Federal Tax Bulletin - Issue 93 - July 17, 2015

Pot Dealer's Appeal Goes Up in Smoke; Expenses of Medical Marijuana Business Aren't Deductible

While a taxpayer's medical marijuana dispensary business was legal under California law, Code Sec. 280E precluded him from deducting any amount of ordinary or necessary business expenses associated with the business, other than cost of goods sold, because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. Olive v. Comm'r, 2015 PTC 229 (9th Cir. 2015).

Background

In 2004, Martin Olive quit college and opened a medical marijuana dispensary in California. The dispensary had a single business, the distribution of medical marijuana. Olive sought the help of local friends and marijuana suppliers and began operating the unlicensed medical marijuana dispensary, which he named "The Vapor Room," as a sole proprietorship. The Vapor Room was a place where its patrons, almost all of whom were recipients under the California Compassionate use Act of 1996 (CCUA) (including some with terminal diseases such as cancer or HIV/AIDs), could socialize and purchase and consume medical marijuana.

Gross sales grew from over $1 million the first year to $3 million the second year. However, because of expenses, the amount of net income reported to the IRS was small. Upon auditing the business, the IRS assessed tax deficiencies and penalties because the IRS concluded that Code Sec. 280E precluded any deductions. Under Code Sec. 280E, a taxpayer cannot deduct any amounts, other than cost of goods sold, for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances prohibited by federal law.

Observation: The Tax Court allowed Olive to deduct his costs of goods sold, but because of questionable substantiation concluded that 75.16 percent of sales was a reasonable measure of the Vapor Room's COGS. Those deductions were not at issue before the Ninth Circuit.

Olive argued that his business did not consist of illegal trafficking in a controlled substance because the business was legal under California law. Thus, Code Sec. 280E did not apply. The Tax Court did not agree and, in Olive v. Comm'r, 139 T.C. No. 2 (2012), held that Code Sec. 280E precluded Olive from deducting any amount of ordinary or necessary business expenses associated with the operation of the Vapor Room dispensary because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. Olive appealed to the Ninth Circuit.

Analysis

On appeal, Olive focused on the wording in Code Sec. 280E. His argument relied primarily on the phrase "consists of." According to Olive, the use of the words "consists of" were most appropriate when a listing is meant to be exhaustive. The word "consisting," he argued, was not synonymous with the word "including." Relying on that proposition, Olive contended that, for Code Sec. 280E purposes, a business "consists of" a service only when that service is the sole service that the business provides. Because the Vapor Room provided caregiving services and sold medical marijuana, Olive said that his business did not "consist of" either one alone and therefore did not fall within the ambit of Code Sec. 280E.

To support his line of reasoning, Olive cited the Tax Court's decision in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007). In that case, the taxpayer's income-generating business included providing not only medical marijuana, but also extensive counseling and caregiving services. The Tax Court concluded that the business's primary purpose was to provide caregiving services to its members and that its secondary purpose was to provide its members with medical marijuana. After considering the degree of economic interrelationship between the two undertakings, the Tax Court concluded that the taxpayer in CHAMP was involved in more than one trade or business.

Olive also argued that Code Sec. 280E should not be construed to apply to medical marijuana dispensaries because those dispensaries did not exist when Congress enacted Code Sec. 280E. Congress added that provision, he argued, to prevent street dealers from taking a deduction. According to Olive, Congress could not have intended for medical marijuana dispensaries, now legal in many states, to fall within the ambit of "items not deductible" under the Internal Revenue Code.

The Ninth Circuit affirmed the Tax Court and held that Code Sec. 280E precluded Olive from deducting any amount of ordinary or necessary business expenses associated with the Vapor Room dispensary because it was a trade or business consisting of trafficking in controlled substances prohibited by federal law. The court called Olive's reliance on the CHAMP decision misplaced. To illustrate the difference between the Vapor Room and the business in CHAMP, the court drew an analogy between a business that sold books and offered its customers comfortable chairs and complimentary cookies and a business that sold books but also operated a cafin which customers could buy coffee and pastries. The latter business, the court noted, operated two trades or businesses while the former only operated one trade or business.

With respect to Olive's argument that the Ninth Circuit should consider Congressional intent in enacting Code Sec. 280E, the court said that had no bearing on its analysis. It is common for statutes to apply to new situations, the court noted, and found that the application of the statute was clear. According to the court, application of the statute did not depend on the illegality of marijuana sales under state law; the only question the court could ask was whether marijuana is a controlled substance prohibited by federal law. If Congress now thinks that the policy embodied in Code Sec. 280E is unwise as applied to medical marijuana sold in conformance with state law, the court concluded, it can change the statute but the court could not.

Observation: Even though states such as Washington and Colorado have begun legalizing both medical and recreational use of marijuana, it remains a controlled substance at the federal level. Accordingly, businesses that sell marijuana are still trafficking in controlled substances for purposes of Code Sec. 280E, and likely will be subject to the limitations on deductions imposed by that section for purposes of calculating their federal income taxes.

For a discussion of the nondeductibility of expenditures incurred in connection with the illegal sale of drugs, see Parker Tax ¶96,512.

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"Welfare Benefit Fund" Was Really a Split-Dollar Insurance Arrangement

The Tax Court determined that because a purported welfare benefit plan was really a split-dollar insurance arrangement, corporate employers could not deduct payments made to the plan. Further, the court held that the shareholder-employees for whom the insurance was purchased were required to realize income from the policies. Our Country Home Enterprises, Inc. v. Comm'r, 145 T.C. No. 1 (2015).

Background

In the early 1990s Ronald Snyder began looking for a way for employers to fund greater benefits than pension plans allowed. Snyder established the Sterling Plan in October 2002 as a way for employers to fund and receive those greater benefits.

