Federal Tax Bulletin - Issue 104 - December 18, 2015

House Permanently Extends Numerous Tax Provisions Including Increased Section 179 Expensing and Enhanced Child Tax Credit

On Thursday afternoon, December 17, 2015, the House of Representatives passed the Protecting Americans from Tax Hikes Act of 2015. At press time, the bill was headed to the Senate, which is expected to pass it and send it onto the President, who has said he will sign it. H.R. 2029 (12/16/15).

H.R. 2029 ("the bill") permanently extends many tax provisions that previously had been up for renewal for one or two years at a time. The uncertainty each year for individuals and businesses alike as to whether Congress would revive expired tax provisions that taxpayers had come to rely on led to problems in estimating taxes due, made business investment decisions more difficult, and delayed the release of tax forms. Some years even saw extension legislation passed for years that had already ended.

In addition to permanently extending numerous tax breaks, the bill temporarily extends dozens of others for periods ranging from two to five years. The bill also contains various other tax provisions, including a few new tax breaks for families. The omnibus spending bill, attached as an amendment to H.R. 2029, would also delay the start of the "Cadillac Tax" on high cost employer sponsored health insurance from 2018 to 2020.

Business Tax Provisions

Permanent Extension of Section 179 Expensing and Modification of Amounts Eligible for Expensing

One of the biggest wins for businesses is the permanent extension of the small business Code Sec. 179 expensing limitation and phase-out amounts in effect from 2010 to 2014 of $500,000 and $2 million, respectively. Both the $500,000 and $2 million limits are indexed for inflation beginning in 2016. For 2015, the limitation and phase-out amounts were slated to be $25,000 and $200,000, respectively.

The special rules that allow expensing for computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also are permanently extended.

The bill modifies the expensing limitation by treating air conditioning and heating units placed in service in tax years beginning after 2015 as eligible for expensing. The provision further modifies the expensing limitation with respect to qualified real property by eliminating the $250,000 cap beginning in 2016.

Temporary Extension and Modification of Bonus Depreciation

The bill extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property placed in service during 2015, 2016 and 2017 and phases down, with 40 percent in 2018, and 30 percent in 2019.

The bill continues to allow taxpayers to elect to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service during 2015. The bill modifies the AMT rules beginning in 2016 by increasing the amount of unused AMT credits that may be claimed in lieu of bonus depreciation. The bill also modifies bonus depreciation to include qualified improvement property and to permit certain trees, vines, and plants bearing fruit or nuts to be eligible for bonus depreciation when planted or grafted, rather than when placed in service.

Permanent Extension of Research and Development Credit and Eligibility of Small Businesses to Claim the Credit Against AMT

Another big win for businesses is the permanent extension of the research and development (R&D) tax credit.

Additionally, beginning in 2016, a qualified small businesses ($50 million or less in gross receipts) may claim the R&D credit against alternative minimum tax (AMT) liability, and the credit can be utilized by certain small businesses ($5 million or less in gross receipts and no gross receipts for any tax year preceding the five-tax-year period ending with such tax year) against the employer's payroll tax (i.e., FICA) liability.

Other Business Tax Breaks Extended

Work Opportunity Tax Credit. The bill extends through 2019 the work opportunity tax credit. The provision also modifies the credit beginning in 2016 to apply to employers who hire qualified long-term unemployed individuals (i.e., those who have been unemployed for 27 weeks or more) and increases the credit with respect to such long-term unemployed individuals to 40 percent of the first $6,000 of wages.

New Markets Tax Credit. The bill authorizes the allocation of $3.5 billion of new markets tax credits for each year from 2015 through 2019.

15-Year Straight-Line Cost Recovery for Qualified Property. The bill permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property.

Classification of Certain Race Horses as 3-Year Property. The bill temporarily extends the 3-year recovery period for race horses to property placed in service during 2015 or 2016.

7-Year Recovery Period for Motorsports Entertainment Complexes. The bill extends the 7-year recovery period for motorsport entertainment complexes to property placed in service during 2015 or 2016.

Accelerated Depreciation for Business Property on an Indian Reservation. The bill extends accelerated depreciation for qualified Indian reservation property to property placed in service during 2015 or 2016. It also modifies the deduction to permit taxpayers to elect out of the accelerated depreciation rules.

Special Expensing Rules for Certain Film and Television Productions. The bill extends through 2016 the special expensing provision for qualified film, television, and live theater productions. In general, only the first $15 million of costs may be expensed.

Look-Thru Treatment of Payments between Related Controlled Foreign Corporations. The bill extends through 2019 the look-through treatment for payments of dividends, interest, rents, and royalties between related controlled foreign corporations.

Wage Credit for Employees on Activity Military Duty. The bill permanently extends the 20 percent employer wage credit for employees called to active military duty. Beginning in 2016, the provision modifies the credit to apply to employers of any size, rather than employers with 50 or fewer employees, as under current law.

Exclusion of 100 Percent of Gain on Certain Small Business Stock. The bill permanently extends the temporary exclusion of 100 percent of the gain on certain small business stock for non-corporate taxpayers to stock acquired and held for more than five years. This provision also permanently extends the rule that eliminates such gain as an AMT preference item.

Miscellaneous Business Tax Provisions Extended Through 2016. The bill also extends through 2016 the following business tax breaks:

• Indian employment tax credit.
• Railroad track maintenance credit.
• Mine rescue team training credit.
• Qualified zone academy bonds.
• Election to expense mine safety equipment.
• Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico.
• Empowerment zone tax incentives.
• Temporary increase in limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands.
• American Samoa economic development credit.

