Federal Tax Bulletin - Issue 144 - July 11, 2017

IRS Targets Eight Regulations in Attempt to Reduce Regulatory Burden

In furtherance of Executive Order 13789, the Treasury Secretary has identified eight tax-related regulations that will be evaluated for possible amendment or repeal. Included in the eight regulations are (1) the temporary partnership liability regulations under Code Sec. 752, which significantly changed the rules relating to partnership disguised sales and the allocation of partnership liabilities; (2) the proposed regulations under Code Sec. 2704, which would impose major restrictions on valuation discount planning for transfers among family members of interests in family owned businesses; and (3) the final and temporary regulations under Code Sec. 385, which were a dramatic deviation from decades of debt/equity law. Notice 2017-38.

Background

On April 21, 2017, President Trump issued Executive Order (EO) 13789, a directive designed to reduce tax regulatory burdens. The order instructed the Secretary of the Treasury to review all "significant tax regulations" issued on or after January 1, 2016, and submit two reports, followed promptly by concrete action to alleviate the burdens of regulations that meet the criteria outlined in the order. Specifically, Section 2 of EO 13789 directed the Treasury Secretary to submit a 60-day interim report identifying regulations that meet the following criteria:

(1) they impose an undue financial burden on U.S. taxpayers;

(2) they add undue complexity to the federal tax laws; or

(3) they exceed the statutory authority of the IRS.

The order further instructs the Treasury Secretary to submit a final report to the President by September 18, 2017, recommending specific actions to mitigate the burden imposed by regulations identified in the interim report.

Scope of the Treasury Department's Review

From January 1, 2016, through April 21, 2017, the IRS issued 105 temporary, proposed, and final regulations. According to the Treasury Secretary, 53 of the 105 regulations issued during the relevant review period are minor or technical in nature and generated minimal public comment. To ensure a comprehensive review, the Treasury Department treated the remaining 52 regulations as potentially significant and reexamined all of them for the purpose of formulating the interim report. Based on that reexamination, the Treasury Department identified regulations that meet the criteria of the President's order and qualify as significant in view of the Presidential priorities for tax regulations outlined in EO 13789.

The Treasury Department has concluded that the following eight regulations meet at least one of the first two criteria specified by Section 2 of EO 13789. Consistent with the order, the Treasury Department intends to propose reforms - potentially ranging from streamlining problematic rule provisions to full repeal - to mitigate the burdens of these regulations in a final report submitted to the President.

Temporary Regulations under Section 752 on Liabilities Recognized as Recourse Partnership Liabilities (T.D. 9788)

These temporary regulations generally provide:

(1) rules for how liabilities are allocated under Section 752 solely for purposes of disguised sales under Code Sec. 707; and

(2) rules for determining whether "bottom-dollar payment obligations" provide the necessary "economic risk of loss" to be taken into account as a recourse liability.

Practitioners said that the first rule was novel and would unduly limit the amount of partners' bases in their partnership interests for disguised sale purposes, which would negatively impact ordinary partnership transactions. Practitioners were also concerned that the bottom-dollar payment obligation rules would prevent many business transactions compared to the prior regulations and suggested their removal or the development of more permissive rules.

Proposed Regulations under Section 2704 on Restrictions on Liquidation of an Interest for Estate, Gift and Generation-Skipping Transfer Taxes (REG-16311302)

Code Sec. 2704(b) provides that certain noncommercial restrictions on the ability to dispose of or liquidate family-controlled entities should be disregarded in determining the fair market value of an interest in that entity for estate and gift tax purposes. These proposed regulations would create an additional category of restrictions that also would be disregarded in assessing the fair market value of an interest.

Practitioners expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens. Practitioners were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious.

Final and Temporary Regulations under Section 385 on the Treatment of Certain Interests in Corporations as Stock or Indebtedness (T.D. 9790)

These final and temporary regulations address the classification of related-party debt as debt or equity for federal tax purposes. The regulations are primarily comprised of -

(1) rules establishing minimum documentation requirements that ordinarily must be satisfied in order for purported debt among related parties to be treated as debt for federal tax purposes; and

(2) transactional rules that treat as stock certain debt that is issued by a corporation to a controlling shareholder in a distribution or in another related-party transaction that achieves an economically similar result.

Practitioners criticized the financial burdens of compliance, particularly with respect to more ordinary course transactions and requested a longer delay in the effective date of the documentation rules. They also criticized the complexity associated with tracking multiple transactions through a group of companies and the increased tax burden imposed on inbound investments.

Proposed Regulations under Section 103 on Definition of Political Subdivision (REG-129067-15)

These proposed regulations define a "political subdivision" of a state (e.g., a city or county) that is eligible to issue tax-exempt bonds for governmental purposes under Code Sec. 103. The proposed regulations require a political subdivision to possess three attributes: (1) sovereign powers; (2) a governmental purpose; and (3) governmental control.

Practitioners said that the longstanding "sovereign powers" standard was settled law and had been endorsed by Congress, and additional limitations were unnecessary. Practitioners also argued that the proposed regulations would disrupt the status of numerous existing entities and that it would be burdensome and costly for issuers to revise their organizational structures to meet the new requirements of the proposed regulations.

Temporary Regulations under Section 337(d) on Certain Transfers of Property to Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs) (T.D. 9770)

These temporary regulations amend existing rules on transfers of property by C corporations to REITs and RICs generally. In addition, the regulations provide additional guidance relating to certain newly-enacted provisions of the Protecting Americans from Tax Hikes Act of 2015, which were intended to prevent certain spinoff transactions involving transfers of property by C corporations to REITs from qualifying for nonrecognition treatment.

