Federal Tax Bulletin - Issue 98 - September 25, 2015

Taxpayers Can Reduce Value of Gift for Assumption of Section 2035(b) Estate Tax Liability

The Tax Court held that a donor's daughters' assumption of a potential Code Sec. 2035(b) estate tax liability as a condition of a gift could be factored into calculating the fair market value of the gifted property for purposes of the gift tax. The court noted the assumption was a detriment to the daughters and a benefit to the donor such as would be considered by a willing buyer and willing seller in determining a sale price of the transferred property rights. Steinberg v. Comm'r, 145 T.C. No. 7 (2015).

In Steinberg v. Comm'r, 141 T.C. No. 8 (2013) (Steinberg I), the Tax Court had previously determined that it would no longer follow its decision in McCord v. Comm'r, 120 T.C. 358 (2003), rev'd, 461 F.3d 614 (5th Cir. 2006), in which it held that a couple had improperly reduced their gross gift value by the actuarial value of the donees' obligation to pay potential estate taxes. In Steinberg I, the court held that a willing buyer and a willing seller in appropriate circumstances could consider the donee's assumption of the Code Sec. 2035(b) estate tax liability when determining a sale price. The Tax Court then had to decide whether a net gift agreement is such an appropriate circumstance.

In another victory for taxpayers, in Steinberg v. Comm'r, 145 T.C. No. 7 (2015), the court agreed that an appropriate circumstance arises when the donee's assumption of the Code Sec. 2035(b) estate tax liability is a detriment to the donee and is a benefit to the donor. Additionally, the court also concluded that the fact that the estate tax payment was contingent rather than certain did not preclude use of the Code Sec. 7520 rates in valuing such payment.

Background

Jean Steinberg entered into a binding gift agreement with her four daughters under which she gave them property. In exchange, the daughters agreed to assume and to pay any federal gift tax liability imposed as a result of the gifts. The daughters also agreed to assume and pay any federal or state estate tax liability imposed under Code Sec. 2035(b) as a result of the gifts in the event that Steinberg passed away within three years of the gifts. Under Code Sec. 2035(b), a decedent's gross estate is increased by the amount of any gift tax paid by the decedent or the decedent's estate on any gift made by the decedent during the three-year period preceding the decedent's death. The daughters' agreement to assume the federal or state estate tax liability resulted in the gift agreement being a net gift agreement. Steinberg lived through the three-year period.

To determine the fair market value of the property rights she transferred pursuant to the net gift agreement, Steinberg hired William Frazier, a qualified appraiser. Frazier concluded that the aggregate value of the net gift on the date it was made, April 17, 2007, was approximately $71,600,000 He determined that the present value of the net gifts was the fair market value of assets conveyed by transfer from Steinberg less the liabilities (tax or otherwise) assumed by her daughters. According to the valuation, the payment by the daughters of their share of the estate taxes was a contingent liability and the probability of this liability could be calculated. Steinberg also reduced the fair market value of the properties by an amount representing the value of the daughters' assumption of the Code Sec. 2035(b) estate tax liability.

The IRS disallowed the discount for the daughters' assumption of the Code Sec. 2035(b) estate tax liability. According to the IRS, Frazier's valuation analysis was flawed because it failed to consider contingencies such as Steinberg's health and general medical prognosis. The IRS also argued that the daughters' assumption of the Code Sec. 2035(b) estate tax liability in the net gift agreement did not create any new burden on the daughters or benefit for Steinberg because the daughters would have had to bear the burden of the Code Sec. 2035(b) estate tax liability either under New York law or as beneficiaries of Steinberg's residuary estate. The IRS also said that Frazier incorrectly applied Code Sec. 7520 rates as the discount factor in calculating the value of the daughters' assumption of the contingent estate tax liability. Specifically, the IRS contended that the Code Sec. 7520 rates were not applicable because they apply only to annuities, life interests, terms of years, remainders, and reversionary interests.

Issues

The issues before the Tax Court were:

(1) whether a donee's promise to pay any federal or state estate tax liability that may arise under Code Sec. 2035(b) if the donor dies within three years of the gift should be considered in determining the fair market value of the gift, and

(2) if so, the amount, if any, that the promise to pay reduces the fair market value of the gift.

Tax Court's Opinion

The Tax Court held that the daughters' assumption of a potential Code Sec. 2035(b) estate tax liability was a detriment to the daughters and a benefit to Steinberg similar to what would be considered by a willing buyer and willing seller in determining the sales price of transferred property rights. Thus, the court concluded that the daughters' promise to pay any federal or state estate tax liability that might arise under Code Sec. 2035(b) if Steinberg died within three years of the net gift agreement should be considered in determining the fair market value of the gift.

With respect to the IRS's argument that Frazier's valuation analysis was flawed because it failed to consider contingencies such as Steinberg's health and general medical prognosis, the court said that Frazier took the possibility of Steinberg's death within three years of executing the net gift agreement into account because the daughters' liability for the Code Sec. 2035(b) estate tax was contingent on that possibility. And, the court noted, Frazier used the IRS's own mortality tables, which necessarily take some account of a person's health and general medical prognosis when arriving at a probability of death, to do so.

