Federal Tax Bulletin - Issue 91 - June 29, 2015

IRS Finalizes Estate and Gift Tax Exclusion Portability Regulations

The IRS has issued final regulations that provide guidance under Code Secs. 2010 and 2505 on the estate and gift tax applicable exclusion amount, in general, as well as on the applicable requirements for electing portability of a deceased spousal unused exclusion (DSUE) amount. T.D. 9725 (6/16/15).

Background

In December 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA) amended Code Sec. 2010(c) to allow portability of the estate and gift tax exclusion amount between spouses. The portability was scheduled to expire after December 31, 2012, but in January 2013, the American Taxpayer Relief Act of 2012 made it permanent.

Code Sec. 2010(c)(2) defines the applicable exclusion amount, used to determine the applicable credit amount, as the sum of the basic exclusion amount and, in the case of a surviving spouse, the deceased spousal unused exclusion (DSUE) amount. The basic exclusion amount, which is adjusted for inflation annually, is $5.43 million for 2015.

Observation: A surviving spouse may use the DSUE in addition to his or her exclusion amount, allowing for a maximum exclusion of $10.86 million in 2015.

The IRS issued temporary and proposed regulations in T.D. 9593 (6/18/12) and REG-141832-11 (6/18/12) that clarified how the portability rules should be applied. The IRS has now finalized the proposed regulations and removed the temporary regulations, and made clarifying changes and revisions after consideration of practitioner comments.

The final regulations are effective on June 12, 2015.

Making the Portability Election

In order for a surviving spouse to take into account a DSUE amount, the executor of the estate of the deceased spouse must file an estate tax return, compute the DSUE amount on that return, elect portability of the DSUE amount on that return, and ensure that the return is filed by the due date (including extensions). The regulations require every estate electing portability of a decedent's DSUE amount to file an estate tax return within nine months of the decedent's date of death, unless an extension of time for filing has been granted.

If there is no executor, any person in possession of any property of the decedent may file the estate tax return on behalf of the estate of the decedent and, in so doing, elect portability of the decedent's DSUE amount, or, by complying with certain requirements, may elect not to have portability apply.

The regulations provide that a portability election is irrevocable once the due date (as extended) of the return has passed.

Computing the DSUE Amount

The regulations require that an executor include a computation of the DSUE amount on the estate tax return of the decedent to allow portability of that decedent's DSUE amount. A complete and properly-prepared return contains the information required to compute a decedent's DSUE amount.

Code Sec. 2010(c)(4)(A) and Code Sec. 2010(c)(4)(B)(i) and (ii) define the DSUE amount as the lesser of:

(1) the basic exclusion amount, or

(2) the excess of applicable exclusion amount of the last deceased spouse of the surviving spouse, over the amount with respect to which the tentative tax is determined on the estate of such deceased spouse.

Availability of Extension of Time to Elect Portability

A practitioner commenting on the temporary regulations requested that the final regulations address the availability of an extension of time under Reg. Secs. 301.9100-2 and 301.9100-3 to elect portability under Code Sec. 2010(c)(5)(A).

Reg. Sec. 301.9100-2(b) provides an automatic six-month extension of time for making certain statutory and regulatory elections if the return is timely filed. Because the portability election is deemed to be made by the timely filing of a complete and properly prepared estate tax return, the IRS notes this relief provision will not be helpful with regard to the portability election unless the return was not complete or properly prepared and that any insufficiency is corrected within six months from the unextended due date of the return.

The IRS notes that an extension of time under Reg. Sec. 301.9100-3 to elect portability may be available to estates that are under the value threshold described in Code Sec. 6018. Accordingly, the final regulations provide that an extension of time to elect portability may be granted to estates with a gross estate value below that threshold amount and thus not otherwise required to file an estate tax return.

Observation: As transitional relief in the wake of TRUIRJCA and ATRA, the IRS has published guidance in Notice 2012-21 and Rev. Proc. 2014-18 regarding the availability of an automatic extension of time for executors of certain estates under the filing threshold of Code Sec. 6018(a) to file an estate tax return to elect portability of an unused exclusion amount. The IRS continues to receive, and continues to consider, requests for permanent extensions of this type of relief, but notes that such relief is not included in the final regulations.

Effect of Portability Election Where DSUE Amount is Uncertain

Another commenter on the temporary regulations requested that the final regulations address whether an estate can make a "protective" election if a DSUE amount is not reflected on an otherwise complete and properly prepared estate tax return at the time of its timely filing, but subsequent adjustments to amounts on the estate tax return would result in unused exclusion of that decedent.

For example, an executor files a complete and properly prepared estate tax return that shows a DSUE amount equal to zero and does not opt out of portability. At the same time, the executor also files a claim for a refund and subsequently, the estate becomes entitled to a deduction which reduces the estate tax and results in unused exemption.

The IRS notes that the executor in the example properly elected portability, and the recomputed DSUE amount will be available. The final regulations clarify that the computation requirement in Code Sec. 2010(c)(5)(A) will be satisfied if the estate tax return is prepared in accordance with the requirements of Reg. Sec. 20.2010-2(a)(7). Accordingly, the IRS concluded that there is no need for a protective election.

Requirement of a "Complete and Properly Prepared" Estate Tax Return

The temporary regs provided a special rule applicable to estates that are not otherwise required to file an estate tax return under Code Sec. 6018. For these estates, the executor does not need to report the value of certain property that qualifies for the marital or charitable deduction. The temporary regulations also included exceptions to the special rule.

