Federal Tax Bulletin - Issue 73 - October 10, 2014

Figurehead Shareholders Can't Shield Patent Owner from Ordinary Income on Royalties

Code Sec. 1235 allows payments received by a patent owner on the transfer of a patent to be characterized as long-term capital gains rather than ordinary income if certain conditions are met. This rule does not apply to any transfer, directly or indirectly, between related persons. However, neither the Code nor the regulations specifically address whether the patent characterization rule of Code Sec. 1235 applies to transfers of a patent to a corporation that is not related to a patent holder but is indirectly controlled by the holder.  

This issue of first impression in the Tax Court was addressed in Cooper v. Comm'r, 143 T.C. No. 10 (9/23/14). In Cooper, a patent inventor transferred his patents to, and received royalty payments from, a corporation in which he owned a 25 percent interest. The remainder of the corporation was owned by friends. The Tax Court was asked to determine whether the patent inventor's control over an unrelated corporate transferee defeats capital gain treatment. The court concluded that the substance of the transaction rather than its form controlled and, thus, the taxpayer's control over the unrelated corporate transferee defeated capital gain treatment. As a result, the income the inventor received was all ordinary income.

Observation: The story in Cooper is a cautionary tale for taxpayers. While a taxpayer can meet all the criteria laid out by the Code to obtain favorable tax treatment, the IRS and courts can look beyond the formalities to the substance of the transaction. In this case, the substance of the transactions was that the owner of many patents transferred the patents to a corporation that he indirectly controlled through friends in an effort to have ordinary income from his patents recharacterized as capital gain. The outcome in this case could have broad implications for other situations where taxpayers try to get around related-party rules by using friends or acquaintances.

Facts

James Cooper is an engineer and the inventor of numerous patents. His patents are primarily for products and components used in the transmission of audio and video signals. In 1983, James and his wife, Lorelei, incorporated Pixel Corporation for the purpose of designing and manufacturing audio and video signal processing products. James and Lorelei also incorporated Technology Licensing Corp. (TLC) with Lois Walters, Lorelei's sister, and Janet Coulter, a long-time friend of Lorelei and her sister. TLC was incorporated by the Coopers to engage in patent licensing and patent commercialization.  

The Coopers chose Lois and Janet as additional shareholders in TLC because they wanted TLC to have the "aura" of a fully operating licensing corporation but also wanted people James could trust to be the shareholders, officers, and directors of TLC. The Coopers had hired an attorney to provide advice on forming TLC. Among other things, the attorney advised the Coopers on the requirements of Code Sec. 1235 and how to qualify the royalty payments to James from TLC as capital gain. The attorney advised the Coopers that (1) they could not control TLC directly or indirectly and (2) their stock ownership in TLC had to be less than 25 percent of the total outstanding stock. The Coopers owned 24 percent of the TLC stock and Lois and Janet each contributed $3,800 for a 38 percent ownership of TLC. Lois and Janet also acted as officers and directors of TLC.

In 1997, James and Pixel entered into agreements with TLC purportedly transferring all of James and Pixel's rights in the patents (subject patents) to TLC. Under each TLC agreement, the licensor (i.e., James or Pixel) would receive 40 percent of all gross proceeds received by TLC for any sublicense and 40 percent of all damages received in litigation or settlement of litigation. The licensor then would receive 90 percent of all remaining net proceeds as defined in the TLC agreements.

The amount of the royalties paid each year to James was determined under the TLC agreements by accountants hired by TLC. Neither Lois nor Janet, who were the majority shareholders as well as officers and directors, reviewed and verified the amount of royalties paid to James each year. Similarly, neither Lois nor Janet negotiated the terms of TLC's agreements to license the patents to other companies. Instead, they relied on TLC's attorneys and James' technical expertise with regard to TLC's licensing activities. For 2006 2008, Lois and Janet's duties as directors and officers consisted largely of signing checks and transferring funds as directed by TLC's accountants and signing agreements as directed by TLC's attorneys. The only compensation Lois and Janet received from TLC were director's fees paid during some years and long-term care insurance policies purchased by TLC. TLC had no employees and paid no compensation to anyone.

The Coopers jointly filed Forms 1040 for years 2006 through 2008 and reported the royalty payments James received from TLC as capital gain on Schedules D, Capital Gains and Losses, attached to their Forms 1040. The amounts of royalty payments that the Coopers reported for 2006, 2007, and 2008 were $3,248,886, $1,933,010, and $1,597,450, respectively. The IRS issued a notice of deficiency determining that the royalties James received from TLC did not qualify for capital gain treatment under Code Sec. 1235 because James controlled TLC. The Coopers took their case to the Tax Court.

Recharacterizing Ordinary Income as Capital Gain under Code Section 1235

Code Sec. 1235(a) provides that a transfer (other than by gift, inheritance, or devise) of all substantial rights to a patent by any holder is treated as the sale or exchange of a capital asset held for more than one year, regardless of whether the payments are contingent on the productivity, use, or disposition of the property transferred. Thus, for the transfer of a patent to qualify as a sale or exchange, the owner must transfer "all substantial rights" to the property.

Generally, the term "all substantial rights" means all rights that are of value at the time the rights are transferred. The retention of the right to terminate the transfer at will is the retention of a substantial right.Under Code Sec. 1235(d), transfers between related persons, as defined in Code Sec. 267(b), are not eligible for capital gain treatment. Under Code Sec. 1235(d), a corporation and an individual owning 25 percent or more of the stock of such corporation directly or indirectly are related persons. Under Reg. Sec. 1.1235-2(b)(4), the retention of a right to terminate the transfer at will is the retention of a substantial right for the purposes of Code Sec. 1235.

IRS Arguments

Arguing before the Tax Court, the IRS did not dispute that (1) the transfer of the patents to TLC under the TLC agreements was other than by gift, inheritance, or devise; (2) James qualified as a holder of the subject patents; and (3) the Coopers owned less than 25 percent of TLC for purposes of Code Sec. 1235(d). However, the IRS argued that, under Reg. Sec. 1.1235-2(b)(4), James effectively retained a right to terminate the transfers under the TLC agreements because he indirectly controlled TLC through its directors, officers, and shareholders. Therefore, the IRS contended that James did not transfer all substantial rights in the subject patents and was not entitled to capital gain treatment.