The court disagreed with the IRS's assertion that the net gift agreement duplicated New York law. The court noted that the IRS's argument was based on a New York State statute entitled "Apportionment of federal and state estate or other death taxes; fiduciary to collect taxes from property taxed and transferees thereof" and that the statute provided that a fiduciary may be required to pay estate tax with respect to any property required to be included in the gross estate unless the testator otherwise directs in his or her will that an amount of the tax will be equitably apportioned among the persons interested in the gross estate to whom property is disposed of. In such case, the court noted, those benefited must contribute the amounts apportioned against them. At the time of the gifts at issue, the Tax Court said, it was not possible to determine whether the N.Y. statute would apply to this case. When the gifts were made on April 17, 2007, the court observed, Steinberg was still alive and entirely capable of changing her domicile before her death. Thus, the court said, there was the possibility that the law of a state other than New York would apply to Steinberg's estate.

The court also noted that, at the time of the gifts, it was not possible to determine the provisions of Steinberg's will that would exist at the time of her death. As matter of law, Steinberg was entitled to change the provisions of her will before her death. At the time Steinberg and her daughters signed the net gift agreement, the court observed, there was no guaranty that the daughters would remain beneficiaries under Steinberg's residuary estate. The court therefore concluded that, because on the date of the gifts it was not certain that the law of New York or any other state would require the donees to pay ratable shares of the estate tax that might be incurred under Code Sec. 2035(b) on the gift tax paid with respect to the gifts, the provision of the net gift agreement that required the daughters to pay those shares of estate tax was not duplicative or illusionary.

Finally, with respect to the use of the Code Sec. 7520 rates to value the gift, the court concluded that the fact that the payment was contingent rather than certain did not preclude use of the Code Sec. 7520 rates. The IRS, the court said, had not persuaded it that there was a more appropriate method that should have been used. Thus, the valuation by Frazier was proper.

For a discussion of the effect a donee's assumption of estate or gift tax liability has on the fair market value of a gift, see Parker Tax ¶ 222,765.

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Late Filings by Individual Partners Preclude Abatement of Penalty for Late Form 1065

Where some partners did not timely file their personal income tax returns, a partnership did not qualify for the reasonable cause exception to the Code Sec. 6698 penalty for late filing of the partnership tax return. The court held that Rev. Proc. 84-35 reasonably interpreted this exception as requiring all partners to timely file their personal returns. Battle Flat, LLC v. U.S., 2015 PTC 340 (D. S.D. 2015).

Battle Flat, LLC, is a partnership with 10 or fewer partners (small partnership) that was assessed a penalty under Code Sec. 6698 for late filing of its Form 1065 for tax years 2007 and 2008. The IRS had previously abated a Code Sec. 6698 penalty against Battle Flat in 2006. When the IRS refused to abate the penalty for 2007 and 2008, the partnership took its case to a district court. Battle Flat and the IRS disputed the amount of deference, if any, owed to Rev. Proc. 84-35, which sets forth the procedures under which small partnerships will not be subject to the penalty imposed by Code Sec. 6698 for failure to timely file a partnership return.

Observation: Battle Flat received an abatement of a late filing penalty for 2006, even though the LLC apparently did not meet the requirements of Rev. Proc. 84-35. In its correspondence with the taxpayer, the IRS stated that the abatement was based solely on the partnership's compliance history, and that the type of penalty relief granted was a one-time consideration available only for a first-time penalty.

Practice Aid: See Parker ¶ 320,430 for a sample letter requesting abatement of the Code Sec. 6698 late filing penalty under the provisions of Rev. Proc. 84-35.

Under Code Sec. 6698(a), the IRS can assess penalties for each month (or fraction thereof) against a partnership for failing to file a partnership tax return, Form 1065, on or before the filing deadline. The penalty provisions do not apply if the partnership's failure to timely file its tax return is due to reasonable cause. The term "reasonable cause" is not defined in the statute. Instead, the taxpayer bears the burden of proving it meets the reasonable cause exception.

Rev. Proc. 84-35 provides that a domestic partnership composed of 10 or fewer partners will generally be considered to have met the reasonable cause test and will not be subject to the penalty imposed by Code Sec. 6698 for the failure to file a complete or timely partnership return, provided that the partnership, or any of the partners, establishes, if so requested by the IRS, that all partners have fully reported their shares of the income, deductions, and credits of the partnership on their timely filed income tax returns.

Not all Battle Flat partners timely filed their income tax returns in 2007 and 2008. For the 2007 tax year, six partners of Battle Flat failed to timely file their personal income tax returns. For the 2008 tax year, three Battle Flat partners failed to timely file their personal income tax returns. Battle Flat requested that the court not enforce Rev. Proc. 84-35, arguing that reasonable cause exception is satisfied so long as all the partners in a small partnership file their personal income tax returns, timely or otherwise.

The district court found Battle Flat's interpretation of the exception to be unreasonable, siding with the IRS. The court noted that neither Code Sec. 6698 nor its legislative history explicitly impose a requirement that the individual partners timely file his or her individual income tax returns in order for the partnership to qualify for the reasonable cause exception and thereby be exempt from the penalty provisions of Code Sec. 6698. Only Rev. Proc. 84-35 imposes the requirement that the partners timely file his or her individual tax returns, and the court found that requirement to be a reasonable interpretation of the penalty exception. The court noted that the IRS has consistently held the position that the reasonable cause exception to Code Sec. 6698 requires all partners in a small partnership to timely file their individual personal income tax returns, and enforced Rev. Proc. 84-35.

