Federal Tax Bulletin - Issue 53 - January 3, 2014

IRA Withdrawals Pursuant to Forged Signatures by Wife Aren't Taxable to Husband

Two thousand and eight was not a very good year for Andrew Roberts. Not only did he separate from his wife, Cristie, but, unbeknownst to him, she was forging his signature and taking withdrawals out of his IRA accounts and depositing them into a joint account only she could access. Apparently thinking they were still on good terms, Andrew allowed Cristie to prepare their tax return for 2008, as she had done in prior years.

Although he understood they would be filing a joint return, as in the past, she in fact prepared his return with a filing status of single. In addition, she omitted the IRA distributions from his income, underreported his W-2 income, and overstated the credit for tax withheld. She then filed the return electronically and had the refund deposited electronically into the same bank account used for the misappropriated IRA funds. In 2010, Andrew received a notice of deficiency from the IRS.

In Roberts v. Comm'r, 141 T.C. No. 19 (12/30/13), the Tax Court was asked to decide an issue of first impression: whether IRA withdrawals, made pursuant to forged withdrawal requests, that are not received by or used for the economic benefit of the purported distributee are includible in his gross income. Luckily for Andrew, the Tax Court judge concluded that that the answer is "no."

Background

In 2008, Andrew Roberts worked for the U.S. Air Force and his wife, Cristie, worked for Bethel Transportation. While they maintained joint checking accounts at Washington Mutual and Harborstone Federal Credit Union, Andrew exclusively used the Harborstone account and Christie exclusively used the Washington Mutual account. Andrew did not have a checkbook for, write checks on, or make withdrawals from, the Washington Mutual account, and he did not receive or review the bank statements for the Washington Mutual account during 2008. Andrew also owned two IRA accounts, one at AIG SunAmerica and one at ING. Read more...

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Supreme Court Reverses Fifth Circuit; Valuation-Misstatement Penalty Applies to Sham Partnerships

The Supreme Court was recently asked to decide whether the 40 percent valuation-misstatement penalty applied in the case of partnerships deemed to be shams. Two lower courts held that the penalty did not apply. Unfortunately for the taxpayer in Comm'r v. Woods, 2013 PTC 374 (S. Ct. 12/3/13), the Supreme Court reversed the lower courts' decisions and held that, once the partnerships were deemed not to exist for tax purposes because they were shams, no partner could legitimately claim a basis in his partnership interest greater than zero.

Any underpayment resulting from use of a non-zero basis was therefore "attributable to" the partner's having claimed an adjusted basis in the partnerships that exceeded the correct amount of such adjusted basis. The Supreme Court concluded that, under the relevant regulations, when an asset's adjusted basis is zero, a valuation misstatement is automatically deemed "gross" for purposes of applying the 40 percent underpayment penalty.

Background

Taxpayers are subject to a 20 percent accuracy-related penalty with respect to any portion of an underpayment of tax that is attributable to a substantial valuation misstatement. The penalty is increased to 40 percent in the case of a gross valuation misstatement.

In 2010, the Code was amended to add Code Sec. 6662(b)(6), effective for underpayments attributable to transactions entered into after March 30, 2010. That penalty applies specifically to transactions lacking in economic substance. The new penalty covers all sham transactions, including those that do not cause the taxpayer to misrepresent value or basis; thus, it can apply in situations where the valuation misstatement penalty cannot.

Observation: According to the Supreme Court, the fact that both penalties may potentially apply to sham transactions resulting in valuation misstatements is not problematic because, while penalties might overlap in a given case, a taxpayer generally cannot receive more than one accuracy-related penalty for the same underpayment.

Facts

Gary Woods and his employer, Billy Joe McCombs, participated in an offsetting-option tax shelter designed to generate large paper losses that they could use to reduce their taxable income. To that end, they purchased from Deutsche Bank a series of currency option spreads. Each spread was a package consisting of a long option, which Woods and McCombs purchased from Deutsche Bank and for which they paid a premium, and a short option, which Woods and McCombs sold to Deutsche Bank and for which they received a premium. Because the premium paid for the long option was largely offset by the premium received for the short option, the net cost of the package to Woods and McCombs was substantially less than the cost of the long option alone.

Woods and McCombs contributed the spreads, along with cash, to two partnerships, which used the cash to purchase stock and currency. When calculating their basis in the partnership interests, Woods and McCombs considered only the long component of the spreads and disregarded the nearly offsetting short component. As a result, when the partnerships' assets were disposed of for modest gains, Woods and McCombs claimed huge losses.

Although they had contributed roughly $3.2 million in cash and spreads to the partnerships, they claimed losses of more than $45 million. The IRS sent each partnership a Notice of Final Partnership Administrative Adjustment, disregarding the partnerships for tax purposes and disallowing the related losses. It concluded that the partnerships were formed for the purpose of tax avoidance and thus lacked "economic substance"-i.e., they were shams. As there were no valid partnerships for tax purposes, the IRS determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40-percent penalty for gross valuation misstatements.

