IRS Issues Inflation Factors and Reference Prices for Calculating Sec. 45 Credits; IRS Issues Reference Price for Section 45I Credit; IRS Issues Applicable Percentage for Depletion of Marginal Properties in 2018 ...
Taxpayer Was Independent Contractor, Notwithstanding Employee Status Indicated on Form W-2
The Tax Court held that an aerospace engineer who provided consulting services to a company through a temporary employment agency was a statutory employee, even though he received a Form W-2 indicating that he was a common law employee, and thus could report business income and expenses on Schedule C and avoid the Schedule A limitations on the deduction of unreimbursed employee business expenses and the phaseout of itemized deductions. However, the Tax Court disallowed the taxpayer's deductions for business and other expenses due to the taxpayer's failure to adequately substantiate the expenses. Fiedziuszko v. Comm'r, T.C. Memo 2018-75.
In a case of first impression, the First Circuit affirmed a district court and held that an employee of the IRS "willfully violates" a bankruptcy discharge order when the employee knows of the discharge order and takes an intentional action that violates that order. Under Code Sec. 7433(e), the court said, the IRS's good faith belief that it has a right to collect purportedly discharged debts is not relevant to determining whether it willfully violated a discharge order and, in the instant case, the IRS met the applicable standard and violated a discharge order and was thus liable for damages. IRS v. Murphy, 2018 PTC 165 (1st Cir. 2018).
Tax Court Reduces Taxpayer's Basis in Solar Panel Venture, but Finds in Taxpayer's Favor on Bonus Depreciation and Other Issues
The Tax Court held that a taxpayer who purchased solar panels installed on host properties, and who acquired rights under agreements with the host property owners to provide electricity contingent on receiving tax credits and other incentives, had a basis in the solar equipment equal to the amount of a promissory note that partially financed the purchase but could not include in his basis a down payment that was never made, nor a credit for rebates that the host property owners assigned to the previous solar panel owner before the sale. The Tax Court also found that the taxpayer's investment qualified for the bonus depreciation deduction and that the taxpayer (1) was at risk with respect to the promissory note, (2) materially participated in the venture for purposes of the passive loss rules, and (3) was not liable for penalties assessed by the IRS because he had reasonable cause and acted in good faith. Golan v. Comm'r, T.C. Memo. 2018-76 (2018).
IRA Trustee Must Withhold Federal Taxes on Amounts Paid to Unclaimed Property Fund
The IRS ruled that a payment by individual retirement account (IRA) trustee of an individual's interest in an IRA to a state's unclaimed property fund, as required by state law, is subject to federal income tax withholding under Code Sec. 3405. In addition, the payment by the trustee is subject to reporting under Code Sec. 408(i). Rev. Rul. 2018-17.
The Third Circuit affirmed a district court and held that a 50 percent partner in an architectural company was a responsible person and thus was liable for trust fund penalties relating to the nonpayment of employment taxes for years 2007-2009. The court rejected the taxpayer's argument that payment of the taxes was the responsibility of his deceased business partner. Commander v. Comm'r, 2018 PTC 151 (3d Cir. 2018).
The Eleventh Circuit held that a member of an Indian tribe who received per capita distributions of revenue from tribal gaming activities was not entitled to exclude the distributions from income as Indian general welfare benefits under the Tribal General Welfare Exclusion Act (GWEA). The court found that Congress specifically intended that such distributions be subject to tax when it passed the Indian Gaming Revenue Act (IGRA) and found that the GWEA, enacted after the IGRA, was not intended to release such payments from taxation. U.S. v. Jim, 2018 PTC 161 (11th Cir. 2018).
The Federal Circuit denied a bank's refund claim resulting from losses and deductions it claimed it incurred from the amortization and abandonment of intangible assets obtained through mergers with failing savings and loan institutions in the 1980s. The Federal Circuit upheld a finding by the Court of Federal Claims that the bank had zero basis in the assets because there were significant errors in the bank's valuation, and it rejected the bank's argument that the Claims Court should have undertaken an independent allocation of basis among the assets. WMI Holdings Corp. v. U.S., 2018 PTC 160 (Fed. Cir. 2018).
Taxpayer Was Independent Contractor, Notwithstanding Employee Status Indicated on Form W-2
The Tax Court held that an aerospace engineer who provided consulting services to a company through a temporary employment agency was a statutory employee, even though he received a Form W-2 indicating that he was a common law employee, and thus could report business income and expenses on Schedule C and avoid the Schedule A limitations on the deduction of unreimbursed employee business expenses and the phaseout of itemized deductions. However, the Tax Court disallowed the taxpayer's deductions for business and other expenses due to the taxpayer's failure to adequately substantiate the expenses. Fiedziuszko v. Comm'r, T.C. Memo 2018-75.
In 2012, Slawomir Fiedziuszko was a semiretired aerospace engineer who worked as a consultant for Space Systems Loral (Loral). Fiedziuszko found consulting work by attending conferences and traveling to visit potential clients. He provided services to Loral through West Valley Engineering Co., a temporary employment agency. Fiedziuszko's contract with Loral began in 2011 and ended in July 2012. He worked primarily from home on a satellite development project.
West Valley processed Fiedziuszko's weekly pay and withheld income, social security and Medicare taxes. West Valley did not offer any benefits other than a deferred compensation plan. On Fiedziuszko's 2011 Form W-2, West Valley checked the box indicating that he was a statutory employee. However, West Valley did not check that box on Fiedziuszko's 2012 Form W-2.
Mr. Fiedziuszko and his wife, Alicia, filed a joint tax return for 2012 on Form 1040, which they prepared themselves. The Fiedziuszkos took the position that Mr. Fiedziuszko was a statutory employee and claimed deductions on Schedule C, Profit or Loss from Business, for expenses related to Mr. Fiedziuszko's consulting business. These expenses included $2,000 for supplies, $5,000 for travel (including meals and lodging), $9,500 for insurance, and $2,000 for advertising. They also claimed a deduction of $29,000 for self-employed health insurance.
Mrs. Fiedziuszko was diagnosed with morbid obesity in 2011; Mr. Fiedziuszko was also considered obese and displayed prediabetic indications. On the advice of their doctor, the Fiedziuszkos entered a medically supervised weight loss program designed by Health Management Resources (HMR) and administered through a healthcare provider. The Fiedziuszkos reported approximately $16,000 of deductible medical expenses for the cost of the HMR program, as well as expenses for other medical services. In total, the Fiedziuszkos claimed over $19,000 of medical expense deductions for 2012.
The Fiedziuszkos also claimed charitable contribution deductions in 2012 of $2,800 in cash contributions and over $27,000 in noncash contributions. Mr. Fiedziuszko claimed he made cash contributions to a church and noncash contributions to Goodwill consisting of furniture, clothing, and miscellaneous household goods.
