Federal Tax Bulletin - Issue 111 - March 25, 2016

Recently Released Blue Book Addresses Questions Posed by the New Partnership Audit Regime

In the Bipartisan Budget Act of 2015, Congress repealed the TEFRA partnership audit procedures and replaced them with a centralized system for audit, adjustment, assessment, and collection of taxes. Certain eligible partnerships can elect out of the provisions. While the new rules are generally effective for partnership tax years beginning after December 31, 2017, partnerships may elect to apply them to any partnership returns for partnership tax years beginning after November 2, 2015, and before January 1, 2018.

Last week, the Joint Committee on Taxation released the General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16), otherwise referred to as the "Blue Book." The Blue Book, which was prepared by the staff of the Joint Committee on Taxation in consultation with the staffs of the House Committee on Ways and Means and the Senate Committee on Finance, provides further insight into the overhaul of the partnership audit rules and addresses some of the questions that had been posed by practitioners on various aspects of how the new rules might apply.

New Streamlined Audit Approach Audits at the Partnership Level

The main feature of the new audit rules is the streamlined approach to partnership audits. Audits for a particular year will occur at the partnership level. An underpayment of tax determined as a result of an audit of a tax year is imputed to the year during which the adjustment is finally determined, and generally is assessed against, and collected from, the partnership with respect to that year rather than the year being audited.

For purposes of the centralized system, the partnership tax year to which the item being adjusted relates is called the "reviewed year." For example, in an audit of a partnership's 2018 tax year, 2018 is the reviewed year. The "adjustment year" refers to -  

(1) in the case of an adjustment pursuant to the decision of a court (under the centralized system's judicial review provisions), the partnership tax year in which the decision becomes final;  

(2) in the case of an administrative adjustment request, the partnership tax year in which the administrative adjustment request is made; or  

(3) in any other case, the partnership tax year in which the notice of final partnership adjustment is mailed.  

For example, in the case of adjustments with respect to a partnership's 2018 tax year resulting in an imputed underpayment assessed in 2020 that the partnership then litigates in Tax Court, the decision of which is not appealed and becomes final in 2021, the adjustment year is 2021.

Under the new rules, any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership tax year, and any partner's distributive share thereof, is determined at the partnership level.

Alternative to Partnership Paying Any Imputed Underpayment - Tiered Partnership Issues and Indemnification Agreements

As an alternative to having a partnership pay an imputed underpayment in an adjustment year, a partnership may elect to furnish to the IRS and to each partner of the partnership for the reviewed year, a statement of the partner's share of any adjustments to income, gain, loss, deduction and credit as determined in a notice of final partnership adjustment. In this case, each such partner takes these adjustments into account and pays the tax. In the case of an imputed underpayment for which this election is made, interest is determined at the partner level and it is determined at a modified and higher rate than that which would otherwise apply. Practitioners had questioned what would happen in a tiered partnership arrangement and what would be the effect of any indemnification agreements protecting reviewed-year partners.

According to the Blue Book, in the case of tiered partnerships, a partnership that receives a statement from the audited partnership is treated similarly to an individual who receives a statement from the audited partnership. In other words, the recipient partnership takes into account the aggregate of the adjustment amounts determined for the partner's tax year including the end of the reviewed year, plus the adjustments to tax attributes in the following tax years of the recipient partnership. The recipient partnership pays the tax attributable to adjustments with respect to the reviewed year and the intervening years, calculated as if it were an individual, for the tax year that includes the date of the statement.

The Blue Book notes that the recipient partnership, its partners in the tax year that is the reviewed year of the audited partnership, and its partners in the year that includes the date of the statement, may have entered into indemnification agreements under the partnership agreement with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year that includes the date of the statement. According to the Blue Book, because the payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are similarly nondeductible.

Observation: Because the Blue Book treats the upper-tier partnership as an individual and not as a partnership, it is unclear whether an upper-tier partnership to which adjustments are pushed out can also push adjustments out to its partners. Additional guidance may be required.

Basis Adjustments for Partnership-Level Tax

Under the centralized audit system, the flow through nature of the partnership is unchanged, but the partnership is treated as a point of collection of underpayments that would otherwise be the responsibility of partners. The Blue Book notes that a basis adjustment (reduction) to a partner's basis in its partnership interest is made to reflect the nondeductible payment by the partnership of the tax. Concomitantly, the partnership's total adjusted basis in its assets is reduced by the cash payment of the tax. Thus, parallel basis reductions are made to outside and inside basis to reflect the partnership's payment of the tax.

Clarification of How Opt-Out Election Applies

A partnership may elect out of the centralized system (and it and its partners are governed by the prior rules) for a partnership tax year if it meets certain eligibility requirements. One of the eligibility requirements is that, for the tax year, the partnership is required to furnish 100 or less Schedules K1 with respect to its partners. Another eligibility requirement is that each of the partners is an individual, a deceased partner's estate, a C corporation, a foreign entity that would be required to be treated as a C corporation if it were a domestic entity, or an S corporation (provided special rules are met). The law provides that the IRS may issue regulations or other guidance with respect to how this rule will apply to other partners.

