Federal Tax Bulletin - Issue 97 - September 11, 2015

Proposed Regulations Address Tax on Gifts and Bequests from Expatriates

The IRS has issued proposed regulations relating to the Code Sec. 2801 tax on U.S. citizens and residents who receive gifts or bequests from certain individuals who relinquished U.S. citizenship or ceased to be lawful permanent residents of the U.S. on or after June 17, 2008. REG-112997-10 (9/10/15).

Background

Prior to the enactment of the Heroes Earnings Assistance and Relief Tax Act of 2008,

(the HEART Act), citizens and long-term residents of the U.S. who expatriated to avoid U.S. taxes were subject to an alternative regime of U.S. income, estate, and gift taxes under Code Secs. 877, 2107, and 2501, respectively, for a period of 10 years following expatriation.

Because citizens and residents of the United States generally are subject to estate tax on their world-wide assets at the time of death, Congress determined that it was appropriate, in the interests of tax equity, to impose a tax on U.S. citizens or residents who receive, from an expatriate, a transfer that would otherwise have escaped U.S. estate and/or gift taxes as a consequence of expatriation. Thus, the HEART Act added new Code Sec. 2801 and new chapter 15 to the Code, effective for transfers occurring on or after June 17, 2008. The Code Sec. 2801 tax applies to covered gifts and bequests regardless of whether the property transferred was acquired by the donor or decedent before or after expatriation.

The regulations are proposed to be effective when finalized.

General Rules and Definitions for Code Section 2801

Prop. Reg. Sec. 28.2801-1 sets forth the general rules of liability under Code Sec. 2801 for the tax on certain gifts and bequest from covered expatriates. This tax is imposed on U.S. citizens or residents who receive, directly or indirectly, covered gifts or covered bequests (including distributions from foreign trusts attributable to covered gifts and covered bequests) from a covered expatriate.

Prop. Reg. Sec. 28.2801-2 defines the term "citizen or resident of the United States" as an individual who is a citizen or resident of the U.S. under the general estate and gift tax rules. Accordingly, whether an individual is a "resident" is based on domicile in the U.S. The proposed regulations generally define the term "covered gift" by reference to the general definition of gift for gift tax purposes, and defines the term "covered bequest" as any property acquired directly or indirectly because of the death of a covered expatriate. Such property generally is property that would have been includible in the gross estate of the covered expatriate had he or she been a U.S. citizen at time of death. Prop. Reg. Sec. 28.2801-2 also provides definitions for "domestic trust," "foreign trust," "electing foreign trust," "U.S. recipient," "power of appointment," and "indirect acquisition of property."

The proposed regulations provide that, if an expatriate meets the definition of a covered expatriate, the expatriate is considered a covered expatriate for purposes of Code Sec. 2801 at all times after the expatriation date, except during any period beginning after the expatriation date during which such individual is subject to U.S. estate or gift tax as a U.S. citizen or resident. Code Sec. 2801 defines "covered expatriate" as an individual who expatriates on or after June 17, 2008, if, on the expatriation date:

(1) the individual's average annual net income tax liability is greater than $124,000 (indexed for inflation) for the previous five taxable years,

(2) the individual's net worth is at least $2,000,000 (not indexed), or

(3) the individual fails to certify under penalty of perjury that he or she has complied with all U.S. tax obligations for the five preceding taxable years.

Exceptions Applicable to Covered Gifts and Covered Bequests

Prop. Reg. Sec. 28.2801-3 addresses rules and several exceptions to the definitions of "covered gift" and "covered bequest." These exceptions include taxable gifts reported on a covered expatriate's timely filed gift tax return, and property included in the covered expatriate's gross estate and reported on such expatriate's timely filed estate tax return, provided that the gift or estate tax due is timely paid.

Qualified disclaimers of property made by a covered expatriate are also excepted from the definition of a covered gift and a covered bequest, as are charitable donations that would qualify for the estate or gift tax charitable deduction. In addition, the proposed regulations provide exceptions for a gift or bequest to a covered expatriate's U.S. citizen spouse if the gift or bequest, if given by a U.S. citizen or resident, would qualify for the gift or estate tax marital deduction.

The proposed regulations also provide that, if a covered expatriate makes a transfer in trust and such transfer is a covered gift or covered bequest, the transfer is treated as a covered gift or covered bequest to the trust, without regard to the beneficial interests in the trust or whether any person has a general power of appointment or a power of withdrawal over trust property.

Liability for Code Section 2801 Tax

Prop. Reg. Sec. 28.2801-4 provides rules regarding who is liable for the payment of the Code Sec. 2801 tax. Generally, the U.S. citizen or resident who receives the covered gift or covered bequest is liable. Similarly, the proposed regulations provide rules explaining that a domestic trust that receives a covered gift or covered bequest is treated as a U.S. citizen and thus is liable for payment of the Code Sec. 2801 tax.

Calculation of Tax

Prop Reg. Sec. 28.2801-4 also provides guidance on how to compute the Code Sec. 2801 tax. Generally, the tax is determined by reducing the total amount of covered gifts and covered bequests received during the calendar year by the dollar amount of the per-donee exclusion under Code Sec. 2503(b) in effect for that year ($14,000 in 2015), and then multiplying the net amount by the highest estate or gift tax rate in effect during that calendar year.

Observation: The IRS intends to issue Form 708, U.S. Return of Gifts or Bequests from Covered Expatriates once the proposed regulations are finalized and will provide the due date for filing Form 708 and for payment of the Code Sec. 2801 tax liability in the final regulations.

For purposes of calculating the tax, the value of a covered gift or covered bequest is the fair market value of the property on the date of its receipt by the U.S. citizen or resident.

Treatment of Foreign Trusts and Election to be Considered a Domestic Trust

Prop Reg. Sec. 28.2801-5 provides guidance on the treatment of foreign trusts under Code Sec. 2801. If a covered gift or covered bequest is made to a foreign trust, the Code Sec. 2801 tax applies to any distribution from that trust to a recipient that is a U.S. citizen or resident, unless the foreign trust elects to be treated as a domestic trust. The Code Sec. 2801 tax applies only to the portion of a distribution from a nonelecting foreign trust that is attributable to covered gifts and covered bequests contributed to the foreign trust. The proposed regulations define the term "distribution" broadly to include any direct, indirect, or constructive transfer from a foreign trust, including each disbursement from such a trust pursuant to the exercise, release, or lapse of a power of appointment.

