IRS's Expert Finds the Service Miscalculated Allowable Energy Credits; Taxpayer Couldn't Prove Exclusive Business Use of Aston Martin, Depreciation Denied; Tax Court Erred in Defining "Deposits" and "Loans," Decision Vacated ...
By winning the White House and holding on to their majorities in the House and Senate, Republicans are in a position to fulfill campaign promises to reduce individual and corporate tax rates, repeal healthcare taxes, repeal the estate tax, and possibly implement broad, substantive tax reform.
The Tax Court determined that gross proceeds received by a married couple upon the foreclosure of their vacation home included a "cash for keys" payment received in conjunction with a deed in lieu of foreclosure agreement. The court rejected the IRS's arguments that the payment was ordinary income, finding it was inexorably linked to the relinquishment of their home and should be treated as part of the amount realized in the exchange. Bobo v. Comm'r, T.C. Summary 2016-74.
The Tax Court held that the wife of a silent owner of a restaurant and wine bar was not a responsible person and was not liable for trust fund recovery penalties with respect to unpaid employment taxes. The court noted that the woman spent most of her time taking care of her severely disabled son and her role at the restaurant was ministerial. Fitzpatrick v. Comm'r, T.C. Memo. 2016-199.
Exchange of Property Between Related Parties Doesn't Qualify as a Like-Kind Exchange
The Tax Court held that an exchange of property between related parties did not qualify for deferred recognition of gain under the like-kind exchange rules of Code Sec. 1031. The court determined the transaction was structured with a tax avoidance purpose, noting that the aggregate tax liability of the taxpayer and the related person that arose from their like-kind exchange and a sale transaction was significantly less than the hypothetical tax that would have arisen from the taxpayer's direct sale of the relinquished property. The Malulani Group, Limited and Subsidiary v. Comm'r, T.C. Memo. 2016-209.
Deferred Compensation Was Subject to Substantial Risk of Forfeiture Where Employer Provided Twenty-Five Percent Match
The IRS Office of Chief Counsel advised that where an employee entered into an agreement to defer payment of portion of his salary for three years, and his employer matched 25 percent of the deferred amounts, the deferred compensation was subject to a substantial risk of forfeiture under Code Sec. 409A. Accordingly, the taxpayer would not be required to currently include the amounts in gross income. CCA 201645021.
Modified Child Support Order Didn't Contradict Taxpayer's Claim That He Was Custodial Parent
The Tax Court held that a taxpayer was entitled to take dependency exemptions, the earned income tax credit, and child tax credits for the year at issue. The court found that the IRS's argument that the taxpayer wasn't the custodial parent and wasn't entitled to the exemptions and credits was entirely based on a child support order effective after the year at issue, and thus inapplicable. The court also determined that the taxpayer had reasonable cause for incorrectly claiming head of household filing status and thus was not liable for penalties assessed by the IRS. Tsehay v. Comm'r, T.C. Memo. 2016-200.
The IRS has issued final regulations that remove a rule that a deemed discharge of indebtedness - for which a Form 1099-C, Cancellation of Debt, must be filed - occurs at the expiration of a 36-month non-payment period. The IRS noted that reporting under this rule could mislead taxpayers into believing their debt had been discharged and that they had incurred cancellation of debt income, even though the creditor was still seeking to collect the debt. T.D. 9793 (11/10/16).
Treasury Department Provides Advice on Maximizing Education Tax Credits by Proper Allocation of Scholarships
The Treasury Department has issued a fact sheet discussing ways students can maximize education credits by allocating scholarships, such as the Pell Grant, between tuition and living expenses. The Treasury noted that allocating grants to living expenses, rather than to tuition and related expenses, can increase available education credits, effectively offsetting the income increase from allocating the grant to living expenses. Treasury Fact Sheet - Interaction of Pell Grants and Tax Credits.
Republican Election Sweep Sets the Stage for Major Tax Changes in 2017
By winning the White House and holding on to their majorities in the House and Senate, Republicans are in a position to fulfill campaign promises to reduce individual and corporate tax rates, repeal healthcare taxes, repeal the estate tax, and possibly implement broad, substantive tax reform.
With a Republican government seated for the first time in a decade, 2017 will bring numerous tax changes. Among the most likely to pass and the most important are these four:
- Across the board reductions in individual income tax rates.
- Reduction in the top corporate income tax rate.
- Repeal of healthcare taxes and credits enacted under the Affordable Care Act (Obamacare).
- Repeal of the estate tax.
All of the above changes were centerpieces of the Trump campaign and were also featured in a tax reform plan put forward last summer by House Speaker Paul Ryan and Ways and Means Chairman Kevin Brady ("Ryan-Brady plan"). All are likely to garner enough support to pass the Senate.
It's fairly likely that Congress will also eliminate several itemized deductions to help pay for the reduction in individual tax rates and repeal the alternative minimum tax. Both proposals are common to the Trump plan and the Ryan/Brady plan.
Less clear are the prospects for various other proposals appearing in one plan but not the other, such as President-elect Trump's proposal to allow families to deduct childcare expenses for children under age 13, or the Ryan/Brady proposal to exclude from tax 50 percent of investment income.
It's also unclear whether the tax changes will be retroactive to January 1.
Observation: Many practitioners are wondering about the implications of the election results for year-end tax planning. Our opinion is that while the Republican sweep may tip the scales on some year-end decisions about accelerating/deferring income or deductions, it's not really a game changer for a couple of reasons. First, we don't know whether next year's changes will be retroactive to January 1 or even apply in 2017. Second, it's possible that any rate reductions will be phased in, as they were back in 2001, when the top rate only went from 39.6 percent to 39.1 percent (on its way to 35 percent, five years later). So while factoring likely 2017 changes into year-end decisions makes sense, it's important not to weight them excessively.
Another open question is whether changes will come in the form of targeted legislation along the lines of the Economic Growth and Tax Relief Reconciliation Act of 2001, or a comprehensive tax reform package more akin to the Tax Reform Act of 1986. When Ryan and Brady unveiled their blueprint for tax reform last June, it seemed unlikely the proposals outlined would receive serious consideration. However, with the election of Donald Trump (who adopted key aspects of the Ryan/Brady blueprint in September), and Republicans holding onto their majority in both houses, there is now a good chance that Congress will pursue broad tax reform.
