Federal Tax Bulletin - Issue 68 - August 2, 2014

Circuits Split on Legality of Obamacare Insurance Subsidies in States with Federally Run Insurance Exchanges

In 2013, the Supreme Court upheld the legality of the Affordable Care Act (ACA), also known as "Obamacare." However, that didn't stop the foes of Obamacare, who have continued challenging the law at every turn. Last week, within hours of each other, two federal courts of appeal arrived and opposite decisions regarding insurance reimbursements for federal run insurance exchanges. Obamacare opponents were elated when 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.

The elation of the ACA opponents was tempered, however, by a contradictory decision issued just hours later by the Fourth Circuit. In King v. Burwell, 2014 PTC 364 (4th Cir. 7/22/14), the Fourth Circuit held that, because the statutory language of Code Sec. 36B, the provision under which the health insurance subsidy is calculated, 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. While not surprising, the 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. On Thursday July 31, the peittioners in King v. Burwell petitioned the U.S. Supreme Court to review the case.

Background

Congress enacted the Affordable Care Act in 2010 to increase the number of Americans covered by health insurance and decrease the cost of health care. Under the ACA, individuals must maintain minimum essential health care coverage. Those who do not maintain such coverage are subject to a penalty. The penalty does not apply, however, to individuals for whom the annual cost of the cheapest available coverage, less any tax credits, would exceed 8 percent of the taxpayer's projected household income.

The ACA provides a complex network of interconnected policies focused primarily on helping individuals who do not receive coverage through an employer or government program to purchase affordable insurance directly. Central to this effort are the health insurance Exchanges. Exchanges are governmental agencies or nonprofit entities that serve as both gatekeepers and gateways to health insurance coverage. Among their many functions as gatekeepers, Exchanges determine which health plans satisfy federal and state standards, and they operate websites that allow individuals and employers to enroll in those that do.

Section 1311 of the ACA delegates primary responsibility for establishing Exchanges to individual states. However, because Congress cannot require states to implement federal laws, if a state refuses or is unable to set up an Exchange, Section 1321 of the ACA provides that the federal government, through the Department of Health and Human Services (HHS), will establish and operate such an Exchange within the state. The majority of states have not set up an Exchange; thus, individuals in those states must purchase insurance through a federal Exchange.

Under Code Sec. 36B, Exchanges also serve as the gateway to the refundable tax credits through which the ACA subsidizes health insurance. Generally speaking, Code Sec. 36B authorizes credits for taxpayers with household incomes between 100 and 400 percent of the federal poverty line. But Code Sec. 36B's formula for calculating the credit also limits who may receive the subsidy. According to the formula in Code Sec. 36B(b)(1), the credit is to equal the sum of the premium assistance amounts for each coverage month. Under Code Sec. 36B(b)(2), the premium assistance amount is based on the cost of a "qualified health plan enrolled in through an Exchange established by the State under [section] 1311 of the [ACA]." Likewise, a "coverage month" is defined in Code Sec. 36B(c)(2)(A)(i) as a month for which, "as of the first day of such month the taxpayer . . . is covered by a qualified health plan . . . that was enrolled in through an Exchange established by the State under section 1311 of the [ACA]."

In 2012, the IRS issued Reg. Sec. 1.36B-2(a)(1) in which it interpreted Code Sec. 36B to allow credits for insurance purchased on either a state- or federally-established Exchange. The regulation applies to "an Exchange serving the individual market for qualified individuals . . . , regardless of whether the Exchange is established and operated by a State (including a regional Exchange or subsidiary Exchange) or by HHS."

The Main Arguments

While the Obamacare opponents and the government argued that the ACA, read in its totality, evinces clear congressional intent, they disputed what that intent actually is. The opponents argued that taxpayers can receive credits only for plans enrolled in through an Exchange established by a state under Section 1311 of the ACA; thus, the IRS cannot give credits to taxpayers who purchased insurance on an Exchange established by the federal government because the federal government is not a state.

The government argued that ACA opponents were taking a blinkered view of the ACA and that Sections 1311 and 1321 of the Act establish complete equivalence between state and federal Exchanges, such that when the federal government establishes an Exchange, it does so standing in the state's shoes. Furthermore, the government argument went, whereas opponents' construction of Code Sec. 36B renders other provisions of the ACA absurd, the government's view brings coherence to the statute and better promotes the purpose of the Act.

Thus, the question before the courts was whether an Exchange established by the federal government is an "Exchange established by the State under Section 1311" of the ACA and whether the ACA permits the IRS to provide tax credits for insurance purchased through federal Exchanges.

Halbig v. Burwell Decision

In Halbig v. Burwell, the D.C. Circuit concluded that the ACA opponents had the better argument. As a result, the court held that a federal Exchange is not an "Exchange established by the State under Section 1311," and Code Sec. 36B does not authorize the IRS to provide tax credits for insurance purchased on federal Exchanges.

In reaching this conclusion, the court first examined Code Sec. 36B in light of ACA Sections 1311 and 1321, which authorize the establishment of state and federal Exchanges. The court concluded that Code Sec. 36B plainly distinguishes Exchanges established by states from those established by the federal government. The court agreed that Sections 1311 and 1321 establish some degree of equivalence between state and federal Exchanges. Indeed, the court said that if Code Sec. 36B had authorized credits for insurance purchased on an "Exchange established under section 1311," the IRS regulation would stand. But, the court noted, Code Sec. 36B actually authorizes credits only for coverage purchased on an Exchange established by the state under Section 1311, and the government had offered no textual basis in Sections 1311 and 1321 or elsewhere for concluding that a federally established Exchange is, in fact or legal fiction, established by a state.