Practitioners expressed concern that the REIT spinoff rules could result in over-inclusion of gain in some cases, particularly where a large corporation acquires a small corporation that engaged in a Code Sec. 355 spinoff and the large corporation subsequently makes a REIT election.

Final Regulations under Code Section 7602 on the Participation of a Person Described in Code Sec. 6103(n) in a Summons Interview (T.D. 9778)

These final regulations provide that persons described in Code Sec. 6103(n) and Reg. Sec. 301.6103(n)-1(a) with whom the IRS contracts for servicessuch as outside economists, engineers, consultants, or attorneysmay receive books, papers, records, or other data summoned by the IRS and, in the presence and under the guidance of an IRS officer or employee, participate fully in the interview of a person who the IRS has summoned as a witness to provide testimony under oath.

Practitioners objected to the IRS's ability to contract with outside attorneys and permit them to question witnesses under oath, and noted that the U.S. Senate Finance Committee approved legislation in 2016 that would prohibit the IRS from delegating to third-party contractors the authority under Code Sec. 7602.

Final Regulations under Section 987 on Income and Currency Gain or Loss With Respect to a Section 987 Qualified Business Unit (T.D. 9794)

These final regulations provide rules for (1) translating income from branch operations conducted in a currency different from the branch owner's functional currency into the owner's functional currency, (2) calculating foreign currency gain or loss with respect to the branch's financial assets and liabilities, and (3) recognizing such foreign currency gain or loss when the branch makes a transfer of any property to its owner.

Practitioners said that the transition rule in the final regulations imposes an undue financial burden on taxpayers because it disregards losses calculated by the taxpayer for years prior to the transition but not previously recognized. Practitioners also stated that the method prescribed by the final regulations for calculating foreign currency gain or loss was unduly complex and costly to comply with, particularly where the final regulations differ from financial accounting rules.

Final Regulations under Section 367 on the Treatment of Certain Transfers of Property to Foreign Corporations (T.D. 9803)

Code Sec. 367 generally imposes immediate or future U.S. tax on transfers of property (tangible and intangible) to foreign corporations, subject to certain exceptions. These final regulations eliminate the ability of taxpayers under prior regulations to transfer foreign goodwill and going concern value to a foreign corporation without immediate or future U.S. income tax.

Practitioners complained that the final regulations would increase burdens by taxing transactions that were previously exempt, noting in particular that the legislative history to Code Sec. 367 contemplated an exception for outbound transfers of foreign goodwill and going concern value. Practitioners also argued that an exception should be provided for transfers of foreign goodwill and going concern value in circumstances that would not lead to an abuse of the exception.

Comments Requested

The Treasury Department and the IRS are requesting comments on whether the regulations described above should be rescinded or modified, and in the latter case, how the regulations should be modified in order to reduce burdens and complexity.

Comments from the public are due by August 7, 2017. Comments should be submitted to: Internal Revenue Service, CC:PA:LPD:PR (Notice 2017-38), Room 5205, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224. Alternatively, comments may be hand-delivered Monday through Friday between the hours of 8:00 a.m. to 4:00 p.m. to: CC:PA:LPD:PR (Notice 2017-38), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC. Comments may also be submitted electronically via the following e-mail address: Notice.Comments@irscounsel.treas.gov. Commenters should include Notice 2017-38 in the subject line of any electronic submissions. Comments will be available for public inspection and copying.

Additionally, the IRS noted that in Notice 2017-28 it had invited public comment on recommendations for the 2017-2018 Priority Guidance Plan for tax rules and regulations, including recommendations relating to Executive Order 13777. The IRS said that taxpayers may submit recommendations for tax guidance at any time during the year.

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Expenses for Meals Provided to Professional Hockey Team While Away from Home Were Fully Deductible

The Tax Court held that the owners of a professional hockey team could fully deduct the cost of pregame meals provided to team players and team personnel while the team was away from home. While the deduction for meal expenses under Code Sec. 274 is generally limited to 50 percent, the team's pregame meals qualified for the exception for de minimis fringe benefits. Jacobs v. Comm'r, 148 T.C. 24 (2017).

Background

Jeremy and Margaret Jacobs own the Boston Bruins, a National Hockey League (NHL) franchise, through three S corporations. Each NHL team plays 82 regular season games per season, 41 at arenas in cities other than Boston. The NHL requires teams to arrive in the away city at least six hours before the start of an away game. Under the collective bargaining agreement (CBA) between the league and the teams and the players, a team must travel the day before the game if the flight to the away city is greater than 150 minutes.

For the years at issue, the Bruins traveled to away games with a contingent that typically included 20-24 players plus the coaches, medical personnel, trainers, equipment managers, communications personnel, travel logistics managers, public relations/media personnel, and other employees. The Bruins made their hotel arrangements before the beginning of the season. The contracts between the team and the hotels typically included sleeping accommodations and banquet or conference rooms where pregame meals and snacks were served. The hotels prepared the pregame meals and snacks according to the Bruins' specifications, and the food was made available to all team employees.

IRS Limits Meal Expenses to 50 Percent

The Jacobses claimed deductions for meal expenses provided to the Bruins' traveling employees in cities other than Boston. The deductions totaled approximately $127,000 for 2009 and $142,000 for 2010. The IRS issued a notice of deficiency disallowing 50 percent of the claimed deductions under Code Sec. 274(n), which generally provides that only 50 percent of meal expenses are deductible unless an exception applies.