Taxpayer Arguments

The Coopers argued that James did not control TLC and that the directors, officers, and shareholders of TLC acted independently of James in their corporate decision making. The Coopers relied on the facts regarding control in Lee v. U.S., 302 F. Supp. 945 (E.D. Wis. 1969), and Charlson to support their contention that the directors, officers, and shareholders of TLC acted independently of James in their corporate decision making and that they are entitled to capital gain treatment under Code Sec. 1235.

In Lee, the taxpayer transferred patents to a closely held corporation. The three shareholders of the corporation were unrelated but were all friends. The taxpayer owned 24 percent of the outstanding stock of the corporation. The IRS argued that the taxpayer had not transferred all substantial rights in his patents because he controlled the corporation the exclusive licensee of the patents and thus the taxpayer did not effectively transfer his patents under Code Sec. 1235. The district court rejected the IRS's contentions stating, among other things, that there was no evidence presented suggesting the taxpayer was able to force the other shareholders or directors to do his bidding.

In Charlson, the taxpayer transferred an exclusive license to a corporation to use, manufacture, and sell items incorporating his patents in exchange for 80 percent of the royalties that the corporation received from licensing the patents to others. The corporation was formed for the specific purpose of purchasing and licensing the taxpayer's patents, and the shareholders and directors of the corporation were all trusted business associates, friends, and employees of the taxpayer. The taxpayer treated the royalties he received from the corporation as capital gain under Code Sec. 1235. The IRS argued that the taxpayer had not transferred all substantial rights in the patents to the corporation because he controlled the corporation.

The Court of Claims in Charlson examined the legislative history of Code Sec. 1235 and found it was clear that the retention of control by a holder over an unrelated corporation can defeat capital gains treatment if the retention prevents the transfer of all substantial rights. The court supported its conclusion by reasoning that the holder's control over the unrelated corporation "places him in essentially the same position as if all substantial rights had not been transferred." The court found further support for its reasoning in the legislative history of Code Sec. 1235, advising that a court should closely examine all of the facts and circumstances of transactions under Code Sec. 1235 and not rely solely on the terms of the transfer agreement to determine whether a patent owner transferred substantially all rights in a patent to a transferee.

The court in Charlson found that although the relationships among the taxpayer, the corporation, and the shareholders made more probable the existence of prohibited retained control, the evidence did not establish that the taxpayer was able to exercise such control over the corporation. Instead, the court found that corporation exercised its rights in the patents according to its own discretion even though it frequently sought, received, and followed the taxpayer's advice.

Tax Court's Analysis

The Tax Court began it analysis by noting that the issue of whether Code Sec. 1235 applies to transfers to a corporation not related to the holder but indirectly controlled by the holder is not addressed in either the Code or regulations. Thus, the issue was one of first impression for the Tax Court. The court did observe, however, that the question had arisen in the Charlson case and, although the court ultimately sided with the taxpayers, the court had concluded that such control could prohibit the transfer of substantially all rights in a patent and therefore preclude capital gain treatment under Code Sec. 1235.

The Tax Court agreed with the Charlson court that retention of control places the holder in essentially the same position as if the patent had not been transferred, thereby precluding the application of Code Sec. 1235. The court further agreed that Congress intended for a transferor's acts to speak louder than his words in establishing whether a sale of a patent has occurred. Accordingly, the Tax Court held that retention of control by a holder over an unrelated corporation can defeat capital gain treatment under Code Sec. 1235 because the retention prevents the transfer of all substantial rights in the patent.

In support of its conclusion that James retained control, the Tax Court noted that, as officers and directors of TLC, Lori and Janet took numerous actions that were inconsistent with acting independently and in the best interest of the corporation. Among other things, they approved TLC's transfer of potentially valuable patents to James for no consideration. At least in one instance, James almost immediately licensed one of these patents to another corporation related to James for which that corporation received a royalty of $120,000. As shareholders, Lori and Janet signed a stock restriction agreement placing restrictions on their ability to transfer shares of stock in TLC to anyone other than the Coopers, without receiving any consideration in exchange. The stock restriction agreement did not place similar restrictions on the Coopers. Indeed, the court said, it was unclear what material decisions, if any, the officers and directors of TLC made independent of James. Accordingly, the Tax Court concluded that such control by James existed and, thus, James was not entitled to capital gain treatment on his royalty income.

Practice Tip: Thus, for individual contemplating transferring patents to a corporation in which friends and acquaintances are shareholders and officers, there must be documentation that those shareholders and officers are able to act independently, have a say in the business, and are appropriately compensated.

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Tax Court Mostly Agrees with Taxpayer on Research Credit; Appropriate Compensation Is Issue of First Impression

The research tax credit was added to the Code in 1981 as a temporary provision at a time when research and development jobs were significantly declining in the United States. It has proved extremely popular and is generally included in the annual "Tax Extenders" bill that is often signed into law by the President near the end of the calendar year. It was most recently extended for a two-year period by The American Taxpayer Relief Act of 2012, resulting in it being retroactively reinstated to cover calendar year 2012 and prospectively extended to cover calendar year 2013. However, as a result of Congressional gridlock, it has yet to be extended to 2014, although most experts expect that it will because both political parties view it as a highly valuable business tax incentive. Thus, the recent Tax Court decision in Suder v. Comm'r, T.C. Memo. 2014-201 (10/1/14), is relevant for businesses that are, or may be, engaged in research activities for which they intend to take the research tax credit.

In Suder, the IRS disallowed a company's research tax credits in full, unsuccessfully arguing on numerous fronts that the company did not qualify for the credits. However, in an issue of first impression, the Tax Court did find that part of the CEO's compensation used to calculate the research tax credits was unreasonable under Code Sec. 174(e). This is a departure from most reasonable compensation cases, as the decision on whether compensation is reasonable is generally determined under Code Sec. 162. The Suder case provides a roadmap for taxpayers calculating the research tax credit (RTC) by showing what the Tax Court will look for in deciding if a taxpayer's activities qualify for the credit and what the court considers in determining if compensation is reasonable for purposes of calculating qualified research expenditures (QREs).

