Federal Tax Bulletin - Issue 107 - February 1, 2016

Assessments Against NFL Team Owner Weren't Invalidated by IRS Breach of Closing Agreement

The Ninth Circuit held that although the IRS breached a closing agreement with a partnership by not allowing the taxpayer enough time to review computational adjustments before making assessments, the breach did not invalidate those assessments. Davis v. U.S., 2016 PTC 30 (9th Cir. 2016).

Background

The late Allen Davis served as coach, then general manager, and finally as the principal owner of the Oakland (and Los Angeles) Raiders for over fifty years. Davis had the largest interest in the Oakland Raiders, a California limited partnership (the Partnership), which owned and operated the professional football team. Davis was also the president of A.D. Football, Inc., the sole general partner and tax matters partner (TMP) of the Partnership.

The Partnership and the IRS were involved in long-running Tax Court litigation. In 2005, the Partnership and the IRS reached a settlement over tax years 1988 through 1994. The closing agreement, which concluded the litigation, was signed by Davis as the President of the Partnership's TMP. Under this agreement, the IRS was required to make computational adjustments to determine the effect of the settlement on each partner's tax liability, pursuant to Code Sec. 6231(a)(6). Paragraph Q of the agreement gave the partners procedural rights related to those computations, allowing each partner at least 90 days to review and comment on the adjustments proposed by the IRS with respect to the implementation of the settlement (and at least 60 days to review any revised adjustments) prior to the IRS assessing such amounts.

The agreement was implemented through three stipulations filed in the Tax Court, one each for tax years 1990, 1991, and 1992. They were signed by Stuart Lipton, counsel for the Partnership and its TMP, A.D. Football. On June 6, 2006, the Tax Court approved and entered the stipulated decisions.

The IRS did not distribute its calculations of each partner's computational adjustments until June 2007. Davis responded a few weeks later, but by the time the IRS sent revised calculations on August 27, 2007, it had no time to wait 60 days for Davis to review these calculations because the statute of limitations to make assessments was about to expire. On September 4, 2007, the IRS issued assessments against Davis for 1990, 1992, and 1995.

In 2011, Davis brought suit in federal district court, seeking refunds for all three tax years, based on the IRS's breach of Paragraph Q. Before the district court, the IRS argued that it did not breach the agreement, and that even if it did, the breach did not invalidate the assessments. The district court granted Davis's motion for summary judgment, holding that the IRS's breach of the Closing Agreement invalidated the assessments, and the IRS appealed.

Breach of the Closing Agreement Didn't Invalidate Assessments

Before the Ninth Circuit Court, the IRS admitted that it breached Paragraph Q of the closing agreement by making the September 2007 assessments without giving Davis a second opportunity to review its calculations. Thus, the court said, the issue was whether, as the district court concluded, that breach of contract invalidated the subsequent assessments.

The court noted Davis did not seek damages, the usual remedy for a breach of contract, instead arguing that any assessments made in breach of the agreement were invalid. Davis relied primarily on Code Sec. 7121(b)(2), which provides that closing agreements are "final and conclusive." Davis stated that the Tax Court incorporated the agreement into its decision, making it enforceable as a court order. But, the court observed, the fact that a contract is "final" does not dictate the remedy for its breach. And, the court said, Davis offered no support for the unlikely proposition that, because a settlement with the IRS is "final" and court-approved, the remedy for any breach, however small, is to free the taxpayer from his pre-existing obligation to pay taxes. If that were the case, the court noted the IRS justifiably would be reluctant to enter into closing agreements for fear that a minor error could have major consequences.

Davis alternatively argued that Philadelphia & Reading Corp. v. United States, 944 F.2d 1063 (3d Cir. 1991), establishes that the remedy for the breach of a closing agreement is invalidation of subsequent assessments. In that case, a settlement waived the statutory requirement that the IRS mail a notice of deficiency prior to making assessments. The settlement agreement expressly conditioned that waiver on the IRS delaying the assessments until after it had approved a schedule of overpayments, so that the taxpayer, which had overpaid taxes in certain years and underpaid in others, could pay only the net balance owed. The IRS, however, assessed taxes before the overpayments had been approved and, more importantly, without sending the statutorily mandated notice of deficiency. The Third Circuit held that the assessments were invalid.

The court observed that, because the IRS had failed to approve the schedule of overpayments, the Third Circuit found that the taxpayer's contractual waiver of its statutory right to receive a notice of deficiency never came into effect and the assessments were therefore not authorized by statute. In the instant case, by contrast, the IRS violated no law in making the assessments. Because Davis' obligation to pay taxes assessed comes from the Code, not the agreement, the IRS's failure to perform its contract with the Partnership, the court said, could not relieve Davis of his statutory obligation to pay taxes.

