Federal Tax Bulletin - Issue 109 - February 26, 2016

Taxpayer Escapes Penalty Where Self-Directed IRA Funds Went Straight to Investment

No distribution from a self-directed IRA occurred where the IRA's custodian, at the request of the IRA's owner, issued a wire transfer directly to a corporation to obtain the corporation's stock for the IRA, and more than 60 days thereafter, that corporation issued the stock in the name of the IRA. The court determined that the owner, at most, acted as a conduit for the transfer and that the 60-day rollover requirement did not apply. McGaugh v. Comm'r, T.C. Memo. 2016-28.

Background

Since 2002, Raymond McGaugh has maintained a self-directed individual retirement account (IRA) with custodian Merrill Lynch, and the IRA held 10,000 shares of stock in First Personal Financial Corp. (FPFC). In the summer of 2011, McGaugh requested that Merrill Lynch use funds from his IRA to purchase an additional 7,500 shares of FPFC stock. For unknown reasons, Merrill Lynch refused to purchase the shares directly. McGaugh then requested that Merrill Lynch initiate a wire transfer of $50,000 directly to FPFC. Merrill Lynch complied, and FPFC issued the stock certificate in the name of IRA more than 60 days after the wire transfer.

Because Merrill Lynch received the stock certificate from FPFC more than 60 days after the wire transfer, it believed the transfer to be outside the 60-day limitation period for a qualified rollover transaction under Code Sec. 408(d)(3). Believing the transaction to be subject to the rollover rules, and believing the transfer to be outside the 60-day limit, Merrill Lynch reported the $50,000 transaction as a taxable distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. and refused to treat the FPFC stock as an asset of the IRA.

The IRS issued McGaugh a notice of deficiency for 2011. The IRS determined that the wire transfer issued by Merrill Lynch constituted a distribution from McGaugh's IRA that was includible in his gross income and, because he had not yet reached age 59 1/2, it was an early distribution subject to the 10 percent additional tax of Code Sec. 72(t).

Code Sec. 408(d)(1) provides that any amount paid or distributed out of an IRA is included in gross income by the payee or distributee. Those amounts are subject to a 10 percent additional tax if the taxpayer has not yet attained age 59 1/2 (Code Sec. 72(t)).

An amount will not be treated as a taxable distribution from an IRA if it is a qualified rollover, and a distribution is considered a qualified rollover contribution if the entire amount an individual receives is paid into a qualifying IRA or other eligible retirement plan within 60 days of the distribution.

Self-Directed IRAs

A self-directed IRA is simply an IRA under which the IRA owner has control over the type of investments that will be held in the IRA. Thus, the owner of a self-directed IRA may choose from the complete range of investments permitted for IRAs - including real estate, limited partnerships, mortgages, notes, franchise businesses, etc. - rather than being limited to the typical investments offered by IRA custodians and trustees (stocks, bonds, mutual funds, etc.). This higher degree of flexibility in choosing IRA investments allow for the IRA owner to invest in assets with greater wealth-building potential. However, there are also potential pitfalls with self-directed IRAs. Because of the types of investments taxpayers with self-directed IRAs are able to make, these taxpayers also run a greater risk of running afoul of the prohibited transaction rules.

While self-directed IRAs can hold different types of property, the Code does not require that IRA trustees or custodians must give the owner of a self-directed IRS the option to invest IRA funds in any asset that is not prohibited by statute. IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA. Several cases are instructive as to what can happen where a self-directed IRA owner attempts to go around the custodian of a self-directed IRA.

In Ancira v. Comm'r, 119 T.C. 135 (2002), a taxpayer who maintained a self-directed IRA wanted to invest in specific assets. The taxpayer made requests by telephone to the IRA's investment adviser. When the taxpayer requested that his IRA purchase a particular company's stock, the investment adviser informed him that, while the issuing company's stock could be held as an asset of the IRA, the custodian would not purchase the stock because the stock was not publicly traded. Subsequently, the investment adviser determined that the IRA could invest in the issuing company's stock if the custodian issued a check payable to the issuing company and the taxpayer delivered the check to the issuing company. The taxpayer used a "Distribution Request Form" to request a check made payable to the issuing company, and the custodian sent the taxpayer the requested check. The taxpayer forwarded the check to the issuing company, and the issuing company issued a stock certificate which stated that the IRA was the owner of several hundred shares of the issuing company's stock. The IRA custodian held the stock certificates. In that situation, the Tax Court held that there was no IRA distribution to the taxpayer.

