Federal Tax Bulletin - Issue 65 - June 20, 2014

Final Circular 230 Regs Create a Single Set of Standards for All Written Tax Advice; Covered Opinion Rules Eliminated

On June 12, almost two years after issuing proposed regulations, the Treasury Department issued final regulations (T.D. 9668) under Circular 230 which eliminate the complex covered opinion rules universally hated by tax practitioners. In their place, the IRS expanded the requirements previously in place for written tax advice, thus creating a single standard. Under the prior rules, a significant amount of time and money was spent in determining if advice to a client fell under the covered opinion rules. The elimination of the burden on practitioners in complying with the covered opinion rules should result in an overall decrease in the costs associated with obtaining written tax advice.

The new rules do, however, come with an increased risk for certain managers. The final regulations broaden the requirement for procedures to ensure compliance with Circular 230 by requiring that an individual with principal authority for overseeing a firm's federal tax practice take reasonable steps to ensure the firm has adequate procedures in place to comply with Circular 230. Such individuals may be subject to discipline under Circular 230 where the compliance procedures are inadequate. In the absence of a person or persons identified by the firm as having the principal authority and responsibility, the IRS may identify one or more individuals subject to these provisions.

Finally, the new rules modify other provisions in Circular 230 to ensure that practitioners meet certain standards of conduct, such as the timely filing of tax returns, and modify the consequences of failing to meet those standards.

Observation: The covered opinion rules are seen by many as the genesis of the "Circular 230 disclaimer" attached by tax practitioners to all correspondence and emails. In the opinion of many tax practitioners, the former covered opinion rules contributed to overuse, as well as misleading use, of disclaimers on most practitioner communications, even when those communications did not constitute tax advice.

Standards for Written Tax Advice

The final Circular 230 regulations modify the rules governing written tax advice to ensure that practitioners meet certain standards of conduct when serving as representatives of persons before the IRS. Read more...

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Supreme Court Affirms 7th Cir: Inherited IRAs Not Exempt from Bankruptcy Estate

Last week, the Supreme Court settled an enduring dispute about whether or not a debtor is entitled to shield an inherited IRA from a bankruptcy estate. In the case at issue, a woman had inherited an IRA from her mother. Nine years later, the woman filed for bankruptcy and sought to exempt the inherited IRA from the bankruptcy estate by using the retirement funds exemption in Bankruptcy Code Section 522(b)(3)(C). A bankruptcy court concluded that an inherited IRA does not share the same characteristics as a traditional IRA and disallowed the exemption. A district court reversed, explaining that the exemption covers any account in which the funds were originally accumulated for retirement purposes. The Seventh Circuit disagreed and reversed the district court. In Clark v. Rameker, 2014 PTC 277 (S. Ct. 6/12/14), the Supreme Court unanimously agreed with the Seventh Circuit and held that the taxpayer could not exempt her inherited IRA from the bankruptcy estate. In so holding, the Court drew a distinction between traditional and Roth IRAs, which are protected from a bankruptcy estate, and inherited IRAs, which are not.

Practice Tip: As discussed below, if the taxpayer had inherited the IRA from a spouse, she would have had the option to roll over the IRA funds into a traditional IRA, which would have protected the amounts from the bankruptcy estate. However, the option to roll over an inherited IRA to a traditional IRA needs to be weighed against the possible detriments of such action. For example, certain distributions before age 59 and 1/2 years old are subject to the 10 percent penalty tax on early withdrawals, whereas such distributions from an inherited IRA are not.

Background

In 2000, Ruth Heffron established a traditional IRA and named her daughter, Heidi, as the sole beneficiary of the account. When Ms. Heffron died in 2001, her IRA which was then worth just over $450,000 passed to Heidi and became an inherited IRA. Heidi elected to take monthly distributions from the account. In October 2010, Heidi and her husband filed for Chapter 7 bankruptcy. They identified the inherited IRA, by then worth roughly $300,000, as exempt from the bankruptcy estate under Bankruptcy Code Section 522(b)(3)(C). The bankruptcy trustee and unsecured creditors of the estate objected to the claimed exemption on the ground that the funds in the inherited IRA were not "retirement funds" within the meaning of the statute.

Bankruptcy and the IRA Exemption

When an individual debtor files a bankruptcy petition, the debtor's legal or equitable interests in property become part of the bankruptcy estate. To help the debtor obtain a fresh start, however, the Bankruptcy Code allows debtors to exempt from the bankruptcy estate limited interests in certain kinds of property. Bankruptcy Code Section 522(b)(3)(C) and (d)(12) allow debtors to protect retirement funds to the extent those funds are in a fund or account that is exempt from tax under Code Secs. 401, 403, 408, 408A, 414, 457, or 501(a). These provisions cover many types of accounts, three of which were relevant in the instant case.

The first two are traditional and Roth IRAs, which are covered by Code Sec. 408 and Code Sec. 408A, respectively. Both types of accounts offer tax advantages to encourage individuals to save for retirement. Qualified contributions to traditional IRAs, for example, are tax-deductible. Roth IRAs offer the opposite benefit although contributions are not tax deductible, qualified distributions are tax free. To ensure that both types of IRAs are used for retirement purposes and not as general tax-advantaged savings vehicles, certain withdrawals from both types of accounts are subject to a 10 percent penalty if taken before an accountholder reaches age 59 and 1/2.

The third type of account, as at issue in the instant case, is an inherited IRA. An inherited IRA is a traditional or Roth IRA that has been inherited after its owner's death. If the heir is the owner's spouse, as is often the case, the spouse has a choice. The spouse may "roll over" the IRA funds into his or her own IRA, or he or she may keep the IRA as an inherited IRA, subject to certain requirements. When anyone other than the owner's spouse inherits the IRA, he or she may not roll over the funds; the only option is to hold the IRA as an inherited account.

