IRS Clarifies Requirements for "Substantial Risk of Forfeiture" in Final Regs

Final regulations provide several clarifications regarding whether a substantial risk of forfeiture exists in connection with property received in exchange for services. T.D. 9659.

Generally, under Code Sec. 83(a), if a service provider (who can be either an employee or independent contractor) or a beneficiary of a service provider receives property in connection with the performance of services, the service provider must include all or a portion of the property's fair market value in income in the year he or she receives the property. However, if the property is subject to certain restrictions (as in the case of certain restricted stock), its value is generally not included in income until it becomes "substantially vested." Property is substantially vested when it is either transferable or not subject to a substantial risk of forfeiture.

Regulations that had been in place under Code Sec. 83 caused considerable confusion over what constitutes a substantial risk of forfeiture. The IRS addressed issues that were causing that confusion in proposed regulations issued in 2012. On February 26, the IRS finalized those regulations in T.D. 9659.

Observation: The final regulations apply to property transferred on or after January 1, 2013, and thus are relevant for 2013 tax returns.

According to the IRS, the revised final regulations are intended to clarify the definition of a substantial risk of forfeiture and are consistent with the interpretation that the IRS historically has applied. Thus, from the IRS's perspective, they do not constitute a narrowing of the requirements to establish a substantial risk of forfeiture.

Background on Code Section 83(a)

Code Sec. 83(a) provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of the property (determined without regard to lapse restrictions) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, is included in the gross income of the service provider in the first tax year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture. Thus, if the property received is subject to a substantial risk of forfeiture and is nontransferable, the person receiving the property does not have current taxable income from the transaction.

Under Code Sec. 83(c)(1), the rights of a person in property are subject to a substantial risk of forfeiture if that person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual.

Code Sec. 83(c)(3) provides that so long as the sale of property at a profit could subject a person to suit under Section 16(b) of the Securities Exchange Act of 1934 (the Exchange Act), that person's rights in the property are subject to a substantial risk of forfeiture, and are not transferable. Reg. Sec. 1.833(j) further provides that, for purposes of Code Sec. 83, if the sale of property at a profit within six months after the purchase of the property could subject a person to suit under Section 16(b) of the Exchange Act, the person's rights in the property are treated as subject to a substantial risk of forfeiture and as not transferable until the earlier of (1) the expiration of that six-month period, or (2) the first day on which the sale of such property at a profit will not subject the person to suit under Section 16(b) of the Exchange Act.

Consistent with Code Sec. 83(c)(3) and Reg. Sec. 1.833(j), Rev. Rul. 200548 provides that the only provision of the securities law that would delay taxation under Code Sec. 83 is Section 16(b) of the Exchange Act. The ruling further provides that other transfer restrictions (such as restrictions imposed by lock-up agreements or restrictions relating to insider trading under Rule 10b5 of the Exchange Act) do not cause rights in property taxable under Code Sec. 83 to be substantially nonvested. Rev. Rul. 200548 notes that the IRS intends to amend the Code Sec. 83 regulations to explicitly set forth the holdings in the ruling.

Reg. Sec. 1.83-3(k) provides a special rule under which property is subject to substantial risk of forfeiture and is not transferable so long as the property is subject to a transfer restriction to comply with certain pooling-of-interests accounting rules.

Confusion Caused by Prior Regulations

The prior regulations under Code Sec. 83 provided that, whether or not a risk of forfeiture was substantial depended on the facts and circumstances, and a substantial risk of forfeiture existed where rights in property transferred were conditioned, directly or indirectly, upon (1) the future performance (or refraining from performance) of substantial services by any person, or (2) the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture was substantial if the condition was not satisfied.

Confusion arose under these regulations as to whether other conditions might also give rise to a substantial risk of forfeiture. Confusion also arose as to whether, in determining if a substantial risk of forfeiture existed, the likelihood that a condition related to the purpose of the transfer would occur had to be considered. According to the IRS, a conclusion that such likelihood need not be considered would lead to unintended anomalies. For example, assume that stock transferred by an employer to an employee was made nontransferable and also subject to a condition that the stock would be forfeited if the employer's gross receipts fell by 90 percent over the next three years. Assume also that the employer is a longstanding seller of a product, and that there is no indication there will be a fall in demand for the product or an inability of the employer to sell the product, so that it is extremely unlikely that the forfeiture condition will occur. Although, arguably, the condition is a condition related to the purpose of the transfer because it would, to some degree, incentivize the employee to prevent such a fall in gross receipts, the IRS said it did not believe that such a condition was intended to defer the taxation of the stock transfer.

Clarifications in Revised Regulations

The final regulations issued in February provide several clarifications on whether a substantial risk of forfeiture exists in connection with property subject to Code Sec. 83.

First, the final regulations clarify that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.833(j) and Reg. Sec. 1.83-3(k), a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer.

Second, the final regulations clarify that, in determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered.

Finally, the final regulations state that, except as specifically provided in Code Sec. 83(c)(3) and Reg. Sec. 1.833(j) and Reg. Sec. 1.83-3(k), transfer restrictions do not create a substantial risk of forfeiture, including transfer restrictions that carry the potential for forfeiture or disgorgement of some or all of the property, or other penalties, if the restriction is violated. This additional language incorporates the IRS's holding in Rev. Rul. 200548. Therefore, Rev. Rul. 200548 is obsolete as of February 26, 2014.

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Tax Lien on Pension Plan Survives Bankruptcy Due to Ambiguity in Debtor's Petition

A taxpayer who used ambiguous language in a bankruptcy petition was found to have listed his account in an ERISA-qualified pension plan as excluded (rather than exempt) property, which resulted in an IRS tax lien against the account surviving the bankruptcy. Gross v. Comm'r, 2014 PTC 94 (9th Cir. 2/14/14).

