Federal Tax Bulletin - Issue 150 - October 4, 2017

GOP Releases Tax Reform Blueprint

On September 27, the Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance released a nine-page framework for overhauling the tax code ("the framework"). The framework calls for: (1) modest cuts in individual tax rates, to be offset by the elimination of most itemized deductions, (2) repeal of the estate and generation skipping transfer taxes, (3) a maximum 25 percent tax rate on pass-through business income, and (4) a sharp cut in the top corporate tax rate to 20 percent, to be partially offset by elimination of corporate tax preferences. GOP Tax Framework (9/27/2017).

While the framework is lighter on specifics than the 2016 Trump campaign tax plan ("2016 Trump tax plan") and the 2016 plan released by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady ("2016 Ryan-Brady plan"), it fills in some of the blanks from the single-page tax reform outline released by the White House in April.

Changes Affecting Individuals

Eliminating Personal Exemptions While Increasing the Standard Deduction. Under the framework, the standard deduction will be nearly doubled to $24,000 for married taxpayers filing jointly, and $12,000 for single filers. However, this larger standard deduction incorporates personal exemptions, which are eliminated. The combined effect for most taxpayers would be a roughly 15% increase in the amount of income excluded from taxation.

Example: Under present law, the first $10,400 of income earned by a single taxpayer under age 65 is exempt from income tax ($6,350 standard deduction plus $4,050 personal exemption). Under the framework, the first $12,000 in income would escape taxation, a $1,600 (or 15.4%) improvement.

Observation: This change will be detrimental to taxpayers who itemize rather than take the standard deduction because they will lose their personal exemptions and receive no benefit from the increased standard deduction.

Replacing Dependency Exemptions with Tax Credits. In lieu of dependency exemptions for children, the framework provides for a significant, but unspecified increase the child tax credit ($1,000 under current law). The first $1,000 of the credit will continue to be refundable. In addition, the framework would add a non-refundable credit of $500 for non-child dependents.

Observation: The framework is silent on the amount of the increase in the child tax credit, but the 2016 Ryan-Brady plan may provide a clue. That plan called for a $500 increase in the credit in conjunction with the elimination of dependency exemptions. Such a tradeoff would be a small win for taxpayers in the current 10 percent bracket, and a loss for most taxpayers in higher brackets, to whom a dependency exemption can be worth as much as $1,337 ($4,050 dependency exemption amount times the top tax rate of 33% that applies before the phaseout of dependency exemption).

Consolidating Seven Tax Brackets into Three Tax Brackets. While current law has seven tax brackets, the framework would reduce that number to three tax brackets - 12%, 25%, and 35%. The framework adds that an additional top rate may apply to the highest-income taxpayers in order to ensure that the reformed tax code is at least as progressive as the existing code. The framework doesn't indicate the thresholds at which the different rates apply.

Observation: The proposed increase in the bottom rate from 10 percent to 12 percent bucks a three-decade trend in tax legislation during which the bottom rate has either been left alone or reduced. The last tax law to increase the bottom rate was the Tax Reform Act of 1986, which offset the change with large increases in both the standard deduction and personal and dependency exemptions.

Eliminating Itemized Deductions Other Than Mortgage Interest and Charitable Donations. The framework states that it will eliminate "most itemized deductions" with the exception of the mortgage interest deduction and the deduction for charitable contributions. On this point, the framework's language departs subtly from the language of the Ryan-Brady plan, which explicitly calls for the elimination of all itemized deduction other than the ones for mortgage interest and charitable contributions. The softer language of the framework appears to signal an expectation that some other deductions may be spared.

Observation: Coming off a highly destructive hurricane season, it will be interesting to see if Congress has the resolve to eliminate the casualty loss deduction - the same deduction that it just enhanced for victims of Hurricanes Harvey, Irma, and Maria with H.R. 3823, The Disaster Tax Relief and Airport and Airway Extension Act of 2017.

Any battle over the casualty loss deduction will pale in comparison to the one over the deduction for state and local taxes (SALT deduction), a tax preference backed by powerful interest groups and dear to tens of millions of middle class taxpayers - many of whom would stand to see their federal taxes increase significantly (despite rate cuts) if it were repealed. The battle over the SALT deduction is expected to play out primarily in the House, where the focus will be on 33 Republican representatives from New York, New Jersey, California, and six other high tax states.

Alternative Minimum Tax (AMT). The framework would repeal the AMT, finding it unnecessary in light of the simplification that the overhaul of the tax code will bring.

Capital Gain Tax Rates. The framework makes no mention of reducing capital gain tax rates. Such reductions were a prominent feature of both the 2016 Trump tax plan and the Ryan-Brady plan.

Other Provisions Affecting Individuals. According to the framework, numerous other exemptions, deductions and credits for individuals riddle the tax code and the repeal of many of these provisions is envisioned in order to make the system simpler and fairer for all families and individuals, and allow for lower tax rates. However, without being specific, the framework states that tax benefits that encourage work, higher education and retirement security will be retained.

Eliminating the Estate Tax and Generation-Skipping Transfer Taxes. The framework repeals the estate tax and the generation-skipping transfer tax.

Changes Affecting Domestic Businesses

Limiting Tax Rate Applicable to Passthrough Income. The framework limits the maximum tax rate that applies to the business income of small and family-owned businesses conducted as sole proprietorships, partnerships, and S corporations to 25 percent.

Reduction in Top Corporate Tax Rate. The framework reduces the corporate tax rate to 20 percent and notes that this is below the 22.5 percent average of the industrialized world. The corporate AMT is also slated for repeal.

Enhanced Expensing. Another big boost for businesses is the framework's proposal to allow businesses to immediately write off the cost of new investments in depreciable assets (other than structures) made after September 27, 2017.

Limitation of Interest Expense Deduction; Repeal of Other Business Deductions. The framework proposes to partially limit the deduction for net interest expense incurred by C corporations. Because of the framework's substantial rate reduction for all businesses, it proposes the elimination of the Code Sec. 199 domestic production activities deduction. In addition, the framework advises that numerous other special exclusions and deductions will be repealed or restricted, without mentioning them by name.

Business Tax Credits. The framework explicitly preserves business credits in two areas where it says that tax incentives have proven to be effective in promoting policy goals important in the American economy: research and development (R&D) and low-income housing. While the framework envisions repeal of other business credits, it notes that Congressional committees may decide to retain some other business credits to the extent budgetary limitations allow.

Changes Affecting International Businesses

The framework aims to transform the existing "offshoring" model to an American model by eliminating incentives to keep foreign profits offshore by exempting them when they are repatriated to the United States. It will replace the existing, outdated worldwide tax system with a 100 percent exemption for dividends from foreign subsidiaries (in which the U.S. parent owns at least a 10 percent stake), resulting in a new "territorial" tax system.

To transition to this new territorial system, the framework treats foreign earnings that have accumulated overseas under the old system as repatriated. Accumulated foreign earnings held in illiquid assets will be subject to a lower tax rate than foreign earnings held in cash or cash equivalents. Payment of the tax liability will be spread out over several years.

To prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations. The framework anticipates that Congressional committees will incorporate rules to level the playing field between U.S.-headquartered parent companies and foreign-headquartered parent companies.

Effects on Deficit; Distributional Effects

Because the framework does not specify thresholds for individual tax rates, key amounts such as the additional child tax credit, and which corporate tax preferences will be curtailed, it can only be scored for its effect on the deficit by making assumptions about the missing details.

The Tax Policy Center (TPC), a well-respected tax policy think tank, has done just that, using information from the 2016 Trump tax plan, the 2016 Ryan-Brady plan, and statements from the Trump Administration and Congressional leaders to fill in the blanks.

The conclusion of their preliminary analysis is that the framework would reduce federal revenue by $2.4 trillion over the next decade, followed by a reduction of $3.2 trillion over the following decade, and that taxpayers with incomes in the top 1 percent would get the lion's share of the tax benefits (50 percent of the benefits in 2018; 80 percent by 2027). The TPC also concluded that by 2027, nearly 30 percent of taxpayers with incomes between $50,000 and $150,000 would see their federal tax bill rise, as would 60 percent of those with incomes between $150,000 and $300,000.

Although the numbers are preliminary and somewhat speculative, they conform with an emerging consensus that implementation of the framework would create several relatively narrow groups of winners and a few broad groups of losers. Big winners would include most C corporations and their shareholders, highly affluent individuals, heirs to large estates, and owners of passthrough businesses with enough income to benefit from the proposed 25 percent rate cap. Losers would include taxpayers outside those groups who currently itemize, and taxpayers in the middle tax brackets (25, 28, and 33 percent) with multiple dependents.

What's Next for Tax Reform

In public comments, Treasury Secretary Steve Mnuchin and National Economic Council Director Gary Cohn have stood by an aggressive timeline that would have the President signing tax reform into law by year's end. Most informed sources outside the White House are skeptical about that time frame.

Before a legislative push can even begin in earnest, the House and Senate will have to pass and then reconcile competing budget resolutions to unlock the reconciliation process in the Senate (which is necessary for tax reform to be able to pass the Senate with a simple majority).

When that hurdle is cleared, legislators will face the arduous task of filling in all of the blanks in the tax framework, including specifying which business tax breaks will be eliminated to pay for sharp reductions in the top corporate and passthrough tax rates, and the details of a new territorial tax system for multinationals. The fact that none of the heavy lifting required to complete corporate tax reform has been done, looms as the single biggest obstacle to getting tax reform done this year, and raises questions about whether it can even be accomplished without bipartisan support.

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Disaster Tax Relief Becomes Law; Provides Enhanced Casualty Loss Deductions and Other Tax Breaks to Hurricane Victims

Last week, the President signed into law the Disaster Tax Relief and Airport and Airway Extension Act of 2017 (the Act), providing multiple tax relief measures to victims of Hurricanes Harvey, Irma, and Maria. In addition to increasing the amount of deductions for personal casualty losses and making the deduction available to taxpayers who take the standard deduction, the Act also provides for employment-related tax credits, relaxes retirement plan rules, suspends limitations on charitable contributions, and makes it easier for taxpayers to meet income requirements for the earned income tax credit and the child tax credit. H.R. 3823 (9/29/2017).

Practice Aids: See ¶320,098, for a sample client letter explaining Hurricane Harvey tax relief, ¶320,097 for a letter explaining Hurricane Irma tax relief, and ¶320,096 for a letter explaining Hurricane Maria tax relief.

The Act also extends several federal aviation programs, aviation taxes, and public health programs and modifies requirements for purchasing flood insurance. It extends through March 31, 2018, the expenditure authority for the Airport and Airway Trust Fund and the taxes that finance the fund, including fuel taxes, ticket taxes, and taxes related to fractional ownership programs.

Enhancements to Casualty Loss Deduction Rules

Generally, the deduction for a casualty loss of personal-use property is subject to a $100 reduction rule (only losses above $100 are counted) and the loss is limited to the extent it exceeds 10 percent of the taxpayer's adjusted gross income. The new law removes the 10 percent of adjusted gross income limitation, but increases the $100 floor to $500. It also allows individuals to claim a casualty loss even if they do not itemize their deductions by adding the amount of the loss to their standard deduction.

To qualify, a loss must be attributable to a federally declared disaster and occur in an area determined by the President to warrant assistance by the federal government under the Stafford Act. The deduction is limited to the "net disaster loss" which consists of the excess of personal casualty losses attributable to a federally declared disaster over personal casualty gains.

Employee Retention Tax Credit Available to Businesses

The act provides that eligible employers with an employee retention credit of 40 percent of qualified wages with respect to each eligible employee for 2017. The amount of qualified wages which may be taken into account cannot exceed $6,000 paid to an eligible individual (making the maximum credit $2,400 per eligible employee).

A taxpayer is considered an eligible employer if it conducted an active trade or business on the applicable disaster date for the taxpayer's location, and the trade or business was inoperable on any day after that date and before January 1, 2018, as a result of damage sustained by reason of the Hurricane which affected the taxpayer's location. Applicable disaster dates are as follows: August 23, 2017 for Hurricane Harvey; September 4, 2017 for Hurricane Irma; and September 16, 2017 for Hurricane Maria.

An eligible employee means an employee whose principal place of employment on the applicable disaster date, with such eligible employer was in the applicable Hurricane disaster zone.

Retirement Plan Rules Relaxed

The Act contains the following relief provisions regarding retirement plans:

(1) The 10 percent early withdrawal penalty tax in Code Sec. 72(t) will not apply to any qualified hurricane distribution made from a taxpayer's qualified retirement plan.

(2) The aggregate amount of distributions from a qualified retirement plan received by an individual which may be treated as qualified hurricane distributions for any tax year cannot exceed the excess (if any) of (i) $100,000, over (ii) the aggregate amounts treated as qualified hurricane distributions received by such individual for all prior tax years.

(3) If a distribution to an individual would (without regard to (2), above) be a qualified hurricane distribution, a plan will not be treated as violating any requirement of the Code merely because the plan treats such distribution as a qualified hurricane distribution, unless the aggregate amount of such distributions from all plans maintained by the employer (and any member of any controlled group which includes the employer) to such individual exceeds $100,000.

(4) Any individual who receives a qualified hurricane distribution may, at any time during the three-year period beginning on the day after the date on which such distribution was received, make one or more contributions in an aggregate amount not to exceed the amount of such distribution to an eligible retirement plan of which such individual is a beneficiary and to which a rollover contribution of such distribution could be made under Code Secs. 402(c), 403(a)(4), 403(b)(8), 408(d)(3), or Code Sec. 457(e)(16). If such contributions are made with respect to a qualified hurricane distribution from an eligible retirement plan other than an individual retirement plan, then the taxpayer will, to the extent of the amount of the contribution, be treated as having received the qualified hurricane distribution in an eligible rollover distribution and as having transferred the amount to the eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution. If such contributions are made with respect to a qualified hurricane distribution from an individual retirement plan, then, to the extent of the amount of the contribution, the qualified hurricane distribution will be treated as a distribution described in Code Sec. 408(d)(3) and as having been transferred to the eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution.

