Federal Tax Bulletin - Issue 106 - January 16, 2016

1099 Reporting Takes on New Prominence as Sharp Penalty Increases Take Effect

With hefty increases in information reporting penalties (as high as $250 per late 1099) taking effect on January 1, timely issuance of 1099s has become a critical imperative for many businesses. The new urgency for timely issuance is compounded by the continued presence of questions on Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, asking whether the taxpayer made any payments in 2015 that would require the taxpayer to file Form(s) 1099.

Practice Aid: See ¶320,690 for a sample CLIENT LETTER that explains the requirement to file Form 1099 and the significance of the 1099 question on the various returns.

Increased Penalties for Failing to File Correct 1099s

Last June, Congress enacted hefty increases in the penalties imposed under Code Secs. 6721 and 6722 for failures relating to information returns and payee statements. The changes, which were included in the Trade Preferences Extension Act of 2015 (Pub. L. 114-27), took effect on January 1.

Information reporting penalties apply if a payer fails to file timely, fails to include all information required to be shown on a return, or includes incorrect information on an information return (including all variations of Form 1099).

The amount of the penalty is based on when the correct information return is filed. For returns required to be filed for the 2015 tax year, the penalty is:

(1) $50 per information return for returns filed correctly within 30 days after the due date (up from $30 under the prior law), with a maximum penalty of $500,000 a year ($175,000 for certain small businesses);

(2) $100 per information return for returns filed more than 30 days after the due date but by August 1 (up from $60 under prior law), with a maximum penalty of $1,500,000 a year ($500,000 for certain small businesses); and

(3) $250 per information return for returns filed after August 1 or not filed at all (up from $100 under prior law), with a maximum penalty of $3,000,000 a year for most businesses but $1,000,000 for certain small businesses.

For purposes of the lower penalty, a business is a small business for any calendar year if its average annual gross receipts for the three most recent tax years (or for the period it was in existence, if shorter) ending before the calendar year do not exceed $5 million.

Observation: This year's increase in information return penalties represents the second time in just a few years that Congress has enacted sharp increases. For 1099s filed after August 1 or not filed at all, taxpayers face a 500% increase in the per-item penalty compared with the pre-2010 amount.

Persons who are required to file information returns electronically but who fail to do so (without an approved waiver) are treated as having failed to file the return unless the person shows reasonable cause for the failure. However, they can file up to 250 returns on paper; those returns will not be subject to a penalty for failure to file electronically. The penalty applies separately to original returns and corrected returns.

The penalty also applies if a person reports an incorrect taxpayer identification number (TIN) or fails to report a TIN, or fails to file paper forms that are machine readable.

The penalty for failure to include the correct information on a return does not apply to a de minimis number of information returns with such failures if the failures are corrected by August 1 of the calendar year in which the due date occurs. The number of returns to which this exception applies cannot be more than the greater of 10 returns or 0.5 percent of the total number of information returns required to be filed for the year.

If a failure to file a correct information return is due to an intentional disregard of one of the requirements (i.e., it is a knowing or willing failure), the penalty is the greater of $500 per return or the statutory percentage of the aggregate dollar amount of the items required to be reported (the statutory percentage depends on the type of information return at issue). In addition, in the case of intentional disregard of the requirements, the $5,000,000 limitation does not apply.

The Protecting Americans from Tax Hikes Act (Pub. L. 114-113) added a safe harbor from the application of these penalties in circumstances in which the information return or payee statement is otherwise correctly filed but includes a de minimis error of the amount required to be reported on such return or statement. In general, a de minimis error of an amount on the information return or statement need not be corrected if the error for any single amount does not exceed $100. A lower threshold of $25 is established for errors with respect to the reporting of an amount of withholding or backup withholding.

1099 Question Remains on Major Tax Forms

The 2015 Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, all contain questions asking if the taxpayer made any payments in 2015 that would require the taxpayer to file Form(s) 1099. If the answer is "yes," then the IRS wants to know if the taxpayer did, or will, file the required Forms 1099.

The questions first showed up in 2011 and practitioners immediately expressed concern that their clients may not be aware of the full ramifications of incorrectly reporting Form 1099 income and the impact on their own liability for checking these boxes. If a client reports that all Form 1099s were filed when they were not, he or she is committing perjury (because the returns are signed under penalties of perjury). If the client reports that not all Form 1099s were filed, then that's a red flag for an audit.

If a taxpayer has a business that uses sporadic labor, the Form 1099 questions can present a dilemma in certain situations. For example, how does a taxpayer who intermittently employs workers by picking them up at places where such workers congregate, answer the questions? If any of these workers are used several times during the year in the taxpayer's business, the amounts paid to that worker will most likely exceed $600, and the taxpayer will be responsible for issuing a Form 1099-MISC to that independent contractor. What if the workers will accept only cash? Without proper documentation, how does the taxpayer prove that no one individual was paid more than $600?

With the penalties once again sharply increasing for information returns and payee statements filed in 2016, these questions are more relevant than ever.

Form 1099-MISC

Generally, any person, including a corporation, partnership, individual, estate, and trust, which makes reportable transactions during the calendar year, must file information returns to report those transactions to the IRS. However, a payer does not need to file Form 1099-MISC for payments not made in the course of the payer's trade or business. A payer is engaged in a trade or business if it operates for gain or profit. Thus, personal payments are not reportable. Nonprofit organizations are considered to be engaged in a trade or business and are subject to the reporting requirements. For other exceptions to filing a Form 1099-MISC, see ¶252,565.

