Federal Tax Bulletin - Issue 64 - June 06, 2014

Tax Court Draws Bright Line on Use of Completed Contract Method by Developers

In 2012, residential land developer Howard Hughes Corporation (HHC) went before the Tax Court to contest a $144 million assessment by the IRS. According to the IRS, the developer's contracts to sell land through bulk sales, pad sales, finished lot sales, and custom lot sales were not home construction contracts and, thus, the developer's use of the completed contract method was improper. Additionally, the IRS contended that some of the contracts were not long-term construction contracts eligible for the percentage-of-completion method of accounting.

In the meantime, while waiting for the decision in its case, HHC had reason to be hopeful because another developer scored a big victory in February against the IRS. In Shea Homes, Inc. v. Comm'r, 142 T.C. No. 3 (2014), one of the largest private homebuilders in the United States successfully argued that it could defer profits under the completed contract method on home sales in a planned community until 95 percent of that community, including common improvements and amenities, was completed and accepted. As a result, the homebuilder was able to defer taxes on millions in profits.

Unfortunately, HHC was not so lucky. In The Howard Hughes Company, LLC v. Comm'r, 142 T.C. No. 20 (6/2/14), the Tax Court held that the developer's contracts were not home construction contracts and, thus, gain or loss from such contracts could not be reported using the completed contract method. An important consideration for the court was the fact that HHC did not build homes on the land it sold, nor did qualifying dwelling units exist on the sold land at the time of the sales.

There was one positive note: The court rejected the IRS's assertion that certain HHC contracts were not long-term construction contracts and, thus, HHC was entitled to use the percentage-of-completion method.

In reaching its decision in the instant case, the Tax Court recognized the potential tension with Shea. Its decision in Howard Hughes, the court said, is meant to draw a bright line as to the type of contracts that can qualify as home construction contracts eligible for the completed contact method. As such, a taxpayer's contract can qualify as a home construction contract only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units. In Shea, the Tax Court noted, the taxpayers closed their contracts only after a certificate of occupancy had been issued and simultaneously with the purchaser's taking possession of their house. It is not enough for the taxpayer to merely pave the road leading to the home, the court said, though that may be necessary to the ultimate sale and use of a home.

Practice Tip: In light of this decision, practitioners with clients using the completed contract method may need to reevaluate whether that is the proper method based on the type of sales their clients are engaging in.

Observation: There is some concern that this decision could hurt the real estate industry just as it is recovering from the real estate crash in the late 2000s. This is because developers starting new projects will not be able to defer as much income as they otherwise might under the completed contract method and thus will have more up-front costs in the way of tax bills.

Background

In 2007 and 2008, HHC and its subsidiaries were in the residential land development business. They generated revenue primarily by selling property to builders who would then construct and sell homes. In some cases, they also sold property to individual buyers who would then construct single-family residential homes. The land HHC sold and still sells is part of a large master-planned community known as Summerlin. Summerlin is divided into three geographic regions: Summerlin North, Summerlin South, and Summerlin West. Each of these three geographical regions is further divided into villages, each of which averages about 500 acres. Villages are further divided into parcels, or neighborhoods, which contain the individual lots. Summerlin is termed a planned community because it involves residential and commercial areas and provides space for attendant public and private resources and facilities.

HHC Sales Contracts

Sales by HHC generally fell into one of four categories: (1) pad sales; (2) finished lot sales; (3) custom lot sales; and (4) bulk sales. In a pad sale, HHC, after dividing the village into parcels, constructed the entire infrastructure in the village up to a parcel boundary. HHC then sold the parcel to a buyer, who was usually a homebuilder. The builder, with HHC's approval, was responsible for the entire infrastructure (such as streets and utilities) within the parcel and subdividing the parcel into lots. In a finished lot sale, HHC also divided the village into parcels. They then further constructed any additional needed parcel infrastructure, divided the parcels into lots, and sold the neighborhoods to a buyer, usually a homebuilder. In finished lot sales, HHC constructed the entire infrastructure up to the lot line. In both the pad sales and the finished lot sales, HHC contracted with homebuilders through building development agreements (BDA).

Custom lot sales were essentially the same as finished lot sales, except that HHC sold the individual lots. The buyers of these individual lots were individuals who were contractually bound to build a residential dwelling unit. The purchase sales contracts required the individuals to agree that they would occupy the home for at least one year or, if the home was sold before then to a third party, to pay additional consideration of 10 percent of the third-party price. Finally, in a bulk sale, HHC sold an entire village to a purchaser. The purchaser was responsible for subdividing the village into parcels and lots and for constructing all of the infrastructure improvements within the village.

Common Improvements

The BDAs, loan agreements, governmental laws, and other legal obligations required HHC to build common improvements in Summerlin. These improvements included rough grading; roadways; sidewalks; utility infrastructure, such as water, sewer, gas, electricity, and telephone; storm water drainage; parks; trails; landscaping; entry features; signs; and perimeter walls. Upon completion of a common improvement, HHC transferred ownership or granted easements to the respective community association or, where appropriate, the municipality. Generally, community associations received some roads, swimming pools, open spaces, and medians, whereas the municipalities received police stations, fire stations, other roads, traffic signals, and street lights.

Some of these improvements were necessary for construction of the dwelling units. The allocable costs attributable to HHC's improvement construction activities exceeded 10 percent of the various total contract prices. HHC designed all the common improvements in an effort to make Summerlin an attractive community. In addition, HHC monitored and maintained approval control over all construction in Summerlin, including construction of the dwelling units.

HHC's Tax Reporting

In 2007 and 2008, HHC used the completed contract method of accounting in computing gain or loss from the contracts for sale of residential real property in Summerlin intended for residential buildings planned to contain four or fewer residential units per building. Under HHC's methods of accounting, each BDA, custom lot contract, and bulk sale agreement was a home construction contract, and they were not completed until HHC incurred 95 percent of the direct and indirect costs allocable to the agreement or contract. At that point, HHC reported gain from the BDAs, custom lot contracts, and the bulk sale agreements.

