Losses from Hunting Consulting Business Aren't Deductible; No Charitable Deduction Allowed Where Taxpayer Expects Substantial Benefit; Travel Expenses Relating to House Remodeling Project Are Capital Expenditures ...
Taxpayers May Continue to Rely on Rev. Proc. 2004-34 for Advance Payments
As a result of the enactment by the Tax Cuts and Jobs Act of 2017 (TCJA) of a new provision dealing with the tax treatment of advance payments, the IRS is providing transitional guidance until more formal guidance can be issued. Noting that the TCJA provision largely tracks the approach in Rev. Proc. 2004-34, the IRS stated that a taxpayer receiving advance payments (regardless of whether the taxpayer has an applicable financial statement) may continue to rely on the 2004 revenue procedure until further guidance is issued. Notice 2018-35.
Hearing Officer Not Required to Substantively Analyze Supervisor's Approval of Penalty
The Tax Court held that there was no abuse of discretion by a settlement officer (SO) in a collections due process hearing where the SO determined that a computer-generated IRS record showing a supervisor's printed name but not the supervisor's signature was sufficient evidence of IRS supervisory approval. The Tax Court found that the SO was not required to analyze the thought process of the approving supervisor but only to verify that the supervisor approved in writing the initial determination of the penalty. Blackburn v. Comm'r, 150 T.C. No. 9 (2018).
IRS Issues Interim Guidance on Business Interest Limitation Rules Effective in 2018
The IRS has announced its intention to issue proposed regulations to assist taxpayers in complying with the interest expenses limitation rules enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Until such regulations are issued, the IRS is providing interim rules, including guidance allowing taxpayers to carryover disallowed interest under pre-TCJA rules for the last tax year beginning before January 1, 2018, to the taxpayer's first tax year beginning after December 31, 2017. Notice 2018-28.
First Circuit Reverses Tax Court; Roth IRA Arrangement Did Not Lack Economic Substance
The First Circuit held that approximately $1.4 million in dividend distributions from a domestic international sales corporation to two Roth IRAs was not an excess contribution subject to excise tax. The First Circuit reversed the Tax Court's holding that the distributions were in essence dividends to the owners of the Roth IRAs under the substance over form doctrine because it found that the transactions were a permitted tax avoidance arrangement under the Code and were consistent with Congress's intent in permitting DISC distributions to Roth IRAs. Benenson v. Comm'r, 2018 PTC 98 (1st Cir. 2018).
Late Filing of Carryback Application to Wrong Year Was Not an Informal Refund Claim
A district court held that a corporation that filed a Form 1139, Corporation Application for Tentative Refund, to carry back losses to a year other than the earliest possible year and failed to file the Form 1139 within one year of the close of the relevant loss year, did not make an informal refund claim to stop the running of statute of limitations. The court held that the corporation, which had sophisticated legal and tax representation, could not reasonably rely on inaccurate statements by the IRS because it knew or should have known about the requirements for filing a carryback claim as well as the applicable statute of limitations. UKP Holdings, Inc. v. U.S., 2018 PTC 99 (E.D.N.Y. 2018).
The Bankruptcy Appellate Panel for the Eighth Circuit Court of Appeals reversed a bankruptcy court's decision that a worker's compensation attorney's affidavit stating his opinion on the value of the debtor's pending claim for worker's compensation on the petition date was substantial evidence to rebut the IRS's proof of claim. The Eighth Circuit found that the affidavit was not substantial evidence of value because it did not contain the financial or factual information necessary to support the attorney's opinion and the IRS never had the opportunity to cross examine the attorney. In re Austin, 2018 PTC 100 (B.A.P. 8th Cir. 2018).
Taxpayers May Continue to Rely on Rev. Proc. 2004-34 for Advance Payments
As a result of the enactment by the Tax Cuts and Jobs Act of 2017 (TCJA) of a new provision dealing with the tax treatment of advance payments, the IRS is providing transitional guidance until more formal guidance can be issued. Noting that the TCJA provision largely tracks the approach in Rev. Proc. 2004-34, the IRS stated that a taxpayer receiving advance payments (regardless of whether the taxpayer has an applicable financial statement) may continue to rely on the 2004 revenue procedure until further guidance is issued. Notice 2018-35.
Background
Code Sec. 451(a) provides that the amount of any item of gross income is included in gross income for the tax year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period.
Reg. Sec. 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. All the events that fix the right to receive income generally occur when: (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest.
Rev. Proc. 2004-34 provides a full inclusion method and a deferral method of accounting for the treatment of advance payments for goods, services, and other items. Under the full inclusion method, advance payments are included in income in the year of receipt. Under the deferral method, an advance payment is included in gross income for the tax year of receipt to the extent recognized in revenue in a taxpayer's applicable financial statement for that tax year or earned (for taxpayers without an applicable financial statement) in that tax year, and the remaining amount of the advance payment is included in the next succeeding tax year after the tax year in which the payment is received.
The Tax Cuts and Jobs Act of 2017 (TCJA) redesignated certain provisions of Code Sec. 451 and created new Code Sec. 451(b) and new Code Sec. 451(c). Code Sec. 451(b)(1)(A)(i) provides that for an accrual method taxpayer, the all events test for any item of gross income is not treated as met any later than when the item is taken into account as revenue in an applicable financial statement of the taxpayer. Code Sec. 451(c)(1)(A) generally provides that an accrual method taxpayer must include an advance payment in gross income in the tax year of receipt. Alternatively, under Code Sec. 451(c)(1)(B), an accrual method taxpayer may elect to defer the recognition of all or a portion of an advance payment to the tax year following the tax year in which the payment is received, except any portion of such advance payment that is required under Code Sec. 451(b) to be included in gross income in the tax year in which the payment is received.
