Social Security Wage Base Increases to $117,000 in 2014; IRS Issues Regs on Voluntary Withholding Agreements; Dividends by Alaska Native Corporation Eligible for Voluntary Withholding; Proposed Procedure Would Provide Advanced Pricing Guidance ...
Final and Proposed Regs on 3.8% Net Investment Income Tax Contain Substantial Changes
The IRS released final and proposed regulations relating to the net investment income tax which contain major changes from prior proposed rules and include revised proposed rules for calculating net gain on the disposition of an interest in a partnership or S corporation. T.D. 9644 (12/2/13); REG-130843-13 (12/2/13).
Inconsistent Reporting and Failure to Meet All-Events Test Precludes Accelerated Deductions
The Tax Court disallowed a taxpayer's accelerated deductions because neither the required performances nor the payment due dates with respect to the majority of the deductions occurred before the close of the year, and the liabilities were treated inconsistently for financial and tax purposes. VECO Corporation & Subs. v. Comm'r, 141 T.C. No. 14 (11/20/13).
Final regulations provide guidance for employers and individuals on implementing the Additional Medicare Tax and address the repayment of prior year wages on which the additional tax has been paid. T.D. 9645 (11/29/13).
Wading into an area that has been fraught with controversy (much of it involving the IRS itself), the IRS has issued proposed regulations that would preclude the granting of 501(c)(4) tax-exempt status to organizations with certain political activities. REG-134417-13 (11/29/13).
The IRS has issued final regulations requiring information reporting on Form 1098, Mortgage Interest Statement, by persons who receive mortgage insurance premiums, including prepaid premiums, aggregating $600 or more during any calendar year. T.D. 9642 (11/27/13).
While a limited partnership formed by a Mary Kay consultant could not deduct retirement contributions to the consultant's deferred compensation plan, the consultant herself could deduct the contributions as employer business expenses; post-retirement distributions from the company were taxable as self-employment income derived from her trade or business. Peterson v. Comm'r, T.C. Memo. 2013-271 (11/25/13).
Income received by a taxpayer's S corporation in a Code Sec. 351 transaction with its subsidiary under a stock purchase agreement is reclassified as ordinary income under Code Sec. 1239 because the taxpayer's S corporation and its subsidiary were related persons for purposes of Code Sec. 1239. Fish v. Comm'r., T.C. Memo. 2013-270 (11/25/13).
IRS Failed to Show that Dual Resident's Center of Vital Interests Were in the U.S.
The IRS failed to establish that a dual resident's center of vital interests was in the United States for tax purposes and that he was thus taxable as a U.S. resident. Escobedo v. U.S., 2013 PTC 367 (S.D. Cal. 11/14/13).
Because the underlying policies of a terminated welfare benefit plan owned by the taxpayers were substantially certain to be distributed to them or placed within their control, the value of the policies were includible in the taxpayers' income. Gluckman v. Comm'r, 2013 PTC 371 (2d Cir. 11/22/13).
A company could not exclude from its cigarette gross receipts the part of the sale price attributable to the cost of the cigarette stamp tax and, as a result, the company failed to prove that its average annual gross receipts for the three-tax-year period did not exceed $10 million for any of the years at issue; thus the company was subject to the uniform capitalization rules of Code Sec. 263A. City Line Candy & Tobacco Corporation, 141 T.C. No. 13 (11/19/13).
Fourth Circuit Upholds Prison Term for Former Corrections Officer Turned Tax Preparer
The four-year prison sentence handed down to a former corrections officer turned tax return preparer was appropriate in light of the estimated $2.1 million tax loss he caused to the government. Ukwu v. U.S., 2013 PTC 370 (4th Cir. 11/22/13).
Final and Proposed Regs on 3.8% Net Investment Income Tax Contain Substantial Changes; Rules on Dispositions of Interests in Passthroughs Revised
The 3.8 percent net investment income tax rules of Code Sec. 1411 that became effective in 2013 have kept many practitioners guessing about whether certain items of income are subject to the tax, how the rules apply, and what planning opportunities might be available to navigate around the tax. Some of these questions were answered on November 26, when the IRS released 217 pages of final regulations (T.D. 9644 (12/2/13)) and 89 pages of proposed regulations (REG-130843-13 (12/2/13)) on the net investment income tax (NIIT).
There are several substantial changes in the final regulations of which practitioners should be aware: Read more...
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Inconsistent Reporting and Failure to Meet All-Events Test Precludes Accelerated Deductions
Taxpayers often try to accelerate deductions for tax purposes to obtain the tax benefits such deductions provide. If the taxpayer meets certain tests, accelerated deductions are appropriate. In VECO Corporation & Subs. v. Comm'r, 141 T.C. No. 14 (11/20/13), the taxpayer implemented a proposed change in accounting method and in so doing accelerated deductions for certain liabilities attributable to periods after the close of the tax year. The company claimed it was entitled to accelerate the deductions under the all-events test and/or the recurring item exception to the economic performance rules. However, for financial statement purposes, the taxpayer accrued the liabilities over more than one tax year. The Tax Court disallowed the accelerated deductions because (1) neither the required performances nor the payment due dates with respect to the majority of the deductions occurred before the close of the year, and (2) the liabilities were treated inconsistently for financial and tax purposes and were material items for tax purposes.
Background
VECO Corporation is the common parent of an affiliated group of corporations engaged in multiple businesses, such as oil and gas field services, newspaper publishing, manufacturing, construction, equipment rental, wholesale sales, leasing, and engineering. For its fiscal year ending (FYE) March 31, 2005, and certain prior years, VECO entered into a number of service contracts, licensing contracts, insurance contracts, and real property and equipment leases.
