Top Ten Tax Developments of 2014: Drama, Confusion and Eleventh Hour Decisions.
(Parker Tax Publishing January 1, 2015)

The year 2014 had it all: an eleventh hour tax extenders law, major new IRS guidance on tangible personal property, another Obamacare vs. Opponents battle in the federal courts, the end of the much-maligned Circular 230 covered opinion rules, and a brawl between the AICPA and the IRS over the certification of unlicensed tax preparers. Delve deeper with Parker's list of the most important changes of 2014.

1. Tax Extenders Drama, Again

After leaving taxpayers to spend the year guessing whether the $500,000 Section 179 expensing limit and dozens of other popular tax breaks would be extended for 2014, Congress broke up a two year period of nearly perfect inaction on the tax front by passing the Tax Increase Prevention Act (TIPA) in mid-December. Signed by the President on December 19, the law extends retroactively for one year, nearly all of the tax breaks that had been temporarily extended by ATRA two years earlier.

In addition to extending enhanced Section 179 expensing, 50-percent bonus depreciation, the research tax credit, and more than fifty other provisions, TIPA also added new Code Sec. 529A, providing a tax-favored savings plan option for the disabled modeled after the popular 529 college savings plans. The new law also cleaned up the Code a bit, making technical corrections to a dozen tax laws passed over the past decade, and removing hundreds of "deadwood" provisions that have been accumulating since the second Eisenhower administration.

Of course Congress also set itself up to repeat the tax extenders drama again in 2015, as the extended provisions all expire on December 31, 2014. The only differences for 2015 are: (1) for the first time, the extenders drama will pit the Democratic President against a Congress boasting Republican majorities in both houses, and (2) there seems to be more than the usual buzz about putting real tax reform on the table.

For a full discussion of the Tax Increase Prevention Act of 2014, see Tax Extenders Bill Passes Congress, President Expected to Sign into Law.

2. Overhaul of Capitalization, Expense, and Disposition Rules for Tangible Personal Property

The most significant development for taxpayers coming out of the IRS was the continuation of guidance, in the form of regulations and revenue procedures, dealing with the overhaul of the tangible personal property rules. Beginning in 2013, the IRS issued final tangible property regulations which provided rules for (1) amounts paid or incurred for materials and supplies; (2) amounts paid or incurred for repairs and maintenance; (3) capital expenditures; (4) amounts paid or incurred for the acquisition and production of tangible property; and (5) amounts paid or incurred for the improvement of tangible property.

Compliance Tip: Taxpayers were given the choice of applying the final rules to tax years beginning on or after January 1, 2014; however, taxpayers were also permitted to apply these rules to tax years beginning on or after January 1, 2012, if they so chose. Alternatively, for tax years beginning on or after January 1, 2012, and before January 1, 2014, taxpayers were allowed to apply temporary regulations issued in 2012.

The guidance continued in 2014, with final regulations on the disposition of tangible property and revenue procedures on obtaining automatic IRS consent on the many accounting method changes involved in complying with the various regulations.

T.D. 9689 (8/18/14) contained final regulations for determining the gain or loss on dispositions of tangible property, identifying the asset disposed of, and accounting for partial dispositions of MACRS property. While the final regulations generally retain all the provisions found in the proposed regulations, some provisions were modified, including the rules for determining the unadjusted depreciable basis of a disposed asset, or portion of an asset, in a general or multiple asset account, and the manner of making certain disposition elections for assets included in a general asset account (GAA) when Code Sec. 280B (relating to demolition of structures) applies.

Practice Tip: While taxpayers had several options for accounting for property dispositions before these final regulations were issued, all taxpayers are expected to comply with the final regulations, effective for tax years beginning on or after January 1, 2014. Thus, practitioners need to review the current fixed asset accounting policies of their clients to see if they are in compliance with the final regulations. Those that are not will need to file for an accounting method change with the IRS.

For a full discussion of the final regulations on dispositions of MACRS property, see IRS Finalizes Regs on Dispositions of Tangible Depreciable Property.

Indicative of the sweeping nature of the new tangible personal property rules, the IRS also issued three separate (and massive) Revenue Procedures outlining how taxpayers can obtain automatic IRS consent to change accounting methods relating to the new regulations.

