Federal Tax Bulletin - Issue 71 - September 12, 2014

Ninth Circuit Decision Substantially Unravels FedEx's Business Model; Drivers Aren't Independent Contractors

There is no shortage of cases dealing with the classification of workers as either employees or independent contractors. In certain occupations, employers typically seek to characterize a worker as an independent contractor in order to save money on employment taxes and benefits they would otherwise have to pay. However, if certain criteria are met, the IRS and courts will reclassify those workers as employees, leaving the company to pay back taxes and benefits. That is exactly what happened to a well-known package delivery company when it classified its drivers as independent contractors. In Alexander v. FedEx Ground Package System, Inc., 2014 PTC 451 (9th Cir. 8/27/14), the Ninth Circuit reversed a district court and held that FedEx's drivers were not independent contractors. The fact that FedEx's operating agreement with the drivers labeled the drivers as independent contractors did not make them so when viewed in the light of the entire agreement, the relevant policies and procedures, and state law.

Observation: The Ninth Circuit noted that its verdict essentially unravels FedEx's business model. However, the court said, FedEx was not entitled to "write around" the principles and mandates of state labor law by constructing a "brilliantly drafted" employment contract that created the constraints of an employment arrangement with the drivers in the guise of an independent contractor model. As a result of the employment contract, the court observed, FedEx not only had the right to control, but had close to absolute control over the drivers based on interpretation and obfuscation.

Background

As a central part of its business, FedEx contracts with drivers to deliver packages to its customers. The drivers must wear FedEx uniforms, drive FedEx-approved vehicles, and groom themselves according to FedEx's appearance standards. FedEx tells its drivers what packages to deliver, on what days, and at what times. Although drivers may operate multiple delivery routes and hire third parties to help them with their work, they may do so only with FedEx's consent.

FedEx contends its drivers are independent contractors under California law. Drivers for FedEx in California between 2000 and 2007 filed a class action suit arguing otherwise. Class members worked for FedEx's two operating divisions, FedEx Ground and FedEx Home Delivery. FedEx Ground deals primarily with business-to-business deliveries, while FedEx Home Delivery deals primarily with residential deliveries.

FedEx Operating Agreement with Drivers

FedEx drivers are required to sign an operating agreement when they are hired. One section of the agreement, titled "Background Statement," states: "[T]his Agreement will set forth the mutual business objectives of the two parties . . . but the manner and means of reaching these results are within the discretion of the [driver], and no officer or employee of FedEx . . . shall have the authority to impose any term or condition on [the driver]is contrary to this understanding." Another provision under a section titled "Discretion of Contractor to Determine Method and Means of Meeting Business Objectives," states: "[N]o officer, agent or employee of FedEx . . .shall have the authority to direct [the driver] as to the manner or means employed . . . . For example, no officer, agent or employee of FedEx . . . shall have the authority to prescribe hours of work, whether or when the [driver] is to take breaks, what route the [driver] is to follow, or other details of performance..."

FedEx Policies and Procedures

In addition to the operating agreement, FedEx's relationship with its drivers also is governed by various policies and procedures prescribed by FedEx. For example, FedEx drivers are required to pick up and deliver packages within their assigned primary service areas. Drivers must deliver packages every day that FedEx is open for business, and must deliver every package they are assigned each day. They must deliver each package within a specific window of time negotiated between FedEx and its customers. After each delivery, drivers must use an electronic scanner to send data about the delivery to FedEx. FedEx does not require drivers to follow specific delivery routes. However, FedEx tells its managers to design and recommend to its drivers routes that will reduce travel time and minimize expenses and maximize earnings and service.

While FedEx does not expressly dictate working hours, it structures drivers' workloads to ensure that they work between 9.5 and 11 hours every working day. If a driver's manager determines that the driver has more work than he or she can reasonably be expected to handle in a 9.5 to 11-hour day, the manager may reassign part of the driver's workload to other drivers. Drivers are paid according to a formula that includes per-day and per-stop components.

FedEx has the authority to reconfigure a driver's service area upon five days' written notice. Drivers have the right to propose a plan to avoid reconfiguration, using means satisfactory to FedEx. FedEx has the right to reject a driver's plan. Should a driver's service area be reconfigured in such a way that the driver gains customers, FedEx may reduce that driver's pay to compensate other drivers who lost customers in the reconfiguration.

A driver's managers may conduct up to four ride-along performance evaluations each year, to verify that the driver is meeting the standards of customer service required by the operating agreement. Managers are supposed to observe and record small details about each step of a delivery, including whether a driver uses a dolly or cart to move packages, demonstrates a "sense of urgency," and "[p]laces [his or her] keys on [the] pinky finger of [his or her] non-writing hand" after locking the delivery vehicle. After finishing a ride-along evaluation, managers are supposed to give immediate feedback to drivers about the quality of their work. According to FedEx, this feedback constitutes mere recommendations that drivers are free either to follow or disregard.

FedEx requires its drivers to provide their own vehicles. Vehicles must not only meet all applicable federal, state, and municipal laws and regulations, but also must be specifically approved by FedEx. The operating agreement allows FedEx to dictate the identifying colors, logos, numbers, marks, and insignia of the vehicles. All vehicles must be painted "FedEx white," a specific shade of Sherwin-Williams paint, or its equivalent. They must be marked with the FedEx logo, and be maintained in a clean and presentable fashion free of body damage and extraneous markings. FedEx requires vehicles to have specific dimensions, and all vehicles must also contain shelves with specific dimensions. Drivers must provide maintenance at their own expense and must bear all costs and expenses incidental to operation of the vehicle. Drivers authorize FedEx to pay for vehicle licensing, taxes, and fees, and to deduct these costs from the drivers' pay. The operating agreement requires drivers to comply with personal appearance standards and wear a FedEx uniform "maintained in good condition."

