Federal Tax Bulletin - Issue 139 - May 2, 2017

Extensions of Variable Prepaid Forward Contracts Did Not Constitute a Sale of Property

In an issue of first impression, the Tax Court held that a taxpayer's execution of variable prepaid forward contract (VPFC) extensions did not constitute sales or exchanges of property under Code Sec. 1001 and the open transaction treatment afforded to the original VPFCs continues until the transactions are closed by the future delivery of stock. The court also concluded that the taxpayer did not engage in constructive sales of stock under Code Sec. 1259. Est. of McKelvey v. Comm'r, 148 T.C. No. 13 (2017).

Background

Andrew McKelvey was the founder and chief executive officer of Monster Worldwide, Inc. (Monster), a company known for its website, monster.com. Monster.com helps inform job seekers of job openings that match their skills and desired geographic location.

In 2007, McKelvey entered into variable prepaid forward contracts (original VPFCs) with two investment banks. Pursuant to the terms of the original VPFCs, the investment banks made prepaid cash payments to McKelvey, and he was obligated to deliver variable quantities of Monster stock to the investment banks on specified future settlement dates in 2008 (original settlement dates). McKelvey treated the execution of the original VPFCs as open transactions pursuant to Rev. Rul. 2003-7, and did not report any gain or loss for 2007. In Rev. Rul. 2003-7, the IRS ruled that VPFCs that meet certain criteria are open transactions when executed and do not result in the recognition of gain or loss until the future delivery of property. In that ruling, the IRS concluded that a shareholder who entered into a VPFC secured by a pledge of stock neither caused a sale of stock under Code Sec. 1001 nor triggered a constructive sale under Code Sec. 1259.

In 2008, before the original settlement dates, McKelvey paid consideration to the investment banks to extend the settlement dates until 2010 (VPFC extensions). The extensions provided that (1) McKelvey would pay additional consideration specifically for the extension of the settlement and/or averaging dates, and (2) the terms of the original VPFCs remained in full force and effect. McKelvey did not report any gain or loss upon the execution of the VPFC extensions and continued the open transaction treatment. McKelvey died in 2008 after the execution of the VPFC extensions.

While agreeing that the original VPFCs were entitled to open transaction treatment under Code Sec. 1001, the IRS determined that the execution of the VPFC extensions in 2008 constituted sales or exchanges of property under Code Sec. 1001, and thus McKelvey should have reported gain from the transactions for 2008. McKelvey's estate disagreed, contending that no sale or exchange took place and, thus, no gain or loss should be recognized upon the extensions of the VPFCs. The Tax Court was asked to decide what tax consequences, if any, occurred when McKelvey extended the settlement and averaging dates of the original VPFCs in 2008.

Analysis

Before the Tax Court the IRS argued that the extensions to the original VPFCs resulted in taxable exchanges of the original VPFCs. According to the IRS, McKelvey possessed three valuable rights in the original VPFCs: (1) the right to the cash prepayments; (2) the right to determine how the VPFCs would be settled (i.e., whether with stock or in cash, and if stock, which specific shares); and (3) the right to substitute other collateral. The IRS also argued that the extensions to the original VPFCs resulted in constructive sales of the underlying shares of Monster stock pursuant to Code Sec. 1259. Under Code Sec. 1259, in the event there is a constructive sale of an appreciated financial position, a taxpayer must recognize gain as if that position were sold, assigned, or otherwise terminated at its fair market value on the date of the constructive sale.

McKelvey's estate argued that the extensions to the original VPFCs merely postponed the settlement and averaging dates of the contracts, did not trigger any tax consequences to McKelvey, and that the "open" transaction treatment provided by Rev. Rul. 2003-7 should continue until the contracts are settled by delivery of the Monster stock. Neither the court nor the two parties could find any cases addressing the tax consequences resulting from extensions to VPFCs. Thus, the issue was one of first impression for the Tax Court.

The Tax Court held that McKelvey's execution of the VPFC extensions did not constitute sales or exchanges of property under Code Sec. 1001, and the open transaction treatment afforded to the original VPFCs under Rev. Rul. 2003-7 should continue until the transactions are closed by the future delivery of stock.

In looking at the contractual provisions in the VPFC extensions, the court found that the provisions were not property rights but rather procedural mechanisms designed to facilitate McKelvey's delivery obligations. At the time he extended the original VPFCs, the court noted, McKelvey had only delivery obligations and not property rights in the contracts. These were purely liabilities, the court said. Thus, the court concluded that the VPFC extensions did not constitute exchanges of McKelvey's "property" in the original VPFCs under Code Sec. 1001.

The court also held that McKelvey did not engage in constructive sales of stock in 2008 pursuant to Code Sec. 1259. According to the court, because the IRS conceded that the original VPFCs were properly afforded open transaction treatment under Code Sec. 1001 and because the open transaction treatment continued when McKelvey executed the extensions there was no merit to the argument that the extended VPFCs should be viewed as separate and comprehensive financial instruments under Code Sec. 1259.

For a discussion of the rules for determining whether a sale of property has occurred for purposes of recognizing gain or loss under Code Sec. 1001, see Parker Tax ¶110,110. For a discussion of the rules relating to Code Sec. 1259, see Parker Tax ¶116,140.

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Trump Administration Releases Outline of Tax Reform Plan

Last week, the Trump administration released a one-page outline of a tax reform plan which includes, among other things, a large reduction in corporate taxes, a reduction in the number of individual tax brackets and individual tax rates, the elimination of the estate tax, the repeal of the 3.8 percent net investment income tax and the alternative minimum tax, and the imposition of a territorial tax system to level the playing field for American companies. A detailed blueprint of the plan is expected by early summer. Trump Tax Outline (4/26/17).

Calling the plan the "biggest individual and business tax cut in American history," Treasury Secretary Mnuchin said the reduction in taxes called for in the package would not make the deficit worse and tax reform would pay for itself with growth, the reduction of various deductions, and the closing of loopholes. According to Mnuchin, the Treasury Department and the White House will be working closely with the House and Senate to turn the one-page plan into a bill that Congress can pass and that President Trump can sign. Mnuchin acknowledged that there were "lots of details" that have yet to be worked out.