Solely for purposes of Code Sec. 2801, a foreign trust may elect to be treated as a domestic trust. Consequently, the Code Sec. 2801 tax is imposed on the electing foreign trust when it receives covered gifts and covered bequests, rather than on the U.S. trust beneficiaries when distributions are made from the trust. Prop. Reg. Sec. 28.2801-5(d)(3) provides guidance on the time and manner of making the election. The trustee must make the election on a timely filed Form 708.

Interaction with Other Code Sections

Prop. Reg. Sec. 28.2801-6 provides guidance on the interaction of Code Sec. 2801 with various other sections of the Code including:

(1) how the basis rules under Code Secs. 1014, 1015(a), and 1022 impact the determination of the U.S. recipient's basis in the covered gift or covered bequest;

(2) clarifying the applicability of the GST tax to certain Code Sec. 2801 transfers;

(3) discussing the interaction of Code Sec. 2801 and the information reporting provisions of Code Secs. 6039F and 6048(c); and,

(4) addressing the Code Sec. 6662 accuracy-related penalties on underpayments of tax, the Code Sec. 6651 failure to file and pay penalties, and the Code Sec. 6695A penalty on substantial and gross valuation misstatements attributable to incorrect appraisals.

Recipient's Responsibility to Determine Applicability

Prop. Reg. Sec. 28.2801-7 provides guidance on the responsibility of a U.S. recipient to determine if tax under Code Sec. 2801 is due. Under the proposed regulations, the burden is on that U.S. citizen or resident to determine whether the expatriate was a covered expatriate and, if so, whether the gift or bequest was a covered gift or covered bequest.

The proposed regulations also include administrative regulations that address filing and payment due dates, returns, extension requests, and recordkeeping requirements with respect to the Code Sec. 2801 tax.

For a discussion of the tax on gifts and bequests received from covered expatriates, see Parker Tax ¶ 223,100.

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Taxpayer Can't Use Principal-Residence Exclusion to Reduce Gain from Reacquiring Principal Residence

A taxpayer cannot use the principal-residence exclusion to exclude from income amounts received as liquidating damages on the reacquisition of a principal residence. DeBough v. Comm'r, 2015 PTC 303 (8th Cir. 2015).

Background

In 1966, Marvin DeBough purchased a home and surrounding 80 acres of mixed-use land in Minnesota for $25,000. In 2006, DeBough sold the property for $1.4 million pursuant to an installment contract. The buyers' indebtedness was secured by the property. Because the property was his principal residence, DeBough excluded $500,000 of gain from income on his 2006 tax return pursuant to Code Sec. 121 (i.e., the principal-residence exclusion). This left taxable income of almost $158,000 on the sale of the property. DeBough reported this income as installment sale income, beginning in 2006. For 2006, 2007, and 2008, DeBough received $505,000 from the buyers and reported $56,920 as taxable installment sale income during those years.

In 2009, the buyers defaulted and DeBough reacquired the property. DeBough kept the $505,000 he had previously received from the buyers as liquidated damages. On his 2009 tax return, DeBough treated this event as a reacquisition of property in full satisfaction of indebtedness under Code Sec. 1038. In calculating his realized gain on the reacquisition, DeBough again applied the $500,000 principal-residence exclusion and thus reduced the amount reported as long-term capital gains related to the reacquisition. DeBough did not resell the property.

In 2012, citing Code Sec. 1038, the IRS determined DeBough had underreported $448,080 in long-term capital gain for 2009 by applying the principal-residence exclusion to his gain calculation. DeBough objected and took his case to the Tax Court.

Tax Court's Opinion

Under Code Sec. 1038(a), if a sale of real property gives rise to indebtedness to the seller which is secured by the real property sold, and the seller reacquires the property in partial or full satisfaction of such indebtedness, then, except as provided in Code Sec. 1038(b) and Code Sec. 1038(d), no gain or loss results to the seller from such reacquisition, and no debt becomes worthless or partially worthless as a result of such reacquisition. Under Code Sec. 1038(b), in the case of a reacquisition of real property to which Code Sec. 1038(a) applies, gain results from such reacquisition to the extent that the amount of money and the fair market value of other property (other than obligations of the purchaser) received, before such reacquisition, with respect to the sale of such property, exceeds the amount of the gain on the sale of such property returned as income for periods before such reacquisition.

There is a limited exception to the general rule for calculating gain when reacquired property was originally sold as the taxpayer's principal residence. Under Code Sec. 1038(e), if a taxpayer reacquires property that was his principal residence, but then resells that property within one year, the taxpayer can continue to apply the principal-residence exclusion when calculating taxable gain.

The Tax Court agreed with the IRS and held that, under Code Sec. 1038, DeBough was not entitled to the principal-residence exclusion because he had not resold the property within one year. As a result, the general rules applicable to reacquisitions of real property as outlined in Code Sec. 1038(b), the court said, acted to override the principal-residence exclusion, and the prior status of the property as a principal residence was no longer relevant for tax purposes. DeBough appealed to the Eighth Circuit.

Eighth Circuit's Analysis

Before the Eighth Circuit, DeBough argued the Tax Court's interpretation of Code Sec. 1038 was contrary to the intent of Congress and produced an unduly harsh result. DeBough agreed that, because he did not resell the property within a year of reacquisition, Code Sec. 1038(e) did not apply. However, he contended that the Tax Code was silent on the question of whether the principal-residence exclusion nevertheless remained available even when a reacquired principal residence is not resold within one year. There is nothing in Code Sec. 1038, he argued, that requires a taxpayer to recognize gain.

