Federal Tax Bulletin - Issue 67 - July 18, 2014

Consistency Rule Is Focus of Fifth Circuit's Decision in Research Tax Credit Case

In calculating the research tax credit, the consistency rule is an important concept, but not one that is often the center of a court case. In order to equitably measure the increase in qualified research spending between the two periods measured to calculate the credit, the consistency rule holds that the same standard must be applied in both periods. That concept was the focus of a recent decision by the Fifth Circuit in Trinity Industries, Inc. v. U.S., 2014 PTC 326 (5th Cir. 7/2/14).

Observation: While the research tax credit does not apply to amounts paid or incurred after 2013, it has typically been part of the "tax extenders" package that Congress periodically passes. However, due to gridlock in Congress, the bill extending the research tax credit, as well as other credits, is currently stalled in the Senate (the bill that passed the House in May would permanently extend and make changes to the calculation of credit). While many believe the bill will become law and be made retroactive, there is some uncertainty as to which credits will survive. Because the research tax credit is a favorite on both sides of the aisle, it is generally assumed that this credit will continue.

In the Trinity case, a shipbuilder argued that, under the consistency rule, it should be able to remove four vessels from its base period qualified research expenses (QREs) since those vessels were similar, in terms of how much experimentation was involved, to four vessels a lower court removed from the shipbuilders claim year QREs. By reducing the base period QREs, the shipbuilder would receive a higher research tax credit on its 1994 and 1995 tax returns. The Fifth Circuit agreed with the shipbuilder's premise and remanded the case back to the lower court to consider if the criteria that was applied to remove ships from the claim year QREs was similar enough to remove the four ships cited by the shipbuilder from its base year QREs.

Calculating the Research Tax Credit

Taxpayers are allowed a credit for certain research expenses paid or incurred in a trade or business. Generally, the research credit is allowed for increasing research activities. Under Code Sec. 41, the credit is equal to the lesser of:

(1) 20% x (claim year QREs a base amount), and 20% x (50% x claim year QREs); or

(2) the base amount, which is equal to a fixed base percentage times the average annual gross receipts for the four years preceding the claim year (i.e., the base years).

In (2), above, the fixed base percentage is equal to the aggregate base period QREs / aggregate base period gross receipts.

The claim year is the year in which the research credit is claimed. As discussed below, for the taxpayer in Trinity, the base years were tax years ending 3/31/1985 through 3/31/1989.

Observation: In 2005, the Energy Policy Act of 2005 expanded the research credit to apply to certain energy research consortiums for tax years ending after August 8, 2005.

Under Code Sec. 41(d), to constitute QREs, the following four requirements be met: (1) the expenses must be of the type deductible under Code Sec. 174; (2) the research must be undertaken for the purpose of discovering information which is technological in nature; (3) the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer; and (4) substantially all of the research activities must constitute elements of a process of experimentation for a qualified purpose. Reg. Sec. 1.41-4(a)(6) provides that the fourth requirement is met if 80 percent or more of the research activities constitute elements of a process of experimentation.

The four-part QRE test is applied separately to each business component of the taxpayer, which is defined to include any product held for sale, lease, or license, or used by the taxpayer in its trade or business. However, if each of the four requirements is not met with respect to an entire business component, the shrinking-back rule in Reg. Sec. 1.41-4(b)(2) may be applied to bring some expenses into the QRE calculation. Under the shrinking-back rule, the four requirements are applied first at the level of the discrete business component, but if these requirements are not met at that level, then they apply at the most significant subset of elements of the product.

This shrinking back of the product continues until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. Accordingly, the rule is applied only if a taxpayer does not satisfy the four requirements with respect to the overall business component.

There is also a consistency rule which plays a role in computing QREs by ensuring that the research tax credit due is not overstated or understated because the taxpayer inconsistently compares QREs in the base period years and the claim year. Code Sec. 41(c)(6)(A) and Reg. Sec. 1.41-3(d)(1) provide that the QREs taken into account in computing the fixed base percentage must be determined on a basis consistent with the determination of QREs for the credit year.

Background

Trinity Industries, Inc. designs and builds ships. On amended tax returns for its tax years ending March 1994 and March 1995, Trinity took a research tax credit because its claim year expenses in developing certain vessels constituted QREs. In calculating its research tax credit, Trinity reported a fixed base percentage (i.e., the ratio of base period QREs over base period gross receipts) of 1.3152 percent and 1.1325 percent for the 1994 and 1995 tax years, respectively. The tax returns did not report the base period QREs or the base period gross receipts used to calculate the fixed base percentage. The IRS denied the research tax credit in full.

Trinity filed a tax refund suit in district court and hired James Bennett to testify as an expert on the amount of research tax credits that should be allowed for Trinity's 1994 and 1995 tax returns. Based on documentation provided by Trinity, Bennett provided specific calculations of the base period QREs, the base period gross receipts, and the fixed base percentage. Bennett calculated the overall base period QREs as $49,483,136. Dividing this base period QRE amount by the base period gross receipts of $3,851,683,536 yielded a fixed base percentage of 1.2847 percent, which was slightly lower than the fixed base percentages reported in the amended tax returns. Bennett submitted a report finding that the consistency rule under Code Sec. 41(c)(6) was satisfied on Trinity's amended tax returns. Bennett noted only one caveat to this conclusion: the records available for the claim years were more complete than those available for the base period years due to records being destroyed as a result of Hurricane Katrina. Thus, he estimated certain costs for the base period.

