Federal Tax Bulletin - Issue 129 - December 5, 2016

Developer's Losses in Real Estate Downturn Don't Translate into Deductible Losses

The Eleventh Circuit affirmed the Tax Court and held that a real estate developer could not deduct losses resulting from the housing crisis because the properties had not been abandoned as of the end of the year the loss was taken. Because the properties were encumbered by recourse debt, the loss deductions could not be taken before the year a foreclosure sale occurs, regardless of whether the property was abandoned by or became worthless to the mortgagor in a prior year. Tucker v. Comm'r, 2016 PTC 489 (2016).

Background

Harvey Tucker was the president, director, and sole shareholder of Paragon Homes Corporation, a Florida S corporation in the business of real estate acquisition, development, and sales. Paragon took out recourse mortgages with several banks, including Platinum Bank, Branch Banking & Trust Co. (BB&T), Wachovia Bank, and Fidelity Bank. Tucker personally guaranteed the mortgage loans on Paragon's properties.

In 2007 and 2008, the residential real estate market went into sharp decline. According to Tucker, Paragon was essentially out of business and insolvent by the end of 2008. Paragon had no sales and no revenue and, as a result, stopped operations at the end of 2008. Tucker claimed that at the end of 2008, he owed more than $2 million on Paragon's "underwater" properties. Paragon closed its office, dismissed its employees, and stopped making payments on its mortgages, insurance premiums, and taxes. At the close of 2008, Paragon had approximately $12,000 in its bank accounts. According to Tucker, Paragon's real estate inventory - individually and in the aggregate - was "worthless" as of December 31, 2008, because "prices had fallen through the floor. There was no demand and we couldn't generate any sales." However, in 2009, Paragon initiated the process to build a single-family home on one of its properties and, in 2010, sold a property and used the proceeds to satisfy a mortgage loan with one of its lenders.

Although Tucker and Paragon were relieved of all mortgage obligations with Platinum Bank and BB&T at the end of 2009, they were both still personally liable for mortgage loans with Fidelity and Wachovia at that time. In order to protect his personal assets from creditors, Tucker established a family limited partnership, the Harvey L. Tucker Family LLLP (Tucker LLLP). In December of 2009, Paragon transferred $400,000 to Tucker and he used the money to fund Tucker LLLP. On December 28, 2009, Paragon directly transferred $358,255 to Tucker LLLP.

In 2010, Fidelity and Wachovia filed foreclosure suits against Tucker and Paragon with respect to certain properties. Several months later, proceeds from certain property sales were used to repay in full the mortgage loans held by Fidelity.

At the end of 2008, Paragon wrote down the value of its real property holdings and claimed a loss deduction under Code Sec. 165, which flowed through to Tucker's personal tax return. Tucker justified the write down by arguing that Paragon abandoned the properties in 2008 or, in the alternative, that the properties became worthless. Tucker claimed a net operating loss deduction for 2008 as a result of the pass through of losses from Paragon and elected to carryback the loss to his 2003 through 2006 tax returns. The IRS disallowed these deductions and Paragon's write down of its real property holdings in 2008 and the case went to the Tax Court.

Deducting Property Losses

Under Code Sec. 165, a deduction is allowed for losses stemming from closed and completed transactions, which may include abandonment of an asset or an asset becoming worthless. Case law provides that, to show abandonment of an asset, there must be  

(1) an intention on the part of the owner to abandon the asset; and  

(2) an affirmative act of abandonment.  

Additionally, the abandonment must occur in the tax year for which the deduction is claimed. Mere nonuse alone is not sufficient to accomplish abandonment. A Code Sec. 165 loss for the worthlessness of mortgaged property requires worthlessness of the taxpayer's equity in the property. When a taxpayer's real property is secured by a recourse obligation, no loss deduction is available until the year of a foreclosure sale, regardless of whether the taxpayer claims to have abandoned the property in a prior year or claims the property became worthless in a prior year.

Tucker's Arguments

Tucker argued that Paragon's investments in its properties were "closed and completed" at the end of 2008 because it was impossible for Paragon to spend additional money on its properties or to ever pay any money towards any deficiency judgment obtained by the banks at that time or thereafter. Tucker argued that any money subsequently invested in the properties or paid to the banks came from his own pocket, not from Paragon, because he was personally liable for the mortgage loans as a result of his guaranties. In essence, Tucker argued that the facts and circumstances of his case distinguished it from other cases involving recourse loans and, thus, the general rule precluding a loss deduction until foreclosure in cases involving recourse debt should not apply.

Tax Court's Decision

The Tax Court held that Tucker had not met his burden of establishing the abandonment or worthlessness of the properties by the end of 2008; thus, he was not entitled to a deduction for the decline in the value of Paragon's properties in 2008. Paragon was personally liable for the mortgage loans regardless of whether it could pay, the court noted. This meant that the banks could go after Paragon for the remainder of the debt if the proceeds from foreclosure were inadequate to cover Paragon's debt obligations. A taxpayer's equity in mortgaged property for which the taxpayer is personally liable, the court said, is not worthless before a foreclosure sale because the property continues to have some value which, when determined by the sale, bears directly upon the extent of the owner's liability for a deficiency judgment. The court thus concluded that Paragon's properties continued to have value before their respective foreclosure sales in 2009 and 2010 even if, as Tucker claimed, Paragon had no additional funds to reimburse its lenders. Furthermore, the court observed, Paragon had funds in 2008 that Tucker transferred a year later to Tucker LLLP, as a way to preclude reimbursement to lenders.