Employee Class Action Suit

A group of FedEx drivers originally filed a class action suit in a California court in December 2005 on behalf of a class of California FedEx drivers, asserting claims for employment expenses and unpaid wages under the California Labor Code on the ground that FedEx had improperly classified the drivers as independent contractors. The employees also brought claims under the federal Family and Medical Leave Act (FMLA), which similarly turns on the drivers' employment status.

Between 2003 and 2009, similar cases were filed against FedEx in approximately 40 states. The Judicial Panel on Multidistrict Litigation consolidated these FedEx cases for multidistrict litigation (MDL) proceedings in the District Court for the Northern District of Indiana (i.e., the MDL Court). The drivers moved for class certification. The MDL Court certified a class for the drivers' claims under California law. It declined to certify the employees' proposed national FMLA class.

FedEx's Argument: Entrepreneurial Opportunities

According to FedEx, its drivers' entrepreneurial opportunities, i.e., the ability to take on multiple routes and vehicles and to hire third-party helpers, were inconsistent with employee status. FedEx relied not on California law for this argument, but on the D.C. Circuit Court's decision in FedEx Home Delivery v. National Labor Relations Board, 563 F.3d 492 (D.C. Cir. 2009). In FedEx Home Delivery, a divided panel of the D.C. Circuit reversed an agency decision that FedEx drivers were employees. The majority shifted the emphasis away from the "unwieldy control inquiry," asking instead whether the putative independent contractors had significant entrepreneurial opportunity for gain or loss. It held that the evidence favoring a finding the drivers were employees was clearly outweighed by evidence of entrepreneurial opportunity.

Lower Court Decision

The MDL Court denied nearly all of the drivers' motions for summary judgment and granted nearly all of FedEx's motions. The MDL Court held that the drivers were independent contractors as a matter of law in each state where employment status is governed by common-law agency principles. The MDL Court remanded the case to the district court to resolve the drivers' claims under the FMLA. Those claims were settled, and the district court entered its final judgment. The drivers appealed.

Borello Decision

To reach its conclusion favoring FedEx, the MDL Court purportedly applied the common law test from S.G. Borello & Sons, Inc. v. Department of Industrial Relations, 769 P.2d 399 (Cal. 1989), but ultimately focused on the entrepreneurial opportunities FedEx afforded to the drivers. In S.G. Borello & Sons, a commercial produce grower (Borello), hired agricultural laborers under written sharefarmer agreements. The agreements recited that each laborer was deemed a principal and independent contractor rather than employer and employee. The sharefarmers agreed to harvest the crop, assisted by members of their families. They could contract for the amount of land they wished to harvest on a first-come, first-serve basis. The sharefarmers were totally responsible for the care of the plants in their assigned plots during the harvest period. They were required to furnish their own tools and their own transportation to and from the field. The method and manner of accomplishing the harvest, according to the agreement, was left solely to the sharefarmers, though they agreed to use accepted agricultural practices in order to provide for the maximum harvest. The sharefarmers set their own hours and were free to decide when to pick the crop in order to maximize the profit. Borello had no right to discharge a sharefarmer or his workers during the harvest, and no recourse if the harvesters abandoned the field. Although the sharefarmers had significant autonomy over the harvest itself, the California Supreme Court reasoned that Borello retained all necessary control over the harvest portion of its operations and held that the sharefarmers were employees as a matter of law.

In FedEx's case, the MDL Court concluded that, while the right to control is a primary consideration in employment status, the right to control wasn't dispositive. What was dispositive, the court said, was the drivers' class-wide ability to own and operate distinct businesses, own multiple routes, and profit accordingly.

Ninth Circuit's Analysis

The Ninth Circuit agreed with the FedEx drivers. Reversing the lower court, the Ninth Circuit held that the drivers were employees as a matter of law. The court began its analysis by noting that the dispute was controlled by California law and that determinations of employment status under California law are governed by the multi-factor test set forth in S.G. Borello & Sons. Under California law, the principal test of an employment relationship is whether the person to whom service is rendered has the right to control the manner and means of accomplishing the result desired. Similarly, the right to terminate at will, without cause, is strong evidence in support of an employment relationship. Other important factors, the court noted, were (1) whether the one performing services is engaged in a distinct occupation or business; (2) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the principal or by a specialist without supervision; (3) the skill required in the particular occupation; (4) whether the principal or the worker supplies the instrumentalities, tools, and the place of work for the person doing the work; (5) the length of time for which the services are to be performed; (6) the method of payment, whether by the time or by the job; (7) whether or not the work is a part of the regular business of the principal; and (8) whether or not the parties believe they are creating the relationship of employer-employee.

With respect to the right to control the drivers, the Ninth Circuit found that FedEx's operating agreement and policies and procedures unambiguously allowed FedEx to exercise a great deal of control over the manner in which its drivers did their jobs. First, the court stated, FedEx can and does control the appearance of its drivers and their vehicles. FedEx controls its drivers' clothing from their hats down to their shoes and socks and requires drivers to paint their vehicles a specific shade of white, mark them with the distinctive FedEx logo, and to keep their vehicles clean and presentable and free of body damage and extraneous markings. These detailed requirements, the court said, clearly constitute control by FedEx over its drivers.

Second, the court noted, FedEx can and does control the times its drivers work. Although the operating agreement does not allow FedEx to set specific working hours down to the last minute, it was clear to the court that FedEx had a great deal of control over drivers' hours because it structures drivers' workloads so that they have to work 9.5 to 11 hours every working day. The court rejected FedEx's argument that, because drivers can hire helpers to do their work for them, they are free to complete a full day's work in less than 9.5 hours. The court noted that (1) managers can adjust drivers' workloads to ensure that they never have more or less work than can be done in 9.5 to 11 hours, (2) drivers can't leave their terminals in the morning until all of their packages are available, (3) drivers must return to the terminals no later than a specified time, and (4) if drivers want their vehicles loaded, they must leave them at the terminal overnight. The combined effect of these requirements, the court concluded, was to substantially define and constrain the hours that FedEx's drivers can work.