The Sterling Plan (Plan) is a purported welfare benefit plan consisting of the respective separate plans that each participating employer customizes to apply to its employees alone. The Plan pays death, medical, and disability benefits with respect to a participating employee to the extent that his or her participating employer selects. Each employer selects the general provisions, the participation requirements, and the vesting schedule applicable to its plan. Each employee designates to whom the Plan will pay the benefits with respect to him or her.

The death benefit that the Plan agrees to pay to a participating employee is the face amount of an insurance policy that the Plan purchases on the employee's life. The employer effectively pays the premiums on the insurance policy through its payments to the Plan, and the insurance policy usually has a cash value component that increases annually. The Plan's payment of any nondeath benefit to an employee is generally limited to the cash value of the insurance policy related to that employee. An employer may terminate its participation in the Plan and cause each of its employees to be fully vested in his or her policy (including its cash value). A participating employee, upon retiring, may take his or her insurance policy in satisfaction of any postretirement death benefit payable as to the employee.

Our Country Home Enterprises, Inc. and Netversity, Inc. are C corporations, each wholly owned by a single individual shareholder. Code Environmental Services, Inc. is an S corporation owned equally by three other individual shareholders. Each of the five shareholders was employed by the corporation he owned. Our Country and Environmental each participated in the Sterling Plan and caused the plan to purchase insurance on the lives of their shareholder-employees. Netversity participated in the Sterling Plan but did not cause the Plan to purchase insurance on an employee's life.

Between 2010 and 2011, the IRS mailed deficiency notices to Our Country, Environmental, and Netversity disallowing the claimed deductions each company had taken for payments made to the Plan on the grounds that the purchased policies were split-dollar insurance arrangements subject to the "economic benefit regime rules," which disallow such deductions. The IRS also sent deficiency notices to the shareholder-employees of the companies, asserting that each of the five individuals had realized income from participation in the Sterling Plan. In addition to disallowing the deductions, the IRS assessed a Code Sec. 6662(a) penalty for understatement of tax, and an additional Code Sec. 6662A penalty for an understatement with respect to a reportable transaction.

Observation: The parties consolidated the Our Country, Environmental, and Netversity cases to serve as test cases for issues related to the Sterling Plan. The parties in approximately 40 other cases pending before the Tax Court agreed to be bound by one or more of the final decisions.

Insurance Policies were Compensatory Arrangements

An arrangement between an owner and a nonowner of a life insurance contract is a split-dollar life insurance arrangement if it is a compensatory arrangement under the special rule of Reg. Sec. 1.61-22(b)(2)(ii).

An arrangement is a compensatory arrangement if it meets each of the three prongs of Reg. Sec. 1.61-22(b)(2)(ii):

(1) The first prong requires that the arrangement be entered into in connection with the performance of services and not as part of a group term life insurance plan described in Code Sec. 79.

(2) The second prong requires that the employer or service recipient pays, directly or indirectly, all or any portion of the premiums.

(3) The third prong requires that either: (a) the beneficiary of all or any portion of the death benefit is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to designate as the beneficiary; or (b) the employee or service provider has any interest in the policy cash value of the life insurance contract.

The Tax Court determined that the life insurance policies provided to the employees of Our Country and Environmental through the companies' participation in the Sterling Plan were split-dollar life insurance arrangements because they were compensatory arrangements within the meaning of the special rule of Reg. Sec. 1.61-22(b)(2)(ii). The court noted that the parties had agreed the corporate employers were treated as the owners of the life insurance policies.

The court found the arrangements fell within the special rule because they met each prong of the three-prong test. First, the court noted each of the companies' single employer plans provided life insurance benefits to the employees in exchange for their performance of services, and the benefits were not provided as part of a group term life insurance plan described in Code Sec. 79. Second, the court observed that each single employer plan paid all the premiums on the life insurance policies through the employer's payments to the Plan. And third, the court noted the employees participating in the single employer plans designated the beneficiaries of the death benefits payable under the plans, which in substance were the death benefits payable under the insurance policies. The court also found, as to the third prong, that the employees in each single employer plan had an interest in the cash value of the respective life insurance policies that covered them.

Observation: No life insurance was purchased or outstanding by Netversity during the relevant years. Any arrangement involving Netversity and the Sterling Plan, therefore, was not a split-dollar life insurance arrangement during those years.

Deductions Disallowed for Payments to the Sterling Plan

Because the life insurance policies relating to the Our Country and Environmental shareholder-employees were split-dollar life insurance arrangements, the court stated that the two companies could deduct an expense related to the arrangements only if the deduction met the rules of Reg. Sec. 1.83-6(a)(5). That section provides that the amount of an allowable deduction in such a situation equals the income an employee must recognize upon the transfer to the employee of the ownership of the life insurance policy, plus the amount determined under Reg. Sec. 1.61-22(g)(1)(ii).

The court noted that Our Country and Environmental did not transfer any life insurance policy to their participating employees, nor did the shareholder-employees recognize any income from their participation in the Sterling Plan. The court thus concluded that Our Country and Environmental could not deduct their payments to the Plan.

With regard to Netversity, the court stated it had repeatedly held in similar settings that Code Sec. 162(a) does not allow an employer to deduct its payments to a purported welfare benefit plan as ordinary and necessary business expenses, citing Neonatology Assocs., P.A. v. Comm'r, 115 T.C. 43 (2000), White v. Comm'r, T.C. Memo. 2012-104, and cases cited therein. Although the referenced cases involved the actual purchase of life insurance and Netversity's case did not, the court stated the holdings in those cases applied with equal force, and concluded that Netversity could not deduct its payment to the Sterling Plan.

Shareholder-Employees Required to Recognize Income

The federal income tax consequences of a split-dollar life insurance arrangement are generally determined through either the economic benefit provisions of Reg. Sec. 1.61-22(d) through (g), or through the loan provisions of Reg. Sec. 1.7872-15. In general, the loan provisions apply where there is a "split-dollar loan" within the meaning of section 1.7872-15(b)(1), and the economic benefit provisions apply where there is not a split-dollar loan, unless the nonowner of the life insurance contract makes premium payments on the insurance contract as other than consideration for economic benefits (Reg. Sec. 1.61-22(b)(3)(i)).