The court then rejected the government's arguments that it had to uphold the IRS's regulation to avoid rendering the reporting requirements in Code Sec. 36B(f) superfluous. That provision requires the IRS to reduce a taxpayer's end-of-year credit by the amount of any advance payments made by the government to the taxpayer's insurer to offset the cost of monthly premiums. Code Sec. 36B(f)(3) also requires "each Exchange" (i.e., both state and federal Exchanges) to report certain information to the government. The D.C. Circuit dismissed the government's contention that these reporting requirements assume that credits are available on federal Exchanges, as well as the government's argument that the requirements would be superfluous, even nonsensical, as applied to federal Exchanges if the court were to reject that assumption. Even if credits are unavailable on federal Exchanges, the court said, reporting by those Exchanges still serves the purpose of enforcing the individual mandate.

Finally, turning to the ACA's purpose and legislative history, the court found that the government again came up short in its efforts to overcome the statutory text. According to the court, the government's appeal to the ACA's broad aims did not demonstrate that Congress manifestly meant something other than what Code Sec. 36B says. A broader interpretation of the rule in Code Sec. 36B, the court noted, has major ramifications. By making credits more widely available, the court said, Reg. Sec. 1.36B-2(a)(1) gives the individual and employer mandates broader effect than they would have if credits were limited to state-established Exchanges.

The individual mandate requires individuals to maintain "minimum essential coverage" and, in general, enforces that requirement with a penalty. But the penalty does not apply to individuals for whom the annual cost of the cheapest available coverage, less any tax credits, would exceed 8 percent of their projected household income. Thus, the amount of the credit may determine on which side of the 8-percent threshold millions of individuals fall. By making tax credits available in the states with federal Exchanges, the court observed, the IRS regulation significantly increases the number of people who must purchase health insurance or face a penalty.

The IRS regulation, the court said, affects the employer mandate in a similar way. Like the individual mandate, the employer mandate uses the threat of penalties to induce large employers to provide their full-time employees with health insurance. Specifically, the court said, the ACA penalizes any large employer who fails to offer its full-time employees suitable coverage if one or more of those employees "enroll[s] . . . in a qualified health plan with respect to which an applicable tax credit . . . is allowed or paid with respect to the employee." As a result, the court said, even more than with the individual mandate, the employer mandate's penalties hinge on the availability of credits. If credits were unavailable in states with federal Exchanges, employers there would face no penalties for failing to offer coverage. The IRS regulation, the court concluded, has the opposite effect: by allowing credits in such states, it exposes employers there to penalties and thereby gives the employer mandate broader reach.

King v. Burwell

In King v. Burwell, ACA opponents appealed a district court holding that the statute as a whole clearly evinced Congress's intent to make the tax credits available nationwide. The Fourth Circuit upheld the lower court and in doing so, reached a different conclusion than the D.C. Circuit. According to the court, because the case involved a challenge to an agency's construction of a statute, application of the two-step analytic framework set forth in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), was appropriate. At Chevron's first step, a court looks to the "plain meaning" of the statute to determine if Congress's intent is clear in the statute regarding the question presented. If the statute speaks directly to that issue, that is the end of the inquiry and the agency is not afforded deference in its regulation. However, if the statute is susceptible to multiple interpretations, i.e., it is ambiguous or is silent on an issue, then the next step is to defer to the agency's interpretation so long as it is based on a permissible construction of the statute. A statute is ambiguous, the court noted, only if the disputed language is reasonably susceptible of different interpretations.

The court considered the ACA opponents argument that the plain language of Code Sec. 36(b)(2)(A) and Code Sec. 36B(1) was determinative and that by defining the terms "coverage months" and "premium assistance amount" by reference to Exchanges "established by the State under [ Sec. ] 1311," Congress limited the availability of tax credits to individuals purchasing insurance on state Exchanges. Under this construction, the court observed, the premium credit amount for individuals purchasing insurance through a federal Exchange would always be zero.

The court said the ACA opponents' position was sensible and, if Congress did in fact intend to make the tax credits available to consumers on both state and federal Exchanges, it would have been easy to write in broader language, as it did in other places in the statute. However, the court noted, when conducting statutory analysis, a court cannot confine itself to examining a particular statutory provision in isolation. Rather, the meaning or ambiguity of certain words or phrases may only become evident when placed in context. In this case, the court held that the statutory language in Code Sec. 36B was ambiguous and subject to multiple interpretations. As a result, the court concluded that deference should be given to the IRS's regulations as a permissible exercise of the agency's discretion.

In upholding the regulation, the Fourth Circuit cited the Supreme Court's statement in National Federation of Indep. Bus. v. Sebelius, 2012 PTC 167 (2012), where the Court noted that Congress passed the ACA to "increase the number of Americans covered by health insurance and decrease the cost of health care." Thus, the Fourth Circuit noted Congress' intent of the law to cover as many Americans as possible supporting the government's argument that the ACA was drafted to incorporate both state run and federally run exchanges.

What's Next?

