Federal Tax Bulletin - Issue 137 - April 3, 2017

Nonresident Aliens' U.S. Summer Jobs Don't Qualify as "Away From Home"; No Deduction Allowed for Travel Expenses

The Tax Court held, in an issue of first impression, that nonresident alien individuals working summer jobs obtained through the U.S. Department of State's Summer Work Travel Program were not "away from home" for purposes of Code Sec. 162(a)(2), and therefore were not permitted to deduct travel and living expenses they paid in connection with the program. The individuals were, however, permitted to deduct expenses for travel health insurance to the extent those expenses satisfied the requirements of Code Sec. 213(a). Liljeberg v. Comm'r, 148 T.C. No. 6 (2017).

Background

In 2012, Richard Liljeberg, Anna Zolotareva, and Enda Conway, foreign nationals and full-time students at foreign universities, participated in the U.S. Department of State's Summer Work Travel Program (SWTP). The program facilitates educational and cultural exchanges in order to increase mutual understanding between the people of the United States and of other countries and assist the Department of State in furthering its foreign policy objectives. All three participants were issued J visas, a nonimmigrant visa issued to an alien who has no intention of abandoning his or her foreign residence. The participants lived in and were citizens of Finland, Russia, and Ireland, respectively. Each worked summer jobs under the four-month program and travelled while in the U.S. Liljeberg worked as a lifeguard in the Wisconsin Dells, Zolotareva worked as a housekeeper in the State of Washington, and Conway worked as a restaurant server in New York.

All of the participants were full-time students in their home countries in 2012. Zolotareva and Conway had no business connections with their home countries during the SWTP. Liljeberg was employed part-time as a security guard in Finland but quit that job before arriving in the U.S. and did not resume it on his return. Liljeberg lived with his mother before coming to the U.S. and in a rental home upon his return to Finland. Zolotareva lived with her parents in Russia before coming to the U.S. and after she returned home later in 2012; she did not pay rent or utilities. Conway lived with his mother in Ireland and sent money to her during the program to maintain his home there. All three maintained driver's licenses and voter registrations in their home countries.

Each participant filed a Form 1040NR, U.S. Nonresident Alien Tax Return, for 2012 and claimed unreimbursed employee expense deductions for expenses incurred to travel to and from the U.S. and for travel medical insurance. In addition, Conway claimed a deduction for meal and entertainment expenses. Other expenses initially claimed as deductions were the subject of concessions by the parties and were not at issue.

Analysis

Nonresident aliens are subject under Code Sec. 871 to U.S. federal income tax on income that is effectively connected with the conduct of a U.S. trade or business. J visa holders are treated as nonresident alien individuals engaged in a U.S. trade or business under Code Sec. 871(c). Code Sec. 873(a) permits nonresident aliens to take deductions only if, and to the extent to which, they are connected with income that is effectively connected with the conduct of a U.S. trade or business.

Deductions are generally not permitted for personal, living or family expenses. However, under Code Sec. 162(a)(2), a deduction is permitted for ordinary and necessary business expenses incurred while the taxpayer is traveling away from home. Home is generally defined for these purposes as the vicinity of the taxpayer's principal place of employment, not where his or her personal residence is located, although an exception applies for temporary employment. Under Peurifoy v. Comm'r, 358 U.S. 59 (1958), the location of a personal residence may be claimed as a taxpayer's home if the taxpayer is away from home on a temporary, rather than indefinite or permanent basis.

A temporary absence alone does not make a personal residence a tax home. The taxpayer must have a business reason to maintain a distant, separate residence. For example, in Hantzis v. Comm'r, 638 F.2d 248 (1st Cir. 1981), a student attending law school in Boston was not permitted to deduct the expenses of maintaining a residence in Boston during a summer job in New York because her reasons for keeping the Boston residence were solely personal in nature. Thus, for temporary employment, the tax home is the location of the temporary job, and the taxpayer is not away from home for purposes of Code Sec. 162(a)(2) unless business exigencies require the maintenance of the separate residence. The purpose of this rule is to mitigate the burden on a taxpayer who, for business reasons, must maintain two places of abode and incur additional and duplicate living expenses.

The issue before the Tax Court was the location of the SWTP participants' homes for tax purposes during the SWTP. If their homes abroad were their tax homes for purposes of Code Sec. 162, then the away-from-home requirement would be satisfied and the travel and living expense deductions permitted. However, if their summer job sites constituted their tax homes, then the participants were not away from home and could not deduct the expenses associated with the SWTP.

Students' Arguments

The SWTP participants argued that, under the terms of their visas, they were permitted to stay in the U.S. no longer than four months and had to maintain residences abroad. Moreover, their employers benefitted from their keeping homes abroad because the employers could therefore legally employ them and recognize employment tax savings, among other benefits. By maintaining close links to their home countries (driver's licenses, voter registrations, etc.) and intending to return at the end of the SWTP, the participants asserted that their tax homes were in their respective home countries. In the participants' view, they were engaged in the temporary business of being employees in the U.S. and should be allowed to deduct their ordinary and necessary business expenses while away from home. They argued that, under Peurifoy, because their work was temporary, they did not need to show the existence of business exigencies or that they were employed or otherwise engaged in a trade or business before accepting temporary work at a second location. Regarding health insurance, the participants argued that the travel insurance they purchased was not only in furtherance of their trade or business but was required as a condition of procuring a J visa and as a condition of their participation in the SWTP and thus their employment. They therefore asserted that the travel health insurance expenses were also deductible under Code Sec. 162.