A debtor may exempt from his bankruptcy estate certain property, including retirement funds, to ensure that the debtor has at least some property with which to make a fresh start. Property that is exempt from the bankruptcy estate (exempt property) is not available to satisfy prepetition debts during or after the bankruptcy, except for debts secured by liens that are not avoided in the bankruptcy and federal tax liens for which the IRS filed a notice of federal tax lien before the debtor filed his bankruptcy petition. In contrast, liens on prepetition assets that are excluded from the bankruptcy estate (excluded property) are not affected by the bankruptcy proceeding that is, they generally survive the bankruptcy, even absent a prepetition notice of federal tax lien.

In Gross v. Comm'r, 2014 PTC 94 (9th Cir. 2/14/14), a taxpayer learned a hard lesson about the cost of being ambiguous in listing an interest in an ERISA-qualified pension plan as exempt or excluded property in a bankruptcy petition. Because the taxpayer's bankruptcy petition indicated that his interest in the plan was excluded from the bankruptcy estate, the Ninth Circuit held that the IRS maintained a valid lien on that interest after the taxpayer's bankruptcy case closed.

Observation: This case is a cautionary tale of what can happen when vague or confusing language is used in a bankruptcy petition. Because there is no formal procedure within the bankruptcy process to clarify what property is excluded, and confusion has resulted from this lack of clarity, it's important for practitioners to ensure that a bankruptcy petition is very clear as to the property that is exempt, rather than excluded, from the bankruptcy estate. As the Ninth Circuit noted, any ambiguity in a bankruptcy schedule is construed against the debtor.

Facts

On October 16, 2005, Stuart Gross filed a bankruptcy petition under chapter 7 of the U.S. Bankruptcy Code. On the date he filed his bankruptcy petition, Stuart owned an interest in an ERISA-qualified pension plan from the Director's Guild of America (the DGA plan) valued at $300,000. Stuart listed his interest in the DGA plan on Schedule B, Personal Property, attached to the bankruptcy petition. On Schedule C, Property Claimed as Exempt, which he also attached to the bankruptcy petition, Stuart listed as exempt the full value of his interest in the DGA plan. He included the following description on Schedules B and C:

This is an ERISA Qualified Pension Plan which is not property of the estate but in an abundance of caution has been listed herein and exempted.

No objections to the exemptions Stuart claimed on his Schedule C were filed. In June 2006, the bankruptcy court entered an order of discharge, and on August 7, 2006, the bankruptcy court entered an order closing Stuart's bankruptcy case. On the same day Stuart's bankruptcy case was ordered closed, the IRS sent Stuart a levy notice. The levy notice indicated that Stuart owed federal income taxes for 1998, 1999, 2000, and 2001 totaling $270,041. The IRS had not filed a notice of federal tax lien (NFTL) with respect to any of the federal income tax liabilities that were the subject of the levy notice by the time Stuart had filed his bankruptcy petition.

Stuart timely requested a Collection Due Process (CDP) hearing to dispute the IRS's intent to levy on his future entitlement to an annuity from the DGA plan. On October 29, 2007, the IRS issued a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330. In that notice, the IRS sustained the proposed levy because Stuart's interest in the DGA plan was excluded from Stuart's bankruptcy estate, and the IRS was not precluded from attaching (or levying) assets excluded from the bankruptcy estate.

The Parties' Arguments

In the Tax Court, Stuart argued that the exclusion of an interest in an ERISA-qualified pension plan is permissive rather than mandatory, and that he properly included the DGA plan account in his chapter 7 bankruptcy estate and claimed it as exempt without objection. Thus, according to Stuart, the IRS cannot levy on the DGA plan account because the IRS did not file a valid NFTL as required under Bankruptcy Code Section 522(c)(2)(B).

The IRS argued that the exclusion of an ERISA-qualified pension plan account is mandatory and cannot be included in the bankruptcy estate, even for the sole purpose of listing it as exempt. The IRS further argued that even if a debtor may include an ERISA-qualified pension plan account in the bankruptcy estate and claim it as exempt, Stuart did not do so; instead, he excluded the DGA plan account by describing it on his bankruptcy schedules as an "ERISA Qualified Pension Plan which is not property of the estate." Either way, in the IRS's view, the DGA plan account was excluded. Thus, the IRS concluded that the statutory lien survived the bankruptcy, and the IRS may collect from the DGA plan.

Observation: In an amicus brief filed in the Tax Court proceeding, the Center for the Fair Administration of Taxes took the position that, as a matter of law, all bankruptcy debtors are entitled to the benefit of Bankruptcy Code Section 522(c)(2)(B) with respect to their interests in ERISA qualified pension plans, regardless of whether they claim that their interests in such plans as exempt.

Excluded vs. Exempt Property

The filing of a petition in bankruptcy automatically creates a bankruptcy estate consisting of all legal or equitable interests of the debtor in property as of the beginning of the case. The bankruptcy estate includes all of the debtor's prepetition property and rights to property, except property excluded from the estate under Bankruptcy Code Section 541. Bankruptcy Code Section 541(c)(2), as interpreted by the Supreme Court in Patterson v. Shumate, 504 U.S. 753 (1992), allows a debtor to exclude an interest in an ERISA-qualified pension plan from his bankruptcy estate.

In addition, Bankruptcy Code Section 522 allows a debtor to exempt from his bankruptcy estate certain property, including retirement funds. Property that is exempt from the bankruptcy estate under Bankruptcy Code Section 522 is not available to satisfy prepetition debts during or after the bankruptcy, except debts secured by liens that are not avoided in the bankruptcy and Code Sec. 6321 liens for which a valid NFTL has been filed.

