Federal Tax Bulletin - Issue 110 - March 11, 2016

IRS Issues Proposed Regs on Estate Basis Reporting; AICPA Pushes for Deadline Extension

Just weeks before an initial filing deadline, the IRS has issued proposed regulations that provide guidance regarding the basis consistency requirements under Code Sec. 1014(f) for reporting property acquired from a decedent, and the reporting requirements under Code Sec. 6035 with respect to the value of such property. REG-127923-15 (3/4/16).

In 2015, Congress enacted a law which imposed on executors of estates additional information reporting requirements. These reporting requirements, which require filing with the IRS and providing to the beneficiary a statement regarding consistent basis reporting between estates and persons acquiring property from a decedent, have caused concern among tax practitioners and executors alike because of the time frame in which the reporting is required and the lack of guidance from the IRS to facilitate proper compliance.

While a new form was released earlier this year on which executors must report the required information, complaints are mounting that the March 31, 2016, deadline to file the form needs to be extended. Some corporate fiduciaries, such as banks and trust companies that have multiple estate tax filings a month, argue that they need time to automate the reporting process. The reporting deadline of 30 days after the estate tax return is filed, practitioners say, is a problem because an executor typically does not know within 30 days of filing the estate tax return which beneficiary will receive what asset.

On March 4, the IRS issued proposed regulations (REG-127923-15) aimed at facilitating compliance with the new rules. However, at press time, there has been no mention from the IRS about extending the March 31 deadline.

Background

In 2015, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Pub. L. 114-41, 7/31/15) enacted Code Sec. 1014(f) and Code Sec. 6035, imposing two new estate tax reporting requirements.

Under Code Sec. 1014(f), the basis of certain property acquired from a decedent may not exceed the value of that property as finally determined for federal estate tax purposes, or if not finally determined, the value of that property as reported on a statement made under Code Sec. 6035. Code Sec. 6035 imposes reporting requirements with respect to the value of property included in a decedent's gross estate for federal estate tax purposes. These new provisions are effective for estate tax returns filed after July 31, 2015.

Compliance Tip: The requirements under Code Sec. 6035 are met by filing Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, with the IRS, and Schedule A, Information Regarding Beneficiaries Acquiring Property From a Decedent, which is part of Form 8971, with the person acquiring an interest in the decedent's property. In Notice 2016-19, the IRS delayed until March 31, 2016, the due date for all Forms 8971 and all Schedules A required to be filed with the IRS or provided to beneficiaries, respectively, after July 31, 2015, and before March 31, 2016. Temporary regulations (T.D. 9757 (3/4/16)) reiterate the transition relief provided in Notice 2016-19.

Observation: The AICPA, in a letter to the IRS dated March 4, 2016, has requested that the IRS further delay the estate basis reporting due date from March 31, 2016, until May 31, 2016. In its letter, the AICPA observed that the proposed regulations were released for public inspection on March 2, 2016, just 29 days before the March 31 deadline. The AICPA noted that not only will practitioners need more time to work through the many issues presented in the proposed regulations (such as when a supplemental filing is needed or when a zero basis might apply), but also tax software providers will need the time to update their programs for correctly processing the new Form 8971 Schedule A. Of primary concern, the AICPA said, are returns where there is a significant volume of assets (e.g., many securities within numerous brokerage accounts) that require updated software to effectively bridge the data.

Once finalized, the proposed regulations will apply to property acquired from a decedent or by reason of the death of a decedent whose return required by Code Sec. 6018 is filed after July 31, 2015. Taxpayers may rely on the proposed regulations until they are finalized.

General Requirements for Information Return and Statements under Code Section 6035

In general, for purposes of the filing requirements in Code Sec. 6035, the proposed regulations provide that an executor who is required to file an estate tax return is also required to file an "information return" (defined as Form 8971 and a copy of the included Schedule A) with the IRS to report the "final value" of certain property (discussed below), the recipient of that property, and any other information required. The executor also is required to provide a "statement" (defined as the Schedule A) to each beneficiary who has who has received or will receive property from the estate or by reason of the decedent's death.

Compliance Tip: Under Code Sec. 6018, an executor is required to file an estate tax return where the gross estate at the decedent's death exceeds the basic exclusion amount in effect under Code Sec. 2010(c) for the calendar year which includes the date of death ($5,430,000 for 2015). Otherwise, no estate tax return is required. Any applicable exclusion amount that remains unused as of the death of a spouse (the deceased spousal unused exclusion or DSUE amount) generally is available for use by the surviving spouse, as an addition to the surviving spouse's applicable exclusion amount. To elect portability of the DSUE, a Form 706 must be filed even though it is not otherwise required.

The proposed regulations provide that the executor is required to file the information return with the IRS, and is required to provide each beneficiary with that beneficiary's statement, on or before the earlier of the date that is 30 days after the due date of the estate tax return (including extensions actually granted, if any), or the date that is 30 days after the date on which that return is filed with the IRS.

Property Reported on Information Return and Statements

The proposed regulations define the property to be reported on an information return and statement(s) as all property included in the gross estate for estate tax purposes with four exceptions:

(1) Cash (other than coins or paper bills with numismatic value);

(2) Income in respect of a decedent;

(3) Items of tangible personal property for which an appraisal is not required; and,

(4) Property that is sold or otherwise disposed of by the estate (and therefore not distributed to a beneficiary) in a transaction in which capital gain or loss is recognized.

The proposed regulations provide that the filing requirements of Code Sec. 6035 do not apply to a return filed by an estate solely to make the portability election under Code Sec. 2010(c)(5), or a generation-skipping transfer tax election or exemption allocation, because these returns are not required by Code Sec. 6018.

