Parker's Federal Tax Bulletin - Issue 79 - January 1, 2015

Top Tax Developments of 2014

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 the December 18, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-12-18).

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 the August 29, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-08-29).

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. Rev. Procs. 2014-16, 2014-17, and 2014-54 are explained in the January 30, 2014, March 13, 2014, and September 26, 2014 issues of Parker's Federal Tax Bulletin, respectively (PFTB 2014-01-30, PFTB 2014-03-13, and PFTB 2014-09-26).

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 the August 2, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-08-02).

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 the June 20, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-06-20).

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 the November 72, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-11-07).

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 the April 10, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-04-10).

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 the July 3, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-07-03). For a discussion of the AICPA's failed lawsuit, see the November 7, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-11-07).

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 the February 27, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-02-27) and the June 6, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-06-06), respectively.

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 the June 20, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-06-20).

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 the August 2, 2014, issue of Parker's Federal Tax Bulletin (PFTB 2014-08-02).

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Taxpayers' Lodging Expenses Allowed; New York Apartment Was Not Tax Home

The Tax Court held that a couple performing consulting services throughout the Northeast could deduct lodging expenses arising from a New York City apartment because they had no principle place of employment and their tax home was their permanent residence in Mississippi. McClellan v. Comm'r, T.C. Memo. 2014-257.

The victory on the lodging expense issue was the only bright spot for the taxpayers in a case where the Tax Court rejected a number of other claimed deductions (e.g., home office, meal and entertainment, capital loss carryover, NOL carryover) for lack of substantiation.

Background

In 1998, Oliver and Cecile McClellan created BCMC, a consulting business for call centers. From 1998 until 2004, the Mississippi residents engaged in multiple business activities, including a real estate business, a general consulting business, and writing books. In 2004 BCMC entered into a working arrangement with Messages, Inc., which was the flagship company of a consortium of call centers based throughout the United States.

Beginning in 2004, Messages, Inc. rented to the McClellans a two-bedroom apartment in New York City for $1,000 per month. The McClellans occupied only one bedroom of the apartment. Various independent contractors hired by Messages, Inc. occupied the second bedroom and shared common space with the McClellans for approximately one-third of each year. Living in the New York City apartment permitted the McClellans to work on site at the various call center locations assigned to BCMC for consulting services. The McClellans provided services to not only Messages, Inc., but also to a consortium of other call centers located in 12 cities throughout the Northeastern United States.

The McClellans continued to own a single-family home in Gulfport, Mississippi that they had purchased in 1994 and had used as their principal residence since 2001. They spent approximately 20 percent of their time at their Gulfport home, and continued to pay mortgage principal and interest and other expenses associated with the residence while staying in New York City.

On their 2006, 2007, and 2008 tax returns, the McClellans deducted rent and other expenses associated with the New York City apartment on Schedule C, along with a wide array of other expenses attributed to BCMC.

In 2012, the IRS issued a notice of deficiency rejecting the rent deduction and almost all of the McClellans' other Schedule C deductions. In its notice, the IRS allowed just $6,879 of the $372,003 in deductions claimed.

Analysis

At trial, the IRS argued on most issues that the McClellans had failed to provide evidence that the claimed expenses had actually been incurred. The Tax Court sided with the IRS across the board, disallowing a myriad of expenses for lack of substantiation. The court rejected the McClellans' claim that that their tax records were destroyed by Hurricanes Katrina and Rita in 2005 and Hurricane Gustav in 2008, because they failed to provide proof of such destruction.

With respect to the lodging expenses, the IRS took a different approach, arguing that New York City was the McClellans' tax home during each year at issue, thereby rendering the outlays for the expenses for the New York City apartment nondeductible personal expenses. The McClellans countered that their tax home was in Gulfport, Mississippi, not New York.