IRS's Position

In the view of the IRS, each SWTP participant had a principal place of business at the location of their summer job in the U.S. Their tax homes were therefore in the U.S. and not their home countries. The participants were all full-time students during 2012, and pursuing an education full-time is not a trade or business. Zolotareva and Conway were not employed in their home countries, and although Liljeberg had been employed part time in Finland, he quit that job before coming to the U.S. and did not return to it after the SWTP ended.

The IRS argued that in the case of temporary work, the taxpayer must have a business rather than personal reason for living in two places, and the SWTP participants did not have business reasons for maintaining personal residences in their home countries. Given that the purpose of the rule allowing deductions for travel away from home is to lessen a taxpayer's burden of maintaining two residences when required to do so by their trade or business, the IRS pointed out that neither Liljeberg nor Zolotareva had incurred any such duplicate expenses and, although Conway did send money home to his mother, he had failed to demonstrate he incurred any substantial living expenses. Finally, with regard to travel health insurance, the IRS asserted that those expenses were deductible only under Code Sec. 213(a), to the extent they exceed 10 percent of the taxpayer's adjusted gross income.

Tax Court's Decision

The Tax Court followed the Hantzis decision in holding that, because no business reason existed for keeping homes abroad, the SWTP participants could not deduct the travel and living expenses paid in connection with their participation in the SWTP. None of the participants had business connections with their home countries during the SWTP; therefore, they could not have been away from home in 2012 for purposes of Code Sec 162(a)(2). The fact that their visas required them to keep a foreign residence, the court said, did not mean their foreign residence qualified as a home for tax purposes, as no immigration law specifically required the keeping of a second home or the incurring of duplicate living expenses. Nor was there any contractual obligation with any party that required the SWTP participants to keep a second home. To the extent the participants incurred any expenses to maintain a residence in their home countries, those expenses were by their personal choice and not by a dictate of their employers or the law.

On the issue of health insurance, the Tax Court ruled that the participants could deduct the costs of health insurance under Code Sec. 213(a), but not under Code Sec. 162. The fact that health insurance is required by an employer or a provision of law is irrelevant; as an inherently personal expense, the cost of health insurance is deductible only to the extent permitted under Code Sec. 213(a).

For a discussion of the rules for deducting travel expenses when "away from home," see Parker Tax ¶91,105.

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Second Circuit Reverses Imposition of Accuracy-Related Penalty; IRS Did Not Obtain Supervisory Approval

The Second Circuit held that a taxpayer should have been permitted to raise as a defense to the imposition of an accuracy-related penalty by the IRS the fact that the IRS failed to obtain the written supervisory approval required under Code Sec. 6751 before assessing the penalty. The court also registered its disapproval with a divided 2016 Tax Court opinion which reached the opposite conclusion on the same issue, possibly signaling a shift in how much the courts will scrutinize IRS procedures used in assessing penalties against a taxpayer. Chai v. Comm'r, 2017 PTC 124 (2d Cir. 2017).

Facts

Jason Chai is an architect who was involved in at least 131 tax shelter arrangements. In 2003, he received a $2 million bonus payment from Delta Currency Trading, LLC, one of several corporations set up to market and advise the tax shelters. The payment was reported on Form 1099 for 2003, but Chai did not include the amount in taxable income. He took the position that it constituted the return of capital from his tax shelter investments. Chai's 2003 tax return also showed an overall loss of $11.5 million, consisting mostly of tax shelter partnership losses.

The IRS audited Chai's 2003 tax return and characterized the $2 million payment as self-employment income and asserted a deficiency in Chai's self-employment tax. The IRS also assessed a 20 percent accuracy-related penalty. Assessments relating to additional income tax were postponed due to partnership audit proceedings relating to the tax shelters that had to be completed before any income tax could be assessed. Chai took his case to the Tax Court.

Tax Court's Decision

Before the Tax Court, Chai argued that the $2 million payment was a return on investment and not compensation and, thus, was not subject to self-employment tax. Chai asserted that, as an investor, he agreed to serve as an accommodating party only in the hope of reaping investment gains. The Tax Court rejected this argument and said it was quite clear that Chai's primary purpose was to earn compensation in exchange for his services as an accommodating party.

Chai also argued that the IRS failed to meet its burden with respect to the imposition of the accuracy-related penalty. Specifically, he argued, compliance with Code Sec. 6751(b)(1)'s written-approval requirement was part of the IRS's burden of production to demonstrate compliance with that requirement in imposing the penalty. Because the issue was raised for the first time post-trial, the Tax Court declined to consider the argument, finding it untimely and that the IRS would be prejudiced by its consideration.

Code Sec. 6751(a) provides that the IRS must include with each penalty notice information with respect to the name of the penalty, the Code section under which the penalty is imposed, and a computation of the penalty. Code Sec. 6751(b)(1) generally requires supervisory approval of the initial determination of a penalty assessment. Specifically, it provides that no penalty can be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Treasury Secretary may designate. However, Code Sec. 6751(b)(2)(A) provides that this rule does not apply to Code Secs. 6651, 6654, or 6655 penalties and Code Sec. 6751(b)(2)(B) provides that this rule doesn't apply to any other penalty automatically calculated through electronic means.

Chai appealed both holdings to the Second Circuit.