Business Tax Reform

The outline calls for slashing corporate taxes from 35 percent to 15 percent, setting up a territorial tax system to level the playing field for American companies, imposing a one-time tax on "trillions of dollars held overseas," and eliminating tax breaks for special interests. Although the one-pager is silent on whether the reduced rate would apply to pass-through entities, as proposed in Trump's campaign tax plan, administration officials have confirmed that it would, but provided no details on how it would work.

Notably missing from the outline was any mention of the border-adjusted corporate tax that is the centerpiece of the "Better Way" tax blueprint supported by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady ("Ryan-Brady plan"). The omission has been widely interpreted as signaling that the administration will not support the controversial proposal.

Individual Tax Reform

The outline calls for reducing the individual tax brackets from seven to three. Those three tax brackets would have rates of 10 percent, 25 percent, and 35 percent. The rates are the same as the ones proposed by the Trump campaign last September, except for an increase in the highest rate from 33 percent to 35 percent. Taking a step back from the campaign tax plan, the outline does not indicate the thresholds for the brackets.

In addition, the outline calls for nearly doubling the standard deduction to $12,000 for single taxpayers and $24,000 for married filing jointly. The amounts match the ones in the Ryan/Brady plan, reflecting significant reductions from the $15,000/$30,000 amounts proposed by Trump during the campaign. The outline doesn't indicate if the enhanced standard deduction would be coupled with the elimination of personal and dependency exemptions, as was proposed in the campaign tax plan.

The plan would eliminate all itemized deductions other than those for home mortgage interest and charitable contributions. The language in the outline is somewhat cryptic on this point, stating that the intent is to "Eliminate targeted tax breaks that mainly benefit the wealthiest taxpayers ..." and "Protect the home ownership and charitable gift tax deductions." But the administration has confirmed that this means repealing all itemized deductions other than the two being protected.

Finally, the outline calls for providing unspecified tax relief to families with child and dependent care expenses, repealing the alternative minimum tax, repealing the estate tax, and repealing the 3.8 percent net investment income tax.

Effect on the Deficit

Responding to questions from CNBC reporters as to how much the Administration's tax reform plan would affect the deficit, OMB Director Mick Mulvaney said "there is no way to score what we put out" because the plan was purposefully light on details. According to Mulvaney, this wasn't done to hide the numbers; instead the blueprint is an opening start for discussions with all the various parties that need to be involved in tax reform. It was meant as a guideline for a future tax reform bill, he said.

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IRS Clarifies 2015 Changes to Section 179 Expensing and Bonus Depreciation

In a new revenue procedure addressing certain provisions enacted in 2015, the IRS provides rules for making a Code Sec. 179 election on an amended return, clarifies how the Code Sec. 168(k)(5) election relating to additional depreciation for certain plants interacts with the Code Sec. 179 election; and discusses the types of air conditioning or heating units that qualify as Code Sec. 179 property. Rev. Proc. 2017-33.

Background

The Protecting Americans From Tax Hikes Act of 2015 (PATH Act) amended Code Sec. 179 by -

(1) making permanent the treatment of qualified real property as Section 179 property under Code Sec. 179(f);

(2) making permanent the permission granted under Code Sec. 179(c)(2) to revoke without IRS consent any election made under Code Sec. 179 and any specification contained in that election; and

(3) allowing certain air conditioning or heating units to be eligible as Code Sec. 179 property under Code Sec. 179(d)(1).

The PATH Act also amended Code Sec. 168(k) by (1) extending the placed-in-service date for property to qualify for the additional first year depreciation deduction; (2) modifying the definition of qualified property under Code Sec. 168(k)(2); (3) extending and modifying the election under Code Sec. 168(k)(4) to increase the alternative minimum tax (AMT) credit limitation in lieu of the additional first year depreciation deduction; and (4) adding Code Sec. 168(k)(5), which allows a taxpayer to elect to deduct the additional first year depreciation for certain plants.

The Path Act also added Code Sec. 168(k)(5), which allows a taxpayer to elect to deduct additional first year depreciation for any specified plant that is planted before January 1, 2020, or grafted before that date to a plant that has already been planted, by the taxpayer in the ordinary course of its farming business, as defined in Code Sec. 263A(e)(4). If the taxpayer makes this election, the additional first year depreciation deduction is allowable for any specified plant for the tax year in which that specified plant is planted or grafted and that specified plant is not treated as qualified property under Code Sec. 168(k) in the plant's placed-in-service year. The percentage of the additional first year depreciation deduction is (1) 50 percent for any specified plant planted or grafted after 2015 and before 2018; (2) 40 percent for any specified plant planted or grafted during 2018; and (3) 30 percent for any specified plant planted or grafted during 2019.

Code Sec. 168(k)(5)(B) defines a specified plant as (1) any tree or vine that bears fruits or nuts, and (2) any other plant that will have more than one yield of fruits or nuts and that generally has a pre-productive period of more than two years from the time of planting or grafting to the time at which such plant begins bearing fruits or nuts. The term "specified plant" does not include any property that is planted or grafted outside of the United States. Code Sec. 168(k)(5) applies to specified plants that are planted or grafted after December 31, 2015.

As a result of the above changes, practitioners questioned

(1) whether a Section 179 election could be made on an amended return without IRS consent;

(2) how the Code Sec. 168(k)(5) election relating to additional depreciation for certain plants interacted with the Code Sec. 179 election; and

(3) what types of air conditioning or heating units qualified as Code Sec. 179 property.

The IRS issued Rev. Proc. 2017-33, which is effective April 20, 2017, to address these questions.

Taxpayers Can Elect Section 179 on an Amended Tax Return Without IRS Consent

In Rev. Proc. 2017-33, the IRS provides that, for any tax year beginning after 2014, a taxpayer can make a Code Sec. 179 election with respect to any Section 179 property without the IRS's consent on an amended federal tax return for the tax year in which the taxpayer places in service the Section 179 property. The IRS said it is going to amend Reg. Sec. 1.179-5(c) to incorporate this guidance.

