Federal Tax Bulletin - Issue 90 - June 12, 2015

Lump-Sum Payment toward Lessor's Construction Costs Was Rental Income in Year Received

The Tax Court held that a lessee's lump sum payment toward lessor's construction expenses was rental income. Because the lease agreement only stated when rent was payable and did not specifically allocate rent to specific periods, the court held the entire payment was includible in the taxpayer's income in the year of receipt. Stough v. Comm'r, 144 T.C. No. 16. Read more...

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Tax Court: Defective Change in Accounting Method Can't Be Reversed Years Later without IRS Consent

The Tax Court determined that, although the taxpayer's initial application for automatic consent to change its method of accounting was defective, its consistent use of the new method over seven years constituted a method change. Accordingly, the court rejected the taxpayer's attempt to revert back to its old method without IRS consent. Hawse v. Comm'r, T.C. Memo. 2015-99.

Background

James Hawse was the president and sole shareholder of JHH, Motor Cars, Inc. (JHH), an S corporation that sold new and used vehicles and operated a full service automobile repair and parts department. In 1985, JHH elected to use the last-in, first-out (LIFO) method of accounting for its vehicles inventory. JHH did not make a similar LIFO election for its parts inventory, which it identified using the specific identification method and valued on the basis of lower of cost or market.

In early 2001, Hawse, anticipating that he might sell his dealership, sought to terminate JHH's LIFO election because he viewed the LIFO method as an impediment to the eventual sale of his business. Hawse was concerned that the LIFO method would impede a sale, because either he or the purchaser might have to recapture the accumulated LIFO reserve if he sold the dealership.

JHH attached a Form 3115, signed by Hawse, to its 2001 Form 1120S, requesting the IRS' automatic consent to revoke its LIFO election for the vehicles inventory in favor of the specific identification method pursuant to the automatic consent provisions of Rev. Proc. 99-49. On the Form 3115, JHH stated it would make the necessary Code Sec. 481(a) adjustment by recapturing its stored LIFO reserve of $1,084,437 over a period of four years. JHH further stated that it currently identified its vehicles inventory using the LIFO method, valued at cost, and that going forward, it would identify that inventory using the specific identification method, valued at the lower of cost or market.

JHH did not attach a statement to its Form 3115 explaining how its proposed new methods of identifying and valuing its vehicles inventory were consistent with the requirements of Reg. Sec. 1.472-6 relating to a change from the LIFO method, or how these methods conformed to the LIFO method change requirements of Rev. Proc. 99-49.

On its 2001 through 2007 returns JHH used the specific identification method of accounting for its entire inventory. JHH also made the required Code Sec. 481(a) adjustment, reporting income of $271,109 from the recaptured LIFO Reserve on each of its 2001, 2002, 2003, and 2004 income tax returns. However, contrary to its representation that it would value its entire inventory at the lower of cost or market, JHH used different valuation approaches for its various inventories.

In 2009, Hawse was informed by his accountant that, the IRS had been rejecting Forms 3115 that were filed for automatic terminations of LIFO elections. Hawse claimed his accountant's information was based on a webinar that included an IRS Motor Vehicle Technical Specialist and subsequent discussion with an auto dealership industry professional who advises on LIFO accounting method issues. It appeared that the IRS' position was that dealerships could not use the automatic change provisions to terminate the LIFO method if, after filing their LIFO termination applications, the dealerships did not use the same method of inventory valuation for their entire non-LIFO inventory.

Because JHH had been using different valuation approaches, the accountant advised Hawse that JHH should file amended returns to reinstate the LIFO method for vehicles inventory and to reverse the related Code Sec. 481(a) adjustments. In 2009, JHH filed amended returns for 2002 through 2007 that reflected the valuation of the taxpayer's new inventory under LIFO, consistent with its initial election.

On its amended returns for 2002 and 2003, consistent with its goal of reverting to the LIFO method, JHH reversed the Code Sec. 481(a) adjustment that it had earlier made, computed additional LIFO reserve amounts for years 2001, 2002, and 2003 and claimed deductions for these additional LIFO reserve amounts and refunds as a result of these adjustments on its 2002 and 2003 amended returns.

In 2012, the IRS denied the claimed refunds and rejected the accounting method change on the amended returns.

Consistent Application of Accounting Method was a Change, Despite Defective Application

Under Code Sec. 446(e), once a taxpayer has used an accounting method and filed a first return, the taxpayer must receive approval from the IRS before making any change to that accounting method. Taxpayers may receive automatic consent for an accounting method change by filing a current Form 3115 that follows the requirements laid out under the current automatic consent revenue procedure. Rev. Proc. 99-49 provided the relevant procedures for obtaining automatic consent to change a method of accounting in 2001, the year in which JHH filed its Form 3115.

Under Reg. Sec. 1.466-1(e)(2)(ii)(a), a change in accounting method includes a change in the treatment of any item that involves the proper time for the inclusion of the item in income.