Arguments on Appeal

Tucker appealed and argued that abandonment of the properties was indicated by Paragon closing its office, dismissing its employees, and stopping payments on its obligations by December 31, 2008. According to Tucker, Reg. Sec. 1.165-1(d) supported his taking a loss in 2008 because the regulation provides that a loss is treated as sustained during the tax year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such tax year. According to Tucker, the 2008 market crash was just such an event.

Eleventh Circuit Affirms Tax Court

The Eleventh Circuit affirmed the Tax Court's decision. The Tax Court's finding that there was no indication that any of Paragon's properties were abandoned by the end of 2008 was not clearly erroneous. Paragon continued to develop and sell the properties throughout 2009 and 2010, the court noted. Tucker also funneled more than $800,000 of his personal money into Paragon's business account in order to facilitate construction on the properties. And Paragon never offered to reconvey the properties back to the mortgagees in lieu of foreclosure. Instead, the Eleventh Circuit observed, Paragon signed settlement agreements with Platinum and BB&T in late 2009 and these overt acts did not indicate to the court an intention to abandon the properties.

In reaching its conclusion, the Eleventh Circuit cited the decision in Comm'r v. Green, 126 F.2d 70 (3d Cir. 1942), a case involving a loss deduction on the abandonment of real property. In Greene, the Third Circuit explained that whether a mortgage at issue is a recourse mortgage is of "fundamental importance" to resolving the case. That is because where the mortgagor retains liability for the debt, the property continues until the foreclosure sale to have some value which, when determined by the sale, bears directly upon the extent of the owner's liability for a deficiency judgment. The Eleventh Circuit noted that Tucker was seeking to evade this general rule by relying on his novel interpretation of Reg. Sec. 1.165-1(d).

While the court found case law support for Tucker's contention that market events can sufficiently "fix" a loss such that a deduction could be taken in the year that the loss occurs, none of those cases involved recourse loans or a nominally defunct business that continued to develop and sell the allegedly worthless asset after its alleged dissolution. Moreover, the court observed, Tucker could point to no case law supporting his "tortured and novel" reading of the regulation. The thrust of the regulation, the court said, is that a taxpayer may only claim a deduction under Code Sec. 165(a) in the year that the amount of the loss becomes readily ascertainable and the total losses to Paragon were not ascertainable or fixed at the end of 2008.

The court also addressed Tucker's contention that his actions after 2008 were intended to protect himself from his creditors and personal obligations on the mortgages, and that he did not act to protect or save Paragon. The court noted there was no case law support for an argument that Tucker's subjective intention to act purely for his own protection was sufficient to meet his burden of showing he had an abandonment loss. And, the court observed, his argument that Paragon was essentially defunct and out of business by the end of 2008 was belied by the evidence indicating that Paragon continued taking part in transactions after 2008.

For a discussion of the deductibility of real estate losses where property is underwater and abandoned, see Parker Tax ¶114,520.

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Gift Arose from Merger of Family's Corporations; Case Remanded to Consider Challenges to IRS Valuation

The First Circuit affirmed the Tax Court's determination that an IRS notice of deficiency assessing gift taxes from the merger of the taxpayers' corporation with their sons' was not arbitrary, despite the IRS's initial failure to appraise the corporations. However, the court held the Tax Court erred in accepting the IRS's valuation of the corporations without first allowing the taxpayers an opportunity to challenge the valuation. Cavallaro v. Comm'r, 2016 PTC 486 (1st Cir. 2016).

Background

In 1979, William and Patricia Cavallaro started Knight Tool Co. (Knight), a contract manufacturing company that made custom tools and machine parts. In 1982, Knight deviated from its traditional business and developed a liquid-dispensing system for adhesives called CAM/ALOT. Although Knight invested substantial resources in CAM/ALOT's development, the product had significant flaws, and profits failed to outpace production costs. As a result, the

Cavallaros decided to refocus on their core business. Their son, Ken, however, continued to believe in the CAM/ALOT technology and along with his two brothers, Paul and James, organized a new corporation, Camelot Systems, Inc. (Camelot), to further develop it.

Everyone who worked on CAM/ALOT systems after Camelot's incorporation, including Ken, remained on the Knight payroll and received all their wages from Knight. In addition, Knight manufactured the CAM/ALOT systems, while Camelot sold and distributed them to third parties.

Camelot also did not have its own bank accounts and, with minor exceptions, Camelot's bills were paid using Knight's funds.

In 1994, the Cavallaros hired both accountants and lawyers to review their estate plan. There was significant friction between these two groups of advisers; the lawyers wanted the Cavallaros to claim that the value of the CAM/ALOT technology was vested in Camelot - and so was already owned by Ken, Paul, and James - whereas the accountants objected to this proposal because it was at odds with the overwhelming evidence that Knight owned the technology and always had. The lawyers' view prevailed, and both groups of professionals suggested that a 1987 transfer of the CAM/ALOT technology be memorialized in affidavits and a confirmatory bill of sale. Members of the Cavallaro family signed these documents in May 1995.