On appeal, the IRS offered two arguments with respect to the Code Sec. 6751 issue. First, it said that written approval was not required under the exception in Code Sec. 6751(b)(2)(B) for penalties assessed by electronic means. Second, it argued that the Tax Court had not abused its discretion in declining to consider Chai's post-trial argument because, under Graev v. Comm'r, 147 T.C. 16 (2016), it would have been premature to challenge the IRS's failure to satisfy its written-approval requirement until the Tax Court's decision on the penalty had become final. The IRS also cited the Internal Revenue Manual which, it said, instructs IRS personnel that a penalty is calculated by electronic means if the penalty is assessed free of any independent determination by an IRS employee as to whether the penalty should be imposed.

Citing the majority opinion in Graev, the IRS said Chai could not argue that the IRS failed to satisfy its written approval obligation under Code Sec. 6751(b)(1) until after the Tax Court's decision on the penalty became final and the IRS assessed the penalty. The Graev majority held that the written approval required by Code Sec. 6751 may be obtained at any time before the penalty is assessed, although five dissenters concluded that the written approval must be obtained prior to the initiation of Tax Court proceedings regarding penalties. The Graev majority found the absence of a time requirement to, unambiguously, mean that the written approval may be obtained at some, but no particular, time prior to assessment.

Second Circuit's Decision

The Second Circuit affirmed the Tax Court's order upholding the self-employment tax deficiency. However, it reversed the Tax Court's order upholding the accuracy-related penalty finding that the IRS was required to obtain written supervisory approval before issuing the notice of deficiency and did not do so.

First, the court determined that Chai's penalty did not fall within the exception to the written supervisory approval requirement for penalties automatically calculated through electronic means. The court found no evidence that the penalty, which under Code Sec. 6662(b) can be attributable to one or a combination of causes, was or could have been made electronically. To the contrary, there was evidence that the penalty determinations were made either by an IRS manager or a revenue agent working under the manager's authority.

Second, the court found that the IRS was required under Code Sec. 6751(b)(1) to show that it obtained written supervisory approval of the initial penalty determination no later than the date the IRS issued the notice of deficiency, or filed an answer or amended answer asserting the penalty. The court determined that compliance with Code Sec. 6751(b) is part of the IRS's burden of production and proof in a deficiency case in which a penalty is asserted, and that the IRS failed to meet its burden with respect to the accuracy-related penalty it sought to impose on Chai.

Finding the language of Code Sec. 6751(b) ambiguous and reviewing the legislative history to determine Congress's intent, the Second Circuit agreed with the Graev dissenters. Where the Graev majority found the absence of a time requirement to, unambiguously, mean that the written approval required in Code Sec. 6751(a) may be obtained at some, but no particular, time prior to assessment, the Second Circuit disagreed. Because "the assessment" is the formal recording of a taxpayer's tax liability in the IRS's records, the court said, it is essentially the last of a number of steps before the IRS can collect a deficiency. Thus, the court found the term "initial determination of such assessment" in Code Sec. 6751(b)(1) to be ambiguous. The IRS can determine a deficiency, the court said, but it cannot determine an assessment.

The court noted that Code Sec. 6751(b)(1) says that no penalty can be assessed unless the "initial determination of such assessment" is approved in writing by a supervisor. On its face, the court said, the statute does not require the approval at any particular time before assessment.

Turning to Congress's intent, the court found that the purpose of the statute is to prevent IRS agents from threatening unjustified penalties in order to encourage taxpayers to settle. But, as the Graev dissent pointed out, once an unapproved penalty has been upheld by the Tax Court, the supervisor's approval of the initial determination would add nothing to the process, and such approval in a case where the Tax Court had held the taxpayer not liable for the penalty would be completely moot. Nor, the Second Court noted, would the Tax Court's decision to uphold a penalty determination be sufficient to solve the problem. The IRS could still use the threat of penalties as a bargaining chip in settlement negotiations. If successful, the Tax Court would be none the wiser since the taxpayer would have settled rather than file a Tax Court petition to litigate the propriety of the penalty.

The court also reasoned that if supervisory approval is required, it must be obtained when the supervisor has the discretion to give or withhold it. Once the Tax Court decision is final, that discretion is lost because at that point, Code Sec. 6215(a) provides that the entire amount redetermined as the deficiency "shall" be assessed. Moreover, for the supervisor's approval to be given force, it must be issued not merely before the Tax Court proceeding ends but before it is initiated. Code Sec. 6751(b) requires supervisory approval of the "initial" determination. The statute would not make sense, the court said, if it permitted written approval of the initial determination up until and even contemporaneously with the IRS's final determination, because the IRS might still have discretion during the proceeding to concede a penalty.

According to the court, the last moment the approval of the initial determination actually matters is immediately before the taxpayer files suit or penalties are asserted in a proceeding. And, because a taxpayer can file a petition at any time after receiving notice of a deficiency, the truly consequential moment of approval is the IRS's issuance of the notice of deficiency, or the filing of an answer or amended answer asserting penalties. The court thus held that Code Sec. 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency, or files an answer or amended answer, asserting the penalty.

For a discussion of the procedural requirements for computing penalties, see Parker Tax ¶262,195.

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Administrative Tasks Don't Count Towards 39-Week Moving Expense Deduction Requirement

The Tax Court held that a married couple was not entitled to deduct over $17,000 in moving expenses because the husband was not a full-time employee at his new place of employment for at least 39 weeks following the couple's move from Pennsylvania to California. The court rejected the couple's argument that routine preliminary administrative tasks performed by the husband before his official start date started the clock running on the 39-week requirement. Anderson v. Comm'r, T.C. Summary 2017-17.