Code Sec 162(a)(2) permits taxpayers to deduct traveling expenses, including amounts expended for lodging and meals, if such expenses are:

(1) ordinary and necessary;

(2) incurred while away from home; and

(3) incurred in the pursuit of a trade or business.

In order to deduct travel expenses a taxpayer generally must show that he or she was away from home overnight when the expenses were incurred (U.S. v. Correll, 389 U.S. 299 (1967)). The Tax Court has held that for purposes of Code Sec. 162(a)(2) a taxpayer's "home" is generally the vicinity of the taxpayer's principal place of employment (Mitchell v. Comm'r, 74 T.C. 578 (1980)). When a taxpayer accepts temporary work in a place away from his residence, he may deduct the living expenses incurred at the temporary post of duty because it would not be reasonable to expect him to move his residence under such circumstances (Tucker v. Comm'r, 55 T.C. 783 (1971)).

The Tax Court found that between 2006 and 2008, the McClellans had no principal place of employment and their tax home was their permanent residence in Mississippi. In reaching this conclusion, the court pointed to the fact that the couple provided services to Messages, Inc. on a temporary basis, and provided services for multiple other businesses during the same time period. Additionally, while the record did not indicate where the McClellans stayed while providing consulting services in the 12 different northeastern cities, the court deemed it was fair to assume it was not Mississippi. The court found further support that the New York apartment was not the McClellans' tax home because the couple was required to share that apartment with other independent contractors.

The IRS additionally argued that the McClellans' lodging deductions should be disallowed as their work assignments from Messages, Inc., were indefinite rather than temporary within the purview of the flush language in Code Sec 162(a), which provides that a "taxpayer shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year." The Tax Court disagreed, as it did not find it appropriate to group all of the McClellans' work assignments from separately owned call centers to form one period of employment. Rather, the court viewed each of the work assignments as a separate period of self-employment, concluding that the work assignments away from Gulfport did not exceed the 1-year threshold.

Thus, because of its findings that the McClellans maintained a permanent residence in Mississippi and had no principal place of employment, the Tax Court held that Mississippi was the couple's tax home during 2006 through 2008 and they were entitled to deduct lodging expenses totaling $42,593.

For a discussion of lodging expenses and related deductions, see Parker Tax ¶ 91,105.

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Tax Court Weighs Effects of Landlord's Disability in Determining "Real Estate Professional" Status

Taxpayer, a disabled veteran, was held to be a real estate professional for purposes of Code Sec. 469 passive activity losses, as he personally performed nearly all activities related to renting and maintaining a triplex apartment. Factoring in the taxpayer's disabilities, the Tax Court rejected the IRS's contention that it was highly unusual for the owner of a single property to spend more than 750 hours on those activities. Lewis v. Comm'r, T.C. Summary 2014-112 (12/23/14).

Background

Bill Lewis is a retired Vietnam veteran. During his service in the Marine Corps he sustained injuries that left his right arm 50 percent disabled and his feet 30 percent disabled. The Department of Veterans Affairs determined that Lewis is 60 percent disabled, and he receives monthly disability assistance. He also needed knee replacement surgery and has difficulty seeing. During 2010 (the first of two tax years at issue) he was 63 years old. Read more...

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IRS Clarifies Who Gets Mortgage Interest Deductions in Three Nettlesome Scenarios

The IRS's Office of Chief Counsel (IRS) clarified which taxpayer is entitled to claim mortgage interest deductions in three situations in which taxpayers who are potentially entitled to a deduction with respect to the same mortgage file separate tax returns. CCA 201451027.

In all three situations, the IRS makes a sometimes unstated assumption that the taxpayers meet the requirements to deduct mortgage interest under Code Sec. 163 that are not discussed in the facts of the situation.

Situation 1 - Co-Mortgagor Spouse Dies

Facts: Taxpayers are a married couple and are jointly and severally liable on a mortgage, but one spouse dies before the end of the tax year and the bank issues a Form 1098 under the deceased spouse's social security number. The surviving spouse files a separate return. Payment may be made from a joint account or from separate funds of either taxpayer.

