Federal Tax Bulletin - Issue 108 - February 12, 2016

IRS Finalizes New Form 8971 for Reporting Estate Distributions; Delays Filing Deadline to March 31

The IRS has finalized Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, which is used to fulfill new reporting requirements when filing Forms 706. While Notice 2015-57 initially delayed until February 29, 2016, the time for filing Form 8971 where the form was due before February 29, the IRS has now delayed the due date another month, until March 31, 2016. Notice 2016-19.

Background

In 2015, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Pub. L. 114-41, 7/31/15) enacted Code Sec. 1014(f) and Code Sec. 6035, imposing two new estate tax reporting requirements.

Under Code Sec. 1014(f), the basis of certain property acquired from a decedent may not exceed the value of that property as finally determined for federal estate tax purposes, or if not finally determined, the value of that property as reported on a statement made under Code Sec. 6035. Code Sec. 6035 imposes reporting requirements with respect to the value of property included in a decedent's gross estate for federal estate tax purposes. These new provisions are effective for estate tax returns filed after July 31, 2015.

Under Code Sec. 6035, the executor of any estate required to file an estate tax return under Code Sec. 6018(a) must provide both the IRS and the person acquiring any interest in property included in the decedent's gross estate for federal estate tax purposes, with a statement identifying the value of each interest in such property as reported on any Forms 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and any other information that the IRS requires. If a beneficiary is required to file Form 706 under Code Sec. 6018(b), he or she must provide the IRS and each other person holding an interest in the inherited property with a statement identifying the value of each interest in the property, as reported on any Forms 706.

The requirements under Code Sec. 6035 are met by filing Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, and Schedule A, Information Regarding Beneficiaries Acquiring Property From a Decedent, which is part of Form 8971.

IRS Finalizes Form 8971 and Delays Filing Deadline

On January 29, 2016, the IRS released the final version of Form 8971. Form 8971 and Schedule A must be filed by the executor or beneficiary no later than the earlier of: (1) 30 days after the day Form 706 was required to be filed (including extensions), or (2) 30 days after the Form 706 was actually filed.

In Notice 2016-19, the IRS delayed until March 31, 2016, the due date for: (1) all Forms 8971 (including the attached Schedule(s) A) required to be filed with the IRS after July 31, 2015, and before March 31, 2016, and (2) all Schedules A required to be provided to beneficiaries after July 31, 2015, and before March 31, 2016.

Observation: Previously, in Notice 2015-57, the IRS made February 29, 2016, the due date for (1) all Forms 8971 (including the attached Schedule(s) A) required to be filed with the IRS after July 31, 2015, and before February 29, 2016; and (2) all Schedules A required to be provided to beneficiaries after July 31, 2015, and before February 29, 2016.

If there is an adjustment to the value of the inherited property after Form 8971 has been filed, a supplemental statement must be filed no later than 30 days after the adjustment is made.

Compliance Tip: An executor is required to file an estate tax return where the gross estate at the decedent's death exceeds the basic exclusion amount in effect under Code Sec. 2010(c) for the calendar year which includes the date of death ($5,430,000 for 2015). Otherwise, no estate tax return is required. Any applicable exclusion amount that remains unused as of the death of a spouse (the deceased spousal unused exclusion or DSUE amount) generally is available for use by the surviving spouse, as an addition to the surviving spouse's applicable exclusion amount. To elect portability of the DSUE, a Form 706 must be filed even though it is not otherwise required.

As part of the new law enacted in 2015, Congress instructed the IRS to issue regulations relating to the application of these rules to property with regard to which no estate tax return is required to be filed, and to situations in which the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property. In Notice 2016-19, the IRS advised that it expects to issue proposed regulations under Code Sec. 1014(f) and Code Sec. 6035 shortly. As of press time, no such regulations have been issued. However, the instructions to Form 8971 provide that the filing requirement of Form 8971 does not apply to an executor of an estate that is not required to file a Form 706 because the gross estate plus adjusted taxable gifts are less than the basic exclusion amount, but who does so for the sole purpose of making an allocation or election with respect to the generation-skipping transfer tax.

The instructions do not address whether Form 8971 is required when a Form 706 is filed solely to elect portability of the deceased spousal unused exclusion (DSUE) amount under Code Sec. 2010(c)(5)(A). Informal conversations with the IRS have indicated that Form 8971 is not required in such cases. However, at press time, no formal guidance on this point has been issued.

Caution: The instructions to Form 8971 and Schedule A provide that a form or schedule filed with the IRS without entries in each field will not be processed. A form with an answer of "unknown" will not be considered a complete return.

The AICPA has pointed out in a comment letter to the IRS on the draft Form 8971, Form 8971 and Schedule A require taxpayer identification numbers, but foreign persons may not possess an existing individual tax identification number (ITIN). Obtaining an ITIN can often take several months, and the IRS may not have the authority to request the ITIN information of foreign persons under existing regulations. Reg. Sec. 301.6109-1(b)(2) and (c) provides the rules for when a return can be filed with another person's identifying information and provides limited circumstances where a foreign person must obtain an ITIN. These limited circumstances, the AICPA noted, do not provide for basis reporting. The AICPA suggested that the IRS allow "unknown" or "unknown - foreign" for the TIN of foreign beneficiaries on Form 8971 or Schedule A.

