Federal Tax Bulletin - Issue 146 - August 8, 2017

Corporation's Intercompany Transactions with CFCs Result in Income Recognition

The Tax Court granted summary judgment and held that the following transactions constituted investments in U.S. property and thus resulted in various amounts being included in a corporation's income: (1) an outstanding intercompany loan balance owed by a subsidiary of the corporation to a controlled foreign corporation (CFC); (2) a CFC's guarantee of a subsidiary's loan and direct or indirect pledge of assets as security for that loan; and (3) a trade receivable balance owed by a subsidiary to a CFC. However, no summary judgment was granted where there remained a material dispute of fact as to whether trade receivable balances owed by a subsidiary to another CFC, which were incurred in an ongoing trade or business between those entities, were "ordinary and necessary" to carrying on their respective trades or businesses. Crestek, Inc. & Subs v. Comm'r, 149 T.C. No. 5 (2017).

Facts

Crestek, Inc. is the parent of a group of companies that includes a number of controlled foreign corporations (CFCs). Before fiscal year (FY) 2008, one of Crestek's domestic subsidiaries (S1) borrowed money from the CFCs, and those loans remained outstanding throughout FY 2008 and FY 2009. Also before FY 2008, S1 borrowed money from a Malaysian bank. CFC-1, Crestek's Malaysian subsidiary, guaranteed this loan. Before mid-2005, CFC-1 sold completed products to another domestic subsidiary (S2), for which S2 incurred payment obligations in the form of trade receivables. CFC-1 stopped manufacturing operations in mid-2005. The net trade receivable balance owed by S2 to CFC-1 remained constant at $7.92 million from mid-2005 through the end of FY 2009.

After mid-2005, another CFC, CFC-2, assumed the manufacturing activities of CFC-1 and sold completed products to S2. The net trade receivable balance owed by S2 to CFC-2 rose to $18.41 million in the last quarter of FY 2009.

After auditing Crestek, the IRS determined that all of these transactions gave rise to investments in "United States property" under Code Sec. 956(c)(1)(C) and accordingly determined that Crestek was required to include various amounts in gross income under Code Sec. 951(a)(1)(B).

Income Resulting from U.S. Ownership of a CFC

Under Code Sec. 951(a)(1)(B), each U.S. shareholder of a CFC generally must currently include in its gross income an amount determined under Code Sec. 956 with respect to that shareholder. Code Sec. 956 provides that U.S. shareholders of a CFC that invests certain earnings and profits in U.S. property must recognize income on the grounds that the investment is substantially the equivalent of a dividend being paid to them. The income inclusion amount is the lesser of:

(1) the excess, if any, of (a) the shareholder's pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of such tax year, over (b) the amount of earnings and profits of the CFC described in Code Sec. 959(c)(1)(A) with respect to such shareholder; or

(2) the shareholder's pro rata share of the applicable earnings of the CFC.

Code Sec. 956(c)(1) defines U.S. property for purposes of this rule and Code Sec. 956(c)(1)(C) provides that U.S. property includes an obligation of a U.S. person. Under Reg. Sec. 1.956-1(e)(1), the amount of the investment in U.S. property with respect to such obligation is the CFC's adjusted basis in the obligation reduced by certain liabilities. The amount includible in income is reduced by any previously taxed E&P of the CFC and the includible amount cannot exceed the U.S. shareholder's pro rata share of the applicable earnings of the CFC.

There are several types of property that are not considered U.S. property. For example, Code Sec. 956(c)(2)(C) provides that U.S. property does not include any obligation of a U.S. person arising in connection with the sale or processing of property if the amount of the obligation outstanding at no time during the tax year exceeds the amount that would be ordinary and necessary to carry on the trade or business of both the other party to the sale or processing transaction and the U.S. person had the sale or processing transaction been made between unrelated persons.

Crestek's Arguments

Crestek made several arguments against the income inclusion and an argument that most of the IRS's proposed Code Sec. 956 inclusions were attributable to investments in U.S. property that the CFCs had made in tax periods before FY 2008. In Crestek's view, the IRS was obligated to make any adjustments under Code Sec. 956 for the year in which the CFCs first acquired the U.S. property in question, not for any later period.

Crestek also argued that, even if a Code Sec. 956(a) inclusion is required, the Tax Court must redetermine its income for previous years to correctly account for current earnings and profits. Crestek cited Code Sec. 6214 for the proposition that the Tax Court, in redetermining a deficiency for a particular year, "shall consider such facts with relation to the taxes for other years * * * as may be necessary correctly to redetermine the amount of such deficiency."

Tax Court's Decision

The Tax Court held that Crestek had to recognize income as a result of being a U.S. shareholder of CFCs that were investing E&P in U.S. property. According to the court, the outstanding intercompany loan balance owed by S1 to the CFCs constituted U.S. property held by the CFCs, within the meaning of Code Sec. 956(c)(1)(C), during FY 2008 and FY 2009. The court also held that CFC-1's guaranty of S1's loan and the direct or indirect pledge of assets as security for that loan constituted U.S. property held by CFC-1, within the meaning of Code Sec. 956(c)(1)(C) and (d), during FY 2008 and FY 2009. With respect to the $7.92 million trade receivable balance owed by S2 to CFC-1, which had been outstanding for at least three years and bore no interest, the court found that this was in excess of the amount that "would be ordinary and necessary" in a transaction between unrelated parties, within the meaning of Code Sec. 956(c)(2)(C), to carry on their respective trades or businesses. Thus, the court said, the trade receivable constituted U.S. property held by CFC-1 during FY 2008 and FY 2009.

However, the court denied summary judgment with respect to the CFC-2 transaction because there remained a material dispute of fact as to whether the trade receivable balances owed by S2 to CFC-2, which were incurred in an ongoing trade or business between those entities, were "ordinary and necessary" to carrying on their respective trades or businesses.