Because partnerships that have a partnership as a partner are not listed as entitles that can opt-out, many practitioners assumed that a tiered partnership could not make the opt-out election. However, the Blue Book seems to negate that assumption. According to the Blue Book, to the extent that such rules are consistent with prompt and efficient collection of tax attributable to the income of partnerships and partners, IRS guidance may provide rules permitting an opt-out election in the case of a partnership (the first partnership) with one or more direct or indirect partners which are themselves partnerships. Under any such guidance with respect to tiered partnerships, the sum of all direct and indirect partners (including each partnership and its partners) may not exceed 100 persons with respect to which a statement must be furnished, and each partner must be identified. That is, eligibility of the first partnership to make the election requires the first partnership to include (in a manner prescribed by the IRS) a disclosure of the name and taxpayer identification number (TIN) of each direct partner of the first partnership and each indirect partner (including each partnership and its partners) in every tier, and requires that each is taken into account in determining whether the 100-or-fewer-statements criterion is met.

Practitioners had several other questions as to how the opt-out provision might apply. One question, for example, was how this provision might apply where a partnership has a disregarded entity or a trust as a partner, or a C corporation that is a real estate investment trust (REIT) or a regulated investment company (RIC). According to the Blue Book, a C corporation partner that is a REIT or a RIC does not prevent the partnership from being able to elect out, provided the applicable requirements are met. With respect to a partner that is a disregarded entity, the Blue Book has an example which assumes that a partner of a partnership is a disregarded entity such as a state-law limited liability company with only one member, a domestic corporation. According to the Blue Book, IRS guidance in this case may provide that the partnership can make the election if the partnership includes a disclosure of the name and TIN of each of the disregarded entity and the corporation that is its sole member, and each of them is taken into account as if each were a statement (i.e., Schedule K-1) recipient in determining whether the 100-or-fewer-statements criterion is met.

As another example, the Blue Book says that IRS guidance on the opt-out election may provide that a partnership with a trust as a partner can make the election if the partnership includes a disclosure of the name and TIN of the trustee, each person who is or is deemed to be an owner of the trust, and any other person that the IRS determines to be necessary and appropriate, and each one of such persons is taken into account as if each were a statement recipient in determining whether the 100-or-fewer-statements criterion is met. According to the Blue Book, similar guidance may be provided with respect to a partnership with a partner that is a grantor trust, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner, or a trust receiving property from a decedent's estate for a two-year period.

Partners Bound by Actions of Partnership

Under TEFRA, there was a notification requirement where the IRS had to notify partners when an audit was begun and to notify partners of proposed adjustments. For purposes of the centralized system, the partnership acts through its partnership representative. The Blue Book makes clear that the partnership representative has the sole authority to act on behalf of the partnership under the centralized system. Under the centralized system, the partnership and all partners of the partnership are bound by actions taken by the partnership. Thus, for example, partners may not participate in or contest results of a partnership audit.

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IRS Allows Taxpayers to Use Either New or Old Form 3115 Before April 20

In conjunction with the revision of Form 3115 at the end of last year, the IRS is providing a transition period in which taxpayers can use either the December 2015 Form 3115 or the December 2009 Form 3115. Announcement 2016-14.

In January, the IRS finalized a December 2015 revision of Form 3115, Application for Change in Accounting Method, and its instructions. The December 2015 Form 3115 is the current Form 3115 and replaces the December 2009 version of the form.

Ordinarily, a taxpayer applies for consent to change a method of accounting for federal income tax purposes by completing and filing the most current Form 3115. However, to allow a reasonable transition to the December 2015 Form 3115, the IRS announced that it will accept either the December 2015 Form 3115 or the December 2009 Form 3115 filed on or before April 19, 2016, except where the use of the December 2015 Form 3115 is specifically required in guidance published by the IRS.

Taxpayers filing Forms 3115 after April 19, 2016, must use the December 2015 Form 3115. The

IRS is encouraging taxpayers to use the December 2015 Form 3115 before April 20, 2016. Regardless of the form used, taxpayers must provide all the information required by Rev. Proc. 2015-13 (or Rev. Proc. 2011-14, if the taxpayer is making a change under certain transition rules in Rev. Proc. 2015-13, as modified by Rev. Proc. 2015-33.).

Rev. Proc. 2015-13 requires a taxpayer filing a request for an automatic accounting method change to file its original Form 3115 with its tax return and a duplicate of that Form 3115 with the IRS in Ogden, Utah. Beginning in January 2016, the duplicate copy of Form 3115 for an automatic change request is filed with the IRS at the following address: Internal Revenue Service, 201 West Rivercenter Blvd., PIN Team Mail Stop 97, Covington, KY 41011-1424

According to Announcement 2016-14, if before April 20, 2016, a taxpayer filed its duplicate copy of Form 3115 with the IRS in either Ogden, Utah, or Covington, Kentucky, using the December 2009 Form 3115, the taxpayer may file its original Form 3115 with its return on either the December 2009 Form 3115 or the December 2015 Form 3115.

The Form 3115 was revised to take into consideration changes made by Rev. Proc. 2015-13, the guidance used for accounting method changes, as well as to update the form for other changes that have occurred since 2009.

The new Form 3115 gives taxpayers the ability to list multiple automatic change numbers on the same Form 3115, revises some of the questions regarding a taxpayer's eligibility to request an automatic change method, and expands the requirement to provide a legal basis for a proposed method change. Previously, a legal basis was only required for changes needing advance consent; now they are also needed for certain automatic change requests as detailed in the instructions.

The instructions to the December 2015 Form 3115 reflect additions and deletions to the designated automatic accounting method change numbers and also contain helpful charts of what parts to complete depending on the type of change (i.e., automatic or non-automatic) is being requested as well as a chart showing what schedules to complete for some of the more common accounting method changes.