Before the election, there had been some discussion about the possibility of tax extender legislation. However, with real tax reform on the table, it's more likely that any extender legislation may be rolled into next year's tax package rather than worked on as a separate piece of legislation before year end.
A discussion of the specific changes included in the Trump plan and the Ryan/Brady plan follows.
Observation: There's no discussion of a Senate plan below, because, to date, there isn't one. Nonetheless, the Senate and its unique procedural rules will play a key role in shaping 2017 tax legislation. Senate Republicans will need to either win over at least eight Democrats to avoid a filibuster, or they'll have to use a budget process known as reconciliation to move any tax bill, which would constrain the contents of the bill. While this is unlikely to have much effect on the repeal of Obamacare, it will have a considerable impact on whether comprehensive tax reform gets done and, if so, on the makeup of the reforms.
I. Individual Tax Reform
On the individual tax front, it seems clear that the centerpiece of any tax reform package will be a reduction in individual tax rates, the elimination of the marriage tax penalty, the elimination of some itemized deductions, and the repeal of the alternative minimum tax. Both the Trump plan and the Ryan/Brady plan tinker with the standard deduction and personal exemption, as well as the taxation of investment income.
Trump Plan
During the presidential campaign, Donald Trump promised to reduce individual taxes across-the-board. Single individuals earning less than $25,000, or married individuals filing jointly and earning less than $50,000 would not owe any income tax, according to Trump.
As far as wealthy individuals, Trump promised that the rich would pay their fair share. Specifically, under the tax plan proposed by Trump, the current seven tax brackets would be collapsed into three brackets, with low-income taxpayers having an effective income tax rate of 0 percent. The Trump plan proposed that the brackets and rates for married taxpayers filing a joint return would be
(1) income of $75,000 or less: 12 percent;
(2) income of more than $75,000 but less than $225,000: 25 percent;
(3) income of more than $225,000: 33 percent.
The tax brackets and rates for single filers would be one-half of these amounts. The marriage penalty would be eliminated. Trump's tax plan would retain the existing capital gains rate structure (maximum rate of 20 percent) with the revised tax brackets. Carried interest, which is generally treated as capital gains, would instead be taxed as ordinary income. The 3.8 percent net investment income tax and the alternative minimum tax (AMT) would both be repealed.
Under Trump's plan, the standard deduction for joint filers would increase to $30,000, from $12,600, and the standard deduction for single filers would be $15,000. Personal exemptions would be eliminated as would the head-of-household filing status. In addition, the Trump plan recommends capping itemized deductions at $200,000 for married-joint filers or $100,000 for single filers.
Trump's plan would also allow certain families to fully deduct the average cost of childcare from their taxes. The deduction would be available for children under age 13 and would be capped at an average cost for the age of the child. The deduction would also apply to eldercare for a dependent. The deduction would not be available to taxpayers with total income over $500,000 (married filing jointly) or $250,000 (single).
The Trump plan would also offer spending rebates for childcare expenses to certain low-income taxpayers through the earned income tax credit (EITC). In addition, all taxpayers would be able to establish Dependent Care Savings Accounts (DCSAs) for the benefit of specific individuals, including unborn children, with annual contributions being limited to $2,000 per year. When established for children, the funds remaining in the account when the child reaches 18 could be used for education expenses.
To encourage lower-income families to establish DCSAs for their children, Trump's plan proposes that the government would provide a 50 percent match on parental contributions of up to $1,000 per year for these households.
Finally, because of the reduction in rates and the increase in the standard deduction, Trump's plan proposes to do away with personal exemptions and most itemized deductions. However, charitable deductions and mortgage interest deductions would continue to be available.
Ryan/Brady Plan
The Ryan/Brady vision for individual tax reform also has three tax brackets: 12 percent, 25 percent, and 33 percent, with a zero percent bracket for low-income individuals. Like the Trump tax plan, the Ryan/Brady plan would repeal the AMT. With respect to the taxation of investment income, the Ryan/Brady plan would allow for families and individuals to deduct 50 percent of their net capital gains, dividends, and interest income, leading to basic rates of 6 percent, 12.5 percent, and 16.5 percent on such investment income depending on the individual's tax bracket.
In an effort to simplify the Tax Code, the Ryan/Brady plan calls for consolidating the basic standard deduction, the additional standard deduction, the personal exemption, the personal exemption for dependents, and the child tax credit into two simpler benefits - a larger standard deduction ($24,000 for married individuals filing jointly, $18,000 for single individuals with a child in the household, and $12,000 for other individuals, adjusted annually for inflation) and an enhanced child and dependent tax credit. Under the Ryan/Brady plan, the child tax credit and personal exemptions for dependents would be consolidated into an increased child tax credit of $1,500, with the first $1,000 being refundable, as under current law. A non-refundable credit of $500 would also be allowed for non-child dependents. The marriage penalty that exists in the current-law phase-out of the child credit would be eliminated, so that married couples would be able to earn up to $150,000 before their child tax credits start phasing out.
The Ryan/Brady plan does not include a proposal similar to Trump's plan in which individuals can deduct the average cost of childcare. Nor does it include spending rebates for childcare expenses for low-income taxpayers.
Like the Trump plan, the Ryan/Brady plan proposes to eliminate personal exemptions and most itemized deductions, but leaves in place charitable deductions and mortgage interest deductions. Despite this being an area of agreement between the two plans, the proposal is likely to be controversial.
II. Business Tax Reform
As with the individual income tax proposals, the centerpiece of both Trump's and the Ryan/Brady business tax reform proposals is a reduction in corporate tax rates. Both plans would also eliminate most deductions and credits, except for the research and development credit.