With respect to Crestek's argument that the IRS had to make any adjustments under Code Sec. 956 for the year in which the CFCs first acquired the U.S. property in question, the court said that the statute does not require that the income inclusion be made for the first year in which the CFC acquires its investment or that the inclusion be made for any particular year. To the contrary, the court noted that Code Sec. 956(a)(1)(A) defines the inclusion for any particular year by reference to "the amounts of United States property held (directly or indirectly) by the controlled foreign corporation" during that year. Thus, where a CFC holds an item of U.S. property for multiple years, Code Sec. 956(a) permits an inclusion in income for any one of those years.

With respect to the argument that the Tax Court had to redetermine Crestek's income for previous years to correctly account for current earnings and profits, the court found this argument misguided. Crestek's own E&P, the court said, was wholly irrelevant in determining the proper amount of a Code Sec. 956 inclusion attributable to investment in U.S. property by Crestek's CFCs. The entities whose tax attributes are relevant to this determination, the court said, are the CFCs and not Crestek's.

For a discussion of income resulting from investment in U.S. property, see Parker Tax ¶201,510.

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Senate Rejects Multiple Healthcare Bills, Pulls Away from Obamacare Repeal

After narrowly clearing procedural hurdles to move healthcare legislation to the Senate floor, debate on various alternatives culminated in the defeat of three separate Obamacare repeal bills. Former presidential candidate John McCain (R-AZ) joined Susan Collins (R-ME), Lisa Murkowski (R-AK), and 48 Democrats in voting against the final bill, likely ending Congressional Republicans' efforts to repeal the Affordable Care Act (ACA) for the year.

The proposals the Senate debated represented three distinct approaches to ACA repeal:

(1) The Better Care Reconciliation Act (BCRA), a comprehensive repeal-and-replace bill;

(2) The Obamacare Repeal and Reconciliation Act (ORRA), which would have repealed (without replacing) most of the ACA; and

(3) The Health Care Freedom Act ("Skinny Repeal"), a bare bones repeal of a few of the ACA's core provisions.

After allotting 20 hours for debate, the Senate proceeded to consider each proposal on three successive days.

Three Defeats for Obamacare Repeal

First up was the BCRA, the repeal-and-replace plan Senate Republicans had been developing for months. The final version of the bill included numerous changes from the bill introduced in June, including retention of the net investment income tax (NIIT). The final bill also included the Cruz amendment, which would allow insurance companies to sell stripped down health plans side-by-side with full-coverage plans complying with Obamacare's essential benefit regulations. When the measure came to a procedural vote to determine if it could move forward, nine Republicans joined 48 Democrats to reject the bill 43 to 57.

Next, the Senate considered ORRA, the latest iteration of the so-called "clean repeal" legislation passed by the Senate in December 2015. The bill would have eliminated all of the ACA's taxes and credits, including the individual and employer mandates, the NIIT, and the premium tax credit. According to the Congressional Budget Office (CBO), 32 million fewer people would have health insurance in 2026 under ORRA, compared with current law. Six Republican who voted for a virtually identical bill in 2015 flipped positions to vote against it, helping to send it to a 45-55 defeat.

Capping a week of healthcare drama, Senate leadership introduced their much-anticipated "skinny repeal" bill just hours before a scheduled midnight vote. The bill included four tax provisions: (1) permanent repeal of the individual mandate; (2) repeal of the employer mandate for eight years; (3) repeal of the medical device tax for three years; and (4) an increase in health saving account contribution limits for three years. The bill also would have defunded Planned Parenthood and made it easier for states to obtain waivers for some of the ACA's insurance regulations. CBO scoring indicated that 16 million people would lose health insurance within ten years under skinny repeal.

Senate leadership pitched the bill as a vehicle to get to conference with the House, where they said a comprehensive repeal-and-replace plan could be negotiated - and they almost succeeded. Despite concerns that the bare bones legislation that "was never meant to become law" might simply pass the House and be signed by an eager President, the measure fell just one vote shy of the number needed for Vice President Pence to cast a tiebreaker. Instead, McCain, Collins, and Murkowski voted with the Senate's Democrats to defeat the bill, 49 to 51.

What's Next for Healthcare

In the wake of the defeats, President Trump has made clear that he wants Congress to press forward with repeal and has berated Senate Republicans for their apparent willingness to accept defeat. Several conservatives in the House, including Freedom Caucus Chairman Mark Meadows (R-North Carolina), have also voiced support for resuming the campaign.

But all indications are that the Senate is done with ACA repeal for the year. In a floor speech after the failed vote on skinny repeal, Majority Leader Mitch McConnell (R-KY) said "it is time to move on." More bluntly, Orrin Hatch (R-UT) echoed the sentiments of many Senate Republicans when he said "We're not going back to health care ... I'm sick of it."

While ACA repeal may be dead for the year, Congress may still have to deal with the question of funding cost-sharing reduction (CSR) payments, which are made to insurance companies to compensate them for offering lower out-of-pocket costs to low income enrollees. Funding the payments (and thereby taking away the President's discretion to discontinue them) would almost certainly require bipartisan support, and could be part of a broader package of ACA tweaks.

It also remains possible that NIIT repeal could be rolled into tax reform, as was proposed in the White House's tax outline released in April (Trump Tax Outline).

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Royalty Payments Reclassified as Excess Roth IRA Contributions under Substance over Form Doctrine

The Tax Court recharacterized royalty payments to a partnership owned by a family's individual Roth IRAs as excess contributions to the Roth IRAs, thus finding the family members liable for the excise tax on excess contributions. The arrangement failed the substance over form test in Notice 2004-8 because the partnership was only a conduit to divert funds to the Roth IRAs. Block Developers, LLC v. Comm'r, T.C. Memo. 2017-142.