Woods took his case to court, and a Texas district court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The IRS appealed, and the Fifth Circuit affirmed the lower court's decision.

Applicability of Valuation-Misstatement Penalty

Taxpayers who underpay their taxes due to a "valuation misstatement" may incur an accuracy-related penalty. A 20-percent penalty applies to the portion of any underpayment that is attributable to any substantial valuation misstatement. There is substantial valuation misstatement if the value of any property (or the adjusted basis of any property) claimed on any income tax return is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.

Under Code Sec. 6662(h), if the reported value or adjusted basis exceeds the correct amount by at least 400 percent, the valuation misstatement is considered not merely substantial, but "gross," and the penalty increases to 40 percent.

Under Reg. Sec. 1.6662-5(g), when an asset's true value or adjusted basis is zero, the value or adjusted basis claimed is considered to be 400 percent or more of the correct amount, so that the resulting valuation misstatement is automatically deemed "gross" and subject to the 40-percent penalty.

Taxpayer's Argument

Woods primarily argued that the economic-substance determination did not result in a valuation misstatement because the statutory terms "value" and "valuation" connote "a factual - rather than legal - concept." Thus, Woods said, the penalty applies only to factual misrepresentations about an asset's worth or cost, not to misrepresentations that rest on legal errors (like the use of a sham partnership).

In the alternative, Woods argued that any underpayment of tax in this case would be "attributable," not to the misstatements of outside basis, but rather to the determination that the partnerships were shams-which he described as an "independent legal ground."

Supreme Court's Analysis

The Supreme Court rejected Woods' primary argument, saying it doubted that the term "value" would be limited to factual issues and exclude threshold legal determinations. But even if the term "value" were limited to factual matters, the Supreme Court said, the statute refers to "value" or "adjusted basis." The Court said there was no justification for extending any limitation on the term "value" to the term "adjusted basis," which plainly incorporates legal inquiries. An asset's basis is simply its cost; but calculating its adjusted basis requires the application of a host of legal rules, the Court noted, including specialized rules for calculating the adjusted basis of a partner's interest in a partnership. The statute contains no indication that the misapplication of one of those legal rules cannot trigger the penalty.

The Court observed that, to overcome the plain meaning of "adjusted basis," Woods was asking the Court to interpret the parentheses in the statutory phrase "the value of any property (or the adjusted basis of any property)" as a signal that "adjusted basis" is merely explanatory or illustrative and has no meaning independent of the term "value."

According to the Court, given the compelling textual evidence to the contrary, the parentheses cannot bear that much weight. For one thing, the terms reappear later in the same sentence without the parentheses-in the phrase "such valuation or adjusted basis." Moreover, the Court noted, the operative terms are connected by the conjunction "or." In its ordinary use, the Court said, the term "or" is almost always disjunctive; that is, the words it connects are to be given separate meanings. There is no way, the Court stated, that the term "adjusted basis" can be regarded as synonymous with the term "value." Finally, the Court observed, the term's second disjunctive appearance is followed by "as the case may be," which eliminates any lingering doubt that the terms "value" and "adjusted basis" are alternatives.

With respect to Woods' alternative argument, the Court noted that his argument was the rationale that the Fifth and Ninth Circuits have adopted for refusing to apply the valuation-misstatement penalty in cases similar to Woods. The Court rejected the argument's premise: The economic substance determination and the basis misstatement are not "independent" of one another. This is not a case where a valuation misstatement is a mere side effect of a sham transaction, the Court observed. Rather, the overstatement of outside basis was the linchpin of the tax shelter at issue and the mechanism by which Woods and McCombs sought to reduce their taxable income. In this type of tax shelter, the Court noted, the basis misstatement and the transaction's lack of economic substance are inextricably intertwined, so attributing the tax underpayment only to the artificiality of the transaction and not to the basis over valuation was making a false distinction. In short, the partners underpaid their taxes because they overstated their outside basis, and they overstated their outside basis because the partnerships were shams. The Court thus had no difficulty concluding that any underpayment resulting from the tax shelter was attributable to the partners' misrepresentation of outside basis (i.e., a valuation misstatement).

As a result, the Supreme Court reversed the Fifth Circuit and held that the district court had jurisdiction to determine whether the partnerships' lack of economic substance could justify imposing a valuation-misstatement penalty on the partners. Under TEFRA's framework, a court in a partnership-level proceeding has jurisdiction to determine the applicability of any penalty that relates to an adjustment to a partnership item, the Court said. A determination that a partnership lacks economic substance, the Court held, is such an adjustment.

TEFRA authorizes courts in partnership-level proceedings to provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though imposing the penalty requires a subsequent, partner-level proceeding. In that later proceeding, the Court stated, each partner may raise any reasons why the penalty may not be imposed on him specifically. Applying those principles to the Woods case, the district court had jurisdiction to determine the applicability of the valuation-misstatement penalty and, the Court concluded, the valuation-misstatement penalty applies in this case.