On its FYE 2005 tax return, VECO reported total income of over $71 million and claimed total deductions of more than $64 million. VECO also attached to its return a Form 3115, Application for Change in Accounting Method. VECO reported on an attachment to the Form 3115 that it was currently deducting liabilities as follows: (1) With respect to liabilities for which economic performance was satisfied by payment, VECO capitalized the liability and amortized the payment over the life of the agreement; (2) with respect to liabilities for which economic performance was not satisfied by payment, VECO deducted the liabilities in the period to which they related.
VECO proposed a change in its accounting method to: (1) deduct liabilities in the year incurred under the all-events test, with modifications under the recurring item exception for insurance and maintenance agreement payments; and (2) with respect to rent liabilities for which economic performance was not satisfied by payment, deduct those liabilities in the year the liabilities were fixed and determinable with reasonable accuracy, and where economic performance had occurred. VECO implemented its proposed change in accounting method and prepared its FYE 2005 Form 1120 accordingly. As a result of the change in accounting method, VECO claimed deductions for prepaid expenses and accrued expenses attributable to periods after March 31, 2005, under the theory that its tax treatment of the expenses was permitted under the all-events test of Code Sec. 461 and/or the recurring item exception under Code Sec. 461(h)(3).
An example of one such expense was an agreement between VECO and a technology company in which the technology company licensed use of its software and agreed to provide software maintenance services to VECO over a six consecutive year period from April 30, 2003, through March 30, 2008. VECO treated $200,235, which was attributable to the period April 1 to August 1, 2005, as an FYE 2006 expense on its financial statements but deducted that amount on it FYE 2005 tax return. Expenses relating to other agreements were treated in a similar manner.
In a notice of deficiency, the IRS disallowed the portions of the deductions attributable to periods after March 31, 2005, and accordingly determined a $1.9 million tax deficiency for VECO's FYE 2005 tax year. The IRS determined that VECO was not permitted to change its method of accounting for its prepaid and accrued expenditures. According to the IRS, VECO failed to establish that it incurred the expenses attributable to the disputed deductions in FYE 2005.
All-Events Test and Recurring Item Exception
Whether an accrual method taxpayer has incurred a deductible expense is determined under the all-events test of Code Sec. 461. Under this test, the amount of any deduction or credit allowed for income tax purposes is taken for the tax year that is the proper tax year under the method of accounting used in computing taxable income. Under the accrual method of accounting, a liability is incurred, and generally deducted for federal income tax purposes, in the tax year in which:
(1) all the events have occurred that establish the fact of the liability;
(2) the amount of the liability can be determined with reasonable accuracy; and
(3) economic performance has occurred with respect to the liability.
Conditions (1) and (2) are known as the traditional "all-events test," and existed before the addition of condition (3). To satisfy the traditional all-events test (i.e., conditions (1) and (2)), the liability must be final and definite in amount, must be fixed and absolute, and must be unconditional. The fact-of-liability prong of the all-events test looks to whether legal rights or obligations exist as of the close of the tax year, not the probability that such rights or obligations will arise at some point in the future. A liability is considered fixed when payment is unconditionally due or when the required performance occurs on the part of the other party.
If the liability is attributable to the provision of services or property to the taxpayer by another person, economic performance occurs as the person provides such services or property. If the liability is attributable to the use of property by the taxpayer, economic performance occurs as the taxpayer uses such property.
However, a taxpayer can treat services or property as being provided to the taxpayer as the taxpayer makes payment to the person providing the services or property if the taxpayer can reasonably expect the person to provide the services or property within 3-1/2 months after the date of payment. Code Sec. 461(h)(3) provides an exception (the recurring item exception) to the general rule requiring economic performance. Under the recurring item exception, a taxpayer may treat an item as incurred during any tax year if (1) the all-events test with respect to such item is met during the tax year, and (2) economic performance with respect to such item occurs within the shorter of a reasonable period after the close of the tax year or 8-1/2 months after the close of the tax year; (3) such item is recurring in nature and the taxpayer consistently treats items of such kind as incurred in the tax year in which the requirements of (1), above, are met; and (4) either the item is not a material item, or the accrual of such item in the tax year in which the requirements of (1), above, are met results in a more proper match against income than accruing such item in the tax year in which economic performance occurs.
Code Sec. 461(h)(3)(B) and Reg. Sec. 1.461-5(b)(4) address the materiality requirement and provide that (1) in determining whether a liability is material, consideration is given to the amount of the liability in absolute terms and in relation to the amount of other items of income and expense attributable to the same activity; and (2) a liability is material if it is material for financial statement purposes under generally accepted accounting principles (GAAP); (3) the treatment of an item for financial statement purposes is taken into account in determining if an item is material; and (4) a liability that is immaterial for financial statement purposes is not necessarily immaterial for tax purposes.
VECO argued that upon its entering into the various agreements, its liabilities under those agreements became fixed by virtue of its assumption of the contractual obligations. The IRS disagreed that VEOC's execution of each agreement constituted an event that fixed VECO's liability for the entire obligation under the agreement.
According to the IRS, VECO failed to satisfy the economic performance requirement and the materiality or matching requirement of the recurring item exception for all of the disputed deductions. VECO disagreed, contending that economic performance with respect to each expense item occurred within 8-1/2 months after the close of its FYE 2005 and that each expense item was not material.
Tax Court's Decision
The Tax Court held that because neither the required performances nor the payment due dates with respect to the majority of the accelerated deductions occurred before the close of VECO's 2005 tax year, VECO failed to satisfy the first requirement of the all-events test. In other words, VECO failed to prove that all of the events had occurred to establish the fact of the liabilities. According to the court, the execution of a contract contemplating payment, without more, is not an event that fixes the payor's liability.