Code Sec. 451(c)(4)(A) defines an advance payment as any payment:
(1) the full inclusion of which in the gross income of the taxpayer for the tax year of receipt is a permissible method of accounting;
(2) any portion of which is included in revenue by the taxpayer in an applicable financial statement, or such other financial statement as the IRS may specify, for a subsequent tax year; and
(3) which is for goods, services, or such other items as may be identified by the IRS.
Code Sec. 451(c) generally contains rules similar to the ones in Rev. Proc. 2004-34.
Notice 2018-35 Provides Interim Guidance for Rev. Proc. 2004-34
According to the IRS, it expects to issue guidance for the treatment of advance payments to implement the changes made to Code Sec. 451 by TCJA. In Notice 2018-35, the IRS states that, until further guidance for the treatment of advance payments is applicable, taxpayers, with or without applicable financial statements, may continue to rely on Rev. Proc. 2004-34 for the treatment of advance payments. During this time, the IRS will not challenge a taxpayer's use of Rev. Proc. 2004-34 to satisfy the requirements of Code Sec. 451, although the IRS will continue to verify on examination that taxpayers are properly applying Rev. Proc. 2004-34.
In addition, the IRS said that it intends to modify Section 16.07 of Rev. Proc. 2017-30 to provide a waiver of the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 to enable taxpayers to make a change to a method of accounting that is permitted under Rev. Proc. 2004-34.
IRS Requests Practitioner Suggestions for Future Guidance
The IRS is inviting practitioners to make suggestions for future guidance under Code Sec. 451(b) and (c). In particular, it is requesting comments concerning the following issues under Code Sec. 451(c):
- whether taxpayers without an applicable financial statement may continue to use the deferral method, as provided in Rev. Proc. 2004-34;
- whether clarity is needed for the definition of an "applicable financial statement" under Code Sec. 451(b)(3);
- whether the definition of "applicable financial statement" under Code Sec. 451(b) and (c) should be the same as the definition in Section 4.06 of Rev. Proc. 2004-34;
- whether other items in addition to those listed in Section 4.01(3) of Rev. Proc. 2004-34 should be included in the definition of an "advance payment";
- whether certain payments other than those listed in Section 4.02 of Rev. Proc. 2004-34 should be excluded from the definition of an "advance payment";
- whether any new procedural rules for changing a method of accounting for advance payments would be appropriate and helpful; and
- the extent, if any, to which the IRS may provide procedures expanding the rules of Code Sec. 451(c) to apply to additional taxpayers and types of income.
Comments must be submitted by May 14, 2018. Comments, identified by Notice 2018-35, may be sent by mail to: Internal Revenue Service; Attn: CC:PA:LPD:PR (Notice 2018-35); Room 5203; P.O. Box 7604; Ben Franklin Station; Washington, D.C. 20044. Comments may also be delivered by hand or by courier Monday through Friday between the hours of 8 a.m. and 4 p.m. to: Courier's Desk; Internal Revenue Service; Attn: CC:PA:LPD:PR; (Notice 2018-35); 1111 Constitution Avenue, NW; Washington, DC 20224. Finally, persons may submit comments electronically to Notice.Comments@irscounsel.treas.gov. The subject line should say "Notice 2018-35."
For a discussion of the tax treatment of advance payments, see Parker Tax ¶241,720.
Hearing Officer Not Required to Substantively Analyze Supervisor's Approval of Penalty
The Tax Court held that there was no abuse of discretion by a settlement officer (SO) in a collections due process hearing where the SO determined that a computer-generated IRS record showing a supervisor's printed name but not the supervisor's signature was sufficient evidence of IRS supervisory approval. The Tax Court found that the SO was not required to analyze the thought process of the approving supervisor but only to verify that the supervisor approved in writing the initial determination of the penalty. Blackburn v. Comm'r, 150 T.C. No. 9 (2018).
Beginning in 2000, Emergency Response Training, Inc. (ERT) fell behind on its employment tax liabilities. Specifically, ERT failed to file a number of Forms 941, Employer's Quarterly Federal Tax Return, or satisfy numerous self-reported employment tax liabilities during 2000 through 2011.
In 2012, Scott Blackburn and another individual were determined by the IRS to be responsible persons and an IRS revenue officer asserted trust fund recovery penalties (TFRPs) against them. At the time, Senior Revenue Officer Janet Reed was the manager of the officer who made the initial TFRP determination. Later in 2012, the revenue officer changed her determination regarding the second individual's TFRP liability and submitted a request for supervisory approval to assert TFRP liabilities against Blackburn. A Form 4183, Recommendation re: Trust Fund Recovery Penalty Assessment, was generated showing Reed's approval of the TFRP determination against Blackburn. The computer-generated Form 4183 did not contain Reed's signature but showed her name in the supervisor signature block. In November 2012, the IRS assessed TFRP liabilities against Blackburn for the fourth quarter of 2003 and the fourth quarter of 2004. After a collections due process hearing, a settlement officer (SO) upheld the TFRP assessment.
