Federal Tax Bulletin - Issue 54 - January 16, 2014

IRS Finally Releases Draft Instructions for Form 8960; Plays Down Gaps in Net Investment Income Tax Guidance

Effective for tax years beginning after 2012, Code Sec. 1411 imposes a 3.8 percent net investment income tax on individuals and trusts and estates where certain criteria are met. In August, the IRS released a draft of Form 8960, Net Investment Income Tax Individuals, Estates, and Trusts, upon which the calculation of this tax is reported. Finally, last week, the IRS issued a draft of the instructions to go with the form.

While the Form 8960 draft instructions do little to clarify some of the bigger issues taxpayers have with respect to the net investment income tax - for example, whether an activity rises to the level of a non-Code Sec. 1411 trade or business such that the income from the activity is exempt from the tax - they do provide several worksheets that are helpful in calculating some of the line items on Form 8960. The worksheets use information from other forms to calculate the amounts reported on Form 8960 for (1) net gains and losses; (2) deduction recoveries; (3) the itemized deduction limitation on deductions allocable to investment income; (4) the income of a trader in financial instruments that maintain more than one trade or business; and (5) modified adjusted gross income. The instructions also include a detailed example for using net operating losses (NOLs) in the calculation of the net investment income tax. However, use of NOLs will not apply to the 2013 tax year because only NOLs incurred after 2012 are available to be used against the net investment income tax.

At 19 pages, the draft instructions are dwarfed by the hundreds of pages of final and proposed regulations on the net investment income tax. Thus, it is almost impossible for anyone to rely solely on the Form 8960 instructions to correctly calculate the tax.

Form 8960 is modeled after the final regulations. While taxpayers can use either the final regulations or the 2012 proposed regulations in calculating the net investment income tax for the 2013 tax year, the 2013 regulations are such an improvement over the 2012 proposed regulations that there would be few situations, if any, that using the 2012 proposed regulations would result in a better answer for taxpayers.

Form 8960 must be attached to any return where Line 16 is greater than zero (individuals) or Line 20 is greater than zero (estates and trusts).

No Time for an IRS Publication This Year

IRS officials have noted that it has been challenging for them to try to come up with regulations to implement the net investment income tax provisions, while also distilling those regulations into 19 pages of instructions and worksheets that can be read at an eighth-grade level, the criteria the IRS uses when writing forms instructions. According to the IRS, a lengthy net investment income tax publication will eventually be released. But, the short amount of time the IRS had to come up with final regulations, a form, and form instructions did not leave any time for an IRS publication for the 2013 tax year.

Glitch in Instructions

One of the more favorable changes in the final regulations was the allowance of losses in excess of gains as a properly allocable deduction to the extent the losses would be allowable in computing taxable income for income tax purposes. Thus, for example, the $3,000 capital loss ($1,500 in the case of an individual filing as married filing separately) is allowed as a properly allocable deduction. The total net gains and losses are calculated on the Net Gains and Losses Worksheet in the Form 8960 instructions. However, there is a glitch in that worksheet in which the lines that pull in the capital loss carryovers result in more income being taxed than is appropriate. The IRS has acknowledged this and said that this section of the worksheet will be revised.

Application to Estates and Trusts

The net investment income tax applies to estates and trusts with income above a certain threshold. The only revision to Form 1041 is the addition of a line to Schedule G on the Form 1041 for the input of the net investment income tax calculated on the Form 8960. Otherwise, the bulk of the calculations for estates and trusts are done on the Form 8960 and the worksheets in the instructions.

Interaction of Passive Activity Recharacterization Rules and Code Section 1411

The net investment income tax rules of Code Sec. 1411 rely heavily on the passive activity loss rules of Code Sec. 469 and, without a solid understanding of the rules under Code Sec. 469, practitioners may have a difficult time computing a client's net investment income tax. The general rule is that, if an activity is nonpassive for purposes of Code Sec. 469, it's nonpassive for purposes of the net investment income tax. Once an activity is characterized as nonpassive, then the next step is to determine whether income from the activity rises to the level of being derived in the ordinary course of a trade or business and, thus, exempt from the net investment income tax.

The IRS has specified three areas where income and gain recharacterized under Code Sec. 469 as "not from a passive activity" will not be considered a Code Sec. 1411 trade or business and thus will be exluded from being subject to the net investment income tax. These three areas are: (1) the developer rule in Reg. Sec. 1.469-2T(f)(5); (2) the self rented property rule in Reg. Sec. 1.469-2(f)(5); and (3) the significant participation rule in Reg. Sec. 1.469-2T(f)(2).

Former Passive Activities

The instructions address the impact of losses previously disallowed because they were from a passive activity that is no longer passive with respect to the taxpayer. For example, a student who owns shares in a family S corporation business, but did not participate in the business because he or she was going to school, may have suspended losses from the activity. If the student then graduates and goes into the family business, the activity is no longer a passive activity. The instructions provide that, in such a case, a prior tax year's unallowed loss from the former passive activity is allowed to the extent of current year income from the activity. For purposes of determining the taxpayer's net investment income, suspended losses from such former passive activities are allowed as a properly allocable deduction, but only to the extent nonpassive income from the same activity is included in the taxpayer's net investment income in that year.