For a discussion of accounting method changes, see Parker Tax ¶241,590.

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IRS Delays Filing Deadline for Estate Basis Reporting to June 30

The IRS has, for a third time, delayed the due date for filling Form 8971 under Code Sec. 6035 to comply with new reporting requirements regarding the basis of property included in a decedent's estate. The form is now due by June 30, 2016. Notice 2016-27.

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.

The requirements under Code Sec. 6035 are met by filing Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, with the IRS, and Schedule A, Information Regarding Beneficiaries Acquiring Property From a Decedent, which is part of Form 8971, with the person acquiring an interest in the decedent's property.

In Notice 2016-19, the IRS delayed until March 31, 2016, the due date for all Forms 8971 and all Schedules A required to be filed with the IRS or provided to beneficiaries, respectively, after July 31, 2015, and before March 31, 2016.

In early March, the IRS issued proposed regulations (REG-127923-15) providing guidance regarding the basis consistency requirements under Code Sec. 1014(f) for reporting property acquired from a decedent, and the reporting requirements under Code Sec. 6035 with respect to the value of such property. Many practitioners expressed concern about the tight timing between the issuance of the proposed regs and the due date for Form 8971.

The AICPA, in a letter to the IRS dated March 4, 2016, requested that the IRS further delay the estate basis reporting due date from March 31, 2016, until at least May 31, 2016. In its letter, the AICPA observed that the proposed regulations were released for public inspection on March 2, 2016, just 29 days before the March 31 deadline. The AICPA noted that not only would practitioners need more time to work through the many issues presented in the proposed regulations, tax software providers would also need the time to update their programs for correctly processing the new Form 8971 and Schedule A.

Reporting Deadline Extended to June 30, 2016

In Notice 2016-27, the IRS delayed until June 30, 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 June 30, 2016; and

(2) all Schedules A required to be provided to beneficiaries after July 31, 2015, and before June 30, 2016.

Taxpayers who fail to file Form 8971 with the IRS or to provide beneficiaries with a copy of the Schedule A by the due date may be subject to penalties under Code Sec. 6721 or Code Sec. 6722.

Compliance Tip: Under the proposed regulations, the filing requirements of Code Sec. 6035 do not apply to a return filed by an estate solely to make the portability election under Code Sec. 2010(c)(5), or a generation-skipping transfer tax election or exemption allocation.

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

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Court Rejects IRS Attempt to Keep Secret the Names on Its BOLO List

The Sixth Circuit upheld a district court order that the IRS provide a tea party group, which is suing the IRS for delays they and others were subjected to when filing for tax-exempt status, with the names of organization on the IRS's "Be On The Lookout" list. The court ordered the IRS comply to with the district court's discovery orders without redactions, and without further delay. U.S. v. NorCal Tea Party Patriots, 2016 PTC 113 (6th Cir. 2016).

In 2010, the IRS began to pay unusual attention to Code Sec. 501(c) applications from groups with certain political affiliations. According to a report issued by the Treasury Department Inspector General, the IRS developed and used inappropriate criteria to identify applications from organizations with "Tea Party" in their names. The IRS then expanded the criteria to inappropriately include organizations with other specific names (e.g., Patriots) or policy positions. As to the policy positions, the IRS gave heightened scrutiny to organizations concerned with government spending, government debt or taxes, lobbying to "make America a better place to live," or criticizing how the country is being run. The IRS collected these criteria on a spreadsheet that become known as the "Be On the Lookout" (BOLO) listing. According to the Inspector General's report, these inappropriate criteria remained in place for more than 18 months and applicants whom the IRS flagged with the BOLO criteria were sent to a so-called "team of specialists," where the applicants experienced significant delays and requests for unnecessary information.

A tea party group, NorCal Tea Party Patriots, filed a lawsuit against the IRS alleging that the IRS subjected them to delays and intrusive scrutiny when they applied for tax-exempt status. NorCal also sought to certify a class that would include generally all dissenting groups targeted for additional scrutiny by the IRS.

As part of the discovery process relating to class certification, NorCal asked the IRS to identify organizations that the IRS flagged for special attention using the BOLO criteria, as well as two spreadsheets that the IRS provided to the Inspector General in connection with his report. NorCal specified that they wanted "the names of class members as shown on the IRS's internal lists" so that they could identify fellow members of the putative class.

The IRS refused to produce the information and instead moved for a protective order from a district court. In support, the IRS argued that any information contained in an application for tax-exempt status, including the applicant's name, is confidential "return information" that the IRS is barred from disclosing to the district court. The district court agreed that NorCal's requests encompassed "return information," but held that the IRS could disclose the documents nonetheless under an exception allowing disclosure where "the treatment of an item reflected on such return is directly related to the resolution of an issue" in a judicial proceeding. The district court thus ordered the IRS to produce the documents. The IRS moved for reconsideration, and the court modified its order to permit the IRS to redact any employer identification numbers; but otherwise the court again ordered production of the documents.

The IRS then appealed the district court's order to the Sixth Circuit by filing a writ of mandamus. The IRS argued that the names and other identifying information of organizations that apply for tax-exempt statusalong with the applications themselvesare confidential "return information" under Code Sec. 6103. Citing Code Sec. 6103(b)(2)(A), the IRS argued that the names of applicants for tax-exempt status are "other data, received by, recorded by, furnished to, or collected by the Secretary . . . with respect to the determination of the existence, or possible existence, of liability" for a tax and thus is protected return information.