The Justice Department has asked for an "en banc" review by the D.C. Circuit Court's decision. An en banc review involves a review of the decision by all judges on the D.C. Circuit. Most commentators feel that the decision will not be upheld by the full D.C. Circuit Court since a majority of the judges on the circuit are Democratic appointees (as opposed to the Republican majority on the panel that released the opinion). If the D.C. Circuit overturns the panel, then the Supreme Court is less likely to take the case, as the circuit split will have been resolved. However, if the entire circuit upholds the decision, then the case would likely end up in the Supreme Court to resolve the split.

On July 31, the Plaintiffs from the Fourth Circuit case filed a petition with the Supreme Court seeking appeal of the lower court's decision. In their Writ of Certiorari, the Plaintiffs urged the Court to hear the appeal because of the circuit split, overwhelming national effect, and because of how essential Code Sec. 36B is to operation of the ACA. Further, the petition notes how the statute is unambiguous and so the IRS rule should be invalidated because it expands the healthcare law, which has the plain meaning of only applying to state established exchanges. However, the Supreme Court may or may not grant the cert. petition, depending on if the D.C. Circuit reverses and holds for the government. Some commentators have noted that the Supreme Court is wary of getting into another ACA battle and thus may only address the questions if forced to do so. On the other hand, given the great uncertainty and sizable impacts on millions of individuals and hundreds of thousands of employers, the Court might be inclined to take swift action.

Observation: There are two other pending federal district court cases on the same subsidy issue, one in Indiana (Indiana v. IRS) and one in Oklahoma (Pruitt v. Sebelius). The Indiana lawsuit filed in 2013 and the Oklahoma lawsuit first filed in 2011 (amended in 2012 to add the IRS rule challenge) are nearly identical to each other. The cases could ultimately be appealed to the Seventh and Tenth Circuits respectively. Thus, even if the Supreme Court declines to hear appeals of the D.C. Circuit and Fourth Circuit cases, the Court will likely have another opportunity to review the healthcare subsidy issue in the not-to-distant future.

Notwithstanding the cases, scholars and commentators have posed other ways to resolve the issue outside of the judicial process. At the federal level, Congress could amend the healthcare law to remedy the reimbursements issue statutorily to support or incorporate the IRS rule. Alternatively, states currently without exchanges could decide to run their own exchanges or partner with the federal government or other states in a manner that allows them to be deemed to have their own exchange. Both avenues would avoid the legal concerns currently debated in the federal cases.

With the split decision and until the issues are settled in court or by Congress (not expected until sometime next year at the earliest), the administration and the IRS confirm that the subsidies will not halt and Americans in all states enrolled in plans purchased through exchanges and expecting the credit will receive the payments under Code Sec. 36B as the law stands.

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Final Regs Address Creation of S Corp Basis with Back-to-Back Loans; "Actual Economic Outlay" Standard Replaced

Under Code Sec. 1366, an S corporation shareholder can take into account losses and deductions to the extent of the adjusted basis of the shareholder's stock and the adjusted "basis of any indebtedness" of the S corporation to the shareholder. The Code does not define "basis of indebtedness," but several court cases have interpreted Code Sec. 1366 to require an investment in the S corporation that constitutes "an actual economic outlay." Under the "actual economic outlay" standard, courts have held that S shareholders had to be made "poorer in a material sense" in order to increase their bases of indebtedness. Some courts concluded that an S corporation shareholder was not poorer in a material sense if the shareholder borrowed funds from a related entity and then lent those funds to his S corporation. See e.g. Oren v. Commissioner, 357 F.3d 854 (8th Cir. 2004) (discussed below). Disputes often arose over when a back-to-back loan gave rise to an actual economic outlay.

In order to reduce the uncertainty over whether certain loan transactions involving multiple parties, including back-to-back loan transactions, create shareholder basis in indebtedness, the IRS addressed the issue in proposed regulations in 2012 which it has now finalized in T.D. 9682 (7/23/14). The final regulations clarify the requirements for increasing basis of indebtedness and assisting S corporation shareholders in determining with greater certainty whether their particular arrangement creates debt basis. The final regulations provide that in order for an S shareholder to increase basis of indebtedness, the shareholder need only prove that the debt is a bona fide debt under federal tax principles. A shareholder need not otherwise satisfy the "actual economic outlay" doctrine. However, for purposes of determining whether a guarantee gives rise to debt basis, the "actual economic outlay" standard still applies.

Practice Tip: Originally, these regulations were only to apply to transactions entered into on or after the regulations were finalized. However, in a favorable development for taxpayers, the IRS reconsidered and the final regulations allow taxpayers to rely on the new rules for indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the statute of limitations on tax assessments has not expired before July 23, 2014.

Background

Under Code Sec. 1366(d)(1), the aggregate amount of losses and deductions that an S corporation shareholder takes into account for any tax year cannot exceed the sum of that shareholder's adjusted basis in stock and adjusted basis of any indebtedness of the S corporation to that shareholder. The intent of the provision is to limit the loss that a shareholder takes into account for that shareholder's investment in the corporation; that is, the adjusted basis of the stock in the corporation owned by the shareholder and the adjusted basis of any indebtedness of the corporation to the shareholder.

Reg. Sec. 1.1366-2 limits the deduction of passthrough items of an S corporation to its shareholder. Under Reg. Sec. 1.1366-2(a)(1), a shareholder's aggregate amount of losses and deductions taken into account under Reg. Sec. 1.1366-1(a)(2), (3), and (4) for any tax year of the S corporation cannot exceed that shareholder's adjusted basis in stock in the corporation and adjusted basis of any debt of the corporation to that shareholder.