Importantly, inherited IRAs do not operate like ordinary IRAs. Unlike with a traditional or Roth IRA, an individual may withdraw funds from an inherited IRA at any time, without paying a tax penalty. In fact, the owner of an inherited IRA not only may, but must withdraw its funds; the owner must either withdraw the entire balance in the account within five years of the original owner's death or take minimum distributions on an annual basis. And unlike with a traditional or Roth IRA, the owner of an inherited IRA may never make contributions to the account.

Taxpayer's Arguments

Heidi argued that funds in an inherited IRA are retirement funds regardless of whether they currently sit in an account bearing the legal characteristics of a fund set aside for retirement because they previously had when the initial owner of the account set aside the funds in question for retirement by depositing them in a traditional or Roth IRA. The initial owner's death, Heidi contended, does not in any way affect the funds in the account.

Supreme Court's Analysis

The Supreme Court held that funds in an inherited IRAs are not "retirement funds" within meaning of Bankruptcy Code Section 522(b)(3)(C). The ordinary meaning of "retirement funds," the Court stated, is properly defined as sums of money set aside for the day an individual stops working. According to the Court, three legal characteristics of inherited IRAs provide objective evidence that they are not "retirement funds" for the purposes of the Bankruptcy Code exception. First, Internal Revenue Code Sec. 219(d)(4) states the holder of an inherited IRA may never invest additional money in the account. Second, under Internal Revenue Code Sec. 408(a)(6) and Code Sec. 401(a)(9)(B), holders of inherited IRAs are required to withdraw money from the accounts, no matter how far they are from retirement. Finally, the holder of an inherited IRA may withdraw the entire balance of the account at anytime and use it for any purpose without penalty.

The purpose of the Bankruptcy Code's retirement funds exemption provisions, the Court said, is to effectuate a careful balance between the creditor's interest in recovering assets and the debtor's interest in protecting essential needs. Allowing debtors to protect funds in traditional and Roth IRAs ensures that debtors will be able to meet their basic needs during their retirement years. By contrast, the Court observed, nothing about an inherited IRA's legal characteristics prevent or discourage an individual from using the entire balance immediately after bankruptcy for current consumption. The retirement funds exemption should not be read in a manner that would convert the bankruptcy objective of protecting debtors' basic needs into a "free pass," the Court reasoned.

According to the Court, Heidi's arguments did not overcome the statute's text and purpose. The claim that funds in an inherited IRA are retirement funds because, at some point, they were set aside for retirement, conflicts with ordinary usage and would render the term "retirement funds," as used in Bankruptcy Code Section 522(b)(3)(C), superfluous. Congress could have achieved the exact same result, the Court noted, without specifying the funds as "retirement funds."

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June 30 Deadline Looms for New Electronic FBAR Filing

As the upcoming June 30, 2014, deadline for taxpayers filing their Report of Foreign Bank and Financial Accounts (FBAR) grows closer, practitioners should be prepared for using a different filing process than in previous years.

Last year, the Financial Crimes Enforcement Network (FinCEN) announced that only electronic FBAR submissions will be accepted for the 2013 reporting year. Along with the announcement, FinCEN introduced electronic FinCEN Form 114, which supersedes the former hard copy TD F 90-22.1. FinCEN Form 114 must be filed electronically through the Bank Secrecy Act (BSA) E-Filing System. Printed versions of the new FBAR form will not be accepted.

Under the Bank Secrecy Act, the FBAR must be filed by a U.S. person if that person had a financial interest in or signature authority over at least one financial of bank account located outside the United States and the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the reportable calendar year. FBAR filings may be required even though a U.S. person holding a foreign financial account has no taxable income related to the account. A U.S. person includes: U.S. citizens; U.S. residents; entities, including, but not limited to corporations, partnerships, or limited liability companies, created or organized in the United States or under the laws of the United States; and trusts and estates formed under the laws of the United States.

Compliance Tip: While the deadline for most FBARs for a calendar year is the following June 30 (i.e., June 30, 2014, for calendar year 2013), the FBAR deadline was extended to June 30, 2015, by FinCEN Notice 2013-1 for certain individuals with signature authority over but no financial interest in one or more foreign financial accounts. FinCEN Notice 2013-1 was preceded by three earlier extensions that applied to similarly situated individuals.

Caution: Except for situations referred to in the previous paragraph, no extensions are granted for FBARs. An extension for the taxpayer's income tax return DOES NOT extend the due date for filing an FBAR. The late filing penalty for FBARs can reach $10,000 for non-willful violations, and increases to the greater of $100,000 or 50% of the account balance for willful violations.

FinCEN Form 114 is obtained by accessing the BSA E-Filing System. It is provided in Adobe PDF format with expandable fields and pre-populated drop-down menus for inputting account information. While a new section was added permitting input of third-party preparer information, there is still only one digital signature line on the form; no additional line exists to designate a third-party to file on behalf of another or for spouses to designate which spouse will file. To address this limitation, FinCEN Form 114a, Record of Authorization to Electronically File FBARs, has been created. This separate form provides the authorization of additional designations. However, it is not electrically filed with the FinCEN Form 114. Instead, a hard copy of FinCEN Form 114a is retained by the preparer and the account owner and made available to FinCEN or the IRS upon request.

To use the BSA E-Filing System, third-party preparers must register with the BSA in advance of filing the FBARs and ensure they meet the required system specifications. The BSA E-Filing System allows for the secure filing of discrete and batched forms. There are no user fees or other direct costs for using the BSA E-Filing System.

For a discussion of the FBAR reporting requirement, see Parker Tax ¶203,170.

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Closely Held Company Did Not Transfer Goodwill to Owner

A solely owned trucking company did not distribute intangible assets (in the form of goodwill) to its owner and, thus, there was no subsequent gift of such assets by the owner to his sons, who had organized a new trucking company. Bross Trucking, Inc. v. Comm'r, T.C. Memo. 2014-107 (6/5/14).

