Home Builder Triumphs over IRS; Tax Court Allows Deferral of Millions

A recent Tax Court decision is good news for home builders and real estate developers who seek to defer profits on a long-term contract. Such taxpayers often battle with the IRS over the amount of profits includible in income in any given year. For taxpayers using the percentage of completion accounting method, the battle often centers on the percentage of the contract completed. For taxpayers using the completed contract method of accounting, the battle often centers on whether the builder or developer meets the requirements for using that method and when the contract is considered completed. In Shea Homes, Inc. and Subs. v. Comm'r, 142 T.C. No. 3 (2014), a case involving one of the largest private homebuilders in the United States, the taxpayer successfully argued that it could defer profits under the completed contract method on home sales in a planned community until 95 percent of that community, including common improvements and amenities, was completed and accepted. As a result, the taxpayer was able to defer taxes on millions in profits.

Facts

Shea Homes, Inc. and Subsidiaries (SHI), is an affiliated group of corporations with SHI being the common parent. Shea Homes Limited Partnership (SHLP) is a limited partnership and J F Shea, LLC (JFLP), is the tax matters partner of SHLP. Other related businesses include Vistancia, LLC (Vistancia), a limited liability company, and Shea Homes Southwest, Inc. (SHSI), the tax matters partner of Vistancia.

SHI, SHLP, and Vistancia are builders/developers of planned communities, ranging in size from 100 homes to more than 1,000 homes in Colorado, California, and Arizona. During 2004 and 2005, they sold homes in 114 developments. SHI, SHLP, and Vistancia advertise that they provide their customers with more than just the "bricks and sticks" of a home and emphasize the features and lifestyle of the community to potential buyers. The costs incurred in their home construction businesses include: (1) acquisition of land; (2) financing; (3) municipal and other regulatory approvals of entitlements; (4) construction of infrastructure; (5) construction of amenities; (6) construction of homes; (7) marketing; (8) bonding; (9) site supervision and overhead; and (10) taxes. Their primary source of revenue from the home development business is from the sale of houses.

SHI, SHLP, and Vistancia constructed their developments in a sequence of stages consisting of: (1) grading land; (2) initial construction of amenity and infrastructure common improvements; (3) construction of homes; and (4) construction and finalization of any remaining common improvements. The amount of time it took to grade the land and initially construct the amenities and common infrastructure varied with the size, surface and subsurface condition, and nature of the development.

SHI, SHLP, and Vistancia charged a single price for their homes. They did not charge separate prices for the home, the lot, improvements to the lot, infrastructure and amenity common improvements, financing, fees, property taxes, labor and supervision, architectural and environmental design, bonding, or any other costs. Before the buyer and seller could close escrow on a home, SHI, SHLP, and Vistancia were required to either construct all common improvement areas for the development (or phase) or post a bond. Therefore, in some instances the buyers were required to pay the full contract price before all of the common improvements and amenities promised for that development were completed.

To monitor operational performance and income tax compliance, SHI, SHLP, and Vistancia divided the total incurred direct and indirect costs by the total budgeted direct and indirect costs. Their tax departments made relevant adjustments to reflect what it considered to be the requirements of Code Sec. 460. If the incurred costs were equal to or greater than 95 percent of the budgeted costs, then the businesses reported income for that tax year from homes that had closed in escrow up to that date. If the incurred costs did not exceed 95 percent, then any income from homes that closed in escrow that year was deferred.

All the businesses use the accrual method of accounting. During the years at issue, SHI, SHLP, and Vistancia used the completed contract method of accounting to defer revenue, costs of sales, and income from sales of homes that closed in escrow. The businesses then recognized part of that income for federal income tax purposes in the following years.

The IRS included in income the amounts SHI, SHLP, and Vistancia deferred using the completed contract method and assessed a deficiency as a result.

Accounting for Long-Term Contracts

Code Sec. 460 governs how taxpayers report income from long-term contracts. It generally provides that taxpayers who receive income from long-term contracts must account for that income through the percentage of completion method. This method essentially requires a taxpayer to recognize income and expenses throughout the duration of a contract. However, home construction contracts are excepted from this rule and, under Code Sec. 460(e), income from such contracts may be accounted for under the completed contract method.

Under Code Sec. 460(f)(1), a long-term contract is any contract for the manufacture, building, installation, or construction of property if such contact is not completed within the tax year the contract is entered into. While the statute does not define completion, which is determined on a contract-by-contract basis, Reg. Sec. 1.460-1(c)(3) provides that a contract is completed when it first meets one of two tests. These tests are commonly known as the (1) use and 95 percent completion test, and (2) the final completion and acceptance test.

Under the first test, the contract is completed upon use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95 percent of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer. Under the second test, the contract is completed upon final completion and acceptance of the subject matter of the contract. In this case, the determination of whether final completion and acceptance has occurred depends on all the relevant facts and circumstances.

Home Construction Contracts

As previously noted, while the percentage completion method is generally required for long-term contracts, there is an exception for home construction contracts. Under Code Sec. 460(e), income from home construction contracts may be accounted for under the completed contract method. Generally, a taxpayer using the completed-contract method to account for a long-term contract must take into account in the contract's completion year the gross contract price and all allocable contract costs incurred by the completion year.

A contract is a home construction contract if the taxpayer (including a subcontractor working for a general contractor) reasonably expects to attribute 80 percent or more of the estimated total allocable contract costs (including the cost of land, materials, and services), determined as of the close of the contracting year, to the construction of (1) dwelling units in buildings containing four or fewer dwelling units (including buildings with four or fewer dwelling units that also have commercial units); and (2) improvements to real property directly related to, and located at the site of, the dwelling units.

Under Reg. Sec. 1.460-3(b)(2)(iii), a taxpayer includes in the cost of the dwelling units their allocable share of the cost that the taxpayer reasonably expects to incur for any common improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that the taxpayer is contractually obligated, or required by law, to construct within the tract or tracts of land that contain the dwelling units.