The Tax Court found the economic benefit provisions applied to the shareholder-employees of Our Country and Environmental because no-split dollar loans were involved, and the shareholders did not make any premium payments on the insurance contracts. The corporate employers, the court stated, as the owners of the life insurance contracts, had therefore provided economic benefits to their shareholders, as the nonowners of the insurance contracts. The court held that the shareholders must recognize the full value of the economic benefits, net of any consideration that they paid to their employers for the benefits.

Because Netversity's payment to the Sterling Plan was not an ordinary and necessary business expense deductible under Code Sec. 162(a), and because it conferred an economic benefit on the owner for his primary (if not sole) benefit, the Tax Court concluded that the payment was a constructive distribution from Netversity to its owner. Since Netversity had sufficient earnings and profits to characterize the distribution as a dividend under Code Sec. 301(c)(1), the court held that it was a taxable dividend.

The Tax Court also upheld the Code Sec. 6662(a) and Code Sec. 6662A penalties, because the taxpayers were unable to show a reasonable cause for the understatements, and did not report their involvement with the Sterling Plan on their returns.

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Court Rejects IRS Attempt to Put S Corporation on Cash Method; Disallows Deductions for Fossil Contributions

A taxpayer could not deduct charitable contributions of fossils because he did adequately satisfy the substantiation requirements. However, a majority of disputed expenses of the taxpayer's wholly owned S corporation were allowed because the S corporation was an accrual basis taxpayer and not a cash method taxpayer as argued by the IRS. Isaacs v. Comm'r, T.C. Memo. 2015-121.

Background

Veterinarian James Isaacs owned and operated two veterinary clinics. One was owned through Calabasas Veterinary Center, Inc. (CVC), a wholly owned S corporation, and the other through Encino Veterinary Clinic, Inc. (EVC), a wholly owned C corporation.

In 2006 and 2007, Dr. Isaacs donated trilobite fossils to California Academy of Sciences (CAS), a Code Sec. 501(c)(3) organization. With respect to the donations, he claimed charitable deductions of $136,500 and $109,800. Dr. Isaacs filed Forms 8283, Noncash Charitable Contributions, and Part IV, Donee Acknowledgment, was signed by an individual on behalf of CAS acknowledging the contribution. Neither the acknowledgments on Forms 8283 nor letters and related correspondence attached to Dr. Isaacs' tax returns stated whether CAS had provided goods or services in exchange for the gifts. Both of Dr. Isaacs' Forms 8283 bore the signature "Jeffrey R. Marshall" in Part III, Declaration of Appraiser. The CVC tax returns for years 2006-2008 reported losses of approximately $73,000, $53,000 and $275, respectively, which were passed through to Dr. Isaacs' personal tax returns.

The IRS disallowed deductions for the fossil contributions and disallowed certain passthrough deductions reported on CVC's 2006-2008 tax returns. According to the IRS, CVC improperly accrued certain expenses at year end despite otherwise maintaining its books on a cash basis. The IRS also assessed accuracy-related penalties. Dr. Isaacs disagreed with the adjustments, arguing that CVC's books were kept on the accrual basis and, thus, the disputed expenses were deductible.

One of the disputed CVC deductions was an $85,000 expense recorded in Quickbooks as "Due to/Due from CVC" and a corresponding adjusting journal entry for EVC for the same amount on the same date. Dr. Isaacs testified that these journal entries reflected reimbursements by CVC to EVC for inventory items ordered in bulk and paid for by EVC but distributed to CVC during the year. Dr. Isaacs further testified that EVC had included in income the reimbursements it received from CVC. The IRS contended that, although EVC's 2006 tax return reported such income on the accrual method, CVC was a cash method taxpayer and thus could not deduct the $85,000 expense because it had not actually been paid. The IRS further argued that Dr. Isaacs did not substantiate the $85,000 deduction. Dr. Isaacs said that he could not provide the log book substantiating the deduction because his former bookkeeper had stolen it along with other business records and refused to return them.

The IRS also disallowed a $100,000 deduction by CVC for office overhead for 2007. Dr. Isaacs testified that this $100,000 expense consisted of a management fee paid by CVC to EVC for 2007, pursuant to interoffice policy, and introduced checks substantiating the payment of $51,000 of this amount in 2007 and the remainder in 2008. Tax returns reflected that EVC included the $100,000 in income in 2007. The IRS argued that the cash method more clearly reflected CVC's income and thus, the entire $100,000 could not be deducted in 2007.

Deductions for Fossil Contributions Denied

In order to deduct charitable contributions, certain substantiation requirements must be met. First, for all contributions of $250 or more, a taxpayer generally must obtain a contemporaneous written acknowledgment from the donee and the acknowledgment must state, among other things, whether the donee provided any goods or services in exchange for the gift. Second, for noncash contributions in excess of $500, a taxpayer must maintain reliable written records with respect to each donated item. Third, for noncash contributions of property with a claimed value of $5,000 or more, a taxpayer must obtain a "qualified appraisal" of the donated item(s) and attach to his or her tax return a fully completed appraisal summary on Form 8283.

At trial, Jeffrey Marshall, who the court recognized as an expert appraiser of fossils, identified the signature on Dr. Isaacs' 2006 and 2007 Forms 8283 as his own, but did not recall signing the forms. He similarly identified his signature on two letters that purported to be appraisals of the fossils but said he did not write or even recognize the letters. Dr. Isaacs admitted during trial that he had written the letters himself and presented them to Mr. Marshall for signature.

