Post-Assessment Tax Documents Not "Returns" Under Bankruptcy Code; Taxpayer's Disclaimer of Interest in Husband's Trust Not a Gift; Pet Spa Was Not a Charitable Organization; COD Income Realized Despite Contrary Statements from IRS and Lender ...
A company could not exclude from its cigarette gross receipts the part of the sale price attributable to the cost of the cigarette stamp tax. As a result, the company failed to prove that it was eligible for a small reseller exception to Code Sec. 263A and thus was subject to the uniform capitalization rules. City Line Candy & Tobacco Corporation, 2015 PTC 349 (2nd Cir. 2015).
Company's Production of Unit Doses of Medicine Qualifies for Section 199 Deduction
A company's business of selling unit doses of medicines involved the sale of qualifying production property which was manufactured, produced, grown, or extracted and the company thus qualified for the Code Sec. 199 domestic production activities deduction. Precision Dose, Inc. v. U.S., 2015 PTC 345 (W.D. Ill. 2015).
The IRS has begun releasing draft 2015 tax forms and related instructions. The Forms 1040 instructions note that the filing deadline for 2015 returns is April 18, 2016, due to the Emancipation Day holiday in the District of Columbia. Taxpayers who live in Maine and Massachusetts have until April 19, 2016, to file their returns because of the Patriot's Day holiday in those states. The following are some highlights of what's been released so far.
IRS Vows to Fight 8th Circuit Decision Excluding Certain CRP Payments from Self-Employment Income
The IRS has announced that, outside the Eight Circuit, it will not follow the decision in Morehouse v. Comm'r, in which the appellate court held that Conservation Reserve Program payments were not self-employment income, but rather rentals from real estate. AOD 2015-02.
Early IRA Distribution Used to Pay Nondependent Son's Medical Expenses Was Subject to Penalty
Although using a premature IRA distribution to pay medical expenses of a child is an exception to the imposition of the 10 percent penalty tax on early IRA distributions, the fact that the taxpayer did not claim her son as a dependent and failed to demonstrate that he was a dependent precluded her from avoiding the penalty. Ireland v. Comm'r, T.C. Summary 2015-60.
Supreme Court Lets Ninth Circuit Reversal of the Tax Court Stand; Partners Cannot Selectively Opt Out of TEFRA Proceedings
The Supreme Court let stand a decision rejecting partners' arguments that they could opt in and out of TEFRA proceedings on the basis of different types of partnership interests. JT USA v. Comm'r, No. 14-1476 (S. Ct. 10/5/15).
The Tax Court determined a taxpayer in the habit of making short term loans to friends and acquaintances was not engaged in lending as a business. Thus, an unpaid loan was not deductible as a business bad debt, and could only be claimed as a capital loss when it became wholly worthless. Cooper v. Comm'r, T.C. Memo. 2015-191.
Multiple, successive pawn loans between the same parties and collateralized with the same personal property are related transactions for purposes of the Code Sec. 6050I reporting requirement when the debt from one loan is shifted to a subsequent loan. CCA 201540013.
Couple Must Recognize Interest Income on Payments Received from Daughter's Company
Even if the taxpayers suffered fraud and would not be able to recover loans made to their daughter's company, the open transaction doctrine did not support the taxpayers' argument that payments received in relation to the loan were a return of capital rather than interest income. Friedman v. Comm'r, T.C. Memo. 2015-177.
Drought-Stricken Farmers and Ranchers Have More Time to Replace Livestock; 49 States Affected
Certain U.S. counties qualify for an extended replacement period under Code Sec. 1033(e) for livestock sold on account of drought in specified counties. Notice 2015-69.
Cigarette Reseller Not Eligible for Small Reseller Exception; UNICAP Rules Apply
A company could not exclude from its cigarette gross receipts the part of the sale price attributable to the cost of the cigarette stamp tax. As a result, the company failed to prove that it was eligible for a small reseller exception to Code Sec. 263A and thus was subject to the uniform capitalization rules. City Line Candy & Tobacco Corporation, 2015 PTC 349 (2nd Cir. 2015).
Background
City Line Candy & Tobacco Corporation (City Line), an accrual method taxpayer, is a reseller and licensed wholesale dealer of cigarettes in New York. Under New York law, all cigarettes possessed for sale must bear a stamp issued by the New York tax commissioner. Pursuant to this law, City Line, a licensed cigarette stamping agent for New York, buys cigarette packs for sale, purchases and affixes cigarette tax stamps to those cigarette packs, and sells the stamped cigarette packs to subjobbers and retailers in New York City and throughout New York. Under New York law, City Line is required to include, and did include, the cost of the cigarette tax stamps in the sale price of the cigarettes.
In computing its gross receipts from cigarette sales for financial statement purposes, City Line totaled the gross sale prices of the cigarettes sold during each year. However, for income tax reporting purposes, City Line adjusted its gross receipts from cigarette sales by subtracting the approximate cost of cigarette tax stamps purchased during the fiscal year and reporting as its gross receipts the resulting net amount.
In a notice of deficiency, the IRS determined that City Line had underreported its gross receipts for each of its 2004 through 2006 fiscal years in an amount approximately equal to the cost of the cigarette tax stamps purchased during that tax year. Consequently, the IRS determined that City Line had additional gross receipts of almost $6 million, $5 million, and $5 million for 2004, 2005, and 2006, respectively. As a result of the adjustments to City Line's gross receipts, the IRS also determined that the company's average annual gross receipts for the three-taxable year period ending with the tax year preceding each of the 2004-06 tax years exceeded $10 million; therefore the company was not eligible for the "small retailer" exception in Code Sec. 263A(b)(2)(B) and was subject to the UNICAP rules.
Tax Court Decision
The Tax Court held that the IRS correctly determined City Line Candy & Tobacco's gross receipts on the basis of the entire sale price of the cigarettes it sold, including that part of the sale price attributable to the cost of the cigarette tax stamps. As a result, the court said that City Line was subject to the UNICAP rules of Code Sec. 263A because it failed to prove that its average annual gross receipts for the three-taxable-year period ending with the tax year preceding each of the years in issue, when correctly calculated to include the entire sale price of the cigarettes it sold, did not exceed $10 million for any of those years (the threshold for the small retailer exception). The court also concluded that the cigarette tax stamp costs were indirect costs that had to be capitalized under the UNICAP rules and such costs are handling costs that the IRS properly allocated, in part, to City Line's ending inventory using the simplified resale method.