The IRS advised that, in the year of death, if the surviving spouse files a separate return, the decedent's return should include income and deductions applicable up to the time of death. The amount of interest deductible on the decedents return is dependent upon whether payment was from joint or separate accounts. If the decedent paid interest from a joint account before death, there is a presumption the payment was made equally by each owner and consequently the decedent's return should reflect one-half of the interest paid from the joint account before the time of death.

The IRS further advised that in the years following the year of death, the surviving spouse is entitled to the deduction for interest since the surviving spouse is liable on the note, assuming the surviving spouse makes the interest payments and all other requirements are met.

Situation 2 - Unmarried Co-Mortgagors

Facts: Taxpayers are an unmarried couple and are jointly and severally liable on a mortgage, and the bank either issues a Form 1098 under only one social security number, or both. One or both taxpayers claims the mortgage interest deduction on their individual returns. Payment may be made from a joint account or from separate funds of either taxpayer.

The IRS advised that both taxpayers are entitled to claim the mortgage interest deduction to the extent of the mortgage interest paid by either taxpayer, since both are liable on the mortgage.

As in Situation 1, the IRS advised that the amount of interest each taxpayer can deduct is depends upon whether payment was from joint or separate accounts. If the mortgage interest is paid from the taxpayers individual accounts, each may claim the mortgage interest deduction paid from each separate account. In the event the interest was paid out of a joint account in which each taxpayer has an equal interest, it would be presumed that each has paid an equal amount. However, clear evidence that the funds used were provided by one taxpayer or the other can overcome the presumption. Finney v. Comm'r, T.C. Memo. 1976-329.

Situation 3 - Co-Owner Not Liable on Mortgage

Facts: Various combinations of relatives co-own a house and the co-owners are all liable on a mortgage note. Consistent with its previous advice in the CCA, the IRS states that each owner may take a deduction for the amount each one pays subject to the limitations and requirements of section 163(h).

In a variation of Situation 3, the IRS considered the plight of a co-owning relative who is not directly liable on the mortgage. The IRS quoted Reg. Sec. 1.163-1(b), which states that "interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness." The IRS proceeded to cite favorably a line of Tax Court cases in which a taxpayer who is an equitable owner of a residence was permitted to deduct mortgage interest even though the taxpayer's family member was liable on the mortgage, rather than the taxpayer. Uslu v. Comm'r, T.C. Memo. 1997-551; Amundsen v. Comm'r, T.C. Memo. 1990-337.

For a discussion of qualified residence interest, see Parker Tax ¶83,515.

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Disabled Coast Guard Veteran Can't Exclude Retirement Payments from Income

A disabled Coast Guard veteran was unable to exclude, under Code Sec. 104(a)(4), retirement payments stemming from his disability as he was unable to prove he was qualified for disability compensation from the Veterans Administration. Campbell v. Comm'r, T.C. Summary 2014-109.

Background

In 1990, the U.S. Coast Guard granted Kevin Campbell temporary disability retirement after concluding he was unfit for duty due to a diagnosis of insulin dependent diabetes mellitus. The Coast Guard evaluated Campbell and assigned him a Department of Veterans Affairs standard schedule of rating disabilities (VASRD) rating of 40 percent, which entitled him to monthly retirement pay equal to his base pay multiplied by his disability rating. The Coast Guard also informed him that Federal income tax would be withheld from his monthly retirement payments. In 1995, the Coast Guard notified Campbell that his condition now qualified as a permanent physical disability and he would be permanently retired from the Coast Guard. The Coast Guard assigned him a new VASRD rating of 60 percent, and again informed him that Federal income tax would be withheld.

From 1992 to 1995, Campbell made several unsuccessful attempts to convince the Coast Guard that his retirement pay was exempt from federal tax. However, the Coast Guard continued to issue to Campbell Forms 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting that he had received taxable retirement pay. Campbell provided the Forms 1099-R to his accountant, who concluded that the retirement payments were not includable in income, and proceeded to exclude the payments on Campbell's tax returns.

