Federal Tax Bulletin - Issue 55 - January 30, 2014

IRS Updates Accounting Method Procedure for Adopting Favorable Capitalization Rules

Last September, the IRS issued final regulations which address when amounts paid to acquire, produce, or improve tangible property must be capitalized. The final regulations are generally effective for tax years beginning on or after January 1, 2014, but may be adopted for earlier years under certain circumstances. The IRS also issued proposed regulations on dispositions of MACRS property and general asset accounts, which were expected to be finalized before 2014. Once those regulations are finalized, taxpayer will have the choice of applying them to years beginning on or after January 1, 2014, or for earlier years if certain conditions are met.

There are many favorable methods and safe harbors in the final capitalization regulations that taxpayers may want to adopt. To do so, however, taxpayers must file for an accounting method change.   Read more...

IRS Guidance Clarifies When Promotional Allowances Count as Domestic Production Gross Receipts

Whether or not promotional trade allowances received by a retailer are considered purchase price adjustments or separate sources of income is important for retailers calculating the domestic production activities deduction. If treated as separate items of income, the promotional allowances can increase the retailer's domestic production activities deduction because they are considered domestic production gross receipts (DPGR). In AM-2014-001, the Chief Counsel's Office explains how to determine whether the promotional allowances constitute DPGR and gives examples of when such allowances are considered a separate item of income and thus eligible to increase the retailers domestic production activities deduction.

Background

Under the facts in AM-2014-001, vendors and retailers enter into co-operative advertising arrangements (CAAs). The arrangements require retailers to produce printed advertisements of the vendors' products and to distribute the printed advertisement flyers in the retailers' stores and through mail and in newspapers. Retailers usually circulate flyers free of charge to retail customers.

The flyers increase foot traffic to the retailers' stores and may increase customer interest and demand for the advertised products offered at the retailers' internet websites. Vendors may be the manufacturer, supplier, wholesaler, or distributor of the product who directly or indirectly sells the product to retailers at the wholesale level. In general, the retailers include the vendors' products in the retailers' flyers under written or oral agreements negotiated annually or on an ad hoc basis with the vendor.

Although the terms of the CAAs between retailers and vendors may differ, the CAAs often require retailers to provide specific advertising services and may specify:

• the advertising media;
• the products that will be featured;
• the placement of the product in the flyer;
• the conditions for advertising specific products;
• the use of the vendor's name and logo;
• the size, length, and frequency of advertisement; and
• the substantiation and payment processes.

Retailers are responsible for all aspects of the production and distribution of the flyers and normally bear the entire up-front cost of the flyers. Under the terms of the CAAs with the vendors, the retailers receive allowances from the vendors for providing specific advertising services. Under the terms of some CAAs, the flyers must meet the vendors' specifications as a condition of retailers receiving allowances. Often CAAs provide that allowances are calculated based on the volume of the advertised products that the retailers purchase from vendors during a specified period.

Typically vendors pay the retailers directly, or the vendors may reduce the amount owed by the retailers for prior purchases, or the vendors may issue a credit to the retailers for future purchases. The vendors may pay allowances periodically (e.g., as a vendor's products are featured in the flyer) or at fixed intervals. Vendors may require retailers to submit invoices, reimbursement substantiation claims, or proofs of performance of the advertising services required under the agreements before paying the allowances.

Domestic Production Activities Deduction

Under Code Sec. 199, taxpayers can deduct an amount equal to 9 percent (for tax years beginning after 2009) of the lesser of (1) the taxpayer's qualified production activities income (QPAI) for the tax year, or (2) taxable income.

QPAI is the excess (if any) of (1) the taxpayer's DPGR for the tax year, over (2) the sum of the cost of goods sold that are allocable to DPGR and other expenses, losses, or deductions that are properly allocable to DPGR.

DPGR is a taxpayer's gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (which includes tangible personal property) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.

In calculating the domestic production activities deduction, taxpayers are required to determine gross receipts and cost of goods sold using the same accounting method used for federal income tax purposes.

Generally, gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of qualifying production property, a qualified film, or utilities do not include advertising income and product-placement income. While gross receipts from advertising are generally non-DPGR because the receipts are derived from providing a service, there is an exception allowing advertising-related gross receipts to qualify as DPGR in cases of certain tangible personal property.

Specifically, Reg. Sec. 1.199-3(i)(5)(ii) provides that a taxpayer's gross receipts that are derived from the disposition of newspapers, magazines, telephone directories, periodicals, and other similar printed publications that are MPGE in whole or in significant part within the United States include the advertising income from advertisements placed in those media, but only if the gross receipts, if any, derived from the disposition of the newspapers, magazines, telephone directories, or periodicals are (or would be) DPGR.

Purchase Price Adjustments Versus Separate Items of Income

As a general principle, taxpayers in the retail industry compute gross income from sales during a year by subtracting the cost of the goods sold (CGS) from gross sales receipts. Generally, when payments are made by vendors to retailers as an inducement to purchase merchandise, the payments are not separate items of gross income but instead are an adjustment to the cost or price of the merchandise purchased (purchase price adjustment).