Christopher and Sandra Anderson moved from Pennsylvania to California on March 7, 2012, incurring $17,415 in moving expenses. On June 7 of that year, Mr. Anderson signed an employment agreement with DLC, a consulting firm, stating that full-time employment would begin on July 16 and continue for one year. The contract contained a nonsolicitation clause prohibiting Anderson from performing services for DLC's clients other than through DLC during the term of the agreement and for one year after its termination, expiration, or cancellation. It also stated that it contained the entire agreement between the parties and that any modifications had to be set forth in a signed document.

Shortly after the June 7 signing of the agreement, Mr. Anderson assisted DLC in assembling marketing materials highlighting his background and experience. He also participated in employee training programs. The Andersons took a 10-day family vacation later that month. Mr. Anderson did not begin providing consulting services to DLC's clients until July 16, the contract start date. He received his first paycheck on July 27, compensating him for work performed during the two-week period ending July 22.

Code Sec. 217(a) permits a deduction for moving expenses paid or incurred during the tax year in connection with the commencement of work by a taxpayer as an employee at a new principal place of work. To qualify for the deduction, the taxpayer must, under Code Sec. 217(c), be employed full time in the general location of the new principal place of work for at least 39 weeks during the 12-month period immediately following the taxpayer's arrival in the new location. Given that Mr. Anderson arrived in California on March 7, he had to have worked as a full-time employee for at least 39 weeks over the 12-month period beginning on that date.

The Andersons argued that Mr. Anderson satisfied the 39-week requirement because he became a full-time employee when he signed the employment contract on June 7. They contended that as of June 7, Mr. Anderson could not seek alternative employment opportunities, and that DLC treated him as a full-time employee by asking for his assistance in preparing marketing materials and engaging in training activities. The IRS asserted that Mr. Anderson was not an employee of DLC, full-time or otherwise, until July 16 as provided in the employment agreement.

The Tax Court agreed with the IRS and found that, in light of the employment agreement and DLC's payroll records, Mr. Anderson first became a full-time employee on July 16. The employment contract stated that it began on that date and that it contained the entire agreement between the parties. Further, Mr. Anderson acknowledged that he first provided consulting services to DLC's clients, was first added to DLC's payroll, and first became eligible for employee benefits on July 16.

The court also found no support for the Andersons' contention that Mr. Anderson was barred from seeking other employment as of the June 7 contract signing date; the terms of the nonsolicitation agreement stated that it was not effective until July 16. The Andersons' contention that Mr. Anderson should be considered a full-time employee because DLC requested his assistance with marketing materials and his participation in training activities was unpersuasive. The court noted that employment generally begins when the employer is under an obligation to pay the employee, and there was no evidence to show that DLC was obliged, nor that Mr. Anderson expected, to be paid for these routine preliminary administrative tasks.

For a discussion of the requirements that must be met in order to deduct moving expenses, see Parker Tax ¶80,505.

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Disbarred Attorney Isn't Subject to IRS Oversight With Respect to Tax Return Prep

A district court held that the IRS Office of Professional Responsibility (OPR) did not have jurisdiction over a tax preparer and disbarred attorney who offered to write a written memorandum to a taxpayer about the manner in which she may want to file her taxes. He was not a representative of persons before the IRS. Sexton v. Hawkins, 2017 PTC 134 (D. Nev. 2017).

James Sexton Jr. is a former attorney who was disbarred from practice in South Carolina after pleading guilty in 2005 to four counts of mail fraud and one count of money laundering. In 2008, he was also suspended by the IRS Office of Professional Responsibility (OPR) from practicing before the IRS. Prior to and during his suspension, Sexton provided tax return preparation services for individual clients.

In 2012, Sexton was the subject of an OPR complaint by a former client whose individual tax returns he prepared for 2010 and 2011. He had also offered to send a written memorandum analyzing the client's options regarding her business's tax obligations but, upon learning of Sexton's disbarment, the client fired him and filed the OPR complaint. OPR then initiated an investigation of whether Sexton was violating his suspension from practicing before the IRS. OPR sent requests for disclosures regarding Sexton's background and detailed information on his business, as well as requests for documents provided by Sexton to clients relating to the preparation of tax returns.

Sexton sued for declaratory and injunctive relief, arguing that the IRS's authority does not extend to individuals who are not representatives before the IRS and, therefore, the IRS lacked jurisdiction over him.

The IRS is authorized under 31 U.S. C. Section 330, also known as Circular 230, to regulate the practice of representatives of persons before the IRS. The IRS argued that its authority and jurisdiction extend to tax professionals who are not authorized to practice before the IRS because they are suspended from practice before the IRS. Further, it asserted that it has jurisdiction under 31 U.S.C. Section 330 over tax professionals who provide written tax advice, regardless of whether they represent clients in a typical tax controversy before the IRS.

Sexton argued that, consistent with the analysis of the D.C. Circuit in Loving v. I.R.S., 2014 PTC 73 (D.C. Cir. 2014), the authority of the IRS does not extend to individuals who are not representatives of persons before the IRS, and that therefore the IRS lacks jurisdiction over Sexton. In Loving, the D.C. Circuit addressed the question of whether the IRS's authority to regulate the practice of representatives of persons before the Department of the Treasury encompasses authority to regulate tax-return preparers like Sexton. The D.C. Circuit answered in the negative, finding that tax preparers are not representatives under Circular 230 and that preparing and signing tax returns are not considered as practice before the Treasury Department. The term "practice before" an agency, the court said, ordinarily refers to practice during an investigation, adversarial hearing or other adjudicative proceeding, and merely preparing and signing a tax return does not meet this standard.