A practitioner suggested that one exception was made unnecessarily broad by its reference to "another provision of the Code." The practitioner was concerned that, because the fair market value of a bequeathed asset determines the basis of that asset in the hands of the legatee, the value of all estate assets would have an impact on Code Sec. 1014, and, thus, all assets would have to be valued. In referring to value needed to determine an estate's eligibility, the IRS did not intend to include a basis determination under Code Sec. 1014. Accordingly, the language of Reg. Sec. 20.2010-2T(a)(7)(ii)(A)(2) has been clarified.

Special Rules for Qualified Domestic Trusts

The qualified domestic trusts (QDOT) rules in the temporary regs provide that the executor of a decedent's estate claiming a marital deduction for property passing to a QDOT must compute the decedent's DSUE amount in the same way as for any other decedent. However, because the estate tax payments made from the QDOT after the decedent's death are part of the decedent's estate tax liability, the earliest date such a decedent's DSUE amount may be included in determining the applicable exclusion amount is the date of the event that triggers the final estate tax liability of the decedent under Code Sec. 2056A.

Observation: Generally, this scenario occurs upon the termination of all QDOTs created by or funded with assets passing from the decedent or upon the death of the surviving spouse).

A practitioner expressed concern over this delay in the surviving spouse's ability to use the decedent's DSUE amount in circumstances where the surviving spouse becomes a U.S. citizen after the decedent's estate tax return is filed and after property passes to a QDOT.

Under Code Sec. 2056A(b)(12), the estate tax imposed under Code Sec. 2056A(b)(1) will cease to apply to property held in a QDOT if the surviving spouse becomes a United States citizen and either of the following requirements are met:

(1) the spouse was a resident of the United States at all times after the death of the decedent and before the spouse becomes a citizen of the United States, or

(2) no tax was imposed by Code Sec. 2056A(b)(1)(A) with respect to any distribution before the spouse becomes a citizen.

The IRS concluded that, if the surviving spouse of the decedent becomes a citizen of the United States and the requirements under Code Sec. 2056A(b)(12) and the corresponding regulations are satisfied so that the tax imposed by Code Sec. 2056A(b)(1) no longer applies, then the decedent's DSUE amount is no longer subject to adjustment and will become available for transfers by the surviving spouse as of the date the surviving spouse becomes a citizen of the United States. Accordingly, the final regulations make clarifying changes.

Availability of DSUE Amount by Surviving Spouse Who Becomes a Citizen of the United States

A practitioner requested that the final regulations allow a surviving spouse who becomes a U.S. citizen after the death of the deceased spouse to take into account the DSUE amount of such deceased spouse.

Because a surviving spouse who becomes a U.S. citizen is subject to the estate and gift tax rules of chapter 11 and 12 that apply to U.S. citizens and residents, the IRS believes it is appropriate that such a surviving spouse be permitted to take into account the DSUE amount available from any deceased spouse as of the date such surviving spouse becomes a U.S. citizen, provided the deceased spouse's executor has made the portability election. Accordingly, the final regulations include such a rule in Reg. Secs. 20.2010-3 and 25.2505-2.

Order of Credits

The IRS notes that the amount of the allowable credit in Code Secs. 2012 through 2015 can be determined only after subtracting the applicable credit amount determined under Code Sec. 2010 from the tax imposed by Code Sec. 2001. Accordingly, to the extent the applicable credit amount is applied to reduce the tax imposed by Code Sec. 2001 to zero, the credits in Code Secs. 2012 through 2015 are not available. The rule in Code Sec. 2010(c)(4) for computing the DSUE amount does not take into account any unused credits arising under Code Secs. 2012 through 2015.

Based on these considerations, the IRS concluded that no adjustment to the computation of the DSUE amount to account for any unused credits is warranted. Accordingly, Reg. Sec. 20.2010-2(c)(3) clarifies that eligibility for credits against the tax imposed by Code Sec. 2001 does not factor into the computation of the DSUE amount.

[Return to Table of Contents]

Taxpayer Hit with Taxes and Penalties for Collecting a Salary from a Business Started with a Self-Directed IRA

A taxpayer engaged in a prohibited transaction when he used a self-directed IRA to invest in a used car business and then collected a salary from the business. Ellis v. Comm'r, 2015 PTC 180 (8th Cir. 2015).

Self-directed individual retirement accounts (IRAs) have gained attention lately as a tool that taxpayers can use to invest in new business ventures. Rather than withdraw money from an IRA and pay tax on the withdrawal, as well as the 10 percent penalty tax if the IRA owner is under 59 and 1/2, an individual can direct his or her IRA to make the investment. However, as the taxpayers in Ellis v. Comm'r, 2015 PTC 180 (8th Cir. 2015) discovered, failing to successfully navigate the tax landmines associated with using a self-directed IRA in a business venture can leave a taxpayer far worse off than if he or she had withdrawn the money from the IRA in the first place.

In Ellis, the taxpayer used his IRA to invest in a used car business and the business compensated him for his services in managing the business. The Tax Court held that this was a prohibited transaction. As a result, the IRA lost its tax-favored status and the entire fair market value of the IRA was treated as taxable income. The taxpayer was also hit with a penalty tax of over $32,000, as well as accuracy-related and late-filing penalties. On appeal, the Eighth Circuit upheld the Tax Court's holding. The situation in the instant case is a cautionary tale for anyone who wants to use their IRA to invest in a business. While it can be done, it's important to find a reputable IRA sponsor experienced in dealing with self-directed IRA investments to help negotiate the pitfalls inherent in such investments.