The Tax Court held that Dr. Isaacs could not deduct any amounts for the contribution of the fossils to CAS. Dr. Isaacs, the court observed, introduced no evidence other than his Forms 8283 of the approximate dates and manner of the fossils' acquisition, their costs or other bases, or the method by which their purported fair market values were determined. In addition, there was no qualified appraisal and no acknowledgement that no goods or services were provided in exchange for the donation. The court noted that, of the three requirements Dr. Isaacs was required to meet in order to substantiate the charitable deductions, he met none of them.

Attempt to Put CVC on Cash Method Rejected

With respect to the disputed $85,000 expense, the Tax Court held that the expense was deductible. Dr. Isaacs, the court said, had established that CVC's former bookkeeper, Ms. Lopez, stole business records and refused to return them. The bookkeeper's egregious conduct, the court concluded, was not reasonably foreseeable. Thus, because the business records were lost as a result of circumstances beyond Dr. Isaacs' control, the court allowed him to substantiate expenses with other credible evidence.

The court found that Dr. Isaacs' description of the reason for the $85,000 expense, his introduction of an interoffice policy to support that explanation, and his uncontroverted testimony that EVC included the $85,000 in income for 2006, constituted enough evidence to support the deduction. The court similarly determined that the $100,000 management fee was also deductible.

The Tax Court rejected the IRS's attempt to put CVC on the cash method. The court found that, although mixed, the evidence tended to show that CVC computed its income for tax purposes under the accrual method. The court also noted that (1) CVC reported small opening and closing balances for accounts receivable and payable on its balance sheets, (2) the IRS had not made any determinations under Code Sec. 446(b) in the notice of deficiency purporting to change CVC's method of accounting, and (3) the notice of deficiency made no reference to CVC's method of accounting, thus making the change in the method a new matter before the court, which the court would not consider.

For a discussion of the recordkeeping and substantiation requirements for property contributions, see Parker Tax ¶84,190.

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Final Regs Address ACA Issues in Supreme Court's Hobby Lobby Decision

IRS issues final regulations on the coverage of certain preventative services under the Affordable Care Act in light of the Supreme Court's ruling in Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014). T.D. 9726 (7/14/15).

Background

The Affordable Care Act (ACA), which was enacted in March of 2010, reorganizes, amends, and adds to the provisions of the Public Health Service Act (PHS Act) relating to group health plans and health insurance issuers in the group and individual markets. Section 2713 of the PHS Act, as added by the ACA, requires that non-grandfathered group health plans and health insurance issuers offering non-grandfathered group or individual health insurance coverage provide coverage of certain specified preventive services without cost sharing.

These preventive services include, with respect to women, preventive care and screenings provided for in comprehensive guidelines supported by the Health Resources and Services Administration (HRSA), including all Food and Drug Administration (FDA)-approved contraceptives, sterilization procedures, and patient education and counseling for women with reproductive capacity, as prescribed by a health care provider (i.e., contraceptive services). The HRSA Guidelines exclude services relating to a man's reproductive capacity, such as vasectomies and condoms.

On July 14, the Department of Treasury, Department of Labor, and the Department of Health and Human Services (collectively, the Departments) published final regulations (T.D. 9726) on coverage of certain preventative services under Section 2713 of the PHS Act. Among other things, the regulations finalize proposed regulations issued August 2014 in light of the Supreme Court's ruling in Burwell v. Hobby Lobby Stores, Inc., 134 S. Ct. 2751 (2014), that, under the Religious Freedom Restoration Act of 1993 (RFRA), the requirement to provide contraceptive coverage could not be applied to certain closely held for-profit entities that had a religious objection to providing coverage for some or all the FDA-approved contraceptive methods.

Definition of "Closely Held For-Profit Entity"

The proposed regulations discussed two possible approaches to defining a closely held for-profit entity. Under the first proposed approach, a qualifying closely held for-profit entity would be a for-profit entity where none of the ownership interests in the entity are publicly traded, and where the entity has fewer than a specified number of shareholders or owners. The preamble to the regulations cited precedent in other areas of federal law for limiting the definition of closely held entities to those with a relatively small number of owners. Under the second proposed approach, a qualifying closely held entity would be a for-profit entity in which the ownership interests are not publicly traded, and in which a specified fraction of the ownership interest is concentrated in a limited and specified number of owners. The preamble also cited precedent in this area in federal law, which limits certain tax treatment to entities that are more than 50 percent owned by or for not more than five individuals.

Under the final regulations, the accommodation with respect to the coverage of contraceptive services is extended to a for-profit entity that is not publicly traded, is majority-owned by a relatively small number of individuals, and objects to providing contraceptive coverage based on its owners' religious beliefs. This definition includes for-profit entities that are controlled and operated by individual owners who are likely to have associational ties, are personally identified with the entity, and can be regarded as conducting personal business affairs through the entity. Those entities appear to be the types of closely held for-profit entities contemplated by Hobby Lobby, which involved two family-owned corporations that were operated in accordance with their owners' shared religious beliefs. The Departments also believe that the definition adopted includes the for-profit entities that are likely to have religious objections to providing contraceptive coverage. Based on the available information, the Departments said it appears that the definition adopted in the final regulations includes all of the for-profit entities that have as of the date of issuance of the regulations challenged the contraceptive coverage requirement in court.

Eligibility for the Accommodation

Under the August 2014 proposed regulations and the final regulations, the first step that an eligible organization (whether it be a nonprofit entity or a closely held for-profit entity) must meet in order to avail itself of the accommodation is that the entity must oppose providing coverage for some or all of any contraceptive item or service required to be covered on account of religious objections. In the case of a for-profit entity, the entity must be opposed to providing these services on account of its owners' religious objections. The final regulations exclude publicly traded entities from the definition of an eligible organization.

Drawing on the tax-law definition, with appropriate modifications, the regulations establish that to be eligible for the accommodation, a closely held, for-profit entity must, among other criteria, be an entity that is not a nonprofit entity, and have more than 50 percent of the value of its ownership interests owned directly or indirectly by five or fewer individuals, or must have an ownership structure that is substantially similar. For purposes of defining a closely held for-profit entity, the regulations use a definition that is more flexible than the tax-law definition of closely held corporation.