The AICPA also noted that in many cases, "unknown" may be the correct answer to the question in Part II of Form 8971: "How many beneficiaries received (or are expected to receive) property from the estate?" because an executor may not complete the search for heirs by the date Form 706 is filed. The AICPA suggested that the IRS require the executor to attach an explanation if the executor cannot furnish a specific number, and further suggested that if an explanation is provided, the IRS consider the Form 8971 as complete and process the Form.

For a discussion new reporting requirement under Code Sec. 6035, see Parker Tax ¶228,925.

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Fifth Circuit Affirms Tax Court; Self-Rental Rule Applies to Classify Rental Income as Nonpassive

The Fifth Circuit held that, while Code Sec. 469 does not specifically refer to S corporations, it applied to the taxpayers' wholly owned S corporation because the corporation was merely a pass-through entity. Further, the self-rental rule of Reg. Sec. 1.469-2(f)(6) applied and rental income received from a lease of property by the taxpayer's S corporation to their wholly owned C corporation was nonpassive income, thus denying them passive loss deductions against that rental income. Williams v. Comm'r, 2016 PTC 45 (5th Cir. 2016).

Background

During 2009 and 2010, Larry Williams and his wife, Dora, owned 100 percent of two companies: BEK Real Estate Holdings, LLC (BEK Real Estate), an S corporation, and BEK Medical, Inc. (BEK Medical), a C corporation. Larry worked full time for BEK Medical and materially participated in the trade or business activities of BEK Medical for purposes of the passive loss rules of Code Sec. 469. Neither of the Williamses materially participated in the activities of BEK Real Estate or otherwise engaged in a real property trade or business.

In 2009 and 2010, BEK Real Estate leased to BEK Medical commercial real estate which BEK Medical used in its trade or business activities. BEK Real Estate had net rental income of approximately $53,000 and $49,000 from BEK Medical in 2009 and 2010, respectively. The Williamses reported these amounts on their 2009 and 2010 tax returns as passive income on Schedules E, Supplemental Income and Loss. They offset these amounts with passive losses from other S corporations, partnerships, and personally owned rental properties. Upon audit, the IRS reclassified BEK Real Estate's rental income as nonpassive income pursuant to Reg. Sec. 1.469-2(f)(6) and disallowed the couple's passive losses that were claimed in excess of their adjusted passive income for 2009 and 2010.

Reg. Sec. 1.469-2(f)(6), the so-called "self-rental rule," provides that an amount of the taxpayer's gross rental activity income for the tax year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property (1) is rented for use in a trade or business activity in which the taxpayer materially participates for the tax year; and (2) is not described in Reg. Sec. 1.469-2T(f)(5), which relates to certain property rented incidental to development activity.

Observation: In essence, the self-rental rule provides that when a taxpayer rents property to his own business, the income is not passive activity income. Thus, the impact of the IRS concluding that BEK Real Estate's lease of commercial real estate to BEK Medical fell under the self-rental rule meant that: (1) the Williamses' rental income was deemed nonpassive; (2) the Williamses could not deduct from their rental income any of their passive activity losses; and (3) they owed income tax on the rental income of approximately $8,700 and $17,600 for 2009 and 2010, respectively.

Analysis

Before the Tax Court, the Williamses raised two arguments. First, they argued that because Code Sec. 469 does not define "taxpayer" to include S corporations, the IRS lacked the authority to define "taxpayer" to include S corporations in the associated regulations. Second, they argued that the self-rental rule in Reg. Sec. 1.469-2(f)(6) did not apply since the lessor, BEK Real Estate, did not materially participate in the trade or business of BEK Medical. The Tax Court rejected these arguments and held for the IRS. The Williamses appealed to the Fifth Circuit.

The Fifth Circuit affirmed the Tax Court's holding. With respect to the argument that the word "taxpayer" in Code Sec. 469 does not include S corporations, the Fifth Circuit agreed with the Tax Court's conclusion that Code Sec. 469 did not need to specifically refer to S corporations because S corporations are merely pass-through entities, and its individual shareholders are the ultimate taxpayers. Thus, an S corporation is not a taxpayer; rather, its shareholders are taxpayers. Because S corporations do not pay taxes directly, the court said, there is no need for Code Sec. 469 to include S corporations in its list of potential "taxpayers."

The court then addressed the Williamses' argument that Reg. Sec. 1.469-2(f)(6) did not apply because the lessor S corporation, BEK Real Estate, did not materially participate in the trade or business of the lessee C corporation, BEK Medical. The Fifth Circuit again agreed with the Tax Court that there was no basis for the Williamses' reading of the regulation in that way. According to the court, the proper focus is not on BEK Real Estate, a non-taxpayer S corporation, but on the actual taxpayers, the Williamses.