Practice Tip: In this case, the CEO's wages were based on the company's growth, overall value, and cashflow. In other words, they were based on the success of the company's business. The court in Suder noted that, while the compensation might be reasonable from a business standpoint, the test of reasonableness is different for purposes of Code Sec. 174(e). Thus, a compensation deduction may be reasonable under Code Sec. 162 for calculating a company's taxable income, but practitioners may need to adjust such compensation when calculating that same company's research tax credit.

Facts

Eric Suder worked for Candela Corporation until it went out of business. Eric then started a company out of his garage called Estech Systems, Inc. (ESI), through which he designed telephone systems for small and midsize businesses. ESI was incorporated as an S corporation and Eric owned 90 percent of the corporation. Doug, an ESI employee, owned the other 10 percent. Under Eric's leadership, ESI went into the business of designing telephone systems for small and midsize businesses. By 2004, Eric had grown ESI into a company with approximately 125 employees, including a team of roughly 40 engineers, and gross revenues of approximately $38.5 million.

For tax years 2004 through 2007, ESI filed a Form 1120S in which it claimed a credit for increasing research activities under Code Sec. 41. In addition to owning 90 percent of ESI, Eric was also its CEO and most compensated employee. Eric claimed flow-through research tax credits of approximately $450,000 for each year from 2004 through 2007 on his Forms 1040. In computing the credits, Eric claimed QREs for 76 projects. Most of ESI's QREs were attributable to Eric's wages. In 2009, the IRS issued Eric a notice of deficiency disallowing the research tax credits in full and assessing accuracy-related penalties. Eric took the case to the Tax Court.

The threshold question before the Tax Court was whether the activities for which the credits were taken constituted "qualified research" within the meaning of Code Sec. 41(d). Eric and the IRS stipulated 12 of the 76 projects as being a representative sample for purposes of determining whether ESI's employees performed qualified research during the years at issue.

Calculation of Research Tax Credits

Eric's entitlement to the research tax credits turned on whether ESI incurred QREs during the years at issue. QREs are defined in Code Sec. 41(b)(1) as the sum of a taxpayer's in-house research expenses and contract research expenses. Under Code Sec. 41(b)(2), in-house research expenses include wages paid or incurred in relation to an employee for qualified services performed by the employee and the amounts paid or incurred for supplies used in the conduct of qualified research. Qualified services means services consisting of engaging in qualified research or engaging in the direct supervision or direct support of research activities that constitute qualified research. Under Code Sec. 41(b)(3), contract research expenses are equal to 65 percent of the amounts paid or incurred by the taxpayer to a person other than an employee of the taxpayer for qualified research. Therefore, to be eligible for research tax credits, Eric had to prove that ESI performed qualified research, or paid someone else to perform qualified research, during the years at issue.

Qualified research is research that satisfies four tests listed in Code Sec. 41(d)(1). First, expenditures connected with the research must be eligible for treatment as expenses under Code Sec. 174 (the Section 174 test). Second, the research must be undertaken for the purpose of discovering technological information (the technological information test). Third, the taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Fourth, substantially all the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test).

The above tests are applied separately to each business component. A "business component" is defined as a product, process, computer software, technique, formula, or invention that the taxpayer holds for sale, lease, or license or uses in its trade or business.

Under Code Sec. 174(e), a taxpayer may deduct a research and development expenditure only to the extent the amount is reasonable under the circumstances. Under Reg. Sec. 1.174-2(a)(6), the amount of an expenditure is reasonable if it would ordinarily be paid by similar enterprises for similar activities under similar circumstances.

Allocation of Qualified Services

In 2003, ESI hired Alliantgroup, LP, to perform a research and development tax credit study (R&D study) for 1999 to 2002. As part of the R&D study, Alliantgroup created a spreadsheet listing the employees at ESI that performed qualified services, the employees' titles, the percentage of time that each employee spent performing qualified services, and the employees' wages reported on Forms W-2. Alliantgroup looked at the roles and responsibilities of each employee and consulted with senior management in making the percentage allocations.

Alliantgroup worked primarily with Mr. Wende, the senior vice president of product operations and product development. After working with Alliantgroup on the R&D study, Mr. Wende felt that he understood how to compute ESI's research tax credit going forward. For 2004-2007, each of the years at issue, Mr. Wende prepared a spreadsheet listing each employee that received an allocation of time spent on qualified services and his or her allocation. In determining an employee's allocation, Mr. Wende counted the time that the employee spent discussing ideas for new products, researching new products and features, writing specifications, designing new products, building prototypes, testing prototypes, repairing bugs and defects in prototypes, writing software, working on the alpha and beta tests, and doing similar activities. If the employee had worked at ESI in the prior year, Mr. Wende used the prior year's allocation as a starting point and considered whether the employee's role had changed since the prior year.

Mr. Wende believed that 80 percent would have been an appropriate allocation for Eric for 2004-2007 to reflect Eric's role as the creative genius behind product development at ESI. Unlike typical CEOs, Eric spent most of his time steering product development at ESI from the idea generation stage all the way through alpha testing. Eric did spend some time, though, working on the business aspects of ESI. And so, in a measure of conservatism, Mr. Wende decided to allocate 75 percent of Eric's time to qualified services. Mr. Wende gave ESI's engineers, product managers, and product testers 100 percent allocations for the most part. However, Mr. Wende did not count maintenance work as time spent on qualified services, and so he gave lower allocations to those employees that performed maintenance more than sporadically. Mr. Wende gave some employees at ESI small allocations, generally 5 percent or 10 percent, if they spent a small amount of time assisting with new product development. These employees generally had roles that did not directly relate to new product development, such as quality control or shipping and handling.

After Mr. Wende finished making his percentage allocations for ESI's employees, he provided his spreadsheet to ESI's accounting department, who then entered the employees' wages and totaled up the wages for qualified services. ESI reported wages for qualified services of $9,650,761 for 2004, $8,877,903 for 2005, $8,728,067 for 2006, and $11,994,452 for 2007 on Form 6765, Credit for Increasing Research Activities. Wages for qualified services accounted for more than 95 percent of the QREs that ESI reported for the years at issue.

