Federal Tax Bulletin - Issue 72 - September 26, 2014

IRS Issues Final Guidance in Tangible Property Saga; Extends Time to Make Late Partial Asset Disposition Election

Last week, the IRS released Rev. Proc. 2014-54 the last bit of expected guidance in the multi-year overhaul of the tax rules on tangible property. Rev. Proc. 2014-54 provides the procedures taxpayers must follow to obtain automatic IRS consent for certain accounting method changes relating to tangible property dispositions.

Prior tangible property guidance has been controversial at times, and often contained changes to the applicable dates to which the rules applied. With respect to changing deadlines, Rev. Proc. 2014-54 is no exception. But, similar to prior changes, the deadline change in Rev. Proc. 2014-54 is favorable to taxpayers because it extends by one year the deadline for making a late partial disposition election and having it treated as an automatic accounting method change.

Practice Tip: One of the more important changes made in the 2013 proposed regulations and 2014 final regulations was the addition of a partial disposition rule. Under that rule, taxpayers can claim a loss on the disposition of a structural component (or a portion thereof) of a building or upon the disposition of a component (or a portion thereof) of any other asset without identifying the component as an asset before the disposition event. The rule minimizes circumstances in which an original part and any subsequent replacements of the same part are required to be capitalized and depreciated simultaneously. In Rev. Proc. 2014-17, the IRS allowed taxpayers to make a late partial disposition election where they had not timely made such an election under the proposed regulations. However, the election could only be made for any tax year beginning on or after January 1, 2012, and beginning before January 1, 2014. In Rev. Proc. 2014-54, the IRS extends the timeframe for making the election to any tax year beginning on or after January 1, 2012, and beginning before January 1, 2015.

In addition to extending the time for making a late partial disposition election, Rev. Proc. 2014-54 provides for other changes, including additional accounting method changes, as a result of the final property disposition regulations issued this past August.

Practice Tip: Practitioners need to review the current fixed asset accounting policies of their clients to see if they are in compliance with the final regulations and determine if making a late partial disposition election will benefit their clients. For most clients, the automatic accounting method change rules will apply to a late partial disposition election. However, Form 3115 will still need to be filed.

Background

Code Sec. 263 provides the general rules for the tax treatment of capital expenditures. However, determining whether expenditures are for capital improvements or for ordinary repairs is a highly factual determination. Recognizing that the standards for applying Code Sec. 263 were difficult to discern and apply in practice and led to considerable uncertainty and controversy for taxpayers, the IRS embarked on a decade-long mission to revise the rules and give more certainty to taxpayers on how to account for such expenditures. That mission began on January 20, 2004, when the IRS issued Notice 2004-6 announcing an intention to issue regulations providing guidance in this area. After a period of public comment, the IRS issued temporary regulations in December 2011.

Subsequently, additional guidance in the form of proposed regulations, technical amendments, and revenue procedures were issued. The last set of regulations was issued on August 18, when the IRS finalized the rules under Reg. Secs. 1.168(i)-1, 1.168(i)-7, and 1.168(i)-8 on dispositions of tangible depreciable property subject to Modified Accelerated Cost Recovery System (MACRS) depreciation. The final regulations not only provide rules for determining gain or loss upon the disposition of MACRS property, they also provide rules for identifying the asset disposed of and accounting for partial dispositions of MACRS property.

Compliance Tip: The final regulations apply to tax years beginning on or after January 1, 2014. With respect to tax years beginning on or after January 1, 2012, and before January 1, 2014, taxpayers have three choices as to the rules they can apply: (1) the rules under the final regulations; (2) the rules under the 2013 proposed regulations; or (3) the rules under the temporary regulations.

In March, the IRS issued Rev. Proc. 2014-17, which modified the rules in the Appendix of Rev. Proc. 2011-14 for obtaining automatic IRS consent to: (1) change a method of accounting for dispositions of tangible depreciable property; (2) change a method of accounting for depreciation of MACRS property; and (3) change a method of accounting for the treatment of general assets accounts. The issuance of final regulations in August on the tax treatment of dispositions of tangible property necessitated the issuance of Rev. Proc. 2014-54.

Observation: Generally, to change a method of accounting a taxpayer must receive the consent of the IRS. However, the IRS periodically issues revenue procedures in which it provides the procedures a taxpayer must follow in order to automatically obtain IRS consent to make a particular accounting method change. These procedures update the Appendix of the current accounting method change procedure, currently Rev. Proc. 2011-14. The general rules for making an accounting method change are spelled out in the body of Rev. Proc. 2011-14, and the Appendix describes the specific accounting method changes to which a subsequent revenue procedure applies.

Additional Accounting Method Changes Provided in Rev. Proc. 2014-54

In Rev. Proc. 2014-54, Sections 6.38 through 6.40, the IRS provides for the following three additional automatic accounting method change procedures:

(1) certain accounting method changes for disposing of a building or a structural component or disposing of a portion of a building (including its structural components) to which the partial disposition rule applies;

(2) changes in the method of accounting for disposing of Code Sec. 1245 property or a depreciable land improvement or disposing of a portion of Code Sec. 1245 property or a depreciable land improvement to which the partial disposition rule applies;

(3) a change in method of accounting for disposing of an asset subject to a general asset account election under Code Sec. 168(i)(4) and the applicable regulations.