Following Loving, the district court found that Sexton was not subject to the IRS's regulatory authority under 31 U.S.C. Section 330. First, the court found no support for the IRS's argument that the statute creates an inherent jurisdiction or authority over former practitioners who are not authorized to practice before the IRS because of a suspension from practice for misconduct. Second, the court rejected the IRS's argument that 31 U.S.C. Section 330 extends to tax professionals who offer written tax advice regardless of whether they represent clients in a tax controversy. The court did not find persuasive or controlling the pre-Loving decisions cited by the IRS. Nor did the court agree with the IRS's attempt to distinguish Loving on the basis that the taxpayers in that case were tax return preparers who were not in the business of authoring written tax opinions; rather, the court found that Loving supported a narrow reading of 31 U.S.C. Section 330. The court further read the statute to authorize the IRS to impose standards on the rendering of written tax advice, but not to sanction such advice or the offering of it. Having already determined under Loving that practice before the IRS means practice during an investigation, adversarial hearing, or adjudicative proceeding, the district court found the work of tax preparers is not covered by this definition and that the plain language of the statute did not support the IRS's more expansive reading.

Finally, because Congress had created a separate regulatory scheme directly related to tax preparers under Code Secs. 6694, 6695, and 6713, the court found that Congress did not intend for 31 U.S.C. Section 330 to authorize the IRS to separately regulate tax preparers. There was no authority to support the IRS's argument that written advice need not be given in the context of an actual proceeding or investigation by the IRS. Finally, the court noted that Sexton only offered to provide written advice, but did not actually do so.

For a discussion of the Loving case as it relates to the regulation of tax practice by the IRS, see Parker Tax ¶270,101.

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Proposed Revenue Procedure Addresses Changes Relating to New FASB Standards

The IRS issued proposed guidance on procedures for requesting consent to change an accounting method where the change is made as a result of, or directly related to, the adoption of new financial accounting standards relating to the accounting for revenue from contracts with customers. For many entities, the new standards are effective for annual reporting periods beginning after December 15, 2018; however, for publicly-traded entities, certain not-for-profit entities, and certain employee benefit plans, the standard are effective for annual reporting periods beginning after December 15, 2017. Notice 2017-17.

On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) jointly announced new financial accounting standards for recognizing revenue (new standards), titled "Revenue from Contracts with Customers." The new standards are effective for publicly-traded entities, certain not-for-profit entities, and certain employee benefit plans for annual reporting periods beginning after December 15, 2017. For all other entities, the new standards are effective for annual reporting periods beginning after December 15, 2018. Early adoption is allowed for reporting periods beginning after December 15, 2016.

Since the joint announcement, FASB and IASB have revised the new standards and provided guidance on how to implement the new standards in certain situations. In 2015, the IRS issued Notice 2015-40, which requested comments on federal tax accounting issues relating to the adoption of the new standards, including, whether the new standards are permissible methods of accounting for federal income tax purposes, the types of accounting method change requests that might result from adopting the new standards, and whether the current procedures for obtaining IRS consent to change a method of accounting are adequate to accommodate those requests.

According to the IRS, very few comments were received. Some practitioners requested additional time to respond and others reported that, as a result of adopting the new standards, taxpayers might request multiple accounting method changes.

The IRS has now issued Notice 2017-17, which addresses only the procedures for obtaining IRS consent to a qualifying same-year method change. The IRS continues to seek comments on issues of conformity between the new standards and the Code and regulations, and are considering addressing these issues in separate guidance. Qualifying same-year method changes may include automatic changes for which existing guidance, including Rev. Proc. 2015-13 and Rev. Proc. 2016-29, already provides automatic change procedures. Taxpayers requesting consent for automatic changes for which existing guidance already provides automatic change procedures must use the existing automatic change procedures to make a request. For qualifying same-year method changes for which existing guidance does not provide automatic change procedures but which comply with Code Sec. 451 or other guidance regarding the tax year of inclusion of income, the taxpayer must make the change under the proposed revenue procedure described in Notice 2017-17.

The IRS noted that the adoption of the new standards may create or increase differences between financial accounting and tax accounting rules. Practitioners have been concerned about whether the new standards are permissible methods of accounting that may be used for federal income tax purposes. Accordingly, the IRS is continuing to seek comments on the specific issues identified in Notice 2015-40 regarding conformity between the new standards and the Code and the regulations. Notice 2017-17 lists the specific questions to which the IRS is seeking practitioner input.

For a discussion of criteria that must be met to make an accounting method change, see Parker Tax ¶241,590.

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Court Rejects IRS Attempt to Recover Home Sale Proceeds from Debtor's Wife

The First Circuit affirmed a district court holding that half of the proceeds from the sale of a couple's home, in order to pay a tax judgment against the husband, could be retained by the wife rather than turned over to the IRS. However, with respect to the 50/50 allocation of funds directly traceable to the husband's tax shelter which led to the judgment, the court vacated and remanded the lower court's decision so the lower court could specifically consider the 14 factors required under Massachusetts law when dividing up certain property. U.S. v. Baker, 2017 PTC 145 (1st Cir. 2017).

Background

In December 2002, Scott Baker and his business partner sold eight Planet Fitness gyms to Bally Fitness for approximately $15 million, including Bally Fitness stock that he later sold for $3.4 million. He used a Son-of-BOSS tax shelter to reduce his taxable income on gains from the Planet Fitness sale, and reported a $2.5 million loss on his 2002 return, which he filed separately from his wife, Robyn. Scott then amended his tax returns for 1997-2001 to carry back the loss, leading the IRS to refund virtually all of the taxes that Scott and his wife had paid in the years 1999-2001.