Facts

By 2005, Terry Ellis had accumulated a sizable amount in his 401(k) retirement plan from his many years of service as a pharmaceutical company employee. In 2005, Ellis hired a law firm to advise him on restructuring his investment holdings. The following month, the firm helped Ellis and his wife organize CST, a Missouri limited liability company formed to engage in the business of selling used vehicles. Ellis received distributions from his 401(k) plan and rolled them over into an IRA.

CST's operating agreement listed the original members of CST as Ellis' self-directed IRA, owning 980,000 membership units or 98% in exchange for an initial capital contribution of $319,500, and an unrelated party owning the remaining 20,000 membership units or 2%. Ellis was designated as the general manager for CST and given full authority to act on behalf of the company.

To compensate him for his services as general manager, CST paid Ellis a salary of almost $10,000 in 2005 and approximately $29,000 in 2006. The wages were drawn from CST's corporate checking account and were reported as income on the Ellises' joint tax returns for both years. The Ellises also reported pension distributions of approximately $321,000 on their 2005 tax return but did not report any portion of these distributions as taxable. Nor did they report that Ellis' IRA purchased a total of 980,000 membership units of CST in 2005. The Ellises likewise did not disclose that CST, an entity that had paid compensation to Mr. Ellis in 2005, was owned primarily by his IRA.

In 2011, the IRS sent the Ellises a notice of income tax deficiency, assessing an accuracy-related penalty and a late-filing penalty. The IRS determined that Ellis engaged in prohibited transactions under Code Sec. 4975(c) by (1) directing his IRA to acquire a membership interest in CST with the expectation that the company would hire him, and (2) receiving wages from CST. As a result of these transactions, the IRS said, the IRA lost its status as an IRA and its entire fair market value was treated as taxable income under Code Sec. 408(e)(2). Ellis and his wife disagreed with the assessment and filed suit in Tax Court.

The Tax Court upheld the IRS's assessment and determined that Ellis had formulated a plan in which he would use his retirement savings as startup capital for a used car business and use the business as his primary source of income. Because Ellis could direct his compensation from CST, the Tax Court concluded that he engaged in the transfer of plan income or assets for his own benefit in violation of Code Sec. 4975(c)(1)(D) and dealt with the income or assets of his IRA for his own interest or account in violation of Code Sec. 4975(c)(1)(E). The Ellises appealed to the Eighth Circuit.

Limitations on the Use of Nontaxable IRA Distributions

Code Sec. 4975 limits the allowable transactions for certain retirement plans, including IRAs under Code Sec. 408(a). It does so by imposing an excise tax on a list of prohibited transactions between a plan and a disqualified person. Under Code Sec. 4975(c)(1)(D) and (E), prohibited transactions include (1) any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; or (2) any act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account. Such transactions are prohibited even if they are made in good faith or are beneficial to the plan.

If a disqualified person engages in a prohibited transaction with an IRA, the plan loses its status as an IRA and, under Code Sec. 408(e)(2), its fair market value as of the first day of the tax year is deemed distributed and included in the disqualified person's gross income.

Taxpayer's Arguments

On appeal to the Eighth Circuit, Ellis relied on a Department of Labor regulation, 29 C.F.R. Sec. 2510.3-101, also known as the Plan Asset Regulation, in arguing that a prohibited transaction did not occur because his salary was drawn from CST's corporate account and not from the income or assets of the IRA.

Ellis also argued that the payment of wages in this circumstance was exempt under Code Sec. 4975(d)(10). That provision excludes from the list of prohibited transactions the receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of the person's duties with the plan.

Eighth Circuit's Analysis

The Eighth Circuit affirmed the Tax Court. In doing so, the Eighth Circuit rejected Ellis' reliance on the Plan Asset Regulation because, the court said, the plain language of Code Sec. 4975(c) prohibits both direct and indirect self-dealing of the income or assets of a plan. The Plan Asset Regulation, the court stated, cannot be read to nullify the general rule against indirect self-dealing. The court also cited a Department of Labor Opinion which explains that certain transactions between a disqualified person and a corporation in which a plan invests are prohibited regardless of whether they meet the Plan Asset Regulation.

With respect to the alternative argument that the wages were exempt under Code Sec. 4975(d)(10), the Eighth Circuit cited Lowen v. Tower Asset Management, Inc. 829 F.2d 1209 (2d Cir. 1987) for the proposition that such exemption applies only to compensation for services rendered in the performance of plan duties. CST compensated Ellis for his services as general manager of the company, the court observed, not for any services related to his IRA. Thus, Code Sec. 4975(d)(10) did not apply in this case.

For a discussion on self-directed IRAs, see Parker Tax ¶134,505.

[Return to Table of Contents]

Transfer of Assets to Wholly Owned Corporation Not a Sale; Capital Gain Treatment Denied

The transfer of a sole proprietorship's assets to a corporation wholly owned by the taxpayer and his wife was a capital contribution rather than a sale of property and payments subsequently received by the taxpayers were ordinary income rather than capital gains. Bell v. Comm'r, T.C. Memo. 2015-111.

Background

In 2008 through 2010, the years at issue, J. Michael Bell (Michael) and Sandra Bell lived in California. During this time, there were a number of defaults on loans secured by residential real estate. Lenders often acquired at foreclosure sales many of the residential properties securing their loans. These types of properties were known as "real estate owned properties" (REOs). During the years at issue, Michael was a licensed real estate broker and Sandra was a certified real estate appraiser and a licensed real estate sales agent. Michael also assisted lenders with their REO portfolios and his compensation for such work was principally commissions paid when the property was sold. Until September 1, 2008, Michael operated his real estate business as a sole proprietorship. As a result of the increase in his REO work, Michael incorporated his business under the name MBA Real Estate, Inc. (MBA).