It was undisputed, the court said, that the property leased to BEK Medical was rented for BEK Medical's use in a trade or business activity, and it was likewise undisputed that the relevant taxpayer, Larry Williams, materially participated in BEK Medical's business. Thus, the court concluded, the self-rental rule in Reg. Sec. 1.469-2(f)(6) applied and operated to classify the rental income from that lease as nonpassive income.

For a discussion of the self-rental rule, see Parker Tax ¶247,150.

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IRS Addresses Tax Implications of Partner Guarantees of Certain Partnership Liabilities

Where a partner's guarantee of a partnership's obligation to satisfy a promissory note upon the occurrence of certain events was sufficient to cause the guaranteeing partner to bear the economic risk of loss for that obligation, the guaranteed debt was treated as recourse financing for purposes of applying the basis allocation rules under Code Sec. 752. CCA 201606027.

The IRS Office of Chief Counsel (IRS) was asked for advice about partner guarantees of certain partnership liabilities. The partnership at issue is a limited liability company that owns, either directly or indirectly, a number of corporate subsidiaries. Specifically, the IRS was asked whether:

(1) If one partner guarantees the partnership's obligation to satisfy a promissory note in the event of, among other events, the partnership admitting in writing that it is insolvent or unable to pay its debts when due, or its voluntary bankruptcy or acquiescence in an involuntary bankruptcy, does that guarantee preclude the promissory note from qualifying as a nonrecourse obligation of the partnership under Code Sec. 752?

(2) If the partnership's sole business activity involves acquiring existing hotels, renovating them, installing personal property appropriate to improve the properties' utility as hotels, and holding and maintaining the premises, but does not include the hotels' day-to-day operations, does this business activity qualify as an "activity of holding real property" within the meaning of Code Sec. 465(b)(6)(A)?

(3) If a partner guarantees partnership debt that otherwise meets the requirements of qualified nonrecourse financing within the meaning of Code Sec. 465(b)(6), are the other non-guarantor partners entitled to treat the obligation as qualified nonrecourse financing within the meaning of Code Sec. 465(b)(6) or otherwise at risk with respect to the guaranteed obligation?

(4) What are the implications if the partnership operating agreement provides that, in the event that the guaranteeing partner makes a payment under the guarantee, the guaranteeing partner has the right to call for the non-guaranteeing partners to make capital contributions and, if they fail to do so, treat ratable portions of the payment as loans to those partners, adjust their fractional interests in the partnership, or enter into a subsequent allocation agreement under which the risk of the guarantee would be shared among the partners? Is that provision sufficient to make the non-guaranteeing partners personally liable with respect to the guaranteed obligation for the purposes of Code Sec. 752 and Code Sec. 465?

In response to these questions, the IRS advised that:

(1) If a partner guarantees an obligation of the partnership and the guarantee is sufficient to cause the guaranteeing partner to bear the economic risk of loss for that obligation within the meaning of Reg. Sec. 1.752-2(b)(1), the guaranteed debt is properly treated as recourse financing for purposes of applying the basis allocation rules of Code Sec. 752. For this purpose, certain contingencies, such as the partnership admitting in writing that it is insolvent or unable to pay its debts when due, its voluntary bankruptcy, or its acquiescence in an involuntary bankruptcy, after taking into account all the facts and circumstances, are not so remote a possibility that it is unlikely the obligation will ever be discharged within the meaning Reg. Sec. 1.752-2(b)(4) that would cause the obligation to be disregarded under Reg. Sec. 1.752-2(b)(3).

(2) Where the partnership's sole business activity includes acquiring existing hotels, renovating them, installing personal property appropriate to improve the properties' utility as hotels, and holding and maintaining the premises, but does not include the hotels' day-to-day operations, the partnership is engaged in an "activity of holding real property" within the meaning of Code Sec. 465(b)(6)(A).

(3) When an individual partner guarantees a partnership obligation, the amount of the guaranteed debt no longer meets the definition of "qualified nonrecourse financing" under Code Sec. 465(b)(6)(B), and the amount of the guaranteed debt is no longer includible in the at-risk amount of the other non-guaranteeing partners, if the guarantee is bona fide and enforceable by creditors of the partnership under local law.

(4) To the extent the guaranteeing partner has the right under the partnership operating agreement to call for the non-guaranteeing partners to make capital contributions and, if they fail to do so, treat ratable portions of the payment as loans to those partners, adjust their fractional interests in the partnership, or enter into a subsequent allocation agreement under which the risk of the guarantee would be shared among the partners, this right generally will not be sufficient to make the non-guaranteeing partners personally liable with respect to the guaranteed obligation for the purposes of Code Sec. 752 and Code Sec. 465.

For a discussion of calculating a partner's share of recourse liabilities, see Parker Tax ¶25,115. For a discussion of the effect of qualified nonrecourse financing on a partner's at-risk amount, see Parker Tax ¶247,520.