Noting that this was a case of first impression requiring it to interpret the relationship between Code Sec. 121 and Code Sec. 1038, the Eighth Circuit affirmed the Tax Court and held that DeBough was not entitled to use the principal-residence exclusion to reduce his reacquisition gain. Under Code Sec. 1038, the court said, a taxpayer may disregard gain associated with the reacquisition of property, except to the extent that the taxpayer received money from the sale of the property before the reacquisition that is more than "the amount of gain on the sale" that was "returned as income" in any tax period before the reacquisition. In the instant case, the court observed, the parties agreed that DeBough received $505,000 from the sale of the property before reacquiring the property, and claimed $56,920 in gain on the tax returns filed before reacquiring the property.

The Eight Circuit said that it read Code Sec. 1038(b) as acknowledging two types of gain upon the reacquisition of real property: gain that was "returned as income" (that is, reported as income on a prior tax return) and gain that had not yet been "returned as income." On his 2006, 2007, and 2008 tax returns, the court noted, DeBough reported gain totaling $56,920; i.e., he "returned" $56,920 "as income." On the other hand, the court stated, Code Sec. 121(a) states that gross income does not include gain from the sale of a taxpayer's principal residence and, in the case of a joint return, gain of $500,000 can be excluded from gross income. The principal-residence exclusion is thus excluded from income. According to the court, having been excluded from income in 2006, the $500,000 principal-residence exclusion could not be considered gain that was "returned as income" on a prior tax return.

The court then addressed DeBough's argument that the Tax Code was silent on the question of whether the principal-residence exclusion nevertheless remained available even when a reacquired principal residence is not resold within one year. The court said that if DeBough was right, then the Code Sec. 1038(e) exception would be completely unnecessary. Noting that it is a settled rule of statutory construction that a court must, if possible, construe a statute to give every word some operative effect, the Eighth Circuit declined to render this part of a statute entirely superfluous.

For a discussion of the rules relating to reacquisitions of real property, see Parker Tax ¶114,550.

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IRS Has an Unlimited Time to Assess Excise Tax When Form 5330 Is Not Filed

The Tax Court did not abuse its discretion by reconsidering a mistake it made and, thus, its holding that the IRS has an unlimited period of time to assess excise tax if Form 5330 is not filed, regardless of whether the taxpayer has notified the IRS in other filings of a prohibited allocation with respect to S corporation stock held by an ESOP, was affirmed. Law Office of John H. Eggertsen v. Comm'r, 2015 PTC 319 (6th Cir. 2015).

Background

In 1998, John Eggertsen purchased all the outstanding shares of stock in a corporation which then elected to be taxed as an S corporation. Eggertsen had a law practice which he ran through the S corporation. In 1999, Eggertsen's law firm established an employee stock ownership plan (ESOP) and Eggertsen transferred the S corporation stock to the ESOP in order to obtain favorable tax treatment. All of the stock in the ESOP was allocated to John. As a result of the ESOP holding the S corporation stock, the law firm would not pay tax on its income but would pass it through to its owner, the ESOP; the ESOP would not owe tax at the plan level and Eggertsen, who ultimately owned the shares, would not owe tax on the income generated in the ESOP until the stock was distributed at retirement.

Many ESOPs, including Eggertsen's, did not have broad-based employee coverage and did not benefit the rank-and-file employees as well as they benefited highly compensated employees and historical owners. Congress found this to be a problem and, in 2001, amended the ESOP provisions to require broad-based employee ownership. Affected taxpayers were given a grace period to come into compliance with the new rules. A 50 percent excise tax on S corporation ESOPs that violated the new rule was imposed. The new rule came into effect on January 1, 2005, for the law firm's ESOP. The new legislation also provided that, if an ESOP did not meet the new requirements, the plan would face other stiff penalties, including loss of its ESOP status. This rule also came into effect on January 1, 2005, but the law firm's ESOP had an additional six months (until June 30, 2005) to comply with respect to the pre-2005 allocation made to Eggertsen.

Eggertsen filed Form 1120S for tax year 2005, and attached Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. The company's return showed that the ESOP owned 100 percent of the stock of the company. The ESOP filed Form 5500, Annual Return/Report of Employee Benefit Plan for 2005. On the return, the ESOP showed (1) that it was maintained by the company; (2) that there were three participants, one of which was identified by name and two others who were not named but were listed as "active participants"; (3) the value of the assets held; and (4) that the assets consisted exclusively of employer securities. An amended Form 5500 was subsequently filed which showed the year end value of employer securities held by the ESOP as being $401,500. The ESOP did not file Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for 2005.

In 2011, the IRS issued a notice of deficiency determining that Eggertsen was a disqualified person with respect to the ownership of the S corporation stock in the ESOP and, as a result, a non-allocation year occurred with respect to the ESOP in 2005. Thus, Eggertsen owed an excise tax of 50 percent of the prohibited allocation of $401,500.

Tax Court Decision

Under Code Sec. 409(p)(3)(A), a nonallocation year is any plan year of an ESOP holding shares in an S corporation if, at any time during the plan year, disqualified persons own at least 50 percent of the number of outstanding shares of the S corporation (including deemed-owned ESOP shares) or at least 50 percent of the sum of the outstanding shares of the S corporation (including deemed-owned ESOP shares) and the shares of synthetic equity in the S corporation owned by disqualified persons. Under Code Sec. 409(p)(4), a person is disqualified if the person is either a member of a deemed 20-percent shareholder group, or a deemed 10-eprcent shareholder. The law firm and the IRS agreed that 2005 was a nonallocation year.

The Tax Court held that 2005 was a nonallocation year with respect to the ESOP, resulting in the imposition of the excise tax on any ownership by Eggertsen. However, the court concluded that the statute of limitations in the Code Sec. 4979A provision for assessing the excise tax had expired. Subsequently, in Eggertsen P.C. v. Comm'r, 143 T.C. No. 13 (2014), the Tax Court said it made a mistake on the statute of limitations issue and reversed itself, holding that the general statute of limitations under Code Sec. 6501, rather than under Code Sec. 4979A, applied for assessing an excise tax stemming from an impermissible allocation of securities in an ESOP. Thus, Eggertsen was liable for the excise tax.