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IRS Announces 2014 Filing Season to Begin on January 31

The IRS announced plans to open the 2014 filing season on January 31; no tax returns will be processed until that date. IR-2013-100 (12/18/13).

In mid-December, the IRS announced January 31, 2014, as the date it has set to open the 2014 tax filing season. According to the IRS, the new opening date for individuals to file their 2013 tax returns will allow the IRS adequate time to program and test its tax processing systems. The annual process for updating IRS systems saw significant delays in October following the 16-day federal government shutdown.

According to IRS Acting Commissioner Danny Werfel, the late January opening gives the IRS enough time to get things right with its programming, testing, and systems validation. As a result of the government shutdown, the IRS had to change the original opening date from January 21 to January 31, 2014.

The 2014 date is one day later than the 2013 filing season opening, which started on January 30, 2013, following January tax law changes made by Congress under the American Taxpayer Relief Act (ATRA). The extensive set of ATRA tax changes affected many 2012 tax returns, which led to the late January opening.

Many software companies are expected to begin accepting tax returns in January and hold those returns until the IRS systems open on January 31. The IRS cautioned that it will not process any tax returns before January 31, so there is no advantage to filing on paper before the opening date. Taxpayers will receive their tax refunds much faster by requesting the direct deposit option.

Observation: IRS systems, applications, and databases must be updated annually to reflect tax law updates, business process changes, and programming updates in time for the start of the filing season. The October closure came during the peak period for preparing IRS systems for the 2014 filing season. Programming, testing, and deployment of more than 50 IRS systems is needed to handle processing of nearly 150 million tax returns. Updating these core systems is a complex, year-round process, with the majority of the work beginning in the fall of each year. About 90 percent of IRS operations were closed during the shutdown, with some major work streams closed entirely during this period, putting the IRS nearly three weeks behind its tight timetable for being ready to start the 2014 filing season. According to the IRS, there are additional training, programming, and testing demands on its systems this year in order to provide additional refund fraud and identity theft detection and prevention.

The IRS noted that the April 15 tax deadline is set by statute and will remain in place. However, taxpayers can request an automatic six-month extension to file their tax return. The request is made on Form 4868, which can be filed electronically or on paper.

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DOMA-Related Guidance Addresses Tax Treatment of Employee Benefit Arrangements

The IRS has issued additional guidance, in question-and-answer format, on the application of the Supreme Court's Windsor decision to certain rules governing the federal tax treatment of various types of employee benefit arrangements. Notice 2014-1.

Until the recent decision of the Supreme Court in U.S. v. Windsor, 2013 PTC 167 (2013), found it unconstitutional, Section 3 of the Defense of Marriage Act (DOMA) prohibited the recognition of same-sex marriages for purposes of federal tax law. As a result, employers could not permit employees to elect coverage of same-sex spouses on a pre-tax basis under a cafeteria plan unless the spouse otherwise qualified as a tax dependent of the employee. Following the Windsor decision, the IRS issued Rev. Rul. 2013-17, in which it ruled that, for federal tax purposes, if a same-sex couple is married in a state where it is legal to perform same-sex marriages, the marriage is recognized for federal tax purposes.

On December 16, the IRS issued Notice 2014-1, in which it clarified that a cafeteria plan may treat a participant who was lawfully married to a same-sex spouse as of the date of the Windsor decision (June 26, 2013) as if the participant experienced a change in legal marital status. Thus, a cafeteria plan may permit such a participant to revoke an existing election and make a new election in a manner consistent with the change in legal marital status. For purposes of election changes due to the Windsor decision, an election may be accepted by the cafeteria plan if filed at any time during the cafeteria plan year that includes June 26, 2013, or the cafeteria plan year that includes December 16, 2013. A cafeteria plan may also permit a participant who marries a same-sex spouse after June 26, 2013, to make a mid-year election change due to a change in legal marital status. Any election made with respect to a same-sex spouse (and/or the spouse's dependents) must satisfy the requirements of the regulations concerning election changes generally.

An election made under a cafeteria plan with respect to a same-sex spouse as a result of the Windsor decision generally takes effect as of the date that any other change in coverage becomes effective for a qualifying benefit that is offered through the cafeteria plan. With respect to a change-in-status election that was made by a participant in connection with the Windsor decision between June 26, 2013, and December 16, 2013, the cafeteria plan will not be treated as having failed to meet the requirements of Code Sec. 125 or Reg. Sec. 1.125-4 to the extent coverage under the cafeteria plan becomes effective no later than the later of:

(1) the date that coverage under the cafeteria plan would be added under the cafeteria plan's usual procedures for change in status elections; or

(2) a reasonable period of time after December 16, 2013.