As previously noted, the Code does not define what constitutes debt basis for this purpose. However, several courts, including the Sixth Circuit in Maloof v. Comm'r, 456 F.3d 645 (2006), and the Tax Court in Hitchins v. Comm'r, 103 T.C. 711 (1994), interpreted the provision to require an investment in the S corporation constituting an actual economic outlay by the shareholder in order to create debt basis. Often, shareholders attempted to obtain debt basis by borrowing from another person typically, a related entity and then lending the proceeds to the S corporation (a back-to-back loan transaction). Alternatively, some S corporation shareholders sought to restructure an existing loan of the S corporation into a back-to-back loan by assuming the S corporation's liability on the loan and creating a commensurate obligation from the S corporation to the shareholder.

Such transactions lead to disputes concerning when a back-to-back loan gave rise to an actual economic outlay, and in particular, whether a shareholder had been made "poorer in a material sense" as a result of the loan.

"Actual Economic Outlay" Standard No Longer Applies to Back-to-Back Loans

The final regulations provide that if a loan transaction represents bona fide indebtedness of the S corporation to the shareholder, the shareholder can increase debt basis. Therefore, an S corporation shareholder need not otherwise satisfy the "actual economic outlay" doctrine for purposes of increasing debt basis.

The key requirement of the regulations is that purported indebtedness of the S corporation to a shareholder must be bona fide indebtedness to the shareholder. In determining what constitutes bona fide indebtedness, general federal tax principles apply. Those principals generally depend on whether a valid debtor-creditor relationship exists and whether a transfer was made with a real expectation of repayment and an intention to enforce the debt. This determination in turn depends on all the facts and circumstances, including whether (1) there was a promissory note or other evidence of indebtedness; (2) interest was charged; (3) there was any security or collateral; (4) there was a fixed maturity date; (5) a demand for repayment was made; (6) any actual repayment was made; (7) the transferee had the ability to repay; (8) any records maintained by the transferor and/or the transferee reflected the transaction as a loan; and (9) the manner in which the transaction was reported for federal tax purposes is consistent with a loan.

Example: Al is the sole shareholder of two S corporations, ABC and DEF. In May 2014, ABC made a loan to DEF. In December 2014, ABC assigned its creditor position in the note to Al by making a distribution to Al of the note. Under local law, after ABC distributed the note to Al, DEF was relieved of its liability to ABC and was directly liable to Al. Whether DEF is indebted to Al rather than ABC is determined under general federal tax principles and depends upon all of the facts and circumstances. If the note constitutes bona fide indebtedness from DEF to Al, the note increases Al's basis of indebtedness in DEF.

In the preamble to the final regulations, the IRS recognized that there are numerous ways, including certain circular cash flows, in which an S corporation can become indebted to its shareholder. The above example illustrates a loan originating between two related entities restructured to be from the S corporation to the shareholder. This shows that the debt need not originate between the S corporation and its shareholder, provided that the resulting debt running between the S corporation and the shareholder is bona fide. The IRS is aware, however, of cases involving circular flow of funds that do not result in bona fide indebtedness. As an example, it cited the case of Oren v. Comm'r, 357 F.3d 854 (8th Cir. 2004).

In Oren, the taxpayer owned three S corporations. The three S corporations entered into a series of loan transactions whereby one corporation loaned, over three years, approximately $15 million to the taxpayer, who in turn made loans totaling the same amount to the other two S corporations, both of which lent over time the same amount back to the first S corporation. Each loan transaction within a cycle occurred on the same day or within a few days of each other. The terms of the loans, including interest rate and repayment conditions, were the same in each transaction. The first S corporation's checks were drafted against its sweep account with its bank. That bank permitted the corporation to lend funds to the taxpayer so long as he contemporaneously lent the same amount to another related entity. All checks were drawn on the taxpayer or entity's bank account. The taxpayer signed all of the notes himself, except the note from the first corporation to him, which was signed by that corporation's president. The taxpayer and the S corporations paid all interest due under the loan agreements by check. The Eighth Circuit affirmed the Tax Court and held that the taxpayer's loans were not actual economic outlays because he was in the same position after the transactions as before (i.e. he was not materially poorer afterwards). In the preamble to the final regulations, the IRS indicated that this was the appropriate result and noted that, under the final regulations, whether a restructuring will result in bona fide indebtedness depends on the facts and circumstances.

Observation: Some comments on the proposed regulations requested clarification regarding the basis treatment when an S corporation shareholder or a partner contributes the shareholder's or partner's own note to an S Corporation or a partnership, as an S corporation shareholder does not increase her basis in the stock of her S corporation under Code Sec. 1366(d)(1)(A). In order to expedite finalization of the proposed regulations, the IRS has limited the scope to the basis of indebtedness, and will continue to study issues relating to stock basis.

"Actual Economic Outlay" Standard Still Applies to Guarantees

The final regulations provide a special rule in Reg. Sec. 1.1366-2(a)(2)(ii) for guarantees. This rule provides that a shareholder does not obtain basis of indebtedness in the S corporation merely by guaranteeing a loan or acting as a surety, an accommodation party, or in any similar capacity relating to a loan. When a shareholder makes a payment on bona fide indebtedness of the S corporation for which the shareholder has acted as guarantor or in a similar capacity, the shareholder may increase the shareholder's basis of indebtedness to the extent of that payment.