The District Court Case

The district court conducted a two-phase trial. In Phase I, the court decided that Trinity was wrongly denied credits for two of the six projects it considered in calculating the research tax credit because those two projects met all four requirements for constituting QREs. According to the court, the other four vessels the XFPB, the T-AGS 60, the Crew Rescue Boat, and the Hurley Dredge did not meet the fourth QRE requirement: that substantially all of the research activities in developing the project (i.e., 80 percent or more) were part of a process of experimentation. In reaching its conclusion, the court did not apply the shrinking-back rule in analyzing the claim year QREs because Trinity was unable to offer evidence of its expenses at a more specific level partly because of Hurricane Katrina destroying many of its records.

In Phase II of the trial, two other vessel projects (the Queen of New Orleans and the Penn Tugs), as well as the method of calculating Trinity's base period QREs were at issue. With regard to its base period QRE calculation, a Trinity Vice President of Engineering, Phil Nuss, testified that the 10 vessels identified by Bennett in his report were the vessels used in computing the base period QREs on the amended tax returns. When asked if he believed expenses related to those 10 vessels should still be counted as QREs given the district court's Phase I order holding that certain claim year vessel expenses were not QREs, Nuss replied that expenses relating to four of the ten base period vessels should no longer be counted. According to Nuss, two of the base period vessels were similar to the Hurley Dredge, one of the claim year vessels held not to be qualified research in Phase I, since they all involved Trinity constructing a vessel based on a design provided to Trinity by a third party. In addition, Nuss believed that another base period vessel was like the Crew Rescue Boat, another claim year vessel held not to be qualified research in Phase I, since it was also not a complicated technological boat to build. Finally, Nuss testified that a fourth base period vessel was like the XFPB, which the district court held was not qualified research in Phase I, since it similarly had some experimental features but not enough to satisfy the QRE test. Nuss thus concluded that these four base period vessels should no longer be included in the base period QRE figure, though the other six base period vessels still should be.

After Phase II concluded, the IRS and Trinity addressed whether the other two vessel projects at issue (i.e., the Queen of New Orleans and the Penn Tugs) constituted QREs, as well as the proper base period QRE figure under the consistency rule. Trinity made two distinct arguments about the consistency rule. First, it argued that it had followed the consistency rule on its amended tax returns by calculating both its claim year QREs and its base period QREs using an all-or-nothing approach i.e., meaning it did not shrink-back to subcomponents of any vessels in the base period or the claim years. Thus, it should be allowed the credit it originally took on the amended return.

Second, Trinity argued that it should be able to remove four vessels from its base period QREs as calculated on its amended tax returns, since those vessels were similar, in terms of how much experimentation was involved, to the four vessels held not to be claim year QREs in Phase I. In Phase I, the district court articulated a different standard for "prototype" than Trinity applied on its returns. With respect to four of the projects claimed by Trinity, the court found that the integration of subsystems did not rise to the level required for the cost of developing and constructing the entire vessel to qualify. Given this standard, pursuant to the consistency rule, Trinity argued that its base period QREs had to be reevaluated to ensure they were determined in a manner consistent with the QREs in the claim years. Trinity noted that under the standard articulated in Phase I, four vessel projects in the base period should not be treated as QREs because, for each of these vessels, the identification, configuration and integration of the components of the vessels were not sufficiently complex for the vessels to constitute prototypes under the court's standard.

Trinity contended that, after removing the four base period vessels from the base period QRE figure of $49,483,136, the base period QRE amount would equal $26,706,987. The reduction of the base period QRE amount by over $20 million would reduce Trinity's fixed base percentage and increase its overall research tax credit.

In its Phase II order, the district court concluded that Trinity was wrongly denied a tax credit for one of the two vessels at issue (the Queen of New Orleans) but was correctly denied a tax credit for the other (the Penn Tugs) because it did not meet the fourth QRE requirement. The court held that Trinity was entitled to a credit of approximately $136,000 for 1994 and $0 for 1995.

With respect to Trinity's second argument, the court rejected Trinity's request to reduce its base period QRE by over $20 million. Trinity appealed to the Fifth Circuit.

Appeal to Fifth Circuit

While presenting two arguments to the court, only one gained traction the same argument that Trinity made before the district court where it contended that it should be allowed to remove the four base period vessels from the base period QRE figure of $49,483,136. Before the Fifth Circuit, Trinity argued that, under a proper application of the consistency rule, the court should calculate its base period QREs as $26,706,987: the base period QRE amount used in the Bennett report less the QREs attributable to the four vessels Nuss said would not satisfy the district court's Phase I QRE standard.

The Fifth Circuit agreed with Trinity that if certain base period vessels are just as experimental as claim-year vessels held not to be qualified research, those base period vessels should not be counted as qualified research for purposes of the base period QRE calculation.

Code Sec. 41 allows a taxpayer to claim a tax credit for claim year research expenses that exceed the research expenses spent in an earlier comparison period, the base period years.

To equitably measure the increase in qualified research spending between the two periods, the Fifth Circuit said, the same standard should be applied in determining whether certain projects pursued in the two periods are sufficiently experimental to be qualified research.