Example: ABC Corporation sponsors a cafeteria plan with a calendar year plan year. Amy, an ABC employee, married Bonnie in October 2012, in a state that recognized same-sex marriages. During open enrollment for the 2013 plan year, Amy elected to pay for the employee portion of the cost of self-only health coverage through salary reduction under the cafeteria plan. ABC permits same-sex spouses to participate in its health plan. On October 5, 2013, Amy elected to add health coverage for Bonnie under ABC's health plan, and made a new salary reduction election under the cafeteria plan to pay for the employee portion of the cost of Bonnie's health coverage. ABC was not certain whether such an election change was permissible, and accordingly declined to implement the election change until the publication of Notice 2014-1. After publication of Notice 2014-1, ABC determines that Amy's revised election is permissible as a change-in-status election. ABC enrolls Bonnie in the health plan as of December 20, 2013, and begins making appropriate salary reductions from Amy's compensation for Bonnie's coverage beginning with the pay period starting December 20, 2013. The cafeteria plan is administered in accordance Notice 2014-1.

Notice 2014-1 also addresses the situation in which a cafeteria plan participant has elected to pay for the employee cost of health coverage for the employee on a pre-tax basis through salary reduction under a cafeteria plan, and is also paying the employee cost of health coverage for a same-sex spouse under a health plan of the employer on an after-tax basis. Specifically, the notice addresses when, and under what circumstances, the employer must begin to treat the amount that the employee pays for spousal coverage as a pre-tax salary reduction. Notice 2014-1 provides that an employer that, before the end of the cafeteria plan year including December 16, 2013, receives notice that such a participant is married to the individual receiving health coverage must begin treating the amount that the employee pays for the spousal coverage as a pre-tax salary reduction under the plan no later than the later of:

(1) the date that a change in legal marital status would be required to be reflected for income tax withholding purposes under Code Sec. 3402; or

(2) a reasonable period of time after December 16, 2013.

For this purpose, a participant may provide notice of the participant's marriage to the individual receiving health coverage by making an election under the employer's cafeteria plan to pay for the employee cost of spousal coverage through salary reduction or by filing a revised Form W-4 representing that the participant is married.

In the case of a cafeteria plan participant who elected to pay for the employee cost of health coverage for the employee on a pre-tax basis through salary reduction under a cafeteria plan and also paid for the employee cost of health coverage for a same-sex spouse under the employer's health plan on an after-tax basis, the participant's salary reduction election under the cafeteria plan is deemed to include the employee cost of spousal coverage, even if the employer reports the amounts as taxable income and wages to the participant. Thus, the amount that the participant pays for spousal coverage is excluded from the gross income of the participant and is not subject to federal income or federal employment taxes. This rule applies to the cafeteria plan year including December 16, 2013, and any prior years for which the applicable limitations period under Code Sec. 6511 has not expired.

In general, a cafeteria plan participant may choose to pay for the employee cost of same-sex spouse coverage on a pre-tax basis through the remaining pay periods in the current cafeteria plan year by providing notice of the participant's marital status to the employer or the cafeteria plan, or to continue paying for these benefits on an after-tax basis. In either case, the participant may seek a refund of federal income or federal employment taxes paid on any amounts representing the employee cost of spousal health coverage that were treated as after-tax and may exclude these amounts from gross income when filing an income tax return for the year.

EXAMPLE: Assume the same facts as the previous example, except that starting January 1, 2013, Amy paid for the employee portion of health coverage for Bonnie under ABC's group health plan on an after-tax basis. The value of Bonnie's health coverage was $500 per month, and this amount was included as taxable income and wages to Amy for payroll purposes with respect to all pay periods starting January 1, 2013. On October 5, 2013, Amy made a change-in-status election under the cafeteria plan electing to pay for the employee cost of Bonnie's health coverage on a pre-tax basis through salary reduction. ABC implemented the change in status election on November 1, 2013, and excluded the cost of Bonnie's coverage from Amy's gross income and wages with respect to all remaining pay periods in 2013 starting November 1, 2013. Amy and Bonnie file a joint federal income tax return for 2013. The value of Bonnie's health coverage for the full 2013 tax year (including the $5,000 of coverage ($500 per month for 10 months) that ABC initially reported as includible in gross income with respect to all pay periods from January through October) may be excluded from gross income on the couple's joint return for 2013. Amy may also request a refund of any federal employment taxes paid on account of such coverage.

For a discussion of changing and revoking elections under a cafeteria plan, see Parker Tax ¶122,540.

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Grad School Deduction Disallowed Where Taxpayer Was Not Established in a Trade or Business

A student could not deduct post-graduate educational expenses as unreimbursed employee business expenses because he was not established in a trade or business before enrolling in the post-graduate program. Hart v. Comm'r., T.C. Memo. 2013-289. Read more...