HHC broke down estimated BDA costs into three categories: (1) direct village costs; (2) regional costs, and (3) finished lot costs. Direct village costs consisted of the cost for the common improvements that benefit only the village that was the subject matter of the contract. Regional costs consisted of common improvements that benefited more than one village. Finished lot costs were the costs that benefit only the neighborhood or parcel in which the finished lots were located.

The IRS determined that HHC was not eligible to use the completed contact method because its contacts did not qualify as home construction contracts. As a result, the IRS changed HHC's method of accounting from the completed contract method to the percentage-of-completion method. The resulting tax deficiency was approximately $144 million.

Before the Tax Court, the IRS raised an additional issue. According to the IRS, the custom lot contracts and the bulk sale agreements were not long-term contracts and, thus, were not eligible for the percentage-of-completion method of accounting. With respect to the custom lot contracts, the IRS argued that HHC did not have a legal obligation to perform the construction activities contemplated by the contracts and, thus, the contracts were not construction contracts. Because HHC was already obligated by statute to complete various improvements (i.e., had a preexisting duty), the IRS said, the obligations were not contractual obligations. With respect to the bulk sales contracts, the IRS said that because HHC failed to prove that it was required to construct anything under these contracts, HHC failed to carry its burden of proving the contracts were entitled to a long-term contract method of accounting.

Home Construction Contracts and the Completed Contract Method

Gain or loss on home construction contracts can be accounted for under the completed contract method. Code Sec. 460(e)(6) defines a home construction contract as any construction contract if 80 percent or more (i.e., the 80 percent test) of the estimated total contract costs (as of the close of the tax year in which the contract was entered into) are reasonably expected to be attributable to certain specified activities with respect to dwelling units contained in buildings containing four or fewer dwelling units, and improvements to real property directly related to such dwelling units and located on the site of such dwelling units. The specified activities are defined under Code Sec. 460(e)(4) as the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.

Tax Court's Analysis

Percentage-of-Completion Issue

The Tax Court began by rejecting the IRS's argument that neither the custom lot contracts nor the bulk sale contracts were eligible for the percentage-of-completion method. With respect to the custom lot contracts, the court said it was not clear that the preexisting duty rule applied in these cases. First, the contracts between HHC and the purchasers were valid contracts with valid consideration independent of the duties with respect to the development, the court said. Second, while the Nevada statute seemed to grant purchasers a cause of action if HHC failed to construct improvements as shown on site plans or plats, the statute explicitly provides that the civil remedy provided for is in addition to, and not exclusive of, any other available remedy or penalty. Therefore, the court said, it was uncertain whether a Nevada court would apply the preexisting duty rule to HHC's contracts.

The court also disagreed with the IRS argument that Reg. Sec. 1.460-1(b)(2) codifies the preexisting duty rule. That regulation, the court noted, clearly states that "how the parties characterize their agreement (e.g., as a contract for the sale of property) is not relevant" in determining the existence of a Code Sec. 460 construction contract. Rather, the regulation allows a taxpayer to include the allocable costs "if the taxpayer is contractually obligated, or required by law, to construct the common improvement." Nothing in the regulation, the court observed, requires that the contract be the sole source of the obligation, and, in fact, it indicates the opposite - that the obligation may be noncontractual.

With respect to the bulk sale agreements, the court said these are merely pad sale BDAs on a larger scale. The court noted that it had heard credible testimony from HHC's Vice President of Finance that the bulk sale contracts were BDAs and that HHC was obligated to build the same types of common improvements that benefited the property sold, such as regional water lines, traffic signals, and detention basins. Thus, the court held that these contracts were also construction contracts that may be accounted for as long-term contracts.

Completed Contract Issue

The Tax Court held that HHC was not eligible to use the completed contract method. Use of the completed contract method, the court said, depended on whether the HHC contracts qualified as home construction contracts. The issue centered on whether the contract qualifies if the seller does not build the house or any improvements on the lot. There was no disagreement that the structures to be built upon the land sold would be dwelling units.

An important factor in denying HHC's use of the completed contract method was that HHC did not build homes on the land it sold, nor did qualifying dwelling units exist on the sold land at the time of the sales. HHC did not establish that, at the time of each sale, qualifying dwelling units would ever be built on the sold land.

The Tax Court found one particular bulk sale agreement especially troubling, as no construction had yet occurred years after the sale. And, in that case, because the purchaser-builder defaulted on the contract, HHC still owned half of the property. As far as the court knew, no qualifying dwelling units might ever be built on the property, and deferral of income from contracts that might not ever result in qualifying dwelling units seemed entirely inappropriate to the court in these circumstances.

HHC, the court observed, closes the contracts and receives revenue without needing to build a single home. In contrast, the court observed, the taxpayers in Shea Homes closed their contracts only after a certificate of occupancy had been issued and simultaneously with the purchaser's taking possession of their house. In the instant case, the court said, HHC is under no contractual obligation to build homes as their contracts are merely for the sale of land, developed to varying degrees, to builders or individual customers who may eventually build homes on that land.

The court reviewed how Code Sec. 460(e)(6) defines a home construction contract by reference to the estimated total contract costs attributable to construction activity "with respect to" (1) dwelling units and (2) improvements to real property directly related to the units and located on the site of the dwelling units. Moreover, Reg. Sec. 1.460-3(b)(2)(i), the court noted, clarifies that the allocable contract costs to be included in the 80 percent test must be attributable to the construction of the units and the improvements thereto.