On October 1, 2008, MBA and Michael entered into a purchase agreement. For $225,000, Michael agreed to sell MBA all the work in process, customer lists, contracts, licenses, franchise rights, trade names, goodwill, and other tangible and intangible assets of his sole proprietorship. When the purchase agreement was signed, MBA had no capital, no assets, and no shareholders. A couple weeks later, MBA issued 250 shares to Michael and 250 shares to Sandra in exchange for $500. No appraisal was performed. The $225,000 purchase price was determined exclusively by the Bells. The Bells allocated $25,000 of the purchase price to a five-year franchise license agreement Michael had entered into in 2004. The remaining $200,000 of the purchase price was allocated to 40 contracts between Michael and various lenders and entities to assist during the REO process.

The property subject to one of the 40 contracts was sold before September 1, 2008, and MBA booked a $10,800 account receivable for this contract. The other 39 contracts required additional services by Michael; there was no certainty that these contracts would produce income. The purchase agreement stated that the purchase price was payable in monthly installments of $10,000 or more on the first of each month and that the unpaid principal amount was subject to 10 percent interest each year. MBA did not provide any security for the purchase price, and no promissory note was executed. The purchase price was eventually paid in full, but MBA did not make all payments timely.

On their returns for the years at issue, the Bells reported long-term capital gain from the sale of the assets on Form 6252, Installment Sale Income. The Bells also reported interest income for years 2008, 2009, and 2010, and MBA reported substantially the same amounts as interest expense on its returns for those years. MBA amortized the $225,000 purchase price over five years. At the end of 2008 and 2009, MBA had accumulated earnings and profits (E&P) of approximately $88,000 and $158,000, respectively. During 2008 and 2009, MBA distributed to Michael and Sandra approximately $45,000 and $109,000, respectively. MBA's current E&P for 2010 and its accumulated E&P of $158,000 exceeded a $53,000 distribution to the Bells in 2010.

The Bells' 2008 return was due by April 15, 2009, but was not filed until June 20, 2009. MBA's 2008 tax return was due by March 15, 2009, and was filed on March 14, 2009. In 2012, the IRS sent notices of deficiency to the Bells and MBA, determining that the Bells' entire gain from the 2008 sale was ordinary income.

Analysis

According to the IRS, the transfer of Michael's sole proprietorship's assets to MBA was a capital contribution subject to Code Sec. 351 rather than a sale generating capital gains. The IRS further argued that the payments made to the Bells were in fact dividends and that the assets transferred to MBA could not be amortized or depreciated.

The Bells and MBA countered that the statute of limitations barred the IRS assessment for the 2008 tax returns. In addition, the Bells and MBA argued that the transfer of the sole proprietorship's assets to MBA was a sale that created a debtor-creditor relationship and should be respected as such.

The Tax Court held that the deficiency notices issued to the Bells and MBA were timely and that the transfer of assets to MBA was a capital contribution governed by Code Sec. 351. With respect to the timeliness of the deficiency notices, the Tax Court noted that Code Sec. 6501 generally requires that taxes be assessed within three years after a return is filed. Since the deficiency notices were sent via certified mail on February 7, 2012, they were issued before the expiration of the three-year period and thus were timely.

With respect to the characterization of the transfer of assets to MBA, the court examined various factors, noting that an appeal in this case would go to the Ninth Circuit, which has applied an 11-factor test to determine whether a shareholder's transfer to a corporation is a sale or capital contribution. The Tax Court noted that the sole purpose of MBA's organization was to incorporate Michael's sole proprietorship and that the inseparable relationship between MBA's organization and the transfer of the sole proprietorship's assets weighed in favor of finding that the transfer was a capital contribution. This was particularly so, the court said, in the light of the lack of evidence of a business purpose for the transaction.

The court also observed that payments that depend on earnings or come from a restricted source indicate an equity interest. MBA acquired essentially all of its assets, which had very little, if any, liquidation value, in exchange for the promise of repayment in the purchase agreement, the court noted. Without income it would be impossible for MBA to make any payments due under the purchase agreement, and repayment was completely contingent on MBA's earnings. Consequently, the court found that this factor weighed in favor of finding that the transfer was a capital contribution. The court also noted that because the transaction took place between MBA and Michael, and Michael and Sandra later became MBA's sole shareholders, this factor was another indication that the transaction was a capital contribution.

While the court did find several factors that indicated the transaction was a sale namely the parties' intent, the fixed maturity date of payments, and the wording in the purchase agreement the preponderance of evidence indicated to the court that the transaction was a capital contribution and not a sale.

Since the court concluded that the Bells' transfer of the sole proprietorship's assets to MBA was a capital contribution, MBA's payments to the Bells in the years at issue had to be treated as distributions, not installment payments. Because MBA's accumulated E&P in each of the years exceeded the amount distributed to the Bells, the distributions were dividend income for tax purposes.

Finally, the court held that, under Code Sec. 362(a), MBA's initial basis in all of the property it received in connection with the Code Sec. 351 transaction was the same as the Bells' basis in the property. With respect to the transferred contracts and goodwill, the court found that the Bells had no basis in those items and thus MBA had no basis. As a result, MBA was not entitled to any depreciation or amortization with respect to those items.

For a discussion the rules relating to the transfer of property to a corporation, see Parker Tax ¶45,105.