Example: Al is a shareholder of ABC, an S corporation. In 2014, ABC received a loan from a bank. The bank required Al's guarantee as a condition of making the loan to ABC. Beginning in 2015, ABC could no longer make payments on the loan and Al made payments directly to the bank from his personal funds until the loan obligation was satisfied. For each payment Al made on the note, Al obtained basis in the debt. Thus, Al's debt basis in ABC increased in 2015 to the extent of Al's payments to the bank under the guarantee agreement.

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IRS Guidance Attempts to Resolve Circular Relationship Between Code Sections 36B and 162(l)

The Affordable Care Act (ACA) is proving to be a challenge for tax return preparers, not only because of the complexity of the rules involved but also for the many unresolved questions the law presents. One of the bigger issues confronting preparers is how to calculate the premium tax credit under Code Sec. 36B that is available to taxpayers who purchase their own health insurance on a state or federal Exchange.

The issue for practitioners is how to calculate the premium tax credit for a taxpayer who is taking a deduction under Code Sec. 162(l) for health insurance premiums, because the credit is based in part on the taxpayer's modified adjusted gross income which is calculated after the deduction under Code Sec. 162(l). Thus, because the Code Sec. 162(l) deduction is allowed in computing adjusted gross income and because adjusted gross income is necessary for computing the premium tax credit, the taxpayer must know the allowable Code Sec. 162(l) deduction to compute the premium tax credit; and the amount of the Code Sec. 162(l) deduction is based on the amount of the Code Sec. 36B premium tax credit. Consequently, where a taxpayer is eligible for both a Code Sec. 162(l) deduction and a Code Sec. 36B premium tax credit, it may be difficult to determine the amounts of those items.

To address this problem, the IRS has issued Rev. Proc. 2014-41 and temporary and proposed regulations under Code Sec. 162. This guidance provides taxpayers with calculation methods to compute the premium tax credit and the deduction under Code Sec. 162(l).

Practice Tip: Use of the calculations described in Rev. Proc. 2014-41 is optional. According to the IRS, taxpayers can determine the Code Sec. 162(l) deduction and the Code Sec. 36B tax credit using any method, provided that the amounts claimed satisfy the applicable requirements.

Interaction of Code Section 36B and Code Section 162(l)

Under Code Sec. 36B, a taxpayer is eligible for a premium tax credit if the taxpayer enrolls in a qualified health plan. The premium tax credit is an advanceable, refundable tax credit designed to help eligible individuals and families with low or moderate income afford health insurance purchased through the Health Insurance Marketplace, also known as the Exchange, beginning in 2014. A taxpayer can choose to have the credit paid in advance to the taxpayer's insurance company to lower the taxpayer's monthly premiums, or the taxpayer can claim all of the credit when filing his or her tax return for the year. If the taxpayer chooses to have the credit paid in advance, the amount paid in advance must be reconciled with the actual credit when the taxpayer's return is filed. Under Code Sec. 36B(f)(2)(A), if an advanced credit payment for a tax year exceeds the credit allowed for the year, the taxpayer's tax is increased by the amount of the excess payment. However, under Code Sec. 36B(f)(2)(B), this increase in tax is limited where the taxpayer's household income is less than a certain amount (i.e., the limit on the additional tax).

The amount of the credit is based on the taxpayer's household income and a taxpayer's household income is calculated using modified adjusted gross income. Modified adjusted gross income is adjusted gross income plus certain additional items. Consequently, the amount of a taxpayer's premium tax credit is based in part on the amount of the taxpayer's adjusted gross income. Read more...

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IRS Delays Effective Date of Regs on Bundled Estate and Trust Costs

As a result of concerns over certain costs incurred by estates and trusts other than grantor trusts after the effective date of the regulations under Code. Sec. 67 (originally scheduled to take effect for tax years beginning on or after May 9, 2014), the IRS has delayed that date to tax years beginning after December 31, 2014. T.D. 9664 (7/17/14).

Generally, under Code Sec. 67(a), miscellaneous itemized deductions incurred by an individual are deductible only to the extent the aggregate of those deductions exceeds two percent of adjusted gross income (AGI). Under Code Sec. 67(b), certain itemized deductions are excluded from the definition of miscellaneous itemized deductions. Code Sec. 67(e) provides that the AGI of an estate or nongrantor trust is computed in the same manner as an individual. However, the deduction for costs paid or incurred in connection with the administration of the estate or nongrantor trust that would not have been incurred if the property were not held in such estate or trust are deductible in arriving at AGI. Therefore, such deductions are not subject to the two-percent-of-AGI floor. In May of 2014, the IRS issued final regulations providing guidance on which costs incurred by estates and nongrantor trusts are subject to the two-percent floor on miscellaneous itemized deductions.

Observation: The rule in Code Sec. 67(e) does not apply to expenses of grantor trusts because, under Reg. Sec. 1.67-2T(b)(1), such expenses are treated as miscellaneous itemized deductions of the grantor or other person treated as the owner of the trust. They are not treated as expenses of the trust itself.