In Affiliated Foods, Inc., v. Comm'r, 128 T.C. 62 (2007), the Tax Court held that a purchase price adjustment or a price rebate that a taxpayer receives for goods that it has purchased for resale is not, itself, an item of gross income but, instead, is treated as a reduction in the cost of the goods sold. A purchase price adjustment may still indirectly affect the amount of a retailer's gross income if it results in a reduction in CGS.

The test for whether a payment, credit, allowance, or rebate is a purchase price adjustment is what the parties intend and for what purpose the payment, credit, allowance, or rebate was paid. If the purpose was to adjust the price of the item between the parties, then the consideration given, regardless of the time or manner of the adjustment, is a purchase price adjustment and is not a separate item of gross income.

The seminal case addressing purchase price adjustments is Pittsburgh Milk v. Comm'r, 26 T.C. 707 (1956). In that case, the Tax Court concluded that allowances that a milk producer paid to buyers lowered the sales price of the milk for income tax purposes. The court held that only the net price was includable in the seller's gross income, even though the discounts were illegal. Thus, when a payment is made from a seller to a purchaser, and the purpose and the intent of the payment is to reach an agreed upon net selling price, the payment is an adjustment to the sales price. However, the Tax Court also said that, if an allowance is contingent upon the performance of services by the purchaser, the allowance is not a trade or other discount. Accordingly, any payment, reduction in any amount owed to a vendor by a retailer for prior purchases, or credit issued by a vendor to a retailer for future purchases that represents compensation for services performed, or to be performed, would be a separate item of gross income and not a trade or other discount that reduces the cost of merchandise purchases.

The IRS has issued guidance concluding that payments received that constitute adjustments to the purchase price are not includible in gross sales. For example, in Rev. Rul. 84-41, the IRS ruled that a manufacturer's rebate received by an automobile dealer is a trade discount and should be treated as a reduction in the cost of the automobile purchased, and not as an item of gross income.

Example: ABC is a retailer and sells electronic products at its stores. Vendor XYZ enters into an agreement with ABC under which ABC is required to perform advertising services for XYZ. Specifically, ABC will receive an allowance for including specifically described advertisements of XYZ's products (the advertised products) in ABC's weekly flyer. ABC must comply with XYZ's advertising policies and procedures in order to receive the allowance. The amount of the allowance is calculated based on a percentage of ABC's purchase costs of the advertised products during a stated period. The allowance is a reasonable amount in relation to the advertising services ABC performs. Under these facts and circumstances, even though the amount of the allowance is calculated by reference to the cost of advertised products purchased by ABC, the purpose and intent of the allowance is to compensate ABC for providing advertising services for XYZ, and, therefore, the allowance is treated as a separate item of gross income for the performance of advertising services. In 2014, XYZ pays a $5 allowance to ABC under the agreement. Before receiving the allowance, ABC's gross receipts from the sale of the advertised products is $100, its cost for the products sold is $20, and its total cost to produce and distribute the flyer is $25.

Under these facts, for federal income tax purposes, the $5 allowance is treated as a separate item of gross income for the performance of advertising services. ABC's gross income from the placement of XYZ's products in ABC's flyers is $5. ABC's gross income from the sale of the advertised products is $80 ($100 gross receipts - $20 CGS). ABC's taxable income, before calculating the Code Sec. 199 deduction, is $60 ($80 gross income from sales of the advertised products + $5 advertising service income - $25 deductible expense). Because the allowance is a separate item of gross income, it must be so characterized for purposes of calculating the Code Sec. 199 deduction. For purposes of Code Sec. 199, the $5 allowance is advertising income from ABC's performance of advertising services. Gross receipts from advertising are generally non-DPGR because the receipts are derived from providing a service. However, the exception to this rule that allows gross receipts derived from advertising to qualify as DPGR in cases of certain tangible personal property applies. Under these facts, ABC's gross receipts derived from placing XYZ's advertisements in the flyers qualify as DPGR if ABC meets all other applicable requirements of Code Sec. 199. Therefore, assuming ABC meets all other applicable requirements, the $5 allowance is included in DPGR.

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Eligibility for Bonus Depreciation Applies to Individual Properties in Construction Complex

The determination of whether properties being developed in a construction complex are qualified properties eligible for bonus depreciation applies separately to each property; properties don't qualify simply because the overall project meets the definition for "qualified property." CCM 20140202F.

Under the facts in CCM 20140202F, a taxpayer owns and operates a hotel complex that consists of several adjacent buildings including a casino, a hotel, a restaurant and convention center building, and above-ground parking structures. Before opening the casino complex, the taxpayer acquired a building located on the site and entirely renovated the building to construct restaurant and food service areas for the casino complex. In the following years, the taxpayer completed four separate construction projects involving four existing buildings at the Hotel complex. One of these projects was the renovation and expansion of a particular building called the "C Building."

The C Building project included the complete renovation of existing restaurant and food service areas in the original square foot portion of the building. Also included in the project was the construction of a new, two-level, addition along one side of the existing structure to provide space for additional uses, including offices, lounges, bars, conference/convention rooms, ballroom, and a theater. After completion of the project, a cost segregation study was performed to classify the various items of property constructed within the project for depreciation purposes.