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Debtors Exempt Interest in Home Did Not Remove It from Bankruptcy Estate

A debtor couple's claimed exemption of an interest in their home did not remove the property from the bankruptcy estate; thus, the bankruptcy trustee had the authority to sell the property and use the proceeds to pay an IRS tax lien and unsecured creditors. Reeves v. Comm'r, 2013 PTC 364 (4th Cir. 11/20/13).

In March 2010, Garon and Diane Reeves filed a joint Chapter 7 bankruptcy petition. On the real property schedule of their petition, Schedule A, the couple listed their home in North Carolina. At a bankruptcy hearing in July 2010, the parties stipulated that the fair market value of the couple's home was $325,000. There was no dispute that the property was encumbered by a mortgage of $195,500 and by a federal tax lien of approximately $382,300. The couple had no equity in the home over and above the mortgage and federal tax lien. Under North Carolina law, married debtors can exempt an aggregate interest in real property used as a residence, not to exceed $70,000, from a bankruptcy estate.

On Schedule C of their bankruptcy petition, Garon and Diane claimed an exemption of $60,000 as the value of their entire interest in their home, acknowledging that they had no equity in the property. The bankruptcy trustee objected. The bankruptcy court denied the trustee's objection on the grounds that the debtors could assert and reserve their exemption in the home notwithstanding their lack of equity. Subsequently, the trustee sought the authority to sell the couple's home to generate funds the majority of which would be applied to satisfy the federal tax lien and the balance to pay unsecured creditors. The bankruptcy court approved the trustee's motion and a district court affirmed the bankruptcy court order.

Bankruptcy Code Section 522(b) provides a list of property a debtor can seek to exempt from the bankruptcy estate. The property that a debtor is authorized to exempt is defined as an interest, the value of which may not exceed a certain dollar amount, in a particular asset under Bankruptcy Code Section 522(d)(9).

Garon and Diane acknowledged that upon filing their bankruptcy petition, their interest in the home became the property of the bankruptcy estate. They also acknowledged that the amount of the liens on their home exceeded its actual value, thereby eliminating any equity interest they may have had.

The couple argued that they were entitled to exempt their interest in the property even though they had no equity in it. The couple argued that, since their actual interest in the home (i.e., zero) did not exceed the amount of aggregate interest for which they were entitled to claim as exempt (i.e., $60,000) under state law, the bankruptcy court's granting of their exemption removed the property from the bankruptcy estate and, as a result, the trustee had no authority to sell it.

The Fourth Circuit affirmed the district court and concluded that the bankruptcy trustee could sell the couple's home as part of the bankruptcy estate. The court rejected as without merit the couple's argument that the property had been removed from the bankruptcy estate. The court cited Schwab v. Reilly, 130 S. Ct. 2652 (2010), which distinguished between exempting an asset itself from the bankruptcy estate and exempting an interest in such asset from the bankruptcy estate. Under Bankruptcy Code Section 522(d)(9), the property claimed as exempt was an interest in a particular asset, not the asset itself. Thus, the effect of the bankruptcy court allowing Garon and Diane's exemption in the home was to exempt their interest in the home from the estate, not in the home itself, the court noted.

The couple's home remained part of the bankruptcy estate even though the bankruptcy court allowed them to reserve an exemption of $60,000 as their aggregate interest in the home, which was subordinate to the mortgage and federal tax lien.

For a discussion of IRS procedures in jeopardy, receiverships, and bankruptcies, see Parker Tax ¶262,500.

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Founder of Buy.com Cannot Escape Penalties on Transaction to Shelter Stock Sale Gains

Capital losses arising from a businessman's participation in a tax shelter that lacked economic substance were properly disallowed because the series of financial transactions presented no reasonable probability of generating a profit; gross valuation misstatement and negligent underpayment penalties were imposed. Blum v. Comm'r, 2013 PTC 392 (10th Cir. 12/18/13).

In 1998, Scott Blum, a successful businessman, founded Buy.com, an online retail marketing company. Scott made two sales of Buy.com stock that resulted in $45 million in capital gains. Scott contacted KPMG, and one of its accountants recommended an Offshore Portfolio Investment Strategy (OPIS) tax shelter as an investment strategy for reducing the amount of capital gains Scott would have to report for tax purposes. The OPIS tax shelter was designed to create large, artificial losses for taxpayers by allowing them to claim a large basis in certain assets to offset actual capital gains. OPIS clients paid a relatively small amount of money in order to claim a disproportionately large basis in certain assets and use that basis to shelter their own otherwise taxable income. Scott signed an engagement letter that provided that KPMG would receive a fee for serving as tax adviser to Scott on the OPIS transaction. On his 1998 federal income tax return, Scott claimed a $45 million loss. Subsequently, KPMG provided Scott with an opinion letter that explained the legal justification for the financial transactions and concluded that the IRS would "more likely than not" view the transactions as legitimate. In 2001, investigations by Congress and the IRS revealed a widespread practice of using basis-shifting to create paper losses for clients, thereby reducing their tax liabilities. The investigation also revealed that, even within KPMG, there was concern about the potential illegality of these transactions.

