Federal Tax Bulletin - Issue 156 - November 28, 2017

Senate Tax Bill Clears Finance Committee; Floor Debate Expected This Week

Shortly before heading off for Thanksgiving recess, the Senate Finance Committee approved its version of the Tax Cuts and Jobs Act (TCJA) by a vote of 14 to 12, setting the stage for floor debate and a possible vote on the bill later this week. H.R. 1-Senate (11/16/2017).

The Finance Committee vote on TCJA ("Senate Bill") came just hours after the House passed its own version of tax reform ("House Bill"), 227 to 205.

Practice Aid: For an in-depth explanation of the Senate Bill, see the November 14, 2017, issue of Parker's Federal Tax Bulletin (PFTB 2017-11-14). For an in-depth explanation of the House Bill, see the November 7, 2017 issue (PFTB 2017-11-07). For a discussion of the key differences between the two bills, see the November 16, 2017 issue (PFTB 2017-11-16).

For individuals, the most notable provisions of the Senate Bill include the reduction in most income tax rates, the increase in the standard deduction along with the repeal of the personal exemption deduction, the doubling of the child tax credit, the elimination of the state and local tax (SALT) deduction, a reduction in the amount of gain on the sale of a principal residence that is excludible from income for certain high-income filers, the elimination of numerous other deductions, the elimination of the alternative minimum tax (AMT), the repeal of the Affordable Care Act's individual healthcare mandate, and an increase in the exemption under which an individual's estate is exempt from the estate tax. Under the Senate Bill, the reduced income tax rates, the elimination of the AMT and the elimination of most deductions are set to expire after December 31, 2025.

For businesses, key provisions include the reduction of the corporate tax rate to 20 percent, increased expensing of qualified property placed in service during the year, a new 17.4 percent deduction against certain pass-through entity income, the repeal of numerous business credits, such as the work opportunity credit, the repeal of the deduction for income attributable to domestic production activities, and the repeal of the like-kind exchange rules for exchanges of other than real property.

The Senate Bill has dozens of provisions that differ from the ones in the House Bill, not the least of which is a fundamentally different approach to the new tax break for pass-through entity income. For a rundown of the key differences, see the see the November 16, 2017, issue of Parker's Federal Tax Bulletin (PFTB 2017-11-16).

Before moving to the Senate floor, the Senate Bill will face one last procedural hurdle. On Tuesday, the bill will be taken up by the Senate Budget Committee, on which Republicans hold a single seat majority. Senator Ron Johnson (R-WI) and Bob Corker (R-TN), both of whom are seen as potential "no" votes on the Senate Bill, hold seats on the Budget Committee.

If approved by the Budget Committee, floor debate on the tax bill is expected to begin on Wednesday, with a possible vote to follow later in the week. Unlike the House Bill, which was subject to a straight up or down vote when it reached the House floor, the Senate Bill will be open for amendments and is widely expected to be modified in order to win over wavering members. The Wall Street Journal has reported that changes may include adding a provision similar to the one in the House Bill allowing taxpayers to deduct state and local property taxes, with limits. A tweet by President Trump on Monday indicated that a sweetening of tax breaks on pass-through income may also be in the works.

As with healthcare repeal, Republicans can only afford to lose only two members of their own caucus if Democrats are unified in opposition. Republicans who have voiced the strongest opposition to the current version of the Senate Bill include -

• Ron Johnson (R-WI) - concerns that pass-through entity tax breaks are not sufficiently generous;
• Susan Collins (R-ME) - concerns over the repeal of individual healthcare mandate and benefits of the bill being tilted too strongly to high income taxpayers;
• Jeff Flake (R-AZ) - concerns about the impact of tax cuts on the federal deficit; and
• Bob Corker (R-TN) - concerns about the impact of tax cuts on the federal deficit.

John McCain (R-AZ), who has generally praised the Senate Bill, is nonetheless considered a possible "no" because of concerns about its impact on defense spending. At press time, his stated position on the bill is "undecided."

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Tax Court Disallows Loss from Dissolution of S Corporation Due to Lack of Economic Substance

The Tax Court disallowed the losses claimed by a married couple who transferred personal assets to a wholly owned S corporation which in turn transferred the assets to a family limited partnership, then dissolved the S corporation and received the partnership interest with a discounted value as a liquidating distribution. The Tax Court found that because the transaction was organized for the sole purpose of tax avoidance and lacked economic substance, the taxpayers were not entitled to deduct any loss relating to the arrangement. Smith v. Comm'r, T.C. Memo. 2017-218.

Facts

Robert Smith worked for National Coupling Co., a manufacturer of couplings and valves, for 36 years. He owned approximately 58 percent of the company. Smith was a vice president and was in charge of manufacturing, engineering, intellectual property work, and trademarks. Smith is also an inventor and the owner of hundreds of patents. In 2009, National Coupling was sold and Smith retired. He received a $600,000 bonus, $248,000 from the sale of his stock, and $181,000 from the surrender of two company sponsored life insurance policies. Smith's total employee compensation was $664,000 for 2009. After the sale, Smith signed a two year consulting contract with National Coupling and received around $38,000 under the contract in 2009.

Smith had worked on a patent for a sprinkler system while working at National Coupling. Smith had worked on the sprinkler device in 2005 or 2006, and a U.S. patent application was filed in 2006. The U.S. patent was issued in 2014 and a Canadian patent was issued in 2009. Smith believed he would retain patent rights to the sprinkler system after the sale of National Coupling, although the documents relating to the sale did not grant Smith the right to the patent.

Smith's financial adviser recommended that Smith and his wife obtain estate planning advice. He referred them to Richard Shanks, an experienced attorney and CPA, who prepared various estate planning documents for the Smiths including wills and medical directives. Shanks also recommended a tax planning strategy intended to reduce the tax on Smith's 2009 compensation. He proposed that the Smiths transfer their cash and securities to a wholly owned S corporation, which would then transfer the assets to a family limited partnership (FLP). Shanks said the FLP would provide asset protection. The S corporation would own the FLP, and the FLP would hold the cash and securities. The S corporation would be formed and dissolved in the same year. In the dissolution, it would distribute the partnership interest to the Smiths as a liquidating distribution. Shanks would determine the fair market value of the distributed partnership interest using large discounts for lack of marketability and lack of control, generating a tax loss on the dissolution. Shanks charged a flat fee of $23,200 for his services. He did not charge a separate fee for the dissolution of Ventures.