As originally issued, the final regulations apply to tax years beginning on or after May 9, 2014. Therefore, fiduciaries of existing trusts and calendar-year estates would implement the rules beginning January 1, 2015. However, the rules would apply immediately to any non-grantor trust created after May 8, 2014, the estate of any decedent who dies after May 8, 2014, and any existing fiscal-year estate with a tax year beginning after May 8, 2014. Practitioners complained that that the effective date in the regulations did not give fiduciaries of these trusts and estates sufficient time to implement the changes necessary to comply with the regulations. Specifically, practitioners were concerned about allowing fiduciaries sufficient time to design and implement the necessary program changes to determine the portion of a bundled fee attributable to costs that are subject to the two-percent floor versus costs that are not subject to the two-percent floor.

In response to practitioners' requests, the IRS amended the effective date of the final regulations to apply to tax years beginning on or after January 1, 2015.

For a discussion of the deductibility of administration and fiduciary expenses, see Parker Tax ¶53,125.

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Regs Confirm Subsequent Events Are Not Relevant to Deductibility of Research and Experimental Expenses

Final regulations on the deductibility of research and experimental expenses confirm that the ultimate success, failure, sale, or other use of the research or property resulting from the research or experimentation is not relevant in determining the deductibility of such expenses. T.D. 9680 (7/21/14).

In 1957, the IRS issued regulations under Code Sec. 174. Reg. Sec. 1.174-2(b)(1) provided that under Code Sec. 174, expenditures for the acquisition or improvement of property subject to an allowance for depreciation or depletion were not deductible under Code Sec. 174 in the year of the acquisition or improvement. However, the regulations treated depreciation deductions as Code Sec. 174 expenditures to the extent that the property to which the allowances related was used in connection with research and experimentation. The 1957 regulations further provided, in Reg. Sec. 1.174-2(b)(4), that expenditures resulting in depreciable property to be used in the taxpayer's trade or business were still deductible to the extent of amounts expended for research or experimentation. The rules in Reg. Sec. 1.174-2(b)(1) and Reg. Sec. 1.174-2(b)(4) are referred to as the "Depreciable Property Rule." Until a proposed change in 2013, the Depreciable Property Rule remained unchanged from the rule's adoption in the 1957 regulations.

In 2013, the IRS issued proposed regulations reflecting the following revisions to the research and experimental expense regulations. First, the proposed regulations amended Sec. 1.174-2(b)(4) to provide that the "Depreciable Property Rule" was an application of the general definition of research or experimental expenditures and should not be applied to exclude otherwise eligible expenditures from being deducted. Second, to counter an interpretation that Code Sec. 174 eligibility could be reversed by a subsequent event, the proposed regulations provided that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation was not relevant to determining eligibility. Third, the proposed regulations defined the term "pilot model" as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term included a fully-functional representation or model of the product or a component of a product. Fourth, the proposed regulations clarified the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under Code Sec. 174 because these costs are not for research or experimentation. Finally, the proposed regulations provided a shrinking-back rule, similar to the rule provided in Reg. Sec. 1.41-4(b)(2), to address situations in which the requirements of Reg. Sec. 1.174-2(a)(1) are met with respect to only a component part of a larger product and not with respect to the overall product itself.

On July 21, the IRS finalized these regulations with very few changes. With respect to pilot models, the final regulations modify Example 5 to clarify that it is not necessary for each pilot model to be tested for a discrete purpose for the costs of multiple pilot models to qualify as research and experimental expenditures. Another change dealt with the shrinking-back rule,because some practitioners requested that this rule be eliminated as it was peculiar to Code Sec. 41 and served no purpose in Code Sec. 174. In response, the IRS clarified that the shrinking-back rule is intended to ensure that Code Sec. 174 eligibility is preserved in instances in which a basic design specification of the product may be established, but there is uncertainty with respect to certain components of the product, even if uncertainty arises after production of the product has begun. While the substance of the shrinking-back rule was retained in the final regulations, in response to practitioner concerns and to avoid any unintended confusion with the shrinking-back rule of Reg. Sec. 1.41-4(b)(2), the term "shrinking-back rule" was deleted from Reg. Sec. 1.174-2(a)(5).

The final regulations apply to tax years ending on or after July 21, 2014. However, taxpayers have the option of applying the final regulations to tax years for which the statute of limitations has not expired.

For a discussion of the rules for deducting research and experimental expenditures, see Parker Tax ¶95,500.

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Taxpayer Can't Deduct Unredeemed Perks Associated with Loyalty Program

A taxpayer's obligation to redeem certain perks given to customers as part of a loyalty reward program was subject to a condition precedent that was only satisfied after the close of taxpayer's tax year, and the exception to the all-events test for trading stamps or premium coupons did not apply to allow a current year deduction. Giant Eagle, Inc. v. Comm'r, T.C. Memo. 2014-146 (7/23/14). Read more...

     

U.S. Corporation Cannot Deduct Fine Paid to Commission of European Community

In determining if a fine paid to the Commission of the European Community was deductible, the phrase "government of a foreign country," as used in Reg. Sec. 1.162-21(a) denying deductions for fines paid to governments, may refer both to the government of a single foreign country and to the governments of two or more foreign countries. Guardian Industries Corp. v. Comm'r, 143 T.C. No. 1 (7/17/14). Read more...

     

No Abuse of Discretion Found Where IRS Refused to Rescind Levy Notice

The IRS was not precluded from issuing Letters CP 90 (Final Notice of Intent to Levy) after the taxpayer submitted an offer for an installment agreement, and the IRS's determination not to rescind the CP 90 was not an abuse of discretion. Eichler v. Comm'r, 143 T.C. No. 2 (7/23/14).