[Return to Table of Contents]

Expenses for Lawsuit against Condo Homeowner's Association Are Partially Deductible

A condo owner was allowed to deduct on her Schedule C a percentage of legal fees incurred to sue her homeowner's association because of unruly dogs in the building, mold in her bathroom, and noise problems; and, because the IRS failed to prove that interest expense relating to her equine activity was not an expense incurred in a trade or business, that amount was deductible as well. McMillan v. Comm'r, T.C. Memo. 2015-109.

Background

Denise McMillan lives in a condo unit in which she maintains a home office where she works in the information technology and database management field (IT activity). A homeowners association (HOA) has various duties and responsibilities with respect to the condo unit. In 2005, McMillan filed a lawsuit against the HOA and various unnamed persons in which she complained of: (1) dogs running wild, dogs barking, and dogs defecating around the property; (2) construction defects related to the presence of mold in her bathroom; and (3) construction defects that caused noise problems. The HOA litigation was settled in June 2010.

In 2009, in connection with the HOA litigation, McMillan was involved in a separate legal action involving misdemeanor criminal charges connected with her attempt to gather evidence for the HOA litigation. She incurred legal expenses of $26,312 in 2009 in connection with both the HOA litigation and the separate legal action.

McMillan also incurred expenses in 2009 relating to an equine activity. She testified that she is an international dressage rider and trainer and that, in 2009, she trained horses, although a moving company had lost her records documenting that activity. From 1999 through January 2008, McMillan owned a horse named Goldrush. From at least 1999 through 2009, McMillan did not compete in any horse shows with Goldrush or any other horse. McMillan was unsuccessful in breeding Goldrush and, as a result decided to send him to Australia in the hope that his breed and bloodline would make him an attractive breeding stallion there. However, in January 2008, after Goldrush arrived in Australia, he became unexpectedly ill and died. From 2004 through 2009, McMillian included as part of her tax return a Schedule C for the equine activity. She reported expenses but no net income from the activity in those years and only reported receipts in 2004.

With her 2009 tax return, McMillan filed two Schedules C, and a Form 8829, Expenses for Business Use of Your Home. On the Schedule C relating to her IT activity, McMillan took a deduction of $26,312 for legal expenses relating to the HOA litigation. The Form 8829 reported 50 percent as the business use percentage for McMillan's business use of her home. On the Schedule C relating to her equine activity, McMillan reported zero receipts and expenses of $7,486. Of that amount, $5,690 was interest expense related to indebtedness McMillan incurred in 2007 to transport Goldrush to Australia.

The IRS disallowed the legal expenses and the equine activity deductions. With respect to the legal expenses, the IRS argued that the expenses were not related to McMillan's IT activity and were personal nondeductible expenses. With respect to the equine activity, the IRS said the expenses should be disallowed for two reasons: (1) the equine activity was not a going concern and McMillan was therefore not carrying on a trade or business, and (2) the equine activity was not an activity engaged in for profit within the meaning of Code Sec. 183.

Analysis

The Tax Court held that McMillan could deduct 50 percent of the legal expenses and the interest expense of $5,690 on the equine activity debt. The Tax Court noted that the dispute giving rise to the legal expenses arose principally on account of McMillan's claims of noise and other factors interfering with her use and enjoyment of her condo. While such expenses would generally not be deductible as ordinary and necessary business expenses, the court concluded that, because McMillan reported a 50 percent business use of the condo unit, she was entitled to deduct 50 percent of the legal expenses. The IRS, the court said, failed to prove that McMillan used any lesser percentage of the unit for business or that the complained-of noise and other factors did not affect her business use of the unit.

On the basis of McMillan's history of substantial losses in her equine activity from 2004 through 2009, the court found that, during 2009, she did not carry on the equine activity to make a profit. Thus, the court sustained the IRS's disallowance of deductions for all of the equine activity expenses other than the $5,690 interest expense. With respect to the interest expense, the court held that the IRS failed to show that the interest was not deductible irrespective of whether, in 2009, the equine activity was engaged in for profit. While Code Sec. 163(h) disallows an interest deduction for personal interest, the court observed, interest paid or accrued on indebtedness properly allocable to a trade or business generally is not personal interest. In general, the court noted, interest expense on a debt is allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures and in the instant case, the court stated, the debt financed expenditure was for the transport of Goldrush to Australia in 2007.

The court held that McMillan could deduct the interest expense because the IRS failed to prove that the equine activity was not a trade or business in 2007 or that, even if it was, it was not an activity engaged in for profit in 2007. The court concluded that the interest expense was deductible because the IRS failed to prove that the debt-financed expenditure to transport Goldrush to Australia in 2007 was not a trade or business expenditure in an activity engaged in for profit.

For a discussion of the deductibility of legal expenses, see Parker Tax ¶90,150. For a discussion of interest allocation rules, see Parker Tax ¶83,580.

[Return to Table of Contents]

Eleventh Circuit Rejects Estate's Attempt to Dodge Code Sec. 642(g)'s Bar on Double Deduction

The Eleventh Circuit reversed a district court decision that res judicata applied to prevent the IRS from collecting certain taxes but affirmed the district court's holding preventing an estate from taking an estate tax deduction and an income tax deduction for settlement payments made in various lawsuits. Batchelor-Robjohns v. United States, 2015 PTC 179 (11th Cir. 2015).