In July 2009, the Smiths organized RACR Ventures, Inc., an S corporation, RACR Partnership, Ltd., an FLP, and Smith Management Trust, a revocable management trust. Smith and his wife each owned 50 percent of Ventures. Ventures owned a 98 percent limited partnership interest RACR Partnership. Smith and his wife were each 1 percent general partners until they transferred their interests to the Smith Trust and became cotrustees and beneficiaries.

From the outset, the Smiths understood that Ventures would not hold any assets. They were aware that Ventures would immediately transfer its assets to RACR Partnership and be dissolved by the end of 2009. The Smiths understood that Ventures was the vehicle they would use to minimize their 2009 tax liability. Their handwritten notes from their meeting with Shanks identified the RACR structure as a vehicle to minimize tax for 2009. Emails between the Smiths and Shanks acknowledged a "liquidation" in 2009 and stated that Ventures "goes away" that year. Ventures had no business activities. It did not have a bank account, did not issue stock certificates, did not keep meeting minutes, and did not follow corporate formalities.

The Smiths filed dissolution documents in December 2009 stating that they had organized Ventures to pursue business opportunities and were dissolving it to reduce overhead because they had not found any profitable opportunities. In the dissolution, Smith and his wife each received a 49 percent limited partnership interest in RACR Partnership. They transferred 1 percent limited partnership interests to two trusts in the names of each of their sons. At the end of 2009, the Smith Trust owned a 2 percent general partnership interest in RACR Partnership, Smith and his wife each owned a 48 percent limited partnership interest, and the children's trusts owned 1 percent limited partnership interests.

On their 2009 tax return, the Smiths reported income of approximately $850,000 and an ordinary loss deduction of around $750,000 from the Ventures dissolution. The IRS issued a notice of deficiency disallowing the loss on the grounds that the transaction lacked economic substance. The Smiths petitioned the Tax Court for redetermination.

Analysis

The Smiths argued that Ventures was organized to manufacture and sell Smith's sprinkler device once he received a U.S. patent. They claimed that they transferred their personal assets to Ventures to finance this new business and that the assets were then transferred to RACR Partnership for asset protection purposes. According to the couple, Ventures was dissolved due to the unforeseeable circumstances of the patent not being issued and Smith's increased involvement in his consulting work.

The Tax Court found that the RACR transaction lacked economic substance and disallowed the losses. It found that under Fifth Circuit precedent, a transaction is respected for tax purposes only if it exhibits an objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance. A transaction is void if it fails to meet any one of these three factors. The Fifth Circuit has recognized that the second and third factors overlap and that if a transaction is shaped totally by tax avoidance features, it lacks a genuine business purpose.

The Tax Court held that the transaction failed to alter the Smiths' economic position in any way that affected objective economic reality. It found that the RACR structure was a circular flow of funds among related entities used to generate an artificial tax loss to offset the couple's income. The court noted that the couple had constant control over the assets they contributed to Ventures. It found that the structure of the transaction did not affect their financial position and did not cause real dollars to meaningfully change hands. The Smiths understood from the beginning that they would not lose control over their personal assets. The Tax Court further determined that, contrary to their testimony at trial, the Smiths always intended to dissolve Ventures by the end of 2009 and never intended that it would manufacture the sprinkler device.

The Tax Court also analyzed the subjective business purpose element and found that the Smiths' subjective purpose was solely tax avoidance. The Tax Court did not find credible the couple's claims that they organized Ventures to manufacture the sprinkler device. It found that Smith should have expected the U.S. patent to be issued shortly after October 2009, but that Ventures was dissolved only one month later. Based in part on the couple's handwritten notes from their initial meeting with Shanks, the Tax Court determined that the couple intended from the beginning to organize and dissolve Ventures within the same year to generate a tax loss. The fact that Shanks received a flat fee for the RACR structure, and did not charge a separate fee for the dissolution of Ventures, was further evidence to the Tax Court that the couple lacked a business purpose in forming Ventures.

The Tax Court found that Shanks designed the tax structure to include the application of a substantial discount of the Smiths' assets used in the strategy so that the structure would produce a loss even if the assets appreciated in value during Ventures' short existence. The Tax Court also noted that the Smiths could have protected their assets through the limited partnership framework without first transferring the assets to Ventures. Accordingly, the Tax Court concluded that Ventures lacked economic substance and the couple was not entitled to deduct any loss relating to Ventures or the RACR structure.

The Tax Court also upheld the IRS's determination of an accuracy related penalty. It found that the Smiths were not acting in good faith because they continued to represent that Ventures had a business purpose even though they never intended to conduct any business activities through Ventures. Their knowledge from the outset that Ventures would not last past 2009 negated the defense that they reasonably relied on Shanks, the Tax Court found.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700.

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Casualty Loss Available for Repairs to Certain Deteriorating Concrete Foundations

The IRS issued a revenue procedure allowing certain taxpayers to take a casualty loss deduction for amounts paid to repair damage to their personal residences resulting from deteriorating concrete foundations caused by the presence of the mineral pyrrhotite. The casualty loss deduction can be taken in the year the taxpayer pays to have the related repairs done. Rev. Proc. 2017-60.

Facts

According to the IRS, residents in the northeastern part of the United States have reported problems with certain residential concrete foundations. In August 2015, the Connecticut Office of the Attorney General and the Connecticut Department of Consumer Protection (DCP) began investigating numerous complaints by homeowners concerning deteriorating concrete foundations. The conclusions of the investigation are available in the "Report on Deteriorating Concrete in Residential Foundations" issued by the DCP on December 30, 2016.