The consistency rule, the court s stated, applies to cases like Trinity's where the district court decided that certain claim year projects were not sufficiently experimental to pass the fourth QRE requirement that 80 percent or more of the research activities involved in the project constitute elements of a process of experimentation and Trinity simply asked the court to consider whether four of its base period projects were also not sufficiently experimental to pass that same test.

The court concluded that Trinity was entitled to have a consistent QRE test applied to projects in the base period years and the claim years and remanded the case to the district court for the limited purpose of making a factual determination as to whether to credit the testimony given that the four base period vessels were as experimental as (or less experimental than) the four claim year vessels held not to satisfy the fourth QRE requirement.

If the district court credits this testimony against any possible conflicting testimony or evidence, then those four base period vessels should be removed from the base period QRE calculation, and the resulting base period QRE figure would be $26,706,987. If the district court finds that the four base period vessels (or some of them) were more experimental than the four claim year vessels and were sufficiently experimental to qualify as QREs, then the base period QRE figure should include the expenses associated with those vessel projects, the Fifth Circuit said.

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IRS Streamlines Application Process for Small Organizations Applying for 501(c)(3) Status

Unless subject to a specific exception, all organizations seeking tax-exempt status under Code Sec. 501(c)(3) must, as a condition of exemption, apply for recognition of exempt status with the IRS. Until recently, the application could only be filed by mail on Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. However, on July 1, the IRS released Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The new form, which is only available to smaller nonprofits that meet certain criteria, consists of three pages compared with Form 1023's 26 pages. In addition, while Form 1023 must be mailed to the IRS, Form 1023-EZ is filed electronically on Pay.gov. Since the process of applying for tax-exempt status under Code Sec. 501(c)(3) using Form 1023 can be time consuming as well as expensive if the organization has to hire a professional to manage the application process, the new streamlined process is welcome news for smaller nonprofits.

Observation: The change will allow the IRS to speed the approval process for smaller groups and free up resources to review applications from larger, more complex organizations while reducing the application backlog. Currently, the IRS has more than 60,000 Code Sec. 501(c)(3) applications pending, many for more than eight months.

At about the same time that Form 1023-EZ was issued, the IRS issued (1) Rev. Proc. 2014-40, which sets forth procedures for applying for and for issuing determination letters on tax exempt status under Code Sec. 501(c)(3) using Form 1023-EZ, and (2) final and temporary regulations which amend the current regulations to allow the IRS to adopt the new streamlined application process.

Organizations Eligible and Ineligible to File Form 1023-EZ

In order to be eligible to file Form 1023-EZ, an entity must be a U.S. organization with assets valued at $250,000 or less and annual gross receipts of $50,000 or less. However, Rev. Proc. 2014-40 provides a rather long list of organizations not eligible to submit Form 1023-EZ. The following are ineligible to use the new streamlined process:

(1) organizations with projected annual gross receipts of more than $50,000 in either the current tax year or the next two years;

(2) organizations with annual gross receipts that have exceeded $50,000 in any of the past three years;

(3) organizations with total assets the fair market value of which is in excess of $250,000;

(4) organizations formed under the laws of a foreign country (U.S. territories and possessions are not considered foreign countries);

(5) organizations that do not have a mailing address in the U.S. (territories and possessions are considered the U.S. for this purpose);

(6) organizations that are successors to, or controlled by, an entity suspended under Code Sec. 501(p) (suspension of tax-exempt status of terrorist organizations);

(7) organizations that are not corporations, unincorporated associations, or trusts;

(8) organizations that are successors to a for-profit entity;

(9) organizations that were previously revoked or that are successors to a previously revoked organization (other than an organization the tax-exempt status of which was automatically revoked for failure to file a Form 990 series return or notice for three consecutive years);

(10) churches or conventions or associations of churches described in Code Sec. 170(b)(1)(A)(i);

(11) schools, colleges, or universities described in Code Sec. 170(b)(1)(A)(ii);

(12) hospitals or medical research organizations described in Code Sec. 170(b)(1)(A)(iii) or Code Sec. 501(r)(2)(A)(i) and cooperative hospital service organizations described in Code Sec. 501(e);

(13) cooperative service organizations of operating educational organizations described in Code Sec. 501(f);

(14) qualified charitable risk pools described in Code Sec. 501(n);

(15) supporting organizations described in Code Sec. 509(a)(3);

(16) organizations that have as a substantial purpose providing assistance to individuals through credit counseling activities such as budgeting, personal finance, financial literacy, mortgage foreclosure assistance, or other consumer credit areas;

(17) organizations that invest, or intend to invest, 5 percent or more of their total assets in securities or funds that are not publicly traded;

(18) organizations that participate, or intend to participate, in partnerships (including entities or arrangements treated as partnerships for federal tax purposes) in which they share profits and losses with partners other than Code Sec. 501(c)(3) organizations;

(19) organizations that sell, or intend to sell, carbon credits or carbon offsets;

(20) Health Maintenance Organizations (HMOs);

(21) Accountable Care Organizations (ACOs), or organizations that engage in, or intend to engage in, ACO activities (such as participation in the Medicare Shared Savings Program (MSSP) or in activities unrelated to the MSSP described in Notice 2011-20);

(22) organizations that maintain, or intend to maintain, one or more donor advised funds;

(23) organizations that are organized and operated exclusively for testing for public safety and that are requesting a foundation classification under Code Sec. 509(a)(4);

(24) private operating foundations;

(25) organizations that are applying for retroactive reinstatement of exemption under Sections 5 or 6 of Rev. Proc. 2014-11, after being automatically revoked; and

(26) an organization that is identified or designated as a terrorist organization within the meaning of Code Sec. 501(p)(2).