Individual Tax Provisions

Permanent Extension of the Enhanced Child Tax Credit

One of the biggest wins on the individual side, is the permanent extension of the enhanced child tax credit (CTC). The CTC is a $1,000 credit. To the extent the CTC exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit (the additional child tax credit) equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). Until 2009, the threshold dollar amount was $10,000 indexed for inflation from 2001 (which would be roughly $14,000 in 2015). Since 2009, however, this threshold amount has been set at an unindexed $3,000 and was scheduled to expire at the end of 2017, returning to the $10,000 (indexed for inflation) amount. The bill permanently sets the threshold amount at an unindexed $3,000.

The bill prohibits an individual from retroactively claiming the child tax credit by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a qualifying child for whom the credit is claimed did not have an ITIN. The bill applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

Finally, the bill expands the paid preparer due diligence requirements, to cover returns claiming the child tax credit.

Permanent Extension of Earned Income Tax Credit

Low- and moderate income workers are eligible for the earned income tax credit (EITC). For 2009 through 2017, the EITC amount had been temporarily increased for those with three (or more) children and the EITC marriage penalty had been reduced by increasing the income phase-out range by $5,000 (indexed for inflation) for those who are married and filing jointly. The bill makes these provisions permanent.

The bill also eliminates the exception from the 20-percent penalty for erroneous refunds and credits that applied to the EITC, but provides reasonable-cause relief from the penalty. The provision generally applies to returns filed after December 31, 2015.

Further, the bill expands the paid-preparer due diligence requirements with respect to the EITC, and the associated $500 penalty for failures to comply.

Finally, the bill prohibits an individual from retroactively claiming the EITC by amending a return (or filing an original return if he failed to file) for any prior year in which he did not have a valid social security number. The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

Permanent Extension of Enhanced American Opportunity Tax Credit (AOTC)

The Hope Scholarship Credit is a credit of $1,800 (indexed for inflation) for various tuition and related expenses for the first two years of post-secondary education. It phases out for AGI starting at $48,000 (if single) and $96,000 (if married filing jointly). These amounts are also indexed for inflation. The American Opportunity Tax Credit (AOTC) takes those permanent provisions of the Hope Scholarship Credit and increases the credit to $2,500 for four years of post-secondary education, and increases the beginning of the phase-out amounts to $80,000 (single) and $160,000 (married filing jointly) for 2009 to 2017. The bill makes the AOTC permanent.

The bill also prohibits an individual from retroactively claiming the AOTC by amending a return (or filing an original return if he failed to file) for any prior year in which the individual or a student for whom the credit is claimed did not have an individual taxpayer identification number (ITIN). The provision applies to returns, and any amendment or supplement to a return, filed after the date of enactment.

Finally, effective for tax years beginning after December 31, 2015, the bill expands the paid preparer due diligence requirements, to cover returns claiming the AOTC.

Other Tax Breaks for Individuals Extended

Deduction for Certain Expenses of Elementary and Secondary School Teachers. The bill permanently extends the above-the-line deduction (capped at $250) for the eligible expenses of elementary and secondary school teachers. Beginning in 2016, the provision also modifies the deduction to index the $250 cap to inflation and include professional development expenses.

Parity for Exclusion from Income for Employer-Provided Mass Transit and Parking Benefits. The bill permanently extends the maximum monthly exclusion amount for transit passes and van pool benefits so that these transportation benefits match the exclusion for qualified parking benefits. These fringe benefits are excluded from an employee's wages for payroll tax purposes and from gross income for income tax purposes.

Extension of Deduction of State and Local General Sales Taxes. The bill permanently extends the option to claim an itemized deduction for state and local general sales taxes in lieu of an itemized deduction for state and local income taxes. The taxpayer may either deduct the actual amount of sales tax paid in the tax year, or alternatively, deduct an amount prescribed by the IRS.

Exclusion from Gross Income of Discharge of Qualified Principal Residence Indebtedness. The bill extends through 2016 the exclusion from gross income of a discharge of qualified principal residence indebtedness. It also modifies the exclusion to apply to qualified principal residence indebtedness that is discharged in 2017, if the discharge is pursuant to a written agreement entered into in 2016.

Mortgage Insurance Premiums Treated as Qualified Residence Interest. The provision extends through 2016 the treatment of qualified mortgage insurance premiums as interest for purposes of the mortgage interest deduction. This deduction phases out ratably for a taxpayer with AGI of $100,000 to $110,000.

Above-the-Line Deduction for Qualified Tuition and Related Expenses. The bill extends through 2016 the above-the-line deduction for qualified tuition and related expenses for higher education. The deduction is capped at $4,000 for an individual whose AGI does not exceed $65,000 ($130,000 for joint filers) or $2,000 for an individual whose AGI does not exceed $80,000 ($160,000 for joint filers).

Miscellaneous Provisions Affecting Individuals

The bill also introduces a few provisions aimed at providing additional tax breaks for families:

(1) an exemption from gross income any payments from certain work-learning-service programs that are operated by a work college;

(2) elimination of the residency requirement for qualified ABLE programs; and

(3) a provision allowing a taxpayer to roll over amounts from an employer-sponsored retirement plan (e.g., 401(k) plan) to a SIMPLE IRA, provided the plan has existed for at least two years.