The Tax Court noted that JHH's initial application for automatic consent failed to comply with all the terms and conditions of Rev. Proc. 99-49: JHH did not cite on Form 3115 the applicable section of the revenue procedure's appendix, nor did it attach to Form 3115 a separate statement describing how its new methods of identifying and valuing its inventory conformed to the requirements. The court stated that while the two defects might appear trivial, the revenue procedure itself demanded strict compliance with all requirements and the defects precluded JHH receiving automatic consent to change its method of accounting from LIFO to specific identification.

Having concluded that JHH did not receive automatic consent for a method change, the Tax Court stated it would need to decide whether, notwithstanding this failure, JHH's filing of its 2001 through 2007 tax returns in accordance with a new method of accounting was itself a method change.

The court questioned Hawse' assumption that, because the IRS did not automatically consent to JHH's requested accounting method change, that no change in fact occurred and JHH was still on the LIFO method. The court found Hawse misconstrued Code Sec. 446(e), noting that section creates a legal duty to seek advance consent to a change in accounting method, but it does not bar a change from occurring without consent. The court pointed out that Code Sec. 446(e) affords the IRS the power to grant retroactive changes in accounting methods as well as prospective ones. It concluded that when the IRS examined JHH's 2002 and 2003 returns and determined that JHH had revoked its LIFO election in 2001, the IRS had plainly accepted the change.

The court observed that in Huffman v. Comm'r, 126 T.C. 322 (2006), the Tax Court emphasized that the consistent treatment of an item involving a question of timing will establish such treatment as a method of accounting. Because use of the specific identification method rather than the LIFO method accelerated JHH's recognition of vehicle sales income, the court determined it involved a question of timing under Reg. Sec. 1.466-1(e)(2)(ii)(a). The court observed that in Johnson v. Comm'r, 108 T.C. 448 (1997), it had found that a two-year deviation could establish a new method of accounting, and determined that JHH's seven-year consistent use of the specific identification method established that treatment as a method of accounting under Huffman.

Thus, notwithstanding its failure to secure the IRS' automatic consent, the court determined JHH changed its method of accounting from LIFO by accounting for its vehicles inventory on the specific identification method on its 2001 through 2007 tax returns.

Amended Return and Attempted Reversion to LIFO

Because JHH had changed its method of accounting by consistently applying the proposed method change over seven years, the Tax Court determined JHH's attempt to revert to the LIFO method with its amended returns was a second attempt to change its accounting method.

First, the court noted it had previously held that a taxpayer changes its method of accounting when it changes its treatment of an item in order to adhere to a method adopted pursuant to a prior accounting election (Capital One Fin. Corp. v. Comm'r, 130 T.C. 147 (2008)). On its amended returns JHH changed its treatment of its vehicles inventory to adhere to its previously elected LIFO method, and the court found that was an accounting method change.

Second, the court noted under Reg. Sec. 1.446-1(e)(2)(ii)(c), a change from specific identification to LIFO is a change in an overall plan or system of identifying items in inventory and thus qualifies as an accounting method change.

Third, the court found the two changes that JHH proposed to make with its amended returns involved material items: the first change reversed the Code Sec. 481(a) recapture of LIFO reserve and the second change computed LIFO reserve amounts for tax years 2001, 2002, and 2003 and deducted them. The court determined JHH's reversal of the Code Sec. 481(a) adjustment and deduction of additional LIFO reserve amounts retroactively postponed its recognition of LIFO reserve; hence, both changes related to the proper timing of income and thus amounted to changes in the treatment of material items under Reg. Secs. 1.446-1(e)(2)(ii)(a) and (c).

Accordingly, the court held the changes that JHH made on its amended returns constituted a retroactive change in method of accounting for which the IRS's consent was required, and the IRS was well within its discretion to refuse such consent and to refuse to accept JHH's amended returns.

Conclusion

The Tax Court found JHH did not receive automatic consent under Rev. Proc. 99-49 to change its method of accounting for its LIFO inventory to specific identification, but, notwithstanding this failure, by consistently accounting for that inventory on its 2001 through 2007 returns using the specific identification method, JHH nevertheless changed its method of accounting. Further, the court determined JHH's amended returns, on which it attempted to revert to the LIFO method, reflected a second change in method of accounting to which JHH also did not obtain the IRS's consent. Accordingly, the Tax Court held the IRS was entitled to reject JHH's amended returns and Hawse was not entitled to his claimed refunds.

For a discussion of accounting method changes, see Parker Tax ¶ 241,590.

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Section 4980D Healthcare Penalty Relief for Small Employers Set to End on June 30

In Notice 2015-17, published February 18, 2015, the IRS provided transition relief, set to expire on June 30, from the assessment of $100 per day, per employee penalties under Code Sec. 4980D for small employers who reimburse or pay a premium for individual health insurance for an employee. Transition relief will remain in place until at least December 31, however, for S corps that have similar arrangements with 2-percent shareholder-employees. The IRS is expected to provide future guidance on whether the penalty applies in those situations.

Transition Relief Provided in Notice 2015-17

Historically, many small employers have favored "employee payment plans" where employees would choose their own insurance plans and employers would reimburse the costs over conventional group health plans. Structured properly, such arrangements provided many of the tax benefits of group health plans without the administrative burdens and high costs.