For purposes of the eligibility requirement in (3), above, a good faith estimate of the fair market value of the organization's assets is sufficient.

Procedures for Requesting Exempt Status Using the New Streamlined Process

In order to obtain exempt status under Code Sec. 501(c)(3) using Rev. Proc. 2014-40, an eligible organization must submit a completed Form 1023-EZ. Form 1023-EZ is considered complete if it:

• includes responses for each required line item on the form, including (a) an accurate date of organization and an attestation that the organization has completed the Form 1023-EZ eligibility worksheet, as in effect on the date of submission, (b) is eligible to apply for exemption using Form 1023-EZ, and (c) has read the instructions for Form 1023-EZ and understands the requirements to be exempt under Code Sec. 501(c)(3);
• includes the organization's correct employer identification number (EIN);
• is electronically signed, under penalties of perjury, by an individual authorized to sign for the organization (as specified in the form instructions); and
• is accompanied by the correct user fee.

The user fee is currently $400. In future years, the user fee will be announced in a successor revenue procedure to Rev. Proc. 2014-8.

A Form 1023-EZ is not considered complete if the organization's name and EIN do not match the records in the IRS's Business Master File. Furthermore, a Form 1023-EZ submitted by an organization that is not an eligible organization will not be considered completed.

An incomplete Form 1023-EZ will not be accepted for processing by the IRS even if it has been successfully submitted through www.pay.gov.

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Taxpayer Entitled to Dependency Exemption for Homeless Friend; No Deduction for Book Writing Activity

A taxpayer was entitled to a dependency exemption for a homeless friend, who had no means of support, that he allowed to share his apartment; but he was not entitled to deductions for his book writing expenses because that activity was still in the start-up phase. Ballard-Bey v. Comm'r, T.C. Summary 2014-62 (7/3/14).

Derrick Ballard-Bey and his wife, Kimberly, married in September 2009. Around that time, Kimberly moved out of her mother's home and into Derrick's apartment. Derrick's childhood friend, Darcy Abney, who was otherwise homeless, was already living in Derrick's apartment. Darcy lived with Derrick during 2009, 2010, and part of 2011, was unemployed during those years, and had no other source of support. Derrick provided food to Darcy while Darcy lived with him. During 2009 and 2010, Darcy would occasionally spend a few nights at a girlfriend's home but would always return to live with Derrick. Two months after Derrick and Kimberly married, a dispute over Darcy's presence in the apartment led to Derrick and Kimberly separating until sometime in 2011.

In 2009, 2010, and 2011, Derrick worked for the Washington Metropolitan Area Transit Authority. Derrick also tried his hand at being an author. By the end of 2009, Derrick had completed a second rough draft of a book about transitioning out of involuntary treatment facilities and imprisonments, something with which he was familiar. In early 2010, Derrick contacted several traditional publishing houses to inquire about the possibility of having his book published. However, he became dissatisfied with the long and uncertain process associated with publishing through a traditional publishing house and decided that self-publishing was a better option. At the time, however, Derrick could not afford to hire book editors and decided that he would sell items related to the subject matter of his book writing activity, including "T-shirts and mugs and different things," the income from which he would use to hire book editors and consultants to prepare his book for publication.

In 2010, Derrick hired a consultant to help him with his endeavors. On the consultant's recommendation, Derrick hired a website and graphic design company to create a logo, a book cover, and a website template. He hired another company to build a website from which he could sell his book and other related items and to provide other Internet-related services for the website, including annual website hosting, website optimization, and social media services. Also in 2010, Derrick retained an intellectual property attorney to assist him with copyright and trademark matters with respect to his book writing activity. Specifically, the attorney helped Derrick file electronic copyright applications for the logo and artwork that had been created. By late 2011, Derrick had completed a 600-page draft but had not raised the funds necessary to hire book editors and publish the book.

On his 2009 and 2010 tax returns, Derrick took a dependency exemption for Darcy. On his 2009, 2010, and 2011 Schedules C, Derrick: (1) reported gross receipts of $250 and $750 for 2009 and 2010, respectively, and zero gross receipts for 2011; and (2) reported net losses of $23,143, $9,640, and $18,358, respectively. The IRS denied the dependency exemptions for Darcy and the deductions for Derrick's book writing activity.

The Tax Court upheld the dependency exemptions for Darcy. The court noted that Code Sec. 152(d)(2) lists eight types of qualifying relationships which will qualify a taxpayer to take a dependency deduction one of which applies to an individual, other than the taxpayer's spouse, who has the same principal place of abode as the taxpayer and is a member of the taxpayer's household for the tax year. In order for an individual to be considered a member of a taxpayer's household, the court observed, the taxpayer must maintain the household and both the taxpayer and the individual must occupy the household for the entire tax year. A taxpayer maintains a household when he or she pays more than one-half of the expenses for the household. On the basis of Derrick's testimony and a notarized statement from Kimberly, the Tax Court was satisfied that Darcy lived with Derrick and had the same principal place of abode as Derrick during 2009 and 2010. The court was also satisfied that no individual other than Derrick supported Darcy and that Darcy had no other source of income or support. Because Darcy had no other source of income or support, the Tax Court assumed that Derrick provided more than one-half of Darcy's support.