The IRS disallowed losses generated by OPIS and similar transactions and, rather than individually prosecute each scheme, settled with the majority of OPIS purchasers in 2003. Scott did not accept a settlement offer. The IRS sent Scott a deficiency notice regarding his 1998 and 1999 returns, disallowing the losses he claimed in connection with the OPIS transaction and imposing penalties for gross valuation misstatement and negligent underpayment of taxes. In Scott's petition challenging the notice of deficiency, the Tax Court concluded that the IRS correctly disallowed the losses under the economic substance doctrine and both penalties were appropriate.

Under the common-law economic substance doctrine, tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income tax are denied.

Observation: The Health Care and Education Reconciliation Act of 2010 codified the economic substance test in new Code Sec. 7701(o). Effective for transactions entered into after March 23, 2010, Code Sec. 7701(o)(1) states that, for any transactions or series of transactions to which the economic substance doctrine applies, the transaction is treated as having economic substance only if: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (2) the taxpayer has a substantial purpose for entering into the transaction (apart from federal income tax effects).

Scott argued that the Tax Court erred in disallowing the OPIS losses under the economic substance rule and in imposing the gross valuation misstatement and negligent underpayment penalties because he relied in good faith on KPMG's representations.

The Tenth Circuit affirmed the Tax Court holding that the OPIS financial transactions were sham transactions that lacked economic substance. In rejecting Scott's argument that the OPIS transaction presented a reasonable probability of generating a profit, the court found that the OPIS transaction was designed to reduce Scott's tax liability. The court cited Jackson v. Comm'r., 966 F.2d. 598 (10th Cir. 1992), in which the Tenth Circuit held that, in determining whether to disregard a transaction, the court must ask: (1) what was the taxpayer's subjective business motivation and (2) did the transaction have objective economic substance?

The court noted that the Tax Court made four factual findings in support of its decision. First, the $45 million loss claimed by Scott was grossly disproportionate to the $6 million he invested in the OPIS. The loss was fictional, as Scott did not actually lose $45 million. Second, the OPIS transaction was planned and executed in a manner designed to produce a massive tax loss. The transaction, which included a stock purchase in the amount of the desired capital loss and an options collar, was timed to limit the potential for huge gains and was completely controlled by KPMG. Third, the transaction did not provide a reasonable expectation of profit. Fourth, the profit potential the OPIS transaction presented was de minimis compared to the tax benefits of declaring capital losses of $45 million. The court concluded that the Tax Court did not err in relying on expert testimony and finding that a remote possibility of profitability did not justify a large multi-step series of financial transactions. The court also noted that the timing of Scott's Buy.com stock sale and execution of the KPMG engagement letter, along with his failure to investigate the economic consequences of the OPIS transaction, indicated his attraction to the OPIS transaction for its tax benefit potential and nothing more.

The Tenth Circuit held that the penalties for gross valuation misstatement and negligent underpayment under Code Sec. 6662 were properly imposed. The court calculated that Scott's basis in the transaction was no more than what he actually paid for the stock and options (almost $3 million) - a misstatement of over 400 percent of what Scott actually owed for taxes. Moreover, the invalidation of the transaction under the economic substance doctrine did not prohibit the imposition of the gross valuation misstatement. Further, although KPMG instigated the tax evasion scheme, Scott knew that KPMG was not rendering independent tax advice, he signed an engagement letter with a material misrepresentation, and he filed his return claiming an improper deduction before he received KPMG's formal tax opinion. Therefore, Scott did not act with reasonable cause or in good faith, the court concluded.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700.

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IRS Rules on Tax Treatment of Payments under National Mortgage Settlement Agreement

Guidance is provided on the tax treatment of payments received by taxpayers under the National Mortgage Settlement agreement. Rev. Rul. 2014-2.

In 2012, the U.S. government and the attorneys general of 49 states and the District of Columbia entered into a National Mortgage Settlement (NMS) agreement with five bank mortgage servicers to address mortgage loan servicing and foreclosure abuses. One component of the NMS is a Borrower Payment Fund (Fund), which the parties intend to be structured as a qualified settlement fund under Reg. Sec. 1.468B-1. The terms of the settlement agreements provide that: (1) the five mortgage servicers collectively will pay approximately $1.5 billion into the Fund; (2) the Fund will make NMS payments to certain borrowers who lost their principal residences in foreclosure on or after January 1, 2008, and on or before December 31, 2011; (3) each borrower's transaction must meet certain requirements for the borrower to receive an NMS payment; and (4) for each NMS payment, the borrower must provide certain certifications under penalties of perjury. The NMS payment for each loan is the same amount (approximately $1,400).