Trump Plan
While Trump's plan did not originally differentiate between corporate and small business tax rates, and there was some talk of reduced tax rates applying to unincorporated businesses like partnerships, that talk has been walked back. Under the Trump plan, the corporate tax rate would be reduced from 35 percent to 15 percent. In addition, the corporate AMT would be eliminated. Key to the Trump plan is a proposal for a 10 percent tax on a deemed repatriation of corporate profits held offshore.
The Trump plan would also allow U.S.-based manufacturers to elect full expensing of plant and equipment. However, if this election is made, a manufacturer would not be entitled to interest expense deductions. Trump's plan would also eliminate most corporate deductions and credits except for the research and development credit.
The Trump plan also proposes that businesses that pay a portion of an employee's childcare expenses would be able to exclude those payments from income.
Ryan/Brady Plan
Under the Ryan/Brady plan, the top tax rate for corporations would be cut to 20 percent and the top tax rate applicable to small businesses and pass-through entities would be 25 percent. Under this approach, sole proprietorships and pass-through businesses would pay or be treated as having paid reasonable compensation to their owner-operators. Such compensation would be deductible by the business and would be subject to tax at the graduated rates for families and individuals. The compensation that is taxed at the lowest individual tax bracket rate of 12 percent effectively would further reduce the total income tax burden on these small businesses and pass-through entities.
The Ryan/Brady plan would also provide that a business could fully and immediately write off the cost of investments. The write-off would apply to tangible and intangible property, but not land. In addition, a business would be allowed to deduct interest expense against any interest income, but no current deduction would be allowed for net interest expense. Any net interest expense would instead be carried forward indefinitely and allowed as a deduction against net interest income in future years.
With respect to net operating losses (NOLs), the Ryan/Brady plan would allow such losses to be carried forward indefinitely and increased by an interest factor that compensates for inflation and a real return on capital. Carrybacks of net operating losses would not be permitted and the deduction allowed with respect to an NOL carryforward in any year would be limited to 90 percent of the net taxable amount for such year determined without regard to the carryforward.
The Ryan/Brady plan would generally eliminate special-interest deductions and credits in favor of providing lower tax rates for all businesses and eliminating taxes on business investment. The aim is to allow business decisions to be made based on the economic potential rather than the availability of targeted tax benefits. The Code Sec. 199 domestic production activities deduction would be among the popular tax breaks eliminated by this proposal.
Similar to the Trump plan, however, the Ryan/Brady plan would keep the research and development credit.
With respect to international taxation, the Ryan/Brady plan moves toward a cash-flow tax approach for businesses, which reflects a consumption-based tax. According to the plan, this approach will allow the United States to counter the border adjustments that U.S. trading partners apply in their value added taxes. The cash-flow based approach that will replace the United States' current income-based approach for taxing both corporate and non-corporate businesses would be applied on a destination basis. This means that products, services and intangibles that are exported outside the United States will not be subject to U.S. tax regardless of where they are produced. It also means that products, services and intangibles that are imported into the United States will be subject to U.S. tax regardless of where they are produced. According to the Ryan/Brady plan, this will eliminate the incentives created by the current tax system to move or locate operations outside the United States and will allow U.S. products, services, and intangibles to compete on a more equal footing in both the U.S. market and the global market.
III. Repeal of Obamacare
President-elect Trump and the Republicans in Congress have promised to repeal and replace Obamacare. A key aspect of this will be the repeal of a group of taxes that are integral to the healthcare law. These taxes include:
- the 3.8 percent Net Investment Income Tax (NIIT);
- the .9 percent additional Medicare tax;
- the penalties associated with the individual and employer mandates;
- the tax on "Cadillac" healthcare plans; and
- the excise tax on medical devices.
The Ryan/Brady plan does not address what would replace Obamacare, other than to say that the issues surrounding a repeal are being addressed by a Health Care Task Force. The Trump campaign's position has been that replacing Obamacare will entail a combination of health savings accounts, allowing the sale of health insurance across state lines, a federally subsidized high-risk pool, and the creation of a patient-centered health care system that promotes choice, quality, and affordability.
Various experts have pointed out that dismantling Obamacare may prove more difficult than originally thought, mainly because the health care law has grown to provide more than 20 million Americans with health coverage (12 million through the health insurance exchanges, and 8 million through Medicaid expansion), and that keeping just the popular parts (such as requiring insurance companies to cover preexisting conditions) is impractical.
Given the challenges of the "replace" part of "repeal and replace", there seems to be an emerging consensus that there will have to be a transitional period, perhaps running through 2017, during which premium subsidies, federally funded Medicaid expansion, healthcare market reforms, and other aspects of Obamacare will continue. If so, it raises the question of whether Congress would repeal the taxes that pay for the program while the federal government continues to incur its cost. As a result, practitioners shouldn't be surprised to see delayed effective dates for both the repeal of Obamacare's healthcare provisions and the taxes that fund them.
IV. Repeal of the Estate Tax
Both Trump and Ryan/Brady agree on eliminating the estate tax, although Trump's plan includes an exception.
Trump Plan
The Trump plan would repeal the estate tax, but capital gains held until death and valued over $10 million would be subject to tax, with an exemption from such tax for small businesses and family farms. To prevent abuse, contributions of appreciated assets into a private charity established by the decedent or the decedent's relatives would be disallowed.
Ryan/Brady Plan
The Ryan/Brady plan would eliminate the estate tax, as well as the generation-skipping transfer tax.
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Taxpayers Weren't Required to Include "Cash for Keys" Payment in Ordinary Income
The Tax Court determined that gross proceeds received by a married couple upon the foreclosure of their vacation home included a "cash for keys" payment received in conjunction with a deed in lieu of foreclosure agreement. The court rejected the IRS's arguments that the payment was ordinary income, finding it was inexorably linked to the relinquishment of their home and should be treated as part of the amount realized in the exchange. Bobo v. Comm'r, T.C. Summary 2016-74.
Background
In 2008, Karl and Kimberly Bobo owned their primary residence in California but worked in management positions requiring frequent travel to North Carolina. The couple purchased a second house in North Carolina in March 2008 for $850,000, securing a nonrecourse mortgage note to finance 90 percent of the purchase price and making a down payment of $85,000.