Blackburn appealed the SO's decision in the Tax Court. He did not contest his liability for the TFRP, but argued that the SO had failed to fulfill the requirement under Code Sec. 6330(c)(1) to verify that the IRS had fulfilled all of its legal and procedural requirements. Blackburn reasoned that under Code Sec. 6751(b)(1), the IRS may not assess a penalty unless an IRS supervisor has personally approved the determination in writing; supervisory approval is part of the IRS's burden of production under Graev v. Comm'r, 149 T.C. No. 23 (2017). According to Blackburn, the SO's verification responsibility required a meaningful review, including a factual analysis of the supervisor's thought process, and he argued that by relying solely on the Form 4183 to verify that a supervisor approved the TFRP determination, the SO did not fulfill the Code Sec. 6330(c)(1) verification requirement. The IRS filed for summary judgment, arguing that Code Sec. 6751(b)(1) does not apply to a TFRP assessment and that even if it did, the Form 4183 fulfilled that requirement.
The Tax Court ruled in favor of the IRS, finding that the SO properly verified the assessment of the TFRP. The Tax Court held that Code Sec. 6330(c)(1) does not require an analysis of the thought process of the approving supervisor under Code Sec. 6751(b), but rather verification that the supervisor approved in writing the initial determination of the penalty. The Tax Court explained that, because it found no abuse of discretion regarding verification of compliance with Code Sec. 6751(b), it did not need to address the legal question of whether Code Sec. 6751(b) applies to the TFRP.
In the Tax Court's view, Blackburn was arguing that the SO's verification responsibility under Code Sec. 6330(c)(1) included making a determination of a meaningful approval of the merits of the liability. The Tax Court found no case law support for requiring a substantive review of the SO's thought process. Rather, the court found that the SO's review of the administrative steps taken before assessment is accepted as adequate under Code Sec. 6330 as long as there is supporting documentation in the administrative record. Imposing the requirement of a substantive review on the SO would, in the view of the Tax Court, allow the taxpayer to avoid the limitations of pursuing the underlying liability in a CDP hearing and apply a level of detail in the verification process that had never previously been required.
The Tax Court found that the treatment of Form 4340, Certificate of Assessment and Payments, as presumptive evidence that a tax was validly assessed was an apt parallel to the issue regarding Form 4183. Form 4340 is used to prove that an assessment has been made and is considered presumptive proof of a valid assessment. The Tax Court explained that the IRS may rely on Form 4340 where the taxpayer has not shown any irregularity in the assessment procedure that would raise a question about the validity of an assessment. An assessment requires a signature and is made by an IRS officer's signing the summary record of assessments; the officer's signature is not required on the Form 4340. In the court's view, even though Form 4183 does not have an actual signature, in the context of a review for abuse of discretion, its mere existence in the administrative record supports the SO's verification.
The Tax Court found that it had consistently held in prior decisions that reliance on standard administrative records was acceptable to verify assessments. The court reasoned that Form 4183 was similar to Form 4340, which had previously been found to be an IRS record that reflected compliance with administrative procedures. Form 4183, in the court's view, provided a similar mechanism to demonstrate supervisory approval. The Tax Court concluded that, regardless of whether supervisory approval was required before the TFRP assessment, a record of such prior approval was present in this case.
For a discussion of CDP hearings, see Parker Tax ¶260,540.
IRS Issues Interim Guidance on Business Interest Limitation Rules Effective in 2018
The IRS has announced its intention to issue proposed regulations to assist taxpayers in complying with the interest expenses limitation rules enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Until such regulations are issued, the IRS is providing interim rules, including guidance allowing taxpayers to carryover disallowed interest under pre-TCJA rules for the last tax year beginning before January 1, 2018, to the taxpayer's first tax year beginning after December 31, 2017. Notice 2018-28.
Background
Before the Tax Cuts and Jobs Act of 2017 (TCJA), Code Sec. 163(j) disallowed a deduction for disqualified interest paid or accrued by a corporation in a tax year if two threshold tests were satisfied. The first threshold test was satisfied if the payor's debt-to-equity ratio exceeded 1.5 to 1.0 (i.e., safe harbor ratio). The second threshold test was satisfied if the payor's net interest expense exceeded 50 percent of its adjusted taxable income (generally, taxable income computed without regard to deductions for net interest expense, net operating losses, the domestic production activities deduction, depreciation, amortization, and depletion).
For purposes of pre-TCJA Code Sec. 163(j), disqualified interest included interest paid or accrued to (1) related parties when no federal income tax was imposed with respect to such interest; (2) unrelated parties in certain instances in which a related party guaranteed the debt; or (3) a real estate investment trust (REIT) by a taxable REIT subsidiary of that REIT.
Interest amounts disallowed for any tax year under pre-TCJA 163(j) were treated as interest paid or accrued in the succeeding tax year and could be carried forward indefinitely. In addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest expense) could be carried forward three years.
Pre-TCJA Code Sec. 163(j)(6)(C) provided that all members of the same affiliated group were treated as one taxpayer. In addition, Code Sec. 163(j)(9)(B) provided the IRS with the authority to issue regulations providing for adjustments in the case of corporations that are members of an affiliated group as may be appropriate for carrying out the purposes of Code Sec. 163(j). Proposed regulations under pre-TCJA Code Sec. 163(j) were issued on June 18, 1991, and contained a rule that would treat all members of an affiliated group as one taxpayer for purposes of Code Sec. 163(j), without regard to whether such affiliated group filed a consolidated return, as well as other rules relating to affiliated corporations.
