Federal Tax Bulletin - Issue 123 - September 9, 2016

Ninth Circuit Affirms Home Builder's Use of Completed Contract Method for Planned Community

The Ninth Circuit affirmed the Tax Court and held that a homebuilder and its affiliates properly accounted for income from their home construction contracts under the completed contract method of accounting. In doing so, the court rejected the IRS's contention that the subject matter of the contracts at issue was limited to a buyer's purchase of a house and lot, concluding instead that the subject matter of the contracts also included the development and its common improvements and amenities. As a result, the taxpayer was able to defer taxes on home sales in a planned community until 95 percent of the community was completed and accepted. Shea Homes, Inc. and Subsidiaries v. Comm'r, 2016 PTC 323 (9th Cir. 2016).

Background

Shea Homes, Inc. and Subsidiaries (SHI), is an affiliated group of corporations and a builder and developer of planned communities ranging in size from 100 homes to more than 1,000 homes in Colorado, California, and Arizona. SHI prides itself on providing customers with more than just the "bricks and sticks" of a home and emphasizes the features and lifestyle of a community to potential buyers.

SHI purchases land in various stages, from completely raw to finished lots in developed communities. Its business involves the analysis and acquisition of land for development, the construction and marketing of homes, and the design and/or construction of developments and homes on the land acquired. The costs incurred in its home construction business include: (1) acquisition of land; (2) financing; (3) municipal and other regulatory approvals of entitlements; (4) construction of infrastructure; (5) construction of amenities; (6) construction of homes; (7) marketing; (8) bonding; (9) site supervision and overhead; and (10) taxes. SHI's primary source of revenue from the home development business is from the sale of houses, a process that tends to take place over more than one tax year. SHI treats its home sale contracts as long-term home construction contracts and reports income using the completed contract method (CCM). Under Reg. Sec. 1.460-1(c)(3)(i), a taxpayer's contract is completed upon the earlier of:

(1) use of the subject matter of the contract by the customer for its intended purpose and at least 95 percent of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer; or

(2) final completion and acceptance of the subject matter of the contract.

In addition, Reg. Sec. 1.460-1(c)(3)(ii) provides that the date of contract completion is determined without regard to whether one or more secondary items have been used or finally completed and accepted.

SHI constructs its developments in a sequence of stages consisting of: (1) grading land; (2) initial construction of amenity and infrastructure common improvements; (3) construction of homes; and (4) construction and finalization of any remaining common improvements. The amount of time it takes to grade the land and initially construct the amenities and common infrastructure vary with the size, surface and subsurface condition, and nature of the development. SHI charges a single price for its homes. Before closing on a home, SHI must either construct all common improvement areas for the development (or phase) or post a bond. Therefore, in some instances the buyers pay the full contract price before all of the common improvements and amenities promised for that development are completed.

In reporting its taxable income, SHI applies the 95 percent test to determine the year of contract completion and, hence, the year in which it recognizes income from the long-term home construction contracts.

For the years at issue, SHI took the position that the subject matter of the home construction contracts included the development in which the home was situated. For each tax year, SHI would calculate, on a development-by-development basis, whether it had incurred at least 95 percent of the budgeted costs of the development, including the costs of the houses and the common improvements and amenities. If the incurred costs were equal to or greater than 95 percent of the budgeted costs, then SHI reported income for that tax year from homes that had closed in escrow up to that date. If the incurred costs did not exceed 95 percent, then SHI deferred any income from homes that closed in escrow that year.

Shea Homes and IRS Positions

The IRS disagreed with SHI's tax treatment of its home sale contracts and assessed tax deficiencies. According to the IRS, SHI and its affiliates could not defer amounts under the CCM until the completion of a future common improvement because the primary subject matter of the contract was the home, and the cost of common improvements and any future obligations were secondary items and did not impact when a contract was completed on the subject matter. In effect, the IRS's position was that the subject matter of a contract for a home sale in a planned community development was limited to the house and lot alone. Citing Reg. Sec. 1.460-1(c)(3)(ii), the IRS said that anything other than the house and lot - for example, the common improvements - constituted "secondary items" to be ignored in determining when the contract was completed. In the IRS's view, SHI's home construction contracts were complete, under the final completion test, once a home purchase closed in escrow, even if SHI had not yet finished the development or the common improvements and amenities to which the buyer was entitled pursuant to his sale contract with SHI.

SHI argued that the subject matter of its contracts with the buyers went beyond a mere house and lot sale because it included the common improvements and the other requirements needed to create a house within the particularly oriented planned community development that the buyer had bargained for. Therefore, SHI said, it had properly applied the 95 percent test to determine the date of contract completion, and its method of accounting reflected the subject matter of its home construction contracts and clearly reflected income. SHI argued that the IRS's proposed method of recognizing income upon closing of a home purchase in escrow did not clearly reflect income.

Tax Court Sides with Shea Homes

The Tax Court agreed with SHI and held that the subject matter of the contracts consisted of the home and the larger development, including amenities and other common improvements. The court concluded that SHI and its affiliates properly reported income and losses from sales of homes in their planned developments using their interpretation of the CCM. According to the Tax Court, all aspects of the planned community development were understood by SHI and its buyers to be what was bargained for, and the home sale contracts reflected that understanding. SHI and its buyers had contracted for the entire lifestyle of the development and its amenities, the court noted, and the subject matter of each individually purchased home included the development, or phase of development, and its common improvements and amenities. The IRS appealed to the Ninth Circuit.

Arguments on Appeal

Before the Ninth Circuit, the IRS argued that SHI had to report income from its long-term contracts for the years in which the contracts closed in escrow because, in the IRS's view, the subject matter of the contract is the home and the lot upon which it sits. For other contracts, the IRS contended, SHI must account for the income under their normal method of accounting.