In a subsequent case, Dabney v. Comm'r, T.C. Memo. 2014-108, the Tax Court found that, in its role as an IRA trustee, Charles Schwab had the power to prohibit the purchase and holding of real property. And, in fact, Charles Schwab had a policy prohibiting the holding of real estate in an IRA. Thus, where a taxpayer tried to get around this policy by taking a distribution from his self-directed Charles Schwab IRA and buying property, at first titled in his own name and then titled in the name of his self-directed IRA, the taxpayer was taxable on the distribution. The court found that the taxpayer did not act as an agent on behalf of Charles Schwab and that the Charles Schwab IRA could not have purchased the property because of its policy against holding real estate in an IRA.

Tax Court's Analysis

The Tax Court began by noting that neither the Code nor the regulations provide specific guidance on whether or when an amount is considered to have been "paid or distributed out of an individual retirement plan" through the use of the beneficiary as a conduit from the custodian to the investment. The court noted, however, that in Ancira, it addressed a case involving facts similar to McGaugh's. Thus, the Tax Court held that because no cash, check, or wire transfer ever passed through McGaugh's hands, he was therefore not a literal "payee or distributee" of any amount under Code Sec. 408(d)(1) and was thus not subject to the 10 percent penalty tax.

The owner of an IRA, the court stated, is entitled to direct the investment of the funds without forfeiting the tax benefits of an IRA. Even acknowledging that McGaugh pulled all the strings, the court found the funds the IRA released went straight to investment in additional shares and resulted in the shares being issued straight to the IRA. Citing its decision in Ancira, the court said that McGaugh was merely a conduit of the IRA funds and that money received as a mere agent or conduit is not includible in gross income.

The Tax Court rejected the IRS's reliance on its Dabney decision, noting that in the instant case, Merrill Lynch previously permitted FPFC stock as an asset to be held in McGaugh's IRA, and its subsequent correspondence seemed to indicate that if the stock at issue had been received within the 60-day period, it would have been accepted. Further, the court observed, the stock certificate in the instant case bears the name of the IRA as its owner; and it is therefore not like the real property in Dabney that, for more than a year, was titled in the name of the individual taxpayer. The taxpayer in Dabney, the court observed, requested a distribution in order to conduct a real estate transaction not permitted by the IRA, whereas McGaugh directed the IRA to make a permissible investment.

The Tax Court thus concluded that McGaugh did not receive a distribution when Merrill Lynch made the wire transfer to FPFC. Consequently, the court noted, the 60-day limitation on a rollover under Code Sec. 408(d)(3) was not relevant to the instant case, and the timing of the mailing of the shares (i.e., more than 60 days after the wire transfer) did not alter the conclusion that there was no distribution from the IRA to McGaugh.

For a discussion of self-directed individual retirement accounts, see Parker Tax ¶ 134,505.08.

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Trade Act Increases Minimum Penalty for Failing to File an Income Tax Return

On February 24, 2016, President Obama signed The Trade Facilitation and Trade Enforcement Act of 2015. One of the revenue raisers in the Act increased the minimum penalty for failing to timely file an income tax return from $135 to $205. H.R. 644 (2/24/16).

On February 23, 2016, Congress sent The Trade Facilitation and Trade Enforcement Act of 2015 (the Act) to the President. He signed the legislation on February 24 and it is now awaiting a public law number. One of the more popular items in the Act is a permanent moratorium on internet access taxes.

As a revenue raiser, the Act includes an increase in the penalty for failing to file an income tax return. Before the Act, Code Sec. 6651 provided that, in the case of a failure to file a return of income tax within 60 days of the return's due date (determined with regard to any extensions of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, the taxpayer is subject to an addition to tax of not less than the lesser of $135 or 100 percent of the amount required to be shown as tax on such return.

Effective for tax returns filed after December 31, 2015, the Act increases the minimum penalty from $135 to $205.

For a discussion of the penalty for failing to file a tax return on time, see Parker Tax ¶262,105.

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Final Regs Issued on Foreign Financial Asset Reporting for Specified Domestic Entities

The IRS has finalized regulations that provide the conditions under which a domestic entity will be considered a specified domestic entity subject to foreign financial asset reporting requirements under Code Sec. 6038D. T.D. 9752 (2/23/16).