The Bobos began experiencing financial difficulties and sought loan modifications from the companies holding mortgages on the California and North Carolina houses. Although the taxpayers did not qualify for a modification for the loan on the North Carolina house, a mortgage company, Green Tree Services, LLC (Green Tree), informed the couple that they might qualify for a "deed in lieu of foreclosure" program. Since they could no longer afford to make payments on the North Carolina mortgage loan, the Bobos applied for and were accepted into this program.
In May 2012, the taxpayers entered into a deed in lieu of foreclosure agreement with Green Tree. Under the terms of this agreement the couple signed the deed to the North Carolina house over to Green Tree and, in exchange, the mortgage company forgave the balance of their note on the property. The couple also agreed to vacate the property by a certain time and meet other specified requirements, including leaving the property in broom-swept condition. In exchange for agreeing to those terms, they would receive a $20,500 "cash for keys" payment.
Observation: Cash for keys programs were designed by mortgage lenders to allow them to gain possession of a property quickly and avoid a long foreclosure process. Lenders issue these payments in exchange for borrowers' vacating a property quickly and leaving it in good condition.
Following the close of the agreement, Green Tree issued Karl a Form 1099-MISC, Miscellaneous Income, for the cash for keys payment. The cash for keys payment was characterized as nonemployee compensation. Green Tree also issued a Form 1099-A, Acquisition or Abandonment of Secured Property, to Karl, reporting an acquisition date of May 29, 2012, a loan principal balance outstanding of $716,426, and fair market value (FMV) of the property of $607,500. Green Tree calculated that the taxpayers had cancellation of debt income of $108,926, the difference between the outstanding loan balance and the FMV of the North Carolina house.
The taxpayers' CPA, Harry Bergland, Jr., prepared their 2012 income tax return. The Bobos attached to their Form 1040 a Form 8949, Sales and Other Dispositions of Capital Assets, relating to the disposition of the North Carolina house. On the Form 8949, the couple claimed a cost basis of $850,000 in the North Carolina house and gross proceeds of $736,926 from the deed in lieu of foreclosure transaction with Green Tree, resulting in a loss of $113,074. Bergland calculated the gross proceeds by adding the cash for keys incentive payment to the fair market value of the North Carolina house and the cancellation of debt income.
Following an examination, the IRS reclassified the $20,500 payment from Green Tree as ordinary income.
Analysis
Under Code Sec. 1001(a), the gain or loss recognized on a sale or exchange is the difference between the amount realized from the disposition and the property owner's adjusted basis. Under Code Sec. 1001(b), the amount realized from the disposition is the sum of any money received in the transfer plus the fair market value of property (other than money) received. When a taxpayer's obligation to repay a nonrecourse mortgage is extinguished, he includes the amount of the extinguished debt in his amount realized under Code Sec. 1001(b). In Allan v. Comm'r, 86 T.C. 655 (1986), the Tax Court held that the transfer of property by deed in lieu of foreclosure constitutes a "sale or exchange" for federal income tax purposes.
Before the Tax Court, the IRS argued that the $20,500 cash for keys payment was an incentive payment which the Bobos received only by fulfilling the conditions of the program. The IRS asserted that the payment was not part of the amount realized in the exchange and should instead be considered ordinary income.
The Tax Court disagreed with the IRS, stating it was clear that Green Tree did not hire Karl for services or have another reason to issue the cash for keys payment. Rather, the court said, the cash for keys payment was part of a single transaction, noting that Green Tree paid the Bobos $20,500 to avoid the lengthy and expensive legal process of foreclosure as part of the deed in lieu of foreclosure process.
The court stated that the instant case was similar to 2925 Briarpark, Ltd. v. Comm'r, T.C. Memo. 1997-298, in which a partnership secured a nonrecourse loan to purchase land and finance construction. The partnership later defaulted on the loan and found a third party willing to purchase the property once the bank holding the loan removed a lien on the property. The bank agreed to release the partnership from the lien and loans if the partnership assigned the sale proceeds from the property to the bank and included payments from the partnership and the general partner. In that case, the Tax Court did not treat the cash sale and the discharge of the loan as two independent events because there was ample evidence the sale and the discharge were the result of a single transaction, the sale of the property.
The court noted that similar to the partnership in 2925 Briarpark, Ltd., which had multiple agreements relating to the exchange of the property, the Bobos had two agreements with Green Tree stemming from the exchange of property: the deed in lieu of foreclosure agreement and the cash for keys agreement. Looking at the substance of the transaction, the court stated, the two agreements were inseparable; Green Tree would not have issued the cash for keys payment but for the taxpayers agreeing to sign over the deed to the property.
The court held that the cash for keys payment should be treated as part of the deed in lieu of foreclosure transaction and included in the amount realized on the North Carolina house, and determined that the Bobos had correctly calculated their loss on the transaction.
For a discussion of determining gain or loss from a sale or exchange of property, see Parker Tax ¶110,140.
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Wife Who Spent Time Caring for Disabled Son Was Not a Responsible Person
The Tax Court held that the wife of a silent owner of a restaurant and wine bar was not a responsible person and was not liable for trust fund recovery penalties with respect to unpaid employment taxes. The court noted that the woman spent most of her time taking care of her severely disabled son and her role at the restaurant was ministerial. Fitzpatrick v. Comm'r, T.C. Memo. 2016-199.
In 2004, James Stamps and Edward Fitzpatrick purchased the franchise rights to a wine bar and restaurant in Jacksonville, Florida, called the Grape. They agreed to be equal partners with James being the president and managing partner overseeing the business operations while Edward would be a silent partner and passive investor with some executive authority but no day-to-day duties.
Edward's wife, Christina, has a high school education had no ownership interest in the business. Her primary responsibility during the years at issue was to serve as caregiver to her disabled son, Evan, who suffers from a rare metabolic disorder called citrullinemia. As a result of the disorder, Evan has severe autism, cerebral palsy, and limited mobility. He is required to take over 50 pills a day and cannot be left for any significant amount of time without adult supervision. Because of the substantial amount of attention Evan required, Christina was unable to devote significant effort to any business enterprise.