Alternatively, the IRS argued that if the Ninth Circuit held that the subject matter of the contracts was broader than the house and the lot, the court should apply the 95 percent completion test without regard to the costs attributable to common improvements because such improvements are secondary items. SHI rejected that analysis, contending that the common improvements are part of the primary subject matter of the contract - not secondary items - and that it could include such allocable costs in applying the 95 percent test.

Ninth Circuit's Rejects IRS Theories

The Ninth Circuit affirmed the Tax Court's decision. The contractual documents at issue, the court concluded, consisted of more than just the purchase and sale agreement. When such documents are examined together, the court said, it becomes readily apparent that the primary subject matter of the contracts includes the house, the lot, improvements to the lot, and common improvements to the development. The court found the amenities to be of great importance to, and a crucial aspect of, SHI's sales effort and thus an essential element of the home purchase and sale contract.

With respect to the IRS's alternative argument regarding the cost of the improvements being treated as secondary items, the court noted that the regulations do not define the term "secondary items." However, the court said, it was clear that the primary subject matter of the contracts included the improvements to the lot as well as the common improvements to the development and thus the improvements were an essential element of the home purchase and sale contract. The court noted that the appropriate scope of each contract as it involved common or exclusive off-lot amenities was a factual question and the IRS did not show that SHI's choices of development or phase as the scope for purposes of the 95 percent test as it involved off-lot amenities were improper or unreasonable.

Finally, the Ninth Circuit said that it was cognizant that its opinion could lead some taxpayers to believe that large developments might qualify for extremely long, almost unlimited deferral periods. It cautioned that a determination of the subject matter of the contract is based on all the facts and circumstances and that if one of the SHI's affiliates had, for example, attempted to apply the contract completion tests by looking at all contemplated phases, it was unlikely that the subject matter as contemplated by the contracting parties could be stretched that far. Additionally, the court noted, Reg. Sec. 1.460-1(c)(3)(iv)(A) (relating to final completion and acceptance) may prohibit taxpayers from inserting language in their contracts that would unreasonably delay completion until such a super development is completed.

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Partnership Not Entitled to Capital Gain Treatment on Forfeited Deposit

The Tax Court held that, where a partnership received as income a $9.7 million deposit forfeited by a prospective buyer of its hotel when the deal fell through, the deposit was taxable as ordinary income. The court rejected the partnership's argument that, under Code Sec. 1234A, the income was capital gain because the sale of the hotel would have been treated as capital gain under Code Sec. 1231. CRI-Leslie, LLC v. Comm'r, 147 T.C. No. 8 (2016).

Background

In 2005, CRI-Leslie, a partnership, purchased the Radisson Bay Harbor Hotel in Tampa, Florida. The property consisted of both land and improvements thereon. The improvements included the hotel, a restaurant, a swimming pool, a parking lot, and landscaping.

In 2006, CRI-Leslie agreed to sell the hotel to RPS, LLC. Under a purchase and sale agreement, CRI-Leslie agreed to sell the property to RPS, LLC for $39 million. RPS, LLC put down a nonrefundable deposit of $9.7 million in connection with the agreement. The deposit was to be applied to the property's purchase price at closing. The agreement was revised and amended several times over the next two years, including an increase in the property's purchase price to $39.2 million. RPS, LLC, defaulted on the agreement in 2008. CRI-Leslie kept the $9.7 million and reported the deposit income as net long-term capital gain on its 2008 partnership income tax return. The IRS rejected that characterization and assessed a deficiency based on its determination that the $9.7 million deposit was ordinary income to the partnership.

Code Sec. 1221(a)(2) excludes depreciable property used in the taxpayer's trade or business, as well as real property used in a trade or business, from the definition of a capital asset. CRI-Leslie and the IRS agreed that the property at issue was real property used in CRI-Leslie's hotel and restaurant business, meaning that it fell within Code Sec. 1221(a)(2) and was therefore not a capital asset under Code Sec. 1221(a). However, the parties agreed that the property was properly classified under Code Sec. 1231(b)(1) as property used in the trade or business of CRI-Leslie. Had CRI-Leslie sold the property in 2008, the gain from the sale would have resulted in Code Sec. 1231 gain, which would have been treated as long-term capital gain under Code Sec. 1231(a)(1).

Tax Treatment of Gains and Losses from Terminations of Certain Contractual Rights

Code Sec. 1234A addresses the tax treatment of gains or losses from terminations of certain contractual rights. It provides that a gain or loss attributable to the cancellation, lapse, expiration, or other termination of certain rights, obligations, or contracts is treated as a capital gain or loss. The provision applies to (1) a right or obligation (other than a securities futures contract, as defined in Code Sec. 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a Code Sec. 1256 contract not described in (1) which is a capital asset in the hands of the taxpayer. The IRS has not issued any final regulations under Code Sec. 1234A.

Issue of First Impression Before the Tax Court

The Tax Court stated that the issue before it was one of first impression: whether CRI-Leslie was entitled to capital gain treatment under Code Sec. 1234A for its right to retain the forfeited $9.7 million deposit from a canceled sale of real property used in its trade or business, where such sale would have generated a capital gain. The court noted that while Code Sec. 1234A extends to rights or obligations relating to capital assets, Code Sec. 1221(a)(2) excludes depreciable property used in the taxpayer's trade or business, as well as real property used in his trade or business, from the definition of a capital asset.

Partnership's Position

According to CRI-Leslie, Congress enacted Code Sec. 1234A to ensure that taxpayers received the same tax characterization of gain or loss whether the property is sold, or the contract to which the property is subject, is terminated. It is inconsistent to treat termination payments on a contract as ordinary income, the partnership contended, where a sale of the underlying property would have been taxed at capital gain rates.