Taxpayer and IRS Arguments

For the purpose of determining whether a contract qualifies as a home construction contract, Reg. Sec. 1.460-3(b)(2)(iii) makes it clear that the taxpayer includes, for purposes of the 80 percent test, costs attributable to common areas. However, SHI and the IRS disagreed as to whether that regulation affected the tests that determine when the taxpayer completes the contract for the purposes of deciding whether the contract is a long-term contract.

Under the IRS's interpretation of the completed contract method, SHI, SHLP, and Vistancia should have reported income from their long-term contracts for the years in which the contracts closed in escrow. According to the IRS, the subject matter of the contract is the home and the lot upon which it sits. Consequently, each contract is completed, within the meaning of Code Sec. 460, in the year in which escrow closes.

According to SHI, SHLP, and Vistancia, the subject matter of the contracts is broader and encompasses the entire development or, in some instances of larger developments, the development phase of which the home is a part. In support of that position, they argued that a contract comprises all documents provided to the buyer, any documents expressly referenced therein or incorporated therein by law, and easements, restrictions, and other documents recorded as encumbrances on a home purchaser's title. They asserted that these documents collectively set forth the rights and obligations of the buyer and seller. Therefore, other than secondary items if any, the final completion and acceptance does not occur until the final road is paved and the final bond is released. As a result, the use and 95 percent completion test is met first when SHI, SHLP, and Vistancia incur 95 percent of the phase's or development's costs. SHI, SHLP, and Vistancia argued that because the 80 percent test for a home construction contract includes the allocable share of the costs of common improvements, the 95 percent test also must include these costs.

The IRS urged an alternative theory that said that, if the Tax Court held that the subject matter of the contracts is broader than the house and the lot, the court must apply the 95 percent completion test without regard to the costs attributable to common improvements because they are secondary items. However, according to SHI, SHLP, and Vistancia, these common improvements are part of the primary subject matter of the contract, not secondary items, and they may include such allocable costs in applying the 95 percent test.

Tax Court's Analysis

The Tax Court began by analyzing which documents are considered part of the contracts. The court concluded that the purchase and sale agreement did not alone serve as the exclusive embodiment of the entire agreement between the parties. Buyers of homes from SHI, SHLP, and Vistancia, the court noted, are consciously purchasing more than the "bricks and sticks" of the home. The purchase and sale agreement specifically includes a checklist ensuring that the purchaser receives other related documents. The court also observed that purchasers of homes in the developments were conscious of the elaborate amenities and would have understood that the price they paid for a home included the amenities of the development.

Further evidence that SHI, SHLP, and Vistancia were obligated to their lot purchasers for much more than the purchase and sale agreement sans amenities, the court said, was the hefty performance bonds that were required by state and municipal law in order to secure the builder's performance with respect to the completion of the common improvements in each development. For the performance bonds to be exonerated, the obligees had to approve the completion of the amenity subject matter. Homeowners associations in each of the developments, as well as the municipalities and states in which the developments were situated, were identified as obligees in the performance bonds. Purchasers of homes automatically became members in the homeowners association.

The Tax Court rejected the IRS's view that the subject matter of the contract consisted solely of the house, the lot, and improvements to the lot, noting that Reg. Sec. 1.460-3(b)(2) explicitly acknowledges that the subject matter of a home construction contract extends beyond the construction of a home.

The Tax Court also rejected the IRS's contention that the costs not directly associated with the houses, the lots, and improvements to the lots were secondary items under Reg. Sec. 1.460-1(c)(3)(ii) and thus the homebuilders were forbidden from taking those items into account in determining the contract completion date. The court noted that the term "secondary items" is not defined in the regulations and that the determination of what constitutes a secondary item is resolved by reference to the facts and intent of the contracting parties. The court again agreed with the homebuilders' view that because the contracts were about the lifestyle, including access to the planned community, the amenities, and the infrastructure, this meant to the court that the common improvements were part of the primary subject matter of the contract.

The court concluded that the contract documents consisted of much more than just the purchase and sale agreement. This conclusion led the court to hold that SHI, SHLP, and Vistancia appropriately included the costs of common improvements in determining the contract completion date. Further, the nature of the business and the contract documents also led the court to conclude that the common improvements were not secondary items and did not have to be accounted for separately.

[Return to Table of Contents]

Complying with Court Order Wasn't Good Enough to Get Dependency Deduction or Child Tax Credit

For a noncustodial parent to take a dependency exemption deduction or child tax credit for a child, the parent must jump through numerous hoops. Just having a divorce decree or support order that states that the noncustodial parent is entitled to the deduction or credit is not enough. Several cases have illustrated this and another one was decided this week.

In Swint v. Comm'r, 142 T.C. No. 6 (2/24/14), the Tax Court disregarded the terms of a state court support order that provided that the noncustodial parent was entitled to a dependency exemption deduction and child tax credit as long as he stayed current with his child support obligations. The problem was that the court entry was not signed by either party to the order, and the release of the dependency exemption deduction by the child's custodial parent was conditional. As a result, the Tax Court agreed with the IRS that, because there was no written unconditional declaration from the custodial parent that she would not claim the child as a dependent, the noncustodial parent was precluded from taking the dependency deduction and child tax credit.

Practice Tip: Practitioners with noncustodial parents relying on court orders granting dependency deductions or other tax benefits should inquire as to whether the custodial parent has signed a nonconditional document granting such tax benefits. For tax years beginning on or after July 2, 2008, it's imperative that the noncustodial parent have a Form 8332, or a written statement meeting all of the Form 8332 requirements, signed by the custodial parent.