Knight and Camelot subsequently prepared to merge. As part of their preparations, the Cavallaros hired accountant Timothy Maio to determine the respective values of the two companies. Using a market-based approach, Maio valued the proposed combined entity at $70-$75 million and valued Knight's portion at just $13-$15 million. Maio assumed that Camelot owned the CAM/ALOT technology and that Knight was a contractor for Camelot. On December 31, 1995, Knight and Camelot merged in a tax-free merger that left Camelot as the surviving corporation.

In 1998, the IRS opened an examination of Knight's and Camelot's 1994 and 1995 income tax returns, during which the IRS identified a possible gift tax issue in connection with the 1995 merger. The IRS determined - without first having obtained an appraisal - that Camelot had a pre-merger value of $0, and that when Knight merged with Camelot, William and Patricia Cavallaro each made a taxable gift of $23,085,000 to their sons. As a result, the IRS determined each of the Cavallaros incurred an increase in tax liability in the amount of $12,696,750. The IRS also imposed additions to tax for failure to file gift tax returns and fraud penalties. The Cavallaros took their case to the Tax Court.

Tax Court's Analysis

Before the Tax Court, the IRS disclosed that - after the notices of deficiency were issued - it directed accountant Marc Bello to appraise the value of both Knight and Camelot at the time of the merger. Working under the assumption that Knight rather than Camelot owned the CAM/ALOT technology, Bello valued the combined entities at approximately $64.5 million, concluding that Camelot was worth $22.6 million. Because the deficiencies would therefore be lower than those set forth in the original notices, the Cavallaros used the Bello report to argue that the original notices of deficiency were arbitrary and excessive. While noting that it was true that the IRS did not obtain an appraisal before issuing the notices of deficiency, the Tax Court held that there was a sufficient basis for issuing the notices and, thus, that they were not arbitrary.

The Tax Court ultimately concluded that the Cavallaros were deficient in paying the gift tax due for calendar year 1995: William owed $7,652,980 and Patricia owed $8,009,020. The court also determined that no penalties for underpayment were due and that there were no additions to tax due for failure to file a gift tax return because the taxpayers disclosed all the relevant facts regarding Knight and Camelot to their experienced accountants and estate-planning attorneys and followed their advice in good faith. The taxpayers appealed the decision to the First Circuit.

First Circuit's Analysis

On appeal, the Cavallaros renewed their argument that the Tax Court erred in not finding that the original notices of deficiency were arbitrary and excessive. In addition, they argued that the Tax Court improperly concluded that Knight owned all of the CAM/ALOT-related technology, and that the court erred by failing to consider alleged flaws in Bello's valuation of the two companies.

The First Circuit noted the IRS's original deficiency notices assumed that, premerger, Camelot had no value. According to the Cavallaros, the IRS's later realignment with the Bello valuation established that the IRS used no formula and lacked any support at all for that initial $0 valuation; thus, the couple argued that the IRS's assessment was without rational foundation and was excessive. However, the court remarked, the IRS had discovered - prior to issuing the original notices of deficiency - that the Cavallaros had followed the advice of an estate-planning lawyer, Hamel, who advocated disregarding or suppressing facts showing that Knight owned the CAM/ALOT technology in order to memorialize technology transfers financially advantageous to the Cavallaro family. That, the court stated, together with related documents, was a sufficient basis for concluding that Camelot's value was de minimis. Accordingly, the circuit court held that the original deficiency notices were not arbitrary and excessive.

The Cavallaros also challenged the Tax Court's finding that Knight owned all of the CAM/ALOT technology, but the court determined that the record supported the Tax Court's determinations. The court noted that Knight created the first CAM/ALOT system, and, even after Camelot's incorporation, the companies' financial affairs overlapped significantly. Further, the court said, The CAM/ALOT trademark was registered to Knight until the day of the merger, and four patent applications, each filed by William, identified Knight - not Camelot - as his assignee. The court held that the Cavallaros advanced no argument that would warrant overturning the Tax Court's finding that Knight owned all of the CAM/ALOT technology at the time of the merger.

Lastly, the court observed that in challenging the valuation provided by Bello and relied upon by the Tax Court, the Cavallaros argued that the Tax Court erred when it refused to consider their evidence that the Bello valuation was flawed. The Cavallaros attempted to show that the IRS' valuation was arbitrary and excessive by challenging Bello's methodology, but the Tax Court refused to hear those challenges on the grounds that, even if the Cavallaros were right, they could not show the correct amount of their tax liability. The court determined that the Cavallaros should have had the opportunity to rebut the Bello report and to show that the IRS' assessment was "arbitrary and excessive." If they had succeeded in doing so, the court said, the Tax Court should have then determined for itself the correct amount of tax liability rather than simply adopting the IRS's assessment, as it had done. Accordingly, the First Circuit remanded the case so that the Tax Court could evaluate the Cavallaros' arguments that the Bello valuation had methodological flaws that made it arbitrary and excessive.

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Mortgage Modifications Qualify for Debt Forgiveness If Entered into Before Provision Expires

The IRS has issued a notice providing that qualified principal residence debt will still be considered discharged under the exclusion in Code Sec. 108(a) if, before January 1, 2017, a mortgage loan servicer sends a borrower-homeowner a notice in conjunction with a written Trial Period Plan (TPP) under the Principal Reduction Modification Program (PRMP) or the Home Affordable Modification Program (HAMP), even if the related mortgage modification occurs after that date. Notice 2016-72.