With respect to the change in (3) above, the IRS noted that this change also may affect the determination of gain or loss from disposing of the asset and may affect whether the taxpayer must capitalize amounts paid to restore a unit of property

Late Partial Disposition Election

The most important change in Rev. Proc. 2014-54 is found in section 6.33 and involves the timing of the late partial disposition election. The IRS will treat the making of the late election under Rev. Proc. 2014-54 as a change in method of accounting. As previously noted, a taxpayer may make this change for any tax year beginning on or after January 1, 2012, and beginning before January 1, 2015. In addition, Rev. Proc. 2014-54 provides that the scope limitations, which generally act to prevent a taxpayer from taking advantage of automatic consents to change a method of accounting, do not apply to a taxpayer making a late partial disposition election.

A partial disposition election can benefit taxpayers who have disposed of a portion of an asset but are continuing to depreciate that asset. As illustrated in the examples below, the partial disposition election will allow them to change from depreciating the asset to recognizing gain or loss on that disposition.

Example: ABC Company, a calendar year taxpayer, acquired and placed in service a truck in 2009. The truck is described in asset class 00.242 of Rev. Proc. 87-56. ABC depreciates the truck under MACRS and does not reasonably expect to replace the engine of the truck more than once during its class life of six years. The engine is a major component of the truck. In 2012, ABC replaced the engine of the truck and applied Reg. Sec. 1.168(i)-8T and Reg. Sec. 1.263(a)-3T for its 2012 tax year. Because the truck is the asset for disposition purposes, ABC did not recognize a loss on the retirement of the engine and continues to depreciate the original engine. Further, ABC capitalized the new engine as an improvement, classified the new engine under asset class 00.242 of Rev. Proc. 87-56, and is depreciating the new engine under MACRS. ABC decides to apply Reg. Sec. 1.168(i)-8 (the final regulation issued in August on accounting for dispositions of MACRS property) beginning with its 2013 tax. ABC also decides to make the late partial disposition election for the truck's original engine that ABC retired in 2012. Although the truck is the asset for disposition purposes, the partial disposition results in the retirement of the engine being treated as a disposition. Thus, in accordance with Rev. Proc. 2014-54, ABC may file a Form 3115 with its 2013 federal income tax return to make the late disposition election for the engine and change from depreciating that original engine to recognizing a loss upon its retirement.

Section 6.33 of Rev. Proc. 2014-54 provides that the extension of the automatic accounting method change for a late partial disposition election does not apply to the following:

(1) a taxpayer who makes a late partial disposition election under the proposed regulations but who does not apply all the provisions of the applicable proposed regulations;

(2) any asset of which the disposed portion was a part that is not owned by the taxpayer at the beginning of the year of change;

(3) a taxpayer making any late election after the time period allowed in which to make the election (as specified in Section 6.33(3) of the APPENDIX to Rev. Proc. 2011-14); or

(4) the partial disposition election specified in Reg. Sec. 1.168(i)-8(d)(2)(i) (relating to certain asset classifications) that is made pursuant to Reg. Sec. 1.168(i)-8(d)(2)(iii), or in Prop. Reg. Sec. 1.168(i)-8(d)(2)(i) that is made pursuant to Prop. Reg. Sec. 1.168(i)-8(d)(2)(iii).

Additional Modifications Made by Rev. Proc. 2014-54 to Rev. Proc. 2011-14

As noted above, after the final tangible property disposition rules were issued in August, a new procedure was necessary to guide taxpayers on how to effect certain accounting method changes and to eliminate procedures that no longer apply. As a result, in addition to modifying the rules in the Appendix of Rev. Proc. 2011-14, Rev. Proc. 2014-54 also modifies the Appendix by:

• removing Section 6.19 (lessor improvements abandoned at termination of lease) because it is obsolete;
• revising Section 6.29 (disposition of a building or structural component) to provide that such provision does not apply to any demolition of a structure to which Code Sec. 280B and Reg. Sec. 1.280B-1 apply;
• revising Sections 6.32 (general asset account elections), 6.34 (revocation of a general asset account election), and 6.35 (partial dispositions of tangible depreciable assets to which the IRS's adjustment pertains) to allow these changes in method of accounting to be made under Code Sec. 1.168(i)-1 or Reg. Sec. 1.168(i)-8;
• revising Section 6.37 (permissible to permissible method of accounting for depreciation of MACRS property) to provide additional changes in method of accounting that are consistent with Reg. Sec. 1.168(i)-1 or Reg. Sec. 1.168(i)-8; and
• revising Section 10.11 (tangible property) to clarify that this provision in the Appendix, which deals with accounting method changes for supplies and materials, does not apply to amounts paid or incurred for certain materials and supplies that the taxpayer has elected to capitalize and depreciate under Reg. Sec. 1.162-3(d) or Reg. Sec. 1.162-3T(d).