Second Circuit Appeal
On appeal, the Second Circuit affirmed the Tax Court. City Line argued it qualified for the "small reseller" exception to the Code Sec. 263A uniform capitalization rules and that its tax stamp purchases were deductible selling expenses. According to City Line, the Tax Court erred by calculating its gross receipts based on its total revenue, including the part attributable to tax stamps, and not solely based on the price of the cigarettes themselves.
The Circuit Court noted that whether it included the stamps' value determined whether City Line's gross receipts exceed the threshold for the "small reseller" exception in Code Sec. 263A(b)(2)(B). The court found that City Line's own financial accounting included the stamps in its gross receipts, and determined the Tax Court rightly found that City Line has failed to show why its tax accounting should differ.
Having determined that the uniform capitalization rules applied to City Line, the court turned to whether they permitted City Line to deduct the cost of stamps as an expense or required City Line to capitalize them as an indirect cost.
City Line offered three arguments for treating its stamp costs as deductible, which the court said contradicted each other and failed independently. City Line first suggested that the stamps were actually a direct cost, but the court stated that would not change the outcome, since direct costs must also be capitalized pursuant to Code Sec. 263A(a)(2)(A). Alternatively, City Line argued that the stamps qualified as a deductible selling expense, but the court noted that Reg. Sec. 1.263A-1(e)(3) specifically list taxes as an example of indirect costs that must be capitalized to the extent they are properly allocable to property acquired for resale.
Finally, City Line argued that Robinson Knife Mfg. Co. v. Comm'r, 600 F.3d 121 (2d Cir. 2010) limits the capitalization requirement and permits the deduction of indirect costs tied directly to sales. Robinson Knife, the Second Circuit observed, interpreted Reg. Sec. 1.263A-1(e)(3) as including two limitations on the requirement that indirect costs be capitalized. First, the court noted, that case required capitalization only of costs that are a "but-for cause" of the taxpayer's production or sales activity. The court said this causation test was easily satisfied in the instant case, since City Line's cigarette sales would have been illegal but for the stamps, and the Tax Court found that City Line's stamping activity was an integral part of its resale activity. Second, Robinson Knife permitted the deduction of costs that are (1) calculated as a percentage of sales revenue from certain inventory, and (2) incurred only upon sale of such inventory. The court determined City Line's situation failed the second prong because, under New York law, City Line became liable for the cigarette tax as soon as it offered the cigarettes for sale, not when it sold them. The court stated that accepting City Line's reading would permit it to take an immediate deduction for costs associated with future sales, precisely the kind of temporal mismatch Code Sec. 263A seeks to avoid.
Observation: The IRS amended Reg. Sec. 1.263A-1(e)(3) after Robinson Knife to include the capitalization of indirect costs that are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. The revised regulations were not effective during the years at issue.
For a discussion of the uniform capitalization rules, see Parker Tax ¶242,380.
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Company's Production of Unit Doses of Medicine Qualifies for Section 199 Deduction
A company's business of selling unit doses of medicines involved the sale of qualifying production property which was manufactured, produced, grown, or extracted and the company thus qualified for the Code Sec. 199 domestic production activities deduction. Precision Dose, Inc. v. U.S., 2015 PTC 345 (W.D. Ill. 2015).
Background
Precision Dose, Inc. sells unit doses of medications. A unit dose is a drug in a non-reusable container intended for administration as a single dose to a patient. The specific unit doses that Precision sells are different liquid, oral drugs sealed in various size cups and syringes. The company buys, in bulk, certain drugs it deems marketable in unit doses and suitable for sale in unit doses.
In producing unit doses, Precision engages in a process that runs the gamut from deciding what drugs to consider for possible unit doses; testing to determine their suitability and marketability; preparing specifications and documentation for the materials to be used and standard operating procedures for all processes and equipment to be used; developing cups and syringes (and the molds from which they will be made); working with the vendors that will make the containers; buying cups and syringes; contracting with laboratories to conduct stability studies to insure the drug remains within specifications when put into a unit dose and to establish expiration dates; running validation batches; setting up and conducting fill operations; conducting in process testing; conducting post-fill processing; performing release testing to determine if the unit doses are ready for release to customers; and batch record reviews to confirm no anomalies occurred during production.
Precision claimed a domestic production deduction under Code Sec. 199 on its 2007 and 2008 tax returns, resulting in tax refund requests of approximately $73,000 and $74,000, respectively.
Under Code Sec. 199(a)(1), a taxpayer can deduct a portion of its qualified production activities income, which is determined from the taxpayer's domestic production gross receipts. Domestic production gross receipts are defined, in part, as proceeds from the sale of qualifying production property (QPP) which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States.
Reg. Sec. 1.199-3(e)(1) defines MPGE generally as including, among other things, manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP; making QPP out of scrap, salvage, or junk material as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles. The regulation also provides that if a taxpayer packages, repackages, labels, or performs minor assembly of QPP and the taxpayer engages in no other MPGE activity with respect to the QPP, such actions do not qualify as MPGE with respect to that QPP.
The IRS disallowed Precision's refund claim because it said that Precision only engaged in repackaging of materials. Precision argued that its activities did not fall within the repackaging exception and that it engaged in MPGE with respect to QPP and, thus, income received from its sales "qualified production activities income" entitling it to the Code Sec. 199 deduction.
Analysis
A district court rejected the IRS's argument and granted Precision's refund request. Precision, the court noted, produces unit doses and the dictionary defines the transitive verb "produce" as "to cause to have existence or to happen." There was no doubt in the court's mind that Precision causes the unit doses to come into existence. According to the court, without Precision doing what it does with the drugs, cups and syringes, they are simply drugs, cups and syringes. It is Precision's activities, its application of its processes to the drugs, cups, and syringes, that produce a unit dose.
The court then looked at the exception to the definition of MPGE for packaging, repackaging, labeling, and minor assembly. Even if Precision's activities otherwise meet the definition of MPGE, the court observed, those activities are not MPGE if those activities are only packaging, repackaging, labeling or minor assembly with respect to the unit doses which are the QPP at issue.
The court noted that Precision looks for drugs it believes it can successfully process into and sell as unit doses. Drug manufacturers, the court said, do not seek bids from companies to repackage their drugs into small packages. Precision engaged in market research to determine which drugs to buy to turn into unit doses, and worked with potential customers to identify needs for new unit dose products. The court drew an analogy between Precision's activities and those in U.S. v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013), where the taxpayer's S corporation designed gift baskets, outsourced the production of the baskets, and then filled the baskets with various items, like chocolate and wine. The court in Dean observed that the S corporation's production process changed the form and function of individual items by creating distinct gifts and that the company's complex production process was similar to purchasing various automobile parts from suppliers and assembling them to create the car itself. The Dean court said that, while come of the company's activities might have constituted packaging or repackaging, that "subassembly process" was only part of the complex production process that resulted in a distinct final product.