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Hobby Loss Case Highlights Problems with Renting Property to Related Party

An S corporation's losses from a horse-breeding activity were denied because the activity had extensive losses and was not engaged in for a profit. In addition, the S corporation's shareholders were not entitled to remove rental income from their individual tax returns after the S corporation was denied deductions for rent paid to the shareholders for the use of a horse farm. Est. of Stuller v. U.S., 2016 PTC 34 (7th Cir. 2016).

Wilma Stuller and her late husband, Harold, bred Tennessee Walking horses on their horse farm in Tennessee. They incorporated the horse-breeding operation in a wholly owned S corporation, L.S.A., Inc. (LSA). LSA made annual rent payments to the Stullers for the use of a horse farm owned by the Stullers. LSA deducted the payments and those deductions flowed through to the Stullers on their personal tax returns. Additionally, the Stullers reported the rental payments as income on their personal tax returns.

The IRS disallowed the losses taken with respect to the horse-breeding operation because it determined that the activity was not engaged in for profit. As a result, the IRS assessed taxes and penalties against the Stullers. After paying up, Wilma Stuller, Harold's estate, and LSA sued for a refund. At trial, a district court excluded testimony from the Stullers' proposed expert and held that LSA was not operated with a good faith intent to profit and, therefore, its losses were not deductible as business expenses. The objective factors most significant to the district court were the unbusinesslike manner in which the Stullers operated LSA, the Stullers' history of steady losses with only one barely profitable year, and the substantial tax benefit LSA provided to the Stullers, given their income from other business ventures. The court also denied a request to refund the taxes paid by the Stullers on rental income received from LSA. Wilma Stuller, Harold's estate, and LSA appealed to the Seventh Circuit.

The Seventh Circuit affirmed the district court. While acknowledging that a horse trainer hired by the Stullers had over 50 years of experience, the court noted that his expertise did not extend to the financial and business aspects of running a horse-breeding operation. The court observed that LSA kept only minimal records for tax purposes and did not retain records of expenses, horse training, or prizes won by horses. The recordkeeping for LSA, the court said, did not adequately track expenses and other important information that would have allowed the Stullers to make informed business decisions.

The Seventh Circuit also noted that, despite consistent and significant annual losses, LSA did not change its operating methods or adopt any new techniques that would significantly turn around its finances. In particular, the court said, the structure of the Stullers' agreement with their horse trainer made it difficult from the outset for LSA to make a meaningful profit on any LSA-bred horse because the trainer automatically received half the sale proceeds for any LSA-bred horse, in addition to the right to breed his horses with LSA's horses for free and to trade horses with LSA, even though LSA incurred all of the associated expenses with breeding and raising the horses. According to the court, the Stullers never came close to turning a meaningful profit through LSA. The best objective indicator that their horse-breeding was a hobby and not a business, the court said, was the Stullers high tolerance for loss. LSA's losses were relatively consistent, the court noted, ranging from $130,000 to $190,000 per year during 1999 to 2005.

The court then rejected the Stullers' request for a refund of taxes paid on rental income received from LSA. Denial of the Stullers' corporate-level deduction for LSA's losses, the court noted, did not change the fact that the Stullers annually received lease income from LSA, which was reported on their returns. According to the court, because denial of the corporate deduction did not change the fundamental principle that an S corporation is a separate entity from its shareholders, the denial of a corporate-level deduction for an S corporations' shareholder does not entitle the taxpayer to remove rental income from an individual tax return. The Seventh Circuit concluded that the Stullers could not now ignore the business forms they chose themselves in order to improve their tax treatment with the benefit of hindsight.

Observation: The Stuller case is a cautionary tale of the whipsaw effect that can occur when rent payments pass from a flow-through entity engaging in an activity, the losses from which may be disallowed, to taxpayers reporting the rental income on their individual returns. In the Stuller's case, the couple essentially created income on which they had to pay taxes. Because the related entity's losses were disallowed hobby losses, there was no offset to their rental income.

For a discussion of the determination of whether an activity is engaged in for profit, see Parker Tax, ¶97,505.

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Taxpayer Who Didn't Meet Common-Law-Marriage Test Had to Use Single Filing Status

While a taxpayer satisfied four of the five elements of Oklahoma's common-law-marriage test, there was no evidence that he and his live-in girlfriend held themselves out as married in any formal settings and, thus, his filing status was single. The taxpayer was, however, entitled to a dependency exemption deduction for his girlfriend; but no dependency exemption deductions or child tax credits were allowed for the girlfriend's daughter and granddaughter. Morris v. Comm'r, T.C. Summary 2016-6.

