Federal Tax Bulletin - Issue 94 - August 4, 2015

Prop Regs on Disguised Payments for Partnership Services Focus on Importance of Entrepreneurial Risk

On July 23, the IRS issued proposed regulations (REG-115452-14) under Code Sec. 707 which provide guidance to partnerships and their partners on when an arrangement will be treated as a disguised payment for services. The proposed regulations stress that entrepreneurial risk is the most important factor to consider and an arrangement that lacks significant entrepreneurial risk will be considered a disguised payment for services.

The proposed regulations also provide notice of proposed modifications to Rev. Procs. 93-27 and 2001-43, relating to the issuance of interests in partnership profits to service providers, as well as proposed changes to the guaranteed payment rules under Code Sec. 707(c).

The proposed regulations would apply to all arrangements entered into or modified after the date final regulations are published. If an arrangement was entered into or modified on or before that date, the determination of whether it is a disguised fee for services under Code Sec. 707(a)(2)(A) would be based on the statute and the guidance provided in the legislative history of Section 73 of the Tax Reform Act of 1984.

Background

Code Sec. 707(a)(2) was enacted as part of the Tax Reform Act of 1984 and grants the IRS authority to issue regulations identifying transactions involving disguised payments for services. Code Sec. 707(a)(2)(A) provides that if a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of services and allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in its capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner under Code Sec. 707(a)(1).

The grant of authority to issue regulations under Code Sec. 707(a)(2) stemmed from Congress's concern that partnerships had been used effectively to circumvent the rule to capitalize certain expenses, and other rules and restrictions concerning various types of expenses, by making allocations of income and corresponding distributions in place of direct payments for property or services.

Congress determined that allocations and distributions that were, in substance, direct payments for services should be treated as a payment of fees rather than as an arrangement for the allocation and distribution of partnership income. Congress differentiated these arrangements from situations in which a partner receives an allocation (or increased allocation) for an extended period to reflect its contribution of property or services to the partnership, such that the partner receives the allocation in its capacity as a partner. In balancing these potentially conflicting concerns, Congress anticipated that the regulations would take several factors into account in determining whether a service provider would receive its putative allocation and distribution in its capacity as a partner, with the most important factor being whether the payment is subject to significant entrepreneurial risk as to both the amount and the fact of payment.

Arrangements Treated as Disguised Payments for Services

Under Prop. Reg. Sec. 1.707-2(b), an arrangement is treated as a disguised payment for services if:

(1) a person (service provider), either in a partner capacity or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership;

(2) there is a related direct or indirect allocation and distribution to the service provider; and

(3) the performance of the services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner.

If an arrangement is treated as a disguised payment for services under these rules, it is treated as a payment for services for all purposes of the Code. Thus, the partnership must treat the payments as payments to a non-partner in determining the remaining partners' shares of taxable income or loss. Where appropriate, the partnership must capitalize the payments or otherwise treat them in a manner consistent with the recharacterization.

In the preamble to the proposed regulations, the IRS states that Code Sec. 707(a)(2)(A) generally should not apply to arrangements that the partnership has reasonably characterized as a guaranteed payment under Code Sec. 707(c).

Application and Timing

The proposed regulations apply to a service provider who purports to be a partner even if applying the regulations causes the service provider to be treated as a person who is not a partner. Further, the proposed regulations may apply even if their application results in a determination that no partnership exists. The regulations also apply to a special allocation and distribution received in exchange for services by a service provider who receives other allocations and distributions in a partner capacity under Code Sec. 704(b).

The proposed regulations characterize the nature of an arrangement at the time at which the parties enter into or modify the arrangement. Although Code Sec. 707(a)(2)(A)(ii) requires both an allocation and a distribution to the service provider, the IRS noted that a premise of Code Sec. 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption in the proposed regulations that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying Code Sec. 707(a)(2)(A).

While the IRS acknowledged that some arrangements provide for distributions in a later year, and those later distributions may be subject to independent risk, it said that recharacterizing an arrangement retroactively is administratively difficult. Thus, the proposed regulations characterize the nature of an arrangement when the arrangement is entered into (or modified) regardless of when income is allocated and when money or property is distributed. The proposed regulations apply to both one-time transactions and continuing arrangements.

The proposed regulations do not address the timing of inclusion by the service provider or the timing of a deduction by the partnership other than to provide that each is taken into account by applying all relevant sections of the Code and all relevant judicial doctrines.

Prop. Regs Stress the Importance of Significant Entrepreneurial Risk

The proposed regulations follow Congress' lead in stressing entrepreneurial risk as the most important factor in determining whether or not an arrangement constitutes a payment for services. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services. An arrangement in which allocations and distributions to the service provider are subject to significant entrepreneurial risk will generally be recognized as a distributive share but the ultimate determination depends on the totality of the facts and circumstances.

Whether an arrangement lacks significant entrepreneurial risk is based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. For example, a service provider who receives a percentage of net profits in both a partnership that invests in high-quality debt instruments and a partnership that invests in volatile or unproven businesses may have significant entrepreneurial risk with respect to both interests.

The following facts and circumstances create a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services unless other facts and circumstances establish the presence of significant entrepreneurial risk by clear and convincing evidence:

(1) capped allocations of partnership income if the cap is reasonably expected to apply in most years;

(2) an allocation for one or more years under which the service provider's share of income is reasonably certain;

(3) an allocation of gross income;

(4) an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g. if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise); or

(5) an arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.