Observation: Proposed regulations (REG-136459-09 (8/27/15)) under Code Sec. 199 add an example based on the facts in U.S. v Dean, but reaches the opposite conclusion. In the example, the taxpayer is not considered to have engaged in the MPGE of QPP. The propose regs are not effective until finalized.
The district court rejected the IRS's argument that Dean was wrongly decided because the court failed to understand that all the corporation's activities were just part of the repackaging process. According to the court, the products assembled in Dean were each a unique product, similar to the way the unit dose is a unique product.
For a discussion of the activities that constitute MPGE for purposes of the Code Sec. 199 deduction, see Parker Tax ¶96,110.
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IRS Begins Launching 2015 Draft Forms and Instructions; What's New for 2015
The IRS has begun releasing draft 2015 tax forms and related instructions. The Forms 1040 instructions note that the filing deadline for 2015 returns is April 18, 2016, due to the Emancipation Day holiday in the District of Columbia. Taxpayers who live in Maine and Massachusetts have until April 19, 2016, to file their returns because of the Patriot's Day holiday in those states. The following are some highlights of what's been released so far.
Forms 1040, 1040A, and 1040EZ: Direct Deposits to myRA Now Available
Forms 1040, 1040A, and 1040EZ contain a number of changes, most notably the ability to have a tax refund deposited directly into a new retirement savings program called "myRA." This is a starter retirement account offered by the Treasury Department. The program allows individuals to establish Roth individual retirement accounts (Roth IRAs) with a Treasury Department designated custodian. The purpose of these accounts is to allow savers to begin investing for retirement with no start-up costs and no fees. Participants in the program can continue to make periodic electronic contributions in any amount to their account and the amounts contributed will be invested exclusively in new retirement savings bonds. The designated custodian for the program will purchase and hold the bonds for the benefit of the participants. The new savings bond is only available to participants in myRA and will protect the principal contributed while earning interest at a rate previously available only to federal employees invested in the Government Securities Investment Fund (G Fund) of their Thrift Savings Plan. Individuals can continue to participate in the program until their account balance reaches $15,000 or until they have participated in the program for 30 years, whichever occurs first. At any time, participants can transfer their balance to a commercial financial services provider to take advantage of a broader array of retirement products available in the marketplace. Because the accounts offered through the program are Roth IRAs, they have the same tax treatment and follow the same rules as Roth IRAs. Participants can keep their account and can continue investing in the retirement savings bond even if they change jobs.
Forms 1040, 1040A, 1040EZ: Nonqualified Distributions from ABLE Savings Accounts Treated as Other Income
In December 2014, as part of the Tax Extenders legislation, President Obama signed into law the Achieving a Better Life Experience (ABLE) Act of 2014. ABLE enacted Code Sec. 529A to create tax-free savings accounts for individuals with disabilities. ABLE Plans are state-sponsored accounts that supplement benefits provided through private insurance, the Medicaid program, the supplemental security income program, the beneficiary's employment, and other sources. To qualify, the beneficiary must have become blind or disabled before reaching age 26. In contrast to qualified tuition plans, only one 529A plan is permitted per beneficiary. Additionally, the beneficiary must be a resident of the state that established the account.
Contributions are in after-tax dollars but earnings grow tax-free just like with 529 college savings accounts. Withdrawals must be for qualified expenses, or else the earnings portion are subject to regular income tax and a 10-percent penalty. State penalties may also apply. For 2015, contributions of up to $14,000 are allowed. Distributions are tax-free if used to pay the beneficiary's qualified disability expenses. Contributions are not deductible and withdrawals for nonqualified expenses or distributions which exceed the qualified disability expenses are reported on Form 1040 as Other Income.
Form 5329: Sections Revised and Added for Nonqualified Distributions and Excess Contributions Relating to ABLE Savings Accounts
Nonqualified distributions from 529 ABLE Plan accounts are subject to a 10-percent penalty tax. In addition, excess contributions to the account are subject to tax. As a result, Part II of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, was revised for the penalty tax and a new Part VIII was added to reflect the tax on excess 529 ABLE Plan contributions.
Forms 1040, 1040A, 1040EZ: IRS Now Reserving Lines for Possible Late Legislation
While drafts of the Forms 1040 have not yet been released, the instructions to those forms note that Congress has sometimes extended expired tax benefits after form instructions, and sometimes the forms themselves, have been printed. Thus, those lines are now shown as "Reserved" in the instructions in case Congress extends such tax benefits. Benefits that expired for 2015 but which may be resurrected at the last minute include the deduction for educator expenses and the tuition and fees deduction. It remains to be seen if the actual form itself, once released, will show those lines as "reserved" since Congress has been known to reinstate deductions retroactively to a prior year.
Form 3115: Automatic Change Codes Moved to IRS Website; Change in Filing Address
Form 3115, Application for Change in Accounting Method, is used by taxpayers to request a change in either an overall method of accounting or the accounting treatment of a particular item. There are two procedures for which a taxpayer may request a change in method of accounting: (1) automatic change request procedures, and (2) non-automatic change request procedures. In prior years, instructions to Form 3115 listed the automatic accounting method change numbers for each automatic change request being reported on Form 3115.
In the draft instructions to the 2015 Form 3115, the IRS states that it will no longer include these automatic change numbers in the instructions to Form 3115. Instead, to allow for more timely updates, the IRS has moved the codes to the IRS website at irs.gov/form3115.
Observation: The IRS's decision to move the automatic change numbers from the printed instructions to its website comes in the wake of an uproar over the IRS's failure to update the instructions for the 2014-15 tax season. The outdated instructions omitted more than two-dozen new codes required for changes relating to the final tangible property regulations (a.k.a., the "repair regs").
In previous years, there were several addresses from which a taxpayer had to choose for sending a Form 3115 to the IRS. The IRS has simplified the filing addresses for Form 3115 as follows:
For automatic change requests by mail and private delivery service the filing address is: Internal Revenue Service, 201 West Rivercenter Blvd., PIN Team Mail Stop 97, Covington, KY 41011-1424.
For non-automatic change requests by mail and private delivery service the filing address is: Internal Revenue Service, Attn: CC:PA:LPD:DRU, Room 5335, 1111 Constitution Ave., NW, Washington, DC 2004.