Pursuant to Notice 2013-54, the "employee payment plans" discussed above are considered to be group health plans that fail to meet certain market reform requirements under the Affordable Care Act ACA. As such, employers who reimburse the health insurance premiums of their employees are subject to a $100 per day, per employee penalty under Code Sec. 4980D (reaching up to $36,500 per employee, per year).

Notice 2015-17 provides limited transition relief for coverage sponsored by an employer that is not an Applicable Large Employer (ALE). Specifically, the notice provides that the excise tax under Code Sec. 4980D will not be asserted for any failure to satisfy the market reforms by employer payment plans that pay, or reimburse employees for individual health policy premiums or Medicare Part B or Part D premiums (1) for 2014 for employers that are not ALEs during 2014, and (2) for January 1 through June 30, 2015 for employers that are not ALEs during 2015. After June 30, 2015, such employers may be liable for the excise tax.

Practice Tip: For employers who are unable to replace an employee payment plan with a conventional group health plan, Notice 2015-17 clarifies that there is an additional avenue for avoiding the Code Sec. 4980D penalty. The notice states that if, instead of providing reimbursements, an employer increases an employee's compensation, but does not condition the payment of the additional compensation on the purchase of health coverage (or otherwise endorses a particular policy, form, or issuer of health insurance), the arrangement will not be considered an employer payment plan and will not be subject to the penalty. While this is by no means a tax-efficient way to provide health insurance, an employer that still has an impermissible employee payment plan in place may find it attractive compared with paying a $100 per penalty, at least as a stopgap.

Transition Relief for Certain S Corp Healthcare Arrangements to Continue Until at Least December 31

Notice 2008-1 provides that if an S corporation pays for or reimburses premiums for individual health insurance coverage covering a 2-percent shareholder (as defined in Code Sec. 1372(b)(2)), the payment or reimbursement is included in income, but the 2-percent shareholder-employee may deduct the amount of the premiums under Code Sec. 162(l) (a "2-percent shareholder-employee healthcare arrangement").

The IRS acknowledged in Notice 2015-17 that it is unclear under the existing guidance whether such 2-percent shareholder-employee healthcare arrangements are subject to the market reforms and the associated penalties under Code Sec. 4980D.

Accordingly, the IRS stated in the notice that the excise tax under Code Sec. 4980D will not be asserted for any failure to satisfy the market reforms by a 2-percent shareholder-employee healthcare arrangement until future guidance states that the penalty applies to such arrangements, and at the very least will not be asserted at any time prior to January 1, 2016. Further, unless and until such additional guidance provides otherwise, an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 solely as a result of having a 2-percent shareholder-employee healthcare arrangement.

Single Participant S Corp Healthcare Arrangements Are Not Subject to Section 4980D Penalty

In addition, the IRS reiterated that Code Sec. 9831(a)(2) provides that the market reforms do not apply to a group health plan that has fewer than two participants. Accordingly, arrangements covering only a single employee are generally not subject to the market reforms. However, if an S corporation maintains more than one such arrangement for different employees (whether or not 2-percent shareholder-employees), all such arrangements are treated as a single arrangement covering more than one employee so that the exception in Code Sec. 9831(a)(2) does not apply.

For this purpose, if both a non-2-percent shareholder employee of the S corporation and a 2-percent shareholder employee of the S corporation are receiving reimbursements for individual premiums, the arrangement would be considered a group health plan for more than one current employee. However, if an employee is covered under a reimbursement arrangement with other-than-self-only coverage (such as family coverage) and another employee is covered by that same coverage as a spouse or dependent of the first employee, the arrangement would be considered to cover only the one employee.

For a discussion of group health plan requirements, including the Code Sec. 4980D excise tax, see Parker Tax ¶ 195,500.

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Lackluster Attempts to Rent Vacation Condo Precludes Deductions

The Tax Court held that because taxpayers made minimal efforts to rent out their former vacation home, the condo had not been converted for an income-producing purpose and thus taxpayers could not take deductions for rental expenses or a loss on the property's sale. Redisch v. Comm'r, T.C. Memo. 2015-95.

Background

Between April 2003 and December 2010 Robert and Pamela Redisch purchased and sold two pieces of property in Hammock Dunes, a luxury oceanfront community under development in Florida. In 2002 they rented a golf villa and, after enjoying their stay, decided to purchase land in the community with the intention of building a seasonal residence. After spending more time as renters at Hammock Dunes, the Redisches decided to sell the land and buy an oceanfront condo instead. In 2004 they purchased a condo in one of the community's buildings (Porto Mar) for $875,000, which became a seasonal home for them and their daughter.

After their daughter's tragic death in 2006, the Redisches stopped staying at Porto Mar. Rather than immediately selling the property, the couple decided to rent it out to generate cash in the short term, believing that they could sell it later at a profit. The Redisches continued to visit Hammock Dunes, staying with a friend as a guest for weeks or months at a time.