Background

Lisa Swint was married to Tommy Swint. Before marrying Lisa, Tommy had a child with Tonia Wilson. An agreed entry between Tommy and Tonia was filed in February 1998 by the Juvenile Division of an Ohio court. With respect to the dependency exemption deduction, the agreed entry provided that Tommy would be entitled to the dependency exemption deduction for the child, but that failure to keep current with his support obligations would result in a forfeiture of that right until such time as the arrearages were eliminated. The agreed order was not signed by Tommy or Tonia.

Lisa and Tommy filed a joint federal income tax return for 2009 claiming a dependency exemption deduction and a child tax credit for Tommy's child with Tonia. Tommy subsequently died in 2010. The IRS disallowed the deduction and credit for Tommy's child because, according to the IRS, the child was not a "qualifying" child of Tommy's.

Special Rule for Divorced Parents Claiming Dependency Exemption

In the case of divorced or separated parents, Code Sec. 152(e) provides a special rule to determine which parent is entitled to a dependency exemption deduction for a child. Generally, a child who is in the custody of one or both parents for more than one-half of the calendar year, and who receives more than one-half of his or her support from parents who are divorced or separated or who live apart at all times during the last six months of the calendar year, is considered the qualifying child of the custodial parent. The custodial parent is defined as the parent having custody for the greater portion of the calendar year. The noncustodial parent is defined as the parent who is not the custodial parent. In Tommy's case, his minor child did not live with him and, thus, Tommy was the noncustodial parent.

Under Code Sec. 152(e), a child is treated as a qualifying child of the noncustodial parent rather than of the custodial parent when certain requirements are met. One of the requirements for the child to be the qualifying child of the noncustodial parent is that the custodial parent must sign a written declaration (in such manner and form as IRS regulations prescribe) that the custodial parent will not claim the child as a dependent for any tax year beginning in such calendar year. The declaration must be made either on a completed Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, or on a statement conforming to the substance of Form 8332.

For tax years beginning on or after July 2, 2008, Reg. Sec. 1.152-4(e)(1)(ii) provides that a court order signed by the custodial parent does not satisfy the applicable requirements for a noncustodial parent to take a dependency exemption. However, the regulations provide a transition rule that creates a carve-out to this rule. A written declaration executed in a tax year beginning on or before July 2, 2008, that satisfies the requirements for the form of a written declaration in effect at the time the written declaration is executed, will be treated as meeting the applicable requirements.

Form 8332 requires a taxpayer to furnish the name of the child; the name and social security number of the noncustodial parent claiming the dependency exemption deduction; the social security number of the custodial parent; the signature of the custodial parent; the date of the custodial parent's signature; and the years for which the claims were released.

IRS and Taxpayer Positions

Lisa argued that the agreed entry filed February 13, 1998, sufficed as a written declaration conforming to the substance of Form 8332. The IRS countered that divorce decrees, or comparable documents, do not suffice for the purposes of a written waiver by Form 8332 or a substantially conforming document under Code Sec. 152(e).

Tax Court's Analysis

The Tax Court began its analysis by noting that, as February 13, 1998, there was no prohibition on using a court order, decree, or separation agreement as a written declaration for purposes of Code Sec. 152(e). The court noted that a court order or decree or a separation agreement entered before July 2, 2008, could be a written declaration if it satisfied the other requirements in effect at the time of the entry. The agreed entry was filed on February 13, 1998. Therefore, the court had to determine whether the agreed entry satisfied the requirements of a written declaration that were in effect as of February 13, 1998.

As of February 13, 1998, Code Sec. 152(e)(2)(A) provided that the noncustodial parent could claim the dependency exemption deduction if the custodial parent signed a written declaration (in such manner and form as IRS regulations prescribed) that the custodial parent would not claim the child as a dependent for the tax year. Satisfying the signature requirement is critical, the court observed, to the successful release of the dependency exemption within the meaning of Code Sec. 152(e)(2). In the instant situation, the court concluded that because there was no signature on the agreed entry, the signature requirement was not satisfied.

Further, the court noted that the language, "will not claim," is unconditional. As a result, in order for a written declaration to comply with Code Sec. 152(e)(2)(A), the declaration by the custodial parent that he or she "will not claim such child as a dependent" must also be unconditional. The agreed entry provided that Tommy would be entitled to claim the minor child only if he was current in his child support obligations. If Tommy were not current on those obligations, then Tonia would have been entitled to claim the minor child. The release of the dependency exemption deduction by Tonia in the agreed entry was conditional. Accordingly, the Tax Court held that the declaration in the agreed entry did not satisfy the unconditional declaration requirement.

As a result, the Tax Court concluded that, because the written declaration at issue was not signed by the custodial parent and was not unconditional, it did not meet the requirements for a written declaration that were in effect on or before July 2, 2008. Therefore, Lisa was not entitled to a dependency exemption deduction or a child tax credit for the child.

[Return to Table of Contents]

IRS Updates Procedure for Elections under New Capitalization Rules

The IRS issued a revised version of Rev. Proc. 2014-16, relating to procedures for electing changes in method of accounting relating to the final capitalization rules, which contains some clarifications to an earlier released version of the procedure. Rev. Proc. 2014-16.

Last September, the IRS issued final regulations that address when amounts paid to acquire, produce, or improve tangible property must be capitalized. The final regulations are generally effective for tax years beginning on or after January 1, 2014, but may be adopted for earlier years under certain circumstances. There are many favorable methods and safe harbors in the final capitalization regulations that taxpayers may want to adopt. To do so, however, taxpayers must file for an accounting method change. While the IRS is granting automatic consent to change to many of these new methods, Form 3115, Application for Accounting Method Change, must still be filed and the appropriate procedures followed. Generally, the procedures to be filed for accounting method changes are contained in Rev. Proc. 2011-14. In January, the IRS issued an advanced version of Rev. Proc. 2014-16, which advised taxpayers on the procedures for making such accounting method changes. Rev. Proc. 2014-16 modifies the procedures in Rev. Proc. 2011-14.

