IRS Releases Regulations Addressing Notional Principal Contracts; June AFRs Issued; IRS Addresses Disposition of Stock Received from an Incentive Stock Option; Tie-breaker Rule Prevents Taxpayer from Claiming Dependency Exemptions and Credits ...
Long Delay in Enforcement of Loan Did Not Establish Taxpayer had Cancellation of Debt Income
The Tax Court held that although the creditor waited ten years to enforce collection of an outstanding loan, the taxpayer-debtor did not receive cancellation of debt (COD) income. Additionally, cancellation of debt income from a forgiven loan was excludable under the Code Sec. 108 insolvency exception. Johnston v. Comm'r, T.C. Memo. 2015-91.
IRS Addresses Application of Preparer Penalties in Scenarios Involving Amended Returns
The IRS Office of Chief Counsel issued advice on assessing penalties against return preparers in four different scenarios involving the preparation of amended returns. CCA 201519029.
The Ninth Circuit affirmed a Tax Court's ruling that because a portion of a taxpayer's retirement payments was based on his years of service, the amount exceeding what he would have received solely based on disability was subject to taxation. Sewards v. Comm'r, 2015 PTC 153 (9th Cir. 2015).
Charitable Deduction Permitted for Bargain Sale of Property to Retirement Home Developers
The Tax Court held that a taxpayer's sale of property to a charitable organization for less than its fair market value was a bargain sale, entitling the taxpayer to a charitable contribution deduction. However, the taxpayer was required to recalculate his claimed deduction, as the property was valued incorrectly. Davis v. Comm'r, T.C. Memo. 2015-88.
The IRS has issued proposed regulations that provide guidance regarding the application of the modified carryover basis rules of Code Sec. 1022 that affect property transferred from certain decedents who died in 2010. REG-107595-11 (5/11/15).
Flower Retailer's Plan to Donate Profits Failed "Operational Test" for 501(c)(3) Status
Affirming a Tax Court decision denying a request for declaratory judgment granting tax-exempt status to a nonprofit corporation, the Ninth Circuit Court found the company's plan to donate profits from online sales of flowers to charitable organizations did not meet the "operated exclusively for a charitable purpose" test under Code Sec. 501(c)(3). Zagfly, Inc. v. Comm'r, 2015 PTC 159 (9th Cir. 2015).
The Tax Court held that because a taxpayer was actively seeking reimbursement from his landlord for personal property damages incurred in a house fire, he could not claim casualty loss deductions under Code Sec. 165. Hyler v. Comm'r, T.C. Summary 2015-34.
KPMG Partner Incorrectly Claimed Basis Step-Up for Shares Transferred to Nonresident Alien Wife
The Tax Court held that because a taxpayer had incorrectly claimed a basis step-up for shares with zero basis he had gifted to his nonresident alien wife and was subject to a gross valuation misstatement penalty. The court found he could not avoid the penalty by claiming he relied on professional advice, because given his extensive experience as a CPA, the reliance was not reasonable. Hughes v. Comm'r, T.C. Memo. 2015-89.
Nail Salon's Underreported Income Garners 75% Fraud Penalty, But Only for One Owner
The Tax Court held that taxpayers' deficiencies from their jointly owned nail salons were due to fraud, but the court imposed 75 percent fraud penalties against only one owner, finding the second owner merely followed the directions and actions of the first. Duong v. Comm'r, T.C. Memo. 2015-90.
Long Delay in Enforcement of Loan Didn't Establish Taxpayer had Cancellation of Debt Income
The Tax Court held that although the creditor waited ten years to enforce collection of an outstanding loan, the taxpayer-debtor did not receive cancellation of debt (COD) income. Additionally, cancellation of debt income from a forgiven loan was excludable under the Code Sec. 108 insolvency exception. Johnston v. Comm'r, T.C. Memo. 2015-91.
Background
Harold Johnston has worked in the telecommunications industry since 1968 and in 1996 he cofounded Summit Communications, Inc. (Summit) to provide communications-related services to businesses in Hawaii.
In 1998, Johnston was approached by Al Hee, the founder of another communications services provider, Sandwich Isles Communications, Inc. (SIC), to manage SIC's telephone operations. Johnston was initially hesitant to join SIC as he felt a duty to ensure Summit's financial well-being. In order to induce Johnston, Hee offered him (in addition to salary and benefits) a loan of $450,000, with the understanding that if he accepted the loan, Johnston would in turn lend the $450,000 to Summit in order to support its operations.
Johnston and SIC executed an employment agreement in 1998, which allowed Johnston to continue to serve as a director and chief executive officer of Summit, and stated that the SIC loan would become due upon the termination of Johnston's employment with SIC. Later that year, Johnston requested an additional $20,000 loan from SIC's parent company, Waimana Enterprises, Inc., and passed the funds on to Summit. In 2000, SIC sold its interest in the original $450,000 loan to Waimana.
Shortly after Johnston began his employment with SIC, Summit began to receive sizable contracts from SIC, and in late 2000 it became apparent that Johnston was needed to manage Summit full time because of its rapid growth. In 2001, with Hee's approval, Johnston resigned his position with SIC. Although his resignation triggered his repayment obligations for the SIC loan, SIC and Waimana did not demand repayment of the SIC loan at that time, nor did either company issue a Form 1099-C, Cancellation of Debt.
In 2001 SIC received a large loan from the U.S. Department of Agriculture to finance a project to provide telecommunications service to rural communities in Hawaii. With the additional financing SIC reduced its reliance on Summit, which forced Johnston to reduce expenses, cut salaries, and lay off employees. Johnston continued to work for Summit until it filed for bankruptcy in 2002, and he went back to work for SIC in 2005.
Hee met with Johnston in 2011 and notified him that the SIC loan was still due and owing. The Waimana loan had been written off in 2007, and was not discussed. Johnston arranged to begin making payments on the SIC loan via payroll deductions from his SIC paycheck.