CRI-Leslie argued that there is an inherent ambiguity in the apparent meaning of Code Sec. 1234A and urged the Tax Court to look at congressional intent behind the enactment of Code Sec. 1234A. The partnership cited a related Senate Committee Report and said that, even if the statute is unambiguous, the legislative history was clearly contrary to the statute's plain meaning.

IRS's Position

The IRS urged the Tax Court to interpret Code Sec. 1234A narrowly and look no further than the statute's plain and unambiguous wording. Code Sec. 1234A expressly references a "capital asset in the hands of the taxpayer," the IRS noted, and since the Radisson Bay Harbor Hotel was Code Sec. 1231 property, it was not a capital asset as defined in Code Sec. 1221 and thus did not fall under Code Sec. 1234A.

The IRS cited case law requiring federal courts to give effect to congressional intent that is made clear in a statute, noting that congressional intent is to be discerned primarily from the statutory text. The IRS further noted that by the time Congress enacted Code Sec. 1234A in 1981, the separate definitions of "capital asset" and "property used in the taxpayer's trade or business" were already firmly established in the Code. Since Congress presumably enacts legislation with knowledge of the law, the IRS said, a newly enacted statute is presumed to be harmonious with existing law and judicial concepts.

Tax Court's Decision

The Tax Court held that CRI-Leslie was not entitled to capital gain treatment on the forfeited deposit. Code Sec. 1234A, the court said, applies only to capital assets, not Code Sec. 1231 property.

In reaching its decision, the Tax Court noted that it had recently examined Code Sec. 1234A in Pilgrim's Pride Corp. v. Comm'r, 141 T.C. 533 (2013). While noting that the issue in Pilgrim's Pride was a different issue than in the instant case, the Tax Court said its analysis of the statute's purpose remained unchanged: Congress originally enacted Code Sec. 1234A to combat straddles and other transactions exploited by tax shelter promoters and, in 1997, extended the statute's application to all types of property that are (or on acquisition would be) capital assets in the hands of the taxpayer. The Tax Court noted that the Fifth Circuit reversed its ultimate decision in Pilgrim's Pride and held that Code Sec. 1234A applied to the abandonment of rights or obligations with respect to capital assets but not to the abandonment of the assets themselves. However, the Tax Court observed, the Fifth Circuit did not dispute the Tax Court's interpretation of the legislative purpose underlying the enactment of Code Sec. 1234A. The Fifth Circuit further reiterated the understanding underlying the entire body of Code Sec. 1234A law; that by its plain terms, Code Sec. 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets).

In conclusion, the Tax Court rejected the partnership's argument that the tax treatment allowed under Code Sec. 1234A should be extended to Code Sec. 1231 property, saying that it would instead defer to the will of Congress as manifested in the text of the statute.

For a discussion of Code Sec. 1234A and the tax treatment of gains and losses on the termination of certain contracts, see Parker Tax ¶116,130.

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Payment of S Shareholder's Personal Expenses Were Loan Repayments, Not Wages

Advances made by the sole shareholder of an S corporation to the corporation before 2009 were intended to be loans and thus the corporation's payment of the shareholder's personal expenses were loan repayments and not wages subject to employment taxes. However, advances made to the corporation after 2008, when its business was deteriorating, were more in the nature of capital contributions because there was no reasonable expectation of repayment. Scott Singer Installations, Inc. v. Comm'r, T.C. Memo. 2016-161.

Background

In 1981, Scott Singer formed Scott Singer Installations, Inc. (Singer Installations), an S corporation. He was the president and sole shareholder and served as the corporation's sole corporate officer. Singer Installations was primarily engaged in servicing, repairing, and modifying recreational vehicles. As the company's business increased, Scott began raising money from various sources to fund the company's growth. In 2006, he established a $224,000 home equity line of credit and, in less than a year, had drawn on the entire line of credit in order to advance funds to his corporation. Also in 2006, Scott established an $87,443 line of credit by refinancing a home mortgage. He likewise advanced the entire amount to his company in the same year. In 2008, Scott established a general business line of credit of $115,000 and advanced all the funds to his company. Scott also borrowed $220,000 from his mother and her boyfriend and advanced all the funds to his company throughout 2007 and 2008. Scott advanced a total of $646,443 to his corporation between 2006 and 2008. While all of the advances were reported as shareholder loans on the company's general ledgers and Forms 1120S, no promissory notes were issued between Scott and his company, no interest was charged, and there were no maturity dates imposed.

After the 2008 recession, Singer Installation's business started declining and Scott was unable to borrow from commercial banks. He financed Singer Installation's operations from 2009 through 2011 by borrowing an additional $513,099 from his mother and her boyfriend and advancing the funds to his company. Scott also began charging business expenses to personal credit cards.

Scott worked full time for Singer Installations and occasionally hired a service technician, two laborers, and an individual to help with internet sales. Singer Installation filed the appropriate employment tax forms and paid employment taxes on wages paid to each employee except Scott. Singer Installations did not report paying wages to Scott during 2010 or 2011.

Singer Installations reported operating losses of $103,305 for 2010 and $235,542 for 2011. During the same years, Singer Installations paid $181,872 of Scott and his wife's personal expenses, such as their mortgage and car loan payments, by making payments from its bank account to the Singers' creditors. These payments were treated on Singer Installation's general ledger and Forms 1120S as repayments of shareholder loans and were not deducted as business expenses.