With respect to Derrick's book writing activity, the Tax Court denied all deductions. The court found that Derrick undertook his book writing activity with the honest intent to generate a profit. Nonetheless, the court said, his profit-seeking activity was not functioning as a going concern in 2010 or 2011. Although it appeared to the court that Derrick took steps directed toward establishing an active book writing business, his plans to begin the book writing venture were not realized by the end of 2011. At no point during the years in issue, the court noted, did Derrick ever offer any item for sale on his website or otherwise, nor did he, as of the end of 2011, publish his book. Because Derrick did not met his burden of showing that the startup phase was completed and that he began seeking a profit in 2010 or 2011, the expenses relating to the book writing activity were not ordinary and necessary business expenses or Code Sec. 212 expenses for the years in issue. Instead, the court concluded, such expenses are considered startup expenses that cannot be currently deducted.

For a discussion of the dependency exemption deduction and the general requirements for deducting trade or business expenses, see Parker Tax ¶10,720 and ¶90,101.

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IRS Withdraws Favorable Prop Regs on IRA Rollovers in Light of Bobrow Decision

In light of a recent Tax Court decision, the IRS has withdrawn Prop. Reg. Sec. 1.408-4(b)(4)(ii), which had provided that the one-year waiting period between IRA rollovers applied on an IRA-by-IRA basis. REG-209459-78 (7/11/14).

Under Code Sec. 408(d)(3)(B), an individual can make only one tax-free rollover from a traditional IRA to another traditional IRA in any one-year period. The one-year waiting period begins on the date the distribution is made. Prop. Reg. Sec. 1.408-4(b)(4)(ii) and IRS Publication 590, Individual Retirement Arrangements (IRAs), currently provide that the one-year waiting period is applied on an IRA-by-IRA basis. Under this interpretation, an individual who makes a tax-free rollover of any part of a distribution from a traditional IRA cannot, within a one-year period, make a tax-free rollover of any later distribution from that same IRA. The individual also cannot make a tax-free rollover of any amount distributed within the same one-year period from the IRA into which he or she made the tax-free rollover.

However, in Bobrow v. Comm'r, T.C. Memo. 2014-21, the Tax Court held that the one-year waiting period applies on an aggregate basis, rather than on an IRA-by-IRA basis. That means an individual cannot make a tax-free IRA-to-IRA rollover if he or she had made such a rollover involving any of the individual's IRAs in the preceding one-year period. Subsequent to the case, the IRS issued Announcement 2014-15, in which it said it anticipated following the interpretation of Code Sec. 408(d)(3)(B) in Bobrow and would withdraw the proposed regulation and revise Publication 590 to the extent needed to follow that interpretation.

On July 11, the IRS officially withdrew Prop. Reg. Sec. 1.408-4(b)(4)(ii). However, in response to concerns over implementing the rollover limitation as interpreted in Bobrow, the IRS stated that it will not apply the Bobrow interpretation of the one-year waiting period to any rollover that involves an IRA distribution occurring before January 1, 2015. The IRS also stated that regardless of the ultimate resolution of the Bobrow case, it expects to issue a proposed regulation under Code Sec. 408 that will provide that the IRA rollover limitation applies on an aggregate basis. However, in no event would the regulation be effective before January 1, 2015.

Practice Tip: These actions will not affect an IRA owner's ability to transfer funds from one IRA trustee directly to another, because such a "trustee-to-trustee transfer" is not a rollover and, therefore, is not subject to the one-waiting period.

For a discussion of rollovers of distributions from traditional IRAs, see Parker Tax ¶134,540.

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Tax Court Erred in Using Federal Interest Rate in Fraudulent Transfer Case; State Interest Rate Was Appropriate

The Tax Court erred in applying the federal tax interest rate under Code Sec. 6601 in calculating a taxpayer's liability resulting from a fraudulent transfer; instead state rules on calculating the interest applied. Schussel v. Werfel, 2014 PTC 336 (1st Cir. 7/8/14).

In 2003, the Tax Court held that George Schussel was liable, under Code Sec. 6901, as the recipient of a fraudulent transfer from his former company, Digital Consulting, Inc. (DCI), a Massachusetts corporation. The court found George liable for the company's back taxes (including penalties) of over $4.9 million, plus interest of at least $8.7 million.

Under Code Sec. 6601, federal interest on a tax obligation accrues automatically, usually from the date when the tax payment first becomes late. In a fraudulent transfer case, that interest is part of the debt owed by the taxpayer-transferor to the IRS, all of which may usually be collected from a fraudulent transferee to the extent of the amount fraudulently transferred. What was at issue in George's case was the prejudgment interest asserted against George on the amount of the transfer deemed to be avoidable (i.e., the amount that George must give back).