Facts

Jan Jansson is an engineer who patented a design for Verdura Blocks, a retaining wall system consisting of interlocking concrete blocks. Jansson currently sells the blocks at 30-40 outlet stores. Jansson originally formed an S corporation that he named Soil Retention Systems, Inc. He subsequently split his business into different S corporations (SR businesses) in order to minimize potential liability. One of the companies, Soil Retention Products (SR Products), has 30 employees and manufactures and distributes the blocks. The other companies include a company that rents equipment to Jansson's other businesses and a company that handles design work for particular jobs. Jansson's wife and two children are employed in various roles in these companies. Each business is technically run as a separate unit of Jansson's overall enterprise but the businesses share office space and management and resources. In addition, much of the SR businesses' documentation bears only the name of "Soil Retention."

Jansson hired Bill Maxam, a lawyer and entrepreneur, as his estate planner. Jansson's goal was for his businesses to survive his retirement. Jansson had previously considered selling his patents but a deal never materialized. Maxam came up with a complicated plan for Jansson's retirement. First, Maxam bought two of Jansson's most successful patents. Next, each member of the Jansson family opened a Roth IRA. Maxam then formed a partnership, Block Developers, LLC, and each Jansson Roth IRA acquired an equal interest in Block Developers. Maxam was also a partner in Block Developers. Jansson sold his patents to Block Developers for $250,000 and SR Products entered into a licensing agreement with Block Developers to pay a 10 percent royalty on its sales of Verdura Blocks. Block Developers paid for the patents in large part by allowing SR Products to reduce its royalty payment by $249,000. From 2001 through 2007, SR Products paid around $1.2 million to Block Developers in royalties, $800,000 of which went into the Janssons' Roth IRAs.

On their individual tax returns for 2005 and 2006, none of the Janssons reported excess contributions to their Roth IRAs. In December 2008, the IRS sent each of the Roth IRAs, as partners of Block Developers, a notice of beginning of administrative proceeding (NBAP) to notify them that it was auditing Block Developers' 2005 tax return. Less than a year later, the IRS also sent NBAPs to the IRAs for Block Developers' 2006 return.

In December 2009, NBAPs were sent to each Jansson individually to provide notice that Block Developers' 2005 and 2006 returns were being audited. The IRS advised that the NBAPs were untimely, and that the Janssons could elect to have their items in the partnership treated as nonpartnership items. Each Jansson opted out of the partnership proceeding for both years. The IRS later rechecked its records and realized that it had sent NBAPs to the Roth IRAs in December 2008 for 2005. The IRS closed its investigation and issued each of the Janssons a notice of deficiency for 2006. A notice of final partnership administrative adjustment (FPAA) was sent to Maxam as the tax matters partner of Block Developers.

The Janssons filed petitions for review in the Tax Court, arguing that the court lacked jurisdiction because all items in the notices of deficiency were partnership adjustments that had to be determined at the partnership level. Therefore, only the Block Developers case could go forward, according to the Janssons. The IRS argued that the Janssons' election to opt out for 2005 was ineffective because the IRS had in fact sent timely NBAPs to the IRAs, and it was their responsibility to pass on the NBAPs to the Janssons as indirect partners of Block Developers.

The Tax Court dismissed the Janssons' individual petitions for lack of jurisdiction because the notices were issued before a final partnership determination. Based on the lack of jurisdiction, the court did not decide whether the Janssons could elect to treat their partnership items as nonpartnership items for 2005. Block Developers' petition for 2005 went forward as the only proceeding in the case for that year.

The IRS then realized that the NBAPs to the Janssons were untimely for 2006, meaning the Janssons had the right to opt out of the partnership proceeding for 2006. The IRS sent notices of deficiency to the Janssons for 2006 only, and the Janssons filed Tax Court petitions to challenge them. Thus, the Tax Court had to consider Block Developers' petition for review of the FPAAs for 2005 and 2006, and the Janssons' petitions for review of their individual notices for 2006.

Analysis

First, the Tax Court addressed a procedural challenge by the Janssons regarding 2005. The Janssons argued that as indirect partners of Block Developers, the IRS was required to send NBAPs to each of them. The Janssons argued that because they did not personally receive NBAPs for 2005, they should be allowed to opt out of the partnership proceeding for that year.

The regulations under Code Sec. 6223 provide that an agent is not required to search IRS records for information on indirect partners. The parties agreed that the revenue agent learned that the Janssons were indirect partners, and the issue was whether, having made that determination, the agent was required to send NBAPs to the indirect partners rather than just to the Roth IRAs. The Tax Court determined that under the regulations, the IRS was permitted, but not required, to use information it discovered on its own. Therefore, the Janssons were not permitted to opt out of the partnership proceeding for 2005.

Next, the Tax Court looked at whether the Janssons had made excess contributions to their Roth IRAs. Code Sec. 4973 imposes an excise tax of 6 percent for excess Roth IRA contributions. Excess contributions are the lesser of (1) the amount of the excess contribution, or (2) the value of the account as of the end of the tax year. The tax applies each year until the excess contributions are eliminated. An excess contribution is defined in part as a contribution to a Roth IRA that exceeds the amount allowable as a contribution.

In Notice 2004-8, the IRS identified some transactions using Roth IRAs as abusive tax avoidance transactions, and it identified excess contributions as their key element. The Notice describes transactions involving an individual who owns a business, has a Roth IRA, and has a corporation owned by the Roth IRA. The transactions typically include the exchange of property from the existing business to the corporation owned by the Roth IRA for less than fair market value. The effect of the transaction is to transfer value to the corporation comparable to a contribution to the Roth IRA. The Notice states that the IRS will challenge these types of transactions under several theories, including substance over form.