Unlike exempt property, excluded property never becomes part of the bankruptcy estate and is therefore never subject to the bankruptcy estate trustee's or the debtor's power to avoid the Code Sec. 6321 lien. Thus if a Code Sec. 6321 lien on excluded property has not expired or become unenforceable under Code Sec. 6322, it survives the bankruptcy.

Tax Court's Analysis

The Tax Court noted that there is no formal procedure within the bankruptcy process to clarify what property is excluded, and confusion has resulted from this lack of clarity. According to the court, simply listing an ERISA-qualified pension plan account, an excludable asset, on Schedule C is not necessarily sufficient to claim an exemption if all the facts including any statements made on the bankruptcy schedules indicate that the debtor excluded the ERISA-qualified pension plan account from his bankruptcy estate.

The court observed that on Schedule C of his bankruptcy petition, Stuart stated that the DGA plan account was not property of the estate, but in an abundance of caution was listed on the bankruptcy schedules and claimed as exempt. The court concluded that Stuart's pension plan account was properly excludable from his bankruptcy estate under Bankruptcy Code Section 541(c)(2) and Patterson v. Shumate, and that Stuart had in fact excluded the pension plan account from his bankruptcy estate. As a result, the Code Sec. 6321 lien that attached to the pension plan account before bankruptcy continued to attach to Stuart's interest in his pension even after his personal liability for his tax liabilities was discharged in bankruptcy.

Observation: Because the court found that Stuart excluded his DGA plan account from his bankruptcy estate, there was no need for the court to decide whether the exclusion of an ERISA-qualified pension plan account from a bankruptcy estate is mandatory or permissive.

Ninth Circuit Affirms Tax Court's Decision

The Ninth Circuit affirmed the Tax Court's decision, holding that the IRS maintained a valid lien on Stuart's interest in the DGA plan. According to the court, in Patterson v. Shumate, the Supreme Court held that an ERISA plan is properly excluded from a bankruptcy estate, and here, Stuart's Chapter 7 schedules explicitly stated that the DGA plan was not part of the estate. Although the schedules went on to suggest that his interest in the ERISA plan might be "exempted," any ambiguity in a bankruptcy schedule is construed against the debtor. Because his interest in the DGA plan was not part of Stuart's Chapter 7 estate, the bankruptcy proceedings did not affect the IRS's Code Sec. 6321 lien. Thus, the Ninth Circuit concluded that the Tax Court had properly determined that the Code Sec. 6321 lien remained attached to Stuart's interest in the plan, and the IRS may levy that asset.

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Final Form 8960 Instructions Contain Several Clarifications and Changes

The IRS has finalized the instructions for Form 8960, Net Investment Income Tax - Individuals, Estates, and Trusts. While the final instructions are very similar to the draft instructions issued in January, there are several changes that practitioners should be aware of.

First, an additional note was added to the instructions under the heading "Safe Harbor for Real Estate Professionals." There is a safe harbor for a real estate professional for purposes of the passive activity rules under Code Sec. 469 for a taxpayer that participates in each rental real estate activity for more than 500 hours during the tax year, or participated in a rental real estate activity for more than 500 hours in any five tax years (whether or not consecutive) during the 10 tax years immediately before the current tax year. For purposes of the net investment income tax, if a taxpayer qualifies for this safe harbor, the gross rental income from the taxpayer's rental real estate activity is treated as though derived in the ordinary course of a trade or business and is not included in net investment income.

The new note in the instructions clarifies that if the taxpayer is a real estate professional under Code Sec. 469(c)(7), but is unable to satisfy the qualifications for the safe harbor for the net investment income tax, the taxpayer is not precluded from establishing that the gross income and gain or loss from the disposition of property associated with the rental real estate activity is not included in net investment income.

Second, the draft instructions on installment sales of a partnership interest or S corporation stock stated that the difference between the amount of gain reported for regular tax purposes and the amount reported for net investment income tax purposes had to be reported on an attachment to the return for the first year only (i.e., the year of sale). The draft instructions specifically stated that no attachment was necessary in subsequent years. The final instructions deleted this and instead require an attachment to all subsequent returns where an installment payment is received.

Third, the final instructions made changes to the annuities section. The description of Line 3, was changed from "Annuities From Nonqualified Plans" to just "Annuities," and the instructions now advise taxpayers to enter on Line 3 the gross income from all annuities except annuities paid from the following: Section 401 - Qualified pension, profit-sharing, and stock bonus plans; Section 403(a) - Qualified annuity plans purchased by an employer for an employee; Section 403(b) - Annuities purchased by public schools or Section 501(c)(3) tax-exempt organizations; Section 408 - Individual Retirement Accounts (IRAs) or Annuities; Section 408A - Roth IRAs; Section 457(b) - Deferred compensation plans of a state and local government and tax-exempt organization; and amounts paid in consideration for services (for example, distributions from a foreign retirement plan that are paid in the form of an annuity and include investment income that was earned by the retirement plan). The draft instructions did not include the enumerated list of annuities excluded from gross annuities included in Line 3 of Form 8960.

Fourth, the IRS added two notes to the end of the instructions for Line 7 - Other Modifications to Investment Income. The first note clarifies that expenses associated with the trade or business of trading in financial instruments or commodities that are reported on the taxpayer's Schedule C (Form 1040) are reported on Form 8960, Line 10. The other note provides that an early withdrawal penalty reported on Form 1040, Line 30, is reported on Form 8960, Line 10.

Fifth, the IRS revised the section on the treatment of a Form 8814, Parents' Election to Report Child's Interest and Dividends. Instead of listing the steps to calculate the amount of a child's dividend and capital gain distribution, a new paragraph simply states that parents electing to include their child's dividends and capital gain distribution in their income by filing Form 8814 must include on Form 8960, Line 7, the amount on Form 8814, Line 12, excluding Alaska Permanent Fund Dividends.

For a discussion of the general rules relating to the net investment income tax, see Parker Tax ¶141,500.