The district court also noted that the Eighth Circuit, to which the district court's decision would be appealable, has not explicitly addressed the level of deference owed to an IRS revenue procedure. The court looked to various Supreme Court decisions and concluded that deference should be given to Rev. Proc. 84-35.

For a discussion of the late filing penalty under Code Sec. 6698, see Parker Tax ¶28,550.

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Guidance Addresses Retroactive Application of Bonus Depreciation Extended by TIPA

The IRS has issued guidance on how fiscal year taxpayers can retroactively elect to take the 50-percent bonus depreciation deduction for qualified property placed in service during the 2014 portion of fiscal years beginning in 2013. The guidance, which additionally addresses carrying over disallowed Code Sec. 179 deductions for qualified real property, also applies to calendar year taxpayers with short tax years in 2014. Rev. Proc. 2015-48.

Rev. Proc. 2015-48 applies to taxpayers who filed their 2013 returns (or 2014 short year returns) before enactment of the tax extenders bill on December 19, 2014.

Prior to amendment by the Tax Increase Prevention Act of 2014 (TIPA), Code Sec. 168(k)(1) allowed a 50-percent additional first year depreciation deduction for qualified property acquired by a taxpayer by December 31, 2013. TIPA extended the placed-in-service date to December 31, 2014 (December 31, 2015 in the case of certain property).

Retroactive Application of 50-Percent Additional First Year Depreciation Deduction

If, on its return for its tax year beginning in 2013 and ending in 2014 (2013 tax year) or its tax year of less than 12 months beginning and ending in 2014 (2014 short tax year) a taxpayer did not deduct the 50-percent additional first year depreciation (bonus depreciation), and did not make an affirmative election not to deduct the bonus depreciation, the taxpayer may claim the bonus depreciation by filing either:

(1) An amended federal tax return for the 2013 tax year or the 2014 short tax year before the taxpayer files its federal tax return for the first tax year succeeding the 2013 tax year or the 2014 short tax year; or

(2) A Form 3115, Application for Change in Accounting Method, with the taxpayer's tax return for the first or second tax year succeeding the 2013 tax year or the 2014 short tax year if the taxpayer owns the property as of the first day of the year of change.

If, on its tax return for the 2013 tax year or the 2014 short tax year a taxpayer made an affirmative election to not deduct the bonus depreciation, the taxpayer may revoke that election provided the taxpayer files an amended return for the 2013 tax year or the 2014 short tax year in a manner that is consistent with the revocation of the election and by the later of (1) December 4, 2015, or (2) before the taxpayer files its return for the first tax year succeeding the 2013 tax year or the 2014 short tax year.

If the taxpayer makes the retroactive election for its 2013 tax year, the election applies to both 2013 qualified property and 2014 qualified property in the same class of property for which the election is made. If the taxpayer makes the retroactive election for its 2014 short tax year, the election applies to 2014 qualified property in the same class of property for which the election is made.

Carryover of 2010, 2011, 2012, or 2013 Disallowed Code Section 179 Deduction for Qualified Real Property

Code Sec. 179(a) allows a taxpayer to elect to treat the cost (or a portion of the cost), subject to a dollar limitation, of any Code Sec. 179 property as an expense for the tax year in which the taxpayer places the property in service. Under Code Sec. 179(f), a taxpayer may elect to treat qualified real property as Code Sec. 179 property.

Prior to amendment by TIPA, Code Sec. 179(f)(4) provided that a taxpayer that elected to apply Code Sec. 179(f) and elected to expense under Code Sec. 179(a) the cost (or a portion of the cost) of qualified real property placed in service during any tax year beginning in 2010, 2011, 2012, or 2013 could not carryover to any tax year beginning after 2013 the amount that was disallowed as a Code Sec. 179 deduction under the tax income limitation of Code Sec. 179(b)(3)(A) (disallowed Code Sec. 179 deduction). Such amounts were required to be treated as an amount for which the Code Sec. 179 election was not made and as property placed in service on the first day of the taxpayer's last tax year beginning in 2013 for purposes of computing depreciation.

A taxpayer that treated the amount of a disallowed Code Sec. 179 deduction as property placed in service on the first day of the taxpayer's last tax year beginning in 2013 may either (1) continue that treatment, or (2) if the period of limitations for assessment under Code Sec. 6501(a) is open, amend its return for the last tax year beginning in 2013 to carryover the disallowed Code Sec. 179 deduction to any tax year beginning in 2014.

The amended return for the taxpayer's last tax year beginning in 2013 must include any collateral adjustments to tax income or the tax liability (for example, the amount of depreciation allowed or allowable in the last tax year beginning in 2013 for the amount of the disallowed Code Sec. 179 deduction). Such collateral adjustments must also be made on amended returns for any affected succeeding tax years.

Round 4 Extension Property

Under Code Sec. 168(k)(4), corporations and certain automotive partnerships can elect for their first tax year ending after March 31, 2008, to accelerate pre-2006 unused research credits or minimum tax credits in lieu of claiming the bonus depreciation allowance. Generally, this election applies to eligible qualified property acquired after March 31, 2008, and placed in service before January 1, 2015.

Rev. Proc. 2015-48 provides guidance on the time and manner for making an election to apply, or to not apply, Code Sec. 168(k)(4) to "round 4 extension property" (i.e. property that is eligible qualified property solely by reason of the extension of Code Sec. 168(k)(2) by TIPA).