(5) In the case of any qualified hurricane distribution, any amount required to be included in gross income for such tax year will be includible ratably over the three-tax-year period beginning with such tax year, unless the taxpayer elects not to have this rule apply for any tax year. For purposes of this provision, rules similar to Code Sec. 408A(d)(3)(E), relating to an acceleration of the inclusion of such amounts in income, apply.

(6) Any individual who received a qualified distribution may, during the period beginning on the applicable disaster date for the taxpayer's location (e.g., August 23 for Hurricane Harvey), and ending on February 28, 2018, make one or more contributions in an aggregate amount not to exceed the amount of such qualified distribution to an eligible retirement plan of which such individual is a beneficiary and to which a rollover contribution of such distribution could be made under Code Secs. 402(c), 403(a)(4), 403(b)(8), or Code Sec. 408(d)(3), as the case may be.

(7) The limit on loans from a qualified employer plan to a qualified individual that are not treated as taxable distributions is increased from $50,000 to $100,000, and the repayment of such loan may be delayed from the regular repayment term by an additional year.

Modification of Earned Income for Purposes of the Earned Income Credit and Child Tax Credit

If a taxpayer is eligible for the earned income credit and the child tax credit for 2017, and the taxpayer's earned income for the 2017 tax year is less than the taxpayer's earned income for 2016, the earned income credit and child tax credit may, at the taxpayer's election, be determined by substituting 2016 earned income for 2017 earned income. For residents of Puerto Rico determining the child tax credit, social security taxes are used instead of earned income.

Suspension of Limitations on Charitable Contributions

A temporary suspension of the limitations on charitable contributions applies with respect to qualified contributions, which are defined as those made between August 23, 2017, and December 31, 2017, to a charitable organization and made for relief efforts with respect to the hurricane disaster areas. The taxpayer must make an election to apply these rules. In the case of a partnership or S corporation, the election is made separately by each partner or shareholder.

For a discussion of special tax rules relating to disaster relief, see Parker Tax ¶79,300.

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Taxpayer Can File Joint Return After Original Return Erroneously Reported Single Status

The Tax Court held that a return that a taxpayer originally filed, erroneously claiming single status, did not constitute a "separate return" within the meaning of Code Sec. 6013(b) and, thus, the taxpayer and his wife were entitled to file a joint return and pay joint return tax rates for the year at issue. The Tax Court concluded that the term "separate return" means a return on which a married taxpayer has claimed the permissible status of married filing separately, rather than a return on which a married taxpayer has claimed a filing status not properly available to him or her. Camara v. Comm'r, 149 T.C. No. 13 (2017).

Facts

Fansu Camara was married to Aminata Jatta. Nevertheless, on his 2012 Form 1040, which he filed on April 15, 2013, Mr. Camara erroneously checked the box for single filing status. In a notice of deficiency issued to Mr. Camara for his 2012 tax year, the IRS changed his filing status from single to married filing separately. On May 8, 2015, Mr. Camara and Ms. Jatta timely petitioned the Tax Court with respect to that notice of deficiency as well as a notice of deficiency that the IRS issued to them for their 2013 tax year. On May 27, 2016, Mr. Camara and Ms. Jatta filed with the IRS a joint 2012 return, which they had both signed. Ms. Jatta had not previously filed a 2012 return.

The couple and the IRS agreed that if Mr. Camara and Ms. Jatta were entitled to elect joint filing status for 2012, the joint return that they filed on May 27, 2016 - after receiving the notice of deficiency and petitioning the Tax Court - correctly reflected their 2012 tax liability with certain agreed-upon changes. And the IRS conceded that Mr. Camara and Ms. Jatta met the substantive requirements for joint filing status and rates for 2012. However, the IRS contended that Code Sec. 6013(b)(2) barred Mr. Camara and Ms. Jatta from filing a joint return, and consequently, they were procedurally barred from claiming the benefits generally available to married taxpayers who file a joint return.

Code Sec. 6013 governs whether a married couple may file a joint return. Under Code Sec. 6013(a), a married couple can "make a single return jointly of income taxes" subject to three restrictions, which are not applicable in this case. Code Sec. 6013(b) permits married taxpayers to elect in certain circumstances to switch from a separate return to a joint return. Code Sec. 6013(b)(1) provides that if an individual has filed a "separate return" for a tax year for which that individual and his or her spouse could have filed a joint return, that individual and his or her spouse may nevertheless "make a joint return" for that year. Because the Code Sec. 6013(b) election applies only where an individual has filed a separate return, limitation under Code Sec. 6013(b)(2) likewise apply only if the individual has filed a separate return. The term "separate return" in Code Sec. 6013(b)(1) is not defined in the Code or the regulations.

IRS Arguments

The IRS argued that Mr. Camara's original 2012 return, on which he erroneously claimed single filing status, constituted a "separate return" within the meaning of Code Sec. 6013(b)(1) and, consequently, two limitations under Code Sec. 6013(b)(2) applied to prevent Mr. Camara from making the Code Sec. 6013(b) election to switch to a joint return. The two limitations that the IRS invoked were in Code Sec. 6013(b)(2)(A) and Code Sec. 6013(b)(2)(B). The first limitation bars the Code Sec. 6013(b) election after three years from the filing deadline (without extensions) for filing the return for that year. The second limitation bars the Code Sec. 6013(b) election after there has been mailed to either spouse, with respect to such tax year, a notice of deficiency, if the spouse, as to such notice, files a petition with the Tax Court within 90 days.

According to the IRS, the two limitations were satisfied because: (1) the date on which Mr. Camara and Ms. Jatta filed a joint return - May 27, 2016 - was more than three years after Mr. Camara filed a separate return; and (2) Mr. Camara received a notice of deficiency, and filed a petition with the Tax Court before filing a joint return.

The IRS also cited the Sixth Circuit's decision in Morgan v. Comm'r, 807 F.2d 81 (6th Cir. 1986), aff'g T.C. Memo. 1984-384, as compelling a decision in its favor. Morgan involved married taxpayers who filed "protest returns" claiming married filing jointly status for some years and married filing separately status for other years. Affirming the Tax Court, the Sixth Circuit in Morgan held that Code Sec. 6013(b)(2) precluded the husband from claiming the benefits of joint return filing status after the IRS issued a notice of deficiency calculating his tax on the basis of married filing separately.

Tax Court Holding

The Tax Court held that the 2012 return that Mr. Camera originally filed, erroneously claiming single status, did not constitute a "separate return" within the meaning of Code Sec. 6013(b). Thus, Mr. Camera and his wife were entitled to file a joint return and pay joint return tax rates for that year.