According to the IRS, the home construction contract exception requires the taxpayer to actually build dwelling units or to build improvements to real property directly related to and located on the site of such dwelling units.

HHC, on the other hand, argued the statute contemplates a broader definition of home construction costs. Under its interpretation, HHC's development costs are allocable to the contracts and the costs benefit the dwelling units and real property improvements related to and located on the site of such dwellings sold. Thus, HHC contended that the costs were therefore attributable to the dwelling unit construction activity and that these costs should count towards meeting the 80 percent test. Accordingly, Code Sec. 460(e)(6) applied even though HHC did not construct the dwelling units. This conclusion follows, HHC said, because the statute does not confine the availability of the completed contract method of accounting to those taxpayers who build the dwelling units' "sticks and bricks" and/or real property improvements related to and located on the dwelling units' lots.

The Tax Court noted that HHCs' interpretation of the statute would make any construction cost tangentially related to a dwelling unit or real property improvement related to and located on the site of the dwelling unit a cost to be counted in determining whether a contract is a home construction contract. Without HHC's development work, the court said, the pads and lots would be mere patches of land in a desert. Thus, the court found that HHCs' work may indeed be necessary for the ultimate home to feasibly be built and occupied. But these correlations, the court concluded, do not mean that those costs are necessarily incurred "with respect to" qualifying dwelling units. According to the court, "with respect to" implies a stronger proximate causation than HHC's interpretation permitted.

Ultimately, the Tax Court rejected HHC's interpretation and concluded that none of HHC's costs were attributable to the construction of the dwelling units because HHC did not intend to build such units, and neither the units nor the real property improvements related to and located on the site of the dwelling units had yet been built.

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Rancher's Ownership History Is Antithesis of Farming Syndicate; Cash Method Allowed

In a case of first impression, the Fifth Circuit rejected IRS attempts to label a long-time rancher as a farming syndicate solely because she owned her ranch through an S corporation. Burnett Ranches, Ltd. v. U.S., 2014 PTC 249 (5th Cir. 5/22/14).

Generally, farming syndicates are prohibited by Code Sec. 464 (acting in conjunction with Code Sec. 448) from using the cash method to deduct amounts paid for feed, seed, fertilizer, or other similar farm supplies. Instead, such deductions are only allowed in the tax year these items are consumed or used. Section 464 was enacted to close a tax loophole that involved limited partnerships and similar investment entities acquiring interests in agricultural trades or businesses that had large tax operating losses, as a result of expensing costs under the cash method for things like supplies and feed, then selling fractional interests in those entities to sophisticated passive investors. Those passive investors, who had nothing to do with farming, generally had large taxable incomes and would offset their respective shares of the farm's tax losses against their unrelated taxable incomes. In response, Congress enacted Code Sec. 464. However, Congress carved out exceptions to this rule that allow individuals, families, and entities legitimately and directly engaged in agricultural enterprises to use the cash method.
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Tax Court Set to Decide If Estate Must Pay Tax on Worthless Madoff Account

The Tax Court rejected the IRS's request for summary judgment, opening the door for a possible refund of estate taxes if the estate can prove that a hypothetical willing buyer of a Madoff-managed investment account could have reasonably known that Madoff was operating a Ponzi scheme at the time of the decedent's death. Est. of Kessel v. Comm'r, T.C. Memo. 2014-97 (5/21/14).

In Kessel, the essential issue was whether a defined benefit pension plan consisting of purported holdings from a Madoff Ponzi scheme account had taxable value on the date of the decedent's death for estate tax purposes. The Tax Court ruled against the IRS's summary judgment motions, finding that there were issues of material fact for determining the fair market value of the plan assets and whether, at the time Mr. Kessel died, a hypothetical buyer and seller would have reasonably known that Madoff was operating a Ponzi scheme.

The estate of decedent Bernard Kessel had as an asset a defined benefit pension plan. Upon Mr. Kessel's death, the beneficiaries of the plan were Mr. Kessel's wife, Iris Steel, and his son. After Mr. Kessel's death, Iris, as executrix, contacted Madoff Investment Securities, LLC for a valuation of the pension plan account in order to file the estate's tax return. Madoff Investments sent Iris a listing of the account's securities and their prices. After requesting a valid extension to file and pay, the estate timely filed its return and reported $4.8 million as the pension funds assets; the sum Madoff Investment Securities had appraised the account.

The estate paid approximately $1.9 million in tax. When the Ponzi scheme was discovered a year later, accompanied by the resulting prosecutions and eventual collapse of Madoff Investment Services, the estate attempted but failed to recover approximately $3.2 million of assets presumably owed to the estate by Madoff Investment Securities. The appointed trustee for Madoff's business denied the pension plan's claim. Over the years, the Kessels had withdrawn approximately $5.5 million from the investment account and this was about $2.8 million more than they had deposited. As a result, the trustee also filed suit to "clawback" some of the pension plan funds transferred to the family in order to reimburse other hurt Madoff investors. As a result, the estate filed a supplemental federal estate tax return claiming the pension fund held by Madoff Investments was valueless as a result of the Ponzi scheme and requesting a refund of the tax previously paid.

The IRS denied the refund request and found the estate had greater income than reported on the return. The estate filed a petition in Tax Court arguing that the fair market value of the Madoff account was zero, not the $4.8 million the estate had reported. The IRS moved for partial summary judgment on two grounds. First, the IRS asked the Tax Court to identify the Madoff account as opposed to the Madoff account's purported holdings as the property subject to federal estate tax. Second, the IRS took the position that the Madoff account had a fair market value of $4.8 million for estate tax purposes because the existence of the Madoff Ponzi scheme was unknown at the date of the decedent's death.

The Tax Court did not agree with the IRS and held that the estate's Madoff account could be a taxable and legal interest in personal property but, until both side presented more facts at trial, the court could not decide this issue.