Rev. Proc. 2014-54 also includes charts summarizing the changes in methods of accounting that may be made under Rev. Proc. 2011-14 for dispositions of MARCS property and charts that summarize the late elections under the current and proposed Reg. Secs. 1.168(i)-1 and 1.168(i)-8 that are treated as a change in method of accounting.

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Debtor's Lavish Lifestyle Doesn't Preclude a Discharge of Taxes

Generally, a debtor in bankruptcy can discharge all debts that arose before the filing of his or her bankruptcy petition. However, a debtor cannot discharge any tax debts with respect to which the debtor made a fraudulent return or willfully attempted to evade or defeat. Late last month, the Tenth Circuit in In re Vaughn, 2014 PTC 436 (10th Cir. 8/26/14) relied on this provision when it held that a cable TV executive, who purchased expensive homes, automobiles, and jewelry that significantly depleted his assets so he could not pay his taxes, did not meet the criteria for having his taxes discharged in bankruptcy. One of the factors cited by the court was the debtor's luxurious lifestyle. However, dealing with a similar situation in Hawins v. Franchise Tax Board of California, 2014 PTC 477 (9th Cir. 9/15/14), the Ninth Circuit took a different approach and concluded that a lavish lifestyle before filing for bankruptcy did not necessarily preclude a debtor's taxes from being discharged; instead taxes are nondischargeable if the debtor had a specific intent to evade the taxes. The court remanded the case to the lower court to determine if the debtor had "specific intent" to evade his tax liability at the time he was living large.

Background

William "Trip" Hawkins designed and received an undergraduate degree in Strategy and Applied Game Theory from Harvard University, and an M.B.A. from Stanford University. After college, he became one of the earliest employees at Apple Computer, where he ultimately became Director of Marketing. He left Apple to co-found Electronic Arts, Inc. (EA), which became the world's largest supplier of computer entertainment software. Trip owned 20 percent of EA and served as its Chief Executive Officer. By 1996, his net worth had risen to $100 million. That year, he divorced his first wife, Diana, and married his second wife, Lisa. Tripp and Lisa bought a $3.5 million home, where she cared for their two children and Tripp's two children from his first marriage. They flew in a private jet, their children attended expensive private schools, they bought an ocean-side condo in La Jolla, and employed a large private staff.

Beginning in 1994, Trip began selling his EA stock to invest in a new company, 3DO. His accountants at KPMG advised him to shelter the gains in a foreign leveraged investment portfolio (FLIP) and an offshore portfolio investment strategy (OPIS). Both strategies were designed to generate large paper losses to shield the capital gains from the sale of EA stock from tax. Read more...

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IRS Clamps Down on Corporate Inversions and Related Transactions

The IRS intends to issue regulations, which will generally be effective with respect to transactions completed on or after September 22,2014, to address recent inversion transactions that the IRS feels are tax avoidance transactions and are inconsistent with certain provisions in the Code. Notice 2014-52 (9/23/14).

In light of the ongoing concern over U.S. companies engaging in inversion transactions, the IRS has issued Notice 2014-52 in an effort to stem the tide of inversion transactions. Notice 2014-52 describes regulations that the IRS intends to issue with respect to inversion transactions. In an inversion transaction, a U.S. company reincorporates for tax purposes in a foreign country but keeps most of its operations in the United States. Typically, the U.S. company reincorporates in a country with a lower tax rates with the aim of paying less U.S. taxes.

An inversion transaction may permit the top corporate parent in the newly inverted group, a group still principally comprised of U.S. shareholders and their controlled foreign corporations (CFCs), to avoid Code Sec. 956 by accessing the untaxed earnings and profits of the CFCs without a current tax to the U.S. shareholders. This is a result that the U.S. shareholders could not achieve before the inversion. The ability of the new foreign parent to access deferred CFC earnings and profits would in many cases eliminate the need for the CFCs to pay dividends to the U.S. shareholders, thereby circumventing the purposes of Code Sec. 956. Inversion transactions also facilitate the avoidance of Code Sec. 956 through other techniques. After an inversion transaction, the inverted group may cause an expatriated foreign subsidiary to cease to be a CFC using transactions that avoid the imposition of U.S. income tax, so as to avoid U.S. tax on the CFC's pre-inversion earnings and profits.

In Notice 2014-52, the IRS states that it intends to issue regulations that will

• disregard certain stock of a foreign acquiring corporation that holds a significant amount of passive assets;
• disregard certain non-ordinary course distributions;  
• provide guidance on the treatment of certain transfers of stock of a foreign acquiring corporation (through a spin-off or otherwise) that occur after an acquisition;  
• prevent the avoidance of Code Sec. 956 through post-inversion acquisitions by CFCs of obligations of (or equity investments in) the new foreign parent corporation or its non-CFC foreign affiliates;  
• prevent the avoidance of U.S. tax on pre-inversion earnings and profits of CFCs through post-inversion transactions that otherwise would terminate the CFC status of foreign subsidiaries and/or substantially dilute the U.S. shareholder's interest in those earnings and profits; and  
• limit the ability to remove untaxed foreign earnings and profits of CFCs through related party stock sales subject to Code Sec. 304.

Notice 2014-52 provides that the regulations to be issued will apply to transactions completed on or after September 22, 2014.