The Tax Court began its analysis by noting that the issue raised by the IRS has not been formally addressed by the Tax Court in a reported or reviewed opinion. The court also noted that no Court of Appeals has held that a single return or a head of household return is a separate return for the purposes of Code Sec. 6013(b) and the two Appeals Court cases that have considered this issue, Ibrahim v. Comm'r, 788 F.3d 834 (8th Cir. 2015) and Glaze v. Comm'r, 641 F.2d 339 (5th Cir. 1981), have held the opposite. The court also observed that some Memorandum Opinions had interpreted "separate return" to include a single return or a head of household return for this purpose. For the most part, however, those Memorandum Opinions merely accepted the rationale of earlier cases, and the ultimate authority for those Memorandum Opinions appeared to be traceable to earlier cases where the effect of an erroneous claim of filing status was neither addressed nor even presented as an issue.

The Tax Court noted that its decision in the instant case would be appealable to the Sixth Circuit. However, the court rejected the IRS's argument that the Sixth Circuit's holding in Morgan compelled it to rule in the IRS's favor. Morgan, the court said, did not squarely address the issue presented in the instant case because Morgan did not explain the effect under Code Sec. 6013(b) of a married taxpayer's initial filings of a return erroneously claiming single status.

The court did find, however, that the Fifth Circuit, in Glaze, squarely addressed the issue. In Glaze, the Fifth Circuit held that filing a return with an erroneous claim to an impermissible filing status (i.e., a filing status of single when the taxpayer was married) did not constitute an "election" to file a separate return. The Fifth Circuit in Morgan, the court observed, distinguished Glaze on the grounds that Glaze involved no protest return and the taxpayer had not attempted to file a return as a married taxpayer originally. The Tax Court found that Mr. Camara's case was distinguishable from Morgan on the same grounds on which Glaze was distinguished in Morgan. Mr. Camara neither filed a protest return nor attempted to file a return as a married taxpayer originally.

Considering the context of Code Sec. 6013(b) as a whole and giving due regard to the Fifth Circuit's opinion in Glaze, as well as an Eight Circuit's opinion in Ibrahim, the Tax Court concluded that the term "separate return" means a return on which a married taxpayer has claimed the permissible status of married filing separately, rather than a return on which a married taxpayer has claimed a filing status not properly available to him or her.

Finally, the court also noted that the legislative history showed that Code Sec. 6013(b)(1) was intended only to provide taxpayers flexibility in switching from a proper initial election to file a separate return to an election to file a joint return; it was not intended to foreclose correction of an erroneous initial return.

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Farm Rental Income from Wholly Owned S Corporation Was Not Subject to Self-Employment Tax

The Tax Court held that the owners of a farm who rented a portion of it to a wholly owned S corporation that contracted with an unrelated company to raise chickens did not have to include the rent as self-employment (SE) income because the rent payments were at or below fair market value and the IRS failed to show a nexus between the rents and the owners' obligation to participate in the business. While there were several dissenting opinions, the Tax Court ruled that, because of the reversal of a prior Tax Court decision on similar facts, it was reconsidering its prior holdings. Martin v. Comm'r, 149 T.C. No. 12 (2017).

Facts

Charles and Laura Martin, a married couple, owned a 300 acre farm in Texas consisting of various agricultural and horticultural structures as well as their personal residence. Mrs. Martin performed the farm's bookkeeping while Mr. Martin performed a portion of the physical labor and other management services as necessary.

In 1999, the Martins began constructing the first of eight poultry houses in which they would raise young chickens called broilers. The houses were built according to detailed specifications provided by Sanderson Farms, Inc. (Sanderson), the third largest poultry producer in the U.S. Each poultry house had over 22,000 square feet of usable space. The Martins also installed over $1.2 million in specialized equipment including heating, air conditioning, and other improvements.

In 2000, the Martins entered into a 15 year Broiler Production Agreement (BPA) with Sanderson. The agreement contained extensive instructions and requirements for the Martins as the growers of broiler chickens. Several times per year, Sanderson would deliver a flock of broilers to the Martins, along with the daily necessary proprietary blend of feed for the birds, and would return 49 days later to pick them up. In carrying out Sanderson's detailed instructions, the Martins were allowed to hire additional laborers or employees, but their discretion ended there. Sanderson retained ownership of the broilers and all feed consumed or unconsumed by the flock. Sanderson required the broilers to be cared for according to their standards and its employees checked on the broilers daily throughout the 49 day cycle. The program restricted the broilers' diet and required any deviation to be specifically approved by Sanderson.

In 2004, the Martins formed CL Farms, Inc. as an S corporation. The Martins entered into oral employment agreements with CL Farms and set their salaries at amounts consistent with those of other broiler growers. The Martins also relied on a 2003 appraisal that analyzed the costs of running the broiler operation as an investment (rather than as active participants), and they priced CL Farms' activities to exceed the appraisal's projected labor and management costs. Mrs. Martin would provide bookkeeping services to the corporation and Mr. Martin, along with any hired laborers or employees, would provide the needed labor and management services. Sanderson approved an assignment of the Martins' BPA to CL Farms in 2005. CL Farms' BPA anticipated relying on employees to meet the requirements of the Sanderson broiler growing program. CL Farms, rather than the Martins, would be responsible as the grower; nothing in the BPA required the Martins to personally perform the grower duties.

The Martins entered into a five year lease with CL Farms by which CL Farms would rent the farm from the Martins (excluding their residence and 10 acres). The lease included structures, 176,000 square feet of poultry houses, and equipment. CL Farms agreed to pay rent of $1.3 million to the Martins over the term of the lease. CL Farms had to make each rent payment regardless of whether it had fulfilled its requirements as the grower to Sanderson or received sufficient income. The rent amount represented fair market rent and was consistent with amounts paid by other Sanderson growers for the use of similar premises.

At no point during 2008 and 2009, the years at issue, were the Martins obligated or compelled to perform farm related activities as a condition to CL Farms' obligation to pay rent to the Martins under the lease. The Martins were similarly not obligated to perform farm related activities in CL Farms' production of agricultural commodities. Although the Martins materially participated in broiler production activity, CL Farms consistently hired numerous laborers to clean and reset the houses between flocks. CL Farms also hired professional and legal counsel in connection with the farm's management. For 2008 and 2009, CL Farms paid approximately $78,000 and $86,000, respectively, for labor, employee benefits, and professional services.

The Martins reported the rent payments from CL Farms as rental income that was excludable from self-employment (SE) income. The Martins reported rental income of $259,000 for 2008 and $271,000 for 2009. The IRS determined that these amounts were subject to SE tax because they constituted net SE earnings under Code Sec. 1402. Deficiencies of around $13,000 and $15,000 were determined for 2008 and 2009, respectively. The Martins petitioned the Tax Court for a redetermination of the deficiencies.

Under Code Sec. 1402, rental income is generally excluded from a taxpayer's SE income. However, under Code Sec. 1402(a)(1)(A), the rent earned by the owner of land is subject to SE tax if the income is derived under an arrangement pursuant to which the owner is required to materially participate in the agricultural production and the owner actually materially participates.