Investigators concluded that the deterioration of the concrete foundations was caused by the presence of pyrrhotite in the concrete mixture used to pour the foundations. Pyrrhotite is a naturally existing mineral in stone aggregate, which is used to produce concrete. Pyrrhotite oxidizes in the presence of water and oxygen, leading to the formation of expansive mineral products, and causing concrete to deteriorate prematurely.

Observation: Estimates by the office of Connecticut Governor Dannel Malloy indicate that approximately 34,000 residences in Connecticut alone may be at risk of damage from foundations deteriorating due to the presence of pyrrhotite.

Pursuant to Connecticut Public Act No. 16-45, Connecticut residents with deteriorating concrete foundations may request a reassessment of the assessed value of their homes based on a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete.

The IRS said it has received inquiries about whether a loss resulting from a deteriorating concrete foundation constitutes a deductible casualty loss within the meaning of Code Sec. 165, the tax year any such loss would be deductible, and how the amount of the loss would be computed.

General Rules for Deducting Casualty Losses

Code Sec. 165(a) generally allows taxpayers to deduct losses sustained during the tax year that are not compensated for by insurance or otherwise. For personal-use property, such as a taxpayer's personal residence, Code Sec. 165(c)(3) limits an individual's deduction to losses arising from fire, storm, shipwreck, or other casualty, or from theft. A casualty is damage, destruction, or loss of property that results from an identifiable event that is sudden, unexpected, and unusual. Damage or loss resulting from progressive deterioration of property through a steadily operating cause has been held not to be a casualty loss.

A casualty loss is allowed as a deduction only for the taxable year in which the loss is sustained. However, if the taxpayer has a claim for reimbursement of the loss from insurance or otherwise, for which there is a reasonable prospect of recovery, no portion of the loss is deductible until it can be ascertained with reasonable certainty whether the reimbursement will be received. If a taxpayer deducted a loss and in a subsequent taxable year receives reimbursement for the loss, the taxpayer does not recompute the tax for the taxable year in which the deduction was taken, but includes the amount of the reimbursement in gross income for the taxable year in which received, subject to the provisions of Code Sec. 111, relating to recovery of amounts previously deducted.

The amount of a taxpayer's casualty loss generally is the decrease in the fair market value of the property as a result of the casualty, limited to the taxpayer's adjusted basis in the property. To simplify the computation of a casualty loss deduction, existing regulations permit taxpayers to use the cost to repair the damaged property as evidence of the decrease in value of the property.

Code Sec. 165(h)(1) and (2) impose two limitations on casualty loss deductions for personal use property. First, a casualty loss deduction is allowable only for the amount of the loss that exceeds $100 per casualty. Second, the net amount of all of a taxpayer's casualty losses (in excess of casualty gains, if any) is allowable only for the amount of the losses that exceeds 10 percent of the taxpayer's adjusted gross income (AGI) for the year.

Revenue Procedure 2017-60

According to the IRS, in view of the unique circumstances surrounding the damage caused by deteriorating concrete foundations containing the mineral pyrrhotite, it is appropriate to provide a safe harbor method that treats certain damage resulting from deteriorating concrete foundations as a casualty loss and provides a formula for determining the amount of the loss. As a result, in Rev. Proc. 2017-60, the IRS provides that, if an individual taxpayer is within the scope of Rev. Proc. 2017-60, the IRS will not challenge the taxpayer's treatment of damage resulting from a deteriorating concrete foundation as a casualty loss if the loss is determined and reported as provided in Rev. Proc. 2017-60.

Observation: The current tax reform proposals from both the House and the Senate would eliminate the deduction for personal casualty losses such as the one described in Rev. Proc. 2017-60 for tax years beginning after December 31, 2017. The House Tax Reform proposal eliminates all personal casualty loss deductions while the Senate Tax Reform Bill eliminates all such deductions except where the casualty relates to damage in a presidentially-declared disaster area. As noted below, if a taxpayer qualifies for a casualty loss under Rev. Proc. 2017-60, the casualty loss is treated as occurring in the year the taxpayer pays to repair the damage caused by a deteriorating concrete foundation.

Rev. Proc. 2017-60 applies to any individual taxpayer who pays to repair damage to that taxpayer's personal residence caused by a deteriorating concrete foundation that contains the mineral pyrrhotite.

A taxpayer who pays to repair damage to that taxpayer's personal residence caused by a deteriorating concrete foundation may treat the amount paid as a casualty loss in the year of payment. For purposes of Rev. Proc. 2017-60, the term "deteriorating concrete foundation" means a concrete foundation that is damaged as a result of the presence of the mineral pyrrhotite in the concrete mixture used to pour the foundation. The safe harbor under Rev. Proc. 2017-60 is available to a taxpayer who has obtained a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete, and has requested and received a reassessment report that shows the reduced reassessed value of the residential property based on the written evaluation from the engineer and an inspection pursuant to Connecticut Public Act No. 16-45 (Act). The safe harbor also is available to a taxpayer whose personal residence is either in Connecticut or outside of Connecticut, provided the taxpayer has obtained a written evaluation from a licensed engineer indicating that the foundation was made with defective concrete containing the mineral pyrrhotite.

The amount of a taxpayer's loss resulting from the deteriorating concrete foundation is limited to the taxpayer's adjusted basis in the property. In addition, the amount of the loss may be limited depending on whether the taxpayer has a pending claim for reimbursement (or intends to pursue reimbursement) of the loss through property insurance, litigation, or otherwise. A taxpayer who does not have a pending claim for reimbursement, and who does not intend to pursue reimbursement, may claim as a loss all unreimbursed amounts (subject to the adjusted basis limitation) paid during the taxable year to repair damage to the taxpayer's personal residence caused by the deteriorating concrete foundation. A taxpayer who has a pending claim for reimbursement, or who intends to pursue reimbursement, may claim a loss for 75 percent of the unreimbursed amounts paid during the taxable year to repair damage to the taxpayer's personal residence caused by the deteriorating concrete foundation. A taxpayer who has been fully reimbursed before filing a return for the year the loss was sustained may not claim a loss. A taxpayer who has a pending claim for reimbursement, or who intends to pursue reimbursement, may have income or an additional deduction in subsequent taxable years depending on the actual amount of reimbursement received.