In 1972, Chester Bross organized Bross Construction to engage in various road construction projects. As Chester's road construction projects grew, he organized several other companies, including CB Equipment and CB Asphalt, to provide services and equipment to the construction projects. In 1982, Chester organized, and was the sole owner of, Bross Trucking. He did not have an employment contract with Bross Trucking, nor did he sign a noncompete agreement. None of Chester's three sons ever worked for Bross Trucking. Bross Trucking's principal customers were Bross Construction, CB Asphalt, and Mark Twain Redi-Mix, Inc. Mark Twain Redi-Mix was owned by Chester's wife, Mary, and two of the Bross sons.

As a result of certain publicized regulatory problems with government agencies which oversee trucking businesses, Chester was afraid that his trucking business might be shut down. In July 2003, Chester and his three sons met with an attorney to discuss the best way to ensure that the Bross family businesses had a suitable trucking provider. To meet their goals, the attorney recommended that the Bross sons start a new trucking business. The Bross sons agreed and organized a new company called LWK Trucking. They created a different type of trucking company that provided more services than Bross Trucking. Chester Bross was not involved in managing LWK Trucking. LWK Trucking hired several of the employees that had worked for Bross Trucking. In 2004, about 50 percent of LWK Trucking's employees had worked for Bross Trucking.

On August 22, 2001, Chester and Mary Bross, and their three sons organized Bross Holding Group. Initially the Bross family owned Bross Holding Group in the following percentages: Chester, 37.5 percent; Mary, 25 percent; and each of the three Bross sons, 12.5 percent. Shortly after organization, Bross Holding Group acquired sole ownership of Bross Construction and CB Equipment. Later it acquired CB Asphalt. Chester never conveyed Bross Trucking to Bross Holding Group. In 2006, Chester and Mary gave portions of Bross Holding Group to their three sons and reported the gifts and paid gift tax for the 2006 tax year. They did not report any gifts for tax year 2004, the year LWK Trucking began to do business.

The IRS assessed a corporate income tax deficiency of almost $900,000 on Bross Trucking as well as an accuracy related penalty of approximately $177,000 for the 2004 tax year. The IRS also assessed gift taxes and penalties on Chester and Mary of almost $1.7 million for the 2004 tax year.

According to the IRS, Bross Trucking distributed intangible assets to Chester on February 1, 2004, and Chester then made a gift of the appreciated intangibles, principally goodwill, to his three sons, who used the intangibles in their new trucking company. The IRS said that Chester and Mary should have filed a gift tax return and paid gift tax for tax year 2004. The Tax Court was asked to decide whether Bross Trucking, Inc. distributed appreciated intangible assets to Chester on February 1, 2004, under Code Sec. 311(b) and whether Chester gave any distributed intangible assets to his three sons in 2004.

The Tax Court held that Bross Trucking did not distribute assets to Chester in 2004 and, accordingly, Chester did not give his sons the alleged distributed assets. Thus, neither Chester nor Mary was required to report and pay gift taxes for 2004.

According to the Tax Court, the only reasonable interpretation of the IRS's position was that Bross Trucking transferred goodwill to Chester which he then transferred to his sons. Citing Martin Ice Cream Co. v. Comm'r, 110 T.C. 189 (1998), the Tax Court noted that a business can distribute only corporate assets and cannot distribute assets that it does not own. Specifically, a corporation cannot distribute intangible assets that are individually owned by its shareholders. While Bross Trucking might have had corporate goodwill at some point, most of it was lost by the time of the alleged transfer because of negative attention resulting from state investigations and scrutiny. According to the Tax Court, the only attribute of goodwill that Bross Trucking may have corporately owned and transferred to Chester was a workforce in place. While the IRS argued that "most" of the Bross Trucking employees became LWK Trucking employees, the court said the evidence showed that only about 50 percent of LWK Trucking's employees formerly worked at Bross Trucking. The Tax Court was unconvinced that most of Bross Trucking's workforce in place was transferred when only 50 percent of the current employees were previously Bross Trucking employees. Instead, it appeared to the court that LWK Trucking assembled a workforce independent of Bross Trucking. This was demonstrated, the court said, by the new key employees and services offered by LWK Trucking and that the former Bross employees could have been recruited away.

The court found that the remaining attributes assigned to Bross Trucking's goodwill all stemmed from Chester's personal relationships. Bross Trucking's established revenue stream, its developed customer base, and the transparency of the continuing operations were all spawned from Chester's work in the road construction industry, the court said. Further, the lack of an employment contract between Chester and Bross Trucking showed the court that Bross Trucking did not expect to - and did not - receive personal goodwill from Chester. Accordingly, Chester's personal goodwill remained a personal asset separate from Bross Trucking's assets.

The court found no indication that LWK Trucking used any relationship that Chester personally forged. The Bross sons, the court observed, were in a similarly close capacity to Bross Trucking's customers to develop relationships apart from Chester's relationships. Cultivating and profiting from independently created relationships are not the same as receiving transferred goodwill. While it was true that LWK Trucking's and Bross Trucking's customers were similar, the court said that did not mean that Bross Trucking transferred goodwill; instead the record showed that LWK Trucking's employees created their own goodwill.

The Bross Trucking case demonstrates that courts are moving in support of personal goodwill as an item of property that can be sold or transferred. However, this is not the only existing view. There have been differing court decisions across the country and in U.S. Tax Court on whether professional personal goodwill is truly property or rather it is future earning potential of the person who creates it, which cannot be transferred. The reasons for this view include: considering that the goodwill depends on the presence of a particular person in the business and thus, that is not marketable; that goodwill is only associated with the company or company name and so not transferable; it has no or only nominal resale value; and personal goodwill is simply not transferable as established through precedent. See Bateman v. United States, 490 F.2d 549 (9th Cir. 1973); Hall v. Commissioner, 19 T.C. 445, 460 (1952); Coates v. Commissioner, 7 T.C. 125, 134 (1946); Clukey v. Clukey, No. 391,871, 1998 Conn. Super. LEXIS 2260. (Conn. Super. Ct. Aug. 12, 1998); Taylor v. Taylor, 386 N.W.2d 851 (Neb. 1986); Powell v. Powell, 648 P.2d 218, 223-24 (Kan. 1982); Holbrook v. Holbrook, 309 N.W.2d 343 (Wis. Ct. App. 1981) Nail v. Nail, 486 S.W.2d 761, 764 (Tex. 1972).