Third, the court said, FedEx can and does control aspects of how and when drivers deliver their packages because (1) it assigns each driver a specific service area, which it "may, in its sole discretion, reconfigure," (2) it tells drivers what packages they must deliver and when, and (3) it negotiates the delivery window for packages directly with its customers. The operating agreement, the court said, requires drivers to comply with "standards of service." With respect to FedEx's argument that there are details of its drivers' work that it does not control, the court said that the "right-to-control" test does not require absolute control. FedEx's lack of control over some parts of its drivers' jobs does not counteract the extensive control it does exercise, the court concluded.

The Ninth Circuit noted that in S.G. Borello & Sons, the California Supreme Court reasoned that a business entity may not avoid its statutory obligations by carving up its production process into minute steps, then asserting that it lacks control over the exact means by which one such step is performed by the responsible workers.

Finally, with respect to FedEx's reliance on the D.C. Circuit's decision in FedEx Home Delivery, the Ninth Circuit said that even if that decision was correct, it had no bearing on the instant case. There is no indication, the Ninth Circuit stated, that California had replaced its longstanding right-to-control test with the new entrepreneurial-opportunities test developed by the D.C. Circuit. Instead, the court said, California cases indicate that entrepreneurial opportunities do not undermine a finding of employee status.

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Supreme Court's Home Concrete Opinion Doesn't Affect Prior Tax Court "Gross Income" Decisions

Just two years ago, the Supreme Court clamped down on the number of years the IRS could go back and assess tax deficiencies. Its decision in U.S. v. Home Concrete & Supply, LLC, 2012 PTC 94 (S. Ct. 2012), was a big win for taxpayers because the Court limited the IRS to a three-year statute of limitations period, rather than the six-year statute of limitations, in situations where a taxpayer overstates the basis of property sold. In Barkett v. Comm'r, 143 T.C. No. 6 (8/28/14), the taxpayers hoped to capitalize on the Home Concrete decision, by arguing that it invalidated IRS regulations on the calculation of gross income for purposes of determining whether a taxpayer omitted more than 25 percent of gross income from its tax return, thus extending the limitations period to six years. Unfortunately for the taxpayers, the Tax Court held that earlier opinions where it considered this issue continued to apply and were not invalidated by the Home Concrete decision. As a result, proceeds from the taxpayers' sales of investments did not constitute "gross income." for purposes of determining whether the three- or six-year statute of limitations applied. By reducing the total gross income that went into the 25 percent calculation, the court affirmed that the taxpayers omitted more than 25 percent of gross income on their returns and were thus subject to the six-year statute of limitations period.

Background

Douglas Barkett and his wife, Rita, filed their 2006 and 2007 Forms 1040 on September 17, 2007, and October 2, 2008, respectively. The Barketts were 80.04 percent partners in Barkett Family Partners, a limited partnership. They were also 100 percent shareholders of Unicorn Investments, Inc., an S corporation. These entities reported extensive investment activity on their 2006 and 2007 returns, the gains and losses of which the Barketts then included on their returns. The Barketts reported capital gains from the sale of investments of approximately $123,000 for 2006 and $314,000 for 2007. They reported amounts realized from the sale of investments of more than $7 million for 2006 and more than $4 million for 2007.

The IRS sent the Barketts a notice of deficiency (NOD) on September 26, 2012, determining income tax deficiencies for 2006 to 2009. With respect to the Barketts' 2006 and 2007 returns, the IRS determined that gross income of approximately $630,000 and $432,000, respectively, was omitted. These amount represented additional gain on investments. On the original returns, the Barketts reported gross income totaling almost $272,000 and $341,000.

A dispute arose as to the correct limitation period that applied the three year limitations period or the six year limitations period. If the three-year limitations period applied, then the NOD was outside the limitations period. In determining which limitations period applied, the Barketts argued that the amounts they realized on the sales of the investments, not the gains on the sales, should be included in gross income stated on the return.

Statute of Limitations

Generally, under Code Sec. 6501(a), the IRS has three years after a taxpayer files a return to assess tax or send a notice of deficiency (NOD). The limitations period extends to six years under Code Sec. 6501(e)(1) if the taxpayer omits from gross income an amount properly includible in gross income and such amount is in excess of 25 percent of the amount of gross income stated in the return. The IRS issued the NOD to the Barketts more than three years but less than six years after they filed their 2006 and 2007 returns. In determining the appropriate limitations period, the omitted gross income is divided by the amount of gross income stated on the tax return. If the omitted gross income is more than 25 percent of the included amount, the six-year limitations period applies.

While the Barketts and the IRS agreed that the omitted income amounts were $630,000 and $432,000 for tax years 2006 and 2007, respectively, they disagreed over the amounts of gross income stated on those tax returns. According to the Barketts, the gross income stated in their returns should include the amounts realized from the sales of investment assets (i.e., gross proceeds on the sales). The IRS argued that gross income on the returns should include only the gain reported from those sales (i.e., amounts realized less bases of assets sold).

Observation: The larger the gross income reported on a tax return, the better chance a taxpayer has of not having omitted 25 percent of gross income and thus escaping the six-year statute of limitations period.

Supreme Court Decisions

In 1958, the Supreme Court was asked to decide what constituted omitted income for statute of limitations purposes. In Colony, Inc. v. Comm'r, 357 U.S. 28 (1958), the taxpayer had overstated the basis in property it had sold and had consequently underreported its gain on the sale. The IRS argued that the underreported gain constituted "omitted gross income" for the purpose of determining whether the extended statute of limitations period applied. The Supreme Court disagreed, citing legislative history. The Court determined that in enacting the statute extending the limitations period, Congress intended to give the IRS additional time to review a taxpayer's return when the taxpayer had reported no information about a given transaction. In such cases, the Court said, the IRS is particularly disadvantaged because the return does not alert the IRS to suspicious activity requiring further investigation. When an understatement results from misreported information, rather than a complete omission, the IRS is at no such disadvantage, and the understatement should not contribute to triggering an extension of the statute of limitations period.