The Fiedziuszkos received pension and annuity payments in 2012 totaling over $72,000 and reported on Forms 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. They included only $37,000 of the payments in income, although the Forms 1099-R indicated that all of the income was taxable.
The IRS issued a notice of deficiency in 2015 determining a deficiency of over $31,000 and applying a substantial underpayment penalty of $6,200. The IRS determined that Mr. Fiedziuszko was not a statutory employee for 2012, and therefore could not report business income and expenses on Schedule C. All of the Fiedziuszkos' deductions were disallowed on the basis that they were not adequately substantiated. The notice further determined that the Fiedziuszkos failed to report all of their pension income, and applied a Code Sec. 6662(a) penalty for a substantial understatement. The Fiedziuszkos challenged the notice in the Tax Court.
To substantiate the Fiedziuszkos' expenses, Mr. Fiedziuszko prepared for trial statements of fact outlining his business expenses. He also prepared a statement listing the dates and amounts of payments for the HMR weight loss program. Mr. Fiedziuszko's cash contributions to the church were documented by calendar pages with handwritten notes, some of which were illegible. A list of the items donated to Goodwill showed each item's claimed fair market value, which was simply the listed sale price for a similar item on EBay or Amazon as of October 2014.
The Tax Court held that Mr. Fiedziuszko was a statutory employee in 2012 and thus was entitled to report business income and expenses on Schedule C and avoid the Schedule A limitations on the deduction of unreimbursed employee business expenses and the phaseout of itemized deductions. However, the court denied all of the Fiedziuszkos' claimed business and medical expense deductions due to lack of substantiation. The court also held that Mr. Fiedziuszko's pension income was includible in income, and upheld the substantial understatement penalty.
The court found that the totality of the circumstances showed that Mr. Fiedziuszko was a statutory employee in 2012. The fact that his Form W-2 did not indicate he was a statutory employee was, in the court's view, a mistake. His Form W-2 for 2011 indicated he was a statutory employee and the court found that nothing changed between 2011 and 2012, because Mr. Fiedziuszko was providing services under the same contract. Further, the facts showed that Mr. Fiedziuszko and Loral intended to form an independent consulting relationship. Mr. Fiedziuszko worked out of his home office, advertised his services to several companies, and was hired through a temporary staffing agency. The relationship was a temporary assignment, and the weekly payroll deposits and withholdings were consistent, in the court's view, with a consulting contract.
The court, however, disallowed all of Mr. Fiedziusko's business expenses due to lack of substantiation. Mr. Fiedziuszko's travel, lodging and meal expenses did not meet the heightened substantiation requirements of Code Sec. 274(d) because the court found that the calendar and statement of facts provided by Mr. Fiedziuszko did not provide a sufficient basis for determining the amounts of the expenses. Moreover, while Mr. Fiedziuszko provided a total amount he claimed he spent on supplies, he did not provide any supporting documentation other than checking account statements, which did not specify for what services the payments were made or allocate between business and personal use.
The Tax Court also found that, while the Fiedziuszkos incurred expenses for medical care under Code Sec. 213, they failed to adequately substantiate the expenses. In the court's view, a statement that Mr. Fiedziuszko prepared for trial was not an itemized statement from the medical care provider as requested by the IRS. Nor was his statement and testimony sufficient substitutes for an itemized statement, because there was no additional corroborating documentation for the payments.
The court found that the Fiedziuszkos failed to substantiate their charitable contributions. They produced no evidence of the cash contributions other than cryptic calendar entries. The Fiedziuszkos also failed to present reliable written records of their noncash contributions or evidence of the condition of the items donated. With respect to the clothing and household items, the court found that the Fiedziuszkos did not establish that their condition was in good used condition or better.
The court found that Mr. Fiedziuszko's pension income that the couple received was taxable in full based on the Forms 1099-R. The Tax Court also held that the Fiedziuszkos did not show reasonable cause for the underpayment of tax and upheld the assessed penalty because they failed to explain the understatement or to adequately substantiate their expenses.
For a discussion of determining employment status, see Parker Tax ¶210,110. For a discussion of substantiation requirements of expenses, see Parker Tax ¶91,130. For a discussion of the penalty for a substantial understatement of tax, see Parker Tax ¶262,120.10.
IRS Liable for Damages for Willfully Violating Bankruptcy Discharge Order
In a case of first impression, the First Circuit affirmed a district court and held that an employee of the IRS "willfully violates" a bankruptcy discharge order when the employee knows of the discharge order and takes an intentional action that violates that order. Under Code Sec. 7433(e), the court said, the IRS's good faith belief that it has a right to collect purportedly discharged debts is not relevant to determining whether it willfully violated a discharge order and, in the instant case, the IRS met the applicable standard and violated a discharge order and was thus liable for damages. IRS v. Murphy, 2018 PTC 165 (1st Cir. 2018).
Background
In 2005, William Murphy filed a Chapter 7 petition in bankruptcy court. On Schedule E of his bankruptcy petition, Murphy listed his income tax obligations to the IRS for the years of 1993-1998, 2000, 2001, and 2003, as well as a 2003 tax obligation to the Maine Revenue Services. Murphy's tax obligations were by far the largest liabilities he sought to discharge. In his petition, Murphy listed total liabilities of approximately $600,000 of which approximately $546,000 were tax obligations. On January 20, 2006, Assistant U.S. Attorney Frederick Emery, Jr. filed an appearance on behalf of the IRS in the bankruptcy proceeding.
In 2006, the bankruptcy court granted Murphy a discharge. The discharge order stated that the "debtor is granted a discharge under section 727 of title 11, United States Code, (the Bankruptcy Code)." Beneath the bankruptcy judge's signature, was a notice which stated, in bold and capital letters, "SEE THE BACK OF THIS ORDER FOR IMPORTANT INFORMATION." The back of the order provided an explanation of bankruptcy discharge in a Chapter 7 case, stating that "[t]he discharge prohibits any attempt to collect from the debtor a debt that has been discharged." The order listed some of the common types of debts which are not discharged and specifically noted that "[d]ebts for most taxes" are not discharged.
The IRS did not believe that the discharge relieved Murphy of his tax obligations. Rather, the IRS viewed Murphy's taxes as excepted from discharge under 11 U.S.C. Sec. 523(a)(1)(C), which excludes from discharge any tax if "the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax." Based on its earlier investigations into Murphy, the IRS believed that Murphy had willfully attempted to evade taxes during all of the years in question and informed Murphy of its beliefs. On February 20, 2009, the IRS issued levies against several insurance companies with which Murphy then did business in an attempt to collect on Murphy's tax obligations.