James and Edward formed Dey Corp., Inc. Dey Corp. purchased and operated the Grape franchise. James was the only person listed in the articles of incorporation as an officer and director. Shortly after James and Edward began engaging in preliminary business matters, James was unexpectedly hired for a short-term job at a beverage distributor in Puerto Rico. Therefore most of the preopening responsibilities fell upon Edward. Because of his busy schedule, Edward directed Christina to carry out some of those responsibilities. She opened bank accounts and engaged the services of Paychex, a payroll company. One of the services provided by Paychex was the payment of payroll taxes and electronically filing Forms 941, Employer's Quarterly Federal Tax Return.
The Grape opened in March 2005 and was run primarily by James and a general manager he hired, Kris Chislett. Kris was responsible for carrying out the day-to-day business operations and was Paychex's main contact during the periods at issue, and he maintained control over the payroll process.
Christina did not have a significant role at the Grape. Her main responsibilities were delivering checks, relaying electronic bank account balances to Kris, and delivering the business' mail that was sent to her private mailbox. She occasionally transferred funds to and from the corporate bank account at the direction of James or her husband and sometimes issued checks at their direction for some of the business' recurring monthly expenses. Christina made no operational decisions and did not have the background, education, or training to hold a management position at the Grape. Because no one was usually at Grape on the Tuesday morning the PayChex payroll package was delivered, Paychex started delivering the Grape's payroll package to Christina and Edward's home. It was usually necessary for Christina to sign the checks because Tuesday was Kris's day off and there was no one else onsite available to sign the payroll checks. Christina was not responsible for and did not review statements included in the Paychex package.
Within a year of opening, the Grape was losing money. In 2008, Paychex attempts to withdraw money from the Dey Corp bank account to cover payroll taxes were rejected. Paychex continued to produce payroll checks and reference copies of Forms 941 and debit the funds from the Dey Corp bank account. However, it did not debit the payroll tax portion from the account, make payroll deposits on the business' behalf, or file Forms 941. Christina was unaware these services had been canceled.
The Grape closed in 2011 and shortly thereafter, an IRS investigator went to the office of Dey Corp.'s CPA to discuss unpaid payroll taxes from the third quarter of 2008 through the closing of the restaurant. The CPA contacted Edward and Christina and notified them of the unpaid payroll taxes. This was the first time the couple had knowledge that federal payroll deposits had not been made for various quarters and that Forms 941 remained unfiled.
After conducting an investigation, an IRS officer recommended assessing trust fund recovery penalties (TFRPs) under Code Sec. 6672 against James, Kris, and Christina. Both James and Kris successfully administratively contested the assessments. James filed a request for abatement which was granted and Kris was granted relief by the IRS Office of Appeals. Christina challenged the liabilities during her CDP hearing but the IRS found her to be liable for the penalties which added up to over $150,000. Christina then took her case to the Tax Court.
Before the Tax Court, the IRS argued that Christina exercised substantial financial control over Dey Corp. and that at all times was a de facto officer of the corporation because she opened two corporate bank accounts, had signatory authority on both accounts, and signed checks on behalf of the corporation.
Christina argued that she lacked decision-making authority and did not exercise significant control over corporate affairs. She further asserted that despite her signatory authority, she was not a responsible person within the meaning of Code Sec. 6672 because she had a limited role in the business' payroll process and merely signed payroll checks for the convenience of the corporation. According to Christina, James and Kris were responsible for running the corporation day to day and her duties were ministerial.
The Tax Court held that Christina was not a responsible person and thus was not liable for the TFRPs assessed against her. The court began by noting that liability for a TFRP is imposed only on (1) a responsible person who (2) willfully fails to collect, account for, or pay over the withheld tax. The court also commented on the credibility of the nine witnesses called to testify. The court found Christina and Edward, as well as a couple other witnesses to be credible. However, the court did not find the testimony of James, Kris, and another individual to be credible. The court also had little confidence in any of the documents the IRS obtained from Kris. The court found that the preponderance of the evidence showed that Christina's role was ministerial and that she lacked decision-making authority.
The court also noted that Christina spent most of her time taking care of her disabled son and, that as a result of having to constantly lift Evan, she developed spinal stenosis which required periodic injections and epidurals. Consequently, she usually visited the corporation only once a week, on Tuesdays, for less than an hour each time.
Finally, the court said it was puzzled by the fact that James, the president of the corporation and a hands-on owner, and Kris, the day to-day manager, successfully evaded in the administrative phase any personal liability for the TFRPs.
For a discussion of the liability for trust fund recovery penalties, see Parker Tax ¶210,108.
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Exchange of Property Between Related Parties Doesn't Qualify as a Like-Kind Exchange
The Tax Court held that an exchange of property between related parties did not qualify for deferred recognition of gain under the like-kind exchange rules of Code Sec. 1031. The court determined the transaction was structured with a tax avoidance purpose, noting that the aggregate tax liability of the taxpayer and the related person that arose from their like-kind exchange and a sale transaction was significantly less than the hypothetical tax that would have arisen from the taxpayer's direct sale of the relinquished property. The Malulani Group, Limited and Subsidiary v. Comm'r, T.C. Memo. 2016-209.
Background
The Malulani Group, Limited (Malulani Group), is a Hawaii corporation that leased commercial real estate in various states, including Hawaii and Maryland. For the years at issue, The Malulani Group, Limited filed a consolidated return with its wholly owned subsidiary, MBL Maryland, Inc. (MBL). The Malulani Group also owned approximately 70 percent of the common shares of Malulani Investments, Limited (MIL), which owned real estate throughout the United States.