The proposed regulations adopt the definition of the term "executor" found in Code Sec. 2203 and expand it to include a person required to file a return under Code Sec. 6018(b).

Final Value of Property for Purposes of the Basis Consistency Requirements

For purposes of the Code Sec. 1014(f) basis consistency requirements, the proposed regulations provide that a taxpayer's initial basis in property acquired from a decedent may not exceed the "final value" of the property. The limitation applies to the property whenever the taxpayer reports to the IRS a taxable event with respect to the property (for example, depreciation or amortization) and continues to apply until the property is sold, exchanged, or otherwise disposed of in one or more transactions that result in the recognition of gain or loss.

The proposed regulations define the "final value" of property as the value reported on the estate tax return once the period of limitations on assessment has expired. If the IRS determines a value different from the value reported, the final value is that value once it can no longer be contested by the estate. If the value determined by the IRS is contested by the estate, the final value is the value determined in an agreement between the IRS and the estate, or the value determined by a court. The proposed regulations also provide that the recipient of property to which the consistency requirement applies may not claim a basis in excess of the value reported on the statement required to be provided under Code Sec. 6035(a) before the final value of that property has been determined.

Example: At the time of his death, David owned 50 percent of a partnership valued at $8 million and subject to nonrecourse debt of $2 million. His interest in the partnership is reported on his estate tax return as $4 million. The IRS accepts the return as filed and, after the time for assessing the tax under expires, David's sole beneficiary, Claire sells her interest in the partnership for $6 million in cash. The "final value" of David's interest in the partnership is $4 million, and Claire's basis in her interest in the partnership at the time of its sale is $5 million (the final value of David's interest ($4 million) plus 50 percent of the $2 million nonrecourse debt). Following the sale of her interest, Claire reports taxable gain of $1 million, thus complying with the consistency requirement.

Because, under Code Sec. 1014(f)(1), basis cannot exceed the property's final value, the proposed regulations additionally provide that, if the final value differs from the initial basis claimed, a deficiency and an underpayment may result. For purposes of the Code Sec. 6662(b)(8) accuracy related penalty for underpayments due to inconsistent basis reporting, the proposed regulations interpret Code Secs. 1014(f) and 6662(k) to require only that the beneficiary's initial basis of the inherited property cannot exceed the final value of the property for estate tax purposes. The IRS stated that adjustments to the basis of the inherited property permitted by other sections of the Code as a result of post-death events (for example, depreciation or amortization, or a sale, exchange, or disposition of the property) will not cause the taxpayer's basis in the property to be treated as exceeding the final value of the property.

Final Value of After-Discovered or Omitted Property

For property that is discovered after the filing of the federal estate tax return or is otherwise omitted from that return, if such property would have generated an estate tax liability if it had been reported, the proposed regulations provide two different results based on whether the period of limitation on assessment has expired for the estate tax imposed on the estate.

The proposed regulations provide that, if the executor reports the after-discovered or omitted property on an estate tax return filed before the statute of limitations expires, the final value of the property is determined under Prop. Reg. Sec. 1.1014-10(c)(1) or (2). Alternatively, if the after-discovered or omitted property is not reported before the period of limitation on assessment expires, the final value of the after-discovered or omitted property is zero.

In situations in which no federal estate tax return was filed, the proposed regulations provide that the final value of all property includible in the gross estate subject to the consistent basis requirement is zero until the final value is determined under Prop. Reg. Sec. 1.1014-10(c)(1) or (2).

Property Subject to Basis Consistency Requirements

The consistent basis requirement of Code Sec. 1014(f)(1) only applies to property included in the estate that increases the estate tax liability payable by the decedent's estate. The proposed regulations define this property as property includible in the gross estate under Code Sec. 2031, as well as property subject to tax under Code Sec. 2106, that generates an estate tax liability in excess of allowable credits.

The proposed regulations specifically exclude all property reported on a federal estate tax return required to be filed by Code Sec. 6018 if no estate tax is imposed upon the estate due to allowable credits. In cases where the estate tax is imposed on the estate, the proposed regulations exclude property that qualifies for a charitable or marital deduction because this property does not increase the estate tax liability. In addition, the proposed regulations exclude any tangible personal property for which an appraisal is not required under Reg. Sec. 20.2031-6(b) (relating to the valuation of certain household and personal effects) because of its value.

Beneficiaries' Receipt of Statements

The proposed regulations provide that each beneficiary who receives property to be reported on the estate's information return must receive a copy of a statement reporting the property distributable to that beneficiary. In addition, if the beneficiary is a trust, estate, or business instead of an individual, the statement is provided to the entity.

If the executor does not know what property will be used to satisfy the interest of each beneficiary by the due date of the beneficiary's statement, the proposed regulations require the executor to report on the statement all of the property that could be used to satisfy that beneficiary's interest. The IRS noted that although this results in duplicate reporting of those assets on multiple statements, because each beneficiary will have been advised of the final value of each property that may be received by that beneficiary, he or she will be able to comply with the basis consistency requirement, if applicable.

If the executor is unable to locate a beneficiary by the due date of the information return, the proposed regulations require the executor to report that on the information return and explain the efforts taken to locate the beneficiary. If the executor subsequently locates the beneficiary, the executor is required to provide the beneficiary with a statement and file a supplemental information return with the IRS within 30 days of locating the beneficiary. If the executor is unable to locate a beneficiary and distributes the property to a different beneficiary who was not identified in the information return as the recipient of that property, the executor is required to file a supplemental information return with the IRS and provide the successor beneficiary with a statement within 30 days after distributing the property.