Secondary Considerations in Determining If an Arrangement Is a Payment for Services

Besides entrepreneurial risk, the proposed regulations list the following additional factors the IRS will consider in determining whether or not an arrangement constitutes a payment for services:

(1) the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;

(2) the service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment;

(3) the service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity;

(4) the value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution; or

(5) the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under Code Secs. 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Example: ABC Partnership constructed a building that is projected to generate $100,000 of gross income annually. Al, an architect, performs services for ABC for which Al's normal fee would be $40,000 and contributes cash in an amount equal to the value of a 25 percent interest in ABC. In exchange, Al will receive a 25 percent distributive share for the life of the partnership and a special allocation of $20,000 of ABC gross income for the first two years of the partnership's operations. The ABC partnership agreement satisfies the requirements for economic effect, including requiring that liquidating distributions are made in accordance with the partners' positive capital account balances. The special allocation to Al is a capped amount and the cap is reasonably expected to apply. The special allocation is also made out of gross income. Under the proposed regulations, the capped allocations of income and gross income allocations are presumed to lack significant entrepreneurial risk. No additional facts and circumstances establish otherwise by clear and convincing evidence. Thus, the allocation lacks significant entrepreneurial risk. Accordingly, the arrangement provides for a disguised payment for services as of the date that Al and ABC enter into the arrangement and the payment should be included in income by Al.

Modifications to Revenue Procedures 93-27 and 2001-43

Rev. Procs. 93-27 and 2001-43 provide guidance on the treatment of the receipt of a partnership profits interest for services provided to or for the benefit of the partnership and lists specific situations to which the procedures do not apply. In the preamble to the proposed regulations, the IRS indicates that it intends to modify the exceptions set forth in those revenue procedures to include an additional exception for profits interests issued in conjunction with a partner forgoing payment of a substantially fixed amount.

[Return to Table of Contents]

IRS Provides Economic Performance Safe Harbor for Ratable Service Contracts

The IRS has provided a safe harbor for accrual method taxpayers to treat economic performance as occurring ratably on contracts that provide services on a regular basis. Under the safe harbor, which is effective for tax years ending on or after July 30, 2015, a taxpayer can ratably expense the cost of regular and routine services as the services are provided under the contract. The IRS also provides procedures for obtaining automatic consent to change to the safe harbor method of accounting. Rev. Proc. 2015-39.

Background

Under the accrual method of accounting, a liability is incurred, and generally taken into account for federal income tax purposes, in the tax year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy (collectively referred to as the "all events test"), and (3) economic performance has occurred with respect to the liability.

In general, if the liability of a taxpayer is based on services performed for the taxpayer, economic performance occurs as the person provides those services.

Two exceptions allow a taxpayer to accelerate the accrual of a liability into a year prior to the year that the services are performed: the 3-1/2 month rule and the recurring item exception.

Under the 3-1/2 month rule in Reg. Sec. 1.461-4(d)(6)(ii), a taxpayer may treat economic performance as occurring as the taxpayer makes payment to the person providing the services if the taxpayer can reasonably expect the person to provide the services within 3-1/2 months after the taxpayer makes the payment. Reg. Sec. 1.461-4(d)(6)(iv) provides that if different services are required to be provided to the taxpayer under a single contract, economic performance occurs over the time each service is provided. In Caltex Oil Venture v. Commissioner, 138 T.C. 18, 36 (2012), the Tax Court construed the 3-1/2 month rule as contemplating that all of the services called for under an undifferentiated, nonseverable contract must be provided within 3-1/2 months of payment.

Under the recurring item exception in Code Sec. 461(h)(3)(A) and Reg. Sec. 1.461-5(b), a liability is treated as incurred for a tax year if: (1) at the end of the tax year, all the events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (2) economic performance occurs on or before the earlier of the date that the taxpayer files a timely return (including extensions) for the tax year, or the 15th day of the ninth calendar month after the close of the tax year; (3) the liability is recurring in nature; and (4) either the amount of the liability is not material or the accrual of the liability in the tax year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the tax year in which economic performance occurs.

Safe Harbor for Ratable Service Contracts

Under the safe harbor method of accounting for ratable service contracts, a taxpayer may treat economic performance as occurring on a ratable basis over the term of the service contract in order to apply the 3-1/2 month rule and the recurring item exception.

A contract is a ratable service contract if:

(1) the contract provides for similar services to be provided on a regular basis, such as daily, weekly, or monthly;

(2) each occurrence of the service provides independent value, such that the benefits of receiving each occurrence of the service is not dependent on the receipt of any previous or subsequent occurrence of the service, and;

(3) the term of the contract does not exceed 12 months.

Contract renewal provisions will not be considered in determining whether a contract exceeds 12 months.

If a single contract includes services that satisfy the above requirements and services (or other items) that do not satisfy those requirements, the services (or other items) that do not satisfy the requirements must be separately priced for the contract to qualify as a ratable service contract.

The safe harbor is effective for tax years ending on or after July 30, 2015.

Consent to Change to Method of Accounting under the Safe Harbor

A change in the treatment of ratable service contracts to conform to the safe harbor method is a change in method of accounting and a taxpayer wishing to change to the safe harbor method must use the automatic consent procedures in Rev. Proc. 2015-13 and Rev. Proc. 2015-14. As such, the IRS has modified Rev. Proc. 2015-14 to add new Section 19.21, Economic Performance Safe Harbor for Ratable Service Contracts, to the list of automatic changes.

Observation: The designated automatic accounting method change number for a change to the safe harbor for ratable service contract is "220."

The eligibility rule in section 5.01(1)(f) of Rev. Proc. 2015-13, requiring that the taxpayer has not made or requested a change for the same item during any of the five tax years ending with the year of change, does not apply to a taxpayer that wants to make a change for a taxpayer's first, second, or third tax years ending on or after July 30, 2015.