The court found that the IRS's breach of its contract entitled Davis to a remedy, but that remedy could not be the invalidation of the tax assessments. Moreover, the court observed, although the breach denied Davis an opportunity to comment on the amounts of the assessments before they were made, it did not prevent him from challenging the assessed amounts. The court noted Davis could have sought to challenge those amounts in an administrative refund claim or a refund action under Code Sec. 6230(c)(1)(A) but instead "threw a Hail Mary" and sought a full refund. "That pass falls incomplete", the court said, holding that the IRS's breach of Paragraph Q did not invalidate the assessments.

Assessment Was Within the Statute of Limitations

Although TEFRA generally provides that the tax treatment of partnership items will be determined at the partnership level, the IRS can enter into settlement agreements with individual partners (Code Sec. 6224). The settling partner's partnership items then convert to nonpartnership items, under Code Sec. 6231(b)(1), and the partner can be dismissed from the partnership-level proceeding (Code Sec. 6226(d)(1)(A)).

If the IRS "enters into a settlement agreement with the partner" under Code Sec. 6231(b)(1)(C), the partner's partnership items convert to nonpartnership items, which triggers a one-year statute of limitations under Code Sec. 6229(f)(1). If the IRS does not enter "into a settlement agreement with the partner," then the one-year statute of limitations under Code Sec. 6229(d) begins to run when the Tax Court decision becomes final (Code Sec. 7481(a)(1)).

The Ninth Circuit found that the Tax Court approved the stipulated decision documents in the instant case on June 6, 2006, and the decision became final 90 days later.

Davis argued that those documents were each a "settlement agreement with the partner," under Code Sec. 6231(b)(1)(C), so that the statute of limitations expired on June 6, 2007, one year after their entry. Davis relied on the prefatory language of the stipulated decisions, which provided that the adjustment to the Partnership's returns was made "[p]ursuant to the agreement of the parties in this case." Davis argued that, under Code Sec. 6226, all partners were parties to the Tax Court proceeding, so each stipulation was "a settlement agreement with the partner. Because the one-year statute of limitations under Code Sec. 6229(f) ended on June 6, 2007, Davis argued that the IRS' September 4, 2007 assessments were too late.

The IRS argued that the individual partners did not enter into a settlement agreement with the government on June 6, 2006. Rather, they were bound by force of law when the tax court entered the stipulated decision documents, because the individual partners were parties to the tax court proceeding under Code Sec. 6226(c), and a decision by the tax court in a partnership action is binding on all parties. Because the individual partners did not "enter into a settlement agreement with" the IRS for purposes of Code Sec. 6231(b)(1)(C), the applicable statute of limitations under Code Sec. 6229(d) expired on September 4, 2007, one year and 90 days after the stipulated decisions were entered. Accordingly, the IRS argued, its September 4, 2007 assessments were timely.

The court concluded that, under the plain language of Code Sec. 6231(b)(1)(C), the IRS does not "enter into a settlement agreement with the partner" when it enters into a settlement agreement with the TMP, and the individual partner is bound merely by operation of the tax court's decision to which the partner is a party. In the instant case, the court found, the stipulations were not agreements with Davis individually; he did not sign them, nor did anyone purporting to represent him in his individual capacity. Instead, the court noted, each stipulation was signed only by an attorney for the IRS and Stuart Lipton, in his capacity as counsel for the Partnership and its TMP, A.D. Football. Thus, the stipulations, like the agreement, were only between the IRS and the Partnership. The court did point out that the documents had consequences for Davis, but they were not agreements "with" him under Code Sec. 6231(b) because nothing in TEFRA indicates that Congress meant the word "partner" in Code Sec. 6231(b) to mean "tax matters partner."

Accordingly, because the agreement and stipulations were not a "settlement agreement with" Davis within the scope of Code Sec. 6231(b), the circuit court held that the assessments made on September 4, 2007 were timely as they occurred within one year after the Tax Court decision became final.

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Exceptions to Section 199 Gross Receipts Rule on Computer Software Don't Override General Rule

In determining if gross receipts from providing online computer access qualify for the Code Sec. 199 deduction, the online software exceptions of Reg. Sec. 1.199-3(i)(6)(iii) must be narrowly construed and do not override the general rule that gross receipts from providing online services, such as Internet access, do not qualify for the deduction. CCA 201603028.

In CCA 201603028, the IRS Office of Chief Counsel (IRS) was asked to address a situation in which a taxpayer was arguing that certain limited exceptions to the general rule that service-related gross receipts are not eligible for the Code Sec. 199 deduction operated to override the general exclusion of online services income.

The domestic production activities deduction under Code Sec. 199 is equal to 9 percent of the lesser of the taxpayer's qualified production activities income (QPAI) or taxable income. However, the amount of the deduction is limited to 50 percent of the W-2 wages paid by the taxpayer that are allocable to the taxpayer's domestic production gross receipts (DPGR). Thus, if there is no DPGR, there is no Code Sec. 199 deduction.