Thus, in this case, the Tax Court cites and follows the key cases backing the property theory of personal goodwill, finding that Chester has personal professional goodwill separate from the business goodwill of Bross Trucking, but Bross did not actually transfer that goodwill. The case further moves the personal goodwill as property concept because the court discusses and identifies the other intangible assets subsumed within goodwill, items that can be sold or transferred which have tax consequences.

For a discussion of the taxation of the sale of goodwill, see Parker Tax ¶117,135.

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Self-Directed IRA's Purchase of Real Estate Was a Taxable Distribution

The fact that the custodian of the taxpayer's self-directed IRA did not allow IRAs to hold real property (even though applicable tax rules permit such holdings) meant that a distribution from that IRA that was used to purchase property titled in the IRA's name, was a taxable distribution. Dabney v. Comm'r, T.C. Memo. 2014-108 (6/5/14).

In 2008, Guy Dabney rolled over funds from an individual retirement account (IRA) to a preexisting self-directed IRA he had with Charles Schwab & Co., Inc. He found some real estate (the "Briand Head" property) he wanted to purchase and hold in the IRA. He conducted some Internet research and came to the conclusion that IRAs are permitted to hold real property for investment. He proceeded to have his Charles Schwab IRA purchase the Brian Head property. Before initiating the purchase, Guy called Charles Schwab's customer service line where a customer service representative informed him that Charles Schwab did not allow alternative investments, which would include the purchase and holding of real property.

On the basis of his telephone conversations with the Charles Schwab customer service representative and talks with his CPA, as well as his own research, Guy arranged what he believed to be a viable way to have his Charles Schwab IRA purchase the Brian Head property, even though Charles Schwab did not allow alternative investments. His plan was to have funds wired directly from the IRA to the seller of the Brian Head property and to have title to the property placed in the name of "Guy M. Dabney Charles Schwab & Co. Inc. Cust. IRA Contributory." He planned to then resell the property for a small gain and to contribute the proceeds from the sale back into the IRA.

In 2009, Guy, who was under 59 and 1/2 years old, bought the property with $114,000 he took from his IRA. In seeking the funds from his IRA, Guy completed a distribution request form from Charles Schwab selecting an early distribution with no known exceptions. However, Guy continued to presume that his transaction would not be classified as an early distribution. Charles Schwab wired $114,000 directly to the bank account of the company handling the property sale. Guy directed the company to name "Guy M. Dabney Charles Schwab & Co. Inc Cust. IRA Contributory" as the owner of the property. However, because of a bookkeeping error by the company, title to the property was placed in Guy's name. In 2011, Guy subsequently found a buyer for the property. It was not until the sale that he discovered that the property was incorrectly titled in his own name. Guy promptly sought and received a scrivener's affidavit from the company in which it admitted fault for the error. Guy sold the property and received $127,226 after taxes and fees.

Charles Schwab issued Guy a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for 2009. The Form 1099-R stated that he had received an early distribution of $114,000 from his Charles Schwab IRA and that no exceptions to the early distribution penalty applied.

Guy did not report the withdrawal on his Form 1040. He argued that the $114,000 withdrawal was not a taxable distribution because the withdrawal was either: (1) a purchase by the IRA, or (2) a transfer between IRA trustees. According to Guy, he acted as a conduit through which his Charles Schwab IRA purchased the property. Guy cited the holding in Ancira v. Comm'r, 119 T.C. 135 (2002), as support for his argument.

In Ancira, a taxpayer maintained a self-directed IRA. In order to direct funds from the IRA to be invested in specific assets, the taxpayer made requests by telephone to the IRA's investment adviser. When the taxpayer requested that his IRA purchase a particular company's stock, the investment adviser informed the taxpayer that, while the issuing company's stock could be held as an asset of the IRA, the custodian would not purchase the stock because the stock was not publicly traded. Subsequently, the investment adviser determined that the IRA could invest in the issuing company's stock if the custodian issued a check payable to the issuing company and the taxpayer delivered the check to the issuing company. The taxpayer used a "Distribution Request Form" to request a check made payable to the issuing company, and the custodian sent the taxpayer the requested check. The taxpayer forwarded the check to the issuing company, and the issuing company issued a stock certificate which stated that the IRA was the owner of several hundred shares of the issuing company's stock. The custodian held the stock certificates. In Ancira, the Tax Court held that there was no IRA distribution to the taxpayer.

The IRS argued that Guy's Charles Schwab IRA did not purchase the property because Charles Schwab's policies do not permit the purchase or holding of real property and that a trustee-to-trustee transfer did not occur.

The Tax Court agreed with the IRS and held that the $114,000 distribution was taxable to Guy in 2009. While IRAs are, as a statutory matter, permitted to hold real property, the Tax Court was not aware of any provision in the Code that requires an IRA trustee or custodian to give the owner of a self-directed IRA the option to invest IRA funds in any asset that is not prohibited by statute. IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA, the court noted. The court found that, in its role as an IRA trustee, Charles Schwab had the power to prohibit the purchase and holding of real property and that Guy's Charles Schwab IRA was not capable of holding real property. Thus, the court found, unlike in Ancira where the investment company authorized the IRA funds for purchase of other assets and the taxpayer directed the action, Guy did not act as an agent on behalf of Charles Schwab and that the Charles Schwab IRA did not purchase the Brian Head's property.

The court further held that because the title company to which the $114,000 was transferred was not an IRA trustee, there could be no trustee-to-trustee transfer.