Installment Sales

The Form 8960 instructions clarify what happens when a taxpayer that had an installment sale of an interest in an S corporation or a partnership in a year before the net investment income tax took effect receives payments in a year in which the net investment income tax is in effect. In such cases the taxpayer must adjust his or her net gain amount in the year of disposition, even if the disposition occurred before 2013. The difference between the amount reported for regular tax and for purposes of the net investment income tax is then taken into account when each payment is received. A statement must be attached to the taxpayer's return in the first year the taxpayer is subject to the net investment income tax, but doesn't need to be attached in subsequent years.

Safe Harbor for Real Estate Professionals

The final regulations added a safe harbor rule for certain real estate professionals. Under this rule, if a real estate professional participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last 10 tax years (one or more of which may be tax years before the effective date of Code Sec. 1411), then the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. The safe harbor test also provides that, if the hour requirements are met, the real property is considered as used in a trade or business for purposes of calculating net gain under the net investment income tax provisions. Under Reg. Sec. 1.469-9, taxpayers may group their rental activities for purposes of meeting the 500 hour tests.

The Form 8960 instructions on the safe harbor requirements are somewhat misleading in that they state that a real estate professional qualifies for the safe harbor if the professional participated in each rental real estate activity for more than 500 hours during the tax year. What is not mentioned is the grouping rule that allows taxpayers to combine their rental activities for purposes of the 500-hour tests. It is also helpful to remember that, under Reg. Sec. 1.469-5T(f)(3), a taxpayer can count his or her spouse's participation in the activity in determining if the 500-hour test is met.

Issues with Regrouping Rules

While the instructions discuss when a taxpayer can use the regrouping rules, they do not address any of the many questions that practitioners have about how those rules will operate in certain situations.

Under an economic grouping rule in Code Sec. 469, a taxpayer can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity loss rules. The grouping rules are important because they determine the scope of a taxpayer's trade or business and whether or not that trade or business is a passive activity for purposes of the net investment income tax.

The final regulations allow a taxpayer to regroup activities during the first tax year beginning after 2012, in which (1) the taxpayer meets the applicable income threshold to be subject to the net investment income tax, and (2) has net investment income. According to the IRS, if a taxpayer does not have a net investment income tax liability, the reason for allowing the regrouping does not apply. The IRS decided not to expand the scope of the regulations to allow regrouping by partnerships and S corporations, because if it did, then taxpayers with no tax liability under Code Sec. 1411 indirectly would be allowed to regroup.

The final regulations added a provision allowing a taxpayer to regroup on an amended return, but only if the taxpayer was not subject to Code Sec. 1411 on his or her original return (or previously amended return), and if, because of a change to the original return, the taxpayer owes net investment income tax for that tax year. This rule applies equally to changes to modified adjusted gross income or net investment income upon an IRS examination.

However, regrouping on an amended return can lead to multiple issues for which the IRS has not released any guidance. For example, what if a taxpayer amends a 2014 tax return and is allowed to regroup because he or she is subject to the net investment income tax in that year for the first time. Then, in 2017, the taxpayer has a loss that he or she carries back to 2014 and that loss eliminates the net investment income tax, so that regrouping would not have been allowed. Or what if a taxpayer has an open return being audited and is allowed to regroup in a way that would favorably impact subsequent year but those years are closed?

The IRS has stated that practitioners can expect to see a series of guidance in the form of revenue rulings, revenue procedures, and regulation projects over the coming years aimed at clarifying the many questions practitioners have about the net investment income tax. For many tax professionals, the additional guidance can't come soon enough.

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Form 1099 Questions on Tax Forms Continue to Plague Practitioners

The 2013 Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, all contain questions asking if the taxpayer made any payments in 2013 that would require the taxpayer to file Form(s) 1099. If the answer is "yes," then the IRS wants to know if the taxpayer did, or will, file the required Forms 1099. The questions first showed up in 2011 and coincided with an increase in the penalties for failing to file correct information returns and payee statements. Practitioners immediately expressed concern that their clients may not be focused enough on the ramifications of not correctly reporting Form 1099 income and on their own liability for checking these boxes. If a client reports that all Form 1099s were filed when they were not, the client may be perjuring himself or herself. If the client reports that not all Form 1099s were filed, then that's a red flag for an audit.

Practice Aid: See ¶320,690 for a client letter which explains the requirement to file Form 1099 and the significance of the 1099 question on the various returns.

If a taxpayer has a business that uses sporadic labor, the Form 1099 questions can present a dilemma in certain situations. For example, how does a taxpayer who intermittently employs workers by picking them up at places where such workers congregate, answer the questions? If any of these workers are used several times during the year in the taxpayer's business, the amounts paid to that worker will most likely exceed $600 so that the contractor is responsible for issuing a Form 1099-MISC to that individual. What if the workers will accept only cash. Without proper documentation, how does the taxpayer prove that no one individual was paid more than $600?

Form 1099-MISC

Generally, any person, including a corporation, partnership, individual, estate, and trust, that makes reportable transactions during the calendar year must file information returns to report those transactions to the IRS. However, a payer does not need to file Form 1099-MISC for payments not made in the course of the payer's trade or business. Thus, personal payments are not reportable. A payer is engaged in a trade or business if it operates for gain or profit. Nonprofit organizations are considered to be engaged in a trade or business and are subject to the reporting requirements. For other exceptions to filing a Form 1099-MISC, see ¶252,565.