Taxpayer's Arguments for 100 Percent Deduction

The Jacobses filed a Tax Court petition arguing that the meals were fully deductible under Code Sec. 274(n)(2)(B), which provides that the 50 percent limitation does not apply if meal expenses are excludible from the gross income of the recipient as a de minimis fringe under Code Sec. 132(e). The operation of a meal facility is a de minimis fringe if (1) the eating facility is owned or leased by the employer, (2) the facility is operated by the employer, (3) the facility is located on or near the employer's business premises, (4) the meals are furnished during, or immediately before or after, the employees' workday, and (5) the annual revenue from the facility normally equals or exceeds the direct operating costs of the facility (the revenue/operating cost test). The de minimis fringe rule applies to highly compensated employees only if access to the meal facility is available to each member of an employee group, defined under a reasonable classification by the employer, and does not discriminate in favor of highly compensated employees.

Tax Court's Decision

The Tax Court held that the Bruins' provision of pregame meals to players and personnel at away city hotels qualified for the de minimis fringe exception, and the cost of the meals was therefore not subject to the 50 percent limitation. First, the Tax Court determined that the meals were provided in a nondiscriminatory manner with respect to highly compensated employees. The court found that the classification of traveling employees was a reasonable grouping given the nature of the team's business. It also found that the meals were provided to all of the traveling employees on substantially the same terms, and any discrepancy between anticipated and actual meal attendees was a function of cost reduction concerns and not discrimination.

Next, the Tax Court found that the pregame meals met all of the other requirements for a de minimis fringe under Code Sec. 132(e). The Tax Court noted that the Bruins owned or leased the eating facilities because, although the hotel contracts were not specifically identified as leases, they were leases in substance because they gave the Bruins the right to use and occupy the meal rooms. Although the Bruins did not provide separate consideration for the meal rooms, the court found that they were essential to the team's away city business operations and that the hotels provided the rooms free of charge because the Bruins paid for lodging and food. Further, the Bruins dictated several aspects of the setup of the rooms, including the furnishings and the presence of audiovisual equipment, as well as requiring the hotel not to disclose the location of the rooms to the general public. In the Tax Court's view, the agreements between the team and the hotels qualified as contracting with another to operate an eating facility for its employees as described in Reg. Sec. 1.132-7(a)(3).

Next, the Tax Court determined that the away city hotels qualified as part of the Bruins' business premises. An employer's business premises include places where employees perform a significant portion of their duties or where the employer conducts a significant portion of its business. The hotels were the Bruins' business premises, in the view of the Tax Court, not only because the team's business required it to travel, but also because, under league rules and the CBA, it was required to arrive at least six hours before a game and in some cases the day before a game. The hotels were essential to the Bruins' effective preparation and were used by the team to conduct business, according to the Tax Court. The court reasoned that the pregame meals provided essential nutrition to the players to maximize performance and were a forum for the team to maximize preparation time and conduct team business. The court also noted that it was not possible to conduct all of the team's necessary activities in Boston or at the opposing teams' arenas. The court rejected the IRS's arguments that the employees' activities at the hotels were insignificant compared to the actual games and that the team spent quantitatively less time at each away city hotel than at the team's Boston facilities. The Tax Court reasoned that the team preparation activities at the hotels provided important benefits to the players throughout the season. Further, although the time spent in any one city was far less than the time the team spent in Boston, half of the team's regular season games were required to be away games.

The Tax Court then applied the revenue/operating cost test. Under Reg. Sec. 1.132-7(a)(2), an employer-operated eating facility satisfies the revenue/operating cost test if the employer can reasonably determine that the meals are excludable to employees under Code Sec. 119. An employee can exclude meals under Code Sec. 119 if they are furnished on the employer's business premises and for the employer's convenience. Meals are provided for the employer's convenience under Reg. Sec. 1.119-1(a)(1) if furnished for a substantial noncompensatory business reason.

The Tax Court held that the pregame meals were provided for a substantial noncompensatory business reason because they were provided first and foremost for nutritional and performance reasons. The pregame meals enabled the Bruins to effectively manage a hectic schedule by minimizing unproductive downtime and maximizing time dedicated to activities that helped further the team's goal of winning hockey games. There was thus a substantial noncompensatory reason for the meals and they were therefore furnished for the convenience of the team. Having earlier found that the hotels were the team's business premises, the Tax Court concluded that the meals passed the test for employee excludability under Code Sec. 119, and the revenue/operating cost test was therefore satisfied.

For a discussion of the deduction for meal and entertainment expenses, see Parker Tax ¶91,115.

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Individual Who Directed IRA to Purchase Stock Did Not Receive Taxable IRA Distribution

The Seventh Circuit held that an individual did not receive a taxable distribution from his individual retirement account (IRA) when he directed his IRA custodian to purchase stock on his behalf but the custodian did not accept the resulting share certificate. The individual did not actually or constructively receive any cash or assets from his IRA for the year at issue, but simply bought stock, which was a permissible IRA transaction. McGaugh v. Comm'r, 2017 PTC 299 (7th Cir. 2017).

Raymond McGaugh opened a self-directed individual retirement account (IRA) with Merrill Lynch, Pierce, Fenner & Smith, Inc. (Merrill Lynch) in 2002. McGaugh's IRA held stock in First Personal Financial Corp. (FPFC) , a privately held company. In 2011, he requested that Merrill Lynch use money from his IRA to buy an additional 7,500 shares of FPFC. When Merrill Lynch declined to make the purchase on McGaugh's behalf, McGaugh called Merrill Lynch and initiated a wire transfer of $50,000 from his IRA directly to FPFC. The transfer occurred in October 2011.

In November 2011, FPFC issued a stock certificate in the name of "Raymond McGaugh IRA FBO Raymond McGaugh" and mailed it to Merrill Lynch. Merrill Lynch claimed to have received the certificate in early 2012. Merrill Lynch did not retain the certificate because it believed the transaction impermissibly exceeded the 60 day window for rollovers of IRA assets under Code Sec. 408(d)(3). Merrill Lynch attempted to send the certificate to McGaugh twice in February 2012, but the post office returned it both times; McGaugh claimed it was mailed to the wrong address. On the second attempt, the envelope was marked as refused. Merrill Lynch then sent the certificate by FedEx and it was not returned. The shares were never deposited into McGaugh's IRA. The location of the certificate was unknown; the IRS contended that McGaugh possessed it, but McGaugh denied that allegation.