Practice Tip: Had he gone about it in a different way, Guy could have achieved his goal of increasing the value of his IRA by investing in real property using funds from the IRA. The flaw was not in his intent but in his execution. Had he initiated a rollover or a trustee-to-trustee transfer of funds from his Charles Schwab IRA to a different IRA - one that permitted the purchasing and holding of real property - he would have achieved his goal without any unintended tax consequences.

Observation: The Tax Court did not enforce accuracy-related penalties because Guy had acted with reasonable cause and in good faith given his honest belief that the transaction was workable since the law permits IRAs to invest in real property, but his investment firm's policies require otherwise.

For a discussion of the use of self-directed IRA, see Parker Tax ¶134,505

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Overpayment of Estate's Nondeferred Taxes Can Be Applied to Deferred Portion; Court Denies Refund of Taxes

While Code Sec. 6402 requires the IRS to refund to the taxpayer any "balance" of over paid taxes, an estate had no balance to refund where it made an estimated estate tax payment and indicated it was going to defer estate tax under Code Sec. 6166; the overpayment of estimated taxes used for the nondeferred portion could then be applied to reduce the deferred portion. Estate of McNeely v. U.S., 2014 PTC 279 (D.C. Minn. 6/12/14).

On December 8, 2009, the Estate of Donald McNeely filed IRS Form 4768, requesting an extension of time in which to file the estate's federal tax return. An estimated tax payment of $2,492,088 accompanied the extension request. In a cover letter, the estate also announced its intention to seek deferred estate tax treatment under Code Sec. 6166. The IRS replied in February alerting the estate can it only request a deferred payment election when a timely Form 706 estate tax return is filed. On June 9, 2010, the estate filed its estate tax return. Because the decedent's interest in his closely-held businesses exceeded thirty-five percent of the adjusted gross estate, the estate sought to pay estate tax on a deferred basis, pursuant to Code Sec. 6166. In addition, based on the estate's revised calculations in Form 706, the estate determined that the correct tax on the non-deferred portion of the federal estate tax - assuming that the IRS granted the Code Sec. 6166 request - was $512,223. Because it had previously estimated and paid $2,492,088, the estate requested a refund of $1,979,865. The estate noted that this would leave a balance of $8,613,651 on the deferred portion of the federal estate tax.

On August 2, 2010, the IRS responded, acknowledging that the estate's Code Sec. 6166 request was pending. The IRS also denied the estate's request for a refund, saying that Code Sec. 6403 required that the overpayment be credited against the unpaid installments. The IRS noted that the unpaid installments would be due 12/9/2014 through 12/9/2023. Thus, the IRS said, the $1,979,861 overpayment would be used beginning 12/9/2014 against the unpaid installments due. According to the IRS, under Code Sec. 6403, no refund was allowable until the total payments exceed the tax due.

The estate objected to the IRS's denial of a refund because it had directed the estimated tax payment to be applied to the "non-deferred portion of the federal estate tax." Further, the estate argued that Code Sec. 6403 did not apply to the non-deferred portion of the federal estate tax because it applies only to overpayments of taxes payable in installments. A final determination letter from the IRS said that, under Code Sec. 6402 and Code Sec. 6403, any overpayment had to be applied to reduce the balance of remaining estate tax due and could not be refunded. Courts have held that Code Sec. 6403 applies to Code Sec. 6166 estate tax deferred installment payments.

When an overpayment of tax occurs, the IRS has the authority under Code Sec. 6402 to credit the overpayment to certain other taxes and obligations owed by the taxpayer and to refund any balance to the taxpayer. In the case of a tax payable in installments, Code Sec. 6403 provides that if the taxpayer has paid as an installment of the tax more than the amount determined to be the correct amount of the installment, the overpayment is credited against the unpaid installments, if any. If the amount already paid, whether or not on the basis of installments, exceeds the amount determined to be the correct amount of the tax, the overpayment must be credited or refunded as provided in Code Sec. 6402.

Before a district court, the estate argued that Code Sec. 6403 did not apply to the overpayment of the nondeferred portion of its federal estate tax liability because the estate paid it before making the Code Sec. 6166 election. In addition, the estate said that Code Sec. 6402 required a refund of the overpayment, rather than a credit, in recognition of the estate's special rights to defer payment under Code Sec. 6166. The estate cited three decisions from other district courts in support of its position that the IRS improperly exercised its discretion to credit the overpayment. In each case, the taxpayer elected to defer estate tax payments under Code Sec. 6166. All three estate taxpayers made overpayments based on IRS valuation errors and were denied refunds. In each case, the respective courts granted a refund, rather than a credit to the taxpayers' future installments. According to one of the courts, Code Sec. 6166 creates a very valuable right for taxpayers and the proper application of Code Sec. 6402 is to credit overpayments against taxes then due but not to liabilities which by law come due in the future.

The district court held that the McNeely estate was not entitled to a refund. According to the court, Code Sec. 6402 and its related regulations demonstrate that Congress granted the IRS discretionary authority to apply overpayments to any tax liability. While Code Sec. 6402 also requires the IRS to refund any "balance" to the taxpayer, at the time the estate made its estimated payment, its net tax liability was over $9 million. As such, the estate paid $1,979,861 against the more than $9 million tax liability. Thus, there was no balance to refund. Moreover, the court said, even if Code Sec. 6403 were determined to be the applicable statute, the result would be the same because, if the amount of the overpayment exceeds the full amount of the tax due whether on the basis of installments or otherwise the IRS may either credit or refund the overpayment, as provided in Code Sec. 6402.

The McNeely court addressed and distinguished the Estate's cited cases, first noting that the Ninth Circuit reached the opposite conclusion. In Estate of Bell v. Comm'r, 928 F.2d 901 (9th Cir. 1991), court held that an overpayment of Code Sec. 6166 installments was governed by Code Sec. 6403, which permitted the IRS to credit overpayments against unpaid installments. The court found that Code Sec. 6403 was "clear and unambiguous" and observed that Code Sec. 6166 contained no specific language to negate the effect of Code Sec. 6403 in the case of overpayments.