Eighth Circuit's McNamara Decision

In McNamara v. Comm'r, 236 F.3d 410 (8th Cir. 2000), the Eighth Circuit reversed the Tax Court's holding that rental income was subject to SE tax on facts that were materially indistinguishable from the Martins' case. The Eighth Circuit held that, based on the term "derived" in the statute, there had to be a nexus between the rental agreement and the arrangement requiring the owners' material participation. The Eighth Circuit held that, regardless of material participation, rental payments at or below market rate strongly suggest that the rental agreement stands on its own as an independent transaction and is not part of an arrangement for participation in agricultural production.

The IRS, noting its nonacquiescence in AOD 2003-03 in the Eighth Circuit's McNamara decision, did not address the nexus issue with respect to the Martins' case. It said that, under the facts and circumstances, there existed an arrangement between the Martins and both CL Farms and Sanderson that required the Martins to materially participate in the production of poultry on their farm. According to the IRS, the rental income was subject to SE tax because such an arrangement existed and the Martins actually materially participated in the production of the broilers. The Martins took the position that, under McNamara, their rent payments were not subject to SE tax because the payments were at the market rate and there was no nexus between the lease and either the BPA or their employment agreements.

Tax Court's Decision

The Tax Court, following the Eighth Circuit's decision in McNamara, held that the Martins' rental income for 2008 and 2009 was not subject to SE tax because the rents they received represented fair market rent and were consistent with amounts paid by other Sanderson growers for the use of similar premises. The Tax Court interpreted McNamara as creating a presumption that, regardless of material participation, a rental agreement stands on its own where rental payments are at or below market rate, and that, in such a case, the burden shifts to the IRS to produce evidence of a nexus between the rental agreement and the arrangement requiring material participation by the owner. The Tax Court said that, because it had found that the rents were at market value, and the IRS did not address the nexus issue, it had no alternative but to conclude that the rental agreement was separate and distinct from the Martins' employment obligations and, therefore, the rental income was not includable in their net SE income.

The Tax Court asserted that the fair market rents were enough to establish that the rental agreement stood on its own, but it cited two additional facts to support its conclusion. First, the Tax Court noted that the Martins had invested over $1.2 million in the improvements required by Sanderson, and under the rental agreement, CL farms used around 10 acres and the single use structures for purposes of the BPA. Practically speaking, the agreement functioned as a return on investment rather than income recharacterization, according to the Tax Court. Second, the Martins had obtained an appraisal detailing the costs of operating the farm purely as an investment and priced CL Farms' activities to exceed the appraisal's projected costs. The Tax Court reasoned that these amounts were not merely remainder payments to the Martins after the rent checks were cashed, but rather were appropriate amounts for CL Farms to spend for the services required to operate its broiler houses as well as its grazing and other agricultural activities. The structure of these expenses demonstrated to the Tax Court the lengths to which the Martins went to operate CL Farms as a legitimate business, and not as a way to avoid SE tax.

Observation: There were two dissenting opinions. In one, two judges said that the presence of market rate rents should have been only one factor tending to show that there was no arrangement providing compensation for labor, and not a special factor giving rise to a presumption that shifted the burden of production. In the other, four judges would have held that the Eighth Circuit's focus on market value rents in McNamara was not supported by the plain language of Code Sec. 1402, and would have treated that decision as binding only in the Eighth Circuit.

For a discussion of calculating a farmer's net earnings from self-employment, see Parker Tax ¶168,130.

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U.S. Helicopter Pilot Employed in Iraq Qualified for Foreign Earned Income Exclusion

The Tax Court held that a helicopter pilot who worked for a government contractor in Iraq for two thirds of the year was eligible for the foreign earned income exclusion. The Tax Court determined that, given his economic and social ties to Iraq and the fact that he intended to continue working there indefinitely, the pilot's tax home was in Iraq and he was a bona fide resident of Iraq. Linde v. Comm'r, T.C. Memo. 2017-180.

Facts

Jesse Linde is a helicopter pilot from Alabama who retired from the Army in 1992. In 1995, he resumed his piloting career in the private sector, living and working in Saudi Arabia and then in Bosnia. Linde rejoined the Army after September 11, 2001. In 2005, he retired from the Army a second time.

In 2009, Linde took a job with U.S. government contractor Blackwater Security Consulting in Iraq. Linde was in his mid-fifties at the time and concerned about his employment prospects in the U.S., which had an abundance of younger helicopter pilots. Linde's age was not as great an obstacle in Iraq as long as he could pass a physical, which he did. Linde decided he would work in Iraq until he was ready to permanently retire, while his wife remained in Alabama.

Linde began working for Blackwater in April 2009. When Blackwater lost its government contract, Linde became an employee of Blackwater's successor, DynCorp. Linde signed a one year employment agreement with DynCorp, which he expected would be renewed each year. His contract was renewed as expected, and throughout 2010-2012 Linde worked in Iraq as a pilot for DynCorp. He lived in Iraq for 248 days in 2010, 240 days in 2011, and 249 days in 2012. Linde's job was to transport government officials to various locations in Iraq. In furtherance of this duty Linde communicated regularly with Iraqi intelligence personnel and several Iraqi civilians. In 2012, Linde was promoted and became responsible for overseeing 36 other pilots in Iraq.

Linde's work schedule generally consisted of 60 straight days of 12 hour shifts followed by break periods of 30 days. DynCorp could not keep all of its employees in Iraq at one time, so it required its helicopter pilots to leave Iraq every 60 days. Linde was provided with a round trip ticket to Kuwait at the end of each 60 day period. From there, Linde flew to the U.S. at his own expense. Each trip involved multiple flights and usually required three days of travel time. Linde sometimes spent time in Europe before flying to the U.S.

Linde spent his breaks at his and his wife's home in Alabama. While there, he spent time with Mrs. Linde and their adult children. The special healthcare needs of Linde's son in law, an Army veteran who was seriously injured while on active duty in Iraq, made overseas travel extremely difficult for Mrs. Linde and the children. Otherwise, Linde would have arranged to have his family join him in Europe during his breaks.

In Iraq, Linde lived in a container housing unit (CHU) provided by Dyncorp. The CHU is a large metal container with two bedrooms and a shared bathroom. No one else stayed in Linde's bedroom when it was unoccupied, and he kept his personal belongings there while he was out of the country.

When he was not working, Linde went on group excursions to local markets to buy food and building materials, which he used for small construction projects in his CHU. He also dined in restaurants and socialized with several Iraqi interpreters he had befriended at work.

Since joining the Army in 1972, Linde has had an account with the Armed Forces Bank that he can use anywhere, including Iraq. From February 2010 through May 2011 he also had an Iraqi bank account at the U.S. Embassy. He closed that account when the bank stopped operating its branch there. Meanwhile, Linde kept his vehicles in Alabama, where he was registered to vote and licensed to drive.

Linde did not pay taxes to the Iraqi government during the years at issue. DynCorp began withholding Iraqi income taxes in May 2013. That year, Linde's work schedule changed to 90 straight days of 12 hour shifts with 30 day break periods.

