Services Performed for Corporation's Joint Ventures Were Capital Contributions; Marijuana Excise Tax Treated as Reduction in Amount Realized; Final Regs Address Basis Determination for CRTs; Unsigned Divorce Agreement Prevents Taxpayer from Claiming Dependency Exemption ...
Congress Swaps Partnership and C Corp Deadlines, Overturns Supreme Court Decision
On July 31, President Obama signed into law a bill that restructures the due dates for Partnership and C corporation tax returns beginning with the 2016 tax year, with a goal of reducing the need for extended and amended tax returns. The new law also effectively reverses the Supreme Court's decision in United States vs. Home Concrete & Supply, changes the due date for FBAR filings, and makes a few other permanent changes to the tax code. H.R. 3236 (7/31/2015).
Effective July 1, 2016, the IRS will end the automatic extension of time to file information returns on forms in the W-2 series (except Form W-2G). The IRS will also plans to end automatic filing extensions for all other information returns included under Reg. Sec. 1.6081-8T at an undetermined date that will be no earlier than January 1, 2018. T.D. 9730 (8/13/15), REG-132075-14 (8/13/15).
Ninth Circuit Reverses Tax Court: Unmarried Co-owners Apply Mortgage Interest Limitation on Per-Taxpayer Basis
Earlier this month, in an issue of first impression, the Ninth Circuit reversed the Tax Court and held that, when unmarried taxpayers co-own a qualifying residence, the limitation on the qualified residence interest deduction applies on a per-taxpayer rather than on a per-residence basis. Voss v. Comm'r, 2015 PTC 275 (9th Cir. 2015)
IRS Issues Final Regs on Determining Distributive Share When a Partner's Interest Changes
The IRS has issued final regulations regarding the determination of a partner's distributive share of partnership items of income, gain, loss, deduction, and credit when a partner's interest changes during a partnership tax year. T.D. 9728 (8/3/15).
IRS Issues Prop. Regs. Regarding Allocable Cash Basis and Tiered Partnership Items
The IRS has issued proposed regulations regarding the determination of a partner's distributive share of certain allocable cash basis items and items attributable to an interest in a lower-tier partnership during a partnership tax year in which a partner's interest changes. REG-109370-10 (8/3/15).
The taxpayers' participation in their boat charter business rose to the level of material participation for purposes of the passive activity loss rules. The fact that the taxpayers' friends and acquaintances were participants on some of their boat charters did not, per se, make those charters personal vacations or preclude them from being counted for purposes of the material participation test. Kline v. Comm'r, T.C. Memo. 2015-144.
Field-packing materials that a farming corporation buys that are "on hand" are governed by Reg. Sec. 1.162-3, which does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed if the taxpayer deducted such costs for a prior tax year. Agro-Jal Farming Enterprises, Inc. v. Comm'r, 145 T.C. No. 5 (2015).
Collision damages to a company's rental vehicles, which had to be disposed of, did not arise from a casualty because the occurrence of the damage was not unusual in the ordinary course of the company's business of renting vehicles and, thus, the company could not deduct the estimated repair costs as a casualty loss. CCA 201529008.
Tax Court Limits Charitable Contribution Deduction for Remainder Interests in CRTs
Where the payout of two NIMCRUTs is the lesser of the trust income or a fixed percentage, an annual distribution amount equal to the fixed percentage stated in the trust instruments must be used to determine whether the estate of the decedent who created the NIMCRUTs is eligible for a charitable contribution deduction. Est. of Schaefer v. Comm'r, 145 T.C. No. 4 (2015).
IRS to Issue Regulations on Transfers of Property to Partnerships with Related Foreign Partners In Notice 2015-54, the IRS announced its intention to issue regulations under Code Sec. 721(c) to ensure that when a U.S. person transfers certain property to a partnership that has foreign partners related to the transferor, the associated income or gain will be taken into account by the transferor either immediately or periodically. The prospective regulations, which are discussed in detail in the notice, aim to prevent partnerships from transferring highly appreciated intangible assets to a foreign partnership and shifting the gain to the foreign partner, and will apply to transfers occurring on or after Aug. 6, 2015.
Congress Swaps Partnership and C Corp Deadlines, Overturns Supreme Court Decision
On July 31, President Obama signed into law a bill that restructures the due dates for Partnership and C corporation tax returns beginning with the 2016 tax year, with a goal of reducing the need for extended and amended tax returns. The new law also effectively reverses the Supreme Court's decision in United States vs. Home Concrete & Supply, changes the due date for FBAR filings, and makes a few other permanent changes to the tax code. H.R. 3236 (7/31/2015).
The changes were included in the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the Act), in part to help offset costs of the stop-gap spending measures.
Modified Due Dates for Partnership and C Corp Returns
H.R. 3236 (the Act), modifies the due dates for Partnership and C corporation tax returns, effective for the 2016 tax year.
Once the new rules take effect, partnerships will be required to file their returns by the 15th day of the third month following the close of a tax year. For calendar year partnerships, the due date will be March 15, instead of April 15.
Observation: The filing deadlines for S corp returns remain unchanged, meaning that partnership and S corp returns will now share the same due dates.
In general, C corporations will have until the 15th day of the fourth month following the close of the tax year to file their returns. For calendar year C corps, this means the due date will be April 15, instead of March 15.
A special rule exempts C corps with fiscal years ending on June 30 from this change until tax years beginning after Dec. 31, 2025. Thus, the filing deadline for such corporations will remain September 15 until 2026 (when it will change to October 15).
The AICPA has applauded the changes. "The new structure will provide more accurate information to taxpayers in a more logical flow and reduce the number of extended and amended individual and corporate tax returns that are filed each year," stated AICPA president and CEO Barry Melancon.
Automatic Extension Periods Changed
For calendar year C corporations, Code Sec. 6081(b) provides a five month automatic extension for returns for tax years beginning after December 31, 2015 and ending before January 1, 2026. The extension period is a month shorter than under present law, but results in the same September 15 extended deadline because of the new April 15 original due date.
For fiscal year C corps with tax years ending on dates other than June 30, the length of automatic extensions remains unchanged at six months. For fiscal year C corps with tax years ending on June 30, a special seven month automatic extension applies for tax years beginning after December 31, 2015 and ending before January 1, 2026.
For tax years ending after December 31, 2025, automatic extensions for all C corporations will be for six months.
The Act also requires the IRS to modify appropriate regulations to provide maximum extensions for certain other returns of calendar year taxpayers for tax years beginning after Dec. 31, 2015, including:
- a 6 month extension ending on Sept. 15 for partnerships filing Form 1065;
- a 5-1/2 month extension ending on Sept. 30 for trusts filing Form 1041;
- a 3-1/2 month extension ending on Nov. 15 for employee benefit plans filing Form 5500;
- and a 6 month extension ending on Nov. 15 for exempt organizations filing Form 990.
Reversal of Supreme Court Decision in United States vs. Home Concrete & Supply
In U.S. v. Home Concrete & Supply, LLC, 2012 PTC 94 (S. Ct. 4/25/12), the Supreme Court held that taxpayer misstatements that overstate the basis in property do not fall within the scope of the Code Sec. 6501(e)(1) extended statute of limitations. That section extends the normal three year limitation period for assessments to six years where a taxpayer omits from gross income an amount in excess of 25 percent of the amount stated on the return.
The Court determined that an "understatement" of basis was not an "omission" for purposes of the statute. In reaching this decision, the Court looked at the legislative history of the provision and concluded that Congress intended an exception to the usual three-year statute of limitations only in a restricted type of situation - a situation that did not include overstatements of basis. As a result of the decision, the taxpayers were allowed to avoid certain taxes from their participation in a Son-of-BOSS transaction because the IRS didn't discover their overstated basis until after the normal three year period.