Observation: The Tax Court's holding effectively gives the IRS an unlimited period to assess excise tax if Form 5330 is not filed, regardless of whether the taxpayer has notified the IRS of the prohibited allocation in other filings.

The law firm appealed. On appeal, the law firm raised three alternative arguments: (1) it did not owe any excise tax for 2005; (2) the three-year statute of limitations in Code Sec. 6501 bars the assessment; and (3) the Tax Court should not have entertained the IRS's motion for reconsideration.

Sixth Circuit Analysis

The Sixth Circuit rejected the law firm's arguments and affirmed the Tax Court's holding. The court noted that both the law firm and the IRS agreed that 2005 was a nonallocation year. The Sixth Circuit agreed with that determination as well. That left the question, the court said, of whether such reality triggered the excise tax. Citing the language in Code Sec. 409(p)(3), the Sixth Circuit said it did.

With respect to the statute of limitations issue, the court noted that there are several exceptions to Code Sec. 6501's general rule that the IRS has three years to assess a tax after a return is filed.

First, the court observed, the limitations clock may start in some settings even when the taxpayer fails to file the right return or filed the wrong return but with all of the necessary information. A key predicate for this exception is that the return filed must contain sufficient data to calculate tax liability. In this instance, however, the filed returns would not allow the IRS to calculate the law firm's excise tax liability.

Second, the court noted, the statute of limitations sometimes starts based on a more generous notice standard, which looks not to whether "the return" has been filed but whether a filed form provides a clue as to an omission. But this notice standard, the court said, concerns only Code Sec. 6501(e), a provision not applicable in this case. According to the court, the question was not whether the law firm made an omission on a filed return; it was whether it filed the right return at all.

Third, Code Sec. 6501(b)(4) provides that, for the excise tax in Code Sec. 4979A and other excise taxes, the limitations clock may begin with the filing of a return on which an entry has been made with respect to the applicable excise tax. The court noted that while the law firm may have made entries on its other returns with respect to the Code Sec. 4979A tax, the law firm made no entry that would alert the IRS to the occurrence of a nonallocation year. Thus, that exception did not apply.

Finally, the Sixth Circuit said that the Tax Court did not abuse its discretion by using reconsideration to correct a mistake. The Sixth Circuit said it knew of no case where a lower court, acting within the bounds of the applicable procedural rules, granted reconsideration to correct an acknowledged mistake and a federal court held on appeal that doing so was incorrect.

For a discussion of ESOPs and S corporations, see Parker Tax ¶33,560.

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Prop. Regs Clarify Calculation of Code Sec. 6707A Penalties on Reportable Transactions

Proposed regulations clarify the calculation of the penalty under Code Sec. 6707A for failing to include on any return or statement any information required to be disclosed under Code Sec. 6011 with respect to a reportable transaction. REG-103033-11 (8/28/15).

The regulations are proposed to be effective when finalized.

Background

Code Sec. 6707A imposes a penalty on a taxpayer who has a duty to disclose a reportable transaction and fails to do so. It also imposes a requirement that certain taxpayers disclose in filings with the Securities and Exchange Commission (SEC) any requirement to pay a penalty under (1) Code Sec. 6707A with respect to a listed transaction, (2) Code Sec. 6662A with respect to an undisclosed reportable transaction, or (3) Code Sec. 6662(h) with respect to an undisclosed reportable transaction.

Code Sec. 6707A was amended by the Small Business Jobs Act of 2010 (Jobs Act). Before the Jobs Act, the penalty was $10,000 in the case of a natural person ($50,000 in any other case) and, in the case of a listed transaction, $100,000 in the case of a natural person ($200,000 in any other case). In some cases, this structure resulted in penalties that were potentially disproportionate to the tax benefit derived from the transaction.

The Jobs Act amended Code Sec. 6707A(b) to make the penalty 75 percent of the decrease in tax shown on the return as a result of a reportable transaction, with a minimum penalty amount of $10,000 ($5,000 in the case of a natural person). The maximum penalty amount is $200,000 ($100,000 in the case of a natural person) for failure to disclose a listed transaction, or $50,000 ($10,000 in the case of a natural person) for failure to disclose any other reportable transaction.

The IRS notes that proposed regulations are necessary because previously issued regulations did not take the Jobs Act amendments into consideration. The proposed regulations (1) simplify the meaning of the term "return," (2) define the term "decrease in tax" for purposes of calculating the penalty, (3) clarify the reporting obligations of a taxpayer for transactions subsequently identified in guidance that the taxpayer participated in before issuance of the guidance, (4) clarify the minimum and maximum amount of a penalty under Code Sec. 6707A(b)(2) and Code Sec. 6707A(b)(3), and (5) discuss a technical correction which the IRS believes need to be made with respect to SEC reporting.

Proposed Clarify Code Sec. 6707A Penalty Calculations

Currently, the regulations generally refer to original returns, amended returns, and applications for tentative refund in every case where all three terms are relevant. The proposed regulations streamline these references by defining the term return'' to include all three.

The proposed regulations define "decrease in tax" generally as the difference between the amount of tax reported on the return as filed and the amount of tax that would be reported on a hypothetical return where the taxpayer did not participate in the reportable transaction. The amount of tax shown on the hypothetical return will reflect adjustments that result mechanically from backing out the reportable transaction, such as tax items affected by an increase in adjusted gross income resulting from non-participation in the reportable transaction. In some situations, a taxpayer's participation in a listed transaction creates a liability for a tax that would not exist absent participation in the transaction. To capture this tax, the proposed regulations include in the definition of the decrease in tax any other tax that results from participation in the reportable transaction but was not reported on the taxpayer's return.

Example: Robert participated in a nonlisted reportable transaction and, because he failed to disclose his participation, is subject to a penalty under Code Sec. 6707A. After offsetting gross income with the losses generated in the reportable transaction, Robert's return reported adjusted gross income of $100,000. The return also reported $12,000 of medical expenses, $2,000 of which were deductible after applying the 10 percent floor. If Robert's return had not reflected participation in the reportable transaction, his adjusted gross income would have been $140,000. The decrease in tax shown on Robert's return as a result of the transaction would take into account both the tax on the $40,000 difference in adjusted gross income and the tax on the $2,000 adjustment to Robert's deductible medical expenses caused by the increase in adjusted gross income.