Amounts paid for improvements or additions that increase the value of the taxpayer's personal residence above its pre-loss value are not allowed as a casualty loss. Only amounts paid to restore the taxpayer's personal residence to the condition existing immediately prior to the damage qualify for loss treatment.

Compliance Tip: A taxpayer claiming a casualty loss under Rev. Proc. 2017-60 must report the amount of the loss on Form 4684, Casualties and Thefts, and must mark "Revenue Procedure 2017-60" at the top of that form. Taxpayers are subject to the $100 limitation imposed by Code Sec. 165(h)(1) and the 10-percent-of-AGI limitation imposed by Code Sec. 165(h)(2).

Taxpayers who choose not to apply the safe harbor treatment provided by Rev. Proc. 2017-60 are subject to all of the generally applicable provisions governing the deductibility of losses under Code Sec. 165. Accordingly, these taxpayers must establish that the damage, destruction, or loss of property resulted from an identifiable event that is sudden, unexpected, and unusual, and was not the result of progressive deterioration through a steadily operating cause. These taxpayers also must prove that the loss is properly deductible in the taxable year claimed by the taxpayer and not in another year. Further, these taxpayers must prove the amount of the claimed loss and must prove that no claim for reimbursement of any portion of the loss exists for which there is a reasonable prospect of recovery.

Effective Date

Rev. Proc. 2017-60 is effective for federal income tax returns (including amended federal income tax returns) filed after November 21, 2017.

For a discussion of the rules relating to casualty deductions, see Parker Tax ¶84,505.

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Chief Counsel's Office Disputes Court's Decision Involving S Corporations

The Chief Counsel's Office concluded that the Federal Claims Court decision in Morton v. U.S., 98 Fed. Cl. 596 (2011), which had the effect of excluding wholly owned or majority owned S corporations from precedent set by the Supreme Court in Moline Properties v. Comm'r, 63 S. Ct. 1132 (1943), is an aberration that the IRS should not follow. According to the Chief Counsel's Office, even though Moline Properties was decided before the enactment of S corporations, it is broadly applicable to S corporations, and not just to situations involving a corporate level tax, as was implied by the court in Morton. CCM 201747006.

Background - Supreme Court's Moline Properties Decision

In Moline Properties v. Comm'r, 63 S. Ct. 1132 (1943), the Supreme Court held that a corporation created for a business purpose or to carry on a business activity will be respected as an entity separate from its owner for federal tax purposes.

Under the facts in that case, an individual conveyed real estate to a corporation in 1928 as part of a security arrangement at the suggestion of the creditor. The corporation assumed the mortgages, with the individual receiving all the stock which he then transferred to a voting trustee appointed by the creditor. The stock served as security for an additional loan to the individual. That loan was repaid in 1933, with control of the corporation reverting to the individual. The real estate was later sold, with the proceeds received by the individual and deposited in his personal account.

The business of the corporation consisted of the assumption of the individual's original obligation to the creditor, the defense of the real estate in a condemnation proceeding, and the institution of a suit to remove deed restrictions from some of the property, though the expenses of the suit were paid by the individual. A portion of the property was also leased as a parking lot. Once the last parcel of real estate was sold, the corporation did not transact any further business, but it was never dissolved. Originally, the loss stemming from the real estate for 1934 and the gain for 1935 were reported on the corporation's return, but the corporation filed a refund claim for 1935 with the individual including the gain on his personal return for that year (and including a gain in 1936 on his original 1936 individual return). The IRS disallowed the individual's treatment of the gains and losses on his individual return.

The Board of Tax Appeals held for the taxpayer on the grounds that because of the corporation's limited purpose it "was a mere figmentary agent which should be disregarded in the assessment of taxes." The Fifth Circuit reversed, holding that the individual, having formed a corporate entity for reasons sufficient to him, was bound to his choice and the corporation must be recognized for tax purposes. The Supreme Court affirmed Fifth Court's holding, stating that: "The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity."

The Court did recognize an exception to its general rule when "the corporate form ... is a sham or unreal." With regard to Moline Properties, the Court found that the corporation had been created by the shareholder for his advantage and served a special function.

Federal Claims Court's Morton Decision

In Morton v. U.S., 98 Fed. Cl. 596 (2011), the Court of Federal Claims concluded that Moline Properties did not apply to S corporations in the context of a Code Sec. 183 hobby loss case. Under the facts in that case, Peter Morton (Morton), a co-founder of the Hard Rock Cafe restaurant chain, also established the Hard Rock Hotel, Inc. (HRH), a C corporation, which owned and operated the Hard Rock Hotel and Casino in Las Vegas. Morton owned all or most of several S corporations, including Red, White, and Blue Pictures (RWB), Lily Pond Investments (LP), and 510 Development Corporation (510). RWB owned the real estate underlying some of the Hard Rock Cafe sites and acted as landlord. LP was a holding company with all the voting shares and 94 percent of the total shares of HRH. 510 performed various other services for the Hard Rock Hotel, such as marketing and public relations, design, management, and accounting, and was also the employment vehicle for Morton's staff.

RWB bought a Gulfstream-III (G-III) aircraft. Morton said that he purchased the plane through RWB to take advantage of the corporation's limited liability protection. He advanced to RWB all funds used to operate the plane and advanced to 510 all funds used to pay the salaries of its crew. Morton used the plane both for personal travel and for uses which he maintained were related to the business of HRH or more generally "to promote the Hard Rock brand." Morton personally claimed deductions for business use of the G-III for 1999 through 2001 under Code Sec. 162, as well as depreciation deductions.