Charitable Giving Incentives

Contributions of Capital Gain Real Property Made for Conservation Purposes

The bill permanently extends the charitable deduction for contributions of real property for conservation purposes. It also permanently extends the enhanced deduction for certain individual and corporate farmers and ranchers. The bill modifies the deduction beginning in 2016 to permit Alaska Native Corporations to deduct donations of conservation easements up to 100 percent of taxable income.

Tax-Free Distributions from Individual Retirement Accounts for Charitable Purposes

The bill permanently extends the ability of individuals at least 70 1/2 years of age to exclude from gross income qualified charitable distributions from individual retirement accounts (IRAs). The exclusion may not exceed $100,000 per taxpayer in any tax year.

Charitable Deduction for Contributions of Food Inventory

The bill permanently extends the enhanced deduction for charitable contributions of inventory of apparently wholesome food for non-corporate business taxpayers. The bill modifies the deduction beginning in 2016 by increasing the limitation on deductible contributions of food inventory from 10 percent to 15 percent of the taxpayer's AGI (15 percent of taxable income (as modified by the provision) in the case of a C corporation) per year. The bill also modifies the deduction to provide special rules for valuing food inventory.

Tax Treatment of Certain Payments to Controlling Exempt Organizations

The bill permanently extends the modification of the tax treatment of certain payments by a controlled entity to an exempt organization.

Basis Adjustment to Stock of S Corporations Making Charitable Contributions of Property

The bill permanently extends the rule providing that a shareholder's basis in the stock of an S corporation is reduced by the shareholder's pro rata share of the adjusted basis of property contributed by the S corporation for charitable purposes.

Energy Incentives

The bill extends the following energy tax incentives for alternative and renewable energy sources through 2016.

• Credit for nonbusiness energy property;
• Credit for alternative fuel vehicle refueling property.
• Credit for 2-wheeled plug-in electric vehicles
• Second generation biofuel credit.
• Incentives for biodiesel and renewable diesel.
• Credit for Indian coal facilities.
• Credits with respect to facilities producing energy from certain renewable resources.
• Credit for energy-efficient new homes.
• Special allowance for second generation biofuel plant property.
• Deduction for energy efficient commercial buildings.
• Special rule for sales or dispositions to implement FERC or State electric restructuring policy for qualified electric utilities.
• Excise tax credits relating to certain fuels.
• Credit for new qualified fuel cell motor vehicles.

Health-Care Related Tax Provisions

The bill provides for a two-year moratorium on the 2.3-percent excise tax imposed on the sale of medical devices under the Affordable Care Act. Thus, the tax will not apply to sales during calendar years 2016 and 2017. The omnibus spending bill, attached as an amendment to H.R. 2029, would also delay from 2018 to 2020 the start of the "Cadillac tax" on high-cost employer sponsored health coverage.

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Standard Mileage Rates Decrease in 2016 for Business, Medical, and Moving Purposes

The IRS issued the 2016 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical, or moving purposes. Notice 2016-1.

Beginning on January 1, 2016, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

• 54 cents per mile driven for business purposes;
• 19 cents per mile driven for medical or moving purposes; and
• 14 cents per mile driven in service of charitable organizations.

While the business rate decreased by 3.5 cents, the medical, and moving expense rates decreased 4 cents from the 2015 rates. The charitable rate is a fixed statutory amount that does not change from year to year.

The standard mileage rate for business is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs.

Taxpayers have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates. A taxpayer may not use the business standard mileage rate for a vehicle after using any depreciation method under the Modified Accelerated Cost Recovery System (MACRS) or after claiming a Code Sec. 179 deduction for that vehicle. In addition, the business standard mileage rate cannot be used for more than four vehicles used simultaneously.

These and other requirements for a taxpayer to use a standard mileage rate to calculate the amount of a deductible business, moving, medical, or charitable expense are in Rev. Proc. 2010-51. Notice 2016-01 also contains the amount a taxpayer must use in calculating reductions to basis for depreciation taken under the business standard mileage rate and the maximum standard automobile cost that a taxpayer may use in computing the allowance under a fixed and variable rate plan.

For a discussion of the rules relating to the use of the standard mileage rate, see Parker Tax ¶91,110.

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Stock Transferred to Children's Trusts 41 Years Ago Are Subject to Gift Tax

Stock in a family corporation that was transferred 41 years ago by the taxpayer to his children was a taxable gift because the transfers were the result of donative intent and were not transactions made in the ordinary course of business. Redstone v. Comm'r, T.C. Memo. 2015-237.

Background

A family feud involving billionaire Sumner Redstone, his brother, Edward, and their father, Mickey, resulted in a June 30, 1972, settlement in which stock in the family owned business, National Amusements, Inc. (NAI), was distributed to Edward after he was forced out of NAI. In that settlement, the parties agreed that NAI would purchase for $5 million the 66 2/3 shares Edward was deemed to own. The settlement agreement further required Edward to execute irrevocable declarations of trust for the benefit of his two children. As a result, 33 1/3 shares of NAI that Edward claimed belonged to him were transferred to a trust for the benefit of his children.

Three weeks after the settlement agreement was signed, on July 21, 1972, Sumner executed irrevocable declarations of trust for the benefit of his two children. These trusts were styled the Brent Dale Redstone Trust (Brent Trust) and the Shari Ellin Redstone Trust (Shari Trust). Sumner was named the sole trustee of each trust. That same day, 16 2/3 of the NAI shares originally registered in Sumner's name were re-issued to the Brent Trust; 16 2/3 shares were re-issued to the Shari Trust; and the remaining 66 2/3 shares were re-issued to Sumner. Based on advice from tax professionals, neither Sumner nor his wife filed a gift tax return for the calendar quarter ending September 30, 1972.