Once a listed transaction or a transaction of interest is identified by published guidance, a taxpayer has a reporting obligation if the taxpayer participated in the transaction before the issuance of the guidance and the statute of limitations for the year of the taxpayer's participation remains open. Under the proposed regulations, the taxpayer may use a single disclosure statement to disclose multiple years of participation in a reportable transaction. Because the taxpayer can disclose multiple years of participation on a single statement, the taxpayer's failure to complete and submit the disclosure statement properly will result in no more than one penalty under Code Sec. 6707A. The proposed regulations provide, however, that the amount of that penalty is determined by taking into account the aggregate decrease in tax shown on all of the returns for which disclosure was not provided. Thus, the decrease in tax will be determined separately for each year of participation for which only a single disclosure statement was required and the amount of the penalty will be 75 percent of the aggregate decrease in tax in all years for which disclosure was required, subject to the minimum and maximum penalty amount limitations.

The proposed regulations also clarify that because each separate failure to disclose a reportable transaction gives rise to a new penalty under Code Sec. 6707A(a), the minimum and maximum limits on the amount of the penalty apply separately to each failure to disclose.

Finally, the proposed regulations clarify a technical error the IRS believes Congress made in Code Sec. 6707A(e) with respect to a reference to Code Sec. 6707A(b)(2). The IRS said it did not believe that Congress intended its reference to Code Sec. 6707A(b)(2) to impose the maximum penalty on violations of Code Sec. 6707A(e). According to the IRS, this would be contrary to the purpose of the 2010 amendments to Code Sec. 6707A, which sought to make the penalty proportionate to the tax benefit derived by the transaction. Code Sec. 6707A(e) deals with the required reporting to the SEC of penalties imposed on the taxpayer under Code Secs. 6707A, 6662A, or 6662(h).

For a discussion of the penalty under Code Sec. 6707A, see Parker Tax, ¶253,170.

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Son's Unauthorized Incorporation of Father's Business Precludes Deduction of Business Expenses on Form 1040

The unauthorized act by a business owner's son of incorporating his father's business was ratified by the father when he filed corporate documents with the state; thus, expenses of the business could not be deducted on the father's personal income tax returns. Rochlani v. Comm'r, T.C. Memo. 2015-174.

Background

Manjit Rochlani started Ultimate Presales in 2006 and was the proprietor of the business. Through Ultimate Presales, Rochlani and his wife bought and resold sporting, concert, and other tickets. Without permission from his parents and while he was still a minor, the Rochlanis' son, Khushal, incorporated Ultimate Presales in Michigan in July 2006 using an online legal service. Khushal was unaware of the tax differences between a sole proprietorship and a corporation when he registered the business as a corporation. When the paperwork arrived, Mr. Rochlani asked Khushal about the incorporation but did nothing to stop or unwind the incorporation process.

Subsequently, Rochlani filed corporate annual reports for Ultimate Presales with the Michigan Department of Energy, Labor & Economic Growth. The Rochlanis used personal credit cards to make all purchases related to the business because Ultimate Presales did not have a business credit card. Further, all business expenses were paid from, and business income was deposited into, the Rochlanis' personal bank accounts.

On their Form 1040s for 2008 and 2009, the Rochlanis attached Schedule C, Profit or Loss From Business, identifying the principal business of Ultimate Presales as "Sell Goods" in 2008 and "Sell Goods and Tickets" in 2009. The Rochlanis reported Schedule C losses of $41,610 for 2008 and $44,066 for 2009. The reported business expenses included business use of their home, supplies expenses, office expenses, legal and professional expenses, advertising expenses, travel expenses, car and truck expenses, other expenses, contract labor expenses, depreciation and Code Sec. 179 expenses, and commissions and fees expenses.

Upon auditing the returns, the IRS adjusted the Rochlanis' tax liabilities to reflect the removal of the Schedules C, asserting that Ultimate Presales was a corporation. The Rochlanis took their case to the Tax Court, arguing that the court should disregard the corporate form.

Analysis

The Tax Court held that the Rochlanis could not disavow the corporate form and thus upheld the IRS's adjustments. The issue, the court said, was whether Ultimate Presales is a corporation for federal income tax purposes. To decide whether Ultimate Presales should be respected as a corporation, the court looked at whether the Rochlanis were bound by Khushal's unauthorized act of registering Ultimate Presales as a corporation.

While it was clear to the court that Khushal was not authorized or instructed by Rochlani to register Ultimate Presales as a corporation, the court noted that, upon learning that the business had been registered, Rochlani did nothing to undo what his son had done. In fact, the court observed, Rochlani ratified his son's act. Under Michigan law, unauthorized acts may be ratified explicitly or implicitly. And the unauthorized acts of an agent are ratified if the principal accepts those acts with knowledge of the material facts. While Khushal's act of incorporating Ultimate Presales was unauthorized, Rochlani thereafter respected, at least in part, the corporate form by filing annual reports with the Michigan Department of Energy, Labor & Economic Growth. In doing so, the court said, he recognized and ratified the corporate form.

The Tax Court concluded that, because Ultimate Presales was a corporation, the Rochlanis were not entitled to deduct losses from Ultimate Presales on their personal 2008 and 2009 returns.

For a discussion of the tax implications in choosing an entity in which to operate a business, see Parker Tax ¶29,500.

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Increase to a Reserve Account Does Not Satisfy the Bad Debt Charge-Off Requirement

Where a taxpayer's books indicated that the entry to record a partial bad debt was in the nature of a reserve for an anticipated future loss and not a sustained loss, no tax deduction was allowed. FAA 20153501F.

In FAA 20153501F, IRS Field Attorneys (IRS) were asked whether a taxpayer was entitled to a partial bad debt deduction. Under Code Sec. 166(a)(2) and Reg. Sec. 1.166-3(a)(2), a taxpayer can claim a bad debt deduction for a debt that is only partially recoverable. However, the amount deducted cannot exceed the amount charged off within the tax year. The taxpayer alleged that it charged off the claimed debt from its books and, thus, the deduction was proper.