In 2010, in connection with an audit of SIC's return, the IRS audited Johnston's return for 2007. Despite the fact that he had been insolvent in 2007, Johnston agreed to an income adjustment of $20,000 related to COD income from the Waimana loan, resulting in a partial assessment of tax due for 2007. In 2013 IRS sent Johnston a notice of deficiency determining that he had failed to report COD income for the SIC and Waimana loans in 2007.
$450,000 SIC Loan
A debt of a taxpayer that is discharged by the creditor generally must be included in the gross income of the taxpayer. Thus, gross income generally includes cancellation of debt (COD) income (Code Sec. 61(a)(12); Reg. Sec. 1.61-12(a)).
The IRS argued that Johnston realized COD income in 2007 because SIC and Waimana failed to take collection action on the $450,000 SIC loan before the period of limitations for collection expired in 2007. The Tax Court noted, however, that the expiration of the period of limitations generally does not cancel a debt, but simply provides a defense for the debtor in an action by the creditor, citing Miller Trust v. Comm'r, 76 T.C. 191 (1981).
The Tax Court disagreed with the IRS's claim that the SIC loan had been canceled, pointing out that Hee testified that Waimana considered the SIC loan outstanding and that Johnston was repaying the SIC loan via payroll deductions of $1,000 per month. The court also noted that if the SIC loan had been forgiven, Waimana would have a strong incentive to report the loan as discharged so that it could benefit from a bad debt deduction, and that Johnston did not receive a Form 1099-C from Waimana discharging the SIC loan.
The IRS took issue with the fact that Johnston did not make a payment on the SIC loan until after the IRS examined his 2007 return, arguing that Johnston sought to repay the SIC loan only to escape taxes. The Tax Court disagreed, noting Johnston sought to repay the SIC loan because he understood it was his obligation to repay it. Additionally, the court noted a reasonable person would not agree to pay an unenforceable debt to save a fraction of that debt on taxes.
$20,000 Waimana Loan
Code Sec. 108(a)(1)(B) excludes COD income from gross income if the discharge occurs when the taxpayer is insolvent. The amount of income excluded cannot exceed the amount by which the taxpayer is insolvent (Code Sec. 108(a)(3)).
The IRS additionally argued that Johnston realized COD income in 2007 from discharge of the $20,000 Waimana loan. Although Johnston's agreement to this adjustment during the 2010 audit resulted in a partial assessment of tax for 2007, he disputed this claim at trial. The court agreed with the IRS, noting that the fact the Waimana loan was written off in 2007 demonstrated the intention of Waimana to forgive the loan. Additionally, the court found no evidence that Johnston was repaying the loan, or that Waimana considered the loan outstanding.
However, the court concluded that because Johnston was insolvent in 2007, and neither the IRS's nor Johnston's calculations of his insolvency exceeded the canceled debt, the COD income of $20,000 was excludable from his income under Code Sec. 108(a)(1)(B).
Despite the delay in enforcing the SIC loan, because Johnston and Hee understood that it was still due and owing and he was repaying the loan through payroll deductions, the Tax Court held Johnston did not have COD income in 2007 from the SIC loan. Additionally, although the Waimana loan was forgiven in 2007, the court held that COD income was excludable due to Johnston's insolvency that year.
For a discussion of COD income, see Parker Tax ¶72,300.
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IRS Addresses Application of Preparer Penalties in Scenarios Involving Amended Returns
The IRS Office of Chief Counsel issued advice on assessing penalties against return preparers in four different scenarios involving the preparation of amended returns. CCA 201519029.
Background
In response to an inquiry from a Senior Technician Reviewer, the IRS Office of Chief Counsel (IRS) provided advice on the application of return preparer penalties in four different scenarios involving the preparation of amended returns.
Scenario 1: A return preparer made amended returns for three consecutive years which contained an understatement of liability due to willful or reckless conduct. The taxpayer had filed the prepared amended return for the first year, but not the subsequent years' amended returns, waiting to see if the first amended return was accepted. The refund claimed on the first amended return was not allowed. Each amended return for all three years had the return preparer's signature on them. The IRS also had copies of the amended returns for all three years obtained during the investigation which did not have the preparer's signature on them, but did have a watermark stating "Preparer Copy."
Scenario 2: A return preparer made an amended return that contained an understatement of liability due to willful or reckless conduct. The refund claimed on the amended return was disallowed, but the IRS only secured a copy of the amended return that had not been signed by the preparer.
Scenario 3: A return preparer made an amended return that contained an understatement of liability due to willful or reckless conduct. The amended return was not filed, and the IRS only secured copies of an unsigned copy from the return preparer.
Scenario 4: A return preparer made an amended return after the period of limitations for refunds had expired and the amended return was filed.
Analysis
A tax return preparer is liable for an understatement penalty if he or she prepares a return or claim for refund which results in an understatement of tax liability due to the preparer's willful attempt to understate the liability on the return or claim for refund, or due to a reckless or intentional disregard of rules or regulations (Code Sec. 6694(b)).
A tax return preparer is liable for an understatement penalty if he prepares a return or claim for refund which results in an understatement of tax liability due to a position that the tax return preparer knew or should have known to be unreasonable (Code Sec. 6694(a)).
A tax return preparer may have to pay a penalty if he or she aids, assists, or advises another person in preparing any portion of a return or claim and knows that this would result in an understatement of that other person's tax liability (Code Sec. 6701(a)).
The IRS noted that Code Sec. 6694(b) does not require that a return be filed for the penalty to apply, only that a return has been prepared, and that under Reg. Sec. 1.6694-1(a)(2) a return is prepared when it is signed. The IRS advised that if an amended return made by a preparer contained an understatement of liability due to willful or reckless conduct, the Code Sec. 6694(b) penalty could apply if the amended return is either signed by the preparer, or if it not signed by the preparer, if the amended return is filed.