The type of reportable transaction determines the Form 1099 that must be filed. Most of the issues revolving around the filing of Forms 1099, involve Form 1099-MISC and the reporting of non-employee compensation. In general, a payer must file Form 1099-MISC, Miscellaneous Income, for each person to whom the payer has paid during the year:

(1) at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest;

(2) at least $600 in rents, services (including parts and materials), prizes and awards, other income payments, medical and health care payments, crop insurance proceeds, cash payments for fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish, or, generally, the cash paid from a notional principal contract to an individual, partnership, or estate;

(3) any fishing boat proceeds; or

(4) gross proceeds to an attorney.

In addition, Form 1099-MISC must be filed to report direct sales of at least $5,000 of consumer products made to a buyer for resale anywhere other than a permanent retail establishment. Form 1099-MISC must also be filed for each person from whom a taxpayer has withheld any federal income tax under the backup withholding requirement (discussed below), regardless of the amount of the payment.

Compliance Tip: The deadline for filing paper Forms 1099-MISC is generally the last day of February following the calendar year for which the filing is made. The due date is extended until the last day of March for payers who file electronically. If the regular due date falls on a Saturday, Sunday, or legal holiday, Form 1099-MISC is due the next business day.

Backup-Withholding Requirement

There is a backup withholding requirement that applies to a reportable payment if the payee does not furnish a taxpayer identification number (TIN). The backup withholding rate is equal to 28 percent of the amount paid. The backup withholding requirement does not apply to payments made to tax-exempt, governmental, or international organizations.

In determining whether a payee has failed to provide a TIN, a payer is required to process the TIN within 30 days after receiving it from the payee or in certain cases, from a broker. Thus, the payer may take up to 30 days to treat the TIN as having been received.

Penalties for Failing to File Correct Information Returns

If a payer fails to file a correct information return by the due date and cannot show reasonable cause for failing to do so, the payer may be subject to a penalty. The penalty applies if the person fails to file timely, fails to include all information required to be shown on a return, or includes incorrect information on a return. The penalty also applies if a person files on paper when required to file electronically, reports an incorrect taxpayer identification number (TIN) or fails to report a TIN, or fails to file paper forms that are machine readable. The amount of the penalty is based on when the correct information return is filed. For returns required to be filed for the 2013 tax year, the penalty is:

• $30 per information return for returns filed correctly within 30 days after the due date (by March 30 if the due date is February 28), with a maximum penalty of $250,000 a year ($75,000 for certain small businesses);
• $60 per information return for returns filed more than 30 days after the due date but by August 1, with a maximum penalty of $500,000 a year ($200,000 for certain small businesses); and
• $100 per information return for returns filed after August 1 or not filed at all, with a maximum penalty of $1,500,000 a year for most businesses but $500,000 for certain small businesses.

For purposes of the lower penalty, a business is a small business for any calendar year if its average annual gross receipts for the most recent three tax years (or for the period it was in existence, if shorter) ending before the calendar year do not exceed $5 million.

Persons who are required to file information returns electronically but who fail to do so (without an approved waiver) are treated as having failed to file the return, and are therefore subject to a penalty of up to $100 per return unless the person shows reasonable cause for the failure. However, they can file up to 250 returns on paper; those returns will not be subject to a penalty for failure to file electronically. The penalty applies separately to original returns and corrected returns.

Observation: For each fifth calendar year beginning after 2012, each of the dollar amounts described above is subject to indexing for inflation.

The penalty for failure to include the correct information on a return does not apply to a de minimis number of information returns with such failures if the failures are corrected by August 1 of the calendar year in which the due date occurs. The number of returns to which this exception applies cannot be more than the greater of 10 returns or 0.5 percent of the total number of information returns required to be filed for the year.

The penalty for a failure to include the correct information on a return does not apply to inconsequential errors or omissions. If a failure to file a correct information return is due to an intentional disregard of one of the requirements (i.e., it is a knowing or willing failure), the penalty is the greater of $250 per return or the statutory percentage of the aggregate dollar amount of the items required to be reported (the statutory percentage depends on the type of information return at issue). In addition, in the case of intentional disregard of the requirements, the $1,500,000 limitation does not apply.

Can IRS Limit Deductions to $600 Where No Form 1099 Is Filed?

Some practitioners have questioned whether or not the IRS can limit a compensation deduction to $599, the cutoff for not reporting nonemployee compensation, where a Form 1099-MISC is not filed. While there is nothing in the Code or regulations on this, nor is there any case law on point, some practitioner have reported IRS agents telling them that if they had not produced Form 1099s for compensation deductions taken on a return, the nonemployee compensation deduction would be limited to an amount not required to be reported on Form 1099-MISC.

What Constitutes a Trade or Business That Requires Reporting on Form 1099?

The characterization of an activity as a "trade or business" took on a new importance in 2013 with the implementation of the net investment income tax. Effective for tax years beginning after December 31, 2012, individuals are subject to a 3.8 percent tax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. Generally, income from a trade or business (with the exception of certain commodities trading income) is exempt from the net investment income tax.

As previously mentioned, taxpayers not in a trade or business aren't required to file Form 1099s. Whether a taxpayer is considered to be in a trade or business has become a hot topic because of the net investment income tax. As a result, taxpayers may be claiming that their activity is not subject to the net investment income tax because it rises to the level of a trade or business without considering the impact that will have on their Form 1099 filing requirements and the associated penalties if such forms aren't filed.