To learn more regarding Rev. Procs. 2014-16 see IRS Updates Accounting Method Procedure for Adopting Favorable Capitalization Rules. To learn more regarding Rev. Procs. 2014-17 see IRS Issues Procedures for Accounting Method Changes on Tangible Property Dispositions.To learn more regarding Rev. Procs. 2014-54 see IRS Extends Time to Make Late Partial Asset Disposition Election.

3. Monumental Circuit Split Sets Up Supreme Court Review of Obamacare Tax Regs

After the Supreme Court affirmed the validity of the Affordable Care Act (ACA), otherwise known as "Obamacare," in 2012, the push back has continued in the courts. In July, two appellate courts reached opposite conclusions on the same day as to the validity of the insurance subsidy provided in Code Sec. 36B for insurance purchased on federal Exchanges. Regulations under Code Sec. 36B allow insurance subsidies for health insurance purchased on both federal and state Exchanges.

In Halbig v. Burwell, 2014 PTC 363 (D.C. Cir. 7/22/14), the D.C. Circuit Court held that the ACA unambiguously restricts the insurance subsidy to insurance purchased on state Exchanges; thus, insurance purchased on federal Exchanges, the court said, is not eligible for the subsidy. Since only 16 states plus the District of Columbia have elected to set up their own Exchanges, with the rest using federal Exchanges, the decision could severely undermine the effectiveness of the ACA.

Just hours later, the Fourth Circuit, in King v. Burwell, 2014 PTC 364 (4th Cir. 7/22/14), reached the opposite conclusion. The Fourth Circuit held that, because the statutory language of Code Sec. 36B is ambiguous and subject to multiple interpretations, deference should be given to the IRS guidance under Code Sec. 36B as a permissible exercise of the agency's discretion.

OBSERVATION: The Supreme Court granted review of King in November, and if it follows a similar time table to the one that played out in the landmark 2012 Obamacare case, a decision will most likely arrive toward the end of the Court's spring term next June.

For a full discussion of Halbig and King decisions, see Circuits Split on Legality of Obamacare Insurance Subsidies in States with Federal Exchanges.

4. Final Circular 230 Regs Eliminate Covered Opinion Rules

In June, the Treasury Department issued final regulations (T.D. 9668 (6/12/14)) under Circular 230, which eliminated the complex covered opinion rules universally loathed by tax practitioners. In their place, the IRS expanded the requirements previously in place for written tax advice, thus creating a single standard. Under the prior rules, a significant amount of time and money was spent in determining if advice to a client fell under the covered opinion rules. The elimination of the burden on practitioners in complying with the covered opinion rules should result in an overall decrease in the costs associated with obtaining written tax advice.

The new rules do, however, come with an increased risk for certain tax managers. The final regulations broaden the requirement for procedures to ensure compliance with Circular 230 by requiring that an individual with principal authority for overseeing a firm's federal tax practice take reasonable steps to ensure the firm has adequate procedures in place to comply with Circular 230. Such individuals may be subject to discipline under Circular 230 where the compliance procedures are inadequate. In the absence of a person or persons identified by the firm as having the principal authority and responsibility, the IRS may identify such individuals.

For a full discussion of the final Circular 230 regulations, see Circular 230 Regs Create a Single Set of Standards for All Written Tax Advice.

5. Proposed Partnership Regulations Embrace "Hypothetical Sale" Approach for Hot Asset Distributions

In November, the IRS issued proposed regulations in REG-151416-06 (11/03/14) embracing the "hypothetical sale" approach for measuring whether a distribution reduces a partner's interest in the partnership's Section 751 property, and allowing greater flexibility in determining tax consequences when a reduction occurs. The proposed regulations also replace the asset exchange approach with a "hot asset sale" approach to determine the tax consequences when Code Sec. 751(b) applies.

Under the hypothetical sale approach, a partner's interest in Section 751 property is determined by reference to the amount of ordinary income that would be allocated to the partner if the partnership disposed of all of its property for fair market value immediately before the distribution.

The hot asset sale approach deems the partnership to distribute the relinquished Section 751 property to the partner whose interest in the partnership's Section 751 property is reduced, and then deems the partner to sell the relinquished Section 751 property back to the partnership immediately before the actual distribution.

The proposed regulations also provide new rules under Code Sec. 704(c) to help partnerships compute partner gain in Section 751 property more precisely, and describe how basis adjustments under Code Secs. 734(b) and 743(b) affect the computation of partners' interests in Section 751 property.