Accordingly, the IRS advised that in Scenario 1, the Code Sec. 6694(b) penalty may be assessed for all three years because the preparer made and signed an amended return that contained an understatement due to willful or reckless conduct.
The IRS advised that in Scenario 2, the Code Sec. 6694(b) penalty may be assessed because the preparer made and filed an amended return that contained an understatement of liability due to willful or reckless conduct.
However, the IRS advised that in Scenario 3, the Code Sec. 6694(b) penalty should not be assessed because although the preparer made and signed an amended return that contained an understatement due to willful or reckless conduct, the amended return was not filed and there was no evidence the preparer signed the amended return.
The IRS also advised that the Code Sec. 6694(b) penalty could be assessed if amended returns were filed but the IRS disallowed the refund, noting that there is no requirement that the IRS allow the amounts claimed on an amended return before the penalty may be assessed.
With respect to Scenario 4, the IRS advised that the penalties under Code Sec. 6694(a)(2), 6694(b), or 6701 should not be assessed merely because the preparer made and filed a claim for refund after the period of limitations had expired. The IRS stated that this is because a time barred claim is denied for being made too late, not because there is an understatement of liability under the definition in Code Sec. 6694(e), noting the claim for refund may in fact reflect the correct tax liability. In addition, the IRS noted there may be extenuating circumstances that weigh against asserting the penalty when an amended return appears to be filed out of time; for example, the amended return may be perfecting an earlier timely informal claim for refund and informal refund claims have been held to toll the statute of limitations.
For a discussion of civil penalties against practitioners for understatements, see Parker Tax ¶276,300.
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Portion of Disability Retirement Payments Based on Years of Service were Taxable
The Ninth Circuit affirmed a Tax Court's ruling that because a portion of a taxpayer's retirement payments was based on his years of service, the amount exceeding what he would have received solely based on disability was subject to taxation. Sewards v. Comm'r, 2015 PTC 153 (9th Cir. 2015).
Background
Jay Sewards worked for the Los Angeles County Sheriff's Department until 2000, when he was placed on involuntary medical disability leave due to service-connected injuries. While on disability leave, he continued to receive his monthly $14,093 salary. Because he suffered his injury after more than 34 years on the job, Sewards was eligible for two types of retirement plans, one based on his length of service (service retirement) and a different plan based on his injuries (disability retirement).
In 2001, Seward requested, and the Los Angeles County Employees Retirement Association (LACERA) granted, that the service retirement take effect upon the expiration of his disability leave. The amount of Seward's service retirement payment was determined, by reference to his length of service, to be $12,861 a month.
In 2002, Sewards applied for and was granted disability retirement retroactive to the date upon which his service retirement took effect, replacing his service retirement. The disability retirement plan would provide him with at least one-half of his final monthly salary but would grant his full service retirement allowance if it was higher. Because half his monthly salary was only $7,046, Sewards received $12,861 under the disability retirement plan.
In each year from 2001 through 2005, LACERA sent Sewards a Form 1099-R indicating that the taxable amount of his retirement allowance was not determined; as a result Sewards paid no tax on the pension. In 2006, LACERA sent Sewards another Form 1099-R indicating that a portion of his retirement allowance was taxable. However, on his 2006 return, Sewards did not report any portion of the income from his disability retirement allowance.
The IRS issued a notice of deficiency determining that the portions of Seward's month disability retirement payments that exceeded the one half portion of his final monthly salary were taxable. Sewards petitioned the Tax Court, arguing that the entire benefit was excludable. However, the court noted that while the statute authorizing the disability retirement payments to Sewards was in the nature of a workers' compensation act, and he was guaranteed at least $7,046 a month under that statute, the $12,861 he received monthly was determined by reference to his length of service.
Thus, the Tax Court held that the portions of the monthly payments exceeding the guaranteed amount (which worked out to $5,815) were not excludable from income, and Sewards appealed to the Ninth Circuit.
Analysis
Code Sec. 104(a)(1) provides that retirement payments are excludable from gross income if they are received under a workers' compensation act or a statute in the nature of a workers' compensation act. Reg. Sec. 1.104-1(b) provides, however, that Code Sec. 104(a)(1) does not apply to the extent the payments are determined by reference to the employee's age or length of service or the employee's prior contributions, even if the employee's retirement is occasioned by occupational injury.
On appeal, Sewards argued that the payments he received from his disability retirement plan did not fall within the limitation in Reg. Sec. 1.104-1(b) because, even though the payments were calculated based on his years of service, he was eligible for retirement and the payments solely because of his disability. Sewards claimed that the regulation applied only where an individual qualified for a retirement allowance based on years of service, rather than because of a disability.
The IRS argued that the limitation applies when an individual who retires with a disability receives an allowance amount that is at least in part based on his years of service.
The Ninth Circuit Court rejected Stewards' argument, finding his interpretation was not supported by the text of the regulation. The court noted that like any other LA County employee who retired with a service-connected disability, Sewards was entitled to receive one-half his final salary based on his injuries. However, the court found that Sewards received additional amounts under his disability retirement plan to bring his pension up to what he would have received under the service retirement plan. Because that additional amount was determined in reference to his years of service, it was limited by Reg. Sec. 1.104-1(b), and was not excludable from income as a disability-related payment.
Sewards also argued that the IRS's interpretation of the regulation was inconsistent with Code Sec. 104(a)(1) and was thus invalid. The court disagreed, noting that while Code Sec. 104(a)(1) provides that workmen's compensation payments for injury or sickness are excludable, it leaves open the question of how to determine whether a payment is made for injury or sickness, as opposed to some other reason. The court stated the regulation simply clarifies when a payment is made for personal injuries or sickness, and when it is made for some other reason, such as years of service. Moreover, the court pointed out that the IRS's interpretation of the regulation was consistent with forty years of previous Revenue Rulings.
The Ninth Circuit held that the $7,046 portions of his retirement payments, equal to one half his monthly salary, were excludable disability payments, but because the additional $5,815 portions were paid based on his years of service, under Reg. Sec. 1.104-1(b) they were not excludable. Accordingly, the Ninth Circuit affirmed the Tax Court's ruling.