The taxpayer argued that the project at issue constituted a "turnkey project" and as such, under PLR 201210004, final acceptance did not occur until the contractor completed all the work for the project. Based on this assumption, the taxpayer said it did not incur costs for the construction projects and underlying properties until the year when final acceptance of the project occurred. And because that year was a year in which bonus depreciation applied, the taxpayer argued that the costs incurred were eligible for bonus depreciation.

The Chief Counsel's Office disagreed and concluded that underlying properties do not become qualified properties for purposes of the bonus depreciation rules of Code Sec. 168(k)(2)(A) simply because the overall project meets the definitions for "qualified property" under those rules. According to the Chief Counsel's Office, the taxpayer was required to separately identify the properties associated with the project to determine which assets constitute "qualified property." Thus, a taxpayer cannot argue that a property qualifies for bonus depreciation simply because the project to which that property relates qualifies (based on contract date, acquisition date and placed in service date of the "project"). Rather, a taxpayer is required to separately identify the properties associated with a project to determine which assets constitute "qualified property" for purposes of eligibility for bonus depreciation. The guidance also discusses the difference between turnkey projects and design, bid, build (DBB) projects for purposes of determining whether property qualifies for bonus depreciation.

For a discussion of property that qualifies for bonus depreciation, see Parker Tax ¶94,120.

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IRS Provides Simplified Method for Obtaining Extension to Make Portability Election

A simplified method is provided for certain taxpayers to obtain an extension to make a "portability" election, by which a decedent's unused exclusion amount becomes available to apply to the surviving spouse's subsequent transfers during life or at death. Rev. Proc. 2014-18.

In 2010, Code Sec. 2010(c) was amended to allow the estate of a decedent who is survived by a spouse to make a portability election. The election allows the surviving spouse to apply the deceased spousal unused exclusion (DSUE) amount to the surviving spouse's own transfers during life and at death. The portability election applies to estates of decedents dying after December 31, 2010, if the decedent was survived by a spouse.

The DSUE amount is the lesser of (1) the basic exclusion amount, or (2) the excess of the applicable exclusion amount of the last deceased spouse of the surviving spouse over the amount with respect to which the tentative tax is determined on the deceased spouse's estate. The basic exclusion amount is $5,000,000, as adjusted for inflation in each year after 2011.

If an estate elects portability, it must file an estate tax return, the due date of which is nine months after the decedent's date of death or the last day of the period covered by an extension. Code Sec. 2010(c)(5)(A) provides certain requirements the executor of the estate of a deceased spouse must satisfy to allow the decedent's surviving spouse to apply the decedent's DSUE amount to the surviving spouse's transfers. In particular, the executor must elect portability of the DSUE amount on a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, which must include a computation of the DSUE amount. Under Code Sec. 2010(c)(5)(A), a portability election is effective only if made on a Form 706 that is timely filed.

According to the IRS, it has issued several letter rulings granting an extension of time to elect portability in situations in which a decedent's estate was not required to file an estate tax return because of the value of the gross estate and adjusted taxable gifts. The IRS has determined that, in such circumstances, it is appropriate to provide a simplified method to obtain an extension of time to elect portability provided that certain requirements are met. In such a case, the decedent's DSUE amount then will be available to apply to the surviving spouse's transfers.

Rev. Proc. 2014-18 applies only if:

(1) the taxpayer is the executor of the estate of a decedent who (i) has a surviving spouse; (ii) died after December 31, 2010, and on or before December 31, 2013; and (iii) was a citizen or resident of the United States on the date of death.

(2) the taxpayer is not required to file an estate tax return (as determined based on the value of the gross estate and adjusted taxable gifts and without regard to Reg. Sec. 20.2010-2T(a)(1));

(3) the taxpayer did not file an estate tax return within the time prescribed for filing an estate tax return required to elect portability; and

(4) all requirements of section 4 of Rev. Proc. 2014-18 are satisfied.

Thus, Rev. Proc. 2014-18 includes estates of decedents survived by a same-sex spouse that were not eligible to elect portability until after the decision in U.S. v. Windsor, 2013 PTC 167 (S. Ct. 2013) and the publication of Rev. Rul. 2013-17, in which the IRS 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.

Rev. Proc. 2014-18 does not apply to taxpayers who timely filed an estate tax return for the purpose of electing portability. Such taxpayers either already elected portability of the DSUE amount by timely filing that estate tax return or have affirmatively opted out of portability.

Practice Tip: Taxpayers who are not eligible for relief under Rev. Proc. 2014-18 because they do not meet the requirements or because the decedent died after December 31, 2013, may request an extension of time to make the portability election by requesting a letter ruling.

For a discussion of the portability election, see Parker Tax ¶220,110.

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Regs Address Treatment of Sales-Based Royalties and Sales-Based Vendor Chargebacks

The IRS issued final regulations that address the capitalization and allocation of royalties that are incurred upon the sale of property produced or property acquired for resale (sales-based royalties), as well as final regulations relating to adjusting inventory costs for certain allowances, discounts, or price rebates earned on the sale of merchandise (sales-based vendor chargebacks). T.D. 9652 (1/13/14).