The Sixth Circuit rejected the IRS's arguments and held that the names, addresses, and taxpayer identification numbers of applicants for tax-exempt status are not "return information" under Code Sec. 6103. The court emphasized that the phrase "data, received by, recorded by, furnished to, or collected by the Secretaryas used in Code Sec. 6103(b)(2)(A), does not entitle the IRS to keep secret in the name of "taxpayer privacy," every internal IRS document that reveals IRS mistreatment of a taxpayer or applicant organization in this case or future ones. According to the court, Code Sec. 6103 was enacted to protect taxpayers from the IRS, not to protect the IRS from taxpayers. The court ordered the IRS comply to with the district court's discovery orders without redactions, and without further delay.

For a discussion of the rules relating to unauthorized disclosure of return information, see Parker Tax ¶265,153.

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Payments Made to Ex-Spouse Before Divorce Was Finalized Were Alimony

The Tax Court determined that payments a taxpayer made to his ex-wife pursuant to a pretrial court order, but before their divorce was finalized, met the statutory definition of alimony. Anderson v. Comm'r, T.C. Memo. 2016-47.

Background

Barry Anderson and his ex-wife separated and began divorce proceedings in 2009. At the time of the separation and divorce, Anderson owned at least two parcels of real property in Alabama: the marital home and a home in Dauphin Island, Alabama. Anderson moved to the Dauphin Island home when he left the marital residence in 2009. Anderson's ex-wife was not working at the time of the separation and divorce.

In November, 2009, a circuit court ordered Anderson and his ex-wife to "maintain status quo as to payment of house note or rent, utilities, food, necessities, fixed credit obligations, etc." Anderson continued to make the mortgage payments for the marital home and the Dauphin Island residence. Anderson also transferred $1,000 to his ex-wife every month from January to December 2010. The memo lines on the October, November, and December checks stated "Alimony payment # 1", "Alimony # 2", and "Alimony # 3", respectively.

In November 2010, the circuit court entered a judgment of divorce dissolving Anderson's marriage. Paragraph 5 of the judgment stated: "Defendant Husband will pay as rehabilitative alimony the sum of $1,000.00 per month, for twenty-four (24) months."

Anderson claimed a deduction for $12,565 of alimony payments on his 2010 income tax return. The IRS mailed Anderson a notice of deficiency, in which it determined that Anderson was entitled to an alimony deduction of $3,000, as evidenced by the $1,000 checks written in October, November, and December of 2010. The IRS disallowed Anderson's deduction for the payments made in January through September of that year.

Analysis

Code Sec. 215(a) allows a deduction for alimony or separate maintenance payments paid during the tax year. Code Sec. 71(b)(1) sets forth a four-pronged test to determine if a payment is alimony, and all four requirements must be met:

(1) the payment must be received pursuant to a divorce instrument;

(2) the divorce instrument must not designate the payment as one that is not includible in income;

(3) the payor and payee must not still live together; and

(4) there must not be a liability to continue making payments after the payor's death.

The Tax Court noted that the term "divorce or separation instrument" as defined in the Code includes a written instrument incident to a decree of divorce or separate maintenance. The court determined that the circuit court's pretrial order was connected with a decree of divorce, because the circuit court sent the order to both parties before the trial that produced the divorce judgment, and found it was thus a written instrument incident to a decree of divorce. As such it satisfied the first requirement for deductibility.

The court found that Anderson's payments also met the second and third requirements since the circuit court's pretrial order made no mention of the tax ramifications of the payments and Anderson credibly testified that he had moved out of the marital home in September 2009.

The court next noted that because the pretrial order was silent as to whether the payments would cease upon the death of the payee spouse, it had to look to Alabama law. Alabama, the court said, has two categories of alimony: alimony in gross and periodic alimony. The court observed that periodic alimony is a payment for the future support of the payee spouse payable from the current earnings of the payor spouse. The purpose of periodic alimony, the court said, is to support the former dependent spouse and enable that spouse, to the extent possible, to maintain the status that the parties had enjoyed during the marriage. The court noted that periodic alimony ceases at the death of either spouse.

The court found that Anderson's payments in January through September 2010 were to maintain the financial status quo of the parties until a judgment of divorce was entered. In other words, the court said, the purpose of the payments was to maintain the status the parties had enjoyed during the marriage. The court determined those payments were periodic alimony payments under Alabama law and, therefore, would have ended upon the death of either spouse. Thus, the court held that Anderson's January through September 2010 payments met the definition of alimony under Code Sec. 71.

For a discussion of taxation of alimony and separate maintenance payments, see Parker Tax ¶14,220.

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IRS Announces First Increase in Interest Rates on Underpayments and Overpayments since 2011

The IRS has provided the interest rates on tax overpayments and underpayments for the calendar quarter beginning April 1, 2016. Rev. Rul. 2016-6.

For purposes of determining the interest rate on tax overpayments and underpayments under Code Sec. 6621, the Secretary of Treasury determines the federal short-term rate for the first month in each calendar quarter. The rates are issued in a quarterly revenue ruling from the IRS.

In Rev. Rul. 2016-6, the IRS announced that the interest rates on tax overpayments and tax underpayments will increase by one percentage point each for the calendar quarter beginning April 1, 2016. The increases are the first since the fourth quarter of 2011.

Under Rev. Rul. 2016-6, an overpayment rate of 4 percent (3 percent in the case of a corporation) and an underpayment rate of 4 percent apply for the calendar quarter beginning April 1, 2016.