Background

The Hiring Incentives to Restore Employment (HIRE) Act (Pub. L. 111-147, 3/18/10) added Code Sec. 6038D, which requires individual taxpayers with an interest in a "specified foreign financial asset" during the tax year to attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets is greater than a threshold amount ($50,000 on the last day of the tax year or $75,000 at any time during the tax year). The provision also gives the IRS authority to apply these rules to any domestic entity that is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets, in the same manner as if the entity were an individual.

Compliance Tip: Disclosures under Code Sec. 6038D are made on Form 8938, Statement of Specified Foreign Financial Assets.

In 2011, the IRS issued Prop. Reg. Sec. 1.6038D-6 (REG-130302-10), which set forth the conditions under which a domestic entity will be considered a specified domestic entity and, therefore, required to report specified foreign financial assets in which it holds an interest.

In T.D. 9752 (2/23/16), the IRS finalized Prop. Reg. Sec. 1.6038D-6. Pertinent changes made to the proposed regulations are discussed below.

The final regulations apply to tax years beginning after December 31, 2015.

"Principal Purpose" Test Eliminated

Under the "principal purpose" test in the proposed regulations, a corporation or partnership is treated as formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets if either:

(1) at least 50 percent of the corporation or partnership's gross income or assets is passive; or

(2) at least 10 percent of the corporation or partnership's gross income or assets is passive and the corporation or partnership is formed or availed of by a specified individual with a principal purpose of avoiding Code Sec. 6038D.

The IRS stated that a 50-percent passive assets or income threshold appropriately captures situations in which specified individuals may use a domestic corporation or partnership to circumvent the reporting requirements of Code Sec. 6038D, and that it believes taxpayers should be able to determine their reporting requirements based on objective requirements rather than a subjective principal purpose test.

Therefore, the final regulations eliminate the principle purpose test for determining whether a corporation or partnership is a specified domestic entity.

Modifications to Definition of Passive Income

The proposed regulations under Code Sec. 6038D defined "passive income" by listing specific items of income that are treated as passive.

Regulations under Code Sec. 1472 (also enacted as part of the HIRE Act) and finalized in T.D. 9610 (1/28/13), contained a definition of passive income for purposes of identifying certain active nonfinancial foreign entities. This definition also contained a list of items that was similar, although not identical, to the list in the proposed regulations.

The IRS noted that the definitions of passive income under Code Secs. 1472 and 6038D serve a similar function, which is to identify entities that have a high risk of being used for tax evasion and to reduce compliance burdens for active entities. The final regulations adopt several of the modifications to the term "passive income" that were included in the final Code Sec. 1472 regulations.

The IRS also pointed out that the proposed regulations did not specify how to determine whether 50 percent of a corporation's or partnership's assets are passive assets. The final regulations provide that the passive asset percentage is determined based on a weighted average approach similar to the rule in Reg. Sec. 1.1472-1(c)(1)(iv). Under this test, corporations or partnerships may use either fair market value or book value to determine the value of their assets.

In addition, the final regulations provide that rents and royalties derived in the active conduct of a trade or business conducted "at least in part" by employees of the corporation or partnership will not be considered passive income.

Aggregation Rules Simplified

The proposed regulations provided that, for purposes of applying Prop. Reg. Sec. 1.6038D-6(b)(1)(i) and the reporting threshold, all domestic corporations and domestic partnerships that have an interest in specified foreign financial assets and are closely held by the same specified individual are treated as a single entity, and each such related corporation or partnership is treated as owning the specified foreign financial assets held by all such related corporations or partnerships.

Similarly, the proposed regulations provided that, for purposes of applying the passive income and asset thresholds, all domestic corporations and domestic partnerships that are closely held by the same specified individual and connected through stock or partnership interest ownership with a common parent corporation or partnership are treated as a single entity, and each member of such a group is treated as owning the combined assets and receiving the combined income of all members of that group.

The IRS stated that it is not necessary both to treat a group as a single entity and to attribute the assets or income of members of the group to an entity. Accordingly, the final regulations simplify the aggregation rules by eliminating the reference to treating all domestic corporations and partnerships as a single entity.

Reporting Threshold is Applied Only Once

Under the proposed regulations, a domestic entity applies the reporting threshold in Reg. Sec. 1.6038D-2T(a)(1) to determine whether it is a specified domestic entity.