In 2009, Murphy filed an adversarial proceeding seeking a declaration that his tax obligations from 1993-1998, 2000, and 2001 had been discharged. In this proceeding, Assistant U.S. Attorney Emery (Emery) again represented the IRS. According to the IRS, Emery failed to submit evidence to the bankruptcy court that the IRS had developed during its investigation into Murphy's tax obligations. Instead, the IRS claimed that Emery merely filed a summary of the IRS's allegations of Murphy's tax evasion, without submitting any admissible evidence to support the allegations.
In 2009, Murphy filed an adversarial proceeding seeking a declaration that his tax obligations had been discharged. In this proceeding, Emery represented the IRS. In 2010, the bankruptcy court granted summary judgment in Murphy's favor and declared that Murphy's tax obligations had been discharged. The bankruptcy court later noted that it granted summary judgment in large part because the IRS's opposition to summary judgment fell far short of applicable substantive and procedural standards. The IRS did not appeal the bankruptcy court's 2010 summary judgment ruling.
Subsequently, Emery was diagnosed with frontotemporal dementia (FTD). According to the IRS, symptoms of FTD include "impairment of executive function, such as the cognitive skill of planning and organizing." Based on Emery's medical records and the opinions of three physicians, the IRS believed that Emery was already experiencing the symptoms of FTD in 2010.
In February 2011, Murphy filed a complaint against the IRS and sought damages under Code Sec. 7433(e), alleging that an employee of the IRS willfully violated the bankruptcy court's 2006 discharge order in 2009 by issuing levies against the insurance companies with which he did business and thereby attempting to collect on his discharged tax obligations. Code Sec. 7433(e) provides that if, in connection with any collection of federal tax with respect to a taxpayer, any officer or employee of the IRS willfully violates any provision of 11 U.S.C. Sec. 362 (relating to an automatic stay) or Sec. 524 (relating to effect of discharge), such taxpayer may petition the bankruptcy court to recover damages against the United States.
The IRS responded that it did not willfully violate the order because it reasonably believed Murphy's tax obligations were excepted from discharge under 11 U.S.C. Sec. 523(a)(1)(C) based on its investigation into his alleged tax evasion.
The bankruptcy court granted summary judgment for Murphy on the Code Sec. 7433(e) claim. The IRS then appealed to the district court. While the district court concluded that the bankruptcy court should have considered Emery's impairment, it nonetheless agreed with the bankruptcy court's definition of "willfully violates" as used in Code Sec. 7433(e). The district court found that, by 1998, the term had an established meaning in the context of violations of both automatic stays and discharge injunctions, and under this established meaning, a creditor's "good faith belief in a right to the property is not relevant to a determination of whether the violation was willful."
On remand, the parties entered into a settlement agreement, whereby the IRS waived certain arguments and accepted that the 2010 summary judgment ruling conclusively determined that Murphy's tax obligations had been discharged. The IRS reserved the right, however, for further appeal of its arguments that a debtor is not entitled to damages where a creditor's violation of a discharge order reflects a reasonable belief that the debt involved was excepted from discharge, and/or that the "willfully violates" language in Code Sec. 7433(e) should be construed to permit the IRS to defend against liability for violating the discharge on the basis that its employee reasonably believed that the tax involved is excepted from discharge (i.e., the "willfully violates" issue).
As part of the settlement, the IRS agreed to pay $175,000 in damages once it had exhausted the reserved right to appeal. The settlement did not resolve whether or not the deficiencies in the IRS's response to Murphy's motion for summary judgment were caused by any mental disability of the part of Emery at the time of the summary judgment proceedings. On January 4, 2017, the bankruptcy court entered final judgment against the United States, and the district court affirmed the judgment. The IRS appealed to the First Circuit.
IRS Arguments
The sole issue before the First Circuit was the bankruptcy court's resolution of a legal question involving the construction of the phrase "willfully violates" as used in Code Sec. 7433(e). The IRS argued that it cannot "willfully violate" an automatic stay or discharge order if it has a good faith belief that its actions do not violate a bankruptcy court's order. In support of its position, the IRS presented two arguments. First, it claimed that, before Congress enacted Code Sec. 7433(e) in 1998, all creditors could raise a good faith defense to allegations that they willfully violated an automatic stay or discharge order. Second, it posited that even if most creditors could not raise a good faith defense, such a defense must be available to the IRS because Code Sec. 7433(e) is a waiver of sovereign immunity that must be construed narrowly.
First Circuit's Analysis
The First Circuit affirmed the bankruptcy and district court and concluded that the phrase "willful violation" had an established meaning in the context of violations of automatic stays as of 1998 and that a creditor willfully violated the automatic stay if it knew of the automatic stay and took an intentional action that violated the automatic stay. A good faith belief in a right to
the property, the court said, is not relevant to determining whether the creditor's violation is willful.
With respect to the IRS's first argument, the court noted that the term, "willful violation" already had an established meaning in 1998 and Congress used that established meaning in Code Sec. 7433(e) to set the standard for evaluating violations of both automatic stays and discharge orders. The court also rejected the IRS's alternative argument that even if there was a generally accepted definition of "willful violation," such a definition is too broad to be applied against the United States because Code Sec. 7433(e) is a waiver of sovereign immunity and such waivers must be narrowly construed. According to the court, by directly linking the phrase "willfully violates" in Code Sec. 7433(e) to Sections 362 and 524 of the Bankruptcy Code, Congress sought to use the generally accepted definition of the phrase "willful violation" in this context as the limit to the waiver of sovereign immunity. And, when the court looked past 1998, it found that subsequent caselaw and the administrative materials from the IRS itself both confirmed that the generally accepted standard should control. For that reason, the court did not believe sovereign immunity required it to adopt a more narrow definition of the term "willfully violates."
Observation: Judge Lynch dissented, saying that to the best of her knowledge, this was the first opinion by a circuit court construing the phrase "willfully violates" in Code Sec. 7433(e) and the first to deprive the United States, through the IRS, of its sovereign immunity under that statute even where the United States acted on a reasonable and good faith belief that a discharge injunction did not apply to its collection efforts against a tax debtor.
For a discussion of civil penalties for the unauthorized collection of taxes, see Parker Tax ¶260,550.
IRS Clarifies 2018 Standard Mileage Rates Notice in Light of New Tax Law
The IRS modified Notice 2018-3, issued in December 2017, to provide additional information in light of changes made by the Tax Cuts and Jobs Act of 2017. Notice 2018-42.