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IRS Issues Procedures for Accounting Method Changes on Tangible Property Dispositions

A new revenue procedure modifies the rules for obtaining automatic IRS consent to: (1) change a method of accounting for dispositions of tangible depreciable property, (2) change a method of accounting for depreciation of MACRS property; and (3) change a method of accounting for the treatment of general assets accounts. Rev. Proc. 2014-17.

Last September, the IRS issued final regulations under Reg. Sec. 1.167(a)-4, which provides rules for depreciating or amortizing leasehold improvements, and Reg. Sec. 1.168(i)-7, which provides rules for accounting for property depreciated under MACRS. The final regulations replaced temporary regulations issued in December 2012.The final regulations generally apply to tax years beginning on or after January 1, 2014, but also permit taxpayers to apply these provisions to tax years beginning on or after January 1, 2012. Alternatively, the final regulations also allow a taxpayer to apply the temporary regulations under Reg. Sec. 1.167(a)-4T and Reg. Sec. 1.168(i)-7T to tax years beginning on or after January 1, 2012, and before January 1, 2014.

Also last September, the IRS reissued proposed regulations relating to the dispositions of tangible property and the tax treatment of general asset accounts (GAAs). Specifically, the IRS issued (1) Prop. Reg. Sec. 1.168(i)-1, which will modify the rules for GAAs; (2) Prop. Reg. Sec. 1.168(i)-7, which will address the accounting rules for depreciation of MACRS property; and (3) Prop. Reg. Sec. 1.168(i)-8, which will provide rules for dispositions of MACRS property. The proposed regulations, when finalized, will apply to tax years beginning on or after January 1, 2014, and will permit a taxpayer to choose to rely on them for tax years beginning on or after January 1, 2012, and before January 1, 2014. Alternatively, the proposed regulations, when finalized, will permit a taxpayer to apply the temporary regulations under Reg. Sec. 1.168(i)-1T, Reg. Sec. 1.168(i)-7T, and Reg. Sec. 1.168(i)-8T to tax years beginning on or after January 1, 2012, and before January 1, 2014.

Previously, the IRS issued Rev. Proc. 2012-20, which provided the procedures for taxpayers to obtain automatic IRS consent to change to methods of accounting provided for in Reg. Secs. 1.167(a)-4T, 1.168(i)-1T, 1.168(i)-7T, and Reg. Sec. 1.168(i)-8T.

The IRS has now issued Rev. Proc. 2014-17, which supersedes Rev. Proc. 2012-20 and provides the procedures by which a taxpayer may obtain the automatic IRS consent to change to the methods of accounting provided in Reg. Secs. 1.167(a)-4, 1.168(i)-7, 1.167(a)-4T, 1.168(i)-1T, 1.168(i)-7T, 1.168(i)-8T, and Prop. Reg. Secs. 1.168(i)-1, 1.168(i)-7, and 1.168(i)-8. Rev. Proc. 2014-17 also modifies Rev. Proc. 2011-14, the general procedure for obtaining IRS consent to change accounting methods.

Observation: The IRS had previously issued Rev. Proc. 2014-16, which modified Rev. Proc. 2011-14 and provides guidance on automatic method changes relating to many of the final capitalization rules issued last September. The IRS has said that once the final disposition regulations are issued, another revenue procedure will be issued addressing the accounting method changes relevant to those regulations.

One of the more significant features of Rev. Proc. 2014-17 are the provisions in Section 6.29 and 6.33, which allow a taxpayer to recognize gain or loss on buildings, structural components, and other property previously disposed of that the taxpayer is continuing to depreciate. However, taxpayers have only a limited time in which to make this change. This change in method of accounting is only available for a tax year beginning on or after January 1, 2012, and beginning before January 1, 2014. In addition, certain scope limitations, which generally act to prevent a taxpayer from taking advantage of automatic consents to change a method of accounting, do not apply to a taxpayer that makes this change. Thus, these provisions will be mostly beneficial to taxpayers filing 2013 tax returns.

Another important provision of Rev. Proc. 2014-17 is Section 6.34, which allows the revocation of a general asset account election under Reg. Sec. 1.168(i)-1T or Prop. Reg. Sec. 1.168(i)-1 to be treated as a change in method of accounting for a limited period of time. This change in method is available for a limited time and may only be made for a tax year beginning on or after January 1, 2012, and beginning before January 1, 2015.

Example: Z, a calendar year taxpayer, acquired and placed in service a building and its structural components in 2000. Z depreciates this building and its structural components under MACRS. The roof is a structural component of the building. Z replaced the entire roof in 2010. On its 2010 federal tax return, Z did not recognize a loss on the retirement of the original roof and continued to depreciate the original roof. Z also capitalized the cost of the replacement roof and has been depreciating this roof under MACRS since June 2010. Z filed with its 2012 federal tax return, a Form 3115 to: (1) make a late general asset account election to include the building (including its structural components) placed in service in 2000 in one general asset account and the replacement roof in a separate general asset account; and (2) make a late qualifying disposition election for the retirement of the original roof in 2010. As a result, Z removed the original roof from the general asset account and reported a net negative Code Sec. 481(a) adjustment on the Form 3115 of $10,000, which is the loss recognized upon the retirement of the original roof. Z decides to apply Prop. Reg. Sec. 1.168(i)-1 and Prop. Reg. Sec. 1.168(i)-8 for its tax year ending December 31, 2013.  

Z files a Form 3115 with its 2013 tax return to revoke the general asset account election for the building (including its structural components) placed in service in 2000 and for the replacement roof, and to change to treating the building (including its original roof and other original structural components) placed in service in 2000 as an asset and the replacement roof as a separate asset for disposition purposes. Assume the depreciation for the original roof is $500 for the 2012 tax year. The net positive Sec. 481(a) adjustment for this change is $9,500 (loss of $10,000 claimed on the 2012 return for the retirement of the original roof less depreciation of $500 for the original roof for 2012) and is included in Z's taxable income for 2013.