In 2008 the Redisches listed Porto Mar with the Hammock Dunes realty office, removed most of their personal belongings and changed one of the bedrooms into a child's room at the suggestion of a real estate agent. The realtors featured Porto Mar in a portfolio of rental properties and told prospective land purchasers the condo was available to rent while building. The Redisches received inquiries from only two potential renters. Neither rented the property or even qualified as potential tenants (one wanted it for only two months and the other had a large dog; both situations conflicted with building restrictions).

In June 2009, acknowledging a lack of rental activity, the Redishes listed Porto Mar with another agent for either rental or sale. Later, as other units in the building went into foreclosure, the Redisches reduced the sales price of their unit and in 2010 sold Porto Mar for $725,000.

The Redisches filed joint returns for 2009 and 2010, including in each return a Schedule E, Supplemental Income and Loss, claiming losses related to the attempt to rent Porto Mar in 2009 and its sale in 2010. The IRS assessed deficiencies for 2009 and 2010 in the amounts of $77,793 and $89,155, respectively, plus accuracy-related penalties under Code Sec. 6662(a).

Analysis

Under Code Sec. 212 an individual can deduct expenses incurred during the taxable year for property held for the production of income. Code Sec. 165 (a) allows a loss to be deducted if incurred during a taxable year in any transaction entered into for profit and not otherwise compensated. An individual can claim a loss on property purchased or constructed as a primary residence if, before its sale, it is rented or otherwise used for an income-producing purpose and this use continues up to the time of sale. Reg. Sec. 1.165-9(b). Under both sections the profit motive must be the taxpayer's primary purpose.

The Tax Court has identified five factors relevant to determining if a taxpayer had a profit motive when considering whether residential property has been converted to an income producing purpose:

(1) length of time the house was occupied by the individual as his residence before placing it on the market for sale;

(2) whether the individual permanently abandoned all further personal use of the house;

(3) character of the property (recreational or otherwise);

(4) offers to rent; and

(5) offers to sell (Grant v. Comm'r, 84 T.C. 809 (1985)).

The Tax Court noted the Redisches initially bought property in the Hammock Dunes community intending to build a home, but instead purchased the Porto Mar condo. The court found they used the Porto Mar property as a seasonal home for four years before abandoning their personal use of it in 2008. Despite frequenting Hammock Dunes in later years, the Redishes never resided in the Porto Mar condo, staying with friends instead.

Although the couple planned to rent the condo, the tax court found their attempts were lackluster at best. The court noted that while Mr. Redisch testified that he signed a one-year agreement with a realty company, he did not provide any other evidence of such an agreement. Even if he had produced the contract, the court pointed out that the efforts of the realty company to rent out the Porto Mar property were limited to featuring it in a portfolio kept in the company's office and telling prospective buyers that it was available when showing it as a model. The court found it unsurprising that the minimal effort yielded only minimal interest; only two potential renters inquired about the condo, and both had interests that conflicted with building restrictions.

The court noted Mr. Redisch did not testify regarding any other tactics that he attempted to employ to rent out the Porto Mar property, other than getting a new real estate agent in 2009. Additionally, the court found Mr. Redisch did not provide any evidence, beyond a copy of a multiple listing service listing of the Porto Mar property, of the actions taken by the second agent to rent out the home.

Accordingly, the Tax Court determined that the Redisches did not make a bona fide attempt to rent out the Porto Mar property and therefore did not convert it to one held for the production of income. The Tax Court held that the Redisches were not entitled to their claimed losses and upheld accuracy-related penalties for 2009 and 2010.

For a discussion of rental income and expenses, see Parker Tax ¶ 86,105.

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Land Held for Development Not a Capital Asset, Gain from Sale was Ordinary Income

The Tax Court determined that taxpayers' extensive and ongoing efforts to develop a parcel of property demonstrated that their primary purpose was to sell the property in the ordinary course of business, and held that they were required to report their gain as ordinary income. Fargo v. Comm'r, T.C. Memo. 2015-96.

Background

Victor Fargo and his wife, Victoria King have been engaged in the California real estate business since the 1980s. King is a licensed real estate broker and the couple conducted their business through a number of entities, including Fargo Industries Corp. (Fargo Corp), a C corporation wholly owned by Fargo, and Girard Development, L.P. (Girard LP), a partnership of which Fargo and King were the majority partners.

In 1988, Fargo Corp acquired a leasehold from La Jolla Country Club, and planned to develop a 72-unit apartment complex and retail space on the property. The company also acquired the improvements that had been developed on the land, including a tenant-occupied building leased by a medical company, along with plans, drawings, reports, surveys, and a permit. Fargo Corp, Girard LP and other entities owned by Fargo and King used part of the building as office space.

In 1991 Fargo Corp transferred the leasehold in the property to Girard LP for a capital contribution credit. Due to a dramatic decline in the La Jolla real estate market in the 90's, development of the property was suspended. Despite the decline, in 1997 the partnership purchased the property from La Jolla Country Club for $1,750,000 as part of an attempt to obtain financing to continue development, and through 2001 the property was developed for residential use. However, the extent of physical improvements to the property was limited to minor repairs.

The only effort to sell the property was made in 1993, when Girard LP entered into a marketing and brokerage agreement with a real estate company owned by King. Even then, no substantial efforts were made to solicit potential buyers.