The Janssons argued that Notice 2004-8 did not apply because the sale of the Verdura Block patents and the corresponding royalty rate were both at fair market value. They also asserted that there were legitimate business reasons for the arrangement. The patents were sold to generate cash, Block Developers was formed to protect Jansson's assets, and Block Developers would increase profits by licensing the patents to other manufacturers, the Janssons said.

Applying the substance over form doctrine, the Tax Court found that Block Developers was nothing more than a conduit to get money into the Roth IRAs, and was not engaged in any real business activity. First, the court rejected the argument that the patent sale and licensing agreement was at fair market value and thus not prohibited under Notice 2004-8. According to the court, the applicable test was whether the transaction lacked substance, and proper valuations of the patents and royalty rates did not by themselves determine that issue.

The Tax Court found important similarities in this case to the facts in Polowniak v. Comm'r, T.C. Memo. 2016-31, where the substance over form analysis was applied to a Notice 2004-8 transaction. The court observed that, as in Polowniak, Block Developers did not keep consistent records, and billing statements to SR Products did not match up with payments. There was little evidence as to any actual services provided by Block Developers, which did not have a single employee, the court noted. The court found that the parties did not adhere to written agreements regarding royalty payments. Block Developers, the court said, did not employ anyone to perform even menial administrative tasks, and there was no evidence that it ever tried to market the Verdura Block patents.

The court found the Janssons' arguments that Block Developers had a legitimate business purpose to be without merit. The sale of patents to generate cash was illogical, according to the court, because the money Block Developers paid for the patents came from SR Products, so no new capital was raised. The claim that Block Developers would protect Jansson's assets was unfounded because no evidence showed any additional protection of the assets beyond the web of corporations Jansson had already formed. Jansson said he hoped to increase profits on the patents by having Block Developers license them to other companies, but the court found that Block Developers did not attend trade shows or produce any marketing materials for Verdura Blocks. Rather, the court found that this work was done by Jansson or through SR Systems.

Finally, the court acknowledged that the substance-over-form doctrine is not something the IRS can use to pound every Roth IRA transaction it doesn't like. The Sixth Circuit, the court noted, recently reversed Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017), one of the Tax Court's decisions rooted in the doctrine. In Summa, the taxpayers had a similar setup: a business entity whose sole purpose was to transfer money into Roth IRA accounts. The Tax Court distinguished the Sixth Circuit's holding because the conduit entity in that case was a domestic international sales corporation (DISC) whose sole purpose was to transfer money into Roth IRA accounts. The Sixth Circuit said that a DISC's congressionally approved purpose was tax avoidance, so the transactions at issue could not be recharacterized under substance over form. The Tax Court concluded that, unlike a DISC, Block Developers was an LLC that was meant to have a real business purpose, and that the substance over form doctrine therefore applied.

For a discussion of Roth IRA transactions that the IRS considers abusive, see Parker Tax ¶135,160.

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Co-owner Liable for Employment Taxes Not Paid by Other Co-owner

A district court held that a corporation's 50-percent owner was liable for trust fund penalties relating to employment taxes that went unpaid. While the other 50-percent owner was responsible for preparing and paying the employment taxes, the court found that the taxpayer exercised enough influence and control over the company's financial affairs to be held liable. U.S. v. Hartman, 2017 PTC 343 (E.D. Mich. 2017).

Facts

Jon Hartman was the 50 percent co-owner and Chief Executive Officer of Spectrum Tool & Design, Inc., while the company operated from April 2001 to October 2005. Dan Ott was 50 percent co-owner and Chief Operating Officer from April 2001 until Hartman laid him off in August 2005. Both Hartman and Ott had authority to handle money for Spectrum, open and close bank accounts in its name, and sign checks. Generally, Hartman signed employees' paychecks, whereas Ott prepared the payroll tax deposit checks. Until December 2003, Spectrum used a third-party payroll service provider, ADP, to process its paychecks.

In December 2003, Spectrum was unable to pay the full amount of gross payroll (including taxes) due to ADP, and ADP terminated the contract. Spectrum was able to pay employees their net payroll during this period, meaning that Spectrum was unable to remit the gross payroll due to its inability to remit the payroll tax portion. Hartman admitted that he knew, in December 2003, that Spectrum could not timely pay its payroll taxes, but said that he and Ott anticipated that they would be able to pay back the shortfall in January or February 2004. After being dropped by ADP, Spectrum began using an in-house software system for handling payroll, at Ott's behest.

According to Hartman, he did not learn that Ott was routinely failing to pay the payroll taxes until July 2004 - at which time he arranged a meeting with the IRS to discuss the shortfalls. Hartman described independently discovering accounting irregularities in the in-house software; getting "nosy," and going through Ott's desk, where he discovered that Ott had not been paying the taxes. Up until that point, Hartman claimed that Ott was creating payroll tax checks regularly, leading Hartman to think Ott was paying those. According to Hartman, at the first IRS meeting the IRS told him to focus on staying current and then "try to get the back ones caught up." Spectrum could not stay current, however, necessitating another meeting with the IRS in October 2004. At the October 2004 meeting, Hartman discovered that Ott had not been keeping up with Spectrum's current taxes.

At that meeting with the IRS, Hartman signed Forms 941 for quarterly periods ending December 31, 2003 through September 30, 2004. Those returns reflected employment taxes that had not been paid. In May 2005, an IRS Revenue Officer interviewed Hartman. The interview was documented on a Form 4180, which Hartman signed, acknowledging that he examined the information on the form and that it was true. On the form, Hartman admitted, among other things, that he determined financial policy for the business; directed or authorized the payment of bills; authorized or signed payroll checks; and authorized or made federal tax deposits. He indicated that he did not prepare, review, sign, or transmit payroll tax returns. On the Form 4180, Hartman also admitted that while the delinquent taxes were increasing, he authorized the payment of certain of Spectrum's other financial obligations, including payroll, utilities, rent, supplies, operating expenses, loan payments, and equipment leases.