Merrill Lynch characterized the wire transfer as a taxable distribution and issued a Form 1099-R, which McGaugh claimed he never received. In 2014, the IRS issued a notice of deficiency indicating that McGaugh had failed to report a $50,000 distribution for 2011. It assessed approximately $13,500 in taxes and a substantial understatement penalty of approximately $2,700. McGaugh filed a Tax Court petition and the Tax Court granted summary judgment in his favor. In doing so, the court noted that the stock certificate bore the name of the IRA, not McGaugh, as its owner. The IRS appealed that decision to the Seventh Circuit.

The IRS argued that even though McGaugh never physically received any cash or other assets from his IRA, he nevertheless took a distribution because he constructively received the proceeds. The IRS's primary argument was that McGaugh constructively received funds from his IRA when he directed Merrill Lynch to wire the money at his discretion to FPFC. McGaugh could not circumvent the rules on taxable income simply by directing a distribution to a third party, the IRS said.

The Seventh Circuit held that McGaugh did not have actual or constructive receipt of any assets from his IRA during 2011, and therefore did not receive a taxable IRA distribution during that time. In the court's view, it was clear that the share certificate was never in McGaugh's physical possession during 2011, nor was there evidence that he had any control over the shares or the rights associated with them that could give rise to a finding of constructive receipt. The Seventh Circuit determined that McGaugh did not direct a distribution to a third party; he bought stock, and such a purchase is a prototypical permissible IRA transaction. Further, there was no indication that McGaugh orchestrated the purchase for the benefit of FPFC or for any reason other than because he wished to obtain stock to be held in his IRA. There was thus no evidence that McGaugh constructively received funds, either in ordering Merrill Lynch to wire funds to FPFC or in any other respect.

For a discussion of taxable distributions from IRAs, see Parker Tax ¶134,535.

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Firefighter Is Taxable on Disability Retirement Converted to a Service Retirement

The Tax Court held that disability retirement payments, which the taxpayer excluded from income as amounts received under a statute similar to workmen's compensation, should have been included in the taxpayer's income because they were paid from a state retirement pension and the payments were determined by reference to the taxpayer's age and length of service. Similarly, when such payments were converted to a service retirement allowance, they were also taxable. Taylor v. Comm'r, T.C. Memo. 2017-132.

Background

Jack Taylor was a North Carolina fireman for over 24 years before retiring on disability in 1991. At that time, he began receiving from the Local Governmental Employees' Retirement System of North Carolina (LGERS) a disability retirement allowance computed with reference to his age, length of service, and average final compensation. Subsequently, Taylor also began receiving a pension from the North Carolina Firemen and Rescue Squad Workers' Pension Fund (FRSWPF). When he turned 60 in August 2004, LGERS sent Taylor a letter notifying him that he was being transferred from disability retirement to regular service retirement, effective September 1, 2004.

For 2012, Taylor was paid approximately $35,000 in retirement benefits by LGERS and $2,000 in retirement benefits by FRSWPF. Taylor received information returns from LGERS and FRSWPF showing taxable distributions of those amounts but reported only $2,324 of taxable retirement income. The IRS issued a notice of deficiency and assessed additional income tax to reflect the amount of tax due after including Taylor's total retirement pay in taxable income.

Taylor argued that his retirement income from LGERS was nontaxable. He petitioned the Tax Court, contesting the inclusion of the LGERS payments in income. However, Taylor did not assert a dispute regarding the FRSWPF payment's taxability and so those payments were not at issue before the Tax Court.

Taxability of Retirement Income

Under Code Sec. 104(a)(1), gross income does not include amounts received under workmen's compensation acts as compensation for personal injuries or sickness. Reg. Sec. 1.104-1(b) provides that this exclusion also applies to statutes in the nature of workmen's compensation acts which provide compensation to employees for personal injuries or sickness incurred in the course of employment. The exclusion, however, does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee's age or length of service, or the employee's prior contributions, even though the employee's retirement is occasioned by an occupational injury or sickness.

LGERS Plan

LGERS is a defined benefit plan established under North Carolina law and funded by employer and employee contributions. Under the plan, an employee with at least five years of service may retire on a disability retirement allowance upon medical certification of incapacity for the further

performance of his duties. A beneficiary's payments are reduced if he is determined to be engaged in or be able to engage in a gainful occupation paying more than a certain amount. In lieu of this reduction, the beneficiary irrevocably may elect to convert his disability retirement allowance to a service retirement allowance calculated on the basis of his average final compensation and creditable service at the time of disability retirement and his age at the time of conversion to service retirement.

An employee retiring on disability after July 1, 1982, receives a service retirement allowance if he has qualified for an unreduced service retirement allowance. Otherwise, the allowance equals "a service retirement allowance calculated on the member's average final compensation prior to his disability retirement and the creditable service he would have had had he continued in service until the earliest date on which he would have qualified for an unreduced service retirement allowance." The service retirement allowance for an employee that is not a law enforcement officer retiring from service on or after July 1, 1990, but before July 1, 1992, equals 1.64 percent of the employee's average final compensation multiplied by the number of years of creditable service, provided that the service retirement date occurs (1) on or after his 65th birthday upon completing five years of service, (2) after completing 30 years of service, or (3) on or after his 60th birthday upon completing 25 years of service. The retirement allowance is reduced if the employee did not satisfy the minimum service requirements.