In 2010, the IRS issued Reg. Sec. 301.6501(e)-1, which explained when gross income should be considered omitted for purposes of triggering the extended limitations period. Reg. Sec. 301.6501(e)-1(a)(1)(iii) provided that when taxpayers understate their income from a property sale because they overstated their basis in the property, the amount of the understatement is considered omitted income. The regulation directly conflicted with the Colony decision which held that such an understatement was not omitted gross income. In U.S. v. Home Concrete & Supply, LLC, 2012 PTC 94 (2012), the Supreme Court resolved the conflict by holding that the portion of the regulation concerning omitted gross income was invalid.

In Home Concrete, the taxpayer overstated its basis in a partnership it had sold and had consequently underreported its gain on the sale. The IRS again argued, this time under the regulation, that the underreported gain constituted "omitted gross income". The Court held that the regulation was invalid because it conflicted with the Colony holding. The Court followed its Colony analysis and held that the underreported gain was not omitted gross income and that it did not belong in the numerator of the statute of limitations calculation. The Home Concrete decision addressed only when gross income is considered omitted. It did not address how to calculate gross income.

Tax Court's Decision

The Tax Court sided with the IRS, noting that it has considered this issue before and concluded that capital gains, and not the gross proceeds, are treated as the amount of gross income stated in the return for purposes of Code Sec. 6501(e). The court cited its opinions in Insulglass Corp. v. Comm'r, 84 T.C. 203 (1985), and Schneider v. Comm'r, T.C. Memo. 1985-139. Those cases, the court observed, were decided on the basis of Code Sec. 61(a), which defines gross income as all income from whatever source derived, including gains derived from dealings in property.

With respect to Reg. Sec. 301.6501(e)-1, the Tax Court noted that the Supreme Court's Home Concrete decision only invalidated the portion of the regulation concerning omitted gross income. The Tax Court rejected the Barketts' argument that the Supreme Court also invalidated the regulation's instructions concerning the calculation of gross income and, thus, the prior Tax Court cases. The Tax Court also found support for its conclusion in a comment by the Supreme Court in Home Concrete, where the Court explained how to calculate income under the general statutory definition of "gross income."

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Obamacare Insurance Subsidy Case to be Reheard by Entire D.C. Circuit Court

On December 17, 2014, the entire panel of the D.C. Circuit Court will rehear the case involving the issue of whether Code Sec. 36B authorizes the IRS to provide tax credits for health insurance purchased on federal Exchanges. Halbig v. Burwell, 2014 PTC 456 (D.C. Cir. 9/4/14).

There have been a number of controversies brewing over the Affordable Care Act also known as "Obamacare." One of the biggest is whether the Code Sec. 36B premium assistance credit is available for insurance purchased through federal Exchanges. Code Sec. 36B includes language that could be interpreted as limiting the availability of the premium assistance credit to taxpayers who enroll in qualified health plans on state-established Exchanges. However, the IRS, in final regulations issued in May 2012, interpreted Code Sec. 36B to allow credits for insurance purchased on either a state or a federally established Exchange. The IRS's broader interpretation of "Exchange" has significant implications with respect to the individual mandate.

The individual mandate requires individuals to maintain "minimum essential coverage" and, in general, enforces that requirement with a penalty. However, the penalty does not apply to individuals for whom the annual cost of the cheapest available coverage, less any Code Sec. 36B tax credits, would exceed 8 percent of their projected household income. Thus, by making tax credits available in the states with federal Exchanges, the IRS rule significantly increases the number of people who must purchase health insurance or face a penalty.

This controversy has led to a conflict in the circuits. The conflicting cases involved individuals in states that had not established a state-run Exchange and were facing penalties as a result of failing to buy comprehensive health insurance. In Halbig v. Burwell, 2014 PTC 363 (D.C. Cir. 2014), rev'g 2014 PTC 23 (D. D.C. 2014), the D.C. Circuit held that Code Sec. 36B, by its plain language, does not authorize the IRS to provide tax credits for insurance purchased on federal Exchanges; thus, the court vacated the part of the regulations that allows the credit in such cases. In King v. Burwell, 2014 PTC 364 (4th Cir. 2014), aff'g 2014 PTC 88 (E.D. Va. 2014), the Fourth Circuit reached the opposite conclusion and found that the statute is ambiguous and that the IRS's interpretation is a permissible construction of the statutory language. As such, the court was required to defer to the IRS's interpretation.

Both cases were decided by a three-judge panel and the losing party in either case is entitled to seek a review by the entire court a so-called en banc review. Alternatively, they may appeal to the Supreme Court. In July of 2014, the attorneys representing the losing party in the King decision, asked the Supreme Court for an expedited review. The Supreme Court has not indicated a desire to take on the case.

On September 4, 2014, the losing party in the Halbig decision asked that an en banc panel of the D.C. Circuit review the decision and the court agreed. The D.C. Circuit said it would rehear the case on December 17, 2014.

For a discussion of taxpayers eligible for the health plan premium assistance credit, see Parker Tax ¶102,610.

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IRS Issues Nonacquiescence in Employment Tax Withholding Case

The IRS will not follow the Tax Court's holding in Dixon v. Comm'r, 141 T.C. No. 3 (2013), because it contends that it is not obligated to honor an employer's designation of delinquent employment tax payments toward a specific employee's income tax liability. AOD 2014-01 (8/29/14).