In addition, Prop. Reg. Secs. 1.6038D-6(b)(1)(i) and 1.6038D-6(c)(1) provide that, in order to be treated as a specified domestic entity, an entity must have an interest in specified foreign financial assets that exceeds the reporting threshold. The IRS noted that these proposed sections suggested that a specified domestic entity is required to apply the reporting thresholds a second time to determine whether it has a reporting requirement.

The final regulations eliminate the requirement to apply Reg. Sec. 1.6038D-2(a)(1) as part of determining whether an entity is a specified domestic entity. Instead, a specified domestic entity applies the reporting threshold once, as part of determining whether it has a filing obligation.

Definition of Current Beneficiary for Domestic Trusts

The proposed regulations provided that a trust described in Code Sec. 7701(a)(30)(E) is a specified domestic entity if and only if the trust has one or more specified persons as a current beneficiary. The term "current beneficiary" means any person who during a tax year is entitled to, or may receive, a distribution from the principal or income of the trust.

The final regulations clarify that a current beneficiary also includes any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the tax year, but does not include any holder of a general power of appointment that is exercisable only on the death of the holder.

For a discussion of the information reporting requirements for an interest in a specified foreign financial asset, see Parker Tax ¶203,175.

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Tenth Circuit: Colorado Use Tax Reporting Requirement on Out-of-State Sellers Doesn't Violate Commerce Clause

The Tenth Circuit held that a Colorado law imposing notice and reporting obligations on out-of-state sellers that do not collect Colorado sales tax was constitutional. Reversing a district court decision, the court determined the law does not violate the Constitution's "dormant" Commerce Clause doctrine because it does not discriminate against or unduly burden interstate commerce. Direct Marketing Association v. Brohl, 2016 PTC 72 (10th Cir. 2016).

Background

Colorado, like many other states, relies on purchasers to calculate and pay a use tax on their purchases from out-of-state retailers that do not collect sales tax. But few individual taxpayers in Colorado or elsewhere pay the use tax, with experts reporting that the compliance rate on remote retail sales with no collection obligation is only four percent.

In 2010, Colorado attempted to address use tax non-compliance by enacting a law (the Colorado law) that imposes notice and reporting obligations on "non-collecting retailers" (i.e. retailers that do not collect sales tax). Under the law, such retailers are required to: (1) send a transactional notice to purchasers informing them that they may be subject to Colorado's use tax; (2) send Colorado purchasers who buy more than $500 of goods from the retailer an annual purchase summary reminding them of their obligation to pay use taxes on those purchases; and (3) send to the Colorado Department of Revenue an annual customer information report listing their customers' names, addresses, and total amounts spent.

Observation: Retailers who made less than $100,000 in total gross sales in Colorado in the previous calendar year, and who reasonably expect gross sales in the current calendar year to be less than $100,000, are exempt from the notice and reporting obligations of the Colorado law. In addition, the law does not apply to sales of services or to retailers that make sales solely by means of download of digital goods or software.

In 2010, Direct Marketing Association (DMA) - a group of businesses and organizations that market products via catalogs, advertisements, broadcast media, and the Internet - challenged the Colorado law in federal district court contending that the law violates the dormant Commerce Clause because it discriminates against and unduly burdens interstate commerce.

The district court determined the law was unconstitutional, but on appeal, the Tenth Circuit reversed the decision, holding the district court did not have jurisdiction because of the Tax Injunction Act (TIA). The Supreme Court granted certiorari, and held that because the Colorado law does not require out-of-state retailers to assess, levy, or collect use tax, the TIA's jurisdictional bar was inapplicable and remanded the case back to the Tenth circuit.

Analysis

On remand, the Tenth Circuit held that the Colorado law does not violate the dormant Commerce Clause because it does not discriminate against or unduly burden interstate commerce.

Observation: The Commerce Clause, in Article I, Section 8, Clause 3 of the Constitution, provides that "Congress shall have power . . . [to] regulate commerce . . . among the several States." The Supreme Court has long interpreted the Commerce Clause to not only to empower Congress to regulate interstate commerce, but also to implicitly limit states' ability to do so. This interpretation has become known as the "dormant" Commerce Clause because the limitation on states' power to regulate interstate commerce is not explicitly addressed in the Constitution.