The Parties' Arguments

Eric argued that ESI faced numerous technical uncertainties in building exponentially larger phone systems than it had ever attempted, adding innovative and improved software features, and incorporating the new and different technological hardware components needed to stay competitive. Every single one of these identified uncertainties, Eric said, was of a type specifically contemplated by Code Sec. 41 and thus eligible for the research tax credit.

The IRS argued that there was little evidence showing uncertainty regarding the capability, method, or appropriate design of the projects as of the beginning of ESI's product-development activities. According to the IRS, the evidence introduced by Eric showed ESI encountered uncertainty that was inherent in every large development effort, including uncertainty resulting from deadlines, lack of resources, unexpected delays, and human error.

The IRS did not dispute that the 12 projects satisfied the technological information test and the business component test. However, with respect to the process of experimentation test, the IRS argued that Eric showed that ESI chose among design alternatives by applying engineering know-how, publicly available knowledge, or by committee. These methods, the IRS said, are not processes of experimentation as required by Code Sec. 41.

Eric argued that ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved (1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, (2) testing these alternative in a scientific manner, (3) analyzing the results, (4) refining the initial hypothesis or discarding it for another if necessary, and (5) repeating the same, if necessary.

The IRS also argued that Mr. Wende lacked the tax or accounting educational background and experience to make accurate wage QRE percentage allocations and challenged Eric's salary as being unreasonable under Code Sec. 174(e).

Tax Court's Analysis

The Tax Court held that 11 of the 12 projects satisfied the four-part test for qualified research. With respect to the first test (i.e., the Section 174 test), the court agreed with Eric that uncertainties as to capability, method, or appropriate design were present in all 12 projects. Each of the 12 projects began as an idea to develop a new hardware product, software product, or both. Senior management vetted the ideas in the senior product strategy meetings and follow-up meetings and ESI's product managers, engineers, technicians, and other employees then transformed the ideas into commercially ready products. Neither senior management nor anyone else at ESI, the court noted, had information detailing the exact steps to create the products or their ultimate design. Moreover, the Tax Court observed, because the products were all proprietary, publicly available information of that type did not exist.

With respect to the process of experimentation test, the Tax Court rejected the IRS's argument that publicly available knowledge describing the appropriate design of the products existed. Many of ESI's engineers came from well respected companies, the court noted, and brought with them a great deal of knowledge which they applied, along with their institutional knowledge of ESI, in the design of new products. According to the court, neither Code Sec. 41 nor the regulations require taxpayers to "reinvent the wheel." The court concluded that 80 percent or more of the activities with respect to each of the 12 projects constituted elements of a process of experimentation. However, the court concluded that only 11 of the 12 projects were undertaken for a qualified purpose. The court noted one of the projects was undertaken to change the look and feel of the user interface, and thus did not qualify for the research tax credit.

The court also found Mr. Wende's percentage allocations were a reasonable estimate of the percentages of time ESI's employees spent performing qualified services for 2004-07. The court found that because Mr. Wende worked closely with Alliantgroup on the R&D study, he had learned a great deal from that experience and had sufficient knowledge of the Code Sec. 41 research tax credit to make appropriate percentage allocations.

With respect to evaluating the reasonableness of Eric's compensation for purposes of including it in the QREs for 2004-2007, the court stated the most important factor was how Eric's salary compared to CEOs performing similar services in similar companies. Both Eric and the IRS called experts to testify, but the court found Eric's expert to be more credible and agreed that it was appropriate to compensate Eric in the 90th percentile of CEOs for the years at issue. However, the court also looked at other factors. While Eric continued driving product development during the years at issue, the court noted that he was semiretired by 2004 and worked an average of only 20 to 30 hours per week at ESI. Eric's other time was devoted to nonprofits in the Dallas area that were unaffiliated with ESI. According to the court, Eric's part-time work schedule at ESI raised doubt as to the reasonableness of his compensation. The court looked at Eric's wages in comparison to ESI's ordinary business income and found that Eric's wages were approximately 4 and 1/2 times, 6 times, 5 and 1/2 times, and 5 and 1/2 times ESI's ordinary business income for years 2004-2007, respectively.  

According to the court, Eric's high compensation relative to ESI's income suggested that his compensation was, at least in part, unreasonable. In addition, the court observed that Eric's wages were significantly higher in 2004-2007 than they had been in prior years, notwithstanding the fact that he was not named as an inventor on any new patent applications filed from 2004 to 2007. As a result, the court reduced Eric's compensation for purposes of calculating the research tax credit.

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IRS Issues Guidance on Allocation of After-Tax Amounts to Rollovers

This IRS has issued rules for allocating pre-tax and after-tax amounts among disbursements that are made to multiple destinations from a Code Sec. 401(a) qualified plan, a 403(b) plan, or a governmental 457(b) plan. Notice 2014-54 (9/18/14); REG-105739-11 (9/19/14).

Subject to certain exceptions, if any portion of an eligible rollover distribution paid to an employee from a qualified plan trust is transferred to an eligible retirement plan (including an IRA), the transferred portion is not taxable in the year paid. Generally, the maximum amount that may be rolled over is the portion of the distribution that would otherwise be includible in gross income.  

However, a participant can roll over even the nontaxable portion if the rollover is made:

(1) through a direct trustee-to-trustee transfer to a qualified plan trust or to a 403(b) annuity contract and the trust or contract provides for separate accounting for the amounts transferred (and earnings), including separately accounting for the portion of the distribution that is includible in gross income and the portion that is not includible, or  

(2) to an IRA. In either of these cases, the amount transferred is treated as consisting first of the portion of the distribution that would otherwise be includible in gross income.

Under Code Sec. 402A, an applicable retirement plan i.e., a qualified plan, a 403(b) plan, or a governmental 457(b) plan, may include a designated Roth account. A qualified distribution from a designated Roth account is not includible in gross income. Reg. Sec. 1.402A-1, Q&A-5(a) provides rules for a distribution from a designated Roth account that is rolled over. These rules provide in part that any amount paid in a direct rollover is treated as a separate distribution from any amount paid directly to the employee.