The IRS disallowed the deductions but the court held that Morton was allowed to consider the activities of all of his wholly-owned or majority owned S corporations together as a "unified business enterprise" in determining whether disputed expenses were attributable to an activity "engaged in for profit." The court's holding strongly implied that Moline Properties is only relevant in a situation where the taxpayer is attempting to avoid a corporate-level income tax. The court relied primarily on two cases to support its conclusion: Campbell v. Comm'r, 868 F.2d 833 (6th Cir. 1989), and Kuhn v. Comm'r, T.C. Memo. 1992-460.

Chief Counsel's Office Rejects Morton Decision

In CCM 201747006, the Office of Chief Counsel discusses the history of the Moline Properties doctrine, as it relates to S corporations, and the decision in Morton. The Chief Counsel's Office concluded that the Morton decision is an aberration that the IRS should not follow and that Moline Properties is broadly applicable to S corporations, and not just to situations involving a corporate level tax.

The Chief Counsel's Office observed that, while the Moline Properties decision predated the enactment of subchapter S in 1958, it has been applied to S corporations in several cases. The Chief Counsel's Office also pointed to the decision in Deputy v. DuPont, 208 U.S. 488 (1940), as supporting its position, noting that the DuPont decision is also often cited for the treatment of corporations as entities separate from their owners for tax purposes

The Chief Counsel's Office noted that, since the Morton decision, Steinberger v. Comm'r, T.C. Memo 2016-104, is the only case that has cited and discussed Morton. In so doing, the Tax Court distinguished and, thereby limited, Morton's holding, the Chief Counsel's Office said. In Steinberger, the Tax Court rejected a taxpayer's argument that he should be able to combine the activities conducted by separate entities, an airplane leasing business and medical practice, as a single activity to overcome the Code Sec. 183 limitation. The Tax Court declined to apply Morton's holding for two reasons. First, the taxpayer in Steinberger and the taxpayer in Morton had significantly different ownership in the entities that each attempted to combine. Specifically, in Steinberger, the taxpayer owned approximately 14 percent of the professional association (i.e., the professional practice) and, with his spouse, 100 percent of an LLC (i.e., an airplane leasing business). In Morton, the taxpayer owned the majority or all of the interest in the corporations he sought to combine. Second, unlike Morton, the taxpayer in Steinberger failed to show the two businesses were a unified business enterprise. Supporting this conclusion, the Steinberger court noted that in Morton "the entity that owned the airplane ... did more than just own the airplane - it also owned the real property on which several of the Hard Rock Cafes were built and served as landlord of those cafes."

Finally, with respect to the Federal Claims Court's reliance on Campbell and Khun, the Chief Counsel's Office noted that the IRS did not acquiesce in Campbell (AOD 1993-001) and that the Morton court acknowledged that in Kuhn, the taxpayer owned the asset in his own name rather than in that of an entity.

For a discussion of the Moline Properties decision, see Parker Tax ¶31,926.

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Taxpayer's Losses from Texas Ranch Allowed; Ranch Activity Was Engaged in for Profit

The Tax Court held that a taxpayer who owned several businesses and a Texas ranch was entitled to deduct the ranch's losses because the ranching activity was engaged in for profit. The Tax Court found that the ranch was run in a businesslike manner and had 25 full time employees, and that its losses for the years at issue were partly due to some of the operations being in their startup phases. Welch v. Comm'r, T.C. Memo. 2017-229.

Facts

Finis Welch has been involved in vocational agriculture activities since high school. Welch has been in a wheelchair since a severe car accident during his freshman year of college. He earned a bachelor's degree in agricultural economics in 1961 and a Ph.D. in economics in 1966. Welch became an economics professor and taught for 40 years before retiring in 2003.

Welch began testifying as an expert witness in civil litigation cases beginning in the 1970s. In 1976, he founded Welch Consulting, a private consulting firm that provides economic and statistical consulting for lawsuits involving discrimination claims. Welch formed several other companies over the years, including a research firm and a software company.

In 1987, Welch purchased 130 acres to grow hay as a cash crop and to raise cattle. The ranch, called Center Ranch, grew to become a multioperational, 8,700 acre ranch with 25 full time employees who receive salaries ranging from $25,000 to $115,000. Over the years Welch realigned his workforce to reflect current needs and fired employees for nonperformance or inappropriate behavior. During 2007 through 2009, the years at issue, Welch spent Thursday nights through Sundays at Center Ranch.

The ranch is split into several divisions which are almost all noncontiguous tracks of land that were purchased at different times. The three main operations are cattle, hay and horses. Center Ranch also has a veterinary clinic, a trucking operation, and a timber operation.

For the years at issue, Welch reported losses of between $2 million to $4 million resulting from Center Ranch. The largest expenses were depreciation, labor, and feed. The IRS sent notices of deficiency determining that Welch's ranch activity was not engaged in for profit and reduced the amount of his allowable losses. Welch petitioned the Tax Court for redetermination.

Analysis

In arguing that the ranch was not engaged in for profit, the IRS looked to the factors provided in the regulations under Code Sec. 183, which examine (1) whether the activity is carried on in a businesslike manner, (2) the taxpayer's expertise, (3) the time and effort spent on the activity, (4) the taxpayer's expectation that the assets would appreciate, (5) the taxpayer's success in other professional areas, (6) the activity's history of income, losses and profits, and (7) the taxpayer's financial status and the extent of personal pleasure and recreation gained from the activity.

According to the IRS, mistakes in Center Ranch's books and records, and the fact that Welch had no written business plan, showed that the ranch was not run for profit. The IRS pointed out that Welch was at the ranch only on weekends and therefore did not spend a significant amount of time at the activity. The IRS further argued that Welch's profit motive should include an expectation that he would recover all of the ranch's past losses.

The Tax Court held that Welch's ranching activity was engaged in for profit. First, it determined that Center Ranch's cattle, hay and horse operations were one activity. The Tax Court found that the activities were highly organizationally and economically interrelated; the hay operation provided feed for the cattle and horses, and the cattle operation provided calves for training the cutting horses. Supporting operations, including the vet clinic and trucking operation, benefited the inner workings of the ranch and were available as for hire services to others, according to the Tax Court. All of Center Ranch's major operations were similar in that they were common operations for a working ranch in Texas.