Conclusion

Practitioners should advise their clients to have non-employee workers or workers complete a Form W-9 if they believe payments to any individual might add up to $600 or more for the year. To the extent anyone is paid more than $600, a Form 1099-MISC should then be issued at the end of the year. Practitioners should also document in their files that they've had this discussion with clients and may want to consider revising their engagement letter to reflect the documentation a client will need in order to take certain deductions on the return. Similarly, practitioners may want to warn their clients about the trade-offs for claiming they are in a trade or business in an effort to escape the net investment income tax and their responsibility for filing Form 1099s when they are in a trade or business.

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Financial Adviser's Control over Taxpayers' Self-Directed IRA Proves Costly

Self-directed IRAs have become increasingly popular in recent years because they allow an IRA owner to have more control over the type of investments that will be held in the IRA. For example, the owner of a self-directed IRA may choose from a range of investments permitted for IRAs - including real estate, limited partnerships, mortgages, notes, franchise businesses, etc. - rather than being limited to the typical investments offered by IRA custodians and trustees (stocks, bonds, mutual funds, etc.). This higher degree of flexibility in choosing IRA investments allows the IRA owner to invest in assets with greater wealth-building potential. According to a 2011 report by the Investment Company Institute, U.S. investors held approximately $4.7 trillion in IRAs. Estimates from various sources approximate that investors' hold 2 percent, or $94 billion, of IRA retirement funds in self-directed IRAs.

The large amount of money held in self-directed IRAs makes them attractive targets for fraud promoters. A self-directed IRA can be costly if the IRA owner does not properly manage the investments and leaves that task to someone else. Such was the case in Berks v. Comm'r, T.C. Summary 2014-2 (12/30/13), where a couple rolled over the funds from their IRA to a self-directed IRA after being advised to do so by their financial adviser. The financial adviser invested the couple's self-directed IRA in five real estate partnerships that, after several years, went belly up. Because the couple never received the proper documentation from the adviser regarding notes issued to the self-directed IRA by the partnerships, and could not properly document their losses, they were hit with tax deficiencies and penalties relating to the depletion of their IRA assets.

Background

In the late 1990s, Bernard and Claire Berks' financial adviser, J. Richard Blazer, presented them with a proposal to invest in various real estate partnerships. Mr. Blazer was the president of a venture capital firm. The Berks had known Mr. Blazer since the mid-1980s and considered him a friend. The Berkses decided to invest and, with Mr. Blazer's help, they rolled over money from preexisting IRAs into separate self-directed IRA accounts that they opened with a firm called TCA. Mr. Blazer recommended TCA to the Berkses because it would accept promissory notes in IRA accounts for which it served as custodian and he had a good working relationship with the firm. TCA recognized Mr. Blazer as the Berkses' authorized representative. Read more...

What to Do about Missing or Incorrect Forms W-2 and 1099

If a missing or corrected Form W-2 or Form 1099 is not received by February 14, the IRS should be contacted, and the IRS will attempt to obtain the information from the employer.

Employers/payers have until January 31 to issue certain informational documents. If a Form W-2 or Form 1099-R is not received by January 31, or the information is incorrect on these forms, the taxpayer should contact the employer/payer.

If a missing or corrected Form W-2 or Form 1099 is still not received by February 14, the IRS should be contacted at 800-829-1040 for assistance. When calling the IRS, the following information is necessary: the taxpayer's name, address (including ZIP code), phone number, and social security number, as well as the employer/payer's name, address (including ZIP code), and phone number, employer identification number (if known), an estimate of the wages earned by the employee, the federal income tax withheld, and the dates of employment.

After February 14, the IRS will contact the employer/payer and request the missing form. The IRS will also send the taxpayer a Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., along with a letter containing instructions.

Where a taxpayer does not receive the missing form in sufficient time to file his or her tax return on a timely basis, the taxpayer may use the Form 4852 to complete the return. If the taxpayer subsequently receives the missing or corrected Form W-2 or Form 1099-R after a return is filed and a correction to the originally filed return needs to be made, then the taxpayer should file Form 1040X, Amended U.S. Individual Income Tax Return.

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Claiming Mortgage Interest and Real Estate Taxes on Other Property Doesn't Preclude First-Time Homebuyer Credit

An individual who claimed deductions for mortgage interest and real estate taxes on real property that was not his principal residence was not disqualified from being considered a first-time homebuyer for purposes of the first-time homebuyer credit. Brewer v. Comm'r., T.C. Memo. 2013-295 (12/30/13).

James Brewer, an employee of the IRS, purchased a residential condominium in Staten Island, New York in January 2005. He lived at the property until June 2005 when he moved to New Jersey with his companion. James used a mailbox in New Jersey to receive all his mail, obtained a New Jersey driver's license, and attended church in New Jersey. From 2005 to 2007, his companion's sister lived at the Staten Island property but did not pay rent to James at any time.

In 2008, James and his companion bought a single-family home in New Jersey. His realtor for the sale completed a Form HUD-1, Uniform Settlement Statement, and listed James's Staten Island property as his address. For 2005 and 2006, James filed a New York and a New Jersey part-year resident tax return. For 2007, he filed only a New Jersey state resident tax return and claimed deductions for real estate taxes and mortgage interest in connection with the Staten Island property.