The focus of a dormant Commerce Clause challenge, the court said, is whether a state law discriminates against interstate commerce. The court observed that a statute may discriminate against interstate commerce on its face or in practical effect, citing C & A Carbone, Inc. v. Town of Clarkstown, 511 U.S. 383 (1994).

The Colorado law is not facially discriminatory, the court said, because on its face, the law does not distinguish between in-state and out-of-state economic interests. Instead, the court noted, it imposes differential treatment based on whether the retailer collects Colorado sales or use taxes.

The court also concluded the Colorado law does not favor in-state economic interests and is not discriminatory in its effects. The court stated the notice and reporting obligations of the Colorado law are discriminatory only if they constitute differential treatment of in-state and out-of-state economic interests that benefits the former and burdens the latter, thereby altering the competitive balance between in-state and out-of-state firms. The court found that DMA had not produced significant evidence establishing such discriminatory treatment.

The court next analyzed the Supreme Court's decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992), which held that, under the dormant Commerce Clause doctrine, a state may not require a retailer having no physical presence in that state to collect and remit sales tax on the sales it makes there. The court determined Quill's bright-line physical presence rule did not extend beyond the realm of sales and use tax collection.

The court observed that DMA relied solely on Quill for its claim that the Colorado law unduly burdens interstate commerce, and that the district court also limited its analysis of undue burden to Quill. The court noted that, as the Supreme Court repeatedly stated in its TIA analysis, the Colorado law does not require out-of-state retailers to assess, levy, or collect use tax on behalf of Colorado, and instead only imposes notice and reporting obligations.

Because the Colorado law does not require the collection or remittance of sales and use taxes, the court determined Quill was not controlling in the instant case and could not identify any good reason to extend the bright-line rule of Quill to the notice and reporting requirements of the Colorado law. Thus, the court concluded that the Colorado law does not impose an undue burden on interstate commerce.

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Law Firm Is Liable for Penalties for Using Year-End Bonuses to Zero Out Income

A law firm was liable for accuracy-related penalties for mischaracterizing, as compensation for services, dividends paid to its shareholder attorneys. The firm did not have substantial authority for treating as compensation year-end bonuses that completely eliminated its income and left its shareholder attorneys with no return on their invested capital. Brinks Gilson & Lione v. Comm'r, T.C. Memo 2016-20.

Background

Brinks Gilson & Lione is an intellectual property law firm organized as a corporation. In 2007 and 2008, it prepared its financial statements on the cash basis and had approximately 150 attorneys, 65 of whom were shareholders. The firm also had a non-attorney staff of approximately 270. For 2007 and 2008, the board of directors met to set compensation and share ownership percentages. On the basis of the year's budget, the board determined the amount available for all shareholder attorney compensation.

Because the board's estimate of the amount available for compensation-year payments to shareholder attorneys was only an estimate, each shareholder attorney received during the course of the compensation year only a percentage of his expected compensation (draw), with the expectation of receiving an additional amount (i.e., a year-end bonus) at the end of the year. The board intended the sum of the shareholder attorneys' year-end bonuses (bonus pool) to exhaust book income. For 2007 and 2008, the law firm calculated the year-end bonus pool to equal its book income for the year after subtracting all expenses other than the bonuses. Thus, the law firm's book income was zero for each year: Its income statements showed revenue exactly equal to expenses.

On its 2007 and 2008 tax returns, the law firm included the year-end bonuses in the amount it claimed as a deduction for officer compensation. Before filing its return for each year, the law firm did not specifically ask its accountants, McGladrey & Pullen (McGladrey) whether the full amount of the year-end bonuses it paid to shareholder attorneys was deductible as compensation for services. And McGladrey, who prepared the law firm's tax returns, did not comment on the deductibility of the bonuses.

When the IRS audited the law firm's 2007 and 2008 tax returns, it disallowed various deductions, including the year-end bonuses. The IRS and the law firm entered into a closing agreement which provided that, among other things, portions of the law firm's officer compensation deductions relating to the year-end bonuses should be disallowed and re-characterized as non-deductible dividends. As a result, the law firm had underpayments of tax liability of approximately $1.1 million for 2007 and $1 million for 2008. The IRS assessed accuracy-related penalties under Code Sec. 6662.

Analysis

The law firm argued it was not liable for the penalties because it had substantial authority for its tax treatment of year-end bonuses and because it had reasonable cause for the underpayments since it relied on a reputable accounting firm to prepare its tax returns.