Background

In 1999, George Batchelor sold the stock in his aviation business, International Air Leases, Inc. (IAL), to International Air Leases of Puerto Rico, Inc. (IALPR) for $502 million. As part of the transaction, IALPR gave Batchelor a promissory note for $150 million, which was secured by IAL assets that had been transferred in the sale. Additionally, IAL and IALPR negotiated an option for Batchelor to buy back some of the transferred assets ("Option Assets"). Later that year, Batchelor exercised his option to buy back these assets for almost $93 million, thus reducing the $150 million note by that amount. The following year, IALPR paid off the note. As a result of the transaction, Batchelor received capital gains and interest income, and IAL realized a capital gain through its sale of the Option Assets. Batchelor reported the income he received from the sale as capital gain, and paid capital gains tax on the proceeds

In 2002, IAL was placed into involuntary bankruptcy and later that year, Batchelor died. The IRS determined that IAL was liable for approximately $100 million in unpaid taxes, largely as a result of its attempt to use a tax shelter scheme after the stock sale. The IRS sought to collect IAL's corporate income tax obligation directly from Batchelor's estate under a transferee liability theory. In a district court, the IRS attempted to prove that the sale of the IAL stock rendered IAL insolvent because the transferring parties undervalued the Option Assets such that Batchelor received excess consideration relative to the actual fair market value of the IAL stock. The district court, however, struck the experts testimony on the value of the Option Assets based on the IRS's failure to comply with certain procedural rules and granted summary judgment in favor of Batchelor's estate (Batchelor I). Consequently, the value of the Option Assets was not decided in Batchelor I.

In 2004, the IRS sued Batchelor's estate based on its determination that Batchelor had underreported his capital gains in conjunction with the IAL sale on his personal income tax returns (Batchelor III). Batchelor's estate subsequently paid the $6.7 million deficiency and filed for a refund. The IRS denied the estate's refund request.

Following the sale of Batchelor's ownership interest in IAL to IALPR, a number of parties filed civil lawsuits challenging the transaction. From 2002 to 2004, the estate settled each of the pending claims against it and deducted settlement payments of $41 million from the gross estate under Code Sec. 2053(a)(3). The estate later sought a refund of $8.3 million on its 2005 income tax return for those payments pursuant to Code Sec. 1341. The IRS denied the refund request.

Batchelor's estate filed suit in district court seeking refunds for amounts it had paid the IRS. In Counts I and II, the estate sought refunds of tax payments relating to payments to the IRS in Batchelor III. Count III of the estate's complaint involved the settlement payments the estate made in connection with the civil lawsuits. The estate argued that after taking the estate tax deduction for the lawsuit settlement payments, it was also entitled under Code Sec. 1341 to an $8.3 million credit on its 2005 income tax return for the $41 million returned to the plaintiffs in the lawsuits as settlement payments.

With respect to Counts I and II, the district court held that the IRS was precluded by res judicata from defending against the estate's claim that the value of the Option Assets had been accurately reported in calculating Batchelor's 1999 and 2000 income tax obligations. With respect to Count III, the district court rejected the estate's claim, finding that Code Sec. 642(g) barred the estate from claiming both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment.

The case was appealed to the Eleventh Circuit.

Analysis

With respect to Counts I and II, the IRS argued that res judicata was not applicable because the personal income tax claims against Batchelor and the transferee liability claim against IAL in Batchelor I were not the same cause of action. Alternatively, even if the claims were part of the same cause of action, the IRS said it could not have asserted the instant claims in Batchelor I given that the it had not yet issued a Notice of Deficiency with respect to the income tax claims against Batchelor at the time the complaint in Batchelor I was filed.

With respect to Count III, the estate argued that Code Sec. 162 and Code Sec. 212 provided a basis for permitting a "double deduction" of the settlement payments at issue because the payments arose out of Batchelor's business activities and thus were ordinary and necessary business expenses.

The Eleventh Circuit reversed the district court's holdings on Counts I and II, finding that the district court erred in applying res judicata to bar the IRS's claims in Counts I and II.

The Eleventh Circuit affirmed the district court's holding on Count III. With respect to the estate's argument that Code Sec. 1341 applied to allow a double deduction, the court noted that Code Sec. 1341 does not, by itself, create an independent tax deduction and instead applies only if another code section would provide a deduction for the item in the current year. Thus, the Eleventh Circuit said, the dispute involved in Count III could not be resolved simply by reference to Code Sec. 1341. To determine whether another code section would provide a deduction for the item in the current year, the Eleventh Circuit agreed with the district court that the tax code provisions relating to overlapping estate and income tax deductions were relevant.

The court noted that Code Sec. 642(g) applied to prevent an estate from claiming both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment. However, the court observed, Code Sec. 642 contains an exception for income in respect of decedents and Code Sec. 642(g) does not apply to such income. Thus, a double deduction is permitted for taxes, interest, business expenses, and other items accrued at the date of a decedent's death that fall within Code Sec. 2053(a)(3) as claims against the estate, as long as they are also allowable under Code Sec. 691(b). Code Sec. 691(b), in turn, provides that a decedent's estate may claim both deductions if the expense falls within one of six statutes: Code Secs. 162, 163, 164, 212, 611, or 27. The district court in this case, the Eleventh Circuit said, properly required the estate to show that one of these statutes applied in order to claim both an estate tax deduction under Code Sec. 2053 and an income tax deduction for the same payment.

With respect to the estate's argument that Code Sec. 212 and Code Sec. 162 allowed a double deduction, the court cited the decision in Kimbell v. U.S., 490 F.2d 203 (5th Cir. 1974), in which the Fifth Circuit determined that a payment made by a taxpayer in satisfaction of a liability arising from an earlier transaction, on which that taxpayer reported capital gain, must be treated as a capital loss at least to the amount of the capital gain, rather than as a Code Sec. 162 business expense. It was undisputed, the Eleventh Circuit said, that Batchelor obtained the $41 million of income (that was used to pay the plaintiffs in the lawsuits) as a result of his sale of IAL stock.