Notice 2014-54 provides rules for allocating pre-tax and after-tax amounts among disbursements that are made to multiple destinations. These allocation rules generally apply to distributions made on or after January 1, 2015. Under Notice 2014-54, in determining the portion of a disbursement of benefits from a plan that is not includible in gross income under the rules of Code Sec. 72, all disbursements of benefits from the plan to the recipient that are scheduled to be made at the same time (disregarding differences due to reasonable delays to facilitate plan administration) are treated as a single distribution regardless of whether the recipient has directed that the disbursements be made to a single destination or multiple destinations.

Practice Tip: If the pre-tax amount in aggregated disbursements that are treated as a single distribution is less than the amount of the distribution that is directly rolled over to one or more eligible retirement plans, the entire pre-tax amount is assigned to the amount of the distribution that is directly rolled over. In such a case, if the direct rollover is to two or more plans, then the recipient can select how the pre-tax amount is allocated among these plans by informing the plan administrator of the allocation before making the direct rollovers.

If the pre-tax amount in aggregated disbursements in a distribution equals or exceeds the amount of the distribution that is directly rolled over to one or more eligible retirement plans, the pre-tax amount is assigned to the portion of the distribution that is directly rolled over, up to the amount of the direct rollover (so that each direct rollover consists entirely of pre-tax amounts). Any remaining pre-tax amount is next assigned to any 60-day rollovers (i.e., rollovers that are not direct rollovers) up to the amount of the 60-day rollovers. If the remaining pretax amount is less than the amount rolled over in 60-day rollovers, the recipient can select how the pre-tax amount is allocated among the plans that receive 60-day rollovers. If, after assigning the pre-tax amount to direct rollovers and 60-day rollovers, there is a remaining pre-tax amount, that amount is includible in the distributee's gross income. If the amount rolled over to an eligible retirement plan exceeds the portion of the pre-tax amount assigned or allocated to the plan, the excess is an after-tax amount.

Along with Notice 2014-54, the IRS issued proposed regulations under Code Sec. 402A. Under the proposed regulations, the requirement in Reg. Sec. 1.402A-1, Q&A-5(a) (relating to distributions from designated Roth accounts) that "any amount paid in a direct rollover is treated as a separate distribution from any amount paid directly to the employee" would not apply to distributions made on or after the applicability date of final regulations, which is proposed to be January 1, 2015. However, taxpayers may apply the proposed regulations to distributions made before that date, so long as the distributions are made on or after September 18, 2014. For distributions from designated Roth accounts, the allocation rules of Notice 2014-54 will apply to distributions made on or after the applicability date.

For distributions made on or after September 18, 2014, but before the allocation rules of Notice 2014-54 apply, taxpayers may apply a reasonable interpretation of the last sentence of Code Sec. 402(c)(2) to allocate after-tax and pre-tax amounts among disbursements made to multiple destinations. The IRS also intends to update its safe harbor in Code Sec. 402(f) explanations to reflect this revised method for applying the last sentence of Code Sec. 402(c)(2).

For a discussion of rollovers of distributions from qualified plans, see Parker Tax ¶131,550.

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Divided Tax Court Holds That CSRS Did Not Accept Contribution as a Rollover

A taxpayer who used an IRA withdrawal to fund an increased annuity under the Civil Service Retirement System (CSRS) was subject to tax on the withdrawal because CSRS did not accept the taxpayer's contribution as a rollover. Bohner v. Comm'r, 143 T.C. No. 11 (9/23/14).

Dennis Bohner was a federal employee and participated in the Civil Service Retirement System (CSRS) during his years of government service. After he retired, the Office of Personnel Management (OPM) mailed him a letter dated April 13, 2010, explaining that he could increase his CSRS retirement annuity by sending $17,832 with respect to creditable government service for a period during which no retirement contributions had been withheld from his salary. The letter required that he deposit the funds within 15 days of the date of the letter. The letter was silent on whether the deposit could be made through a tax-free rollover contribution. Dennis elected to deposit the $17,832. Because he did not have enough funds to make the entire payment directly from his bank account, he borrowed a portion of the $17,832 from a friend. On April 27, 2010, Dennis mailed a check to OPM for $17,832.

During 2010, Dennis maintained a traditional IRA. He made two separate requests to withdraw funds from his IRA during 2010; a request for a $5,000 distribution, of which $4,500 was sent to him on April 15, 2010, and $500 was withheld to satisfy federal income tax liability in connection with the distribution; and a request for a $12,832 distribution, which was sent to him in full (with no withholding) on May 3, 2010. Dennis used the funds he received from his IRA to reimburse his friend and to replenish his bank account. The IRA custodian issued Dennis a Form 1099-R in which it reported $17,832 of distributions and listed the entire $17,832 as taxable income. On his 2010 Form 1040A, Dennis reported receiving the $17,832 of distributions from his IRA, but did not report any of the $17,832 as taxable income. The IRS issued Dennis a deficiency notice treating the $17,832 withdrawal from the IRA as taxable income.

CSRS is a retirement plan designed to provide retirement annuities to federal civil service employees. An eligible employee contributes portions of his or her salary to CSRS, and the employing agency withholds the contributions from the employee's salary. Matching contributions are made from funds appropriated for the employing agency. To make up for years for which no retirement contributions were withheld from a civil service employee's pay, CSRS includes a provision that allows the employee to elect to make a deposit for creditable government service and thus increase his or her CSRS retirement annuity.

In general, any amount paid or distributed out of an IRA is included in the taxpayer's gross income as provided in Code Sec. 72. However, this general rule does not apply to a rollover contribution. A rollover contribution is any amount paid or distributed out of an IRA to the individual for whose benefit the account or annuity is maintained if the entire amount received is paid into an eligible retirement plan no later than 60 days after receipt. An eligible retirement plan includes a qualified trust, which is defined as a tax-exempt employees' trust described in Code Sec. 401(a).