In Notice 2018-42, the IRS clarified that (1) while Notice 2018-3 provides that the standard mileage rate for 2018 is 54.5 cents per mile for all miles of business use including unreimbursed employee travel expenses deductible as a miscellaneous itemized deduction, deductions for such unreimbursed business expenses are not allowed for years 2018-2025; (2) the 2018 standard mileage moving rate can only be used by members of the U.S. Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station; and (3) because of increased depreciation limitations for passenger automobiles placed in service after December 31, 2017, the maximum standard automobile cost for purposes of applying the fixed and variable rate (FAVR) allowance may not exceed $50,000 for passenger automobiles (including trucks and vans) placed in service after December 31, 2017.
On December 14, 2017, the IRS issued Notice 2018-3, which provides the optional 2018 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes. On December 22, the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted into law. TCJA amended Code Sec. 67, relating to the deduction of miscellaneous itemized deductions, including the deduction of unreimbursed employee travel expenses. TCJA also amended Code Sec. 217, relating to the deduction for moving expenses, and increased the depreciation limitations for passenger automobiles placed in service after December 31, 2017.
In Notice 2018-3, the IRS identified a standard mileage rate of 54.5 cents per mile for all miles of business use (business standard mileage rate) that taxpayers were to use, including to deduct unreimbursed employee travel expenses as a miscellaneous itemized deduction under Code Sec. 67. TCJA suspends all miscellaneous itemized deductions that are subject to the two-percent of adjusted gross income floor under Code Sec. 67, including unreimbursed employee travel expenses. This suspension applies to tax years beginning after December 31, 2017, and before January 1, 2026. Thus, the business standard mileage rate listed in Notice 2018-3 cannot be used to claim an itemized deduction for unreimbursed employee travel expenses during the suspension. However, deductions for expenses that are deductible in determining adjusted gross income are not suspended. For example, members of a reserve component of the Armed Forces of the United States, state or local government officials paid on a fee basis, and certain performing artists are entitled to deduct unreimbursed employee travel expenses as an adjustment to total income, not as an itemized deduction on Schedule A of Form 1040, and therefore may continue to use the business standard mileage rate.
For the use of an automobile as a part of a move for which the expenses are deductible under Code Sec. 217, Notice 2018-3 provided a standard mileage rate of 18 cents per mile. For tax years beginning after December 31, 2017, and before January 1, 2026, TCJA suspends the deduction for moving expenses. This suspension does not apply to members of the Armed Forces of the United States on active duty who move pursuant to a military order and incident to a permanent change of station to whom Code Sec. 217(g) applies. Thus, other than those to whom Code Sec. 217(g) applies, the standard mileage rate is not applicable for the use of an automobile as part of a move occurring during the suspension.
In Notice 2018-3, the IRS identified a maximum standard automobile cost of $27,300 for passenger automobiles (excluding trucks and vans) and $31,000 for trucks and vans for purposes of substantiating reimbursement allowances under a fixed and variable rate (FAVR) plan. However, TCJA increased the depreciation limitations for passenger automobiles placed in service after December 31, 2017. As a result, the maximum standard automobile cost may not exceed $50,000 for passenger automobiles (including trucks and vans) placed in service after December 31, 2017.
For a discussion of the tax treatment of miscellaneous itemized deductions, see Parker Tax ¶85,100. For a discussion of the tax treatment of moving expenses, see Parker Tax ¶80,500. For a discussion of the substantiation of reimbursement allowances under a FAVR plan, see Parker Tax ¶91,130.
Tax Court Reduces Taxpayer's Basis in Solar Panel Venture, but Finds in Taxpayer's Favor on Bonus Depreciation and Other Issues
The Tax Court held that a taxpayer who purchased solar panels installed on host properties, and who acquired rights under agreements with the host property owners to provide electricity contingent on receiving tax credits and other incentives, had a basis in the solar equipment equal to the amount of a promissory note that partially financed the purchase but could not include in his basis a down payment that was never made, nor a credit for rebates that the host property owners assigned to the previous solar panel owner before the sale. The Tax Court also found that the taxpayer's investment qualified for the bonus depreciation deduction and that the taxpayer (1) was at risk with respect to the promissory note, (2) materially participated in the venture for purposes of the passive loss rules, and (3) was not liable for penalties assessed by the IRS because he had reasonable cause and acted in good faith. Golan v. Comm'r, T.C. Memo. 2018-76 (2018).
Donald Golan is an account representative for a dealer of precious metals. Golan sought an investment to generate extra income, and in 2010 was introduced to Ken Salveson, owner of Solar Energy Equities LLC. Through the LLC, Salveson offered property owners discounted electricity in exchange for permission to install solar panels on their properties. The LLC would retain ownership of the panels in order to take advantage of tax credits and rebates. The LLC would then sell the solar equipment, along with all related rights and obligations, to a buyer. One such buyer was Golan, who bought solar equipment on three host properties.
The host properties included a warehouse, a rental property, and a residential property in California. For each property, Salveson assisted the owners with applying to connect the solar panels to the electric grid. Salveson and the owners then entered into a power purchase agreement (PPA) under which Salveson's LLC would sell discounted electricity to the owners for a five-year term, and the LLC would retain ownership of the panels and the rights to any tax or other benefits. In each case, the property owners became entitled to utility rebates of between $16,000 and $20,000 as of the time they installed bidirectional meters to monitor the flow of electricity. Each owner assigned the rebate to Salveson's LLC as required under the PPAs.
Golan purchased the solar equipment for the three host properties in January 2011. The sale was effected by an asset purchase agreement, a promissory note, a guaranty by Golan, and a bill of sale. Golan agreed to buy the solar equipment on the host properties, in addition to the rights and obligations under the PPAs. The purchase agreement specified that the original use of the solar equipment began on or after the closing date.
The purchase price was $300,000, which equaled the sum (1) a $90,000 down payment, (2) a $57,750 credit for the rebates the host property owners had assigned to Salveson, and (3) Golan's promissory note in the principal amount of $152,250. The note provided for 2 percent interest and matured in 2041, but did not have a fixed payment amount. It was secured by the solar equipment and, in the event of default, Salveson agreed to seek recourse against the equipment before exercising any rights against Golan. Golan also provided a guaranty ensuring his personal liability for the amount borrowed. To further evidence the transfer of the equipment, Golan signed copies of the PPAs. Although the PPAs were all dated July or August 2010, Golan signed them in January 2011.
Sometime after the sale, the utility company connected the solar equipment on the host properties to the electric grid. The equipment began generating electricity and the property owners began making monthly payments under the PPAs. Golan was unable to pay the $90,000 down payment in 2011. Although Golan was in default, Salveson continued to honor the contract, and Golan directed the property owners to pay their electric bills directly to Salveson. Salveson credited these payments to toward the note, which was never amended to account for the unpaid down payment. Golan made partial payments toward the down payment in 2012 and 2013. Golan remained in default for $10,000, but Salveson did not cancel the contract or assert any claims for breach.