A former employee receiving a disability retirement allowance, upon reaching the earliest date on which he would have qualified for an unreduced service retirement allowance, is no longer subject to further medical reexaminations or a reduction in benefits by engaging in gainful employment with an employer not participating in LGERS. Furthermore, the former employee ceases to receive a disability retirement allowance and instead is considered a beneficiary in receipt of a service retirement allowance.

Taxpayer's Position

To support his contention that his LGERS retirement income was excludible from gross income, Taylor argued that the payments were neither a "retirement pension" nor an "annuity" as referenced in Reg. Sec. 1.104-1(b). Taylor pointed out that North Carolina law defines both "annuity" and "pension" as "payments for life." He likened his situation to that of the taxpayer in Picard v. Comm'r, 165 F.3d 744 (9th Cir. 1999), rev'g T.C. Memo. 1997-320, where the Ninth Circuit held in the taxpayer's favor on the excludability of disability retirement income. Taylor argued that, as was the case with the taxpayer in Picard, if he were determined to be fit for work, his disability retirement payments would cease. Because he was subject to medical re-examinations and his disability retirement allowance could be reduced if he were determined to be able to earn over a certain amount, Taylor maintained that his payments were not for life and so were not "a retirement pension or annuity" for purposes of Reg. Sec. 1.104-1(b).

Moreover, Taylor submitted that while North Carolina law allows disability beneficiaries to "convert" a disability retirement allowance to a reduced service retirement allowance if they are determined to be engaged in or able to engage in a gainful occupation paying more than a certain amount, another provision which also treats disability retirement beneficiaries as service retirement beneficiaries when they reach the earliest date on which they would have qualified for an unreduced service retirement allowance, uses a different word: "considered." To Taylor, this meant that beneficiaries are not transferred from one retirement system to another and, under Tax Court precedent, there is a requirement that there be a clear, unambiguous formal transfer of a taxpayer from one system to another.

IRS's Position

While the IRS admitted that Taylor was not eligible for an unreduced service retirement allowance under LGERS as of the date of his retirement (i.e., because he was only 46 years old with 24 years and 8 months of creditable service), it argued that, since Taylor's disability retirement allowance was calculated with reference to his age and length of service, it was includible in his gross income. According to the IRS, regardless of the initial classification of

Taylor's retirement income, Taylor was no longer receiving a disability retirement allowance. The IRS pointed out that, under North Carolina law, once a beneficiary in receipt of a disability retirement allowance becomes eligible for an unreduced service retirement allowance, he is deemed to be in receipt of the latter. This occurred, the IRS said, when Taylor turned 60 years old in 2004, eight years before the tax year in issue. The IRS cited several Tax Court cases in which disability payments initially were excludable but later became includible in gross income when the taxpayer would have qualified for a service retirement pension had he continued to work. As in those cases, the IRS said, Taylor's retirement payments are includible in his gross income as nondisability pension income.

The IRS also argued that the situation in Picard differed from Taylor's case in two respects: first, Taylor's disability benefit and service retirement allowance both are computed with regard to his age and length of service and not his employment anniversary, and second, Taylor's disability retirement allowance converted to a service retirement allowance when he turned 60 years of age in 2004.

Tax Court's Decision

The Tax Court held that LGERS is a governmental plan within the meaning of Code Sec. 414(d). Accordingly, payments from LGERS are payments from a "retirement pension or annuity" as those words are used in Reg. Sec. 1.104-1(b) and Taylor's disability retirement allowance under LGERS was a retirement pension determined by reference to his age and length of service. As a result, the court said it did not need to address the extent to which Taylor was transferred from a disability retirement allowance to a service retirement allowance. Neither allowance was excludible from income as amounts received under a workmen's compensation act or a statute in the nature of such.

For a discussion of the exclusion from gross income of amounts received under workmen's compensation acts as compensation for personal injuries or sickness, see Parker Tax ¶75,905.

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Partnership Can't Deduct Contribution of Remainder Interest in Property to University

The Tax Court held that a partnership was not entitled to a deduction for the charitable contribution of a remainder interest in real property because it failed to substantiate the value of the property on its tax return. The partnership was liable for a gross valuation misstatement penalty because its valuation of the property exceeded the correct value by more than 400 percent and the partnership did not have reasonable cause for the misstatement. RERI Holdings I, LLC v. Comm'r, 149 T.C. No. 1 (2017).

Background

In March 2002, RERI Holdings I, LLC (RERI) paid $2.95 million to acquire a remainder interest in land and a web hosting facility in Hawthorne, California (Hawthorne property). The Hawthorne property, consisting of 288,000 square feet, was leased in 2000 by its then owner, Intergate.LA II LLC (Intergate) to AT&T Corp. The annual rent ranged from approximately $3.8 million to $5.6 million. In 2001, Red Sea Tech I, Inc. (Red Sea) acquired the Hawthorne property from Intergate.

Red Sea assigned to RS Hawthorne, LLC (Hawthorne) its interest in the property in 2002. Hawthorne then acquired the property from Intergate, subject to the AT&T lease, for approximately $42 million. Hawthorne financed the acquisition with a bank loan of approximately $43.6 million. An appraisal for the bank valued the property at $47 million as of August 16, 2001, based on a discounted cash flow analysis.

Hawthorne's sole member at the time of the acquisition was RS Hawthorne Holdings, LLC (Holdings). Red Sea was the sole member of Holdings. After Hawthorne acquired the property, Red Sea assigned its member interest in Holdings to RJS Realty Corp. (RJS) but kept an estate for years in the Hawthorne property with a scheduled expiration in December 2020. RERI purchased the remainder interest from RJS in March 2002 for $2.95 million. Under the agreement, Holdings continued to own all of the beneficial interest in Hawthorne, and Hawthorne continued to own the property.