Under Code Sec. 108(a)(1)(E), the discharge of indebtedness income related to a discharge of qualified principal residence debt (i.e., a mortgage on the taxpayer's home) is generally excludable from gross income. Qualified principal residence debt is debt that is incurred to buy, build, or substantially improve the principal residence of the taxpayer and that is secured by that residence, and also includes a loan secured by the borrower's principal residence that refinances the debt, but only to the extent of the amount of the refinanced debt.

Observation: The maximum amount of discharged debt that a borrower may exclude from gross income under the qualified principal residence debt exclusion is $2,000,000 ($1,000,000 for a married individual filing a separate return).

The Protecting Americans from Tax Hikes Act of (PATH Act) extended the relief under Code Sec. 108(a)(1)(E) to arrangements entered into and evidenced in writing before January 1, 2017, in order to protect a borrower-homeowner who is in the process of obtaining a permanent modification of the mortgage loan during 2016, although the permanent modification of the mortgage loan resulting in discharge of indebtedness would not occur until after 2016.

The Principal Reduction Modification Program (PRMP) offers mortgage loan modifications to certain seriously delinquent, underwater borrower-homeowners who are still struggling in the aftermath of the 2008 financial crisis. The PRMP is a targeted, one-time offering for borrower-homeowners whose loans are owned or guaranteed by Fannie Mae or Freddie Mac and who meet specific eligibility criteria. For a borrower-homeowner to take advantage of the PRMP, the mortgage loan servicer must solicit the borrower-homeowner's participation by sending the borrower-homeowner a notice of PRMP eligibility in conjunction with a written Trial Period Plan (TPP) or, for a borrower-homeowner in an active TPP, a separate notice of PRMP eligibility in a written opt-out letter. If the conditions set out in the TTP are satisfied within a required time frame, then the borrower-homeowner is offered a permanent modification of the terms of the mortgage loan. The modification includes monthly mortgage payments that are lower than or equal to those under the old mortgage loan and, generally, a principal reduction. The Home Affordable Modification Program (HAMP), currently available through the end of 2016, offers a similar program to help distressed borrower-homeowners lower their monthly mortgage payments.

Notice 2016-72 provides that, for purposes of the exclusion for qualified principal residence debt, such debt is discharged "subject to an arrangement that is entered into and evidenced in writing before January 1, 2017" within the meaning of Code Sec. 108(a)(1)(E)(ii) if:

(1) before that date, a mortgage servicer sends a borrower-homeowner under the PRMP a notice in conjunction with a written TPP or, for a borrower-homeowner in an active TPP, a separate notice in a written opt-out letter outlining the terms and conditions of the permanent mortgage loan modification following completion of the active TPP;

(2) the borrower-homeowner satisfies all of the Trial Period and PRMP Conditions; and

(3) the borrower-homeowner and servicer enter into a permanent modification of the mortgage loan on or after January 1, 2017.

A similar conclusion applies to a TPP under HAMP.

For a discussion of the qualified principle residence debt exclusion, see Parker Tax ¶76,125.

For a discussion of the Home Affordable Modification Program, see Parker Tax ¶72,330.

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Court Rejects Sunoco's $300 Million Refund Claim Relating to Fuel Mixture Credit

The Court of Federal Claims, in an issue of first impression, held that the Code Sec. 6426 fuel mixture credit reduces a taxpayer's gross excise tax liability under Code Sec. 4081, leading to a reduction in the taxpayer's costs of goods sold and an associated increase in taxable income. The court rejected the taxpayer's $300 million refund claim, as well as the taxpayer's argument that the credit is a tax-free payment that does not reduce gross excise tax liability and, thus, does not reduce cost of goods sold. Sunoco, Inc. v. Comm'r, 2016 PTC 492 (Fed. Cl. 2016).

Sunoco, Inc., a fuel producer, filed suit in the Court of Federal Claims seeking a $300 million tax refund for tax years 2005 to 2008, based on its interpretation of the Code Sec. 6426 alcohol fuel mixture credit (mixture credit). The court noted that the case was one of first impression, and that Sunoco's arguments turned exclusively on statutory interpretation.

As a fuel producer that blends ethanol into its fuel, Sunoco, Inc. is entitled to claim the mixture credit against its excise tax liability under Code Sec. 4081. The court, citing to Mohawk Liqueur Corp. v. U.S., 324 F.2d 241 (6th Cir. 1963), noted that excise tax payments are includable in a taxpayer's cost of goods sold, and that the cost of goods sold reduces the taxpayer's gross income. With lower gross income comes lower income tax liability. The court observed that one could compare the relationship between excise tax liability and income tax liability to two people on a seesaw: when excise tax liability goes up, income tax liability goes down, and vice versa.

The question central to the case was whether a taxpayer like Sunoco must include its net excise tax liability, reduced by the mixture credit, in its cost of goods sold, or whether Sunoco could include its gross excise tax liability, without a reduction for the mixture credit, in its cost of goods sold. The court observed that if the mixture credit is interpreted as a reduction of excise tax liability, as argued by the IRS, then the taxpayer's income tax liability would increase as a result of that reduction. However, the court said, if the mixture credit does not affect the taxpayer's excise tax liability - as Sunoco argued - then the taxpayer's income tax liability would decrease.