For a discussion of amounts received under workers compensation acts, see Parker Tax ¶75,905.
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Charitable Deduction Permitted for Bargain Sale of Property to Retirement Home Developers
The Tax Court held that a taxpayer's sale of property to a charitable organization for less than its fair market value was a bargain sale, entitling the taxpayer to a charitable contribution deduction. However, the taxpayer was required to recalculate his claimed deduction, as the property was valued incorrectly. Davis v. Comm'r, T.C. Memo. 2015-88.
Background
Bob Davis is a Texas entrepreneur, real estate investor and a limited partner in Sun West Land, Ltd. (Sun West), which invests in real estate. Donald Perry was the President and CEO of Sears Methodist Retirement System, Inc. (SMRS) and its charitable foundation (the Foundation). SMRS is a charitable organization that builds, develops, and operates various senior living centers throughout northwest Texas.
In 2003 Davis informed Perry that Sun West had land in Waco that would be ideal for the next SMRS retirement community. The following year Davis purchased two tracts of land from Sun West and an adjoining tract from an unrelated real estate group. In 2005 Davis began discussions with Perry to sell a portion of the newly purchased land to the Foundation. Although part of the land was within an undevelopable flood zone, Perry did not object to its inclusion because it was scenic and could be used for recreational purposes.
Davis retained Bruce Cresson II to appraise the property, and Cresson estimated the fair market value of the land to be $4.1 million. The appraisal included a negative 30 percent adjustment due to the flood zone restrictions offset by a positive 30 percent adjustment due to the property's scenic value.
Perry told Davis SMRS could not pay more than $2 million, but suggested a transfer for less than fair market value could qualify as a "bargain sale" and, thereby, entitle Davis to a charitable deduction for the difference between the sale price and the fair market value. Perry also told Davis he could potentially receive other benefits, such as a right to name a building erected on the land, and could have family members reside in the retirement community at reduced rates.
In 2005, Davis conveyed the land to the Foundation for $2 million in cash, but because Davis and Perry had been unable to agree on the details of the extra benefits, they were not included. In October of 2005 Perry sent Davis a letter briefly describing the property and noting that his gift to the organization was $2.1 million, the difference between the $2 million the Foundation gave Davis and the $4.1 million appraised fair market value of the property.
On his 2005 return, Davis included a Form 8283, Noncash Charitable Contributions, reporting a $2.1 million charitable contribution deduction. He applied $566,960 of the contribution to 2005, and carried over and applied $416,390 and $170,981 of the remaining amounts to his 2006 and 2007 returns, respectively.
In 2010, the IRS issued a notice of deficiency to Davis for 2005, 2006, and 2007 denying the entirety of the claimed charitable contribution deductions.
Analysis
A bargain sale of property to a qualified charitable organization is a sale or exchange for less than the property's fair market value and is treated as partly a charitable contribution and partly a sale or exchange (Reg. Sec. 1.170A-4(c)(2)(ii)).
A taxpayer making a charitable contribution of $250 or more must obtain a contemporaneous written acknowledgment from the donee including: (1) the amount of cash and a description of any property other than cash contributed; (2) whether the donee organization provided any goods or services in consideration, in whole or in part, for the contributed property; and (3) a description and good faith estimate of the value of any goods or services provided (Code Sec. 170(f)(8)(B)).
The IRS argued that Davis lacked charitable intent when he sold the land, noting that he structured the transaction as a contribution only after being informed of the concept of a bargain sale. The Tax Court disagreed, finding Davis sold the land to the Foundation for less than its fair market value with the intention of transferring the difference as a charitable contribution. The court reasoned the mere fact that Perry suggested conveying the land in part as a charitable contribution did not mean that Davis lacked charitable intent.
The IRS next argued that Perry's October 2005 letter failed to satisfy the contemporaneous written acknowledgment requirements because it did not disclose goods and services, other than the $2 million, that Davis received in connection with the sale. The court disagreed with the IRS, noting that because Davis and Perry never reached an agreement on additional benefits there were no goods or services other than the $2 million in cash to disclose, and found the letter met the requirements.
However, the court disagreed with Cresson's valuation of the property and determined that its value was less than $4.1 million, claiming the reduced value of the land due to its location in the flood zone could not be completely offset by an increase in value derived from its scenic nature. The court instead adopted the conclusion of the IRS's expert that a 15 percent negative adjustment should be taken into account to reflect the flood zone restrictions, without the offsetting positive adjustment.
The Tax Court thus held that Davis was entitled to his $566,960 charitable deduction in 2005 from the bargain sale of his property to the Foundation, but required the carryover deductions for 2006 and 2007 to be recalculated based on the reduced valuation.
For a discussion of bargain sales, see Parker Tax ¶84,170.
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IRS Issues Proposed Regs Clarifying Code Section 1022 Carryover Basis Rules
The IRS has issued proposed regulations that provide guidance regarding the application of the modified carryover basis rules of Code Sec. 1022 that affect property transferred from certain decedents who died in 2010. REG-107595-11 (5/11/15).
Background
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) enacted Code Sec. 2210, which eliminated both the estate tax on the estate of any decedent who died in 2010 and the generation skipping transfer (GST) tax for generation-skipping transfers made in 2010. On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA) became law and retroactively reinstated the estate and GST taxes. However, TRUIRJCA allows the executor of an estate of a decedent who died in 2010 to elect not to have the estate tax apply to the decedent's estate, but rather, to have the provisions of Code Sec. 1022 apply (i.e., the Section 1022 election). Code Sec. 1022 applies to estates of decedents dying in calendar year 2010 only if the executor makes the Section 1022 Election.