In 2010, the IRS issued proposed regulations that clarified that sales-based royalties, like other royalties, may be capitalizable to property a taxpayer produces or acquires for resale. Royalty costs are capitalizable when they are incurred in securing the contractual right to use a trademark, corporate plan, manufacturing procedure, special recipe, or other similar right associated with property produced or property acquired for resale. Sales-based royalty costs are royalties that are incurred only upon the sale of property produced or acquired for resale.

The proposed regulations provided that sales-based royalties required to be capitalized must be allocated only to property that has been sold or, for inventory property, deemed to be sold under the taxpayer's inventory cost flow assumption. In response to practitioner concerns that the requirement to allocate sales-based royalties only to cost of goods sold would unduly burden taxpayers using simplified allocation methods, the final regulations provide that the allocation of sales-based royalties to property sold is optional rather than mandatory.

Therefore, under the final regulations, taxpayers can either allocate sales-based royalties entirely to property sold and include those costs in cost of goods sold or to allocate sales-based royalties between cost of goods sold and ending inventory using a facts-and-circumstances cost allocation method described in Reg. Sec. 1.263A-1(f) or a simplified method provided in Reg. Sec. 1.263A-2(b) (the simplified production method) or Reg. Sec. 1.263A-3(d) (the simplified resale method). The final regulations also clarify that sales-based royalties that a taxpayer allocates entirely to inventory property sold are included in cost of goods sold and may not be included in determining the cost of goods on hand at the end of the tax year regardless of the taxpayer's cost flow assumption.

Like the proposed regulations, the final regulations address the tax treatment of sales-based vendor chargebacks. A sales-based vendor chargeback is an allowance, discount, or price rebate to which a taxpayer becomes unconditionally entitled by selling a vendor's merchandise to specific customers identified by the vendor at a price determined by the vendor. The final regulations provide that a sales-based vendor chargeback decreases cost of goods sold and does not reduce the cost of goods on hand at the end of the tax year.

Example: ABC is a wine wholesaler and purchases bottles of Ledo Wine from the manufacturer, Ledo Vineyards, for $10 a bottle. Ledo Vineyards has agreements with specific customers that allow those customers to acquire Ledo Wine from the vineyard's wholesalers for $6 a bottle. Under an agreement between ABC and Ledo Vineyards, ABC must sell bottles of Ledo Wine to specific customers at the prices the vineyard has negotiated with such customers (i.e., $6 a bottle) and, in exchange, Ledo Vineyards agrees to provide a price rebate to ABC equal to the difference between ABC's cost for Ledo Wine and the price Ledo Vineyard is required to charge specific customers under the agreement (i.e., a difference of $4 a bottle). ABC sells Ledo Wine to Le Jardin Restaurant for $6 a bottle. Under the agreement between ABC and Ledo Vineyard, the price rebate can be paid to ABC, credited against Ledo Vineyard's invoice to ABC for its purchases of the wine, or it can be credited to ABC's future purchases of wine from the vineyard. Under the terms of the agreement, ABC is unconditionally entitled to the price rebate when it sells Ledo Wine to Le Jardin Restaurant. The price rebate received by ABC for the sale of the wine to the restaurant is a sales-based vendor chargeback. Therefore, the amount of the sales-based vendor charge back, $4 per bottle of wine, whether paid to ABC, credited against Ledo Vineyard's invoice to ABC for its purchase of Ledo Wine, or credited against a future purchase, decreases cost of goods sold and does not reduce the cost of Ledo Wine on hand at the end of the tax year.

For a discussion of valuing inventories where sales-based vendor chargebacks are involved, see Parker Tax ¶242,310.

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Change from Open Transaction Doctrine Is Accounting Method Change

A change from open transaction treatment to realization treatment is a change in method of accounting, requiring a Code Sec. 481(a) adjustment. CCA 201403015.

In CCA 201403015, the Office of Chief Counsel was asked whether a change from open transaction treatment to current recognition of income or gain (i.e., realization treatment) is a change in accounting method and, if so, whether a Code Sec. 481(a) adjustment should be recognized in connection with the change, and whether the Code Sec. 481(a) adjustment may reflect amounts attributable to closed tax years.

Reg. Sec. 1.446-1(e)(2)(ii)(a) provides that a change in method of accounting includes a change in the overall plan of accounting for gross income or deductions, or a change in the treatment of any material item used in such overall plan. A material item, the Chief Counsel's Office noted, includes any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. In determining whether timing is involved, the pertinent inquiry is generally whether the accounting practice permanently affects the taxpayer's lifetime taxable income or merely changes the tax year in which taxable income is reported. An accounting practice that involves the timing of when an item is included in income or when it is deducted, the Chief Counsel's Office observed, is considered a method of accounting.

Additionally, the Chief Counsel's Office stated, if a change in accounting practice does involve timing, then it is an accounting method change, even if it also arguably involves a change in how the item of revenue or expense is characterized, such as changing from treating transactions as sales to treating them as leases. According to the Chief Counsel's Office, certain cases, such as Underhill v. Comm'r, 45 T.C. 489 (1966), are sometimes read to stand for the proposition that changes involving a change in the "characterization" of an item are not accounting method changes. However, the Chief Counsel's Office noted, Reg. Sec. 1.446-1(e)(2)(ii)(b) enumerates numerous adjustments that do not constitute changes in method of accounting, but contains no exception for changes that alter the characterization of an item.