In making its case that it had substantial authority for deducting the year-end bonuses, the law firm cited the Tax Court's decision in Law Offices - Richard Ashare, P.C. v. Comm'r, T.C. Memo. 1999-282. In Ashare, the Tax Court allowed a corporate law firm to deduct an amount it paid to its sole shareholder as compensation that exceeded the firm's revenues for the year. Brinks Gilson & Lione also claimed that Code Sec. 83 and its accompanying regulations, dealing with transfers of property in connection with services, supported the proposition that all amounts paid to its shareholder attorneys should be treated as compensation for services. In particular, the law firm argued that, because its shareholder attorneys received their stock in connection with their employment and were required to sell it back to the firm at a price equal to its cash book value, the shares they hold do not represent "real" equity interests that entitle them to a return on their invested capital.

The IRS relied on the Tax Court's decision in Pediatric Surgical Assocs., P.C. v. Comm'r, T.C. Memo. 2001-81, in which the court held that amounts paid to shareholder employees of a corporation do not qualify as deductible compensation to the extent that the payments are funded by earnings attributable to the services of nonshareholder employees or to the use of the corporation's intangible assets or other capital. Instead, the IRS noted, amounts paid to shareholder employees that are attributable to those sources must be nondeductible dividends.

The IRS also relied on Mulcahy, Pauritsch, Salvador & Co. v. Comm'r, 2012 PTC 114 (7th Cir. 2012), in which the Seventh Circuit denied a corporation's deduction of consulting fees paid to entities owned by the taxpayer's founding shareholders. The taxpayer sought to justify the deduction of the consulting fees on the grounds that they were, in effect, additional compensation to its shareholders. The Seventh Circuit reasoned that treating the consulting fees as salary reduced the firm's income, and thus the return to the equity investors, to zero or below in two of the three tax years at issue, even though the firm was doing fine. According to the court, when a thriving firm that has nontrivial capital reports no corporate income, it is apparent that the firm is understating its tax liability.

The Tax Court upheld the penalty assessment after concluding that the law firm failed to show that it had substantial authority or reasonable cause for deducting in full the year-end bonuses. The court said it did not doubt the critical value of the services provided by employees of a professional services firm. Indeed, the court noted, the employees' services may be far more important, as a factor of production, than the capital contributed by the firm's owners. According to the court, recognizing those basic economic realities might justify the payment of compensation that constitutes the vast majority of a firm's profits, after payment of other expenses--as long as the remaining net income still provides an adequate return on invested capital. But, in the instant case, the court said, the law firm did not have substantial authority for the deduction of amounts paid as compensation that completely eliminated its income and left its shareholder attorneys with no return on their invested capital.

The court also found that the law firm's reliance on McGladrey did not constitute reasonable cause or good faith because McGladrey did not provide the firm with advice regarding the deductibility of the year-end bonuses and the information that the law firm provided to McGladrey was inaccurate in characterizing as compensation for services amounts that were determined to be dividends.

For a discussion of accuracy related penalties and exceptions to the penalties, see Parker Tax ¶ 262,120.

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Judge Couldn't Deduct Expenses from Gross Income under "Fee Based" Public Official Exception

A state court judge was not eligible to use Code Sec. 62(a)(2)(C), a little known provision which neither the Tax Court nor any other court had previously analyzed, to deduct from gross income unreimbursed business expenses related to his official position. Because the judge was not a public official compensated on a fee basis, his unreimbursed employee business expenses were only deductible from adjusted gross income. Jones v. Comm'r, 146 T.C. No. 3 (2016).

Michael Jones is an Arizona judge who incurred unreimbursed business expenses relating to his official position. The CPAs who prepared his 2008, 2009, and 2010 tax returns deducted those expenses from gross income to arrive at adjusted gross income (AGI). While unreimbursed business expenses are generally only deductible from AGI, the CPAs took the position that the judge was entitled to deduct the expenses in arriving at AGI based on Code Sec. 62(a)(2)(C). Under Code Sec. 62(a)(2)(C), an above-the-line deduction is allowed for expenses paid or incurred with respect to services performed by an official as an employee of a state or a political subdivision thereof in a position compensated in whole or in part on a fee basis.