With respect to George's liability for interest, the IRS argued before the Tax Court that George was liable for DCI's back taxes, plus interest, as determined under Code 6601, from the due date of DCI's tax returns. The Tax Court held George liable for DCI's back taxes, plus prejudgment interest at the federal rate (i.e., under Code Sec. 6601) from the respective dates on which DCI's income taxes were due. So calculated, prejudgment interest alone totaled approximately $8.7 million by the time the IRS issued its notice of the amounts due, leaving George liable for over $13.6 million plus further accruing interest at the federal rate.

George appealed to the First Circuit. While not disputing that his company fraudulently transferred millions of dollars to him in an effort to avoid paying income taxes to the IRS, George did dispute how much he owed the IRS as a result of the transfers. He argued that the Tax Court erred in applying the federal tax interest rate under Code Sec. 6601 in calculating his liability. Instead, he argued, he should only be liable for the much lower amount of prejudgment interest that would be due under Massachusetts law.

Essentially, the IRS argument before the First Circuit was that where state law provides the basis for transferee liability, the ratio of IRS debt to assets transferred on the date of transfer operates as a toggle switch to pick whether state or federal law controls prejudgment interest.

The First Circuit agreed with George and held that state law controlled in calculating prejudgment interest. The court noted that the language of both Code Sec. 6901 and Code Sec. 6601 was sufficiently abstract that it could be read as providing partial support for the IRS. Under Code Sec. 6901(a), transferee liability is assessed and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred. And Code Sec. 6601 provides generally that any reference to any tax imposed is deemed also to refer to interest imposed by Code Sec. 6601. Thus, there was some appeal to the First Circuit in the IRS's claim that Code Sec. 6601 is simply one of the same tax provisions and limitations to which transferee liability is subject under Code Sec. 6901. The legislative history of Code Sec. 6901, the court noted, could also be read as providing some support for the more limited idea that interest accrues at the federal rate from the date of the transfer. Ultimately, however, the court found the answer to the issue in the Supreme Court's interpretation of a prior version of Code Sec. 6901. In Comm'r v. Stern, 357 U.S. 39 (1958), the Supreme Court held that another of Code Sec. 6901's predecessor statutes, Section 311 of the Internal Revenue Code of 1939, provided only the procedure by which the IRS could assert substantive right against transferees created by other laws--it did not create any such rights. Thus, where, as in Stern, state fraudulent transfer law supplied the substantive rule, state law controlled "the existence and extent of [transferee] liability."

While the statutory language has changed some since then, the Stern decision still controlled the outcome in the instant case and requires that state law dictate the existence and extent of George's transferee liability. In turn, both Massachusetts and federal courts treat prejudgment interest as a substantive part of a state-law remedy. Since Code Sec. 6901 governs only procedure, and since prejudgment interest is generally a matter of substance, the court said that it follows that Code Sec. 6901 does not govern prejudgment interest where the substantive law is state law. Thus, the First Circuit remanded the case back to the Tax Court to calculate the any prejudgment interest assessed above the amount transferred, at the Massachusetts rate from the date of the IRS notice to the taxpayer.

For a discussion of Code Sec. 6901 and the fraudulent transfer rules, see Parker Tax ¶262,530.

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IRS Addresses Interaction of Sec. 121 Exclusion and Sec. 469(g)

On the sale of a principal residence that was also a rental property in which losses were suspended due to the passive activity rules, gain on the subsequent sale of the property is excludible under Code Sec. 121; to the extent that the suspended passive activity losses exceed the gain excluded under Code Sec. 121, the losses are treated as not from a passive activity due to the rule on dispositions of interests in passive activities. CCM 201428008 (7/11/14).

The Office of Chief Counsel was asked about the appropriate tax treatment of suspended passive activity losses from a passive rental activity formerly used as a taxpayer's principal residence. Specifically, the question involved whether the gain recognized on the sale of the home to an unrelated party was excluded from the taxpayer's gross income under Code Sec. 121.

Under the facts of the memorandum, an individual bought a principal residence for $700,000 and owned and used the home as his principal residence for two years before converting it into a

rental property. During each year that the property was rented, it produced $10,000 in net losses which were disallowed because they were passive losses. Within three years of renting the property, the individual sold the entire property to an unrelated third party for $800,000, realizing a net gain on the sale of $100,000 (not taking into account the $30,000 suspended passive losses). The individual meets the requirements to exclude the gain from gross income as provided under Code Sec. 121(a).

Code Sec. 121(a) provides that gross income does not include gain from the sale or exchange of property if, during the five-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating two years or more. The amount of gain excluded cannot exceed $250,000 (or $500,000 in the case of a joint return).

Where an individual has a loss from a passive activity that is disallowed in the current year, the disallowed loss is treated as a deduction allocable to the activity in the next tax year. These disallowed losses are commonly referred to as "suspended passive activity losses."

Under Code Sec. 469(g)(1)(A), if a taxpayer disposes of his or her entire interest in a passive activity to an unrelated party, and all gain or loss realized is recognized, then the excess of any loss from such activity for the tax year over any net income or gain for such tax year from all other passive activities is treated as a loss which is not from a passive activity.

Code Sec. 121 is an exclusion provision for gain realized under Code Sec. 1001(a) and recognized under Code Sec. 1001(c). Specifically, Code Sec. 121(a) provides that gross income does not include gain from the sale or exchange of a principal residence up to a certain amount. Thus, Code Sec. 121 is simply an exclusion provision for gain that is realized and recognized in the year of sale.