In 2008, James filed a New Jersey state resident tax return. On his federal income tax return, James listed the New Jersey home as his address and claimed a first-time homebuyer credit in connection with his purchase of the property. The IRS disallowed the credit and issued a notice of deficiency.

Code Sec. 36 provided a refundable credit to an individual who was a first-time homebuyer of a principal residence after April 8, 2008, and before May 1, 2010 (or October 1, 2010, for purchasers with a binding contract before May 1, 2010). Under Code Sec. 36(c)(1), a taxpayer was eligible for the first time homebuyer credit on the purchase of a principal residence if: (1) he or she did not have a present ownership interest in a principal residence during the three-year period ending on the date of the purchase of the principal residence for which the first-time homebuyer credit is claimed; or (2) he or she owned and used the same home as his or her principal residence for any five consecutive years during the eight-year period before the date of the purchase. The credit was phased-out for higher income taxpayers.

For purposes of this credit, the term "principal residence" has the same meaning as in Code Sec. 121 (i.e., the provision that allows taxpayers to exclude from gross income gain from the sale of a principal residence, if certain requirements are met). Under Reg. Sec. 1.121-1(b)(2), if a taxpayer alternates living between two properties, using each residence for successive periods of time, the property the taxpayer uses a majority of the time during the year generally is considered the taxpayer's principal residence. In addition to the taxpayer's use of the property, other relevant factors, such as the taxpayer's place of employment and the principal place of abode of family members, may determine the taxpayer's principal residence.

James argued that the Staten Island property stopped being his principal residence when he moved to New Jersey in 2005. Thus, the required three years had passed, since he owned a principal residence.

The IRS contended that James was not a first-time homebuyer since he held an ownership interest in the Staten Island property and used the property as his principal residence.

The Tax Court held that the Staten Island property was not James's principal residence after 2005 and, thus, he qualified as a first-time homebuyer for purposes of the credit. James's credible testimony demonstrated that he moved out of the Staten Island property in 2005. Moreover, the Form HUD-1, completed by the realtor on his behalf, did not indicate James's principal residence as it only required an address of the borrower, not his home address. James's 2007 and 2008 returns also indicated that he lived solely in New Jersey. Finally, the court said that the deductions for mortgage interest and real estate taxes on the Staten Island property were not conclusive as to James's principal residence because James was entitled to claim the deductions even though the property was not his principal residence.

For a discussion of the first-time homebuyer credit, see Parker Tax ¶260,130.

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Taxpayer Establishes Reasonable Cause for Failing to Honor IRS Levies and Escapes 50 Percent Penalty

The manager of a limited liability company was not personally liable for his failure to honor certain tax levies issued by the IRS because he established that there was a bona fide dispute over the effectiveness of the levies and, therefore, he had reasonable cause not to honor the levies. U.S. v. 911 Management, LLC, 2014 PTC 3 (D. Ore. 1/2/14).

Daniel Dent was the sole manager of 911 Management, LLC, until its dissolution in 2010. Daniel was the only person authorized to conduct business and make payments on behalf of 911 Management. The company had three members, including Kathy Weathers, who was allocated a 35 percent distribution of the LLC's profits. In 2005, Kathy and her husband, Thomas, were convicted of tax evasion and failing to file tax returns. Thomas was sentenced to prison.

Beginning in 2006, 911 Management made guaranteed membership distributions to Kathy on a monthly basis. In 2007, two license agreements were created under which 911 Management would operate and receive the income from two hotels leased by Kathy and Thomas. In exchange, the Weathers couple would receive a license fee equal to 3 percent of the monthly gross proceeds generated from the hotel operations. In 2007, the IRS served three notices of levy against the bank accounts of 911 Management to satisfy Kathy and Thomas's outstanding federal tax liabilities for tax years 1996 through 2005. In response, 911 Management filed an action against the government for wrongful levy.

In February 2008, the IRS served two notices of levy on 911 Management and Daniel to collect some of Kathy and Thomas's outstanding federal tax liabilities. After the levies were served, an IRS revenue officer informed Daniel that the levies attached both the monthly membership distribution and the 3 percent fee generated from operation of the hotels. The levy forms contained instructions and excerpts of various statutes. After consulting the LLC's attorney, Daniel responded to the IRS that he understood all the tax liabilities of the Weatherses were satisfied and the company did not pay wages or salary to the Weatherses. The IRS revenue officer replied in a letter that the levies attached to all monies paid to the Weathers couple, not just wages and salaries, and Daniel was required to comply with the levies. In April 2008, the IRS sent two final demand for payment forms regarding the notices of levy based on the Weatherses' outstanding tax liabilities. As manager of 911 Management, Daniel continued to make the guaranteed monthly distributions and 3 percent licensing proceeds to Kathy and Thomas until the company dissolved.

The government sued 911 Management and Daniel for the balance of the Weatherses' unpaid tax liabilities for which the levies were issued and for a 50 percent penalty for failure to honor the levies without reasonable cause. The court entered a default judgment against 911 Management for $129, 200 and ruled that Daniel was personally liable for the default judgment amount.

Code Sec. 6332 provides that any person in possession of property or rights to property subject to levy must surrender such property or rights to the IRS upon demand, except such property or rights that are subject to attachment or execution under any judicial process.