Generally, only certain activities generate DPGR. One of those activities is the lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) manufactured, produced, grown, or extracted (MPGE) in whole or significant part within the United States. QPP is defined as tangible personal property, computer software, and sound recordings.

In Notice 2005-14 and the first proposed regulations issued under Code Sec. 199, the IRS took the position that the disposition requirement for computer software was met only when computer software was provided to customers on a tangible medium (disk or CD) or by download over the Internet. All software accessed only over the Internet was treated as a service (i.e., non-qualifying for Code Sec. 199). Thus, Reg. Sec. 1.199-3(i)(6)(ii) provides that gross receipts derived from customer and technical support, telephone and other telecommunication services, online services (such as Internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services are not gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software. Thus, such gross receipts are not DPGR.

Reg. Sec. 1.199-3(i)(6)(iii) provides two exceptions under which gross receipts derived by a taxpayer from providing computer software to customers for the customers' direct use while connected to the Internet are treated as being derived from the disposition of such computer software and are, thus, treated as DPGR. Under the first exception (i.e., self-comparable exception), gross receipts are treated as being derived from the disposition of computer software if the taxpayer also derives, on a regular and ongoing basis in the taxpayer's business, gross receipts from the disposition to customers of computer software that:

(1) has only minor or immaterial differences from the online software;  

(2) has been MPGE by the taxpayer in whole or in significant part within the United States; and  

(3) has been provided to such customers either affixed to a tangible medium (for example, a disk or DVD) or by allowing them to download the computer software from the Internet.

Under the second exception (i.e., third-party comparable exception), gross receipts are from a disposition if another person derives, on a regular and ongoing basis in its business, gross receipts from the disposition of substantially identical software (as compared to the taxpayer's online software) to its customers pursuant to an activity described in (3), above

In CCA 201603028, the IRS advised that the exceptions in Reg. Sec. 1.199-3(i)(6)(iii) do not operate to override the general rule in Reg. Sec. 1.199-3(i)(6)(ii) that online services income is not DPGR. The IRS noted that the preamble to the temporary regulations which introduced the exceptions in Reg. Sec. 1.199-3(i)(6)(iii) stated that the exceptions were made "as a matter of administrative convenience." At the same time the exceptions were introduced, the IRS stated, the temporary regulations did not modify the rule that gross receipts from providing online services do not qualify as DPGR. As a general matter, the IRS observed, all service gross receipts are treated as non-DPGR. According to the IRS, the exceptions apply only if a taxpayer derives gross receipts from providing customers access to computer software MPGE in whole or in significant part by the taxpayer within United States for the customer's direct use while connected to the Internet. The IRS noted that this threshold requirement was totally ignored by the taxpayer in arguing that the exceptions to the general rule in Reg. Sec. 1.199-3(i)(6)(ii) overrode that rule.

Observation: Examples in the regulations that follow the Reg. Sec. 1.199-3(i)(6) rules demonstrate how all of the rules in that provision apply, including when the exceptions are relevant. Examples 1 through 3 hold that a taxpayer that produces computer software to enable online banking, participation in an online auction, or the provision of telecommunication services generates fees that are entirely attributable to services and such gross receipts do not constitute DPGR. Other examples illustrate when the exceptions are relevant and when gross receipts are DPGR. Those examples include:  

• fees from providing tax preparation computer software for the customers' direct use over the Internet when the taxpayer does not provide any other goods or service in connection with the online software;
• fees from providing access to payroll management computer software for the customers' direct use over the Internet when the taxpayer does not provide any other goods or service in connection with the online software; and
• fees from providing customers access to the computer software games for the customers direct use while connected to the Internet when the taxpayer does not provide any other goods or services in connection with the online software games.

For a discussion of gross receipts that constitute DPGR for purposes of Code Sec. 199, see Parker Tax ¶96,110.

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Proposed Regs Address "Normal Retirement Age" for Governmental Pension Plans; Provide New Safe Harbors

The IRS has issued proposed regulations providing guidance and multiple safe-harbors regarding the "normal retirement age" under governmental pension plans. The normal retirement age is used for purposes of the exception to the general rule that distributions from such plans commence after retirement. REG-147310-12 (1/27/16).

Background

Code Sec. 401(a) sets forth the qualification requirements for a trust forming part of a stock bonus, pension, or profit-sharing plan of an employer. Several of these qualification requirements are based on a plan's normal retirement age, including the requirement that the plan provide for definitely determinable benefits (generally after retirement). Final regulations under Code Secs. 401(a) and 411(d)(6) defining normal retirement age for the definitely determinable requirement were published in 2007 (2007 regulations).

The 2007 regulations generally require that a pension plan be established and maintained primarily to provide systematically for the payment of definitely determinable benefits over a period of years, usually for life, after retirement. The 2007 regulations include two exceptions to the general rule that payments commence after retirement:

(1) payments can commence after attainment of normal retirement age; and  

(2) payments can commence after an employee reaches age 62.