According to the Chief Counsel's Office, because the $100,000 of gain realized is recognized upon the sale of the individual's entire interest in a passive activity to an unrelated party, Code Sec. 469(g)(1)(A) applies. Therefore, to the extent that that the suspended passive activity losses exceed any net income or gain for the tax year of the disposition from all other passive

activities, the $30,000 losses are treated as not from a passive activity. Because the $100,000 gain on the sale of the residence is excluded from the individual's gross income under Code Sec. 121, it is not an item of passive activity gross income for purposes of Code Sec. 469. Therefore, the $100,000 excluded gain from the sale will not offset the $30,000 suspended passive activity losses from the property. Thus, the suspended losses are treated as not from a passive activity and maybe deducted.

For a discussion of the rules relating to suspended losses from passive activities and dispositions of interests in passive activities, see Parker Tax ¶247,160.

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IRS Issues Final Regs on Longevity Annuity Contracts

On July 2, 2014, the IRS issued final regulations that amend the required minimum distribution rules to accommodate deferred annuities that begin at an advanced age. T.D. 9673 (7/2/14).

Code Sec. 401(a)(9) provides required minimum distribution rules for Code Sec. 401(a) qualified trusts. In general, under these rules, the distribution of a participant's entire interest must begin by the required beginning date, which is generally April 1 of the calendar year following the later of (1) the calendar year in which the participant reaches age 70 1/2 or (2) the calendar year in which the participant retires. The ability to delay distribution until the calendar year in which a participant retires does not apply in the case of a 5-percent owner or an IRA owner. Generally, the participant's entire interest must be distributed over the life of the participant or the lives of the participant and a designated beneficiary (or over a period not extending beyond the life expectancy of the participant or the life expectancy of the participant and a designated beneficiary). Code Sec. 403(b) plans, traditional IRAs, and Code Sec. 457(b) eligible deferred compensation plans also are subject to the required minimum distribution rules.

Under prior rules, if an annuity contract held under a defined contribution plan had not yet been annuitized, the interest of a participant or beneficiary under that contract was treated as an individual account for purposes of required minimum distribution rules. Thus, the value of that contract had to be included in the account balance used to determine required minimum distributions from the participant's individual account.

Final regulations have now been issued which amend the required minimum distribution rules for contracts that satisfy certain requirements, including a requirement that distributions begin no later than age 85. Under the regulations, before annuitization, the value of these contracts, referred to as "qualifying longevity annuity contracts" (QLACs), is excluded from the account balance used to determine required minimum distributions. The final regulations apply to qualifying contracts used in qualified defined contribution plans, Code Sec. 403(b) annuity plans, IRAs, and Code Sec. 457(b) eligible governmental plans. The final regulations generally adopt the provisions of the proposed regulations the IRS issued in February 2012, with several changes.

The proposed regulations had provided that for a contract to constitute a QLAC, the amount of the premiums paid for the contract under the plan on a given date could not exceed the lesser of $100,000 or 25 percent of the employee's account balance on the date of payment. The final regulations increase the $100,000 premium limit to $125,000. The final regulations also provide that the $125,000 dollar limitation will be adjusted at the same time and in the same manner as under Code Sec. 415(d), except that (1) the base period is the calendar year quarter beginning six months before the effective date of the regulations, and (2) any increase that is not a multiple of $10,000 is rounded to the next lowest multiple of $10,000.

Under the proposed regulations, if a premium for a contract caused the total premiums to exceed either the dollar or percentage limitation, the contract would fail to be a QLAC beginning on the date the excess premium was paid. Under the final regulations, if an annuity contract would fail to be a QLAC solely because premiums for the contract exceed the premium limits, the contract will not fail to be a QLAC if the excess premium is returned to the non-QLAC portion of the employee's account by the end of the calendar year following the calendar year in which the excess premium was paid.

The proposed regulations provided that the only benefit that could be paid under a QLAC after the employee's death was a life annuity, payable to a designated beneficiary, which met certain requirements. Under the final regulations, a QLAC may offer a return of premium (ROP) feature that is payable before and after the employee's annuity starting date.

Observation: A ROP feature guarantees that if the annuitant dies before receiving payments at least equal to the total premiums paid under the contract, then an additional payment is made to ensure that the total payments received are at least equal to the total premiums paid under the contract.

Like the proposed regulations, the final regulations provide that a QLAC does not include a variable contract under Code Sec. 817, an indexed contract, or a similar contract. However, the final regulations provide that the IRS may provide exceptions to this rule.

The proposed regulations provided that a contract would not be a QLAC unless it stated, when issued, that it was intended to be a QLAC. Under the final regulations, this language may be included in a rider or endorsement to the contract. Also, this requirement is satisfied if a certificate is issued under a group annuity contract and the certificate, when issued, states that the employee's interest under the group annuity contract is intended to be a QLAC. The final regulations also include a transition rule under which an annuity contract issued before January 1, 2016, will not fail to be a QLAC merely because the contract does not satisfy this requirement, provided that when the contract is issued the employee is notified that the contract (or a certificate under a group annuity contract) is intended to be a QLAC, and the contract is amended (or a rider, endorsement, or amendment to the certificate is issued) no later than December 31, 2016, to state that the contract is intended to be a QLAC.