Interaction of Code Sections 168(k)(5) and 179

With respect to the interaction of Code Sec. 168(k)(5) and Sec. 179, Section 4.05 of Rev. Proc. 2017-33 provides that, if a taxpayer makes the Code Sec. 168(k)(5) election for a specified plant (1) the additional first year depreciation deduction provided by Code Sec. 168(k) is allowed for that specified plant for regular tax and alternative minimum tax purposes for the tax year in which the specified plant is planted or grafted by the taxpayer; (2) that specified plant is not treated as qualified property under Code Sec. 168(k) in its placed-in-service year, and (3) the depreciation deductions under Code Sec. 168 for that specified plant, after deducting the additional first year depreciation, are allowed for its placed-in-service year and subsequent tax years. Further, pursuant to Code Sec. 263A(c)(7), Code Sec. 263A does not apply to any amount deducted under the Code Sec. 168(k)(5) election.

Compliance Tip: The Code Sec. 168(k)(5) election must be made by the due date, including extensions, of the federal tax return for the tax year in which the taxpayer plants or grafts the specified plant to which the election applies. Generally, the election is made in the manner prescribed on Form 4562, Depreciation and Amortization, and its instructions. However, special procedures apply if the taxpayer did not make the Code Sec. 168(k)(5) election for a specified plant planted or grafted by the taxpayer after December 31, 2015, on its timely filed federal tax return for its tax year beginning in 2015 and ending in 2016 or its tax year of less than 12 months beginning and ending in 2016. In this case, the taxpayer is treated as making the election for that specified plant if the taxpayer (i) on that return, deducted the 50-percent additional first year depreciation for that specified plant; and (ii) did not revoke the deemed election provided under this provision within the time and in the manner described below.

Generally, the Code Sec. 168(k)(5) election, once made, may be revoked only with the written IRS consent. In order to obtain such consent, the taxpayer must submit a request for a letter ruling pursuant to Rev. Proc. 2017-1 (or successor). If a taxpayer made, or would be treated as having made, the Code Sec. 168(k)(5) election for a specified plant, an automatic extension of six months from the due date, excluding extensions, of the taxpayer's federal tax return for the tax year in which such specified plant is planted or grafted is granted to revoke that election, provided the taxpayer timely filed the taxpayer's federal tax return for that taxable year and, within this six-month extension period, the taxpayer, and all taxpayers whose tax liability would be affected by the Code Sec. 168(k)(5) election, files an amended federal tax return for that taxable year in a manner that is consistent with the revocation of the election.

If a taxpayer makes the Code Sec. 168(k)(5) election for a specified plant, the adjusted basis of that specified plant is reduced by the amount of the additional first year depreciation deduction allowed or allowable under Code Sec. 168(k), whichever is greater. This remaining adjusted basis is the cost of the specified plant for purposes of Code Sec. 179, before the application of Code Sec. 179(d)(3) and Reg. Sec. 1.179-4(d).

Air Conditioning or Heating Units That Qualify as Section 179 Property

In Rev. Proc. 2017-33, the IRS provides that an air conditioning or heating unit qualifies as Code Sec. 179 property if such unit is Code Sec. 1245 property, depreciated under Code Sec. 168, acquired by purchase for use in the active conduct of the taxpayer's trade or business, and placed in service by the taxpayer in a tax year beginning after 2015. The IRS cites portable air conditioners, such as window air conditioning units, and portable heaters, such as portable plug-in unit heaters, that are placed in service by the taxpayer in a tax year beginning after 2015, as units that may qualify as Section 179 property. Generally, an example of an air conditioning or heating unit that will not qualify as Section 179 property is any component of a central air conditioning or heating system of a building, including motors, compressors, pipes, and ducts, whether the component is in, on, or adjacent to a building.

If a component of a central air conditioning or heating system of a building meets the definition of qualified real property, as defined in Code Sec. 179(f)(2), and the component is placed in service by the taxpayer in a tax year beginning after 2015, the component may qualify as Code Sec. 179 property if the taxpayer elects to apply Code Sec. 179(f).

For a discussion of property that qualifies for the Code Sec. 179 election, see Parker Tax ¶97,710. For a discussion of how the election is make, see Parker Tax ¶94,750.

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Retired Police Officer Granted Hardship Waiver for Late Retirement Rollover; Major Depression Was a Condition Qualifying for a Waiver

The Tax Court granted a hardship waiver to a retired police officer who, due to a major depressive disorder, failed to roll over his pension distributions to a qualified retirement account within 60 days. Because the distributions were nontaxable, the additional 10 percent tax on early distributions did not apply. Trimmer v. Comm'r, 148 T.C. No. 14 (2017).

Background

In 2011, John Trimmer retired from the New York Police Department at age 47 after 20 years of service. Before retiring, he found a job as a security guard to supplement his pension income and to help finance his sons' college educations. His security guard job fell through shortly after he retired and he was unable to find another position. Three weeks after retiring, Trimmer began experiencing symptoms relating to a major depressive disorder. He became antisocial, irritable, and uncommunicative; he rarely left the house, had trouble sleeping, lost weight, and neglected his hygiene and grooming. He stopped coaching his sons' sporting events and stopped attending their school events. He did little with his days, although he did occasionally write checks from his and his wife's joint checking account.

In May and June 2011, after his depression had set in, Trimmer received two retirement account distribution checks, one for approximately $99,000 and the other for approximately $1,700. The checks lay on his dresser for over a month until he deposited them into a bank account in July 2011. In April 2012, on the advice of his tax return preparer, Trimmer opened an IRA and rolled the funds over from the account where the two checks had been deposited. Trimmer and his wife made no use of any of the funds before they were rolled over to the IRA. They reported the distributions as nontaxable on their 2011 tax return.