In addition, the court held that VECO did not satisfy all of the requirements for the recurring item exception because the liabilities underlying the deductions were prorated over more than one tax year, were treated inconsistently for financial statement and tax purposes, and were material items for tax purposes.
With respect to the materiality requirement, the court noted that VECO prepared its financial statements in accordance with GAAP and accrued its liabilities under certain agreements and leases over more than one year for financial statement purposes. On its FYE 2006 financial statement, the court observed, VECO treated the disputed deductions as expenses for that year but deducted the expenses on its tax return for the prior tax year. Guided by Code Sec. 461(h)(3)(B) and an example in the legislative history, the court concluded that the liabilities giving rise to the disputed deductions were material because VECO prorated the liabilities between two years on its financial statements and took an inconsistent position with respect to the liabilities for financial statement and tax reporting purposes.
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Final Regs on .9% Additional Medicare Tax Address Repayment of Prior Year Wages
Final regulations provide guidance for employers and individuals on implementing the Additional Medicare Tax and address the repayment of prior year wages on which the additional tax has been paid. T.D. 9645 (11/29/13).
The Patient Protection and Affordable Care Act (PPACA) enacted an Additional Medicare Tax on income above threshold amounts. The IRS has now issued final regulations that provide guidance for employers and individuals relating to the implementation of the Additional Medicare Tax, including the requirement to withhold Additional Medicare Tax on certain wages and compensation, the requirement to file a return reporting Additional Medicare Tax, the employer process for adjusting underpayments and overpayments of Additional Medicare Tax, and the employer and individual processes for filing a claim for refund of Additional Medicare Tax.
In particular, the final regulations address how employers should treat repayment by an employee of wage payments received by the employee in a prior year for Additional Medicare Tax purposes (for example, a sign-on bonuses paid to employees that are subject to repayment if certain conditions are not met). Employers cannot make an adjustment or file a claim for refund for Additional Medicare Tax withholding when there is a repayment of wages received by an employee in a prior year because the employee determines liability for Additional Medicare Tax on the employee's income tax return for the prior year; however, the employee may be able to file an amended return claiming a refund of the Additional Medicare Tax.
In the preamble to the final regulations, the IRS notes that, under current employment tax adjustment procedures, if the repayment occurs within the period of limitations for a refund, the employer can repay or reimburse the social security and Medicare taxes withheld from the wage payment to the employee and file a refund claim, or make an interest-free adjustment, for the social security and Medicare tax overwithholding. However, the final regulations provide that an employer may adjust overpaid Additional Medicare Tax withheld from employees only in the calendar year in which the wages or compensation are paid, and only if the employer repays or reimburses the employee the amount of the overcollection before the end of the calendar year. Under the final regulations, in the case of an overpayment of Additional Medicare Tax for a year for which an individual has filed Form 1040, a claim for refund should be made by the individual on Form 1040X, Amended U.S. Individual Income Tax Return. Since a wage repayment reduces the wages subject to Additional Medicare Tax for the period during which the wages were originally paid, the employee is entitled to file an amended return (on Form 1040X) to recover the Additional Medicare Tax with respect to the repaid wages.
Observation: In this situation, the Additional Medicare Tax is treated differently than federal income tax. For federal income tax purposes, wages paid in a year are considered income to the employee in that year, even when the wages are repaid by the employee to the employer in a subsequent year. If an employee repays wages to an employer in a year following the year in which the wages were originally paid, the employee cannot reduce the federal income tax for the prior year (i.e., the employee cannot file an amended income tax return for the prior year using Form 1040X). Instead, depending on the circumstances, the employee may be entitled to a deduction for the repaid wages (or in some cases, if the requirements of Code Sec. 1341 are satisfied, a reduction of tax) on his or her income tax return for the year of repayment. By contrast, the Additional Medicare Tax is part of FICA and, similar to social security tax and Medicare tax, the repayment of wages reduces the employee's liability for Additional Medicare Tax for the prior year.
For a discussion of the Additional Medicare Tax, see Parker Tax ¶213,115.
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Proposed Regs Aim to Restrict Political Activities by Tax-Exempt Organizations
Wading into an area that has been fraught with controversy (much of it involving the IRS itself), the IRS has issued proposed regulations that would preclude the granting of 501(c)(4) tax-exempt status to organizations with certain political activities. REG-134417-13 (11/29/13).
Code Sec. 501(c)(4) provides a federal income tax exemption, in part, for civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare. The regulations under Code Sec. 501(c)(4) have not been amended since 1959, although Congress took steps in the intervening years to address the relationship of political campaign activities to tax-exempt status. In particular, Code Sec. 527, which governs the tax treatment of political organizations, was enacted in 1975 and provides generally that amounts received as contributions and other funds raised for political purposes are not subject to tax.
Organizations may apply for tax-exempt status under Code Sec. 501(c)(4) if they operate to promote social welfare. The IRS currently applies a facts-and-circumstances test to determine whether an organization is engaged in political campaign activities that do not promote social welfare. The proposed regulations are aimed at reducing the need to conduct fact-intensive inquiries by replacing the facts-and-circumstances test with more definitive rules.
Currently, an organization exempt from tax under Code Sec. 501(c)(4) may engage in political campaign activities if those activities are not the organization's primary activity. In contrast, organizations exempt under Code Sec. 501(c)(3) are absolutely prohibited from engaging in political activities. It is problematic that Code Sec. 501(c)(4) does not define "political campaign activities"; instead, the definition and interpretation of terms used generally occurs under Code Sec. 501(c)(3). Certain people and groups have protested that organizations engaging in political activities, such as campaigning for particular candidates, should not be tax exempt.
The proposed regulations define the term "candidate-related political activity," and would amend current regulations by providing that the promotion of social welfare does not include this type of activity. The IRS also seeks comments on other aspects of the qualification requirements, including what proportion of a Code Sec. 501(c)(4) organization's activities must promote social welfare.