As to the second argument, the Tax Court said it is unclear whether a hypothetical willing buyer and seller of the Madoff account could have reasonably known or foreseen that Madoff was operating a Ponzi scheme at the time of Mr. Kessel's death. The court considered Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929), in which the Supreme Court held that subsequent events may not be considered to determine date of death value of a decedent's gross estate. The Tax Court focused on how to determine the fair market value of personal property subject to federal estate tax. The fair market value standard, the court explained, is defined by what a willing buyer would pay a willing seller, both having reasonable knowledge of the relevant facts.

The court made a distinction between later occurring events affecting the value of the property transferred from later occurring events that do not affect the value, the latter which may be relevant to the determination of fair market value regardless of their foreseeability at the time of the transfer. In this vein, the court noted the fact that some people had questioned the consistent success of the Madoff investments long before the Ponzi scheme become publically known, citing to congressional committee meetings and materials. Importantly, the court rejected the IRS's contention that the Ponzi scheme was not foreseeable or knowable until it was discovered and collapsed in December 2008. Thus, the court determined there continued to be facts in dispute regarding the hypothetical buyers and sellers and what information they would have had access to for determining the fair market value of assets in the Madoff account.

The Tax Court concluded that a trial is necessary to determine whether a buyer and seller would reasonably have known or foreseen there was a Ponzi scheme at play and what affect this information would have on the fair market value of the pension account. A final ruling from the Tax Court can provide helpful guidance for taxpayers similarly situated.

The case presents one of many issues that have arisen as a result of the Madoff Ponzi scheme. Not only did many investors lose their life savings, there are ancillary matters such as taxation which carry uncertain results. If the court holds that the Madoff account value was $4.8 million at the date of his death, and thus the estate is required to pay tax on that amount, taxpayers in like positions will face serious consequences. Moreover, such a decision should raise questions about the realization and recognition of gain and loss because the estate had not actually realized any gain.

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Change of Intent Does Not Transform Gain on Property's Sale to Capital Gain

The fact that a property owner's intent with respect to property he purchased changed did not transform gain on the later sale of the property from ordinary income into capital gain. Allen v. U.S., 2014 PTC 254 (N.D. Calif. 5/28/14).

Frederic Allen purchased a plot of land in East Palo Alto, California, in 1987 with the intention of developing the land. Over the following several years, Fredrick and his wife, Phyllis, expended significant efforts to develop the land. They purchased engineering plans and took out a second mortgage to finance the project. Additionally, Fredrick's own development company created ten development plans for the property and sought investors and partners to aid in the work. In 1999, the couple entered into an agreement with Clarum Corporation whereby they sold the property for a lump sum and percentage of the profit made on units sold on the property. Fredrick's firm also conducted some civil engineering work on the property until Clarum changed the nature of the development. In 2004, the Allens received a final installment payment from Clarum of $63,662 along with a 1099-MISC for the amount. The Allens characterized the $63,662 payment as capital gain while the IRS said it was ordinary income. Read more...

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District Court Decision Highlights Split in Circuits on At-Risk Provision

A taxpayer was at risk with respect to his guarantee through an LLC on a loan to purchase a jet that was then leased out at a large loss; since the average customer use of the jet was less than seven days, a court held that the taxpayer's lease activity was not a rental activity and was thus excepted from the passive loss rules that would have limited the amount of deductible loss. Moreno v. U.S., 2014 PTC 241 (W.D. La. 5/19/14).

Michel and Tiffany Moreno filed for a tax refund as a result of suffering a loss of almost $4.8 million that arose out of their acquiring and leasing a Learjet aircraft in 2005. The aircraft was owned and operated through Aerodynamic, LLC, a limited liability company owned solely by Michel. Aerodynamic was a disregarded entity for tax purposes, and Aerodynamic's operations were reported on Michel and Tiffany's Schedule C. The aircraft purchase was financed by a loan from General Electric Capital Corporation (GE) to Aerodynamic in the amount of the purchase price. The loan was secured by a security interest granted to GE in the aircraft, the corporate guaranty of Dynamic Industries, Inc., and an individual personal guaranty by Michel. Dynamic Industries, Inc. was owned by Moreno Energy, Inc., which was 98 percent owned by Michel. Once acquired, Aerodynamic leased the aircraft to various lessees throughout the remainder of 2005.

Aerodynamic suffered losses in 2005 and, as a result, Michel deducted the losses on his and Tiffany's personal return and sought a refund of approximately $667,000 in taxes plus interest. The IRS denied the refund request, arguing that Michel was not at risk under Code Sec. 465 with respect to the aircraft leasing activity, and that the aircraft leasing activity constituted a rental activity, subject to the passive activity loss rules of Code Sec. 469. Michel countered that he was at risk with respect to the leasing activity and that the activity was not a rental activity by reason of the exception in Reg. Sec. 1.469-1T(e)(3)(ii)(A). That exception excludes from rental activity the lease of tangible property where the average period of customer use is less than seven days. According to Michel, he was at risk on the loan because he personally guaranteed its repayment. If the loan defaulted and the sale of the aircraft was not sufficient to pay off the debt, he argued, GE could pursue him and/or Dynamic.

Under Code Sec. 465(b)(1)(B) and Code Sec. 465(b)(2)(A), a taxpayer is considered at risk for an activity for amounts borrowed with respect to such activity provided the taxpayer is personally liable for the repayment of such amounts. However, under Code Sec. 465(b)(4), a taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements. While the IRS agreed that Michel personally guaranteed the repayment of the GE loan to Aerodynamic and thus satisfied Code Sec. 465(b)(2)(A), it said that the substance and economic realities of the transaction protected Michel from ever being required to satisfy his obligation and, therefore, the transaction fell within the exception from at-risk treatment provided by Code Sec. 465(b)(4). The IRS did not argue that Michel was protected against loss arising out of his personal guaranty through nonrecourse financing, guarantees, or stop loss agreement. The issue was whether, under Code Sec. 465(b)(4), Michel was protected against loss through other similar arrangements and the IRS argued that he was.