The type of reportable transaction determines the specific Form 1099 that must be filed. Most of the issues revolving around the filing of Forms 1099, involve Form 1099-MISC and the reporting of non-employee compensation. In general, a payer must file Form 1099-MISC, Miscellaneous Income, for each person to whom the payer has paid during the year:

(1) at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest;

(2) at least $600 in rents, services (including parts and materials), prizes and awards, other income payments, medical and health care payments, crop insurance proceeds, cash payments for fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish, or, generally, the cash paid from a notional principal contract to an individual, partnership, or estate;

(3) any fishing boat proceeds; or

(4) gross proceeds to an attorney.

In addition, Form 1099-MISC must be filed to report direct sales of at least $5,000 of consumer products made to a buyer for resale anywhere other than a permanent retail establishment. Form 1099-MISC must also be filed for each person from whom a taxpayer has withheld any federal income tax under the backup withholding requirement (discussed below), regardless of the amount of the payment.

Compliance Tip: The deadline for filing paper Forms 1099-MISC is generally the last day of February following the calendar year for which the filing is made. The due date is extended until the last day of March for payers who file electronically. If the regular due date falls on a Saturday, Sunday, or legal holiday, Form 1099-MISC is due the next business day.

Backup-Withholding Requirement

A backup withholding requirement applies to reportable payments where the payee does not furnish a taxpayer identification number (TIN). The backup withholding rate is equal to 28 percent of the amount paid. The requirement does not apply to payments made to tax-exempt, governmental, or international organizations.

In determining whether a payee has failed to provide a TIN, a payer is required to process the TIN within 30 days after receiving it from the payee or in certain cases, from a broker. Thus, the payer may take up to 30 days to treat the TIN as having been received.

Can IRS Limit Deductions to $600 Where No Form 1099 Is Filed?

Some practitioners have questioned whether or not the IRS can limit a compensation deduction to $599, the cutoff for not reporting nonemployee compensation, where a Form 1099-MISC is not filed. While there is nothing in the Code or regulations on this, nor is there any case law on point, some practitioners have reported IRS agents telling them that if they had not produced Form 1099s for compensation deductions taken on a return, the nonemployee compensation deduction would be limited to an amount not required to be reported on Form 1099-MISC.

What Constitutes a Trade or Business That Requires Reporting on Form 1099?

The characterization of an activity as a "trade or business" took on a new importance in 2013 with the implementation of the net investment income tax. Effective for tax years beginning after December 31, 2012, individuals are subject to a 3.8 percent tax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. Generally, income from a trade or business (with the exception of certain commodities trading income) is exempt from the net investment income tax.

As previously mentioned, taxpayers not in a trade or business are not required to file Form 1099s. Whether a taxpayer is considered to be in a trade or business has become a hot topic because of the net investment income tax. As a result, taxpayers may be claiming that their activity is not subject to the net investment income tax because it rises to the level of a trade or business without considering the impact that will have on their Form 1099 filing requirements and the associated penalties if such forms are not filed.

Conclusion

Practitioners should advise their clients to have non-employee workers or contractors complete a Form W-9 if they believe payments to any individual might add up to $600 or more for the year. To the extent anyone is paid more than $600, a Form 1099-MISC should then be issued at the end of the year. Practitioners should also document in their files that they've had this discussion with clients and may want to consider revising their engagement letter to reflect the documentation a client will need to take certain deductions on the return. Similarly, practitioners may want to warn their clients about the trade-offs for claiming they are in a trade or business in an effort to escape the net investment income tax and their responsibility for filing Form 1099s when they are in a trade or business.

[Return to Table of Contents]

IRS Withdraws Controversial Prop Reg Allowing Nonprofits to Collect Donor SSNs

A proposed regulation under Code Sec. 170(f)(8) that would give charitable organizations the option of reporting information to the IRS on donor's who contributed $250 or more during the year, including the donor's social security numbers, has been withdrawn. REG-138344-13 (1/8/16).

Last year, the IRS issued Prop. Reg. 1.170A-13(f)(18) (REG-138344-13 (9/17/15)). The proposed regulation was aimed at implementing an exception to the contemporaneous written acknowledgement (CWA) requirement for substantiating charitable contribution deductions of $250 or more.

Code Sec. 170(f)(8) requires the substantiation of charitable contributions of $250 or more and Reg. Sec. 1.170A-13(f) provides rules on substantiating charitable contributions of $250 or more. Generally, a taxpayer who claims a charitable contribution deduction for any contribution of $250 or more must obtain substantiation in the form of a CWA from the donee organization. While the CWA need not be in any particular form, Code Sec. 170A(f)(8)(B) provides that it must contain the following information:  

(1) the amount of cash and a description of any property other than cash contributed;  

(2) whether any goods and services were provided by the donee organization in consideration for the contribution; and  

(3) a description and good faith estimate of the value of any goods and services provided by the donee organization or a statement that such goods and services consist solely of intangible religious benefits.

The CWA must also be contemporaneous. A CWA is contemporaneous if it is obtained by the taxpayer on or before the earlier of the date the taxpayer files an original return for the tax year in which the contribution was made or the due date (including extensions) for filing the taxpayer's original return for that year.

Code Sec. 170(f)(8)(D) provides an exception to the CWA requirement. Under the exception, a CWA is not required if the donee organization files a return that includes the information described in Code Sec. 170(f)(8)(B).

The proposed regulations immediately caused an uproar because they proposed to give donee organizations the option of "donee reporting." This would involve the charitable organization reporting to the IRS the information required in Code Sec. 170A(f)(8)(B), as well as the donor's name, address, and taxpayer identification number. Thus, the charitable organization would have to have a means to store, maintain, and readily retrieve the return information for a specific taxpayer if and when substantiation was required in the course of an examination.