Supplemental Reporting

The proposed regulations generally require a supplemental information return and corresponding supplemental statements when there is a change that causes the information reported on the initial information returns and statements to be incorrect or incomplete (e.g. the discovery of property not reported on the estate tax return, or a change in the value of property pursuant to litigation).

In addition, the IRS stated it is concerned that opportunities may exist for the recipient of a decedent's property to circumvent the purpose of the consistent basis reporting requirements (for example, by making a gift of the property to a complex trust for the benefit of the transferor's family). Accordingly, the proposed regulations provide that in general, with regard to property reported on a statement provided to a recipient, when the recipient distributes or transfers (by gift or otherwise) all or any portion of that property to a related transferee, the transferor is required to file with and provide to the IRS and the transferee a supplemental statement documenting the new ownership of this property (subsequent transfers rule).

Observation: Practitioners have pointed out that the subsequent transfers rule may exceed the IRS's statutory authority, noting that Code Sec. 6035 does not contain provisions relating to subsequent transfers of property.

For a discussion of basis in property inherited from a decedent, see Parker Tax ¶110,530.

For a discussion of the reporting requirements under Code Sec. 6035, see Parker Tax ¶228,925.

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No Theft Loss Where Couple Can't Prove Year They Abandoned Arbitration Claim

Because a couple did not produce objective evidence that they abandoned an arbitration claim in 2004, they were not entitled to a theft loss in that year for investment losses suffered in a pump-and-dump scheme. Adkins v. U.S., 2016 PTC 79 (Fed. Cl. 2016).

Charles and Jane Adkins suffered investment losses resulting from a decline in the value of stock purchased in a pump-and-dump scheme. The scheme was run by brokers at Donald & Co., who would arrange to purchase large blocks of stock in various companies; encouraging its customers to purchase these stocks, artificially inflating the stocks' prices by, among other means, hyping the stock; and then, once the price of a particular stock was sufficiently inflated, selling the stock that it owned, resulting in gains for the company and, due to the subsequent decline in the stock price to a normal, uninflated level, losses for the company's customers.

By the beginning of 2002, the Adkinses' investment with Donald & Co. had dropped dramatically. The Adkinses filed an arbitration claim against Donald & Co and several of its brokers, alleging that they had manipulated the value of the stock, causing the couple to incur substantial losses.

In May of 2004, a federal grand jury indicted several principals and employees of Donald & Co (defendants). Mr. Adkins took the indictment to mean that the government intended to seize any documentation concerning the identity and ownership of the defendants' assets, foreclosing his ability to prove the existence of a theft loss and locate assets that could be used to reimburse him and his wife for their loss. Mr. Adkins further interpreted the indictment to mean that the government was going to seize all of the defendants' assets, preventing him from attaching those assets to recover their loss.

In September of 2004, several employees of Donald & Co. pled guilty to securities fraud and other charges. They received prison terms, fines, mandatory restitution in an amount to be determined, and forfeiture. By the end of 2004, no amounts had been paid to the victims of the fraud. In 2005, additional prosecutions were taking place. The broker who had sold stocks to the Adkinses pled guilty to securities fraud and was sentenced to prison, fines, and mandatory restitution. In 2008, the Adkinses formally withdrew their arbitration claim.

While the criminal proceedings were pending, the Adkinses attempted to recoup some of their losses by claiming a tax deduction under Code Sec. 165. They timely filed amended returns for 2001 through 2004 reflecting a total theft loss of approximately $2.6 million. Approximately $2.3 million of that loss came from the Donald & Co. pump-and-dump scheme and most of the rest was attributable to purchases made via the third-party brokers. The IRS disallowed the refund claims and the Adkinses protested to the IRS Office of Appeals.

An Appeals Officer issued a memorandum on April 5, 2011, which concluded that the Adkinses had sustained a theft loss of $2.5 million - the claimed theft loss minus the portion of the loss attributable to the stock purchased through third-party brokers - and were therefore entitled to the corresponding refunds. However, at the time the Appeals Officer issued his memorandum, the IRS Office of Appeals lacked jurisdiction to settle the case because the Adkinses had filed a refund suit in the U.S. Court of Federal Claims. That suit had been filed on December 10, 2010. In the suit, the Adkinses sought income tax refunds totaling almost $320,000 for investment losses in their Donald & Co. accounts. The couple determined that the loss occurred in 2004 and carried back losses not used up in that year to earlier years. In that case (Adkins v. U.S., 2013 PTC 386 (Fed. Cl. 2013)), the court disallowed refunds relating to losses the Adkinses suffered from stock purchased through third-party brokers because there was no privity between the Adkinses and Donald & Co. with respect to those purchases. With respect to the other losses, the court held that whether the Adkinses had a reasonable prospect of recovery in 2004 was a genuine issue of material fact and that neither the IRS nor the Adkinses was entitled to summary judgment.

The Adkinses filed suit again, arguing that they were entitled to a refund for investment theft losses sustained in 2004. According to the couple, they sustained the loss in 2004 because by the end of that year, they had no reasonable prospect of recovering on their arbitration claim.

The Federal Claims Court held that the Akinses did not prove that their loss occurred in 2004 and, thus, rejected their refund claim. Under the factual circumstances presented, the court said, the test was not whether the Adkinses had a reasonable prospect of recovering on their arbitration claim in 2004, but was instead whether, in 2004, they could have ascertained with reasonable certainty that they would not recover on their arbitration claim. To satisfy their burden under the latter test, the court said, the Adkinses were required to produce objective evidence that they abandoned their arbitration claim in 2004. Because they failed to do so, the court concluded that they were not entitled to a theft loss deduction for the 2004 tax year.