Background

Robert Morris began dating Regina Downing in October 2004. Neither Morris nor Downing had been married previously. In August 2007, Downing and her then 14-year-old daughter, Thadra, moved into Morris's home. Thadra is not Morris's biological or adopted child. Morris and Downing did not file for a legal marriage certificate or participate in any type of marriage ceremony. The couple kept their finances separate. They did not jointly acquire any property, such as a house, a vehicle, or a bank account. Nor did they jointly participate in any financial transactions, such as obtaining insurance or loans. The title to Morris's house remained solely in his name. In 2009, Downing became unemployed. In 2012, Morris also became unemployed and drew unemployment benefits.

Downing was still unemployed in 2012 and did not have any income in that year. During 2012, Downing and Thadra lived in Morris's house free of charge, although Thadra moved out in September of 2012. Morris paid for the household food and for the utilities. Morris also provided a car for Thadra to use. Thadra, who was 18 years old at the beginning of 2012, attended a local high school and worked 20 hours per week at a grocery store, where she earned the minimum wage of $7.25 per hour. She used her wages for gas and other personal expenses; she did not contribute the wages to the household.

In June of 2012, Thadra gave birth and, one month later, went back to work. She lived in Morris's house until she received federally subsidized housing in September 2012, at which point she and her baby moved out. Downing cared for the baby during the day while Thadra worked. Downing continued to do this until the baby entered daycare in June 2013.

On his 2012 federal income tax return, Morris claimed dependency-exemption deductions for Downing, Thadra, and Thadra's baby. He also claimed a $276 child tax credit and a $724 additional child tax credit, head-of-household filing status, and a $3,217 earned income credit. The IRS disallowed all of Morris's credits and dependency-exemption deductions and calculated his tax using single-filing status. Subsequently, the IRS conceded that Downing was a dependent of Morris. The case ended up in Tax Court where the court was asked to decide (1) whether Morris was married under Oklahoma common law as of the end of 2012; (2) whether Morris was entitled to dependency-exemption deductions for Thadra and her baby; (3) whether Morris was entitled to the child tax credits; and (4) Morris's correct filing status.

Analysis

The Tax Court held that Morris's filing status was single and that he was not entitled to dependency exemption deductions or child tax credits for Thadra and her baby. The court also concluded that he was not entitled to the earned income credit.

In determining Morris's filing status, the court looked to Oklahoma law and noted that Oklahoma recognizes common-law marriages if a couple: (1) has an actual and mutual agreement to be married; (2) has a permanent relationship; (3) has an exclusive relationship; (4) cohabit; and (5) hold themselves out publicly as spouses. Because the IRS did not dispute the first four elements, the court focused on the fifth element.

The court noted that Morris repeatedly claimed that he had a "shoe box full of paperwork" proving that he was married but declined to provide the documentation to the court. Because Morris failed to produce papers on which he and Downing would have stated whether they were married, the Tax Court presumed that on paper they had stated they were single. On the basis of that presumption, the court concluded that Morris had not proven by clear and convincing evidence that he and Downing held themselves out publicly as married and, thus, they did not have a valid common-law marriage. The court also observed that Downing filed her returns using single status and that Morris's 2012 tax return reflected head-of-household status, which is a status available only to unmarried people.

With respect to the dependency-exemption deductions, child tax credits and earned income credit, the court found that neither Thadra nor her baby were a qualifying child or a qualifying relative with respect to Morris. Morris was neither Thadra's biological nor adoptive father, the court said, and thus Thadra was not a qualifying child. Nor, the court said, was Thadra related to Morris through any of the eight categories of relationships under Code Sec. 152(d)(1) that could make her a qualifying relative of Morris. Similarly, the court noted, Thadra's baby was not a qualifying child or relative of Morris's. Thus, Morris was not eligible for the dependency-exemption deductions and the child tax credits. And, because he did not have any qualifying children for 2012 and his wages for the year exceeded the earned income threshold for a taxpayer without qualifying children, the court concluded that Morris was not entitled to the earned income credit for 2012.

For a discussion of the requirements that must be met in order to claim a dependency exemption deduction and child tax credits, see Parker Tax ¶10,720 and ¶100,705, respectively.

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IRS Releases 2016 Inflation-Adjusted Amounts for Items Made Indexable by PATH

The IRS has updated Rev. Proc. 2015-53 to provide the inflation adjustments for items that, beginning in 2016, are adjusted for inflation due to the enactment of the Protecting Americans from Tax Hikes (PATH) Act. These items include Code Sec. 179 expensing, the deduction for certain expenses of elementary and secondary school teachers, and qualified transportation fringe benefits. Rev. Proc. 2016-14.

Background

The Protecting Americans from Tax Hikes (PATH) Act (Pub. L. 114-113, 12/18/15) permanently extended many tax breaks and introduced inflation indexing for four items:

(1) The Code Sec. 179 expensing limitation.

(2) The Code Sec. 179 phaseout threshold, which reduces the expensing limitation dollar for dollar (but not below zero) by any amount by which the cost of Code Sec. 179 property placed in service during the year exceeds that threshold.

(3) The above-the-line deduction for the eligible expenses of elementary and secondary school teachers.