After the IRS assessed trust fund recovery penalties against Renald Eichler, Eichler requested a partial pay installment agreement. Before Eichler's request was entered into the IRS computer system or acted upon, the IRS sent Eichler a Notice CP 90. Eichler timely requested a collection due process (CDP) hearing, renewing his request for an installment agreement and asserting that the CP 90 should be withdrawn as invalid under Code Sec. 6331(k)(2), which prohibits the IRS from making a levy while an offer for an installment agreement is pending. During the CDP hearing, the IRS's settlement officer conditioned acceptance of an installment agreement on Eichler's making an $8,520 downpayment. Eichler declined, saying that would result in economic hardship to him.

The IRS sent a final determination sustaining the proposed levy on the ground that Eichler had declined the IRS's proposed installment agreement and rejected Eichler's request that the CP 90 be withdrawn as invalid.

Eichler argued before the Tax Court that the IRS abused its discretion when it refused to rescind the notices of intent to levy. He reiterated his argument that Code Sec. 6331(k)(2) precluded the IRS from issuing a notice of intent to levy while an installment agreement offer is pending.

The Tax Court rejected Eichler's argument and held that Code Sec. 6331(k)(2) did not preclude the IRS from issuing the CP 90 after Eichler submitted his offer for an installment agreement. According to the court, Code Sec. 6331(k)(2) bars the IRS from making a levy while a taxpayer's offer for an agreement request is pending; it does not bar the IRS from issuing notices of intent to levy. The court noted that Reg. Sec. 301.6331-4(b)(1) expressly provides that while levy is prohibited, the IRS may take actions other than levy to protect the interests of the government. A notice of intent to levy is an action other than a levy to protect the interests of the government as unlike a levy, it is merely preliminary to a collection action, rather than a collection action barred by Code Sec. 6331(k)(2).

The Tax Court also held that the IRS's determination not to rescind the CP 90 was not an abuse of discretion under relevant provisions of the Internal Revenue Manual.

Finally, the Tax Court remanded the case for further proceedings because the record did not allow for a meaningful review of the IRS's determination regarding the appropriateness of Eichler's $8,520 down payment as a condition of an installment agreement.

For a discussion of the rules relating to IRS levies, see Parker Tax ¶260,540.

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Final Regs Reject Deduction of Unamortized Start-up and Organizational Costs of Partnership Undergoing a Technical Termination

Final regulations address the deductibility of start-up expenditures and organizational expenses for partnerships following a technical termination of the partnership and require continued amortization of start-up and organizational expenses. T.D. 9681 (7/23/14).

Under Code Sec. 195, an electing taxpayer can deduct start-up expenditures in the tax year in which the active trade or business begins. The amount that may be deducted in that year is the lesser of (1) the amount of start-up expenditures with respect to the active trade or business, or (2) $5,000, reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000.

Code Sec. 709 generally provides that no deduction is allowed for any amounts paid or incurred to organize a partnership or to promote the sale of (or to sell) an interest in the partnership. However, a partnership may elect to deduct organizational expenses in the year in which the partnership begins business. The amount that may be deducted is the lesser of (1) the amount of the organizational expenses of the partnership, or (2) $5,000, reduced (but not below zero) by the amount by which the organizational expenses exceed $50,000. In any case in which a partnership is liquidated before the end of the amortization period, any deferred expenses attributable to the partnership that were not allowed as a deduction by reason of Code Sec. 709 may be deducted to the extent allowable under Code Sec. 165. However, there is no partnership deduction with respect to its capitalized syndication expenses.

Code Sec. 708(b)(1)(B) provides that a partnership is considered as terminated if, within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits (i.e., a technical termination).

As a result of some taxpayers taking the position that a technical termination entitles a partnership to deduct unamortized start-up expenses and organizational expenses, the IRS has issued regulations which deny such treatment. According to the IRS, deducting unamortized start-up expenses and organizational expenses in such cases is contrary to the congressional intent underlying Code Secs. 195, 708, and 709. After issuing proposed regulations in December of 2013, the IRS has now finalized such regulations. The final regulations provide that a new partnership formed due to a transaction, or series of transactions, resulting from a technical termination of a prior partnership must continue amortizing the start-up and organizational expenses using the same amortization period adopted by the terminating partnership.

For a discussion of the rules relating to a technical termination of a partnership, see Parker Tax ¶26,530.

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D.C. Court Deals Another Blow to IRS; Rejects Contingent Fee Prohibition on Certain Refund Claims

Citing the D.C. Circuit Court decision in Loving v. U.S., 2014 PTC 73 (2014), a district court held that the IRS lacks statutory authority to regulate the preparation and filing of ordinary refund claims by tax practitioners subject to Circular 230. Ridgely v. Lew, 2014 PTC 356 (D. D.C. 7/16/14).

Under 31 U.S.C. Section 330, the Treasury Secretary has authority to regulate "persons" who practice before the Treasury Department. Under this authority, the Secretary of the Treasury publishes regulations governing "practice" before the IRS in the Code of Federal Regulations, Title 31, part 10. These regulations are commonly known as "Circular 230." Most of Circular 230 outlines duties and restrictions concerning "practice" before the IRS as they relate to practitioner character, reputation, and competency. However, Congress has not defined the meaning or scope of the term "practice," a term on which this case hinges.