If the change in accounting practice does involve timing, then it is an accounting method change even if it also arguably involves a change in how the item of revenue or expense is characterized, such as changing from treating transactions as sales to treating the transactions as leases. Certain court cases, the Chief Counsel's Office noted, are sometimes read to stand for the proposition that changes involving a change in the "characterization" of an item are not accounting method changes. However, Reg. Sec. 1.446-1(e)(2)(ii)(b) enumerates numerous adjustments that do not constitute changes in method of accounting, but contains no exception for changes that alter the characterization of an item. In fact, the Chief Counsel's Office noted, Reg. Sec. 1.446-1(e)(2)(iii), Example 11, includes corrections of erroneous characterizations among changes in methods of accounting. In addition, numerous cases have held that a change in characterization can be a change in method of accounting. For example, in Standard Oil Co. v. Comm'r, 77 T.C. 349 (1981), the Tax Court held that changing the characterization of Code Sec. 1250 property to Code Sec. 1245 property was a change in method of accounting and, in Capital One v. Comm'r, 130 T.C. 147 (2008), aff'd, 659 F.3d 316 (4th Cir. 2011), a change in the characterization of late fees from fee income to original issue discount was a change in method of accounting.

The facts in the CCA 201403015 were redacted, but the Chief Counsel's Office concluded that a change from open transaction treatment to realization treatment is a change in accounting method requiring a Code Sec. 481(a) adjustment. The Code Sec. 481(a) adjustment is computed with respect to relevant amounts in all tax years preceding the year of change, whether the tax years are open or closed under the statute of limitations.

For a discussion of what constitutes a change in method of accounting, see ¶241,590.

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IRS Did Not Exceed Authority by Extending Health Care Credit to Insurance from Federal Exchanges

The IRS is authorized by the Patient Protection and Affordable Care Act to extend the premium tax credits to private individuals who purchase health insurance on a federally facilitated exchange in states that declined to establish their own health insurance exchanges. Halbig v. Sebelius, 2014 PTC 23 (D. D.C. 1/15/14).

The Patient Protection and Affordable Care Act (PPACA) established American Health Benefit Exchanges to facilitate the purchase of health insurance by private individuals and small businesses, as required under the PPACA. The PPACA also authorizes a federal tax credit, under Code Sec. 36B, for many low- and middle-income individuals to offset the cost of insurance purchased on these exchanges. Under PPACA, the states were given a deadline for establishing an exchange. Each health plan offered through an exchange must provide certain minimum benefits as set forth by the Department of Health and Human Services (HHS). However, if a state declines or fails to establish its own exchange, HHS will establish an exchange in that state. Currently, 34 states rely on federally facilitated exchanges.

The IRS issued regulations that make the Code Sec. 36B tax credit available to qualifying individuals who purchase health insurance on state-run or federally facilitated exchanges. A group of individuals and employers living in states that have declined to establish exchanges filed suit on the grounds that the regulations violate the plain language of PPACA, which provides that an individual's tax credit is calculated based on the cost of insurance purchased on an exchange established by a state. Thus, they argued, to the extent the regulations provide tax credits for individuals who purchase insurance on federally facilitated exchanges, the regulations exceed the IRS's statutory authority and are arbitrary, capricious, and contrary to law.

A district court held that the IRS was authorized to grant tax credits to individuals who purchase insurance on federally facilitated exchanges, as well as to those who purchase insurance on state-run exchanges. Looking at the plain language of Code Sec. 36B, the court noted that the provision did not distinguish between taxpayers living in states with state-run exchanges and those in states with federally facilitated exchanges. Although the federal government is not a "state" which is defined in PPACA, where a state does not establish an exchange, the federal government can create an exchange on behalf of that state, the court observed.

According to the court, the plaintiffs' proposed construction of the law, i.e., that tax credits are available only to those purchasing insurance from state-run exchanges, is counter to the central purpose of PPACA to provide affordable health care to virtually all Americans.

For a discussion of the Code Sec. 36B premium assistance tax credit, see Parker Tax ¶102,601.

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No Refund or Credit Allowed for Overpayment under Offshore Voluntary Disclosure Initiative

No credit towards penalties for other years is available to a taxpayer who overpaid tax on unreported income through the offshore voluntary disclosure initiative. CCA 201404011.

A taxpayer entered into an offshore voluntary disclosure initiative (OVDI) for certain years. As part of the OVDI process, the taxpayer filed an amended return reporting previously unreported income and also made a payment of the additional tax reported as owed on the amended return. At the time the additional amount was paid, the assessment statute expiration date (ASED) had passed.

The IRS Exam section determined that the taxpayer over-reported the additional income and, as a result, overpaid the additional tax due for the year of the unreported income. The taxpayer never filed a claim for refund. The Exam section asked the Chief Counsel's Office whether the amount of the overpaid taxes may be credited to the taxpayer's penalty balance in a different tax year.