Furthermore, the district court noted that in Estate of Shapiro v. Comm'r, 111 F.3d 1010 (2d Cir. 1997), the Second Circuit attempted to reconcile the holdings of the district court and Ninth Circuit cases. According to the Second Circuit, the district court cases which found in favor of the estates could, in fact, be reconciled with Estate of Bell by drawing out the implicit distinction: when the overpayment of a Code Sec. 6166 installment is voluntarily made (e.g., is the result of a mistake on the part of the taxpayer), it will be credited against outstanding installments under Code Sec. 6403, but when the overpayment is both the result of erroneous or wrongful conduct on the part of the government and made under protest by the taxpayer, it will be refunded to the taxpayer in order to preserve the taxpayer's statutory right to defer payment under Code Sec. 6166.

For a discussion of the special rule for installment payments of estate tax relating to interests in a closely held business, see Parker Tax ¶228,930.

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Certain Taxpayers Can Now Elect Alternative Simplified Credit on Amended Returns

Final regulations remove the prohibition on making the alternative simplified credit on an amended return and temporary regulations allow the election on amended returns of certain taxpayers. REG-133495-13 (6/3/14); T.D. 9666 (6/3/14).

Code Sec. 41(a) provides an incremental tax credit for increasing research activities (research credit) based on a percentage of a taxpayer's qualified research expenses above a base amount. A taxpayer can apply the rules and credit rate percentages under Code Sec. 41(a)(1) to calculate the credit (commonly referred to as the regular credit) or a taxpayer can make an election to apply the alternative simplified credit (ASC) and credit rate percentages under Code Sec. 41(c)(5) to calculate the credit. Section 41(c)(5)(C) provides that an ASC election under Code Sec. 41(c)(5) applies to the tax year for which made and all succeeding tax years unless revoked with IRS.

In 2011, the IRS issued final regulations (T.D. 9528 (6/10/11)) on the election and calculation of the ASC. Reg. Sec. 1.41-9(b)(2) provides that a taxpayer makes an election under Code Sec. 41(c)(5) by completing the portion of Form 6765, Credit for Increasing Research Activities, relating to the ASC election, and attaching the completed form to the taxpayer's timely filed (including extensions) original return for the tax year to which the election applies. Reg. Sec. 1.41-9(b)(2) also provides that a taxpayer may not make an election under Code Sec. 41(c)(5) on an amended return and that no extension of time to make an election under Code Sec. 41(c)(5) will be granted.

After the issuance of the final regulations, the IRS received requests to amend the regulations to allow taxpayers to make an ASC election on an amended return. According to practitioners, the burden of substantiating expenditures and costs for the base period under the regular credit are costly, time-consuming, and difficult, and taxpayers often need additional time to determine whether to claim the regular credit or the ASC.

In response to these requests, the IRS has issued final regulations which remove the rule in Reg. Sec. 1.41-9(b)(2) prohibiting a taxpayer from making an ASC election for a tax year on an amended return. In its place, the IRS has issued temporary regulations that allow a taxpayer to make an ASC election for a tax year on an amended return.

However, the IRS said, permitting changes from the regular credit to the ASC on amended returns could result in more than one audit of a taxpayer's research credit for a tax year. Accordingly, the temporary regulations provide that a taxpayer that previously claimed, on an original or amended return, a Code Sec. 41 credit for a tax year may not make an ASC election for that tax year on an amended return. In addition, the temporary regulations provide that a taxpayer that is a member of a controlled group in a tax year may not make an election under Code Sec. 41(c)(5) for that tax year on an amended return if any member of the controlled group for that year previously claimed the research credit using a method other than the ASC on an original or amended return for that tax year.

Compliance Tip: As with all claims under Code Sec. 41, taxpayers must maintain sufficient books and records to substantiate the credit on the amended returns.

For a discussion of the alternative simplified credit, see Parker Tax ¶104,905.

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Use of Professionals to Value Easement Contribution Precluded Assessment of 40% Penalty

Where a taxpayer obtained a qualified appraisal, analyzed that appraisal, commissioned a second appraisal as a check against the first one, and submitted a professionally prepared tax return, the assessment of the 40 percent gross undervaluation penalty resulting from the taxpayer's overvaluation of an easement contribution was deemed clearly erroneous. Whitehouse Hotel Limited Partnership v. Comm'r, 2014 PTC 279 (5th Cir. 6/11/14).

In 1997, Whitehouse Hotel Limited Partnership conveyed a conservation easement to the Preservation Alliance of New Orleans d/b/a Preservation Resource Center (PRC), a Louisiana nonprofit corporation dedicated to historical preservation. On its 1997 tax return, which was prepared by Whitehouse's financial auditors, Whitehouse claimed a $7.445 million charitable contribution deduction for the easement donation. The amount of the deduction was determined by an appraisal opinion submitted by an appraiser well-qualified to evaluate, appraise, and testify about commercial real estate. The IRS allowed a deduction of only $1.15 million for the easement and assessed a gross undervaluation penalty under Code Sec. 6662(h) of 40 percent of the portion of the tax underpayment. Whitehouse challenged both the valuation of the easement as well as the gross undervaluation penalty in Tax Court.

The Tax Court concluded that Whitehouse had overvalued its deduction, although not by as much as the IRS had originally calculated. The Tax Court also found that Whitehouse had misstated its deduction by more than 400 percent and upheld the gross valuation misstatement penalty. According to the Tax Court, Whitehouse presented no evidence to show it had undertaken the steps required in Code Sec. 6664(c)(3) to show that it met the reasonable cause exception in Code Sec. 6664(c)(1) to be excused from the penalty. Whitehouse appealed to the Fifth Circuit.

The Fifth Circuit remanded the case back to the Tax Court, holding that the Tax Court erred in not determining the effect of the easement on the fair market value of the buildings to which the easement related. On remand, the Tax Court essentially came back with the same conclusion that Whitehouse overvalued the easement contribution and that the gross valuation misstatement penalty applied. Whitehouse again appealed to the Fifth Circuit. Whitehouse argued that, because the Tax Court rejected the expert opinion of the appraiser hired by Whitehouse and again accepted the appraisal by the IRS expert, the Tax Court ignored the Fifth Circuit's mandate.