The IRS has now published Rev. Proc. 2014-16 in the Internal Revenue Bulletin dated February 24, 2013. This newer version of Rev. Proc. 2014-16 contains some clarifications that were not in the earlier version.

Specifically, the revised version contains a clarification that taxpayers should not net the Code Sec. 481(a) changes when submitting a Form 3115 for more than one accounting method change under the new capitalization regulations. The earlier version of Rev. Proc. 2014-16 provided a change to the Appendix of Rev. Proc. 2011-14 that said that:

A taxpayer that wants to make one or more changes in method of accounting pursuant to this section 10.11 of the APPENDIX relating to the same identified unit of property or, in the case of a building, the same identified building structure or building system should file such change on the same Form 3115 and provide a single section 481(a) adjustment for all the changes related to the identified property. If one or more changes related to the identified property generate a negative section 481(a) adjustment and other changes related to the same identified property generate a positive section 481(a) adjustment, the taxpayer may provide a single negative section 481(a) adjustment for all the changes related to the identified property generating such negative adjustment and a single positive adjustment for all the changes related to the identified property generating such positive adjustment.

The revised version of Rev. Proc. 2014-16 simply provides:

Except as provided in paragraph 10.11(6)(b) of this APPENDIX, a taxpayer changing to a method of accounting provided in Section 10.11 of this APPENDIX must apply section 481(a) and take into account any applicable section 481(a) adjustment in the manner provided in sections 5.03 and 5.04 of this revenue procedure.

The reference above to "this revenue procedure" refers to Sections 5.03 and 5.04 in Rev. Proc. 2011-14, the revenue procedure that Rev. Proc. 2014-16 is updating.

The updated procedure also clarifies, in Section 11.09(1)(a), that the change to a reasonable allocation method described in Reg. Sec. 1.263A-1(f)(4) does not apply to all property, but rather applies just to self-constructed assets.

For a discussion of the rules relating to Code Sec. 481 adjustments when changing a method of accounting, see Parker Tax ¶241,595.

[Return to Table of Contents]

Court Agrees with IRS on Valuing Estate's Closely Held Stock Using NAV Method

The valuation of closely held stock in a company whose main asset was publicly held stock was better determined using the net asset value method rather than the capitalization-of-dividends method, and a discount was appropriate for the capital gains built-in tax liability. Est. of Richmond v. Comm'r, T.C. Memo. 2014-26 (2/11/14).

At the time of her death, Helen Richmond owned a 23.44 percent interest in a family-owned personal holding company (PHC), whose assets consisted primarily of publicly traded stock. On Helen's estate tax return, the executor reported the fair market value of her interest in PHC as $3.1 million using a capitalization-of-dividends method to value the interest. The estate also reduced the valuation of the interest by the amount of built-in capital gains tax that would result from selling the stock.

The IRS assessed a deficiency, based on its alternate valuation of the stock using the net asset value (NAV) method and its rejection of any discount for the built-in capital gains tax liability. According to the IRS, no discount was appropriate because it was uncertain when, if ever, such liability would be recognized.

The Tax Court held that the fair market value of Helen's interest in PHC was better determined by using the NAV method. The court further held that a discount was appropriate for the built-in gains tax liability but not the dollar-for-dollar discount used by the estate. According to the court, the most reasonable discount was based on the present value of the cost of paying off that liability in the future.

While noting that PHC's historic rate for turning over its securities was 70 years, the court found that this 70-year assumption did not take into account PHC's unique, subjective investment goals. The court observed that PHC had received advice to diversify its portfolio (i.e., to sell stock more quickly than its 70-year trend would call for) and a rational buyer would expect a turnover period shorter than 70 years. The decision by PHC not to follow that advice was not irrational, the court said, but it was particular to PHC's subjective goals. Even assuming that the PHC management would indefinitely follow its traditional philosophy and would sell stock only at the 70-year pace, and assuming that PHC shareholders would refuse to sell at prices that presumed a shorter turnover, that refusal would not affect the fair market value of PHC, the court concluded. It would instead indicate that PHC's particular managers and owners were willing to forfeit or forgo some of PHC's fair market value in order to pursue other aims. The court concluded that a more realistic turnover period was 20 to 30 years and, applying various discounts, came up with a discount of $7.8 million.

For a discussion of the valuation of closely held stock for estate tax purposes, see Parker Tax ¶225,400.

[Return to Table of Contents]

Millions Received from Qui Tam Award Is Ordinary Income, Not Capital Gain

A taxpayer's qui tam award for bringing to light systematic fraud against the government is ordinary income and not capital gain. Patrick v. Comm'r, 142 T.C. No. 5 (2/24/14).

Craig Patrick was the reimbursement manager for Kyphon, Inc., a company that designed, manufactured, and marketed minimally invasive equipment to treat certain spinal conditions. The equipment allowed for treatment by outpatient procedure. Kyphon feared that medical providers would avoid purchasing the equipment because performing the procedure on an outpatient basis would no longer generate revenue from overnight hospital stays. Therefore, Kyphon instructed its sales representatives to market the procedure as an inpatient procedure. Certain medical providers that purchased the equipment had patients admitted when undergoing the treatment and billed this expense to the government under Medicare.

Criag and another Kyphon employee, Charles Bates, believed that Kyphon's practices violated federal law. Craig and Charles agreed to file a qui tam complaint and to split any relator's award. Craig collected various documents he had helped create during his employment that demonstrated Kyphon's practices. Criag also kept some internal Kyphon documents and external marketing material. Craig and Charles filed a qui tam complaint alleging Kyphon had defrauded the government. Kyphon eventually settled the matter for $75 million. The government intervened after Kyphon agreed to the settlement. Craig and Charles then filed additional qui tam complaints against various medical providers. Those entities also entered into cash settlements to resolve the complaints.