Every few years, the IRS issued to Campbell a Notice CP-2000 proposing to increase his taxable income by the amount of his Coast Guard retirement pay. Mr. Campbell forwarded the notices to his accountant, who would promptly contact the IRS and assert that the retirement pay was exempt from tax. After these exchanges, Campbell normally received a "No Change" letter from the IRS accepting his tax return as filed.

In 2011, Campbell received Coast Guard retirement pay of $9,210. He timely filed a joint federal income tax return for 2011 on which he excluded the retirement pay. The IRS issued a notice of deficiency determining that Campbell's retirement pay was required to be included in gross income.

Analysis

Code Sec. 104(a)(4) provides that amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country are not included in gross income. However, Code Secs. 104(b)(1) and (2) limit the exclusion to an individual who would be entitled to receive disability compensation from the Veterans Administration (VA).

The Tax Court concluded that Campbell failed to prove his eligibility for the exclusion under Code Sec. 104(a), as the VA's disability benefits process was different from the Coast Guard's process and Campbell did not have enough information to prove he otherwise would have qualified for the exclusion under Code Sec. 104(b). The court reasoned that while the Coast Guard and the VA use the same VASRD rating system, the Coast Guard applies the VASRD system differently than the VA. In drawing this distinction, the court stated that the Coast Guard evaluates whether a service member is able to perform his or her military duties at a given time, while the VA rates disabilities by weighing the impact of an injury or illness on a veteran's earning capacity in a civil occupation over his or her lifetime.

Practice Tip: Even when a veteran receives a VA disability compensation award, reaping the initial tax benefits can be tricky. When the VA grants disability compensation, it normally backdates the award. This can have the effect of retroactively converting prior retirement payments from taxable income to nontaxable income. Because the retroactive effects can reach into previous years, a taxpayer receiving a VA disability compensation award is often in the position of having to file an amended return to garner the full tax benefit. See ¶15,385 for detailed guidance on preparing and amending tax returns involving VA disability awards.

Since Campbell was unable to provide documents or information related to a disability rating based on an earlier examination by the VA, the Tax Court concluded it was unable to determine whether Campbell otherwise would be entitled to VA disability benefits within the meaning of Code Sec. 104(b) and therefore Campbell could not exclude his Coast Guard disability retirement pay.

For a discussion of disability benefits resulting from military service, see Parker Tax ¶ 15,385.

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IRS Announces 2015 Filing Season to Begin on January 20, 2015

The IRS announced plans to open the 2015 filing season as scheduled on January 20, 2015. No tax returns will be processed prior to that date. IR-2014-119 (12/29/14).

The announcement comes in the wake of Congress's last minute passage of the tax extenders bill, which had cast some doubt on whether tax season would begin on time. The extenders bill retroactively renewed more than 50 tax provisions that expired at the end of last year through the end of 2014. The final legislation, the Tax Increase Prevention Act of 2014, was signed into law on Dec. 19, 2014.

IRS Commissioner John Koskinen stated the IRS has reviewed the late tax law changes and determined there was nothing preventing them from continuing updating and testing processing systems. IRS employees will continue an aggressive schedule of testing and preparation of the systems during the next month to complete the final stages needed for the 2015 tax season.

The IRS also reminded taxpayers that filing electronically is the most accurate way to file a tax return and the fastest way to get a refund. The IRS stated that there is no advantage to filing paper returns in early January instead of waiting for e-file to begin, because it will begin processing both electronic and paper returns on January 20.

More information about IRS Free File and other information about the 2015 filing season will be available in January.