Linde's tax returns were prepared by Bob Wills, an experienced accountant and tax return preparer in Alabama with a large number of clients who are helicopter pilots. Linde provided Wills with extensive information about his work in Iraq and the expenses he sought to deduct. Wills advised Linde that he was eligible for the foreign earned income exclusion and that Linde's travel expenses were deductible. Linde, who has no accounting or tax background, believed Wills' advice was reasonable.

Linde excluded as foreign earned income approximately $62,000 for 2010, $88,000 for 2011, and $88,000 for 2012. He also claimed unreimbursed travel expense deductions of $8,000, $9,300, and $9,800 for 2010, 2011, and 2012, respectively, and nontravel business expenses of approximately $200 for 2011 and 2012.

The IRS issued a notice of deficiency for the years at issue on the determination that Linde was not eligible for the foreign earned income exclusion. It also said Linde was liable for a penalty under Code Sec. 6662. Linde petitioned the Tax Court for review.

Foreign Earned Income Exclusion Rule

Under Code Sec. 911(a), a qualified individual may elect to exclude foreign earned income from gross income. To qualify, the individual's tax home must be in a foreign country and the individual must be either a bona fide resident of a foreign country or be physically present in the country for at least 330 days in a 12 month period (physical presence test). Linde conceded that he did not satisfy the physical presence test but argued that his tax home was in Iraq and that he was a bona fide resident of Iraq.

Tax Court's Decision

The Tax Court held that Linde qualified for the foreign earned income exclusion because his tax home was in Iraq and he was a bona fide resident of Iraq. The Tax Court determined that Linde's principal place of employment was in Iraq. However, under Code Sec. 911(d)(3), Linde's tax home could not be in Iraq if his abode was in the United States. The Tax Court considered the relative strength of Linde's ties to Iraq and the U.S. and concluded that his abode was in Iraq because his ties there were stronger than his ties to the U.S. The Tax Court reasoned that Linde's economic and social life was centered in Iraq. His career prospects in the U.S. were limited, but he could continue working as a helicopter pilot in Iraq for the foreseeable future. The Tax Court noted that Linde did not work in any other country besides in Iraq and spent two thirds of each year there. In fact, Linde's economic ties to Iraq grew stronger over time, according to the Tax Court, as he opened a bank account there in 2010 and accepted a promotion in 2012. Moreover, Linde's use of his free time in Iraq to socialize with other contractors and Iraqi interpreters, make improvements to his CHU, and visit local markets and restaurants demonstrated to the Tax Court an effort to create a domestic and personal life for himself there.

The Tax Court held that Linde was a bona fide resident of Iraq because he began working for DynCorp with the intention of remaining in Iraq indefinitely. The Tax Court noted that Linde's continued employment in Iraq confirmed this intention, as did the fact that he spent two thirds of each year there, and his absences from Iraq were at the behest of DynCorp. The fact that Linde was employed under one year contracts did not disprove that Linde's employment in Iraq was indefinite, in the Tax Court's view, because his contract was routinely renewed and he expected his contract would continue to be extended. Linde's continued employment there after the years at issue demonstrated to the Tax Court that his expectations were correct.

Next, the Tax Court turned to Linde's unreimbursed employee business expenses and held that they were properly disallowed. The Tax Court determined that Linde could not deduct the cost of his flights to and from the U.S. because, although DynCorp did not permit Linde to stay in Iraq during his breaks, he did not have a business purpose for his travel between Kuwait and the U.S. As to Linde's other expense deductions, the Tax Court disallowed the cost of a computer because it found that Linde had not specified the amount of business use of the computer relative to total use, and found that Linde's other expenses were not reimbursable and therefore not deductible.

Finally, the Tax Court found that Linde was not liable for a penalty imposed by the IRS because he reasonably relied in good faith on Wills, a competent tax adviser. Linde fully disclosed to Wills all relevant facts concerning his employment in Iraq and his related expenses, the Tax Court found. Although Wills' advice regarding deductibility of expenses was incorrect, Linde did not have a tax or accounting background, and the Tax Court was satisfied that Linde reasonably relied on the advice he was given.

For a discussion of the foreign earned income exclusion, see Parker Tax ¶200,120.

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Gay Man's Costs to Father Children through IVF Aren't Deductible Medical Expenses

The Eleventh Circuit held that a gay man's costs to father children through in vitro fertilization (IVF) were not deductible medical expenses under Code Sec. 213 and the disallowance of the deduction did not violate the man's equal protection rights. According to the court, the deduction did not apply because the costs to compensate the women who served as an egg donor and a gestational surrogate were not incurred for the purpose of affecting the man's reproductive function, and the man's equal protection rights were not violated because he was treated no differently from similarly situated heterosexual taxpayers who claimed deductions for IVF related expenses. Morrissey v. U.S., 2017 PTC 435 (11th Cir. 2017).

Joseph Morrissey is a gay man who, with his partner, decided in 2010 to try to have children through in vitro fertilization (IVF), with Morrissey serving as the biological father. The IVF process involved collecting Morrissey's sperm, fertilizing eggs donated by one woman, and implanting the embryos into the uterus of a second woman who served as a gestational surrogate. Between 2010 and 2014, Morrissey paid expenses relating to seven IVF procedures, three egg donors, three surrogates, and two fertility specialists. These expenses totaled over $100,000. In 2011, the year at issue, Morrissey paid nearly $57,000 for IVF related expenses. Of that total, only about $1,500 was for procedures on Morrissey's body, which included blood tests and sperm collection. The remaining $55,000 went to identifying, retaining, and compensating the women who served as the egg donor and the gestational surrogate, as well as reimbursing them for travel expenses and paying for their medical care.

Morrissey did not initially claim a deduction for medical expenses on his 2011 tax return and paid approximately $22,000 in taxes for that year. In December 2012, Morrissey filed an amended 2011 return that claimed a medical expenses deduction of over $36,000. Based on the newly claimed deduction, Morrissey sought a refund of around $9,500. In 2011, the deduction for medical care expenses under Code Sec. 213 applied to expenses exceeding 7.5 percent of adjusted gross income. The $1,500 that Morrissey spent on his own blood work and sperm collection did not meet the 7.5 percent threshold, so Morrissey could not deduct those expenses unless he could also deduct the more significant costs associated with the identification, retention, compensation and care of the egg donor and gestational surrogate.

The IRS denied Morrissey's refund and disallowed his IVF related deduction in its entirety because the Code Sec. 213 deduction applies only to medical services provided to the taxpayer, his spouse, or a dependent. Morrissey appealed to the IRS Office of Appeals, which upheld the disallowance. Morrissey then filed a refund suit in a Florida district court. Morrissey argued that the deduction was authorized under the plain language of Code Sec. 213. He also contended that the IRS violated his equal protection rights by disallowing the deduction. The district court granted the IRS's motion for summary judgment, and Morrissey appealed to the Eleventh Circuit.