(4) The maximum monthly exclusion amount for transit passes and van pool benefits so that these transportation benefits match the exclusion for qualified parking benefits.

For all four items, PATH provided that indexing will begin in 2016.

Inflation Adjusted Amounts for 2016

For tax years beginning in 2016, under Code Sec. 179(b)(1) the aggregate cost of any Code Sec. 179 property that a taxpayer elects to treat as an expense cannot exceed $500,000 (same as last year).

Under Code Sec. 179(b)(2)(C), the $500,000 limitation is reduced (but not below zero) by the amount the cost of Code Sec. 179 property placed in service during the 2016 tax year exceeds $2,010,000 (up from $2,000,000).

For tax years beginning in 2016, under Code Sec. 62(a)(2)(D) the amount of the deduction allowed under Code Sec. 162 for expenses of an eligible educator in connection with books, supplies (other than nonathletic supplies for courses of instruction in health or physical education), computer equipment (including related software and services) and other equipment, and supplementary materials used by eligible educators is limited to $250 (same as last year).

For tax years beginning in 2016, the monthly limitation under Code Sec. 132(f)(2)(A) regarding the aggregate fringe benefit exclusion amount for transportation in a commuter highway vehicle and any transit pass is $255 (same as last year).

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Temp Regs Expand Guidance on Safe Harbor for Allocating Creditable Foreign Taxes

The IRS has issued temporary and proposed regulations providing guidance on the operation of an existing safe harbor rule, used for partnership allocations of creditable foreign tax expenditures (CFTE), regarding Code Sec. 743(b) adjustments, deductible allocations and nondeductible guaranteed payments, and inter-branch payments. T.D. 9748 (2/4/16); REG-100861-15 (2/4/16).

Background

A creditable foreign tax expenditure (CFTE) is a foreign tax paid or accrued by a partnership that is eligible for the foreign tax credit. Allocations of creditable foreign taxes do not have substantial economic effect and, accordingly, such expenditures must be allocated in accordance with the partners' interests in the partnership. Reg. Sec. 1.704-1(b)(4)(viii)(a) provides a safe harbor under which an allocation of a CFTE is deemed to be in accordance with the partners' interests in the partnership if:

(1) the CFTE is allocated (whether or not pursuant to an express provision in the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTE relates; and

(2) allocations of all other partnership items that, in the aggregate, have a material effect on the amount of CFTEs allocated to a partner are valid.

In order to apply the safe harbor, a partnership must (1) determine the partnership's CFTE categories, (2) determine the partnership's net income in each CFTE category, and (3) allocate the partnership's CFTEs to each category. Partnership allocations of CFTEs in a CFTE category must be in proportion to the allocations of the partnership's net income in the CFTE category. A partnership groups its activities into one or more CFTE categories based generally on whether net income from the activities is allocated to partners in the same sharing ratios as the CFTEs (Reg. Sec. 1.704-1(b)(4)(viii)(c)(2)).

Temporary and proposed regulations issued in T.D. 9748 (2/4/16) and REG-100861-15 (2/4/16) provide guidance on the operation of the safe harbor regarding:

(1) Code Sec. 743(b) adjustments,

(2) Special rules for deductible allocations and nondeductible guaranteed payments, and

(3) Inter-branch payments.

The temporary regs also make organizational and other non-substantive changes that clarify how items of income are assigned to an activity and how a partnership's net income in a CFTE category is determined.

The text of temporary regulations serves as the text of the proposed regulations. The regulations are generally effective on February 4, 2016.

Effect of Section 743(b) Adjustment

Currently, the regulations do not state whether an adjustment under Code Sec. 743(b) is taken into account in computing the partnership's net income in a CFTE category.

The IRS believes that a transferee partner's Code Sec. 743(b) adjustment with respect to its interest in a partnership should not be taken into account in computing the partnership's net income in a CFTE category because the basis adjustment is unique to the transferee partner and because the basis adjustment ordinarily would not be taken into account by a foreign jurisdiction in computing its foreign taxable base. According to the IRS, taking a transferee partner's Code Sec. 743(b) adjustment into account to compute the net income in a CFTE category could change the partners' relative shares of this net income, and their allocable shares of CFTEs under the safe harbor, solely as a result of the transfer of the partnership interest and not as a result of a change to the allocation of any partnership items under the partnership agreement. Thus, Reg. Sec. 1.704-1T(b)(4)(viii)(c)(3)(i) provides that, for purposes of computing a partnership's net income in a CFTE category, the partnership determines its items without regard to any Code Sec. 743(b) adjustments that its partners may have to the basis of property of the partnership.

The IRS noted that a partnership that is a transferee partner may have a Code Sec. 743(b) adjustment in its capacity as a direct or indirect partner in a lower-tier partnership. As an exception to the general rule, the temporary regulation provide that a Code Sec. 743(b) adjustment in such case is taken into account when determining the partnership's net income in a CFTE category.