The Trimmers received an IRS Notice CP2000, Proposed Changes to Your 2011 Form 1040, in December 2013 indicating that they had failed to report approximately $100,000 of taxable retirement income, and that they were also liable under Code Sec. 72(t) for an additional 10 percent tax on early distributions from a qualified plan. According to the IRS, the Trimmers owed almost $40,000 in additional taxes. The notice advised that if the Trimmers disagreed, they should complete an attached response form and send it to the IRS. Trimmer replied to the notice with a letter contesting the assessment. He explained his condition and noted that none of the retirement funds had been spent and that the funds had already been rolled over to an IRA. Trimmer said that such a large tax bill would cripple his family and that no harm was done by the late rollover. He asked the IRS to consider the facts and come to a fair decision.

The IRS responded with a letter telling Trimmer that he did not need to do anything else at that time, and that they would tell him what action they would take within 60 days. Three days later, an IRS operations manager denied the request for relief. No mention was made in the denial letter of the IRS's authority to grant a hardship waiver or of the procedure for applying for one. The letter also did not acknowledge any of Trimmer's particular circumstances. It stated that if Trimmer disagreed, he should respond and explain why. In August 2014, the IRS issued a notice of deficiency, and the Trimmers took their case to the Tax Court.

Analysis

Under Code Sec. 402(a), a distribution from a retirement plan is generally taxable. However, the recipient can, under Code Sec. 402(c)(1), exclude from income any portion of a distribution that is rolled over within 60 days to an eligible retirement plan. The rollover exclusion is generally not available after 60 days, but the IRS can waive the 60-day requirement under a hardship exception provided in Code Sec. 402(c)(3)(B). Under that provision, a hardship waiver may be granted by the IRS where the failure to do so would be against equity or good conscience.

Rev. Proc. 2003-16 provides guidance about applying for hardship waivers under Code Sec. 402(c)(3)(B) and states that a taxpayer must apply for a hardship exception to the 60-day rollover requirement by submitting a private letter ruling (PLR) request under the procedures outlined in Rev. Proc. 2003-4 and include a user fee with the application. The IRS subsequently issued Rev. Proc. 2016-47, which modified Rev. Proc. 2003-16 and had an effective date of August 24, 2016. Rev. Proc. 2016-47 authorizes "additional" hardship waivers where, during an audit, the IRS determines that the taxpayer qualifies for a waiver of the 60-day rollover requirement under Code Sec. 402(c)(3)(B).

Before the Tax Court, the Trimmers argued that the hardship exception should apply because the failure to timely rollover the retirement amounts was caused by Trimmer's major depressive disorder. The IRS contended that the Trimmers failed to apply for relief by requesting a PLR and paying a fee as required in Rev. Proc. 2003-16. The IRS contended that its Examination Division lacked the authority to consider a hardship waiver under Code Sec. 402(c)(3)(B) and that, in any event, the IRS's exercise of discretion in denying a hardship waiver was not subject to judicial review. The IRS also said that, because Rev. Proc. 2016-47 had not been issued as of the time when the Trimmers' 2011 return was under audit, the IRS's Examination Division did not have the authority to determine whether the Trimmers qualified for a waiver. Finally, according to the IRS, there was no abuse of discretion in denying a hardship waiver because Trimmer failed to establish that he was unable to complete the rollovers within 60 days of the distributions.

The Tax Court held that Trimmer was entitled to a hardship waiver under Code Sec. 402(c)(3)(B) and that the 10 percent additional tax on early distributions under Code Sec. 72(t) did not apply.

According to the Tax Court, the IRS had the authority to consider Trimmer's request for a hardship waiver in the course of auditing his tax return. Nothing in Rev. Proc. 2003-16, the court said, prevented the IRS's ability to consider a hardship waiver in the course of auditing a return. Nor was there any such constraint in Code Sec. 402(c)(3)(B). Moreover, the court noted, the Internal Revenue Manual gives examiners the authority to recommend the proper disposition of all issues, including those raised by the taxpayer. Regarding Rev. Proc. 2016-47, the Tax Court reasoned that the purpose and effect of the 2016 modification of Rev. Proc. 2003-16 was not to create some new authority that had not previously existed for IRS examiners to consider hardship waivers during audits, but rather to make clear the existence of that authority.

Having determined that the IRS could consider a hardship waiver request during an examination, the Tax Court also found that Trimmer's letter in response to the IRS's notice constituted a waiver request. In response to that request, the IRS did not decline to consider the issue, nor did it advise Trimmer that he was required to submit a PLR request. Their response, the court noted, was that Trimmer need not do anything else at that point, and that the IRS would notify Trimmer of its decision. When the IRS denied Trimmer's request, the court observed, it did not say the reason for the denial was that Trimmer had made the request in the wrong manner.

Next, the Tax Court held that it had jurisdiction to consider the IRS's denial of Trimmer's waiver request. According to the court, reviewing the waiver denial was necessary in order to determine the merits of the deficiency determination.

Considering the merits of Trimmer's hardship waiver request, the Tax Court held that Trimmer's depression was a disability that significantly impaired his ability to perform day-to-day activities, and that his failure to meet the 60-day rollover requirement was attributable to his disability. The court found that Rev. Proc. 2003-16 specifies the factors for the IRS to consider in deciding whether to grant the waiver, one of which is the inability to complete a timely rollover due to disability. Reviewing Trimmer's symptoms during the relevant period, the court concluded that Trimmer's depression satisfied the disability requirements as provided in Rev. Proc. 2003-16.

Finally, the court also held that the additional 10 percent tax on early distributions under Code Sec. 72(t) did not apply since none of the distributions were taxable.

For a discussion of hardship waivers under Code Sec. 402(c)(3)(B), see Parker Tax ¶131,550.

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Court Denies IRS Attempt to Reclassify Workers; Denies Taxpayers' Request to Recoup Costs

A district court held that, even though two companies that provided home care workers to elderly clients won their battle with the IRS and were entitled to classify their workers as independent contractors, the company was not entitled to recoup attorney's fees and administrative costs relating to the case. After looking at various factors, and noting the lack of any legal precedent, the district court found that the IRS's position that the companies' workers were employees and not independent contractors was substantially justified. Nelly Home Care, Inc. v. U.S., 2017 PTC 191 (E.D. Pa. 2017).