The Fifth Circuit upheld the Tax Court's decision with respect to the valuation of the easement but rejected its enforcement of the gross undervaluation penalty. The court noted that it left the determination of the property's highest and best use, which would determine the value of the easement, up to the Tax Court and concluded that the Tax Court did not ignore its mandate. However, the court noted that, in its prior opinion, it was skeptical of the Tax Court's conclusion that following the advice of accountants and tax professionals was insufficient to meet the requirements of the good faith defense to avoid the penalty assessment, especially with respect to the complex task of valuation involving many uncertainties. Because Whitehouse obtained a qualified appraisal, analyzed that appraisal, commissioned a second appraisal as a check against the first one, and submitted a professionally prepared tax return, the Fifth Circuit concluded that the assessment of the 40 percent gross undervaluation penalty was clearly erroneous.

For a discussion of the penalty on a substantial or gross valuation misstatement with respect to charitable deduction property, see Parker Tax ¶262,120.

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Federal Circuit Affirms Estate's Reliance on Bad Advice Was Reasonable Up to a Point

An estate had reasonable cause to delay filing its tax return until the decedent's spouse became a U.S. citizen so that the estate could take the marital deduction; however, there was no reasonable cause for waiting nine months after the wife became a citizen and all ancillary matters were resolved. Liftin v. U.S., 2014 PTC 276 (Fed. Cir. 6/10/14).

Morton Liftin died on March 2, 2003, and his son, John, was appointed executor of the estate. The decedent's will provided for direct bequests to, among others, his surviving spouse, Anna Liftin, who was a U.S. resident and a citizen of Bolivia at the time of the decedent's death.

Under Code Sec. 6075(a), the estate was required to file a federal estate tax return by December 2, 2003, nine months after the decedent's death. Code Sec. 6081(a) grants an extension of time of up to six months for the filing of a return, and Reg. Sec. 20.6081-1 provides that the total allowable time for filing, including extensions, is 15 months from the decedent's death. The executor hired his former law partner, John Dadakis, an estate and gift tax planning expert, to assist with the estate's federal estate tax return. Dadakis advised that the estate tax marital deduction is not available if the surviving spouse is not a U.S. citizen. However, Code Sec. 2056(d)(4) provides that, if the spouse becomes a citizen before the estate tax return is filed and has been a resident of the United States at all times after the decedent's death and before becoming a citizen, the estate may take the marital deduction.

On November 26, 2003, six days before the estate's return and taxes were due, the estate requested a six-month extension to file its return and pay the taxes due. The IRS granted the estate's request, setting a new deadline of June 2, 2004. On January 20, 2004, the estate made a tax payment of $877,300, an amount the estate estimated would be sufficient to satisfy the taxes due even if it were unable to claim the marital deduction.

Subsequently, the executor and Dadakis became aware that Mrs. Liftin intended to apply for U.S. citizenship. The executor knew, however, that Mrs. Liftin's naturalization process might not be completed before the June 2, 2004, tax return deadline. Based on his interpretation of Reg. Sec. 20.2056A-1(b), Dadakis advised the estate that its late filing of the tax return in order to claim the marital deduction would not trigger a penalty as long as the return was filed within a reasonable time after Mrs. Liftin became a naturalized U.S. citizen and other ancillary matters were completed. The executor found this advice to be reasonable, particularly because the estate had already paid more than the amount of tax the executor believed would ultimately be due.

Mrs. Liftin became a U.S. citizen on August 3, 2005. In February of 2006, the estate entered into an agreement settling certain claims Mrs. Liftin had against the estate. On May 9, 2006, the estate filed its tax return claiming the marital deduction in the amount of the value of the property passing to Mrs. Liftin and reflecting a tax due of approximately $679,000 and an overpayment of approximately $199,000.

The IRS did not contest the marital deduction, but did assess a penalty under Code Sec. 6651 of almost $170,000 for late filing and late payment. The estate filed a refund claim, which the IRS denied. After an administrative appeal, the IRS granted a partial refund of $34,000, leaving a claim of approximately $136,000. In its administrative appeal, the estate argued that the statutes and regulations related to the marital deduction provided reasonable cause for the estate's late filing.

The Court of Federal Claims divided that two-year delay into two periods the 14 months up to the August 2005 grant of U.S. citizenship to Mrs. Liftin, and the nine months from then until the May 2006 filing. The court held that the executor's reliance on Dadakis' erroneous advice was reasonable to the extent the advice was to wait until Mrs. Liftin became a U.S. citizen. That advice, the court noted, concerned a substantive question of tax law regarding the interaction between the statutes and regulations providing for the marital deduction and the statutes and regulations setting the deadline for filing the estate's return. The executor had no basis to question Dadakis' advice; moreover, the court said, there was no evidence to suggest that the executor was acting in bad faith. Requiring the executor to challenge Dadakis, the court said, would nullify the very purpose of seeking the expert's advice in the first place.

However, the Federal Claims Court concluded that once Mrs. Liftin was naturalized, there was no reasonable cause for the estate to wait an additional nine months to file its estate tax return. Because Dadakis' advice that the estate could delay filing until all the ancillary matters were resolved was not an interpretation of substantive tax law, there was no reasonable cause for the delay in filing the estate tax return. The estate appealed to the Federal Circuit.

The Federal Circuit affirmed the Federal Claims Court decision and held that the penalty assessed on the nine-month period before the May 2006 filing was appropriate. The court concluded that the executor lacked reasonable cause for the delay in filing during that period.

Though fully able to file, the court noted, the executor simply relied on the advice of counsel that he should wait to file until the resolution of various "ancillary" matters advice for which he obtained no explanation and that rested on the unreasonable assumption that incompleteness of information justified delay in filing.