Hartman fired Ott in August 2005 for performance issues. However, even after firing Ott, Hartman still used Ott to pay Spectrum's employment taxes. Following an investigation, the IRS assessed trust fund liabilities against Hartman and petitioned a district court for summary judgment against Hartman. In his defense, Hartman argued that he was unaware of the deficiencies until after the fact and that it was Ott's job to handle the taxes.

Liability for Trust Fund Penalties

Code Sec. 6671 imposes personal liability on a corporate officers who is under a duty to pay wrongfully diverted taxes. Under Code Sec. 6672, the government must prove that a person was responsible for paying the taxes and willfully failed to pay the taxes due.

In Kinnie v. U.S., 994 F.2d 279 (6th Cir. 1993), the Sixth Circuit, the circuit to which the decision in the instant case would be appealable, held that whether one is considered a person responsible for paying over employment taxes to the government under Code Sec. 6672 is a question focusing upon the degree of influence and control which the person exercised over the financial affairs of the corporation, and, specifically, disbursements of funds and the priority of payments to creditors.

In Kinnie, a 50 percent owner and vice president of a company tried to invoke his status as a passive investor, in arguing that he was not a "responsible person" under Code Sec. 6672. The Sixth Circuit rejected this argument, noting that the vice president was a 50 percent shareholder during all the quarters that the company failed to pay withholding taxes, had authority to sign checks, had an accountant review the books for possible diversion of corporate funds and had forced the president to leave the corporation and ultimately shut down the corporation. The Sixth Circuit rejected the taxpayer's defense that he had "delegated" the duty to pay the taxes to the president, stating that there may be more than one person deemed a responsible person within a corporation and one who possesses significant control over the company's financial affairs may not escape liability by delegating the task of paying over the taxes to someone else. Moreover, the Kinnie court held that liability requires the existence of only significant as opposed to absolute control of the corporation's finances.

District Court's Ruling

Citing the Sixth Circuit's decision in Kinnie, the district court held that Hartman was a responsible person with respect to the employment taxes at issue. While Hartman had no responsibilities related to calculating or paying the payroll taxes and Ott maintained this duty even after he was laid off in May 2005, the district court said it was undisputed that Hartman had the authority to pay the payroll taxes if he wished to do so. The court found that every single basis for finding the taxpayer in Kinnie to be a "responsible person" was present. The court noted that Hartman possessed the same title, ownership interest, check-writing authority, and ability to force his coowner out of the business as the taxpayer in Kinnie did. And, just as the taxpayer in Kinnie was able to commission an inspection of the books to see if his partner was misappropriating funds, Hartman initiated meetings with the IRS upon discovering that the accounting balances didn't add up. In fact, the district court observed, Hartman had more responsibility and involvement than the taxpayer in Kinnie.

With respect to the issue of willfulness, the court agreed with the government that Hartman recklessly disregarded a known or obvious risk that employment taxes were not being paid. The court cited the decision in In re Premo, 116 B.R. 515 (Bankr. E.D. Mich. 1990), where a bankruptcy court surveyed three typical scenarios in which a finding of willfulness can be based on reckless disregard. The district court found two of those to be particularly apt in Hartman's case. First, courts have held that reliance upon the statements of a person in control of the finances of a company (in this case, Ott) may constitute reckless disregard when the circumstances show that the responsible person (i.e., Hartman) knew that the person making the statements was unreliable. Second, the district court said, courts have held that willful conduct also includes failure to investigate or to correct mismanagement after having noticed that withholding taxes have not been remitted to the government.

For a discussion of responsible person liability, see Parker Tax ¶210,108.

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Unemployment Income Returned in a Later Year Was Taxable in Year Received

The Tax Court held that unemployment compensation received in one year but returned in a later year was taxable in the year received. The taxpayer's argument that the rescission exception to the claim of right rule applied was rejected because the taxpayer did not recognize the need to repay the compensation and make provisions for repayment in the year the income was received. Yoklic v. Comm'r, T.C. Memo. 2017-143.

Michael Yoklic filed for unemployment benefits in April 2012 with the Arizona Department of Economic Security (DES). DES found him eligible to receive $240 per week from May to August 2012. Yoklic received a total of $3,360 in unemployment benefits during this period. In August 2012, DES issued a determination letter, followed by decision letters in September and October 2012. The letters stated that Yoklic was not entitled to the unemployment benefits he received and that he had received an overpayment of $3,360. Yoklic did not file a request for review. He repaid the benefits to DES the following year, in September 2013.

DES issued a Form 1099-G, Certain Government Payments, reporting Yoklic's unemployment compensation of $3,360 paid in 2012. When Yoklic prepared his 2012 tax return, he did not report the unemployment compensation. The IRS sent Yoklic a notice of deficiency in 2014, determining that the reported unemployment compensation was fully taxable because it was considered a substitute for wages. Yoklic petitioned the Tax Court for redetermination of the deficiency.

Unemployment compensation is included in gross income under Code Sec. 85. For a cash basis taxpayer, Code Sec. 451(a) provides that the amount of any item of income is included in gross income for the year in which it was received. The doctrine of claim of right provides that if a taxpayer receives income without an obligation to repay it or any restriction on its disposition, the income is included in the year of receipt, even if the income must be repaid in a later year. However, there is a rescission exception which provides that income received under a claim of right need not be included in income if, in the year of receipt, the taxpayer (1) recognizes an existing and fixed obligation to repay the amount received and (2) makes provisions for repayment.