Special Rules for Deductible Allocations and Nondeductible Guaranteed Payments

For purposes of the safe harbor for allocating CFTEs, Reg. Sec. 1.704-1(b)(4)(viii)(c)(3)(ii) provides a special rule that reduces the partnership's net income in a CFTE category to the extent foreign law allows a deduction for an allocation or payment of an allocated amount to a partner (for example, because foreign law characterizes a preferential allocation of gross income as deductible interest expense). In addition, to the extent that foreign law does not allow a deduction for a guaranteed payment that is otherwise deductible under U.S. law, Reg. Sec. 1.704-1(b)(4)(viii)(c)(3)(ii) provides another special rule that requires an upward adjustment to the partnership's net income in a CFTE category (these two rules are collectively referred to as the "special rules").

The current final regulations do not expressly address situations in which an allocation or distribution of an allocated amount or guaranteed payment gives rise to a deduction for purposes of one foreign tax, but is made out of income subject to another tax imposed by the same or a different foreign jurisdiction. Accordingly, the temporary regulations revise the special rules to address situations in which allocations (or distributions of allocated amounts) and guaranteed payments that give rise to deductions under foreign law are made out of income with related CFTEs.

In addition, the current final regulations provide that the adjustment to income attributable to an activity for a preferential allocation depends on whether the allocation of the item of income (or payment thereof) results in a deduction under foreign law. According to the IRS, this rule was intended to apply even if the foreign law deduction occurred in a different taxable year. The temporary regulations clarify that a guaranteed payment or preferential allocation is considered deductible under foreign law for purposes of the special rules if the foreign jurisdiction allows a deduction from its taxable base either in the current year or in a different taxable year.

Removal of Inter-branch Payment Rule Did Not Affect Special Rules

For tax years beginning before January 1, 2012, the special rules in Reg. Sec. 1.704-1(b)(4)(viii)(c)(3)(ii) discussed above included a cross-reference confirming that inter-branch payments described in Reg. Sec. 1.704-1(b)(4)(viii)(d)(3) were not subject to the special rules (the "inter-branch payment rule"). In 2012, the IRS published temporary regulations (T.D. 9577) that, in part, removed the inter-branch payment rule, and the associated cross-reference.

The IRS stated the inclusion and subsequent removal of the cross-reference did not change the purpose of the special rules or expand their scope to provide for reductions in income in a CFTE category if a partnership makes a disregarded payment that is deductible under foreign law. Accordingly, the temporary regulations clarify that the special rule for preferential allocations applies only to allocations (or distributions of allocated amounts) to a partner that are deductible under foreign law, and not to other items that give rise to deductions under foreign law. For example, the special rule does not apply to reduce income in a CFTE category by reason of a disregarded inter-branch payment, even if the income out of which the inter-branch payment is made is not subject to tax in any foreign jurisdiction.

According to the IRS, some taxpayers take the position that withholding taxes assessed on the first payment in a series of back-to-back disregarded inter-branch payments do not need to be apportioned among the CFTE categories that include the income out of which the payment is made. The temporary regulations include new examples clarifying that under Reg. Sec. 1.704-1(b)(4)(viii)(d)(1) withholding taxes must be apportioned among the CFTE categories that include the related income.

Effective Date and Modification of Existing Transition Rule

The temporary regulations generally apply for partnership tax years that both begin on or after January 1, 2016, and end after February 4, 2016.

For a discussion of the allocation of creditable foreign taxes, see Parker Tax ¶20,635.35.

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Court Awards Couple $4,000 in Emotional Damages for IRS's Violations of Automatic Stay

A couple going through bankruptcy proved that IRS notices demanding payment and advising of imminent enforcement were in violation of an automatic stay and that those violations caused significant emotional harm. As a result, the couple was awarded $4,000. In re Hunsaker, 2016 PTC 43 (Bankr. D. Or. 2016).

Background

Jonathan Hunsaker is a retired Oregon State Police trooper. His wife, Cheryl, works in the business office of a local hospital. The couple filed a bankruptcy petition under Chapter 13 of the Bankruptcy Code on November 5, 2012. The case was difficult from the outset because property acquired by the couple as their homestead was discovered to be subject to disputed claims by secured creditors and the local government.

A plan of reorganization was confirmed on September 3, 2014, and an automatic stay under Bankruptcy Code Section 362(a) became effective when the bankruptcy petition was filed. Under the automatic stay provisions, a bankruptcy petition for relief operates as a stay, applicable to all entities, of "the commencement or continuation, including the issuance or employment of process, of a judicial, administrative or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case." Under Bankruptcy Code Section 362(k), an individual injured by a willful violation of the stay can recover actual damages, including costs and attorneys' fees, as well as punitive damages in appropriate circumstances. Actual damages under Bankruptcy Code Section 362(k) includes damages for emotional distress.

Since their bankruptcy case began, the Hunsakers made all required plan payments. The IRS was scheduled as a creditor at the time the case began and received notice of the bankruptcy filing. A certificate of notice was filed on November 8, 2012, and the IRS filed a proof of claim, in the amount of $9,301, five days later.