Sunoco's argument, the court stated, treated the mixture credit as a tax-free payment of its gross excise tax liability, which would significantly reduce Sunoco's income tax liability because it would not reduce Sunoco's cost of goods sold. The IRS argued that Sunoco's interpretation would result in a windfall that Congress did not intend, citing the mixture credit's plain language and legislative history to show that Congress intended to replace the previous excise tax exemption for alcohol mixtures with an "equivalent benefit," rather than a significantly larger combined excise and income tax incentive.

Noting that the statutes at issue were not crystal clear, the court found the IRS's interpretation more persuasive. The court held that the mixture credit must be treated first as a reduction of the taxpayer's excise tax liability, with any remaining amount treated as tax-free payment. Had Congress intended, as Sunoco argued, to drastically increase the tax incentives fuel producers receive from blending alcohol into their fuels, the court said, one would expect to see at least some inkling of this intent in the legislative history or the Code. No such inkling appeared and the court concluded that Sunoco was not entitled to a tax refund.

For a discussion of the manufacturer's excise tax on fuel, see Parker Tax ¶236,101.

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Doctor Subject to Payroll Tax Penalty for Paying Employees Before IRS

A family doctor, whose medical practice owed over $10 million in unpaid payroll and withholding taxes, was a responsible person and was liable for payroll tax penalties when he paid his employees before paying the IRS. The court rejected the doctor's argument that the $100,000 he loaned to his practice to pay his employees was "encumbered" and thus the payment was not a willful transfer of unencumbered funds to a creditor other than the IRS. McClendon v. U.S., 2016 PTC 484 (S.D. Tex. 2016).

Background

Dr. Robert McClendon founded Family Practice Associates of Houston, a medical-service provider, in 1979. In 1995, Family Practice hired Richard Stephen, Jr., as its Chief Financial Officer. By 2009, Family Practice owed over $10 million in unpaid payroll and other withholding taxes. Dr. McClendon learned that these taxes were unpaid on May 11, 2009. Stephen pleaded guilty to three counts of felony theft of money that he embezzled from Family Practice. Family Practice stopped operating and remitted its remaining receivables to the IRS to pay toward the tax liability.

McClendon made a $100,000 personal loan to Family Practice for the restricted purpose of using the funds to pay the May 15, 2009, payroll. Family Practice used that loan to pay its employees. As a result of McClendon paying his employees before paying back payroll taxes to the IRS, the IRS assessed a total of $4.3 million in tax penalties under Code Sec. 6672. McClendon paid a small part, then sued for a refund and abatement of the remaining penalty amount.

Code Sec. 6672 Penalty

To ensure that payroll and withholding taxes are remitted to the Treasury Department, Code Sec. 6672(a) imposes a penalty on any person required to collect, truthfully account for, and pay over any payroll and withholding tax. Under this provision, the term "liability" is composed of two elements:  

(1) that the taxpayer was a "responsible person," and  

(2) that the taxpayer willfully failed to collect, account for, or pay over such taxes.

Several courts, including the Fifth Circuit (to which the instant case would be appealable), have held that in the case of individuals who are responsible persons both before and after withholding tax liability accrues, there is a duty to use unencumbered funds acquired after the withholding obligation becomes payable to satisfy that obligation and failure to do so when there is knowledge of the liability constitutes willfulness.

Taxpayer's Arguments

McClendon conceded that he was a "responsible person." However, he contended that he did not willfully fail to collect, account for, or pay taxes that Family Practice owed to the IRS. McClendon first argued that because he loaned the money to Family Practice on the understanding that it could use the money only to cover payroll, the funds were "encumbered." According to McClendon, because he loaned the money to Family Practice with the express restriction that it could use the money only to cover payroll, the funds were "encumbered" and willfulness is shown as a matter of law only by evidence that a responsible person directed "unencumbered" funds to a creditor other than the government.

McClendon also argued that he had reasonable cause to provide a way to pay the employees because "he acted morally and generously in using his own money to make sure Family's staff . . . were paid for the work they had performed."

District Court's Opinion

The district court began by citing Logal v. U.S., 195 F.3d 229, 232 (5th Cir. 1999), for the principle that willfulness is normally proved by evidence that a responsible person paid other creditors with knowledge that withholding taxes were due at the time to the United States. Payment of wages to employees, the court noted, counts as a payment to a creditor for purposes of this principle. According to the court, if a responsible person knows that withholding taxes are delinquent, and uses corporate funds to pay other expenses, even to meet the payroll out of personal funds he lends the corporation, he has acted willfully within the meaning of Code Sec. 6672.

Thus, the district court rejected McClendon's arguments and granted summary judgment to the IRS. The Fifth Circuit, the court concluded, has made clear that a taxpayer who consciously decides to use unencumbered funds to pay a creditor other than the government cannot benefit from the reasonable-cause defense. The court found no basis for a different result in McClendon's situation.

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

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Proposed Regs Address IPIC Pooling for Dollar-Value LIFO Method of Accounting

The IRS has issued proposed regulations relating to the establishment of dollar-value last-in, first out (LIFO) inventory pools by taxpayers that use the inventory price index computation (IPIC) pooling method. The regulations generally provide that a taxpayer whose trade or business consists of both manufacturing or processing activity and resale activity cannot commingle the manufactured or processed goods and the resale goods within the same IPIC pool. The regulations are effective when finalized. REG-125946-10 (11/28/16).