TCJA amended Code Sec. 163(j) to provide new rules limiting the deduction of business interest expense for tax years beginning after December 31, 2017. For any taxpayer to which Code Sec. 163(j) applies, Code Sec. 163(j)(1) now limits the taxpayer's annual deduction for business interest expense to the sum of:
(1) the taxpayer's business interest income for the tax year;
(2) 30 percent of the taxpayer's adjusted taxable income for the tax year; and
(3) the taxpayer's floor plan financing interest (generally interest incurred in purchasing large items such as vehicles from showroom floors or lots) for the tax year.
The limitation applies to all taxpayers, except for certain taxpayers that meet the gross receipts test in Code Sec. 448(c) (i.e., taxpayer generally with $25 million or less in gross sales for the three-tax-year period ending with the prior tax year), and applies to all trades or businesses, except certain trades or businesses listed in Code Sec. 163(j)(7) (which includes any electing real property trade or business or any electing farming business). The amount of any business interest not allowed as a deduction for any tax year as a result of the business interest expense limitation is treated as business interest paid or accrued in the next tax year and may be carried forward. Code Sec. 163(j) does not provide for the carryforward of any excess limitation. The pre-TCJA provision which treated an affiliated group as one taxpayer, and which authorized super affiliation rules, were removed by TCJA and no equivalent provisions were provided in Code Sec. 163(j), as amended by TCJA.
The Conference Report to TCJA notes that interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision. The Conference Report also notes that in the case of a group of affiliated corporations that file a consolidated return, the limitation applies at the consolidated tax return filing level. There is no mention in the Conference Report of applying Code Sec. 163(j) to affiliated groups that do not file a consolidated return.
IRS to Allow Carryover of Pre-TCJA Disallowed Interest to Post-TCJA Years
Before TCJA, C corporations that could not deduct all of their interest expense under Code Sec. 163(j)(1)(A) could carry their disallowed disqualified interest forward to the succeeding tax year. Such interest was treated as paid or accrued in the succeeding tax year. Similarly, under Code Sec. 163(j)(2), as amended by TCJA, taxpayers that cannot deduct all of their business interest because of the limitation in Code Sec. 163(j)(1) may carry their disallowed business interest forward to the succeeding tax year, and such interest is treated as business interest paid or accrued in the succeeding tax year.
In Notice 2018-28, the IRS announced that it intends to issue regulations clarifying that taxpayers with disqualified interest disallowed under pre-TCJA 163(j)(1)(A) for the last tax year beginning before January 1, 2018, may carry such interest forward as business interest to the taxpayer's first tax year beginning after December 31, 2017. The regulations will also clarify that business interest carried forward will be subject to potential disallowance under Code Sec. 163(j), as amended by TCJA, in the same manner as any other business interest otherwise paid or accrued in a tax year beginning after December 31, 2017.
The regulations will also address the interaction of Code Sec. 163(j) with Code Sec. 59A, relating to the tax on base erosion payments of taxpayers with substantial gross receipts. The regulations will provide that business interest carried forward from a tax year beginning before January 1, 2018, will be subject to Code Sec. 59A in the same manner as interest paid or accrued in a tax year beginning after December 31, 2017, and will clarify how Code Sec. 59A applies to that interest.
For tax years beginning before 2018, a corporation that was subject to the limitation in Code Sec. 163(j)(1) was allowed to add to its annual limitation any "excess limitation carryforward" from the prior year. As amended by TCJA, Code Sec. 163(j) does not have a provision that would allow an excess limitation carryforward. Thus, the IRS intends to issue regulations clarifying that no amount previously treated as an excess limitation carryforward may be carried to tax years beginning after December 31, 2017.
All Interest Paid or Accrued by C Corporation Is Business Interest Expense and Income
The IRS also intends to clarify in future regulations that, solely for purposes of Code Sec. 163(j), in the case of a taxpayer that is a C corporation, all interest paid or accrued by the C corporation on indebtedness of such C corporation will be considered business interest, and all interest on indebtedness held by the C corporation that is includible in gross income of such C corporation will be business interest income. Such regulations will not apply to S corporations. Regulations also will address whether and to what extent interest paid, accrued, or includible in gross income by a non-corporate entity such as a partnership in which a C corporation holds an interest is properly characterized, to such C corporation, as business interest within the meaning of Code Sec. 163(j)(5) or business interest income within the meaning of Code Sec. 163(j)(6).
Application to Consolidated Groups
Consistent with congressional intent as reflected in the Conference Report, the IRS intends to clarify in future regulations that the limitation on the amount allowed as a deduction for business interest applies at the level of the consolidated group.
Impact on Earnings and Profits
The IRS said the future regulations will clarify that the disallowance and carryforward of a deduction for a C corporation's business interest expense will not affect whether or when such business interest expense reduces earnings and profits of the payor C corporation.
Business Interest Income and Floor Plan Financing of Certain Pass-Thru Entities
Under Code Sec. 163(j)(4), the annual limitation on the deduction for business interest expense must be applied at the partnership level and any deduction for business interest must be taken into account in determining the non-separately stated taxable income or loss of the partnership. According to the IRS, although Code Sec. 163(j)(4) is applied at the partnership level with respect to the partnership's indebtedness, Code Sec. 163(j) may also be applied at the partner level in certain circumstances. The IRS intends that future regulations will provide that, for purposes of calculating a partner's annual deduction for business interest under Code Sec. 163(j)(1), a partner cannot include the partner's share of the partnership's business interest income for the tax year except to the extent of the partner's share of the excess of (1) the partnership's business interest income over (2) the partnership's business interest expense (not including floor plan financing). Additionally, the IRS intends to issue regulations providing that a partner cannot include such partner's share of the partnership's floor plan financing interest in determining the partner's annual business interest expense deduction limitation under Code Sec. 163(j). Similar rules will apply to any S corporation and its shareholders.