In reaching its holding, the court cited Reg. Sec. 1.165-1(d)(3), which provides that if a taxpayer has a reasonable prospect for recovery in the year that he discovers his loss, then he cannot claim the theft loss deduction until the year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether or not such reimbursement will be received, the court noted, may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. And, the court observed, Reg. Sec. 1.165-1(d)(2)(i) requires that, when a taxpayer claims that the year he sustained his loss is fixed by his abandonment of the claim for reimbursement, he must be able to produce objective evidence of his having abandoned the claim, such as the execution of a release.

According to the court, the objective evidence in the record supported two abandonment dates other than 2004: (1) 2003, when the Adkinses' arbitration attorneys requested that the NASD adjourn a scheduled hearing and when the Adkinses stopped paying their arbitration attorneys, or (2) 2008, when the Adkinses formally withdrew their arbitration claim. Accordingly, the court found that the Adkinses did not meet their burden of establishing that they sustained their theft loss in 2004.

For a discussion of when a theft loss is deductible, see Parker Tax ¶84,540.

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Payments to Related Company for Product Development Were Constructive Dividends to Common Owner

The Tax Court determined that payments one company paid to a related company to develop a "hand washing monitoring system" were not deductible and were instead constructive dividends to the company's common owner. Deductions were allowed for the portion of the payments relating to expenses for information technology services. Key Carpets, Inc. v. Comm'r, T.C. Memo. 2016-30.

Background

Raymond Johnson and his wife incorporated Key Carpets, Inc. in 1994 primarily to sell carpets to realtors. Key Carpets was a successful business with over $2 million in gross receipts each year. In 1995, Johnson incorporated another company, Clean Hands, and was its sole shareholder. Johnson originally incorporated Clean Hands because he intended to reserve the name for a hand washing monitoring system that Key Carpets had begun to develop. The initial hand washing monitoring system was intended to work by dispensing soap when a person activated the system using a radio frequency identification (RFID) badge. Johnson intended to sell the RFID hand washing monitoring system (RFID system) to food service businesses so that employers could verify an employee's compliance with sanitation requirements.

In 2006 Clean Hands hired a computer technician to assist with the development of the RFID system. Johnson decided to hire the technician as a Clean Hands employee rather than as a Key Carpets employee because an employee was needed to work on the RFID system full time. After hiring the technician Johnson decided that the RFID system was no longer feasible, and the technician began working for Clean Hands to develop a new hand washing monitoring system that was voice activated (voice-activated system).

In addition to assisting with the development of the voice-activated system, the technician provided information technology (IT) services to Key Carpets. Key Carpets had a preexisting office location that included office space for Clean Hands in the back of that building, enabling the technician to easily work for both companies. The technician maintained a time log of his work during 2007, including his time spent developing the voice-activated system and providing IT services to Key Carpets, but did not maintain a log for 2008.

Key Carpets paid Clean Hands, ostensibly for developing the voice-activated system and providing Key Carpets with IT services. For 2007 and 2008 Key Carpets claimed deductions for "computer service and consulting" with respect to the amounts paid to Clean Hands. During an audit of Key Carpets, the IRS determined that only $3,928 of the claimed "computer service and consulting" expenses were allowable as a deduction, representing the portion of the expenses allocable to the technician's salary for IT services. The IRS did not allow Key Carpets to deduct for 2007 the portion of the technician's salary expense that the auditor determined was allocable to developing the hand washing monitoring system. For 2008, The IRS disallowed the entire deduction because the computer technician did not maintain a time log.

In 2012, the IRS issued a notice of deficiency for 2007 and 2008 to Key Carpets that disallowed the claimed deductions for "computer service and consulting," and a separate notice of deficiency to the Johnsons that determined that the payments from Key Carpets to Clean Hands were constructive distributions from Key Carpets to the couple.

Analysis

The Tax Court noted that although Key Carpets had an ownership interest in the initial RFID badge-activated hand washing system, the company had no ownership interest in the new voice-activated system that the technician developed as a Clean Hands employee, and that it received no benefits from the payments to Clean Hands for the development of the system. Therefore, the court said, the expenses were not ordinary and necessary, and Key Carpets could not deduct the amounts paid to Clean Hands for the development of the voice-activated system.

The court held that Key Carpets was, however, entitled to deduct the portion of the payments to Clean Hands for wage expenses allocable to the technician's providing IT services to Key Carpets. The court found that on the basis of the technician's credible testimony that he spent at least 15 percent of his time providing IT services to Key Carpets. Although for 2008 the technician did not maintain a time log of his work, the court determined the record supported finding that the technician provided similar IT services to Key Carpets in 2008 as he did in 2007. The court thus determined that Key Carpets was entitled to deduct 15 percent of the computer technician's salary expense.

With regard to the issue of constructive dividends, the court stated that whether a payment is a constructive dividend depends on whether it was primarily for the benefit of the shareholder. The court noted that it had previously held, in Gilbert v. Comm'r, 74 T.C. 60 (1980), that a transfer between related corporations can result in a constructive dividend to their common shareholder when the shareholder receives a personal benefit. Additionally, the court stated, where a shareholder is required to make capital contributions and causes a related company to pay the contributions, the payments are for the personal benefit of the common shareholder (Stinnett's Pontiac Serv., Inc. v. Comm'r, T.C. Memo. 1982-314).