Form 8885: Health Coverage Tax Credit Reinstated
The Trade Preferences Extension Act of 2015, enacted June 29, 2015, extended and modified the expired Health Coverage Tax Credit (HCTC). Previously, those eligible for HCTC could claim the credit against the premiums they paid for certain health insurance coverage through 2013. The HCTC can now be claimed for coverage through 2019. As a result, the IRS has revived Form 8885, Health Coverage Tax Credit. A draft of the 2015 Form 8885 may be found at irs.gov/pub/irs-dft/f8885--dft.pdf
Taxpayers that want to claim the credit for 2014 must wait for IRS guidance. The credit cannot be claimed using an old or altered Form 8885 because, while the new law is similar to the version that expired in 2013, it includes modifications that affect how the credit is administered.
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IRS Vows to Fight 8th Circuit Decision Excluding Certain CRP Payments from Self-Employment Income
The IRS has announced that, outside the Eight Circuit, it will not follow the decision in Morehouse v. Comm'r, in which the appellate court held that Conservation Reserve Program payments were not self-employment income, but rather rentals from real estate. AOD 2015-02.
Late last year, in Morehouse v. Comm'r, 2014 PTC 534 (8th Cir. 2014), the Eighth Circuit handed taxpayers a victory when it reversed a Tax Court holding that payments received by a nonfarmer landowner under the Conservation Reserve Program (CRP) were includible in self-employment income. In Morehouse v. Comm'r, 140 T.C. 350 (2013), the Tax Court, relying on a decision by the Sixth Circuit, rejected the argument that such payments were excludible from self-employment earnings under Code Sec. 1401(a)(1) as rentals from real estate. According to the court, the payments were includible in self-employment income because the taxpayer was engaged in a trade or business and there was a nexus between that trade or business and the CRP payments. In reversing the Tax Court, the Eighth Circuit distinguished the Sixth Circuit case and relied on two IRS revenue rulings issued in the 1960s that contradicted the Sixth Circuit's decision.
On September 23, the IRS issued AOD 2015-02, a nonacquiescence to the Eight Circuit's holding in Morehouse. According to the IRS, the Eighth Circuit misinterpreted the IRS rulings and an amendment to Code Sec. 1401(a)(1) excluding certain CRP payments from self-employment income served to clarify that other CRP payments are not excluded from self-employment income.
Background
Rollin Morehouse inherited land in three counties in South Dakota in 1994 and then purchased various interests in land from his relatives. Most of the land was tillable cropland. Rollin did not personally farm any of the land but instead rented the tillable portions to individuals who farmed their rented portions. In 1997, Rollin placed much of the tillable cropland into the U.S. Department of Agriculture (USDA) CRP program. This required Rollin to implement a conservation plan and refrain from using the land for agricultural purposes. In return, the Commodity Credit Corporation (CCC) executed the CRP contracts that entitled Rollin to receive annual payments from the USDA.
Rollin received CRP payments of $37,872 in both 2006 and 2007. He and his wife filed joint tax returns for both years and identified their occupations as "self-employed." On Schedules E of their tax returns, the Morehouses listed the CRP payments for both years as "rents received" and excluded the payments from self-employment income.
Code Sec. 1401 imposes a tax on self-employment income and Code Sec. 1402(b) defines self-employment income as the net earnings from self-employment, with certain exceptions. Under Code Sec. 1402(a), the term "net earnings from self-employment" is defined in part, to mean the gross income derived by an individual from any trade or business carried on by such individual less allowable deductions. Certain categories of income are excluded from the term. One of those categories, under Code Sec. 1402(a)(1), is most rentals from real estate.
Observation: In 2008, Congress amended Code Sec. 1402(a)(1) to provide that CRP payments made to social security benefit recipients should be treated as rental income, effective for tax years beginning after December 31, 2007. Thus, the amendment was effective after the years at issue in the Morehouse case.
The IRS assessed a deficiency, saying the Morehouses owed self-employment tax because the CRP payments were self-employment income. According to the IRS, the payments were appropriately characterized as payments from a trade or business of conducting an environmentally friendly farming operation.
Prior Case Law and Rulings
In Morehouse, the IRS relied on a prior decision by the Sixth Circuit to bolster its claim that the CRP payments were subject to self-employment tax. In Wuebker v. Comm'r, 110 T.C. 431 (1998), the taxpayers were active farmers who claimed their CRP payments constituted rentals from real estate. The Tax Court agreed and held that the payments were excludable from self-employment income. However, the Sixth Circuit (205 F.3d 897 (6th Cir. 2000)) reversed the Tax Court and concluded that CRP payments to farmers do not fall within the "ordinary or natural" meaning of the phrase "rentals from real estate," and that therefore CRP payments to farmers are not excludable from self-employment tax as rentals from real estate. Subsequently, in Notice 2006-108, the IRS issued a proposed ruling in which it said that CRP rental payments (including incentive payments) to an individual not otherwise actively engaged in the trade or business of farming who enrolls land in CRP and fulfills the CRP contractual obligations by arranging for a third party to perform the required activities, are includible in net income from self-employment and are not excludible as rentals from real estate.
In contrast, as support for its decision in Morehouse, the Eighth Circuit relied on Rev Rul. 60-32 and Rev. Rul. 65-149, and distinguished the decision in Wuebker. In Rev. Rul. 60-32, the IRS characterized payments attributable to the acreage reserve program and the conservation reserve program of the old Soil Bank Act (a predecessor program to the CRP) as payments in the nature of receipts from farm operations in that they replace income which producers could have expected to realize from the normal use of the land devoted to the program. The IRS ruled that such payments were includible in income under Code Sec. 61. The ruling also discusses the requirements under the Soil Bank Act that payments are equitably shared amongst landlords, operators, tenants and sharecroppers. The ruling concluded that Soil Bank Act payments were included in determining net earnings from self-employment if the recipient operated his farm personally or through agents or employees, or if the farm is operated by others and the recipient materially participates in the production of commodities or management of such production. The ruling also concludes that if the recipient does not operate the farm or does not materially participate in the production or management of production of commodities (i.e., in the case of a landlord/tenant relationship), payments received are not includible in determining net earnings from self-employment.
In Rev. Rul. 65-149, the IRS elaborated on Rev. Rul. 60-32 by providing that income derived from the operation of a farm, regardless of the form of the income (cash sales, Commodity Credit Corporation loans, government subsidies like soil bank payments, conservation reserve payments, etc.), should be treated in a manner consistent with the position of the IRS as set forth in Rev. Rul. 60-32. In other words, if this income is received by a farm operator, or a landlord who materially participates, it should be treated as self-employment income; but if it is received by a landlord who does not materially participate, it should be treated as rental income and excluded from net earnings from self-employment.