Background

Code Sec. 472 permits a taxpayer to account for inventories using the last-in, first-out (LIFO) method of accounting. The LIFO method of accounting for goods treats inventories on hand at the end of the year as consisting first of inventories on hand at the beginning of the year and then of inventories acquired during the year. Reg. Sec. 1.472-8(a) provides that taxpayers can elect to determine the cost of its LIFO inventories using the dollar-value method, under which cost is determined by using "base-year" costs expressed in terms of total dollars, rather than the quantity and price of specific goods as the unit of measurement. The "base-year" cost is the aggregate of the cost of all items in a "pool," which generally consists of groups of substantially similar items.

Any taxpayer that elects to use the dollar-value LIFO method to value LIFO inventories can also elect to use the inventory price index computation (IPIC) method to compute the base-year cost and determine the LIFO value of a dollar-value pool for a trade or business. Reg. Sec. 1.472-8(b)(4) governs the application of the IPIC pooling method to manufacturers and processors, while Reg. Sec. 1.472-8(c)(2) governs the application of the IPIC pooling method to wholesalers, retailers, jobbers, and distributors. For manufacturers and processors, IPIC pools may be established based on the 2-digit commodity codes in Table 9 of the Producer Price Index Detailed Report (PPI Detailed Report).  

For retailers, IPIC pools may be established based on either the general expenditure categories in Table 3 of the Consumer Price Index Detailed Report (CPI Detailed Report), or based on the 2-digit commodity codes in the PPI Detailed Report.  

Wholesalers, jobbers, or distributors using the IPIC pooling method can only use the 2-digit commodity codes to establish IPIC pools.  

In addition, a taxpayer establishing IPIC pools may combine IPIC pools that comprise less than 5 percent of the total inventory value of all dollar-value pools to form a single miscellaneous IPIC pool. If the resulting miscellaneous IPIC pool is less than 5 percent of the total inventory value of all dollar-value pools, the taxpayer may combine the miscellaneous IPIC pool with its largest IPIC pool.

The general pooling rules of Reg. Sec. 1.472-8(b) and (c) provide that where a taxpayer is engaged in both a manufacturing or processing activity and a wholesaling or retailing activity, separate pooling rules apply to the separate activities, and goods purchased for resale may not be included in the same pool as manufactured or purchased goods. On the other hand, the IPIC pooling rules address circumstances where a trade or business consists entirely of a manufacturing, processing, retailing, or wholesaling activity. According to the IRS, there is some confusion concerning how the IPIC pooling rules apply where a taxpayer is engaged in both a manufacturing or processing activity and a wholesaling or retailing activity. Accordingly, the IRS has issued proposed regulations to address the confusion.

Proposed Regs Clarify IPIC Pooling

The proposed regulations generally clarify that an IPIC-method taxpayer who elects the IPIC pooling method described in Reg. Sec. 1.472-8(b)(4) or (c)(2) and whose trade or business consists of both manufacturing or processing activity and resale activity may not commingle the manufactured or processed goods and the resale goods within the same IPIC pool.

Under the proposed regulations, a manufacturer or processor using the IPIC pooling method under Reg. Sec. 1.472-8(b)(4) that is also engaged, within the same trade or business, in wholesaling or retailing goods purchased from others can elect to establish dollar-value pools for the manufactured or processed items accounted for using the IPIC method based on the 2-digit commodity codes in the PPI Detailed Report. If the manufacturer or processor makes this election, the manufacturer or processor must also establish pools for its resale goods in accordance with Reg. Sec. 1.472-8(c)(2) (that is, based on the general expenditure categories in the case of a retailer or the 2-digit commodity codes in the case of a retailer, wholesaler, jobber, or distributor).

Similarly, a wholesaler, retailer, jobber, or distributor using the IPIC pooling method under Reg. Sec. 1.472-8(c)(2) that is also engaged, within the same trade or business, in manufacturing or processing activities can elect to establish dollar-value pools for the resale goods accounted for using the IPIC method in accordance with Reg. Sec. 1.472-8(c)(2) (that is, based on the general expenditure categories in the case of retailer or the 2-digit commodity codes in the case of a wholesaler, retailer, jobber, or distributor). If the wholesaler, retailer, jobber, or distributor makes this election, it must also establish pools for its manufactured or processed goods based on the 2-digit commodity codes.

If the taxpayer chooses to use the 5-percent method of pooling, the proposed regulations provide that resale IPIC pools of less than 5 percent of the total value of inventory can be combined to form a single miscellaneous IPIC pool of resale goods. The taxpayer can also combine the IPIC pools of manufactured or processed goods of less than 5 percent of the total value of inventory to form a single miscellaneous IPIC pool of manufactured or processed goods. If the resale miscellaneous IPIC pool or the manufacture or processed IPIC pool is less than 5 percent of the total value of inventory, the taxpayer can combine the miscellaneous IPIC pool with the largest resale IPIC pool, or the largest manufactured or processed pool, whichever is applicable. These miscellaneous IPIC pools cannot be combined with any other IPIC pool (that is, a pool of manufactured goods cannot be combined with a pool of resale goods, or vice versa).

Each of these 5-percent rules is a method of accounting, thus, a taxpayer cannot change to, or cease using, either 5-percent rule without obtaining the IRS's prior consent.

The regulations are proposed to be effective when finalized.