The IRS also objected to Michel's contention that he was not involved in a rental activity because he fit within the exception of Reg. Sec. 1.469-1T(e)(3)(ii)(A), which excludes activities involving the use of tangible property where the average use of such property is seven days or less. The argument centered on how the average period of customer use is calculated. According to the IRS, each lease agreement constituted a contract with a definite term the life of the aircraft with a reservation of right to terminate. Because none of the agreements were terminated in 2005, each lessee had a continuous and recurring right to use the aircraft from the time each agreement was entered into, through the end of 2005. Thus, the average period of customer use of the aircraft was 85 days.

According to Michel, the lease agreement was a contract without a definitive term. The agreement, Michel noted, did not provide the lessee with a continuous or recurring right to use the aircraft because (1) the agreement could be terminated at the will of the parties at any time the aircraft was in the possession of the owner, and (2) each use of the aircraft by the lessee was subject to the owner's approval.

The statute does not define or explain the phrase other similar arrangements in Code Sec. 465(b)(4). The Second, Eighth, Ninth, and Eleventh Circuits apply an economic realities test to determine whether a borrowed amount is protected against loss under Code Sec. 465(b)(4). Under this test, whether a taxpayer is personally liable for repayment of borrowed amounts is determined by analyzing whether the taxpayer is ultimately liable for repayment of the borrowed amounts in a worst-case scenario. Whether the taxpayer has engaged in a loss-limiting arrangement prohibited by Code Sec. 465(b)(4) is determined by whether a transaction is structured by whatever method to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable. Under the economic realities test, a theoretical possibility that the taxpayer will suffer an economic loss is insufficient to avoid the application of Code Sec. 465(b)(4).

By contrast, the Sixth Circuit applies a payor of last resort test to determine whether a borrowed amount is protected against loss. This test asks whether, under both Code Sec. 465(b)(2) and Code Sec. 465(b)(4), in a worst-case scenario, the individual taxpayer will suffer any personal, out-of-pocket expenses. The Tax Court has said that whichever standard is used, the ultimate decision rests on the substance of the transaction in light of all the facts and circumstances. The Fifth Circuit, the circuit to which this case is appealable, has not addressed the standard to be applied.

The district court held that Michel was at risk with respect to the Aerodynamic loan. The court said that while it tended to agree with the Sixth Circuit's interpretation of Code Sec. 465(b)(4) and its application of the payor of last resort test, Michel was considered at-risk under either test. The court noted that the cases cited by the IRS all involved a complicated web of circular sale/leaseback transactions that did not exist in Michel's case. Additionally, the court said, in many of the cited cases, the investor's personal liability did not run through to an independent third-party lender as it did in Michel's case, but rather to the investment creator, thus leading the courts to find the taxpayers in those cases were protected against loss.

The district court also agreed with Michel's argument that he was not involved in a rental activity because the average period of customer use was seven days or less; thus, his aircraft leasing was not subject to the passive activity loss rules. The court concluded that each flight by a lessee was a separate rental or lease and, as a result, the average period of customer use in 2005 was less than two days.

Observation: It's not always clear what the average number of days of customer use is for purposes of determining if an activity is excepted from the definition of a rental activity. On occasion, what seems like a short-term rental may, in fact, be much longer. Typically, this happens with related parties, where the lease is for a short period, but there is a renewal option. Reg. Sec. 1.469-1(e)(3)(iii)(D) explicitly provides that the period of customer use is each period during which the customer has a recurring right to use the property, whether or not there is a lease. If someone has the right to use the property all year long, there is one single period of customer use for the year, even if the person or entity uses the property only sporadically for a few hours or days at a time.

For a discussion of when a borrower is considered personally liable on a loan and not otherwise protected from loss, see Parker Tax ¶247,520. For a discussion of the rule excepting an activity from the definition of rental activity where customer use is seven days or less, see Parker Tax ¶247,140.

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Pro-Israel Organization Can Press Ahead with Politically Charged Case

A pro-Israel group can move forward with its complaint that the IRS violated the First Amendment when it implemented an internal review policy that subjected Israel-related organizations applying for tax-exempt status under Code Sec. 501(c)(3) to more rigorous review procedures than other organizations applying for that same status. Z Street, Inc. v. Koskinen, 2014 PTC 251 (D. D.C. 5/27/14).

Z Street is a non-profit corporation incorporated in Pennsylvania. It is dedicated to educating the public about various issues relating to Israel and the Middle East. Z Street filed an application with the IRS seeking to be recognized as a tax-exempt organization under Code Sec. 501(c)(3). In following up on the application, an IRS agent told Z Street's counsel that there were two major concerns about approving the application: first, that the organization engaged in advocacy activities that are not permitted under Code Sec. 501(c)(3); and second, that the IRS had special concerns about applications from organizations whose activities relate to Israel, and whose positions with respect to Israel contradict the current policies of the U.S. government. According to Z Street's counsel, the IRS agent said that the IRS carefully scrutinizes all Code Sec. 501(c)(3) applications that are connected with Israel, and that these cases are being sent to a special unit in the D.C. office to determine whether the organization's activities contradict the Administration's public policies.

Z Street filed a complaint alleging that the IRS violated the First Amendment when it implemented an internal review policy that subjected Israel-related organizations applying for tax-exempt status under Code Sec. 501(c)(3) to more rigorous review procedures than other organizations applying for that same status. Originally, Z Street filed the lawsuit in a Pennsylvania district court. However, that court concluded that Z Street's case was best construed as a controversy arising under Code Sec. 7428, which provides for declaratory judgments in suits related to the classification of organizations under Code Sec. 501(c)(3) and that only three courts have jurisdiction over such suits: the Tax Court, the Court of Federal Claims, and the District Court for the District of Columbia. While the Pennsylvania district court agreed with Z Street, it said it lacked jurisdiction and transferred the case to the D.C district court.