On October 26, 2006, MBL received a letter of intent from an unrelated third party offering to purchase commercial real estate that it owned in Maryland. It reserved to MBL the right to effect an exchange of the property under Code Sec. 1031 and obligated any third-party purchaser to cooperate toward that end. MBL's representative signed the letter of intent on October 31, 2006, and thereafter the Malulani Group and MBL began a search for suitable replacement property. On January 4, 2007, MBL engaged First American Exchange Co. (FAEC) to serve as an intermediary through which the Maryland property could be exchanged. MBL thereupon assigned its rights under the letter of intent to FAEC, and on January 10, 2007, MBL transferred the Maryland property to FAEC and FAEC sold the Maryland property to the third party for approximately $4.7 million. MBL's basis in the Maryland property was almost $2.8 million at the time of transfer.
In order to meet the requirements of Code Sec. 1031(a)(3), MBL had to identify replacement property on or before February 24, 2007 (i.e., 45 days after the sale of the Maryland property). Between October 31, 2006, and February 23, 2007, brokers presented numerous properties owned by unrelated parties to the Malulani Group and MBL as potential replacement properties, and MBL attempted to negotiate the purchase of an office building and an apartment building for that purpose. As of the date of the sale of the Maryland property (January 10, 2007), neither the Malulani Group nor MBL had considered acquiring a replacement property from MIL or any other related party. On February 23, 2007, MBL first identified three potential replacement properties, all belonging to MIL.
On July 3, 2007, FAEC purchased certain Hawaiian real property owned by MIL for $5.52 million and transferred it to MBL as replacement property for the Maryland property. MIL's basis in the Hawaii property was approximately $2.4 million. On its consolidated return for 2007, the Malulani Group reported a realized gain of approximately $1.9 million from the sale of the Maryland property but deferred recognition of the gain under the like-kind exchange rules of Code Sec. 1031. MIL recognized on its 2007 Form 1120 an approximately $3.1 million gain from the sale of the Hawaiian property, which would have increased its regular income tax liability by approximately $1.1 million; however, MIL had sufficient NOLs to fully offset its regular tax liability relating to the sale.
Following an examination, the IRS, citing Code Sec. 1031(f), determined that the $1.9 million gain realized on the sale of the Maryland property did not qualify for Code Sec. 1031 deferred recognition treatment and assessed a deficiency.
Analysis
Code Sec. 1031(f) limits nonrecognition treatment under Code Sec. 1031(a) in the case of like-kind exchanges between related persons. Code Sec. 1031(f)(1) generally provides that if a taxpayer and a related person exchange like-kind property and within two years either one disposes of the property received in the exchange, the nonrecognition provisions of Code Sec. 1031(a) do not apply, and gain or loss must be recognized as of the date of the disposition. Although Code Sec. 1031(f)(1) disallows nonrecognition treatment only for direct exchanges between related persons, Code Sec. 1031(f)(4) provides that nonrecognition treatment does not apply to any exchange which is part of a transaction or series of transactions structured to avoid the purposes of Code Sec. 1031(f). Therefore, Code Sec. 1031(f)(4) may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of qualified intermediaries.
Code Sec. 1031(f)(2) provides exceptions to the disallowance-upon disposition rule for related parties in Code Sec. 1031(f)(1). Specifically, Code Sec. 1031(f)(2)(C) provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS, with respect to the disposition, that neither the exchange nor such disposition had as one of its principal purposes the avoidance of federal income tax.
Before the Tax Court the IRS argued that MBL's exchange was disqualified from nonrecognition treatment pursuant to Code Sec. 1031(f)(4) as a transaction structured to avoid the purposes of Code Sec. 1031(f). The Malulani Group argued that the exchange of the Maryland and Hawaiian properties was not structured to avoid the purposes of Code Sec. 1031(f) because MBL had no "prearranged plan" to conduct a deferred exchange with MIL.
The Tax Court agreed with the IRS and held that the transaction at issue did not qualify for nonrecognition of gain treatment under Code Sec. 1031. The court cited its decisions in Ocmulgee Fields, Inc. v. Comm'r, 132 T.C. 105 (2009), aff'd, 613 F.3d 1360 (11th Cir. 2010), and Teruya Bros., Ltd. & Subs. v. Comm'r, 124 T.C. 45 (2005), aff'd, 580 F.3d 1038 (9th Cir. 2009) which involved transactions where taxpayers received replacement property from related persons in deferred exchanges involving qualified intermediaries, followed by the related persons' sales of the relinquished property. In those cases, the Tax Court concluded that the transactions were the economic equivalent of direct exchanges of property between the taxpayers and the related persons, followed by the related persons' sales of the relinquished property and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purpose of Code Sec. 1031(f). The court also noted that where the aggregate tax liability of the taxpayer and the related person arising from their like-kind exchange and sale transaction is significantly less than the hypothetical tax that would have arisen from the taxpayer's direct sale of the relinquished property, this is an inference that the taxpayer structured the transaction with a tax avoidance purpose.
For a discussion of the rules relating to like-kind exchanges involving related parties, see Parker Tax ¶113,160.
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Deferred Compensation Was Subject to Substantial Risk of Forfeiture Where Employer Provided Twenty-Five Percent Match
The IRS Office of Chief Counsel advised that where an employee entered into an agreement to defer payment of portion of his salary for three years, and his employer matched 25 percent of the deferred amounts, the deferred compensation was subject to a substantial risk of forfeiture under Code Sec. 409A. Accordingly, the taxpayer would not be required to currently include the amounts in gross income. CCA 201645021.
Background
Under the facts of CCA 201645021, a taxpayer entered into an agreement with his employer to defer a portion of his salary that would otherwise have been paid during a specified year, with payment of the deferred amount to be made as a lump-sum payment on January 1 of the third year following the deferment. The deferred amount would only be paid if the employee continued to provide substantial future services until the beginning of that third year.
Under the agreement the employee's salary was reduced by $600 each biweekly pay period (26 x $600 or $15,600) and the employer credited matching amounts to the employee's deferred compensation account of 25 percent of each salary reduction (26 x ($600 / 4) or $3,900) for a total amount deferred of $19,500. The matching amounts were credited each time the salary reduction amount would otherwise have been paid as salary.
An IRS attorney requested advice from the IRS Office of Chief Counsel (IRS) on whether the salary that the employee could have elected to receive as compensation would be treated as subject to a substantial risk of forfeiture under Code Sec. 409A.