For a discussion of the business interest expense limitation as enacted by TCJA, see Parker Tax ¶92,323.
First Circuit Reverses Tax Court; Roth IRA Arrangement Did Not Lack Economic Substance
The First Circuit held that approximately $1.4 million in dividend distributions from a domestic international sales corporation to two Roth IRAs was not an excess contribution subject to excise tax. The First Circuit reversed the Tax Court's holding that the distributions were in essence dividends to the owners of the Roth IRAs under the substance over form doctrine because it found that the transactions were a permitted tax avoidance arrangement under the Code and were consistent with Congress's intent in permitting DISC distributions to Roth IRAs. Benenson v. Comm'r, 2018 PTC 98 (1st Cir. 2018).
Background
Summa Holdings, Inc. is a C corporation and the parent of a consolidated group of manufacturing companies with export sales. Summa Holdings' shareholders include Clement and James Benenson III, a married couple. This case arose from a transaction the Benensons and Summa Holdings engineered to reduce their taxes through the use of a domestic international sales corporation (DISC) and Roth IRAs.
In 2002, the Benensons formed Roth IRAs and deposited $3,500 into them. Each Roth IRA then paid $1,500 for 1,500 shares in JC Export, a newly formed DISC. DISCs were created by Congress in 1971 to subsidize domestic exporting companies. A DISC pays no federal income tax and can receive export income as commissions, which it typically pays out as dividends to the export company's shareholders. The net effect of the DISC is to distribute export revenue to shareholders without taxing it first as corporate income.
The Roth IRAs sold their shares in JC Export to JC Holding, a C corporation formed by the Benensons. Each Roth IRA received a 50 percent stake in JC Holding. The purpose of JC Holding was partly to ensure that the Roth IRAs would avoid having unrelated business income. JC Export then began receiving commissions from the subsidiaries of Summa Holdings and transferred the funds to JC Holding. After setting aside an estimated amount for federal income taxes, JC Holding paid out the remainder to the Roth IRAs as dividends. In 2008, JC Holding transferred approximately $1.4 million to the Roth IRAs. By the end of 2008, each of the Benensons' Roth IRAs was worth over $3.1 million.
The Benensons stipulated that the sole reason for entering into the transactions was to transfer money into their Roth IRAs so that income could accumulate and be distributed on a tax free basis. They also stipulated that they had no nontax business purpose for establishing the Roth IRAs, JC Export, or JC Holding.
In 2004, the IRS issued Notice 2004-08, which described transactions intended to avoid the statutory limits on Roth IRAs. The transactions involved a taxpayer who owned a preexisting business, a Roth IRA maintained for the taxpayer's benefit, and a corporation acquired by the Roth IRA. The taxpayer's business would then transfer value to the corporation owned by the Roth IRA. The Notice described how either the Roth IRA's purchase of shares in the corporation or the transaction between the taxpayer's business and the corporation would not be fairly valued and would therefore have the effect of shifting value into the Roth IRA in excess of the contribution limits. The Notice declared the IRS's intent to deny or reduce deductions made using these transactions.
Summa Holdings and the Benensons received notices of deficiency in 2012, determining that the DISC commissions paid to JC Export in 2008 were in substance dividends to the shareholders of Summa Holdings. The IRS viewed the resulting payments from JC Holding to the Roth IRAs not as dividends but as contributions to the Roth IRAs in excess of the contribution limits allowed by law.
The Tax Court affirmed the IRS's determination in Summa Holdings, Inc. v. Comm'r, T.C. Memo 2015-119 (2015). The Tax Court recharacterized the transaction under the substance over form doctrine, finding that its purpose was to shift funds into the Roth IRAs in violation of the statutory contribution limits. Summa Holdings appealed to the Sixth Circuit, which reversed the Tax Court's decision in Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017). The Sixth Circuit found no basis for recharacterizing the transactions because the DISC and Roth IRAs were used for their congressionally authorized purposes of tax avoidance.
As Massachusetts' residents, the Benensons appealed the Tax Court's decision to the First Circuit. On appeal, the IRS argued that Congress created Roth IRAs to incentivize savings among America's working population and that the contribution limits reflected Congress's intent to limit Roth IRAs' impact on tax revenue and were meant to ensure that Roth IRAs would not be used to divert unlimited business funds into tax shelters. The IRS also saw the Benensons' transaction as different from other investments in privately held companies because it argued that there was no risk involved in the transaction.
Analysis
The First Circuit reversed the Tax Court and held that the arrangement violated neither the letter nor purpose of the relevant statutory provisions. In the court's view, the substance over form doctrine is a tool of statutory interpretation that applies only where the objective economic realities of a transaction are contrary to the plain intent of the Code, and did not apply to the Benensons' arrangement, which the court found was authorized by the Code.