IRS Chief Counsel William J Wilkins lamented that the decision would mean taxpayers in other unsettled Son-of-BOSS cases would likely prevail, given the difficulty of untangling such transactions within the three year limit.
Congress has amended Code Sec. 6501, effectively overruling the Supreme Court's holding, to clarify that an understatement of gross income by reason of an overstatement of unrecovered cost or other basis is an omission from gross income for purposes of the six year statute of limitations under Code Sec. 6501(e).
The Joint Committee on Taxation estimates that this clarification will raise $1.2 billion in revenue by 2025.
Other Changes
In addition to the above modifications to the Tax Code, the Act also provides a new consistency standard for reporting basis in property received by reason of death under Code Sec. 1014, new information reporting requirements for inherited property, additional details taxpayers will need to disclose on mortgage information returns, and an extension for transfers of excess pension assets to retiree health accounts.
For taxpayers with foreign bank accounts, the Act directs the IRS to change the due date for FinCEN Report 114, relating to Report of Foreign Bank and Financial Accounts (FBAR), from June 30 to April 15, with a maximum extension for a six month period ending on Oct. 15, and to provide for an extension under rules similar to those in Reg. Sec. 1.6081-5.
IRS Ends Automatic Extension of W-2 Information Returns to Combat Identity Theft
Effective July 1, 2016, the IRS will end the automatic extension of time to file information returns on forms in the W-2 series (except Form W-2G). The IRS will also plans to end automatic filing extensions for all other information returns included under Reg. Sec. 1.6081-8T at an undetermined date that will be no earlier than January 1, 2018. T.D. 9730 (8/13/15), REG-132075-14 (8/13/15).
Background
Currently Reg. Sec. 1.6081-8 provides an automatic 30-day extension of time to file information returns on forms in the W-2 series (including Forms W-2, W-2AS, W-2G, W-2GU, and W-2VI), 1095 series, 1098 series, 1099 series, and 5498 series, and on Forms 1042-S and 8027, and allows an additional 30-day non-automatic extension of time to file those information returns in certain cases.
Although paper information returns are generally due to be filed by February 28, an extension of time to file may extend the due date until the end of March or, if a non-automatic extension is also granted, the end of April.
Similarly, although electronically-filed information returns are generally due by March 31, an extension of time to file may extend the due date until the end of April or, if a non-automatic extension is also granted, the end of May.
According to the IRS, identity thieves often electronically file their fraudulent refund claims early in the tax filing season, using fictitious wage and other information of legitimate taxpayers. Unscrupulous preparers also electronically file early in the tax filing season, over-claiming deductions and credits and underreporting income for unwitting, as well as complicit, taxpayers. In many cases, the IRS is unable to verify the wage and other information reported on tax returns filed before April 15th, in part because the IRS does not receive the information returns reporting this information until later in the filing season. Receipt of information returns earlier in the filing season will improve the IRS's ability to identify fraudulent refund claims and stop the refunds before they are paid.
Temporary and Proposed Regulations Remove Automatic Extensions
Effective July 1, 2016, T.D. 9730 removes Reg. Sec. 1.6081-8 and replaces with new Reg. Sec. 1.6081-8T.
The temporary regulations in Reg. Sec. 1.6081-8T are substantially identical to current Reg. Sec. 1.6081-8 that will be removed, except that the temporary regulations:
(1) add information returns on forms in the 1097 series and Forms 1094-C, 3921, and 3922 to the list of information returns with procedures prescribed by regulations for the extension of time to file;
(2) remove information returns on forms in the W-2 series (except Form W-2G) from the list of information returns eligible for the automatic 30-day extension of time to file, providing instead a single 30-day non-automatic extension of time to file those information returns; and
(3) clarify that the procedures for requesting an extension of time to file in the case of forms in the 1095 series apply to information returns on Forms 1095-B and 1095-C (but not 1095-A).
The IRS notes that removing the automatic 30-day extension of time to file for information returns on forms in the W-2 series is an affirmative step to accelerate the filing of information returns so they are available earlier in the filing season for use in the IRS's refund fraud detection processes. These information returns are particularly helpful to the IRS for identifying fraudulent identity theft refund claims and preventing their payout.
The IRS intends to eventually remove the automatic 30-day extension of time to file the other forms listed in Reg. Sec. 1.6081-8T and replace it with a single non-automatic 30-day extension of time to file. Therefore, proposed regulations in REG-132075-14 (8/13/15) would remove the automatic 30-day extension of time to file these other information returns.
As currently drafted, the proposed regulations would affect information returns due January 1 of the year beginning after the regulations are finalized, but those final regulations will not be effective any earlier than January 1, 2018.
Ninth Circuit Reverses Tax Court: Unmarried Co-owners Apply Mortgage Interest Limitation on Per-Taxpayer, Not Per-Residnece Basis
Earlier this month, in an issue of first impression, the Ninth Circuit reversed the Tax Court and held that, when unmarried taxpayers co-own a qualifying residence, the limitation on the qualified residence interest deduction applies on a per-taxpayer rather than on a per-residence basis. Voss v. Comm'r, 2015 PTC 275 (9th Cir. 2015)
As noted in the Voss court's dissenting opinion, the decision means that unmarried taxpayers who co-own their home are not limited to deducting the same amount as married taxpayers filing jointly. Instead, they can deduct up to twice the amount of interest as married taxpayers.
The case involves the interpretation of the mortgage and home equity debt limitations under Code Sec. 163(h)(3). That provision states that a taxpayer can deduct the interest paid on home acquisition indebtedness and/or a home equity line of credit for a principal residence and a second home. Specifically, the statute provides that the aggregate amount that a taxpayer may treat as acquisition debt for any year cannot exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return). The aggregate amount that a taxpayer may treat as home equity debt for any year cannot exceed $100,000 ($50,000 in the case of a separate return by a married individual).
Although the statute is specific with respect to a married taxpayer filing a separate return, it does not specify whether, in the case of co-owners who are not married, the debt limits apply on a per-residence or per-taxpayer basis.
Facts
Bruce Voss and Charles Sophy are registered domestic partners in California. They co-own two homes as joint tenants: one in Rancho Mirage, California, and the other, their primary residence, in Beverly Hills, California. In 2002, they refinanced the Rancho Mirage property and obtained a mortgage of $500,000. In 2003, they refinanced their Beverly Hills property and obtained a mortgage of approximately $2,000,000. When they refinanced the Beverly Hills mortgage, Voss and Sophy also obtained a home equity line of credit of $300,000. Voss and Sophy are jointly and severally liable for the mortgages and home equity line of credit. The total average balance of the two mortgages and the line of credit in 2006 and 2007 (the two taxable years at issue) was approximately $2.7 million each year.
Voss and Sophy each filed separate federal income tax returns for 2006 and 2007. In their respective returns, they each claimed deductions for interest paid on the two mortgages and the home equity line of credit. The IRS audited those returns and limited Voss and Sophy's deductible mortgage interest to interest on $1.1 million of debt in total. Thus, the IRS applied the mortgage interest deduction limitation using a per-residence basis, rather than the per-taxpayer basis used by Voss and Sophy.
Observation: It's important to note that, according to the IRS, registered domestic partners may not file a federal return using a married filing separately or jointly filing status. Registered domestic partners are not married under state law and, thus, are not married for federal tax purposes. The IRS notes that this remains the case even after the Supreme Court's decision in U.S. v. Windsor, 2013 PTC 167 (S. Ct. 2013), a decision which treats all married same-sex couples as married for federal tax purposes. See IRS website, Answers to Frequently Asked Questions for Registered Domestic Partners and Individuals in Civil Unions.
Voss and Sophy took their case to the Tax Court, arguing they each should each be allowed a deduction for interest paid on up to $1.1 million of mortgage and home equity indebtedness with respect to the jointly owned residences.