Sumner's transfers of NAI stock to the Brent and Shari Trusts were voluntary. By creating these trusts and transferring 33 1/3 shares of NAI stock to them, Sumner made a gesture of goodwill toward his father, who desired to ensure the financial security of his four grandchildren on equal terms. Sumner was not required to take these actions by the settlement agreement that resolved Edward's lawsuits. The only obligation that the settlement agreement imposed on Sumner was the requirement that he execute certain releases in consideration of mutual releases executed by the other contracting parties.

In 2010, Sumner's 1972 stock transfers came to the IRS's attention and a gift tax examination ensued. The IRS subsequently concluded that Sumner had made a taxable gift of his stock to his children in 1972 and owed gift tax. Steve Hastings, an expert in valuing closely held companies, was asked to value the stock for the IRS. He based his valuation of NAI stock as of July 21, 1972, primarily on the price that NAI paid to redeem Edward's stock on June 30, 1972. According to Hastings, the $5 million price NAI agreed to pay Edward was negotiated at arm's length, was essentially contemporaneous with Sumner's transfer, and yielded a value of $75,000 per NAI common share. Thus, Hastings concluded that the 33 1/3 shares that Sumner transferred to his children's trusts in July 1972 were worth $2.5 million. The IRS assessed gift tax on this amount. Because no gift tax return had been filed for 1972, there was no statute of limitations on the IRS's assessment. The IRS also assessed penalties for fraud and failure to pay gift tax.

Analysis

In Estate of Redstone v. Comm'r, 145 T.C. No. 11 (10/25/15), the Tax Court held that Edward's June 1972 transfer of stock to his children pursuant to the settlement agreement was not a gift but was a transfer of property made in the ordinary course of business. The court found a genuine dispute existed concerning Edward's ownership of NAI stock and that he was forced to relinquish his claim to ownership of 33 1/3 shares in order to obtain from his father and brother an acknowledgment of his ownership of the remaining 66 2/3 shares. Thus, the court held that Edward's transfer of the disputed shares to trusts for his children, at his father's insistence, was thus made for a full and adequate consideration in money or money's worth.

In contrast to its decision regarding Edwards, the Tax Court held that the transfer of stock by Sumner to his children was a taxable gift because it was the result of donative intent and was not a transaction made in the ordinary course of business. In transferring stock to the Brent and Shari Trusts, the court noted, Sumner was essentially motivated by the kinship that he had with his father and his children. Sumner was the sole trustee of both his children's trusts and, the court observed, there was no evidence that he was reluctant to effect this transfer or that it disadvantaged him from a business perspective.

The court concluded that the transfer thus bore all the indicia of donative intent toward the natural objects of his affection. In addition, the court accepted Hasting's valuation of the stock gifted to Sumner's children and his conclusion that NAI would have agreed to pay Edward no more than the amount he would have received by selling his shares to an unrelated third-party buyer.

The Tax Court did not uphold the IRS's assessment of penalties because the court found that Sumner made the requisite showing of a reasonable cause defense.

For a discussion of transfers subject to gift tax, see Parker Tax ¶221,500.

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Campbell Soup Heirs Have Zero Basis in Stock Received in Demutualization

The Tax Court held that taxpayers who sell stock obtained through demutualization cannot claim a basis in that stock for tax purposes because they have a zero basis in the mutual rights that were extinguished during the demutualization. Dorrance v. U.S., 2015 PTC 438 (9th Cir. 2015).

Background

Bennett and Jacquelynn Dorrance formed the Dorrance 1995 Legacy Trust (the Legacy trust), which in turn purchased five life insurance policies in 1996. Bennett Dorrance is the grandson of the founder of the Campbell Soup Company. At the time the Dorrances purchased the life insurance policies, their net worth was approximately $1.5 billion. They bought the policies, which provided $88 million in coverage, to cover estate tax for their heirs so that their heirs would not need to liquidate the family stock portfolio to pay such taxes. Over time, the Dorrances paid premiums totaling approximately $15.3 million.

Along with insurance benefits, the life insurance policies granted the Dorrances' mutual ownership rights in the companies (i.e., mutual rights) for as long as they paid premiums. These mutual companies later demutualized and converted into stock-based companies. The mutual companies compensated the Dorrances for the loss of their mutual rights with shares of stock that they later sold at a gain. The Dorrances originally listed a zero cost basis when reporting their proceeds for 2003 and paid taxes on the full amount of the gain. Subsequently, they filed a claim for a refund, arguing that they did not owe tax on their proceeds either because the stock represented a return of previously paid policy premiums or because their mutual rights were not capable of valuation and, therefore, the entire cost of their insurance premiums should have been counted toward their basis in the stock.

The IRS argued that the couple had no basis in the stock received as a result of the demutualization. The Dorrances countered that the demutualization should be governed by the open transaction doctrine such that proceeds from the stock sale would be considered a return of capital from their premiums, and they would thereby owe no tax. In Dorrance v. U.S., 2012 PTC 199 (D. Ariz. 2012), a district court held that the open transaction doctrine did not apply because the Dorrances' mutual rights were not elements of value so speculative in character as to prohibit any reasonably based projection of worth. However, the district court also held that the Dorrances had met their burden of showing they paid something for the mutual rights because they paid premiums for policies that included both policy rights and mutual rights.