The uproar over the regulations centered on the fact that it allowed charitable organizations to collect the social security numbers of those who donate $250 or more per year. For example, former U.S. congressman, Ron Paul, objected to the collection of social security numbers because "it is quite possible that a future IRS may, by making a simple one-word change in the IRS's regulations, force 501(c)(3)'s to give the IRS the social security numbers of their major donors. It is ironic that the IRS is considering this rule the same week that the Office of Personal Management (OPM) finally finished notifying the 40 million Americans whose personal information may have been comprised when OPM's records were hacked this summer. The OPM hack is just the latest example of government's failure to protect personal information."

The IRS has now withdrawn the proposed regulation.

For a discussion of the substantiation rules for charitable contributions of $250 or more, see Parker Tax ¶84,190.

[Return to Table of Contents]

Sixth Circuit Reverses Tax Court; Foreign Currency Option Can be a Foreign Currency Contract

Although the Tax Court's disallowance of a tax loss by the taxpayers made sense to the Sixth Circuit as a matter of tax policy, it found the plain language of the statute clearly provided a different result and the Sixth Circuit reversed the lower court and held that a foreign currency option can be a "foreign currency contract" under Code Sec. 1256. Wright v. Comm'r, 2016 PTC 4 (6th Cir. 2016).

Background

Code Sec. 1256 provides that an investor who holds certain types of derivatives at the close of the tax year must mark to market those derivatives by treating them as having been sold for their fair market value on the last business day of the tax year. A foreign currency that an investor must mark to market at the end of the tax year is called a "Section 1256 contract."

Terry and Cheryl Wright are co-owners of an investment company called Cyber Advice, LLS, which is taxed as a partnership. In 2002, Cyber Advice purchased a euro put option for a premium of approximately $36.2 million, which gave Cyber Advice the right to sell to 1.2 billion euros to a trading company, Beckenham, for $1.3 billion on the expiration date of the option. Cyber Advice also purchased a euro call option from Beckenham with terms that were the mirror-image of the euro put option (i.e. the option gave Cyber Advice the right to buy 1.2 billion euros from Beckenham for $1.3 billion). At this time, Cyber Advice also sold a krone call and krone put to Beckenham on mirror-image terms. Three days later, Cyber Advice assigned the euro put option and krone put option to a charitable organization, the Foundation for an Educated America. Cyber Advice also sold the euro call option to Beckenham and repurchased the krone call option from Beckenham.

In October 2003, Cyber Advice and the Wrights filed their 2002 income tax returns. Cyber Advice reported short-term capital gains and losses for three of its option transactions but did not report gain from the krone put. It reported a total net short-term capital loss of approximately $3 million. The Wrights took the position that they did not need to recognize the gain from the assignment of the krone put option to the Foundation for an Educated America because over-the-counter options on minor foreign currencies such as the krone were not Section 1256 contracts to which mark-to-market accounting applied. The Wrights also took the position that recognition of a short-term capital loss from the assignment of the euro put option to the Foundation for an Educated America was proper because the assignment of the euro put option resulted in a termination under Code Sec. 1256(c) and because the euro put option was a "foreign currency contract" subject to Code Sec. 1256.

Because Cyber Advice was taxed as a partnership, its loss flowed to the Wrights. The Wrights reported an almost $3 million loss on their return, which aided in reducing the Wrights' capital gains from more than $3.4 million to less than $500,000. Thus, the transactions allowed the Wrights to generate a large tax loss at minimal economic risk or out-of-pocket expense. The IRS determined that the Wrights had improperly claimed the almost $3 million net capital loss in relation to the major-minor transactions.

Observation: A major-minor transaction refers to a currency whose positions are traded through regulated futures contracts (i.e., euros) and a currency that is considered minor because there is not a regulated futures contract for the currency (i.e., the Danish krone).

Analysis

The Tax Court rejected the Wrights' attempt to generate a tax loss in this manner, holding that they could not recognize a loss upon assignment of the euro put option because their option was not a "foreign currency contract" under Code Sec. 1256. The Tax Court explained that a foreign currency option does not meet the "delivery" or "settlement" requirement in Code Sec. 1256(g)(2) because a foreign currency option does not require delivery or settlement "unless and until" the holder exercises the option. The Tax Court cited its decision in Summitt v. Comm'r, 134 T.C. 248 (2010), a case that involved a major-minor transaction. The Tax Court also noted that it was clear that the statute as originally enacted applied only to forward contracts which require delivery of the foreign currency. Further, the Tax Court reasoned that because the phrase "or the settlement of which depends on the value of" was added to Code Sec. 1256 to allow cash-settled forward contracts to come within the term "foreign currency contract," Code Sec. 1256(g)(2)(A)(i) mandated that "foreign currency contracts" require settlement at expiration.

The Wrights appealed to the Sixth Circuit. The issue before the Sixth Circuit was the definition of "foreign currency contract" provided in Code Sec. 1256(g)(2)(A).

The Sixth Circuit reversed the Tax Court and held that the Wrights' euro put option met the "settlement" prong of Code Sec. 1256(g)(2)(A)(i) and thus qualified as a foreign currency contract. The court found the IRS's position that Code Sec. 1256(g)(2)(A)(i) provides that a contract must mandate at maturity either a physical delivery of a foreign currency or a cash settlement based on the value of the currency to be contrary to the plain language of the statute. Contrary to the IRS's assertion, the Sixth Circuit said, the inclusion in Code Sec. 1256 of a rule that applies to the cash settlement of a contract does not make it implicit that a settlement of the contract must actually occur.