Background

In Nelly Home Care, Inc. v. U.S., 2016 PTC 164 (E.D. Pa. 2016), a district court granted summary judgment to two related companies, Nelly LLC and its successor, Nelly Home Care, Inc. (collectively "Nelly"), and held that the companies had a reasonable basis for treating home care workers as independent contractors and not as employees. In that case, the facts indicated that Helen Carney formed and managed both companies, which provided home health care services after matching companions with elderly clients. Carney herself was a companion before starting her own business. While working as a companion, she learned that some home care service providers treated their workers as independent contractors.

After forming Nelly LLC in 2004, Carney conducted a survey of 20 home care companies to determine how they classified their companions for tax purposes. Seven of these companies classified companions as independent contractors. The remaining companies treated them as employees. Shortly after Carney incorporated Nelly Home Care, Inc. in 2009, she attended a mandatory conference at the Pennsylvania Department of Health. At the conference, Carney was told that home care registries, the classification under which Carney registered Nelly Home Care, Inc., treated workers as independent contractors.

In the meantime in 2007, the IRS audited Carney's personal income tax returns for the 2004 and 2005. Carney provided the IRS with information about Nelly LLC, including documents relating to gross receipts, expenses, and copies of independent contractor agreements. As a result of the audit, the IRS concluded Carney had underreported her income, commingled business and personal accounts, and charged 80 percent of her personal expenses through Nelly LLC. Consequently, the IRS adjusted Carney's personal tax liability. The IRS again audited Carney's personal income tax returns in 2011. This time, the audit was resolved with a "no change" determination.

The IRS later began an employment tax audit of Nelly LLC and Nelly Home Care, Inc. It determined that both companies owed a combined total of $4,000 in back employment taxes for tax years 20082012. Nelly paid the tax and promptly sought a refund. After hearing nothing from the IRS for six months, Nelly filed suit in a district court, claiming it was entitled to relief under the safe harbor provisions of Section 530 of the Revenue Act of 1978.

The district court judge granted Nelly's motion for summary judgment. The judge concluded that, while Nelly was not protected by the statutory industry practice or prior audit safe harbors of Section 530, Nelly had a reasonable basis for treating the companions as independent contractors. In reaching this conclusion, the judge considered the cumulative effect of Carney's experience and research, the personal IRS audits which included a review of her companies' business practices, and Pennsylvania regulations. He found that these factors together provided a reasonable basis for Nelly's decision to classify companions as independent contractors. Accordingly, he entered judgment in favor of the companies and against the IRS in the amount of $4,000. After the decision, Nelly sought an award of $100,000 for attorney's fees and costs pursuant to Code Sec. 7430(a), contending it was entitled to the fees and costs because it won the case on summary judgment.

Recovering Litigation or Administrative Costs

Under Code Sec. 7430(a), in any administrative or court proceeding which is brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty, the prevailing party may be awarded a judgment or a settlement for (1) reasonable administrative costs incurred in connection with such administrative proceeding; and (2) reasonable litigation costs incurred in connection with such court proceeding. Code Sec. 7430(c)(4)(A) defines a prevailing party as any party which has substantially prevailed with respect to an amount in controversy, or substantially prevailed with respect to the most significant issue or set of issues presented. However, there is an exception in Code Sec. 7430(c)(4)(B) where the government is the defendant and establishes that its position in the proceeding was substantially justified. In that case, the taxpayer is not treated as a prevailing party even though the taxpayer won the case.

Section 530 Safe Harbors

Section 530 of the Revenue Act of 1978 provides employers with relief from federal employment tax obligations if certain requirements are met. To invoke the safe harbor of Section 530, the taxpayer must establish that it had a reasonable basis for treating the worker as an independent contractor based on either:  

(1) legal precedent;  

(2) a prior audit; or  

(3) a recognized practice of a significant segment of the relevant industry.  

In addition to these statutory bases, there is a judicially created "any reasonable basis" safe harbor. If the employer-taxpayer establishes any of these bases, it is relieved from liability for paying the employer's share of employment taxes for a worker it had incorrectly treated as an independent contractor.

IRS's Arguments

With respect to the underlying case which Nelly won and the IRS lost, the IRS argued that Nelly had not met any of the statutory safe harbors under Section 530. First, it argued Nelly failed to meet the industry practice safe harbor because it did not demonstrate that a significant portion of the home health care services industry classified workers as independent contractors. Second, the IRS contended that the prior audit safe harbor did not apply because Nelly was not the taxpayer audited in 2007, which is a requirement for the prior audit safe harbor provision of Section 530. The IRS also argued that Nelly failed to establish any reasonable basis for treating its workers as independent contractors to satisfy the judicially created safe harbor. To support its position, the IRS emphasized that Nelly had obtained worker's compensation insurance for its companions, which is typically provided for employees and not independent contractors, and it had failed to obtain advice from an accountant or lawyer on how to classify its workers.

The IRS argued that, even though Nelly was successful in the earlier case, it was not a prevailing party because the IRS's position was substantially justified. Thus, the IRS said, Nelly was not entitled to an award for attorney's fees and costs.

District Court's Decision

The district court held that the IRS's position was substantially justified and denied Nelly's request for attorney's fees and costs under Code Sec. 7430(a). The court noted that the term "substantially justified" means the IRS had a reasonable basis in both law and fact. The position taken, the court observed, need not have been correct, only reasonable.

In the underlying case, the court said, there were no cases where courts had considered the position taken by the IRS. Nelly did not succeed in demonstrating that it was entitled to relief under the statutory bases under Section 530. Instead, it convinced the judge that it had a "reasonable basis" for classifying its companions as independent contractors despite the absence of a statutory basis. The reasonable basis ground is fact-specific, the court noted, and is subject to varying interpretations of the facts and circumstances of the case. The reasonable basis result could have gone either way, the court said. Indeed, after reviewing the record, the court opined that it might have ruled differently than the judge in the underlying case. That the IRS did not win on the merits, the court concluded, did not establish that its position was or was not substantially justified.

Additionally, the court stated that the fact that the case was decided on summary judgment did not mean the government's position was not substantially justified. After looking at the various factors, together with the lack of any legal precedent, the district court found sufficient evidence to support the reasonableness of the IRS's position that Nelly's workers were employees, not independent contractors.