The taxpayer relied on Brandtjen & Kluge, Inc. v. Comm'r, 34 T.C. 416 (1960), in which the taxpayer claimed partial bad debt deductions in two consecutive years in the amounts of $28,000 and $12,000. Those were amounts due from a subsidiary. On its books, the taxpayer increased its Reserve for Doubtful Notes and Accounts, which reduced its assets, and debited its Bad Debts account, which reduced its net income. The taxpayer in Brandtjen did not charge-off the $28,000 in its account receivable due from its subsidiary; instead, it made an adjusting journal entry of $28,000 in a new ledger account entitled "Reserve for Loss on B & K Canada" (i.e., the subsidiary). The explanation for the adjusting journal entry was "to charge bad debts with loss from Canadian operation."

In Brandtjen, the Tax Court held that the taxpayer was entitled to the partial bad debt deductions because the title of the new account (i.e., Reserve for Loss on B & K Canada), even though designated as a reserve, was in terms of a loss which had been incurred by reason of existing partial worthlessness, and not of an anticipated future loss.

In the instant situation, the IRS advised that the taxpayer was not entitled to partial bad debt deductions because the amounts were not charged off during the tax years in accordance with Code Sec. 166(a)(2) and Reg. Sec. 1.166-3(a)(2). Citing the decision in Findley v. Comm'r, 25 T.C. 311 (1955), aff'd, 236 F.2d 959 (3d Cir. 1956), the IRS noted that the purpose of the charge-off requirement is to perpetuate evidence of a taxpayer's election to abandon part of the debt as an asset. An increase in a general reserve account, the IRS said, does not constitute the required charge off.

The IRS also cited the decision in International Proprietaries, Inc. v. Comm'r, 18 T.C. 133 (1952), where the Tax Court held that a taxpayer's intent to abandon a charged-off portion of debt must be reflected in its books and records. An increase in a general reserve account does not constitute the required charge off. In International Proprietaries, Inc., the Tax Court concluded that the taxpayer's bookkeeping entries did not comply with the statutory requirement that there be a charge-off. The court rejected the notion that an increase to a reserve account satisfies the charge-off requirement. Rather, the court said, the taxpayer must eliminate the debt as an asset on its books in order to comply with the statutory requirements of charge-off.

According to the IRS, the situation in Brandtjen was not comparable to the taxpayer's situation. The reason that the Tax Court in Brandtjen held in favor of the taxpayer in that case was that the entries in the taxpayer's books were described in words indicating a sustained loss, and not an anticipated future loss. In contrast, the IRS said, the taxpayer's books indicate that the entries were in the nature of a reserve for an anticipated future loss, not a sustained loss.

For a discussion of the rules for deducting a partial bad debt, see Parker Tax ¶98,430.

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IRS Issues Temporary and Proposed Regs Preventing CFCs from Using Partnerships to Defer U.S. Taxation

The IRS has issued proposed and temporary regulations that provide rules regarding the treatment as U.S. property of property held by a controlled foreign corporation (CFC) in connection with certain transactions involving partnerships. In addition, the temporary regs provide rules regarding when a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining foreign personal holding company income (FPHCI). T.D. 9733 (9/2/15); REG-155164-09 (9/2/15).

Background

Code Sec. 956 determines the amount that a U.S. shareholder of a controlled foreign corporation (CFC) must include in gross income under Code Sec. 951with respect to the CFC. In general, the amount taken into account with respect to any U.S. property, including obligations of U.S. persons related to the CFC, is the adjusted basis of the property, reduced by any liabilities.

An anti-avoidance rule in Reg. Sec. 1.956-1T(b)(4) provides that a CFC will be considered to indirectly hold investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) the foreign corporation is to avoid the application of Code Sec. 956 with respect to the CFC.

Congress has stated that Code Sec. 956 is intended to prevent a U.S. shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by preventing the repatriation of income to the U.S. in a manner which does not subject it to U.S. taxation. Accordingly, under Code Sec. 956, the investment by a CFC of its earnings and profits in United States property is taxed to the CFC's shareholders on the grounds that this is substantially the equivalent of a dividend.

Proposed Regulations Expand Scope of Code Sec. 956 to Include Obligations of Foreign Partnerships

The current regulations under Code Sec. 956 do not specifically address when the obligations of a foreign partnership will be treated as United States property.

The IRS has determined that failing to treat an obligation of a foreign partnership as an obligation of its partners could allow deferral of U.S. taxation of CFC earnings and profits in a manner inconsistent with the purposes of Code Sec. 956. The proposed regulations thus treat an obligation of a foreign partnership as an obligation of its partners for purposes of Code Sec. 956, subject to an exception for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner.

The proposed regulations provide that the determination of a partner's share of a foreign partnership's obligation is made in accordance with the partner's interest in partnership profits. The determination of the partner's share is to be made at the close of each quarter of the CFC's taxable year in connection with the calculation of the amount of U.S. property held by the CFC for purposes of Code Sec. 956(a)(1)(B).

The proposed regulations also include a special rule that increases the amount of a foreign partnership obligation that is treated as U.S. property when certain requirements are satisfied. When these requirements are satisfied, proposed Reg. Sec. 1.956-4(c)(3) provides that the amount of the partnership obligation that is treated as an obligation of the distributee partner (and thus as U.S. property held by the CFC) is the lesser of the amount of the distribution that would not have been made but for the funding of the partnership and the amount of the partnership obligation.

Existing Reg. Sec.1.956-2(c)(1) provides that, in general, any obligation of a U.S. person with respect to which a CFC is a pledgor or guarantor is considered U.S. property held by the CFC. The proposed regulations provide that these pledge and guarantee rules apply to a CFC that directly or indirectly guarantees an obligation of a foreign partnership treated as an obligation of a U.S. person and extend the pledge and guarantee rule to pledges and guarantees made by partnerships.