On his 2011 tax return, Golan reported no income and claimed various deductions, including depreciation of $255,000, which he claimed was a special depreciation allowance for qualified property. Golan also attached a Form 3468, Investment Credit, on which he claimed an energy credit of $90,000 (30 percent of $300,000).
The IRS issued a notice of deficiency stating that Golan's Code Sec. 179 allowance was disallowed because the property did not qualify as Code Sec. 179 property. Golan's energy credit was also disallowed; the notice stated that Golan's expenses did not qualify for the rehabilitation credit shown on Form 3468. In addition, the IRS determined that Golan was liable for an accuracy related penalty under Code Sec. 6662. Golan challenged the notice in the Tax Court.
The IRS subsequently acknowledged that the references in the notice to a Code Sec. 179 deduction and a credit under Code Sec. 47 were in error because Golan did not claim a deduction or credit under those Code sections. Nevertheless, it maintained that Golan could not claim the special depreciation allowance (i.e., bonus depreciation under Code Sec. 168(k)(5)) or the energy credit because it said that Golan had no basis in the solar equipment in 2011. The IRS claimed that Golan was not entitled to expense 100 percent of the solar equipment because he did not acquire the property after September 8, 2010 and January 1, 2012 and place it in service before January 1, 2012, as required under Code Sec. 168(k)(5). In the IRS's view, Salveson must have earlier acquired the solar panels because he installed and placed the panels in service on two of the host properties in the summer of 2010. The IRS argued that Golan was not at risk with respect to the investment because Salveson had a prohibited continuing interest in the solar equipment activity under Code Sec. 465(b)(3). The IRS also contended that the venture was a passive activity under Code Sec. 469. Because none of these theories were mentioned in the notice, the Tax Court concluded that the burden of proof shifted to the IRS on these new matters.
The Tax Court held that Golan's basis in the property at issue was limited to the amount of his promissory note ($152,250) and that he could not include in his basis the downpayment of $90,000 or the $57,750 credit for the rebates the host property owners had assigned to Salveson; however, the court rejected all of the IRS's other arguments. Golan's basis was limited to the amount of the note because he failed to make the $90,000 down payment in 2011 and the host property owners had assigned the utility company rebates to Salveson prior to the sale of the solar equipment. The Tax Court viewed the $57,750 credit as a price reduction to account for Salveson's receipt of the rebates before the sale closed. The note, however, was includible because it was issued in exchange for the solar equipment and the court saw no evidence that Golan would not be expected to repay the note or that the equipment was overvalued.
The Tax Court found that Golan qualified for the bonus depreciation allowance under Code Sec. 168(k)(5) since that provision applies to property acquired by the taxpayer after September 8, 2010, and there was no authority for the IRS's position that the special allowance applied only to the original purchasers of manufactured property.
The Tax Court found that Salveson did not have a prohibited continuing interest in the solar equipment activity under Code Sec. 465(b)(3). To have such an interest, Salveson would have had to be entitled to the assets of Golan's venture upon its liquidation or have an interest in his net profits. But the court found that Salveson's interest was a permitted gross receipts interest because he was entitled under the note to all monthly revenue generated by the equipment. The Tax Court also found that Golan materially participated in the venture for purposes of the passive activity loss limitation in Code Sec. 469 because he spent at least 100 hours on it and his participation was not less than that of any other individual.
Finally, the Tax Court held that Golan was not liable for a penalty under Code Sec. 6662(a) because he relied in good faith on his accountant and provided all the information needed to prepare the return.
For a discussion of the basis in property acquired by purchase, see Parker Tax ¶110,505. For a discussion of bonus depreciation, see Parker Tax ¶94,201. For a discussion of determining amounts at risk under Code Sec. 465, see Parker Tax ¶247,520. For a discussion of the material participation tests under the Code Sec. 469 passive activity rules, see Parker Tax ¶247,115.10.
IRA Trustee Must Withhold Federal Taxes on Amounts Paid to Unclaimed Property Fund
The IRS ruled that a payment by individual retirement account (IRA) trustee of an individual's interest in an IRA to a state's unclaimed property fund, as required by state law, is subject to federal income tax withholding under Code Sec. 3405. In addition, the payment by the trustee is subject to reporting under Code Sec. 408(i). Rev. Rul. 2018-17.
Facts
Under the facts in Rev. Rul. 2018-17, an unidentified individual, who is a calendar-year taxpayer and a U.S. person under Code Sec. 7701(a)(30)(A), has an interest in a traditional individual retirement account (IRA) trusteed by Trustee Y. The individual has not made a withholding election with respect to her interest in the IRA. Trustee Y is required under state law to pay the individual's interest in the IRA to the state's unclaimed property fund under which a claim for property may be made by the owner. In 2018, Trustee Y pays the individual's interest in the IRA, which has a value of $1,000, to the state's unclaimed property fund.
The IRS was asked to address the following issues:
(1) Is the payment by Trustee Y of the individual's interest in the IRA to the state's unclaimed property fund subject to federal income tax withholding under Code Sec. 3405?
(2) Is the payment by Trustee Y subject to reporting under Code Sec. 408(i)?
Analysis
Code Sec. 3405 provides federal income tax withholding rules with respect to designated distributions. Generally, a designated distribution is any distribution or payment from or under an employer deferred compensation plan, an IRA, or a commercial annuity. Under Code Sec. 3405(e)(1)(B)(ii), a designated distribution does not include the portion of a distribution or payment that it is reasonable to believe is not includible in gross income. For this purpose, the flush language under Code Sec. 3405(e)(1)(B) provides that any distribution or payment from or under an IRA (other than a Roth IRA) is treated as includible in gross income.
Code Sec. 3405 requires federal income tax to be withheld from two types of designated distributions from IRAs, each with its own withholding rules: periodic payments under Code Sec. 3405(a), and nonperiodic distributions under Code Sec. 3405(b). Under Code Sec. 3405(e)(3), a nonperiodic distribution is a designated distribution that is not an annuity or similar periodic payment. In the case of a nonperiodic distribution under Code Sec. 3405(e)(3), Code Sec. 3405(b)(1) provides that the payor must withhold from such distribution an amount equal to 10 percent of the distribution. Code Sec. 3405(b)(2) provides that an individual may elect not to have Code Sec. 3405(b)(1) withholding apply with respect to any nonperiodic distribution.
Reg. Sec. 35.3405-1T provides rules regarding Code Sec. 3405, including general rules on withholding requirements and specific rules addressing withholding on periodic and nonperiodic distributions, notice and election procedures, and reporting and recordkeeping. Reg. Sec. 35.3405-1 provides rules regarding the medium through which notices required under Code Sec. 3405 may be provided.