For a discussion of the U.S. taxation of foreign corporations, see Parker Tax ¶201,100.

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Deductions for Expenses Incurred in Attempting to Rent Farmhouse Disallowed

The taxpayers could not take rent expense deductions where they made no effort to change their strategy after being unable to find a rent-paying tenant for over 30 years. Meinhardt v. Comm'r, 2014 PTC 468 (8th Cir. 9/10/14).

Donald Meinhardt worked full time at an architectural firm. His wife, Arvilla, operated a day care center out of the couple's home. In 1976, the Meinhardts bought approximately 140 acres of land that was improved with a farmhouse and outbuildings and that also consisted of crop land and pasture land. The couple rented out the farmland separately from the farmhouse. Since buying the land, the Meinhardts have had numerous local farmers lease the crop land and the pasture land. The couple attempted to rent out the farmhouse but were unsuccessful in finding tenants to rent the house in exchange for cash.

From 1976 through 2007, various individuals lived in the farmhouse at different times, often exchanging services (such as repairs and maintenance on the farmhouse) for use of the house. Over the years, the occupants included Arvilla's brother, who lived in the farmhouse seasonally for 20 years; the Meinhardts' daughter and her husband, who lived in the farmhouse for four years; and the Meinhardts' son and his family, who lived in the farmhouse for three months. The Meinhardts never received rent for use of the farmhouse. At various other times, the farmhouse remained vacant. The Meinhardts did not keep or present any detailed records of the value of these barter exchanges or the fair market rental value of the farmhouse.

For 2005-2007, the Meinhardts reported on Schedule E approximately $32,000 in rental income from the rental of crop and pasture land and expenses of approximately $74,500. The expenses consisted of insurance, supplies, repairs, and other expenses associated with the farmhouse. According to the Meinhardts, the farmhouse was available for rent during the years at issue. The IRS denied the expenses relating to the farmhouse.

The Tax Court denied the rent expense deductions, concluding that because the Meinhardts made no effort to change their strategy after being unable to find a rent-paying tenant for over 30 years, they had not put forth a reasonable effort to rent out the farmhouse. Additionally, the fact that the Meinhardts allowed individuals to live in the house rent free connoted personal use to the court. In reaching its conclusion, the Tax Court cited Ray v. Comm'r, T.C. Memo. 1989-623, in which the taxpayer deducted expenses in connection with a house inherited from her mother, which had never been offered for rent or for sale. The taxpayer in Ray claimed the expenses were ordinary and necessary expenses paid for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income within the meaning of Code Sec. 212(1) or (2). The Ray court concluded that, given the almost universal experience with appreciating residential property (which was the case at the time), something more was required than a taxpayer's mere statement that he or she held residential property for investment purposes. The totality of the facts and circumstances convinced the court in Ray that the taxpayer did not possess the requisite profit objective and found similarly in the case of the Meinhardts. The Meinhardts appealed.

The Eighth Circuit affirmed the Tax Court's decision and held that the farmhouse rental expenses were nondeductible. The Eighth Circuit agreed with the Tax Court that there was no indication that the farmhouse was held for the production of income during the tax years in question because the Meinhardts did nothing to generate revenue during the years in issue and had no credible plan for operating it profitably in the future. The court noted that there was no affirmative act, such as renting or holding the property for appreciation in value, to demonstrate that the property was held for the production of income.

For a discussion of the deductibility of rental expenses, see Parker Tax ¶86,105.

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Couple Can Exclude Settlement Proceeds from Abusive Tax Shelter Scheme

Most of the settlement proceeds received from a CPA firm and some of its accountants were excludible from the taxpayers' income because the payment compensated the taxpayers for additional taxes they paid as a result of incompetent advice from the CPA firm. Cosentino v. Comm'r, T.C. Memo. 2014-186 (9/11/14)

In an attempt to provide for their disabled daughter's future, a couple looked to a CPA firm for advice on how to maximize profits from their real estate holdings. Unbeknownst to the couple, the plan recommended by the firm, and acted upon by the couple, was really an abusive tax shelter which led to assessments by the IRS for additional taxes, interest and penalties. The IRS claimed that the resulting settlement was includible in the couple's income. However, in Cosentino v. Comm'r, T.C. Memo. 2014-186 (9/11/14), the Tax Court rejected the IRS's rationale for including the amounts in income and held that the majority of the settlement was excludible from income. Because the taxpayers settled for less than they sued for, the court ratably allocated the portion that was excludible from income. The excludible portions of the settlement related to (1) excess taxes paid, (2) losses incurred as part of the tax shelter which the IRS disallowed as a deduction, (3) fees paid for the bad advice, and (4) penalties paid to the IRS. The portion of the settlement relating to interest that the taxpayers deducted on their return was not excludible from income, however.

Background

Garey Cosentino and his wife, Jo-Ann, had a plan to maximize and accumulate wealth during their lives in order to provide for their permanently disabled adult daughter both during their lives and after their deaths. The plan involved real estate they owned through two pass-through entities, G.A.C. Investments, LLC and Cosentino Estates, LLC. Pursuant to that plan, the couple engaged in several Code Sec. 1031 like-kind exchanges that did not involve boot and, thus, they never recognized gain. Read more...