The overpayment rate for the portion of a corporate overpayment exceeding $10,000 for the calendar quarter beginning April 1, 2016 is 1.5 percent. The underpayment rate for large corporate underpayments for the calendar quarter beginning April 1, 2016, is 6 percent. These rates apply to amounts bearing interest during that calendar quarter.

Under Code Sec. 6621(b)(2)(B), the 3 percent rate that applies to estimated tax underpayments for the first calendar quarter in 2016, as provided in Rev. Rul. 2015-23, also applies to such underpayments for the first 15 days in April 2016.

For a discussion on interest on underpayments and overpayments of tax, see Parker Tax ¶261,500.

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Mortgage Brokerage Activity Doesn't Qualify to Allow Deduction of Real Estate Rental Losses

The Tax Court determined a taxpayer's mortgage brokerage activity did not constitute a "real property brokerage" activity and the hours spent in the activity could not be counted towards meeting the material participation test to deduct real estate rental losses. Guarino v. Comm'r, T.C. Summary 2016-12.

Rodney Guarino has an undergraduate degree in accounting and a master's degree in tax law. He is also a licensed real estate broker in California and an enrolled agent. He brokers real estate mortgages and prepares federal income tax returns as the sole proprietor of Westoaks Financial (Westoaks). In 2008 and 2009, through Westoaks, Guarino originated and serviced residential and commercial real estate loans in California. Westoaks accepted mortgage loan applications from individuals, submitted the applications to various lenders, and sometimes serviced a mortgage loan on behalf of a lender after the closing of the loan transaction. Guarino and his wife also owned several rental properties and incurred losses related to those properties which they deducted on their personal tax returns for 2008 and 2009.

Also in 2008, the Guarinos bought a home from William Lyon Homes, Inc. (WLH), that they used as their personal residence. In connection with this purchase, WLH agreed to pay a $40,000 broker fee to Platt Properties, which is owned by Guarino's brother-in-law. Platt Properties remitted $39,000 of the fee to the Guarinos in 2008. This payment was reported on a Form 1099-MISC, Miscellaneous Income, that Platt issued to the Guarinos for that year and which the Guarinos reported on Schedule C. No self-employment tax was paid on the $39,000.

On audit, the IRS concluded that the $39,000 fee received in 2008 was self-employment income subject to self-employment tax. The IRS also disallowed the rental losses claimed in each year and imposed a Code Sec. 6662(a) accuracy-related penalty for each year. According to the IRS, the rental losses were passive activity losses deductible only as allowable under Code Sec. 469.

Before the Tax Court, the Guarinos argued that the $39,000 fee should not have been reported on Schedule C but instead should have been reported as other income (i.e., it was not income attributable to a trade or business). Thus, they claimed, it was not subject to self-employment tax.

The Guarinos also argued that their mortgage brokerage activity was a real property trade or business within the meaning of Code Sec. 469(c)(7)(C) and, because Guarino spent more than 750 hours providing services in connection with the mortgage brokerage business in 2008 and 2009, and because he spent more time in that business than he did in any other trades or business during each of those years, he was a taxpayer described in Code Sec. 469(c)(7)(B) and entitled to deduct the rental losses.

Code Sec. 469(c)(7)(B) excepts from the passive activity loss rules losses incurred by a taxpayer who meets the criteria of being a real estate professional because (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. Under Code Sec. 469(c)(7)(C), the term "real property trade or business" means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

The IRS argued that, because none of the various logs provided by the Guarinos were reliable enough to establish the amount of time Guarino spent providing services in any activity, there was no credible support in the record for a finding that Guarino spent more than 750 hours in real property trades or businesses. The IRS also disagreed that Guarino's mortgage brokerage business was a real property trade or business, saying it was essentially a financing services business and such a business does not qualify as a real property trade or business.

The Tax Court held that the $39,000 fee was received in connection with a personal transaction, not in connection with a trade or business of either Guarino or his wife. Thus, it did not fit within the definition of net earnings from self-employment and was not subject to self-employment tax.

With respect to the rental real estate losses, the court noted it had concerns about the reliability of Guarino's logs. However, it did not address those concerns because, at the outset, it found that Guarino's mortgage brokerage business was not a real property trade or business within the meaning of Code Sec. 469(c)(7)(C). According to the court, Guarino's focus on the word "brokerage" contained in Code Sec. 469(c)(7)(C) ignored the words "real property" that precede the specific activities listed in Code Sec. 469(c)(7)(C). Those words, the court observed, modify each of those activities. Thus, the court said, while Guarino's mortgage brokerage activity constitutes a "brokerage" trade or business, it does not constitute a "real property brokerage" trade or business. The court thus concluded that Guarino was not brokering real estate; he was brokering financial services. The court observed that the legislative history of Code Sec. 469(c)(7)(C) supports this distinction, noting that Congress considered including financing operations in the activities listed in Code Sec. 469(c)(7)(C) but specifically did not do so. Thus, because Guarino's hours in his mortgage brokerage activities were not in connection with a real property trade or business, he failed the tests set forth in Code Sec. 469(c)(7)(B). However, the court did not uphold the IRS's penalty assessment with respect to the rental loss deductions because, the court found, the Guarinos acted reasonably and in good faith in taking their position.

For a discussion of rental losses and the material participation rules under Code Sec. 469(c)(7), see Parker Tax ¶247,120.