The IRS determined that Scott was an employee of Singer Installations for 2010 and 2011 and that the $181,872 in payments that Singer Installations made on behalf of Scott and his wife were wages subject to employment taxes. Singer Installations agreed that Scott was its employee, but argued that the payments made on behalf of the Singers were loan repayments and not wages subject to employment taxes.

Analysis

The Tax Court held that a substantial portion of the advances by Scott to Singer Installations were intended to be loans and thus the repayments by Singer Installations that related to those advances were not wages subject to employment taxes. In particular, the court noted Scott's intention to create a debtor-creditor relationship with Singer Installations. This intention was evidenced by the fact that Singer Installations' balance sheets reported Scott's advances as increases in loans from Scott each year. Additionally, Singer Installation consistently reported the expenses it was paying on behalf of the Singers as repayments of shareholder loans rather than reporting the payments as business expenses. According to the court, this consistent reporting indicated that Scott and Singer Installations intended to form a debtor-creditor relationship and that Singer Installations conformed to that intention. Second, the court noted, Singer Installation's payments on behalf of the Singers were consistent regardless of the value of the services Scott provided to Singer Installations. Many of the payments Singer Installations made were the Singers' recurring monthly expenses. The consistency of these payments, both in time and in amount, the court stated, is characteristic of debt repayments. Finally, and most importantly, the fact that Singer Installations made payments when the company was operating at a loss strongly suggested to the court that a debtor-creditor relationship existed.

The court then looked at whether Scott had a reasonable expectation of repayment of his advances. When Scott advanced funds to Singer Installations between 2006 and 2008, the court noted, the business was well established and successful. Because the business was operating profitably and showed signs of growth, the court found that Scott was reasonable in assuming his loans would be repaid and thus the advances were intended to create debt rather than equity and there was a reasonable expectation at the time that such advances would be repaid.

However, the court did not find that a similarly reasonable expectation of repayment existed for later advances. When the recession occurred in 2008 and Singer Installation's business dropped off sharply, the court said that Scott should have known that future advances would not result in consistent repayments. According to the court, Scott must have recognized that the only hope for recovery of the amounts previously advanced to Singer Installations was an infusion of capital subject to substantial risk. After 2008, the only source of capital was from Scott's family and his personal credit cards. Accordingly, the court concluded that advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were more in the nature of capital contributions. The court also found that Scott had a sufficient outstanding loan balance at the time the repayments were made so that loan repayments made during 2010 and 2011 were valid as such.

For a discussion of the tax treatment of loans from related entities in the S corporation context, see Parker Tax ¶32,840.

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IRS Addresses Retroactive Application of Bonus Depreciation Extended by PATH

The IRS has issued guidance on how fiscal year taxpayers can retroactively elect to take the 50-percent bonus depreciation deduction for qualified property placed in service during the 2015 portion of fiscal years beginning in 2014. This guidance also applies to calendar year taxpayers with short tax years in 2015. In addition, the guidance addresses carrying over disallowed Code Sec. 179 deductions for qualified real property. Rev. Proc. 2016-48.

Rev. Proc. 2016-48 applies to taxpayers who filed their 2014 returns (or 2015 short year returns) before enactment of the tax extenders bill on December 18, 2015, and is effective on August 26, 2016.

Retroactive Application of 50-Percent Additional First Year Depreciation Deduction

Prior to amendment by the Protecting Americans from Tax Hikes Act of 2015 (PATH), Code Sec. 168(k)(1) allowed a 50-percent additional first year depreciation deduction for qualified property acquired by a taxpayer after 2007 and generally placed in service by December 31, 2014. PATH extended the placed-in-service date to December 31, 2015 (December 31, 2016 in the case of certain property).

Rev. Proc. 2016-48 provides that if a taxpayer did not deduct the 50-percent additional first year depreciation (bonus depreciation) on its return for its tax year beginning in 2014 and ending in 2015 (2014 tax year) or for its tax year of less than 12 months beginning and ending in 2015 (2015 short tax year), and did not make an affirmative election not to deduct the bonus depreciation, the taxpayer may claim the bonus depreciation by filing either:

(1) An amended federal tax return for the 2014 tax year or the 2015 short tax year before the taxpayer files its federal tax return for the first tax year succeeding the 2014 tax year or the 2015 short tax year; or

(2) A Form 3115, Application for Change in Accounting Method, with the taxpayer's tax return for the first or second tax year succeeding the 2014 tax year or the 2015 short tax year if the taxpayer owns the property as of the first day of the year of change.

If a taxpayer made an affirmative election to not deduct the bonus depreciation on its tax return for the 2014 tax year or the 2015 short tax year, the taxpayer may revoke that election provided that the taxpayer files an amended return for the 2014 tax year or the 2015 short tax year in a manner that is consistent with the revocation of the election and by the later of (1) November 11, 2016, or (2) before the taxpayer files its return for the first tax year succeeding the 2014 tax year or the 2014 short tax year.

If the taxpayer makes the retroactive election for its 2014 tax year, the election applies to both 2014 qualified property and 2015 qualified property in the same class of property for which the election is made. If the taxpayer makes the retroactive election for its 2015 short tax year, the election applies to 2015 qualified property in the same class of property for which the election is made.

Carryover of 2010, 2011, 2012, 2013, or 2014 Disallowed Code Section 179 Deduction for Qualified Real Property

Code Sec. 179(a) allows a taxpayer to elect to treat the cost (or a portion of the cost), subject to a dollar limitation, of any Code Sec. 179 property as an expense for the tax year in which the taxpayer places the property in service. Under Code Sec. 179(f), a taxpayer may elect to treat qualified real property as Code Sec. 179 property.