In August 2003, RERI assigned the remainder interest to the University of Michigan. The assignment of the remainder interest included no language to the effect that Holdings continued to own the sole member interest in Hawthorne and Hawthorne continued to own the property. However, a transfer by Holdings of its interest in Hawthorne or of the property would have breached conditions provided in the assignment that created the remainder interest. RERI's assignment to the university identified the transferred property as the remainder interest rather than a fee simple interest in the sole member interest in Holdings. Therefore, on the date of the assignment, Holdings continued to own the sole member interest in Hawthorne, and Hawthorne continued to own the property. Holdings had no material liabilities as of the date of the assignment to the university, and Hawthorne had no material liabilities other than its obligation under the bank loan.

RERI had an appraisal of the remainder interest prepared in September 2003. The appraisal valued the Hawthorne property at $55 million and applied an actuarial factor in order to determine the investment value of the remainder interest. RERI claimed a deduction of approximately $33 million on its 2003 tax return. The amount of the deduction equaled the appraiser's investment value, increased by appraisal and professional fees. RERI attached to its return a Form 8283, Noncash Charitable Contributions, with an appraisal summary. The Form 8283 showed no amount in the space provided for RERI's cost or other adjusted basis in the remainder interest.

The IRS audited RERI and issued a final partnership administrative adjustment (FPAA) in 2008. The FPAA reduced RERI's deduction for the remainder interest on the ground that the contributed property was worth only $3.9 million. A substantial valuation misstatement penalty under Code Sec. 6662(e)(1) was also applied. RERI filed a petition for readjustment of partnership items with the Tax Court in April 2008. In response, the IRS asserted that RERI was not entitled to any deduction for the contribution because it was part of a sham transaction or lacked economic substance. Alternatively, the IRS argued that the deduction should be limited to approximately $1.9 million, the amount which the university realized when it sold the contributed property. The IRS also stated that RERI's claimed deduction resulted in a gross valuation misstatement under Code Sec. 6662(h)(2).

Analysis

Under Reg. Sec. 1.170A-13(c), a charitable donation of property worth more than $5,000 must be substantiated with a fully completed appraisal summary which provides, among other things, the cost or other basis of the donated property. A taxpayer may substantially comply with these requirements if the filings provide enough information for the IRS to evaluate the reported contributions and be alerted to a potential overvaluation. An accuracy related penalty applies under Code Sec. 6662 if an underpayment of tax is due to a substantial or gross valuation misstatement. The substantial valuation misstatement penalty applies if the reported value or basis is 200 percent or more of the correct value or basis. The gross valuation misstatement penalty applies if the claimed value or basis is 400 percent or more of the correct amount. Under Code Sec. 6664(c), a reasonable cause exception applies if a charitable deduction is supported by both a qualified appraisal and a good faith investigation of the value of the contributed property.

The Tax Court held that RERI was not entitled to a charitable deduction because it failed to report its basis in the Hawthorne property on the Form 8283 submitted with its 2003 tax return as required by Reg. Sec. 1.170A-13(c)(2). It also found that RERI was liable for a gross valuation misstatement penalty and that the reasonable cause exception provided in Code Sec. 6664(c) did not apply.

In order to determine whether RERI's liability for either the substantial or gross valuation misstatement penalty under Code Sec. 6662 applied, the Tax Court had to determine the fair market value of the remainder interest as of the date of the contribution to the university. First, the court found that the remainder interest should be valued based on all of the facts and circumstances and not by reference to the standard actuarial factors provided in Code Sec. 7520. According to the Tax Court, because of the limitation on remedies available to the holder of the remainder interest for breaches of protective covenants, the agreement that created the remainder interest did not provide adequate protection to its holder for purposes of Reg. Sec. 1.7520-3(b)(2)(iii). Therefore, the Code Sec. 7520 actuarial factors did not apply and the value of the interest was its actual fair market value, determined without regard to Code Sec. 7520, on the basis of all the facts and circumstances.

The Tax Court determined that, based on the facts and circumstances, the fair market value of RERI's remainder interest in the property on the date of the contribution was approximately $3.4 million. The court calculated the present value of the remainder interest by projecting the cash flows from the property after 2020 and applying a discount rate that reflected the investment risk in the property and the long term applicable federal interest rate for August 2003. Having determined the value, the Tax Court held that RERI's claim of a charitable contribution of approximately $33 million therefore resulted in a gross valuation misstatement because it exceeded the correct value by more than 400 percent. The underpayment of tax resulting from the disallowance of RERI's charitable deduction was attributable to a gross valuation misstatement, according to the Tax Court, to the extent that it reflected the excess of the $33 million value RERI claimed for the remainder interest over the $3.4 million value determined by the court.

RERI's argument that it had reasonable cause for the underpayment was rejected by the Tax Court. In the court's view, RERI did not have good cause for, or act in good faith because RERI's appraisal was based on the February 2002 sale of the Hawthorne property, which was 18 months before the August 2003 assignment to the university. The Tax Court concluded that such a valuation was not sufficient as a matter of law to qualify as a good faith investigation into the value of the property at the time of the gift. Therefore, regardless of whether RERI had relied on a qualified appraisal, it did not meet the requirements for the reasonable cause exception.

For a discussion of the substantiation requirements for noncash contributions over $5,000, see Parker Tax ¶84,190. For a discussion of the accuracy related penalty for substantial or gross valuation misstatements, see Parker Tax ¶262,120.

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IRS Finalizes Streamlined Process for Applying for Sec. 501(c)(3) Nonprofit Status

The IRS finalized temporary and proposed regulations that have applied since July 1, 2014, and that allow the IRS to adopt a streamlined application process that eligible organizations may use to apply for recognition of tax-exempt status under Code Sec. 501(c)(3). The regulations, which were finalized without substantive changes, apply on and after July 1, 2014. T.D. 9819 (6/30/17).