The $41 million at issue, the Eleventh Circuit noted, derived from income Batchelor originally reported as capital gain through the sale of his IAL stock. Batchelor's treatment of this income as capital gain, the court said, determines the character of a subsequent repayment of that income pursuant to Kimbell. Thus, the Eleventh Circuit concluded, a payment made by a taxpayer in satisfaction of a liability arising from an earlier transaction on which that taxpayer reported capital gain, such as the payments at issue, must be treated as a capital loss at least to the amount of the capital gain, rather than as a Code Sec. 162 business expense.

Because the estate failed to identify an applicable deduction identified in Code Sec. 691(b), the Eleventh Circuit found no error in the district court's determination that the estate could not avoid Code Sec. 642(g)'s bar on double deductions, and therefore affirmed on Count III.

For a discussion of the rule disallowing double deductions for estate expenses, see Parker Tax ¶53,130.

[Return to Table of Contents]

Temp Regs Block Corporations from Using Partnerships to Avoid Recognizing Gains

The IRS has issued temporary regulations intended to prevent corporate taxpayers from using a partnership to avoid gain required to be recognized under Code Sec. 311(b) or Code Sec 336(a). The regulations are intended to prevent circumvention of the General Utilities doctrine repeal. The text of the temporary regulations serves as the text of the proposed regulations. T.D. 9722 (6/11/15).

Background

In General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), the Supreme Court held that corporations generally could distribute appreciated property to their shareholders without the recognition of any corporate level gain (the General Utilities doctrine). Beginning in 1969 and ending with the Tax Reform Act of 1986, Congress enacted Code Sec. 311(b) and Code Sec. 336(a) to limit and ultimately repeal the General Utilities doctrine. Under current law, Code Sec. 311(b) and 336(a) require a corporation that distributes appreciated property to its shareholders to recognize gain determined as if the property were sold to the shareholders for its fair market value. Read more...

Proposed Regulations Address Aggregation of Basis in Corporate Stock Distributions

The IRS has issued proposed regulations requiring certain partners to aggregate their bases in stock distributed by the partnership for purposes of applying Code Sec. 732(f), in order to limit instances of basis reduction or gain recognition. The regulations are intended to prevent circumvention of the General Utilities doctrine repeal. REG-138759-14 (6/12/15).

Background

In General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), the Supreme Court held that corporations generally could distribute appreciated property to their shareholders without the recognition of any corporate level gain (the General Utilities doctrine). Beginning in 1969 and ending with the Tax Reform Act of 1986 Congress enacted a series of statutory changes that limited and ultimately repealed the General Utilities doctrine.

The IRS has released proposed regulations for Code Sec. 732 under REG-138759-14 that would require consolidated group members that are partners in the same partnership to aggregate their bases in stock distributed by the partnership for the purpose of applying Code Sec. 732(f), in order to limit the application of rules that might otherwise cause basis reduction or gain recognition. Like the concurrently released regulations under T.D. 9722, which prevent corporations from avoiding gains under Code Secs. 311 and 336, the proposed regulations are intended to prevent taxpayers from contravening the purposes of the General Utilities repeal.

Congress enacted Code Sec. 732(f) due to concerns that a corporate partner could otherwise negate the effects of a basis step-down to distributed property required under section 732(b) by applying the step-down against the basis of distributed stock of a corporation (distributed corporation). Code Sec. 732(f) generally precludes this result by requiring that either the distributed corporation must reduce the basis of its property or the corporate partner must recognize gain (to the extent the distributed corporation is unable to reduce the basis of its property).

Specifically, Code Sec. 732(f) provides that if: (1) a corporate partner receives a distribution from a partnership of stock in another corporation (distributed corporation), (2) the corporate partner has control of the distributed corporation (i.e., ownership of stock meeting the requirements of Code Sec. 1504(a)(2)) immediately after the distribution or at any time thereafter (the "control requirement"), and (3) the partnership's basis in the stock immediately before the distribution exceeded the corporate partner's basis in the stock immediately after the distribution, then the basis of the distributed corporation's property must be reduced by this excess.

The IRS believes that as currently applied, Code Sec. 732(f) may be too broad in some circumstances and too narrow in others. For example, corporate partners may inappropriately avoid the purposes of Code Sec. 732(f) by engaging in transactions in which they receive property held by a distributed corporation without reducing its basis to account for basis reductions under Code Sec. 732(b) made when the partnership distributed stock of the distributed corporation to the corporate partner..

Aggregation of Code Section 732(b) Basis Adjustments

Although Code Sec. 732(f) generally applies on a partner-by-partner basis, the IRS states that in certain circumstances, it is appropriate to aggregate the bases of consolidated group members in a partnership for purposes of applying Code Sec. 732(f). For example, basis aggregation may be appropriate when two or more corporate partners in the same consolidated group (member-partners) receive a deemed distribution of stock in a distributed corporation either because, (1) the partnership elects to be treated as an association taxable as a corporation, or (2) one corporate partner acquires all of the interests in the partnership causing the partnership to liquidate. In these instances, Code Sec. 732(b) may cause one member-partner to increase the basis of distributed stock while another member-partner reduces the basis of distributed stock by an equivalent amount.

Under current law, Code Sec. 732(f) may require the member-partner whose basis is reduced to recognize gain or to reduce the basis of the distributed corporation's property, with no offsetting loss or increase to the basis of the distributed corporation's property with respect to the member-partner whose basis is increased.