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Estate Couldn't Exclude Assets in Which Decedent Retained an Interest after Transfer to Partnership

The Tax Court determined that where a decedent retained an interest in assets transferred to a limited partnership and the transfer was not a bona fide sale, the assets were includible in her gross estate. Estate of Holliday v. Comm'r, T.C. Memo. 2016-51

Background

Sarah Holliday was a resident of Tennessee when she died in 2009, at the age of 84. Her two sons, Joseph and Douglas, were the estate's personal representatives.

During 2003, Holliday had moved to Richland Place, a nursing home, and granted her sons a power of attorney. Douglas attended to Holliday's day-to-day financial needs and Joseph managed her financial assets.

In 2006, Holliday executed a certificate of limited partnership and a limited partnership agreement for Oak Capital Partners, LP (Oak Capital). The agreement described Oak Capital's purpose in broad terms, but one stated purpose was to provide "a means for members of the Holliday family to acquire interests in the Partnership business and property, and to ensure that the Partnership's business and property is continued by and closely-held by members of the Holliday family." Oak Capital's limited partnership agreement also provided that limited partners did not have the right or power to participate in Oak Capital's business, affairs, or operations.

Also in 2006, Holliday executed the articles of organization of OVL Capital Management, LLC (OVL Capital), of which she was the sole member. OVL Capital was created for the primary purpose of being Oak Capital's general partner. Oak Capital was funded with securities transferred from Holliday's account, and a portion of the contribution was made "on behalf of" OVL Capital. This was the only capital contribution made to Oak Capital. In consideration for her contribution Holliday received a 99.9 percent interest in Oak Capital as a limited partner, and OVL Capital received a 0.1 percent interest as a general partner.

On the same day as the contribution, Holliday assigned her interest in OVL Capital to Joseph and Douglas in exchange for $2,959 from each, which equaled the gross value of 0.1 percent of Oak Capital's assets. The purchase created the appearance that Holliday had no control over the assets she transferred to Oak Capital.

The value of Holliday's interest in Oak Capital was reported on Schedule F, Other Miscellaneous Property, of her estate's tax return as $2,428,200. The IRS issued a notice of deficiency determining a $785,019 deficiency in Holliday's estate tax. The parties reached an agreement on all of the issues in the notice of deficiency except for the IRS's determination that the value of the assets of Oak Capital was includible in the value of Holliday's gross estate.

Analysis

A decedent's gross estate includes the value of all property that the decedent transferred but retained the possession or enjoyment of, or the right to the income from, for the decedent's life (Code Sec. 2036(a)). This rule does not apply in cases where the transfer was a bona fide sale for adequate and full consideration.

Thus, Code Sec. 2036(a) applies if the following three conditions are met:

(1) the decedent made an inter vivos transfer of property (i.e., a transfer during the decedent's lifetime);

(2) the decedent retained an interest or right in the transferred property, which the decedent did not relinquish before his or her death; and

(3) the decedent's transfer was not a bona fide sale for adequate and full consideration. (Estate of Bongard v. Comm'r, 124 T.C. 95 (2005); Estate of Jorgensen v. Comm'r, T.C. Memo. 2009-66, aff'd, 2011 PTC 234 (9th Cir. 2011)).

The Tax Court noted that the parties did not dispute that Holliday made an inter vivos transfer of property, but that controversy remained about whether the second and third conditions were met.

With regard to whether Holliday retained possession or enjoyment of the property transferred to Oak Capital, the court stated that under Reg. Sec. 20.2036-1(c)(1)(i), an interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred. The estate denied the existence of an implied or oral agreement that allowed Holliday to retain control of the assets transferred to Oak Capital, but the IRS argued that Section 5 of Oak Capital's limited partnership agreement evidenced Holliday's right to income from the assets transferred to Oak Capital.

The court noted Section 5 provided that "to the extent that the General Partner determines that the Partnership has sufficient funds in excess of its current operating needs to make distributions to the Partners, periodic distributions of Distributable Cash shall be made to the Partners on a regular basis according to their respective Partnership Interests." The court determined this section unconditionally provided that Holliday was entitled to receive distributions from Oak Capital in certain circumstances, and that there was thus an implied agreement that she retained an interest in the transferred property.

With regard to whether Holliday's transfer of the assets to Oak Capital was a bona fide sale for adequate and full consideration, the court pointed out that she stood on both sides of the transaction. The court noted Holliday made the only contribution of capital to Oak Capital and held, directly or indirectly, a 100 percent interest in the partnership immediately after its formation. On the same day as the contribution, the court observed, she assigned her interest in OVL Capital to her sons in exchange for its fair market value, finding there was no meaningful negotiation or bargaining associated with the formation of the partnership. In fact, the court said, Douglas testified that during conversations about forming the partnership Holliday would agree to whatever he, his brother, and their attorney decided to do. The court determined the transfer was not an arm's-length transaction, and found that there was no bona fide sale.

Accordingly, the Tax Court held that the value of the assets Holliday transferred to Oak Capital must be included in the value of her gross estate pursuant to Code Sec. 2036(a)(1).

For a discussion of the treatment of retained interests for estate tax purposes, see Parker Tax ¶225,530.

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Reimbursed Transit Benefits in Excess of 2016 Limitations Not Excludable

The IRS advised employers that lump sum cash payments to employees for transit benefits in excess of the 2016 limitation would not be excludible under Code Sec. 132, even if the payments were to reimburse the employees in connection with retroactive increases in the limits. PMTA-2016-1.