Prop. Reg. Sec. 1.501(c)(4)-1(a)(2)(ii) provides that the promotion of social welfare does not include direct or indirect candidate-related political activity. In defining the new term, "candidate-related political activity," the IRS drew upon existing definitions of political activity under federal and state campaign finance laws, other IRS provisions, as well as suggestions made in unsolicited public comments. Under the proposed guidelines, candidate-related political activity includes (1) communications that expressly advocate for a clearly identified political candidate or candidates of a political party; (2) communications that are made within 60 days of a general election (or within 30 days of a primary election) and clearly identify a candidate or political party; (3) communications expenditures that must be reported to the Federal Election Commission.
Observation: The current regulations provide, in part, that an organization is operated exclusively for the promotion of social welfare within the meaning of Code Sec. 501(c)(4) if it is "primarily engaged" in promoting in some way the common good and general welfare of the people of the community. Some have questioned the use of the "primarily" standard in the Code Sec. 501(c)(4) regulations and suggested that this standard should be changed. The IRS is considering whether the current Code Sec. 501(c)(4) regulations should be modified in this regard and, if the "primarily" standard is retained, whether the standard should be defined with more precision or revised to mirror the standard under the Code Sec. 501(c)(3) regulations. The IRS is requesting comments on whether this standard should be retained.
For a discussion of social welfare organizations exempt from tax under Code Sec. 501(c)(4), see Parker Tax ¶60,510.
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IRS Finalizes Regs for Reporting Mortgage Insurance Premiums for 2013
The IRS has issued final regulations requiring information reporting on Form 1098, Mortgage Interest Statement, by persons who receive mortgage insurance premiums, including prepaid premiums, aggregating $600 or more during any calendar year. T.D. 9642 (11/27/13).
Under Code Sec. 163(h)(3)(E), premiums paid for qualified mortgage insurance by a taxpayer during the tax year in connection with acquisition indebtedness for a qualified residence are treated as qualified residence interest. Before being amended in 2013, this provision was effective only for amounts paid or accrued between January 1, 2007, and December 31, 2011, on mortgage insurance contracts issued on or after January 1, 2007. The American Taxpayer Relief Act of 2012 (ATRA), enacted on January 2, 2013, retroactively applied the tax treatment of qualified mortgage insurance premiums as qualified residence interest for 2012, and it extended that treatment to premiums paid or accrued on or before December 31, 2013, on mortgage insurance contracts issued on or after January 1, 2007. Unless extended or made permanent by further legislation, Code Sec. 163(h)(3)(E) does not apply to amounts paid or accrued after 2013.
In November, the IRS issued final regulations under Code Sec. 6050H, which provides for information reporting for mortgage insurance premiums received on or after January 1, 2013, and during periods to which Code Sec. 163(h)(3)(E) applies. However, there were no final or temporary regulations requiring information reporting with respect to qualified mortgage insurance premiums paid or accrued during 2012. Therefore, information reporting with respect to qualified mortgage insurance premiums was not required for premiums paid or accrued during 2012. Further, the fact that an individual did not receive a Form 1098 reporting the amount of mortgage insurance premiums paid for 2012 does not affect whether the individual satisfied the requirements under Code Sec. 163(h) to treat qualified mortgage insurance premiums as qualified residence interest.
Compliance Tip: Any individual who paid or accrued qualified mortgage insurance premiums in the calendar year ending December 31, 2012, or properly allocated these premiums to the calendar year ending December 31, 2012, on mortgage insurance contracts issued on or after January 1, 2007, and who did not previously treat those amounts as qualified residence interest, may be eligible for a refund if, within the applicable statute of limitations period, a Form 1040X, Amended U.S. Individual Income Tax Return, is filed based on the treatment of those amounts as qualified residence interest.
For a discussion of the treatment of mortgage insurance premiums as qualified residence interest, see Parker Tax ¶83,515.
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Retirement Contributions by Mary Kay Consultant Deductible as Business Expenses; Postretirement Distributions Subject to Self-Employment Tax
While a limited partnership formed by a Mary Kay consultant could not deduct retirement contributions to the consultant's deferred compensation plan, the consultant herself could deduct the contributions as employer business expenses; post-retirement distributions from the company were taxable as self-employment income derived from her trade or business. Peterson v. Comm'r, T.C. Memo. 2013-271 (11/25/13).
Christine Peterson was an independent beauty consultant for Mary Kay, Inc., a wholesale distributor of cosmetics, toiletries, skin care, and related products. She sold Mary Kay brand products and recruited other individuals to join the company. In 1991, Christine entered into a national sales director (NSD) agreement with Mary Kay. She earned commissions from the wholesale purchases of Mary Kay products from her network of independent beauty consultants, sales directors, and national sales directors. Christine entered into a Family Security Program (FSP) and Great Futures Program (GFP) with Mary Kay. Both agreements provided that Mary Kay would make monthly distributions to Christine after completion of five years of NSD service and upon retirement from the company. The distributions would be calculated using a percentage of her average commissions before her retirement, the post-retirement wholesale purchases of her network, and her age at retirement. The agreements stated that each program was intended to be a nonqualified deferred compensation arrangement that was intended to meet the requirements of Code Sec. 409A.
In 2000, Christine and her husband, Roger, entered into the Christine Peterson Defined Benefit Plan and Trust (CP Plan), which was a qualified plan, designating themselves as the trustees and Christine as the employer. In 2002, Christine and Roger formed NSD Interests, L.P., a Georgia limited partnership. Subsequently, the CP Plan was amended to designate NSD Interests as the employer and the couple remained the trustees. Christine received nonemployee compensation from Mary Kay of over $750,000, $799,000, and $890,000 in 2006, 2007, and 2008, respectively. Christine retired from Mary Kay in 2009 and received nonemployee compensation of almost $490,000 under the FSP and GFP agreements. NSD Interests reported the 2006, 2007, and 2008 amounts as income and claimed deductions for retirement contributions to the CP Plan for those years.