Tax Court's Decision
In 2012, in Sophy v. Comm'r, 138 T.C. 204, the Tax Court held that the limitations in Code Sec. 163(h)(3) apply to the aggregate indebtedness on up to two residences, and co-owners not married to each other could not deduct more than a proportionate share of interest on $1.1 million of acquisition indebtedness and home equity debt. In looking at the various definitions used in Code Sec. 163(h)(3), the court noted the repeated use of the phrases "with respect to a qualified residence" and "with respect to such residence" and concluded that the Code focuses on the residence rather than the taxpayer.
The court also noted that the use of "any indebtedness" in the definition of "acquisition indebtedness" was not qualified by language regarding an individual taxpayer. From this, the Tax Court surmised that the phrase referred to the total amount of indebtedness with respect to a qualified residence and which was secured by that residence. Thus, the Tax Court concluded that, when the statute limits the amount that may be treated as acquisition indebtedness, it appeared that what was being limited was the total amount of acquisition debt that could be claimed in relation to the qualified residence, rather than the amount of acquisition debt that could be claimed in relation to an individual taxpayer.
The Tax Court further reasoned that the married-person parentheticals were consistent with its per-residence interpretation, as the parentheticals made clear that married couples (whether filing separately or jointly) are, as a couple, limited to deducting interest on $1 million of acquisition indebtedness and $100,000 of home equity indebtedness. The purpose of the parentheticals, the Tax Court explained, was simply to set out a specific allocation of the limitation amounts that must be used by married couples filing separate tax returns, thus implying that co-owners who are not married to one another may choose to allocate limitation amounts among themselves in some other manner, such as according to percentage of ownership.
Ninth Circuit's Analysis
On appeal, the Ninth Circuit reversed the Tax Court and held that the debt limitation provisions in Code Sec. 163(h)(3) apply on a per-taxpayer basis rather than a per-residence basis.
The court observed that, while the statute is mostly silent about how to deal with co-ownership situations, it is not entirely silent. The court focused on the fact that both the mortgage debt and home equity debt provisions contain a parenthetical that speaks to one common situation of co-ownership: married individuals filing separate returns. The parentheticals provide half-sized debt limits "in the case of a married individual filing a separate return" and the court found Congress's use of the phrase "in the case of" important.
First, the court observed, the parentheticals clearly speak in per-taxpayer terms: the limit on acquisition indebtedness under Code Sec. 163(h)(3)(B)(ii) is "$500,000 in the case of a married individual filing a separate return," and the limit on home equity indebtedness under Code Sec. 163(h)(3)(C)(ii) is "$50,000 in the case of a separate return by a married individual."
Second, the court said, the parentheticals don't just speak in per-taxpayer terms; they operate in a per-taxpayer manner. The parentheticals give each separately filing spouse a separate debt limit of $550,000 so that, together, the two spouses are effectively entitled to a $1.1 million debt limit (the normal limit for single taxpayers). They do not, the court noted, subject both spouses jointly to the $550,000 debt limit specified in the statute.
Finally, the court concluded, the very inclusion of the parentheticals suggests that the debt limits apply per taxpayer. According to the court, if the $1.1 million debt limit truly applied on a per-residence basis, as the Tax Court held, the parentheticals would be superfluous, as there would be no need to provide that two spouses filing separately get $550,000 each. By contrast, the court noted, if the $1.1 million debt limit applies on a per-taxpayer basis, the parentheticals actually do something: they give each separately filing spouse half the debt limit so that the separately filing couple is, as a unit, subject to the same debt limit as a jointly filing couple.
Dissenting Opinion
In a dissenting opinion, Judge Ikuta opined that the majority's interpretation of the debt limitation in Code Sec. 163(h)(3) allows unmarried taxpayers who buy an expensive residence together to deduct twice the amount of interest paid on the debt secured by their residence than spouses would be allowed to deduct. He agreed that the statute's language is ambiguous. However, he found reasonable the IRS interpretation limiting unmarried taxpayers in this situation to a deduction in the same amount as married taxpayers filing jointly and opined that the Tax Court should defer to this reasonable interpretation.
For a discussion of qualified residence interest, see Parker Tax ¶83,515.
IRS Issues Final Regs on Determining Distributive Share When a Partner's Interest Changes
The IRS has issued final regulations regarding the determination of a partner's distributive share of partnership items of income, gain, loss, deduction, and credit when a partner's interest changes during a partnership tax year. T.D. 9728 (8/3/15).
Background
In 2009, the IRS issued proposed regulations in REG-144689-04 to conform the regulations to certain provisions of the Taxpayer Relief Act of 1997, and the Deficit Reduction Act of 1984.
The proposed regulations under Reg. Sec. 1.706-4 provided guidance under Code Sec. 706(d)(1), which requires that, if there is a change in a partner's interest in the partnership during the partnership's tax year, each partner's distributive share of any partnership item of income, gain, loss, deduction, or credit for such tax year is determined by the use of any method in the regulations which takes into account the varying interests of the partners in the partnership during such tax year.
Regulations issued in T.D. 9728 (8/3/15) finalize the proposed regulations with modifications. Reg. Sec. 1.706-4(a)(3) now contains a step-by-step process for making allocations under the final regs. In addition, the remainder of Reg. Sec. 1.706-4 has been reorganized into discrete sections addressing the scope of the final regs, exceptions to the final regs, partnership conventions, extraordinary items, and procedures for partnership decisions relating to final Reg. Sec. 1.706-4.
The final regulations generally apply for partnership tax years that begin on or after August 3, 2015. However, the rules for permissible conventions for each variation under Reg. Sec. 1.706-4(c)(3) do not apply to existing publicly traded partnerships (PTPs) formed prior to April 19, 2009). For purposes of the effective date provision, the termination of a PTP under Code Sec. 708(b)(1)(B) due to the sale or exchange of 50 percent or more of the total interests in partnership capital and profits is disregarded in determining whether the PTP is an existing PTP.
Scope of the Final Regulations
Final Reg. Sec. 1.706-4 provides rules for determining the partners' distributive shares of partnership items when a partner's interest in a partnership varies during the tax year as a result of the disposition of a partial or entire interest in a partnership, or with respect to a partner whose interest in a partnership is reduced, including by the entry of a new partner. The final regulations clarify that deemed dispositions under Reg. Secs. 1.1502-76(b)(2)(vi), 1.1362-3(c)(1), or 1.1377-1(b)(3)(iv) are treated as a disposition of the partner's entire interest in the partnership.
Observation: The final regs refer to these changes in a partner's interest in a partnership as "variations."
The final regulations further provide that, in all cases, all partnership items for each tax year must be allocated among the partners, and no items may be duplicated, regardless of the particular provision of Code Sec. 706 which applies, and regardless of the method or convention adopted by the partnership.
The final regulations provide that partnerships may make certain decisions under Reg. Sec. 1.706-4 only by an agreement of the partners.
For purposes of selecting the proration method, selecting the semi-monthly or monthly convention, performing regular monthly or semi-monthly interim closings, and selecting additional extraordinary items, the term "agreement of the partners" means either an agreement of all the partners to select the method, convention, or extraordinary item in a dated, written statement maintained with the partnership's books and records, including, for example, a selection that is included in the partnership agreement. The term also includes a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, if that person's selection is in a dated, written statement maintained with the partnership's books and records.
Methods for Applying the Varying Interest Rules: Interim Closing and Proration
In the case of a disposition of a partner's entire interest in a partnership, the partner's distributive share of partnership items for the tax year in which the disposition occurs may be determined by a closing of the partnership's books as of the date of disposition (interim closing method).
Alternatively, the partners, by agreement, may determine the departing partner's distributive share by taking his or her pro rata share of partnership items that would have been included in income had he or she remained a partner until the end of the partnership tax year (proration method).