Under the facts in Dixon, James Dixon and his wife, Sharon, were owners, officers, and employees of Tryco Corporation. From 1992 through 1995, Tryco failed to file employment tax returns and pay its employment taxes, including income tax withholding on employee wages. During the same period, the Dixons failed to file their individual income tax returns and pay their individual income taxes. The Dixons were criminally prosecuted for failing to file their income tax returns, and during the plea negotiations, they attempted to pay their delinquent individual income taxes in full. Instead of paying these taxes directly, they transferred funds to Tryco and Tryco used these funds to pay some of its delinquent employment taxes. Tryco additionally designated the payments to be applied to the "withheld income taxes" of the Dixons. Read more...

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Partners Incorrectly Claimed Basis in Contributed Promissory Notes; Reliance on Tax Professional's Oral Advice Negates Penalty

While a partnership's basis in notes contributed by two partners was really zero because the partners' bases were zero, the partnership and its partners were not liable for an accuracy related penalty imposed by the IRS because they relied on the oral advice of their tax attorney in the preparation of the tax returns. VisionMonitor Software, LLC v Comm'r, T.C. Memo. 2014-182 (9/3/14).

Torgeir Mantor and his partner, Alan Smith, started VisionMonitor Software, LLC in 2002. Vision Monitor lost money for the first several years and in order to keep the company afloat, a corporate third partner, AMC, offered to contribute nearly a million dollars if Torgeri and Alan also contributed additional capital. Lacking the liquidity to contribute cash, Torgeri and Alan consulted their longtime attorney, Rick Sympson, to discuss the tax implications of contributing promissory notes to the partnership. Rick performed some cursory research and orally advised Torgeri and Alan that the notes were appropriate capital contributions and would create partnership basis. Although Rick did not issue a written legal opinion and did not review any company documents, Torgeri and Alan agreed to contribute promissory notes to VisionMonitor in 2007 and 2008. Read more...

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Taxpayers Can't Deduct Investment Loss as Theft Loss or as Bad Debt

Where a husband and wife attempted to claim a bad debt or theft loss for money invested in a fraudulent real estate development companythat had filed for bankruptcy, the court disallowed the loss as there was a chance the couple could recover, and did in fact recover, some of their investment. Bunch v Comm'r, T.C. Memo. 2014-177 (8/28/14).

Delbert Bunch was a broker, and his wife Ernestine Bunch a consultant. At the time the

petition was filed, Delbert and Ernestine resided in Las Vegas, Nevada. In 2000, the couple discovered an opportunity in a newspaper advertisement to invest in U.S.A. Commercial Mortgage Co. (Mortgage Co.), which was headed by Joseph Milanowski. Mortgage Co. raised money from investors and made loans to real estate developers. Later that year, Delbert, Ernestine, and some of their family members loaned Mortgage Co. $10 million, of which the couple contributed $4,044,096 in exchange for a note. They were to be paid 20 percent interest per year, with the principal due one year after the final interest payment.

In 2001, several of Mortgage Co.'s loans went in to default and, in April of 2006, Mortgage Co. filed for bankruptcy under chapter 11. In November of 2006, Delbert and other unsecured nonpriority claimants filed a proof of claim for $11,385,662 against Mortgage Co. in order to prove their losses and apply for tax refunds. On their 2006 tax return, Delbert and Ernestine claimed a bad debt deduction of $4,044,096. In 2007, Delbert and Ernestine were informed that they could expect to recover around $500,000 of their loss, and sometime after 2009 they received at least one distribution from Mortgage Co. In 2009, the couple filed an amended 2006 tax return and changed the bad debt deduction to a theft loss deduction.. In 2011, the IRS determined a deficiency of $74,236 for Delbert and Ernestine's 2006 tax return.

Observation: In bankruptcy proceedings, creditors are paid out in order of priority. In general, secured creditors are paid first, with any remaining funds distributed evenly to unsecured creditors.

Under Code Sec. 165(a)(1), an individual taxpayer is entitled to a business or nonbusiness bad debt deduction if certain requirements are met Business bad debts offset ordinary income dollar for dollar, while a nonbusiness bad debt is treated as a capital loss. Additionally, a business bad debt may still be deducted even if it is only partially worthless, but a nonbusiness debt must be wholly worthless for a deduction. To be considered wholly worthless, there must be reasonable grounds for abandoning any hope of recovery.

Code Sec. 165(a) permits a deduction against ordinary income for any loss sustained during the tax year and not compensated for by insurance or otherwise. For individuals, the deduction is limited to, in relevant part, losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. Two elements must be proved to properly substantiate a theft loss deduction. First, the taxpayer must prove that the loss is attributable to a theft in the year for which the deduction is claimed. And second, because Code Sec. 165(a) allows the deduction for the year in which a loss is "sustained," the taxpayer must demonstrate that the loss was incurred in the year for which the deduction is claimed. Generally, a theft loss is treated as sustained during the tax year in which the taxpayer discovers it. However, under Reg. Sec. 1.165-1(d)(2), even after a theft loss is discovered, if a claim for reimbursement exists during the year of the loss and there is a reasonable prospect of at least some recovery, the theft loss deduction will be postponed until the prospect for recovery no longer exists.

The primary issues for the court were (1) whether Delbert and Ernestine could claim a bad

debt deduction for the 2006 tax year, and if not, (2) whether they could claim a theft loss . Delbert and Ernestine attempted to establish their loss by filing a proof of claim in Mortgage Co.'s bankruptcy proceeding.

The court held that Delbert and Ernestine were not allowed a bad debt or theft loss deduction for 2006 because they had not proved there was no reasonable prospect of recovery as of the end of the 2006 tax year. The court found that, because the couple were merely investors in Mortgage Co., their debt was a nonbusiness debt. Subsequently, the court found that there was a reasonable prospect of recovery because the couple had secured a place in the order of distribution from the bankruptcy estate by filing their proof of claim. Thus, because they could not establish by the end of 2006 the amount of the loan they would not recover, Delbert and Ernestine could not deduct the debt as a wholly worthless nonbusiness bad debt in 2006. Similarly, the court denied the theft deduction because, Delbert and Ernestine could not substantiate the amount of alleged theft loss sustained in 2006. Additionally, the court noted that the couple did in fact recovery some amount, further undermining their claim for a deduction in 2006.