The Chief Counsel's Office advised that none of the overpaid taxes could be used to reduce the taxpayer's penalty balance in a different year. According to the Chief Counsel's Office, the original assessment was invalid because the original return had an assessment date earlier than the amended return and, under Rev. Rul. 72-311, an amended return does not revive the period of limitation on assessment or refund. Therefore, the assessment in question was made after the ASED expired. Moreover, the Chief Counsel's Office noted, the IRS took no steps to extend the statutory assessment period for the tax year when it permitted the taxpayer to participate in the OVDI.

The Chief Counsel's Office stated that it had no information that would lead it to believe the statute of limitations would otherwise be open under other exceptions to the general three-year period (e.g., Code Sec. 6501(e)(1)). Under Rev. Rul. 74-580, the Chief Counsel's Office observed, the IRS may refund any payment made under an assessment that was made after the ASED expired. However, the taxpayer must make a timely claim for refund in accordance with Code Sec. 6511 to receive a refund. Since that didn't happen, the IRS cannot refund or credit the overpayment.

For a discussion of the statute of limitations for refunds or credits of tax overpayments, see Parker Tax ¶261,180.

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IRS May Provide Audit Info on Practitioners to OPR

The IRS Exam section may disclose audit information concerning an individual who practices before the IRS to the Office of Professional Responsibility (OPR) for purposes of OPR's disreputable conduct investigation into the tax compliance of that individual. CCA 201403006.

The Office of Chief Counsel was asked whether the Small Business/Self-Employed examination unit (SB/SE Exam) of the IRS may provide to the Office of Professional Responsibility (OPR) information concerning the examination of an individual who engages in practice before the IRS before the examination is resolved for purposes of an OPR investigation into that individual's potential disreputable conduct due to tax noncompliance. Specifically, the issue was whether SB/SE Exam can disclose to OPR, for purposes of an OPR investigation, the audit report and unagreed case package regarding the examination of an individual who engages in practice before the IRS before the case is resolved (i.e., resolved in the Office of Appeals (Appeals) or through the issuance of a statutory notice of deficiency) when OPR referred the practitioner to SB/SE for examination.

In Circular 230, the IRS published regulations governing the practice of representatives before the IRS. OPR is responsible for enforcing Circular 230. As part of its enforcement authority, OPR has the authority to investigate whether a practitioner has violated Circular 230 and to propose sanctions against individual practitioners for violations.

The Chief Counsel's Office noted that, under Section 10.51(a) of Circular 230, a practitioner may be sanctioned for "disreputable conduct," including willfully failing to file a federal tax return in violation of federal tax laws, willfully evading or attempting to evade assessment or payment of federal tax, or conviction of any criminal offense under federal tax laws. As such, in the course of a Circular 230 investigation, OPR may determine it is appropriate to refer a practitioner to the IRS for examination of the practitioner's own tax returns or the tax returns of an entity in which the practitioner is an owner or principal.

An SB/SE revenue agent may then conduct an examination of the practitioner's return or returns and will ultimately issue a revenue agent's report (RAR) containing a determination. The practitioner then has the opportunity to contest the RAR in Appeals. The question before the Chief Counsel's Office was whether OPR can receive a copy of the RAR and unagreed case package, in particular, before Appeals completes its review of the case.

Under Code Sec. 6103(a)(1), an officer or employee of the United States must keep returns and return information confidential unless disclosure is authorized. Under Code Sec. 6103(b)(2), "return information" includes a taxpayer's identity as well as whether the taxpayer's return was, is being, or will be examined. It also includes any other data received by, recorded by, prepared by, furnished to, or collected by the IRS with respect to a return or with respect to the determination of the existence, or possible existence, of liability (or the amount thereof) of any person for any tax, penalty, interest, fine, forfeiture, or other imposition, or offense. Both the RAR and unagreed case package reflect the examination of the taxpayer. The RAR is prepared by the revenue agent at the conclusion of the audit. The RAR and contents of the unagreed case package are "returns and return information" within the meaning of Code Sec. 6103(b)(2). SB/SE employees are therefore prohibited from disclosing the RAR and unagreed case package to OPR unless an exception to section 6103(a)(1) applies.

Under Code Sec. 6103(h)(1), disclosure of returns and return information to officers and employees of the Department of Treasury is permitted, without written request, where the recipient needs to know the information to perform tax administration duties. OPR is a part of the IRS, which is in turn a bureau of the Department of Treasury. Tax administration is broadly defined under Code Sec. 6103(b)(4) and includes "the administration, management, conduct, direction, and supervision of the execution and application of internal revenue laws and related statutes (or the equivalent laws and statutes of a state)."

The Chief Counsel's Office advised that SB/SE Exam may disclose the examination information relating to an individual who engages in practice before the IRS to OPR under Code Sec. 6103(h)(1) for purposes of OPR's disreputable conduct investigation into the tax compliance of that individual. When OPR employees investigate the federal tax compliance of those who are subject to Circular 230, the Chief Counsel's Office observed, they are performing their official tax administration duties. Therefore, Code Sec. 6103(h)(1) authorizes the disclosure of a practitioner's return information to OPR so that OPR can conduct investigations, institute disciplinary proceedings, and pursue sanctions. Further, because OPR has the authority to investigate and proceed with disciplinary actions while a practitioner seeks review of Exam's determination in Appeals, Exam may disclose the RAR to OPR before the conclusion of the Appeals hearing.