Analysis
Code Sec. 409A generally provides that if a nonqualified deferred compensation plan fails to meet certain statutory constructive receipt rules, then all amounts deferred under the plan for all tax years are immediately includible in a participant's gross income to the extent the amounts are not subject to a substantial risk of forfeiture and were not previously included in gross income.
Reg. Sec. 1.409A-1(d)(1) provides that, in general, a substantial risk of forfeiture exists if the receipt of deferred compensation is conditioned on the performance of substantial future services, and the possibility of forfeiture is substantial. In addition, an amount will be considered subject to a substantial risk of forfeiture if the present value of the amount subject to forfeiture is "materially greater" than the present value of the amount the recipient otherwise could have elected to receive absent such risk of forfeiture.
The IRS advised that an amount that an employee could have elected to receive as salary can be treated as subject to a substantial risk of forfeiture under Code Sec. 409A if the employer provides a matching contribution resulting in a 25 percent increase in the present value of the amount deferred.
The IRS noted that, under the facts presented to it, the present value of the amount deferred by the taxpayer was 25 percent greater than the amount he otherwise could have received absent the addition of the substantial risk of forfeiture. The IRS stated that a 25 percent increase in the present value of the amount a service provider could have received absent the risk of forfeiture is a material increase. Accordingly, the IRS advised that the combined deferred amount of the taxpayer's salary ($15,600) plus the deferred amount of the employer's matching contribution ($3,900) was subject to a substantial risk of forfeiture for purposes of Code Sec. 409A. As such, the deferred amounts were not currently included in the taxpayer's gross income.
For a discussion of the tax treatment of amounts deferred under a nonqualified deferred compensation plan, see Parker Tax ¶135,505.
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Modified Child Support Order Didn't Contradict Taxpayer's Claim That He Was Custodial Parent
The Tax Court held that a taxpayer was entitled to take dependency exemptions, the earned income tax credit, and child tax credits for the year at issue. The court found that the IRS's argument that the taxpayer wasn't the custodial parent and wasn't entitled to the exemptions and credits was entirely based on a child support order effective after the year at issue, and thus inapplicable. The court also determined that the taxpayer had reasonable cause for incorrectly claiming head of household filing status and thus was not liable for penalties assessed by the IRS. Tsehay v. Comm'r, T.C. Memo. 2016-200.
Background
Yosef Tsehay, whose first language is not English, worked as a custodian at a community college in Washington. He and his wife were married in 2001 and over the years their relationship was "on-again, off-again." During 2013, the two were married and living together with their five children in a public housing apartment. Tsehay's wife was responsible for paying the rent on the public housing unit, and he paid for food and other expenses of his family. In 2014, the couple separated, and during 2015 they were undergoing divorce proceedings.
Although Tsehay paid a tax return preparer to prepare his return, Tsehay electronically filed the 2013 Form 1040A himself. On the return, he claimed: (1) dependency exemption deductions for four children; (2) the earned income tax credit (EITC) for three children; (3) the child tax credit (CTC) for four children; and (4) head of household filing status. He did not attach a Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, or a statement conforming to the substance of a Form 8332, to his Form 1040A for tax year 2013.
Following an audit, the IRS disallowed Tsehay's claimed dependency exemption deductions, earned income tax credit, and child tax credit for 2013. The IRS also changed his filing status from head of household to single and determined an accuracy-related penalty under Code Sec. 6662(a).
Analysis
Under Code Sec. 151(c), an individual is allowed an exemption deduction for each "dependent," which is generally defined as a qualifying relative or a qualifying child. In addition, taxpayers are entitled to claim the EITC under Code Sec. 32 and the CTC under Code Sec. 24 for qualifying children. Under Code Sec. 152(c), to be a qualifying child of the taxpayer, the child must have had the same principle place of above as the taxpayer for more than one-half of the tax year.
Under Code Sec. 2(b), a taxpayer can file as a head of household if the taxpayer is unmarried, has paid more than half the cost of keeping up a home for the year, and a qualifying person has lived with the taxpayer for more than half the year.
The Tax Court noted that the IRS's determinations stemmed from its records showing that Tsehay was not the custodial parent of his minor children and from his failure to attach a copy of Form 8332 or its equivalent to his return. The IRS provided a copy of a child support order to establish that Tsehay was in fact a "noncustodial parent." However, the court stated, the child support order was entered August 3, 2015, and thus did not apply for the year at issue. The court determined Tsehay had sufficiently established that he and his wife were married during 2013, and thus a Form 8332 to claim dependency exemptions was not required.
The court noted the children claimed on Tsehay's return as dependents had the same principal place of abode as he did for more than one-half of the year at issue and were his qualifying chidlren, and determined that he was entitled to the dependency exemption deductions claimed on his 2013 return. In addition, because he had "three or more" qualifying children for tax year 2013, the court determined he was entitled to the earned income credit and to child tax credits and the additional child tax credits claimed.
With regard to his filing status, Tsehay explained to the court that because he and his wife had separated by the time he was ready to file his 2013 tax return, he had asked his preparer to file for him as "married filing separately." The court noted that the preparer erroneously filed his return as "head of household." Because Tsehay was married for 2013, the court stated he could not qualify for head of household filing status, and noted he also was not eligible to file as single as claimed by the IRS. Instead, the court said, his correct filing status for 2013 was in fact married filing separately.
With regard to the accuracy related penalty, the court observed that Tsehay had a language barrier, sought and relied on professional advice, and was separated from his wife when he filed his return. Under those circumstances, the court stated, Tsehay had reasonable cause and acted in good faith in filing his returns, and declined to impose penalties.
For a discussion of exemptions for dependents, see Parker Tax ¶10,720.
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Failure to Make Debt Payments for 36-Months No Longer Triggers Deemed Discharge
The IRS has issued final regulations that remove a rule that a deemed discharge of indebtedness - for which a Form 1099-C, Cancellation of Debt, must be filed - occurs at the expiration of a 36-month non-payment period. The IRS noted that reporting under this rule could mislead taxpayers into believing their debt had been discharged and that they had incurred cancellation of debt income, even though the creditor was still seeking to collect the debt. T.D. 9793 (11/10/16).