The Sixth Circuit observed that, while the Tax Court's disallowance of the Wrights' claimed tax loss makes sense as a matter of tax policy, the plain language of the statute clearly provides that a foreign currency option can be a "foreign currency contract." The court saw no conceivable tax policy that supported its interpretation of the plain language of Code Sec. 1256, but declined to reform the statutory language for two reasons: (1) an attempt to reform Code Sec. 1256 might unintentionally permit other tax-avoidance schemes, and (2) Congress provided two escape hatches to guard against the type of adverse tax policy outcome at issue. First, under Code Sec. 1256(g)(2)(B), the IRS can issue regulations to exclude any type of contract from the "foreign currency contract" definition if the inclusion of this type of contract would be "inconsistent" with the purposes of Code Sec. 1256. Second, the IRS can prevent taxpayers from claiming tax losses based upon transactions involving offsetting foreign currency options by challenging specific transactions under the economic substance doctrine as lacking in economic substance.

For a discussion of Code Sec. 1256 contracts, see Parker Tax ¶116,150.

[Return to Table of Contents]

Employer Guidance Issued on Retroactive Increase in Excludable Transit Benefits for 2015

To address employers' questions regarding the retroactive application of the increased transit benefits exclusion for 2015 pursuant to PATH, the IRS has issued guidance on how the increase applies and provided a special administrative procedure for employers to use in filing their fourth quarter Form 941, and Forms W-2. Notice 2016-6.

Background

Under Code Sec. 132(a)(5), the value of the qualified transportation benefits provided by an employer to an employee is excludable from the employee's gross income to the extent that value does not exceed certain dollar amounts. Excludable qualified transportation benefits include:

(1) transportation in a commuter highway vehicle between home and work;

(2) transit passes;

(3) qualified parking; and

(4) qualified bicycle commuting reimbursements.

Prior to the enactment of the Protecting Americans from Tax Hikes (PATH) Act of 2015 (Pub. L. 114-113), the adjusted maximum monthly amount excludable for 2015 for transportation in a commuter highway vehicle and/or any transit pass ("transit benefits") was $130 per participating employee and the adjusted maximum monthly amount excludable for qualified parking was $250. PATH permanently amended Code Sec. 132(f) to create parity in the amount of the exclusion for qualified transportation fringes. Accordingly, PATH increased the $130 maximum monthly excludable amount for transit benefits to equal the $250 maximum monthly excludable amount for qualified parking. The increase is effective for the period from January 1, 2015, through December 31, 2015..

Observation: For 2016, the monthly exclusion for both transit benefits and for qualified parking is $255.

Pursuant to the change made by PATH, transit benefits provided during 2015 by an employer to an employee in excess of $130 (the former maximum monthly excludable amount) up to $250 (the amended maximum monthly excludable amount) ("excess transit benefits") are excluded from the employee's gross income and wages. Neither Code Sec. 132, nor the change made by PATH, mandate that employers provide additional transit benefits to their employees for 2015, and employees may not retroactively increase their compensation reduction for 2015 to take advantage of the increase in the excludable amount for transit benefits in 2015.

Employers who originally reported excess transit benefits as includible in gross income and wages and withheld income taxes and FICA taxes would normally be required to file Form 941-X for each quarter to make corrections accounting for the increase in excludable transit benefits.

However, because of the year-end passage of PATH, and the fast-approaching due dates for fourth quarter Forms 941 and Forms W-2, the IRS has provided a special administrative procedure for employers who treated excess transit benefits as wages and that have not yet filed their fourth quarter Form 941 for PATH. Employers who choose to use this special administrative procedure must repay or reimburse their employees for the overcollected FICA tax on the excess transit benefits for all four quarters of 2015 on or before filing the fourth quarter Form 941.

Observation: Employers must act quickly in order to take advantage of this special procedure as the fourth quarter Form 941 is due on February 1, 2016.

Special Administrative Procedure

The procedure allows the employer, in reporting amounts on its fourth quarter Form 941, to reduce the fourth quarter wages reported on lines 2, 5a, 5c, and 5d by the excess transit benefits for all four quarters of 2015. By electing this special administrative procedure, employers will avoid having to file Forms 941-X, and will also avoid having to file Forms W-2c. Additionally, employers using this special procedure do not need to obtain written statements from their employees confirming the employee did not, and will not, make a claim for a refund of FICA tax. This procedure can only be used to the extent that employers have repaid or reimbursed their employees for the employee share of FICA tax attributable to the excess transit benefits.

Practice Tip: Employers who have already filed the fourth quarter Form 941 must use Form 941-X and follow normal procedures to make an adjustment or claim a refund for any quarter in 2015 with regard to the overpayment of tax relating to excess transit benefits.

Employers who paid excess transit benefits and have not furnished 2015 Forms W-2 to their employees must take into account the increased exclusion for transit benefits in calculating the amount of wages reported. Employers who have repaid or reimbursed their employees for the overcollected FICA taxes prior to furnishing Form W-2 (whether they utilized the special administrative procedure or the normal procedures) must reduce the amounts of withheld tax reported. In all cases, employers must report the amount of income tax actually withheld during 2015. The additional income tax withholding will be applied against the taxes shown on the employee's individual income tax return.