Observation: The phrase "qui tam" is short for a Latin phrase meaning one "who pursues this action on our Lord the King's behalf as well as his own." Congress has enacted multiple qui tam provisions, including the False Claims Act (FCA). The FCA imposes civil liability on any person who knowingly presents a false or fraudulent claim for payment or approval and authorizes a person, referred to as the relator, to file under seal a complaint seeking reimbursement on the government's behalf. The relator must serve on the government the complaint and all supporting information the relator possesses before the action may proceed. The government may intervene and prosecute the matter, may request dismissal, or settle the action with the court's approval.

Craig received a relator's share of almost $6 million in 2008 and $850,000 in 2009. The government issued to Craig Forms 1099-MISC, Miscellaneous Income, for the years at issue reflecting those amounts. On their joint individual Form 1040s for 2008 and 2009, Craig and his wife reported the awards (less attorney's fees) as capital gains. The IRS rejected that treatment and issued a deficiency notice. According to the IRS, the income should've been characterized as other income and not capital gain. The Patricks argued that Craig sold information to the government in exchange for a share of any recovery. The IRS, on the other hand, argued that the relator income was similar to a reward and did not satisfy the requirements for capital gains treatment.

The Tax Court held that the information Craig provided to the government was not his property and therefore was not a capital asset. Thus, the income Craig received from the qui tam award was not the result of a sale or exchange of a capital asset and was instead taxable as ordinary income.

The court rejected the Patricks' argument that a relator sells his information to the government, instead agreeing with the IRS that the relator has a statutory obligation to provide all supporting information to the government and this does not constitute a sale or exchange.

The court rejected the couple's assertion that the sale or exchange requirement is met because the qui tam complaint establishes the relator's contractual right to a share of the recovery. Absent a legislature's clear indication to contractually bind the government, the court stated, a law does not create private contractual rights. The government does not purchase information from a relator under the FCA, the court noted, but instead permits the person to advance a claim on behalf of the government. The award is a reward for doing so and no contractual right exists.

The court also rejected the Patricks' contention that the right to future income that vested when Craig filed the qui tam complaints was a capital asset and dismissed their alternative argument that the documents and information provided to the government were capital assets.

Citing numerous cases, the court said that the right to future payments of ordinary income is not a capital asset. A qui tam award, the court observed, is a reward for the relator's efforts in obtaining repayment to the government and is includible in a taxpayer's gross income. The court also rejected the Patricks' argument that Craig had a property interest in the information and documents he disclosed to the government, saying that the documents and information are not a capital asset because Craig did not have a legal right to exclude others from the use and enjoyment of that property.

For a discussion of the taxation of qui tam awards under the FCA, see Parker Tax ¶74,140.

[Return to Table of Contents]

Failure to Attach Required Documents Precludes Interest on Overpayment

Because a foreign bank did not attach to its original income tax return the required documentation for the IRS to mathematically verify its total withholding credit and tax liability for the year in issue, the return was not in processible form, and the bank was not entitled to interest on its overpayment until the date its resubmitted return with the required documentation was filed. Deutsche Bank AG v. U.S., 2014 PTC 84 (Fed. Cir. 2/18/14).

Banking and financial services company, Deutsche Bank, filed its 1999 income tax return, Form 1120F, U.S. Income Tax Return of a Foreign Corporation, in September 2000, after obtaining a six-month extension to file. The bank reported a total tax due of approximately $106 million and total payments of approximately $188 million, which included a credit for taxes withheld at the source of approximately $13 million. Deutsche Bank requested that the resulting overpayment be credited to the 2000 tax year. Form 1120F does not itemize the withholding credit on the return. Instead, the individual withholding credits are derived from various information returns. For 1999, Deutsche Bank received one Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax, and five Forms 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, from six different withholding agents. The instructions for Forms 1120F, 8805, and 1042-S and statements on those forms required Deutsche Bank to attach Forms 8805 and 1042-S to its federal income tax return. The IRS sent back the bank's Form 1120F unprocessed and requested documentation to support the claimed withholding credit. The bank resubmitted the return with Forms 8805 and 1042-S in November 2000. Subsequently, a disagreement arose between Deutsche Bank and the IRS over the amount of overpayment interest that should have been credited to Deutsche Bank.The IRS stated that, since the original return was not filed in processible form, the bank was only entitled to interest from January 2001 when the IRS recorded the resubmitted return as filed.

Deutsche Bank filed suit in the U.S. Court of Federal Claims. The court sided with the IRS, holding that the original return (1) was not filed in processible form because all of the required information was not included with the return, and (2) did not contain sufficient information to allow the mathematical verification of income tax liability. The bank appealed, seeking interest from March to December 2000.

Code Sec. 6611 provides that a taxpayer claiming a refund is entitled to interest on the overpayment when the refund is issued more than 45 days after the due date for filing the return or the actual return filing date. If a return is filed late, interest accrues from the date the late return was filed. Under Code Sec. 6611(g), a return is not treated as filed until it is filed in processible form.

Deutsche Bank argued that Forms 8805 and 1042-S were not required attachments to Form 1120F, and thus its 1999 return was filed in processible form when originally filed.

The IRS contended that the required filing of Forms 8805 and 1042-S allow for the mathematical verification of the claimed withholding credits and tax liability on the return and thus a return is not filed in processible form until those forms are included with the return.

The Federal Circuit affirmed the Claims Court holding that Forms 8805 and 1042-S were required attachments and, without the missing forms, the original return did not contain sufficient required information on the return to permit the mathematical verification of the bank's income tax liability. The court first determined that the statements of Forms 1120F, 8805, and 1042-S, the accompanying instructions, and the general return requirements of Code Sec. 6011 supported the Claims Court's determination that Forms 8805 and 1042-S were required attachments to the bank's return.