The IRS issued notices of deficiency, disallowing the deduction for retirement contributions made by NSD Interests. The IRS contended that NSD Interests was not engaged in a trade or business and, therefore, was not entitled to deduct retirement contributions to the CP Plan under Code Sec. 404(a). The IRS also determined that the post-retirement distributions Christine received in 2009 under the FSP and GFP agreements were subject to self-employment tax.
Code Sec. 404(a) provides in general that contributions paid by an employer to or under a stock bonus, pension, profit-sharing, or annuity plan or compensation paid or accrued on account of any employee under a plan deferring receipt of the compensation are deductible by the employer as business expenses or expenses for the production of income, subject to certain limitations. Reg. Sec. 1.404(a)-1(b) states that a partnership activity does not constitute a trade or business unless the partnership engages in the activity with the predominant purpose and intention of making a profit.
Christine and Roger acknowledged that NSD Interests was not engaged in a trade or business, but instead was created to be the passive recipient of Christine's earnings from Mary Kay. The couple also acknowledged that NSD Interests had no income in 2006, 2007, and 2008, and the income reported on the entity's returns should have been reported on the couple's joint returns. Christine and Roger argued that the distributions they received in 2009 under the FSP and GFP agreements were not subject to self-employment tax.
The Tax Court held that NSD Interests was not entitled to deduct the retirement plan contributions for 2006, 2007, and 2008 because the partnership was not engaged in a trade or business. However, the court found that Christine could deduct the retirement plan contributions to the CP Plan for the three years in issue. Christine was engaged in carrying on a Mary Kay business and was designated the employer when she formed the CP Plan. Although the plan was subsequently amended to designate NSD Interests as the employer, Christine (i.e. a predecessor who maintained the plan) was an employer pursuant to the plan and the retirement contributions were expenses that would be deductible under Code Sec. 162.
The court also held that the post-retirement 2009 distributions under the FSP and the GFP deferred compensation agreements were subject to self-employment tax. Before her retirement, Christine was engaged in a trade or business. Under the two agreements, Christine's distributions were based on her average commissions before her retirement, the volume of wholesale purchases by her network, and her age at retirement. Thus, the court concluded that the distributions were derived from her trade or business. Moreover, the agreements expressly provided that the distributions would be deferred compensation.
For a discussion of the employer deduction for contributions to a qualified plan, see Parker Tax ¶132,100.
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Entrepreneur's Sale of Company Preferred Stock Results in Ordinary Income
Income received by a taxpayer's S corporation in a Code Sec. 351 transaction with its subsidiary under a stock purchase agreement is reclassified as ordinary income under Code Sec. 1239 because the taxpayer's S corporation and its subsidiary were related persons for purposes of Code Sec. 1239. Fish v. Comm'r., T.C. Memo. 2013-270 (11/25/13).
In 1996, Gary Fish, a systems architect, started a technology business. Two years later, he incorporated the business, FishNet Consulting, Inc., as an S corporation. To find additional capital as his business grew, Gary retained a financial adviser to evaluate potential financial partners and possible sale of the company. In a letter of intent dated September 2004, private equity firm Edgewater Funds offered to purchase newly created preferred stock in FishNet Consulting representing 43 percent of the company's outstanding equity. In November 2004, Gary formed Fish Holdings, Inc., an S corporation. In a tax-free reorganization under Code Sec. 368(a)(1)(F), Gary contributed all his FishNet Consulting common stock to Fish Holdings in a Code Sec. 351 transaction. FishNet Consulting and Fish Holdings then executed Form 8869, Qualified Subchapter S Subsidiary (QSub) Election, to treat FishNet Consulting as a QSub. As a result of the QSub election, FishNet Consulting was treated as liquidating into Fish Holdings. In December 2004, Gary and Edgewater signed an agreement for Edgewater's purchase of the newly created preferred stock in FishNet Consulting. FishNet Consulting changed its name to FishNet Security and authorized the issuance of common and preferred stock. Each share of common and preferred stock was entitled to one vote. Its amended articles of incorporation provided certain restrictions: (1) the company could not engage in certain actions without prior consent of a majority of preferred shareholders, and (2) the common shareholders elected three out of the five board of directors, with one of the three directors being independent. The creation of preferred stock terminated FishNet Consulting's S corporation status and QSub election.
FishNet Security paid one-time dividends to Fish Holdings of (1) $2.5 million, and (2) $9,463,000, the sale proceeds from the stock purchase agreement. In the transaction, Fish Holdings was deemed to have contributed all the assets and liabilities of FishNet Consulting (the QSub) to FishNet Security (the newly created C corporation) in exchange for common stock and cash (the sale proceeds from the purchase agreement). The transaction was tax-free to the parties with respect to the stock, but the cash proceeds were taxable boot to Fish Holdings. After closing the purchase agreement, Fish Holdings owned all of FishNet Security's common stock and Edgewater owned all its preferred shares.
On Form 4562, Depreciation and Amortization, attached to its 2005 Form 1120, U.S. Corporation Income Tax Return, FishNet Security reported Code Sec. 197 intangible and depreciable assets and claimed amortization and depreciation deductions. On its 2005 Form 1120S, U.S. Income Tax Return for an S Corporation, Fish Holdings reported the $9,463,000 dividend distribution as long-term capital gain and that characterization flowed through to Gary's individual tax return. The IRS determined that the dividend distribution was ordinary income to Gary.