Temporary Regulations Modify Anti-Avoidance Rule

The temporary regulations modify the current anti-avoidance rule in Reg. Sec. 1.956-1T(b)(4) to apply when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt. In addition, the temporary regs expand the anti-avoidance rule to include transactions involving partnerships that are controlled by the CFC.

Example: Pi Co. is a domestic corporation that wholly owns two controlled foreign corporations, Sif Co. and Fis Co. Sif Co. has $100,000 of undistributed earnings and profits and $10,000 foreign income taxes, but does not have any cash. Fis Co, has earnings and profits of at least $100,000, no foreign income taxes, and substantial cash. Fis Co. loans $100,000 to Sif Co., which then loans $100,000 to Pi Co. A principal purpose of funding Sif Co. through the loan from Fis Co. is to avoid the application of Code Sec. 956 with respect to Fis Co. As a result, Fis Co. is considered to indirectly hold the $100,000 obligation of Pi Co. that is held by Sif Co. Pi Co. will have an income inclusion of $100,000 under Code Secs. 951(a)(1)(B) and 956 with respect to Fis Co., and the foreign income taxes deemed paid by Pi Co. under Code Sec. 960 is $0.

The IRS has determined that CFCs may be engaging in transactions in which a CFC lends funds to a foreign partnership, which then distributes the proceeds from the borrowing to a U.S. partner who is related to the CFC and whose obligation would be United States property if it were held (or treated as held) by the CFC. Taxpayers take the position that Code Sec. 956 does not apply to these transactions even though the CFC's earnings are effectively repatriated to a related U.S. partner.

In response to these transactions, the temporary regs add Reg. Sec. 1.956-1T(b)(5) to address certain cases in which a CFC funds a foreign partnership (or guarantees a borrowing by a foreign partnership) and the foreign partnership makes a distribution to a U.S. partner that is related to the CFC. For purposes of Code Sec. 956, the temporary regs treat the partnership obligation as an obligation of the distributee partner to the extent of the lesser of the amount of the distribution that would not have been made but for the funding of the partnership or the amount of the foreign partnership obligation.

Observation: Reg. Sec. 1.956-1T(b)(5) generally has the same purpose and effect as proposed Reg. Sec. 1.956-4(c)(3) (discussed above) and will be removed when the proposed regulations are finalized.

Temporary Regs Require CFCs to Perform the Relevant Activities for the Active Rents and Royalties Exception

Under Code Sec. 954, foreign base company income (FBCI) generally is income earned by a CFC that is taken into account in computing the amount that a U.S. shareholder of the CFC must include in income under Code Sec. 951. FBCI includes foreign personal holding company income (FPHCI), which includes rents and royalties, unless they are received from a person other than a related person and derived in the active conduct of a trade or business.

The active rents and royalties exception in Code Sec. 954(c)(2)(A) and Reg. Sec. 1.954-2(b)(6) exclude from FPHCI rents and royalties derived in the active conduct of a trade or business and received from a person that is not a related person. In general, the active rents and royalties exception is intended to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business.

The IRS has determined that the CFC must perform the relevant activities (that is, activities related to the manufacturing, production, development, or creation of, or, in the case of an acquisition, the addition of substantial value to, the property at issue) through its own officers or staff of employees in order to satisfy the active rents and royalties exception. Thus, the temporary regs expressly provide that the CFC lessor or licensor must perform the required functions through its own officers or staff of employees. The temporary regs also allow the relevant activities undertaken by a CFC through its officers or staff of employees to be performed in more than one foreign country.

Effective Dates

The temporary regs apply to the tax years of CFCs ending on or after 9/2/15, and to the tax years of U.S. shareholders in which or with which such tax years end.

The proposed regulations are effective for tax years of CFCs ending on or after the date the regulations are finalized, and for tax years of U.S. shareholders in which or with which such tax years end.

For a discussion of amounts a U.S. shareholder of a controlled foreign corporation must include in gross income under Code Sec. 951, see Parker Tax ¶ 201,510.20.

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Court Absolves Poker-Playing President for Corporation's Failure to File Forms W-2 and W-3

Failing to file Forms W-2 and W-3 for two non-consecutive years did not, in and of itself, establish a pattern of conduct of repeatedly failing to file timely and, thus, the penalty under Code Sec. 6721(e) for intentional disregard of the filing requirement did not apply. Hom v. Comm'r, T.C. Summary 2015-49.

John Hom is the owner and president of John C. Hom & Associates, Inc., a geotechnical engineering firm. Hom, the only licensed engineer on staff, performed geotechnical investigations for various projects, explored the subsurface conditions of proposed jobsites, and analyzed the results of fieldwork to provide recommendations for construction. In 2002, Hom decided to become a professional poker player and began to spend less time running his engineering firm.

For 2004 and 2006, John C. Hom & Associates issued Forms W-2, Wage and Tax Statement, to employees, but failed to file those forms and Forms W-3, Transmittal of Wage and Tax Statements, with the Social Security Administration (SSA). Hom generally followed a procedure for issuing Forms W-2 to employees and filing Forms W-2 and W-3 with the SSA. After mailing the forms to the SSA, Hom would save copies of the Forms W-2 and W-3 on his computer. Because he retained copies of the 2004 and 2006 Forms W-2 and W-3 on his computer, Hom believed that he had completed the previous step of filing those forms with the SSA. The IRS assessed penalties of more than $10,000 against John C. Hom & Associates under Code Sec. 6721(e) for intentional disregard of the Form W-2 and W-3 filing requirement. Hom contested the penalty and took the case to the Tax Court.

The Tax Court held that the company was not liable for the Code Sec. 6721(e) penalty. The penalty applies, the court noted, when the failure to file is not accidental, unconscious, or inadvertent. Citing Reg. Sec. 301.6721-1(f)(3), the court looked at the following factors:

(1) whether the failure to file timely was part of a pattern of conduct of repeatedly failing to file timely;

(2) whether a correction was promptly made upon discovery of the failure;

(3) whether the failure to file was corrected within 30 days after the date of any written request from the IRS to file; and

(4) whether the amount of the information reporting penalties is less than the cost of complying with the requirement to file timely.