Before the D.C. district court, Z Street claimed that the IRS's Israel Special Policy constituted viewpoint discrimination in violation of the First Amendment and asked the court to declare that the policy is unconstitutional and issue an injunction ordering the IRS to disclose information about the policy and to bar the IRS from employing the policy when it rules on Z Street's Code Sec. 501(c)(3) application. The IRS characterized Z Street's claim as a complaint about tax liability and asked the court to dismiss the suit. The reasons the IRS gave for dismissing the suit were (1) both the Anti-Injunction Act (AIA) and the so-called tax exception of the Declaratory Judgment Act (DJA) barred the claim; (2) the D.C. district court lacked jurisdiction over the claim because the IRS had sovereign immunity; and (3) Z Street failed to state a claim upon which relief could be granted because it had an adequate remedy at law and thus injunctive relief was not available to it.

The district court held that the case could move forward. The court rejected the IRS's core argument that Z Street was seeking a determination of whether or not it is entitled to Code Sec. 501(c)(3) tax status. According to the court, there was nothing in the record to suggest that Z Street brought the action for the purpose of resolving the matter of its own tax liability because the amended complaint made crystal clear that Z Street was not asking the court to reach any conclusion regarding (or indeed, even to consider) the organization's qualifications for tax-exempt status under Code Sec. 501(c)(3). The court also rejected the IRS's assertions that the AIA, the DJA, or sovereign immunity barred Z Street's request for equitable relief and that it had an adequate remedy at law.

For a discussion of the criteria for becoming a Code Sec. 501(c)(3) organization, see Parker Tax ¶60,510.

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Frivolous Tax Return Penalties Survive Taxpayer's Death

Frivolous tax return penalties assessed under Code Sec. 6702 as a result of the nonpayment of employment tax liabilities survived the taxpayer's death. U.S. v. Molen, 2014 PTC 243 (E.D. Calif. 5/21/14). Read more...

     

Extension of 2009 Return Precludes 2009 Taxes from Being Dischargeable in Bankruptcy

Because a debtor filed for an extension of his 2009 tax return, his 2009 tax liability fell outside the three year rule, and was not dischargeable in bankruptcy. In re Leslie, 2014 PTC 247 (D.C. Iowa 5/21/14).

Craig Leslie fell on hard times due to his former wife's serious illness. Additionally, medical problems make it hard for him to find a job. Craig lives off social security of $1,087 per month and sporadic help from friends and family who sometimes deposit small amounts into his bank account. For his 2009 tax return, Craig obtained an extension from the IRS. The IRS extended his due date to October 15, 2010, and Craig filed his 2009 tax return on October 13, 2010.

On February 15, 2013, Craig filed for Chapter 7 bankruptcy. He listed the IRS as a creditor in his bankruptcy petition based on outstanding amounts due from his 2007 and 2009 federal income taxes. He sought to have his 2007 and 2009 tax liabilities discharged. The IRS did not dispute that Craig's 2007 taxes were dischargeable. However, Craig and the IRS disagreed that his 2009 tax liability was dischargeable.

Section 507(a)(8)(A)(i) of the Bankruptcy Code grants priority status to a tax on or measured by income or gross receipts for a tax year ending on or before the date of the filing of a bankruptcy, where the tax liability was due within three years from the filing of the petition. The IRS argued that because of the extension, Craig's 2009 tax liability was due within three years of the filing of the bankruptcy petition and therefore it was a priority claim under 11 U.S.C. Section 507(a)(8)(A)(i). According to the IRS, that made the 2009 taxes nondischargeable under 11 U.S.C. Section 523(a)(1)(A).

Craig argued that his 2009 tax liability would have been dischargeable if he had not obtained the extension to file his 2009 tax return. According to Craig, his 2009 tax liability should be discharged on hardship and equitable grounds. He argued that he was an honest, but unfortunate debtor, who has simply fallen on hard times and has no ability to pay the IRS.

A district court held that Craig's 2007 tax liability was dischargeable but his 2009 tax liability was not. In order to have the 2009 tax claim fall outside the three year rule, and be dischargeable, Craig needed to file for bankruptcy after October 15, 2013. Instead, the court noted, he filed for bankruptcy on February 15, 2013 eight months too early. The court also noted that there is no exception in the chapter 7 context for hardship or any other equitable grounds. The three-year nondischargeability rule is mandatory.

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Gain or Loss on Disposition of Partnership Interest Is an Affected Item, Tax Court Holds

Gain or loss on the disposition of a bona fide partnership interest is an affected item that requires partner-level determinations if the amount of that gain or loss could be affected by a partner-level determination, even where Code Sec. 754 elections are in effect. Greenwald v. Comm'r, 142 T.C. No. 18 (5/21/14).

Israel Greenwald was a limited partner in Regency Plaza Associates of New Jersey (Regency Plaza), a partnership involved in property development. Regency Plaza was subject to the unified TEFRA partnership audit and litigation procedures. As a result of a transfer of a partnership interest, Regency Plaza attached a Code Sec. 754 election to its 1995 Form 1065, U.S. Return of Partnership Income. In 1996, Regency Plaza filed for bankruptcy and, just over a year later, the bankruptcy was finalized. The partnership owned property that was subject to a mortgage in favor of Beal Bank, which mortgage was security for a nonrecourse debt against property owned by Regency Plaza. The bankruptcy judgment allowed Beal Bank to foreclose its mortgage, and Regency Plaza liquidated in 1997.