In 2001, Centex Homes made an unsolicited offer to purchase the property from Girard LP for $14,500,000, plus a share of the home sales profits, and the sale was completed in 2002. Centex Homes agreed to develop residential townhouses largely on the basis of Fargo's previous plans.

On its 2002 tax return, Girard LP reported a capital gain of $628,222 from the sale of the property. After auditing the return, the IRS issued a notice of final partnership administrative adjustment (FPAA), determining that the partnership had realized ordinary income from the sale in the amount of $7,474,645.

Analysis

Code Sec. 1221(a)(1) defines a capital asset as property held by the taxpayer, but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

The Tax Court has identified several factors for evaluating whether a taxpayer held certain properties primarily for sale to customers in the ordinary course of business, including:

(1) the purpose for which the property was initially acquired;

(2) the purpose for which the property was subsequently held;

(3) the extent to which improvements, if any, were made to the property by the taxpayer;

(4) the frequency, number, and continuity of sales;

(5) the extent and nature of the transactions involved;

(6) the ordinary business of the taxpayer;

(7) the extent of advertising, promotion, or other active efforts used in soliciting buyers for the sale of the property;

(8) the listing of property with brokers; and

(9) the purpose for which the property was held at the time of sale (Maddux Constr. Co. v. Comm'r, 54 T.C. 1278 (1970)).

The Tax Court held that the factors, when viewed together, weighed in favor of finding that, at the time of the sale, the La Jolla property was sold in the ordinary course of business under Code Sec. 1221(a)(1).

The court determined that Fargo Corp's original intent when it acquired the leasehold was to develop the property for resale to customers, and found Girard LP's subsequent purchase further supported that intent. Additionally, the court noted that the partnership never abandoned its development plans, even with the downturn in the La Jolla real estate market, and incurred substantial fees related to development expenses by the time the property was sold. The court found these first two factors favored the IRS's position.

The court found that factors (3), (4), (7), and (8) weighed in favor of Girard LP: the partnership never substantially improved the property; the La Jolla property was its first sale; it did not actively advertise or promote the property for sale outside of a contract with King's real estate office, and, even then, the broker made minimal efforts to contact buyers or market the property. The court did not address the sixth factor.

The court concluded that the fifth and ninth factors strongly favored the IRS. The property was sold to an unrelated entity which agreed to continue to develop the property and share profit with Girard LP, which the court noted was important to the decision to sell the property. The court pointed out the taxpayer's purpose at the time of sale was the most relevant factor, and noted Girard LP had been continuously increasing its development efforts leading up to the sale. The court believed the increased development demonstrated an intent to sell the property to customers rather than to hold it as an investment.

After weighing the factors, the Tax Court held that Girard LP sold the property in the ordinary course of its business under Code Sec. 1221(a)(1), and sustained the IRS's determination that the partnership had realized ordinary income, rather than capital gain on the 2002 sale.

For a discussion of capital assets, see Parker Tax ¶ 111,105.

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IRS Extends Time to File Forms 3115 for Some Fiscal Year Taxpayers and Tweaks Earlier Guidance

The IRS has granted certain fiscal year taxpayers extended time to file Forms 3115 in consideration of the timing of the release of the final tangible property regulations. In addition, the IRS has made clarifying updates to earlier guidance on procedures for obtaining automatic consent for changes in accounting methods. Rev. Proc. 2015-33.

Background

In January of 2015, the IRS issued new revenue procedures, Rev. Procs. 2015-13 and 2015-14, that amplified, clarified, modified and partly superseded the former procedures under Rev. Proc. 2011-14 for changing a method of accounting. The two revenue procedures effectively split former Rev. Proc. 2011-14 into two parts: Rev. Proc. 2015-13 contains the general procedures for changing methods of accounting, either with IRS consent or automatically, and Rev. Proc. 2015-14 lists the automatic changes originally contained in the appendix to Rev. Proc. 2011-14.

Rev. Proc. 2015-33 clarifies several items in Rev. Proc. 2015-13 regarding certain procedures for changing a method of accounting. Specifically, the revenue procedure  

(1) modifies the transition rules of Rev. Proc. 2015-13 to provide additional time to file Forms 3115;  

(2) clarifies when the automatic change procedures do not apply if the taxpayer engages, within the requested year of change, in a transaction to which Code Sec. 381(a) applies;  

(3) clarifies the meaning of "three-month window" under Rev. Proc. 2015-13 for a taxpayer with a 52-53 week tax year; and  

(4) discusses a clarification to the applicable Ogden, UT, address to which taxpayers must mail their Forms 3115.

Additional Time to File Form 3115

The IRS issued final tangible property regulations in T.D. 9636 and T.D. 9689 in August 2013 and September 2014, respectively. The regulations, which generally apply to tax years beginning on or after January 1, 2014, are expected to necessitate changes in accounting methods by many taxpayers.

Section 15.02(1)(a)(ii) of Rev. Proc. 2015-13 provides that a taxpayer may file a Form 3115 for an automatic change under the procedures of either former Rev. Proc. 2011-14 or current Rev. Proc. 2015-13, to request the IRS' consent to change a method of accounting for a tax year ending between May 31, 2014 and January 31, 2015, until the due date (including extensions) of the taxpayer's original federal income tax return for the requested year of change.