Code Sec. 1239 provides that gain on the sale or exchange of property that is depreciable to the transferee is treated as ordinary income if the transaction is directly or indirectly between related taxpayers. An amortizable Section 197 intangible is treated as property subject to depreciation. Related taxpayers include a person and an entity that person controls. A controlled entity is defined as a corporation more than 50 percent of the value of the outstanding stock of which is owned, directly or indirectly, by or for such person.
Observation: The recharacterization of gain under Code Sec. 1239 applies only to gain that is recognized. Thus, in the case of a tax-free exchange, the rule applies only to the extent of any gain recognized on the exchange.
Code Sec. 1563 defines a controlled group as one or more corporations connected through stock ownership with a common parent corporation if the common parent owned either (1) more than 50 percent of the total combined voting power of all classes of stock entitled to vote or (2) more than 50 percent of the total value of shares of all classes of stock of the other corporations.
To apply Code Sec. 1239 to the distribution of sale proceeds from FishNet Security to Fish Holdings, the Tax Court had to determine whether Fish Holdings and FishNet Security were related persons for purposes of Code Sec. 1239. Specifically, the court was asked to decide whether Fish Holdings owned either more than 50 percent of the total combined voting power of all classes of FishNet Security's stock entitled to vote or more than 50 percent of the total value of shares of all classes of FishNet Security's stock.
The Tax Court held that Fish Holdings and FishNet Security were related persons under Code Sec. 1239(b) and the dividend distribution to Fish Holdings and reported by Gary was taxable as ordinary income. After the stock purchase agreement closed, Fish Holdings owned all of FishNet Security's common stock, which was two-thirds of the outstanding shares of stock entitled to vote. Thus, on the basis of record ownership, Fish Holdings owned more the 50 percent of FishNet Security's voting stock. The court cited Hermes Consol., Inc. v. U.S., 14 Cl. Ct. 398 (1988), which found that voting power includes the ability to approve or disapprove fundamental changes in the corporate structure and elect the corporation's board of directors. In this case, Fish Holdings had 50 percent voting power with respect to fundamental corporate changes and could elect 60 percent of the FishNet Security's board. The independence requirement for the one director was not a restriction that reduced its voting power below 50 percent since Fish Holdings was the only shareholder entitled to elect the independent director.
According to the court, the basis for FishNet Security's valuation of the Code Sec. 197 intangibles for purposes of the stock purchase agreement was the goodwill created by Gary. Moreover, Gary continued to have primary control of the company's business after purchase agreement closed. The court also found that Fish Holdings owned more than 50 percent of total value of shares of all classes of FishNet Security's stock at the time the purchase agreement closed. The court relied on the use of the preferred stock's redemption price by the IRS's expert as the appropriate valuation of the preferred stock. Thus, under the voting power and valuation control tests of Code Sec. 1563(a)(1), the court concluded that Fish Holdings and FishNet Security qualified as related persons for purposes of Code Sec. 1239, and the distribution to Fish Holdings was ordinary income to Gary.
For a discussion of the special rules relating to the characterization of gain on sales of depreciable property between related persons, see Parker Tax ¶119,105.
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IRS Failed to Show that Dual Resident's Center of Vital Interests Were in the U.S.
The IRS failed to establish that a dual resident's center of vital interests was in the United States for tax purposes and that he was thus taxable as a U.S. resident. Escobedo v. U.S., 2013 PTC 367 (S.D. Cal. 11/14/13).
In 2005 and 2006, Federico Escobedo was a resident of both the United States and Mexico and maintained permanent homes in both counties. He timely filed a Form 1040, U.S. Individual Income Tax Return, for 2005 and 2006. In 2009, Federico filed amended Forms 1040, claiming refunds for all taxes paid for 2005 and 2006. He asserted that he was entitled to a refund because he should have been considered a resident of Mexico for tax purposes and thus not taxed on his worldwide income. The IRS denied Federico's refund claims. Federico filed suit in a district court and the IRS filed a motion for summary judgment.
The U.S.-Mexico bilateral treaty governs the tax liability of dual residents for federal income tax purposes. The tax treaty provides that where an individual is a resident of both the United States and Mexico, his residence and where he pays income tax, is determined by (1) where he has a permanent home; (2) where his personal and economic relations are closer (center of vital interests); or (3) where he has a habitual abode.
The IRS argued that Federico was properly considered a U.S. resident for tax purposes as his center of vital interests and habitual abode was in the United States.
A district court held that genuine issues of material fact existed as to whether Federico's center of vital interests was in the United States for tax purposes. The court looked to the model treaty of the Organization of Economic Cooperation and Development (OECD), which stated that if an individual has a permanent home in both countries, preference will be given to the one where economic and personal relations of the individual are closer. Factors such as family and social relations, occupation, political and cultural activities, and place of business demonstrate where the individual has retained his centers of vital interest.
During the years in issue, Federico did not dispute that he lived with his partner and three children in the United States and that he owned several homes and other personal property in the United States. His children attended U.S. universities and he received medical services in the United States. However, the court observed that the consideration of personal relations was only one factor in the center of vital interests determination.
Federico was an investor and manager of several businesses in Mexico, which he oversaw and directed. The IRS presented no authority that Federico's oversight did not constitute economic activity regarding the center of vital interests determination. Thus, the court said that there were genuine of issues of material fact with respect to Federico's economic relations within the United States and rejected the IRS's request for summary judgment.
For a discussion of U.S. taxation of U.S. citizens and resident aliens, see Parker Tax ¶200,100.
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Termination of Nonexempt Welfare Benefit Plan Results in Taxable Distributions
Because the underlying policies of a terminated welfare benefit plan owned by the taxpayers were substantially certain to be distributed to them or placed within their control, the value of the policies were includible in the taxpayers' income. Gluckman v. Comm'r, 2013 PTC 371 (2d Cir. 11/22/13).