Code Sec. 508 requires an organization seeking tax-exempt status under Code Sec. 501(c)(3), as a condition of its exemption, to notify the IRS that it is applying for recognition of exempt status as prescribed in the regulations, unless it is specifically excepted from the requirement. Longstanding regulations under Reg. Sec. 1.501(a) - 1, Reg. Sec. 1.501(c)(3) - 1, and Reg. Sec. 1.508 - 1 had required all organizations applying for recognition of Code Sec. 501(c)(3) exempt status to submit a properly completed and executed Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, and to submit with, and as part of, the application, a detailed statement of its proposed activities. Detailed procedures for applying for recognition of exemption are included in annual revenue procedures and in the instructions for Form 1023.

On July 2, 2014, the IRS issued final, temporary, and proposed regulations (T.D. 9674; REG-110948-14) authorizing the IRS to adopt a streamlined application process that eligible organizations may use to apply for recognition of tax-exempt status under Code Sec. 501(c)(3). The 2014 final regulations removed and reserved certain paragraphs of the longstanding final regulations addressed by corresponding paragraphs of the new temporary regulations. Under the temporary regulations, the IRS instituted the streamlined application process on Form 1023 - EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, the detailed procedures for which have been provided in annual revenue procedures, most recently in Rev. Proc. 2017-5, and in the instructions for Form 1023 - EZ. The regulations were effective and applicable on July 1, 2014.

On June 30, 2017, the IRS adopted the temporary and proposed regulations as final without substantive change. According to the IRS, it is continuing to consider improvements to Form 1023-EZ based on its own experience and informal comments received from the public and other stakeholders on the form, including whether to require applicants to submit a brief statement of actual or proposed activities.

For a discussion of the requirements for applying for tax-exempt status under Code Sec. 501(c)(3), see Parker Tax ¶60,590.

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Tax Court Denies Serial Whistleblower's Request for Anonymity

The Tax Court denied a motion for anonymity filed by a whistleblower who had filed several claims for whistleblower awards under Code Sec. 7623 based solely on publicly available information. The whistleblower failed to make a sufficient, fact specific case for anonymity, and his interest in protecting his identity was outweighed by the public's interest in identifying serial claimants of whistleblower awards filing petitions in the Tax Court. Whistleblower 14377-16W v. Comm'r, 148 T.C. No. 25 (2017).

A retired CPA who was a self-described analyst of financial institutions learned of a corporate taxpayer's alleged tax abuse from publicly available sources such as Securities and Exchange Commission (SEC) filings. The whistleblower, who had filed for a whistleblower award, claimed that the corporate taxpayer had understated its income by numerous improper actions, including allegedly failing to report millions of dollars in income received from the sale of gift cards. According to the whistleblower, the corporate taxpayer evaded paying nearly $100 million in taxes.

The IRS denied the whistleblower an award and he appealed the decision in the Tax Court under Code Sec. 7623(b). Concurrently with his petition, he filed a motion with the Tax Court to proceed anonymously. The whistleblower requested anonymity because he said he legitimately feared that if his identity as a tax whistleblower was disclosed, he would be blacklisted from his profession and he and his family would suffer severe financial harm. He claimed that his primary occupation was assisting his spouse in managing a registered investment advisory business, and said that disclosure of his identity would negatively impact his relationship with his spouse and impair his ability to assist with the business and earn income. Disclosure could, he said, alienate business partners who might have relationships with the taxpayers he identified. He also feared retribution from political figures close to those taxpayers.

The Tax Court noted that it was aware of 10 other cases before it in which the whistleblower was appealing the IRS's determination to deny him a whistleblower award. None of the cases, according to the Tax Court, appeared to have resulted from the whistleblower's employment by, or close relationship to, the target taxpayer. Rather, all appeared to have originated from the whistleblower's examination of SEC filings and other publicly available materials.

The IRS argued that the whistleblower had failed to set forth a sufficient, fact specific basis for protecting his confidentiality that would override the public's interest in having access to the record in this case. The whistleblower had no need for anonymity, the IRS reasoned, because he obtained the information in his whistleblower claims from publicly available sources and not from confidential, or insider, sources. The IRS also asserted that the public had an interest in understanding the circumstances surrounding whistleblower filings, including the frequency of filings by a single person based not on insider information but on publicly available information. This type of information was valuable in order to understand how individuals were using the court system, the IRS argued.

The Tax Court denied the whistleblower's motion for anonymity because the whistleblower failed to present a sufficient, fact-specific showing of potential harm that outweighed counterbalancing societal interests in knowing the whistleblower's identity. The Tax Court found only five prior decisions in which it addressed a whistleblower's motion to proceed anonymously. In three of those cases, the whistleblowers made plausible claims that they would be physically threatened as a result of their actions. In the fourth, an employee relationship gave the whistleblower access to internal deliberations and communications regarding the underpayment of tax, and the revelation of such facts would likely severely damage the whistleblower's professional standing in the community in which he customarily earned his living and would jeopardize his employment. In the fifth case, the whistleblower was at risk of losing employment-related benefits, such as retirement benefits.

Unlike those cases, the Tax Court found that the whistleblower in this case did not identity a taxpayer who, upon learning his identity, would have the power to, and might be expected to, act against him. The Tax Court acknowledged the general policy in favor of confidential informants and noted that the whistleblower might suffer some embarrassment or annoyance from the denial of his anonymity request. However, his stated fears of marital discord, alienation of unnamed business partners, and retribution from unnamed political figures were speculative, in the court's view. The Tax Court therefore concluded that the whistleblower had not provided a sufficient fact-specific justification.