For a discussion of the dollar value LIFO method, see Parker Tax ¶242,320.

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IRS's Own Evidence Supports Taxpayer's Mortgage Interest Deductions; Home Office Deduction Denied

The Tax Court determined that a taxpayer was entitled to a mortgage interest deduction for his residence, but denied his home office expense deductions. The court noted that a Form 1098 obtained by the IRS from the mortgage company, was sufficient evidence that the taxpayer paid the interest, despite the fact that the mortgage company had also issued a Form 1099-C in the same year, reporting that a substantial amount of interest on the debt had been forgiven. Alexander v. Comm'r, T.C. Memo. 2016-214.

Malcom Alexander owned two houses during 2010. The first house was in Washington, D.C., and the second was his principal residence in Gaithersburg, Maryland (Gaithersburg house). According to Alexander, he purchased the Gaithersburg house primarily for use in his multilevel network marketing business, and three of its 11 rooms - a first-floor office, a second-floor office, and a "presentation room" - regularly and exclusively for his business.

In 2010 Alexander paid to American Star Financial, Inc. (American Star), mortgage interest of $57,220 in connection with the Gaithersburg house. Also in 2010, American Star issued him a Form 1099-C, Cancellation of Debt, reporting that the company canceled $100,665 of debt relating to the Gaithersburg house, including $52,746 of interest.

On his 2010 income tax return, Alexander claimed a $57,220 deduction for the interest paid on the Gaithersburg house, and claimed he was entitled to a home office expense deduction for the use of 27.27 percent of the house. The IRS audited the return, and denied the deductions.

Code Sec. 163(h) generally allows taxpayers to deduct "qualified residence interest," which includes amounts paid or accrued during the taxable year on acquisition indebtedness (such as a mortgage).

Under Code Sec. 280A(c)(1), taxpayers can deduct expenses attributable to a home office if the expenses are allocable to a portion of the dwelling unit which is exclusively used on a regular basis as the principal place of business for the taxpayer's trade or business.

The Tax Court stated that at trial Alexander testified credibly that he paid $57,220 in mortgage interest to American Star in 2010, noting that a Form 1098, Mortgage Interest Statement, the IRS subpoenaed from the company showed that it received $57,220 of mortgage interest from Alexander in 2010 in connection with the Gaithersburg house.

The IRS argued that American Star canceled Alexander's mortgage interest for 2010 and therefore he did not pay the interest reported as received by American Star on the Form 1098. The court stated it was not persuaded by the IRS's argument for several reasons. First, the court said, the IRS presented no evidence that the reported cancellation of indebtedness was connected to the interest payments American Star reported having received. Second, the court noted the amount of interest reported as canceled on the Form 1099-C ($52,746) was not the same as the amount of interest reported as received by American Star on the Form 1098 ($57,220). Furthermore, the court observed, the IRS conceded before trial that Alexander wasn't liable for the cancellation of indebtedness income reported on the Form 1099-C. Accordingly, the court held that Alexander was entitled to his claimed $57,220 mortgage interest deduction.

With regard to Alexander's claimed home office expense deductions, the court noted that in order to substantiate that he used 3 of 11 rooms (i.e., 27.27 percent) of the Gaithersburg house regularly and exclusively for business purposes, Alexander offered into evidence copies of photographs depicting rooms, folding chairs, and social gatherings. However, the court stated, the copies of photographs did not establish whether the rooms were used regularly and exclusively for the network marketing business. In addition, the court stated that even if Alexander established that he used certain rooms regularly and exclusively for business purposes, he provided no testimony or documentation concerning the size of the house and rooms which would allow it to properly allocate costs. Accordingly, the court sustained the IRS's disallowance of a home office expense deduction.

For a discussion of mortgage interest deductions, see Parker Tax ¶83,515. For a discussion of home office deductions, see Parker Tax ¶85,505.

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IRS Extends Deadlines to Furnish Health Coverage Information to Individuals

The IRS has extended the deadline for providers of minimum essential coverage and applicable large employers to furnish to individual taxpayers Form 1095-B, Health Coverage and Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, reporting health coverage for the 2016 tax year. The deadline has been extended from January 31, 2017, to March 2, 2017. This extension does not apply to forms required to be filed with the IRS. Notice 2016-70.

Affordable Care Act Information Reporting Requirements

Under Code Sec. 6055 and the related regulations, every person that provides minimum essential coverage to an individual during a calendar year must file with the IRS an information return and must furnish to the responsible individual identified on the return a written statement reporting the coverage. Form 1094-B, Transmittal of Health Coverage Information Returns, and Form 1095-B, Health Coverage, are used for purposes of Code Sec. 6055.

Under Code Sec. 6056 and the related regulations, applicable large employers (ALE) subject to the employer shared responsibility provisions sponsoring self-insured group health plans are required to report information about the coverage to the IRS and to full-time employees to which the coverage relates on Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, and Form 1094-C, Transmittal of Employer-Provided Health Insurance Offer and Coverage Information Returns.

Providers of minimum essential coverage and ALEs generally must file the information returns with the IRS on or before February 28 (March 31 if filed electronically) and must furnish the written statement to the responsible individual or full-time employee identified on the return on or before January 31. Failure to file or furnish these forms may subject the provider or ALE to penalties under Code Secs. 6721 and 6722.