In the past, the IRS has taken the position that CSRS is a qualified trust, and the IRS did not dispute that CSRS is a qualified trust in this case. The IRS contended, however, that Dennis's deposit to CSRS did not constitute a rollover contribution under Code Sec. 408(d)(3) because CSRS does not, and is not required to, accept rollovers.

The Tax Court, in a divided decision, held that CSRS did not accept Dennis's deposit as a rollover and therefore, Dennis had to include his IRA withdrawals in income for 2010. The court noted that the letter OPM sent to Dennis after he retired, which explained how he could make a deposit to make up for years for which no retirement contributions were withheld from his pay, was silent on whether the deposit may be made as a rollover. The court also noted that the statutory rules governing CSRS do not specifically permit civil service employees to remit the deposit by means of a tax-free rollover contribution from an IRA or another eligible retirement plan. The related regulations likewise do not require CSRS to accept tax-free rollovers as a form of deposit. Further, deposited amounts take the place of after-tax contributions that were not originally made.

The court pointed out that this case involved an indirect transfer rather than a direct transfer from the IRA to CSRS. As such, CSRS was likely not aware that Dennis was attempting to make a tax-free rollover contribution, and there was nothing in the record to suggest that Dennis informed CSRS of his attempt to make a rollover. Unless it explicitly accepted rollovers, a qualified plan such as CSRS would not be aware of the proper tax treatment of the payment upon distribution. Thus, the majority of the court concluded that CSRS did not accept Dennis's deposit as a rollover.

Observation: Six judges dissented, taking the position that at least the first distribution should have qualified for rollover treatment.

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

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Final Regs Provide Safe Harbor for Local Lodging Expenses

The IRS has finalized regulations, which are effective October 1, 2014, relating to the deductibility of expenses for lodging when an individual is not traveling away from home (i.e., local lodging). T.D. 9696 (10/1/14).

Generally, local lodging expenses for an individual are personal, living, or family expenses that are nondeductible by the individual under Code Sec. 262(a). Depending on the facts and circumstances, however, local lodging expenses may be deductible under Code Sec. 162 as ordinary and necessary business expenses.

The IRS has issued final regulations that provide a safe harbor under which local lodging expenses meeting certain criteria are treated as ordinary and necessary business expenses of an individual. Local lodging expenses that meet either the facts-and-circumstances test or the safe-harbor requirements are deductible by an individual if incurred directly.

Alternatively, if the expenses are incurred by an employer on behalf of an employee, the value of the local lodging may be excludible from the income of the employee as a working condition fringe benefit under Code Secs. 132(a) and (d). If an employer reimburses an employee for local lodging expenses, the reimbursement may be excludible from the employee's gross income if the expense allowance arrangement satisfies the requirements of an accountable plan under Code Sec. 62(c) and the applicable regulations. In either case, the employer can deduct the expenses as ordinary and necessary business expenses.

Under the safe-harbor provision of the regulations, an individual's local lodging expenses are deductible as ordinary and necessary business expenses if: (1) the lodging is necessary for the individual to participate fully in or be available for business functions; (2) the lodging is for a maximum of five days and occurs no more than once per calendar quarter; (3) the individual's employer requires him or her to stay at the lodging overnight; and (4) the lodging is not lavish or extravagant and does not provide significant personal pleasure, recreation, or benefit.

Even if the lodging expenses fall out of the safe-harbor provision, they may still be deductible as ordinary and necessary business, depending on all the facts and circumstances surrounding the lodging expenses.

Example: ABC Company conducts a seven-day training session for its employees at a nearby hotel. The training is directly connected with ABC's trade or business. Some employees are traveling away from home and some employees are not traveling away from home. ABC requires all employees attending the training to remain at the hotel overnight for the bona fide purpose of facilitating the training. ABC pays the hotel costs directly to the hotel and does not treat those costs as employee compensation. Because the training is longer than five calendar days, the lodging safe-harbor rules do not apply. However, the value of the lodging is excludable from the employees' income if the facts and circumstances test is satisfied. In this example, the training is a bona fide condition or requirement of employment, and ABC has a noncompensatory business purpose for paying the lodging expenses. If the employees who are not traveling away from home had paid for their own lodging, the expenses would have been deductible as ordinary and necessary business expenses. Therefore, the value of the lodging is excluded from the employees' income as a working condition fringe, and ABC can deduct the lodging expenses, including lodging for employees who are not traveling away from home, as ordinary and necessary business expenses.

Example: XYZ Company, a professional sports team, requires its team to stay at a local hotel the night before a home game to conduct last-minute training and ensure the physical preparedness of the players. XYZ pays the lodging expenses directly to the hotel and does not treat the value as compensation to the employees. Because the overnight stays occur more than once per calendar quarter, the lodging safe-harbor rules do not apply. However, the value of the lodging may be excluded from income if the facts and circumstances test is satisfied. In this case, the overnight stays are a bona fide condition or requirement of employment, and XYZ has a noncompensatory business purpose for paying the lodging expenses. XYZ is not paying the lodging expenses primarily to provide a social or personal benefit to the team, and the lodging is not lavish or extravagant. If the team members had paid for their own lodging, the expenses would have been deductible as ordinary and necessary business expenses. Therefore, the value of the lodging is excluded from the team members' income as a working condition fringe, and XYZ can deduct the lodging expenses as ordinary and necessary business expenses.

For a discussion of the tax treatment of lodging expenses, see Parker Tax ¶123,510.

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ACA Challenges Continue with Oklahoma Court Invalidating Section 36B Regs

Adding to the tumult surrounding the survival of "Obamacare," a federal court in Oklahoma struck down the IRS regulation interpreting the Affordable Care Act (ACA) as permitting premium subsidies in states with federally established health care Exchanges. Oklahoma v. Burwell, 2014 PTC 515 (E.D. Okla. 9/30/14).

The state of Oklahoma challenged the Patient Protection and Affordable Care and Act (ACA) on the grounds that the use of the word "Exchange" in Reg. Sec. 1.36B-2 is contrary to Code Sec. 36B. Two other federal courts, the D.C. Circuit and the Fourth Circuit, have ruled on this very issue, but taking opposing positions. Read more...