Illustrations of the Safe Harbor Method

The following examples illustrate the application of the safe harbor method of accounting for ratable service contracts. In each example the taxpayer uses an accrual method of accounting for federal income tax purposes, including the use of the 3-1/2 month rule and the recurring item exception, and files its returns on a calendar year basis.

Example 1: On December 31, 2015, Taxpayer enters into a one-year service contract with Janitors Inc. to provide janitorial services on a daily basis to Taxpayer until the end of 2016, at a cost of $3,000 a month to be paid by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment for the services to be provided in January 2016. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer's $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract in Example 1 meets the requirements of a ratable service contract because the janitorial services are to be provided on a regular basis (daily); each daily occurrence of the janitorial service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of previous or subsequent janitorial services; and the contract term does not exceed 12 months. Thus, Taxpayer may treat economic performance as occurring ratably under the contract and under the 3-1/2 month rule Taxpayer incurs a liability in 2015 for the $3,000 paid in 2015.

Example 2: On December 31, 2015, Taxpayer enters into a one-year service contract with Landscapers Inc. to provide landscape maintenance services to Taxpayer from January through December 2016 on a monthly basis at a cost of $4,000. The contract requires Taxpayer to prepay for the twelve months of services with the full payment of $48,000 due on December 31, 2015. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer's $48,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract in Example 2 meets the requirements of a ratable service contract and Taxpayer may treat economic performance as occurring ratably under the contract because the maintenance services are to be provided on a regular basis (monthly); each occurrence of the maintenance service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent maintenance services; and the contract term does not exceed 12 months. Assuming that Taxpayer satisfies the requirements of the recurring item exception, and files its return on September 15, 2016, Taxpayer incurs a liability in 2015 of $34,000 (8.5 months/12 months x $48,000) for the services provided from January 1 through September 15, 2016. For the services provided from September 16 through December 31, 2016, the period outside of the recurring item exception, economic performance occurs ratably as the services are provided to Taxpayer during that time and a liability for these services of $14,000 (3.5 months/12 months x $48,000) is incurred in 2016.

Example 3: On November 30, 2015, Taxpayer enters into a one-year contract for an environmental impact study with Enviro Co. Under the contract, Enviro must complete and deliver the study by November 30, 2016. Taxpayer will pay Enviro $100,000 when the contract is signed and $400,000 when the study is delivered. Enviro performs work on the study during 2015 and 2016 and delivers the completed study to Taxpayer on November 30, 2016. On November 30, 2015, all the events have occurred that establish the fact of Taxpayer's contractually-required payment of $100,000 and the amount of Taxpayer's liability under the contract can be determined with reasonable accuracy.

The contract in Example 3 does not satisfy the definition of a ratable service contract because the servicewill not be provided on a regular basis. Rather, the contract specifies that Enviro will provide to Taxpayer only one service, namely a completed and delivered impact study. Each instance of work on the study during the contract period does not provide independent value to Taxpayer. Instead, each instance of work on the study is dependent on the previous and subsequent work on the study to achieve its completion. Thus, Taxpayer may not treat economic performance as occurring ratably over the term of the service contract pursuant to the safe harbor and may not rely on the safe harbor to incur a liability for any portion of the $100,000 in 2015. Instead, economic performance occurs when the study is completed and a liability of $500,000 for this service is incurred upon its completion.

Example 4: On December 31, 2015, Taxpayer enters into a one-year service contract with IT Co. to provide various IT support and maintenance services to Taxpayer on a daily basis through December 31, 2016. In addition, IT Co. will create an updated human resources software application for Taxpayer (HR software development service). Taxpayer will pay IT Co. a flat fee of $3,000 a month for the IT services and the HR software development service, paid by the end of the prior month. On December 31, 2015, Taxpayer makes a $3,000 payment to IT Co. for the services to be provided in January 2016. As of December 31, 2015, all events have occurred to establish the fact of Taxpayer's $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

The contract in Example 4 does not meet the requirements of a ratable service contract because the contract includes the HR software development service, which is not provided on a regular basis. Under the terms of the contract, the HR software development service consists of only one service, an update to Taxpayer's human resources software application. Each instance of IT Co.'s work on updating the software application during the contract period is dependent on the previous and subsequent work to complete the update and does not provide independent value to Taxpayer. Because the contract does not separately price the HR software development service, Taxpayer may not treat economic performance as occurring on a ratable basis over the term of the service contract.

Example 5: Same facts as in Example 4, except that under the service contract the HR software development service is separately priced at $12,000, with $1,000 of the $3,000 monthly payment allocated to the software development service. The IT services described in the contract meet the requirements for a ratable service contract and Taxpayer may treat economic performance for the IT services as occurring ratably because the IT services are provided on a regular basis (daily); each daily occurrence of IT service provides independent value, such that the benefits from each occurrence of the service are not dependent on the receipt of prior or subsequent IT services; and the contract term does not exceed 12 months. Taxpayer incurs a liability in 2015 for $2,000 of the $3,000 payment for IT services under the 3-1/2 month rule. For the IT services provided from February through December 2016, economic performance occurs ratably as the services are provided to Taxpayer each day and a liability of $22,000 for these services is incurred in 2016. For the HR software development service liability, economic performance occurs when the service is completed and a liability of $12,000 for this service is incurred upon completion.

[Return to Table of Contents]

Final Section 482 Reg Invalid; Fails to Satisfy "Reasoned Decision Making" Standard

In issuing Reg. Sec. 1.482-7(d)(2), which requires controlled parties entering into qualified cost-sharing agreements to share stock-based compensation (SBC) costs, the IRS failed to support its belief that unrelated parties would share SBC costs, failed to satisfy the reasoned decision making standard in Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mutual Auto Ins. Co., 463 U.S. 29 (1983), and had no reasonable explanation for adopting the regulation; thus the regulation is invalid. Altera Corporation and Subs v. Comm'r, 145 T.C. No. 3 (2015).