Reg. Sec. 1.401(a)-1(b)(2)(i) provides that, as a general rule, a normal retirement age under a pension plan must be an age that is not earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed (reasonably representative requirement). Reg. Sec. 1.401(a)-1(b)(2)(ii) provides that a normal retirement age of age 62 or later is deemed to satisfy the reasonably representative requirement.

In the case of a pension plan in which substantially all of the participants are qualified public safety employees, a normal retirement age of age 50 or later is deemed to satisfy the reasonably representative requirement (Reg. Sec. 1.401(a)-1(b)(2)(v)).

Generally, in the case of a pension plan that is not a governmental plan, Code Sec. 411(a)(8) defines the term "normal retirement age" as the earlier of (1) the time a participant attains normal retirement age under the plan or (2) the later of the time a plan participant attains age 65 or the 5th anniversary of the time a plan participant commenced participation in the plan.

Under Code Sec. 411(e)(1), however, the above definition of normal retirement age does not apply to a governmental plan. Instead, a normal retirement age under a governmental plan must satisfy pre-ERISA vesting rules.

As described in Rev. Rul. 71-147, the normal retirement age in a pension or annuity plan under the pre-ERISA vesting rules is generally the lowest age specified in the plan at which the employee has the right to retire without the consent of the employer and receive retirement benefits based on the amount of the employee's service to the date of retirement at the full rate set forth in the plan (that is, without actuarial or similar reduction because of retirement before some later specified age).

Prop. Regs Address Applicability of 2007 Regs to Governmental Plans

The proposed regulations in REG-147310-12 provide that a governmental plan that does not provide for the payment of in-service distributions before age 62 would not fail to satisfy Reg. Sec. 1.401(a)-1(b)(1) merely because the pension plan has a normal retirement age that is earlier than otherwise permitted under the requirements of Reg. Sec. 1.401(a)-1(b)(2) (as amended by the proposed regs). Instead, the earlier normal retirement age under such a plan is treated as the age as of which an unreduced early retirement benefit is payable for purposes of the proposed regs.

The proposed regs also apply the reasonably representative requirement in the 2007 regulations to governmental plans. Thus, the normal retirement age under a governmental plan must be an age that is not earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed.

In addition, the proposed regs apply to governmental plans the safe harbor in the 2007 regulations that a normal retirement age of at least age 62 is deemed to satisfy the reasonably representative requirement.

New Safe Harbors

The proposed regs also provide additional alternative safe harbors. Under these safe harbors, a governmental plan would be deemed to satisfy the reasonably representative requirement if it provides:

(1) a normal retirement age that is the later of age 60 or the age at which the participant has been credited with at least 5 years of service;

(2) a normal retirement age that is the later of 55 or the age at which the participant has been credited with at least 10 years of service; or

(3) A normal retirement age that is the participant's age if the sum of the participant's age plus the number of years of service that have been credited to the participant under the plan equals 80 or more.

Under the proposed regs a governmental plan would also be permitted to combine any of the other safe harbors (except for the qualified public safety employee safe harbors, discussed below) with 25 years of service, so that a participant's normal retirement age would be the participant's age when the number of years of service that have been credited to the participant under the plan equals 25 if that age is earlier than what the participant's normal retirement age would be under the other safe harbor(s).

Observation: Thus, a normal retirement age under a governmental plan would satisfy the reasonably representative requirement if the normal retirement age is the earlier of (1) the participant's age when the participant has been credited with 25 years of service under the plan and (2) the later of age 60 or the age when the participant has been credited with 5 years of service under the plan.

Additional Safe Harbors for Qualified Public Safety Employees

In addition, the proposed regulations include three safe harbors specifically for qualified public safety employees. Under these safe harbors, a governmental plan would be deemed to satisfy the reasonably representative requirement if it provided for:

(1) a normal retirement age for qualified public safety employees that is age 50 or later;

(2) a normal retirement age for qualified public safety employees that is the participant's age when the sum of the participant's age plus the number of years of service that have been credited to the participant under the plan equals 70 or more; or

(3) a normal retirement age for qualified public safety employees that is the participant's age when the number of years of service that have been credited to the participant under the plan equals 20 or more.

The proposed regs provide that a governmental plan is permitted to use one or more of these safe harbors to satisfy the reasonably representative requirement even if a different normal retirement age or ages is used under the plan for one or more other categories of participants who are not qualified public safety employees.

Plans with Multiple Normal Retirement Ages

The IRS notes that governmental plans typically provide multiple normal retirement ages, often based on different benefit structures or classifications of employees in a single plan. To account for this, the IRS states that the use of one normal retirement age for one classification of employees (such as qualified public safety employees) and one or more other normal retirement ages for one or more different classifications of employees would not be inconsistent with the proposed regulations and generally would not be inconsistent with the applicable pre-ERISA requirements.