Upon auditing the judge's tax returns, the IRS concluded that the judge's unreimbursed business expenses could only reduce his taxable income, and not his AGI. The IRS thus assessed a tax deficiency and also determined that the judge was liable for accuracy-related penalties under Code Sec. 6662(a). The argument centered on whether Judge Jones is considered an official compensated on a "fee basis." Because Code Sec. 62(a)(2)(C) had never been analyzed before by any court, the issue was one of first impression.

The IRS argued that the term "compensated on a fee basis" meant something like "paid by a member of the public for a service rendered by a judge who receives the fee." Judge Jones argued that "in a position compensated in whole or in part on a fee basis" means something like "a position funded in whole or in part by fees paid by members of the public for services rendered by judges."

The Tax Court sided with the IRS and held that, under Code Sec. 62(a)(2)(C), a "fee based" public official is an official who receives fees directly from members of the public in compensation for services provided. The court concluded that, while Judge Jones is a public official, he is not a public official compensated on a fee basis. As a result, the judge's unreimbursed employee business expenses were only deductible from AGI and not deductible in arriving at AGI.

The court also held that the judge was not liable for the accuracy-related penalty. The court found that Judge Jones reasonably relied on professional advice. The court also found that the position the judge took was very reasonable in the absence of any case law or regulation.

For a discussion of the tax treatment of unreimbursed employee business expenses, see Parker Tax ¶85,105.

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Subsidies Granted to Taxpayers for Installing Solar Panels Excluded from Income

The IRS ruled that subsidies a state organization granted taxpayers, by way of a reduction in the cost of installing residential solar panels, were excludable from the taxpayers' income pursuant to Code Sec. 136. Because the subsidies weren't income to the taxpayers, the organization was not subject to information reporting requirements under Code Sec. 6041. PLR 201607004.

Background

Under the facts in PLR 201607004, a state established an organization to support the state's environmental and economic development objectives through clean energy and investment. The organization oversees a program that subsidizes the cost of installing residential solar photovoltaic systems (systems) for residential homeowners whose homes are within the service territories of the state's public utilities. The program is funded by a surcharge on electricity bills. From the funds, the organization pays eligible contractors who install the systems for the residential system owners and apply for the subsidies.

The organization calculates the subsidy amount based on the system's specifications, size and efficiency, all of which have a direct impact on the cost of the system. The size of the system is intended to generate only the amount of energy that sufficiently services the electrical needs of the system owner to minimize excessive net metering and ensure that eligible contractors do not recommend a system that would be too large for a system owner.

Upon the installation of a system that satisfies the organization's criteria, an eligible contractor receives a payment from the organization to be applied as a reduction in the total price residents pay for the system. As a condition of receiving the subsidy, the organization is entitled to any renewable energy credits (RECs) and any other tradable energy or environmental related commodity produced or created by the systems.

The organization requested a ruling from the IRS that the payments made by the organization to the contractors in order to subsidize the cost of installing the systems are not included in the gross income of residential system owners by reason of the exclusion provided under Code Sec. 136. The organization also requested a ruling that the subsidies were not subject to information reporting to the system owners under Code Sec. 6041.

Analysis

Code Sec. 136(a) provides that gross income does not include the value of any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure. Code Sec. 136(c) provides that the term "energy conservation measure" means any installation or modification primarily designed to:

(1) reduce consumption of electricity or natural gas, or

(2) improve the management of energy demand, with respect to a dwelling unit (e.g. a house or an apartment).

In general, under Code Sec. 6041 all persons engaged in a trade or business who, in the course of such trade or business, make payments of $600 or more in a tax year to another person must provide information returns regarding the payments to the IRS. Such payments include rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income.

The IRS noted that the legislative history of Code Sec. 136 clarifies that the subsidy need not be provided directly by the public utility to the customer, and that the exclusion applies to the customer to whom a subsidy may be indirectly provided by the utility.

The IRS concluded that the requirements for the exclusion of the subsidies from the gross income of the system owners were satisfied. The IRS determined that the payments were made for purposes, and within the limitations, described in Code Sec. 136(c). Under the legislative scheme enacted by the state as administered through the organization, the IRS said, the payments were made "directly or indirectly" by the state's public utilities, through the organization, to the residential customers.

The IRS thus ruled that the subsidies provided by the organization are excludable from the gross incomes of the system owners for federal income tax purposes, under Code Sec. 136.