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Bankrupt Payroll Processing Company Cannot Reclaim Funds Transferred to IRS

The Fourth Circuit ruled that a payroll processing company going through bankruptcy could not reclaim $28 million transferred to the IRS during the 90 days preceding the filing for bankruptcy. The company had no claim to funds that were held in trust for its employer-clients and were not the company's personal property. In re: FirstPay, Inc., 2014 PTC 592 (4th Cir.).

Background

Prior to bankruptcy, FirstPay, Inc. provided payroll processing services as well as tax reporting and depositing services for numerous employer-clients. Before each payroll date, FirstPay would withdraw funds from client checking accounts and deposit the withdrawn funds into a tax account to cover following amounts: (1) payroll and withholding taxes for which the client was liable; (2) payment of the client's employees' wages; and (3) fees owed to FirstPay for its services.

FirstPay's service agreements with its employer-clients provided that it would hold the tax funds until taxes were due and then remit payments to taxing authorities. However, not all of the funds were used for that purpose. While some funds were transferred to the IRS, FirstPay also conducted several fraudulent transfers from the tax account to an operating account used to pay its own business expenses, and also transferred funds to an exchange and reimbursement account used for lavish personal expenditures by FirstPay's principals. As a result of FirstPay's misappropriation of its clients' funds, a substantial portion of its clients' tax obligations went unpaid, and remained due and owing at the time of the bankruptcy proceedings.

Observation: Although the experiences of FirstPay's clients are by no means typical, the case illustrates the risks inherent in entrusting tax remittances to a payroll processor. As FirstPay perpetrated its fraud, it fully remitted the tax payments of some clients, partially remitted the tax payments of others, and made no payments at all on behalf of the rest. The clients in the latter two groups are faced with the prospect of having to pay their payroll and withholding taxes twice: once to FirstPay (years ago), and a second time directly to the IRS.

In 2003, creditors filed an involuntary Chapter 7 bankruptcy petition against FirstPay in the U.S. Bankruptcy Court for the District of Maryland. In 2005, the bankruptcy estate's trustee sought a judgment that the Government had no claim for taxes or penalties against FirstPay clients whose payroll taxes were paid to FirstPay, but not ultimately remitted to the IRS; avoidance of FirstPay's payments of its clients' payroll taxes to the IRS as preferences under 11 U.S.C. Sec. 547 and as fraudulent conveyances under 11 U.S.C. Sec. 548 and Maryland law; and turnover of avoided transfers under 11 U.S.C. Sec. 550. After a series of appeals and remands, the Fourth Circuit was asked to determine, for purposes of recovering the funds, whether the nearly $28 million FirstPay transferred to the IRS during the 90 days preceding the bankruptcy filing constituted "an interest of the debtor in property" under 11 U.S.C. Sec. 547(b).

Appeal and Analysis

The Trustee's main argument was that the transfer of the tax funds to the IRS qualified as a "transfer of an interest of the debtor in property" under 11 U.S.C. Sec. 547(b), as opposed to funds that FirstPay held in trust for the benefit of its clients. The Trustee proffered that, upon transfer to the debtor, the client tax funds became a debt the debtor owed its clients and therefore the debtor's subsequent transfer of those funds to the IRS was a transfer of an interest of the debtor in property constituting an avoidable preference under 11 U.S.C. Sec. 547(b).

In limited circumstances, a trustee in bankruptcy is permitted to avoid and recover certain payments made by an insolvent debtor preferentially for the benefit of some creditors prior to the filing of the bankruptcy petition. 11 U.S.C. Secs. 547(b), 550(a). These avoidable preferences include transfers made on or within 90 days before the petition is filed. However, the trustee can only avoid a "transfer of an interest of the debtor in property," as only the debtor's property would have been available for distribution among creditors in the absence of the transfer.

Whether an amount is considered an interest of the debtor in property, as opposed to being held in another form such as a trust, depends on state law. Under Maryland law, a trust exists where the legal title to property is held by one or more persons, under an equitable obligation to convey, apply, or deal with such property for the benefit of other persons (From the Heart Church Ministries, Inc. v. African Methodist Episcopal Zion Church, 803 A.2d 548 (Md. 2002)).