Background

Altera Corporation (Altera U.S.) is the parent company of an affiliated group of corporations filing a consolidated tax return. Altera International is a Cayman Islands subsidiary of Altera U.S. In 1997, Altera U.S. and Altera International entered into concurrent agreements: a master technology license agreement (technology license agreement) and a technology research and development cost-sharing agreement (R&D cost sharing agreement).

Under the technology license agreement, Altera U.S. licensed to Altera International the right to use and exploit, everywhere except the United States and Canada, all of Altera U.S.'s intangible property relating to programmable logic devices and programming tools that existed before the R&D cost-sharing agreement (pre-cost-sharing intangible property). In exchange for the rights granted under the technology license agreement, Altera International paid royalties to Altera U.S. As of December 31, 2003, Altera International owned a fully paid-up license to use the pre-cost-sharing intangible property in its territory.

Under a cost-sharing agreement, Altera U.S. and Altera International agreed to pool their respective resources to conduct R&D using pre-cost-sharing intangible property owned by Altera International. Under the R&D cost sharing agreement, Altera U.S. and Altera International agreed to share the risks and costs of R&D activities they performed on or after May 23, 1997. The R&D cost-sharing agreement was in effect from May 23, 1997, through 2007.

From 2004 through 2007, Altera U.S. granted stock options and other stock-based compensation (SBC) to certain employees. Some of the employees of Altera U.S. who performed R&D activities subject to the R&D cost sharing agreement received stock options or other SBC. The employees' cash compensation was included in the cost pool under the R&D cost sharing agreement, but Altera U.S. did not share the SBC costs with Altera International. Altera International made cost-sharing payments to Altera U.S. during 2004-2007 of approximately $648 million.

The IRS assessed a deficiency in Altera U.S.'s taxes for 2004-2007 based on Code Sec. 482 allocations made by the IRS pursuant to Reg. Sec. 1.482-7(d)(2). The regulation, which was issued in 2003, requires participants in qualified cost-sharing arrangements (QCSAs) to share SBC costs to achieve an arm's-length result. Code Sec. 482 authorizes the IRS to allocate income and expenses among related entities to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between related parties. Under Reg. Sec. 1.482-1(b)(1), in determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer.

Analysis

Altera U.S. argued that Reg. Sec. 1.482-7(d)(2) did not apply because the regulation is arbitrary and capricious under Administrative Procedure Act (APA) Section 706(2)(A) and Motor Vehicle Mfrs. Ass'n of the U.S. v. State Farm Mut. Auto Ins. Co., 463 U.S. 29 (1983). The IRS countered that the final regulation was valid under Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), or alternatively, under State Farm.

In State Farm, the U.S. Supreme Court said that, pursuant to APA Section 706(2)(A), a court must hold unlawful and set aside agency actions, findings, and conclusions that the court finds to be arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law. A court's review under this standard is narrow and a court cannot substitute its judgment for that of the agency. However, the Supreme Court said, a reviewing court must ensure that the agency engaged in reasoned decision making and, to engage in reasoned decision making, the agency must examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.

The Tax Court sided with Altera U.S. and held that Reg. Sec. 1.482-7(d)(2) was invalid. The court pointed out that it had previously considered whether controlled taxpayers must include SBC in the pool of costs to be shared. In Xilinx Inc. v. Comm'r, 125 T.C. 37 (2005), aff'd, 598 F.3d 1191 (9th Cir. 2010), the court held that, under 1995 cost-sharing regulations, controlled entities entering into QCSAs need not share SBC costs because parties operating at arm's length would not do so. Under Reg. 1.482-7(d)(2), the court noted, a QCSA produces an arm's-length result only if controlled parties entering into QCSAs share SBC costs.

In reviewing the validity of Reg. Sec. 1.482-7(d)(2), the Tax Court said it was immaterial whether State Farm or Chevron supplied the standard for review because Chevron incorporates the reasoned decision making standard of State Farm and the validity of the regulation turned on whether the IRS reasonably concluded that the regulation was consistent with the arm's length standard. According to the court, the final regulation had to, in any event, satisfy State Farm's reasoned decision making standard.

The Tax Court concluded that the final regulation did not meet this standard because, in issuing it, the IRS failed to support its belief that unrelated parties would share SBC costs. According to the court, there was no evidence in the administrative record to support such reasoning, the IRS failed to articulate why all QCSAs should be treated identically, and the IRS failed to respond to significant comments. Additionally, the court said, the IRS's explanation for its decision to issue the regulation ran counter to the evidence before it.

For a discussion of the rules relating to transfers of intangible property to foreign corporations, see Parker Tax ¶47,560.

[Return to Table of Contents]

Taxpayers Can't Change to Closed Transaction Method of Accounting for Buy-Out Payments

Once a couple elected to report buy-out payments under the open transaction method, generating ordinary income, they were bound to continue using that method absent IRS consent to a change. The taxpayer's were thus unable amend their returns to treat the payments as long-term capital gains. Greiner v. U.S., 2015 PTC 249 (Fed. Cl. 2015).