District Court Determines Taxpayers Had Basis in Demutualized Stocks

In January 2013, in Dorrance v. U.S., 2013 PTC 34 (D. Ariz. 2013), the same court was asked to determine an equitable method to allocate the premiums paid by the Dorrances before demutualization and to apply that amount as a cost basis to calculate the taxable gain, if any, on their sale of stock. The court found that, although the Dorrances' mutual rights contributed to the insurance policies' value from the time the policies were purchased, the cost of the mutual rights could not be determined before demutualization.  

The mutual rights were not separable from the policy rights and could not be sold. Therefore, the court found that the cost associated with acquiring mutual rights could not be established exclusively through the Dorrances' payment of premiums. Instead, the court concluded that the stock basis was equal to the combination of the initial public offering (IPO) value of the shares allocated to the Dorrances for (1) the fixed component representing compensation for relinquished voting rights (i.e., fixed shares) and (2) 60 percent of the variable component representing their past contributions to surplus (i.e., variable shares). Thus, the court concluded that the Dorrances paid for shares of stock in the demutualized companies by contributing to the companies' surplus and by relinquishing voting rights in exchange for the shares. Accordingly, the court said they had a cost basis in their shares of the amount calculated using the above formula and were entitled to a partial tax refund.

Ninth Circuit Finds No Basis in Stock, Reversing Lower Court

The Ninth Circuit reversed the district court and held that taxpayers who sell stock obtained through demutualization cannot claim a basis in that stock for tax purposes because they have a zero basis in the mutual rights that were extinguished during the demutualization.

The error of the Dorrances and the district court, the Ninth Circuit said, was to assume that the value received upon demutualization was linked with some premium value paid by the policyholders in the past. But, the court noted, the stock the Dorrances received in exchange for the membership rights could not be understood as a partial return on their past premium payments and in addition, policyholders do not contribute capital to the companies.

According to the Ninth Circuit, the district court skipped a critical step by examining the value of the mutual rights without evidence of whether the Dorrances paid anything to first acquire them. The basis inquiry, the court said, is concerned with the latter question. The district court also erred when it estimated basis by using the stock price at the time of demutualization rather than calculating basis at the time the policies were acquired. The stock value post-demutualization, the court stated, is not the same as the cost at purchase.

The Ninth Circuit noted that the term "basis" refers to a taxpayer's capital stake in an asset for tax purposes and the taxpayer must prove what, if anything, he actually was required to pay - not what he would have been willing to pay or even what the market value was. The reality, the court said, was that the Dorrances acquired the membership rights at no cost, but rather as an incident of the structure of mutual insurance policies. The court found that the Dorrances failed to prove that they paid anything for the demutualized shares and, thus, the district court erred when it held that there was a calculable cost basis in the Dorrances' membership rights.

Observation: Both the Ninth Circuit and the district court declined to follow the Court of Federal Claims' approach in Fisher v. U.S., 2008 PTC 2 (Fed. Cl. 2008), aff'd in an unpublished opinion, 333 F. App'x 572 (Fed. Cir. 2009), in which the court held that the value of the ownership rights in mutual rights are not discernible and, therefore, the full basis of the insurance policy is taken into account in calculating basis under the rarely-used "open transaction" doctrine.

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Reconstructed Time Logs Help Convince Court That Lawyer Materially Participated in Farming Activity

A lawyer's participation in his cotton farming business rose to the level of material participation for purposes of the passive activity loss rules. The taxpayer spent well over 100 hours each year maintaining the farm, which included hunting wild hogs that frequently ravaged crops. Leland, Jr. v. Comm'r, T.C. Memo. 2015-240.

Background

Clarence McDonald Leland, Jr. is an attorney practicing in Mississippi. In 2004, Leland purchased a 1,276-acre farm in Turkey, Texas and entered into a crop share arrangement with Clinton Pigg, a local farmer. In accordance with their arrangement, Pigg had complete responsibility for planting and harvesting crops, and Leland had complete responsibility for maintaining the infrastructure of the farm.

Of the 1,276 acres, approximately 130 are irrigated and are used by Pigg for planting and harvesting crops. Pigg worked 29-30 hours on the farm in 2009, which included planting cotton, spraying the fields, checking on crops, and harvesting the cotton. In 2010, Pigg sprayed and planted 60 acres of cotton, spending approximately four hours in total on both tasks. The cotton did not develop in 2010, and Pigg subsequently abandoned the crop.

Maintaining the farm required Leland to perform a lot of long, hard work, such as cutting vegetation, clearing land, plowing soil, controlling tree and brush growth, and maintaining fences and farm equipment. Wild hogs are a continuing problem at the farm as they dig underneath fences to get to edible crops and have dug up and broken water lines on the farm. One year, wild hogs ate 250,000 pounds of peanuts that had grown on the farm. As a result, Leland has to spend significant time controlling the wild hog population, which he accomplishes through hunting and trapping. Leland regularly spends time building traps and baiting them with corn millet and Kool-Aid to lure hogs to a specific area, where he waits in a tripod stand with semiautomatic weapons in order to kill them.

Leland performs most of these tasks himself, but he sometimes has assistance from his son or a friend, Steve Coke. Aside from Leland, his son, Coke, and Pigg, no individuals perform any tasks on the farm. Leland visits the farm several times each year in order to perform necessary tasks, commuting approximately 13-16 hours each way, including the time it takes to load equipment onto his trailer.

In 2013, the IRS disallowed losses from the farming activity for 2009 and 2010 and assessed income tax deficiencies of $5,066 and $10,244, respectively, as well accuracy-related penalties for both years.