Under Code Sec. 213, the deduction for medical expenses applies to amounts paid for the purpose of affecting any structure or function of the taxpayer's body. Morrissey acknowledged that, by its terms, the statute applies only to medical care of the taxpayer, not that of a third party. However, Morrissey argued that his IVF expenses qualified because they were made for the purpose of affecting his body's reproductive function. He said that because he and his partner were physiologically incapable of reproducing together, IVF was his only means of fathering his own biological children. Therefore, it was medically necessary to involve third parties (an egg donor and a surrogate) in order to enable his own body to fulfill its reproductive function. Morrissey's equal protection arguments were that the disallowance of the deduction infringed his fundamental right to reproduce and that the IRS applied Code Sec. 213 in a discriminatory manner that disadvantaged Morrissey based on his sexual orientation.

The Eleventh Circuit upheld the district court's rulings disallowing the deduction and rejecting Morrissey's equal protection claim. The court held that Morrissey's claim was foreclosed by the plain language of Code Sec. 213. The Eleventh Circuit reasoned that as a man, Morrissey's body's specific function in the reproductive process was to produce and provide healthy sperm, and the IVF expenses associated with the egg donor and surrogate did not materially influence or alter that function. Morrissey was capable of producing and providing healthy sperm with or without the involvement of an egg donor or a surrogate; his body could perform those functions before he engaged his female counterparts in the IVF process as well as after its completion. The costs of identifying, retaining, compensating and caring for the egg donor and surrogate were therefore not, according to the court, incurred for the purpose of affecting any function of Morrissey's body as required by the statute.

The Eleventh Circuit noted that its reading of Code Sec. 213 was also supported by Tax Court precedent. The Tax Court has consistently rejected attempts by male taxpayers to deduct IVF-related expenses paid to cover the care of unrelated egg donors and gestational surrogates because donor and surrogacy-related IVF processes do not affect the taxpayer's own body. Where the taxpayer presents no evidence that any of the medical care involved him, his spouse, or a dependent, the Tax Court has denied claims for a deduction under Code Sec. 213, the Eleventh Circuit said.

In rejecting Morrissey's equal protection argument, the Eleventh Circuit found that Morrissey's right to IVF and surrogacy assisted reproduction was not a fundamental right because IVF is a relatively new procedure with ethical issues and ongoing political dialogue. The court further found that Morrissey was treated no differently from similarly situated heterosexual taxpayers claiming deductions of IVF related expenses. According to the Eleventh Circuit, the disallowance of Morrissey's claimed deduction was consistent with longstanding IRS guidance and Tax Court precedent.

Moreover, the court reasoned that even if Morrissey had been treated differently from similarly situated heterosexual taxpayers, he had not shown that any difference in treatment was motivated by an intent to discriminate against him. Morrissey's inability to deduct the $1,500 cost of his own bloodwork and sperm collection was not discriminatory because it had nothing to do with any protected characteristic. The deduction was denied only because it did not meet the 7.5 percent of AGI threshold. Further, an IRS agent's statement that Morrissey's decision not to have children with a member of the opposite sex was a personal choice and was seen by the Eleventh Circuit as an innocent (if ill-phrased) remark that did not represent the IRS's final or official word on Morrissey's claimed deduction. Rather, the court pointed out that the IRS's formal letter disallowing the deduction contained no statement of bias and did not even mention Morrissey's sexual orientation.

For a discussion of the deduction for medical expenses, see Parker Tax ¶82,501.

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IRS Issues 2017-2018 Special Per Diem Rates

The IRS issued the 2017-2018 special per diem rates for taxpayers to use in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. The list of high-cost localities differs from the list of high-cost localities in last year's per diem guidance. Notice 2017-54.

In Notice 2017-54, the IRS issued the annual update on 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:  

• the special transportation industry meal and incidental expenses rates (M&IE rates);
• the rate for the incidental expenses only deduction; and
• 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 2017-54 must comply with Rev. Proc. 2011-47, which 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.

For purposes of the high-low substantiation method, the per diem rates are $284 for travel to any high-cost locality and $191 for travel to any other locality within the continental U.S. (up from $282 and $189, respectively). The amount of the $284 high rate and $191 low rate that is treated as paid for meals for purposes of Code Sec. 274(n) is $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S.

The per diem rates for the meal and incidental expenses only substantiation method are $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S. (same as last year).

The list of high-cost localities in Notice 2017-54 differs from the list of high-cost localities in Notice 2016-58. Specifically, the following localities have been added to the list of high-cost localities: Oakland, California; Lewes, Delaware; Fort Myers, Florida; Hyannis, Massachusetts; Petoskey, Michigan; Portland, Oregon; Vancouver, Washington. In addition, the following localities have changed the portion of the year in which they are high-cost localities: Aspen, Colorado; Denver/Aurora, Colorado; Telluride, Colorado; Vail, Colorado; Bar Harbor, Maine; Ocean City, Maryland; Nantucket, Massachusetts; Philadelphia, Pennsylvania; Jamestown/Middletown/Newport, Rhode Island; Jackson/Pinedale, Wyoming. Finally, the following localities have been removed from the list of high-cost localities: Sedona, Arizona; Los Angeles, California; Vero Beach, Florida; Kill Devil, North Carolina.

Notice 2017-54 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, 2017, for travel away from home on or after October 1, 2017. Rates for the period of October 1, 2016 through September 30, 2017, can be found in Notice 2016-58.

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

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Former KPMG Partner Not Liable for Penalties on Disallowed Tax Shelter Losses

The Tax Court disallowed losses from a tax shelter transaction involving offsetting foreign currency options because the underlying option transactions lacked economic substance. However, the taxpayer, a CPA with a law degree who was a former partner at KPMG, was not liable for an accuracy-related penalty because he reasonably relied on a tax professional for advice on matters beyond his understanding. Tucker v. Comm'r, T.C. Memo. 2017-183.

Background

Keith Tucker is the former CEO, director, and chairman of the board of Waddell & Reed Financial, Inc. (WR), a national mutual fund and financial services company. WR was spun off as a public company in 1998, and by 2000, Tucker's stock options had substantially appreciated in value. Tucker realized approximately $41 million in taxable gain when he exercised his stock options in August 2000. WR withheld approximately $11 million in federal income tax from Tucker's compensation relating to the exercise of the options.

Tucker is a CPA and has a law degree. He began his career preparing tax returns for KPMG and eventually became the national director of KPMG's life insurance practice. Tucker left KPMG in 1984 for a position with an investment banking firm. Tucker maintained a relationship with KPMG, and retained KPMG as his personal tax adviser and return preparer from 1984 through 2000.

Tucker also recommended KPMG to manage WR's personal financial planning program for its senior executives. WR's executive program was intended to protect WR's reputation by promoting ethical conduct and tax compliance by WR executives. Tucker recommended his friend and former KPMG colleague, Eugene Schorr, to run the WR executive program. Schorr was in charge of KPMG's New York individual tax practice as well as its national personal financial planning practice. Tucker considered Schorr trustworthy and knowledgeable, and viewed him as the preeminent person at KPMG for coordinating tax return compliance as well as tax and financial planning for executives.