Background

Until June 1, 2004, Jeffrey Greiner was president of Advanced Bionics Corporation. As part of his compensation package, he received stock options. On June 1, 2004, Advanced Bionics merged with Boston Scientific Corporation. In connection with the merger, all stock options held by Greiner and others were vested and then cancelled. In exchange, Greiner and other option holders had the choice of converting their cancelled holdings to either a one-time cash payment at a rate of $21 per share minus the applicable strike price for each option (the cash election), or a one-time cash payment at $11 per share, minus the strike price, plus a contractual "earn-out" right (the earn-out election). Earn-out recipients were eligible to receive pro rata shares of post-merger payments from Boston Scientific to a grantor trust (the Bionics Trust). Earn-out payments were not guaranteed or fixed, but would be measured by the future performance of certain product lines. The payment right would last nine years, from January 1, 2005, through December 31, 2013

Greiner chose the earn-out election. Boston Scientific reported the cash component as gross pay on Greiner's 2004 IRS Form W-2, and Greiner and his wife reported the cash as ordinary compensation income on their 2004 joint federal income tax return. The fair market value of the earn-out right, however, was not reported by Boston Scientific on Greiner's W-2, nor by the couple on their 2004 income tax return. This was consistent with a determination by Advanced Bionics and Boston Scientific to treat the grant of the earn-out right as not immediately subject to tax in 2004. Instead, the parties would report ordinary income on the earn-out right only when later receiving earn-out payments, reflecting an "open" transaction approach. No earn-out payments were made by Boston Scientific in 2005. In 2006 and 2007, Boston Scientific did make earn-out payments and Boston Scientific reported these payments as gross pay on Greiner's Forms W-2. Likewise, Greiner and his wife reported the payments as ordinary compensation income on their 2006 and 2007 tax returns.

Subsequently, Greiner and other earn-out recipients settled litigation with Boston Scientific which resulted in the de-merger of the two companies. Boston Scientific paid the Bionics Trust $1.15 billion in two installments in full satisfaction of all earn-out obligations under the prior agreement. Most of the other outstanding obligations under the merger agreement were terminated. Unlike the earlier earn-out payments, these payments were in fixed installment amounts and not contingent upon the future sales of any Advanced Bionics products. As a result of this agreement, Greiner received approximately $15.1 million and $11.6 million in 2008 and 2009, respectively. Boston Scientific categorized Greiner's 2008 and 2009 payments as gross pay on Greiner's Form W-2 and Greiner and his wife reported these final payments as ordinary compensation income on their 2008 and 2009 tax returns.

Greiner and his wife then amended their 2008 and 2009 tax returns, contending that the original tax returns erroneously classified the earn-out cash payments as compensation income, rather than capital gains from the sale or exchange of a capital asset. According to the couple, they should have determined the fair market value of the earn-out right in 2004 and reported it that year as ordinary compensation income and been immediately taxed on it. After doing so, they contended, they would have held a capital asset. While subsequent earn-out payments in 2006 and 2007 would still have been taxable as ordinary income (after a return of basis), the 2008 and 2009 final payments should have been reported as long-term capital gain, they said. The couple requested a refund based on the difference between the higher ordinary income tax they paid under their original returns, and the lower tax for capital gain allegedly owed under their amended returns.

Analysis

The IRS denied the refund request on three grounds: (1) the couple's reclassification of payments from ordinary income to long-term capital gain reflected a change in method of accounting for which permission was required but never obtained, in violation of Code Sec. 446(e); (2) the change in accounting violated the common-law duty of consistency that the couple, as taxpayers, owed the IRS; and (3) the 2008 and 2009 payments could not qualify as long-term capital gain because the payments did not result from the sale or exchange of a capital asset. According to the IRS, the open transaction approach taken by Greiner and his wife on their original returns was not improper and, having made an open transaction election in 2004, the couple was bound to report the subsequent earn-out payments as ordinary income.

In response, Greiner and his wife presented five arguments. According to the couple: (1) they were seeking only to correct their original reporting of the 2008 and 2009 final payments, which was not an accounting method change; (2) the IRS's change-in-method argument was invalid because there was no "specific material item" that was reported inconsistently in different tax years; (3) their amended returns did not alter the tax years of the 2008 and 2009 final payments and, thus, their attempt to re-categorize those payments as capital gain did not affect the timing of that income and, by extension, could not reflect a change in method of accounting; (4) the change-in-underlying-facts exception to the consent rule in Reg. Sec. 446-1(e)(2)(ii)(b) applied such that, even if the open transaction method were adopted for income connected to the earn-out right (including receipt of the earn-out right itself), they would not be required to seek permission to change that method with respect to the 2008 and 2009 final payments because capital gains treatment of the refund claims were driven by an unexpected change in underlying facts (i.e., termination of the earn-out right); and (5) their proposed amendments did not contravene any public policy underlying the consent requirement.

The Federal Claims Court denied the couple's refund claims, holding that the claims were based on an impermissible change in method of accounting. According to the court, once Greiner and his wife elected to report their earn-out income under the open transaction method, they were bound to continue using it absent the IRS's consent to a change. Because the couple never sought or obtained such consent, the court said, their attempt to retroactively amend their approach to reflect closed transaction reporting and subsequent capital gain was an impermissible change in method of accounting in violation of Code Sec. 446(e).

The court found most of the couple's arguments missed the mark. The court did note that, had the couple originally reported the 2004 earn-out right as a closed transaction, it might have considered whether the 2007 settlement was a change in underlying facts affording the couple the ability to recharacterize the 2008 and 2009 final payments as capital gain without seeking consent. However, the court said, the couple never laid the requisite foundation by reporting the 2004 earn-out right as a closed transaction and could not do so now because the 2004 tax year was closed and was not before the court.

For a discussion of the requirement to get IRS consent for an accounting method change, see Parker Tax ¶241,590. For a discussion of the open transaction doctrine, see Parker Tax ¶110,580.

[Return to Table of Contents]

IRS Removes Requirement to File Copy of Code Sec. 83(b) Election with Returns

With regard to property transferred in connection with the performance of services, the IRS has issued proposed regulations eliminating the requirement to file a copy of a Code Sec. 83(b) election with returns, noting that taxpayers may find it difficult to comply with the requirement when e-filing. Taxpayers may rely on the proposed rules for property transferred on or after January 1, 2015. REG-135524-14 (7/17/15).