For a full discussion of the final regulations, see IRS Proposed Partnership Regs Embrace "Hypothetical Sale" Approach for Hot Asset Distributions.

6. Trusts Can Qualify for Real Estate Exemption to Passive Loss Rules

Until last April, there was a paucity of guidance on whether a trust could establish material participation for purposes of the passive activity rules. This is important because passive activity losses (PALs) are limited where a taxpayer does not materially participate in an activity and trusts are subject to the PAL rules. In April, the Tax Court issued a decision in Frank Aragona Trust v. Comm'r, 142 T.C. No. 9 (4/10/14), the only guidance to come out on the issue of trusts establishing material participation for passive activity purposes since a 2003 district court case.

The issue in Frank Aragona Trust was whether a trust that engaged in real estate rental activities could deduct its losses. Under Code Sec. 469(c)(2), any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity (i.e., it is a "per se" passive activity subject to the passive activity loss rules). Under Code Sec. 469(c)(7), the per se passive activity rule does not apply to the rental real estate activity of any taxpayer who meets both of the following tests:

(1) more than one-half of the "personal services" performed in trades or businesses by the taxpayer during the tax year is performed in real property trades or businesses in which the taxpayer materially participates; and

(2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.

The IRS had argued that trusts cannot qualify for the Code Sec. 469(c)(7) "real estate professional" exception because it requires the performance of personal services by the taxpayer. The IRS also argued that the time spent by employees of the limited liability company that owned the trust and who also served as trustees could not be counted in determining if the trust materially participated in the activity. The Tax Court rejected the IRS's position, holding that a trust can qualify for the Code Sec. 469(c)(7) exception, and that a trust is capable of performing personal services within the meaning of Code Sec. 469(c)(7) because services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.

This decision is important for situations where employees of an entity, which owns a trust engaged in real estate rental activities, are also trustees who perform rental activities for the trust. In such cases, it is important to document the time devoted to being an employee of the entity and the time devoted to being a trustee of the trust. With respect to the time spent as a trustee, it is essential to document the time spent on rental real estate activities; otherwise real estate deductions may be lost as a result of the PAL rules.

For a full discussion of the Frank Aragona Trust decision, see Tax Court Holds That a Trust Can Qualify for Rental Real Estate Exception.

7. IRS Launches Voluntary Annual Filing Season Program; AICPA Sues to Stop Program

In February, the D.C. Circuit Court sealed the fate of the IRS's mandatory Registered Tax Return Preparer (RTRP) program when it affirmed a lower court opinion invalidating the program. In June, the IRS launched a new voluntary program called the Annual Filing Season Program.

In Rev. Proc. 2014-42, the IRS explained the new program and what practitioners have to do to earn a "Record of Completion," which tells the public that that the tax return preparer has met the applicable IRS requirements with respect to tax returns or claims for refund prepared and signed by the practitioner. The program is scheduled to be in place for the 2015 filing season.

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. The Annual Filing Season Program will exempt RTRPs and others who have successfully completed certain recognized national or state tests from the filing season refresher course that will be required for other participants.

Shortly after the IRS announced the new program, the American Institute of Certified Public Accountants (AICPA) filed a lawsuit in D.C. district court challenging it. According to the AICPA, the Annual Filing Season Program is an unlawful exercise of government power. By implementing a purportedly "voluntary" program that is mandatory in effect, the AICPA called the program an end-run around Loving v. IRS, claiming it constitutes arbitrary and capricious agency action promulgated in excess of the agency's statutory authority. The IRS moved to dismiss the complaint, contending that the AICPA, whose membership consists of individual CPAs and accounting firms rather than uncredentialed tax preparers, lacked standing to challenge the Program.

In AICPA v. IRS, 2014 PTC 555 (D. D.C. 10/27/14), a federal district court sided with the IRS and dismissed the AICPA's challenge, rejecting a myriad of theories claiming the program would cause injury to AICPA members and finding the AICPA lacked standing to bring suit.

For a full discussion of Rev. Proc. 2014-42 and the Annual Filing Season Program, see IRS Unveils Voluntary Tax Return Preparer Education Program. For a discussion of the AICPA's failed lawsuit, see Challenge to IRS Filing Program Dismissed - AICPA Can't Prove Risk of Injury.