The court observed that Johnson needed funds to support Clean Hands. Instead of making capital contributions directly to Clean Hands, the court found he caused Key Carpets to transfer funds to the business. The payments, the court said, therefore provided a personal benefit to Johnson and Clean Hands and were constructive dividends.

For a discussion of constructive dividends, see Parker Tax ¶44,120.

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IRS Provides Transition Relief Regarding PATH Act Changes to the Work Opportunity Tax Credit

The IRS has issued guidance and transition relief for employers claiming the work opportunity tax credit (WOTC), as extended and expanded by the Protecting Americans from Tax Hikes (PATH) Act. Notice 2016-22.

Background

The work opportunity tax credit (WOTC) under Code Sec. 51(a) provides a credit to employers based on a percentage of qualified wages paid during the taxable year. Generally, the amount of the WOTC is equal to 40 percent of the qualified first-year wages of members of a targeted group of employees who worked 400 or more hours during the year for the employer. Code Sec. 51(d)(1) lists the targeted groups, which include qualified supplemental nutrition assistance program (SNAP) benefit recipients, qualified veterans, and qualified ex-felons.

PATH extended the WOTC through December 31, 2019 for taxable employers that hire members of a targeted group and for qualified tax-exempt organizations that hire qualified veterans. PATH also amended Code Sec. 51(d)(1) to add qualified long-term unemployment recipients to the list of targeted groups, effective as of January 1, 2016.

Under Code Sec. 51(d)(13)(A), an individual is not treated as a member of a targeted group unless:

(1) on or before the day the individual begins work, the employer obtains certification from the designated local agency that the individual is a member of a targeted group; or

(2) the employer completes a pre-screening notice on or before the day the individual is offered employment and submits such notice to the designated local agency to request certification not later than 28 days after the individual begins work.

To request certification, an employer submits IRS Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, to the designated local agency no later than the 28th day after the day an individual who is a member of a targeted group begins work for the employer. An employer also must submit a Department of Labor Employment and Training Administration Form 9061, Individual Characteristics Form, or Form 9062, Conditional Certification.

Transition Relief Provided for Submitting Pre-Screening Notices

Because PATH extended the WOTC retroactively for 2015 for members of targeted groups, and because PATH created a new targeted group (qualified long-term unemployment recipients), the IRS noted that employers will need additional time to comply with the pre-screening notice requirements in Code Sec. 51(d)(13)(A)(ii) for those targeted groups.

Accordingly, Notice 2016-22 provides that an employer that hired or hires a member of a targeted group, including a long-term unemployment recipient, who began or begins work for that employer on or after January 1, 2015, and on or before May 31, 2016, will be considered to have satisfied the pre-screening notice requirements if the employer submits the completed Form 8850 to the designated local agency to request certification no later than June 29, 2016.

An employer that hires a member of a targeted group, including a long-term unemployment recipient, who begins work for that employer on or after June 1, 2016, is not eligible for the transition relief described in Notice 2016-22 with respect to any such new hire.

For purposes of the transition relief in Notice 2016-22, a qualified long-term unemployment recipient is any individual who, on the day before the individual begins work for the employer (or the day the individual completes the IRS Form 8850 as a prescreening notice, if earlier), is in a period of unemployment that is:

(1) not less than 27 consecutive weeks, and,

(2) includes a period in which the individual received unemployment compensation under state or federal law.

The IRS noted that PATH's amendment and expansion of the targeted groups in Code Sec. 51 to include long-term unemployment recipients will require changes to the forms used by employers to request certification for such individuals hired on or after January 1, 2016. Accordingly, the IRS stated that Form 8850 and Department of Labor Employment and Training Administration Forms 9061 and 9062 are being modified consistent with the guidance in Notice 2016-22.

For a discussion of the work opportunity tax credit, see Parker Tax ¶104,500.

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Amount Received for Gift Cards Redeemable for Goods and Non-Integral Services Are Eligible for Deferral

A company can defer for up to two years, the recognition of advance payment income received from the sale of unredeemed gift cards that are redeemable for goods or non-integral services by applying allocation rules similar to those described in Reg. Sec. 1.451-5(a)(3). TAM 201610017.

Special rules exist for the tax treatment of advanced payments. Under Reg. Sec. 1.451-5(a), an advance payment is defined to include any amount received in a tax year pursuant to, and to be applied against, an agreement for the sale or other disposition in a future tax year of goods held by a taxpayer primarily for sale to customers.

Amounts received for the sale of gift cards are often treated as advance payments. If amounts received for gift card sales are not considered advance payments under the regulations, then such amounts are includible in gross income in the tax year of receipt. Accrual method taxpayers are entitled to a limited deferral for advance payments received for the sale of goods. In such cases, a taxpayer may defer recognition of this income until the tax year that the payments are recognized in revenues under the taxpayer's method of accounting for financial reporting purposes. However, under Reg. Sec. 1.451-1(c), such taxpayers generally may not defer advance payments for inventoriable goods beyond the end of the second tax year following the year the taxpayer receives substantial advance payments.

In TAM 201610017, the IRS National Office (IRS) was asked whether a company could defer for up to two years, under Reg. Sec. 1.451-5, the recognition of advance payment income received from the sale of unredeemed gift cards that may, at the customer's discretion, be redeemed for goods or services.