A taxpayer may elect, under Code Sec. 83(b) to include in gross income, for the tax year in which the property is transferred, the excess of the fair market value of the property at the time of transfer (determined without regard to any restriction other than a restriction that by its terms will never lapse) over the amount paid for the property. The taxpayer may make this election even if he or she paid full value for the property at the time of the transfer, and thus realized no bargain element in the transaction.

Under Reg. Sec. 1.83-2(c), the Code Sec. 83(b) election is made by filing a copy of a written statement with the IRS office where the service provider files a return. In addition, the service provider is required to submit a copy of such statement with his or her income tax return for the taxable year in which such property was transferred.

In recent years, it has come to the attention of the IRS that many taxpayers who wish to electronically file (e-file) their annual income tax return have been unable to do so because of the requirement in Reg. Sec. 1.83-2(c) that a copy of the Code Sec. 83(b) election be submitted with the taxpayer's income tax return. As commercial software available for e-filing income tax returns does not consistently provide a mechanism for submitting a Code Sec. 83(b) election with an individual's e-filed return, an individual who has made such an election would be unable to e-file his or her income tax return in compliance with the regulation and would have to paper file his or her return to comply.

In order to remove this obstacle to e-filing an individual tax return, the proposed regulations would eliminate the requirement under Reg. Sec. 1.83-2(c) that a copy of the Code Sec. 83(b) election be submitted with an individual's tax return for the year the property is transferred.

Taxpayers are still required under Code Sec. 83(b)(2) to file a Code Sec. 83(b) election with the IRS no later than 30 days after the date that the property is transferred to the service provider, which will provide the IRS with the original election. Because Code Sec. 83(b) elections are scanned by the service center receiving the election, an electronic copy of the election is generated which eliminates the need for a taxpayer to submit a copy of the Code Sec. 83(b) election with his or her individual tax return.

Practice Tip: Although taxpayers no longer need to file a copy of their Code Sec. 83(b) election with their returns, they should still keep any such elections on record until the period of limitations expires for the return that reports the sale or other disposition of the property.

If adopted the proposed regulations would be effective January 1, 2016, and would apply to property transferred on or after that date. Taxpayers may rely on the proposed regulations for property transferred on or after January 1, 2015.

For a discussion of Code Sec. 83(b) elections, see Parker Tax ¶ 124,525.

[Return to Table of Contents]

Tax Court Holds Entire Consolidated NOL Is Reduced under Code Sec. 108

Neither the Code nor the consolidated return regulations provide authority for an affiliated group to allocate and apportion a consolidated NOL to the consolidated group members for purposes of reducing tax attributes pursuant to Code Sec. 108(b)(2)(A) and, thus, a consolidated group's entire consolidated NOL had to be treated as the NOL subject to reduction. Marvel Entertainment, LLC v. Comm'r, 145 T.C. No. 2 (2015).

Background

On December 27, 1996, Marvel Entertainment Group, Inc. (MEG) and certain of its operating and inactive subsidiaries filed for bankruptcy under chapter 11 of the Bankruptcy Code. On April 24, 1997, MEG and its subsidiaries became a separate affiliated group (MEG Group) and filed consolidated federal income tax returns for the short taxable years ending December 31, 1997, and October 1, 1998. On October 1, 1998, the MEG Group was acquired by Toy Biz, Inc. and became members of a new consolidated group, Marvel Group, of which Toy Biz was the common parent. In MEG Group's short taxable year ending October 1, 1998, four consolidated group members realized total cancellation of debt (COD) income of approximately $171 million resulting from bankruptcy filings under chapter 11. Each of the four MEG Group debtor members excluded the COD income from gross income under Code Sec. 108(a)(1)(A).

Pursuant to Code Sec. 108(b)(2)(A), on its consolidated federal income tax return for the short taxable year ending October 1, 1998, MEG Group reduced the share of consolidated NOL (CNOL) separately attributable to each of the four members in the group by the lesser of (1) each member's excluded COD income, or (2) each member's allocable share of CNOL. As a result, MEG Group reduced $187 million of CNOL by $89.6 million of the $171 million in excluded COD income.

MEG Group joined the Marvel Group on October 2, 1998, and carried forward into the Marvel Group a CNOL of $96 million. For tax years ending in 1999-2002, $49 million of this CNOL was used by the Marvel Group to offset income. The Marvel Group claimed a CNOL carryforward of $47 million into its taxable year ending December 31, 2003.

The IRS challenged the computation of the CNOL carryforward and assessed deficiencies for Marvel Group's 2003 and 2004 tax returns. According to the IRS, the MEG Group NOL that should have been reduced under Code Sec. 108 was the entire CNOL of the consolidated group. Thus, the IRS said, the MEG Group should have reduced its CNOL as of October 1, 1998, by the total excluded COD income for each of its four members, resulting in a remaining CNOL as of October 2, 1998, of $15.7 million. The IRS concluded that this method of tax attribute reduction would have resulted in no CNOL carryover into the Marvel Group consolidated return for taxable years ending December 31, 2003, and December 31, 2004.

Analysis

For COD income discharged after August 29, 2003, Reg. Sec. 1.1502-28T, prescribes a hybrid approach to attribute reduction. First, tax attributes of the member are reduced and then a look-through rule applies to reduce attributes of the member entity's subsidiaries. Lastly, attributes of the consolidated group are reduced. With slight modifications, this regulation was adopted as final and effective for COD income discharged after March 21, 2005. The Marvel Group argued that the pre-2003 consolidated return regulations allowed for a separate-entity approach under Code Sec. 108(b)(2)(A).