For a discussion of disreputable conduct for which a practitioner may be sanctioned under Circular 230, see Parker Tax ¶273,110.

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Couple's Property Development Activity Did Not Rise to a Trade or Business; No Losses Allowed

A couple could not deduct expenses incurred in the proposed development of a subdivision because their development activity did not rise to the level of a trade or business expenses; nor were they entitled to an abandonment loss when they purportedly stopped the development activity. Chen v. Comm'r, T.C. Summary 2014-6 (1/14/14).

Albert Chen, a retired civil engineer, worked for several utility companies on a contract basis. His wife, Nai-Fen Chen, was a licensed real estate agent for a realty company. In 1980, the couple purchased an 88-acre parcel of land and lived in a single-family home on that property. In 2003, the Chens decided to develop and subdivide the property with a plan to sell individual residential lots. They prepared a business plan and hired MJS Engineering to provide topographical mapping, land surveys, subdivision design, soil testing, and other related services in preparation for submitting the plan to the town planning board. From 2005 to 2009, MJS submitted several revised applications and the Chens made required escrow payments to the town board. In 2009, the board granted preliminary approval for the subdivision plans.

On their 2009 federal income tax return, the Chens claimed deductions on Schedule C, Profit or Loss From Business, for professional expenses relating to the proposed land development and for amounts paid in escrow relating to the land development activity. The couple also claimed deductions for vehicle, meal and entertainment, depreciation, home office, and advertising expenses related to the land development activity. After processing the return, the IRS issued a notice of deficiency, disallowing the deductions and determining that the Chens were liable for an accuracy-related penalty for underpayment of tax.

Code Sec. 162 provides a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Under Code Sec. 165, a deduction is allowed for any loss sustained during the year and not compensated for by insurance or otherwise. For individuals, the deduction is allowed for losses incurred in any transaction entered into for profit.

Albert and Nai-Fen argued that they were entitled to the deductions because they were engaged in the business of developing and selling their property. They also testified that they completely abandoned the development project in 2009 because of a severe decline in the housing market and a change in the wetland laws which decreased the amount of land that could be developed.

The IRS contended that the Chens were not engaged in a trade or business with respect to the development of the 88-acre parcel. Also, the Chens continued to own property and had not demonstrated the property was useless for purposes of an abandonment loss.

Observation: A taxpayer must establish that there was an affirmative act of abandonment in order to deduct an abandonment loss. The mere non-use of property is not sufficient to establish an act of abandonment. However, a taxpayer does not necessarily need to relinquish legal title to the property in order to establish abandonment.

The Tax Court held the Chens were not engaged in the trade or business of developing and selling their property and thus were not entitled to the deductions taken on their return. The court noted that the couple failed to sell any of the lots or submit final subdivision plans. Although Albert testified that sales efforts were set to begin in 2010, they made no marketing efforts to solicit contracts and they received no offers from prospective buyers. The court observed that from 2003 through 2009, most, if not all, of their development activities were devoted to planning and not to the sale and actual subdivision of the property. The court said that the Chens' development activities were in the planning and exploratory phase and did not rise to the level of a trade or business. According to the court, the only way they could deduct their losses was if they abandoned the property.

In determining whether the Chens were entitled to an abandonment loss, the court cited LaPort v. Comm'r, 1671 F.2d 1028 (1982), which found that a taxpayer must satisfy three elements for a finding that property had been abandoned: (1) the property was permanently discarded from use in the taxpayer's business; (2) it was no longer useful in the taxpayer's business; and (3) the usefulness in the taxpayer's business suddenly terminated. In rejecting the Chens' argument that a change in the wetland laws required them to abandon their development project as then formulated, the court stated that the couple failed to show that the law change affected their development efforts in a way that would require complete abandonment. After the law change, the Chens continued to seek preliminary approval of the subdivision plans and made an additional escrow payment to the town board. Further, although the parties stipulated to a severe decline in the housing market in 2009, the Chens admitted in correspondence with the IRS that they would revive efforts to develop the land in the event of an economic recovery. Therefore, the expenses relating to the property were not currently deductible as trade or business expenses or as an abandonment loss.

Finally, the court concluded that the Chens were liable for an accuracy-related penalty because they failed to show reasonable cause and good faith with respect to the underpayment of tax.

For a discussion of the deductibility of expenses relating to real estate development, see Parker Tax ¶90,140.

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Return Not Signed by Former Spouse Was Valid Joint Return; Innocent Spouse Relief Denied

A return filed by a formerly married couple that was not signed by the wife was still a valid joint return because she intended to file a joint return; she was not entitled to innocent spouse relief because the tax liability at issue was attributable solely to her employment income. Zimmerman-Phillips v. Comm'r., T.C. Summary 2014-8 (1/15/14).

Susan Zimmerman-Phillips and her former spouse, Thomas, were married for 25 years. Starting in 1988, Susan and Thomas filed joint federal income tax returns. Thomas would complete the couple's returns each year and Susan would sign the returns without reviewing them. In 2009, the couple separated but agreed to file a joint return for that year upon the advice of their respective attorneys. Susan provided tax documents to Thomas but inadvertently omitted her Form W-2, which reported $74,230 of wages and $8,434 of federal tax withheld for 2009. When Susan contacted Thomas in April 2010 to provide him with additional tax documents, he told her that he had already electronically filed their 2009 joint return. In August 2010, Susan met with Thomas, who gave her a partial copy of their 2009 return. Susan did not file a Form 1040X, Amended U.S. Individual Income Tax Return, to report the omitted W-2 income.