Prior to amendment by PATH, Code Sec. 179(f)(4) provided that a taxpayer that elected to apply Code Sec. 179(f) and elected to expense under Code Sec. 179(a) the cost (or a portion of the cost) of qualified real property placed in service during any tax year beginning in 2010, 2011, 2012, 2013, or 2014 could not carryover to any tax year beginning after 2014 the amount that was disallowed as a Code Sec. 179 deduction under the taxable income limitation of Code Sec. 179(b)(3)(A) (disallowed Code Sec. 179 deduction). Such amounts were required to be treated as an amount for which the Code Sec. 179 election was not made and as property placed in service on the first day of the taxpayer's last tax year beginning in 2014 for purposes of computing depreciation.

Rev. Proc. 2016-48 provides that a taxpayer that treated the amount of a disallowed Code Sec. 179 deduction as property placed in service on the first day of the taxpayer's last tax year beginning in 2014 can either (1) continue that treatment, or (2) if the period of limitations for assessment under Code Sec. 6501(a) is open, amend its return for the last tax year beginning in 2014 to carryover the disallowed Code Sec. 179 deduction to any tax year beginning in 2015.

The amended return must include any collateral adjustments to tax income or the tax liability (for example, the amount of depreciation allowed or allowable in the last tax year beginning in 2014 for the amount of the disallowed Code Sec. 179 deduction). Such collateral adjustments must also be made on amended returns for any affected succeeding tax years.

Round 5 Extension Property

Under Code Sec. 168(k)(4), corporations and certain automotive partnerships can elect for their first tax year ending after March 31, 2008, to accelerate pre-2006 unused research credits or minimum tax credits in lieu of claiming the bonus depreciation allowance. Generally, this election applies to eligible qualified property acquired after March 31, 2008, and placed in service before January 1, 2016.

Rev. Proc. 2016-48 provides guidance on the time and manner for making an election to apply, or to not apply, Code Sec. 168(k)(4) to "round 5 extension property" (i.e. property that is eligible qualified property solely by reason of the extension of Code Sec. 168(k)(2) by PATH).

For a discussion of the bonus depreciation, see Parker Tax ¶94,200.

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Taxpayers' Withdrawal of Excess IRA Contributions Weren't Timely; Seventh Circuit Upholds Penalty

The Seventh Circuit affirmed a district court's holding that married taxpayers weren't entitled to refunds for 2009 of the annual 6 percent excise tax penalty imposed on their excess IRA contributions originally made in 2007 but not withdrawn until 2010. The court concluded that a rule allowing a taxpayer to withdraw excess contributions by his or her Form 1040 filing deadline to avoid the penalty applies only for the tax year in which the excess contribution is made, not to subsequent years in which the funds remain in the retirement account at year's end. Wu v. Comm'r, 2016 PTC 330 (7th Cir. 2016).

Background

In 2007, Michael and Christine Wu each contributed $200,000 to their individual IRAs, using proceeds from the sale of their home. For that tax year, the maximum allowable contribution to an IRA was $4,000. In March 2010, when the Wus realized their mistake, they withdrew from their IRAs the excess contributions and corresponding earnings. They jointly notified the IRS about the excess contributions and asked that the resulting excise taxes under Code Sec. 4973(a) for 2007 through 2009 be waived. The IRS declined to waive the penalties, informing the couple that the taxes had already been assessed for each year.

The Wus promptly paid the excise taxes, and in February 2012 each filed with the IRS a claim for a refund of the taxes attributable to 2009 only. The Wus asserted that they were not liable for the excise tax liability for tax year 2009 because they had withdrawn the excess contributions and corresponding earnings before the filing deadline for their 2009 tax return. In 2013, the IRS rejected their claim and the Wus jointly sued for refunds in a federal district court.

Analysis

Code Sec. 4973(a) provides that "excess contributions" to a retirement account, including an IRA, incur an excise tax of 6 percent for each year the excess remains in the account at the end of each tax year. Code Sec. 4973(b) provides that any contribution which is later withdrawn in a distribution to which Code Sec. 408(d)(4) applies is not treated as an amount contributed for purposes of determining excess contributions and the related penalty. Code Sec. 408(d)(4) allows for the tax-free reversal of IRA contributions up until a taxpayer's Form 1040 filing deadline (including extensions).

Observation: The 6 percent excise tax on excess contributions is distinct from the 10 percent penalty on early withdrawals from a retirement account. While distributions of excess contributions are generally not subject to the early withdrawal penalty, distributions of net income from such contributions are, unless an exception applies.

Before the district court, the Wus argued that the reference to Code Sec. 408(d)(4) in Code Sec. 4973 means that a taxpayer can avoid the 6 percent penalty by withdrawing any excess contributions in an IRA up until the taxpayer's 1040 filing deadline, regardless of whether the excess contributions were made in that tax year or a previous one. The IRS argued that that the Code Sec. 408(d)(4) reference applies only to distributions made by the return deadline for the tax year when the excess contribution was made, not withdrawals of contributions made in earlier tax years.

The district court sided with the IRS's interpretation of Code Sec. 408(d)(4) and held that because the Wus' excess contributions had been made in 2007, they missed the opportunity to avoid incurring taxes again in 2009 by not taking a distribution before the last day of that tax year. The Wus appealed to the Seventh Circuit.

The Seventh Circuit affirmed the district court's holding, concluding that the Wus' interpretation of the relevant Code sections was incorrect and agreeing with the IRS's reading. The phrase "such taxable year" in Code Sec. 408(d)(4), the court said, refers to the tax year in which the contribution was made to the account. The court noted that the Wus made their excess contributions in 2007, stating that for that tax year they could have avoided incurring the annual tax on excess contributions by withdrawing the excess before the return-filing deadline for that tax year (i.e., April 15, 2008). But for any later year, the court said, the Wus could avoid the annual tax only by taking the distribution before the tax year ended.