The IRS advised that income from the unredeemed gift cards can be deferred to the extent the company can make an appropriate estimate of the amounts that are deferrable. In making such estimate, the IRS said that the company should use an allocation method similar to that in Reg. Sec. 1.451-5(a)(3). That regulation provides that if a taxpayer receives an amount pursuant to an agreement that not only obligates the taxpayer to provide goods, but also obligates the taxpayer to perform non-integral services, such amount will be treated as an advance payment only to the extent it is properly allocable to the obligation to provide goods. If the amount not so allocable is less than 5 percent of the total contract price, the amount is treated as allocable to the obligation to provide goods if such treatment does not result in delaying the time at which the taxpayer would otherwise accrue the amounts attributable to such activities (i.e., a de minimis rule).

As the IRS noted, Reg. Sec. 1.451-5(a)(3) is written in the present tense and contemplates a taxpayer receiving an amount pursuant to an agreement to provide goods in the future where a proper allocation can be made in the tax year in which the advance payment is received. Thus, it applies to agreements with specific terms that provide a basis for a proper allocation. In the instant case, the IRS observed, the company's gift cards leave to the discretion of the customer the choice of what items the gift card will be redeemed for and preserves for the customer that discretion until the time when the gift card is redeemed. Until a gift card is redeemed, the company cannot know whether it will be redeemed for services and other items that are not integral to a sale of goods by the company.

Such items, the IRS said, may or may not be de minimis in amount and thus, may or may not be properly allocable to a sale of goods under the rules of Reg. Sec. 1.451-5(a)(3), if applicable. If not integral or properly allocable to the sale of goods, such items cannot be considered "goods" within the meaning of Reg. Sec. 1.451-5(a) (an exception to the general rule of income recognition) and should, the IRS said, be narrowly interpreted. Thus, the IRS stated, for a gift card outstanding at the end of the tax year in which it is purchased, an amount cannot be properly allocated to the provision of goods under the language of Reg. Sec. 1.451-5(a)(3) because what the card will be redeemed for is unknown.

In addition, the IRS stated, the inclusion in Reg. Sec. 1.451-5(a)(2)(i), that gift cards "can" be redeemed for goods may only be given effect by inferring a process similar to Reg. Sec. 1.451-5(a)(3): treating the totality of the company's outstanding gift cards at the end of the tax year of their sale as if they represented a single agreement, and then estimating amounts properly allocable to the sale of goods, integral services, and the amount not so allocable for these gift cards that represent a future sale. Accordingly, the IRS stated that gift cards that can be redeemed for goods and non-integral services are eligible to apply allocation rules similar to those described in Reg. Sec. 1.451-5(a)(3) by treating the total of the company's outstanding gift cards at the end of the tax year of their sale as a single agreement and allowing estimates to be used for the application of Reg. Sec. 1.451-5(a)(3). The IRS concluded that, by applying this approach to company's gift cards, the company is eligible to defer amounts received for its gift cards to the extent it can make an appropriate estimate of the amounts that are deferrable under Reg. Sec. 1.451-5.

For a discussion of the tax rules for reporting advance payments for goods and services, see Parker Tax ¶241,520.

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IRS Entitled to Use Mitigation Provisions to Extend Statute of Limitations

The IRS satisfied all requirements and conditions of the mitigation provisions and thus the statute of limitations for making tax assessments on co-trustees of a trust was extended by one year from the date on which made a determination to accept a refund claim of the trust was made by the IRS. Costello v. Comm'r, T.C. Memo. 2016-33.

Background

In 1998, after their father's death, Sally Costello and her brother became co-trustees of the James V. Costello 1993 Trust (JVC Trust), a trust established by their father. In 2001, John Hancock Funds, which was the custodian of several individual retirement accounts owned by the trust, made distributions totaling approximately $228,000 (JH distributions) to JVC Trust through Costello and her brother. From those JH distributions, JVC Trust made two distributions of approximately $114,000 to Costello and her brother in 2001.

JVC Trust timely filed Form 1041, U.S. Income Tax Return for Estates and Trusts, for its 2001 tax year. It reported the JH distributions as income of approximately $228,000 and also reported a related income distribution deduction of slightly more than $228,000 that essentially caused it to have negative taxable income and no tax due. It also reported on Schedules K-1, Beneficiary's Share of Income Deductions, Credits, etc., that Costello and her brother each received income of approximately $114,000 in 2001. Costello and her brother each timely filed a 2001 Form 1040 reporting trust income of approximately $114,000.

In 2004, the IRS audited JVC Trust's 2001 tax return. Costello signed Form 872, Consent to Extend the Time to Assess Tax, and extended the statute of limitations for assessment for JVC Trust's 2001 tax year to April 15, 2006. The IRS auditor determined that the JH distributions were taxable at the trust level; thus he disallowed the related income distribution deduction and determined a deficiency of approximately $80,000 for JVC Trust. On January 21, 2005, Costello, as a trustee, signed Form 4549, Income Tax Examination Changes, thus agreeing with the determination and waiving JVC Trust's right to appeal the determination.

The IRS auditor also adjusted Costello and her brother's 2001 returns by subtracting the JVC Trust distributions from their gross incomes. These adjustments resulted in tax abatements of approximately $41,000. In January 2005, Costello and her brother signed Forms 4549 agreeing with these changes to their 2001 returns. Around that time, Costello sent a check for approximately $39,000 to the IRS as payment towards JVC Trust's 2001 tax liability. She wrote that check from her personal account. The IRS, on March 21, 2005, issued refunds to Costello and her brother on the bases of their 2001 tax abatements plus interest. Costello then used these refunds to pay the balance of JVC Trust's tax liability.