Eighth Circuit "Misinterpreted" Rulings
In AOD 2015-02, the IRS disagreed with the Eighth Circuit's characterization of Rev. Rul. 60-32 and Rev. Rul. 65-149 as establishing a line of demarcation on the self-employment tax treatment of conservation reserve payments paid to farmers and nonfarmers. The IRS also disagreed with the Eighth Circuit's holding that the CRP payments were consideration paid by the government for use and occupancy of Morehouse's property and thus constituted rentals from real estate excluded from self-employment tax under Code Sec. 1402(a)(1).
According to the IRS, the Eighth Circuit misinterpreted the rulings when it stated that the rulings establish the position that CRP payments made to nonfarmers constitute rentals from real estate and are excluded from the self-employment tax. Rev. Rul. 60-32, the IRS said, concludes that similar payments under the Soil Bank Act are in the nature of receipts from farm operations and are generally included in self-employment income. It does not, the IRS argued, state that payments made to nonfarmers constitute rentals from real estate.
The IRS also noted that, although Rev. Rul. 60-32 does reference "material participation" in the production of commodities, which is a carve-out from the rental exclusion under Code Sec. 1402(a)(1), the material participation standard only applies in the context of arrangements between a landlord who may or may not materially participate in the commodity production on his or her land and the tenant or sharecropper leasing the land. According to the IRS, it does not apply in the context of a non-landlord receiving CRP payments. Consistent with this understanding, in elaborating upon Rev. Rul. 60-32, Rev. Rul. 65-149 states only that payments "received by a landlord who does not materially participate" in the production of commodities (or management of such production) should be treated as rental income that is excluded from self-employment income. Morehouse, the IRS said, was not acting as a landlord, and therefore, contrary to the Eighth Circuit's opinion, neither Rev. Rul. 60-32 nor Rev. Rul. 65-149 supports the conclusion that the CRP payments in Morehouse constituted rentals from real estate.
Amendment to Code Section 1402 "Clarifies" Status of CRP Payments
Finally, the IRS argues in AOD 2015-02 that the 2008 amendment to Code Sec.1402(a)(1), which treats CRP payments made to social security recipients as rentals from real estate effective for tax years beginning after December 31, 2007, served to clarify that other CRP payments are not excluded as rentals from real estate. According to the IRS, Congress neither enacted a blanket exclusion with respect to CRP payments (or CRP payments made to nonfarmers) nor evidenced any disagreement with the analysis of the Sixth Circuit in Wuebker. Although the statutory amendment does not apply to the years at issue in Morehouse, the IRS said the implication is that before the amendment, CRP payments to farmers and non-farmers alike were not excludible from self-employment income as rentals from real estate. If these payments were already excluded as rental payments, the IRS observed, then the amendment would have been unnecessary. According to the IRS, after the amendment, the implication is that CRP payments to farmers and nonfarmers alike are not excludible from self-employment income unless made to social security recipients.
Conclusion
The IRS position is that it will follow Morehouse within the Eighth Circuit but only with respect to cases in which the CRP payments at issue were both (1) paid to an individual who was not engaged in farming before or during the period of enrollment of his or her land in the CRP, and (2) paid before January 1, 2008. For cases without those facts, the IRS will continue to litigate its position in the Eighth Circuit. It will also continue to litigate its position in all cases in all other circuits.
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Early IRA Distribution Used to Pay Nondependent Son's Medical Expenses Was Subject to Penalty
Although using a premature IRA distribution to pay medical expenses of a child is an exception to the imposition of the 10 percent penalty tax on early IRA distributions, the fact that the taxpayer did not claim her son as a dependent and failed to demonstrate that he was a dependent precluded her from avoiding the penalty. Ireland v. Comm'r, T.C. Summary 2015-60.
Background
Cheryl Ireland, a 47-year old hospital worker, had wages of $34,000 in 2011. She also received an IRA distribution that year of approximately $5,300. The bank, which reported the distribution on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., withheld federal income tax of $529 from the distribution. Ireland timely filed her 2011 Form 1040, electing head of household filing status and claiming a personal exemption deduction for herself and a single dependency exemption deduction for her daughter. Although she included her wages in gross income and claimed a credit for the income tax that the hospital withheld from her pay, she did not report the IRA distribution or the related income tax withholding.
The IRS assessed additional taxes based on the premature IRA distribution, as well as the 10-percent penalty tax under Code Sec. 72(t). Although Ireland did not dispute that she received the premature distribution, she argued that her accountant informed her that there was no need to include the distribution in taxable income because she used the funds to pay her son's medical expenses.
Analysis
Generally, if a taxpayer receives a distribution from a qualified retirement plan before attaining age 59 1/2, Code Sec. 72(t) imposes an additional tax equal to 10 percent of the portion of the distribution which is includible in the taxpayer's gross income. However, Code Sec. 72(t)(2)(B) provides an exception to extent that retirement plan distributions do not exceed the amount allowable as a deduction under Code Sec. 213 for amounts paid during the tax year for medical care (determined without regard to whether the taxpayer itemizes deductions for such tax year).
Code Sec. 213 in turn allows as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his or her spouse, or a dependent (as defined in Code Sec. 152) to the extent that such expenses exceed the applicable percentage of adjusted gross income.
The Tax Court held that Ireland was liable for the additional tax assessment. The court concluded that she was not eligible for the exception under Code Sec. 72(t)(2)(B), even assuming that she used the funds in question to pay her son's medical expenses, because she did not claim her son as a dependent for 2011 and failed to demonstrate that her son met the definition of a dependent provided in Code Sec. 152.
Further, the court said that Ireland's alleged reliance on the mistaken advice of her accountant did not excuse her from the obligation to include the IRA distribution in her taxable income or to pay the appropriate amount of federal income tax and additional tax related thereto.
For a discussion of the 10-percent penalty tax on early distributions from qualified retirement plans and the exceptions to the tax, see Parker Tax ¶131,560.
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Supreme Court Lets Ninth Circuit Reversal of the Tax Court Stand; Partners Cannot Selectively Opt Out of TEFRA Proceedings
The Supreme Court let stand a decision rejecting partners' arguments that they could opt in and out of TEFRA proceedings on the basis of different types of partnership interests. JT USA v. Comm'r, No. 14-1476 (S. Ct. 10/5/15).
On October 5, the Supreme Court denied certiorari in JT USA v. Comm'r, 2014 PTC 570 (9th Cir. 2014). The issue in JT USA was whether or not the Tax Equity and Fiscal Responsibility Act (TEFRA) allows a partner in a partnership to make separate elections, as direct and indirect partners, with respect to the election under Code Sec. 6223(e)(3)(B) to have partnership items to which TEFRA proceedings relate treated as nonpartnership items. The Tax Court had said the answer was "yes" but the Ninth Circuit said otherwise. The partners appealed to the Supreme Court which declined to hear the case. Thus, the Ninth Circuit's decision is final.