Employers who repaid or reimbursed their employees for the overcollected FICA taxes after furnishing Forms W-2 to their employees, but before filing Forms W-2 with the Social Security Administration (SSA), must check the "Void" box at the top of each incorrect Form W-2 (Copy A). The employer must prepare new Forms W-2 with the correct information, and send those new Forms W-2 (Copy A) to the SSA. Employers who have already filed 2015 Forms W-2 with SSA must file Forms W-2c, Corrected Wage and Tax Statement, to take into account the increased exclusion for transit benefits and to reflect any repayments or reimbursements of the withheld FICA tax and must furnish copies of Form W-2c to the employees.

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

[Return to Table of Contents]

Sporadic Sales of Real Property Don't Amount to a Trade or Business; Loss on Foreclosure Is Capital

A taxpayer's real estate activities did not amount to a trade or business because his property sales were sporadic, and not frequent and continuous. Thus, a loss on the foreclosure of one of his real estate properties was a capital, not ordinary, loss. Evans v. Comm'r, T.C. Memo. 2016-7.

Background

Jeffrey Evans has worked in the field of real-estate construction and development since he graduated from college in 1973. Since 2002, he has been a full-time employee of Athens Group, a real-estate development firm. Apart from his full-time job at Athens Group, Evans purchased for himself residential real-estate properties that he hoped to either develop for sale or rent to tenants. From 2002 to 2007, Evans bought one rental property in Corona del Mar, California and two tear-down properties: one in Corona del Mar and one in Newport Beach. Over the course of three years, Evans developed the tear-down property in Corona del Mar into a two-condominium building, then sold it. The Newport Beach property, which was purchased on June 26, 2006, for $1.4 million in cash, was a plot of land which included a shack and a garage.

While he owned the Newport Beach property, Evans incurred costs to prepare the property for development. He paid an architect for drawings of the two-unit house that he intended to build there. Evans paid other individuals for electrical and mechanical plans. He incurred additional costs for permits, property taxes, and interest.

In 2007, Evans borrowed $250,000 from a trust, which acquired a lien on the Newport Beach property. He subsequently defaulted on the loan and, in October of 2008, the Newport Beach property was sold in a foreclosure sale for $556,000. As of the end of 2008, Evans knew that the foreclosure sale had occurred, but he did not know whether he was entitled to receive any proceeds from the sale. In 2009, Evans learned that there were proceeds distributable to him and he received $280,325 from the sale of the Newport Beach property.

Evans and his wife filed their 2008 tax return in 2012and reported a $1,041,000 inventory loss from the foreclosure sale of the Newport Beach property. The $1,041,000 loss was equal to the $1,597,000 they reported as their basis in the Newport Beach property minus the $556,000 that they reported as sale proceeds. The Evanses did not report that they had any business income or losses, other than the loss from the foreclosure sale. The couple reported a net operating loss for 2008 of $942,000. The couple filed their 2009 tax return also in 2012 and reported an NOL carryover of $942,000.

The IRS issued the couple a notice of deficiency, which included penalties, in which it determined that the couple owed $370,000 in tax. The notice did not mention or incorporate the loss on the Newport Beach property. The case went before the Tax Court where Evans's position with respect to the loss from the foreclosure sale of the Newport Beach property was: (1) the foreclosure sale resulted in an ordinary loss for 2008, (2) assuming an ordinary loss from the foreclosure sale in 2008, he had an NOL of $942,000 for 2008, (3) he was permitted to carry over this NOL of $942,000 and apply it as a deduction against his 2009 income. Alternatively, Evans asserted that the loss from the foreclosure sale was sustained in 2009, giving rise to an ordinary loss for 2009. The IRS argued that (1) the character of the loss from the foreclosure sale of the Newport Beach property was capital and (2) the loss was sustained in 2008.

Analysis

The Tax Court agreed with the IRS that the loss from the sale of the Newport Beach property was deductible as a capital loss in 2008. The court noted that, under Reg. Sec. 1.165-1(d)(1), a loss is treated as sustained during the tax year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in that tax year. A loss resulting from a foreclosure sale, the court observed, is typically sustained in the year in which the property is disposed of and the debt is discharged (the debt being the debt secured by the property and satisfied - in full or in part - from the proceeds of the foreclosure sale).

The Newport Beach property was sold in a nonjudicial foreclosure sale in 2008, the court observed, and, under California law, a nonjudicial foreclosure sale generally constitutes a final adjudication of the rights of the debtor and the lender, and a debtor whose property is sold in a nonjudicial foreclosure sale has no right to redeem the foreclosed property. Thus, the court concluded, the loss occurred in 2008 because, under operation of California law, the foreclosure of the Newport Beach property in that year extinguished (1) Evans's legal obligation to the trust from which he borrowed money, and (2) Evans's legal rights in the Newport Beach property.

The court rejected Evans's argument that, because he was a cash-method taxpayer and did not receive (or have notice of) the proceeds from the sale until 2009, the loss did not become deductible until 2009. The court said there was no authority to support the proposition that a loss from a sale is not deductible until proceeds from the sale are received by the taxpayer or the taxpayer is notified that proceeds are distributable to him or her.

The court's determination that the loss was a capital loss was the result of it analysis of several factors which led to the conclusion that Evans's personal real-estate-development activities did not constitute a trade or business for purposes of Code Sec. 1221(a)(1). First, the court said that even if Evans acquired the Newport Beach property with the intention of developing it, this does not mean that he was in the business of property development and sales. Second, the court said, if a taxpayer engages in regular (rather than isolated or sporadic) sales of property, such activity would support a finding that he or she is engaged in a trade or business. Apart from the Newport Beach property, the court noted, Evans specifically identified only two properties he had previously acquired. Thus, the court concluded, Evans's property sales were sporadic, and not frequent and continuous. Third, the court noted that Evans supplied very few records related to his personal real-estate transactions, and his testimony concerning his properties was notably vague. According to the court, one generally expects that a person who considers himself or herself in business will maintain books and records for that business. In conclusion, the court surmised that Evans's primary source of income was his full-time job and that any income he may have earned from developing properties accounted for an insubstantial portion of his income.