Thomas Gluckman and his wife, Roby, were employees and majority shareholders of Fownes Brothers & Co., Inc. a clothing accessories manufacturer. Thomas was president and director of Fownes. In December 1999, Fownes, at the direction of the Gluckmans, adopted the Advantage Death Benefit Plan and Trust (i.e., the Advantage Plan), a 10-or-more-employer welfare benefit plan under Code Sec. 419A(f)(6), which offered preretirement life insurance to employees on a tax deductible basis. The plan was not a tax-exempt trust. As of 2000, the Gluckmans were both covered employees. The Advantage Plan was terminated by the plan administrator, BISYS Insurance Services, Inc., effective December 31, 2003. Before that time, Fownes submitted on October 24, 2003, corporate resolutions authorizing a complete distribution of the policies to take effect on November 28, 2003. The resolution was signed by affected participants, including the Gluckmans, each of whom waived the right to purchase the underlying policies.
On December 17, 2003, Thomas signed an agreement providing that Fownes would participate in the Millennium Multiple Employer Welfare Benefit Plan, another 10-or-more-employer welfare benefit plan. The change-of-ownership forms listed the Millennium Plan as the new owner of the insurance policies, as of January 22, 2004. On February 9, 2004, the issuing insurance company acknowledged the change of ownership, and BISYS notified taxpayers that they would be receiving information about their tax obligations in connection with the termination from the Advantage Plan. The Gluckmans did not include as income in 2003 the value of the underlying life insurance policies. The IRS determined that the Gluckmans' interest in the policies was substantially vested and, under Code Sec. 402(b)(1), was required to be included in income. The IRS also assessed and accuracy-related penalty under Code Sec. 6662.
The Tax Court agreed with the IRS and held that once Fownes authorized withdrawal from the Advantage Plan, the underlying policies were substantially certain to be distributed to the Gluckmans or placed within their control, and, more importantly, were placed within the Gluckmans' control no later than early November 2003. The Tax Court rejected the Gluckmans' argument that the policies were at all times owned by a welfare benefit plan and subject to a substantial risk of forfeiture, as well as the argument that the Fownes board of directors, not the Gluckmans, had control over the disposition of the policies. The Gluckmans appealed.
The Second Circuit affirmed the Tax Court's decision. The court noted that, after Fownes withdrew from the Advantage Plan, BISYS provided Fownes, which was controlled by the Gluckmans, with the change-of-ownership and change--f beneficiary forms, giving the Gluckmans the ability to name themselves or another welfare benefit plan as the owner and beneficiary of the underlying policies. According to the court, the fact that the Gluckmans chose to name a different welfare benefit plan as the new owner of the policies did not negate the fact that the Gluckmans had the ability to name themselves or anyone else as owners. The Gluckmans did not establish that anyone else exercised or could have exercised authority over the use or distribution of the policies following the formal termination from the Advantage Plan. The court agreed with the Tax Court that, in October of 2003, the policies were not subject to a substantial risk of forfeiture.
Finally, the Second Circuit observed that, although the Gluckmans could have rebutted the assessment of the penalty by providing evidence that the underpayment was made in good faith and with reasonable cause, they produced no such evidence. As a result, the court also upheld the penalty assessment.
For a discussion of the taxation of distributions from non-exempt employee trusts, see Parker Tax ¶135,505.
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Cigarette Stamp Tax Not Excludible from Gross Receipts; UNICAP Rules Apply
A company could not exclude from its cigarette gross receipts the part of the sale price attributable to the cost of the cigarette stamp tax and, as a result, the company failed to prove that its average annual gross receipts for the three-tax-year period did not exceed $10 million for any of the years at issue; thus the company was subject to the uniform capitalization rules of Code Sec. 263A. City Line Candy & Tobacco Corporation, 141 T.C. No. 13 (11/19/13).
City Line Candy & Tobacco Corporation, an accrual method taxpayer, is a reseller and licensed wholesale dealer of cigarettes in New York. Under New York law, all cigarettes possessed for sale must bear a stamp issued by the New York tax commissioner. Pursuant to this law, City Line Candy & Tobacco, a licensed cigarette stamping agent for New York, buys cigarette packs for sale, purchases and affixes cigarette tax stamps to those cigarette packs, and sells the stamped cigarette packs to subjobbers and retailers in New York City and throughout New York. Under New York law, City Line Candy & Tobacco is required to include, and did include, the cost of the cigarette tax stamps in the sale price of the cigarettes.
In computing its gross receipts from cigarette sales for financial statement purposes, City Line Candy & Tobacco totaled the gross sale prices of the cigarettes sold during each year. However, for income tax reporting purposes, City Line Candy & Tobacco adjusted its gross receipts from cigarette sales by subtracting the approximate cost of cigarette tax stamps purchased during the fiscal year and reporting as its gross receipts the resulting net amount. City Line Candy & Tobacco argued that its average annual gross receipts (determined for income tax reporting purposes) for the three-tax-year period ending with the tax year preceding each of the years in issue did not exceed $10 million. Thus, City Line Candy & Tobacco argued that it qualified for the small reseller exception under Code Sec. 263A(b)(2)(B) for each of the years in issue and consequently was not required to comply with the uniform capitalization (UNICAP) rules of Code Sec. 263A with respect to the cigarettes it acquired for resale.