The current provision does not allow taxpayers with tax years ending after January 31, 2015, to request an automatic change under the procedures of Rev. Proc. 2011-14. Rev. Proc. 2015-33 extends the transition procedures of section 15.02(1)(a)(ii) of Rev. Proc. 2015-13 to all taxpayers for their first tax year in which the final tangible property regulations apply.

Specifically, the revenue procedure modifies section 15.02(1) of Rev. Proc. 2015-13 to allow a taxpayer to request an automatic change under the procedures of either former Rev. Proc. 2011-14 or current Rev. Proc. 2015-13 for a tax year ending on or after May 31, 2014, and beginning before January 1, 2015.

Observation: The transition relief provided in Rev. Proc. 2015-33 applies to all automatic method changes, not just changes pursuant to the final tangible property regulations.

Clarification of When Automatic Change Procedures Don't Apply

Sections 5.01(1)(c) and 5.02 of Rev. Proc. 2015-13 provide that a taxpayer engaging in a liquidation or reorganization transaction to which Code Sec. 381(a) applies may not use the automatic change procedures to request a change to a principal method, as prescribed by Reg. Sec. 1.381(c)(4)-1(d)(1) and 1.381(c)(5)-1(d)(1), because, in general, an acquiring corporation does not need to secure the IRS's consent to use a principal method. Those regulations provide guidance regarding the method of accounting or the inventory method an acquiring corporation must use following a distribution or transfer to which Code Sec. 381(a) applies.

The rules inadvertently excluded from the automatic change procedures certain changes other than a change to a principal method. Accordingly, Rev. Proc. 2015-33 modifies Sections 5.01(1)(c) and 5.02 of Rev. Proc. 2015-13 to exclude from the automatic change procedures only a change to the principle method, as described in Reg. Sec. 1.381(c)(4)-1(c)(1) and 1.381(c)(5)-1(c)(1).

Clarification of the "Three-Month Window"

Section 8.02(1)(a)(ii) of Rev. Proc. 2015-13 provides that a "three-month window" is the period beginning on the fifteenth day of the seventh month of the taxpayer's tax year and ending on the fifteenth day of the tenth month of the taxpayer's tax year. Because the rule is not expressed with reference to the first or last day of a specified calendar month, it is unclear how this provision applies to a taxpayer using a 52-53 week tax year. Accordingly, Rev. Proc. 2015-33 modifies Rev. Proc. 2015-13 to provide that, for determining the "three-month window," the tax year begins on the first day of the calendar month nearest to the first day of the 52-53 week tax year.

Updated Ogden, UT Address

Several provisions of Rev. Proc. 2015-13 provide that a signed copy of the original Form 3115 must be filed with the IRS in Ogden, UT, at the applicable address in section 9.05 of Rev. Proc. 2015-1 (or successor). The U.S. Post Office no longer accepts the Ogden, UT, zip code provided in Rev. Proc. 2015-1 for certified mail. To send certified mail through the U.S. Post Office to the IRS processing facility in Ogden, UT, taxpayers should use the following mailing address:

Internal Revenue Service

1973 Rulon White Blvd.

Mail Stop 4917

Ogden, UT 84201-1000

For a discussion of accounting method change procedures, including the updated procedures in Rev. Procs. 2015-13 and 2015-14, see Parker Tax ¶ 241,590.

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S Corp Incurs Hefty Penalties for Failure to Report Welfare Benefit Fund on Form 8886

A federal district court determined that because taxpayer had enrolled his S corporation in a welfare benefit fund that was a tax avoidance transaction, penalties imposed for failure to file forms reporting his participation in a listed transaction were appropriate. Vee's Marketing Inc. v. U.S., 2015 PTC 166 (W.D. Wis. 2015).

Background

After a profitable year brokering onions as the sole employee of his S corporation, Vee's Marketing, Inc. (VMI), Scott Vee faced a sizable tax bill for 2004. A sales representative from CJA and Associates (CJA) suggested he could reduce his tax burden by setting aside money in its Affiliated Employers Health & Welfare Trust (the Trust), which CJA marketed as a 10-or-more multiple employer welfare benefit fund that was tax-exempt under Code Sec. 419A(f)(6). The salesman told Vee that payments into the fund would reduce the amount of his taxable income, and would provide term insurance plus a paid-up $1,000,000 of life insurance that could, if Vee wished, be used upon retirement for reimbursement of medical expenses.

Vee enrolled VMI in the plan in 2004, contributed $145,000 to the Trust, and paid $1250 in fees. CJA used $5400 of the contribution to pay for one year of term life insurance on Vee's life; the remainder went into an account to fund Vee's death benefit. VMI made additional $20,750 contributions each year from 2005 to 2007. In total, for the years 2004 to 2007, VMI contributed $227,250 to the Trust and deducted that amount from its business income, reducing Vee's taxable income.