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Deduction for Year-End Bonus Denied Because Company Could Not Honor Check

A corporation could not deduct compensation paid to its sole shareholder because the company had insufficient funds to honor the check. Vanney Assoc. v. Comm'r, T.C. Memo. 2014-184 (9/11/2014).

Robert Vanney was the sole shareholder and executive of the architectural firm Vanney Associates. Robert's wife prepared the payroll checks for the company, although she was not an employee or otherwise connected to Vanney Associates. It was common practice at the end of the year to pay a bonus to Robert consisting of the profit remaining in the corporation. At the end of 2008, Vanney Associates paid a year-end bonus to Robert of $815,000. At the time the check was written, the corporate bank account for Vanney Associates had insufficient funds to honor the check. The company filed its income tax return, reporting no taxable income for 2008 and claimed a deduction for compensation to officers, including the $815,000 bonus. The IRS issued a notice of deficiency to Vanney Associates, disallowing deductions claimed for compensation, taxes, and licenses.

Reasonable compensation is deductible under Code Sec. 162. In Springfield Prods., Inc. v. Comm'r, T.C. Memo. 1979-23, the Tax Court held that deductions of payments made by check are dependent on the proper payment of the check. Additionally, in Steinberg v. Comm'r, T.C. Memo. 1995-116, the Tax Court disallowed a deduction where a check was not paid because of insufficient funds.

The sole issue before the court was whether Vanney Associates could deduct the year-end bonus to Robert when the firm had insufficient funds to honor the check. Vanney Associates argued that the payment was unconditional and was made when Robert Vanney took possession.

The Tax Court disallowed the deduction because no proper payment of the check had occurred. The court explained that a check is a contingent payment that is only fulfilled when the funds are actually paid. As such, a deduction for compensation is allowed only when there is actual payment. The court noted that because the check could not be honored at a bank or otherwise used due to the lack of funds, Robert could only loan it back to the company and no actual payment of the amount could be made. Thus, the Tax Court upheld the IRS's disallowance of the compensation deduction.

For a discussion of deductible compensation, see Parker Tax ¶91,101.

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Administrative and Litigation Costs Denied Where IRS Had Substantially Justifiable Position

Taxpayers were not entitled to approximately $13,000 in administrative or litigation costs, even though they prevailed in their appeal of an IRS deficiency assessment, because they did not timely provide the IRS with information supporting their return position. Bussen v. Comm'r, T.C. Memo. 2014-185 (9/11/2014).

Brian and Apryl Bussen filed their 2009 tax return, listing their address at a U.S. military base in Germany. The return reported wages received by Brian, who at the time served with U.S. Air Force, but did not report wages earned by Apryl. The IRS sent the Bussens a notice proposing to increase their taxable income because of approximately $14,000 in unreported wages paid to Apryl in 2009. The Bussens did not dispute that Apryl received the compensation but did dispute, without including any supporting documentation, the proposed increase, arguing that Apryl earned the wages while physically present in Germany and was thus entitled to the foreign earned income exclusion under Code Sec. 911. In July 2012, the IRS mailed a notice of deficiency on the basis that Apryl's compensation was includable in the Bussen's income for 2009. In response, the couple filed a petition for redetermination arguing that the IRS erred in its determination because their 2009 tax home was in Germany and thus the exclusion was proper.

Upon referral to IRS Appeals, the IRS again requested support for the Bussens' position. The couple provided no evidence of Apryl's German residency and made a qualified offer of $0 for 2009, which the IRS rejected. Subsequently, the Bussens sent a copy of Brian's military orders to the Appeals office showing he was stationed in Germany during all of 2009, but the documents did not indicate whether Apryl had accompanied him. After a trial date was set, the Bussens submitted documentation including copies of Apryl's passport, their children's school records, and bank records reflecting transactions in Germany throughout 2009. The IRS conceded the case and sent settlement documents showing no deficiency due, which the Bussens accepted. The Bussens then moved for reasonable litigation or administrative costs of approximately $13,000.

An award of litigation or administrative costs under Code Sec. 7430(a) will be granted if the taxpayer is the prevailing party, has exhausted all administrative remedies with the IRS, and did not unreasonably protract the administrative or court proceedings. To be a prevailing party, the taxpayer must substantially prevail with respect to either the amount in controversy or the most significant issue or set of issues presented, and satisfy the applicable net worth requirements. However, the taxpayer will not succeed as the prevailing party if the IRS can establish that its position was substantially justified. As the Supreme Court held in Pierce v. Underwood, 487 U.S. 522 (1988), to be substantially justified, the position must be justified to a degree that could satisfy a reasonable person. Under Code Sec. 7430(c)4(e)(ii)(I), the qualified offer rule does not apply to any judgment issued pursuant to a settlement.

The Bussens argued that they should be considered the prevailing party because the IRS's position was not substantially justified. The IRS argued that, based on the evidence available to it at the time it took its position in the proceedings, it was substantially justified andacted reasonably.