In November of 2006, Costello executed an amended Form 1041 on behalf of JVC Trust, claiming a refund for its 2001 tax year. The amended return was prepared by an attorney and reversed the determinations made during the IRS audit by once again claiming the income distribution deduction related to the JH distributions. By letter dated August 8, 2008, the IRS made a determination to accept JVC Trust's refund claim of approximately $80,000. The IRS sent to Costello and her brother a notice of deficiency, dated September 2, 2008, with respect to each of their 2001 tax returns. The notices explained that their gross incomes had been adjusted to once again include the approximately $114,000 JVC Trust distributions.

On August 11, 2009, the IRS issued a refund check (including interest) for approximately $124,000 to JVC Trust. Costello, as a trustee, endorsed and deposited the check on November 12, 2009. Costello and her brother argued that, because the statute of limitations had expired with respect to their 2001 tax returns, the IRS could not make an assessment against them for that year.

Analysis

The main issue before the Tax Court was whether the mitigation provisions of Code Sec. 1311 through Code Sec. 1314 allowed the IRS to adjust Costello and her brother's 2001 tax returns in 2008, more than six years after the returns were filed. The court noted that while there are potential extensions and exceptions to the general statute of limitations period, none applied in the instant case. Thus, the IRS was barred from assessing tax for 2001 unless the mitigation provisions of Code Sec. 1311 through Code Sec. 1314 applied.

The following requirements must be met for the mitigation provisions to apply:  

(1) there must have been a "determination" as defined in Code Sec. 1313(a);  

(2) that determination caused one of the errors described in Code Sec. 1312; and  

(3) on the date of that determination, any adjustment to correct the error is barred by operation of law (other than a Code Sec. 7122 compromise or the mitigation provisions).

The Tax Court held that the mitigation provisions applied because (1) the IRS issued a determination regarding JVC Trust's claim for refund, which satisfied Code Sec. 1313(a)(3)(A); (2) the IRS determination accepted the claim for refund of JVC Trust, the correlating inclusion of taxable income had been erroneously excluded by Costello and her brother as described in Code Sec. 1312(5); (3) the 2001 returns of Costello and her brother, as of August 8, 2008, could not be adjusted by operation of law; (4) JVC Trust maintained a position adopted by the IRS determination and that position was inconsistent with the erroneous exclusions of Costello and her brother's 2001 returns as modified; and (5) Costello and her brother, as beneficiaries, were related to JVC Trust in 2001, the year of the error, and in 2006 when JVC Trust first maintained its inconsistent position.

The court concluded that the IRS satisfied all requirements and conditions of the mitigation provisions, and the period of limitations for assessment was thus extended up to one year from August 8, 2008, the date of the final determination. Consequently, the notices of deficiency that the IRS sent to Costello and her brother on September 2, 2008, were timely, and the 2001 tax years were reopened for the limited purpose of correcting the Code Sec. 1312(5) error.

The court said it appeared that Costello and her brother were advocating that where the IRS caused an error to come about, then the mitigation provisions should not be made available to it. However, the court noted, the mitigation provisions equally apply to whoever made the mistake, and the IRS is entitled to correction of an error, if merited.

For a discussion of the mitigation provisions, see Parker Tax ¶260,140.

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Final Regulations Address Awards of Litigation Costs and Attorney's Fees

The IRS has finalized regulations relating to awards of administrative and litigation costs, including attorneys' fees. The final regulations make changes to the net worth limitation and address fee awards where a taxpayer is represented on a pro bono basis. T.D. 9756 (3/1/16).

Background

Code Sec. 7430 generally authorizes a court to award administrative and litigation costs, including attorneys' fees, to a prevailing party in an administrative or court proceeding brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty. To qualify as a "prevailing party" a taxpayer must substantially prevail as to the amount in controversy or the most significant issue in the proceeding, exhaust administrative remedies, meet net worth and size limitations, and pay or incur the costs. The taxpayer generally cannot qualify for an award of costs if the government establishes that its position was substantially justified.

The Taxpayer Relief Act (TRA) of 1997 (Pub. L. 105-34, 8/5/97), and the IRS Restructuring and Reform (RRA) Act of 1998 (Pub. L. 105-206, 7/22/98), contained several amendments to Code Sec. 7430 that were incorporated in proposed regulations issued as REG-111833-99 (11/25/09).

Final regulations issued as T.D. 9756 (3/1/16) adopt, with changes, the proposed regulations. Specifically, the final regulations address the calculation of net worth for the purposes of the limitation, and discuss the award of reasonable attorneys' fees when an individual is representing a party on a pro bono basis.

Additional procedural guidance on the recovery of attorney's fees by individuals who provide pro bono representation, including the rate of compensation for such individuals, has been issued in Rev. Proc. 2016-17 (3/1/16).

The final regulations generally apply to costs incurred and services performed in cases in which the petition was filed after February 29, 2016, but taxpayers may rely on the changes for costs related to petitions filed before March 1, 2016.

Net Worth Limitation

For purposes of the net worth limitations in Code Sec. 7430(d)(4)(A) with regards to joint filers, the proposed regulations noted that the net worth of taxpayers who filed joint returns should be calculated separately.

The final regulations explain how this separate calculation will be conducted in two situations:

(1) When taxpayers who file joint returns jointly petition the court and incur joint costs, each taxpayer qualifies for a separate net worth limitation of $2 million, but the limitation will be evaluated jointly. In this situation, taxpayers will meet the net worth limitation so long as their combined assets are equal to or less than $4 million, regardless of how the assets are distributed.