Finding the Wus' arguments unpersuasive, the Circuit Court affirmed the district court's dismissal of their refund claim.

For a discussion of excess IRA contributions and the excise tax imposed on them, see Parker Tax ¶134,522.

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Royalties Are Ordinary Income Where Doctor Retained Rights in Patents

The Tax Court determined that royalty payments a doctor received under an agreement for the use of his drug delivery technology were taxable as ordinary income, rather than as capital gain. The court held that because the doctor could choose how the technology was used, and retained the right to use the patents outside the pharmaceutical field, he did not transfer "all substantial rights" to the patents and the resulting royalties were not eligible for capital gain treatment under Code Sec. 1235. Spireas v. Comm'r, T.C. Memo. 2016-163.

Background

Spiridon Spireas immigrated to the United States from Greece in 1985 and completed a master's and doctoral studies in pharmaceutical technology and industrial pharmacy. He obtained his Ph.D. degree from St. John's University in 1993. Dr. Spireas became a renowned expert in the science of drug delivery, including "liquisolid" technologies, which created unique formulations for the delivery of a chemical in tablet form, such as a nutritional supplement or a pharmaceutical drug.

In 1997, Dr. Spireas and Dr. Bolton, a St. John's doctor that worked closely with Dr. Spireas, organized Hygrosol Pharmaceutical Corporation (Hygrosol), an S corporation, for the purpose of exploiting the liquisolid technologies they were developing. The doctors each owned 50 percent of Hygrosol and took turns serving as its president and vice president. Between 1996 and 2002, Dr. Spireas and Dr. Bolton were issued, jointly or individually, four U.S. patents related to liquisolid technology. Hygrosol received the royalties related to the patents, and those royalties flowed through to Dr. Spireas and Dr. Bolton.

In June 1998, Hygrosol, Dr. Bolton, and Dr. Spireas (collectively, licensors) entered into a license agreement with Mutual Pharmaceutical Company, Inc. (Mutual), a company whose business focused on developing and marketing generic drugs (1998 license agreement). The agreement granted to Mutual the right to use patents for the liquisolid technology, on a product-by-product basis, to develop, produce, and sell within the U.S. new and generic pharmaceutical drugs, as determined by agreement between the parties. The 1998 license agreement granted Mutual rights to use the liquisolid technology only in the pharmaceutical field. Dr. Spireas retained rights to use his technology to develop vitamins, nutritional supplements, and other health-related products not requiring FDA approval.

In early 2000, Dr. Spireas began work on a new formulation for a drug called "felodipine," used to treat high blood pressure. In March, 2000, Mutual sent Dr. Spireas an engagement letter (2000 engagement letter) addressing the development of three products, including felodipine, and enclosed a check for $30,000 in accordance with the 1998 license agreement. Dr. Spireas countersigned this letter in his capacity as vice president of Hygrosol.

On his income tax returns for 2007 and 2008, Dr. Spireas reported royalties received under the 1998 license agreement as long-term capital gain. Felodipine generated 99.64 percent of this royalty income; the remaining royalties were attributed to the drug propafenone, which was also covered in the 2000 engagement letter. The IRS examined the returns and determined that the royalties received should have been reported as ordinary income.

Analysis

Royalty payments received under a license agreement are generally taxed as ordinary income. However, Code Sec. 1235(a) provides that a transfer of property consisting of all substantial rights to a patent by any holder of that patent is treated as the sale or exchange of a capital asset held for more than one year. Under Reg. Sec. 1.1235-2(b)(1)(iii), this capital gain treatment is not available where the "instrument of transfer" grants rights to the grantee, in fields of use within trades or industries, which are less than all the rights covered by the patent and which exist and have value at the time of the grant.

The Tax Court stated that the central dispute between Spireas and the IRS regarded what the "instrument of transfer" was. The IRS argued that the instrument of transfer was the 1998 license agreement and that Dr. Spireas did not transfer all substantial rights to the liquisolid technology. Dr. Spireas argued that the key document was the 2000 engagement letter; that this letter was in substance a license agreement; and that he transferred all substantial rights to the felodipine and profafenone formulations. The court concluded that the IRS had the stronger argument.

The court stated that the 1998 license agreement was clearly the relevant "instrument of transfer" under Reg. Sec. 1.1235-2(b)(1) because it was the agreement that granted the rights for which Mutual paid. The court found the rights transferred were the rights to use the liquisolid technology and to make and sell products containing that technology. Conversely, the court said, the agreement did not transfer rights to the formulation of any specific drug because no such formulations existed in June 1998; felodipine and propafenone in particular, the court noted, were not selected for development until March 2000.

With regard to the 2000 engagement letter, the court found it was substantially similar to 20 other engagement letters the parties signed to memorialize their selection of certain drugs for further investigation. These engagement letters, the court stated, granted no rights and had no royalty payment terms. Far from constituting freestanding license agreements, the court said, they simply rendered the 1998 license agreement operative with respect to the products that they identified.

The court determined that Dr. Spireas did not transfer "all substantial rights" to the liquisolid technology in the 1998 license agreement. The court found that the rights granted to Mutual were less than all the rights in the technology because the agreement gave Dr. Spireas and his co-licensors effective veto power over the drugs as to which Mutual could exercise its rights, noting that all parties to the license had to agree on which products could be developed. In addition, the court noted that Dr. Spireas retained all rights to use the technology outside the pharmaceutical field (e.g., in developing nutritional supplements, vitamins, and other products not requiring FDA approval). The court stated that the restriction of a license to one field of use, where a reserved field of use has value at the time of the grant, fails to convey "all substantial rights."