For a discussion of the bonus depreciation, see Parker Tax ¶ 94,200.

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No Fraud Found Where IRS and Taxpayer's CPA Turned Their Heads on Improper Inventory Reporting

The IRS did not prove fraud by clear and convincing evidence for purposes of extending the statute of limitations. As a result, a company that had improperly reported its inventory escaped liability for over $13 million in taxes and penalties. Transupport, Inc. v. Comm'r, T.C. Memo. 2015-179.

Background

Harold Foote founded Transupport, Inc. in 1972. During the years in issue, Foote and his four sons were the company's only full-time employees and officers. Transupport is a supplier and surplus dealer of aircraft engines and engine parts for use in military vehicles. It primarily purchased surplus parts from the government in bulk lots that contained parts having little value as well as parts that Transupport wanted for its business. The company bought the lots to acquire items that it expected to sell but ended up with items that would not be sold. The costs of particular items were not specified as part of the purchase transactions.

The company was also a distributor of parts. Distributorship purchases were of specific parts, and the individual item costs were traceable. The purchased distributorship items were susceptible to accurate inventory accounting, and some computer records were kept in later years, but an accurate inventory was never made part of Transupport, Inc.'s financial and tax reporting.

In the 1970s, Transupport hired Elaine Thompson as its accountant and she served as the company's accountant until she died in 2010. She was a CPA and a name partner in her firm. Transupport provided to Thompson handwritten summaries, usually prepared by one of Foote's sons. Thompson, through her accounting firm, prepared compiled financial statements for Transupport for 1990 through 2008. The compiled financial statements were based upon the summaries and upon financial information maintained by Transupport. The financial statements were not audited by Thompson or her firm, and the information on the summaries was never verified by Thompson or her firm.

Thompson prepared Transupport's Forms 1120 using the same financial information provided by Transupport in connection with the preparation of the company's compiled financial statements. Costs of goods sold reported as percentages of purchases ranged from 91 percent for 2008 to over 100 percent for 1999, 2002, 2004, and 2005.

IRS Audits

The IRS audited Transupport's Forms 1120 for 1982, 1983, 1988, 1989, and 1990. The IRS was aware that Transupport did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory, reported in its returns, by using a percentage of sales as costs of goods sold. The examining agent accepted Transupport's representation that, on the basis of Foote's experience in selling the surplus items, Transupport had averaged approximately a 30 percent gross profit margin. Although the examining agents in each audit informed Foote or Thompson that Transupport should maintain a physical inventory, the costs of goods sold were adjusted only to reflect a minor change in the purchases that Transupport made in 1983.

In connection with a potential sale of Transupport in 2007, Foote hired Richard Lodigiani and provided him with estimates of inventory and profit margins on surplus parts. Based on conversations with Foote, Lodigiani prepared a confidential offering memorandum. Included in the memorandum was a document entitled "Recast Financial Summary," in which the profits of Transupport's operations as reported on its financial statement and tax returns were substantially improved.

Foote also provided prospective purchasers with information about engines in inventory in 2007. By any measure, Transupport's inventory at cost or market value in 2007 far exceeded the inventory values reported on its correlating financial statements and tax return. Copies of the documents prepared by Lodigiani were provided to prospective purchasers, including Peter LaHaise. During his conversations with prospective purchasers, Foote never disavowed the information set forth in the Lodigiani documents.

In 2009, the IRS audited Transupport's returns for 2006 and 2007. The audit was conducted by Revenue Agent Robert Canale. By early October 2009, the audit was expanded to include 1999 through 2005. The IRS subsequently issued notices of deficiency in which Transupport's costs of goods sold were adjusted to reflect a 25 percent cost and a 75 percent profit on its sales of surplus parts. Compensation to Transupport's officers other than Foote were reduced to reflect a reasonable allowance for their compensation. The notices also determined that all or part of the underpayments of tax were due to fraud or, to the extent that the fraud penalty did not apply, that an accuracy-related penalty under Code Sec. 6662(a) applied. Additional tax and penalties assessed for 1999 through 2008 totaled over $20 million. The determinations were made on the basis of the admissions in the documents prepared by Lodigiani and statements made to Canale by Foote. Of the 10 years at issue, the statute of limitations barred assessments for seven of those years, absent proof of fraud. Taxes and penalties assessed for those seven years totaled more than $13 million.

Analysis

The Tax Court held that the IRS did not prove fraud by clear and convincing evidence for purposes of extending the statute of limitations and, thus, the IRS assessments for years 1999 through 2005 were barred.

The admissions made in Transupport's promotional materials established, the court said, that the company's officers and shareholders knew that the ending inventory was substantially undervalued. Those materials, the court noted, openly asserted that the accounting method used allowed current write-offs of purchases during the year, and they boasted of a gross profit percentage far in excess of that reported on Transupport's tax returns. However, the court noted, those claims were not concealed. Transupport's methodology had been used for years notwithstanding two prior audits and Transupport's use of a well-qualified accountant who knew or should have known that Transupport did not keep physical inventories. The court was not persuaded, however, that the clear and convincing evidence of underpayments also established fraudulent intent.

The court noted that the actions or inactions of Transupport's accountants and the IRS auditors included no clear warnings to Transupport that its conduct was illegal or fraudulent. According to the court, to the extent that none of these professionals undertook the task of determining Transupport's correct income, they were complicit in the duration of the improper reporting. As a result, the court concluded that fraud had not been established and assessments for 1999 through 2005 were barred.