Forms 3115, Application for Change in Accounting Method, filed under Rev. Proc. 2014-17 must be filed with the IRS office in Ogden, Utah.

For a discussion of the rules relating to dispositions of MACRS property, see Parker Tax ¶94,327.

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Nonprofit Can't Challenge IRS Rules on Tax-Exempt Social Welfare Groups

A nonprofit organization lacked standing to challenge the IRS's refusal to issue regulations addressing a perceived conflict between Code Sec. 501(c)(4) and an IRS regulation that defines organizations entitled to a tax exemption under that provision. Citizens For Responsibility and Ethics in Washington v. U.S., 2014 PTC 100 (D. D.C. 2/27/14).

Citizens For Responsibility and Ethics in Washington (CREW) is a nonprofit, nonpartisan corporation focused on protecting the rights of citizens to be informed about the activities of government officials. In support of its mission, CREW disseminates information to the public about public officials and examines special interests that have influenced elections and elected officials. In 2013, CREW petitioned the IRS to issue a new regulation that conforms to Code Sec. 501(c)(4). CREW asserted that organizations that are primarily engaged in social welfare can file for exemption under Code Sec. 501(c)(4) and keep their donor information private, even if they participate in political campaigns. Since such organizations are not required to disclose donor information, there has been a significant increase in the amount of anonymous money contributed into the political system, and CREW argued that its ability to examine special interests that have influenced elections and elected officials has been hindered. After the IRS failed to act on the petition or amend the regulation, CREW filed suit, seeking declaratory and injunctive relief. The government moved to dismiss the suit for lack of jurisdiction on the ground that CREW lacked standing to bring the suit.

Observation: The case was initiated as a result of the defeat of congressional candidate David Gill in the 13th District of Illinois. He was defeated in one of the closest elections in history, purportedly as a result of expenditures of anonymous money by the American Action Network, a 501(c)(4) organization.

Code Sec. 501(c)(4) provides a tax exemption for nonprofit organizations that are operated exclusively for the promotion of social welfare. The promotion of social welfare does not include direct or indirect participation or intervention in political campaigns on behalf of, or in opposition to, any candidate for public office. Reg. Sec. 1.501(c)(4)-1(a) states that the exemption applies to organizations that are primarily engaged in promoting the common good and general welfare of the community. Such organizations are ones that operate primarily for the purpose of bringing about civic betterments or social improvements.

CREW argued that groups claiming Code Sec. 501(c)(4) status have interpreted the "primary activity" requirement of the regulation to allow them to spend up to 49 percent of their total expenditures on campaign activities without such activities constituting their primary activity.

The IRS contended that there was no injury-in-fact, the alleged injury was not fairly traceable to the disputed IRS regulation, and the remedy sought would not redress the alleged injury.

A district court held that CREW failed to show that the IRS's refusal to initiate a rulemaking procedure regarding the disputed regulation resulted in an injury, since CREW failed to identify any statutory authority that directly granted CREW the right to obtain the donor information it sought. Therefore, any alleged injury resulting from being deprived of the donor information was speculative and hypothetical.

Moreover, there was no causal connection between CREW's inability to access donor information for organizations engaged in political campaign activities and the IRS's alleged failure to reconcile the IRS regulation with the Tax Code requirement that such groups operate exclusively for the promotion of social welfare, the court stated. To support CREW's theory of causation would require the court to speculate not only about the choices of the affected organizations, but also about how those choices may affect their donor's choices and vice versa.

Further, CREW's inability to access donor information for certain Code Sec. 501(c)(4) organizations would not likely be redressed by a favorable decision. CREW's alleged injury was related to the independent decisions of third parties and was not directly connected to the disputed regulation. It was merely speculative that a favorable decision by the IRS would remedy CREW's alleged injury, according to the court.

Finally, CREW failed to show that the IRS's refusal to initiate a rulemaking procedure regarding the disputed regulation impeded CREW's organizational mission. Since there was no causal connection between CREW's inability to access donor information and the IRS's refusal to engage in rulemaking, there was no direct conflict with CREW's organizational mission to examine special interests that have influenced elections and elected officials. Therefore, CREW failed to establish standing, the court concluded.

For a discussion of 501(c)(4) organizations eligible for tax-exempt status, see Parker Tax ¶60,510.

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Ex-Wife Owes Tax on Partnership Income Under Community Property Rules

A former spouse must report half of the community income earned by a partnership formed by her husband with community property assets, regardless of whether she was a partner in the partnership, since she had a present interest in the community property assets that were used to form the partnership. Carrino v. Comm'r., T.C. Memo. 2014-34 (2/25/14).

Vince Carrino, a skilled financial manager, formed CR Traders, LLC (CR LLC) and named himself managing member. CR LLC served as general partner to CR Trader Partners (CR LP), a partnership Vince formed with capital contributions of $850,000. CR LP began operating as a hedge fund, with Vince managing the entity through CR LLC. Vince made the investment without the knowledge or consent of his wife, Ann, with whom he was legally separated from in June 2002. Ann was not listed as a partner of CR LP or as a member of CR LLC on either partnership's 2003 tax return. Ann did not report any income from either CR LP or CR LLC on her 2003 federal income tax return. Subsequently, Ann learned of Vince's investment in CR LP and CR LLP and, in their divorce proceedings, asserted that all of the funds used for that investment were community property funds. In 2006, the divorce court approved the couple's settlement agreement which stated that 72 percent of Vince's current interest in CR LLC was traceable to community property and that the interest would be liquidated and distributed to Ann. In November 2006, CR LP distributed nearly $6.5 million to Ann and the state court dissolved the couple's marriage. For the years at issue, the couple did not file joint returns.