In May 2000, before exercising his stock options, Tucker met with KPMG advisers to discuss his financial and tax planning for 2000. Tucker considered and rejected two tax planning strategies before entering into the transaction at issue. One was rejected because Tucker would be required to dispose of his WR stock and because KPMG would not sign Tucker's return as a tax preparer due to a lack of disclosures. The other transaction, initially recommended by KPMG, was a short options strategy. KPMG later recommended against using short options when the IRS issued Notice 2000-44, which identified short options as a listed transaction. Because of the potential negative impact on his and WR's reputations, Tucker told KPMG that he did not want to participate in an abusive tax scheme. Tucker believed that, as a result of Notice 2000-44 and KPMG's recommendation against the short options strategy, he could trust KPMG not to advise him to invest in an abusive tax strategy.

FX Transaction

In December 2000, Timothy Speiss, the partner in charge of KPMG's Innovative Strategies Group, recommended a transaction involving foreign currency options (FX transaction). Schorr checked with at least one member of KPMG's tax leadership to confirm that the tax leadership approved of such a transaction for Tucker. KPMG offered the FX transaction to three WR executives including Tucker; one other WR executive also participated. Speiss identified four investment advisers (promoter group) that would assist in implementing the FX transaction. The promoter group told Tucker that the potential return on the transaction was $800,000, and the probability that he would earn a profit was 40 percent. Tucker knew about the tax benefits of the FX transaction and also knew the IRS might disallow a loss deduction from it. Tucker worked with Speiss on the transaction and understood that Schorr was not involved.

The FX transaction involved the formation of Epsolon, Ltd., a foreign corporation organized in Ireland. Epsolon was 99 percent owned by Tucker through Sligo, a Delaware S corporation. The FX transaction involved two components, an Epsolon loss component and a Sligo basis component. Epsolon engaged in several foreign currency options transactions that generated net losses. Most of these losses were allocated to Sligo based on its 99 percent ownership of Epsolon. Tucker claimed a basis of approximately $53 million in Sligo as the result of $51 million in premiums paid for foreign currency options and $2 million in purported cash contributions. As an S corporation, Sligo's losses would flow through to Tucker to the extent of his basis. Tucker claimed passthrough losses from Sligo totaling approximately $52 million for 2000 and 2001.

KPMG represented to Tucker that the FX transaction was not covered by Notice 2000-44, and Tucker was notified that KPMG would sign his return. Tucker did not read Notice 2000-44 because he did not think he would understand it and because he trusted KPMG. KPMG recommended the law firm Brown & Wood, which issued two legal opinions concluding that the FX transaction would more likely than not withstand IRS scrutiny. Tucker did not read the BW opinions, trusting KPMG to review them. Speiss prepared a memorandum addressed to Tucker, stating that Notice 2000-44 should not apply and that the transaction should not trigger an accuracy-related penalty. Tucker received a copy of the Speiss memo but did not read it. Schorr prepared an internal memorandum describing the advice KPMG provided to Tucker during 2000, which Tucker read. Schorr's memorandum stated that it was drafted in response to the IRS's increased scrutiny of tax solutions as announced in Notice 2000-44. The memorandum indicated possible penalties of $4 million as a result of the FX transaction and recommended that Tucker set aside investments in that amount to protect himself. Schorr knew that the IRS might disallow the claimed tax treatment of the FX transaction but believed Tucker would not be subject to penalties.

The IRS issued a notice of deficiency disallowing Tucker's claimed loss deduction, resulting a deficiency of over $15 million. It also assessed an accuracy-related penalty of approximately $6 million. Before the Tax Court, the IRS argued that Tucker's claimed losses should be disallowed because the Epsolon options lacked economic substance and the Epsolon options were not entered into for profit. The IRS further argued that the step transaction doctrine prevented separating the gains and losses on the Epsolon options. According to the IRS, the principal purpose of Tucker's acquisition of Epsolon and Sligo was to evade or avoid taxes and that Tucker was not at risk for the claimed losses.

Tax Court's Decision

The Tax Court disallowed the losses on the basis that the Epsolon options lacked economic substance. The Tax Court found that the Epsolon options had no objective economic reality because there was no reasonable possibility of profit and the losses had no actual economic effect. The Tax Court determined that Tucker's potential profit on the options was de minimis as compared to his expected tax benefit. The Epsolon options offered no reasonable expectation of appreciable net gain, according to the Tax Court, but rather were designed to generate artificial losses by gaming the tax code. Further, the transaction had no actual economic effect in the Tax Court's view because Tucker's economic loss did not cause real dollars to meaningfully change hands. The Tax Court found that Tucker should have expected to lose money given the 60 percent chance that each component would result in an economic loss. However, his economic loss was severely limited when compared to his claimed tax losses. The Tax Court found that the expected loss was part of the cost of engaging in the transaction to achieve the desired tax savings. According to the Tax Court, no element of the FX transaction had economic substance; each was orchestrated to serve no other purpose than to provide a structure through which Tucker could reduce his tax burden.

No Penalty Imposed

The Tax Court determined that Tucker was not liable for accuracy-related penalties under Code Sec. 6662 because he reasonably relied on the advice of Schorr, a competent tax professional who had access to all necessary information about the FX transaction.

The Tax Court noted that KPMG was at the time one of the largest accounting firms in the U.S. and that Tucker viewed Schorr as an expert in coordinating tax return compliance and tax and financial planning. According to the Tax Court, Tucker believed he was misled by KPMG. The Tax Court noted that Tucker was forced to resign as WR's CEO and is no longer employable in the financial services industry. He lost his position at WR because of his participation in the FX transaction, and received a large settlement from KPMG for his lost future earnings.

The Tax Court found that Tucker believed KPMG was offering its services as part of the WR executive program, which had been established to ensure that WR executives were in compliance with the tax law. Tucker told KPMG he did not want to engage in a transaction that would lead to IRS scrutiny because of concern for his own and his company's reputations. The Tax Court further noted that after the issuance of Notice 2000-44, Tucker was adamantly against participating in such a transaction and was repeatedly assured by KPMG that the Notice did not apply to the FX transaction. Thus, Tucker believed the FX transaction was a legitimate tax planning solution, in the Tax Court's view.

The Tax Court placed little weight on the fact that Tucker did not review many of the documents relating to the FX transaction. The Tax Court pointed out that Tucker was a senior executive whose normal practice was to rely heavily on his assistant. The fact that Tucker did not read Notice 2000-44 did not preclude a finding of reasonable reliance on his adviser, in the Tax Court's view. The Tax Court pointed out that although Tucker had experience with insurance tax matters early in his career, he left the tax field in 1984 and focused entirely on the financial services industry. Tucker relied on KPMG, in the Tax Court's view, because he believed he would not understand the technical tax implications of the FX transaction. The Tax Court found that despite Tucker's background, CPA license, and law degree, he had little understanding of the complicated tax issues involved in the FX transaction.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700. For a discussion of the reasonable cause and good faith exception to the accuracy-related penalty, see Parker Tax ¶262,127.