Observation: The case ended up before the court only because the IRS's acquiescence in Transupport's methodology ended when a whistleblower saw an opportunity for an informant's reward.

For a discussion of situations in which there is no statute of limitations, see Parker Tax ¶260,130.

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Fifth Circuit Agrees That Custom Homebuilder Must Capitalize CEO's Salary

A custom homebuilder was subject to the uniform capitalization rules and the salary of the president and CEO was also subject to capitalization because a substantial amount of his time and activities directly benefitted, or were incurred by reason of, production activities. Frontier Custom Builders, Inc. v. Comm'r, 2015 PTC 334 (5th Cir. 2015).

Frontier Custom Builders (Frontier) is a custom homebuilder that uses subcontractors for the physical home construction of its custom homes. It did not capitalize many of the costs it incurred in building its custom homes in 2005 but rather deducted those costs. According to Frontier, custom homebuilding is different from speculative homebuilding and this difference kept its custom homebuilding activities out of the reach of the uniform capitalization (UNICAP) rules of Code Sec. 263A.

The Tax Court held that Frontier's use of subcontractors for the physical home construction was not enough to exempt Frontier from capitalizing costs under the UNICAP rules. The creative design of custom homes, the court stated, is ancillary to the actual physical work on the land and was as much a part of a development project as digging a foundation or completing a structure's frame. Therefore, the court rejected Frontier's argument and found Frontier to be a producer of real property subject to Code Sec. 263A. As a result, the court held that Frontier had to capitalize all direct and certain indirect costs of production; capitalize a portion of the cost of its officer's compensation; capitalize a portion of the cost of its nonofficer employees' compensation; and capitalize a portion of its other expenses incurred. Frontier appealed.

On appeal, Frontier argued that it was exempt from the requirements in Code Sec. 263A because its primary business during the year at issue was sales and marketing, not production-related services. Frontier also argued that any production-related costs incurred by its subcontractors were not attributable to Frontier for purposes of Code Sec. 263A. In addition, Frontier contended that even if it was subject to Code Sec. 263A, the compensation of its president and CEO, Wayne Bopp, should not be capitalized because his work related to overall management, overall company policy, general financial accounting, strategic business planning, and marketing, selling, or advertising.

The Fifth Circuit agreed with the Tax Court's decision that most of the amounts deducted by Frontier in 2005 were capitalizable service costs. With respect to the issue of Bopp's salary, the court reasoned that, although many of Bopp's hours were spent managing the company, the record reflected that a substantial portion of Bopp's activities directly benefitted, or were incurred by reason of, production.

Some of his activities, the court noted, included: designing homes that were later produced; creating the processes and procedures for building homes; selecting developers and reviewing subcontractors; resolving issues that arose at worksites during production; selecting and installing the home design software; meeting weekly with project managers to stay apprised of production timelines; and evaluating project managers' productivity reports. These activities were sufficient, the court concluded, to support the capitalization of Bopp's compensation.

For a discussion of the costs that must be capitalized under the UNICAP rules, see Parker Tax ¶242,425.

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Taxpayer's Debt Was Discharged Years Earlier than Form 1099-C Indicated

A taxpayer was not liable for cancellation of debt income in 2011 where the IRS failed to provide any evidence of any significant, bona fide activity that would indicate an active creditor, and thus failed to rebut the presumption that an identifiable event discharging the taxpayer's debt occurred in 2008. Clark v. Comm'r, T.C. Memo. 2015-175.

Background

In December 1999, Patricia Clark entered into a retail installment contract with an automobile dealership to purchase a used 1996 vehicle for $13,547. Clark made a down payment of $1,000 and financed the remaining $12,547. The contract required 60 monthly payments over five years starting January 21, 2000.

The contract also provided that, if the dealership repossessed the vehicle, it could sell the vehicle and apply the proceeds received to what buyer owed. Further, if the dealership repossessed or accepted the voluntary surrender of the vehicle and the original price was $500 or more, and the balance remaining unpaid at the time of default was $300 or more, the buyer would be liable for any deficiency incurred as a result of the sale or disposition of the vehicle and the dealership would have the right to a deficiency judgment.

By 2005, Clark had defaulted on the contract and the vehicle was repossessed in March of that year and sold for $1,300 at an auction in June. The proceeds from the auction were applied to her account in June. However, Clark still owed almost $4,800 on the contract and $740 for collection expenses and late fees. The dealership sent Clark a letter in June 2005, notifying her of the remaining amount owed and requesting that she make contact about payment before the dealership resorted to debt recovery. The dealership assigned Clark's debt to five separate third-party debt collectors. It subsequently wrote off the debt, determined Clark's charge off balance to be approximately $4,600, and reported on Form 1099-C, Cancellation of Debt, that Clark had COD income that was discharged in August 2011. The Form 1099-C indicated that Clark was personally liable for the repayment of the debt.

Clark disputed the cancellation of debt (COD) income. Based upon her understanding of the instructions for Form 1099-C, Clark argued that the debt should not have been deemed canceled in 2011 with the filing of Form 1099-C. Instead, she asserted, the cancellation actually occurred when the dealership failed to receive payment on the debt over a 36-month period that ended December 2008.