For a discussion of whether a taxpayer's activities constitute a trade or business, see Parker Tax ¶90,105.

[Return to Table of Contents]

IRS Agent Erred in Applying Hobby Loss Rules to "Productive Use" Test for Like-Kind Exchange

The IRS Office of Chief Counsel advised that a partnership that exchanged an aircraft for a replacement aircraft held the property for productive use in a trade or business for purposes of Code Sec. 1031. The Chief Counsel's Office disagreed with a revenue agent's analysis that used Code Sec. 183 hobby loss rules to reach the opposite conclusion, finding those rules inapplicable. CCA 201601011.

Background

Under the facts in CCA 201601011, a partnership referred to as "P" owns multiple aircraft which are leased to a partnership referred to as "O." O is the primary business entity of a group of entities, which includes P. The entities' activities involve air travel, particularly by its executives. For both business and legal reasons, the aircraft are owned by P, a separate entity, and leased to O. The aircraft are the only operating assets of P.

The aircraft are principally used by two of O's senior executives for both business and personal purposes. To the extent the executives use the plane for personal purposes, they include the required amount in income as compensation.

In the year at issue, P exchanged the aircraft ("relinquished aircraft") for a replacement aircraft. Both the relinquished and replacement aircraft were leased under a so-called "dry" lease, under which the lessee provides flight crew and other services pertaining to the aircraft. The lease payments for the relinquished aircraft approximated the fair market rental value of the aircraft whereas the lease payments for the replacement aircraft were below market. In both cases, the lease payments were designed to cover the aircraft's carrying costs and were not designed to generate meaningful economic profit.

An examining agent during an audit of the partnership took the position that P did not hold either the relinquished or replacement aircraft for productive use in a trade or business. Because the term "held for productive use in a trade or business" is not defined in the Code or regulations, the agent relied on the hobby loss rules in Code Sec.183 and accompanying cases and regulations to determine whether P held the aircraft for productive use in a trade or business. Using the standards under Code Sec. 183, the agent concluded that P did not hold the aircraft for productive use in a trade or business.

The IRS Office of Chief Counsel (IRS) was asked whether P held the aircraft "for productive use in a trade or business" within the meaning of Code Sec. 1031 where the aircraft were P's only operating assets and did not generate an economic profit for P.

Analysis

Code Sec. 1031(a)(1) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Code Sec. 183 applies to limit the deductions of an individual or an S corporation engaging in an activity without a profit motive.

The IRS determined the aircraft owned by P served a business purpose for O both in terms of business travel and as an employment perk for its senior executives, and advised that the aircraft were held for productive use in a trade or business for purposes of Code Sec. 1031.

The IRS stated that there was no authority suggesting that the standards of Code Sec. 183 should be used to evaluate whether property is held for productive use for purposes of Code Sec. 1031 and consequently did not agree with the examining agent that Code Sec. 183 should be used to evaluate whether the aircraft are property held for productive use in a trade or business.

Although the rent P charged O for use of the aircrafts was insufficient for P to make an economic profit, the IRS noted that many businesses hold and use properties in a way that, if the use of the property were viewed as an activity, do not and could not generate profit. Nevertheless, the IRS said, the property itself is held for productive use in that business, and P's lack of intent to make an economic profit on the aircraft rental did not establish that the aircraft failed the "productive use in a trade or business" standard of Code Sec. 1031.

The IRS also pointed out that businesses, for any number of reasons, opt to hold property, especially aircraft, in a separate entity. In the instant case, the IRS said, O required private aircraft to be available to its senior executives (both for business travel and as an employment perk), and for business and legal reasons the aircraft were owned by a related entity. Were it to disallow Code Sec. 1031 treatment based on the entity structure in the instant case, the IRS said, businesses would be forced to structure their transactions in inefficient and potentially risky ways to achieve Code Sec. 1031 treatment.

Observation: The IRS's analysis only extended to the "productive use in a trade or business" requirement of Code Sec. 1031. The IRS did not advise on whether the exchange met the other requirements to be considered a tax-free like-kind exchange.

The IRS noted that while two facts raised by the examining agent - that P charged below-market rent for the replacement aircraft and that the senior executives, rather than O, owned P - did not disqualify the property from being held for productive use in a trade or business for purposes of Code Sec. 1031, other tax provisions such as Code Sec. 280F or Code Sec. 482 might apply to disallow tax benefits or impose a tax treatment different from the treatment claimed by the partnerships or the senior executives. The IRS also said its conclusion was based on the assumption that P was a legitimate partnership, and if P is a sham entity then the senior executives would be the owners of the aircraft, and its analysis and conclusion would likely be different.

For a discussion of tax-free like-kind exchanges, see Parker Tax ¶113,100.

[Return to Table of Contents]

Hollywood Set Designer Entitled to Deduct Expenses as an Independent Contractor

The Tax Court determined that a taxpayer who built and designed sets for advertisements and TV commercials was an independent contractor, and properly deducted his business expenses on a Schedule C. Quintanilla v. Comm'r, T.C. Memo. 2016-5.

Background

Jorge Quintanilla works in Southern California building sets for advertisements and TV commercials. He sometimes earns his money in his own name, and sometimes through his S corporation, Pre Call, Inc. All business inquiries go to the same cell phone number, and there is little practical difference between situations where Quintanilla works under his own name and those where he works through his corporation.