(2)When taxpayers file a joint return, but petition the court separately and incur separate costs, the limitation will be evaluated separately. In this situation, each taxpayer will have his/her assets applied toward a separate $2 million cap for each spouse.

The final regulations do not adopt the rule in the proposed regulations that the net worth limitation is computed based on the fair market value of the taxpayer's assets. The IRS noted that existing case law generally recognizes that the net worth calculation is made based on the acquisition costs of the taxpayer's assets. Because the case law is clear and provides an existing standard for determining net worth, the IRS stated, the final regulations follow the case law.

Fee Awards Where Taxpayer is Represented Pro Bono

The proposed regulations provided that reasonable administrative costs could be awarded to attorneys for legal services provided on a pro bono basis if, in general, the services were provided to persons of limited financial means or to organizations operating primarily to address the needs of such persons. The IRS has determined that eligibility should not be limited based on the income or financial resources of the recipient beyond the limit provided by Code Sec. 7430(c)(4)(A)(ii). As a result, the final regs do not adopt the rule contained in the proposed regs.

An example in the proposed regulations stated that an award for representation by attorneys employed by a low income taxpayer clinic who do not have a customary hourly rate would be limited to the rate in Code Sec. 7430(c)(1)(B). After publishing the proposed regulations, the IRS determined that details such as the rate of compensation for pro bono attorneys who do not have a customary hourly rate would be better addressed in a revenue procedure. Accordingly, Rev. Proc. 2016-17 provides that pro bono attorneys who do not charge an hourly rate receive the statutory rate for their services unless they establish that a special factor applies to justify a higher hourly rate. The final regulations, therefore, do not contain the example in the proposed regulations.

The proposed regulations did not discuss issues relating to the award of attorneys' fees based on the work of volunteer law students. The IRS stated that awarding fees based on the work of volunteer students may be appropriate and noted that guidance on the issue is provided in Rev. Proc. 2016-17.

For a discussion of recovering litigation or administrative costs, see Parker Tax ¶ 263,540.

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IRS Issues Guidance on Recordkeeping and Rates for Awards of Pro Bono Attorneys' Fees

The IRS has issued guidance on the recovery of administrative and litigation costs by individuals who provide pro bono representation to taxpayers, supplementing final regulations issued as T.D. 9754 (3/1/16). Rev. Proc. 2016-17.

In general, Code Sec. 7430 provides for awards of reasonable administrative and litigation costs, including attorney's fees, incurred by taxpayers who substantially prevail in administrative or court proceedings brought by or against the United States in connection with the determination, collection, or refund of any tax, interest, or penalty. In such circumstances, Code Sec. 7430(c)(3)(B) provides that a court may award fees to an attorney in excess of the fees actually paid where the attorney is representing the prevailing party for no fee or a nominal fee (i.e., pro bono).

Final regulations issued as T.D. 9754 (3/1/16) adopt several amendments to Code Sec. 7430 made by the Taxpayer Relief Act (TRA) of 1997 (Pub. L. No. 105-34, 8/5/97) and the IRS Restructuring and Reform (RRA) Act of 1998 (Pub. L. No. 105-206, 7/22/98), and incorporated in proposed regulations issued as REG-111833-99 (11/25/09).

Rev. Proc. 2016-17 supplements the final regulations by providing additional information related to the recovery of administrative and litigation costs specific to pro bono representation.

Rev. Proc. 2016-17 provides that, to recover fees, a pro bono representative must maintain detailed contemporaneous activity records of all time spent on a case for which fees are being claimed. The records should be similar to billing records maintained by for-profit law firms for non-pro bono representation, and must show the work performed and the time allocated to each task. The records must include time spent by all individuals who provide representation to the taxpayer and must identify the individual's name and position.

Under Code Sec. 7430(c)(1)(B)(iii), attorney fees are limited to a maximum per-hour amount (the statutory hourly rate), which is adjusted for inflation. Rev. Proc. 2015-53 provides that, for fees incurred in calendar year 2016, the statutory hourly rate is $200 per hour.

For pro bono representatives who charge hourly rates, the rate for an attorney fee award is limited to the lesser of the statutory hourly rate or their hourly billing rate, unless they can establish that a special factor, such as the limited availability of qualified attorneys, the difficulty of the issues in the case, or the local availability of tax expertise, justifies a higher rate.

For pro bono representatives who do not charge hourly rates (such as employees of a clinic that provides pro bono services), Rev. Proc. 2016-17 provides for a fixed rate equal to the statutory hourly rate.

Rev. Proc. 2016-17 also provides that reasonable fees may be recovered for work performed by students who have been authorized to practice before the IRS or to practice before the Tax Court under the supervision of a practitioner, and by paralegals or other persons qualified to perform paralegal work who are assisting pro bono representatives. Rev. Proc. 2016-17 provides that a fixed rate equal to 35 percent of the statutory hourly rate applies for such representatives, unless a higher rate is proven to be appropriate.

In addition, Rev. Proc. 2016-17 provides that fees for time claimed for other volunteers (e.g., students or professionals who have not been authorized to practice before the IRS or the Tax Court or paralegal students) working at a pro bono clinic or organization may be recoverable on a case-by-case basis.

Under Rev. Proc. 2016-17, a fee award generally will be paid to the pro bono representative, unless the IRS is specifically instructed by the representative, in writing, to pay the fee to the representative's employer, such as a law firm. Fees awarded for services provided by an employee of a pro bono clinic or organization, or a student affiliated with a pro bono clinic or organization, generally will be paid to the clinic or organization.

For a discussion of recovering litigation or administrative costs, see Parker Tax ¶ 263,540.