With regard to Code Sec. 6041, the IRS noted that the word "income" as used in that section is not defined by statute or regulation, but its appearance in the phrase "fixed or determinable gains, profits, and income" indicated that what is referred to is "gross income," and not the gross amount paid.

Because the subsidies weren't income to the system owners, the IRS ruled that the organization was not required to report the payments under Code Sec. 6041.

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Court Certifies Class Action Status for Lawsuit Challenging PTIN Fees

Several taxpayers challenging the IRS's requirement that tax practitioners pay a fee for obtaining a practitioner tax identification number won their request to turn part of their lawsuit into a class action suit. However, the taxpayers did not demonstrate that the district court had jurisdiction over a restitution request in the lawsuit and the court denied class action status for that aspect of the case. Steele v. U.S., 2016 PTC 58 (D. D.C. 2016).

Adam Steele, Brittany Montrois, and Joseph Henchman filed a lawsuit in the D.C. District Court challenging the IRS's preparer tax identification number (PTIN) fee. The taxpayers argued that because the PTIN does not represent or confer a service or thing of value, the IRS cannot impose any fee at all for the identifying number. Alternatively, the taxpayers argued that even if the IRS is authorized to impose a fee for a PTIN, the amount the IRS charges is excessive and therefore impermissible at its current level. Additionally, the taxpayers seek restitution or return of the PTIN fees collected by the IRS, or alternatively, simply those fees collected that exceed the amount authorized by law.

In pursuing this lawsuit, the taxpayers requested the district court to certify the case as a class action lawsuit by including in the lawsuit all individuals and entities (with some exceptions) who have paid an initial and/or renewal fee for a PTIN. According to the taxpayers, the two alternative grounds they are using to challenge the PTIN fees make the lawsuit ideally suited for class treatment.

The lawsuit is the result of the IRS's issuance of Reg. Sec. 1.6109-2(d). The regulation became effective on September 30, 2010, and specifically requires that all tax return preparers must have a PTIN or other prescribed identifying number that was applied for and received at the time and in the manner, including the payment of a user fee, as may be prescribed by the IRS. This user fee is further described in Reg. Sec. 300.13(b), which states that the fee to apply for or renew a PTIN is $50 per year, which is the cost to the government for processing the application for a PTIN and does not include any fees charged by the vendor. In addition to this $50, the charge for a PTIN also consists of fees charged by a third-party vendor to administer the application and renewal process. In total, the IRS requires an initial fee of $64.25 to obtain a PTIN and an annual $63 renewal fee thereafter.

The IRS's issuance of the PTIN requirement coincided with the issuance of additional regulations aimed at more comprehensively regulating tax return preparers. Although many of these broader regulations were invalidated in Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2014), the IRS continues to require tax return preparers to obtain and pay for a PTIN. According to the IRS, different statutory authority, independent from the statute at issue in Loving, justify the imposition of a PTIN fee. Specifically, the IRS relies on 31 U.S.C. Section 9701, which permits agencies to issue regulations to establish a charge for a "service or thing of value" the agency provides.

The IRS argued against certification, saying that certification was inappropriate because the ability to prepare tax returns for compensation provides a different, more substantial benefit to uncertified tax return preparers than it does to lawyers, CPAs, and other certified tax professionals.

The district court held that the taxpayers satisfied the applicable requirements relating to their request for certification of a class with respect to challenging the IRS's authority to charge a fee for a PTIN. However, the taxpayers did not demonstrate that the district court had jurisdiction over the restitution request. Thus the court denied the taxpayers' request for certification as it related to that aspect of the taxpayers' claims, but noted it could reconsider that ruling, if needed, after the parties more fully brief issues relating to jurisdiction.

The court noted that the IRS imposes the same fee for each PTIN application and that the cost of processing PTIN applications does not vary. As a result, it was clear to the court that the IRS has "acted on grounds that apply generally to the class." When the party opposing the class has established or acted pursuant to a regulatory scheme common to all class members, the court said, certification is appropriate. In analyzing the taxpayers' first claim (i.e., that the IRS wholly lacks the authority to impose a fee for a PTIN), the court said it was difficult to imagine a scenario where certification was more appropriate. Because the IRS required all tax return preparers to obtain a PTIN and uniformly charged $64.25 for the PTIN's issuance and $63 for renewal, the IRS's action applies equally and generally across the entire class, the court said.

For a discussion of the PTIN fee requirement, see Parker Tax ¶275,100.