Scott deposited the proceeds from the sale of the Bally Fitness stock into a Cayman Islands family trust. He instructed the trustee to invest the corpus of the family trust into a hedge fund called International Management Associates (IMA). Late in 2005, the Bakers learned that IMA was in fact a Ponzi scheme and that all of the money had disappeared.

In August of 2005, the Bakers bought a house in Hingham, Massachusetts, which they owned as tenants by the entirety, for just over $1.6 million. In the same month, the IRS began an audit of Scott Baker's 2002 tax return.

In February 2007, the Bakers remortgaged their Hingham property with Scott as the sole mortgagor; on the same day, they established the S&R Realty Trust with Robyn as trustee and transferred the title of their Hingham property into the trust. They also established the C&S Realty Trust on the same day, with Robyn as sole trustee and their two children as primary beneficiaries, and transferred into it a beach house located in Scituate, Massachusetts. Scott did not receive any consideration for transferring his interests in the properties to the trusts. In November 2007, Robyn sold the Scituate property and deposited the $433,000 in proceeds into a South Shore Bank account owned by C&S Trust. She used the majority of the money to pay down loans secured by the Hingham property, and the remainder on living expenses.

On January 10, 2008, the Bakers signed a separation agreement, and the following day they filed for divorce. The agreement, which was incorporated into the final divorce judgment, gave most of the assets to Robyn, but most of the liabilities to Scott. The agreement stipulated that Scott could continue to live in the Hingham property, and he did so after the divorce became final in May of 2008. After the divorce, Robyn continued to refer to Scott as her husband, though she testified at trial that those references were mistakes or oversights.

Following an income tax judgment for over $5 million dollars against Scott in 2015, there was a dispute as to whether, and to what extent, the IRS's tax liens attached to certain assets. After a district court set aside the Bakers' separation agreement as a fraudulent transfer, it proceeded to re-divide and reallocate these assets applying Massachusetts law. The IRS's tax liens attached directly to any assets allocated to Scott. The IRS also argued that its tax liens attached indirectly to certain assets allocated to Robyn. The court determined the allocation of the following assets between Scott and Robyn: (1) funds that were directly traceable to Scott's tax shelter (i.e., the "Escrowed Funds"); and (2) a property the couple owned in Hingham, Massachusetts (i.e., the "Hingham property").

The district court divided both assets more or less evenly, reasoning that it was applying an equitable 50/50 division of the couple's assets consistent with the common-law community property system adopted by Massachusetts and recognized as valid by the IRS. In order to effectuate this division as to the Hingham property, the court ordered it to be sold and half the proceeds to be paid to the IRS and half to Robyn. The IRS had argued that it was entitled to Robyn's half of the proceeds from the sale of the Hingham property on a lien-tracing theory. The district court rejected this theory on the ground that the IRS had not submitted evidence sufficient to trace the liens with the required level of specificity. The IRS appealed to the First Circuit.

IRS's Arguments

Before the First Circuit, the IRS challenged the 50/50 division of the Escrowed Funds on the ground that Massachusetts is not a community property state. In fact, the IRS said, Massachusetts law requires a judge to consider, either explicitly or by clear implication, 14 factors in order to arrive at an equitable division of the parties' assets.

With respect to the Hingham property, the IRS again advanced it argument that it was entitled to Robyn's half of the proceeds from the sale of the Hingham property. The IRS argued that its tax liens attached to any property Scott possessed on or after May 14, 2009, the date of the first tax assessment. The IRS inferred from the Bakers' testimony that one of the Bakers made the mortgage payment on the Hingham property every month up to the time of trial, and that each payment was $6,200. The IRS noted that the district court found that Scott ultimately made the majority of the mortgage payments. Thus, reasoned the IRS, Scott must have paid at least half of the total mortgage payments made on the Hingham property between June 2009 and December 2014 (just before the start of trial) using money on which the IRS had a tax lien. By that logic, the IRS concluded, it had a lien on the property no smaller than $6,200 times 67 months divided by two, or $207,700. Dividing that lien between the two halves of the property, the IRS claimed that it had a lien of $103,850 on Robyn's half, which exceeded her share of the sale proceeds. Thus, the IRS argued, it was entitled to all the proceeds from the sale of the Hingham property.

First Circuit's Decision

Because it was not clear to the First Circuit that the district court considered the 14 factors required to be considered under Massachusetts law to arrive at an equitable division of the couple's assets, it vacated and remanded the determination of the allocation of the Escrowed Funds back to the district court. However, the First Circuit affirmed the district court's decision with respect to the IRS not being entitled to Robyn's half of the proceeds from the sale of the Hingham property.

According to the court, the IRS's argument suffered from a fatal flaw. The court noted that the district court found that "for the lien tracing theory to be viable the government has the burden of showing with particularity the sums transferred by [Scott] Baker to which the tax liens attach." However, the district court never made a finding as to the amount or the number of the mortgage payments. The IRS was relying, the court said, entirely on the testimony of the Bakers which the IRS itself conceded was contradictory for the proposition that the amount of the payment was $6,200 and then assumed that every payment during the relevant time period was made in full. The First Circuit noted that the district court found "neither of the Bakers to be credible witnesses, at least insofar as their financial interests are concerned." The court also noted that one of Robyn's former friends testified that Robyn had problems with honesty and that Robyn even admitted that she struggled with the truth.