In a notice of deficiency, the IRS determined that City Line Candy & Tobacco had underreported its gross receipts for its each of its 2004 through 2006 fiscal years in an amount approximately equal to the cost of the cigarette tax stamps purchased during that tax year. Consequently, the IRS determined that City Line Candy & Tobacco had additional gross receipts of almost $6 million, $5 million, and $5 million for 2004, 2005, and 2006, respectively. As a result of the adjustments to City Line Candy & Tobacco's gross receipts, the IRS also determined that the company's average annual gross receipts for the three-taxable year period ending with the tax year preceding each of the 2004-06 tax years exceeded $10 million; therefore the company was subject to the UNICAP rules of Code Sec. 263A. Under the UNICAP rules, City Line Candy & Tobacco was required to include a portion of certain direct and indirect costs in inventory costs. The IRS classified the cigarette tax stamp costs as general and administrative costs and determined City Line Candy & Tobacco's costs for handling and storage, purchasing, general and administrative, and indirect costs.
Using the simplified resale method without historic absorption (simplified resale method), the IRS determined that City Line Candy & Tobacco had additional Code Sec. 263A capitalizable costs for 2004, 2005, and 2006 of approximately $6,000, $4,000, and $6,000, respectively. The IRS calculated the additional Code Sec. 263A capitalizable costs as the product of the combined absorption ratio and City Line Candy & Tobacco's purported Code Sec. 471 costs at the end of the year.
The IRS also determined that City Line Candy & Tobacco had to increase its inventory costs for 2004, 2005, and 2006 by approximately $252,000, $191,000, and $246,000, respectively. The IRS arrived at these additional amounts by adding the additional Code Sec. 263A costs for each year and City Line Candy & Tobacco's purported Code Sec. 471 costs for each year. The IRS then added the amount of the increase to the company's ending inventory to calculate its adjusted ending inventory for each of the tax years in issue.
The Tax Court held that the IRS correctly determined City Line Candy & Tobacco's gross receipts on the basis of the entire sale price of the cigarettes it sold, including that part of the sale price attributable to the cost of the cigarette tax stamps. As a result, the court said that City Line Candy & Tobacco is subject to the UNICAP rules of Code Sec. 263A because it failed to prove that its average annual gross receipts for the three-taxable-year period ending with the tax year preceding each of the years in issue, correctly calculated to include the entire sale price of the cigarettes it sold, did not exceed $10 million for any of those years. The court also concluded that the cigarette tax stamp costs were indirect costs that had to be capitalized under the UNICAP rules and such costs are handling costs that the IRS properly allocated, in part, to City Line Candy & Tobacco's ending inventory using the simplified resale method.
For a discussion of the uniform capitalization rules, see Parker Tax ¶242,380.
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Fourth Circuit Upholds Four-Year Prison Term for Former Corrections Officer Turned Tax Preparer
The four-year prison sentence handed down to a former corrections officer turned tax return preparer was appropriate in light of the estimated $2.1 million tax loss he caused to the government. Ukwu v. U.S., 2013 PTC 370 (4th Cir. 11/22/13).
Obinna Ukwu was a Maryland corrections officer. In 2006, he started an accounting business as side business. The business offered tax return preparation services, and Obinna operated the business until midway through 2010, when his legal problems began. In the intervening years, business boomed in 2006, his revenue was roughly $8,000, but by 2009, it soared to $175,000.
A criminal investigation in 2010 revealed that Obinna claimed fictional business losses in order to garner tax benefits. At trial, the vast majority of clients testified that these losses were entirely false and that they were not aware that Obinna had invented the numbers on their returns. Obinna also claimed false charitable deductions on his clients' forms. He committed tax fraud on his own income taxes, filing a joint return for his wife and himself, but also filing a separate individual return for his wife under a different name. Finally, Obinna took fees from his clients' bank accounts and refund checks without notifying them.
Obinna was convicted of 12 counts of aiding and assisting in the preparation of false income tax returns under Code Sec. 7206(2) and was sentenced to 51 months in prison. In estimating the amount of tax loss caused by Obinna, the IRS analyzed a non-random sample of returns at trial and found that 90 percent of the Schedule C losses were entirely false. Then, investigators used a random sample to confirm this estimate, reasoning that since the random sample bore the same patterns as the nonrandom sample, the two samples likely contained similar levels of fraud. That is, since the random sample looked like the non-random one, and since 90 percent of returns in the nonrandom sample were completely false, then 90 percent of the random sample was also likely to be completely false. The IRS used this 90 percent number to calculate Obinna's tax loss estimate. The investigators could establish that among the 1000 returns where a Schedule C loss was claimed, Obinna claimed roughly $16.4 million in Schedule C losses. If 90 percent of these losses were entirely fabricated, that meant that roughly $14.6 million of false losses were claimed. Assuming the lowest marginal tax rate of 10 percent, and factoring in state tax losses, the estimated tax loss was roughly $2.1 million. Because this estimate was between $1 million and $2.5 million, the district court concluded that Obinna merited a base offense level of 22 and, thus, a prison term of 51 months.
Obinna appealed, arguing that the district court erred when it estimated the amount of tax loss used to calculate his prison sentence. He argued that the samples used were too small, that it was an error to rely on the non-random sample of returns, and that the IRS never established that the $14.6 million in Schedule C losses were totally fraudulent, rather than partially fraudulent.
The Fourth Circuit affirmed Obinna's sentence. The court noted that the district court did not have to calculate the amount of tax loss with a pharmacist's precision; the sentencing guidelines require only a reasonable estimate. Further, the district court may consider any relevant information regardless of its admissibility, provided that the information is sufficiently reliable. The sentencing court faced a difficult problem because of the sheer size of Obinna's potential fraud. He prepared roughly 1,000 tax returns that reported business losses, the court stated, but the sentencing court and the IRS did not have time to audit each return, interview each taxpayer, and identify the extent of Obinna's crimes. In the end, the court concluded that Obinna's arguments failed because the government need only make a reasonable estimate of the tax loss, and the methodology used, though imperfect, met that standard.
For a discussion of the penalties for making false and fraudulent statements on tax returns, see Parker Tax ¶265,125.