Analysis

Code Sec. 469(a)(1) limits the deductibility of losses from certain passive activities of individual taxpayers. Generally, a passive activity is any activity which involves the conduct of any trade or business and in which the taxpayer does not materially participate. Under Code Sec. 469(h)(1), a taxpayer is treated as materially participating in the activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.

A taxpayer can establish material participation by satisfying any of seven tests provided in Reg. Sec. 1.469-5T(a). One such test requires that the individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.

The Tax Court held that Leland materially participated in his farming activity and thus was entitled to the farming losses he claimed on his return. The court noted that while Leland did not keep contemporary records of time he spent at the farm in 2009 and 2010, his reconstructed logs, receipts and invoices related to farm expenses, and his credible testimony were all reasonable means of calculating time spent on the farming activity during 2009 and 2010, which totaled over 100 hours each year. The court found Leland credibly testified as to his activities at the farm, including the hours he spent each day on various tasks, such as hunting hogs and rebuilding roads. According to those records, the court said, Leland spent 359.9 hours in 2009 and 209.5 hours in 2010 on farm related activities.

The court also stated it was satisfied that Leland's participation was not less than the participation of any other individual, including Pigg, Coke, and Leland's son, during 2009 and 2010.

Accordingly, the Tax Court determined Leland met the Reg. Sec. 1.469-5T(a)(3) material participation test for his involvement in the farming activity during 2009 and 2010, and thus the deductions attributable to that activity were not limited by Code Sec. 469. Since Leland prevailed on this issue, the court said the penalties did not apply.

For a discussion of the seven material participation tests under the passive activity loss rules, see Parker Tax ¶247,115.

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Chief Counsel's Office Rejects Assertion that Treatment of ERP Software Costs Changed with Issuance of Reg. 1.263-4

The IRS has advised that the principles and conclusions of a PLR from 2002 continue to apply to the treatment of certain software costs after the promulgation of intangible regulations in 2004. CCA 201549024.

Background

The IRS Office of Chief Counsel (IRS) was asked to address whether the principles and conclusions of PLR 200236028 continued to apply to the treatment of acquired and developed software costs following the promulgation of Reg. Sec. 1.263(a)-4.

In PLR 200236028 (6/4/02), the IRS addressed the income tax consequences on the purchase, development, and implementation of Enterprise Resource Planning (ERP) software acquired by a taxpayer from a third party. ERP software is a database software system that integrates different business functions such as financial accounting, sales and distribution, materials management, and production planning. Implementation of the ERP system generally involves various categories of costs, including (1) costs to acquire the ERP software package from the vendor, (2) costs to install the acquired ERP software and configure it to the taxpayer's needs through the use of options and templates embedded in the software, (3) software development costs, and (4) costs to train employees in the use of the new software.

The IRS concluded that (1) the cost of the purchased ERP software is to be capitalized under Code Sec. 263(a) and amortized under Code Sec. 167(f) ratably over 36 months, beginning with the month the software is placed in service by the taxpayer; (2) the configuration costs under the taxpayer's consulting contracts are installation/modification costs that are to be capitalized and amortized as part of the purchased ERP software ratably over 36 months; (3) if the taxpayer is solely responsible for a software project, the software development costs are self-developed computer software and are deductible as current expenses under Rev. Proc. 2000-50; and (4) the employee training and related costs are deductible as current expenses under Code Sec. 162.

In 2004, the IRS issued Reg. Sec. 1.263(a)-4, which explains how Code Sec. 263(a) applies to amounts paid to acquire, create, or enhance intangible assets. Under Reg. Sec. 1.263(a)-4(c)(1), a taxpayer must capitalize amounts paid to another party to acquire any intangible from that party in a purchase or similar transaction. Reg. Sec. 1.263(a)-4(c)(1) also provides a nonexclusive list of examples of the types of intangibles taxpayers must capitalize including, in relevant part, computer software.

While the regulation does not specifically address the treatment of ERP implementation costs, the preamble to the regulation indicates that the issue of the treatment of ERP implementation costs is more appropriately addressed in separate guidance dedicated exclusively to computer software issues and that, until such separate guidance is issued, taxpayers may continue to rely on Rev. Proc. 2000-50. To date, no separate guidance has been issued.

Analysis

In CCA 201549024, the IRS notes that some taxpayers have taken the position that the conclusions set forth in PLR 200236028 no longer apply following the issuance of Reg. Sec. 1.263(a)-4. The IRS disagrees with this position and advised that the principles and conclusions of PLR 200236028 continue to apply to the treatment of acquired and developed software costs.

The IRS stated that Reg. Sec. 1.263(a)-4 did not render PLR 200236028 obsolete. The cost of the purchased ERP software (including the sales tax), the IRS stated, are capital expenditures pursuant to Code Sec. 263(a) and Reg. Sec. 1.263(a)-4(c)(1)(xiv). Because the ERP software is not usable to the taxpayer without the option selection and implementation of templates, the IRS advised that costs of option selection and implementation of templates (and its allocable portion of the costs of modeling and design of additional software) are capitalized as part of the purchased ERP software.

The IRS also noted that some taxpayers have taken the position that Rev. Proc. 2000-50 allows the deduction of all software costs, a position with which it also disagreed. Under Rev. Proc. 2000-50, taxpayers may deduct costs to develop, not acquire, computer software if the taxpayer consistently treated the development costs as current expenses deducted in full in accordance with rules similar to those applicable under Code Sec. 174. The IRS advised that Rev. Proc. 2000-50 only applies to the costs for computer software as defined within the revenue procedure.

For a discussion of the tax treatment of amounts paid to acquire or create intangible assets, see Parker Tax ¶99,580.