Yoklic argued that the unemployment compensation should not be included in his 2012 income because he repaid it in 2013. The Tax Court inferred that Yoklic was arguing that the unemployment pay was not includible in income under the rescission exception. The Tax Court rejected that argument and sustained the IRS's determination that Yoklic had $3,360 of taxable unemployment compensation in 2012. The doctrine of rescission did not apply, according to the Tax Court, because there was no evidence that Yoklic made provisions for repayment in 2012. Instead, the court found that the income was not repaid to DES until September 2013 and was thus includible in income in 2012.

For a discussion of the claim of right doctrine, see Parker Tax ¶70,110.

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Rail Carrier Was Not Required to Withhold Taxes on Payments of Stock to Employees

The Eighth Circuit reversed a district court and held that a rail carrier was not required to withhold taxes on payments of stock to its employees or on ratification payments to union member employees. The court found that the payments were not compensation subject to taxes because the stock payments were not money remuneration and the ratification payments were not payments for services rendered by employees. Union Pacific Railroad Company v. U.S., 2017 PTC 350 (8th Cir. 2017).

The Union Pacific Railroad (UP) paid about $75 million in taxes from 1991 to 2007 under the Railroad Retirement Tax Act (RRTA). As a railroad, UP and its employees are not subject to Federal Insurance Contribution Act (FICA) taxes. Instead, they pay tax on benefits provided under the Railroad Retirement Act (RRA). During the years at issue, UP paid its employees in company stock in addition to a monetary salary and paid RRTA taxes on the stock payments. UP also paid RRTA taxes on payments it made to employees when their unions ratified collective bargaining agreements. The payments were intended to encourage unions to ratify collective bargaining agreements. The recipient had to be employed by UP on a certain date and the amount of the payment was determined by the number of hours the employee worked the previous year.

UP sued the IRS in a district court for a refund of the RRTA taxes it paid on the stock payments and the ratification payments, arguing that the RRTA did not require it to pay taxes on these payments. A district court rejected the UP's refund requests and granted summary judgment in favor of the IRS. UP appealed to the Eighth Circuit.

Under Code Sec. 3231(e)(1), the RRTA tax is based on an employee's compensation, which is generally defined as any form of money remuneration paid to an individual for services rendered as an employee. In Reg. Sec. 31.3231(e)-1(a)(1), the IRS has interpreted the statute by adopting the broad FICA definition of compensation in Code Sec. 3121, which includes stock payments.

UP challenged the IRS's broad interpretation of the term "compensation" in the regulation. It focused on the term "money remuneration" in Code Sec. 3231 and argued that the term "money" means a medium of exchange, which does not include stock. The IRS asserted that the term "money" is ambiguous, and that it is either superfluous or has an expansive meaning relating to capital or finance in general. It also noted that Code Sec. 3231 contains various exemptions for noncash payments and argued that these exemptions implied a broad definition of money remuneration. The IRS further argued that stock is the functional equivalent of cash, and finally that its interpretation in the regulation should stand because the purposes of FICA and RRTA are similar.

The Eighth Circuit reversed the district court's decision on both the stock payments and the ratification payments. With respect to the stock payments, the Eighth Circuit declined to defer to the IRS's interpretation of the statute in the regulation. It held that the stock payments were not compensation subject to RRTA taxes because they were not money remuneration. As to the ratification payments, the court held that they were not compensation for purposes of the RRTA because they were not paid for services rendered as employees.

The court began by addressing the meaning of "money" under Code Sec. 3231(e)(1). The court was not convinced that the IRS's expansive definition of money reflected the ordinary, common meaning of the term. According to the court, money refers to a generally accepted medium of exchange which does not include stock. The court found support for this view in a case decided near the time the RRTA was enacted, where an appeals court held that the ordinary meaning of money did not include corporate stocks. The IRS's broad definition of money, in the court's view, also conflicted with a regulation adopted shortly after the passage of the RRTA which defined compensation as "all remuneration in money, or in something which may be used in lieu of money (scrip and merchandise orders, for example)." The court reasoned that there would be no need to include scrip or merchandise orders as examples if, as the IRS asserted, money meant either nothing or all property. To the court, these examples made sense only if the more restrictive meaning of money applied.

Next, the court noted the significance of Congress's use of the term "compensation" in the RRTA statue and "wages" in the FICA statute, reasoning that differences in statutory language convey differences in meaning. The court found that the distinction between these terms is reinforced by the definition of "successor employers" in the RRTA statute. The RRTA statute adopts the FICA definition but uses "compensation" (as defined in the RRTA) where the FICA statute says "remuneration." The court inferred that Congress used these different terms because compensation, which includes only money remuneration, is a subset of remuneration, which Congress used in defining "wages" in the FICA statute. The court reasoned that it would make no sense to swap these terms if compensation had the same meaning as remuneration and wages.

The Eighth Circuit also rejected the IRS's argument that the noncash exemptions from compensation in Code Sec. 3231(e)(1) imply a broader definition of money remuneration. The court determined that none of the exemptions identified by the IRS would be rendered superfluous under UP's reading of the statute because each could include payments consistent with an interpretation of money as a medium of exchange. The exemptions in fact arguably indicated a narrower definition of money, according to the court. For example, where the RRTA statute exempts cash tips under $20, the FICA statute excludes "tips paid in any medium other than cash" as well as cash tips under $20. That Congress did not exclude noncash tips in the RRTA statute suggested to the court that they were already excluded under the general definition of "compensation." Finally, the fact that the noncash exemptions were codified years after the enactment of the general definition of compensation did not amount to an implied repeal in the court's view. The court found no indication that Congress intended to alter the original scope of money remuneration to something beyond a medium of exchange.