Situations in Which No Safe Harbor Applies

Lastly, the proposed regulations provide that in the case of a normal retirement age under a governmental plan that fails to satisfy any of the governmental plan safe harbors, whether the normal retirement age satisfies the reasonably representative requirement would be based on all of the relevant facts and circumstances.

Effective Date

The regulations in REG-147310-12 are proposed to be effective for employees hired during plan years beginning on or after the later of (1) January 1, 2017 or (2) the close of the first regular legislative session of the legislative body with the authority to amend the plan that begins on or after the date that is 3 months after the regulations are finalized.

Governmental plan sponsors may rely on the proposed regulations for periods preceding the effective date, pending the issuance of final regulations. If and to the extent the final regulations are more restrictive than the rules in these proposed regulations, those provisions of the final regulations will be applied without retroactive effect.

For a discussion of qualified plans, see Parker Tax ¶130,100.

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Settlement Proceeds Didn't Qualify as Capital Gain Income from Sale of Goodwill

A taxpayer could not treat income from the proceeds of a settlement agreement with a former employer as capital gain from the sale of goodwill because there was no sale of the taxpayer's business. The court rejected the taxpayer's argument that the proceeds were capital gain income because of the injury to its reputation the taxpayer's tax and accounting business suffered as a result of retaliation by the former employer. Duffy v. U.S., 2016 PTC 9 (Fed. Cir. 2016).

In 1999, James Duffy started his own tax and accounting consulting business. In 2004, United Commercial Bank (UCB) hired him as a consultant and later as its Tax Director and First Vice President. His responsibilities included seeing that his department complied with the accounting and financial disclosure requirements of the Sarbanes-Oxley Act.

In 2006, Duffy witnessed an action at UCB that was allegedly fraudulent and not in compliance with the Sarbanes-Oxley Act. He subsequently reported the incident to management at UCB, including the Chief Financial Officer, the Controller, and the Sarbanes-Oxley Director. Shortly thereafter, the bank put Duffy on administrative leave and then terminated his employment.

Following his departure from UCB, Duffy pursued other employment opportunities and tried to expand his consulting practice. However, he was not successful in these endeavors because, he said, potential employers and clients required a reference from UCB, which was not possible. During this time, Duffy reportedly suffered stress and anxiety from the Sarbanes-Oxley retaliation.

Duffy filed a claim against UCB with the Department of Labor. He alleged that the bank terminated his employment because of his participation in whistleblower activity protected by the Sarbanes-Oxley Act and that the bank retaliated against him to punish him for his refusal to participate in the bank's unethical and illegal conduct. In 2007, UCB and Duffy reached a settlement agreement and the bank paid Duffy $50,000. The settlement agreement stated that Duffy was paid for "the exclusive purpose of avoiding the expense and inconvenience of further litigation." Duffy and his wife filed a joint Form 1040 for 2007 and included the $50,000 in income. Subsequently, Duffy and his wife filed an amended tax return stating that the inclusion of the $50,000 as income was incorrect because that amount was not taxable.

Duffy and his wife argued that, because of the physical injury and physical sickness that Duffy suffered as a result of UCB's conduct, the settlement proceeds should be excluded from income under Code Sec. 104(a)(2). That provision allows a taxpayer to exclude from gross income damages (other than punitive damages) received on account of personal physical injuries or physical sickness. The Supreme Court has developed two independent tests that a taxpayer must meet before a settlement amount may be excluded from gross income under Code Sec. 104(a)(2). First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery was based upon tort or tort type rights. Second, the taxpayer must show that the damages were received on account of personal physical injuries or physical sickness.

Alternatively, Duffy and his wife contended that the settlement proceeds should be treated as capital gain income because of the injury to Duffy's business reputation and business goodwill. The decline in value of Duffy's business reputation and business goodwill as a result of the actions of others, the couple said, should be treated as the disposition of goodwill (i.e., a capital asset). The IRS disallowed their refund claim and the couple took their case to the Court of Federal Claims (Claims Court).

In Duffy v. U.S., 2015 PTC 49 (Fed. Cl. 2015), the Claims Court held that the consideration paid by UCB to avoid litigating Duffy's employment-discrimination and retaliation claims did not qualify as excludible gross income under Code Sec. 104(a)(2). The court also concluded that the $50,000 did not represent gain from the sale or exchange of goodwill associated with a capital asset because there was no sale or exchange of business goodwill and thus there could be no capital gain under Code Sec. 1222. The couple appealed the court's decision regarding the goodwill findings but did not contest the court's decision regarding the exclusion of the settlement proceeds under Code Sec. 104.

The Federal Circuit affirmed the lower court's decision. In reaching its decision, the Federal Circuit noted that several courts have held that the sale of goodwill occurs only when a business or a part of it, to which the goodwill attaches, is sold. Goodwill, the court said, cannot be transferred apart from the business with which it is connected. There was no such sale of Duffy's business, in whole or in part, the court noted. In fact, the court said, the settlement agreement makes clear that its exclusive purpose was to avoid the expense and inconvenience of further litigation on Duffy's claim under the Sarbanes-Oxley Act.