In 2007, Vince filed amended 2003 partnership returns for CR LP and CR LLC, reporting Ann as a partner and including a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., allocating her approximately $750,000 in other income and decreasing Vince's distributive share by that amount. Upon auditing her 2003 individual return, the IRS issued a notice of deficiency to Ann, assessing tax on the $750,000 that the IRS said Ann should have been reported on her return.

Under Code Sec. 66, married couples in community property states who do not file joint tax returns generally must report half of the total community income earned by the spouses during the tax year.

Ann argued that she was not a partner of CR LP during 2003 or at anytime and Vince's investment of community funds in CR LP did not give her a community property interest in CR LP's assets.

The IRS contended that Ann had a present interest in half of the income from Vince's community property share of CR LLC and that interest generated income on which she owed tax.

The Tax Court held that, regardless of whether Ann was a partner in CR LP or a member of CR LLC in 2003, as a married person filing separately, she must report half of the community income that CR LLC earned. Although Ann and Vince separated in 2002, they were legally married until 2006 and, thus, Ann was required to report half of the community income earned by both her and Vince during the year in issue, the court stated. To determine whether Ann had a present interest in the community property income earned by Vince as a member of CR LLC in 2003, the court cited See v. See, 415 P.2d 776 (Cal. 1966), which found that under applicable state community property law, the character of property as separate or community is determined at the time of its acquisition. It was relevant that Vince funded the partnership interest with community property and not that he funded CR LP after the couple separated, the court observed.

In rejecting Ann's argument that her interest in CR LP's income was inchoate (i.e., not fully developed), the court determined that she had a present interest in the income since each spouse's interest in community property during the marriage is present, existing and equal. When Vince invested the community property in CR LP, Ann merely traded her community interest in one asset for a community interest in another asset. In this case, Ann had a present and existing community property interest in Vince's interest in CR LP which he held in the form of a membership interest in CR LLC. The settlement approved by the court in 2006 recognized that interest but did not create that interest. Therefore, Ann was required report half of the community property income that CR LLC earned in 2003, the court concluded.

For a discussion of the treatment of community income, see Parker Tax ¶11,110.

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Fifth Circuit Affirms Tax Court; Partner Can't Deduct Unreimbursed Partnership Expenses

Where a partnership has a reimbursement policy and a partner chooses not to request reimbursement for expenses that qualify for reimbursement under that policy, the partner cannot then deduct such expenses on his individual return. McLauchlan v. Comm'r, 2014 PTC 112 (5th Cir. 3/6/14).

Peter McLauchlan was a partner during 2005 and 2006 at a law firm referred to as "AR." AR partners were required under AR's partnership agreement to pay expenses for business meals, automobiles, travel, entertainment, conventions, continuing legal education, and membership in professional organizations (i.e., indirect AR expenses). Indirect AR expenses were reimbursable under AR's partnership agreement if approved by a managing partner or a designee of the managing partner.

AR had a written reimbursement policy that specifically provided for reimbursement of certain indirect AR expenses. Reasonable travel expenses were reimbursable, including expenses related to client maintenance and development. Interoffice travel expenses involving an automobile were reimbursable. Lease and rental automobile expenses incurred for client travel were reimbursable. Business meals and entertainment were reimbursable if authorized and approved. Continuing legal education expenses were reimbursable if approved. As a matter of routine practice, AR would reimburse other indirect AR expenses that were not provided for in the written reimbursement policy, including state bar membership expenses and professional organization expenses. AR did not have a limit on the amount for which a partner could be reimbursed. There was no routine practice at AR that required Peter to pay any other AR expenses.

During 2005 and 2006, Peter paid various expenses (advertising, home office, automobile, etc.) in connection with practicing law at AR. He was reimbursed for over $60,000 of those expenses. Peter claimed he incurred a total of approximately $100,000 in expenses and deducted the difference on his Form 1040, Schedule C. The expenses for which he was not reimbursed included car and vehicle lease expenses. Peter did not submit such expenses to AR for reimbursement. The IRS disallowed the deduction.

Before the Tax Court, Peter conceded that the disallowed expenses were not deductible on Schedule C, but claimed the unreimbursed partnership expenses were deductible on Schedule E, Supplemental Income and Loss. The Tax Court disallowed Peter's deductions, holding that the expenses were deductible only if they were (1) indirect AR expenses, (2) unreimbursable, and (3) actually incurred. The only indirect AR expenses Peter claimed for 2005 and 2006, the court observed, were for travel, meals, entertainment, automobile expenses, vehicle rental, professional organizations, continuing legal education, and state bar membership expenses. Peter, the court stated, failed to point to any specific expense for which AR denied him reimbursement. Thus, the court concluded that Peter was not required to pay, without reimbursement, any expenses for travel, meals, entertainment, vehicle rental, continuing legal education, professional organizations or state bar memberships. Peter appealed to the Fifth Circuit.

The Fifth Circuit affirmed the Tax Court. The court began by stating the general rule that a partner may not deduct the expenses of the partnership on his individual return, even if the expenses were incurred by the partner in furtherance of partnership business. However, as the court noted, there is an exception to this rule where, under a partnership agreement, a partner is required to pay certain partnership expenses out of his own funds. In this case, the partner is entitled to deduct the amount thereof from his individual gross income.

The Fifth Circuit found that certain expenses Peter claimed as deductions beyond those identified in the partnership agreement, such as for advertising, contract labor, home insurance, interest, office supplies, utilities, and wages, were expenses Peter chose to incur, rather than ones called for by AR's partnership agreement. Thus, the court concluded, they were not deductible on Peter's individual tax return.