The Fourth Circuit Court agreed with the bankruptcy court and the district court, concluding that FirstPay lacked the requisite ownership in the funds paid over to the IRS to categorize them as a transfer of an interest of the debtor in property, and therefore the transfer was not an avoidable preference under 11 U.S.C. Sec. 547(b). The Circuit Court based this conclusion on the fact that the funds were held in trust by the debtor. The court found that all the elements of a valid trust under Maryland law were satisfied, and relied on the unambiguous terms of the service agreements to conclude the tax funds were intended to be held by FirstPay, as an intermediary, only for payment of the clients' taxes and therefore constituted trust property, as opposed to debt.

The Trustee alternately argued the funds transferred to the IRS had been comingled and therefore could not be deemed trust property. However, the court disagreed, finding the funds were not so "mingled and merged" with FirstPay's general assets or dissipated to the point that would prevent the funds from filling the purpose of the trust, but, rather, were identifiable and thus could be traced and connected to the trust.

As the funds were held in trust, they were not a transfer of an interest of the debtor's property within the meaning of 11 U.S.C. Sec. 547(b), thus the Circuit Court held that the transfer was not avoidable, and thus the trustee was unable to reclaim the funds transferred by the debtor to the IRS.

The Court expressed sympathy to the affected employee-clients, many of whom were still liable for the taxes FirstPay failed to remit. However, it noted that the employers had assumed the risk of FirstPay's mishandling of their funds when they selected the firm for vital payroll processing and tax reporting services.

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First-Time Homebuyer Credit Denied Due to Timing of Seller-Financed Contract

The Tax Court held that a taxpayer acquired equitable title to a residence property when she entered in to a seller-financed contract and took on the benefits and burdens of ownership, rather than when delivery of the deed was completed years later. Because the contract was executed prior to window of time during which the first-time homebuyer credit was available, the taxpayer was not eligible for the credit. Wodack v. Comm'r, T.C. Memo. 2014-254 (12/17/14).

Background

In 1993, Rose Wodack entered into a seller-financed land contract with Howard Schlise for a tract of land and a residence. Under the contract, Wodack would pay Schlise an initial amount and make monthly payments towards satisfying the purchase price over a five-year term. The contract allowed for extensions with 30 days' notice and a recalculation of the interest rate.

Wodack was required to pay Schlise annual property taxes, special assessments, and fire and other required insurance premiums. In return, Wodack had the right to take possession of the property at the time of the closing and could improve the property without permission. She resided at the property, made timely monthly payments, and renewed the land contract for two additional five-year terms without issue. In 2006, Schlise passed away and his interest in the property passed to the Schlise Family Trust.

In 2008, when the Schlise Family Trust denied Wodack's request for another contract renewal, she secured a loan and paid the balance owed in full upon the expiration of the contract period. The Schlise Family Trust then transferred the deed to Wodack in November of 2008. On her 2008 tax return, Wodack claimed a first-time homebuyer credit. The IRS issued Wodack a notice of deficiency disallowing this credit, claiming the sale took place in 1993 when she entered the contract. Wodack petitioned the Tax Court for redetermination.

Analysis

First-time homebuyers of a principal residence are entitled to a credit of 10 percent of the purchase price, not to exceed $7,500 (Code Sec. 36(a)). The taxpayer must have purchased the home on or after April 9, 2008, and before July 1, 2009 (Code Sec. 36(h)). The term "purchase" is defined as "any acquisition" (Code Sec. 36(c)(3)). Generally, a transfer is complete upon the earlier of the transfer of legal title, such as a deed, or the practical assumption of the benefits and burdens of ownership. State law controls the determination a taxpayer's interest, while the tax consequences are determined by Federal law. Woods v. Comm'r, 137 T.C. 159 (2011).