For a discussion of when a taxpayer has shown reasonable cause to avoid a penalty for late filing of a return, see Parker Tax ¶262,127.

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Tax Court Has Jurisdiction to Review Whistleblower Awards

The Tax Court has jurisdiction to review the IRS's whistleblower claim award determinations where the whistleblower provided information both before and after the enactment of the Tax Relief and Health Care Act of 2006. Whistleblower 11332-13W v. Comm'r, 142 T.C. No. 21 (6/4/14).

An unnamed taxpayer (Whistleblower W) reported a tax fraud scheme, involving W's employer and related entities, to the government. W provided the government with information regarding the tax fraud scheme from June 2006 through the fall of 2009. W's information formed the basis of the government's action against the target taxpayers. W filed a Form 211, Application for Award for Original Information, in 2008 and submitted to the IRS documentary evidence related to W's involvement in the government's investigation. W resubmitted Form 211 in 2011 seeking an award under Code Sec. 7623(b). Shortly thereafter, the government settled with one of the target taxpayers and recovered more than $30 million dollars in taxes, penalties and interest. The IRS granted W a discretionary award determination under Code Sec. 7623(a) and denied W's request for an award under Code Sec. 7623(b).

In cases where expenses are not otherwise provided for by law, the IRS is authorized under Code Sec. 7623(a) to pay such sums as it deems necessary for: (1) detecting underpayments of tax, or (2) detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws or conniving at the same. Because the discretionary whistleblower awards were seen as arbitrary and inconsistent and because of a lack of standardized procedures and limited managerial oversight with respect to those awards, Congress enacted the Tax Relief and Health Care Act of 2006 (TRHCA). The TRHCA enacted Code Sec. 7623(b) which requires the IRS to pay nondiscretionary whistleblower awards under certain circumstances and to provide the Tax Court with jurisdiction to review such award determinations. The effective date of Code Sec. 7623(b) is December 20, 2006. Under Code Sec. 7623(b), a whistleblower is entitled to a minimum nondiscretionary award of 15 percent of the collected proceeds if the IRS proceeds with administrative or judicial action using information provided in a whistleblower claim. Any amount payable under this rule is paid from the proceeds of amounts collected by reason of the information provided, and any amount so collected must be available for such payments.

W filed a petition seeking a review of the IRS's award determination. The IRS filed a motion to dismiss for lack of jurisdiction, arguing that the Tax Court lacked jurisdiction to review the IRS's award determination because the IRS proceeded against the target taxpayers using information W provided before the effective date of Code Sec. 7623(b). W opposed the IRS's motion on the grounds that W provided information to the government both before and after the effective date of Code Sec. 7623(b).

The Tax Court held that it has jurisdiction to review the IRS's whistleblower claim award determinations where W alleged that information was provided to the IRS before and after the effective date of Code Sec. 7623(b). The Tax Court further held that W satisfied its pleading burden by alleging facts that the IRS proceeded with an action against the target taxpayers using information brought to the IRS's attention by W both before and after the effective date of Code Sec. 7623(b).

For a discussion of the rules relating to whistleblower awards, see Parker Tax ¶262,300.

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Wife's Alzheimers Did Not Create Financial Hardship; No Suspension of Limitations for Claiming Refund

A taxpayer, who claimed that his wife had Alzheimers which lead to problems with filing returns, did not qualify for the financial hardship exception to the running of the statute of limitations and was not eligible to obtain refunds for prior year tax overpayments. Meconi v. U.S., 2014 PTC 275 (D. Del. 6/6/14).

According to Patrick Meconi, his wife managed all of their business and personal financial affairs for forty years. Because of Alzheimer's disease, after the 2003 tax year she was incapable of providing any meaningful information for tax filing purposes and financial information was "co-mingled, misfiled and lost." Patrick contended that he made "generous deposits" to the IRS in 2005, 2006, and 2007 using Form 1040-ES for estimated taxes. Not until 2010 was Patrick able to file original Form 1040 returns for tax years 2004 through 2009. According to Patrick, his tax returns were delayed because of caring for his spouse and his commensurate and personal physical and emotional ordeal. During his wife's illness, Patrick experienced numerous health problems of his own, and underwent seven operations.

After his wife passed away in 2010, Patrick requested refunds relating to earlier years. The IRS issued a refund for overpayments made in 2007 for the 2006 tax year, but denied refunds for earlier years. According to the IRS, the refund claims were invalid under Code Sec. 6511 because the statute of limitation had run on the earlier years. Patrick appealed the IRS determination and provided supplementary documentation of "financial disability" as allowed under Code Sec. 6511(h). The IRS denied the claim, saying that Patrick did not meet the statutory criteria.

A district court held that, while compelling, Patrick's claim against the United States for the refund of overpayments made to the IRS in a good faith effort to pay taxes during a particularly stressful period had to be dismissed. Under Code Sec. 6511(b)(2)(A), the court noted, a taxpayer is unable to recover a credit or refund that exceeds the portion of the tax paid within the three years immediately preceding the filing of the claim. Here, Patrick filed his claim for a refund in 2010 when he submitted six years of tax returns. While the IRS refunded the claimed amount for 2007, it could not refund the claims from 2005 or 2006 because of the statutory limitation of Code Sec. 6511(b)(2)(A). Additionally, the court observed, Code Sec. 6511 (h) provides for a limited exception to the time restrictions. Under Code Sec. 6511(h)(1), the running of the time period is "suspended during any period of such individual's life that such individual is financially disabled. To achieve such relief, the taxpayer must have been under the hardship themself and must proffer specific evidence and documentation, partially attested by a physician, explaining the extent of the disability and the time period during which the taxpayer suffered. The court noted that Congress chose to define "financially disabled" very narrowly and by the plain language of the statute and Rev. Proc. 99-21, neither Patrick nor his wife met the requirements for tolling of the statute of limitations due to financially disability.

For a discussion of the rules relating to the suspension of the statute of limitations during a period of financial hardship, see Parker Tax ¶261,180.