The Tax Court held that the Bussens were not entitled to an award for litigation or administrative costs because the IRS's position was substantially justified. The court explained that the IRS's position was substantially justified because of its knowledge of the facts and circumstances both when the deficiency was issued and when the petition was filed. The court reasoned that because the Bussens' tax return did not report Apryl's wages and, at the time the notice of deficiency was issued the IRS had not received any documentation to support the Bussens' position that Apryl's income was excludible, the IRS was substantially justified in issuing a notice of deficiency.

For a discussion of the criteria taxpayers must meet to recover litigation or administrative costs, see Parker Tax ¶263,540. For information on the foreign earned income exclusion, see Parker Tax ¶78,620.

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Ninth Circuit Reverses Tax Court, Permits Equitable Recoupment for Late Refund Claim

Taxpayer was not prohibited from seeking equitable recoupment due to untimely refund claim; Tax Court's denial of equitable recoupment was found to be erroneous. Revah v. Comm'r, 2014 PTC 488 (9th Cir. 9/17/2014)

In a collections due process hearing relating to an untimely refund claim,Yaaokv Revah argued that the IRS improperly refused to consider the fact that equitable recoupment applied to offset his income tax liabilities. Yaakov had sought to carry back net operating losses to offset income from earlier years and claim the resulting refunds. The IRS found that Yaakov attempted to take the net operating losses in the wrong year, and thus denied the deductions. However, the IRS denied the subsequent refund claims because they were untimely filed.

Yaakov argued that even though the refund claim was time-barred, the IRS Appeals Office should permit equitable recoupment as a defense to collection. The IRS denied Yaakov's equitable recoupment argument on the grounds that equitable recoupment is not a collection alternative and he had previously waived his right to contest the underlying liability. The Tax Court agreed with the IRS, and even though Yaakov asserted he had been unable to exhaust his administrative remedies in a meaningful manner, the court found that equitable recoupment did not apply as there was no inequitable application of inconsistent theories of taxation.

Observation: The equitable recoupment doctrine allows a taxpayer to avoid the bar of an expired statutory limitation period and prevents an inequitable windfall to a taxpayer or to the government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer.

In Estate of Branson v. Comm'r, 264 F.3d 904 (9th Cir. 2001), the court held that in order for a taxpayer to obtain equitable recoupment, he or she must show (1) the same transaction, item, or taxable event is subject to two taxes; (2) the taxes are inconsistent in that the Tax Code authorizes only a single tax; (3) the tax sought to be recouped is time barred; (4) there is an identity of interest between the parties paying the duplicative tax; and (5) the court in which the recoupment claim is brought must independently have jurisdiction to adjudicate the claim.

The Tax Court held that Yaakov's inability to use net operating losses to reduce tax liabilities was the result of his failure to make his refund claims within the proper time period, rather than the result of inconsistent theories of taxation.

The Ninth Circuit reversed the Tax Court's decision, holding that the lower court's denial of equitable recoupment was erroneous. The court relied on U.S. v. Bowcut, 287 F.2d 654 (9th Cir. 1961), in which the Ninth Circuit held that equitable recoupment should be permitted notwithstanding that the cause for relief sought was created by the taxpayer's untimely refund claim. Thus, the circuit court held that although Yaakov did not file his refund claim within the statutory period, the mistake was not grounds to prohibit him from applying for equitable recoupment. The Ninth Circuit remanded the case back to the Tax Court for further proceedings.

For a discussion of the equitable recoupment doctrine see Parker Tax ¶261,180.

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Fractional Discounts on Fair Market Value of Art Appropriate Where Decedent Held Only Fractional Interests

An estate could heavily discount the fair market value of works of art left in the estate to account for the fractional interests a decedent held with his surviving children. Est. of Elkins v. Comm'r, 2014 PTC 483 (9/15/14).

During his life, James Elkins, Jr. and his wife owned over 60 pieces of modern and contemporary art. They each held a 50 percent interest in each work of art and, when James' wife died, her interests in the pieces were split among their three children. Thereafter, James shared fractional interests in the works of art with his three children. James died in 2005 and his estate filed a tax return listing, among other assets, the works of art valued according to his pro-rata share less a discount due to the fact he only owned fractional interests in the pieces. The IRS disallowed the fractional ownership discount and assessed an estate tax deficiency of approximately $9,000,000.

The executors of James' estate petitioned the Tax Court to review and eliminate the deficiency. In the Tax Court, the IRS insisted that absolutely no fractional-ownership discount was allowable. The Tax Court rejected the IRS's zero-discount position, but also rejected the various fractional-ownership discounts adduced by the estate through its expert witnesses. Instead, the Tax Court concluded that a discount of 10 percent should apply across the board to James ratable share of the stipulated FMV of each of the works of art. The estate executors appealed to the Fifth Circuit to determine what, if any, discount should be applied to James' fractional interests.

Under Reg. Sec. 20.2031-1(b), the fair market value of a piece of property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

The primary issue before the Fifth Circuit Court was whether James' estate was taxable on the undiscounted pro rata share of the FMV of the works of art, or whether it was taxable only on those values reduced by fractional-ownership discounts of either (1) a uniform 10 percent each, as held by the Tax Court, or (2) the various percentages that the estate advanced through its expert witnesses. The IRS stuck by its initial assessment that no discount was allowed but offered no evidence to support this conclusion, aside from the testimony of an expert witness that there was no readily available market for fractional interests in works of art. The estate argued that a proper application of the willing buyer/willing seller test would produce prices for James' undivided interests in the works of art substantially below his pro rata share of their respective FMVs. According to the estate, any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a a co-owner with James' descendants, given their determination never to sell their interests in the art.