The First Circuit agreed with the district court that "the equivocal testimony of the Bakers by itself [is not] sufficient to satisfy the government's burden in a lien tracing context." The IRS, the court said, had not met its burden of distinctly tracing its lien, because the evidence it presented was insufficient. The court did note, however, that its decision did not mean to hold that every time the IRS wishes to trace a lien it must be able to prove the amounts involved to the penny but, the court said, it should present the court with more than the testimony of witnesses who struggle with the truth.

For a discussion of tax liens, see Parker Tax ¶260,530.

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Individual Can Ask Bankruptcy Court for Innocent Spouse Relief; Relief Not Limited to Tax Court

The U.S. Bankruptcy Court for the Southern District of Texas held that it had jurisdiction over an individual's claim for innocent spouse relief, rejecting the IRS's contention that the issue could only be decided in the Tax Court. However, the individual first had to file a Form 8857, Request for Innocent Spouse Relief, and wait for the earlier of a final IRS determination or the passage of six months before the court could decide the issue. In re Pendergraft vs. U.S., 2017 PTC 141 (Bankr. S.D. Tex. 2017)

Jane Pendergraft was married to Robert Pendergraft. Before getting married, Ms. Pendergraft bought a house and treated it as her homestead. The day before the marriage she transferred a one-half interest in the house to her future husband in exchange for a promissory note. Mr. Pendergraft assumed the mortgage on the house and executed a deed of trust in favor of Ms. Pendergraft to secure the note.

The Pendergrafts split their household responsibilities. Mr. Pendergraft took exclusive responsibility for the financial activities, including preparing and paying taxes. Ms. Pendergraft subsequently learned that her husband failed to file the couple's income tax returns for 2001-06 and did not pay any of the taxes the couple owed for those years. Ms. Pendergraft had signed the tax returns and had no reason to know that the returns had not been filed or that the taxes had not been paid. In 2008, the IRS had levied several of Ms. Pendergraft's bank accounts. Mr. Pendergraft told her that he had reached an agreement with the IRS to pay $10,000 per month toward the accrued tax balance and that he would file their tax returns on time going forward. All IRS correspondence continued to be sent to Mr. Pendergraft's office address, including all notices of tax liens. In 2016, Ms. Pendergraft discovered, for the first time, that her husband had not paid their income or property taxes for the last 15 years, that they owed over $2 million in taxes, and that they faced possible criminal prosecution. The couple filed a joint chapter 11 bankruptcy petition in 2016 and Ms. Pendergraft began divorce proceedings.

The IRS filed a proof of claim for approximately $2.5 million in taxes, penalties and interest owed. Of the total, approximately $653,000 was secured by tax liens. Ms. Pendergraft filed an adversary proceeding to determine the validity, priority and extent of the IRS's lien against her homestead and to object to the IRS's proof of claim. In response, the IRS moved to dismiss her complaint on the basis that the bankruptcy court lacked jurisdiction to determine whether she was entitled to innocent spouse relief under Code Sec. 6015. According to the IRS, the determination of innocent spouse relief is vested strictly in the IRS and Tax Court.

The bankruptcy court held that it had jurisdiction to review Ms. Pendergraft's taxes, penalties and interests under Code Sec. 6015(e)(1)(A) and 11 U.S.C. Section 505. However, the court ruled that before it could consider the innocent spouse issue, Ms. Pendergraft first had to file a Form 8857, Request for Innocent Spouse Relief, and wait until either the IRS ruled on her request or six months passed.

Under Code Sec. 6013, co-debtors and spouses that file joint tax returns may be jointly and severally liable for their tax liabilities. However, Code Sec. 6015(f) authorizes the IRS to relieve an individual of such liability if, under the facts and circumstances, it is inequitable to hold the individual liable for an unpaid tax or deficiency. Only the IRS can grant innocent spouse relief under Code Sec. 6015(f).

If the IRS denies a claim for innocent spouse relief or fails to make a determination within six months, the Tax Court can grant innocent spouse relief under Code Sec. 6015(e)(1)(A), which provides that the remedy available in the Tax Court is in addition to "any other remedy provided by law." Another remedy provided by law is contained in 11 U.S.C. Section 505(a)(1), which gives bankruptcy courts the power to determine the legality of taxes and tax penalties.

Based a review of the legislative history, the court interpreted 11 U.S.C. Section 505(a)(1) as granting a bankruptcy court the ability to review an IRS grant or denial of equitable relief. The court found that the legislative history showed Congress's intent to give bankruptcy courts the power to determine certain tax issues for the benefit of the bankruptcy estate and to provide a forum for the swift determination of claims (including tax claims). It also showed that Congress did not intend bankruptcy courts to be a forum for tax issues when no need exists for determining the amount of the tax for bankruptcy estate administration purposes. The court found that a determination of Ms. Pendergraft's tax liability under Code Sec. 6015 and 11 U.S.C. Section 505 directly affected the administration of her bankruptcy estate because the IRS filed such liability as a proof of claim in her bankruptcy case.

The court also found that Fifth Circuit precedent and other sources supported its determination that it had jurisdiction. The Fifth Circuit ruled in In re Luongo, 259 F.3d 323, 327 (2001), that 11 U.S.C. Section 505 gives the bankruptcy court broad jurisdiction to determine the legality of any debtor tax liability, limited only by the statute's express limitations and the court's discretion. The court cited the decisions of several other courts outside the Fifth Circuit that also ruled in support of a bankruptcy court's authority under 11 U.S.C. Section 505(a)(1) to determine and remedy a debtor's tax liability.