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Dual Resident Can't Informally Abandon U.S. Resident Status and Escape Tax on Stock Sale

The Tax Court rejected a taxpayer's claim that he was not subject to tax on a sale of U.S. corporate stock because he became a German resident and a U.S. nonresident alien when he "informally" abandoned his status as a lawful permanent resident; the taxpayer was subject to tax on the stock sale under the U.S. - Germany Treaty. Topsnik v. Comm'r, 143 T.C. No. 12 (9/23/14).

In 2004, Gerd Topsnik, a German citizen, made an installment sale of his stock in a U.S. corporation, and he received payments in 2004 through 2009 pursuant to a promissory note executed in connection with the sale. A large down payment was transferred in 2004 along with four smaller equal monthly payments, which continued throughout 2005 and 2009. Gerd filed U.S. individual income tax returns for 2004 and 2005 on which he erroneously reported identical portions of the gain. He did not file U.S. returns for 2006 through 2009.

The IRS challenged Gerd's installment sale reporting for 2004 and 2005 and filed substitutes for returns for 2006 through 2009 on which it included in Gerd's income appropriate portions of Gerd's installment sale gain. According to the IRS, Gerd was liable for income tax deficiencies for 2004 and 2006 through 2009, almost entirely attributable to the gain on his installment sale of stock, and various penalties for 2004 through 2009, all of which were included in a jeopardy assessment under which the IRS levied on the installment payments in partial satisfaction of Gerd's tax liabilities.

Gerd argued that, during the years in issue, he was a German resident and a U.S. nonresident alien because he "informally" abandoned his status as a lawful permanent resident (LPR) in 2003 when he sold his home in Hawaii and allegedly moved back to Germany. Therefore, he said, he was not subject to U.S. tax pursuant to Articles 4 and 13 of the U.S.-Germany Income Tax Treaty.

In support of his argument that an individual may informally abandon resident alien status, Gerd cited U.S. v. Yakou, 428 F.3d 241 (D.C. Cir. 2005). In Yakou, the court concluded that LPR status turned on immigration law. In the case, a taxpayer under investigation by federal agents, left his home in California in 1993, lived in London until 1998, and then returned to his native Baghdad where he lived and worked thereafter, making occasional trips of short duration to the United States to visit his family. He was subsequently arrested and charged with engaging in brokering activities in violation of the Arms Export Control Act and the International Traffic in Arms Regulations (ITAR). He never formally renounced his LPR status by filing Form I-407 with the immigration authorities, and the Board of Immigration Appeals (BIA) had not adjudged that his LPR status had changed. After noting that the controlling statutes and the ITAR were all silent regarding the manner and the point at which LPR status changes, the court looked to decisions of the BIA for guidance. The court and found numerous BIA decisions express in dicta the BIA's view that LPR status can change outside the formal adjudicatory process associated with removal.

Gerd also alleged that, because the IRS moved to dismiss a 2011 district court suit by Gerd to review the IRS's jeopardy assessments and levies encompassing the years in issue, in part, for lack of venue on the ground that Gerd was a resident of Germany, the IRS was now precluded from arguing that Gerd was not a German resident during the years in issue.

In response, the IRS argued that (1) because Gerd did not formally abandon his LPR status (obtained in 1977) until 2010, he remained an LPR during the years in issue, and (2) because he was not taxable by Germany as a German resident during those years, he was not a German resident under Article 4 of the Treaty. Therefore, he was not exempted from U.S. tax by the Treaty.

The Tax Court held that LPR status for federal income tax purposes turns on federal income tax law and is only indirectly determined by immigration law. The court held further that because Gerd did not formally abandon his LPR status as explicitly required by Code Sec. 7701(b)(6)(B) and Reg. Sec. 301.7701(b)-1(b)(1) and (3) until 2010, he remained an LPR during the years in issue, taxable by the United States on his worldwide income, including the gain on his 2004 installment sale of stock. Further, because Gerd was not subject to German tax as a German resident during the years in issue, he was not a German resident pursuant to the Treaty and, therefore, is not exempted by the Treaty from U.S. tax during those years. As a U.S. resident, the Tax Court held that Gerd was subject to U.S. tax under the Treaty on his gain recognized during the years in issue from his 2004 installment sale of the U.S. corporation stock.

With respect to the prior district court litigation, the court noted that such litigation only concerned Gerd's status as a German resident for a year after the years in issue. Thus, the Tax Court concluded, the IRS was not precluded from asserting that Gerd was not a German resident under the treaty during the years in issue. Finally, the Tax Court upheld the penalties but required that the 2004 penalty be recalculated.

For a discussion of who qualifies as a resident alien, see Parker Tax ¶220,110.

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Tax Court Holds That Distinguished Artist's Work Was Not a Hobby

The taxpayer's work as an artist was not a hobby and, thus, the losses from her artist business were not limited by the hobby loss rules; however, the court left for another day a decision on whether the taxpayer's expenses were deductible as ordinary and necessary business expenses. Crile v. Comm'r, T.C. Memo. 2014-202 (10/2/14).

Susan Crile has had a long, varied, and distinguished career as an artist. She has worked for more than 40 years in media that include oil, acrylic, charcoal, pastels, printmaking, lithograph, woodcut, and silkscreen. Her artwork hangs in the permanent collections of at least 25 museums including the Metropolitan Museum of Art, the Guggenheim Museum, the Brooklyn Museum of Art, the Phillips Collection, the Hirshhorn Museum, and art museums at eight colleges and universities. Many prominent corporations, law firms, and government entities have purchased her artwork as well. She is also a full-time tenured professor of studio art at Hunter College in New York City.

During the years at issue, 2004-2009, Susan actively marketed her artwork and was represented by galleries. She supplemented the galleries' efforts by sending exhibition announcements and other promotional materials to her mailing list of nearly 3,000 collectors. She regularly attended art-related events to network with collectors, journalists, and art professionals. She sold, directly or through galleries, a total of 356 works of art during 1971-2013. These sales generated gross proceeds of approximately $1,197,150. After subtracting gallery commissions and other deductions, Susan earned income of approximately $668,000 from sales of her art during these years. Despite substantial gross receipts, Susan has never reported a net profit from her art business.