When hiring Quintanilla, production companies describe what they would like the set to look like, often sending a sketch and occasionally a verbal description. Quintanilla then becomes responsible for making the imagined set a reality. He has some discretion to alter the sketch to make it work. If a company doesn't provide a sketch, he creates one himself. Quintanilla has authority to hire workers to assist him.

Production companies expect Quintanilla to provide any tools he needs to complete a job. He has a large collection of tools, which he stores in two 40-foot steel containers that travel with him to jobsites. These containers are also packed with machinery that Quintanilla uses to fabricate pieces of sets on site.

Quintanilla sometimes is hired subject to hourly union scale rates set by collective bargaining. On other projects he sets his own rate depending on the job at hand. While some companies pay rent for the use of his tools, others do not, in which case he increases his hourly rate to compensate for their use. Some companies pay invoices that Quintanilla prepares based on his estimates, while others pay on the basis of hours billed and reported to them.

When a production company hires Quintanilla as an individual, it generally issues a Form W-2, typically listing a payroll company as the employer. Quintanilla often performs different jobs for different production companies while being paid by the same payroll company.

Quintanilla grossed more than $84,000 in 2009 and almost $90,000 in 2010, and reported his business expenses on Schedule C, claiming he was an independent contractor. The IRS disagreed, stating he was an employee, and determined that Quintanilla had deficiencies in both years.

Analysis

The Tax Court stated it looks to multiple factors to decide whether a worker has enough autonomy in his work to be an independent contractor, including:

(1) the degree of control exercised by the principal over the worker;

(2) the worker's investment in his workplace;

(3) his opportunity to make a profit or suffer a loss;

(4) whether the principal can fire him;

(5) whether the work is part of the principal's regular business; and

(6) the permanency of his relationship with the principal;

The Tax Court concluded that almost all the facts favored finding that Quintanilla was an independent contractor and not an employee.

The most important factor, the court said, was that Quintanilla had a large degree of control as to how to accomplish the tasks he had to do throughout the year. Regardless of whether a production company gave Quintanilla a sketch of the set, or whether it merely gave him a vision for the project, the court found he had a large degree of independence in determining how to accomplish the project. He ordered props and modified them to the specs, he had authority to hire additional workers as needed, and he had the authority not to use workers that weren't performing.

The court, citing Ewens & Miller, Inc., 117 T.C. 263 (2001), also noted the fact that a worker provides his or her own tools or owns a vehicle that is used for his work weighs toward finding him to be an independent contractor.

In regards to the third factor, the IRS argued that the real potential for profit or loss lies with the firms hired to plan marketing campaigns, and with the production companies that shoot commercials and ads, not with Quintanilla. The court disagreed, noting that production workers have some real risk of profit or loss; Quintanilla could accept or decline projects, and at times a production company would give a fixed fee and he would prepare a budget to see if he could perform the work for that amount.

The court did find that the production companies had the right to fire Quintanilla, but it was very seldom exercised. The court noted that because of the short-term nature of the jobs, if a production company or client were dissatisfied with someone's work, that person would generally just never get another request to work for that particular production company or client.

For the fifth factor, the court stated that, while work that is part of the principal's regular business indicates employee status, it was difficult to figure out exactly who the "principal" is on a commercial shoot and found the factor neutral.

Another factor, the court said, is the permanency of a working relationship - the more permanent the relationship, the likelier it shows an employer-employee relationship. The court found that, during the years at issue, Quintanilla worked on 80-100 jobs per year, with the longest commercial shoot being about one month, but most were shorter. The court said the fact that the jobs were so short-term suggested that Quintanilla was an independent contractor rather than an employee.

The court noted that although the usual factors did not help the IRS much, it did have a strong argument in that Quintanilla was a union member, and many of his jobs were priced at rates set through collectively bargained contracts. Union contracts, the court stated, typically provide that workers are employees and not independent contractors. However, Quintanilla explained that he joined unions mainly to obtain health insurance and that all of his jobs came from personal connections, not from a union call board.

After reviewing the factors, the Tax Court found that Quintanilla was an independent contractor, and thus he appropriately deducted his expenses on his Schedule C.

For a discussion of a worker's status as an employee or independent contractor, see Parker Tax ¶210,110.

[Return to Table of Contents]

Repayment of $400,000 to Ex-Boyfriend's Estate Doesn't Preclude Amount from Being Included in Taxpayer's Prior Year Income

The IRS was not collaterally estopped from litigating a state court's finding that over $300,000 received by the taxpayer from a former boyfriend were gifts and not taxable income. Additionally, the doctrine of rescission did not eliminate from her income $400,000 that the taxpayer paid to her former boyfriend's estate because she did not repay the amount in the year of receipt. Blagaich v. Comm'r, T.C. Memo. 2016-2.

Background

On November 29, 2010, Diane Blagaich and her boyfriend, Lewis Burns, entered into a written agreement intended in part to confirm their commitment to each other and to provide financial support for her. Neither Blagaich nor Burns wanted to marry, and the agreement was, at least in some respects, intended to formalize their "respect, appreciation and affection for each other" in the way a marriage otherwise would do. The agreement also required Burns to make an immediate payment of $400,000 to Blagaich, which he did.

Prior to the agreement being signed, Burns had given Blagaich a Corvette automobile because he was worried about her riding her Harley Davidson motorcycle. He had also wired $200,000 to her account to entice her to leave her job and to travel with him, and had given her various checks, totaling $74,000, under similar circumstances. In 2010, Blagaich received approximately $344,000 in cash and property from Burns. Blagaich did not report these amounts as income on her 2010 tax return.