The partnership items for the year of liquidation were determined in partnership-level proceedings. Following those proceedings, the IRS issued notices of deficiency to the partners determining the partners' gain on the liquidation of the partnership, which was based on their outside basis in the partnership. The partners argued that outside basis is a partnership item that should have been determined at the partnership level and that the notices of deficiency were invalid. The partners cited the Tax Court's decision in Tigers Eye Trading, LLC v. Comm'r, 138 T.C. 67 (2012), in which the court held that the determination of outside basis of a sham partnership interest was a partnership item and should have been raised and determined in the prior partnership-level proceeding. In the instant case, the IRS argued that the Tax Court has jurisdiction because outside basis is an affected item that requires partner-level determinations.

The Tax Court held that gain or loss on the disposition of a bona fide partnership interest is an affected item that requires partner-level determinations if the amount of that gain or loss could be affected by a partner-level determination. The Tax Court noted that this issue was addressed in U.S. v. Woods, 134 S. Ct. 557 (2013), concluding that, where a partnership is a sham, no partner-level determinations are necessary to determine outside basis because once partnerships are deemed not to exist for tax purposes, no partner can legitimately claim an outside basis greater than zero. This flows from the fact that there can be no basis in an asset that does not exist, such as nonexistent partnership interest. However, the Tax Court noted that, in the instant case, the partnership at issue was not a sham. Unlike the taxpayers in Woods, the court observed, the outside basis of the partners in this case is not linked to a sham transaction, but rather to specific partner-level facts.

According to the Tax Court, redetermining the amounts of deficiencies resulting from partnership-level adjustments required looking to the partners' specific facts. For example, the court said, if a partner incurred litigation costs in the defense of the ownership of the partnership interest, those costs would be added to the partner's outside basis, but they would not be taken into account as part of a Code Sec. 754 election or any other partnership-level determination. To make such a determination, the IRS is required to follow deficiency procedures. Under these facts, the court concluded, outside basis is an affected item requiring partner-level determinations, and the Tax Court has jurisdiction over these cases.

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

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IRS Pilot Program Aims to Help Small Businesses with Retirement Plan Penalties

The IRS is beginning a one-year pilot program in June to help small businesses with retirement plans that owe penalties for not filing reporting documents. By filing current and prior year forms during this pilot program, such businesses can avoid penalties. Rev. Proc. 2014-32.

As part of the program, the IRS is reaching out to small businesses that maintain retirement plans and may have been unaware that they had a filing requirement. The IRS projects that this program will bring a significant number of small business owners into compliance with the reporting requirements.

Plan administrators and sponsors who do not file an annual Form 5500 series return can face stiff penalties up to $15,000 per return. Those who have already been assessed a penalty for late filings are not eligible for this program.

Practice Tip: The program is open only to retirement plans generally maintained by certain small businesses, such as those in an owner-spouse arrangement or eligible partnership.

Multiple late retirement plan returns may be included in a single submission. If a retirement plan has delinquent returns for more than one plan year, penalty relief may be available for all of these returns. Similarly, delinquent returns for more than one plan may be included in a single penalty relief request. No filing fee will be charged during the pilot program. More information on how to participate in the program can be found in Rev. Proc. 2014-32.

For a discussion of the penalty that applies when plan administrators fail to file the required reports, see Parker Tax ¶262,175.

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IRS Can't Collect Taxes from Heiresses Prodded into Stock Deal by Tax Advisers

Three sisters, who were co-trustees of several trusts holding millions of dollars of appreciated stock, were not liable for the unpaid taxes of the company that purchased the stock; there was no indication that the sisters or their trusts were part of the plan to avoid taxes. Swords Trust v. Comm'r, 142 T.C. No. 19 (5/29/14).

Julia Swords, Margaret Mackell, and Dorothy Brotherton were co-trustees of three trusts set up by their father, son of the founder of Reynolds Metal Co., maker of Reynolds Wrap. The main assets of each trust were shares of Davreyn, a personal holding company (PHC) incorporated in Virginia. Before June 2000, Davreyn held a substantial number of shares in Reynolds Metal. In June 2000, Reynolds Metal merged with Alcoa, Inc., and Davreyn's Reynolds Metal shares were converted into Alcoa shares. As of February 1, 2001, Davreyn held shares of Alcoa stock and an investment in the Goldman Sachs 1999 Exchange Place Fund (Goldman Sachs fund). In February 2001, the value of the Alcoa stock held by Davreyn exceeded $14 million. Robert Griffin, a CPA, provided accounting and tax services to the trusts for decades.

In the late 1990s, the accounting firm of BDO Seidman advised its local offices about an opportunity for PHC shareholders to sell their appreciated PHC stock to a financial buyer in a tax efficient manner. Robert Griffin was advised of the opportunity by Tom Rohman at McGuireWoods LLP. Rohman, learning of the plan himself from BDO. Although Julia, Margaret, and Dorothy had not previously considered selling the trusts' shares in Davreyn, arranging a sale of Davreyn's assets, or liquidating Davreyn, they agreed, on the advice of Griffin and Rohman, to sell the trusts' Davreyn stock to the financial buyer. Rohman did not discuss the buyer's plans with respect to either Davreyn or Davreyn's assets.

According to Rohman, upon the sale of the Davreyn stock, the trusts would recognize long-term capital gain in amounts equal to the difference between the total stock sale price and the trusts' tax bases in the stock. The sale went through, and the trusts paid their tax liability. However, Davreyn opened a foreign bank account and transferred its Alcoa stock to the newly opened account and then liquidated under Code Sec. 331. After engaging in what the IRS termed a SON-OF-BOSS transaction, the buyers reported a net loss on the transaction. Upon an audit of the buyers and Davreyn, the IRS rejected the claimed losses and assessed additional taxes. When the IRS couldn't collect from Davreyn or Davreyn's buyers, it went after Julia, Dorothy, and Margaret.