Because the Departments believe that the tax-law definition might exclude some entities that should be considered to be closely held for purposes of the accommodation, and because some for-profit entities may have unusual or non-traditional ownership structures not readily analyzed under the 5/50 test, the definition under the final regulations also includes, as stated above, entities with ownership structures that are "substantially similar" to structures that satisfy the 5-owner/50-percent requirement.

For purposes of the accommodation, the value of the ownership interests in the entity, whether the total ownership interests or those owned by five or fewer individuals, should be calculated based on all ownership interests, regardless of whether they have associated voting rights or any other privileges. This is consistent with how the tax-law definition of a closely held corporation is applied.

The final regulations provide that the organization's highest governing body (such as its board of directors, board of trustees, or owners, if managed directly by the owners) must adopt a resolution (or take other similar action consistent with the organization's applicable rules of governance and with state law) establishing that the organization objects to covering some or all of the contraceptive services on account of its owners' sincerely held religious beliefs.

The final regulations are effective September 12, 2015.

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Employee Escapes Tax on Advances Reported on 1099-MISC for the Wrong Tax Year

Because amounts reported on a Form 1099-MISC referred to advance payments received in prior tax years, the amounts were not income in the year for which the form was received. Starke v. Comm'r, T.C. Summary 2015-40.

Background

In the late 1990s, former NFL offensive lineman George Starke cofounded the Excel Institute (Excel), a nonprofit corporation that provided a two-year program teaching basic reading, writing, and arithmetic. Excel also provided job counseling and technical training to its students. Initially, Excel did not have any outside funding, and Starke taught many of the classes and largely funded it himself.

After Starke's original board chair passed away, Jack Lyon joined Excel as chair and eventually took over the day-to-day management. Starke's responsibilities subsequently shifted away from management and more into fundraising. Starke's employment with Excel ended in 2010.

During Starke's employment, he was paid a salary plus a housing allowance. He also had access to an American Express card for Excel, but he did not consistently provide receipts to Excel showing his expenses. According to one of Excel's accountants, if an employee made a purchase on one of Excel's credit cards and the employee could not show that it was an expense benefiting Excel, Excel would treat the expense as an advance or prepaid expense on the employee's behalf.

Excel's general ledgers from 2003 to 2010 show various entries labeled advances or prepaid expenses attributable to Starke. All of his advances and prepaid expenses occurred between 2003 and 2006. In contrast, the only entries from 2007 to 2010 are payroll deductions for Starke that offset the previous advances and prepaid expenses.

After Starke's employment ended, Excel mailed him a 2010 Form 1099-MISC, reflecting payments of $83,698. According to Excel's 2010 general ledger, the amount represented advances and prepaid expenses that Starke had not repaid when he left Excel. Starke did not include the amount in his income when he filed his 2010 return.

In 2012, the IRS issued a notice of deficiency to Starke adjusting his income to include the amount from the Form 1099-MISC as nonemployee compensation and determining an accuracy-related penalty under Code Sec. 6662(a).

Analysis

An advance of compensation for future services is taxed at the time the advance is received (Beaver v. Comm'r, 55 T.C. 85 (1970)). In contrast, income from the discharge of indebtedness is taxed at the time it becomes clear that a debt will never have to be paid (Cozzi v. Commissioner, 88 T.C. 435 (1987)).

The Tax Court noted that whether an amount is an advance on compensation or a loan turns on the question of whether a debtor-creditor relationship was established at the time the funds were disbursed. The court stated that in the case of a loan, which is not included in income at the time the funds are disbursed, the parties agree that the amount will be repaid and the debtor-creditor relationship is established at the outset. However, an advance that is considered compensation for services, albeit services to be rendered in the future, constitutes taxable income in the year it is received.

The court found that the amounts reported on the 2010 Form 1099-MISC were not loans because there was no evidence that Starke intended to repay them at the time the payments were made. Further, the court found no evidence of signed documents memorializing a loan agreement, and noted that a 2005 letter from Excel's accountants that set forth a repayment plan characterized the payments as advances rather than loans.

The court stated that because the payments were not loans, it would ordinarily attempt to determine whether the payments were income in the form of advances of compensation. But because the amounts were received in tax years prior to the one at issue, the court determined that the characterization of the payments (beyond "loan" vs. "not loan") was irrelevant, stating that even if the payments were salary advances, they would have been income in the tax year received, not 2010. Accordingly, the court disallowed the IRS's adjustments.

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Beanie Baby Founder Avoids Prison for Tax Fraud Conviction Stemming from UBS Investigation

The Seventh Circuit concluded that the billionaire creator of Beanie Babies, who evaded $5.6 million in U.S. taxes by hiding assets in a Swiss bank account, was deserving of a more lenient sentence than was recommended by the government. The appellate court upheld the district court's sentence of probation and fines, citing the taxpayer's charitable works and generosity. U.S v. Warner, 2015 PTC 231 (7th Cir. 2015).

Background

In 1985, Ty Warner formed Ty, Inc., a plush toy company. His big break came in the 1990s with the introduction of a new toy to the market: the Beanie Baby. A huge success, the Beanie Baby propelled Ty Inc. into a multi-billion dollar company and made Warner rich.

In 1996, during the early period of Beanie Babies' success, Warner opened an offshore bank account at UBS AG (UBS) in Switzerland. Within several years, the account contained $93 million. Warner did not report the account to the IRS.

In 2008, the Justice Department launched a program to aggressively combat offshore tax evasion. The program began with the investigation of UBS. At the same time, the government encouraged tax evaders to come forward on their own by announcing an IRS offshore voluntary disclosure program (OVDP). Under the program, taxpayers who voluntarily disclosed their offshore accounts could avoid criminal prosecution by paying back taxes, interest, and penalties, including 20 percent of the account's peak value. On the other hand, those who continued to hide their assets would face heightened enforcement and severe penalties. Taxpayers had a six month window to take advantage of the OVDP and thousands of taxpayers were admitted into the program.