The proposed regulations provide for the aggregation of basis within the same consolidated group (as defined in Reg. Sec. 1.1502-1(h)), for purposes of Code Sec. 732(f), when two conditions are met:

(1) Two or more of the corporate partners receive a distribution of stock in a distributed corporation;

(2) The distributed corporation is or becomes a member of the distributee partners' consolidated group following the distribution.

Under this rule, Code Sec. 732(f) only applies to the extent that the partnership's adjusted basis in the distributed stock immediately before the distribution exceeds the aggregate basis of the distributed stock in the hands of all members of the distribute corporate partner's consolidated group immediately after the distribution.

Gain Elimination Transactions

The proposed regs also addresses IRS concerns that some corporate partners might eliminate gain in the stock of a distributed corporation while avoiding the effects of a basis step-down in transactions in which the corporate partner's ownership of the distributed corporation does not satisfy the control requirement. For example, a distributed corporation not controlled by a corporate partner might subsequently merge into the corporate partner in a reorganization under Code Sec. 368(a) in which gain is not recognized as part of a plan or arrangement. In this situation, the gain inherent in the stock of the distributed corporation is eliminated, but the basis of the distributed corporation's property is not reduced. If Code Sec. 732(f) does not apply to this transaction, then the basis step-down is negated, contravening the purposes of Code Sec. 732(f) and General Utilities repeal.

Accordingly, the proposed regulations provide that, in the event of a gain elimination transaction, Code Sec. 732(f) shall apply as though the corporate partner acquired control (as defined in Code Sec. 732(f)(5)) of the distributed corporation immediately before the gain elimination transaction.

The proposed regulations are not effective until finalized.

For a discussion on partnership basis in distributed property, see Parker Tax ¶23,525.

[Return to Table of Contents]

Eighth Circuit: Return Filed with Head-of-Household Status Is Not a "Separate Return"

Reversing the Tax Court, the Eighth Circuit held that references in the Code to "separate returns" exclusively refer to the "married filing separately" status. Thus, a taxpayer who had incorrectly filed using the head-of-household status was not barred under Code Sec. 6013(b) from changing his status to "married filing jointly." Ibrahim v. Comm'r, 2015 PTC 190 (8th Cir. 2015). Read more...

Filing the Wrong Withholding Tax Return May Still Start Assessment Period

IRS Field Attorneys advised that where one type of return is required from an employer, but another type is filed, the document filed is still a valid return and will start the period of limitations on assessment if the document meets certain requirements. FAA 20152101F.

Background

In FAA 20152101F, IRS Field Attorneys (IRS) responded to an inquiry regarding the validity of tax returns and running of the period of limitations on assessment under Code Sec. 6501 where employers were required to file one type of return but filed another type. Lawyers in the IRS Office of Chief Counsel concluded that if four specific criteria were met, the filed returns would be valid and the period of limitations would begin as of the deemed filing date.

The IRS addressed this inquiry as it relates to three different scenarios:

Scenario 1: Employer A was required to file a Form 944, Employer's Annual Federal Tax Return, but instead timely filed four Forms 941, Employer's Quarterly Federal Tax Return.

Scenario 2: Employer B was required to file a Form 944, but instead timely filed a Form 941 for the first and second quarters of the tax year, but filed no returns for the third or fourth quarter.

Scenario 3: Employer C was required to file Form 941 for all quarters of the tax year, but instead timely filed a Form 944.

Analysis

Under Code Sec. 6501(a), the limitations period generally begins to run with the filing of a valid return, after which the IRS must make an assessment within three years. Under Code Sec. 6501(b)(2) the filing date is deemed to be April 15 of the succeeding calendar year.

To determine whether a return is valid for assessment period of limitations purposes, courts generally look to see whether the purported return meets four requirements established in Beard v. Comm'r, 82 T.C. 766 (1984) and generally accepted as the "substantial compliance" standard:

(1) Provides sufficient data to calculate the tax liability;

(2) Purports to be a return;

(3) Is an honest and reasonable attempt to satisfy the requirements of the tax law; and

(4) Is executed under penalties of perjury.

With respect to Scenario 1, the IRS advised that, assuming the Forms 941 purport to be returns, are an honest and reasonable attempt to satisfy the filing requirements, are signed under penalty of perjury, and can be used to determine Employer A's annual FICA and income tax withholding liabilities, the Forms 941 meet the Beard formulation and should be treated as valid returns for the purposes of starting the period of limitations on assessment. Because the Forms 941 were timely filed the period of limitations would start to run on April 15 of the succeeding year.

The IRS concluded that for Scenario 2, an argument could be made that the Forms 941 for the first and second quarters of the tax year constitute valid returns under the Beard formulation since they purport to be returns and are signed under penalty of perjury. However, given that Employer B's FICA and income tax withholding liability for the third and fourth quarters will not necessarily be equal to that reported for the first two quarters, the Forms 941 may not be sufficient for purposes of the determining B's annual liability and may not be honest and reasonable attempts to satisfy the tax law. The IRS advised the amounts reflected on the Forms 941 must be assessed within three years of April 15 of the succeeding calendar year.

The IRS advised that for Scenario 3, assuming the Form 944 purports to be a return, is an honest and reasonable attempt to satisfy the filing requirements, can be used to determine C's annual FICA and ITW tax liability, and is signed under penalty of perjury, Employer C's Form 944 meets the Beard formulation and should be treated as a valid return for purposes of the period of limitations on assessment. Because the Form 944 was timely filed, the period of limitations would start to run on April 15 of the succeeding calendar year.

For a discussion on employment tax reporting requirements, including Form 941 and Form 944, see Parker Tax ¶ 216,000.