Generally, under Code Sec. 1014(a), the basis of property acquired from a decedent or to whom the property passed from a decedent is the fair market value of the property at the date of the decedent's death. However, if the decedent died in 2010 and the decedent's executor makes the section 1022 election, then the basis of property in the hands of a person acquiring the property from that decedent is governed by Code Sec. 1022, not Code Sec. 1014.
Under Code Sec. 1022, property acquired from a decedent dying in 2010 is treated as transferred by gift, and the basis of the property is the lesser of the decedent's adjusted basis or the fair market value (FMV) of the property at the date of the decedent's death. The basis of the property is increased by the portion of the aggregate basis increase that is allocated to the property. The aggregate basis increase is $1,300,000, and this limit is increased by certain unused built-in losses and loss carryovers. There is an additional basis increase for property acquired by a surviving spouse.
Although Code Sec 1022 was applicable only to decedents dying in 2010, the IRS notes that basis determined pursuant to that section will continue to be relevant until all of the property whose basis is determined under that section has been sold or otherwise disposed of. Accordingly, the IRS has deemed it necessary to update existing regulations to incorporate appropriate references to basis determined under Code Sec. 1022.
Explanation of Proposed Regulations
The proposed regulations incorporate into the existing regulations, as appropriate, references to Code Sec. 1022 to ensure that references to basis also include basis as determined under that section. Some changes involve simply inserting the words "or section 1022", "and 1022", or similar references. Others (such as Reg. Sec. 1.742-1) require the insertion of a new sentence or an example to expressly address the applicability of Code Sec. 1022. A few changes (such as proposed Reg. Sec. 1.684-3) require the inclusion of a new section to provide a detailed explanation of the application of Code Sec. 1022 in the particular context of the existing regulation. The proposed regulations also provide cross references for section 1022 when appropriate and make other minor, non-substantive changes.
Some of the more significant changes made by the proposed regulations include:
(1) Prop. Reg. Secs. 1.179-4(c)(1)(iv), 1.267(d)-1(a)(3), 1.336-1(b)(5)(i)(A) and 1.355- 6(d)(1)(i)(A)(2) provide that property acquired from a decedent in a transaction in which the recipient's basis is determined under Code Sec. 1022 is not acquired by purchase or exchange for purposes of Code Secs. 179, 267, 336, and 355(d).
(2) Prop. Reg. Sec. 1.742-1(a) provides that the basis of a partnership interest acquired from a decedent whose executor made a Section 1022 Election, is the lower of the adjusted basis of the decedent or fair market value of the interest at the date of decedent's death. The basis of property acquired from a decedent may be further increased under Code Secs. 1022(b) and Code Sec.1022(c), but not above the fair market value of the interest on the date of the decedent's death.
(3) Prop. Reg. Sec. 1.1223-1(b) provides that the holding period under Code Sec. 1223 of the recipient of property acquired from a decedent whose executor made a Section 1022 Election, includes the period that the property was held by the decedent.
(4) Prop. Reg. Sec. 1.1245-4(a)(1) provides that no gain is recognized under Code Sec. 1245(a)(1) upon a transfer of Code Sec. 1245 property from a decedent whose executor made the Section 1022 Election.
(5) Prop. Reg. Sec. 1.1245-3(a)(3) provides that even though certain property is not of a character subject to the allowance for depreciation in the hands of the taxpayer, it may be Code Sec. 1245 property if the taxpayer's basis in the property is determined under Code Sec. 1022 and the property was of a character subject to the allowance for depreciation in the hands of the decedent.
(6) Prop. Reg. Sec. 1.1014-4(a) provides that the basis of property acquired from a decedent, including basis determined under Code Sec. 1022, is uniform in the hands of every person having possession or enjoyment of the property at any time, whether obtained under the will or other instrument or under the laws of descent and distribution.
The changes made by the proposed regulations are effective when finalized.
For a discussion of the section 1022 election, see Parker Tax ¶224,300.
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Flower Retailer's Plan to Donate Profits Failed "Operational Test" for 501(c)(3) Status
Affirming a Tax Court decision denying a request for declaratory judgment granting tax-exempt status to a nonprofit corporation, the Ninth Circuit Court found the company's plan to donate profits from online sales of flowers to charitable organizations did not meet the "operated exclusively for a charitable purpose" test under Code Sec. 501(c)(3). Zagfly, Inc. v. Comm'r, 2015 PTC 159 (9th Cir. 2015).
Analysis
Zagfly, Inc. was organized as a California nonprofit corporation in 2010, but delayed commencing operations pending a final determination of its exempt status. Zagfly planned to engage in an Internet-based business, initially selling flowers as part of an established network of florists. As a flower broker, Zagfly expected to sell flowers at market rates and anticipated earning a sales commission of approximately 10 to 20 percent of the purchase price. When customers purchase flowers from the corporation, they would have the opportunity to designate a charity to receive all of the profit arising from the transaction from a list of tax-exempt organizations approved by Zagfly.
Zagfly also planned to suggest to its users that they allocate a small percentage (1 to 2 percent) of the price of their flower purchase to go to supporting Zagfly. If the users were not inclined to voluntarily elect to allocate funds to the corporation, Zagfly indicated it may need to include its operating expenses in determining the profit' that would go to charitable causes.
Zagfly requested a declaratory judgment from the Tax Court granting it tax-exempt status. The court denied the request, holding that under the "operational test" of Reg. Sec. 1.501(c)(3)-1(c)(1), Zagfly would not be operated exclusively for one or more exempt purposes, and thus was not an exempt organization.
Analysis
To qualify as an exempt organization under Code Sec. 501(c)(3), a corporation generally must demonstrate:
(1) it is organized and will operate exclusively for religious, charitable, scientific, educational, or other specified exempt purposes;
(2) no part of its net earnings will inure to the benefit of a private shareholder or individual;
(3) no part of its activities constitutes intervention or participation in any political campaign on behalf of any candidate for public office; and
(4) no substantial part of its activities consists of political or lobbying activities.