Background
In the 1970s, off-road motorcycle enthusiast John Gregory and his wife, Rita, founded a business that became very successful at selling accessories to enthusiasts of motocross and paintball. In 2000, the Gregorys decided to sell the assets of their company, JT USA, LP, to a large paintball equipment manufacturer for $32 million. Faced with the problem of having to pay tax on a very large capital gain, their solution was to use an alleged Son-of-BOSS transaction to create losses large enough to offset their gain. To effectuate the tax shelter, the Gregorys implemented a complex ownership structure in which they held both direct and indirect interests in JT USA.
The IRS challenged the transaction that produced the losses, sending out a Notice of Final Partnership Administrative Adjustment (FPAA) to the Gregorys shortly before the statute of limitations expired. The Gregorys responded by opting out of the TEFRA proceedings in their capacity as indirect partners, and opting into the proceedings in their capacity as direct partners.
In enacting TEFRA, Congress believed rules were necessary to deal with inevitable snafus, such as what happened in the instant case (i.e., the IRS sending out an FPAA just in time to beat the statute of limitations but without any notice that audit proceedings had begun). The Code has two default rules that might apply in this situation. If the IRS waits so long to notify a partner that the time to challenge the FPAA in court has passed, the default rule in Code Sec. 6223(e)(2) is that an unnotified partner's partnership items are treated as nonpartnership items unless the partner "opts in" to the proceedings; for example, if an unnotified partner learns of a favorable settlement agreement that he would like to glom onto.
If, however, the IRS notices its mistake before the FPAA becomes unchallengeable, the default rule is that an unnotified partner's partnership items remain partnership items subject to the outcome of the partnership-level proceeding unless the partner "opts out," under Code Sec. 6223(e)(3), at which point those items become nonpartnership items. Any items that become nonpartnership items under Code Sec. 6223(e) are subject to the standard deficiency procedures of sections 6211 through 6216. Sec. 6230(a)(2)(A)(ii). And the IRS generally has one year from the time a partner's partnership items become nonpartnership items to send a notice of deficiency to that partner.
The problems in this case began when the IRS sent the FPAA to JT USA just before the statute of limitations was to expire. None of JT USA's partners received an advance notice that an audit was coming, but sending them the FPAA meant they did get notice before the time to challenge the adjustments proposed by the FPAA had run. This meant that the default rule of Code Sec. 6223(e)(3), not Code Sec. 6223(e)(2), applied and any partner entitled to receive notice had the right to opt out and not the right to opt in.
IRS Position
Before the Tax Court, the IRS argued that permitting the same partner to make different elections under Code Sec. 6223(e) would increase the administrative burden on the IRS and lead to inconsistent results, two consequences contrary to TEFRA's major purpose.
Tax Court's Analysis
The Tax Court held that Code Sec. 6223(e)(3)(B) allowed the Gregorys to make separate elections as direct and indirect partners, and thus their elections to opt out as indirect partners were valid. The court noted that both the Uniform Limited Partnership Act (ULPA), and the Revised Uniform Limited Partnership Act recognize that the same person can have a dual capacity in a partnership. The UPLA, the court observed, specifically states that a person may be both a general partner and a limited partner. A person that is both a general and limited partner has the rights, powers, duties, and obligations provided by ULPA and the partnership agreement in each of those capacities. When the person acts as a general partner, the court said, the person is subject to the obligations, duties and restrictions under ULPA and the partnership agreement for general partners. When the person acts as a limited partner, the court observed, the person is subject to the obligations, duties and restrictions under ULPA and the partnership agreement for limited partners.
The court also found that Reg. Sec. 301.6223(e)-2T(c)(1) supported its reasoning, noting that the regulation doesn't say that an election must cover all a partner's partnership interests. Instead, it says that "the election shall apply to all partnership items for the partnership taxable year to which the election relates."
The court did agree that at a very general level allowing a partner to wear two hats seemed to be at odds with TEFRA's overall goal to consolidate partnership proceedings and increase consistency. However, the court noted, the elections under Code Sec. 6223(e) are only available when the IRS fails to provide proper notice; i.e., when the TEFRA process has already gone awry and the rules need to be construed to supply a reasonable fix. The IRS appealed.
Ninth Circuit's Reversal
The Ninth Circuit held the Tax Court erred in concluding that the Gregorys could opt out of the proceedings with respect to their indirect partnership interests, and remanded the case for the court to determine the validity of the IRS's adjustments to partnership items. The appeals court found that the Tax Court and the Gregorys had overcomplicated their interpretation of Code Sec. 6223(e)(3)(B), and that a plain-meaning interpretation was appropriate. The court noted that the statute says "the partner," not "an indirect partner" or any other subset of the term "partner," and allows the partner to have the partnership items of that partner to be treated as nonpartnership items, not some of that partner's items to be treated as such. The use of the definitive article "the" convinced the court that the language of Code Sec. 6223(e)(3)(B) is clear and unambiguous, and means that unless a partner elects to have all of his or her partnership items treated as nonpartnership items, the partner cannot elect out of the TEFRA proceeding.
For a discussion of the rules relating to TEFRA audit procedures, see Parker Tax ¶28,505.
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No Deduction for Bad Debt Where Taxpayer Wasn't in the Lending Business
The Tax Court determined a taxpayer in the habit of making short term loans to friends and acquaintances was not engaged in lending as a business. Thus, an unpaid loan was not deductible as a business bad debt, and could only be claimed as a capital loss when it became wholly worthless. Cooper v. Comm'r, T.C. Memo. 2015-191.
Background
Fred Cooper was a full-time employee of USANA Health Sciences, Inc., where he served as chief operations officer, chief information officer, and president. Cooper owns other business interests, including rental properties, a car wash, a search engine optimization company, a pheasant farm, and a drug manufacturing company.
Cooper was in the habit of making short term loans to friends and acquaintances. From 2005 to 2010, he made a total of twelve loans to eleven borrowers. People to whom he lent money include his secretary, his accountant and her employee, and two business associates. He lent money on a short-term basis and charged high interest rates, occasionally charging an annualized interest rate as high as 40 percent. Cooper did almost none of the due diligence that would be customary in a lending business. He did not conduct credit checks or verify collateral through title searches, and he did not collect information through any loan applications before extending loans.