For a discussion on the tax treatment of bad debt deductions, see Parker Tax ¶ 98,401. For a discussion of the tax treatment of theft loss deductions, see Parker Tax ¶ 84,503.

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Resident Alien Must Include in Tax Refund Interest in Gross Income

A Chinese citizen who for many years lived, studied, and worked in the United States was found to be a resident alien and was required to include in gross income interest on an income tax refund resulting from exclusions permitted by the U.S. Chinese income tax treaty. Shi v. Comm'r, T.C. Memo. 2014-173 (8/26/14).

Zhengnan Shi is a Chinese citizen who had been living in the United States with appropriate visas since 1999, first as a student and later working as a professor at a university. In 2005, Zhengnan filed a Form 1040 and excluded $5,000 of personal service incomeunder the U.S. China income tax treaty. In 2008, Zhengnan filed an amended 2005 Form 1040 in order to change his filing status to that of a resident alien. He claimed he had attainted resident alien status for tax purposes under Code Sec. 7701(b) beginning in 2004 because of his substantial presence in the United States since 1999. As such, Zhengnan claimed he was entitled to exclude $62,711 in wages for 2005 and was due a refund for the amount of tax on that income. The IRS refunded $9,209 plus interest of $2,098 in 2009. Zhengnan did not report the interest income on his 2009 income tax return. The IRS sent Zhengnan a statutory notice of deficiency in 2011 due to the failure to report the interest income. Zhengnan left the country in 2012 after his professorship was not renewed.

Code Secs. 61(a)(5), 861(a)(1), and 871(a)(1)(A) state that interest, even from a refund, is generally taxable as income to the recipient. Under Code Sec. 871(a), a nonresident alien is only taxed on U.S. source income at a rate of 30 percent and is not eligible for certain deductions and credits. However, under Reg. Secs. 1.1-1(a), (b), a resident alien is generally taxed on income similar to a U.S. citizen and files Form 1040. Under Code Sec. 7701(b)(1)(B), a taxpayer's filing status is that of a nonresident alien if he or she is not a U.S. citizen and is not a U.S. resident. To prove residency, the objective substantial presence test requires the person to be physically in the United States for at least 31 days during the calendar year, and for at least 183 days during the calendar year and the two preceding calendar years, calculated pursuant to a weighted formula. Under Code Sec. 7701(b)(1)(A), an alien is a resident if during the tax year he or she is a permanent resident in the U.S., meets the substantial presence test, or makes an election in the first year to be treated as a resident. Under Reg. Sec. 1.871-5, when a nonresident alien becomes a U.S. resident, he or she retains that status until that status is abandoned and the individual leaves the country.

The central issue in the case was whether Zhengnan was liable for tax on unreported interest income and, if so, at what tax rate. The IRS argued that, as a resident alien, Zhengnan was required to report the interest income he received as a result of filing the 2005 amended return. Zhengnan argued that the interest was not taxable for three reasons. First, the interest would not have resulted if the IRS had processed the 2005 tax return correctly and, if done so, the interest would have been due in 2006, a year where the interest would not result in additional tax due. Second, the interest was exempt because it was derived from exempt income under the U.S. China income tax treaty. Lastly, Shi argued that if the interest must be reported, the U.S. China treaty limited the tax rate to 10 percent.

The Tax Court rejected Zhengnan's arguments and held that the interest income was taxable as U.S. tax rates. The court noted that Zhengnan's first argument that the IRS should have known what he had intended to report on his original 2005 return was without merit. The court also noted that Zhengnan's second argument that the interest was not taxable because it resulted from income exempt from tax was also unfounded as Zhengnan could not cite to any authority supporting this reasoning. Finally, the court concluded that Shi's alternate argument that the interest income was taxable but only at a 10 percent rate pursuant to article 10 of the treaty was incorrect. In order for the 10 percent rate to apply, the court stated, Zhengnan had to be a resident of China.

The court noted that once Zhengnan became a U.S. resident and declared his residence in 2005, he remained so until he actually left the United States in 2012; thus Zhengnan was a resident alien in 2009 when he received the interest payment and taxed as a U.S. citizen. Therefore, the court held that the interest was taxable to Zhengnan when he received it in 2009.

For a discussion of the taxation of resident aliens, see Parker Tax ¶200,100. For a discussion of the taxation of nonresident aliens, see Parker Tax ¶200,500.

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Taxpayer Denied Innocent Spouse Relief; Liable for Taxes and Penalty for Unreported Income on Sale of Residence

A taxpayer's claim that, under the innocent spouse relief provisions, she was not required to pay her half of an income tax deficiency from the sale of her and her former husband's home was rejected by the court. Blomberg v. Comm'r, T.C. Summary 2014-82 (8/26/14).

In 2010, during their divorce proceedings, Judith Blomberg and Don Russell sold a house for $1.46 million. They agreed to split the proceeds, with a portion paced in escrow by their respective attorneys to be disbursed at a later date. In July of 2011, a final decree of divorce was issued and Don was to receive the remaining proceeds in the escrow account, preconditioned on certain payments being made, including a $32,500 payment to Judith. In September of 2011, Don informed Judith that they would likely have capital gains tax on the sale of their home as he had calculated a taxable gain of approximately $120,000. Judith replied that Don had omitted over $100,000 in improvements made to the house over the 17 years they had lived there, and that after taking these improvements into account the capital gains would be eliminated. Subsequently, neither Judith nor Don reported any capital gains from the sale of the house on their 2010 tax return.