Background

In Program Manager Technical Advice (PMTA-2016-1), the IRS Office of Chief Counsel (IRS) responded to inquiries from employers regarding the taxability of the retroactive increases in transit benefits. The employers indicated that they provided employees with transit passes that did not exceed the statutory limit under Code Sec. 132(f) at the time the transit pass was provided ("pre-amendment statutory limit").

In recent years, Congress has retroactively amended Code Sec. 132(f) to raise the amount of a transit pass subsidy that could be excluded from an employee's monthly gross income ("post-amendment statutory limit"). The excludable amount was increased from:

• $125 to $240 for 2012 by the American Taxpayer Relief Act (ATRA) (Pub. L. 112-240, 1/2/13);
• $130 to $250 for 2014 by the Tax Increase Prevention Act (TIPA) (Pub. L. 113-295, 12/19/14); and
• 130 to $250 for 2015 by the Protecting Americans from Tax Hikes Act (PATH) (Pub. L. 114-113, 12/18/15).

Observation: PATH permanently amended Code Sec. 132(f) to create parity in the amount of the exclusion for qualified transportation fringes. For 2016, the monthly exclusion for both transit benefits and for qualified parking is $255.

Employers indicated to the IRS that some of their employees incurred transit expenses in excess of the pre-amendment statutory limit in one or more of the calendar years 2012, 2014 and 2015. Employers noted that they provided or are considering providing each such employee a lump sum cash payment in an amount equal to the monthly amount they can substantiate that they spent on transit passes in 2012, 2014 and 2015 in excess of the pre-amendment statutory limit, but not exceeding the monthly post-amendment statutory limit.

Employers requested guidance from the IRS on whether these payments are includible in the employees' income as wages or excludible under Code Sec. 132(f).

Analysis

Code Sec. 132(a)(5) provides that any fringe benefit that is a qualified transportation fringe is excluded from gross income. Code Sec. 132(f)(1)(B) provides that the term "qualified transportation fringe" includes any transit pass, which is defined as any pass, token, farecard, voucher, or similar item that entitles a person to transportation on mass transit facilities whether or not publicly owned.

In addition, a qualified transportation fringe includes a cash reimbursement by an employer to an employee for transit benefits, only if a voucher or similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee (Code Sec. 132(f)(3)).

Qualified transportation fringes exceeding the applicable monthly limit are wages for purposes of the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA) and federal income tax withholding and are reported on the employee's Form W-2, Wage and Tax Statement (Reg. Sec. 1.132-9 Q/A 22(c)).

The IRS stated that if transit passes are readily available in the employer's area, the Code does not provide an income or employment tax exclusion for transit benefits paid to employees in cash. The IRS noted that in many cases transit passes are readily available in the areas about which employers are asking questions. In such cases, the IRS said, any distribution of cash to employees would be wages to the employee and subject to federal income tax withholding and reporting, including distributions provided due to the retroactive increase in the maximum amount of the excludable transit benefit.

If transit passes were not readily available in an area such that employers were permitted to provide transit benefits in the form of cash reimbursements, the IRS stated, such benefits must be provided under a bona fide reimbursement arrangement for expenses actually incurred and substantiated by employees, as described in Reg. Sec. 1.132-9 Q/A 16(c).

The IRS advised that any amount an employer provides in excess of the 2016 statutory monthly limit of $255 is not excludible under Code Sec. 132, even if provided due to the increase in the monthly excludable amount for 2012, 2014 or 2015. The IRS stated such excess amounts in 2016 would be wages to the employee and subject to employment tax withholding and reporting.

According to the IRS, some employers have also requested clarification on language in various Joint Committee on Taxation (JCT) reports regarding the retroactive increase in transit passes. The IRS cited the JCT's General Explanation of Tax Legislation Enacted in the 112th Congress (noting it is representative of language for the later statutory amendments), which provides:

"In order for the extension to be effective retroactive to January 1, 2012, expenses incurred during 2012 by an employee for employer-provided vanpool and transit benefits may be reimbursed (under a bona fide reimbursement arrangement) by employers on a tax-free basis to the extent they exceed $125 per month and are less than $240 per month. Congress intends that the rule that an employer reimbursement is excludible only if vouchers are not available to provide the benefit shall continue to apply, except in the case of reimbursements for vanpool or transit benefits between $125 and $240 for months during 2012. Further, Congress intends that reimbursements for expenses incurred for months during 2012 may be made in addition to the provision of benefits or reimbursements of up to $245 per month for expenses incurred during 2013."

The IRS stated employers have asked whether this language supports the conclusion that any reimbursement would be excludible under Code Sec. 132(f).

The IRS responded that it believes the statutory text is clear: Congress changed the amount of the monthly statutory limit but did not change any other requirements of Code Sec. 132. Furthermore, the IRS stated, Code Sec. 132(f)(2) limits the amount that can be provided by an employer to an employee per month on a tax-free basis.

For a discussion of transit benefits excluded from income, see Parker Tax ¶123,140.

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Seventh Circuit Affirms Penalties for S Corp's Failure to Report Welfare Benefit Fund

The Seventh Circuit affirmed a district court's holding that because a taxpayer had enrolled his S corporation in a welfare benefit fund that was a tax avoidance transaction, penalties for failure to file Form 8886 reporting his participation in a listed transaction were appropriate. Vee's Marketing Inc, v. U.S., 2016 PTC 103 (7th Cir. 2016).