First, the court found that Congress created DISCs to enable export companies and their shareholders to defer tax. The court explained that DISCs were intended to stimulate economic activity and increase exports as well as to place domestic exporters on an equal footing with companies using foreign subsidiaries. According to the court, Congress understood that DISCs would be used in part to increase returns for shareholders. The court found that DISCs were envisioned by Congress as shell corporations with no economic substance. This purpose was reflected in Reg. Sec. 1.994-1(a), which provides that the DISC commission pricing rules do not depend on the extent to which the DISC performs substantial economic functions. In the court's view, a DISC was, by design, a way for domestic companies to defer tax and pay dividends using a structure that might otherwise run afoul of the Code.
The court found merit in the IRS's argument that Roth IRAs were intended to provide a savings mechanism to taxpayers of more modest means than the Benensons. Notwithstanding, the court found that the Benensons were qualified to make their initial contributions in 2002 and reasoned that there was no limit on the amount of dividends a Roth IRA can earn on the stock it holds. The court explained that for wealthy taxpayers, Roth IRAs are strategic vehicles for investing in private companies which may pay out substantial dividends. This use of a Roth IRA was consistent with the purpose of incentivizing long term savings and investment for retirement. As long as the owner of the Roth IRA was qualified to make the initial contributions, the court found that it was not contrary to the statute's purpose to allow their contributions to grow through investment in qualified companies, even during periods where the taxpayers' high income disqualified them from contributing to the Roth IRA.
Next, the court found that Roth IRA and corporate ownership of DISC shares is authorized by the Code. Under Code Sec. 995(g), tax exempt shareholders of DISCs (including Roth IRAs) incur unrelated business income tax on DISC dividends at the corporate income tax rate. Code Sec. 246(d) provides that a corporate shareholder of a DISC is subject to corporate income tax on DISC dividends. Considering Code Secs. 995(g), 246(d) and 408A together, it appeared to the court that Congress contemplated Roth IRAs holding DISC proceeds. The court also noted that in this case, JC Holding paid income tax on the $2.1 million it reported as distributions from JC Export at the corporate tax rate. The court found it was reasonable to assume that when Congress created Roth IRAs, it was aware that traditional IRAs could receive dividends from both C corporations and DISCs and was comfortable with Roth IRAs engaging in the same transactions, as long as a tax equal to the corporate income tax (either under Code Sec. 246(d) or Code Sec. 995(g)) was paid.
The court rejected the IRS's argument that the Benensons' arrangement involved no risk. To the extent risk was required, the court found that it was present in the commissions the DISC received, which depended on the success and profitability of Summa Holdings' export companies. The court added that if the transaction involved a lower risk than other investment structures, it was due to the unique, congressionally designed DISC corporate form.
Notice 2004-8 did not save the IRS's position because, in the court's view, it did not appear that the Benensons' transaction fell with the Notice's scope. Notice 2004-8 describes transactions in which shares are not fairly valued. However, the court found that the IRS never challenged the valuation of the shares the Roth IRAs purchased in either JC Export or JC Holding.
Observation: In a dissenting opinion, one judge would have affirmed the Tax Court's opinion. The dissenting judge reasoned that the purpose of DISCs was to defer corporate income tax, not to implicitly set aside the limits on Roth IRA contributions. The dissenting judge would have found that the transaction was devoid of substance because the companies and Roth IRAs were all owned by members of the same family, the DISC shares were not purchased at market prices, and the sole reason for the transaction was to circumvent the Roth IRA contribution limits.
For a discussion of the taxation of Roth IRA transactions and DISCs, see Parker Tax ¶135,160.
Late Filing of Carryback Application to Wrong Year Was Not an Informal Refund Claim
A district court held that a corporation that filed a Form 1139, Corporation Application for Tentative Refund, to carry back losses to a year other than the earliest possible year and failed to file the Form 1139 within one year of the close of the relevant loss year, did not make an informal refund claim to stop the running of statute of limitations. The court held that the corporation, which had sophisticated legal and tax representation, could not reasonably rely on inaccurate statements by the IRS because it knew or should have known about the requirements for filing a carryback claim as well as the applicable statute of limitations. UKP Holdings, Inc. v. U.S., 2018 PTC 99 (E.D.N.Y. 2018).
In 2010, UKP Holdings, Inc. filed tax returns for 2007 and 2008 reporting over $11 million in losses for 2008. UKP simultaneously filed a Form 1139, Corporate Application for Tentative Refund, indicating that it sought to carry its 2008 losses back to 2007. In doing so, UKP made two errors. First, it tried to carry back the losses to 2007 but was required under Code Sec. 1212 to carry back to the earliest year, which was 2005. Second, UKP failed to file its Form 1139 within one year of the close of the 2008 tax year as required by Code Sec. 6411.
The IRS responded to UKP's filing by returning the Form 1139, explaining that it could not review the form until UKP's 2007 and 2008 tax returns were processed. The IRS did not identify any error in UKP's tentative carryback request; it did not notify UKP that the request was untimely and reflected a carryback to the wrong year. Rather, the IRS directed UKP to refile its application in four to six weeks. UKP never refiled the Form 1139.
In 2011, UKP's attorney, Linda Galler, engaged in a series of communications with IRS Revenue Officer Michael Martin. According to UKP, Martin informed Galler that the Form 1139 would effectuate the carryback of UKP's 2008 losses, and that UKP need not file amended returns. The IRS disputed that assertion, and the record did not contain any such notation in Martin's file.