Analysis

The Tax Court held that Clark did not have COD income in 2011. The court cited its decision in Cozzi v. Comm'r, 88 T.C. 435 (1987), in which it concluded that (1) the moment it becomes clear that a debt will never have to be paid, the debt must be viewed as having been discharged, and (2) the test for determining such moment requires a practical assessment of the facts and circumstances relating to the likelihood of payment and any "identifiable event" which fixes the loss with certainty may be taken into consideration. The Tax Court then looked at Reg. Sec. 1.6050P-1(b)(2)(i)(H), which provides that one such identifiable event is the non-payment testing period described in Reg. Sec. 1.6050P-1(b)(2)(iv). That regulation, the court observed, provides that there is a rebuttable presumption that an identifiable event has occurred during a calendar year if a creditor has not received a payment on a debt at any time during a testing period ending at the close of the year. The testing period under the regulations is generally a 36-month period. The court noted that Reg. Sec. 1.6050P-1(b)(2)(iv) also provides that the presumption that an identifiable event has occurred may be rebutted by the creditor if the creditor (or a third-party collection agency on behalf of the creditor) has engaged in significant, bona fide collection activity at any time during the 12-month period ending at the close of the calendar year, or if facts and circumstances existing as of January 31 of the calendar year following expiration of the 36-month period indicate that the indebtedness has not been discharged.

The Tax Court rejected the IRS's argument that because the dealership took collection actions during the testing period, the presumption that an identifiable event occurred in 2008 was negated. The court found that, while the IRS established that collection agencies were engaged, the evidence did not demonstrate what, if any, collection activities they undertook. Thus, the court concluded, the IRS failed to provide any evidence of any significant, bona fide activity that would indicate an active creditor. The IRS thus failed to rebut the presumption that an identifiable event discharging Clark's debt occurred in 2008.

For a discussion of the determination of the year a debt is discharged, see Parker Tax ¶72,310.

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IRS Eliminates Foreign Goodwill Exception for Tax-Free Transfers of US Intangibles

The IRS has issued proposed regulations that eliminate the foreign goodwill exception for the outbound transfers of intangibles, and limit the scope of property that is eligible for the active trade or business exception. The proposed regs are effective for transfers occurring on or after September 16, 2015. REG-139483-13 (9/16/15).

The proposed rules also apply to transfers occurring before September 16, 2015 resulting from entity classification elections made under Reg. Sec. 301.7701-3 that are filed on or after that date.

Background

Code Sec. 367(a)(1) provides that if, in connection with any exchange described in Code Secs. 332, 351, 354, 356, or 361, a U.S. person (U.S. transferor) transfers property to a foreign corporation (outbound transfer), the transferee foreign corporation will not, for purposes of determining the extent to which gain is recognized on such transfer, be considered to be a corporation. As a result, under Code Sec. 367(a)(1), the U.S. transferor recognizes any gain (but not loss) on the outbound transfer of the property.

An exception in Code Sec. 367(a)(3)(A) provides that the general rule of Code Sec. 367(a)(1) will not apply to any property transferred to a foreign corporation for use by such foreign corporation in the active conduct of a trade or business outside of the United States ("active trade or business exception"). Reg. Secs. 1.367(a)-5 and 1.367(a)-5T address five categories of property ineligible for the exception, which includes intangible property, as defined in Code Sec. 936(h)(3)(B).

Code Sec. 367(d)(1) provides that, in general, if a U.S. transferor transfers any intangible property to a foreign corporation in an exchange described in Code Secs. 351 or 361, the U.S. transferor is treated as having sold the property in exchange for payments that are contingent upon the productivity, use, or disposition of the property. Reg. Sec. 1.367(d)-1T(b) generally provides that this rule does not apply to the transfer of foreign goodwill or going concern value, (foreign goodwill exception).

Congress enacted Code Sec. 367(d) to address problems with respect to outbound transfers of intangible property. Congress had identified issues arising when transferor U.S. companies attempted to reduce their U.S. taxable income by deducting substantial research and experimentation expenses associated with the development of the transferred intangible and, by transferring the intangible to a foreign corporation at the point of profitability, to ensure deferral of U.S. tax on the profits generated by the intangible.

The Senate Finance Committee and the House Committee on Ways and Means each noted in a senate report following the enactment of Code Sec. 367 that they did not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation would result in abuse of the U.S. tax system. However, neither Code Sec. 367 nor its legislative history defines goodwill or going concern value of a foreign branch, nor discusses how goodwill or going concern value is attributed to a foreign branch.

Taxpayers Interpret Code Section 367 to Claim Favorable Treatment for Foreign Goodwill

The IRS notes that, in general, taxpayers interpret Code Sec. 367 and the related regulations in one of two alternative ways when claiming favorable treatment for foreign goodwill and going concern value.

Under one interpretation, taxpayers take the position that goodwill and going concern value are not Code Sec. 936(h)(3)(B) intangible property and therefore are not subject to Code Sec. 367(d). Under this interpretation, taxpayers assert that the foreign goodwill exception has no application. Furthermore, these taxpayers assert that gain realized with respect to the outbound transfer of goodwill or going concern value is not recognized under the general rule of Code Sec. 367(a)(1) because the goodwill or going concern value is eligible for, and satisfies, the active trade or business exception.