During the course of the case, while the automatic stay was in effect, the IRS delivered directly to the Hunsakers four notices, each of which demanded payment and advised of imminent enforcement action if payment was not made promptly. In the notices, the IRS announced its intent to levy on the Hunsakers' social security benefits, state tax refund, and other property.

Each time the Hunsakers brought the notice to the attention of their attorney, their attorney assured them that the collection efforts were unlawful. Their attorney twice wrote to the IRS advising that the Hunsakers were in bankruptcy, and asking that the IRS to cease all collection activity. Although their attorney assured them that the automatic stay prevented the actions threatened by the notices, the effect of the attorney's assurances began to wear thin as the notices continued to come.

Both of the Hunsakers were adversely affected by the notices. The stresses naturally inherent to a complex bankruptcy case were exacerbated by the perceived threat of additional collection actions by the IRS. The Hunsakers filed suit in district court seeking a judgment against the IRS for damages resulting from serial violations of the automatic stay. The couple sought compensation for the emotional distress they endured as a result of the IRS's violations.

Analysis

Before the district court, Mrs. Hunsaker testified to the onset of migraine headaches within hours of receipt of each of the notices. Each spouse noted signs of tension and anxiety in the other, which in turn added to his or her own stress. The couple told the court that they were especially concerned with the threat to levy on Mr. Hunsaker's social security income, because loss of a substantial portion of their income would render their plan of reorganization unfeasible.

The IRS conceded that its actions constituted violations of the automatic stay. However, it argued that it was immune from claims for damages for emotional distress under Bankruptcy Code Section 106. That section provides that, notwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit with respect to, among other sections, Bankruptcy Code Section 362 and that a court may issue against a governmental unit an order, process, or judgment under such sections, including an order or judgment awarding a money recovery, but not including an award of punitive damages. Under Bankruptcy Code Section 101(27), the term "governmental unit" includes the United States and its instrumentalities. According to the IRS, the waiver of sovereign immunity contained in Bankruptcy Code Section 106 does not explicitly provide for an award of damages based on emotional distress.

The district court held that the Hunsakers demonstrated by clear and convincing evidence that: (1) the IRS actions were a violation of the automatic stay; (2) the circumstances surrounding the violations would obviously cause a reasonable person to suffer significant - that is, non trivial or insubstantial - emotional harm; and (3) the Hunsakers in fact sustained significant emotional damages as a result of the stay violations. As a result of its findings, the court awarded the Hunsakers $4,000 in damages.

With respect to the IRS's argument that the waiver of sovereign immunity contained in Bankruptcy Code Section 106 does not explicitly provide for an award of damages based on emotional distress, the court said that applying this rationale would swallow up the waiver of immunity altogether. Under Bankruptcy Code Section 362(k), the court noted, actual damages are allowed; excluding a particular variety or source of the damage because it is not described in that provision would effectively allow the government to escape liability for any form of damages.

Finally, the court observed, in drafting Bankruptcy Code Section 106, Congress explicitly excluded punitive damages, but no other variety. It follows, the court said, that a governmental unit is subject to liability for any type of damages otherwise authorized by the Bankruptcy Code.

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IRS Issues Maximum Values for Employer-Provided Vehicles under Special Valuation Rules

The IRS has issued the maximum vehicle values for 2016 that taxpayers need to determine the value of personal use of employer-provided vehicles under the special valuation rules in Reg. Sec. 1.61-21(d) and (e). Notice 2016-12.

If an employer provides an employee with a vehicle that is available to the employee for personal use, the value of the personal use must generally be included in the employee's income and wages. If the employer meets certain requirements, the employer may elect to determine the value of the personal use using certain special valuation rules, including the vehicle cents-per-mile rule and the fleet-average value rule set forth in Reg. Sec. 1.61-21(d) and (e), respectively.

Both the vehicle cents-per-mile rule and the fleet-average value rule provide that those rules may not be used to value personal use of vehicles that have fair market values exceeding specified maximum vehicle values on the first day the vehicles are made available to employees. These maximum vehicle values are indexed for inflation and must be adjusted annually by referring to the Consumer Price Index.

Notice 2016-12 provides that the maximum value of employer-provided vehicles first made available to employees for personal use in calendar year 2016 for which the vehicle cents-per-mile valuation rule provided under Reg. Sec. 1.61-21(e) may be applicable is $15,900 for a passenger automobile and $17,700 for a truck or van.

The maximum value of employer-provided vehicles first made available to employees for personal use in calendar year 2016 for which the fleet-average valuation rule provided under Reg. Sec. 1.61-21(d) may be applicable is $21,200 for a passenger automobile and $23,100 for a truck or van.

Notice 2016-12 applies to employer provided passenger automobiles first made available to employees for personal use in calendar year 2016.

For a discussion of the special fringe benefit valuation rules, see Parker Tax ¶123,115.