Observation: For purposes of this rule, the term "person," includes an officer or employee of a corporation or a member or employee of a partnership, who is under a duty to surrender the property, or rights to property, or to discharge the obligation.

Daniel argued that the language of the levies was ambiguous, confusing, and contained contrary instructions, and therefore, there was a bona fide dispute over the legal effectiveness of the levies and over the property to be surrendered.

The IRS contended that 911 Management was formed to attempt to provide Kathy with income while Thomas was in prison and that there was no bona fide dispute over the amount of the levied property under Daniel's control or the legal effectiveness of the levies.

A district court held that Daniel established reasonable cause for his failure to honor the 2008 IRS levies. Under the circumstances, including ongoing litigation over the 2007 levies, confusing language in the 2008 notices over whether the levies attached only to funds owed at the time of the levies were issued, and legal counsel's subjective concern that the IRS may have used the wrong levy form, the court found it was objectively reasonable for Daniel to rely on the company legal counsel's direction even though the advice was contrary to the instructions of the IRS revenue officer. Accordingly, Daniel established that there was a bona fide legal dispute over the effectiveness of the 2008 levies on which he relied when he decided to refuse to honor those levies. Therefore, Daniel was not liable for the 50 percent penalty, the court concluded.

For a discussion of IRS levies, see Parker Tax ¶260,540.

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Inherited IRA Is Exempt from Debtors' Bankruptcy Estate

A couple was entitled to claim an exemption from their bankruptcy estate for an inherited IRA because the issuing annuity insurer received a favorable determination from the IRS that the account satisfied the requirements of Code Sec. 408 and the determination was in effect when the debtors filed their bankruptcy petition. In re Trawick, 2013 PTC 411 (Bankr., C.D. Cal. 12/20/13).

In 2003, an annuity insurance company issued an annuity policy as an individual retirement account (IRA) to Roberta Berry. The IRA was issued by the company pursuant to a favorable determination letter from the IRS approving the prototype annuity contract as meeting the requirements of Code Sec. 408. The determination letter received by the company was never revoked. The IRA was subsequently inherited by Roberta's daughter, Stephanie. In 2012, Stephanie and Jeffrey Trawick filed a Chapter 7 bankruptcy petition and claimed an exemption for the inherited IRA. The bankruptcy trustee filed an objection to the debtors' claim of exemption.

Under Bankruptcy Code Section 522(b)(3)(C), funds are exempt from a bankruptcy estate if they meet the following two requirements: (1) the amount the debtor seeks to exempt are retirement funds; and (2) the retirement funds are in an account that is exempt from tax under the provisions of the Internal Revenue Code.

A bankruptcy court held that the funds in the inherited IRA were exempt from the bankruptcy estate. The court cited Mullen v. Hamlin, 465 B.R. 863 (B.A.P. 9th Cir. 2012), in which the Ninth Circuit held that, if the retirement funds were in a retirement account that received a favorable determination from the IRS and the determination was in effect when the bankruptcy petition was filed, then the funds are presumed to be exempt from the bankruptcy estate. The bankruptcy court noted that the funds in the inherited IRA were retirement funds qualifying for exempt status based on the plain language of Bankruptcy Code Section 522(b)(3)(C). Moreover, the debtors showed that the funds were in a retirement account that had received a favorable determination from the IRS, and the determination was in effect as of the date the debtors filed their bankruptcy petition. Further, the trustee presented no evidence to rebut the presumption of exemption. Accordingly, the court concluded that the funds in the inherited IRA were exempt from the estate, and the trustee's objection to the debtors' claim of exemption was denied.

For a discussion of inherited IRAs, see Parker Tax ¶134,550.

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First Circuit Upholds 84-Month Prison Sentence for Evasion of Payroll Taxes

An appellate court determined that, because the taxpayer was the mastermind of several tax evasions schemes, he warranted a longer prison sentence than his co-conspirators. U.S. v. Floyd, 2014 PTC 8 (1st Cir. 1/7/14).

A jury convicted Catherine Floyd and her husband, William Dion, and several others, including Charles Adams, of setting up and operating a series of entities to facilitate the evasion of payroll taxes by third-party employers. One of these entities was Contract America - a company that Charles ran. Instead of paying its employees directly, a client firm would funnel money to Contract America, which then paid the client's employees (or those of them who agreed to participate in the fraud) under the table. Through this contrivance, both the client firm and the participating employees were able to hide from the IRS. Catherine and William complemented the services of Contract America by operating a front company, Talent Management, to work with employees who wanted to stay on the straight and narrow. A firm using this service would funnel money to Talent Management, which would comply with the withholding requirements before paying the affected employees. This made it look as if Talent Management was actually employing the workers and allowed the client firm to remain invisible.

Another scheme involved the provision of "warehouse banking" services. In this operation, Catherine and William commingled their own funds and the funds of many clients in nominee bank accounts. The purpose of this commingling was to confound the IRS about the source of the funds. They executed the warehouse banking scheme through a company called Your Virtual Office (YVO), its successor Office Services, and related entities. Clients delivered funds to Catherine and William, who deposited the funds into a constellation of accounts that they controlled. On request, they would use the deposited funds to defray a client's expenses or to deliver cash. A software program would track the flow of funds. As a capstone to the indictment, the IRS charged Catherine and William with endeavoring to impede the IRS by concealing their ill-gotten gains. The core of these charges was the IRS's contention that Catherine and William operated their warehouse banking scheme so as to obstruct the IRS's assessment of their personal tax liability.