Under a second interpretation, taxpayers take the position that, although goodwill and going concern value are intangible property, the foreign goodwill exception applies. These taxpayers also assert that Code Sec. 367(a)(1) does not apply to foreign goodwill or going concern value, either because of Code Sec. 367(d)(1)(A) (providing that, except as provided in regulations, Code Sec. 367(d) and not Code Sec. 367(a) applies to intangible property) or because of the active trade or business exception.

Proposed Regs Remove Foreign Goodwill Exception and Limit Scope of the Active Trade or Business Exception

The IRS has stated that, in the context of outbound transfers, certain taxpayers attempt to avoid recognizing gain or income attributable to high-value intangible property by asserting that an inappropriately large share (in many cases, the majority) of the value of the property transferred is foreign goodwill or going concern value that is eligible for favorable treatment under Code Sec. 367. The IRS notes that some taxpayers broadly interpret the meaning of foreign goodwill and going concern value for purposes of Code Sec. 367. Specifically, although the existing regulations define foreign goodwill or going concern value by reference to a business operation conducted outside of the U.S., some taxpayers have asserted that they have transferred significant foreign goodwill or going concern value when a large share of that value was associated with a business operated primarily by employees in the United States, where the business simply earned income remotely from foreign customers.

The IRS has determined that allowing intangible property to be transferred outbound in a tax-free manner is inconsistent with the tax policies underlying Code Sec. 367 and sound tax administration and therefore the proposed regulations eliminate the foreign goodwill exception under Reg. Sec. 1.367(d)-1T and limit the scope of property that is eligible for the active trade or business exception generally to certain tangible property and financial assets. Accordingly, under the proposed regulations, upon an outbound transfer of foreign goodwill or going concern value, a U.S. transferor will be subject to either current gain recognition under Code Sec. 367(a)(1) or the tax treatment provided under Code Sec. 367(d).

Separately Issued Temporary Regs Make Coordinating Amendments

Temporary regulations (T.D. 9738 (9/17/15)) clarify the coordination of the application of the arm's length standard and the best method rule in Code Sec. 482 (dealing with transfer pricing arrangements) in conjunction with certain controlled transactions, including controlled transactions that are subject in whole or part to both Code Secs. 367 and 482. The text of the temporary regs also serves as the text of a portion of the proposed regulations, and are effective for tax years on or after September 14, 2015.

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Economic Substance Doctrine Can Be Applied to Disallow Foreign Tax Credits

The economic substance doctrine applies to transactions involving foreign tax credits and, where economic substance is lacking, foreign tax credits will be denied. The Bank of New York Mellon Corporation v. Comm'r, 2015 PTC 243 (2d Cir. 2015).

On September 9, 2015, the Second Circuit heard appeals in tandem from The Bank of New York Mellon Corporation and American International Group, Inc. (AIG), challenging the disallowance of foreign tax credits associated with certain foreign transactions. The credits were disallowed on the basis that the transactions lacked economic substance. AIG challenged an opinion and order of the U.S. District Court for the Southern District of New York and The Bank of New York Mellon Corporation challenged a judgment of the Tax Court.

Between 1993 and 1997, AIG entered into six crosstransactions with foreign financial institutions through its subsidiary, AIG Financial Products (AIG-FP). Each cross-border transaction began with a foreign affiliate, a special purpose vehicle (SPV), created by AIG to hold and invest funds in a foreign country. Through these cross-border transactions, AIG-FP borrowed funds at economically favorable rates below LIBOR (i.e., the London Interbank Offered Rate, the benchmark rate that many banks charge each other for short-term loans) and invested the funds at rates above LIBOR, ostensibly to make a profit.

The transactions effectively reduced AIGtotal tax bill. It also allowed the foreign banks to limit their tax liability, inducing them to accept lower return rates from AIG. Thus, AIG effectively converted certain interest expenses it otherwise would have paid to the foreign banks into foreign tax payments for which it claimed foreign tax credits that it could use in turn to offset unrelated income and reduce its total U.S. tax bill.

AIG claimed that the crosstransactions had economic substance because they were expected to generate a preprofit of at least $168 million for AIG over the life of the transactions. In calculating preprofit, AIG ignored: (1) the foreign tax paid by the SPV; (2) the U.S. tax paid by AIG on the SPVinvestment income; and (3) the value of the foreign tax credits claimed by AIG.

The Bank of New York Mellon Corp. case involved alleged tax deficiencies of approximately $215 million. The Tax Court held a trial on the economic substance of the Structured Trust Advantaged Repackaged Securities (STARS) loan product purchased by Bank of New York Mellon (BNY). The Tax Court held: (1) the effect of foreign taxes must be considered in the preanalysis of economic substance; and (2) STARS lacked economic substance, and thus BNY could not claim foreign tax credits associated with STARS. The Tax Court further held that certain income from STARS was includible in BNYtaxable income and BNY was not entitled to deduct interest expenses associated with STARS, but reversed both rulings on reconsideration.

The Second Circuit affirmed the decisions of the district court and the Tax Court and held that the economic substance doctrine applies to the foreign tax credit regime generally, and that both the district court and Tax Court properly determined the tax implications of the crossand STARS transactions. The Court rejected the contention that foreign tax credits, by their nature, are not reviewable for economic substance. The purpose of the economic substance doctrine, the court said, is to ensure that a taxpayeruse of a tax benefit complies with Congresspurpose in creating that benefit. Accordingly, the court concluded that the economic substance doctrine can be applied to disallow a claim for foreign tax credits.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700.