Warner was aware of the government's investigation of UBS, which was widely publicized, and of the indictment of the banker with whom he'd been working. Warner applied to enter the program within the appropriate timeframe but, unbeknownst to him, he was already under investigation, which made him ineligible for the OVDP.

In September 2013, Warner was charged with willful tax evasion in violation of Code Sec. 7201. The IRS accused him of evading $885,300 in taxes for 2002 by: (1) excluding from his reported income the interest from his offshore assets; (2) fraudulently stating on his tax return that he had no foreign account; and (3) failing to file a Report of Foreign Bank and Financial Account (FBAR), as required by the Bank Secrecy Act.

Warner pled guilty, paid full restitution and a civil FBAR penalty of $53.6 million equal to 50 percent of the maximum balance in his offshore account in 2008 (which was 30 percent higher than the penalty he would have owed had he been admitted to the OVDP). Warner paid both the penalty and restitution before his sentencing hearing. His net worth at the time of sentencing was roughly $1.7 billion.

Lenient Sentence Imposed by Trial Court

In their pre-sentencing submissions, neither side proposed a sentence within the guidelines range, which was 46 to 57 months in prison. The government requested incarceration in excess of a year and a day, a sentence well below the recommended minimum. The probation officer recommended a prison term of 15 months. Warner argued that a sentence of probation with community service would suffice, and that it would provide greater benefit to society. He offered to mentor students in business and product development at three urban high schools on Chicago's South Side. The president of one of the schools submitted a letter detailing specific ways that Warner could help. In addition, approximately 70 people business associates, employees, neighbors, charitable foundations, and others who knew Warner submitted character-reference letters in his behalf.

The district court adopted the findings in a presentence report and agreed with the calculation of the guidelines range. But the judge, citing 18 U.S.C. Sec. 3553(a)(1), decided to impose a below-guidelines sentence based on "the nature and circumstances of the offense and the history and characteristics of the defendant." The judge sentenced Warner to two years' probation with community service, plus a $100,000 fine and costs. The judge was moved by the voluminous and detailed letters submitted in Warner's behalf, which, he said, were quite different from the letters he typically received in other cases.

For example, one letter relayed that in 2012 Warner stopped to ask a stranger for directions. The woman was holding a fundraiser to help raise money to pay for an expensive adult stem cell treatment she needed as a result of kidney failure. Warner later paid for the surgery and then helped her raise awareness of the potential of adult stem cells for treating kidney failure. As a result, she described meeting with leaders in the field and altering the path of research.

Another letter came from the president of the Children's Hunger Fund, an organization serving needy children in orphanages, disaster-stricken areas, and elsewhere. Over 13 years, Warner donated millions of plush toys valued at $70 million and enabled numerous charitable projects. The president called Warner's generosity "nothing short of amazing" and "unprecedented" in his 30-plus years in the nonprofit sector. What is more, the president said, in every instance, Warner "ha[d] humbly requested that no special efforts be made to publicly acknowledge his philanthropy."

Seventh Circuit Upholds Sentence

The government appealed Warner's sentence, claiming it was unreasonable because it did not include prison time. First, the government questioned the value of Warner's letters because many of them came from his employees, former employees, business associates, and attorneys; and because some of the good deeds they reported took place after Warner knew he was under investigation. Second, the government argued that Warner's charity amounted to no more than writing checks and donating excess inventory, which was "nothing unique" considering his enormous wealth.

The Seventh Circuit held that the district court did not abuse its considerable discretion and affirmed Warner's sentence. For starters, the court noted that no statute expressly required the district court to send Warner to prison. Reviewing the district court's choice of sentence, the Seventh Circuit said that (1) the court followed proper procedures, and (2) the court's justification for the sentence was sufficient, applying a deferential abuse of discretion standard.

Due deference led the Seventh Circuit to conclude that Warner's probationary sentence was reasonable in light of the following: (1) Warner's excellent character, as shown by his long history of charity and kindness to others; (2) the isolated and uncharacteristic nature of his tax evasion; (3) his attempt to enter the OVDP; (4) his guilty plea and prompt payment of his liabilities; (5) his $53.6 million FBAR penalty, which was nearly ten times the tax loss; and (6) the fact that the government charged him with only one count and itself sought a well-below-guidelines sentence.

For a discussion of the penalties relating to tax evasion, see Parker Tax ¶265,110.

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"Investor Control" Doctrine Applies to Insurance Policies Effectively Controlled by Venture Capitalist

The Tax Court held that a taxpayer who set up private placement variable life insurance policies in a grantor trust was taxable on the income that built up in those accounts under the "investor control" doctrine; however, he was not liable for the 20 percent penalty tax applicable to substantial understatements of tax. Webber v. Comm'r, 144 T.C. No. 17 (6/30/15).

Background

Jeffrey Webber is a venture-capital investor and private-equity fund manager. In 1998, Webber hired a law firm to provide him with estate planning services. One of the firm's partners, William Lipkind, laid out a complex estate plan that involved establishing a grantor trust and purchasing "private placement" variable life insurance policies. Lipkind acknowledged that this tax strategy had certain tax risks, but he orally assured Webber that the strategy was sound. Webber contributed $700,000 to a grantor trust which then purchased private placement life insurance on the lives of two elderly relatives. The policies were purchased from Lighthouse Capital Insurance Co. (Lighthouse). Webber and various family members were the beneficiaries of the policies.