The court held that because Dr. Spireas did not transfer "property consisting of all substantial rights to a patent" in the 1998 license agreement, Code Sec. 1235(a) did not apply and thus the royalties he received pursuant to the agreement were taxable as ordinary income.

For a discussion on the taxation of gain or loss from the transfer of patents, see Parker Tax ¶117,110.

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IRS Finalizes Regulations Reflecting Same-Sex Marriage Cases and Rulings

The IRS has issued final regulations that reflect the holdings of Obergefell v. Hodges, Windsor v. United States, and Rev. Rul. 2013-17. The regs define terms in the Code describing the marital status of taxpayers in a gender-neutral way for federal tax purposes. In addition, the regs provide that domestic partnerships, civil unions, or other similar relationships are not considered "marriage" for federal tax purposes. T.D. 9785 (9/2/16).

Background

On June 26, 2013, the Supreme Court in United States v. Windsor, 2013 PTC 167 (S. Ct. 2013), held that Section 3 of the Defense of Marriage Act, which generally prohibited the federal government from recognizing the marriages of same-sex couples, was unconstitutional because it violated the principles of equal protection and due process.

Rev. Rul. 2013-17 provided guidance on the Windsor decision's effect on the IRS's interpretation of Code sections that refer to taxpayers' marital status. In the revenue ruling, the IRS ruled that if a same-sex couple is married in a state that recognizes such marriages, that marriage will be recognized for all federal purposes, no matter where the couple lives.

On June 26, 2015, the Supreme Court in Obergefell v. Hodges, 2015 PTC 380 (S. Ct. 2015), held that state laws are "invalid to the extent they exclude same-sex couples from civil marriage on the same terms and conditions as opposite-sex couples" and "that there is no lawful basis for a State to refuse to recognize a lawful same-sex marriage performed in another State on the ground of its same-sex character."

In light of the holdings of Windsor and Obergefell, the IRS determined that, for federal tax purposes, marriages of couples of the same-sex should be treated the same as marriages of couples of the opposite-sex and that, for reasons set forth in Rev. Rul. 2013-17, terms indicating sex, such as "husband," "wife," and "husband and wife," should be interpreted in a neutral way to include same-sex spouses as well as opposite-sex spouses.

Final regulations have been issued that reflect these holdings, and are effective September 2, 2016. The final regulations adopt proposed regulations, issued in October 2015, with few changes. The regulations render Rev. Rul. 2013-17 obsolete, but the IRS stated that taxpayers may continue to rely on the ruling's guidance as it relates to employee benefit plans and the benefits provided under such plans.

Final Regulations Define Terms Relating to Marital Status

The final regulations amend the current regulations under Code Sec. 7701 to provide that, for federal tax purposes, the terms "spouse," "husband," and "wife" mean an individual lawfully married to another individual, and the term "husband and wife" means two individuals lawfully married to each other. These definitions apply regardless of sex.

Proposed regulations, issued in October, 2015, provided that a marriage of two individuals would be recognized for federal tax purposes if that marriage would be recognized by any state, possession, or territory of the U.S. Under this rule, whether a marriage conducted in a foreign jurisdiction will be recognized for federal tax purposes depends on whether that marriage would be recognized in at least one state, possession, or territory of the U.S.

A practitioner raised concerns that this rule in the proposed regulations could be interpreted to treat couples who divorce or who never intended to enter into a marriage under the laws of the state where they live or where they entered into an alternative legal relationship as married for federal tax purposes, if at least one state, possession, or territory of the U.S. recognized the taxpayer as married. To address these concerns, the final regulations provide, for federal tax purpose, a general rule for recognizing a domestic marriage and a separate rule for recognizing foreign marriages.

Under the general rule for domestic marriages, a marriage of two individuals is recognized for federal tax purposes if the marriage is recognized by the state, possession, or territory of the U.S. in which the marriage is entered into, regardless of the married couple's place of domicile.

Under the separate rule for foreign marriages, two individuals entering into a relationship denominated as marriage under the laws of a foreign jurisdiction are married for federal tax purposes if the relationship would be recognized as marriage under the laws of at least one state, possession, or territory of the U.S. This rule enables couples who are married outside the U.S. to determine marital status for federal tax purposes, regardless of where they are domiciled and regardless of whether they ever reside in the U.S.

Registered Domestic Partnerships, Civil Unions, or Other Similar Relationships Are Not Denominated as Marriage

The IRS noted that some couples choose to enter into a civil union or registered domestic partnership even when they could have married, and some couples who are in a civil union or registered domestic partnership choose not to convert those relationships into a marriage even when they have had the opportunity to do so. In many cases, such choices are deliberate, and couples who enter into civil unions or registered domestic partnerships may have done so with the expectation that their relationship will not be treated as a marriage for purposes of federal law.

The IRS observed that, for some of these couples, there are benefits to being in a relationship that provides some, but not all, of the protections and responsibilities of marriage. For example, some individuals who were previously married and receive Social Security benefits as a result of their previous marriage may choose to enter into a civil union or registered domestic partnership (instead of a marriage) so that they do not lose their Social Security benefits. More generally, the rates at which some couples' income is taxed may increase if they are considered married and thus required to file a married-filing-separately or married-filing-jointly federal income tax return.

The IRS said that treating couples in civil unions and registered domestic partnerships the same as married couples who are in a relationship denominated as marriage under state law could undermine the expectations certain couples have regarding the scope of their relationship. Further, no provision of the Code indicates that Congress intended to recognize as marriages civil unions, registered domestic partnerships, or similar relationships.