Reg. Sec. 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as "operated exclusively" for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of the exempt purposes specified in Code Sec. 501(c)(3), and will not be so regarded if more than an insubstantial part of its activities is in furtherance of a non-exempt purpose.
Before the Tax Court, Zagfly argued that although it would fulfill its purpose by engaging in activities that others engage in for commercial gain, its primary motivation was charitable. Zagfly claimed it would not realize a profit since it would donate all operational revenue. The tax court noted an organization may operate a trade or business as a substantial part of its activities and still meet the requirements of section 501(c)(3) so long as the business is not an "unrelated trade or business" as defined in Code Sec. 513(a).
The tax court found that Zagfly intended to sell flowers in direct competition with commercial flower brokers, on a regular and continuous basis with the ultimate aim of maximizing its profits in the form of commissions paid on each completed sale and this business was not substantially related to an exempt purpose under Code Sec. 501(c)(3), except insofar as it provided Zagfly with funds to distribute to charitable organizations. Thus, the tax court held that Zagfly was not "operated exclusively" for an exempt purpose.
On appeal, the Ninth Circuit Court reviewed the Tax Court's denial of Zagfly's application for recognition of tax-exempt status under Code Sec. 501(c)(3) for error. The ninth circuit found that although Zagfly planned to donate its business profits to charitable organizations, the tax court did not err in concluding the donation of business profits was not an exempt purpose. The circuit court adopted the reasoning of the tax court and found that the tax court had properly applied the operational test under Reg. Sec. 1.501(c)(3)-(c)(1).
Because Zagfly would not be operated exclusively for an exempt purpose, the Ninth Circuit Court affirmed the Tax Court's denial of Zagfly's request for status as an exempt organization under Code Sec. 501(c)(3).
For a discussion of 501(c)(3) organizations, including organizational requirements, see Parker Tax ¶60,502.
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Ongoing Litigation Precludes Deduction of Casualty Loss from House Fire
The Tax Court held that because a taxpayer was actively seeking reimbursement from his landlord for personal property damages incurred in a house fire, he could not claim casualty loss deductions under Code Sec. 165. Hyler v. Comm'r, T.C. Summary 2015-34.
Background
Fletcher Hyler worked as a self-employed marketing consultant. Hyler and his wife resided in a single-family house they rented in California. In 2012, while the couple was away, a fire destroyed the house and its contents. Hyler and his wife's personal property was insured through a policy with State Farm Insurance. Hyler had declared bankruptcy in 2004 as a result of a downturn in the economy, and had received an appraisal report of the home's contents, which reflected a total value of $99,380. However, the insurance policy's limit on recovery was only $60,000.
After the fire, Hyler and his wife made a claim against the landlord's insurance company seeking to recoup losses from the house fire not covered by his State Farm policy. The claim was denied, and Hyler filed a lawsuit against the landlord and his insurance company. In 2015, the parties scheduled meetings to mediate the claim.
On his 2012 return Hyler claimed a casualty loss of $1,164,547. Hyler believed the bankruptcy appraiser's valuations did not represent the fair market value of certain items and presented documents to the IRS in which he valued artwork, furnishings, and other personal property at approximately $2 million. The IRS disallowed the claimed casualty losses and determined a deficiency of $18,160 in Hyler's 2010 return.
Analysis
Generally, an individual can deduct losses not compensated for by insurance or otherwise, if the losses are of property not connected with a trade or business or with a transaction entered into for profit if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. (Code Sec. 165(c)).
However, if there is a claim for reimbursement in which there is a reasonable prospect of recovery, the taxpayer is not treated as having sustained a deductible loss from the casualty until it can be ascertained with reasonable certainty whether or not the taxpayer will receive the reimbursement (Reg. Sec. 1.165-1(d)(2)(i)). A loss is treated as sustained during the year in which the loss occurs, as evidenced by closed and completed transactions (Reg. Sec. 1.165-1(d)(1)).
The Tax Court observed that Hyler had made clear during trial in 2015 that legal proceedings were ongoing against the landlord and the landlord's insurance company. Thus, the court stated, Hyler's claim for reimbursement from the fire was not resolved in 2012 and in fact, at the time of trial in early 2015, there existed a claim for reimbursement which Hyler was actively pursuing. The court noted a casualty loss is not recognized in the year of actual occurrence if there exists at that time a reasonable prospect of recovery on a claim for reimbursement.
Additionally, the court stated that the Code and the regulations are clear that a loss is not considered "sustained" while a claim for reimbursement is pending. Citing Hudock v. Comm'r, 65 T.C. 351 (1975), the Court noted that settlement, adjudication, or abandonment of a claim would be considered an event sufficient to render the loss "sustained" within the meaning of Code Sec. 165.
The Tax Court determined that because Hyler's claim against his landlord was ongoing, there was no "closed and completed transaction" required by Reg. Sec. 1.165-1(d)(1) to support a sustained loss. Because Hyler had not sustained a loss from the 2012 fire within the meaning of Code Sec. 165, the tax court held that he was not entitled to the casualty loss deduction, and upheld the IRS's assessed deficiencies.
For a discussion of casualty losses, see Parker Tax ¶84,540.
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KPMG Partner Incorrectly Claimed Basis Step-Up for Shares Transferred to Nonresident Alien Wife
The Tax Court held that because a taxpayer had incorrectly claimed a basis step-up for shares with zero basis he had gifted to his nonresident alien wife and was subject to a gross valuation misstatement penalty. The court found he could not avoid the penalty by claiming he relied on professional advice, because given his extensive experience as a CPA, the reliance was not reasonable. Hughes v. Comm'r, T.C. Memo. 2015-89.
Background
Ian Hughes obtained a CPA license in Texas in 1979, took a job with KPMG LLP that same year, became a partner in 1986 and moved to the London office in 1994. Hughes' career at KPMG focused almost entirely on the tax aspects of corporate transactions. Hughes divorced his first wife in September 2000, and in October 2000 he married Vanessa, a U.K. citizen and his current wife.