Code Sec. 408(i) provides that the trustee of an IRA and the issuer of an endowment contract described in Code Sec. 408(b) or an individual retirement annuity must make such reports regarding such account, contract, or annuity to the IRS and to the individuals for whom the account, contract, or annuity is, or is to be, maintained with respect to contributions (and the years to which they relate), distributions aggregating $10 or more in any calendar year, and such other matters as may be required.
Under Reg. Sec. 1.408-7(a), the trustee of an IRA or the issuer of an individual retirement annuity who makes a distribution during any calendar year must file a report of the distribution for such year. Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., is used to satisfy this reporting obligation.
IRS Ruling
The IRS concluded that the payment of the individual's interest in a traditional IRA to the state's unclaimed property fund is a payment from an IRA that is treated as includible in gross income for purposes of Code Sec. 3405(e)(1)(B)(ii). Thus, the IRS ruled that the payment is a designated distribution for purposes of Code Sec. 3405 and is not an annuity or similar periodic payment under Code Sec. 3405(e)(2). Thus, it is a nonperiodic distribution as defined in Code Sec. 3405(e)(3) and, because the individual with the interest in the IRA had not made a withholding election with respect to the payment, a 10 percent withholding rate applies to the payment pursuant to Code Sec. 3405(b)(1), and Trustee Y must withhold federal income tax of $100 (i.e., 10 percent of the individual's $1,000 interest in the IRA).
The IRS also ruled that, under Code Sec. 408(i), Trustee Y must report the $1,000 distribution from the IRA ($900 of which is paid to the state unclaimed property fund and $100 of which is remitted as federal income tax withholding) on a 2018 Form 1099-R identifying the individual as the recipient.
Observation: The IRS also granted transition relief. Under that relief, a person will not be treated as failing to comply with the withholding and reporting requirements described in Rev. Rul. 2018-17 with respect to payments made before the earlier of January 1, 2019, or the date it becomes reasonably practicable for the person to comply with those requirements.
For a discussion of income tax withholding on pensions, annuities, and IRAs, see Parker Tax ¶212,150.
Taxpayer Can't Lay Blame for Failure to Pay Employment Taxes on Deceased Partner
The Third Circuit affirmed a district court and held that a 50 percent partner in an architectural company was a responsible person and thus was liable for trust fund penalties relating to the nonpayment of employment taxes for years 2007-2009. The court rejected the taxpayer's argument that payment of the taxes was the responsibility of his deceased business partner. Commander v. Comm'r, 2018 PTC 151 (3d Cir. 2018).
Darren Commander, along with his now-deceased business partner Kenneth Skerianz, formed two New Jersey LLCs - Darken Architectural Woodwork Installation and Metropolitan Architectural Woodwork - to fabricate and install architectural woodwork. Commander and Skerianz were each 50 percent owners of Darken, and the company's only officers. The operating agreement gave them joint managerial control of the company and prohibited either one from engaging in major financial transactions without the other's approval. Commander's title was "managing member."
Commander oversaw Darken's business, and Skerianz oversaw the woodwork installation in the field. Both Commander and Skerianz had signing authority on Darken's bank accounts. Commander frequently signed checks, including payroll checks, during the years 2007- 2009. Darken had a stamp of Commander's signature, and Commander regularly directed the employee who handled payroll to issue checks with his signature to employees and creditors. Commander admitted that he decided which bills to pay if there were insufficient funds to pay them all. Darken also had an outside accountant, Frank Dragotto, who prepared Darken's corporate income and employment tax returns. Once Dragotto prepared the returns, he discussed them with Commander and Skerianz before filing.
From 2007-2009, Darken did not fully pay its federal payroll taxes. Commander was aware that employers are required to withhold income and social security taxes from their employees' wages. He also became aware at some point during this time period that Darken owed taxes. Further, he said that "every year we were in business we had some tax issue." Darken paid Commander and Skerianz about $4,000 a week during the period that payroll taxes were delinquent.
Commander said that he first learned that the payroll taxes were not being paid when an IRS agent came to the office. Commander then tried to work with the IRS to pay the delinquent taxes. Dragotto corroborated that Commander was kept apprised of Darken's ongoing tax struggles. Following an administrative investigation, the IRS determined that both Commander and Skerianz were "responsible persons" who had willfully failed to pay over the trust fund taxes. It assessed trust fund recovery penalties against both of them under Code Sec. 6672. After Skerianz died, he was dismissed as a defendant.
The IRS took the case to a district court and sought summary judgment against Commander for $468,000 for 2007, $620,000 for 2008, and $502,000 for 2009. Commander argued that he was not liable for the penalties because he was not a responsible person under Code Sec. 6672. Commander also argued that his failure to pay over the taxes was not willful. In an attempt to manufacture a dispute of material fact, Commander submitted an affidavit in opposition to summary judgment, to the effect that he misspoke in his deposition and meant to say that he later learned of the tax delinquencies between 2007- 2009.
The district court granted the IRS summary judgment, holding that Commander was a responsible person because he was a 50-percent owner, he was one of only two officers, he had check-signing authority, and he exercised his power to pay Darken's bills and sign paychecks. The district court noted that Commander said in a deposition that he learned between 2007 and 2009 that the taxes were not being paid, and that he received regular updates on communications with the IRS regarding the delinquencies. The court concluded that Commander was willful because he paid other creditors after having actual knowledge that the payroll taxes were not being paid, and because he acted with reckless disregard for whether the taxes were being paid.
With respect to Commander's affidavit, the district court said that conclusory, self-serving affidavits are insufficient to withstand a motion for summary judgment. Commander appealed to the Third Circuit.
On appeal, Commander argued that he was not responsible for Darken's payroll or tax contributions because those responsibilities were entirely Skerianz's. He also asserted that summary judgment was inappropriate because he was "never given the opportunity to state his own recollection of the facts," as he would have at trial, and that he was denied the testimony of witnesses who would have corroborated his claims.
The Third Circuit affirmed the district court's holding that Commander willfully caused the trust fund taxes to not be paid. The court noted that willfulness under Code Sec. 6672 is a voluntary, conscious and intentional decision to prefer other creditors over the government. It may also be established, the court said, if the responsible person acts with reckless disregard of a known or obvious risk that withheld taxes may not be remitted to the government. Reckless disregard includes a failure to investigate or correct mismanagement after being notified that withholding taxes have not been paid. Willfulness, the court observed, need not be in bad faith, nor does it require actual knowledge of the tax delinquency.