For a discussion of the taxation of lawsuit proceeds, see Parker Tax ¶74,130.

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IRS Extends Deadline for New Section 501(c)(4) Reporting Requirement

The IRS has extended the deadline for submitting notification under new Code Sec. 506 that an organization intends to operate as a Code Sec. 501(c)(4) organization, pending the issuance of regulations implementing the requirement. The new due date will be no less than 60 days from the date the IRS issues the regulations. Notice 2016-9.

Background

The Protecting Americans from Tax Hikes (PATH) Act (Pub. L. 114-113, 12/18/15) added new Code Sec. 506, under which a Code Sec. 501(c)(4) organization must provide to the IRS notice of its formation and intent to operate as such an organization.

Compliance Tip: An organization may apply to the IRS for recognition that it qualifies for Code Sec. 501(c)(4) tax-exempt status using Form 1024, Application for Recognition of Exemption Under Section 501(a)), but there is no requirement to do so.

Caution: In general, filing Form 1024 will not relieve an organization of the requirement to file the Code Sec. 506 notification. Conversely, a Code Sec. 506 notification is not an application for recognition of tax exempt status.

In general, the Code Sec. 506 notification requirement applies to Code Sec. 501(c)(4) organizations that are established after December 18, 2015 (the date of enactment of PATH). The provisions also apply to any other 501(c)(4) organization that, on or before December 18, 2015, had not:

(1) applied for a written determination of recognition as a Code Sec. 501(c)(4) organization; or

(2) filed at least one annual information return or notice required under Code Secs. 6033(a)(1) or 6033(i) (that is, a Form 990, Return of Organization Exempt From Income Tax, or, if eligible, Form 990-EZ, Short Form Return of Organization Exempt From Income Tax, or Form 990-N (e-Postcard)).

As enacted, Code Sec. 506 requires a Code Sec. 501(c)(4) organization, no later than 60 days after the organization is established, to notify the IRS that it is operating as a Code Sec. 501(c)(4) organization; for existing organizations subject to Code Sec. 506, the notification was due no later than June 15, 2016, 180 days after the date of enactment of PATH.

IRS Extends Period to Submit Section 506 Notifications

In Notice 2016-9, the IRS announced that it intends to issue temporary regulations implementing the Code Sec. 506 notification requirement.

In order to provide adequate transition time for organizations to comply with the new procedures, the IRS has extended the due date for submitting the Code Sec. 506 notification until at least 60 days from the date the temporary regulations are issued. Further, the IRS stated that no penalties under Code Sec. 6652(c)(4) will apply to a Code Sec. 501(c)(4) organization that submits the required notification by the due date provided in the regulations.

For a discussion of Code Sec. 501(c)(4) organizations, see Parker Tax ¶ 60,504.

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Failure to File Required Form Subjects German Citizen to Additional Taxes

A German citizen, who was a long-time U.S. resident, was liable for tax on gains attributable to installment payments received as a result of selling U.S. corporation stock. Further, because he was considered a covered expatriate, the taxpayer was also taxed on the deemed sale of his right to future installment sale proceeds. Topsnik v. Comm'r, 146 T.C. No. 1 (2016).

Background

Gerd Topsnik was born in Germany and has a German passport and a German driver's license. In 1977, he received his U.S. green card and became a lawful permanent resident (LPR) of the United States.

In 2004, Topsnik sold stock in a U.S. corporation at a gain in an installment sale. In 2010, he received 11 equal monthly payments pursuant to a promissory note executed in connection with the sale. On November 20, 2010, Topsnik completed paperwork to formally abandon his U.S. LPR status. Since obtaining his green card, Topsnik failed to file the required Form 8854, Initial and Annual Expatriation Statement, and failed to certify, under penalties of perjury, that he had complied with all of his U.S. federal tax obligations for the five taxable years preceding the tax year that included the expatriation date.

In August of 2011, Topsnik filed a late 2010 Form 1040NR, U.S. Nonresident Alien Income Tax Return. On that return, he claimed that the installment sale proceeds received in 2010 were exempt from tax by virtue of him being a German resident to which the U.S. Germany Tax Treaty applied.

The IRS determined that Topsnik was not a German resident and was liable for an income tax deficiency for 2010 attributable to the 11 installment payment received that year. The IRS also determined that Topsnik was a "covered expatriate" who expatriated in 2010 and, under Code Sec. 877A, had to recognize gain on the deemed sale of his installment obligation on the day before his expatriation. In addition to the tax deficiencies, the IRS also assessed an accuracy-related penalty and a failure to file penalty.