A district court sentenced William, Catherine, and Charles to 84 months, 60 months, and 48 months in prison, respectively. It sentenced other coconspirators, who did not go to trial, more leniently. William appealed, saying that his sentence reflected an unwarranted disparity. According to William, he was similarly situated to his coconspirators, yet sentenced more harshly.

The First Circuit affirmed the district court's sentence. The court noted that William's premise that he did not deserve a longer prison sentence because he was similarly situated as the other coconspirators was undercut by the record. The district court supportably found that William was more culpable than his coconspirators because he was the mastermind of the conspiracies, the First Circuit said. According to the court, it was too obvious to warrant citation of authority that an offender who sits at the top of a criminal hierarchy is not similarly situated to his underlings. Another difference, the court noted, was the fact that William was responsible for a substantially larger tax loss than Charles because Charles did not participate in the warehouse banking scheme. Finally, the court said, the remaining coconspirators cooperated with the government and/or accepted responsibility - a distinction that can justify differential treatment at sentencing.

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IRS Reverses Course on Difficulty of Care Medicaid Payments to Relatives

Certain payments received by an individual care provider under a state Medicaid Home and Community-Based Services Waiver program are difficulty-of-care payments that are excludable from income. Notice 2014-7.

A difficulty-of-care payment is additional compensation received by a foster care provider for providing additional care in the provider's home for a qualified foster individual who has a physical, mental, or emotional handicap. For payments to qualify as difficulty-of-care payments, the state must determine that there is need for additional compensation and the payment must be designated as additional compensation by the payor. Under Code Sec. 131, a difficulty-of-care payment received by a foster care provider is generally excludable from gross income.

For any foster home, this exclusion is limited to five qualified foster individuals over the age of 18, and 10 other qualified foster individuals (Code Sec. 131(c)(2)).

Code Sec. 131 does not explicitly address whether payments under Medicaid waiver programs are qualified foster care payments. In Notice 2014-7, the IRS provides that certain payments received by an individual care provider under a state Medicaid Home and Community-Based Services Waiver program are difficulty-of-care payments excludable from income under Code Sec. 131. According to the IRS, Medicaid waiver programs and state foster care programs share similar oversight and purposes. The purpose of Medicaid waiver programs and the legislative history of Code Sec. 131 reflect the fact that home care programs prevent the institutionalization of individuals with physical, mental, or emotional handicaps. The legislative history notes that the parents are saving the taxpayers' money by preventing institutionalization of these children.

In Notice 2014-7, the IRS is reversing course on the taxation of Medicaid waiver payments to relatives. In the past, the IRS challenged the excludability of Medicaid waiver payments to individual care providers caring for related individuals in the provider's home. In Alexander v. Comm'r, T.C. Summary 2011-48, the Tax Court agreed with the IRS that Medicaid waiver payments to taxpayers caring for a taxpayer's parents living in the taxpayers' home were not excludable under Code Sec. 131 because the taxpayers did not show that they operated a "foster family home" under state law, and the parents were not "placed" in the taxpayers' home by the state. Similarly, in Bannon v. Comm'r, 99 T.C. 59 (1992), the Tax Court agreed with the IRS and held that payments received by the taxpayer for caring for her adult disabled daughter living in the taxpayer's home under a state program for in-home supportive services were not excludable under the general welfare exclusion. Also, IRS Program Manager Technical Advice (PMTA 2010-007) concluded that a biological parent of a disabled child could not exclude payments under Code Sec. 131 because the ordinary meaning of foster care excludes care by a biological parent. In Notice 2014-7, as of January 3, 2014, the IRS states it will no longer assert the position in PMTA 2010-007, or apply the decisions in Alexander and Bannon to conclude that a care giver of a biological relative receiving qualified Medicaid waiver payments may not qualify as a foster care provider under Code Sec. 131 and thus exclude such payments from income.

Notice 2014-7 is effective for payments received on or after January 3, 2014. Taxpayers may apply the notice in tax years for which the statute of limitations on claims for a credit or refund have not expired.

For a discussion of the taxation of difficulty-of-care payments, see Parker Tax ¶78,505.

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Foster Care Payments to Mother Not Excludible from Gross Income

Because a mother was the guardian of her adult handicapped son and owed a legal duty to provide care for him, her provision of care could not be characterized as foster care, and payments she received from the state for providing her son's care were not excludable from gross income as qualified foster care payments. Ray v. U.S., 2014 PTC 4 (S.D. Ohio 1/06/14).

Tony Ray, an adult, lived with his parents, Robert and Elaina. Tony, severely handicapped since birth and diagnosed with several medical conditions, was unable to provide for his own needs and required constant care. When Tony turned age 18, his mother was appointed his legal guardian, and his care was managed by the county board for developmental disabilities. A board-assigned case manager developed an Individualized Service Plan (ISP) for Tony, which set forth the areas of care and support needed, specific descriptions on how the needs would be met, the care provider for each area of need, and the duration for which the need required care. Tony's ISP required that his care be provided by a certified home and community-based waiver or supported living provider. Elaina obtained the required certification through the state (Ohio) and provided for the majority of Tony's needs. Elaina received compensation from the state for the care she provided Tony through a Medicaid program called Individual Options Waiver (IO Waiver), which allows for individuals with developmental disabilities to live at home or in community-based living rather than in an institutional setting.