The Third Circuit agreed with the district court's conclusion that Commander's behavior was willful because he permitted Darken to pay other creditors after he knew that the taxes were in arrears. The record demonstrated to the court that Commander had actual knowledge the taxes were due, that he stated that Darken had tax issues every year it was in business and that each time Dragotto received a notice from the IRS, everyone was made aware of the issue. Despite this knowledge, the Third Circuit observed, Darken paid Commander and Skerianz about $4,000 a week throughout the delinquency.
For a discussion of the trust fund recovery penalty under Code Sec. 6672, see Parker Tax ¶210,108.
Indian Gaming Revenue Is Not Exempt from Tax as Tribal General Welfare Benefits
The Eleventh Circuit held that a member of an Indian tribe who received per capita distributions of revenue from tribal gaming activities was not entitled to exclude the distributions from income as Indian general welfare benefits under the Tribal General Welfare Exclusion Act (GWEA). The court found that Congress specifically intended that such distributions be subject to tax when it passed the Indian Gaming Revenue Act (IGRA) and found that the GWEA, enacted after the IGRA, was not intended to release such payments from taxation. U.S. v. Jim, 2018 PTC 161 (11th Cir. 2018).
Under the Indian Gaming Revenue Act (IGRA), enacted by Congress in 1988, Indian tribes are permitted to engage in gaming and distribute the revenue. Such distributions are taxable income to tribal members under the IGRA, and Tribes are required to report the distributions, notify its members of their tax liability, and withhold tax. In 2014, Congress passed the Tribal General Welfare Exclusion Act (GWEA), codified in Code Sec. 139E. The GWEA excludes from tax any payment to a member of an Indian tribe pursuant to an Indian tribal government program.
In 1990, the Miccosukee Indian Tribe of Florida began operating a gaming facility called Miccosukee Indian Bingo and Gaming (MIBG) on its reservation lands in southern Florida. Since 1984, the Tribe had provided quarterly payments to its members to help them live on the reservation without outside assistance. The distributions were funded by sales taxes and rents from land and oil leases. The Tribe collected the revenue in an account called the nontaxable distribution revenue (NTDR) account. Quarterly distributions from the NTDR account were calculated by dividing the account balance by the number of tribal members.
The Tribe imposed a gross receipts tax on MIBG and collected that revenue in the NTDR account. The NTDR therefore contained both gaming and nongaming revenue, all of which was distributed to members of the Tribe. Almost all of the revenue in the NTDR was gaming revenue; in 2001, MIBG contributed over $32 million to the account, while approximately $164,000 came from other sources. However, the Tribe did not report the distributions from the NTDR account or withhold taxes on them.
In 2001, Tribe member Sally Jim received and cashed distribution checks for herself, her husband, and her two children totaling $272,000 ($68,000 per person). She also earned approximately $26,000 in income from her job that year. She neither filed a tax return for 2001 nor paid taxes on the distributions. In 2004, the IRS assessed tax, penalties and interest against Jim for 2001. Additional tax, penalties, and interest were assessed in 2012 when the IRS became aware of the distributions from the Tribe. Jim did not pay the assessments.
The government sued Jim in a district court in 2014. The Tribe moved to intervene and the district court granted its motion after determining that a ruling could subject the Tribe to withholding and reporting requirements and affect its general welfare program. Jim and the Tribe argued that the distributions were exempt from tax as Indian general welfare benefits under the GWEA and therefore could not be taxed. In the alternative, Jim contended that the government wrongly included in its assessment against her the distributions to her family members. She also argued she should not be liable for penalties because she relied on the advice of Tribal officials and representatives of the Bureau of Indian Affairs.
The district court held that the Tribe's distributions derived from gaming proceeds were not exempt as general welfare payments. The district court also found that, because neither Jim nor the Tribe provided a specific percentage of the revenues that were from nongaming sources, no exemption applied. On the issue of the checks made out to Jim's husband and children, the district court held that Jim exercised sufficient control over the full amount of the distributions to be liable for taxes on them. The district court also found there was no reasonable cause for Jim's failure to file a return and pay taxes because she admitted she forgot to file her return, and the court found that she could not have reasonably relied on the statements of tribal leaders.
The district court entered a judgment against both Jim and the Tribe, and specified that Jim was liable for the unpaid taxes, penalties and interest. The Tribe then filed a motion to amend the judgment, arguing that the district court erred by entering a judgment against it. According to the Tribe, the court had failed to explain the basis of the judgment and that it was therefore likely to lead to confusion regarding who was liable for the amount due and what impact, if any, the judgment had on the Tribe. The district court denied the Tribe's motion to amend the judgment, reasoning that because it had held the distributions that were subject to tax, the Tribe was subjected to reporting and withholding requirements on them. In the district court's view, the circumstances therefore warranted entering a judgment against the Tribe as an intervenor of right with an interest at stake.
Jim and the Tribe appealed to the Eleventh Circuit. On appeal, they again argued that the distributions qualified as Indian general welfare benefits under Code Sec. 139E. The Tribe also argued that the district court abused its discretion in refusing to amend the judgment because the determination that the distributions were subject to tax would affect its ability to preserve the integrity of its general welfare system and governmental functions.
The Eleventh Circuit affirmed the district court's decision. The Eleventh Circuit framed the issue of taxability as one of statutory interpretation: whether the GWEA in effect amended the IGRA. The court reasoned that when Congress enacted the GWEA, it expressed no intent to release the per capita payments of gaming revenue from taxation. In the court's view, Congress spoke clearly when it imposed tax on such payments by enacting the IGRA. If Congress intended the GWEA to undo this arrangement, it knew the words to do so. The Eleventh Circuit further explained that the IGRA imposes tax in a very specific situation, while the later-enacted GWEA provides an exemption of general application for Indian general welfare benefits, without regard to the source of income. In the court's view, where there was no clear intention otherwise, a specific statute could not be nullified by a general one, regardless of the priority of the enactment.
The Eleventh Circuit found that Jim did not address the amount of the distributions constituting gaming revenue, the attribution to her of the checks made out to her family members, or the imposition of the penalty in her appeal, and the court therefore declined to consider those issues. The Tribe's argument that the district court should have amended its judgment was also rejected. The Eleventh Circuit reasoned that the Tribe was aware that the government had asked the district court to declare the distributions to be taxable and that the Tribe therefore had an obligation to withhold taxes on them. As an intervenor, the Tribe was subject to the court's entering of a judgment against it the same as any original party.
For a discussion of amounts excluded from income under Indian tribal government programs, see Parker Tax ¶79,720.
Bank Failed to Establish Basis in Intangible Assets Acquired During S&L Crisis
The Federal Circuit denied a bank's refund claim resulting from losses and deductions it claimed it incurred from the amortization and abandonment of intangible assets obtained through mergers with failing savings and loan institutions in the 1980s. The Federal Circuit upheld a finding by the Court of Federal Claims that the bank had zero basis in the assets because there were significant errors in the bank's valuation, and it rejected the bank's argument that the Claims Court should have undertaken an independent allocation of basis among the assets. WMI Holdings Corp. v. U.S., 2018 PTC 160 (Fed. Cir. 2018).