The court found unpersuasive the IRS's cited authorities in support of its argument against bankruptcy court jurisdiction over innocent spouse relief. First, in the court's view, none of the cited cases definitively invalidated or even acknowledged the Fifth Circuit precedent interpreting 11 U.S.C. Section 505(a)(1) as allowing bankruptcy courts to determine the legality of a tax, fine or penalty. Second, a finding that bankruptcy courts have jurisdiction over innocent spouse relief follows the plain language of Code Sec. 6015(e), which permits an individual to petition the Tax Court or use any other remedy provided by law to review an IRS determination of relief or lack thereof. Third, the court reasoned, finding that bankruptcy courts have jurisdiction over innocent spouse claims under Code Sec. 6015(e)(1)(A) would not lead to inconsistent judgments, be contrary to basic principles of judicial economy, or provide a result contrary to Congress's intent. The IRS argued that if bankruptcy courts can decide innocent spouse claims, a situation could arise where the bankruptcy courts and Tax Courts resolve the same issue at the same time. The court found that this was not the situation in this case because there was no Tax Court proceeding and further that this issue, if it existed, should be left to Congress to resolve.

Finally, although the court decided that it had jurisdiction over Ms. Pendergraft's innocent spouse claim, it found that it could not yet rule on the issue because Ms. Pendergraft had not satisfied the procedural requirements in Code Sec. 6015(f). Under that provision, an individual must first file a Form 8857 or submit an equivalent signed written statement to the IRS. Under Code Sec. 6015(e)(1)(A), the individual may request relief from the Tax Court, in addition to any other remedy provided by law, either (1) at any time after the earlier of the date the IRS mails its final determination or six months after the IRS request is made; and (2) no later than 90 days after the date the IRS mails the final determination.

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

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Jury Convicts Former CFO of Florida Resorts of Tax Offenses, Conspiracy, and Bank Fraud

The former Chief Financial Officer of Cay Clubs Resorts and Marinas faces decades in prison after being convicted of conspiracy, bank fraud, and tax offenses. Trial evidence established that Cay Clubs failed to report more than $74 million in income after raising more than $300 million selling dilapidated properties to unwary investors. 2017 PTC 123.

On March 3, David Schwarz was convicted of conspiracy to commit bank fraud, in violation of 18 U.S.C. Section 1349, two counts of bank fraud, in violation of 18 U.S.C. Section 1344, and one count of interference with the administration of the IRS, in violation of Code Sec. 7212(a). Schwarz faces a statutory maximum of 30 years in prison for each of the conspiracy and bank fraud offenses, and three years for the tax offense. Sentencing is scheduled for May 1, 2017, at the federal courthouse in Key West.

Schwarz was the Vice President and Chief Financial Officer (CFO) of Cay Clubs Resorts and Marinas (Cay Clubs), which operated purported luxury resorts in the Florida Keys, Clearwater, Orlando, Las Vegas, and elsewhere. Between 2004 and 2008, Cay Clubs grew to more than 1,000 employees and became one of the largest employers in the Florida Keys. Schwarz, who was the one-third owner, and Fred Davis Clark, Jr., who was the two-thirds owner, began Cay Clubs in 2004 with fraudulent sales of Cay Clubs units to insiders, using money from Cay Clubs bank accounts to fund the cash to close for purchases, while obtaining mortgage financing from lending institutions. These fraudulent sales were used in marketing materials to falsely show demand for Cay Clubs units and to inflate prices, as Cay Clubs was in reality purchasing units from itself. Proceeds of these sales were diverted to Schwarz and Clark.

Trial evidence established that Cay Clubs raised more than $300 million from approximately 1,400 investors, who purchased units in Cay Clubs developments. Schwarz and Clark failed to remodel the dilapidated properties as they promised investors, while taking millions of dollars out of the company for their own benefit. During the operation of Cay Clubs from 2004 through 2008, Schwarz and Clark diverted more than $30 million in proceeds for themselves, including millions of dollars in cash transfers, which were used to purchase property and other businesses, including a gold mine, a rum distillery, aircraft, and a coal reclamation business.

Trial evidence further showed that as Cay Clubs faced dwindling sales due to its failure to upgrade the dilapidated properties in 2006, Schwarz, Clark, and others engaged in additional fraudulent sales of Cay Clubs units to insiders, including Clark's family members. These mortgage loans were used to prevent Cay Clubs from defaulting on commercial debts. The documents used to obtain these mortgages included falsified signatures and notary attestations, and had Cay Clubs acting as the seller while Schwarz provided the cash to close so that mortgage loans could be obtained to fund the sales.

In the course of this scheme, Schwarz and Clark did not file any corporate tax return for $74 million in income generated by the Cay Clubs entities. Furthermore, neither Schwarz nor Clark filed any individual tax return for these years until after an investigation of Cay Clubs by the U.S. Securities and Exchange Commission (SEC). In 2010 and 2011, Schwarz filed false individual tax returns for tax years 2004, 2005, and 2006, respectively, in which he substantially underreported his income for these tax years and concealed his receipt of millions of dollars in proceeds.

On December 11, 2015, Dave Clark, was convicted by a federal jury in connection with related bank fraud charges and obstruction of the SEC. He was sentenced on February 21, 2016, to 40 years in prison. Former Cay Clubs sales executives Barry Graham and Ricky Lynn Stokes previously pled guilty to conspiracy to commit bank fraud in related cases and were sentenced to 60 months, and 30 months, respectively.

For a discussion of the penalties for interfering with the administration of the Internal Revenue laws, see Parker Tax ¶265,148.