The Fifth Circuit Court affirmed the Tax Court's rejection of the IRS's position. The court affirmed the Tax Court's holding that the estate was entitled to apply a discount, but reversed the Tax Court's holding that the appropriate discount was 10 percent. Instead, the Fifth Circuit concluded that the estate's experts had correctly calculated the applicable discounts to be more than 10 percent. In reaching this decision, the court noted that the IRS had offered no evidence as to why no discount was appropriate. The court realized that a potential willing buyer of the art would be well aware that, by virtue of becoming a co-owner with the heirs to James' estate, he or she could not make a quick resale. Additionally, the court noted the situation was only exacerbated by the various restrictions on partition, alienation, and possession that were attached to the art. Because of this, the court concluded that the discounts determined by the estate's experts were not just the only ones proved in court; they were eminently correct. Therefore, the court rendered judgment in favor of the estate for a refund of taxes of approximately $14,000,000 plus interest.

For more on valuation of estate property for estate tax purposes, see Parker Tax ¶224,700.

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Prelevy Notice Not Available for Third Parties with Alleged Ownership Interests

In a case of first impression, the Tax Court held that only the taxpayer (and not a third party with an alleged ownership interest) is afforded prelevy notice and due process protections under Code Sec. 6330. Greenoak v. Comm'r, 143 T.C. No. 8 (9/16/2014).

James Irwin died in 2009 and Jill McCrory was appointed personal representative of James's estate. The IRS received an estate tax return in December 2010, which reported the estate's probate and nonprobate assets including an offshore trust to which James allegedly made property transfers before death. The offshore trust owned Greenoak Holdings Limited, Southbrook Properties Limited, and Westlyn Properties Limited. The estate failed to timely pay the estate tax reported on the tax return because it did not have funds available. The estate tax was due to the inclusion of an offshore trust's income in James' gross estate. The IRS assessed the tax reported on the estate tax return, along with an additional penalty for failure to timely pay the tax. During a collection due process (CDP) hearing, the estate argued that these penalties should be abated. The IRS disagreed and issued a notice of determination to the representative of James' estate sustaining an assessed levy and declining to abate the penalties. The entities owned by the offshore trust Upon hearing of the notice of determination, filed a petition on their own behalf for a judicial review of the proceedings, claiming they did not receive proper notice of the proposed levy action and were not afforded a fair opportunity to contest the action and underlying tax liability.

Under Code Sec. 6331(a), the IRS is authorized to collect unpaid tax by a levy on property belonging to any person liable to pay that tax who neglects or refuses to pay within 10 days after notice and demand. Under Code Sec. 6330, such a levy cannot be made unless the person has been notified in writing; additionally, that person can request a CDP hearing to challenge the levy, and if the levy is upheld the person can then seek judicial review in the Tax Court. Under Code Secs. 6212 and 6213, the only person entitled to receive a notice of deficiency is the taxpayer.

The primary issues before the Tax Court were whether the ' alleged ownership interest in property that might be subject to levy by the IRS entitled the entities owned by the offshore trust the rights afforded to persons under Code Sec. 6330 and if so, whether the court had jurisdiction under Code Sec. 6330(d) over appeals filed by entities other than the taxpayer liable for the unpaid federal tax. As all prior cases dealing with the court's jurisdiction under Code Sec. 6330 were based on petitions filed by taxpayers or their representatives, this case presented the court with an issue of first impression.

The entities owned by the offshore trust argued that the term "person" in Code Sec. 6330 includes any person who might claim a right in property that is intended to be levied upon even if that person is not the taxpayer or the taxpayer's authorized representative. The entities alleged that they, not the estate, were the owners of the (unspecified) property, and concluded that Code Sec. 6330 applies to them, and that they are a "person" for purposes of receiving notice, a CDP hearing, and being able to appeal the notice of determination sent to the estate.

The Tax Court held that the "person" entitled to the rights and protections under Code Sec. 6330 is the taxpayer liable for the unpaid tax, and that it did not have jurisdiction over petitions filed by a party who was neither the taxpayer nor an authorized representative. The court looked to the text and the legislative history of Code Sec. 6330 in reaching this decision. Under the plain language of the Code Sec. 6330, the court surmised that "the person" referred to in the statute is the person who owes the unpaid tax and the only property that is subject to levy is the property of the person who owes the tax. The court also noted that the legislative history and the regulations both support the conclusion that it is only the taxpayer and not a third party with alleged ownership interest who is afforded prelevy notice and due process protections. The court thus held that a person, other than the taxpayer, who alleges an ownership interest in property which the IRS seeks to levy upon is not entitled to receive a notice of intent to levy and is not able to seek judicial review in the Tax Court. Accordingly, the court lacked jurisdiction under Code Sec. 6330(d) to hear the appeal of the entities owned by the offshore trust.