Circular 230 prohibits a broad range of tax practitioners from charging contingent fees for certain services relating to preparing, filing, or presenting tax returns or refund claims. Specifically, Section 10.27(b) of Circular 230 provides that, with certain exceptions, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the IRS. Section 10.27 defines a matter before the IRS to include tax planning and advice, preparing or filing or assisting in preparing or filing returns or claims for refund or credit, and all matters connected with a presentation to the IRS or any of its officers or employees relating to a taxpayer's rights, privileges, or liabilities. The provision therefore encompasses preparers of refund claims who appear before the IRS only when they prepare and/or file refund claims.

Gerald Ridgely, a practicing CPA, filed suit against the IRS arguing that the IRS exceeded its statutory authority in regulating the preparation and filing of ordinary refund claims refund claims that practitioners file after a taxpayer has filed his original tax return but before the IRS has initiated an audit of the return. A CPA may assist a taxpayer in preparing and filing a refund claim and, in doing so, is not legally representing the taxpayer until the IRS responds to the claim and the CPA submits a power-of-attorney form to the IRS. What Ridgely was challenging in the district court was the IRS's proclaimed authority to regulate fee arrangements entered into by CPAs for preparing and filing ordinary refund claims before the beginning of any adversarial proceedings with the IRS or any formal legal representation by the CPA. Seeking injunctive and declaratory relief, Ridgely sued the Secretary of the Treasury and the Commissioner of the IRS under the Administrative Procedure Act and the Declaratory Judgment Act.

The D.C. district court agreed with Ridgely and held that the IRS lacked authority to regulate the preparation and filing of ordinary refund claims. The court noted that it was not the first court to address this topic, citing the D.C. Circuit Court's decision earlier this year in Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2014). In the Loving decision, the D.C. Circuit grappled with the question of whether the IRS's authority to "regulate the practice of representatives of persons before the Department of the Treasury" encompasses authority to regulate tax-return preparers, whom the court in turn defined as persons who prepare for compensation, or who employ one or more persons to prepare for compensation, all or a substantial portion of any return of tax or any claim for refund of tax under the Internal Revenue Code. The Loving court held that the text, history, structure, and context of Section 330 foreclosed and rendered unreasonable the IRS's interpretation of Section 330.

Although the facts in Loving involved non-CPA tax-return preparers and different provisions of Circular 230 (Sections 10.3-10.6) which impose requirements for preparers to pay a fee, pass a qualifying exam, and complete continuing education classes -- the court noted that Loving expressly addressed two key questions that the Court faced in the instant situation: who are "representatives" and what is "practice" under Section 330? In Loving, the court found that tax-return preparers were not "agents with authority to bind others," and thus were not "representatives" under the ordinary definition. Additionally, Section 330 limits the scope of "practice" to practice before the IRS, which also precludes tax-return preparers as they never appear before the courts. In the district court's view, Loving is controlling precedent with respect to the claims at issue in this case and thus, the IRS lacks authority to regulate the preparation and filing of ordinary refund claims.

For a discussion of the Circular 230 rules for fees, see Parker Tax ¶272,130.

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IRS Announces Maximum Penalties for Failing to Maintain Minimum Health Insurance Coverage

IRS provides the 2014 monthly national average premium for qualified health plans that have a bronze level of coverage for taxpayers to use in determining the penalty that applies to a taxpayer that fails to maintain minimum essential health coverage, as well as an explanation of the methodology used to determine the monthly national average premium amount. Rev. Proc. 2014-46.

The Patient Protection and Affordable Health Care Act (PPACA) provides that, beginning after 2013, nonexempt U.S. citizens and U.S. residents must maintain minimum essential healthcare coverage (i.e., the individual mandate). A penalty, referred to as the "shared-responsibility payment," is imposed upon individuals who do not have such healthcare. For each tax year, the individual shared responsibility payment is the lesser of (1) the sum of the monthly penalty amounts, or (2) the sum of the monthly national average bronze plan premiums for the shared responsibility family. Shared responsibility family means, for a month in a tax year, all nonexempt individuals for whom the taxpayer and the taxpayer's spouse -- if the taxpayer is married and files a joint return with the spouse -- are liable for the shared responsibility payment under Code Sec. 5000A for that tax year. The monthly national average bronze plan premium means, for a month for which a shared responsibility payment is imposed, 1/12 of the annual national average premium for qualified health plans that (1) have a bronze level of coverage, (2) would provide coverage for the taxpayer's shared responsibility family members, and (3) are offered through Exchanges for plan years beginning in a calendar year with or within which the tax year ends.

To simplify the calculation of the individual shared responsibility payment and to help ensure that individuals subject to the limitation on the amount of the individual shared responsibility payment are generally not liable for a payment that materially exceeds the individual's actual cost of coverage, the monthly national average bronze plan premium is based upon the premium charged to individuals aged 21.

In Rev. Proc. 2014-46, the IRS provides that, for purposes of calculating the individual shared responsibility payment, the monthly national average premium for qualified health plans that have a bronze level of coverage and are offered through Exchanges in 2014 is $204 per individual and $1,020 for a shared responsibility family with five or more members. Thus, the maximum yearly penalty for an individual is $2,448. The maximum for a family with five or more members is $12,240.

Observation: The aforementioned premiums may vary, but not by more than a 1.5:1 ratio, for individuals who use tobacco.

For a discussion of the individual shared responsibility payment, see Parker Tax ¶190,101.