The case went to the Tax Court where the sole issue for decision was whether the NOL subject to reduction under Code Sec. 108(b)(2)(A) was the entire CNOL of a consolidated group (single-entity approach) or a portion of a consolidated group's CNOL allocable to each group member (separate-entity approach).

Citing the Supreme Court's decision in United Dominion Industries, Inc. v. U.S., 532 U.S. 822 (2001), the Tax Court held that where a member of a consolidated group has excluded COD income during a consolidated return year before the adoption of Reg. Sec. 1.1502-28T, the NOL subject to reduction under Code Sec. 108(b)(2)(A) is the entire CNOL of the consolidated group.

The court dismissed the Marvel Group's argument that the pre-2003 consolidated return regulations allowed for the separate-entity approach under Code Sec. 108(b)(2)(A). The court noted that the matter at hand involved the tax year ending October 1, 1998, which was before the IRS's issuance of Reg. Sec. 1.1502-28T or the adoption of Reg. Sec. 1.1502-28. The pre-2003 consolidated return regulations, the court stated, did not specifically articulate how a consolidated group should reduce its tax attributes under Code Sec. 108(b). However, the Supreme Court in United Dominion Indus., Inc. v. Comm'r, 532 U.S. 822 (2001), found that the pre-2003 consolidated return regulations did in fact prohibit the allocation of separate NOLs for consolidated group members unless it was within the ambit of a specific regulatory provision.

The issue in the current case, the court said, which was central to the opinion of the Supreme Court in United Dominion, was identifying the appropriate NOL in the consolidated return context. Although the Tax Court acknowledged that the Marvel Group's application of the separate-entity approach in filing its 1998 consolidated tax return was plausible at the time, it was contrary to the rule in the consolidated return regulations as interpreted by the Supreme Court in United Dominion. Thus, the Marvel Group's application of the separate-entity approach for purposes of defining its NOL not only conflicted with the binding precedent of United Dominion, the court said, but also was the approach specifically rejected by the Supreme Court in that case. Because United Dominion clarified that a separate NOL does not exist in the consolidated return regulations, the court found no remaining ambiguity as to this issue for the Marvel Group's consolidated return for the short taxable year ending October 1, 1998.

[Return to Table of Contents]

Land Parcels' Modifiable Boundaries Defeats Deduction for Contribution of Conservation Easement

Because modifications were permitted to the boundaries between land parcels distributed to two partnerships' limited partners and property subject to easements, no charitable deductions for the easements was allowed and the Tax Court upheld a 40-percent gross valuation misstatement penalty. The court also found that the sale of the partnerships' interests in conjunction with the distribution of the parcels were really disguised sales of property under Code Sec. 707. Bosque Canyon Ranch, L.P. v. Comm'r, T.C. Memo. 2015-130.

Background

Bosque Canyon Ranch, L.P. (BCR I), a partnership, owned a tract of land in Bosque County, Texas, on which it spent $2.2 million on improvements. It then marketed limited partnership interest units in BCR I at $350,000 per unit. Each purchaser of a unit received a distribution of an undeveloped five-acre parcel of property and rights to build a house on the property. The distribution of the property was conditioned on BCR I granting the North American Land Trust (NALT), a Code Sec. 501(c)(3) organization, a conservation easement relating to 1,750 acres of the property. On December 29, 2005, BCR I granted an easement to NALT. Between October and December 2005 BCR I received signed subscription agreements and payments totaling $8.4 million from 24 purchasers of the limited partnership units.

In 2006, another related partnership, BCR II, engaged in transactions similar to those engaged in by BCR I. It received approximately $10 million in payments from the sale of land to 23 purchasers. In 2007, BCR II granted a conservation easement to NALT similar to the one granted by BCR I.

The 2005 and 2007 deeds granting the easements provided that portions of the area subject to the easements included the habitat of an endangered species of bird endemic to Texas. Property subject to the easement could not be used for residential, commercial, institutional, industrial, or agricultural purposes. In addition, the partnerships retained various rights relating to the property, including rights to raise livestock; hunt; fish; trap; cut down trees; and construct buildings and recreational facilities. The parcel owners and NALT could, by mutual agreement, modify the boundaries of the parcels, provided that any such modification could not, in NALT's reasonable judgment, directly or indirectly result in any material adverse effect on any of the conservation purposes.

On their tax returns for 2005 and 2007, BCR I and BCR II took charitable contribution deductions of $8.4 million and approximately $10 million, respectively, relating to the easement donations. The IRS challenged the deductions and assessed a 40 percent gross valuation misstatement penalty. According to the IRS, no deduction for the easements were allowed because the deeds conveying the easements violated the perpetuity requirement of Code Sec. 170(h)(2)(C). The IRS also found that the sale of the partnerships' interests were really disguised sales of property under Code Sec. 707(a)(2)(B) and Reg. Sec. 1.707-3(b)(1) and (c)(1).

Analysis

The partnerships argued that the deeds did not violate the perpetuity requirement because any modifications to the boundaries of the land parcels were subject to the reasonable judgment of the NALT, the exterior boundaries of the property subject to the easements could not be modified, and the overall amount of property subject to the easements could not be decreased.

The Tax Court held that, as a result of the boundary modifications, property protected by the 2005 and 2007 easements, at the time they were granted, could subsequently lose this protection. Thus, the restrictions on the use of the property were not granted in perpetuity. Accordingly, the easements did not constitute qualified real property interests and the partnerships were not entitled to charitable deductions relating to the easements.

The Tax Court also concluded that the property transfers to the limited partners who purchased units in BCR I and BCR II were disguised sales for the following reasons: (1) the timing and amount of the distributions to the limited partners were determinable with reasonable certainty at the time the partnerships accepted the limited partners' payments; (2) the limited partners had legally enforceable rights to receive their land parcels and the appurtenant rights; (3) the transactions effectuated exchanges of the benefits and burdens of ownership relating to the land parcels; (4) the distributions to the partners were disproportionately large in relation to the limited partners' interests in partnership profits; and (5) the limited partners received their land parcels in fee simple without an obligation to return them to the partnerships.