For a discussion of the effects of a misclassification of employees, see Parker Tax ¶210,115.

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IRS Updates Automatic Accounting Method Change Procedures

The IRS updated Rev. Proc. 2015-35, the revenue procedure for requesting automatic IRS consent for an accounting method change. The new procedure modifies, clarifies, and obsoletes certain sections of Rev. Proc. 2015-13, as modified and clarified by Rev. Proc. 2016-29, and adds three new automatic accounting method changes. Rev. Proc. 2017-30.

On April 19, the IRS issued Rev. Proc. 2017-30, which updates Rev. Proc. 2015-35. Rev. Proc. 2015-35, as clarified and modified by Rev. Proc. 2016-29, provides the procedures for requesting automatic IRS consent for certain accounting method changes. The new procedure modifies, clarifies, and obsoletes certain sections of Rev. Proc. 2016-29. It also adds three new automatic accounting method changes for which IRS consent is granted. The definitions in Section 3 of Rev. Proc. 2015-23 continue to apply to Rev. Proc. 2017-30.

In Rev. Proc. 2017-30, the IRS added the following changes to the list of automatic change procedures:

(1) changes relating to organizational expenditures under Code Sec. 248;

(2) changes relating to organization fees under Code Sec. 709; and

(3) changes relating to changes from currently deducting inventory to a permissible method of identifying and valuing inventories.

In addition, Rev. Proc. 2017-30 made significant changes to the list of automatic changes in Rev. Proc. 2016-29 (which modified and clarified Rev. Proc. 2015-35) by:

• Removing certain paragraphs relating to inapplicable eligibility rules because those paragraphs are now obsolete;
• Removing certain sections of Rev. Proc. 2016-29 which have become obsolete in their entirety;
• Modifying the rules relating to partial dispositions of tangible depreciable assets to which IRS adjustment pertain to provide that they does not apply to any partial disposition election specified in Reg. Sec. 1.168(i)-8(d)(2)(i) that is not made pursuant to Reg. Sec. 1.168(i)-(d)(2)(iii);
• Changes to the provisions relating to the disposition of a building or structural component and the removal of related provisions that are now obsolete;
• Changes to the provisions relating to certain partial dispositions of an asset;
• Modifications of the accounting method change rules relating to start-up expenditures to include a change in the amortization period of a start-up expenditure to 180 months;
• Elimination of obsolete provisions relating to (i) a change in the treatment of acquisition and holding costs for real property acquired through foreclosure; (ii) a change for sales-based royalties; and (iii) a change in the treatment of sales-based vendor chargebacks under a simplified method;
• Modification of provisions relating to capitalizing interest with respect to the production of designated property to include changes from an improper method of capitalizing interest under Reg. Sec. 1.263A-8 through Reg. Sec. 1.263A-14 to capitalizing interest in accordance with Reg. Sec. 1.263A-8 through Reg. Sec.1.263A-14;
• Modification of rules relating to capitalizing interest with respect to the production of designated property to include changes from an improper method of capitalizing interest to a proper method and to require that the statement attached to a Form 3115 must include details regarding the taxpayer's sub-methods of accounting for determining capitalizable interest in accordance with Reg. Sec. 1.263A-8 through Reg. Sec. 1.263A-14;
• Modification of the rule relating to a change from an improper method of inclusion of rental income or expense to inclusion in accordance with the rent allocation to clarify that the procedure does not apply to rental agreements that provide a specific allocation of fixed rent as described in Reg. Sec. 1.467-1(c)(2)(ii)(A)(2) that allocate rent to periods other than when such rents are payable;
• Modification of the rules relating to impermissible methods of identification and valuation of inventory, to clarify that: (i) a taxpayer can make a change under the automatic consent provisions if the taxpayer is changing from an impermissible method of identifying or valuing inventories under Code Sec. 471, and/or an impermissible method described in Reg. Sec. 1.471-2(f)(1) through (5); (ii) a taxpayer cannot make a change under the automatic consent provisions to allocate costs to inventory under Code Sec. 471 nor under Code Sec. 263A; and (iii) a taxpayer cannot make a change under the automatic consent provisions if the taxpayer is currently deducting inventories;
• Modification of the rules relating to permissible methods of identification and valuation of inventory, to clarify that a taxpayer cannot make a change under the automatic consent rules to allocate costs to inventory under Code Sec. 471 nor under Code Sec. 263A;
• Modification of the rules relating to certain taxpayers that have elected to use the mark-to-market method of accounting under Code Sec. 475(e) or (f) to provide that the eligibility rule in Section 5.01(1)(d) of Rev. Proc. 2015-13 does not apply to this change; however, the waiver of the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 continues to apply to this change;
• Modification of the rule relating to taxpayers changing their method of accounting from the mark-to-market method of accounting described in Code Sec. 475 to a realization method of accounting to clarify that such a change is not limited to a change required by Code Sec. 475;
• Modification of the rule relating to change in qualification as life/nonlife insurance company to clarify that this change applies to an insurance company that changes from being treated as a life insurance company under part I of subchapter L to being treated as a non-life insurance company under part II of subchapter L, or vice versa; and
• Modification of the rule relating to the revocation of the Code Sec. 1278(b) election to provide that, for certain purposes, a taxpayer also is treated as having made a deemed Code Sec. 1278(b) election for a tax year if, for one or more market discount bonds that were acquired by the taxpayer during that tax year, the taxpayer includes in gross income on the tax return for that tax year and on the tax return for the following tax year the market discount attributable to each tax year, other than as a result of a disposition of the bond or a partial principal payment on the bond.

Generally, Rev. Proc. 2017-30 is effective for a Form 3115 filed on or after April 19, 2017, for a year of change ending on or after August 31, 2016, that is filed under the automatic change procedures of Rev. Proc. 2015-13. However certain transition rules apply under which taxpayers have a limited time period to convert a Form 3115 filed under the non-automatic change procedures in Rev. Proc. 2015-13.