The proposed regulations required the partnership and all of its partners to use the same method, interim closing or proration, for all variations in the partners' interests occurring within the partnership's tax year. After considering comments, the IRS agreed that partnerships may be more willing to use the interim closing method, which is generally more accurate but more costly, for significant variations if doing so would not require the partnership to use the interim closing method for all variations, regardless of size, that occur throughout the year. Therefore, the final regulations allow a partnership to use different methods for different variations within the partnership's tax year.
For purposes of the interim closing method, the final regulations provide that a partnership may, by agreement of the partners, perform regular interim closings of its books on a monthly or semi-monthly basis, regardless of whether any variation occurs. The final regulations continue to require a partnership using the interim closing method with respect to a variation to perform the interim closing at the time the variation is deemed to occur, and do not require a partnership to perform an interim closings of its books except at the time of any variation for which the partnership uses the interim closing method.
Under the proposed regulations, if the partners agreed to use the proration method, the partnership was required to allocate the distributive share of partnership items among the partners in accordance with their pro rata shares of the items for the entire tax year. Because the final regulations permit partnerships to use both the proration method and the interim closing method in the same tax year, the rules for the proration method are now based upon the items in each segment, rather than the items for the partnership's entire tax year.
Use of Segments and Proration Periods to Account for Changes in Partnership Interests
For purposes of accounting for the partners' varying interests in the partnership, the proposed regulations required the partnership to maintain, for each partner whose interest changes in the tax year, segments to account for such changes. Under the proposed regulations, a segment was a specific portion of a partnership's tax year created by a variation, regardless of whether the partnership used the interim closing method or the proration method for that variation. Although the final regulations continue to rely on the concept of segments, because the final regulations now permit partnerships to use both the interim closing method and the proration method in the same tax year, the final regulations also contain a new concept of proration periods.
Under the final regulations, segments are specific periods of the partnership's tax year created by interim closings of the partnership's books, and proration periods are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The partnership must divide its year into segments and proration periods, and spread its income among the segments and proration periods according to the rules for the interim closing method and proration method, respectively.
The first segment commences with the beginning of the tax year of the partnership and ends at the time of the first interim closing of the partnership's books. Any additional segment commences immediately after the closing of the prior segment and ends at the time of the next interim closing. However, the last segment of the partnership's tax year ends no later than the close of the last day of the partnership's tax year. If there are no interim closings, the partnership has one segment, which corresponds to its entire tax year.
The first proration period in each segment begins at the beginning of the segment, and ends at the time of a variation for which the partnership uses the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnerships uses the proration method. However, each proration period ends no later than the close of the segment. Thus, segments close proration periods.
Observation: The items subject to proration are the partnership's items attributable to the segment containing the proration period.
The final regulations provide that each segment is generally treated as a separate distributive share period. Additionally, the final regulations provide that for purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership tax year will be applied based on the partnership's satisfaction of the limitation or requirements as of the end of the partnership's tax year. For example, the expenses related to the election to expense a Code Sec. 179 asset must first be calculated (and limited if applicable) based on the partnership's full tax year, and the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method.
Observation: Segments are not treated as separate tax years for purposes of Code Secs. 461(h) and 404(a)(5).
Conventions for Applying the Varying Interest Rules: Calendar Day, Semi-Monthly, and Monthly
For purposes of the final regulations, "conventions" are rules of administrative convenience that determine when each variation is deemed to occur. The regulations provide for three conventions: the calendar day convention, the semi-monthly convention, or the monthly convention.
Under the calendar day convention, each variation is deemed to occur at the end of the day on which the variation occurs.
The semi-monthly convention requires that any variation in a partner's interest occurring during the first through 15th day of the calendar month is deemed to occur at the beginning of the first day of the month, and any variation in a partner's interest occurring during the 16th through the last day of the month is deemed to occur at the beginning of the 16th day of that month.
Under the monthly convention, in the case of a variation occurring on the first through the 15th day of a calendar month, the variation is deemed to occur at the end of the last day of the immediately preceding calendar month. And in the case of a variation occurring on the 16th through the last day of a calendar month, the variation is deemed to occur at the end of the last day of that calendar month.
Observation: The final regulations require partnerships using the proration method to use a calendar day convention. Partnerships using the interim closing method have the option of using a semi-monthly or monthly convention in addition to the calendar day convention.
The final regulations provide that all variations within a tax year are deemed to occur no earlier than the first day of the partnership's tax year, and no later than the close of the final day of the partnership's tax year. Thus, under the semi-monthly or monthly convention, a variation occurring on January 1st through January 15th for a calendar year partnership will be deemed to occur at the beginning of the day on January 1. The conventions are not applicable to a sale or exchange of an interest in the partnership that causes a termination of the partnership under Code Sec. 708(b)(1)(B); instead, such a sale or exchange will be considered to occur when it actually occurred.
The IRS recognizes that the application of the conventions could result in some partners not being allocated any share of partnership items. For example, under the monthly convention, if a new partner buys a partnership interest on or after the 16th day of a month, and sells the entire partnership interest on or before the 15th day of the following month, that partner would not be treated as having been a partner at all for purposes of Reg. Sec. 1.706-4. Accordingly, the final regulations provide that in the case of a partner who becomes a partner during the partnership's tax year as a result of a variation, and ceases to be a partner as a result of another variation, and under the application of the partnership's conventions both such variations would be deemed to occur at the same time, the variations with respect to that partner's interest will instead be treated as occurring when they actually occurred. However, this exception does not apply to publicly traded partnerships with respect to holders of publicly traded units.
Exceptions for Contemporaneous Partners and Certain Service Partnerships
The final regulations adopt, with modifications, two exceptions in the proposed regulations for allocations that would otherwise be subject to the varying interest rules of Reg. Sec. 1.706-4: one exception applies to certain partnerships with contemporaneous partners, and the other exception applies to certain service partnerships.
The "contemporaneous partner exception" provided an exception for dispositions of less than a partners' entire interest in the partnership, provided that the variation in the partner's interest is not attributable to a capital contribution or a partnership distribution to a partner that is a return of capital, and the allocations resulting from the modification otherwise comply with Code Sec. 704(b) and its regulations. The final regulations expand the scope of this exception to include allocations of items attributable solely to a particular segment of a partnership's year among partners who are partners of the partnership for that entire segment.
The second exception in the proposed regulations provided that a service partnership may choose to determine the partners' distributive shares of partnership income, gain, loss, deduction, and credit using any reasonable method, provided that the allocations were valid under Code Sec. 704(b). The IRS noted that the definition of "service partnership" in the proposed regulations was too narrow, and expand the scope of the service partnership exception to any partnership for which capital is not a material income-producing factor.
Extraordinary Items
The final regulations provide special rules for the allocation of "extraordinary items" that apply to partnerships using the proration method or the interim closing method. The proposed regulations included a list of nine extraordinary items, including any item from the disposition or abandonment (other than in the ordinary course of business) of a capital asset, any item from assets disposed of in an applicable asset acquisition, and any item from the settlement of a tort or similar third-party liability. The final regulations retain the list, and provide clarifications to five of the items. In response to comments, the final regulations also add two items to the extraordinary item list.
First, the final regulations adopt a recommendation to allow a partnership to treat additional nonenumerated items as extraordinary items for a tax year if, for that tax year, there is an agreement of the partners to treat consistently such items as extraordinary items. However, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner's return.
Second, the final regulations provide that an extraordinary item includes any item identified as an additional class of extraordinary item in guidance published by the IRS.