Under the proposed regulations, in addition to requiring the contract to state that it is intended to be a QLAC, the issuer of a QLAC would have been required to issue a disclosure containing certain information about the QLAC at the time of purchase. In light of the existing disclosure practices that take into account disclosure requirements under state law and under Title I of ERISA, the final regulations do not require an initial disclosure to be issued to the employee.

The final regulations apply to contracts purchased on or after July 2, 2014. For contracts issued before that date, the rules under Code Sec. 401(a)(9) that were in effect before the regulations were issued generally continue to apply. However, if on or after July 2, 2014, an existing contract is exchanged for a contract that satisfies the requirements to be a QLAC, the new contract will be treated as purchased on the date of the exchange and therefore may qualify as a QLAC.

For a discussion of longevity annuity contracts, see Parker Tax ¶138,100.

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Tax Court Rejects Deduction for Wages Paid to Taxpayer's Children

Where there was no consistent correlation between the hours worked by the taxpayer's children and the amount recorded as paid for the benefit of each child, the lack of correlation precluded a deduction for wages paid to the children. Ross v. Comm'r, T.C. Summary 2014-68 (7/10/14).

Patricia Ross was a sole proprietor engaged in multiple business activities. She ran a business called Ross Professional Services, LLC (RPS) that did government staffing work involving resume and application preparation, and background and reference checks. She was also engaged in consulting and had a tax preparation business.

Patricia's three children worked in her RPS operations. In 2007, the children were ages 15, 11, and 8. In general, the children's work included shredding, stuffing envelopes, copying, sorting checks, filing, "pulling" trash, carrying equipment, and helping to shop for supplies. Patricia prepared timesheets, Forms W-2, Wage and Tax Statement, and other employment tax returns in the names of her children. After researching IRS publications, Patricia did not withhold or pay over employment taxes or income tax in connection with their work. Most of the amounts Patricia considered as wages paid to her children were payments she made to third parties. Two of the children had recorded earnings exceeding $3,000 in 2007, and all three had recorded earnings exceeding $3,000 in 2008. Patricia did not withhold federal income tax with respect to the amounts she considered as wages paid to her children.

As documentation for her expenses regarding the children's wages, most of Patricia's receipts were receipts representing credit card purchases for meals at restaurants, many of them for pizza. A large number and amount of other payments were to Score Learning I, a tutoring play activity service. Patricia also provided checking account statements from her bank on which she made the notation "kids" or their initials next to check card purchases, point of sale debits, and ATM cash withdrawals. According to Patricia, she kept receipts of expenditures that the children "directed" her to make, matched them against their "earnings" and made the appropriate charges against them. She explained that she did not withhold federal income tax with respect to the amounts paid for the benefit of her children because she said they were not required to file tax returns. Among other deductions denied by the IRS, the IRS denied Patricia's deductions for amounts paid to her minor children as wages in 2007 and 2008.

The Tax Court agreed with the IRS and rejected Patricia's wage deductions for her children. The court noted that compensation is deductible as a trade or business expense only if it is: (1) reasonable in amount; (2) based on services actually rendered; and (3) paid or incurred. Compensation meeting those requirements is deductible even if the employer is a parent and the employee is his or her child. However, when a familial relationship is involved, the transaction is more closely scrutinized by the courts. Code Sec. 262(a) generally disallows deductions for personal, living, or family expenses. A normal supposition when payments are made to dependent children or when items are purchased for them, the court said, is that the money or items are in the nature of support and thus nondeductible under Code Sec. 262.

The court commented that certain factors militate against deducting payments to children such as: (1) failing to pay employment taxes and file information returns with respect to the child; (2) paying the child a flat amount determined at the beginning of the year that is not based on the services actually performed; (3) a lack of correlation between the dates and amounts of payments and the hours allegedly worked by the child; (4) failing to maintain adequate records of the child's hours worked and amounts earned; and (5) compensating the child for services which are in the nature of routine family chores.

With respect to Patricia's argument that she did not withhold federal income tax because her children were not required to file tax returns, the court noted that, except for one child in 2007, her children were required to file returns. A single person who is not married, not a surviving spouse, and not the head of a household must file a return if his or her gross income exceeds the sum of the exemption amount and the standard deduction. For both 2007 and 2008, the court stated, the standard deduction was $3,000. Because the children were Patricia's dependents, the exemption amount was zero.

However, the court did note that because Patricia's children were minors during the years at issue, she was not required to withhold and pay over employment taxes from amounts credited to the children or to file information returns for them. While she also maintained records of the amounts of alleged payments she made for the benefit of the children and the hours allegedly worked by the children, the court was dubious as to whether Patricia had shown that the alleged payments were based on services actually performed or that the children were not compensated for services which were in the nature of routine family chores. Additionally, the court could find no consistent correlation between the hours the children worked and the amount recorded as paid for the benefit of the child. That lack of correlation, the court said, militated against the deductibility of the payments.

Considering all the facts and circumstances, the Tax Court concluded that Patricia did not show by a preponderance of the evidence that the amounts she claimed as expenses for wages to her minor children were deductible as business expenses.

For a discussion of the deductibility of compensation paid for the services of a child, see Parker Tax ¶70,310.