With respect to these payments, the following tax issues arose: (1) If a taxpayer receives a payment pursuant to the NMS due to the foreclosure of the taxpayer's principal residence, what is the proper tax characterization of the payment? (2) If the NMS payment is characterized as part of the amount realized on the foreclosure and if that characterization creates or increases a gain on the foreclosure of the principal residence, are there grounds for the taxpayer to exclude from gross income some or all of that gain? (3) If the property for which a taxpayer receives an NMS payment contained one or more additional dwelling units that were not used as the taxpayer's principal residence, how should the NMS payment be allocated between the portion of the property that the taxpayer used as a principal residence and the rest of the property? (4) If a borrower who was eligible for an NMS payment died before receiving it, what is the tax treatment of the person who receives that payment?

In Rev. Rul. 2014-02, the IRS ruled that a taxpayer who receives an NMS payment, pursuant to the NMS agreement due to the foreclosure of the taxpayer's principal residence, must include the payment in income under Code Sec. 1001 as an amount realized on the foreclosure. If a taxpayer includes an NMS payment in the amount realized and, as a result, creates or increases a gain on the foreclosure of the principal residence, the taxpayer may exclude the resulting gain from gross income to the extent permitted under Code Sec. 121.

In addition, the IRS noted, an NMS payment is intended to compensate a borrower for loss of a principal residence rather than for loss on other property. This intention is indicated by the fact that only borrowers who lost their principal residence may receive the payment. Consequently, for purposes of Code Sec. 1001, Code Sec. 121, and Reg. Sec. 1.121-1(e), if a taxpayer receives an NMS payment for loss of a multiple-unit property, a portion of which was used as the taxpayer's principal residence, then the entire NMS payment is allocable to the portion of the property used as a principal residence.

Finally, the IRS stated that a taxpayer that receives a deceased eligible borrower's NMS payment "stands in the shoes" of the borrower for purposes of determining the tax consequences of that payment. Any gain not excluded from gross income under Code Sec. 121 is income in respect of a decedent.

For a discussion of the exclusion of gain from income upon the sale of a principal residence, see Parker Tax ¶77,725.

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Appropriate Statute of Limitations Period Must Be Determined before Nondischargeability of Tax Debts Can Be Resolved

Because a bankruptcy court did not determine whether a debtor sufficiently underreported his income to extend the statute of limitations from three years to six years, the priority and nondischargeability of the debtor's tax liability could not be resolved until additional information was obtained. In re Winters, 2013 PTC 389 (B.A.P. 6th Cir. 12/12/13).

Mark Winters filed his 2004 federal income tax return in September 2005, his 2007 return in November 2008, and his 2008 return in November 2009. In December 2009, the IRS sent a notice of deficiency to Mark for the 2004 tax year, asserting over $143,000 in additional taxes plus penalties. In 2010, Mark filed a petition in the Tax Court challenging the notice of deficiency and, in 2011, he filed a Chapter 7 bankruptcy petition. In the bankruptcy proceeding, Mark sought a determination of the amount of the tax liability owed. The IRS moved for summary judgment, alleging that, because the tax liabilities had not yet been assessed but would have been accessable after the petition date, the liabilities were entitled to priority status under Bankruptcy Code Section 507. In granting the IRS's motion, the bankruptcy court concluded that the IRS claim for 2004 taxes was a nondischargeable priority claim. Mark appealed the bankruptcy court order and his case in the Tax Court was stayed.

Code Sec. 6501 provides generally that a deficiency against a taxpayer must be assessed within three years after the due date of the return or the date the return was filed, whichever is later. However, when a taxpayer omits from gross income an amount that is in excess of 25 percent of the gross income stated on the return, the three-year statute of limitations period is extended to six years.

Bankruptcy Code Section 507 provides for the prioritization of unsecured IRS tax for a tax year ending on or before the date of the filing of a bankruptcy petition.

Observation: The IRS has the authority to collect outstanding federal taxes for 10 years from the date a taxpayer's liability is assessed. The 10-year collection period is suspended for tax periods included in a bankruptcy while an automatic stay is in effect, plus an additional six months.

Mark argued that the 2004 tax debt was dischargeable because the three-year statute of limitations had run before the IRS issued its notice of deficiency.

The IRS contended that the three-year period was extended to six years because Mark omitted more than 25 percent of his gross income from his return.

The bankruptcy trustee argued that the case should go back to the bankruptcy court because neither the bankruptcy court nor the Tax Court had determined the amount of Mark's 2004 tax debt.

The Bankruptcy Appellate Panel for the Sixth Circuit reversed the bankruptcy court holding that the IRS claim for 2004 taxes was a nondischargeable priority claim. The appellate court found that the bankruptcy court failed to determine whether the statute of limitations had run on the 2004 tax liabilities before the IRS issued its notice of deficiency in 2009. The court noted that the IRS motion for summary judgment in the instant case only sought a determination regarding the priority and dischargeability of the 2004 tax debt, not the amount of the debt. Whether the Mark's 2004 tax liability was ultimately nondischargeable depended on the amount by which he underreported his 2004 income. The court concluded that, until that amount has been determined, the issues of the applicable statute of limitation, priority, and dischargeability could not resolved. Accordingly, the court remanded the case to the bankruptcy court to determine the amount of the 2004 tax debt.