Wodack argued the purchase occurred in November 2008 when she paid the Schlise Family Trust the remaining balance under the land contract and received the deed to the property. The IRS argued that, for tax purposes, the purchase occurred on August 3, 1993, the effective date of the land sale contract, when Wodack acquired equitable title and took on the benefits and burdens of the property.

In determining the purchase year, the Tax Court applied Wisconsin law to conclude that Wodack became the equitable owner of the property when she took on the benefits and burdens of ownership. The court noted that the 1993 contract granted Wodack the benefits of right of possession, right to obtain legal title by paying the remaining balance, as well as the burdens of property taxes, assessments, insurance, maintenance and risk of loss. As she had become the equitable owner of the property in 1993, the court determined that, under the meaning of Code Sec. 36(c)(3), Wodack had purchased the property at that time.

The court rejected Wodack's assertion that the purchase occurred in 2008 when she received the deed after paying off the remaining balance on the contract. The court viewed the Schlise Family Trust as holding only bare legal title after the effective date of the contract, concluding the deed was merely security for the unpaid balance. Consequently, Wodack did not "purchase" the property when she received the deed. Because the purchase occurred in 1993, outside the permissible time frame under Code Sec. 36(h), the court held that Wodack was not entitled to the first-time homebuyer credit.

For a discussion of the first time homebuyer credit, see Parker Tax ¶ 102,700.

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IRS Chief Counsel: Government Entities Can Allocate Sec. 179D Deduction to Designers

The IRS's Office of Chief Counsel (IRS) has advised that government entities can allocate deductions under Code Sec. 179D to the designers of energy efficient buildings where the government entity is the owner of the building. Schools, colleges, and universities that are governmental entities are eligible to make the allocation. CCA 201451028.

Background

Code Sec. 179D provides a deduction for all or part of the cost of energy-efficient commercial building property placed in service in a taxable year.

For purposes of Code Sec. 179D, energy-efficient commercial building property is property that: (1) is installed on or in any building located in the United States that is within the scope of Standard 90.1-2001 of the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America (ASHRAE/IESNA); and (2) is installed as part of (a) the interior lighting systems, (b) the heating, cooling, ventilation, and hot water systems, or (c) the building envelope (Code Sec. 179D(c)(1)). Further, it must be certified that the installed systems will reduce the total annual energy and power costs with respect to combined usage of the building's heating, cooling, ventilation, hot water, and interior lighting systems by 50 percent or more as compared to a Reference Building that meets the minimum requirements of Standard 90.1-2001 (Code Sec. 179D(c)(1)(D)).

The deduction is available based upon the ownership of the building. Where the energy efficient commercial building property is installed on or in property owned by a governmental entity, the deduction may be allocated to the person (the designer) primarily responsible for designing the energy efficient commercial building property (Code Sec. 179D(d)(4)).

A designer is a person that creates the technical specifications for installation of energy-efficient commercial building property and may include, for example, an architect, engineer, contractor, environmental consultant or energy services provider who creates the technical specifications for a new building or an addition to an existing building that incorporates energy-efficient commercial building property. A person that merely installs, repairs, or maintains the property is not a designer (Notice 2008-40).

Analysis

In CCA 201451028, the IRS provided clarity regarding the types of entities that can allocate the Code Sec. 179D deduction to the designer of an energy efficient commercial building property.

The IRS advised that, for purposes of the Code Sec. 179D deduction, governmental entities that own property on or in which energy efficient commercial building property is installed can allocate the deduction to the designer. The IRS emphasized that relevant inquiry is whether the owner is a governmental entity.

Accordingly, the IRS advised that schools, colleges, and universities that are governmental entities can allocate the Code Sec. 179D deduction to the designer. Tax-exempt entities and non-profit organizations (including schools, colleges, and universities) that are not governmental entities are not eligible to allocate the deduction to the designer.

For a discussion of the Code Sec. 179D energy-efficient commercial buildings deduction, see Parker Tax ¶96,555.