In addition, proposed regulations under Code Sec. 706 (REG-109370-10 (8/3/15)) published concurrently with the final regulations propose two additional extraordinary items. Taxpayers may rely on these proposed items until the regulations are finalized. The first proposed extraordinary item provides, in general, that for publicly traded partnerships (PTPs), all items of income that are amounts subject to withholding or withholdable payments occurring during a tax year may be treated as extraordinary items by an agreement of the partners. This proposed rule does not apply unless the PTP has a regular practice of making at least four distributions (other than de minimis distributions) to its partners during each tax year. The second proposed additional extraordinary item would include any deduction for the transfer of an interest in the partnership in connection with the performance of services.
The final regulations require the allocation of extraordinary items as an exception to the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and the conventions, which might otherwise inappropriately shift extraordinary items between a transferor and transferee. The final regulations also provide that extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership tax year (for example, the limitation for Code Sec. 179 expenses).
Under the final regulations, extraordinary items must be allocated in accordance with the partners' interests in the partnership item at the time of day that the extraordinary item occurs, regardless of the method and convention otherwise used by the partnership. Thus, if a partner disposes of its entire interest in a partnership on the same day but before an extraordinary item occurs (e.g. the interest is disposed of in the morning, and the extraordinary item occurs in the afternoon), the partnership and all of its partners must allocate the extraordinary item in accordance with the partners' interests in the partnership item at the time of day on which the extraordinary item occurred; in such a case, the transferor will not be allocated a portion of the extraordinary item, regardless of when the transfer is deemed to occur under the partnership's convention.
However, PTPs may, but are not required to, respect the applicable conventions in determining who held their publicly traded units at the time of the occurrence of an extraordinary item.
The final regulations also add a small item exception to the extraordinary item rules. Specifically, the final regulations allow a partnership to treat an otherwise extraordinary item as not extraordinary if, for the partnership's tax year, the gain from all extraordinary items in a particular class is less than five percent of the partnership's gross income, and the aggregate amounts of extraordinary items from all classes that are less than five percent of the partnership's gross income do not exceed $10 million for the taxable year.
IRS Issues Proposed Regs Regarding Allocable Cash Basis and Tiered Partnership Items
The IRS has issued proposed regulations regarding the determination of a partner's distributive share of certain allocable cash basis items and items attributable to an interest in a lower-tier partnership during a partnership tax year in which a partner's interest changes. REG-109370-10 (8/3/15).
Proposed Regulations on Allocable Cash Basis
Code Sec. 706 generally provides rules for the tax years of partners and partnerships.
If during the year a partner's interest in the partnership changes, Code Sec. 706(d)(2) provides rules for determining the partner's distributive share of certain allocable cash basis items. Code Sec. 706(d)(2)(A) provides that if there is a change in any partner's interest in the partnership, then each partner's distributive share of any allocable cash basis item is determined by:
(1) assigning the appropriate portion of such item to each day in the period to which it is attributable, and
(2) allocating the portion assigned to any such day among the partners in proportion to their interests in the partnership at the close of such day.
Code Sec. 706(d)(2)(B) defines "allocable cash basis item" as interest, taxes, payments for services or for the use of property, or any other item specified in regulations, with respect to which the partnership uses the cash method of accounting. Code Sec. 706(d)(2)(C) further provides that if any portion of any allocable cash basis item is attributable to any period before the beginning of the tax year, that portion is assigned to the first day of the tax year. For portions of any allocable cash basis item attributable to any period after the close of the tax year, such portion is assigned to the last day of the tax year.
The proposed regulations provide that the term "allocable cash basis item" generally includes the items of deduction, loss, income, or gain specifically listed in the statute: interest, taxes, and payments for services or for the use of property. The term also includes any allowable deduction that had been previously deferred under Code Sec. 267(a)(2). This provision incorporates the concept of Reg. Sec. 1.706-2T and includes within the meaning of "allocable cash basis item" amounts deferred under Code Sec. 267(a)(2) in the year in which the deduction is allowed. Accordingly, the IRS proposes to withdraw Reg. Sec. 1.706-2T by final regulations issued under Code Sec. 706(d)(2).
In addition, the proposed regulations provide that allocable cash basis items also include any item of income, gain, loss, or deduction that accrues over time and would, if not allocated as an allocable cash basis item, result in the significant misstatement of a partner's income. The IRS believes that items such as rebate payments, refund payments, insurance premiums, prepayments, and cash advances are examples of items which, if not allocated in the manner described in Code Sec. 706(d)(2), could result in the significant misstatement of a partner's income.
Accordingly, the proposed regulations provide that an allocable cash basis item will not be subject to the rules in Code Sec. 706(d)(2) if, for the partnership's tax year:
(1) the total of the particular class of allocable cash basis items (for example, all interest income) is less than five percent of the partnership's gross income, or gross expenses and losses, and;
(2) the total amount of allocable cash basis items from all classes of allocable cash basis items amounting to less than five percent of the partnership's gross income, or gross expenses and losses, does not exceed $10 million in the tax year, determined by treating all such allocable cash basis items as positive amounts.
Observation: The IRS has issued, simultaneously with the proposed regulations, final regulations in T.D. 9728 (8/3/15) under Reg. Sec. 1.706-4 providing general rules for determining partners' distributive shares of partnership items when a partner's interest in a partnership varies during the tax year as a result of the disposition of a partial or entire interest in a partnership, or with respect to a partner whose interest in a partnership is reduced.
Proposed Regulations on Tiered Partnerships
Rev. Rul. 77-311 explains that an upper-tier partnership's distributive share of any items of income, gain, loss, deduction, or credit from a lower-tier partnership is considered to be realized or sustained by the upper-tier partnership at the same time and in the same manner as such items were realized or sustained by the lower-tier partnership. Therefore, in allocating items from a lower-tier partnership, the upper-tier partnership must take into account variations among its partners' interests throughout the year, rather than merely looking to its partners' interests as of the last day of the lower-tier partnership's tax year.
Code Sec. 706(d)(3), enacted in 1984, confirms the analysis of Rev. Rul. 77-311 by providing that if during any tax year of the partnership there is a change in any partner's interest in an upper-tier partnership that is a partner in another partnership (the lower-tier partnership), then each partner's distributive share of any item of the upper-tier partnership attributable to the lower-tier partnership is determined by assigning the appropriate portion of each such item to the appropriate days during which the upper-tier partnership is a partner in the lower-tier partnership and by allocating the portion assigned to any such day among the partners in proportion to their interests in the upper-tier partnership at the close of such day.
With respect to tiered partnerships, the proposed regulations provide that the daily allocation method used for cash basis items applies to all items of the lower-tier partnership if there is a change in any partner's interest in the upper-tier partnership.
The IRS has acknowledged that a lack of information sharing among tiered partnerships may make it difficult to comply with a daily allocation requirement. Thus, the proposed regulations provide an exception from Code Sec. 706(d)(3) if the upper-tier partnership directly owns an interest in less than 10 percent of the profits and capital of the lower-tier partnership ("a de minimis upper-tier partnership"), all de minimis upper-tier partnerships in aggregate own an interest in less than 30 percent of the profits and capital of the lower-tier partnership, and if no partnership is created with a purpose of avoiding the application of the tiered partnership rules of Code Sec. 706(d)(3).
Observation: The application of this exception is determined at each tier, depending on the interests held by the direct partners at each tier. Thus, in the case of an upper-tier partnership owning an interest in a middle tier partnership, which in turn owns an interest in a lower-tier partnership, it may be the case that the exception applies to the upper-tier partnership's interest in the middle tier partnership, but not to the middle tier partnership's interest in the lower-tier partnership (or vice versa).
If the de minimis upper-tier partnership exception applies, the upper-tier partnership may apply the general rules of Reg. Sec. 1.706-4 in allocating items attributable to the lower-tier partnership. However, as explained in Rev. Rul. 77-311, an upper-tier partnership's distributive share of any items of income, gain, loss, deduction, or credit from a lower-tier partnership is considered to be realized or sustained by the upper-tier partnership at the same time and in the same manner as such items were realized or sustained by the lower-tier partnership.