Not long after execution of the agreement, the relationship deteriorated and, on March 10, 2011, Blagaich moved out of Burns' residence. The following day, Burns sent Blagaich a notice of termination of the agreement. Shortly thereafter, Burns came to believe that, contrary to her assurances, Blagaich had been involved in an ongoing romance with another man throughout their relationship. He filed a civil suit seeking nullification of the agreement and a return of the money and property he had given Blagaich. He also caused to be filed with the IRS a Form 1099-MISC, Miscellaneous Income, reporting that he had paid Blagaich $744,000 in cash and property in 2010.

An Illinois court found that Blagaich had fraudulently induced Burns to pay her $400,000 and ordered Blagaich to repay that amount to Burns. The court found that other cash and property were gifts, which Blagaich did not have to return to Burns. At some point during this litigation, Burns died. Blagaich paid the $400,000 to Burns estate in 2014. The IRS increased Blagaich's gross income by the amount reported on the Form 1099-MISC, assessed accuracy-related penalties, and the case ended up in Tax Court.

Analysis

Blagaich asked the Tax Court to take notice of the state court's findings that, except for the agreed payment to her of $400,000, all other cash and property received from Burns were "clearly gifts." Thus, she argued, the IRS was estopped from denying that $344,000 of its adjustment to her 2010 gross income represented the value of gifts received from Burns. As to the remaining $400,000, Blagaich cited the decision in Hope v. Comm'r, 55 T.C. 1020 (1971), for the proposition that the equitable doctrine of rescission applied and reduced her deficiency to $0.

The IRS argued that it was not estopped from maintaining that the cash and property Blagaich received before November 29, 2010, were not gifts because it was not a party, nor in privity with any party, to the state court action. The IRS further argued that the rescission doctrine was inapplicable given Blagaich's failure to return the $400,000 to Burns in 2010.

The Tax Court rejected Blagaich's argument that the IRS was collaterally estopped from litigating the state court's gift finding. The court held that she failed to demonstrate that the IRS was in privity with a party to the state court action. The court also rejected the argument that the doctrine of rescission applied to eliminate the $400,000 from Blagaich's income because she did not repay the $400,000 in the year of receipt (i.e., 2010).

The court noted that its decision in Hope suggested that the rescission doctrine may apply even when repayment of a gain does not formally occur in the year of receipt, but only if, before the end of the year, the taxpayer recognizes his or her liability under an existing and fixed obligation to repay the amount received and makes provisions for repayment. In the instant case, the court noted, there were no facts to indicate that Blagaich recognized such a liability, much less made provision for repayment, in 2010. Indeed, the court observed, the record showed that Blagaich maintained, at least until November 2013, that she was under no obligation whatsoever to return the money paid to her under the agreement.

[Return to Table of Contents]

IRS Announces Changes to Employee Plans Determination Letter Program

The IRS has issued initial guidance in anticipation of the elimination, effective January 1, 2017, of the 5-year remedial amendment cycle system for individually designed plans under the Employee Plans determination letter program. Notice 2016-3.

Revenue Procedure 2007-44 describes procedures for issuing determination letters and the 5-year remedial amendment cycle for individually designed plans. Under these procedures, sponsors of individually designed plans generally can apply for determination letters once every 5 years.

In Announcement 2015-19, the IRS announced important changes to the Employee Plans determination letter program for qualified plans. Effective January 1, 2017, staggered 5-year remedial amendment cycles for individually designed plans will be eliminated and the scope of the determination letter program will be limited to initial plan qualification, qualification upon plan termination, and certain other limited circumstances.

In Notice 2016-3, in anticipation of the elimination of the 5-year remedial amendment cycle, the IRS describes changes to: (1) controlled groups and affiliated service groups that have previously made a Cycle A election; (2) expiration dates on determination letters issued prior to January 4, 2016; and (3) the period during which certain employers may establish or adopt a defined contribution pre-approved plan and, if permissible, apply for a determination letter.

The notice provides that controlled groups and affiliated service groups that maintain more than one plan are permitted to submit determination letter applications during the Cycle A submission period beginning February 1, 2016, and ending January 31, 2017, provided that a prior Cycle A election with respect to the controlled group or affiliated service group had been made by January 31, 2012 (the last day of the previous Cycle A submission period).

In addition, expiration dates included in determination letters issued prior to January 4, 2016, are no longer operative. The IRS states that future guidance will clarify the extent to which an employer may rely on a determination letter after a subsequent change in law or plan amendment.

Notice 2016-3 also provides that the deadline for an employer to adopt a current defined contribution pre-approved plan and to apply for a determination letter, if otherwise permissible, is extended from April 30, 2016, to April 30, 2017, with respect to any defined contribution pre-approved plan adopted on or after January 1, 2016 (other than a plan that is adopted as a modification and restatement of a defined contribution pre-approved plan that had been maintained by the employer prior to January 1, 2016).

In addition, an employer that had adopted a defined contribution pre-approved plan prior to January 1, 2016, continues to have until April 30, 2016, to adopt a modification and restatement of the defined contribution pre-approved plan within the current 6-year remedial amendment cycle for defined contribution plans and to apply for a determination letter, if permissible.

The notice states that the changes described in Notice 2016-3 will be reflected in an update to Rev. Proc. 2007-44, and employers may rely on the guidance in the notice until Rev. Proc. 2007-44 is updated.

For a discussion of qualified plans, see Parker Tax ¶130,120.