Finally, the court sustained the imposition of the 40 percent penalty on the portion of tax underpayment attributable to the gross valuation misstatements resulting from the charitable deductions taken for the easement contributions.

For a discussion of the rules for easement contribution deductions and disguised sales of partnership property, see Parker Tax ¶84,155 and ¶25,520, respectively.

[Return to Table of Contents]

Interest on S Corp Tax Overpayments Is Calculated at Corporate Rate Rather Than Higher Individual Rate

Interest on S corporation tax overpayments is computed at the corporate tax overpayment rate and not the higher rate applicable to individuals. Eaglehawk Carbon, Inc. v. U.S., 2015 PTC 240 (Fed. Cl. 2015).

Eaglehawk Carbon, Inc. is a mining company. Along with four other mining companies, Eaglehawk successfully sued the IRS for a refund of additional interest on coal sale excise tax overpayments made in tax years 1990 through 1996. All five companies are S corporations. The initial tax refunds on which the interest was calculated were made in 2009. The mining companies and the IRS agreed that the relevant provision under which interest on tax overpayments is calculated is Code Sec. 6621(a)(1).

Code Sec. 6621(a)(1) provides that the overpayment rate for interest is the sum of the federal short-term rate (STR) determined under Code Sec. 6621(b), plus 3 percentage points (2 percentage points in the case of a corporation). The flush language to Code Sec. 6621(a)(1) provides that, to the extent that an overpayment of tax by a corporation for any taxable period (as defined in Code Sec. 6621(c)(3), applied by substituting "overpayment" for "underpayment") exceeds $10,000, then "0.5 percentage point" is substituted for "2 percentage points". Code Sec. 6621(c)(3)(A) provides that the term "large corporate underpayment" means any underpayment of a tax by a C corporation for any taxable period if the amount of such underpayment for such period exceeds $100,000.

The mining companies argued that the history of various changes to Code Sec. 6621 and the fact that Code Sec. 6621(c) contains different treatment of C corporations and S corporations regarding underpayment interest showed that Congress could not have treated C and S corporations the same in Code Sec. 6621(a)(1) for the purposes of determining overpayment interest.

The Court of Federal Claims agreed with the IRS and held that, pursuant to the language of Code Sec. 6621(a)(1), the corporate overpayment interest rate formulas set forth in Code Sec. 6621(a)(1) apply to S corporations as well as C corporations. The court said that its reading of the statute was supported by its plain text as well as the canon of statutory construction known as the doctrine of the last antecedent. Neither the statute's legislative history nor IRS administrative materials, the court observed, provided support for a contrary interpretation. According to the court, the mining companies were asking it to infer that the text of Code Sec. 6621(a)(1) meant not what it said, but instead expresses a general concern for S corporations that has been present over the years in Code Sec. 6621(c). The court characterized this argument as a faulty premise that the intent of Congress should be inferred from the enactment of disparate legislative measures over the course of a number of years.

The court noted that, of the relevant legislative acts amending Code Sec. 6621(a)(1), none had legislative history containing any direct reference to S corporations. Nor was there any reference to the difference between S corporations and C corporations, or to the impact of the amendments to Code Sec. 6621(a)(1) on S corporations or pass-through entities in general. Thus, the court said, the mining companies had no clear statement of congressional intent with which they could persuade the court to ignore the plain text of Code Sec. 6621(a)(1).

For a discussion of rates used to compute interest on tax overpayments, see Parker Tax ¶261,520.

[Return to Table of Contents]

IRS Announces Changes to Employee Plans Determination Letter Program

Effective January 1, 2017, the IRS will eliminate the staggered 5-year determination letter remedial amendment cycles for individually designed plans and will limit the scope of the determination letter program for individually designed plans to initial plan qualification and qualification upon plan termination. Announcement 2015-19.

The IRS announced important changes to the Employee Plans determination letter program for qualified plans. The changes to the determination letter filing procedures described in Ann. 2015-19 will be reflected in an update to Rev. Proc. 2007-44.

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

The IRS will eliminate the staggered 5-year remedial amendment cycles for individually designed plans effective January 1, 2017. As of that date, the IRS will no longer accept determination letter applications based on the 5-year remedial amendment cycles. However, sponsors of Cycle A plans, described in Rev. Proc. 2007-44, can submit determination letter applications during the period beginning February 1, 2016, and ending January 31, 2017.

As a result of the elimination of the 5-year remedial amendment cycles, the extension of the remedial amendment period provided in Rev. Proc. 2007-44 will not be available after December 31, 2016, and the remedial amendment period definition in Reg. Sec. 1.401(b)-1 will apply.

Observation: The IRS intends to extend the remedial amendment period for individually designed plans to a date that is expected to end no earlier than December 31, 2017.

Effective January 1, 2017, a sponsor of an individually designed plan will be permitted to submit a determination letter application for a plan on initial qualification (that is, a plan for which a Form 5300, Application for Determination for Employee Benefit Plan, has not been filed or for which a Form 5300 has been filed but a determination letter was not issued with respect to the plan, regardless of when the plan was adopted) and for qualification upon plan termination. In addition, a sponsor will be permitted to submit a determination letter application in certain other limited circumstances that will be determined by the IRS.

In addition, effective July 21, 2015, through December 31, 2016, the IRS will no longer accept off-cycle determination letter applications, except for determination letter applications for new plans, as defined in Rev. Proc. 2007-44, and for terminating plans.

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