The premiums paid for the policies, less various expenses, were placed in separate accounts whose assets inured exclusively to the benefit of the policies. The policies stated that no one but the investment manager could direct investments and the policyholder had no right to require Lighthouse to acquire a particular investment for a separate account. However, the policyholder was allowed to transmit general investment objectives and guidelines to the investment manager, who was supposed to build a portfolio within those parameters. Lipkind explained to Webber that it was important for tax reasons that Webber not appear to exercise any control over the investments that Lighthouse purchased for the separate accounts. Accordingly, when selecting investments for the separate accounts, Webber never communicated by email, telephone, or otherwise directly with Lighthouse or the investment manager. Nonetheless, Webber effectively dictated both the companies in which the separate accounts would invest and all actions taken with respect to these investments.

Acknowledging the risk of an audit, Lipkind concluded that the "investor control" doctrine would not apply because Webber would not be in "constructive receipt" of the assets held in the separate accounts. While assuring Webber that outside legal opinions supported this conclusion, Lipkind did not provide a written opinion.

After auditing Webber's 2006 and 2007 tax returns, the IRS, citing Rev. Rul. 77-85 and the "investor control" doctrine, concluded that Webber retained sufficient control and incidents of ownership over the assets in the separate accounts that he should be treated as their owner for federal income tax purposes. Thus, the IRS said, Webber was responsible for the tax on the income generated in those accounts. The IRS also imposed a 20 percent accuracy-related penalty under Code Sec. 6662.

Analysis

Webber argued that the legislative history behind the addition of Code Sec. 817(h) in 1984 showed that Congress intended to eliminate the "investor control" doctrine. Code Sec. 817(h) provides that a variable contract based on a separate account "shall not be treated as an annuity, endowment, or life insurance contract for any period * * * for which the investments made by such account are not, in accordance with regulations prescribed by the Secretary, adequately diversified."

Alternatively, Webber argued that, if the "investor control" doctrine applied, the tax results should be dictated by Code Sec. 7702(g), which defines the term "income on the contract." Since there was no increase in the policies' cash surrender value during 2006-2007 and there were no premiums paid, Webber contended that Code Sec. 7702(g) limited his income inclusion to the $12,000 of mortality charges paid by the separate accounts during 2006-2007.

The Tax Court agreed with the IRS that the "investor control" doctrine applied. The court concluded that IRS revenue rulings enunciating the "investor control" doctrine were entitled to deference and weight under Skidmore v. Swift & Co., 323 U.S. 134 (1944). The court further held that Webber was the owner of the assets in the separate accounts for federal income tax purposes and was taxable on the income earned on those assets. The court rejected Webber's argument that Code Sec. 817(h) was meant to eliminate the "investor control" doctrine, finding that Congress expressed no intention to displace the "investor control" doctrine. Congress, the court observed, directed that the new diversification standards under Code Sec. 817(h) should govern situations where the investments in the separate account are made, in effect, at the direction of the investor. According to the court, the standards were meant for situations where the investments, though actually selected by the insurance company, were so narrowly focused and undiversified as to be a proxy for mutual funds or other investments publicly available to investors.

With respect to the argument that Code Sec. 7702(g) limited the amount of income inclusion, the court noted that the provision applies to a policyholder if at any time any contract which is a life insurance contract does not meet the definition of life insurance contract under Code Sec. 7702(a). Since both parties agreed that the policies met the definition of "life insurance contract," Code Sec. 7702(g) did not apply, the court said.

Finally, the Tax Court held that Webber was not liable for the accuracy-related penalties under Code Sec. 6662(a) because he relied in good faith on professional advice from competent tax professionals. The court noted that while Lipkind himself did not render a written legal opinion, he reviewed and considered written opinion letters from reputable law firms addressing the relevant issues. Three of these opinion letters, the court observed, specifically addressed the "investor control" doctrine and concluded that the Lighthouse policies, as structured, would comply with U.S. tax laws and avoid application of the "investor control" doctrine. By informing Webber that he concurred with these opinions, the court said, Lipkind provided Webber with professional tax advice on which Webber actually relied in good faith. The court also said that the fact that Webber filed multiple documents with the IRS detailing the transactions supported his testimony that he believe the strategy would successfully withstand IRS scrutiny, as Lipkind had advised. The court also rejected the IRS's characterization of Lipkind as a "promoter," saying that Lipkind had no stake in Webber's estate plan apart from his normal hourly rate.

For a discussion of the "investor control" doctrine, see Parker Tax ¶70,115.

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Taxpayer Can't Deduct Value of House Transferred in Partial Satisfaction of Alimony

The Tax Court held that a taxpayer could not take a loss deduction on the transfer of a residence in lieu of part of her alimony obligations because it was a transfer incident to divorce. The taxpayer was also precluded from taking an alimony paid deduction, because the transfer was not of cash or a cash equivalent. Mehriary v. Comm'r, T.C. Memo. 2015-126.

Background

Married taxpayers Christina Mehriary and Bradley Williams entered into a divorce agreement in January of 2010. The agreement provided that Williams would have exclusive use, ownership, and possession of the marital home at Morton Road in New Bern, North Carolina (Morton property), and Mehriary would receive the residence at Sweet Briar Road in New Bern, North Carolina (Sweet Briar property). The agreement further provided that Mehriary would pay Williams alimony of $4,000 per month for 60 months, commencing February 1, 2010. All payments were to be made to Wells Fargo Bank to pay the mortgage on the Morton property.

On February 19, 2010, the circuit court entered a final judgment of dissolution of marriage.

Less than a year later, Mehriary submitted to Williams a modification to the divorce agreement which stated that she would convey the Sweet Briar property back to her former husband in lieu of $80,000 of the alimony obligation. Williams agreed to and signed the modification, and Mehriary transferred the property on February 16, 2011. In September, Mehriary sent a letter to the circuit court requesting a modification of the divorce decree to reflect the transfer of the Sweet Briar property to Williams in lieu of $80,000 of her alimony obligation.

On her 2011 tax return, Mehriary claimed an $80,000 loss deduction for the transfer of the property, which the IRS subsequently disallowed.