Savings and loan institutions, or thrifts, provide two main services. They maintain customers' deposits in interest bearing savings accounts, and they make mortgage loans funded by these deposits. Thrifts are designed to earn interest on mortgages at a higher rate than they pay on savings accounts. When interest rates rose to unprecedented levels in the 1970s, thrifts became unprofitable. They were locked into fixed rate mortgages, while the interest they were required to pay on savings accounts increased and customers began withdrawing their deposits in favor of alternative investments. Many thrifts became insolvent and failed as a result.
The Federal Savings and Loan Insurance Corporation (FSLIC) responded to the crisis by encouraging healthy thrifts to take over failing ones in so-called supervisory mergers. These transactions relieved the FSLIC of its deposit insurance liability in exchange for providing a package of incentives to the acquiring thrifts. Two of those incentives were branching rights and regulatory account purposes (RAP) rights.
Branching rights permitted acquiring thrifts to open branches in states other than their home states, which was generally prohibited before 1981. RAP rights affected regulatory accounting treatment for business combinations. At the time, thrifts were required to maintain a minimum capital level of three percent of liabilities. This presented an obstacle for the acquiring thrifts because by definition, failing thrifts' liabilities exceeded their assets. Regulators removed this obstacle by permitting acquiring thrifts to treat the failing thrifts' excess liabilities as an asset called supervisory goodwill under Generally Accepted Accounting Principles (GAAP). This goodwill in turn counted toward the acquiring thrifts' minimum regulatory capital requirements, and could be amortized over a forty year period. Such treatment was guaranteed by FSLIC, regardless of future regulatory changes.
Home Savings of America, a subsidiary of the predecessor of WMI Holdings Corp., was a thrift originally based in California. Between 1981 and 1985, Home entered into four supervisory mergers in six states and assumed the acquired thrifts' liabilities in exchange for branching and RAP rights. Home later sold off those branches in an effort to focus on its California presence.
In 1988, Home acquired a New York thrift, Bowery Savings Bank. Prior to the acquisition, the Federal Deposit Insurance Company (FDIC) had been providing Bowery with assistance, including a RAP right, in accordance with a previous government assisted merger. As a result of Home's 1988 acquisition, however, Bowery negotiated a new assistance package which replaced the 1985 RAP right with a new one. Like the supervisory RAP right, the 1988 Bowery RAP right allowed Bowery to count the goodwill arising out of the acquisition toward regulatory capital. However, the 1988 Bowery RAP established a 20 year, rather than a 40 year, amortization period.
WMI sued in the Court of Federal Claims for a tax refund of over $250 million based on the amortization of the RAP rights and the abandonment of Home's branching rights in several states. To support its claims, WMI submitted a valuation report prepared by its expert, Roger Grabowski. The report valued each RAP right as a contractual right, conveyed to Home by FSLIC, which allowed Home to treat the goodwill as an asset for purposes of meeting regulatory capital requirements. Grabowski estimated the cost of raising and maintaining replacement capital to maintain a hypothetical buyer's pre-merger capital level. In other words, he assumed that regulatory approval was required to treat the goodwill created by the transactions as an asset amortizable over 40 years. The report valued the branching rights by forecasting the cash flow a hypothetical buyer would have expected by operating in a state other than its home state and made certain assumptions regarding the number of new branches, the growth of deposits, and the income a buyer would earn on new mortgage loans.
The Claims Court rejected the refund claims because it found that WMI failed to prove Home's basis in the branching rights, RAP rights, and the Bowery government assistance rights to a reasonable degree of certainty. The Claims Court saw the RAP rights not as creating a contractual right but as a guarantee of the right to continue amortizing the goodwill over 40 years even if the regulations later changed. The Claims Court likewise found Grabowski's approach to the branching rights unreasonable and at odds with the economic realities during the savings and loan crisis. With respect to the Bowery rights, the Claims Court found that the 1988 government assistance was materially different from that provided to Bowery in 1985, and rejected WMI's argument that the exchange qualified as a Code Sec. 1031 like-kind exchange.
WMI appealed to the Federal Circuit. It argued that the Claims Court clearly erred by not independently estimating Home's basis in the rights and in holding that the shortcomings in Grabowski's valuations justified a zero basis determination. According to WMI, Grabowski's approach to the RAP rights was supported by a 1981 Federal Home Loan Bank Board memorandum. WMI claimed that the memorandum required acquiring thrifts to apply for authorization to use the purchase method of accounting and to amortize supervisory goodwill. With respect to the branching rights, WMI argued that the Claims Court should have disregarded the assumptions it disagreed with and provided its own inputs using Grabowski's methodology. WMI also asserted that the Claims Court improperly treated the RAP rights valuation errors as a basis for rejecting the valuation of the branching rights.
The Federal Circuit upheld the Claims Court's decision to reject WMI's valuation and apply a zero basis. First, the Federal Circuit found that the Claims Court was not required to undertake an independent valuation analysis where WMI's own evidence was insufficient to allow it to do so. The Federal Circuit explained that a court has discretion to choose a method of valuation but not to make a finding of the value of an asset where there is no evidence to support it. And while it is unreasonable for a court to reject a taxpayer's valuation based on minor flaws, the Federal Circuit found that the Claims Court was correct in concluding that WMI's errors were major and systemic.
The Federal Circuit found that Grabowski's valuation was so flawed that the Claim Court's finding of a zero basis was justified. The Federal Circuit agreed with the Claims Court's finding that Grabowski overvalued the RAP rights as contractual rights. The Federal Circuit found that the reference to an application in the Bank Board memorandum merely reflected the fact that all business combinations were required to obtain regulatory approval, regardless of whether they intended to use the purchase method of accounting. Grabowski's misplaced assumption about the nature of the RAP rights undermined WMI's fair market value determination for those rights, and for that reason the Claim's Court's finding was not clearly erroneous.
The Federal Circuit also agreed with the Claims Court's finding that Grabowski used invalid assumptions in his valuation of the branching rights and relied on outdated market data. The court also noted the high interest rates and customer account closings during the acquisition period and found that these conditions contradicted Grabowski's prediction of significant deposit growth.
Finally, the Federal Circuit agreed with the Claims Court that the exchange of rights in the Bowery acquisition constituted a realization event because the government assistance provided to Bowery in 1988 was materially different from that provided in 1985. For that reason, the Federal Circuit also found that the exchange did not qualify as a like-kind exchange.
For a discussion of determining basis in a taxable exchange, see Parker Tax ¶110,515.