The Fifth Circuit then looked at expenses Peter was required by AR's partnership agreement to incur to determine if those expenses were reimbursable by the partnership. Like the Tax Court, the Fifth Circuit concluded that all of the expenses that Peter was required to incur were reimbursable by either AR's written policy or routine practice. The Fifth Circuit held that, because Peter was not required ultimately to bear any of these expenses, and because he produced no evidence that AR denied him reimbursement, the expenses were not deductible as unreimbursed partnership expenses.

For a discussion of the deductibility of unreimbursed partnership expenses by a partner, see Parker Tax ¶20,522.

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Attorneys Had Effective Control of Partnerships and Thus Can Deduct Expenses

Two attorney investors had effective control of partnerships formed to implement their foreign currency investment strategy; therefore, they were entitled to deduct operational expenses and advisory fees associated with the investment transactions. Klamath Strategic Investment Fund v. U.S., 2014 PTC 108 (5th Cir. 3/3/14).

Charles Patterson and Harold Nix were partners in a law firm. The attorneys received significant fees from the settlement of a tobacco litigation case and approached their accounting firm, Pollans & Cohen, to help investigate investment opportunities. The accounting firm identified Presidio Advisory Services, a firm that specializes in foreign currency trading, as such an opportunity. Patterson and Nix decided to invest in foreign currencies through Presidio and each partner paid Pollans & Cohen a $250,000 advisory fee for its help in identifying Presidio. As part of the investment strategy for the attorneys, Presidio formed two strategic investment funds, Klamath and Kinabalu, which elected to be taxed as partnerships. Presidio also formed two single-member limited liability companies (LLCs) St. Croix and Rogue. The LLCs were taxed as partnerships for tax purposes. Patterson owned 100 percent of St. Croix, and St. Croix owned 90 percent of Klamath. Nix owned 100 percent of Rogue, and Rogue owned 90 percent of Kinabalu. Presidio was the managing member of Klamath, and Kinabalu and owned 10 percent of each.

Presidio's strategy was structured to take place in three stages over a seven-year period, but Nix and Patterson retained the ability to withdraw from the plan. Nix and Patterson ultimately decided to withdraw before the end of the first stage.

In 2004, the IRS issued Final Partnership Administrative Adjustments (FPAAs) to Klamath and Kinabalu. The IRS disagreed with the partnerships' calculation of their tax basis. Specifically, the IRS argued that the transactions were shams or lacked economic substance and should be disregarded for tax purposes. The IRS made adjustments to operational expenses reported by the partnerships, and assessed accuracy-related penalties A district court first granted partial summary judgment for Nix and Patterson, holding that the partnerships' tax treatment of certain amounts borrowed from Presidio and a bank to fund the partnerships was proper. Following a trial, the district court held that, while Patterson and Nix's primary motive in investing in foreign currency was to make a profit, the loan transactions from Presidio and the bank lacked economic substance. According to the district court, Presidio and the bank lacked a true profit motive because they had a private agreement that the investment transactions were to be used only to generate tax losses. The district court held that, because Patterson and Nix had a true profit motive and acted in good faith, they were entitled to deduct on their individual tax returns the interest expenses associated with the loan and foreign currency exchange transactions that they had paid. The district court also found that Patterson and Nix effectively controlled Klamath and Kinabalu, not Presidio as the managing member, and could deduct the operational expenses and advisory fees as well. The IRS appealed.

The IRS argued that the district court erred in relying on legally irrelevant factors in finding that Patterson and Nix had effective control and that the record did not support the court's factual findings.

The Fifth Circuit, affirming the district court, held that Patterson and Nix effectively controlled Klamath and Kinabalu and were entitled to deduct the operational expenses incurred on their individual returns. In determining whether "effective control" existed, the district court concluded that: (1) Patterson and Nix, owners of the single-member LLCs, set the scope of the managing member Presidio's authority; (2) the LLCs were set up to achieve the investment strategy of the loan investors, Patterson and Nix; (3) Patterson and Nix, the non-managing members of the LLC, selected the managing member; and (4) Patterson and Nix had the right to withdraw from the partnerships. The IRS cited no authority that the district court's reliance on these factors was incorrect, the court noted. Moreover, whether the factors were sufficient was a fact-based question.

The evidence, the court observed, firmly supported a finding that the investment agreement defined the investment strategy and confined Presidio to that strategy. In rejecting the IRS's argument that Patterson and Nix could not terminate the partnerships by withdrawing from them, the court found that, as 90 percent owners, their withdrawal had that practical effect. Moreover, their 90 ownership interests suggested effective control. Thus, the Fifth Circuit held that the district court did not clearly err in finding that Patterson and Nix effectively controlled the partnerships.

For a discussion of the factors that go into determining if a purported partnership is a sham partnership, see Parker Tax ¶20,100.

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IRS Didn't Relinquish Claim to Additional Proceeds from Property Taken by Eminent Domain

Where the IRS had a lien on property that a city wanted to take by eminent domain, an IRS Certificate of Discharge on a portion of that property did not cause the IRS to release or abandon any claims it might have on additional proceeds awarded to the taxpayer with respect to that property. Hannon v. City of Newton, 2014 PTC 105 (1st Cir. 2/28/14).

In 2002, Patrick Hannon purchased a beach house in the City of Newton, Massachusetts. In 2007, the IRS recorded a lien on the beach property as well as Patrick's other property as a result of Patrick owing over $4 million in unpaid taxes. Before that, in 2005, creditor Rita Manning had obtained a judgment against Hannon. Subsequent to the IRS obtaining its lien on Patrick's property, Manning also obtained a lien on Patrick's property.

In 2007, the City of Newton sought to take Hannon's property by eminent domain. To facilitate this, the IRS discharged a specific parcel of land from its tax lien with knowledge that the property might be worth more than the City of Newton was paying for it, and there could be a post-taking claim by Hannon to obtain additional money for the property. The Certificate of Discharge issued by the IRS contained an appendix that reserved the force and effect of the tax liens against all other property to which the liens were attached, wherever situated. The IRS obtained a partial satisfaction of the total tax lien from the eminent domain proceeding.

