thus, the court found that Amazon sought to incorrectly apply the regulation. Amazon's motion for summary judgments was therefore denied because there was a disputed question of material fact whether the T&C category contains mixed costs. As a consequence, the court also said it could not rule on the motion for partial summary judgment as to whether the IRS abused its discretion in determining that 100 percent of T&C category costs constituted IDCs until Amazon establishes that the T&C category contains a nontrivial amount of mixed costs.

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President Signs into Law the Highway and Transportation Funding Act of 2014

The Highway and Transportation Funding Act of 2014 was signed into law on August 8, 2014. H.R. 5021.

On August 8, 2014, President Obama signed into law H.R. 5021, the Highway and Transportation Funding Act of 2014. The Act amends the Internal Revenue Code to extend through May 31, 2015, the authority for expenditures from:  

• HTF Highway and Mass Transit Accounts;
• Sport Fish Restoration and Boating Trust Fund; and
• Leaking Underground Storage Tank Trust Fund.

Section 2003 of the Act amends the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code to revise the applicable percentages for determining minimum funding standards for single-employer defined benefit pension plans and exempts plans providing accelerated benefit distributions from the application of such standards. In addition, Section 2004 of the Act amends the Consolidated Omnibus Budget Reconciliation Act of 1985 to extend, through September 30, 2024, certain customs user fees for the processing of merchandise entered or released into the United States.

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Final Whistleblower Rules Expand Who May Qualify for Awards

Final regulations expand the types of individuals who may qualify for whistleblower awards for submitting information on underpayments of tax or violations of the tax laws. T.D. 9687 (8/12/14).

Code Sec. 7623 provides for the payment of an award - a whistleblower award - to an individual who submits information to the IRS relating to the detection of underpayments of tax or the detection and bringing to trial and punishment of persons guilty of violating the tax laws or scheming to do so. The Tax Relief and Health Care Act of 2006 (the 2006 Act) redesignated the authority to pay awards at the discretion of the IRS as Code Sec. 7623(a), and it added a new provision regarding awards to certain individuals as Code Sec. 7623(b). Generally, Code Sec. 7623(b) provides that qualifying whistleblowers are eligible for an award of at least 15 percent, but not more than 30 percent, of the collected proceeds resulting from the action with which the IRS proceeded based on the information provided to the IRS by the whistleblower. In 2012, the IRS issued proposed regulations relating to whistleblower awards. On August 11, the IRS finalized those rules.

Code Sec. 7623 does not specifically exclude any whistleblower from filing a claim for award, although awards under Code Sec. 7623(b) are limited to individuals. Code Sec. 7623(b)(3) requires the Whistleblower Office to deny an award to a whistleblower convicted of a crime arising from the whistleblower's role in planning and initiating the actions that led to the underpayment of tax or tax law violations. The regulations in effect under Code Sec. 7623 at the time of the 2006 Act, however, restricted the eligibility of federal employees to file claims for an award. In proposed regulations, the IRS identified as ineligible certain categories of individuals that would have access to return information of third parties by virtue of their relationship with the federal government. These categories were identified in Notice 2008-4, and their exclusion was based on the understanding that such individuals have a pre-existing legal or ethical obligation to disclose any violations of tax laws.

Practitioners complained that the list of ineligible or excluded claimants included in the proposed regulations was overly broad. The IRS agreed that the categories of ineligible whistleblowers should be narrowly defined. Accordingly, in finalizing the regulations, the IRS removed state and local government employees and members of a federal or state body or commission from the categories of ineligible whistleblowers. However, the IRS determined that the final regulations should continue to reflect the requirements that federal employees and contractors have a duty to disclose information and are prohibited from seeking an award for the performance of such duty. Similarly, under the final regulations, an individual otherwise required to disclose information or precluded from disclosing information by federal law or regulation is not eligible to claim an award for providing such information.

The final regulations also address complaints that awards are not paid promptly enough. The regulations provide that the IRS will pay any award under Code Sec. 7623 to a whistleblower as promptly as circumstances permit after there has been a final determination of tax with respect to the action and after the Whistleblower Office has determined the award and all appeals of the determination are final or the whistleblower has executed an award consent form.

With respect to practitioner complaints that whistleblowers should receive awards more quickly, the IRS noted that an award cannot be made until proceeds have been collected and the taxpayer no longer has a right to seek a refund of the amounts that constitute collected proceeds. The general rule set out in the proposed regulations and adopted in the final regulations provides that a final determination can be made when the proceeds resulting from the action subject to the award have been collected and either the statutory period for filing a claim for refund has expired or any taxpayer subject to the action and the IRS have agreed with finality to the tax or other liabilities for the periods at issue and the taxpayer has waived the right to file a claim for refund. In many cases, the IRS noted, a final determination may occur when the IRS and the taxpayer enter into a closing agreement and the taxpayer makes full payment of the liability.

For a discussion of whistleblower awards, see Parker Tax ¶262,300.