Observation: Taxpayers can add the cost of many home improvements to their basis in a house in order to reduce the amount of gain recognized on the sale of the home. Additionally, if certain requirements are met, a single taxpayer can exempt the first $250,000 of profit from the sale of his or her home, and taxpayers filing jointly can exempt the first $500,000.

In August of 2012, Don told Judith their return had been audited and the IRS had assessed an income tax deficiency of $14,014 and an accuracy-related penalty of $2,803 for their failure to report gain of $43,332 from the sale of their house. At the end of 2012, Don sent the IRS a payment representing his half of the deficiency and accuracy-related penalty, and in April 2013 the IRS sent a letter of deficiency to Judith. To complicate matters further, Judith had not received the $32,500 payment required by the divorce decree due to Don's attorney's mismanagement of his practice. Judith filed an enforcement action against Don and his attorney in February 2013, and Don counter-petitioned to compel Judith to pay her half of the 2010 federal income tax deficiency and penalty. Judith subsequently submitted to the IRS a request for innocent spouse relief, claiming financial hardship, which was rejected.

Generally, under Code Sec. 6013(d)(3), married taxpayers are jointly and severally liable for the tax reported or reportable on their returns. Code Sec. 6015, however, allows a spouse to obtain some relief from liability in certain circumstances. In particular, Code Sec. 6015(f) allows the taxpayer to seek equitable relief if seven threshold conditions are satisfied. Set forth in Rev. Proc. 2013-34, the seven conditions are: (1) the requesting spouse filed a joint federal income tax return for the tax year or years for which relief is sought; (2) the requesting spouse does not qualify for relief under Code Sec. 6015(b) or (c); (3) the claim for relief is timely filed; (4) no assets were transferred between the spouses as part of a fraudulent scheme; (5) the nonrequesting spouse did not transfer disqualified assets to the requesting spouse; (6) the requesting spouse did not knowingly participate in the filing of a fraudulent joint return; and (7) the liability from which relief is sought is attributable to an item of the nonrequesting spouse, unless an exception applies. One of the exceptions is where the requesting spouse establishes that he or she was the victim of abuse before the return was filed.

The primary issue before the court was whether Judith qualified for innocent spouse relief, thus absolving her from the assessed deficiency and penalty. The IRS denied her request, claiming she would not suffer a financial hardship if she were required to pay the deficiency and penalty. Judith argued she was entitled to relief under the abuse exception for the seventh condition (noted above). Alternatively, she argued that she was entitled to relief because (1) she was deprived of the opportunity to contest the deficiency, (2) she had already paid federal income tax through her withholdings and Don had made no payments, (3) the district court had already ruled that a divorce decree compelling her to pay half of all tax liabilities was not enforceable, and (4) she was entitled to equitable relief under Code Sec. 6015(f) because she was never paid the required $32,500.

The Tax Court held that Judith was not entitled to relief from her share of the deficiency and penalty, finding none of her arguments persuasive. First, the court found that Judith did not meet the seventh threshold requirement because the item giving rise to the deficiency was the gain from the sale of the house, which was attributable to both Judith and Don. Additionally, as Don had already paid his half of the deficiency and penalty, the unpaid portions were attributed to Judith. The court also found no evidence in the record to support Judith's claim that the abuse she allegedly suffered prevented her from challenging the decision not to report gain from the sale of the house. Instead, she had actively encouraged claiming no gain on the 2010 joint tax return. Likewise, the court found unpersuasive Judith's claim that she was unable to contest the deficiency amount.

And finally, although sympathetic, the court found that Judith had not established that the failure to pay her $32,500 caused her any financial difficulty or that a denial of relief under Code Sec. 6015(f) would cause financial hardship. Thus, the court concluded that Judith was not entitled to relief from liability for the deficiency and penalty under Code Sec. 6015(f).

For more on innocent spouse relief, see Parker Tax ¶ 260,560.

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Interest Rates on Tax Under and Overpayments Remain the Same for Fourth Quarter

The IRS announced that interest rates on tax underpayments and overpayments will remain the same for the calendar quarter beginning October 1, 2014, as they were for the previous quarter. Rev. Rul. 2014-23 (9/3/14).

The IRS announced that interest rates on underpayments and overpayments of tax for the fourth quarter of 2014. Under the Code Sec. 6621(b), the rate of interest is determined on a quarterly basis. For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a tax period is the federal short-term rate plus one-half (0.5) of a percentage point.

The interest rates will remain the same for the calendar quarter beginning October 1, 2014, as they were for the third quarter of 2014. Thus, the rates will be:

• three (3) percent for overpayments [two (2) percent in the case of a corporation];
• three (3) percent for underpayments;
• five (5) percent for large corporate underpayments; and
• one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.

For a discussion of the rules relating to interest on underpayments and overpayments of tax, see Parker Tax ¶261,500.

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Fraudulent Returns Prevent TV Exec's Taxes from Being Discharged in Bankruptcy

Where a cable TV executive invested his gain on the sale of a cable company in an abusive tax shelter and then purchased expensive homes, automobiles, and jewelry, which significantly depleted his assets, he did not meet the requirements for having his taxes discharged in bankruptcy. In re Vaughn, 2014 PTC 436 (10th Cir. 8/26/14).

James Vaughn was Chief Executive Officer of a cable television acquisition company, FrontierVision Partners, LP. Though James had little formal education beyond high school, he had significant practical business experience. In the decade-and-a-half before becoming CEO of FrontierVision, James served in senior executive positions at a number of cable and communication companies. James had a reputation of being a savvy businessman. Between 1995 and 1999, James shepherded FrontierVision as it grew from a start-up venture into a multi-billion dollar company. In 1999, FrontierVision was sold to another company for about $2.1 billion. James received approximately $20 million in cash and $11 million in the purchasing company's stock from this sale.