The court found that (1) the fact that Hom failed to file the 2004 and 2006 Forms W-2 and W-3 with the SSA did not, in and of itself, establish a pattern of conduct of repeatedly failing to file timely; (2) there was no evidence that the IRS ever prompted the company to correct the failure to file the missing Forms W-2 and W-3; and (3) since no payment is required with the filing of Forms W-2 and W-3, there was no cost of complying with the provision other than the time taken to prepare the Forms W-2 and W-3 and the cost of postage.

The court said Hom testified convincingly that he believed that he filed the 2004 and 2006 Forms W-2 and W-3 because he had retained copies of the forms on his computer and he was in the habit of storing the copies on his computer after the forms were filed. In addition, there was no pattern of conduct that indicated to the court that Hom consistently failed to file Forms W-2 and W-3 since the forms were unfiled only for 2004 and 2006. As a result, the court concluded that, while the evidence was insufficient to establish actual filing of the Forms W-2 and W-3, the evidence did establish that Hom did not intentionally disregard the filing obligation for such forms.

For a discussion of penalties relating to information reporting returns, see Parker Tax ¶262,130.

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Proposed Regs Require Healthcare Plans to Provide Hospital Coverage

The IRS has issued proposed regulations reflecting its determination that plans lacking coverage for in-patient hospitalization services or for physician services do not meet the Affordable Care Act's minimum value (MV) requirement; large employers adopting such a plan may be exposed to penalties under the healthcare law's employer mandate regardless of whether the plan passes muster with IRS's online MV Calculator. REG-143800-14 (9/1/15).

Background

Under Code Sec. 36B(c)(2)(C)(ii), an eligible employer-sponsored plan provides minimum value only if the plan's share of the total allowed costs of benefits provided under the plan is at least 60 percent. Code Sec. 4980H(b) imposes a penalty on applicable large employers (generally those with 50 or more employees) that offer minimum essential coverage under an eligible employer-sponsored plan that is not affordable or does not provide minimum value for one or more full-time employees who receive a premium tax credit subsidy.

In November 2014, the IRS, in conjunction with the Department of Health and Human Services (HHS), concluded that certain group health plans that do not provide coverage for in-patient hospitalization services or for physician services (Non-Hospital/Non-Physician Services Plans) do not meet the minimum value requirements under Code Sec. 36B. According to the IRS, such plans had been designed by their promoters to garner favorable determinations from the online minimum value (MV) calculator even though the plans do not provide minimum value as envisioned under Code Sec. 36B. Accordingly, the IRS stated in Notice 2014-69 that such Non-Hospital/Non-Physician Services Plans are not considered to meet the Code Sec. 36B minimum value requirement, even if the MV calculator indicates otherwise. The notice also advised taxpayers of the IRS's intent to propose regulations reflecting its determination in Notice 2014-69.

Employer Sponsored Plans Must Provide Hospital and Physician Services

The IRS has issued proposed regulations as REG-143800-14 (9/1/15) that provide that an eligible employer-sponsored plan provides minimum value only if the plan's share of the total allowed costs of benefits provided to an employee is at least 60 percent and the plan provides substantial coverage of inpatient hospital and physician services.

Observation: The penalties for employers offering coverage that fails the MV requirement can be as high as $3,000 per year ($250 per month) for each employee who is offered coverage under an employer-sponsored healthcare plan and instead purchases health insurance on an exchange and qualifies for a Code Sec. 36B premium assistance tax credit. Generally, an employee who is eligible to enroll in an employer-sponsored plan that meets the MV requirement will not qualify for a premium assistance tax credit.

The IRS notes that treating plans that fail to provide substantial coverage of inpatient hospital or physician services as providing minimum value would adversely affect employees who may find this coverage insufficient by denying them access to a premium tax credit, while at the same time avoiding the employer shared responsibility payment under section 4980H.

The proposed regs. apply for plan years beginning after November 3, 2014. However, for purposes of the large employer penalty in Code Sec. 4980H(b), the proposed regs. do not apply before the end of the plan year beginning no later than March 1, 2015 to a plan that fails to provide substantial coverage for in-patient hospitalization services or for physician services (or both), provided that the employer had entered into a binding written commitment to adopt the noncompliant plan terms, or had begun enrolling employees in the plan with noncompliant plan terms, before November 4, 2014. This transition relief does not apply to an applicable large employer that would have been liable for a payment under Code Sec. 4980H without regard to the proposed regulations.

For a discussion of the large employer healthcare mandate and related penalties, see Parker Tax ¶191,100.

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IRS Will No Longer Accept $100 Million Checks

Due to limitations on the amounts Federal Reserve banks can process, the IRS will no longer accept payments of $100 million or more by check beginning in 2016. Announcement 2015-23.

The IRS has announced that, beginning in 2016, it will stop accepting payments by check for amounts of $100 million or more. Taxpayers will be required to send two or more checks, or use a wire transfer to make their payments.

The announcement follows a reminder sent by the Bureau of Fiscal Service (Fiscal Service) to the IRS that Federal Reserve banks should not accept checks over the amount of $99,999,999. The Fiscal Service stated that there had been an increase in submissions of large dollar checks by federal agencies to the Treasury General Accounts (TGAs) that were over this amount, in violation of the Fiscal Service's policies.

This limitation on check amounts is in place because Federal Reserve Banks do not handle items in excess of $99,999,999.

Observation: The change in the IRS's check acceptance policy will likely affect only a dozen or so taxpayers. The IRS has indicated that it received and deposited just 14 checks for $100 million dollars or more during the most recent tax season.

The Fiscal Service notes that because no check processing equipment can handle amounts over a million dollars, large dollar items are handled entirely manually. Because of manual processing, the risks of fraudulent activity, processing errors, and uncollectable funds are more likely when checks over these amounts are accepted by TGA depositaries. In addition, the large check items may become lost, mis-shipped, or stolen, and require special handling procedures by the TGA.

The limitation on large checks will apply to all payments made to the IRS, including payments for estate, gift, employment, self-employment, and excise taxes.