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Use of Pesticides on Easement Property Helps Kill Easement Contribution Deduction

The use of chemicals on roughly 63 percent of contributed easement property in the operation of a golf course indicated a lack of conservation purpose. Because the use of pesticides and other chemicals could injure or destroy the ecosystem, such use ran counter to the provisions of Reg. Sec. 1.170A-14(e)(2) and the taxpayers who contributed the easement thus did not qualify for a charitable contribution deduction. Atkinson v. Comm'r, T.C. Memo. 2015-236.

Background

John and Judy Atkinson were members of the Members Club, a North Carolina limited liability company taxed as a partnership. Several entities, including the Members Club and the Reserve Club, own portions of St. James Plantation, a community development in North Carolina (St. James Plantation). Over a period of several years St. James Plantation worked closely with the North American Land Trust (NALT) to create a system of easements over the development with the goal of protecting important habitats.

In 2001, St. James Plantation added nine holes known as the "Cate 9" to the Members Club Golf Course. On December 30, 2003, the Members Club conveyed a conservation easement to NALT of approximately 80 acres covering the area in and around the Cate 9, which was operating as a golf course at the time (2003 easement). The 2003 easement property consisted of six noncontiguous tracts, ranging in size from approximately 5 acres to 23 acres, and consists of fairways, greens, teeing grounds, ranges, rough, ponds, and wetland areas.

The 2003 easement deed identifies two conservation purposes: (1) preservation of the Conservation Area as a relatively natural habitat of fish, wildlife, or plants or similar ecosystem; and (2) preservation of the Conservation Area as open space which, if preserved, will advance a clearly delineated federal, state or local governmental conservation policy and will yield a significant public benefit.

Pursuant to the terms of the 2003 easement, the owners of the easement area retained the right to operate a golf course, make alterations, and engage in certain construction activities. Specifically, the 2003 easement allowed for digging (filling, excavating, dredging, or removing topsoil) as necessary for maintaining golf course sand traps or for the cultivation of sod for use on the golf course.

On its 2003 Form 1065, U.S. Return of Partnership Income, the Members Club deducted a charitable contribution of $5,223,000 as the claimed value of the 2003 easement. The members then reported their allocable share of the charitable deduction on their individual returns. In 2010, the IRS issued a notice of deficiency to each of the individual members disallowing their portion of the charitable contribution deduction. Each of the Members Club taxpayers timely filed a petition with the Tax Court for redetermination of the deficiencies determined in the notices of deficiency.

In 2005, the Reserve Club conveyed a conservation easement on over 90 acres within St. James Plantation to NALT (2005 easement). The 2005 easement encumbers most of the Reserve Club Golf Course and is similar to the 2003 easement. On its 2005 Form 1065, the Reserve Club deducted a charitable contribution of $2,657,500 as the claimed value of the 2005 conservation easement. The IRS issued a notice of final partnership administrative adjustment (FPAA) proposing to disallow the deduction. A petition was filed with the Tax Court for readjustment of the adjustments in the FPAA. The two cases were consolidated.

Analysis

While taxpayers cannot generally deduct gifts of property that consist of less than the taxpayers' entire interest in that property, they can deduct the value of a contribution of a partial interest in property that constitutes a "qualified conservation contribution" as defined in Code Sec. 170(h)(1). For a contribution to constitute a qualified conservation contribution, the contribution must be (1) of a qualified real property interest, (2) to a qualified organization, and (3) exclusively for conservation purposes.

A contribution must satisfy one of the purposes set forth in Code Sec. 170(h)(4) in order to be made exclusively for conservation purposes. Those purposes include (1) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem, and (2) the preservation of open space (including farmland and forest land) where such preservation is for the scenic enjoyment of the general public, or pursuant to a clearly delineated federal, state, or local governmental conservation policy, and will yield a significant public benefit.

The IRS argued that the 2003 easement property was not "relatively natural" because the taxpayers sprayed pesticides, insecticides, fungicides, herbicides, and fertilizers on the fairways, greens, tees, and rough. The IRS cited Reg. Sec. 1.170A-14(e)(2), which provides generally that there is no preservation of open space if, under the terms of the contribution, a significant naturally occurring ecosystem could be injured or destroyed by the use of pesticides.

The Tax Court held that the 2003 and 2005 easements did not comply with the conservation purpose requirement of Code Sec. 170(h) and thus the taxpayers were not entitled to the charitable contribution deductions for the easements.

The court stated it was undisputed that the golf courses used chemicals on roughly 63 percent of the 2003 easement property in the operation of the golf course and the 2003 easement deed did not limit the use of pesticides and chemicals that could destroy the conservation purpose. The court also noted that when preparing a baseline report, a NALT biologist did not consider the use of chemicals on the 2003 easement property. Such a lack of investigation and consideration of chemical usage by the taxpayers' experts, the court said, would make it difficult, if not impossible, to assess the long-term impact of chemical use on the 2003 easement property. According to the court, without any baseline documentation regarding the chemicals' effect on the 2003 easement area, there would be no way for NALT to monitor whether there was any change in soil or water conditions. The court concluded from the IRS expert's testimony that the use of pesticides and other chemicals could injure or destroy the ecosystem and therefore ran counter to the provisions of Reg. Sec. 1.170A-14(e)(2).

With respect to alterations that could be done to the property under the easement, the court noted that, if the 2003 easement property were altered within the terms fully permitted in the 2003 easement deed, the conservation purpose would be significantly undermined. Finally, the court concluded that the 2005 easement suffered from the same problems as the 2003 easement.