If the exception applies to an upper-tier partnership using the proration method in Reg. Sec. 1.706-4, the upper-tier partnership may prorate the items from the lower-tier partnership across the upper-tier partnership's segments (or, if the upper-tier partnership has only one segment for its entire tax year, it may prorate the items across its entire tax year). Even if the de minimis upper-tier partnership exception applies, the upper-tier partnership may choose to allocate the items attributable to the lower-tier partnership according to the tiered partnership rules instead. However, the proposed regulations do not impose on lower-tier partnerships an obligation to disclose to upper-tier partnerships the timing of the lower-tier partnership's items.
Coordination with Proposed Partnership Equity for Services Regulations
On May 24, 2005, the IRS published a notice of proposed rulemaking (REG-105346-03), the proposed Partnership Equity for Services regulations, relating to the tax treatment of certain transfers of partnership interests in connection with the performance of services. Those proposed regulations are not effective until finalized.
The proposed Partnership Equity for Services regulations contain two provisions relating to the varying interest rule under Code Sec. 706.
First, proposed Reg. Sec. 1.706-3(a) is intended to provide an exception to the allocable cash basis item rules of Code Sec. 706(d)(2) for deductions for the transfer of partnership interests and other property subject to Code Sec 83. The IRS has concluded that, in the case of a transfer of a partnership interest in connection with the performance of services, no portion of the partnership's deduction should be allocated to the person who performs the services. However, the IRS has also concluded that the scope of the exception to allocable cash basis treatment in proposed Reg. Sec. 1.706-3(a) may have been too broad because it applies to all transfers of property subject to Code Sec. 83. Therefore, the IRS withdraws proposed Code Sec. 1.706-3(a). Instead, the proposed regulations provide an exception to allocable cash basis treatment for deductions for transfers of partnership interests in connection with the performance of services.
Second, proposed Reg. Sec. 1.706-3(b) provides that a partnership must make certain forfeiture allocations upon forfeiture of a partnership interest for which a Code Sec. 83(b) election was made. The IRS anticipates that if the rules for forfeiture allocations in proposed Reg. Sec. 1.706-3(b) are adopted when the proposed Partnership Equity for Services regulations are finalized, those rules will include in Reg. Sec. 1.706-3(b) an additional exception to the general application of the varying interest rule.
Effective Date
The regulations are proposed to apply to partnership tax years beginning on or after the date the regulations are finalized.
Couple Materially Participated in Charter Boat Business; Losses Not Passive
The taxpayers' participation in their boat charter business rose to the level of material participation for purposes of the passive activity loss rules. The fact that the taxpayers' friends and acquaintances were participants on some of their boat charters did not, per se, make those charters personal vacations or preclude them from being counted for purposes of the material participation test. Kline v. Comm'r, T.C. Memo. 2015-144.
Background
Larry Kline was a captain at Southwest Airlines with more than 25 years of seniority. He was single in 2007 and married his wife, Christine, in 2008. Because he faced mandatory retirement from Southwest at age 60 and loved sailing, he started a boat chartering business to supplement his income later in life. Larry set up a limited liability company (LLC) which purchased two boats. He entered into an agreement with Horizon Charters to manage the boats.
One of the boats had 27 term charters in 2007 and 28 in 2008. The other had up to 10 term charters in 2008. Most of these were bareboat charters, but arrangements could be made through Horizon for provisions and a skipper if necessary. Larry chartered one of the boats twice in 2007 and twice in 2008, accounting for two of the term charters in each year. The average period of customer use for each boat during 2007 and 2008 was seven days or less. Larry was active in advertising his boats to generate bareboat or skippered charters and specifically targeted his marketing efforts towards pilots at Southwest and other airlines. His efforts paid off because each of the times that he chartered one of his boats during the years at issue (i.e., 2007 and 2008), it was to skipper a charter for friends and acquaintances from Southwest and other airlines (Kline charters). In addition to Larry and Christine, three couples participated in each of the 2007 Kline charters, three couples participated in one of the 2008 Kline charters, and two couples participated in the other.
Generally, the expenses for each Kline charter were divided equally among the participants, and a 10 percent fee was added as a profit margin. Following each Kline charter, Larry would send an invoice to the participants for the amount owed. Larry did not owe the customary charter fee to Horizon in connection with the Kline charters.
Larry reported the income from the Kline charters along with the income from the other term charters on the Schedules C attached to the Forms 1040 for 2007 and 2008. On Larry's single return for 2007 and Larry and Christine's joint return for 2008, losses of $105,930 and $98,371, respectively, were reported on Schedule C from the boat charter business.
During an audit, the IRS asked Larry to provide the number of hours spent in connection with the charter activity. While Larry and Christine did not maintain a contemporaneous log of the time spent, Larry did maintain copies of email communications with Horizon. Using this correspondence and records of the length and destination of the Kline charters, Larry and Christine were able to develop a log of the time they spent. The log reflected totals of 470 hours for 2007 and 732.5 hours for 2008. The hours reflected in these totals were based on the following three categories: (1) the boat business, which involved running the charter business, including communication with Horizon, working on administrative aspects, and related matters; (2) advertising, which included promoting the charter business to the public; and (3) the Kline charters, including the preliminary planning and determination of the participants' needs for each trip.
Of the 470 hours for 2007, 386.5 hours were spent by Larry in connection with the two Kline charters. Of the 732.5 hours for 2008, 365.5 hours were attributable to Larry, 271.5 of which were for time he spent in connection with the two Kline charters. The remaining 367 hours for 2008 were attributable to Christine, 254 of which were for the time she spent on the Kline charters.
IRS and Taxpayer Arguments
While the IRS conceded that Larry and Christine were engaged in a charter boat business during 2007 and 2008, it determined that the couple did not materially participate in the business. Thus, the IRS said the losses from the business were passive activity losses that could not be deducted against nonpassive income. Losses are not considered passive if the taxpayer materially participates in the activity. Under Code Sec. 469(h)(1), a taxpayer materially participates in an activity if he or she is involved in its operations on a regular, continuous, and substantial basis. A taxpayer can establish material participation by satisfying any of seven tests provided in Reg. Sec. 1.469-5T(a).
Larry and Christine argued that they satisfied the material participation test in Reg. Sec. 1.469-5T(a)(3). That regulation provides that for purposes of Code Sec. 469, an individual is treated as materially participating in an activity for the tax year if and only if the individual participates in the activity for more than 100 hours during the tax year, and such individual's participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year. For purposes of this test, if a taxpayer's spouse participates in the activity, it is treated as participation by the taxpayer.
The IRS's principal contention was that the Kline charters were personal and that time spent with respect to them did not count towards meeting the material participation test.
Analysis
The Tax Court held that Larry and Christine materially participated in the charter boat business and thus could deduct the losses from the business against nonpassive income. The court looked at whether the Kline charters were personal, noting that this was a critical distinction for 2007 because Larry spent less than 100 hours on the charter business if the time he spent on the Kline charters was not counted.
The court also noted that some of the activities other than those connected with the Kline charters could be considered investor activity and thus not count towards material participation. Accordingly, the primary issue before the Tax Court hinged on whether the time Larry and Christine spent before and during the Kline charters could be counted towards the hours needed to qualify under the material participation test in Reg. Sec. 1.469-5T(a)(3).
Larry, the court observed, continued to work as an airline pilot during the years at issue, and he focused his marketing efforts on other pilots. The court said that the fact that Larry's friends and acquaintances were the Kline charter participants did not, per se, make those charters personal vacations or preclude them from being counted for purposes of the material participation test. According to the court, while Larry and Christine may not have owed the customary charter fee to Horizon in connection with the Kline charters, they engaged in these charters for a profit because they divided the expenses for the Kline charters among the participants and added a 10 percent profit margin, and the income from these charters was included on their Schedules C. The court found that the time Larry and Christine spent preparing for and sailing on the Kline charters could be considered for purposes of determining whether Larry materially participated in the charter business. The purpose of the material participation test, the court observed, is to distinguish actively participating in the operation of a business from investor type activity.