The Eighth Circuit was not persuaded by the IRS's argument that stock is the practical equivalent of cash. The court reasoned that even a stock with a readily ascertainable share price is not money because it is not a medium of exchange; like any property, stock has a cash value and can be exchanged for money, but that does not make it a generally accepted medium of exchange. Nor did the court agree that the RRTA statute should be interpreted to reach as far as the FICA statute because the statutes share a similar purpose. In the court's view, such a vague notion of statutory purpose could not override the actual text of the statute.

Regarding in the ratification payments, the court held that the payments were not compensation because they were not for services rendered. The court found that UP did not exercise control over whether a union ratifies a collective bargaining agreement. Further, although the ratification payments were made from UP's payroll, which generally raises a presumption that the payments are compensation, the court found that UP used its payroll department only because the union's members worked for several companies and UP had to determine which members were UP employees.

For a discussion of the taxes imposed under FICA and RRTA, see Parker Tax ¶213,135 and ¶213,160, respectively.

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Case Not Moot Where IRS Reserves Right to Reassess Penalties at a Later Date

The Tax Court denied an IRS motion to dismiss a taxpayer's petition on the grounds of mootness. The court found that the case was not moot because the IRS did not concede the taxpayer's liability for penalties under Code Sec. 6702 and the IRS reserved the right to reassess those penalties later. Vigon v. Comm'r, 149 T.C. No. 4 (2017).

From June 2010 through July 2011, Dean Vigon submitted a total of nine Forms 1041, U.S. Income Tax Return for Estates and Trusts, on behalf of the Dean M. Vigon Trust - two for tax year 2007, three for tax year 2008, and four for tax year 2009. Three of the Forms 1041 (one for each year) were marked as amended returns. Three others were unsigned, incomplete photocopies of others of the nine forms, and they were sent to the IRS via fax and were not mailed. The IRS treated these as nine separate returns and determined that the positions reflected on the Forms 1041 were frivolous. The IRS therefore assessed nine $5,000 penalties under Code Sec. 6702 for the supposed filing of nine frivolous Forms 1041, filed a notice of federal tax lien (NFTL), and also assessed interest.

Vigon challenged the NFTL by filing a Form 12153, Request for a Collection Due Process or Equivalent Hearing. No collection alternatives were specified on the Form 12153 and an attachment to the form indicated that Vigon was a Canadian citizen and he did not owe any of the taxes, penalties, or interest that had been assessed. During a collection due process (CDP) hearing, Vigon challenged, under Code Sec 6330(c)(2)(B), his underlying liability for the penalties. The IRS Appeals Office sustained the filing of the NFTL. Vigon timely filed a petition with the Tax Court under Code Sec. 6330(d)(1), appealing the determination of the IRS Appeals Office.

As the scheduled Tax Court trial date approached, a motion for continuance was filed on behalf of Vigon, explaining that he was incarcerated in Canada. The court granted the continuance but the IRS subsequently discovered that written managerial approval, as set forth in Code Sec. 6751(b)(1), had not been obtained before the Code Sec. 6702 penalties were assessed and it was not clear whether an exception to obtaining managerial approval otherwise applied. The IRS therefore moved to remand the case to the IRS Appeals Office for a supplemental hearing, during which verification of compliance with Code Sec. 6751(b)(1) would be obtained. The Tax Court granted the IRS motion and, after the supplemental hearing, the IRS once again sustained the filing of the NFTL.

In December 2016, the IRS filed a motion for summary judgment, which the Tax Court denied, identifying genuine disputes of fact about the number of returns filed and about the supervisory approval of penalty assessments under Code Sec. 6751(b)(1).

The IRS subsequently moved for a continuance, explaining that (1) the IRS would abate the penalties at issue; (2)) the process of abating those liabilities was almost complete; (3) the process of releasing the liens at issue had been initiated; and (4) once those processes had been completed, the IRS intended to file a motion to dismiss the case on grounds of mootness. The court granted the motion for continuance but ordered that, if the IRS filed a motion to dismiss on grounds of mootness, then it had to explain how such a motion would give adequate relief to Vigon.

The IRS then filed a motion to dismiss the case on grounds of mootness. The motion stated that "the frivolous return penalties for taxable years 2007, 2008 and 2009 have all been abated and the federal tax liens for all three years have been released." However, the filing by which this ostensible release was made stated that "[w]ith respect to each assessment below, unless notice of lien is refiled by the date in column(e) [i.e., dates in 2021 and 2022], this notice shall constitute the certificate of release of lien as defined in IRC 6325(a)."

The Tax Court denied the IRS's motion to dismiss on grounds of mootness. According to the court, despite the IRS's abatement of the penalties and release of the lien, the CDP case was not moot, in light of Vigon's liability challenge under Code Sec. 6330(c)(2)(B) and the IRS's non-concession as to liability and the IRS's reserving the right to reassess the penalties. The Tax Court noted that ordinarily, once the IRS concedes that there is no unpaid liability for a disputed year upon which a collection action can be based, a proceeding filed in the Tax Court pursuant to Code Sec. 6330 is moot. However, the court said, where a CDP hearing may involve not only collection issues but also challenges to the existence or amount of the underlying tax liability, the IRS's contention that withdrawal of the NFTL by itself moots the entire case was incorrect.

For a discussion of IRS collection procedures and penalties relating to frivolous tax submissions, see Parker Tax ¶260,500 and ¶262,145, respectively.