The Tax Court also noted that this whistleblower was unusual because he had so far brought 11 whistleblower cases in the Tax Court. His supporting documents identified 21 claims against some 40 named and unnamed taxpayers. He also admitted that he had before the IRS 51 claims supplemental to claims in cases already before the Tax Court. According to the Tax Court, each of those as yet unresolved claims could be the source of another adverse determination and a resulting Tax Court petition. The fact that the whistleblower was using publicly available documents to identify the supposed tax abuses meant that the number of cases he could bring was limited only by his own industriousness. In the Tax Court's view, the lack of an employment or other close relationship to the taxpayers identified by the whistleblower suggested that he had no familiarity with a taxpayer's basis for taking what the whistleblower considered an abusive position. For these reasons, the Tax Court reasoned that serial claimants could disproportionately burden the Tax Court with only superficially meritorious petitions.

Noting that a cottage industry of serial whistleblowers had sprung up, the Tax Court said that identifying serial filers by name would enable the public to judge the impact of the serial filer phenomenon by making it possible to know whether the whistleblower appealing an adverse IRS determination had appealed other adverse whistleblower determinations. Moreover, the Tax Court noted that anonymous whistleblower cases require special handling, including sealing the record, suspending use of electronic filing and service, assigning the case to a judge earlier than normal and, in some cases, closing trials to the public.

For a discussion of the confidentiality of whistleblower identities, see Parker Tax ¶262,325.

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Subordination of Mortgages after Conveyance of Property Precludes Charitable Deduction

The Eighth Circuit joined the Ninth and Tenth Circuits in holding that a taxpayer is not entitled to a charitable tax deduction for the donation of an easement to a charitable organization where a mortgage on the easement property is not subordinated to the charitable organization at the time of the donation. The lack of such subordination means that the easement is not protected in perpetuity, and the donation is, therefore, not a deductible qualified conservation contribution. RP Golf v. Comm'r, 2017 PTC 297 (8th Cir. 2017).

Background

In 1997 and 1998, RP Golf, LLC acquired land in Platte County, Missouri. It developed two private golf clubs, The National and The Deuce. To fund the purchase, RP Golf obtained loans from two banks: Hillcrest and Great Southern. Hillcrest financed the original purchase in 1997. Great Southern gave a development loan in 2001. Both loans were secured by deeds of trust on the property.

In December 2003, RP Golf granted a permanent conservation easement to Platt County Land Trust (PLT), a Missouri not-for-profit corporation. The easement's purpose was to "further the policies of the State of Missouri designed to foster the preservation of open space and open areas, conservation of the state's forest, soil, water, plant and wildlife habitats, and other natural and scenic resources."

On April 14, 2004, Great Southern and Hillcrest signed subordinations of their mortgages to PLT's right to enforce the easement. Both subordinations state an effective date of December 31, 2003. Also on April 14, RP Golf filed its 2003 partnership tax return claiming a $16.4 million tax deduction for a charitable qualified conservation contribution under Code Sec. 170(b)(1)(E). The IRS disallowed the deduction, claiming it did not meet the requirements for a qualified conservation contribution under Code Sec. 170(b)(1)(E). RP Golf challenged the IRS's decision in Tax Court.

Analysis

Code Sec. 170(b)(1)(E) allows a deduction for qualified conservation contributions to the extent the aggregate of such contributions does not exceed the excess of 50 percent of the taxpayer's contributions base over the amount of all other allowable charitable contributions. Reg. Sec. 1.170A-14(a) provides that a qualified conservation contribution is a contribution of -

(1) a real property interest;

(2) to a qualified organization;

(3) exclusively for conservation purposes.

Code Sec. 170(h)(4)(A) defines what qualifies as a conservation purpose while Code Sec. 170(h)(5)(A) provides that the conservation purpose must be protected in perpetuity. Reg. Sec. 1.170A-14(g)(2) precludes any deduction for an interest in property which is subject to a mortgage unless the mortgagee subordinates its rights in the property to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity. At issue in this case was whether the property was donated "exclusively for a conservation purpose."

The Tax Court held that RP Golf's easement was not protected in perpetuity, and, therefore, was not a qualified conservation contribution. The Tax Court cited its decision in Mitchell v. Comm'r, 138 T.C. 324 (2012), as affirmed by the Tenth Circuit (775 F.3d 1243 (10th Cir. 2015)), where it concluded that although the subordination regulation is silent as to when a taxpayer must subordinate a preexisting mortgage on donated property, "we find that the regulation requires that a subordination agreement must be in place at the time of the gift." RP Golf appealed to the Eighth Circuit, arguing that it met the "protected in perpetuity" requirement even if the subordination of the mortgages by the banks occurred after the conveyance of the easement. According to RP Golf, because the Code is silent about the timing of a subordination, such subordination is allowed to take place after the conveyance of an easement.

The Eighth Circuit affirmed the Tax Court and held that because the subordination of the mortgage was not in place at the time of the donation, no charitable deduction is available. The Eighth Circuit cited the Tenth Circuit's decision affirming the Tax Court's holding in Mitchell, as well as the Ninth Circuit's decision in Minnick v. Comm'r, 796 F.3d 1156 (9th Cir. 2015). In Minnick, the Ninth Circuit concluded that, for a taxpayer to take a charitable deduction for the donation of a conservation easement, any mortgage on the property must be subordinated to the easement at the time of the donation. In the instant case, the Eighth Circuit said, in order to take a qualified conservation contribution deduction, Hillcrest and Great Southern had to have subordinated their mortgages to PLT's interest before RP Golf conveyed the easement in December 2003.

For a discussion of the requirements for a charitable donation deduction for easement contributions, see Parker Tax ¶84,155.