The IRS determined that each sister's trust was liable under Code Sec. 6901 for transferee liability and assessed a total of over $10 million in taxes, interest, and penalties. Under Code Sec. 6901(a), the IRS can proceed against a transferee of property (i.e., the sisters who received money from the stock sale) to assess and collect federal income tax, penalties, and interest owed by the transferor. A transferee under Code Sec. 6901 includes, among other persons, a shareholder of a dissolved or liquidated corporation.

The end result of the transaction was that the buyers purchased all of the Davreyn stock from the trusts so that they could acquire Davreyn's then principal asset, the Alcoa stock. The purchasing corporations, the IRS said, engaged in a preplanned series of interrelated transactions designed to illegitimately avoid tax on the sale of Davreyn's Alcoa stock. According to the IRS, the sisters' trusts' sales of their Davreyn stock were part of a plan by those trusts to illegitimately avoid corporate tax on the distribution of the Alcoa stock upon Davreyn's liquidation. The IRS argued that the court had to apply the following two-step analysis in determining whether the sisters' trusts were liable for Davreyn's unpaid tax: (1) analyze whether the subject transactions should be recast under federal law using the federal substance-over-form doctrine, and then (2) apply Virginia law, specifically Virginia's trust fund doctrine, to the transactions as recast under federal law.

The Tax Court rejected the IRS's arguments and held that the trusts owned by the sisters did not have transferee liability under Code Sec. 6901. The court also concluded that Code Sec. 6901 required the court to apply state rather than federal law to determine whether a transaction is recast under a substance-over-form (or similar) doctrine. When the trusts sold their Davreyn stock, the court noted, neither the trusts nor their representatives knew that the buyer planned to dissolve Davreyn. When Davreyn was dissolved, no one associated with the trusts had any role in structuring the sale of the Alcoa stock or in deciding to dissolve Davreyn. The trusts, the court observed, had no interest in Davreyn when it was dissolved because they had already sold all of their Davreyn stock. Nor, the court noted, was Davreyn insolvent when the trusts sold their Davreyn stock. Further, the court stated, neither the trusts nor Davreyn's directors attempted to avoid any existing debt of Davreyn. Thus, the court concluded that the IRS failed to establish that an independent basis existed under Virginia law or Virginia equity principles for holding the trust's liable for Davreyn's unpaid tax.

For a discussion of transferee liability under Code Sec. 6901, see Parker Tax ¶262,530.

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Court Shuts Down Atheists' Challenge to Religion-Related Code Provisions

A suit by several atheist organizations to stop the IRS from enforcing certain Code provisions was dismissed because they lacked standing in federal court, American Atheists, Inc. v. Shulman, 2014 PTC 250 (E.D. Ky 5/19/14).

American Atheists, Inc. and two other atheist organizations (the Atheists) filed suit in a Kentucky district court, seeking to stop the IRS from enforcing certain provisions of the Internal Revenue Code that the Atheists asserted were discriminatorily enforced. Among the provisions challenged were the following: (1) under Code Sec. 508, churches are not required to file an application for recognition of tax-exempt status; (2) under Code Sec. 6033, churches are not required to file an annual information return; (3) under Code Sec. 107, ministers of the gospel can receive a parsonage allowance tax free; and (4) under Code Secs. 1402, 3121, and 3401, salaries of ministers of the gospel are exempted from income tax withholding and FICA taxes. The Atheists also noted that, under Code Sec. 7611, the IRS may begin a church tax examination only if an appropriate high-level Treasury official reasonably believes, on the basis of facts and circumstances recorded in writing, that the church may not be exempt from tax or may be carrying on an unrelated trade or business or otherwise subject to tax.

According to the Atheists, the IRS's differing treatment of churches and other tax-exempt entities violates the Equal Protection laws of the Fifth Amendment, the First Amendment, and the Religious Test Clause of Article VI of the Constitution. The Atheists claimed that a number of atheist organizations have tried to obtain IRS classification as religious organizations or churches under Code Sec. 501(c)(3) or to otherwise obtain equal treatment, and most of those applications and attempts were rejected by the IRS. The Atheists argued that they suffered from unconstitutional discrimination and coercion arising from their inability to satisfy the IRS test to gain classification to secure the same treatment as religious organizations or churches under Code Sec. 501(c)(3). The Atheists admitted that they have never sought recognition as a religious organization or church under Code Sec. 501(c)(3); rather, they asserted, it would violate their sincerely held believe to seek classification as a religious organization or church from the IRS.

As its form of relief, the Atheists requested the court issue a judgment declaring that all Tax Code provisions treating religious organizations and churches differently than other Code Sec. 501(c)(3) entities are unconstitutional violations of the equal protection of the laws required pursuant to the Due Process Clause of the Fifth Amendment, the Religious Test Clause of Art. VI, and the Establishment Clause of the First Amendment of U.S. Constitution and enjoining the IRS from continuing to allow preferential treatment of religious organizations and churches under Code Sec. 501(c)(3).

The district court held that the Atheists lacked standing to assert their claims. The court noted that to have standing, the Atheists were required to allege personal injury fairly traceable to the IRS's allegedly unlawful conduct and likely to be redressed by the requested relief. The Atheists' complaint, the court observed, conceded that some atheist organizations have obtained classification as a religious organization or church under Code Sec. 501(c)(3). Thus, the court concluded, the Atheists' assertion that they are subjected to unconstitutional discrimination and coercion due to their alleged inability to gain classification as religious organizations or churches under Code Sec. 501(c)(3) was mere speculation.

For a discussion of tax-exempt organizations that are exempt from the annual return requirement, see Parker Tax ¶65,515.