Though Larry and Christine did not contemporaneously record their time, the court found the time entries they provided to be reasonable reconstructions of the hours that they spent in the charter business and consistent with the requirements of Reg. Sec. 1.469-5T(f)(4). In addition, the court concluded that, on the basis of the invoices Horizon sent to Larry and Christine regarding work done on the boats and the testimony of Horizon's operations manager during the years at issue, Larry and Christine spent more time in connection with the boats than any individual employed by Horizon.
For a discussion of the seven material participation tests under the passive activity loss rules, see Parker Tax ¶247,115.
Farming Corporation Can Deduct Field-Packing Materials in Year Purchased
Field-packing materials that a farming corporation buys that are "on hand" are governed by Reg. Sec. 1.162-3, which does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed if the taxpayer deducted such costs for a prior tax year. Agro-Jal Farming Enterprises, Inc. v. Comm'r, 145 T.C. No. 5 (2015).
Observation: In 2012, the IRS revised Reg. Sec. 1.162-3 as part of its overhaul of the tangible property rules. Generally, under the revised rules, amounts paid to acquire or produce nonincidental materials and supplies are deductible in the tax year in which the materials and supplies are first used or consumed in the taxpayer's operations. Amounts paid to acquire or produce incidental materials and supplies that are carried on hand and for which no record of consumption is kept or of which physical inventories at the beginning and end of the tax year are not taken, are deductible in the tax year in which these amounts are paid, provided that taxable income is clearly reflected.
Background
Agro-Jal Farming Enterprises, Inc. is a farming corporation that grows strawberries and vegetables. When it harvests them, Agro-Jal uses field-packing materials (plastic clamshell containers for the strawberries and cardboard trays and cartons for the vegetables) to hold the produce. Agro-Jal's ability to pack quickly would be significantly weakened if it didn't keep field-packing materials on hand. The packing materials are always used by the end of the tax year following the year in which they are purchased.
Agro-Jal uses the cash method for tax purposes. In 2006-2008, Agro-Jal deducted the full purchase price of the field-packing materials in the year it purchased the materials rather than deducting the amounts as the materials were used.
The IRS assessed a deficiency, arguing that, under Code Sec. 464 and Reg. Sec. 1.162-3 (as the regulation existed in 2006-2008), Agro-Jal could only deduct the cost of the field-packing materials in the years in which they were used.
Taxpayer and IRS Arguments
Code Sec. 464 limits the ability of "farming syndicates" and those who are not "qualified farm-related taxpayers" to use the cash method. While the IRS did not argue that Agro-Jal was a farming syndicate, it looked to the exceptions to capitalization in Code Secs. 464(a) and (f) (which allow immediate deductions for feed, seed, fertilizer, or other similar farm supplies when the amounts prepaid for such expenses don't account for more than 50 percent of all farming expenses during any three-year period) and said they didn't apply to Agro-Jal. While the phrase "other similar farm supplies" is not defined anywhere, the IRS argued that it should be narrowly construed to not include Agro-Jal's field-packing materials.
Reg. Sec. 1.162-3, for the years at issue, provides that taxpayers carrying materials and supplies on hand should include in expenses the charges for materials and supplies only in the amount actually consumed and used in operations during the tax year, PROVIDED THAT the costs of such materials and supplies have not been deducted in determining the net income or loss or taxable income for any previous tax year.
Agro-Jal contended that because it already deducted its materials and supplies in an earlier year - the year it bought them--it wasn't required to defer its deduction until the year the supplies were used or consumed. The company noted that the general rule is that farmers can use the cash method for supplies they use within a year of purchase, but Reg. Sec. 1.162-3 creates a significant exception to that rule. However, Agro-Jal contended, this exception doesn't apply to cash-method taxpayers who meet the condition set forth in the "provided that" clause. If a taxpayer has already deducted costs of supplies for a prior year, Argo-Jal said, the taxpayer isn't subject to the first clause. According to Agro-Jal, the second clause is important to ensure that a deduction is not taken twice by those using the cash method. The first sentence of Reg. Sec. 1.162-3, the company argued, merely emphasizes the need to bar a second deduction for the same supplies when a taxpayer actually uses them in a later year, but doesn't require taxpayers to defer deductions until consumption. Agro-Jal concluded that its interpretation must be correct, because the "provided that" clause would be meaningless if it wasn't read as a conditional limit on the reach of the first clause.
According to the IRS, the "provided that" clause should be read as a limitation or qualification to prevent a double deduction. The IRS said that Agro-Jal's reading of the second clause deprives the first clause of any effect in the case of a cash-method taxpayer while the IRS's reading gives meaning to the whole regulation and produces a logical result.
Analysis
The Tax Court held that Agro-Jal could deduct the cost of the field-packing materials in the year purchased. According to the court, the packing materials that Agro-Jal buys that are not "on hand" are governed by the general rules of cash-method accounting, which allows a current deduction. The court said that the materials that Agro-Jal buys that are "on hand," like the field-packing materials, are governed by Reg. Sec. 1.162-3, which the court concluded does not require a cash-method taxpayer to defer its deductions until the materials are used or consumed if the taxpayer deducted their costs for a prior tax year.
The court held that the "provided that" clause of Reg. Sec. 1.162-3 means that materials and supplies must be deducted as they are used or consumed, on the condition that (or "only if", or "as long as") they haven't been deducted in any prior year. The court agreed with Agro-Jal's interpretation of the phrase "provided that" as used in Reg. Sec. 1.162-3 as meaning that Agro-Jal has to defer its deductions until it uses or consumes the field-packing materials "only if" it didn't deduct them in any prior year.
The court did agree with the IRS, however, on its argument that the term "other similar farm supplies" in Code Sec. 464 did not include Agro-Jal's field-packing material. When a general word or phrase follows a list of more specific words, the court said that the general word or phrase should be narrowly construed to include only things that are akin to the specific words. The court said that, while it didn't doubt that Agro-Jal's field-packing materials were of critical importance to its harvesting process and its overall business operations, the materials weren't critical to the growing of crops or the raising of livestock. Thus, the court concluded that they were not similar enough to the class of items described by the phrase "feed, seed, [or] fertilizer."
For a discussion of the general rule for deducting payments for materials and supplies, see Parker Tax ¶242,705.
Car Rental Company Can't Take Casualty Loss Deduction for Totaled Vehicles
Collision damages to a company's rental vehicles, which had to be disposed of, did not arise from a casualty because the occurrence of the damage was not unusual in the ordinary course of the company's business of renting vehicles and, thus, the company could not deduct the estimated repair costs as a casualty loss. CCA 201529008.
Background
A vehicle rental company offers customers who rent a vehicle the opportunity to purchase a damage waiver. The waiver waives the company's right to seek recovery from the customer or the customer's insurance company for damage to the vehicle while the vehicle is in the customer's custody. If a customer declines the waiver and the vehicle is damaged, the company obtains a third-party estimate of the cost to repair the damage and seeks recovery for the damage from the customer or the customer's insurance company. If one of the company's vehicles is damaged and the customer purchased a waiver, the company either repairs the vehicle or sells it in damaged condition. The company only repairs vehicles it intends to keep in its fleet and does not repair damage to vehicles it determines should be disposed of. The company does not purchase any insurance coverage on its rental vehicles.
With respect to damaged vehicles for which the company could not seek recovery from its customers or their insurer because a waiver was purchased, and that were subsequently disposed of, the company claimed a casualty loss under Code Sec. 165 in the amount of its own estimate of the cost to repair the damage to these vehicles.