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IRS Issues Annual Per Diem Guidance

IRS provides the annual update of the special per diem rates used in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Notice 2015-63.

In Notice 2015-63, the IRS provides the annual update of the special per diem rates used in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Specifically, the notice provides:  

(1) the special transportation industry meal and incidental expenses rates (M&IE rates),

(2) the rate for the incidental expenses only deduction, and  

(3) the rates and lists of high-cost localities for purposes of the high-low substantiation method.

For purposes of the high-low substantiation method, the per diem rates are $275 for travel to any high-cost locality and $185 for travel to any other locality within the continental U.S. The amount of the $275 high rate and $185 low rate that is treated as paid for meals for purposes of Code Sec. 274(n) is $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S.

The per diem rates for the meal and incidental expenses only substantiation method are $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S.

Taxpayers using the rates and the list of high-cost localities provided in Notice 2015-63 must comply with Rev. Proc. 2011-47. In Rev. Proc. 2011-47, the IRS provides rules for using a per diem rate to substantiate, under Code Sec. 274(d) and Reg. Sec. 1.274-5, the amount of ordinary and necessary business expenses paid or incurred while traveling away from home.

Notice 2015-63 is effective for per diem allowances for lodging, meal and incidental expenses, or for meal and incidental expenses only that are paid to any employee on or after October 1, 2015, for travel away from home on or after October 1, 2015. Rates for the period of October 1, 2014 through September 30, 2015, may be found in Notice 2014-57.

For a discussion of the substantiation rules for expenses incurred while traveling away from home, see Parker Tax ¶91,130.

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Multiple Poker Tournament Buy-Ins Aren't Aggregated for Form W-2G Reporting

Multiple buy-ins into a single poker tournament event are not identical wagers and therefore should not be aggregated for purposes of reporting the winnings on Form W-2G. FAA 20153601F.

Under Code Sec. 3402(q)(1), a person making a payment of gambling winnings which are subject to withholding must deduct and withhold from that payment a tax equal to the product of (1) the third lowest rate of tax for an unmarried individual and (2) such payment. The total gambling winnings paid and the amount withheld is reported on Form W-2G, Certain Gambling Winnings.

The term "winnings which are subject to withholding" generally refers to gambling proceeds of more than $5,000 from a wagering transaction if the amount of such proceeds is at least 300 times as large as the amount wagered. In determining the proceeds, the amount of the wager is not included and property which is not money is taken into account at its fair market value.

The facts in FAA 20153601F indicate that a taxpayer hosts poker tournaments consisting of several events. Each event has a set grand prize amount for the winner. Each event has a set "buy-in" amount which a patron must purchase to participate in the event. In exchange for the buy-in, the patron receives a set amount of tournament chips. Tournaments begin at a set time, have limited seating, and alternates are taken through the first six levels of the tournament. Once players bet all their tournament chips, they are eliminated from game play. After being eliminated, a player can re-enter during the alternate period by purchasing an additional buy-in at the same price. Each additional buy-in increases the wagering pool and potential prize amounts. The last player with chips wins first place. Players in the top 10 percent of each tournament field are also awarded cash prizes.

The question arose as to whether multiple buy-ins should be deducted as individual wagers or in the aggregate from winnings in the poker tournament for purposes of reporting the winnings on a Form W-2G.

IRS Field Attorneys (IRS) advised that multiple buy-ins into a single poker tournament event are not identical wagers and therefore should not be aggregated for purposes of withholding and reporting requirements. If a player wins a prize at the close of a tournament, only the buy-in that resulted in the win should be deducted from the winnings to determine the "proceeds from a wager."

In coming to its conclusion, the IRS looked to Reg. Sec. 31.3402(q)-1(c)(1)(ii) which provides that if multiple wagers are identical wagers, they must be aggregated into a single wager for purposes of calculating the proceeds from a wager that is subject to the withholding and reporting requirements. According to the preamble to that regulation, identical bets are those in which winning depends on the occurrence (or non-occurrence) of the same event or events. For example, two wagers on a horse to win a particular race general are identical. However, wagers containing different elements, such as an "exacta" and a "trifecta," are not identical

In the present case, the IRS noted, players are permitted to re-buy-in to the tournament as many times as they wish after they lose their initial buy-in, as long as the tournament has not advanced past the alternate period. Each time they purchase an additional buy-in, the game has advanced and the circumstances that must occur in order for them to win the pool have changed. When the tournament started, for example, there may have been 500 players participating and 50 different tables. When the player buys-in a second time, there might only be 200 players remaining to be eliminated, thus making the odds of winning different. Further, each additional buy-in increases the wagering pool and potential prize amounts.

The IRS observed that, unlike two identical bets placed on a single horse race which would depend on the identical event occurring and do not actually change the odds of winning, a second buy-in at a later time increases a player's odds of winning by giving them an additional chance, increases the wagering pool, and increases the potential prize amounts. An additional buy-in, the IRS concluded, is more like a wager on a different horse or an exacta or trifecta bet at the race track. Therefore, additional buy-ins are not identical wagers and should not be aggregated for the purpose of determining whether the reporting and withholding thresholds have been met. Instead, each buy-in should be treated as a separate wager and only the amount of the winning buy-in should be deducted from the amount of winnings when preparing the Form W-2G and determining withholding requirements.

For a discussion of the reporting requirements for Form W-2G, see Parker Tax, ¶252,597.