For a discussion of the rules for deducting conservation easements, see Parker Tax ¶84,155.

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Felonious Actions of Financial Agents Don't Excuse Penalties on Major League Baseball Player

A former major league baseball play who entrusted a financial manager and an accountant with the tasks of filing and paying his taxes was liable for penalties when those individuals instead embezzled millions of dollars from his bank accounts and did not file his 2007 tax return or pay the tax due. The player's statutory duty was non-delegable and he was not excused from the penalties because of the felonious actions of his financial agents. Vaughn v. U.S., 2015 PTC 447 (6th Cir. 2015).

Background

Maurice "Mo" Vaughn was a major league baseball player from 1991 to 2003. In May 2004, he hired Ra Shonda Kay Marshall and her company, RKM Business Services, Inc., to manage his financial affairs, invest his money, pay his taxes, pay his bills, and allocate funds for his immediate use. Vaughn gave expansive powers to Marshall, including a durable power of attorney, but the arrangement was subject to immediate revocation by Vaughn for any reason. Vaughn also hired a tax accountant, David Krebs of CPA Advisory Group, Inc., to advise and assist in the preparation and filing of his tax returns. Vaughn continued with this arrangement until late 2008.

Vaughn had two bank accounts - one personal account and one business account for Mo Vaughn Investments, LLC. Vaughn deposited his income in these accounts, and Marshall was the sole signatory on both accounts. As such, Marshall was responsible for paying all of Vaughn's bills, giving him a monthly budget, and paying his taxes. In 2004, 2005, and 2006, Marshall properly filed Vaughn's tax returns, but only the 2004 and 2005 taxes were properly paid. In 2007, Marshall neither filed nor paid Vaughn's taxes.

In late in 2008, Vaughn decided to manage his financial affairs on his own, and he terminated his arrangements with both Marshall and Krebs. In the course of reviewing his bank statements, Vaughn discovered that Marshall had been cheating him for years and embezzling large sums of money from his accounts. Rather than investing Vaughn's money, growing his portfolio, and paying his taxes, Marshall was stealing his money, draining his portfolio, and failing to pay his taxes. At the time Vaughn's 2007 taxes were due, his bank accounts were so depleted that he did not even have enough money to cover his tax liability.

Vaughn sued Marshall and RKM Business Services, and currently has outstanding judgments against them for $1.5 million and $3.5 million, respectively. Vaughn filed suit in a district court in an effort to recover the late penalties paid to the IRS under Code Sec. 6651(a)(1) for his 2006 taxes and 2007 taxes. Because he did not properly exhaust his administrative remedies with regard to the 2006 taxes, the district court dismissed that claim. However, the court considered the claim regarding the 2007 taxes, and granted summary judgment to the IRS. Vaughn appealed.

Analysis

Under Code Sec. 6651(a)(1), a taxpayer who fails to file his return by the due date is subject to certain penalties, unless the failure is due to reasonable cause and not due to willful neglect.

Before the Sixth Circuit, Vaughn advanced two arguments as to why he met the reasonable cause exception: (1) because he used ordinary business prudence and care in the selection and use of agents to file and pay his taxes, he should not be responsible for his agents' violating his specific instructions and disregarding their fiduciary duties; and (2) because his agents had the unfettered power to file and pay his taxes, their fraud and embezzlement left him unable to file and pay.

The Sixth Circuit rejected Vaughn's arguments and affirmed the district court's decision. In reaching its decision, the Sixth Circuit cited the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), where the Court specifically addressed the issue of penalties assessed against a taxpayer for his agent's failure to file and pay his taxes. In Boyle, the Court concluded that it requires no special training or effort to ascertain a deadline and make sure that it is met. The failure to make a timely filing of a tax return, the Supreme Court said, is not excused by the taxpayer's reliance on an agent, and such reliance is not reasonable cause for a late filing under Code Sec. 6651(a)(1). The Sixth Circuit also noted that the Boyle Court distinguished between relying on an attorney or accountant for advice regarding one's taxes and relying on an attorney or accountant for the actual filing of one's taxes, saying "[R]eliance by a lay person on a lawyer is of course common; but that reliance cannot function as a substitute for compliance with an unambiguous statute." Vaughn, the court stated, was not facing penalties from the IRS because he relied on the advice of his agents; rather, he was facing penalties because he relied on them to complete and file his tax returns.

With respect to Vaughn's other argument that the nature of his agreement with his agents and the nature of their malfeasance rendered him unable to file and pay his tax returns properly, the court considered his reliance on Matter of American Biomaterials Corp., 954 F.2d 919 (3rd Cir. 1992), in which two corporate officers were discovered defrauding their corporation, failing to file and pay its taxes, and embezzling corporate funds. In that case, the Third Circuit held that because a corporation can act only through its agents and employees, when the officers responsible for filing and paying the corporation's taxes engaged in fraud and embezzlement instead, the corporation became devoid of an agent or employee through which it might act to file and pay its taxes and was, therefore, not liable for penalties for failure to file returns and pay taxes.

Noting factual dissimilarities, the Sixth Circuit found Vaughn's interpretation of Biomaterials flawed. Whereas in Biomaterials there were no other officers in that corporation who would have had legitimate power and authority to oversee and ensure the filing and payment of the company's taxes, Vaughn had both the power and the authority to oversee and ensure the filing and payment of his own taxes, the court said.

For a discussion of the penalties for late filing of returns and late payment of tax, see Parker Tax ¶262,105.