Under Reg. Sec. 1.165-7(a)(3), an automobile owned by a taxpayer, whether used for business purposes or maintained for recreation or pleasure, may be the subject of a casualty loss, including losses arising from fire, storm, or other casualty. In addition, a casualty loss occurs when an automobile owned by the taxpayer is damaged and if: (1) the damage results from the faulty driving of the taxpayer or other person operating the automobile but is not due to the willful act or willful negligence of the taxpayer or of one acting in the taxpayer's behalf, or (2) the damage results from the faulty driving of the operator of the vehicle with which the automobile of the taxpayer collides.
Rev. Rul. 72-592 provides that in order for a loss to qualify as a casualty loss under Code Sec. 165, the loss must result from some event that is:
(1) identifiable,
(2) damaging to property, and
(3) sudden, unexpected, and unusual in nature.
To be "sudden," the event must be one that is swift and precipitous and not gradual or progressive. To be "unexpected," the event must be one that is ordinarily unanticipated, which occurs without the intent of the one who suffers the loss. To be "unusual" the event must be one that is extraordinary and nonrecurring, one that does not commonly occur during the activity in which the taxpayer was engaged when the destruction or damage occurred, and one that does not commonly occur in the ordinary course of day-to-day living of the taxpayer.
Analysis
The IRS Office of Chief Counsel (IRS) advised that collision damages to the company's rental vehicles did not arise from a casualty within the meaning of Code Sec. 165 because the occurrence of such damage was not unusual in the ordinary course of the company's business of renting vehicles. The IRS noted that courts examined similar facts for years before the repeal of the excess profits tax and determined that certain events such as vehicle accidents were not unusual for a car rental business and were an ordinary and necessary expense of doing business. The tax treatment of damages from a vehicle collision as a casualty loss under Code Sec. 165 or as a business expense for the cost of the repairs under Code Sec. 162 made a difference before the repeal of the excess profits tax. Casualty losses could reduce the excess profits tax while business expense deductions did not.
The IRS cited Atlantic Greyhound Corporation v. U.S., 111 F. Supp. 953 (Ct. Cl. 1953), where the court had to determine if the costs of repairing collision damages to the taxpayer's buses were ordinary and necessary business expenses or were casualty losses. The court noted that, during the year at issue, the taxpayer had an average of 243 buses in service averaging 8,029 bus miles per month per bus operated. This amounted to almost 2,000,000 miles per month during that year. The court held that under such circumstances, accident collision damage was expected, normal, and inevitable, and the cost of repairing such damage was an ordinary and necessary expense of doing business.
The IRS noted that the Tax Court also considered a similar issue in Consolidated Motor Lines, Inc. v. Comm'r, 6 T.C. 1066 (1946). In Consolidated Motor Lines, the taxpayer, a freight transporter by motor, argued that it should be able to deduct as losses damages to cargo due to such events as theft, fire, turnover, collision and rain, as well as property damage that arose from accidents in which its vehicles were involved. The court noted that the taxpayer was a motor carrier of freight that operated on a large scale and over several states.
The court held that all the expenses at issue were normally incident to the business of the taxpayer and did not involve any concept of abnormality. The amounts expended were all for recurring expenses that were ordinary and necessary business expenses. The court found that this result applied not only because of the character of the taxpayer's business and operations but also because of the large amounts involved. The court held that a common carrier constantly shipping freight over the public highways may not reasonably be said to suffer unusual casualty or abnormal "loss" as a result of the matters here being considered.
For a discussion of what constitutes a deductible casualty loss, see Parker Tax ¶84,505.
Tax Court Limits Charitable Contribution Deduction for Remainder Interests in CRTs
Where the payout of two NIMCRUTs is the lesser of the trust income or a fixed percentage, an annual distribution amount equal to the fixed percentage stated in the trust instruments must be used to determine whether the estate of the decedent who created the NIMCRUTs is eligible for a charitable contribution deduction. Est. of Schaefer v. Comm'r, 145 T.C. No. 4 (2015).
During his lifetime, Arthur Schaefer established two irrevocable charitable remainder unitrusts (CRUTs). Each trust was designed so that one of Arthur's sons would receive distributions during his life or a term of years with the remainder going to a charity. Each trust instrument states that the trustee must make distributions to the noncharitable beneficiary (i.e., Arthur's sons) of the lesser of the net trust accounting income for the taxable year and a fixed percentage of the net fair market value of the trust assets, valued annually. Each trust instrument also allows the trustee to make additional distributions, limited to trust income, if previous distributions did not equal the fixed percentage. Trusts using this provision are net income with makeup charitable remainder unitrusts (NIMCRUTs).
For each trust to qualify as a charitable remainder trust, thereby making the estate eligible for a charitable contribution deduction, Code Sec. 664(d)(2) requires that the value of the remainder interest must be at least 10 percent of the net fair market value of the property contributed. Code Sec. 664(e) describes how to value a charitable remainder interest. It provides that, for purposes of determining the amount of any charitable contribution, the remainder interest of a CRUT is computed on the basis that an amount equal to 5 percent of the net fair market value of its assets (or a greater amount, if required under the terms of the trust instrument) is to be distributed each year.
The IRS and estate disagreed on how to take into account distributions from a NIMCRUT when valuing the remainder interest. The IRS pointed to Reg. Sec. 1.664-4(a)(3), which indicates that the fixed percentage is distributed implicitly without regard to the net income limitation in the case of a NIMCRUT. The estate argued that NIMCRUT distributions are determined not under this rule but under an exception to this rule in Reg. Sec. 1.664-3(a)(1)(i)(b). According to the estate, in valuing the remainder interest, the distributions are calculated by using the Code Sec. 7520 rate to determine the trust's expected income, so long as the Code Sec. 7520 rate is above 5 percent of the net fair market value of the assets. The IRS argued that the remainder interest is valued using a distribution rate equal to the fixed percentage in the trust instrument.
The Tax Court found the text of Code Sec. 664(e) ambiguous. In describing the distribution to be taken into account for valuation purposes, Code Sec. 664(e) does not expressly use the words "sum certain" or "fixed percentage", the court noted. Instead Code Sec. 664(e) provides that a distribution rate "equal to 5 percent of the net fair market value of its assets (or a greater amount, if required under the terms of the trust instrument)" is to be used. The Tax Court said it was unable to determine on its face whether this provision meant the sum certain (in the case of a CRAT) or the fixed percentage (in the case of a CRUT) or whether it meant something different. The court found the regulations were also ambiguous, and turned to other administrative guidance.
The court noted that, in Rev. Rul. 72-395 and Rev. Proc. 2005-54, the IRS asserts that the remainder interest of a NIMCRUT is valued using the fixed percentage stated in the trust instrument, regardless of the fact that distributions are limited to trust income. After reviewing the legislative history of Code Sec. 664, the Tax Court found the IRS's guidance to be persuasive. Both pieces of guidance, the court said, were thoroughly reasoned and provided examples and explanations based on the applicable provisions. Additionally, the court said, the guidance has withstood the test of time, and the IRS's position also has remained consistent and has been the subject of little litigation.
The legislative history and the administrative guidance, the court said, pointed to only one conclusion - that the value of the remainder interest of a NIMCRUT must be calculated using the greater of 5 percent or the fixed percentage stated in the trust instrument. Accordingly, the court concluded that the estate had to use an annual distribution amount of 11 percent or 10 percent of the net fair market value of the trust assets when valuing the remainder interests of the two trusts. Because the parties had previously stipulated that the estate would not be entitled to a charitable contribution deduction if the remainder interests were valued using this method, the estate was not entitled to a charitable deduction.
For a discussion of the rules relating to CRUTs, see Parker Tax ¶57,115.