In 1999 KPMG spun off its consulting business to a newly formed corporation, KCI, and allocated its shares among the KPMG partners in two classes reported as "founder's shares" and "K-1 shares" (collectively, KCI shares) . Hughes did not contribute funds in connection with KCI's formation. As there was no public market for the KCI shares and no plans for a public offering, there was no fair market value and the basis in the KCI shares was zero.
In late 2000, Hughes began to fear that if the KCI shares were sold, thereby establishing a fair market value, his first wife would seek a portion of the proceeds. After consulting with his U.K. divorce lawyer, Hughes prepared a gift deed and transferred his interest in the KCI shares in trust to Vanessa. Hughes made an additional gift to Vanessa in 2001. Hughes did not advise KPMG of his transfer of the KCI shares to Vanessa either in 2000 or 2001, report the transfer of shares to the U.K. for either year or file the required U.S. gift tax return.
In 2001 KPMG sold the founder's shares and a portion of the K-1 shares. Hughes received $326,990 and $857,270 for the founder's and K-1 shares, respectively. On his 2001 income tax return, Hughes treated the amounts he received from the sale of founder's and K-1 shares as long-term capital gains, claiming zero bases for the KCI shares.
In 2005, Hughes filed an amended return for 2001, revising his bases in the founder's and K-1 shares to reflect a stepped-up basis that he claimed should have resulted from what he believed were income taxable gifts of the KCI shares to Vanessa. The amended return reported zero capital gain attributable to sale of the founder's shares, claiming the bases matched the amount of the sale proceeds, and a lower amount of long-term capital gain from the sale of the K-1 shares.
Hughes represented to the IRS that he had arrived at the newly claimed bases after consulting with his U.K. divorce lawyer and informal talks with colleagues at KPMG as to the U.S. and U.K. tax consequences of his gift of the shares. As a result of these discussions and his own research, Hughes believed that Code Sec. 1041(d) rendered the stock gifts taxable to him, but that pursuant to a tax treaty between the U.S. and the U.K., he was taxable on capital gain only in the U. K., his country of residence at the time of the transfers.
In 2011 the IRS issued a notice of income tax deficiency in the amount of $364,006 with respect to the amended bases for the KCI shares and imposed a 40 percent gross valuation misstatement penalty.
Rejection of Basis Step-Up
When property is acquired in a taxable exchange, its basis is generally the cost of such property (Code Sec. 1012(a)). When property was acquired by gift, by contrast, its basis is the same as it would be in the hands of the donor (Code Sec. 1015(a)).
The IRS argued Hughes' basis in the shares, which it found to be zero, transferred to Vanessa under Code Sec. 1015(a). Hughes countered that, under Code Sec. 1041 (which provides that gain or loss is generally not recognized on a transfer of property from an individual to a spouse, but makes an exception for transfers to nonresident alien spouses), the gifts resulted in taxable income to himself. Since the transfer was taxable, Hughes claimed that under U.S. v. Davis, 370 U.S. 65 (1962), Vanessa took a fair market value basis in the KCI shares. According to Hughes this income was capital gains taxable to him only in the U.K., his country of residence at the time of the gifts, pursuant to a tax treaty.
The Tax Court noted that Code Sec. 1041only applies where gain or loss has been realized and would otherwise be recognized under the Code. The court determined that since gifts are not income taxable events under Code Sec. 102, neither the donor nor donee of a gift realizes gain and thus there is no gain to be recognized, meaning that Code Sec. 1041 would not apply to spousal gift transfers. Because the gifts were not income taxable exchanges, nothing in the Code or the regulations allowed Vanessa to take stepped-up bases in the shares, and the court determined she took transferred bases of zero from Hughes under Code Sec. 1015(a).
The tax court pointed out that since the gifts were not taxable, Davis was inapplicable to Hughes' situation. In Davis, the taxpayer agreed, pursuant to divorce, to transfer shares to his wife in exchange for a release from any future property claims against him, which was deemed a taxable transaction with the wife receiving basis in the shares equal to the value of her extinguished property rights. The tax court determined that even if it were to treat Hughes' gifts of KCI shares to Vanessa as taxable transactions under Davis, Hughes' amount realized and Vanessa's basis in the KCI shares would be the fair market value of what she transferred to Hughes in exchange for the KCI shares; since Vanessa transferred nothing, the fair market value would be zero, and she still would have had zero basis in the shares.
The court noted that Hughes, in concluding that he was not subject U.S. capital gains tax on the transfer, had misread the effective date and relied on a treaty not in effect at the time of his gifts to Vanessa. Since the gifts did not generate income to Hughes, the court stated it was irrelevant whether, under the applicable tax treaty, the U.S. could tax a U.S. citizen resident in U.K. on capital gain, but did note that U.S. income tax treaties regularly include a saving clause that allows the U.S. to tax its citizens' income as if the treaty were not in effect, and the relevant treaty had such a clause.
Gross Valuation Misstatement Penalty
Because Hughes had reported basis when none existed, the Tax Court determined he was subject to the 40 percent gross valuation misstatement penalty.
A 40 percent accuracy-related penalty generally applies to any portion of an underpayment of tax that is attributable to a gross valuation misstatement, defined as an overstatement of 400 percent or more of the actual value or basis claimed on a return (Code Sec. 6662(h)(1)). If the correct value or basis is zero, an amount claimed on a return is considered to be 400 percent or more of the correct amount, triggering the 40 percent gross valuation misstatement penalty (Reg. Sec. 1.6662-2(c)).
A taxpayer can avoid the penalty by showing there was a reasonable cause for the misstatement and the taxpayer acted in good faith (Code Sec. 6664(c)). Taxpayers may argue that he or she had reasonable cause and showed good faith by relying on professional advice (Reg. Sec. 1.6664-4(c)). Reasonable cause and good faith may also be shown by an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge, and education of the taxpayer (Reg. Sec. 1.6664-4(b)(1)).