For a discussion of the rules relating to automatic accounting method changes, see Parker Tax ¶241,590.

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Nonprofit Hospital Was a Corporation for Purposes of Calculating Interest Rate on Overpayments

The Seventh Circuit Court of Appeals affirmed a district court ruling that a nonprofit hospital was a corporation for purposes of determining the interest rate on a refund for an overpayment of tax. The court rejected the hospital's argument that a nonprofit corporation is not a corporation under Code Sec. 6621. Medical College of Wisconsin Affiliated Hospitals, Inc. v. U.S., 2017 PTC 192 (7th Cir. 2017).

Medical College of Wisconsin, a nonprofit corporation, received a refund of Social Security taxes after the IRS ruled that the medical residents, on whose behalf the taxes were paid, were exempt from such taxes until April 1, 2005. When the IRS refunded the overpayment it added approximately $13 million in interest. It later demanded $6.7 million back because it determined that it should have applied the lower interest rate that applies to overpayments by corporations. Medical College returned the funds and sued the IRS in district court to have them restored. The district court ruled in favor of the IRS (2016 PTC 355 (E.D. Wisc. 2016)) and Medical College appealed.

Code Sec. 6621 provides that the interest rate generally applicable to refunds of overpayments is the federal short-term rate plus three percentage points. The rate is lower if the taxpayer is a corporation. For corporations, the formula adds two percentage points for the first $10,000 of the overpayment and 0.5 percentage point for the portion in excess of $10,000.

Medical College argued that, as a nonprofit, it was not a corporation for purposes of Code Sec. 6621 and therefore the higher interest rate should have applied. It based its argument on Code Sec. 6621(c), which applies to large corporate underpayments. Under Code Sec. 6621(c)(3)(A), a large corporate underpayment is an underpayment by a C corporation that exceeds $100,000. Medical College argued this definition of a corporation as a C corporation also applied to Code Sec. 6621(a). To support this argument, the hospital cited the statutory rule of construction that a word means the same thing throughout a statutory section. According to Medical College, as a nonprofit, it was not a C corporation, and if it was not a C corporation, it was not a corporation under Code Sec. 6621(a).

The Seventh Circuit rejected this argument and affirmed the lower court ruling. The court noted that the same issue had been decided by the Second Circuit in Maimonides Medical Center v. U.S., 2015 PTC 456 (2d Cir. 2015) and by the Sixth Circuit in U.S. v. Detroit Medical Center, 2016 PTC 315 (6th Cir. 2016) and found those decisions persuasive.

First, the court disagreed with Medical College's conclusion that a nonprofit corporation is not a C corporation, pointing out that a C corporation is defined under Code Sec. 1361(a)(2) as any corporation that is not an S corporation. Even if Medical College was correct, however, the court did not agree that the definition of a corporation under Code Sec. 6621(a) was limited to a C corporation by Code Sec. 6621(c)(3)(A).

The court noted that Code Sec. 6621(c)(3)(A) does not purport to define "corporation." Rather, it defines "large corporate underpayment" as an underpayment of more than $100,000 by a C corporation. Code Sec. 6621(c)(3)(A), the court found, does not say or imply that every reference to "corporation" in Code Sec. 6621 is to a C corporation. Rather, in the court's view, the use of the word "corporation" in Code Sec. 6621(a) and "C corporation" in Code Sec. 6621(c)(3)(A) implies that a different meaning was intended. The court also called attention to the limiting language in Code Sec. 6621(c)(3), which states that its definitions apply "for purposes of this subsection," meaning that the reference to a C corporation applies only with regard to large corporate underpayments. Finally, the court also found it relevant that Code Sec. 6621(a) uses the definition of "taxable period" from Code Sec. 6621(c)(3). That this is the only reference in Code Sec. 6621(a) to Code Sec. 6621(c)(3) meant, in the court's view, that the rest of Code Sec. 6621(c)(3) applies only to large corporate underpayments, and not to an overpayment.

For a discussion of the interest rate applicable to overpayments and underpayments, see Parker Tax ¶262,110.

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Appeals Court Affirms Disbarment of Attorney by Tax Court

The District of Columbia Court of Appeals held that it had jurisdiction to review the Tax Court's order disbarring an attorney, and it affirmed the order. The attorney's arguments that the Tax Court violated his procedural and substantive due process rights were rejected. Aka v. U.S. Tax Court, 2017 PTC 181 (D.C. Cir. 2017).

In 2009, Wilfred Aka was hired by Martin Kyere to challenge the amount the IRS said Kyere owed in unpaid taxes. Aka filed a petition for redetermination of the notice of deficiency on Kyere's behalf. Aka then failed to appear for a discovery conference, failed to give opposing counsel key documents, and did not appear at the trial. Aka's response to the Tax Court's order to show cause why he should not be disciplined was that he believed he no longer represented Kyere after Kyere failed to pay him on time. The Tax Court rejected that argument and reprimanded Aka for failing to uphold his duties to his client, to opposing counsel, and to the court. The Tax Court decided not to disbar him at that time because he had no prior disciplinary record, showed no bad faith, and was cooperative in the disciplinary proceedings.

Three years later, the Tax Court again ordered Aka to show cause why he should not be disciplined after Aka was accused of similar misconduct in seven other cases. Aka disputed no material facts but blamed his clients for hampering his work on their behalf. The Tax Court found that even if his clients were uncooperative, Aka was still at fault for shirking his duties to opposing counsel and the court. The Tax Court disbarred Aka for willfully violating the Tax Court's orders and rules, and a month later, the Tax Court denied his motion to vacate or modify its disbarment order.

Aka appealed his disbarment to the D.C. Circuit Court, arguing that the disbarment order should be vacated or, in the alternative, that the Tax Court should be compelled to offer steps Aka could take to be reinstated. Aka said the Tax Court's disbarment order violated his procedural and substantive due process rights. The Appeals Court rejected these arguments and affirmed the Tax Court.