The court also found that the bank's original return did not contain sufficient required information, whether on the return or on required attachments, to permit the mathematical verification of the withholding credit or tax liability. In rejecting the bank's argument that the IRS could mathematically verify its total withholding credit from copies of Forms 8805 and 1042-S received from the withholding agents, the court noted that it was irrelevant whether the IRS could have used its audit power or the forms submitted by withholding agents to verify the bank's overpayment. Because Forms 8805 and 1042-S were necessary to permit the mathematical verification of the total withholding credit and tax liability and were not attached to the original return, Deutsche Bank's original return did not contain sufficient required information and thus was not filed in processible form.

For a discussion of interest on underpayments and overpayments of tax, see Parker Tax ¶261,510.

[Return to Table of Contents]

Physician's Expenses Were Properly Treated as Miscellaneous Itemized Deductions on Schedule A

Deductions for storage unit rental, travel, and legal expenses claimed on Schedule C by a practicing neurosurgeon should have been subtracted from her adjusted gross income and claimed on Schedule A as miscellaneous itemized deductions, subject to the 2-percent floor, because the expenses were incurred by virtue of her status as an employee. Vitarbo v. Comm'r., T.C. Summary 2014-11 (2/6/14).

Elizabeth Vitarbo, a licensed and practicing neurosurgeon, entered into a physician recruitment agreement with Wilson Medical Center (WMC) in 2004. The agreement was intended to induce Dr. Vitarbo to establish a neurosurgery practice in the geographic area that WMC served. In return for her doing so, the agreement provided that (1) Dr. Vitarbo would be guaranteed a minimum net income; (2) her moving expenses would be reimbursed; and (3) WMC would pay her student loan debt. Under the agreement, Dr. Vitarbo was obligated to repay those amounts if she failed to fulfill her obligations. Dr. Vitarbo also executed three promissory notes for her debts arising from the agreement. To conduct her medical practice, Dr. Vitarbo formed an S corporation, Wilson Neurosurgical Associates (WNA), of which she was the sole shareholder and employee. In 2006, Dr. Vitarbo began to conduct her medical practice as an employee of an educational institution and she dissolved WNA in 2007. Subsequently a dispute arose between Dr. Vitarbo and WMC. Dr. Vitarbo filed a lawsuit against WMC, claiming she was fraudulently induced to enter into the agreement. The lawsuit was settled in 2007. As part of the settlement, Dr. Vitarbo agreed to repay WMC $240,000. In connection with the lawsuit, Dr. Vitarbo incurred legal fees of $120,000. She paid $60,000 of those fees in 2008.

On her 2008 federal income tax return, Dr. Vitarbo attached Schedule C, Profit or Loss From Business. Her Schedule C showed a net loss of over $51,000, which was comprised of $15,000 of income attributable to her medical practice and deductions for the following expenses: legal fees from the WMC lawsuit ($60,000), rental fees for a storage unit for her medical records ($1,200), and travel to attend professional conferences ($1,000). After processing her return, the IRS treated the deductions for rent, travel, and legal fees as miscellaneous itemized deductions that should have been claimed on Schedule A, Itemized Deductions, instead of on Schedule C.

Under Code Sec. 62, an individual performing services as an employee may deduct expenses paid or incurred in the performance of services as an employee as miscellaneous itemized deductions on Schedule A to the extent the expenses exceed 2 percent of the taxpayer's adjusted gross income. Code Sec. 162 allows a taxpayer to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. Code Sec. 212 provides that a taxpayer can deduct ordinary and necessary expenses paid or incurred for the production of income.

Dr. Vitarbo argued that she was not an employee of WMC and that the deductions were all related to her trade or business as a neurosurgeon and therefore should be subtracted from her gross income in arriving at adjusted gross income.

The IRS contended that the disputed deductions should be taken into account by subtracting them from her adjusted gross income because she did not practice medicine as a sole proprietor at any relevant time. Instead, the IRS stated, she was either an employee of WNA or an employee of the educational institution during the time she provided services to WMC.

The Tax Court held that Dr. Vitarbo should have reported the expenses on Schedule A because she was an employee of WNA until her employment with the educational institution began in 2006. The court noted that, under Code Sec. 62(a), adjusted gross income means gross income minus deductions from various categories. Trade or business expenses are included in the provision if the trade or business of the taxpayer does not consist of the performance of services by the taxpayer as an employee. In this case, Dr. Vitarbo failed to establish that, at any relevant time, she practiced medicine under circumstances other than as an employee or in a manner that required the income and deductions attributable to her medical practice to be shown on Schedule C.

For a discussion of unreimbursed employee expenses, see Parker Tax ¶85,105.

[Return to Table of Contents]

IRS Failed to Prove that Trusts Formed to Conduct Logging Activities Were Shams

Because the IRS failed to prove that two trusts formed by a businessman and his wife were shams and should be disregarded, the couple did not have unreported income from logging activities conducted on the properties owned by the trusts. Close v. Comm'r, T.C. Memo. 2014-25 (2/10/14).

Carl Close operated a medical equipment business. In 1998, Carl and Norman Gissel formed Hidden Valley Trust with Carl as the grantor and Norman as the trustee. The trust beneficiaries were the four children of Carl and his wife, Lisa Marie. The trust purchased property (Nelson Loop Road property) and Carl and Lisa Marie personally guaranteed the mortgage on the property. The couple moved to the property and began logging activities on the property. A portion of the timber proceeds from the logging activities was used to pay down the mortgage and improve the property.

In 2003, Carl and Mike Leach proposed to purchase property (Winch Road property) to be used for logging activities. Carl and Mike agreed to execute a promissory note for the purchase price of the property. They agreed to make two payments on the note, and 70 percent of any timber sales would go to satisfying the balance due on the note. Carl and Mike formed Hidden Valley Ranch, LLC for the purpose of managing the logging, farming, and other operations on the Winch Road property. The company filed a Form 1065, U.S. Return of Partnership Income, for 2003. Carl, Lisa Marie, and Mike formed Lost Creek Irrevocable Trust (Lost Creek Trust) and conveyed their interest in the Winch Road property to the trustee. The children of Carl, Lisa Marie, and Mike were beneficiaries of the Lost Creek Trust.