In March 2006, Cooper lent money to Richard Wolper, the president of Wolper Construction, following an introduction by their common friend, Robert Potter. The promissory note that Wolper and Cooper signed reflected a principal amount of $750,000 and a maturity date of September 29, 2006. The promissory note included a collateral guaranty in the form of a deed of trust on real property owned by Wolper Construction, but no lien was recorded. In October 2006, Cooper extended the March 2006 loan for an additional six months, and a new promissory note was signed for $925,000 which reflected the unpaid $750,000 principle plus the interest due. In April 2007, when the $925,000 came due, Wolper Construction did not pay. Wolper Construction filed a chapter 11 bankruptcy petition in 2008, but Cooper never filed a proof of claim with the bankruptcy court against the bankruptcy estate.
Cooper did not report the Wolper Construction loan on the 2008 return that he filed jointly with his wife, Jennifer Brady. The couple filed amended returns reporting the bad debt in April 2010. The IRS audited Cooper and Brady's 2008 and 2009 tax returns and assessed a deficiency.
Analysis
Code Sec. 166 allows taxpayers to deduct any debt that becomes worthless within the tax year. Business debts and nonbusiness debts are treated differently under Code Sec. 166(d)(2). Nonbusiness debts are defined as debts other than: (1) a debt created or acquired in connection with a trade or business of the taxpayer, or (2) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business.
Taxpayers must treat nonbusiness bad debts as losses from the sale or exchange of a short-term capital asset and can claim the loss only in the year in which the debt becomes wholly worthless (Reg. Sec. 1.166-5(a)(2)). However, business bad debts give rise to deductions that can be offset against ordinary income (Code Sec. 166(a)). If a business debt becomes partly worthless during the year, the amount that becomes worthless is allowed as a deduction (but only to the extent it is charged off on the taxpayer's books during the year) (Reg. Sec. 1.166-3(a)).
The Tax Court looks to various factors to determine whether a taxpayer is in the business of lending, such as the total number of loans made and the time period over which the loans were made; the adequacy and nature of the taxpayer's records; whether the taxpayer sought out the lending business; the amount of time and effort expended in the lending activity; and the relationship between the taxpayer and his debtors. (Scallen v. Comm'r, T.C. Memo. 2002-294).
The Tax Court determined that Cooper was not in the business of lending money, and thus the loans he made were nonbusiness debts, for five reasons:
(1) Cooper made only 12 loans over a six-year period from 2005 to 2010, and lending was not a significant activity for him in terms of the time devoted.
(2) Cooper lent money to people he was acquainted with such as his secretary, his accountant and her employee, and two business associates.
(3) Cooper did not conduct his lending practices with typical business formalities, and never bothered to ensure that the trust deed mentioned in the Wolper Construction loan for $750,000 was ever created or filed.
(4) Cooper did not publicly hold himself out as being in the lending business, did not advertise his lending services or actively seek new clients, and did not maintain a separate office for his lending activity.
(5) Cooper did not keep adequate business records, and did not timely report the loan activities on his returns for 2006, 2007, and 2008, waiting until April 2010 to file amended individual returns for these tax years.
Because the loans were nonbusiness debts, the court noted they would only be deductible in the year in which they became wholly worthless. The court found that Cooper did not establish that he had reasonable grounds to abandon any hope of recovery in 2008 or 2009. Nor did he treat the loan as worthless. To the contrary, he presented the loan as an asset on a 2009 loan application and on a personal financial statement. Further, the court stated, Wolper Construction's bankruptcy did not establish with reasonable certainty that the loan was wholly worthless, because it had reported positive net worth on its bankruptcy schedules as of 2008. Accordingly, the Tax Court held Cooper could not deduct the loan as a bad debt for 2008 or 2009.
For a discussion of business vs. nonbusiness bad debts, see Parker Tax ¶ 98,425.
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Pawnbroker Required to Combine Successive Loans on Same Property for Reporting Purposes
Multiple, successive pawn loans between the same parties and collateralized with the same personal property are related transactions for purposes of the Code Sec. 6050I reporting requirement when the debt from one loan is shifted to a subsequent loan. CCA 201540013.
Background
A licensed pawnbroker operating pawnshops in New York City was in the business of lending money to persons who pawn (pledge) personal property, which is deposited with the pawnbroker as security for the loan. Pawn loans are relatively short-term, and the repayment and redemption period may be fixed by law or by contract. If the borrower does not repay the debt, including interest and other charges, by the end of the loan period, plus any statutory waiting period, the broker may sell the pawned property.
In some instances, a customer with an existing loan from one of the broker's pawnshops will agree to a new loan with the broker because the customer cannot pay off or chooses not to pay off the debt at maturity yet does not want to forfeit the collateral. The new loan is secured with the same collateral as before, which remains in the pawnshop's possession. The amount of the new loan is the same as (or possibly more than) that of the prior loan. The borrower will pay any remaining interest and finance charges not already paid on the old obligation, and that loan ends. The borrower, however, does not pay the principal of the first loan.
Example: A borrower enters into a pawn loan at a pawnshop for $7,000 and pledges a piece of jewelry. Fees and interest over the loan period total $1,250. At or before the end of the term, the borrower returns to the pawnshop and pays $1,250 in cash but not the remaining $7,000. The broker and the borrower make a new loan for $7,000 at the same terms, extinguishing the first loan, and the jewelry is again the collateral. At the end of the repayment period for the second loan, the borrower again pays $1,250 and a third $7,000 loan is made. This event may repeat itself several times before the underlying $7,000 of principal is eventually repaid (and the jewelry is released to the debtor) or the property is forfeited. Each loan in the series has its own number and paperwork, in accordance with state law. By the time all of these loans have concluded, the borrower may have paid, in principal, interest, and fees, an aggregate of more than $10,000 in cash to the broker in the same year.
Code Sec. 6050I(a) provides that any person engaged in a trade or business who, in the course of that trade or business, receives more than $10,000 in cash in one transaction or two or more related transactions is required to file a Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, reporting the transaction(s).
The transaction required to be reported is the underlying event precipitating the payer's transfer of cash to the recipient and includes a loan, payment on a loan or other debt, and an exchange of cash for other cash (Reg. Sec. 1.6050I-1(c)(7)(i)).
The IRS Office of Chief Counsel (IRS) was asked to advise whether transactions like the one described in the above example are related transactions for Form 8300 reporting. The pawnbroker took the position that the transactions are not related transactions because the loans are "legally separate" under state law.
Analysis
The IRS advised that multiple, successive pawn loans between the same parties and collateralized with the same personal property are related transactions for purposes of Form 8300 reporting when the debt from one loan is, in practical terms, shifted to a subsequent loan, even if the loans are separate transactions as a matter of state law. Thus, if the customer pays the pawnbroker in the course of a one-year period more than $10,000 in cash in connection with the related transactions, the pawnbroker must file a Form 8300 reporting the transactions.