In May 2011, Martin submitted UKP's Form 1139 to the IRS for processing. UKP claimed that Martin filed the Form 1139 for the wrong year and, notwithstanding Internal Revenue Manual (IRM) procedure, failed to advise Galler that the Form 1139 was filed after the deadline. Almost two years passed before UKP received a response from the IRS as to the Form 1139.
In the meantime, in February 2013, the IRS sent UKP a notice of its intent to levy taxes owed for 2011. UKP's accountant responded that UKP had not paid its 2011 taxes because it expected a refund from its 2008 losses that it could eventually apply to its 2011 taxes. In response, the IRS notified UKP that its request for a tentative refund for 2007 was denied. The denial was based on the fact that the Form 1139 was filed late and requested a carryback to the wrong year. The IRS told UKP to file amended returns for 2005 through 2008 to protect its interests. UKP never filed any amended returns.
According to UKP, the IRS informed Galler in May 2013 that UKP's 2008 carryback claim had been denied in July 2011. The IRS disputed that and said that as of July 2011, UKP's Form 1139 was being processed. In July 2013, Galler discussed UKP's refund request with an IRS Appeals Settlement Officer (SO). The SO said that UKP's accounts for 2007 and 2008 were closed and put in noncollectible status. The SO advised Galler to contact the IRS Taxpayer Advocate Service to pay UKP's 2011 taxes and file amended returns for all years affected by the refund request. The statute of limitations for UKP's 2005 refund claim, based on its loss carryback from 2008, had long since expired, in September 2012.
In November 2013, the IRS rejected UKP's refund request as untimely. UKP's formal protest was denied in June 2015, although UKP asserted that it was not notified of the denial of its appeal until September 2015.
UKP sued for the refund in a district court. UKP acknowledged that it did not file a timely formal refund claim because it failed to file amended 2005 through 2008 tax returns before the statute of limitations expired in September 2012. UKP also agreed that it never requested a refund for 2005 based on a loss carryback from 2008. UKP argued that its correspondence with the IRS combined with its Form 1139 constituted an informal refund claim.
An informal refund claim stops the running of the statute of limitations if it provides notice to the IRS of a refund claim for a specific year in writing and describes the legal and factual basis for the refund. According to UKP, the IRS was on clear notice that UKP sought to carry back losses from 2008 to 2005. UKP argued that the IRS knew or should have known as a matter of law that UKP's losses had to be carried back to 2005. UKP pointed to the IRS's alleged misstatements and claimed that they formed part of the relevant facts and circumstances that the court should consider in evaluating whether it made an informal refund claim. UKP claimed it was overtly mislead by the IRS into not filing timely amended returns and into erroneously noting the wrong year on its Form 1139. According to UKP, but for the IRS not advising UKP of its mistakes and alerting UKP to the denial of its Form 1139 until after the statutory period expired, UKP would have been able to timely file amended returns.
The district court granted summary judgment in favor of the IRS. The court found that UKP did not file an informal refund claim because its Form 1139 was not a claim for a refund and there was no evidence that UKP communicated to the IRS that it sought to carryback its losses to 2005 or that it sought a refund for its 2005 taxes. According to the court, the law was clear that the mere filing of a Form 1139 did not constitute a formal or informal refund claim. The court also found that UKP's request for a refund for taxes paid in 2007 was simply not a request for a refund of taxes paid in 2005. The court reasoned that no one at the IRS could have known that UKP would seek a refund for a year other than the one it communicated to the IRS. This was particularly true, in the court's view, given that UKP is a large firm represented by sophisticated lawyers and accountants. The court explained that a contrary conclusion would require the IRS to serve an unmanageable function - to perform extensive investigations into the precise reasons and facts supporting every taxpayer's refund claim.
The court characterized UKP's argument regarding the IRS's alleged misstatements as an argument for equitable estoppel, although UKP expressly disclaimed that it was making an estoppel argument. The court held that the IRS was not estopped because UKP could not have reasonably relied on the IRS's alleged misrepresentations and omissions. The court reasoned that UKP knew or should have known the requirements for filing a carryback claim as well as the applicable statute of limitations. It was UKP's responsibility to discover its error in filing Form 1139 after the deadline, to realize that it was required to carry back its 2008 losses first to 2005, and to determine that it was necessary to file amended returns before the statute of limitations expired.
The IRS's disregard for its own rules as set forth in the IRM did not excuse UKP's failure to timely file amended returns. The court explained that IRM provisions do not have the force of law, nor do they bind the IRS or create actionable rights for taxpayers. The court found that the onus was on UKP, not the IRS, to understand the law and file timely amended returns before the statute of limitations expired. The court acknowledged that the IRS's conduct surrounding UKP's carryback and refund request was less than exemplary, but it reasoned that the government cannot expect perfect performance from every employee. The court found that in any event, UKP was cavalier in its reliance on the misstatements and its failure to conduct independent legal due diligence.
For a discussion of reporting carrybacks of corporations, see Parker Tax ¶99,120.
Attorney's Affidavit Insufficient to Rebut IRS's Proof of Claim in Bankruptcy
The Bankruptcy Appellate Panel for the Eighth Circuit Court of Appeals reversed a bankruptcy court's decision that a worker's compensation attorney's affidavit stating his opinion on the value of the debtor's pending claim for worker's compensation on the petition date was substantial evidence to rebut the IRS's proof of claim. The Eighth Circuit found that the affidavit was not substantial evidence of value because it did not contain the financial or factual information necessary to support the attorney's opinion and the IRS never had the opportunity to cross examine the attorney. In re Austin, 2018 PTC 100 (B.A.P. 8th Cir. 2018).