Having ascertained Welch's activity for the years at issue, the Tax Court next determined that Welch's primary purpose in engaging in the ranching activity was to make a profit. First, the Tax Court found that Welch ran the ranch in a businesslike manner, keeping books and records for each of the ranch's operations to determine their income and expenses. The fact that there were mistakes in the books did not negate that the activity was carried on in a businesslike manner, according to the Tax Court. Nor did the lack of a written business plan; rather, the Tax Court found that Welch's business plan was evidenced by his actions, and noted that he did not have a written business plan for any of his other endeavors. The Tax Court found that Welch made business decisions to stop engaging in unprofitable activities and added other operations when third party fees became too costly. The ranch was well known and had 25 full time employees, some of whose wages were above the county's median wage. Vertical integration of the ranch's operations showed an effort to run it more efficiently and generate additional income, according to the Tax Court.

The Tax Court found that Welch's expertise in ranching supported a finding that the ranch was being run for profit. Welch's involvement in agriculture since middle school, and with agricultural economics since college, gave him the expertise necessary to oversee a working ranch. The Tax Court also noted that Welch hired competent professionals, including managers, trainers, and ranch hands.

The Tax Court was unpersuaded by the IRS's argument that the ranch could not be run for profit because Welch was at the ranch only on weekends. The Tax Court reasoned that Welch was at the ranch at least three full days per week and was in daily contact with the ranch manager. He also spoke regularly with the horse and cattle managers, who were full time employees, while he was away from the ranch. The fact that Welch employed 25 full time people to carry on the ranch showed that the ranch was being operated for profit, the Tax Court found.

The Tax Court also rejected the IRS's argument that Welch's profit motive had to include an expectation that he would recoup all of Center Ranch's past losses. The Tax Court found that the relevant inquiry was rather whether Welch would recoup the losses between the years at issue and the time at which future profits were expected. Welch's expectation of an overall profit could be realized with the appreciation of the ranch assets and the value of capital improvements made on ranch property, according to the Tax Court.

Next, the Tax Court considered Welch's success in other professional areas. It found that although Welch had been successful in other endeavors, there was little interplay between his consulting and software businesses and his ranch activity. Because his success was in dissimilar activities, the Tax Court found this factor to be neutral.

The Tax Court reviewed Center Ranch's history income and losses and noted that the ranch had reported losses for every year at issue. However, the Tax Court determined that the losses resulted from increased capital expenses and investment, and found that the ranch generated millions of dollars of gross income for those years. The Tax Court noted that the cattle and horse operations were still in their startup phases for the years at issue and reasoned that Welch was slowly and steadily working towards a profitable cutting horse operation. The Tax Court concluded that the ranch's history of income and losses and the amount of occasional profits, if any, favored the IRS, but the court did not give this factor great weight because those operations were still in their startup phases.

Finally, the Tax Court determined that although Welch had substantial wealth and financial resources unrelated to Center Ranch and contributed $9 million of his own money to the ranch's capital, this unrelated wealth did not preclude a finding that the ranch activity was engaged in for profit. The Tax Court found that the receipt of tax benefits standing alone did not establish a lack of profit motive. The Tax Court also noted that Welch's injuries made him unable to derive personal pleasure from Center Ranch's outdoor operations. The Tax Court concluded that Welch's financial status and elements of personal pleasure or recreation were neutral factors.

Observation: The Tax Court warned Welch that, although it had found him to be engaged in a for profit activity during the years at issue, it was not declaring the ranch to be for profit ad infinitum. The Tax Court stated that if the ranch's future losses could not be reined in, Welch could again find himself defending his profit motive before the Tax Court.

For a discussion of the deductibility farm losses, see Parker Tax ¶162,535.

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Chief Counsel's Addresses Deathbed Purchase of Remainder Interest in a Grantor Retained Annuity Trust

The Office of Chief Counsel advised that where the purchase of a remainder interest in transferred property in which the donor has retained an annuity occurs on the donor's deathbed during the term of the annuity, the remainder does not replenish the donor's taxable estate. In addition, the Office of Chief Counsel advised that a note given in exchange for property that does not constitute adequate and full consideration in money or money's worth for gift tax purposes is not deductible as a claim against a decedent's estate. CCM 201745012.

Under the facts in CCM 201745012, on Date 1, a donor formed Trust 1, an irrevocable discretionary trust for the benefit of the donor's first spouse and issue. Trust 1 terminates on the later of the death of the donor or his first spouse, at which time the principal and any accumulated income are distributed outright to the donor's issue per stirpes. The donor's first spouse predeceased him; the donor then married again.

On Date 2, the donor formed Trust 2, an irrevocable trust for the benefit of the donor and his issue. Under the terms of Trust 2, an annuity is payable to the donor for the term of the trust, and the remainder is payable under the terms of Trust 1.

On Date 3, the donor formed Trust 3, an irrevocable trust for the benefit of the donor and his issue. Under the terms of Trust 3, an annuity is payable to the donor for the term of the trust, and the remainder is payable under the terms of Trust 1.

On Date 4, a date before the expiration of the respective terms of Trusts 2 and 3, the donor purchased the remainder interests in Trusts 2 and 3 from the trustees of Trust 1. The donor paid the purchase price with two unsecured promissory notes and died the following day.

The donor's executor filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, and reported the purchases of the remainder interests as non-gift transfers, asserting that the donor received adequate and full consideration in money or money's worth in the form of the remainder interests in Trusts 2 and 3. The donor's spouse elected to split gifts with the donor.

The donor's death occurred before the expiration of the respective terms of the annuities payable from the assets transferred to Trusts 2 and 3. The donor's executor filed Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and included the corpus of Trusts 2 and 3 in the gross estate pursuant to Code Sec. 2036(a)(1) and Reg. Sec. 20.2036-1(c)(2). The donor's executor deducted the value of the outstanding promissory notes payable to the trustees of Trust 1 as claims against the estate.