Code Sec. 6050P generally requires applicable financial entities (such as financial institutions, credit unions, and federal executive agencies) that discharge indebtedness of $600 or more during a calendar year to file information returns with the IRS and to furnish information statements to the taxpayers whose debt was discharged. Final regulations issued in 1996 provided that a person's debt is deemed to be discharged for information reporting purposes only on the occurrence of an identifiable event specified under Reg. Sec. 1.6050P-1(b)(2), regardless of whether an actual discharge has occurred on or before the date of the identifiable event.
Under Reg. Sec. 1.6050P-1(b)(2)(iv), one such identifiable event is presumed to have occurred if a creditor does not receive a payment for 36 months. The creditor can generally rebut the presumption if the creditor engages in significant bona fide collection activity within a 12-month period ending at the close of the calendar year, or if the facts and circumstances indicate that the debt has not been discharged. A creditor's decision not to rebut the presumption is not an indication that it has discharged the debt, but the creditor is still required to report amounts on a Form 1099-C, Cancellation of Debt, to the debtor taxpayer.
According to the IRS, because reporting under the 36-month rule may not reflect an actual discharge of indebtedness, taxpayers receiving Forms 1099-C may conclude that the debts have, in fact, been discharged, causing the taxpayers to erroneously include in income the amounts reported on Forms 1099-C even though creditors may continue to attempt to collect the debt. The IRS noted that issuing a Form 1099-C before a debt has been discharged may also cause the IRS to initiate compliance actions even though a discharge has not occurred.
Stating that information reporting under Code Sec. 6050P should generally coincide with the actual discharge of a debt, the IRS has issued final regulations that remove the 36-month rule from the list of identifiable events.
The final regulations are applicable to information returns required to be filed, and payee statements required to be furnished, after December 31, 2016.
For a discussion of information reporting requirements relating to the cancellation of debt, see Parker Tax ¶252,530.
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Treasury Department Provides Advice on Maximizing Education Tax Credits by Proper Allocation of Scholarships
The Treasury Department has issued a fact sheet discussing ways students can maximize education credits by allocating scholarships, such as the Pell Grant, between tuition and living expenses. The Treasury noted that allocating grants to living expenses, rather than to tuition and related expenses, can increase available education credits, effectively offsetting the income increase from allocating the grant to living expenses. Treasury Fact Sheet - Interaction of Pell Grants and Tax Credits.
Background
The American Opportunity Tax Credit (AOTC) is a tax credit under Code Sec. 25A that is generally available to students in the first four years of postsecondary education to offset costs for "qualified tuition and related expenses" (QTRE). Such expenses include tuition, required fees, and course materials. The AOTC provides a 100 percent credit for the first $2,000 of QTRE and a 25 percent credit for the next $2,000, for a total credit of up to $2,500. Forty percent of the otherwise allowable AOTC, up to $1,000, is refundable. In addition, students who are not eligible for the AOTC may be eligible for a Lifetime Learning Credit (LLC) in any year of postsecondary study. The non-refundable LLC is equal to 20 percent of up to $10,000 of qualifying expenses per tax return.
The Pell Grant is a government scholarship provided to eligible students based in part on financial need. For the 2015 to 2016 award year, the maximum grant was $5,775. This amount increased to $5,815 for the 2016 to 2017 award year. A student can choose whether to allocate his or her Pell Grant (and many other scholarships) to tuition, fees, and course related materials or to living expenses when filing a tax return. If the student allocates the Pell Grant or other scholarships to tuition and fees, the scholarship reduces the amount of expenses eligible to be used to claim education-related tax credits. If allocated to living expenses, however, then the scholarship becomes taxable for the student. Students have this choice regardless of how the school applies the scholarship.
Pell Grants can be treated in one of two ways for tax purposes:
(1) Tax-free and subtracted from AOTC-eligible expenses: Pell Grants allocated to QTRE are excluded from taxable income, but they are also subtracted from QTRE for purposes of the AOTC and LLC, potentially reducing the credit for which students are eligible; or
(2) Taxable and not subtracted from AOTC-eligible expenses: Pell Grants allocated to living expenses such as room and board are included in the student's taxable income and are not subtracted from QTRE for purposes of the AOTC and LLC, potentially increasing the credit for which students are eligible.
Interaction of Pell Grants and Tax Credits
According to the Treasury Department, many students would benefit by claiming at least a portion of their QTRE for the AOTC, even if that requires including some of their Pell Grant (or other scholarships) in taxable income. If a student's QTRE exceeds his scholarships by $4,000 or more, the student can claim the maximum AOTC without having to include any scholarship in income. But if QTRE minus scholarships is less than $4,000, the student may benefit by including a portion of the scholarship in income in order to claim a larger AOTC.
Under Reg. Sec. 1.25A-5(c), the student generally can treat Pell Grant funds to have been used for non-QTRE, such as room and board, simply by including the funds in income. Because scholarships grants that the student includes in income don't reduce the student's QTRE available to determine the AOTC, including enough of the grant in income to report up to $4,000 in QTRE could increase the credit by enough to increase an available tax refund or reduce the amount of tax owed, even considering any increased tax liability from the additional income. However, the increase in tax liability as well as the loss of other tax credits may be greater than the additional AOTC and may cause a potential tax refund to decrease or the amount of tax owed to increase.
The Treasury noted that the tax-minimizing allocation of Pell Grants and other scholarships between QTRE and living expenses depends on a number of factors, including the terms of each scholarship, the amount of scholarships and expenses, the student's marginal tax rate and income tax available for use against the non-refundable share of AOTC or LLC, and, in the case of tax dependents, the parents' income tax before AOTC or LLC. The calculation of the optimal strategy is especially complicated, the Treasury stated, because in the case of a dependent student it may depend on two tax returns and because a student's marginal tax rate may change depending on how much of the scholarship is included in income.
For a discussion of the American opportunity tax credit, see Parker Tax ¶101,115.