In 2008, Hannon sued the City of Newton, claiming it has not sufficiently compensated him for taking his property. Both the IRS and Rita Manning intervened in the suit and asserted priority to receive any damages awarded. In 2010, a court awarded Hannon $420,000 in damages. The question then arose as to whose lien, Manning's or the IRS's, had priority to obtain the money awarded. A district court ruled in favor of Manning, holding that the IRS's decision to discharge Patrick's beach property from federal tax liens in exchange for payment from the taking of the property meant the IRS had relinquished any tax lien on the later damages award. The IRS appealed.

There was no dispute that before the taking and the filing of the IRS Certificate, Manning's judgment lien was junior to the IRS's tax lien. The question before the First Circuit was whether the IRS Certificate of Discharge issued under Code Sec. 6325(b)(2)(A), and read in light of Code Sec. 6325(b)(3), released or abandoned any claims the IRS had on the post-taking proceeds awarded to Patrick under Massachusetts law.

The First Circuit reversed the district court and held that the IRS lien on the post-taking proceeds was valid and therefore senior. According to the court, the purpose of Code Sec. 6325 is to give clear title to a purchaser, and nothing in the provision purports to discharge any property other than the specific property discharged in the discharge certificate. In this case, the discharge certificate was precise and discharged only a specific piece of real property that Patrick was parting with and that the City of Newton was taking. It did not discharge the other rights that made up Patrick's ownership interest in the beach property, such as his contingent rights to property if that parcel of land was taken by eminent domain and the right to receive an initial damages award, which accrued after the parcel of land was taken by eminent domain, and the right to sue for more damages if Patrick deemed the initial award inadequate.

For a discussion of tax liens, see Parker Tax ¶260,530.

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Knowledge of Ex-Spouse's Income Does Not Derail Equitable Innocent Spouse Relief

Because the only factor weighing against innocent spouse relief was the knowledge factor, the taxpayer was granted equitable innocent spouse relief. Howerter v. Comm'r, T.C. Summary 2014-15 (2/19/14).

Julie Howerter was formerly married to Raymond Gentry. Throughout her marriage to Raymond, Julie prepared their joint federal income tax returns. Raymond would provide Julie with his third-party reporting information and other requested information. Their 2007 joint federal tax return showed a total tax of $2,806 and federal income tax withholding of $8,025, resulting in a refund of $5,219. The IRS subsequently issued a notice of deficiency in which it stated that certain amounts, most notably almost $10,000 received by Raymond in nonemployee compensation from Andy's Express Co. and reported to the IRS on Form 1099-MISC, had not been reported on the 2007 joint tax return.

On January 27, 2010, the IRS received a Form 8857, Request for Innocent Spouse Relief, for tax year 2007 from Julie. In her Form 8857, Julie asserted that she was not liable for the unreported commission income because she was never aware of Raymond's receipt of the commission income and Raymond did not provide her with a Form 1099-MISC indicating that he had received that income. Julie and Raymond divorced on May 11, 2010. Subsequently, the IRS denied Julie innocent spouse relief. Julie appealed to the Tax Court. Raymond intervened in the case and provided copies of emails that indicated Julie was aware of additional income. In response, Julie sent the IRS a letter in which she expressed her concern about the emails Raymond submitted to the IRS that were purportedly from her. In that letter, she included a copy of what she said was the actual email she sent to Raymond. At trial, Julie admitted she was aware that Raymond had received commissions from another company but contended that she was unaware of the commissions Raymond earned from Andy's in 2007.

The Tax Court held that Julie was entitled to innocent spouse relief under Code Sec. 6015(f). Code Sec. 6015(f) provides an alternative means of relief for a requesting spouse who does not otherwise qualify under Code Sec. 6015(b) or (c). Code Sec. 6015(f)(1) provides innocent spouse relief if it would be inequitable to hold the requesting spouse liable for any unpaid tax or any deficiency. Under Code Sec. 6015(f), equitable relief may be granted to a requesting spouse on the basis of the facts and circumstances.

The court looked to Rev. Proc. 2013-34, which provides a three-step analysis to follow in evaluating such a request for relief. First the taxpayer must meet seven threshold conditions, which the IRS admitted Julie met. Next, a requesting spouse can qualify for a streamlined determination of relief if three conditions are met. Because the court concluded that Julie had actual knowledge of the omitted income, she did not qualify for a streamlined determination of relief. Lastly, if the requesting spouse satisfies the threshold conditions but fails to satisfy the conditions for a streamlined determination of relief, a requesting spouse may still be eligible for equitable relief under Code Sec. 6015(f) if, taking into account all the facts and circumstances, it would be inequitable to hold the requesting spouse liable for the underpayment. The court examined the nonexclusive factors that may be considered and concluded that three of the factors were neutral, three weighed in favor of granting relief to Julie, and one weighed against granting relief. The only factor weighing against relief was the knowledge factor. Rev. Proc. 2013-34, the court noted, makes clear that, in the IRS's determination under Code Sec. 6015(f), knowledge of the item giving rise to an understatement or deficiency no longer weighs more heavily than other factors, as it did under Rev. Proc. 2003-61. Balancing all of the facts and circumstances, the Tax Court concluded that the equities favored granting Julie relief under Code Sec. 6015(f).

Observation: The court also noted that, before and since 2007, Julie had timely filed all required Forms 1040, had accurately reported all income earned, did not have an outstanding balance due to the IRS, and had never been in front of the Tax Court before.

For a discussion of innocent spouse relief under Code Sec. 6015(f), see Parker Tax ¶260,560.