Analysis

An expatriate includes any long-term resident of the United States who ceases to be an LPR of the United States. A long-term resident is generally one who is a LPR for 8 of 15 tax years ending with the tax year during which the individual expatriates. An individual is generally an LPR if he or she holds a green card. Under Code Sec. 877A, all property of a covered expatriate is treated as being sold on the day before his or her expatriation date for its fair market value. Any gain arising from the deemed sale is taken into account for the tax year of the deemed sale. A covered expatriate is an individual who fails to file a Form 8854 certifying that the individual has been in compliance with all federal tax laws during the five years preceding the year of expatriation.

Before the Tax Court, Topsnik noted that, in 2011, the IRS had moved to dismiss a district court suit (Topsnik I) on the ground that he was a resident of Germany. Topsnik had filed the district court suit as a result of certain IRS jeopardy assessments and levies and the suit was dismissed, in part, for lack of venue. According to Topsnik, under the doctrine of judicial estoppel, the IRS was now precluded from arguing that he was not a German resident.

The Tax Court held that the judicial estoppel argument did not apply to prevent the IRS from arguing that Topsnik was not a German resident. The court noted that Topsnik's status as a German resident was not an issue in Topsnik I and was not addressed by the parties in that case. The court concluded that Topsnik was not a German resident and that he expatriated on November 20, 2010, when he formally abandoned his status as an LPR. The court also held that Topsnik was liable for tax on gains attributable to the 11 monthly installment payments that were made during 2010 before his expatriation date and, under Code Sec. 877A, was liable for tax on gain from the deemed sale of his right to installment sale proceeds on the day before his expatriation date.

In determining that Topsnik was not a German resident in 2010, the Tax Court looked to the U.S.-Germany Tax Treaty. The treaty test for determining residency in a contracting state (i.e., Germany), the court said, is the individual's liability to pay tax to that state as a resident, which, in the case of Germany, means that the individual must be taxable on his worldwide income. Information on Topsnik obtained from the German competent authority, the court noted, revealed that: (1) for tax year 2010, Topsnik was registered in Germany as a person subject to tax as a nonresident; (2) Topsnik did not file a German tax return for 2010; (3) Topsnik was not registered in a German township, nor did he have a registered residence or habitual abode in Germany in 2010; and (4) since 2000, Topsnik had, on occasion, a room in Germany at his brother's inn free of charge.

According to the court, there was no evidence to refute the information obtained from the German competent authority that indicated Topsnik was not a German resident. As a result, the court found that Topsnik was not a resident of Germany in 2010 as defined by the U.S.-Germany Tax Treaty. Accordingly, the court concluded that the monthly installment payments received by Topsnik were taxable by the United States.

Finally, in determining that Topsnik was liable for tax on gain from the deemed sale of his right to installment sale proceeds, the court found that Topsnik qualified as an expatriate under Code Sec. 877A(g)(2) because he had been an LPR for 10 out of 15 years before formally abandoning his LPR status. In addition, Topsnik qualified as a covered expatriate because, for the year of his expatriation, Topsnik failed to complete and file a Form 8854.

For a discussion of the rules for taxing expatriates, see Parker Tax ¶200,580.

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IRS Advises that it Can Adjust Deferred COD Income for a Closed Tax Year in Some Situations

The Office of Chief Counsel advised that, in certain circumstances, the IRS could adjust the amount of cancellation of debt (COD) income a taxpayer had deferred in a given tax year, despite that year being outside the statute of limitations under Code Sec. 6501. CCA 201604017.

Background

Under the facts of CCA 201604017, a sole proprietor (the taxpayer) made a promissory note in connection with her business that an unrelated individual now holds, and for which $800x remains outstanding. In 2009, the individual agreed to return the note to the taxpayer in exchange for $500x in cash. The taxpayer's acquisition of the note is a "reacquisition" within the meaning of Code Sec. 108(i)(4).

The taxpayer attached a statement to her 2009 return reporting $100x, not $300x, in total COD income in connection with the note reacquisition. On the statement, she also made an election under Code Sec. 108(i) to defer the inclusion of $100x in COD income to the 5-year period beginning with 2014. In a later year, when the 2009 tax year was outside the three year limit on assessment in Code Sec. 6501, the IRS discovered that the sole proprietor failed to include $200x in COD income in 2009.

Code Sec. 108(i)(1) generally provides that, at the election of a taxpayer, COD income in connection with a reacquisition of an applicable debt instrument occurring in 2009 or 2010 is includible in gross income ratably over a 5- tax-year inclusion period beginning with the fifth tax year following the tax year of the reacquisition (if it occurs in 2009) or with the fourth tax year of the reacquisition (if it occurs in 2010).

Code Sec. 108(i)(5)(B)(i) provides that a taxpayer makes a section 108(i) election by attaching to its income tax return for the year the reacquisition occurs a statement that clearly identifies the applicable debt instrument acquired, the amount of income to be deferred by the election, and any other information that the IRS requires.

Rev. Proc. 2009-37 provides the exclusive procedures for making a Code Sec. 108(i) election. Taxpayers may make an election for any portion of the COD income from the reacquisition of any applicable debt instrument. A taxpayer may make a protective election if the taxpayer concludes that a particular transaction does not result in the realization of COD income, but if the IRS later determines that the transaction did result in COD income, the IRS may require the taxpayer to report COD income deferred even if the statute of limitations has expired for the year in which the COD income was realized and the protective election was made.