The IRS said that pawn loans in a series like the one described in the above example are plainly related transactions. The existence of the debt resulting from the first loan, the IRS noted, which the debtor cannot or chooses not to pay off by the maturity date, is the reason for the second loan, and that debt is, in turn, the reason for the third loan, and so on. That the loans are separate transactions does not make them unrelated, the IRS stated, noting it was difficult to imagine the transactions being any more connected without being the same transaction.
Although the pawnbroker emphasized that all of its loans were legally distinct credit extensions under other federal and state laws, the IRS stated that pawn loans are not unique or so different from other types of transactions that they should be treated differently for information reporting purposes. The IRS noted each successive pawn loan is one of a series of connected transactions that are to be treated as related transactions even though the pawnbroker accounts separately for each loan as dictated by state law and provides a separate pawn ticket to the borrower each time.
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Couple Must Recognize Interest Income on Payments Received from Daughter's Company
Even if the taxpayers suffered fraud and would not be able to recover loans made to their daughter's company, the open transaction doctrine did not support the taxpayers' argument that payments received in relation to the loan were a return of capital rather than interest income. Friedman v. Comm'r, T.C. Memo. 2015-177.
Background
Gloria Friedman and her husband, Harvey, invested money in their daughter's business. Their daughter, Kayla, was the president, secretary, and owner of Distinct Advantage Premium Finance, Inc. (Distinct), during 2010. Mrs. Friedman served as treasurer and vice president during that year. Distinct was in the business of financing insurance premiums. On April 1, 2003, Mr. Friedman lent Distinct $887,000 (2003 loan). On April 1, 2007, the Friedmans, through their living trust, lent Distinct $4 million (2007 loan). Both loans were evidenced by promissory notes which called for interest-only payments. The 2003 loan bore interest at a rate of 8% whereas the 2007 loan bore interest at a rate of 9%.
Distinct wrote a check to Mr. Friedman each month during 2010, totaling $40,021. Each check was signed by Kayla and indicated in the memo line that it was for interest. All of the checks to Mr. Friedman were deposited into his and his wife's joint bank account during 2010. Distinct also wrote a check to Mrs. Friedman each month during 2010, totaling $157,500. Each check was signed by Kayla and indicated in the memo line that it was for interest. All of the checks written to Mrs. Friedman were deposited into the joint bank account with her husband during 2010. Distinct recorded the amounts paid to the Friedmans during 2010 as interest expense payments in its general ledger and deducted the amounts as interest expense on its S corporation tax return. Of the over $197,000 the Friedmans received from Distinct in 2010, they reported approximately $73,000 as interest income. The also claimed a capital loss deduction of $3,000 on their 2010 federal income tax return.
Upon auditing the Friedmans' 2010 tax return, the IRS assessed a deficiency. According to the IRS, the payments from Distinct to the Friedmans in 2010 were interest income.
Analysis
Arguing before the Tax Court, the Friedmans claimed that Distinct was defrauded by two separate insurance agents from 2008 to 2011 and that, as a result of the fraud, they were certain that they would never recover the full amounts of their loans to Distinct. Kayla testified that Douglas Terry Dean defrauded Distinct of approximately $1 million in 2008 and 2009 and that James A. Mecha defrauded Distinct of approximately $2 million in 2010 and 2011. The Friedmans provided the Tax Court with a grand jury indictment of Mecha from an Illinois court, but the indictment did not specify the exact dollar amount attributable to Mecha's fraud on Distinct but charged him with theft by deception of more than $1 million.
The Friedmans argued that the open transaction doctrine, also known as the cost recovery method, to support their position that the payments were not interest income. They claimed that Distinct was defrauded from 2008 to 2011 and that they "knew instantly in 2009 or 2010" that they would not be able to recover their loan principal amounts and thus decided to treat the payments as a return of capital.
The Tax Court rejected the Friedmans' argument and held that, even if Distinct suffered losses as a result of fraud, the open transaction doctrine did not support the Friedmans' argument that the payments received in 2010 were not interest. The court noted that it applies the open transaction doctrine only in rare and extraordinary cases where property is considered not to have an ascertainable fair market value and the Friedmans' situation was not such a case. The court also said that the Friedmans had not provided an adequate basis for the court to find that fraud upon Distinct occurred, or if it did, that Distinct would not have had adequate funds with which to repay the Friedmans.
Further, the court noted, Distinct (1) credited the payments to the Friedmans as interest payments in its general ledger, (2) claimed interest expense deductions for the payments on its 2010 tax return, and (3) indicated in the memo line of each check that the payment was "interest." The Friedmans, the court observed, received regular payments of defined dollar amounts in accordance with the terms of the underlying loans and promissory notes. Such payments, the court concluded, were interest income.
For a discussion of the open transaction doctrine, see Parker Tax ¶ 110,580.
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Drought-Stricken Farmers and Ranchers Have More Time to Replace Livestock; 49 States Affected
Certain U.S. counties qualify for an extended replacement period under Code Sec. 1033(e) for livestock sold on account of drought in specified counties. Notice 2015-69.
Under Code Sec. 1033(e)(2), farmers and ranchers who, due to drought, sell more livestock than they normally would may defer tax on the extra gains from those sales. To qualify, the livestock generally must be replaced within a four-year period. The IRS is authorized to extend this period if the drought continues.
Notice 2006-82 provides for extensions of the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion on account of drought, the taxpayer's replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year for the applicable region. For this purpose, the first drought-free year for the applicable region is the first 12-month period that:
(1) ends August 31;
(2) ends in or after the last year of the taxpayer's four-year replacement period determined under Code Sec. 1033(e)(2)(A); and
(3) does not include any weekly period for which exceptional, extreme, or severe drought is reported for any location in the applicable region.
The applicable region is the county that experienced the drought conditions on account of which the livestock was sold or exchanged and all counties that are contiguous to that county. A taxpayer may determine whether exceptional, extreme, or severe drought is reported for any location in the applicable region by reference to U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center.
In the appendix of Notice 2015-69, the IRS lists the counties for which exceptional, extreme, or severe drought was reported during the 12-month period ending August 31, 2015. Accordingly, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2015 (or, in the case of a fiscal year taxpayer, at the end of the tax year that includes August 31, 2015), the replacement period is extended under Code Sec. 1033(e)(2) and Notice 2006-82 if the applicable region includes any county on this list. This extension will continue until the end of the taxpayer's first tax year ending after a drought-free year for the applicable region.
For a discussion of the postponement of gain on livestock resulting from weather-related events, see Parker Tax ¶161,570.