Analysis

Code Sec. 1041(a) provides that no gain or loss is recognized on the transfer of property from one spouse to a former spouse if the transfer is incident to divorce. A transfer of property is incident to divorce if the transfer occurs within one year after the date on which the marriage ceases, or is related to the cessation of the marriage (Code Sec. 1041(c)). A transfer of property is related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer does not occur more than six years after the date on which the marriage ceases (Reg. Sec. 1.1041-1T(b), Q&A-7).

Subject to certain requirements, Code Sec. 215(a) allows a taxpayer a deduction for alimony or separate maintenance payments paid during the tax year. One requirement is that payments be made in cash or a cash equivalent (Code Sec. 71(b)(1)). Transfers of services or property do not qualify as alimony payments (Reg. Sec.1.71-1T(b), Q&A-5).

The Tax Court noted that, under Young v. Comm'r, 113 T.C. 152, the written modification to the divorce agreement transferring the Sweet Briar property constituted a "divorce or separation instrument." Because the transfer was pursuant to a divorce or separation instrument and occurred within one year of Mehriary's divorce from Williams, the court found the transfer was related to the cessation of their marriage, and was incident to their divorce in all respects. Therefore, the court held that under Code Sec. 1041(a) Mehriary could not recognize an $80,000 loss upon the transfer of the Sweet Briar property to Williams.

Alternatively, Mehriary argued that the transfer of the Sweet Briar property to Williams was a deductible alimony payment.

The Tax Court stated that although Mehriary and Williams agreed that the transfer of the property would replace $80,000 of Mehriary's alimony obligation, the intent of the parties does not determine the deductibility of a payment as alimony. Because the transfer was not a payment in cash or a cash equivalent, the court determined it did not constitute alimony.

For a discussion of taxation of alimony and separate maintenance payments, see Parker Tax ¶ 14,220.

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IRS Identifies Basket Option Contracts and Basket Contracts as Reportable Transactions

The IRS has identified two new reportable transactions, basket contracts and basket option contracts, in which a taxpayer attempts to defer income recognition and may attempt to convert short-term capital gain and ordinary income to long-term capital gain through the use of certain contracts. Notice 2015-47; Notice 2015-48.

In a basket option contract, a taxpayer, typically a hedge fund or a high net-worth individual, enters into a contract, denominated as an option, with a counterparty, typically a bank, to receive a return based on the performance of a notional basket of referenced actively traded personal property (the reference basket).

Similarly, in a basket contract, a taxpayer also enters into a contract with a counterparty to receive a return based on the performance of the reference basket. Unlike a basket option contract, the assets that comprise the reference basket for a basket contract may include

(1) interests in entities that trade securities, commodities, foreign currency, or similar property (hedge fund interests),

(2) securities,

(3) commodities,

(4) foreign currency, or

(5) similar property (or positions in such property).

In both types of contracts, the taxpayer, either himself, through a designee, or through a trading algorithm, will determine the assets that comprise the reference basket. While the contract remains open, the taxpayer has the right to request changes in the assets in the reference basket or the specified trading algorithm, although the terms of the contract also permit the counterparty to reject certain changes. The counterparty, however, generally accepts all or nearly all of the changes requested by the taxpayer.

When the contract is entered into, the taxpayer typically makes an upfront cash payment to the counterparty of between 10 and 40 percent of the value of the assets in the reference basket. To manage its risk under the contract, the counterparty typically acquires substantially all of the assets in the reference basket at the inception of the contract and acquires and disposes of assets during the term of the contract, generally when the assets are changed. The counterparty generally supplies the additional cash required to purchase the assets in the reference basket, and the contract typically contains safeguards to minimize its economic risk.

Each type of contract has a stated term of more than one year (or overlaps two of the taxpayer's tax years for a basket contract) but contains provisions that in effect allow either party to terminate the contract at any time with proper notice. The amount that the taxpayer receives upon settlement of the contract is based on the performance of the assets in the reference basket. The taxpayer takes the position that short-term gains and interest, dividend, and other ordinary periodic income from the performance of the reference basket are deferred until the contract terminates and, if the contract is held for more than one year, that the entire gain is treated as long-term capital gain.

The assets in the reference basket would typically generate ordinary income if held directly by the taxpayer, and short-term trading gains and losses if purchases and sales of the assets were carried out directly by the taxpayer.

The IRS is concerned that taxpayers are using basket option contracts, and may be using basket contracts, to inappropriately defer income recognition and convert ordinary income and short-term capital gain into long-term capital gain. In some cases, taxpayers are mischaracterizing a basket option contract as an option, or may be mischaracterizing the form of the basket contract, to avoid application of Code Sec. 1260, U.S. tax liability under Code Secs. 871 and 881, and withholding and reporting obligations.

Effective July 8, 2015, the IRS has identified basket option contracts and substantially similar transactions in effect on or after January 1, 2011 as listed transactions. The IRS lacks enough information to determine whether basket contracts should be identified specifically as a tax avoidance transaction, and, effective July 8, 2015, has identified such transactions entered into on or after November 2, 2006 as transactions of interest.

Observation: If a transaction is identified as a basket option contract under Notice 2015-47 and as a basket contract under Notice 2015-48, the IRS will treat the transaction as a listed transaction.

Any taxpayer, including an individual, trust, estate, partnership, S corporation, or other corporation, that participates in a reportable transaction (described in Reg. Sec. 1.611-4(b) and including listed transactions and transactions of interest) and is required to file a federal tax return or information return must file Form 8886, Reportable Transaction Disclosure Statement, to disclose information for each reportable transaction in which the taxpayer participated.

For each year in which a basket option contract or a basket contract is open, the following parties are treated as participating in the reportable transaction: (1) the purchaser of the contract; (2) any general partner of the purchaser, if the purchaser of the contract is a partnership; (3), any managing member of the purchaser, if the purchaser of the contract is a limited liability company; and (4) the counterparty to the contract.

For a discussion of the disclosure of reportable transactions, see Parker Tax ¶250,140.05.