8. Tax Court Draws Bright Line on Use of Completed Contract Method by Real Estate Developers

In February, a real estate developer scored a big victory against the IRS. In Shea Homes, Inc. v. Comm'r, 142 T.C. No. 3 (2014), one of the largest private homebuilders in the United States successfully argued that it could defer profits under the completed contract method on home sales in a planned community until 95 percent of that community, including common improvements and amenities, was completed and accepted. As a result, the homebuilder was able to defer taxes on millions in profits.

Residential land developer Howard Hughes Corporation (HHC) also had a case before the Tax Court. Because of the taxpayer victory in Shea, HHC was hopeful for a similar resolution. Unfortunately, in The Howard Hughes Company, LLC v. Comm'r, 142 T.C. No. 20 (6/2/14), the Tax Court held that the developer's contracts were not home construction contracts and, thus, gain or loss from such contracts could not be reported using the completed contract method. The court agreed with the IRS that the developer's contracts to sell land through bulk sales, pad sales, finished lot sales, and custom lot sales did not qualify as home construction contracts eligible for the completed contract method. Additionally, the IRS contended that some of the contracts were not long-term construction contracts eligible for the percentage-of-completion method of accounting.

In the wake of these two decisions, a real estate developer's contract can qualify as a home construction contract, the profits from which are eligible for deferral, only if the developer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units. A developer cannot qualify to use the completed contract method if its construction costs merely benefit a home that may or may not be built.

For a full discussion of the Shea and Howard Hughes Corporation decisions, see Home Builder Triumphs over IRS and Tax Court Allows Deferral of Millions and Tax Court Draws Bright Line on Use of Completed Contract Method by Developers.

9. Supreme Court Holds Inherited IRAs Aren't Exempt from Bankruptcy Estate

Also in June, the Supreme Court, in Clark v. Rameker, 2014 PTC 277 (S. Ct. 6/12/14), held that a taxpayer could not exempt her inherited IRA from her bankruptcy estate because funds held in an inherited IRA are not "retirement funds" within meaning of Bankruptcy Code Section 522(b)(3)(C). The decision settled a long-simmering dispute about whether or not a debtor is entitled to shield an inherited IRA from a bankruptcy estate.

In the case at issue, a woman had inherited an IRA from her mother. Nine years later, the woman filed for bankruptcy and sought to exempt the inherited IRA from the bankruptcy estate by using the retirement funds exemption in Bankruptcy Code Section 522(b)(3)(C). A bankruptcy court concluded that an inherited IRA does not share the same characteristics as a traditional IRA and disallowed the exemption. A district court reversed, explaining that the exemption covers any account in which the funds were originally accumulated for retirement purposes. The Seventh Circuit disagreed and reversed the district court; and the Supreme Court upheld the Seventh Circuit's decision.

One of the important things to note with this decision is that, if the taxpayer had inherited the IRA from a spouse, she would have had the option to roll over the IRA funds into a traditional IRA, which would have protected the amounts from the bankruptcy estate. However, the option to roll over an inherited IRA to a traditional IRA needs to be weighed against the possible detriments of such action. For example, certain distributions from a traditional IRA before age 59are subject to the 10 percent penalty tax on early withdrawals, whereas such distributions from an inherited IRA are not. In addition, the required minimum distribution rules are more favorable for inherited IRAs.

For a full discussion of the Supreme Court's decision in Clark v. Rameker, see Supreme Court Affirms That Inherited IRAs Are Not Exempt from Bankruptcy Estate.

10. Final S Corp Regs Replace "Actual Economic Outlay" Standard for Loans Creating Basis

In July, the IRS issued final S corporation regulations in T.D. 9682 (7/23/14) which provide that in order for an S shareholder to increase the basis of indebtedness, and thus be eligible to deduct more losses, the shareholder need only prove that the debt is a bona fide debt under federal tax principles. A shareholder need not otherwise satisfy the "actual economic outlay" doctrine that was previously in place. However, for purposes of determining whether a guarantee gives rise to debt basis, the "actual economic outlay" standard still applies.

While these regulations were originally only to apply to transactions entered into on or after the regulations were finalized, the IRS reconsidered and the final regulations allow taxpayers to rely on the new rules for indebtedness between an S corporation and its shareholder that resulted from any transaction that occurred in a year for which the statute of limitations on tax assessments has not expired before July 23, 2014.

For a full discussion of the final regulations, see IRS Final Regs Address Creation of S Corp Basis with Back-to-Back Loans.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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