For tax years 2004-2009, Susan reported wage income between $86,000 and $106,000, and she reported other taxable income (interest, dividends, capital gains, pensions, and social security payments) between $17,700 and $67,000. On her Schedules C, she reported income and claimed the expenses as deductions in connection with her activity as an artist during the years at issue, including expenses for travel, meals, entertainment, mortgage and utilities.

The IRS assessed a deficiency against Susan for years 2004-2009. First, the IRS determined that Susan's activity as an artist was an activity not engaged in for profit within the meaning of Code Sec. 183 and hence, she was not entitled to claim deductions in excess of the income she derived from her artist activity. Second, if Susan was engaged in a trade or business during the years at issue, the IRS contended that many of the deductions she claimed were not ordinary and necessary expenses incurred in carrying on that business.

The Tax Court rejected the IRS's argument that Susan's work as an artist was a hobby and held that that she was engaged in the trade or business of being an artist. In reaching its conclusion, the court evaluated the nine factors in Reg. Sec. 1.183-2(b) that are relevant in ascertaining whether a taxpayer conducted an activity with the intent to earn a profit. According to the court: (1) Susan's marketing efforts demonstrated a profit objective and showed that she conducted her art activity in a business-like manner; (2) Susan was without doubt an expert artist who understood the economics of her business; (3) because Susan devoted roughly 30 hours per week to her art business during the academic year and worked on her art full time during the summer, she devoted substantial time and effort to her art business; (4) Susan entertained a reasonable expectation that her artwork, over the course of her career, would appreciate significantly in value, and this expectation explained her willingness to continue to sustain operating losses; (5) as far as Susan's success in other activities, the court found that factor to be of limited relevance but, to the extent it was relevant, it favored Susan; (6) Susan's history of losses favored the IRS's position although the court was convinced that such losses did not negate Susan's actual and honest intent to profit from the sale of her art; (7) Susan's minimal profits weighed in the IRS's favor but not terribly heavily; (8) with respect to the factor of Susan's financial status and whether she lacked substantial income or capital from other sources than artist activity, the court said this factor was neutral; and (9) Susan's enjoyment of her art activity was not sufficient to cause it to be classified as a hobby rather than a business.

The Tax Court did not address the IRS's second argument, saying the IRS's contentions concerning the substantiation of Susan's expenses, the character of those expenses as ordinary and necessary, and her liability for penalties and additions to tax would be resolved later.

For a discussion of the hobby loss rules and the factors a court will consider in determining if an activity is a hobby, see Parker Tax ¶97,505.

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IRS e-File Systems Will Be Down for Maintenance October 11th - 14th

IRS e-File system will be down right before the October 15, 2014, filing deadlines. IRS website (9/30/14).

On September 30, the IRS announced that it will conduct its annual Columbus Day power outage beginning Saturday, October 11, 2014, at 3:00 p.m. and ending on Tuesday, October 14, 2014 at 5:00 a.m.

Practitioners will not be able to access the Modernized e-File (MeF) Systems during this time. The shutdown will begin on Saturday, October 11, 2014, at 3:00 p.m. and end at 5:00 a.m. on Tuesday, October 14, 2014.

The IRS noted that states that schedule retrieval of their state submissions may have to change their schedule in order to retrieve submissions in time to validate returns and submit acknowledgements by 2:30 p.m. on October 11, 2014. Anything not retrieved through MeF by 3:00 p.m. cannot be accessed again until MeF re-opens for production on Tuesday, October 14, 2014.

With respect to this maintenance, the IRS listed the following Saturday, October 11 deadlines for transmissions: (1) 1:00 p.m. for transmitting submissions (state and federal) and (2) 3:00 p.m. for retrieving acknowledgements. The deadline on Saturday, October 11 for states transmitting acknowledgements is 2:30 p.m.

The IRS recommends that practitioners monitor the MeF status on the IRS website for any changes.

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IRS Simplifies Reporting of Canadian Retirement Plans; Eliminates Form 8891

A new revenue procedure makes it easier for taxpayers who hold interests in certain Canadian retirement plans to get favorable U.S. tax treatment. Rev. Proc. 2014-55 (10/7/14).

On October 7, 2014, the IRS made it easier for taxpayers who hold interests in certain popular Canadian retirement plans to get favorable U.S. tax treatment. As a result of the change, many Americans and Canadians with either registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) now automatically qualify for tax deferral similar to that available to participants in U.S. individual retirement accounts (IRAs) and 401(k) plans. In addition, the IRS is eliminating a special annual reporting requirement that has long applied to taxpayers with these retirement plans.

Practice Tip: In general, U.S. citizens and resident aliens will qualify for this special treatment as long as they have filed and continue to file U.S. income tax returns for any year they held an interest in an RRSP or RRIF and include any distributions as income on their U.S. returns.

Under a longstanding provision in the U.S.-Canada Tax Treaty, U.S. citizens and resident aliens can defer tax on income accruing in their RRSP or RRIF until it is distributed. Otherwise, U.S. tax is due each year on this income, even if it is not distributed. In the past, however, taxpayers generally were required to elect-in to get tax deferral by attaching Form 8891 to their return and choosing this tax treaty benefit, something many eligible taxpayers failed to do. Before Tuesday's change, a primary way to correct this omission and retroactively obtain the treaty benefit was to request a private letter ruling from the IRS, a costly and often time-consuming process.

Many taxpayers with an interest in a RRSP or RRIF also failed to comply with a reporting requirement; taxpayers must yearly file Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans, reporting details about each RRSP and RRIF, including contributions made, income earned and distributions made. This requirement applied regardless of whether the taxpayer chose the special tax treatment. In Rev. Proc. 2014-55, the IRS said it is eliminating Form 8891, and taxpayers are no longer required to file this form for any year, past or present.

Rev. Proc. 2014-55 does not modify any other U.S. reporting requirements that may apply under the Bank Secrecy Act (BSA) and Code Sec. 6038D.

For a discussion of the tax treatment of Canadian retirement plans and the Form 8891 requirement, see Parker Tax ¶131,515.