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Innocent Spouse Relief Denied for Wife Who Had Reason to Know of Husband's Failure to Pay Taxes

The Tax Court denied innocent spouse relief to a wife whose husband took responsibility for filing the couple's joint tax returns and failed to pay the taxes due for several years. According to the court, the wife's knowledge of her husband's poor credit rating and high levels of debt, plus her previous payment of over $53,000 for one year of the couple's delinquent joint tax liabilities, gave her both actual and constructive knowledge that their taxes had not been paid and would not be paid. Ryke v. Comm'r, T.C. Memo. 2017-144.

Facts

Dr. Nicole Ryke and Jamie Ryke were married in 2004 and are still married. Dr. Ryke is a medical doctor specializing in family medicine. She has no background in accounting or tax law. Mr. Ryke is a self-employed attorney who has practiced in probate and bankruptcy law. The Rykes have four children. During 2009 and 2012, the years at issue, Dr. Ryke was a medical resident working long hours and caring for the children. She paid for her medical education with a combination of support from her grandfather and student loans. She is now in her fifth year of private practice. Her practice has grown, resulting in increased income in 2016.

Mr. Ryke has a history of failing to pay his debts. Dr. Ryke learned of his financial troubles when the couple bought a house before marrying. Although Dr. Ryke did not know the specifics of Mr. Ryke's financial past, she knew he had a low credit score and outstanding student loans. As a result, the Rykes had separate credit cards, and the mortgage was in Dr. Ryke's name alone.

The Rykes filed joint tax returns for 2004 through 2012. Each year, Mr. Ryke gathered documents and gave them to an accountant who prepared the returns. Mr. Ryke would receive the returns, ask Dr. Ryke to sign them, then file them. Dr. Ryke had little opportunity to inspect the returns and did not examine them when she signed them. With the exception of 2009, the tax liability for the years at issue resulted from the Rykes' failure to pay the tax reported as due on the return. For 2009, part of the liability related to two income items the Rykes did not include on their return: short term disability that Dr. Ryke received, and interest. Each year, the Rykes reported a balance due on their return but did not submit payment. Dr. Ryke believed her husband was paying the full tax liability when he filed each return.

In 2011, Dr. Ryke became aware of her and her husband's outstanding joint tax liabilities. She paid the IRS approximately $53,000 for the couple's 2007 and 2008 taxes owed. Dr. Ryke made the payment at her husband's request, believing that it would satisfy their tax liabilities in full. However, Dr. Ryke did not inquire about the amount or source of the outstanding tax liabilities or whether they owed any additional tax. Dr. Ryke finally learned the details of the couple's outstanding tax liabilities in May 2014. On an accountant's advice, Dr. Ryke began filing separate returns starting with her 2013 return. Dr. Ryke is currently in full compliance with the tax laws.

Later in 2014, Dr. Ryke submitted an innocent spouse relief request for 2008 through 2012. The Rykes' liabilities for 2010 and 2011 had been paid, so her request for those years was dismissed. The IRS denied her request for 2008, 2009 and 2012. The Rykes then paid the remaining liability for 2008, leaving approximately $55,000 of outstanding tax debt for 2009 and 2012. In August 2015, Dr. Ryke filed a Tax Court petition to challenge the innocent spouse denial for those years.

Analysis

In general, married taxpayers are jointly and severally liable for the entire tax liability on their joint tax return. If such liability arises from an underpayment, a spouse may request equitable relief under Code Sec. 6015(f). The IRS can grant such relief if, under the facts and circumstances, it is inequitable to hold the spouse liable for the unpaid tax. Rev. Proc. 2013-34 provides seven factors to guide the determination of whether a spouse qualifies for equitable relief. The factors are the requesting spouse's (1) marital status, (2) economic hardship if relief is not granted, (3) knowledge or reason to know that the taxes would not be paid, (4) legal obligation to pay the outstanding tax liability, (5) receipt of a significant benefit from the unpaid tax liability, (6) compliance with tax laws, and (7) mental and physical health.

The Tax Court denied Dr. Ryke's request for relief. Dr. Ryke argued that the liabilities were attributable to tax imposed on her husband's income, and that she was unaware that the tax was not paid when due. Rejecting that argument, the court found that Dr. Ryke did not meet factor (3), above, because she had both knowledge that some of the taxes had not been paid and reason to know that the taxes would not be paid. The court reasoned that before marrying, Dr. Ryke knew Mr. Ryke had poor credit and was in debt. The court also noted that Dr. Ryke learned of the couple's taxes owed in 2011 and paid over $53,000 toward those liabilities; however, she stated that she did not ask about the source of the tax liabilities, or whether the payment was for the full amount. As a result, the court determined that Dr. Ryke had reason to know that her husband was not paying the taxes owed each year, and had actual knowledge of the couple's outstanding tax liabilities. The fact that she did not know the details of the liabilities was immaterial, because she had reason to know their full extent, and failing to obtain actual knowledge did not release her from the liabilities, according to the court.

Applying the remaining six factors, the Tax Court found that those factors were either neutral or weighed slightly in favor of relief, but not enough to change the outcome. The court found that Dr. Ryke did not receive a significant benefit from the underpayment. She was in compliance with the tax laws, having met both her filing requirements and payment obligations since filing separately in 2013. However, Dr. Ryke's efforts to comply with the tax laws from 2013 forward did not negate what the court called her self-imposed ignorance with regard to the couple's outstanding joint tax liabilities.

The Tax Court determined that the remaining factors were neutral. The Rykes remained married, and there was no agreement between them limiting Dr. Ryke's responsibility for joint liabilities. Dr. Ryke did not show that she would suffer economic hardship if no relief was granted, according to the court, because her income exceeded her expenses by $1,400 per month and her medical practice was growing. Finally, Dr. Ryke did not offer evidence that her mental or physical health was impaired currently or at the time of filing, according to the court.

For a discussion of innocent spouse relief, see Parker Tax ¶260,560.