On their original returns for 2006 and 2007, Robert and Elaina included the Medicaid payments in income. They subsequently filed amended returns for those years and excluded the Medicaid payments from income. The Rays' claims for refunds were denied by the IRS on the basis that the amounts did not meet the requirements for the exclusion.

Code Sec. 131 provides that gross income does not include amounts received by a foster care provider during the tax year as qualified foster care payments. Qualified foster care payments are defined as a payment made by a state, political subdivision thereof, or qualified foster care placement agency under a state foster care program that is either (1) a payment to a foster care provider for caring for a qualified foster care individual in the provider's home; or (2) a difficulty-of-care payment.

The Rays argued that Tony was an adult for whom they had no legal duty to provide care and that their voluntary provision of care was "fostering."

The IRS contended that the ordinary meaning of the term "foster care" concerned the placement of a minor into the care of someone who was not the minor's parent by blood or adoption, and the blood relationship between Elaina and Tony eliminated their care from being a foster care relationship.

A district court held that the terms "foster" and "foster care" required the absence of an existing legal duty to care for an individual receiving care in the taxpayer's home. It was undisputed that the Rays received payments from the state and that Tony was placed in the Rays' home by a state agency. However, the terms "foster" and "foster care" for purposes of the foster care payment exclusion are not defined in Internal Revenue Code.

The court looked to state law, which defined "age of majority" as all persons of the age of 18 or more who are under no legal disability and "legal disability" as persons (1) under the age of 18; (2) of unsound mind; (3) in captivity; or (4) under guardianship of the person and estate. Generally, the legal duty of parental care stops when a child reaches the age of majority. The court noted that Tony, an incompetent due to his legal disability, had not reached the age of majority under state law and could not be described as an adult. Moreover, the Rays presented evidence that Elaina was Tony's guardian since he turned age 18.

In rejecting the Rays' argument that Elaina provided care to an individual where she owed no obligation, the court stated that when Elaina became Tony's legal guardian, state law imposed a duty upon her to provide for him. Therefore, the relationship between Elaina and Tony was not a foster care relationship within the meaning of Code Sec. 131, and the payments she received from the state were not excludable from gross income, the court concluded.

Observation: This is exactly the type of situation that Notice 2014-7, discussed above, was meant to address. Under Notice 2014-7, the payments to the Rays would have been excludible from income.

For a discussion of the taxation of foster care payments, see Parker Tax ¶78,500.

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Business Can Exclude Relocation Assistance Payments Resulting from State Exercising Its Eminent Domain Rights

A taxpayer was able to exclude from income amounts received as a result of having to relocate its business due to a state exercising its right and taking the taxpayer's pursuant to eminent domain; and expenses incurred for which the taxpayer has the right to reimbursement are not deductible. PLR 201401001.

In PLR 201401001, an accrual-method taxpayer is organized as a limited partnership. The taxpayer leases certain business premises and maintains locations in various states. After a state agency informed the landlord that it intended to exercise its rights of eminent domain with respect to the taxpayer's business premises, the taxpayer and the state agency executed a Memorandum of Agreement (MOA) for the reimbursement of the taxpayer's anticipated costs to relocate from its business premises. The MOA requires the taxpayer to remove all business operations from the business premises by a certain date. Under the MOA, the parties agreed to relocation payments for the costs of moving and reinstalling specific pieces of machinery and equipment. The MOA also provides that the taxpayer will receive additional payments for all other business relocation costs not included in the relocation payments. The taxpayer incurred relocation expenses in two consecutive years (Years 1 and 2) for replacement site location selection, business property appraisal, equipment purchases, and relocation-related professional fees. The taxpayer did not deduct relocation expenses incurred in Year 1 on its Year 1 federal income tax return and expects to incur the majority of its costs to relocate its business operations, including the costs of substitute equipment, in Year 3. The taxpayer expected to receive the relocation payments and additional payments from State Agency during Year 2 and Year 3.

The taxpayer asked the IRS for the following rulings: (1) that it will not have to include in gross income the relocation payments and additional payments it receives from the state agency under Title II of the Uniform Relocation Assistance and Real Property Acquisitions Policies Act; (2) that the taxpayer will not deduct the relocation and related expenses under Code Sec. 162 to the extent of the amount of the relocation payments and additional payments; and (3) that the taxpayer will not assign any basis under Code Sec. 1012 to any substitute property acquired to replace non-movable equipment and leasehold improvements to the extent such costs do not exceed the relocation payments and additional payments.

The IRS ruled that, under 42 U.S.C. Section 4636, the taxpayer does not include in gross income the relocation payments and additional payments it receives from the state agency. Further, the taxpayer may not deduct moving expenses for existing equipment, the installation of existing and substitute equipment, relocation expenses incurred at the new location and pre-existing locations, and professional and service fees related to the relocation, including negotiation of the MOA with the state agency to the extent they were reimbursed with the relocation payments and the additional payments. Lastly, the taxpayer may not assign any basis under Code Sec. 1012 to substitute equipment acquired to replace non-movable equipment and leasehold improvements at the new location to the extent such costs are reimbursed with the relocation payments and the additional payments.

For a discussion of the deductibility of expenses for which there is a right to reimbursement, see Parker Tax ¶90,120.