The IRS raised two issues in this case and sought advice from the Office of Chief Counsel. First, the IRS questioned whether the remainder interest in transferred property in which the donor has retained an annuity replenishes the donor's taxable estate so as to constitute adequate and full consideration in money or money's worth for gift tax purposes where the purchase of the remainder occurs on the donor's deathbed during the term of the annuity. Second, the IRS questioned whether a note given in exchange for property that does not constitute adequate and full consideration in money or money's worth for gift tax purposes is deductible as a claim against the estate.

The Office of Chief Counsel advised that, where the purchase of the remainder occurs on the donor's deathbed during the term of the annuity, the remainder does not replenish the donor's taxable estate. Citing the Supreme Court's decision in Merrill v. Fahs, 324 U.S. 308 (1945), the Office of Chief Counsel advised that the remainder does not constitute adequate and full consideration in money or money's worth for gift tax purposes.

With respect to the second issue, the Office of Chief Counsel advised that a note given in exchange for property that does not constitute adequate and full consideration in money or money's worth for gift tax purposes is not deductible as a claim against the estate.

For a discussion of the estate tax treatment of transfers with a retained life estate, see Parker Tax ¶225,500.

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Ninth Circuit Denies Foreign Tax Credit Because Investment in Foreign Preferred Stock Was Debt

The Ninth Circuit affirmed a Tax Court decision finding that a taxpayer's investment in the preferred stock of a Dutch company was debt, not equity, and that the taxpayer therefore could not claim foreign tax credits relating to the investment. The Ninth Circuit determined that in resolving the debt/equity question, the relevant test was the parties' subjective intent in creating the instrument. Hewlett-Packard Co. v. Comm'r, 2017 PTC 509 (9th Cir. 2017).

In the 1990s, AIG Financial Products created a Dutch company, Foppingadreed Investments (FOP), which purchased contingent interest notes. The arrangement took advantage of the fact that contingent interest - interest payments that depend on future developments, and may never be paid at all - was immediately taxable in the Netherlands but not in the U.S. FOP issued preferred shares entitling their owners to dividends from the notes. An American company owning FOP preferred stock would thus be entitled to a foreign tax credit for FOP's Dutch taxes. ABN, a Dutch bank, would own FOP's common stock and sell it the contingent notes.

Because the accrued contingent interest was taxable in the Netherlands but not in the U.S., FOP would generate excess foreign tax credits that the U.S. investor could use to offset American taxes on other foreign profits. And, because FOP could do little other than purchase contingent interest notes, the preferred stock essentially guaranteed a fixed stream of payments. FOP was not permitted to have any general creditors.

In 1996, AIG sold the FOP preferred stock to Hewlett-Packard (HP) for approximately $200 million. HP contemporaneously purchased a put option from ABN, giving HP the right to sell its shares to ABN in 2003 or 2007. HP claimed millions in foreign tax credits between 1997 and 2003. In 2003, it exercised its option to sell the preferred back to ABN and reported a capital loss of over $16 million.

The IRS issued two notices of deficiency to HP. One was for a portion of HP's foreign tax credits and the second was for the capital loss. Under Code Sec. 902, HP was entitled to foreign tax credits only if it owned at least 10 percent of the voting stock and received dividends from FOP; in other words, HP's investment had to be equity, not debt. HP petitioned the Tax Court, which found that the transaction was best characterized as debt, and upheld the deficiency relating to the credits. The capital loss deduction was denied based on a finding that the loss was in fact a fee paid for a tax shelter. The Tax Court looked beyond the formal labels attached to the documents and found that the FOP preferred had a de facto maturity date and gave HP de facto creditor's rights. The Tax Court found that HP had an overwhelming economic incentive to divest itself of FOP after 2003 because after that year, FOP would have negative earnings and HP would no longer be able to claim the foreign tax credits. HP filed an appeal with the Ninth Circuit.

The Ninth Circuit held that the Tax Court did not err in finding that HP's investment was best characterized as debt. The court found that the Tax Court properly weighed and considered the factors set forth in A.R. Lantz Co. v. U.S, 424 F.2d 1330 (9th Cir. 1970), which are used to determine the parties' subjective intent in crafting an instrument.

According to the Ninth Circuit, HP never intended to stay in the transaction beyond 2003. The Ninth Circuit also noted that HP's income from the FOP preferred was highly predictable because HP received semiannual payments equal to a percentage of the after tax base interest on the notes. HP had a contractual remedy against ABN as well as FOP if ABN failed to pay interest on the notes. Although payment of the dividends was contingent on FOP's earnings, the Ninth Circuit found that FOP's earnings were all but predetermined. HP's investment, the court concluded, earned it a limited return for a fixed period.

The Ninth Circuit further determined that the Tax Court properly took into account HP's put option as part of the overall transaction. The put was correctly considered to be part of an integrated transaction, according to the Ninth Circuit, because FOP was a party to the shareholders' agreement and was obligated to take all necessary or appropriate actions to implement the put. Moreover, FOP was precluded from issuing additional stock or carrying out any business other than buying contingent interest notes.

With respect to HP's disallowed capital loss, the Ninth Circuit held that the Tax Court's judgment that the loss was a fee paid for a tax shelter was based on a permissible view of the evidence. The Ninth Circuit noted that internal HP communications referred to the "fee" that HP had to pay AIG in order to participate in the FOP deal, and that a clawback agreement obligated AIG to compensate HP if HP did not get its desired tax results.

For a discussion of the foreign tax credit, see Parker Tax ¶101,900.

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Taxpayer Was Shareholder of S Corporation, Despite Poor Relationship with Other Shareholders

The Tax Court held that a shareholder of an S corporation remained a beneficial owner notwithstanding a violation of the shareholder agreement and a poor relationship with the other shareholders, and therefore could not exclude his pro rata share of the S corporation income from his taxable income. The taxpayer could also not take a theft loss deduction for another shareholder's use of corporate funds for personal purposes because the taxpayer failed to prove that a theft occurred. Enis v. Comm'r, T.C. Memo 2017-222.