For a discussion of IRS collection procedures, see Parker Tax ¶260,500.

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Code Section 6707A Penalty Is Based on Tax Shown on Original Rather than Amended Return

In a case of first impression, the Tax Court held that in assessing a penalty under Code Sec. 6707A for failing to include reportable transaction information on a tax return, the amount of the penalty is calculated using the tax shown on the return giving rise to the violation of the disclosure obligation rather than the tax as shown on subsequent, amended returns. Yari v. Comm'r, 143 T.C. No. 7 (9/15/14).

Steven Yari formed Topaz Global Holdings, LLC (Topaz Global), a disregarded entity for federal tax purposes, in 2000. In 2002, Steven formed Faryar, Inc., an S corporation for federal income tax purposes. Faryar entered into agreements with Topaz Global and other companies to provide management services. Also in 2002, Steven opened a Roth individual retirement account (IRA) with an initial contribution of $3,000. The Roth IRA acquired all of the Faryar stock for $3,000, making the Roth IRA the sole shareholder of the S corporation.

For 2002 through 2007, Faryar reported a total net income of over $1.2 million in management fees and interest income less deductions. Because Faryar was an S corporation, the income was not taxed at the corporate level, and because the shareholder was a nontaxable entity, the income was not taxed at the shareholder level. The practical effect of this transaction was twofold: It allowed Steven to effectively exceed the Roth IRA contribution limits and decreased the amount of income Steven otherwise would have reported from Topaz Global because Topaz Global deducted the amounts paid to Faryar as management fees. In Notice 2004-8, the IRS identified transactions such as this as abusive Roth IRA transactions. The IRS has also identified these transactions as listed transactions, potentially subjecting taxpayers who did not disclose participation in these transactions on their federal income tax returns to penalties.

Because Steven did not disclose the transactions on his returns, the IRS assessed a penalty under Code Sec. 6707A and issued a notice of intent to levy to collect the penalty. Steven requested a collection due process hearing, challenging the collection action. While the hearing was pending, the small Business Jobs Act (SBJA) of 2010 amended Code Sec. 6707A to change the method of calculating the penalty. Steven requested that the IRS recalculate the penalty using the amount of tax shown on subsequent amended returns that he had filed. The IRS decided the penalty should be calculated using the amount of tax shown on the original return and declined to change the penalty. Steven appealed this decision.

Code Sec. 6707A(a) imposes a penalty on any person who fails to include on any return or statement any information with respect to a reportable transaction that is required under Code Sec. 6011 to be included with such return or statement. The amount of the penalty before the SBJA depended on whether the transaction was a reportable transaction or a listed transaction. For reportable transactions other than listed transactions, it was $10,000 for natural persons and $50,000 for others, and for listed transactions, it was $100,000 for natural persons and $200,000 for others. The penalty applied regardless of whether the listed or reportable transaction was respected for federal income tax purposes.

The penalty for failing to disclose a listed transaction on a return after enactment of the SBJA is 75 percent of the decrease in tax shown on the return as a result of the transaction (or which would have resulted from the transaction if the transaction were respected for federal income tax purposes). In the case of individuals, Code Sec. 6707A(b)(2) and (3) prescribes minimum and maximum penalties for failing to disclose a listed transaction of $5,000 and $100,000, respectively.

If calculated using the amount of tax shown on Steven's amended returns, the penalty would have been the statutory minimum of $5,000; if calculated using the amount of tax shown on Steven's original return i.e., the return that gave rise to the disclosure obligation the penalty would have been $100,000.

Noting that the case presented an issue of first impression as to whether Code Sec. 6707A requires the IRS to use the tax shown on the return giving rise to the disclosure obligation or to use the tax as shown on subsequent, amended returns, the Tax Court held that the penalty is calculated using the tax shown on the return giving rise to the violation of the disclosure obligation.

For a discussion of the penalties for failing to disclose reportable transactions, see Parker Tax ¶250,140.

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IRS Issues Annual Per Diem Guidance

IRS provides the annual update of the special per diem rates used in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Notice 2014-57 (9/19/14).

In Notice 2014-57, the IRS provides the annual update of the special per diem rates used in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Specifically, the notice provides: (1) the special transportation industry meal and incidental expenses rates (M&IE rates), (2) the rate for the incidental expenses only deduction, and (3) the rates and lists of high-cost localities for purposes of the high-low substantiation method.

Taxpayers using the rates and the list of high-cost localities provided in Notice 2014-57 must comply with Rev. Proc. 2011-47. In Rev. Proc. 2011-47, the IRS provides rules for using a per diem rate to substantiate, under Code Sec. 274(d) and Reg. Sec. 1.274-5, the amount of ordinary and necessary business expenses paid or incurred while traveling away from home.

Notice 2014-57 is effective for per diem allowances for lodging, meal and incidental expenses, or for meal and incidental expenses only that are paid to any employee on or after October 1, 2014, for travel away from home on or after October 1, 2014. Rates for the period of October 1, 2013 through September 30, 2014, may be found in Notice 2013-65.

For a discussion of the substantiation rules for expenses incurred while traveling away from home, see Parker Tax ¶91,130.