Accordingly, the final regulations provide that for federal tax purposes, the term "marriage" does not include registered domestic partnerships, civil unions, or other similar relationships recognized under state law that are not denominated as a marriage under that state's law, and the terms "spouse," "husband and wife," "husband," and "wife" do not include individuals who have entered into such relationships, regardless of domicile.

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Settlement for Disability Benefits Not Excludable as Damages for Sickness

The Tax Court held that a taxpayer's settlement for unpaid disability benefits was not excludable from his gross income. The court found the taxpayer could not prove the settlement proceeds were excludable under Code Sec. 105(c) as payments for the permanent loss of a body function. In addition, the court determined that because the nature of the suit was to recover benefits, not for physical injuries or physical sickness, the proceeds weren't excludable under Code Sec. 104(a)(2). Braddock v. Comm'r, T.C. Summary 2016-46.

Background

Prior to 2009, Richard Braddock was employed by Endress & Hauser (E&H), a company producing a range of instruments designed for use in dangerous environments and extreme conditions. During Braddock's employment with E&H, he was diagnosed with, among other things, a progressive musculoskeletal and neuromuscular syndrome, including progressive musculoskeletal pain. The pain was based on a combination of severe degenerative arthritis and neuromuscular disease. Braddock was provided with long-term disability coverage through the Lincoln National Life Insurance Co. (Lincoln National).

In 2009, Braddock left E&H and filed a claim for long-term disability benefits with Lincoln National, which subsequently denied his claim. In October 2010, Braddock filed a complaint against Lincoln National in a state district court, seeking long-term disability benefits under an ERISA plan pursuant to 29 U.S.C. Sec. 1132(a)(1)(B). In the complaint, the only mention of Braddock's condition was that he became disabled because of "certain problems from which he suffered," alleging that he was "forced to cease working and file a claim for long-term disability benefits."

In January 2011, Braddock signed a settlement agreement under which he accepted $45,000 as a settlement payment in consideration for settling his case and releasing Lincoln National generally. The agreement did not reference Braddock's health problems.

Although Braddock received a 2011 Form W-2 reporting the $45,000 as wage income, he did not report the $45,000 on his 2011 tax return. Following an audit, the IRS increased in Braddock's wage income by $45,000.

Analysis

Under Code Sec. 105(a), amounts received by an employee through accident or health insurance for personal injuries or sickness must be included in gross income to the extent those amounts:

(1) are attributable to contributions by the employer that were not includible in the gross income of the employee; or

(2) are paid by the employer.

Payments that are includable in income under Code Sec. 105(a) may nevertheless be excludable from income under Code Sec. 105(c) if they meet one of two requirements:

(1) the payments are for the permanent loss of a member or function of the body, or the permanent disfigurement of the taxpayer; or

(2) the payments are computed with reference to the nature of the injury and without regard to the period the employee is absent from work.

Code Sec. 104(a)(2) allows taxpayers to exclude from income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal physical injuries of physical sickness.

Before the Tax Court, Braddock argued that the settlement payment of $45,000 was excludable from his gross income under Code Sec. 105(c) or, in the alternative, was excludable under Code Sec. 104(a)(2).

The court noted that the parties did not address who paid the contributions to the disability insurance plan. In order for settlement proceeds to be excludible from income under Code Sec. 105(c), the requirements of Code Sec. 105(a) must first be met. Since Braddock had not proven that his employer paid the disability insurance premiums, he did not meet his burden of proof as to the requirements of Code Sec. 105(a). However, although Braddock did not meet his burden of proof and the court thus did not need to consider whether the settlement payment was excludable under Code Sec. 105(c), the court said that it would address Braddock's assertions since he had premised much of his case on an exclusion under that section.

The court stated that it has long held that insurance payments excludible from gross income under Code Sec. 105(c)(1) must fall into one of three categories: (1) payments for the permanent loss or loss of use of a member of the body; (2) payments for the permanent loss or loss of use of a function of the body; or (3) payments for permanent disfigurement. The court noted it has held that a loss of a function exists if it leaves a taxpayer "effectively without the use of his hands, legs, and feet, as opposed to whether his use is partially impaired." The court found that while Braddock claimed that his injuries "include paralysis, chronic cramping, and chronic pain," he did not provide proof of those assertions or that the settlement payment was for the permanent loss of his arms, legs, or feet or a function of such. Therefore, the court concluded that Braddock could not prove that the settlement payment is excluded from income under Code Sec. 105(c).

With regard to exclusion under Code Sec. 104(a)(2), the court noted that when a taxpayer receives a payment under a settlement agreement, as in the instant case, the nature of the claim that was the actual basis for settlement guides whether the payment is excludable from income. In this case, Braddock needed to show that his settlement payment was in lieu of damages for physical injuries or physical sickness. Braddock's action against Lincoln National, the court observed, was based on the cause of action under 29 U.S.C. Sec. 1132(a)(1)(B). Essentially, the court said, this section allows a person who participates in or benefits from a plan (including disability insurance) that is subject to ERISA to bring a civil action to enforce the participant's or beneficiary's rights under the plan. In filing that complaint, the court stated, Braddock was seeking to recover benefits he claimed Lincoln National owed him under the long-term disability insurance plan. The court noted the complaint expressly stated that Braddock sought long-term disability benefits and made only passing reference to "certain problems from which he suffered." It did not identify Braddock's physical injuries or physical sickness. Because the damages Braddock received were for nonpayment of disability insurance payments, the court found the lawsuit was not in the nature of a claim for recovery for physical injuries or physical sickness and thus the settlement proceeds were not excludable under Code Sec. 104(a)(2).

For a discussion of the exclusion from income of settlement proceeds relating to physical injuries or sickness, see Parker Tax ¶75,910.

For a discussion of amounts received through accident or health insurance, see Parker Tax ¶75,915.