Scott and Anna Austin filed for Chapter 13 bankruptcy in 2014. In their bankruptcy schedules, the Austins listed two pending worker's compensation claims as contingent and unliquidated exempt property. The Austins valued the claims at $0 or an unknown value.
The IRS was listed as a secured creditor. It filed a proof of claim asserting in part a secured claim resulting from a tax lien. The Austins filed an objection to the IRS's claim in January 2015. They objected to the amount of the IRS's priority claim and the amount of the claim listed as secured. The Austins said that no value should be attributable to their worker's compensation claims in determining the secured portion of the IRS's claim. They also argued, in the alternative, that since there were neither settlement offers nor a basis to determine the value of the worker's compensation claims, the present value of the worker's compensation claims should be $0.
After a hearing on the objection, the bankruptcy court held that the Austins had failed to rebut the IRS's claim. The court reasoned that, because the Austins' worker's compensation claims were being pursued at the time the petition was filed, they must have had some value.
In the meantime, the Austins negotiated a settlement of their worker's compensation claims for approximately $21,000 and received a net settlement after attorney's fees of around $15,000. The IRS learned of the settlement and filed an amended claim, which included as part of its secured claim the $15,000 net value of the settlement.
The Austins again objected to the value of the IRS lien against their worker's compensation claims. In support, they filed an affidavit of their worker's compensation attorney, Michael Smallwood, who opined that the worker's compensation claims had a "nuisance" value of $3,000 on the petition date. The IRS responded that the affidavit was not sufficient to overcome the prima facie validity of its claim. The IRS also argued that the value of the worker's compensation claims should be the settlement amount, although the settlement occurred several months after the petition date.
The bankruptcy court heard oral arguments on the second objection. In July 2017, the bankruptcy court ruled that the affidavit was substantial evidence of the value of the worker's compensation claims, sufficient to rebut the presumption of validity of the IRS's claim. The bankruptcy court reasoned that the affidavit was from the attorney who litigated the matter. Further, the bankruptcy court stated that the IRS had not provided additional evidence to prove why it believed the true value of the claim should be the actual settlement amount. The bankruptcy court sustained the objection and valued of the worker's compensation claims at $3,000. The IRS appealed to the Eighth CIrcuit.
Under 11 U.S.C. Sec. 506(a)(1), a claim is a secured claim to the extent of the value of the creditor's interest in the bankruptcy estate's interest in the property. When a creditor files a proof of claim, it is deemed allowed unless a party in interest objects. The filing of an objection does not deprive the proof of claim of its presumption of validity unless the objection is supported by substantial evidence. The objecting party bears the burden of producing substantial evidence as to the value of the collateral securing any portion of the claim. Substantial evidence means relevant financial and factual information that a reasonable person would accept as adequate.
On appeal, the IRS argued that Smallwood's affidavit did not constitute substantial evidence of the value of the claims. According to the IRS, the affidavit contained uncorroborated and self-serving hearsay statements. The IRS also pointed out that it never had the opportunity for cross examination. The Austins argued that no particular method of valuation was required, and valuation questions were for the judge to decide on a case-by-case basis. The Austins said that the affidavit was sufficient proof of the value of the claim because Smallwood handled the case and was an experienced worker's compensation attorney who was in the best position to value the claims as of the petition date.
The Bankruptcy Appellate Panel for the Eighth Circuit reversed the bankruptcy court and held that the Smallwood affidavit was not substantial evidence. First, the court found that the affidavit contained Smallwood's personal opinion of value. The court noted that Smallwood admitted in the affidavit that as of the petition date he did not know the full extent of Mr. Austin's injuries; Mr. Austin had not had any independent medical exams and needed further treatment and analysis.
The court also found that Smallwood provided no evidence of what he did to increase the value of the claims. As the court explained, the claims were for losses due to the injuries Mr. Austin sustained at work. The evidence supporting the losses would be determined by the extent of the injury and worker's compensation schedules. The court reasoned that Smallwood's work had no impact on these factors. While Smallwood's work helped establish the extent of Mr. Austin's injuries and helped to recover the worker's compensation insurance benefits, it had no impact on the value of the claims themselves, as Smallwood did not increase the extent of Mr. Austin's injuries. His efforts simply made the facts known and aided in recovery.
Smallwood stated in the affidavit that at the time of the filing of the petition, no offers in settlement had been made. The court found that Smallwood did not state what demands had been made on Mr. Austin's behalf, nor did he provide any documentation to corroborate his statement that the claim was worth only $3,000 on the petition date, despite settling it for over $21,000 just seven months later. The court noted that Smallwood did not present copies of the actual worker's compensation claims filed, evidence of the statutory scheme for valuing such claims, or evidence of past awards for similar claims.
The court also noted that, because the bankruptcy court did not hold an evidentiary hearing, the IRS had no opportunity to cross examine Smallwood or take testimony, and nothing was admitted into evidence.
The court explained that substantial evidence could have included such things as lost wages, medical bills or worker's compensation schedules. Allowing valuation without a reasonable factual basis, in the court's view, would encourage abuse and allow debtors to avoid a secured creditor's interest in claims simply by failing to obtain the facts necessary to support the claims.
For a discussion of bankruptcy estates, see Parker Tax ¶16,100.