First, the court considered whether it had jurisdiction to review the Tax Court's disbarment order and concluded that it did. Code Sec. 7482 gives federal courts of appeals jurisdiction over decisions of the Tax Court. In determining what constitutes a Tax Court decision, the court noted that Code Sec. 7459, which explains how to determine the date of entry of a Tax Court decision, mentions only declaratory judgments and orders specifying how much a taxpayer owes. The Court of Appeals found that Code Sec. 7459 was not intended to limit appellate jurisdiction. It also noted that it had previously held that Code Sec. 7482 was the controlling provision for appellate review. Under Code Sec. 7482, finality of a Tax Court order is the test for jurisdiction, and in the court's view, a disbarment order was a final order.

Next, the court considered and rejected Aka's due process arguments. The D.C. Circuit said that due process requires a court pursuing disbarment to give attorneys fair notice and a chance to be heard, and to follow its published rules for disbarment proceedings. Aka did not deny that the court satisfied these requirements, but argued that the Tax Court deprived him of due process by failing to lay out steps for his reinstatement. The D.C. Circuit found that due process did not require such guidance, and further, that the Tax Court has in fact published general conditions for reinstatement. Aka's substantive due process claim was that the Tax Court violated his rights by disbarring him absent evidence that he had committed any crime. The court determined that substantive due process protects fundamental liberties and held that there is no substantive due process right to bar membership or against unduly harsh disbarment.

For a discussion of the Tax Court's authority to disbar an attorney, see Parker Tax ¶274,120.

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Questions Exist as to Whether CEO Willfully Failed to File an Accurate FBAR; Summary Judgment Denied

A district court denied summary judgment and held that a question of fact existed as to whether an individual willfully failed to file a Report of Foreign Bank and Financial Accounts (FBAR) with respect to one of his two Swiss bank accounts. According to the court, the taxpayer's testimony regarding the information provided to him by his long-time CPA and what exactly he did with that information, if anything, would be relevant to a determination of his intent. Bedrosian v. IRS, 2017 PTC 180 (E.D. Pa. 2017).

Arthur Bedrosian is a U.S. citizen and the chief executive officer of a manufacturer and distributor of generic medications. Bedrosian opened a savings account with Swiss Credit Corporation, a Swiss bank, in the 1970s. The account was transferred to UBS when UBS acquired Swiss Credit Corporation. As early as 2005, a second account was added. The account number for the first account ended in 6167; the second ended in 5316. Bedrosian met with a UBS banker approximately once a year to review the performance of the accounts. During 2007, the year at issue, both accounts had balances significantly in excess of $10,000. Bedrosian closed both accounts in 2008. He transferred the assets in the account ending in 6167 to another Swiss bank account and the assets for the account ending in 5316 to a domestic bank account.

Throughout the decades, Bedrosian had his accountant, Seymour Handleman, prepare his tax returns. He did not tell Handleman about the UBS accounts until the 1990s. Handleman told him that he should have been reporting the accounts on his tax returns, but that he should not start reporting them because, on Bedrosian's death, the assets would be repatriated as part of his estate and the taxes would be paid at that time. Bedrosian did not report either account until 2007, when Handleman died and Bedrosian hired a new accountant.

Bedrosian's 2007 return reflected, for the first time, that he had assets in a foreign account in Switzerland. Bedrosian also filed a Report of Foreign Bank and Financial Accounts (FBAR) for 2007. However, he reported only the existence of the account ending in 5316, which had assets of approximately $240,000. He did not report the other account, which had assets of approximately $2.3 million. Bedrosian did not report any of the income earned on either account on his 2007 return.

Sometime after 2008, UBS told Bedrosian that it would be providing his account information to the IRS. Before the IRS began its investigation, Bedrosian hired an attorney to determine Bedrosian's reporting obligations. In 2010, Bedrosian filed an amended 2007 return and reported approximately $220,000 of income from the UBS accounts. He also filed an amended FBAR for 2007 on which he reported both UBS accounts.

The IRS began investigating Bedrosian in 2011. In 2013, the IRS notified Bedrosian that it was imposing a penalty of approximately $975,000 for Bedrosian's willful failure to file an FBAR for 2007. The proposed penalty was 50 percent of the maximum value of the account and therefore the largest penalty possible under the regulations.

Bedrosian sued the IRS in 2015, claiming that the IRS had imposed an unwarranted penalty on him resulting in an illegal exaction. In late 2016, both parties moved for summary judgment. The district court denied both parties' motions and held that a question of material fact existed as to whether, under 31 U.S.C. Section 5321, Bedrosian had willfully failed to file an FBAR for his second UBS account.

Under 31 U.S.C. Section 5314, a U.S. citizen must annually file an FBAR to report any financial interest in or signature authority over a foreign bank account. A penalty is imposed under 31 U.S.C. Section 5321 for failing to file an FBAR if the taxpayer's interest in a foreign account exceeds $10,000. The penalty for non-willful failure to file an FBAR cannot exceed $10,000. For willful failures, the penalty is the greater of $100,000 or 50 percent of the account balance at the time of the violation.

The district court began by noting that the term "willful" as used in 31 U.S.C. Sec. 5321, a civil penalty provision, is not clearly defined. Bedrosian argued that the definition of willfulness that applies in the criminal tax penalty context should apply. That standard requires the voluntary, intentional violation of a known legal duty.

The district court ultimately sidestepped the issue and did not articulate a definition of willfulness under 31 U.S.C. Section 5321. It noted that the decisions of other courts considering the issue had concluded that willfulness under that provision means either a knowing or reckless violation. The court also said that it was highly skeptical that the criminal definition should apply in the case of a civil penalty for the failure to file an FBAR. The court concluded by asserting that the jurisprudential trend is toward a definition of willfulness that includes reckless violations.

Under either standard, the court found that whether Bedrosian willfully failed to file an FBAR for 2007 is an inherently factual question. Genuine disputes existed, the court said, as to the extent and timing of Bedrosian's knowledge about his reporting requirements. Further, although 31 U.S.C. Section 5321 does not provide a reasonable cause defense, the court thought that the advice from Handleman would be relevant in determining Bedrosian's intent. For these reasons, summary judgment was denied.

For a discussion of FBAR reporting requirements, see Parker Tax ¶203,170.