In June 1999, a KPMG partner introduced James to a tax strategy known as Bond Linked Issue Premium Structure (BLIPS), which was a product offered by a company called Presidio Advisory Services LLC and marketed by KPMG. FrontierVision had an established relationship with KPMG, which had handled a number of acquisition, tax, and accounting matters for FrontierVision since 1995. Through a series of communications with representatives of KPMG and Presidio, BLIPS was presented to James in detail. Through BLIPS, a desired tax loss could be tailored to offset a participant's actual economic gain, and thereby shelter that gain from tax. KPMG advised James that BLIPS was accompanied by the risks of an IRS audit and the possibility of owing additional taxes. James signed an engagement letter acknowledging the risks.

Shortly after receiving the proceeds relating to the sale of FrontierVision, James divorced his wife, Cindy, and married another woman. In the divorce, Cindy received the marital home, valued at $2.5 million, five luxury automobiles valued at $260,000, and half of the couple's $18 million investment account. James spent a lot of money with his second wife and even set up a $1.5 million trust fund for her daughter. Two years later, he and his second wife divorced. In the divorce, she received the marital home, two luxury cars, and $3.5 million of the couple's brokerage account. James kept a townhouse, a pick-up truck, a Chevy Trailblazer, and the remaining balance of the brokerage account, which was less than $3.5 million.

The IRS assessed taxes, interest, and penalties due for 1999 and 2000 of approximately $14 million. James filed for bankruptcy and asked that the taxes be discharged. A bankruptcy court found that James had filed a fraudulent tax return and willfully evaded his taxes, which provided two independent grounds for finding his tax liability nondischargeable under Bankruptcy Code Section 523(a)(1)(C).

The bankruptcy court cited several facts in support of its finding, including the fact that James exhibited behavior that was inconsistent with his business acumen by participating in the BLIPS investment and subsequently depleting his assets, "knowing as he must have" that the BLIPS investment constituted an improper abusive tax shelter with no economic basis and no reasonable expectation of profit. The court also cited James's purchases of expensive homes, automobiles, and jewelry, following his first divorce which significantly depleted his assets "as if there would be no additional tax to pay." James appealed to the federal district court, which affirmed the bankruptcy court's decision.

James then appealed to the Tenth Circuit. He argued that he did not know of the anticipated tax obligation and thus his actions could not have been willful. He also argued that his reliance on the advice of KPMG, his longtime tax advisor, that the BLIPS transaction was an aggressive but ultimately legitimate tax position might have been at worst unreasonable, thus making him negligent, but not willful.

The Tenth Circuit affirmed the district court. To the extent James disputed that he did not know of the anticipated tax obligation, the Tenth Circuit agreed with the bankruptcy court's findings to the contrary. The Tenth Circuit also found his argument about relying on KPMG's advice to be unpersuasive given all of the circumstances in the case, particularly in light of the bankruptcy court's finding that James's assertion of innocent reliance was simply not credible.

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IRS Tax Liens Don't Reach Property Transferred in Divorce; Failure to Record Transfer Doesn't Matter

Property transferred in a divorce were beyond the reach of the federal tax liens, regardless of the fact that the property transfer pursuant to the divorce was never recorded with the register of deeds. U.S. v. Baker, 2014 PTC 439 (D. N.H. 8/22/14).

The IRS sued Scott and Robyn Baker to force the sale of two parcels of land in New Hampshire pursuant to federal tax liens that had been imposed upon Scott for nonpayment of federal income tax. Scott and Robyn were married in 1998 and, in February of 2000, they bought two parcels of land in New Hampshire as joint tenants with rights of survivorship. The Bakers recorded a quitclaim deed to the properties shortly thereafter. Eight years later, the Bakers filed for divorce. On February 28, 2008, a Massachusetts state court issued a divorce judgment, which became final on May 29, 2008. As part of the divorce, Robyn was awarded the New Hampshire property.

On May 14, 2009, the IRS assessed unpaid income taxes against Scott, sent him a notice of levy, and then recorded a notice of federal tax lien for almost $2.5 million with the registry of deeds of the county in which the property was located. A year later, additional unpaid income taxes were assessed against Scott and a second levy notice was sent to him and recorded with the same county registry of deeds.

The Bakers claimed that the tax liens did not encumber the New Hampshire property because Scott transferred his ownership interest in them to Robyn pursuant to a divorce judgment before the date the tax liens arose. Although the tax liens were in Scott's name, the IRS sued Robyn under Code Sec. 7403(b) because she claimed an interest in the properties. Robyn argued that she owned the properties free of the tax liens because both properties were transferred to her for adequate consideration pursuant to the divorce judgment. The IRS countered that its tax liens were entitled to priority over the divorce judgment because neither the judgment nor any related deed was ever recorded.

A district court held that the properties were beyond the reach of the federal tax liens because Scott had no ownership interest in them when the liens arose. The court rejected the IRS's argument that a divorce decree disposing of real property is ineffective against third persons until the decree or an abstract is filed in the registry of deeds. The court noted that when the IRS asserts a tax lien against a taxpayer's property, the threshold inquiry is directed to the nature of the legal interest the taxpayer has in the property in question. State law, the court said, determines whether the taxpayer has a sufficient legal interest in the property to satisfy this threshold inquiry.

Under New Hampshire law, the court observed, the undivided interest in real estate apportioned by a divorce judgment vests in the grantee spouse by the mere force of the decree as effectually as the same could be done by any conveyance of the grantor spouse himself. Citing New Hampshire case law, the court found that when a stipulation between the parties incorporated and merged into the divorce decree clearly and affirmatively expresses their intention to convey a real property interest, the interest vests in the grantee on the effective date of the divorce decree. The spouses' subsequent failure to comply with a provision of the divorce judgment in this case, the execution and recording of a deed to the properties does not invalidate or delay the conveyance, unless the parties clearly intended for the provision to serve as a condition precedent, the court said.

For a discussion of who has priority with respect to a tax lien, see Parker Tax ¶260,530.