Analysis

The IRS Office of Chief Counsel advised that, in certain situations, the IRS may adjust the amount of COD income deferred by an election under Code Sec. 108(i).

The Office of Chief Counsel noted that while Code Sec. 6501 generally limits the period during which tax may be assessed to 3 years after the date the taxpayer files a return, that section merely prevents assessment and collection of tax beyond the prescribed period of limitations and does not prevent an adjustment that may affect other tax years or other tax liabilities, or does not result in the assessment of a tax. There is a well-developed body of law, the Office of Chief Counsel observed, that provides that the IRS can generally recompute a taxpayer's income for a closed year in determining the deficiency for an open year (the "adjustment theory").

For example, in Comm'r v. Disston, 325 U.S. 442 (1945), the Supreme Court held that examination of events in closed years was allowed in order to correctly determine the gift tax liability in open years. And in ABKCO Industries Inc. v. Comm'r, 56 T.C. 1083 (1971), the Tax Court found that income for a year barred by the statute of limitations could be recomputed to arrive at correct amount for determining net operating loss carryback or carryover to another year.

The ability to adjust a taxpayer's income for a closed year, the Office of Chief Counsel said, is consistent with Rev. Proc. 2009-37, which states that a taxpayer making a protective election will have to include deferred COD income in income if the IRS later determines that the transaction at issue resulted in COD income, even if the year the COD income was realized and the protective election was made is closed.

The Office of Chief Counsel advised that, under a given set of facts, the IRS may be able to apply the adjustment theory to adjust the amount of COD income that a taxpayer has elected to defer under Code Sec. 108(i) even if the taxable year of the election is closed under Code Sec. 6501. It further advised that, the instant case, the IRS may be able to treat the sole proprietor as having realized $300x in COD income in 2009 and having elected to defer the entire $300x amount under Code Sec. 108(i), even if the 2009 taxable year is closed under Code Sec. 6501.

For a discussion of the deferral of COD income for 2009 and 2010, see Parker Tax ¶ 72,320.

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IRS Proposes to Sharply Increases EA Exam Fee as Fewer than Expected are Taking the Exam

The IRS has proposed to increase the fee for taking the Enrolled Agent Exam from $11 to $99 for each of the exam's three parts. The IRS fee is in addition to the fee charged by the contractor that administers the exam. REG-134122-15 (1/26/15).

Background

The Enrolled Agent Special Enrollment Examination (EA exam) is the written examination that tests special competence in tax matters for purposes of that provision, and an applicant must pass all parts of the exam to be granted enrolled agent status through written examination. After becoming enrolled, an enrolled agent must renew enrollment every three years to maintain active enrollment and to be able to practice before the IRS.

The EA exam is comprised of three parts, which are offered during a testing period that begins each May 1 and ends the last day of the following February. Individuals taking the exam must pay a fee for each part. The exam is not available in March and April, during which period it is updated to reflect changes in the relevant law.

The current user fee is $11 to take each part of the EA exam. When determining the current fee, the IRS originally estimated that individuals would take 34,000 parts of the exam each year. That number of parts has not been reached in any year. In the testing periods beginning in 2012, 2013, and 2014, approximately 18,900, 19,500, and 22,400 parts of the exam were administered, respectively.

The contractor that administers the EA exam also charges individuals taking the exam an additional fee for its services. For the May 2015 to February 2016 testing period, the contractor's fee is $98 for each part.

IRS Increases Exam Fee Nine-Fold

Due to increased costs incurred to implement the EA exam program, the IRS has issued proposed regulations that would increase the user fee for the exam to $99 per part.

Observation: If the proposed fee increase is finalized, individuals wishing to take the EA exam will be required to pay a total of $591 to take all three parts of the exam (3 x ($99 IRS fee + $98 contractor fee)) (based on current contractor fees, which are subject to change).

The IRS stated that the increased costs are primarily attributable to the following:

• The cost for background checks required under Publication 4812, "Contractor Security Controls," for individuals working at the contractor's testing centers increased by $270,000 per year;
• 14,000 fewer parts of the EA-SEE per year are estimated to be administrated than the estimated number used to calculate the $11 fee, and the total costs are therefore being recovered from fewer individuals; and
• The costs of verifying the contractor's compliance with the information technology security requirements necessary to protect the information of individuals taking the EA-SEE have increased, because Publication 4812 has strengthened those requirements.

In addition, the IRS stated its original estimates of the cost to oversee the contract did not cover all the work now performed, and it incurs additional costs associated with resolution of test-related issues such as cheating incidents, appeals regarding scores, refund requests, and customer service complaints that have not been resolved at the contractor level.

The fee increase will be effective once the proposed regulations are finalized.