Jay Enis is a businessman, investor and consultant. After moving from New Jersey to Florida in 2000 with his wife, Sue, Enis began working with Jack Burnstein in a partnership with Mr. Burnstein's merchant banking firm, Strategica Capital Associates, Inc.

In 2006, Strategica entered into a consulting agreement with NLS, an S corporation founded by Dr. Mark Ginsburg. NLS is a diagnostic laboratory supplying blood diagnostic testing to dialysis patients. Dr. Ginsburg had approached Enis in 2004 to ask whether he would consider getting involved in NLS. Enis observed at the time that NLS lacked a solid financial infrastructure.

Under a consulting agreement, Strategica agreed to settle NLS's existing liabilities, diversify its business, and implement a financial infrastructure. NLS agreed to pay $60,000 per month for these services. Dr. Ginsburg would own 50 percent of NLS and the other half would be owned by members of Strategica (Strategica Group). Mrs. Enis received 50 percent of Strategica Group's NLS stock, and the remainder was divided among other shareholders. A shareholder agreement named Dr. Ginsburg the president of NLS and Mr. Enis the vice president and treasurer. Although the agreement provided that management decisions were to be decided by a majority vote of the board, the board met only once after executing the agreement. The agreement also required distributions of more than $100,000 to be approved both by Dr. Ginsburg and by a member of Strategica Group, but NLS frequently made such payments without receiving such approval.

The NLS financial statements revealed that Dr. Ginsburg had loaned NLS over $7 million at the time of its organization. Funds paid by NLS on Dr. Ginsburg's behalf, including personal expenses, were charged against the loan, reducing its balance. Interest on the loan was paid to Dr. Ginsburg monthly until a bankruptcy trustee stopped payments.

Beginning in 2009, the relationship between Dr. Ginsburg and Strategica began to deteriorate. Mr. Enis approached Dr. Ginsburg concerning NLS expenses that Enis believed were personal and unrelated to the business, money spent on other ventures, and Dr. Ginsburg's mistreatment of employees. Mr. Enis also took issue with Dr. Ginsburg's prioritizing personal financial obligations over those of NLS. At some point in 2009, members of Strategica were no longer allowed to enter NLS premises and Dr. Ginsburg stopped providing financial information to Strategica shareholders. Eventually, NLS stopped paying Strategica for consulting services. Dr. Ginsburg's financial dealings with NLS were not reported to the police.

In April 2009, Dr. Ginsburg sued NLS and won a judgment for loans he claimed to have made to NLS. Strategica Group shareholders were not aware of the lawsuit. In August 2009, Strategica sued Dr. Ginsburg for breach of the consulting agreement and failure to pay fees and expenses. Dr. Ginsburg filed for bankruptcy in 2010. Mrs. Enis ultimately sold her NLS shares in 2014 for approximately $436,000.

The Enises filed their 2007 joint tax return, which was due in October 2008, in December 2009. Their 2010 return was due in October 2011 but they filed it in June 2012. When their return preparer became ill, they were forced to find another return preparer.

On their 2010 return, the Enises excluded the income from Mrs. Enis's NLS shares on the basis that NLS had initiated litigation to contest her ownership. The Enises stated that they were excluding the NLS income pending resolution of this issue. They claimed several deductions, including a purported theft loss deduction from Dr. Ginsburg's alleged personal use of corporate funds. They also claimed approximately $140,000 in losses from SEI, a partnership they formed to isolate investments in which Mrs. Enis was directly involved. In addition, they claimed a net operating loss (NOL) deduction of around $2.4 million. The claimed NOL deductions were for entities in which SEI was a partner. The Enises attempted to substantiate the NOL deductions by attaching either Schedules K-1 or Forms 1065 for these entities.

The IRS issued notices of deficiency in 2013. It found a deficiency of approximately $184,000 and added a late filing penalty of $45,000 for 2007. For 2010, the notice claimed a deficiency of $358,000 and a penalty of $88,000. The IRS asserted that Mrs. Enis's income from NLS should have been included in income and it disallowed the claimed losses for those years. According to the IRS, the Enises failed to establish their bases in SEI and failed to substantiate their entitlement to the NOL deductions.

The Tax Court upheld the deficiencies and penalties. First, it held that the income from NLS could not excluded because Mrs. Enis was a shareholder for the years at issue. According to the Tax Court, stock ownership for tax purposes is determined by a shareholder's beneficial ownership, and the court found no authority allowing shareholders to exclude S corporation income because of poor shareholder relations alone. Rather, the Tax Court found that cases where a shareholder did not have beneficial ownership generally involved both agreements between shareholders and provisions in the articles of incorporation affecting the shareholder's ownership rights. Moreover, the Tax Court reasoned that Mrs. Enis had not been deprived of the economic benefit of her NLS shares and in fact had ultimately sold those shares for over $436,000.

Next, the Tax Court held that the Enises were not entitled to a theft loss deduction because they failed to prove that Dr. Ginsburg committed a theft. Dr. Ginsburg's personal use of corporate funds did not itself prove that he had the requisite intent to commit a theft. Dr. Ginsburg did not conceal his loan to NLS or the payments made against the loan. Rather, the loan was recorded in NLS's financial statements, which were made available to Strategica Group shareholders. The Tax Court concluded that while some of Dr. Ginsburg's actions may have been against the interests of the Strategica Group shareholders, and may have violated the shareholder agreement, they did not constitute a theft for purposes of Code Sec. 165.

With regard to the claimed losses from SEI, the Tax Court disallowed the deductions because it found that the Enises had failed to substantiate their bases in SEI. The Enises offered only a schedule of expenses from their 2010 return as proof, and the Tax Court found that tax returns alone do not constitute proof of basis. Likewise, the NOL deductions were disallowed because the Enises could not substantiate the losses with any evidence other than the entities' tax returns. Finally, the Tax Court upheld the penalties, finding that the tax preparer's illness did not constitute reasonable cause for the late filings.

For a discussion of determining ownership of an S corporation for tax purposes, see Parker Tax ¶31,935.20. For a discussion of the theft loss deduction, see Parker Tax ¶84,501.