For a discussion of the statute of limitations, see Parker Tax ¶260,130.

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Supreme Court Remands Tax Refund Case to Sixth Circuit to Determine Jurisdictional Issues

The Sixth Circuit should have the first opportunity to consider a new argument by the IRS with respect to jurisdiction in a case involving a refund claim under Code Sec. 6611. Ford Motor Co. v. U.S., 2013 PTC 375 (S. Ct. 12/2/13).

When a taxpayer overpays his taxes, he is generally entitled to interest from the IRS for the period between the payment and the ultimate refund. That interest begins to run "from the date of overpayment." However, the Code does not define "the date of overpayment."

After the IRS advised Ford Motor Company that it had underpaid its taxes from1983 until 1989, Ford remitted a series of deposits to the IRS totaling $875 million. Those deposits stopped the accrual of interest that Ford would otherwise owe once ongoing audits were completed and the amount of its underpayment was finally determined. Later, Ford requested that the IRS treat the deposits as advance payments of the additional tax that Ford owed. Eventually the parties determined that Ford had overpaid its taxes in the relevant years, thereby entitling Ford to a return of the overpayment as well as interest. But the parties disagreed about when the interest began to run under Code Sec. 6611(b)(1). Ford argued that "the date of overpayment" was the date that it first remitted the deposits to the IRS. The IRS countered that the date of overpayment was the date that Ford requested that the IRS treat the remittances as payments of tax. The difference between the parties' competing interpretations of Code Sec. 6611(b) was $445 million.

Ford sued the IRS in federal district court and the IRS did not contest the court's jurisdiction. The court accepted the IRS's construction of Code Sec. 6611(b). The Sixth Circuit affirmed, concluding that Code Sec. 6611 is a waiver of sovereign immunity that must be construed strictly in favor of the IRS.

Ford appealed to the Supreme Court, arguing that the Sixth Circuit was wrong to give Code Sec. 6611 a strict construction. In Ford's view, 28 U.S.C. Section 1346, and not Code Sec. 6611, waives the IRS's immunity from the suit, and Code 6611(b) is a substantive provision that should not be construed strictly. In its response to Ford's petition to the Supreme Court, the IRS contended for the first time that Section 1346(a)(1) does not apply at all. Instead it argued that the only basis for jurisdiction, and the only general waiver of sovereign immunity that encompassed Ford's claim is the Tucker Act, 28 U.S.C. Section 1491(a). Although the IRS acquiesced in jurisdiction in the lower courts, its argument before the Supreme Court was that, if the Tucker Act applies to the suit, jurisdiction over the case was proper only in the U.S. Court of Federal Claims.

The Supreme Court held that the Sixth Circuit should have the first opportunity to consider the IRS's new contention with respect to jurisdiction in the case. Depending on that court's answer, the Supreme Court said, the Sixth Circuit may also consider what impact, if any, the jurisdictional determination has on the merits issues, especially whether or not Code Sec. 6611 is a waiver of sovereign immunity that should be construed strictly. As a result, the Court vacated the judgment of the Sixth Circuit and remanded the case for further proceedings.

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

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IRS Reminds Preparers to Obtain PTINs for 2014 Tax Year

The IRS is reminding professional tax return preparers to renew their Preparer Tax Identification Numbers (PTINs) if they plan to prepare returns in 2014. IR-2013-101 (12/23/13).

The IRS is reminding professional tax return preparers to renew their Preparer Tax Identification Numbers (PTINs) if they plan to prepare returns in 2014. Current PTINs expire December 31, 2013. Anyone, including CPAs and attorneys, who prepares or helps prepare all or substantially all of a federal tax return, claim for refund, or other federal forms for compensation must have a valid PTIN. All enrolled agents also must have a PTIN. Tax professionals can obtain or renew their PTINs at irs.gov/ptin.

Observation: The IRS temporarily suspended the PTIN program earlier in the year after a D.C. district court's decision in Loving v. U.S., 2013 PTC 10 (D.C. D.C. 2013). After the court clarified its order, the IRS reopened the PTIN program.

Those renewing their PTINs can complete the process in about 15 minutes, according to the IRS. The renewal fee is $63. Tools are available to assist any preparers who have forgotten their user name, password, or email address.

New tax return preparers who are obtaining a first-time PTIN must create an online PTIN account as a first step and then follow directions to obtain a PTIN. Their fee is $64.25.

The annual PTIN requirement is part of the IRS's ongoing effort to enhance tax administration and improve services to taxpayers.

There are approximately 700,000 tax preparers with 2013 PTINs. More than 400,000 have already renewed their PTIN, plus more than 25,000 have obtained a first-time PTIN for 2014.

For a discussion of the PTIN requirement, see Parker Tax ¶275,100.