In 2004, Carl was convicted of multiple counts of health care fraud, money laundering, and obstruction of justice and sentenced to prison. In 2006, the IRS notified Mike that it had determined that the Lost Creek Trust was invalid and that amended returns for Hidden Valley Ranch, LLC should be filed reporting zero income. According to the IRS, all income and expenses from the timber operations on the Winch Road property should be reported on partnership returns for an entity known as Lost Creek Partnership. Mike signed and filed Lost Creek Partnership's return for 2003 and attached Schedule K-1 showing that Carl and Mike each had distributive shares of ordinary income, expenses, and deductions. The IRS issued Carl and Lisa Marie separate notices of deficiency for 2003 determining that Carl had unreported income from the logging activities on the Winch Road and Nelson Loop Road properties and imposed additions to tax. The IRS contended that Carl had unreported income from the logging activities because both the Hidden Valley Trust and Lost Creek Trust were shams.

The Tax Court held that the IRS failed to prove that the two trusts were shams and should be disregarded. In its analysis of the validity of the trusts, the court noted that a taxpayer may elect a business form to minimize the incidence of taxation by any means that the law permits. The court cited Markosian v. Comm'r, 73 T.C. 1235 (1980), which sets forth the factors for determining whether a trust has economic substance. In determining that the IRS failed to prove that the Lost Creek Trust and Hidden Valley Trust should be disregarded, the court noted that the IRS failed to present evidence to show that (1) the trustees were not independent; (2) the Closes disregarded the economic interests of the trust beneficiaries; or (3) the Closes disregarded any restrictions imposed by the trust agreement.

For a discussion of situations where trusts may be considered shams, see Parker Tax ¶70,105.

[Return to Table of Contents]

Capitalized Interest Includible in Taxable Amount of Terminated Insurance Policy

A couple who borrowed sums against the husband's life insurance policy and did not repay the loans realized income upon the termination of the policy that included both the loan principal and the capitalized interest that accrued on those loans; the extinguishment of the debt was taxable income and not discharge-of-indebtedness income. Black v. Comm'r, T.C. Memo. 2014-27 (2/12/14).

Boyd Black, an attorney, acquired a whole life insurance policy having cash value and loan features from an insurance company in 1989. Under the terms of the policy, Boyd was allowed to borrow against the policy in an amount not in excess of its cash value. Any policy debt would consist of all outstanding loans, accrued interest, and unpaid interest that would be added to the loan principal. Further, the policy would terminate if the policy debt were equal to the cash value. Boyd borrowed against the policy over time and interest due on each loan accrued pursuant to the terms of the policy. Boyd did not repay the loans.

In 2009, the policy terminated and the outstanding loans were satisfied by the policy proceeds. The insurance company issued to Boyd a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc., reflecting a gross distribution of $196,230 and a taxable amount of $109,500. The taxable amount represented the difference between the outstanding loans when the policy was terminated and Boyd's investment in the policy contract. Boyd self-prepared and timely filed a joint federal income tax return with his wife, Janice, for 2009 and did not report any of the taxable income reflected on the Form 1099-R. In 2011, the couple prepared a Form 1040X, Amended U.S. Individual Income Tax Return, which reflected additional income attributable to the difference between the principal of the loans received from the insurance company less the amount of premiums paid. The amended return was not accepted or processed by the IRS. The IRS issued a notice of deficiency for 2009 and assessed an accuracy-related penalty. According to the IRS, the taxable amount that the Blacks should've taken into income also included the capitalized interest accrued on the loans against the policy.

Boyd and Janice argued that the capitalized interest accrued on the loans is not included in determining the gross distribution and taxable amount from the termination of the policy. They also argued that the termination of the life insurance policy gave rise to a discharge of indebtedness.

Observation: While discharge-of-indebtedness income can be excludible from taxable income in certain situations, the Blacks did not argue that any such exception applied to them.

The Tax Court held that the capitalized interest that accrued with respect to the insurance policy loans was includible in determining the amounts received by the Blacks upon the termination of the life insurance contract. Under the terms of Boyd's insurance policy, the policy loans, including capitalized interest, were treated as bona fide indebtedness, and the capitalized interest was part of the principal of the indebtedness.

The court cited Atwood v. Comm'r, T.C. Memo. 1999-61, which found that capitalized interest is includible in determining the amount of the taxpayer's gross distribution when the insurance policy is terminated. When Boyd's policy was terminated in 2009, the termination gave rise to a gross distribution, a portion of which applied to both loan principal and capitalized interest. The gross distribution, less Boyd's investment in the contract, constituted taxable income, the court noted.

In rejecting the couple's argument that the termination of the policy gave rise to a discharge of indebtedness, the court stated that the loans were not discharged, rather, the loans were extinguished after the insurance company applied the cash value of the policy to the debt owed by Boyd.

Finally, the court concluded that the Blacks were liable for an accuracy-related penalty under Code Sec. 6662(a) because they failed to show reasonable cause and good faith with respect to the underpayment of tax.

For a discussion of loans against a life insurance contract's cash value, see Parker Tax ¶71,930.

[Return to Table of Contents]

2014 Luxury Vehicle Depreciation Limits and Lease Inclusion Amounts Announced

The IRS issued the 2014 luxury vehicle depreciation limitations and the income inclusion amounts for leased vehicles. Rev. Proc. 2014-21.

Under Code Sec. 280F(a), depreciation deductions allowable for passenger automobiles, trucks, and vans are limited to a maximum dollar amount each tax year. This limitation is known as the luxury automobile limitation. The amounts allowable are adjusted each year by an inflation adjustment.