The IRS issued a CP2000 notice to Susan and Thomas proposing an increase in tax arising from the unreported income, as well as penalties and interest. Susan filed Form 8857, Request for Innocent Spouse Relief. The IRS rejected her request.

Code Sec. 6013 provides that a husband and wife may file a joint income tax return. When spouses elect to file a joint income tax return, each spouse becomes jointly and severally liable for the entire tax liability. Generally, under Reg. Sec. 1.6013-1(a)(2), a joint income tax return must be signed by both spouses.

An individual who has filed a joint return may seek innocent spouse relief under Code Sec. 6015. Three types of relief are available: (1) full or apportioned relief; (2) proportionate relief for divorced or separated taxpayers; and (3) equitable relief.

Susan argued that she was unaware that the couple's 2009 joint return had underreported her income because she did not see the return before it was filed. The IRS contended that Susan tacitly consented to the filing of the couple's joint return.

The Tax Court held that the joint return filed by Thomas in 2009 was a valid joint return. In determining that Susan intended to file a joint return with her former spouse, the court noted that Susan did not file a separate return for 2009 even though she had substantial income, the couple had continually filed joint returns since 1988, and their respective attorneys advised them to file jointly after their separation. Moreover, Susan gave her tax documents to Thomas so that he could file their 2009 return.

The court looked to Rev. Proc. 2013-34, which sets forth the threshold requirements for establishing equitable innocent spouse relief, including the condition that the tax liability from which the requesting spouse seeks relief is attributable to an item of the nonrequesting spouse. In this case, the income tax liability at issue was attributable solely to Susan's income. In rejecting Susan's argument that Thomas committed fraud by filing the return without her signature, the court noted that the failure to include her income was not due to any act by Thomas; rather it was Susan who failed to include Form W-2 from her employer with her tax documents and to inform Thomas of the omission. In addition, she should have known as early as April 2010 that the return did not include her income and she failed to determine what impact the omitted income might have had on their 2009 tax liability. Finally, after receiving a copy of the return in August 2010, Susan failed to seek professional advice or file an amended return. Since it was Susan's responsibility to (1) ensure that Thomas received all of her tax documents, (2) inform him that the file was incomplete, and (3) correct any errors on the return, she was not entitled to equitable relief from joint and several liability, the court concluded.

For a discussion of innocent spouse relief, see Parker Tax ¶260,560.

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Family Trusts in Son of BOSS Tax Scheme Liable for New Tax Liabilities

IRS agreements with two family trusts engaged in a Son of BOSS tax shelter extended the statute of limitations and allowed the IRS to assess new tax liabilities on the family trusts. Candyce Martin 1999 Irrevocable Trust v. U.S., 2014 PTC 12 (9th Cir. 1/13/14).

The Chronicle Publishing Company was founded in the mid-1800s by two brothers, Charles and M.H. de Young. In the 1990s, the heirs decided to sell the newspaper's assets to a rival company and distribute the assets according to ownership percentages. To minimize the tax consequences from the proposed sale, the heirs implemented a Son of BOSS (Bond and Option Sales Strategy) tax shelter. The shelter generally involves a series of steps in which assets encumbered by artificial liabilities are transferred into a partnership to increase basis in the partnership and then artificial losses are used to offset gain from other transactions.

The heirs, through family trusts, formed a tiered partnership structure and engaged in a short-term hedging strategy using option contracts. The entities did not treat the short options as liabilities and, as a result, the family trusts and upper-tier partnerships had a large increase in the basis in the partnerships in the lower tiers. The family trusts filed their returns for 2000 and reported losses of over $321 million. As a result of the losses, the heirs did not owe taxes on the proceeds from the Chronicle Publishing sale. In 2004, the IRS audited the 2000 year returns of the partnerships involved in the tax shelter. In connection with an IRS audit of the tax returns for two partnerships involved in the transactions, the IRS executed Form 872-1 (extension agreements) with the family trusts extending the limitations period for assessing taxes and issued a final partnership administrative adjustment (FPAA). The extension agreements contained restrictive language that any deficiency assessment was limited to that resulting from any adjustment directly or indirectly attributable to partnership flow-through items. The FPAA disregarded all of the partnership transactions, and eliminated most of the $321 million loss and increased the heirs' tax liability. Two family trusts challenged the FPAAs. A district court denied the heirs' petition for readjustment of partnership items.

The Ninth Circuit, in affirming in part and reversing in part the district court ruling, concluded that some of the adjustments made in the FPAA were directly due to, caused by, or generated by partnership items that flowed through to the partners, and that the extension agreements therefore encompassed some of the adjustments made by the FPAA and permitted the IRS to subsequently assess new taxes. However, the Ninth Circuit found, the agreements did not extend to adjustments in one of the partnership's FPAA that were not directly attributable to the losses that originated with another partnership.

For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505.