Hughes claimed that because he relied reasonably and in good faith on his divorce lawyer and his colleagues at KPMG, he was not liable for the penalty. The Tax Court disagreed, noting that Hughes' divorce lawyer was not familiar with U.S. tax law and thus plainly lacked sufficient expertise to justify reliance on such matters. As to his KPMG colleagues, the court noted the discussions were highly informal, and Hughes had asked about the taxability of the gifts, not about what basis his wife would receive in the shares.
Hughes also argued he was excused from the penalty because he honestly misunderstood the applicable law. The court agreed that Hughes clearly misunderstood the law applicable to the gifts, but considering his experience, knowledge, and education, the misunderstanding was not reasonable. The court noted that Hughes had been a partner at KPMG for over 20 years, yet failed to notice that the treaty he relied on was not in effect when he transferred the shares. Even though he was not an expert in individual income taxes, the court stated he should have learned, or at least been aware of, basic income tax principles relating to gifts while studying for his CPA licensing exam, and if he did not, the fundamentals should not reasonably have eluded him throughout his KPMG career.
Because the shares had zero basis when transferred to Vanessa, the Tax Court determined that her basis was zero, and because Hughes had reported non-zero basis in those shares on his amended return, the court sustained the IRS's deficiency determination, and upheld the 40 percent gross valuation misstatement penalty.
For a discussion on spousal property transfers, see Parker Tax ¶14,250. For a discussion of tax penalties, see Parker Tax ¶262,100.
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Nail Salon's Underreported Income Garners 75% Fraud Penalty, But Only for One Owner
The Tax Court held that taxpayers' deficiencies from their jointly owned nail salons were due to fraud, but the court imposed 75 percent fraud penalties against only one owner, finding the second owner merely followed the directions and actions of the first. Duong v. Comm'r, T.C. Memo. 2015-90.
Background
Khuong Duong and Dung Tran jointly owned and operated AK Nails and Perfection Nails and split the profits and losses 50-50. Tran was the main stylist and Duong functioned as a store manager.
Despite being unmarried, the taxpayers filed a joint return for 2007, reporting gross receipts of $37,469 from AK Nails on Schedule C. For 2008 Tran and Duong filed separate returns, each reporting income from the salons on a Schedule C. Tran reported gross receipts of $38,347 from AK Nails, Duong reported gross receipts of $44,377 from Perfection Nails.
The IRS selected the taxpayers' returns for audit, focusing on their Schedule C income. During visits from a revenue agent, Duong stated that they had reported all income received by the salons, and denied receiving cash at either location, insisting that customers made all payments by credit or debit card. Additionally, Duong declined to provide the revenue agent with bank statements or other business records that he and Tran possessed.
The taxpayers maintained joint bank accounts, though Duong kept a separate individual account. The revenue agent performed a bank deposit analysis for each joint account, and for 2007 and 2008 calculated $136,813 and $99,933 of presumptive gross receipts, respectively. For Duong's separate account, the agent calculated $17,027 and $51,553 of additional gross receipts. In her calculations, the agent determined that $183,119 of deposits (roughly half the total) were nontaxable.
On the basis of the examination and the revenue agent's calculations, the IRS determined the taxpayers together had deficiencies totaling $83,421 for 2007 and $32,610 for 2008. The IRS issued assessments in 2013, and imposed fraud penalties on both taxpayers.
Analysis
If a taxpayer keeps no books of account or keeps books that are demonstrably inaccurate, the IRS may determine income under methods that clearly reflect income (Code Sec. 446(b)). If a taxpayer has poor records and large unexplained bank deposits, the IRS may use the bank deposits method to estimate the taxpayer's income (Estate of Hague v. Comm'r, 132 F.2d 775 (2d Cir. 1943)).
Code Sec. 6663(a) imposes a 75 percent penalty equal to any part of any underpayment of tax if the underpayment is attributable to fraud. Courts have developed a nonexclusive list of "badges of fraud" to demonstrate fraudulent intent (Bradford v. Comm'r, 796 F.2d 303 (9th Cir. 1986)).
The Tax Court noted that the taxpayers failed to maintain accurate books or records from which their tax liabilities could be computed and Duong refused to provide the revenue agent with any records at all. The court determined the IRS was authorized to calculate their income by using the bank deposits method, and additionally found the taxpayers failed to prove the nontaxability of any deposits beyond the $183,119 that the IRS allowed.
The court next addressed the IRS's determination of fraud penalties against Duong and Tran, and found numerous "badges of fraud" demonstrated that Duong intentionally evaded the payment of tax he knew to be owed.
The court determined Duong had (1) understated his income for both years in issue; (2) maintained inadequate records and failed to provide relevant records to the revenue agent; (3) stated falsely that neither business received cash payments from customers; (4) at trial contradicted himself by stating, implausibly, that AK Nails customers sometimes paid in cash but that Perfection Nails customers never did so; (5) failed to cooperate with the revenue agent, who requested bank statements but never received them; (6) indicated he had merchant receipts but failed to provide them; (7) regularly commingled business and personal funds; and (8) provided testimony at trial concerning cash receipts and alleged nontaxable deposits which lacked credibility.
The court found that these badges of fraud convincingly established that Duong acted with fraudulent intent and the underpayments of tax were due to fraud. However, while several of the same badges of fraud applied to Tran, the court reached the opposite conclusion for her. The court noted Duong bore principal responsibility for the false statements made to the IRS revenue agent, and for the lack of cooperation. The court determined that Tran followed the direction and actions of Duong and that her behavior did not rise to the level of fraud.
Because the agent's implementation of the bank deposits method and her analysis were reasonable with respect to both taxpayers' accounts, and because Duong acted with fraudulent intent with respect to the underpayments, the Tax Court upheld the IRS's notices of deficiency, but imposed the 75 percent Code Sec. 6663(a) fraud penalty only against Duong.
For a discussion of the fraud penalty on underpayments of tax, see Parker ¶262,125.