When CJA set up the Trust, it chose to maintain each participant's account independent of the account of any other participant. The Trust also owned the insurance contracts used to fund the death benefits, which effectively operated as universal life insurance policies. As of 2010, VMI was one of more than 50 employers contributing to the Trust.

In 2011, the IRS determined that VMI should have filed Form 8886, Reportable Transaction Disclosure Statement for each year as a participant in the Trust, claiming that the CJA plan was substantially similar to a tax avoidance transaction described in Notice 95-34. The IRS assessed a $10,000 penalty per year for 2004 to 2007 under Code Sec. 6707A, which imposes penalties on persons who fail to include information on their returns with respect to a reportable transaction. VMI paid the penalties and filed a claim for refund.

Analysis

Code Sec. 419 and Code Sec. 419A generally limit deductions taxpayers can take for contributions to welfare benefit funds. Code Sec. 419A(f)(6) provides an exemption from these limitations for 10-or-more employer plans. In general, for this exemption to apply, no employer may contribute more than 10 percent of the total contributions and the plan must not be experience-rated with respect to individual employers (i.e. structured so that each employer's contributions benefit only its own employees).

In Notice 95-34, the IRS discussed certain trust arrangements that purportedly qualify as multiple employer welfare benefit funds exempt from the limits of Code Sec. 419 and Code Sec. 419A, concluding that such arrangements do not provide the tax deductions that trust promoters claim and, instead, are tax avoidance transactions. Among other warning signs, these arrangements typically invest in variable life or universal life insurance contracts on the lives of the covered employees, but require large employer contributions relative to the cost of the term insurance required to provide death benefits under the arrangement.

The District Court determined that a close look at the Trust showed that although it purported to operate as a 10-or-more employer welfare benefit fund exempt from income tax, it clearly exhibited the warning signs identified by the IRS in Notice 95-34.

The court noted contributions of participants in the Trust were typically invested in variable life or universal life insurance contracts, and VMI's first year contribution to the CJA plan was $165,000, which was far in excess of the $5400 cost of term insurance for the first year.

The court found the Trust exhibited additional warning signs, such as the fact it owned the insurance contracts paid for by participants, and that the Trust, acting through CJA, withdrew cash from Vee's accumulation account on at least four occasions. The court pointed out that when marketing the plan, CJA touted the ability of participants to withdraw funds before death, a feature in common with the listed transaction in Notice 95-34.

The court noted that to receive the value of his life insurance policy, Vee did not have to die before his normal retirement age or become disabled; he was assured of receiving the value of his million dollar life insurance policy so long as his premiums were paid, which was another aspect of the Notice 95-34 transactions. Additionally, since the benefits were designed to relate exactly to the amounts allocated to the employees of the participant's employer, the money that participating employers paid into the plan bought insurance for only their own employees, making the Trust experience-rated with respect to the individual employers.

Finding that the Trust shared substantially all of the features of the listed transactions in Notice 95-34, the District Court determined that the welfare benefit plan in which Vee enrolled VMI was a tax avoidance transaction. Because the plan was a reportable transaction, Vee should have filed Form 8886 for each year in which he participated and the court held the penalties imposed were proper.

For a discussion of welfare benefit plans, see Parker Tax ¶ 98,900.

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Penalties Paid to Employee by Employer for Delayed Final Paycheck Are Not FICA Wages

The IRS Office of Chief Counsel advised that penalty amounts paid to an employee by an employer under the California State Labor Code for the employer's failure to timely pay the employee's final wages were not themselves wages for federal employment tax purposes. CCA 201522004.

Background

In CCA 201522004, the IRS Office of Chief Counsel (IRS) responded to an inquiry about whether payments that an employer is required to make under California law to a terminated or quitting employee if the employer fails to pay the employee's final wages within the required time period provided by state law, are wages for purposes of the Federal Insurance Contributions

Act (FICA), the Federal Unemployment Tax Act (FUTA), and federal income tax withholding.

Under the facts of the CCA, a corporation was required to pay late payment penalties when it failed to pay an employee's final paychecks by the due date provided under California state law.

Section 203 of the California State Labor Code provides for a late payment penalty if an employer willfully fails to pay, by the due dates imposed by the CA Labor Code, any wages of an employee who is discharged or who quits. Under Section 203, if the late payment penalty applies, the wages of the employee continue as a penalty from the due date of the final paycheck at the same rate until paid or until an action, such as filing a complaint in court, is commenced.

The penalty under Section 203 of the State Labor Code is based on the employee's daily rate of pay and is calculated by multiplying the daily wage by the number of days that the paycheck was delayed, up to a maximum of 30 days. The 30-day period is calendar days, and includes weekends and holidays and any other days that the employee would not normally work.

Analysis

The term "wages" is defined in Code Sec. 3121(a) for FICA purposes as all remuneration for employment, with certain specific exceptions. Although there are differences in the statutory exceptions concerning what constitutes wages, the general definition of "wages" for FUTA and Federal income tax withholding purposes are similar to the definitions for FICA purposes.

Reg. Sec. 31.3121(a)-1(c), 31.3306(b)-1(c), and 31.3401(a)-1(a)(2) provide that the name by which remuneration for employment is designated is immaterial. Thus, salaries, fees, bonuses, and commissions on sales or on insurance premiums, are wages if paid as compensation for employment.