The automobile price inflation adjustment for any calendar year is the percentage (if any) by which the consumer price index (CPI) automobile component for October of the preceding calendar year exceeds the CPI automobile component for October 1987. The new car component of the CPI was 115.2 for October 1987 and 144.169 for October 2013. The October 2013 index exceeded the October 1987 index by 28.969. Therefore, the automobile price inflation adjustment for 2014 for passenger automobiles (other than trucks and vans) is 25.1 percent (28.969/115.2 x 100%). The dollar limitations in Code Sec. 280F(a) are multiplied by a factor of 0.251, and the resulting increases, after rounding to the nearest $100, are added to the 1988 limitations to give the depreciation limitations applicable to passenger automobiles (other than trucks and vans) for calendar year 2014.

This adjustment applies to all passenger automobiles (other than trucks and vans) that are first placed in service in calendar year 2014. The inflation factors for trucks and vans are calculated in a similar fashion. The new truck component of the CPI was 112.4 for October 1987 and 151.877 for October 2013. The October 2013 index exceeded the October 1987 index by 39.477. Therefore, the inflation adjustment for 2014 for trucks and vans is 35.1 percent (39.477/112.4 x 100%).

Code Sec. 280F(c) requires a reduction in the deduction allowed to the lessee of a leased passenger automobile, truck, or van. The reduction must be substantially equivalent to the limitations on the depreciation deductions imposed on owners of such vehicles. This reduction requires a lessee to include in gross income an amount determined by applying a formula to the amount obtained from a table. Each table (one for passenger automobiles and one for trucks and vans) shows inclusion amounts for a range of fair market values for each tax year after the vehicle is first leased.

This week, in Rev. Proc. 2014-21, the IRS released the luxury vehicle depreciation limitations and the lease inclusion amounts for 2014.

The depreciation limitations for passenger automobiles placed in service in calendar year 2014 are:

• 1st Tax Year - $3,160
• 2nd Tax Year - $5,100
• 3rd Tax Year - $3,050
• Each Succeeding Year - $1,875.

The depreciation limitations for trucks and vans placed in service in calendar year 2014 are:

• 1st Tax Year - $3,460
• 2nd Tax Year - $5,500
• 3rd Tax Year - $3,350
• Each Succeeding Year - $1,975

For a discussion of the luxury auto limitations, see Parker Tax ¶94,920. For a discussion of the lease inclusion rules, see Parker Tax ¶94,915.

[Return to Table of Contents]

Statute of Limitations Bars Assessment of Excise Tax on ESOP

Although the occurrence of a non-allocation year with respect to an S corporation's employee stock ownership plan triggered the imposition of an excise tax on stock allocated to its sole shareholder, the statute of limitations for assessing the tax had expired. Law Office of John H. Eggersten P.C. v. Comm'r, 142 T.C. No. 4 (2/12/14).

In 1998, John Eggersten purchased all the outstanding shares of stock in J&R's Little Harvest, Inc., an S corporation. In 1999, the company established an employee stock ownership plan (ESOP) and John transferred his stock to the ESOP. Subsequently, the company changed its name to Law Office of John H. Eggersten, P.C. All of the stock in the company was allocated to John under the ESOP. From its establishment in 1999 to 2005, the stock was in an account known as "Company Stock Account." After 2005, the stock was held in an account known as "Other Investment Account."

John filed Form 1120S for tax year 2005, and attached Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. The company's return showed that the ESOP owned 100 percent of the stock of the company. The ESOP filed Form 5500, Annual Return/Report of Employee Benefit Plan for 2005. On the return, the ESOP showed (1) that it was maintained by the company; (2) that there were three participants one identified and the two others were retired or separated participants; (3) the value of the assets held; and (4) that the assets consisted exclusively of employer securities. The ESOP was not required to, and did not, describe the assets held or their respective year end values. The ESOP did not file Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for 2005. In 2011, the IRS issued a notice of deficiency determining that John was a disqualified person and, as a result, a non-allocation year occurred. The notice also determined an excise tax on the amount of the prohibited allocation.

Code Sec. 409(p) provides that an ESOP holding employer securities consisting of stock in an S corporation must provide that no portion of the plan assets attributable to the employer securities may, during a non-allocation year, accrue for the benefit of a disqualified person.

Code Sec. 4979A(a) states that if there is any allocation of qualified securities that violates Code Sec. 409(p) or a non-allocation years with respect to an employee stock ownership plan, a tax is imposed on such allocation equal to 50 percent of the prohibited amount.

Observation: A fundamental purpose of an ESOP is to provide participants with equity ownership in the employer corporation through participation in the ESOP, including distributions of employer securities to participants.

The Tax Court held that the tax year in issue was a non-allocation year with respect to the ESOP, which triggered the imposition of the excise tax on any ownership by John, a disqualified person. The parties conceded that, at all relevant times, all of the company stock was allocated to John under the ESOP and John was a disqualified person. Since a disqualified person owned all the stock of the company, an excise tax was imposed on the company in 2005, the first non-allocation year.

However, the court concluded, the statute of limitations for assessing the excise tax had expired. The last day under the statute for assessing the excise tax, the court noted, was the date that is three years from the later of the ownership that gave rise to the tax or the date on which the IRS was notified of the ownership. In this case, the ownership that gave rise to the excise tax for the company's 2005 tax year existed on the first day of 2005 and throughout that year. The company's Form 1120S and the ESOP's annual return were filed in 2006, and those forms contained the necessary information for the IRS to conclude that one or more disqualified persons owned at least 50 percent of all of the stock in the company and that 2005 was the first non-allocation year with respect to the ESOP. Since the IRS was thus "notified" of the ownership that gave rise to the excise tax in 2006, the statute of limitations for assessing the excise tax expired in 2009. Therefore, the IRS's 2011 notice of deficiency was issued after the statute of limitations had expired.

For a discussion of ESOPs and S corporations, see Parker Tax ¶33,560.