Background

After a profitable year brokering onions as the sole employee of his S corporation, Vee's Marketing, Inc. (VMI), Scott Vee faced a sizable tax bill for 2004. A sales representative from CJA and Associates (CJA) suggested he could reduce his tax burden by setting aside money in its Affiliated Employers Health & Welfare Trust (the Trust), which CJA marketed as a 10-or-more multiple employer welfare benefit fund that was tax-exempt under Code Sec. 419A(f)(6). The salesman told Vee that payments into the fund would reduce the amount of his taxable income, and would provide term insurance plus a paid-up $1,000,000 of life insurance that could, if Vee wished, be used upon retirement for reimbursement of medical expenses.

Vee enrolled VMI in the CJA plan in 2004, contributed $145,000 to the Trust, and paid $1250 in fees. CJA used $5400 of the contribution to pay for one year of term life insurance on Vee's life; the remainder went into an account to fund Vee's death benefit. VMI made additional $20,750 contributions each year from 2005 to 2007. In total, for the years 2004 to 2007, VMI contributed $227,250 to the Trust and deducted that amount from its business income, reducing Vee's taxable income.

When CJA set up the Trust, it chose to maintain each participant's account independent of the account of any other participant. The Trust also owned the insurance contracts used to fund the death benefits, which effectively operated as universal life insurance policies. As of 2010, VMI was one of more than 50 employers contributing to the Trust.

In 2011, the IRS determined that VMI should have filed Form 8886, Reportable Transaction Disclosure Statement for each year as a participant in the Trust, claiming that the CJA plan was substantially similar to a tax avoidance transaction described in Notice 95-34. The IRS assessed a $10,000 penalty per year for 2004 to 2007 under Code Sec. 6707A, which imposes penalties on persons who fail to include information on their returns with respect to a reportable transaction. VMI paid the penalties and filed a claim for refund in a federal district court.

Analysis

Code Sec. 419 and Code Sec. 419A generally limit deductions taxpayers can take for contributions to welfare benefit funds. Code Sec. 419A(f)(6) provides an exemption from these limitations for 10-or-more employer plans. In general, for this exemption to apply, no employer may contribute more than 10 percent of the total contributions and the plan must not be experience-rated with respect to individual employers (i.e. structured so that each employer's contributions benefit only its own employees).

In Notice 95-34, the IRS discussed certain trust arrangements that purportedly qualify as multiple employer welfare benefit funds exempt from the limits of Code Sec. 419 and Code Sec. 419A, concluding that such arrangements do not provide the tax deductions that trust promoters claim and, instead, are tax avoidance transactions. Among other warning signs, these arrangements typically invest in variable life or universal life insurance contracts on the lives of the covered employees, but require large employer contributions relative to the cost of the term insurance required to provide death benefits under the arrangement.

The District Court determined that a close look at the Trust showed that although it purported to operate as a 10-or-more employer welfare benefit fund exempt from income tax, it clearly exhibited the warning signs identified by the IRS in Notice 95-34. Finding that the Trust shared substantially all of the features of the listed transactions in Notice 95-34, the District Court determined that the welfare benefit plan in which Vee enrolled VMI was a tax avoidance transaction. Because the plan was a reportable transaction, Vee should have filed Form 8886 for each year in which he participated and the court held the penalties imposed were proper.

On appeal, the Seventh Circuit affirmed the district court's denial of Vee's refund claim, finding the CJA plan was enough like the plan described in the Notice 95-34 to require a listed-transaction notice to the IRS on Form 8886 and therefore penalties of $10,000 a year for the four years in which he took tax deductions without reporting his participation in the plan were appropriate.

The circuit court found that, like the transaction described in Notice 95-34, VMI's plan was experience rated, meaning that the employer's contributions were allocated to his own employees. That feature, the court said, was inconsistent with the premise of a 10-or-more employers benefit plan that contributions and risks are to be pooled. In effect, the court noted, VMI's plan was a "universal life insurance contract," which provides both current life insurance and a savings feature. VMI's contribution to the CJA plan in its first year, the court noted, was $165,000, but the cost of the term life insurance bought with that money was only $5,400, the difference being placed in an "accumulation account" that earned interest for and was the property of the employee-contributor, Vee.

When Vee later terminated his participation in the plan, the court observed, the plan used $147,000 from the reserve account to buy a paid-up life insurance policy for Vee with a face value of $400,000. The court noted CJA told its customers that the paid-up policy could be sold, and it even helped find buyers. If Vee did so, the court said, he would be taxed on his income from the sale but he would not have been taxed on the income that had gone into his accumulation reserve. Thus, Vee would have financed his acquisition of the life insurance policy that he then sold.

The court noted Vee was obtaining a tax deduction not only for payments that he made for the purchase of term life insurance but also for payments that he could use to fund benefits that did not qualify as health or welfare benefits, even though the plan was a health and welfare benefit plan. As explained in Prosser v. Comm'r, 2015 PTC 40 (2nd Cir. 2015), the court said, such contributions are a mechanism by which owners of participating businesses (such as Vee) could divert company profits, tax-free, to themselves, under the guise of cash-laden insurance policies that were purportedly for the benefit of the businesses, but were actually for personal gain. If Vee kept rather than sold his life insurance, the court noted, upon his death the benefits would accrue to the beneficiaries designated in the insurance policy. Any benefit plan that allowed Vee to convert tax-free contributions to guaranteed payments for either himself or his beneficiaries is a listed transaction within the meaning of Notice 95-34, the court concluded.

For a discussion of welfare benefit plans, see Parker Tax ¶98,900.