Rev. Rul. 2004-110 holds that an amount paid to an employee as consideration for cancellation of an employment contract and relinquishment of contract rights is ordinary income and wages for purposes of FICA, FUTA, and federal income tax withholding.

Rev. Rul. 72-268 held that since payments of unpaid minimum wages and unpaid overtime compensation were remuneration for employment, the payments were wages for federal employment tax purposes. However, the ruling further held that payments representing liquidated damages in addition to unpaid wages and overtime were not remuneration for employment and thus were not wages for federal employment tax purposes.

The IRS noted that the late payment penalty under Section 203 of the California State Labor Code is different from severance pay because it is based on the employer's failure to pay final wages on a timely basis. The IRS found the employee had no right to payment of the late payment penalty based on his services as an employee. The IRS also noted that the Supreme Court of California stated in Pineda v. Bank of America, 241 P.3d 870 (2010) that Section 203 is not designed to compensate employees for work performed but is intended to encourage employers to pay final wages on time and to punish employers who fail to do so.

The IRS pointed out the payment of the penalty did not satisfy the definition of wages in Rev. Rul. 2004-110 because the penalty was not part of the terms and conditions of employment, but a separate statutorily imposed penalty. The IRS found that the penalty was similar to the additional liquidated damages in Rev. Rul. 72-268 that were held not to be wages for employment tax purposes.

The IRS noted the Section 203 late payment penalty is a statutorily-imposed penalty for employer misconduct that is in addition to the employee's wages. The penalty varies in amount based on the extent of the employer's misconduct (i.e., the number of days that the employer fails to pay the wages after the due date) rather than the level of services performed by the employee, and is not a substitute for the employer's liability for the payment of wages. The IRS pointed out that in fact, because the penalty is based on calendar days rather than work days, the penalty amount is not the same as the amount of wages the employee would have received if he worked during the period the penalty was imposed.

Because the penalty payment was in addition to the past-due employment wages and not tied to services performed by the employee, the IRS concluded that, based on Rev. Rul. 72-268, the payment of the late payment penalty was not wages for federal employment tax purposes.

Observation: The IRS cautioned that its conclusion does not apply to the meal and rest period payments made under CA Labor Code Section 226.7. Under that provision, if an employer fails to provide an employee a meal period or rest period in accordance with state requirements, the employer must pay the employee one additional hour of pay at the employee's regular rate of compensation for each day that the meal or rest period is not provided. Because these payments are essentially additional compensation for the employee performing additional services during the time the meal and rest periods should have been provided, the IRS notes it appears those payments would be wages for federal employment tax purposes.

For a discussion of payments subject to withholding, see Parker Tax ¶ 212,110.

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IRS to Refund Registered Tax Return Preparer Test Fees

The IRS has announced that, due to the invalidation of the Registered Tax Return Preparer program, it will be refunding fees incurred by preparers who took the competency test. The IRS has also released a FAQ addressing the refund. IRS RTRP Test Fee Refund FAQ (05/21/15).

Background

In 2011, the IRS issued regulations that mandated testing and continuing education (CE) for paid tax return preparers and created a Registered Tax Return Preparer (RTRP) credential. The RTRP designation was for preparers with valid preparer tax identification numbers, who passed an IRS competency test and completed 15 hours of CE. Return preparers were required to pay a $116 fee to take the test.

In Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2014), the D.C. Circuit Court of Appeals upheld a D.C. District Court's holding that the RTRP program was invalid because the IRS did not have the legal authority to require education and testing. As a result, the IRS is refunding the test fees to individuals who took the Registered Tax Return Preparer test.

Observation: Before the Loving v. IRS decision invalidated the RTRP program, over 62,000 return preparers passed an IRS-administered competency test and completed the requirements to become RTRPs.

In June, 2014, the IRS launched a new voluntary program called the Annual Filing Season Program. In Rev. Proc. 2014-42 (6/30/14), the IRS provided guidance on the new program and what tax return preparers have to do to earn a "Record of Completion," which tells the public they have met the applicable IRS requirements with respect to tax returns or refund claims they have prepared and signed.

RTRP Refunds

The IRS has stated that no action is necessary on the part of preparers who participated in the RTRP program; Letter 5475, RTRP Refund Notification Letter, will be mailed approximately May 28, 2015, to people due an RTRP test refund. Refund checks will be mailed separately approximately June 2, 2015, and preparers should allow until August 2, 2015 to receive the refund.

Preparers who took the test more than once will receive one refund for the total test fees paid ($116 per test attempt). Whether the refund is taxable depends upon a number of factors, including whether the amount was deducted previously as a business expense. . Additionally, refunds will be only issued to the individual who took the test, so third parties, such as businesses, who paid test fees will need to resolve any reimbursement issues directly with the person who took the test.

The IRS will not reimburse other expenses related to taking the test, such as gas and travel or hotel bills. Preparers who passed the test may keep their RTRP Certificate, however, the IRS notes it is no longer valid and serves no purpose when dealing with the IRS.