Due Dates Extended for Furnishing 2016 Information Returns to Taxpayers

According to the IRS, a substantial number of employers, insurers, and other providers of minimum essential coverage need additional time beyond the January 31, 2017, due date to gather and analyze the information and prepare the 2016 Forms 1095-B and 1095-C to be furnished to individuals. Accordingly, Notice 2016-70 extends by 30 days the due date for furnishing the 2016 Form 1095-B and the 2016 Form 1095-C, from January 31, 2017, to March 2, 2017. The automatic extension provisions under Reg. Sec. 1.6055-1(g)(4) and Reg. Sec. 301.6056-1(g)(1) do not apply to these extended dates.

The IRS stated that no similar need for additional time for employers, insurers, and other providers of minimum essential coverage to file with the IRS the 2016 Forms 1094-B, 1095-B, 1094-C, and 1095-C. Therefore, Notice 2016-70 does not extend the due date for filing with the IRS the 2016 Forms 1094-B, 1095-B, 1094-C, or 1095-C, which remains February 28, 2017, if not filing electronically, or March 31, 2017, if filing electronically. Notice 2016-70 does not affect the provisions regarding automatic extensions of time for filing these returns, which is done by submitting a Form 8809, Application for Extension of Time To File Information Returns.

In addition, Notice 2016-70 provides transition relief from penalties under Code Secs. 6721 and 6722 for incorrect or incomplete information reported on the return or statement, provided reporting entities that can show that they have made good-faith efforts to comply with the information-reporting requirements under Code Sec. 6055 and 6056 for 2016 (both for furnishing to individuals and for filing with the IRS). This relief applies to missing and inaccurate taxpayer identification numbers and dates of birth, as well as other information required on the return or statement.

Observation: The information reporting penalties under Code Secs. 6721 and 6722 are $250 per Form 1094-B, Form 1094-C, Form 1095-B, or Form 1095-C with respect to which a failure occurs. The maximum penalty that may be imposed is $3,000,000.

In determining good faith, the IRS takes into account whether an employer or other coverage provider made reasonable efforts to prepare the required information for reporting to the IRS and furnishing it to employees and covered individuals, such as gathering and transmitting the necessary data to an agent to prepare the data for submission to the IRS, or testing its ability to transmit information to the IRS.

For a discussion of the information reporting requirements under the ACA for applicable large employers, see Parker Tax ¶191,160.

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IRS Finalizes Fee Increases for Taxpayers Entering Into Installment Agreements

The IRS has issued final regulations, effective beginning January 1, 2017, that increase the fee taxpayers are required to pay in order to enter into an installment agreement with the IRS. The regulations also establish new fees for taxpayers entering into such agreements online. T.D. 9798 (12/02/16).

Background

Code Sec. 6159 authorizes the IRS to enter into an agreement with any taxpayer for the payment of tax in installments, if the IRS determines that the installment agreement will facilitate the full or partial collection of the tax. Installment agreements are voluntary, and taxpayers may request an installment agreement in person, by completing the appropriate forms and mailing them to the IRS, online, or over the telephone. The terms of an installment agreement generally require the taxpayer to timely pay a minimum monthly payment, file all required tax returns, and pay all taxes in-full.

Since the enactment of the installment agreement program, the IRS periodically develops new ways for taxpayers to enter into and pay for installment agreements, such as through online payment agreements and direct debit online payment agreements. These installment agreement types have not had their own separate user fee, but instead have been included in the existing user fee structure.

To bring user fee rates for installment agreements in line with the current costs to the IRS, final regulations increase the user fee for the existing installment agreement types and introduce new fees for online payment agreements and direct debit online payment agreements. Five of these user fee rates are based on the full cost of establishing and monitoring installment agreements, while the sixth rate is for low-income taxpayers.

New and Increased User Fees for Installment Agreements

For regular installment agreements, taxpayers contact the IRS in person, by phone, or by mail and sets up an agreement to make manual payments over a period of time either by mailing a check or electronically through the Electronic Federal Tax Payment System (EFTPS). The fee for entering into a regular installment agreement is now $225 (increased from $120).

For direct debit installment agreements, taxpayers contact the IRS by phone or mail and sets up an agreement to make automatic payments over a period of time through a direct debit from a bank account. The fee for entering into a direct debit installment agreement is now $107 (increased from $52).

For online payment agreements, taxpayers set up an installment agreement through the IRS website and agree to make manual payments over a period of time either by mailing a check or electronically through the EFTPS. The fee for entering into an online payment agreement is $149 (new for 2017).

For direct debit online payment agreements, taxpayers set up an installment agreement through the IRS website and agree to make automatic payments over a period of time through a direct debit from a bank account. The fee for entering into a direct debit online payment agreement is $31 (new for 2017).

For restructured or reinstated installment agreements, taxpayers modify a previously established installment agreement or reinstate an installment agreement on which the taxpayer has defaulted. The fee for restructuring or reinstating an installment agreement is now $89 (increased from $50).

The low-income rate is a rate that applies when a low-income taxpayer enters into any type of installment agreement, other than a direct debit online payment agreement, and when a low-income taxpayer restructures or reinstates any installment agreement. The low-income rate is $43 (no change, but applies to restructured or reinstated agreements).

The regulations provide that the increased fees apply to installment agreements entered into, restructured, or reinstated on or after January 1, 2017.

For a discussion of installment agreements, see Parker Tax ¶250,515.