Parker's Federal Tax Bulletin - Issue 80 - January 16, 2015

As Deadline Approaches, Stakes Remain High on 1099 Reporting

The presence of questions on Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, asking whether the taxpayer made any payments in 2014 that would require the taxpayer to file Form(s) 1099, continues to cause concern for practitioners and clients alike, as do penalties running as high a $100 per late 1099.

The 2014 Forms 1065, 1120, 1120S, and 1040, Schedules C, E, and F, all contain questions asking if the taxpayer made any payments in 2014 that would require the taxpayer to file Form(s) 1099. If the answer is "yes," then the IRS wants to know if the taxpayer did, or will, file the required Forms 1099.

The questions first showed up in 2011 and coincided with a sharp increase in the penalties for failing to file correct information returns and payee statements. Practitioners immediately expressed concern that their clients may not be aware of the full ramifications of incorrectly reporting Form 1099 income and the impact on their own liability for checking these boxes. If a client reports that all Form 1099s were filed when they were not, he or she is committing perjury (because the returns are signed under penalties of perjury). If the client reports that not all Form 1099s were filed, then that's a red flag for an audit.

Practice Aid: Keep your clients informed. Use Parker's Client Letter as a template or just sign your name at the bottom. CPA CLIENT LETTER: Requirement to File Forms 1099

If a taxpayer has a business that uses sporadic labor, the Form 1099 questions can present a dilemma in certain situations. For example, how does a taxpayer who intermittently employs workers by picking them up at places where such workers congregate, answer the questions? If any of these workers are used several times during the year in the taxpayer's business, the amounts paid to that worker will most likely exceed $600, and the taxpayer will be responsible for issuing a Form 1099-MISC to that independent contractor. What if the workers will accept only cash? Without proper documentation, how does the taxpayer prove that no one individual was paid more than $600?

Form 1099-MISC

Generally, any person, including a corporation, partnership, individual, estate, and trust, which makes reportable transactions during the calendar year, must file information returns to report those transactions to the IRS. However, a payer does not need to file Form 1099-MISC for payments not made in the course of the payer's trade or business. A payer is engaged in a trade or business if it operates for gain or profit, thus, personal payments are not reportable. Nonprofit organizations are considered to be engaged in a trade or business and are subject to the reporting requirements. For other exceptions to filing a Form 1099-MISC.

The type of reportable transaction determines the specific Form 1099 that must be filed. Most of the issues revolving around the filing of Forms 1099, involve Form 1099-MISC and the reporting of non-employee compensation. In general, a payer must file Form 1099-MISC, Miscellaneous Income, for each person to whom the payer has paid during the year:

• at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest;
• at least $600 in rents, services (including parts and materials), prizes and awards, other income payments, medical and health care payments, crop insurance proceeds, cash payments for fish (or other aquatic life) purchased from anyone engaged in the trade or business of catching fish, or, generally, the cash paid from a notional principal contract to an individual, partnership, or estate;
• any fishing boat proceeds; or
• gross proceeds to an attorney.

In addition, Form 1099-MISC must be filed to report direct sales of at least $5,000 of consumer products made to a buyer for resale anywhere other than a permanent retail establishment. Form 1099-MISC must also be filed for each person from whom a taxpayer has withheld any federal income tax under the backup withholding requirement (discussed below), regardless of the amount of the payment.

Compliance Tip: The deadline for filing paper Forms 1099-MISC is generally the last day of February following the calendar year for which the filing is made. The due date is extended until the last day of March for payers who file electronically. If the regular due date falls on a Saturday, Sunday, or legal holiday, Form 1099-MISC is due the next business day.

Backup-Withholding Requirement

A backup withholding requirement applies to reportable payments where the payee does not furnish a taxpayer identification number (TIN). The backup withholding rate is equal to 28 percent of the amount paid. The requirement does not apply to payments made to tax-exempt, governmental, or international organizations.

In determining whether a payee has failed to provide a TIN, a payer is required to process the TIN within 30 days after receiving it from the payee or in certain cases, from a broker. Thus, the payer may take up to 30 days to treat the TIN as having been received.

Penalties for Failing to File Correct Information Returns

If a payer fails to file a correct information return by the due date and cannot show reasonable cause for failing to do so, the payer may be subject to a penalty. The penalty applies if the person fails to file timely, fails to include all information required to be shown on a return, or includes incorrect information on a return. The penalty also applies if a person files on paper when required to file electronically, reports an incorrect taxpayer identification number (TIN) or fails to report a TIN, or fails to file paper forms that are machine readable. The amount of the penalty is based on when the correct information return is filed. For returns required to be filed for the 2014 tax year, the penalty is:

(1) $30 per information return for returns filed correctly within 30 days after the due date (by March 30 if the due date is February 28), with a maximum penalty of $250,000 a year ($75,000 for certain small businesses);

(2) $60 per information return for returns filed more than 30 days after the due date but by August 1, with a maximum penalty of $500,000 a year ($200,000 for certain small businesses); and

(3) $100 per information return for returns filed after August 1 or not filed at all, with a maximum penalty of $1,500,000 a year for most businesses but $500,000 for certain small businesses.

For purposes of the lower penalty, a business is a small business for any calendar year if its average annual gross receipts for the most three most recent tax years (or for the period it was in existence, if shorter) ending before the calendar year do not exceed $5 million.

Persons who are required to file information returns electronically but who fail to do so (without an approved waiver) are treated as having failed to file the return, and are therefore subject to a penalty of up to $100 per return unless the person shows reasonable cause for the failure. However, they can file up to 250 returns on paper; those returns will not be subject to a penalty for failure to file electronically. The penalty applies separately to original returns and corrected returns.

Observation: For each fifth calendar year beginning after 2012, each of the dollar amounts described above is subject to indexing for inflation.

The penalty for failure to include the correct information on a return does not apply to a de minimis number of information returns with such failures if the failures are corrected by August 1 of the calendar year in which the due date occurs. The number of returns to which this exception applies cannot be more than the greater of 10 returns or 0.5 percent of the total number of information returns required to be filed for the year.

The penalty for a failure to include the correct information on a return does not apply to inconsequential errors or omissions. If a failure to file a correct information return is due to an intentional disregard of one of the requirements (i.e., it is a knowing or willing failure), the penalty is the greater of $250 per return or the statutory percentage of the aggregate dollar amount of the items required to be reported (the statutory percentage depends on the type of information return at issue). In addition, in the case of intentional disregard of the requirements, the $1,500,000 limitation does not apply.

Can IRS Limit Deductions to $600 Where No Form 1099 Is Filed?

Some practitioners have questioned whether or not the IRS can limit a compensation deduction to $599, the cutoff for not reporting nonemployee compensation, where a Form 1099-MISC is not filed. While there is nothing in the Code or regulations on this, nor is there any case law on point, some practitioners have reported IRS agents telling them that if they had not produced Form 1099s for compensation deductions taken on a return, the nonemployee compensation deduction would be limited to an amount not required to be reported on Form 1099-MISC.

What Constitutes a Trade or Business That Requires Reporting on Form 1099?

The characterization of an activity as a "trade or business" took on a new importance in 2013 with the implementation of the net investment income tax. Effective for tax years beginning after December 31, 2012, individuals are subject to a 3.8 percent tax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. Generally, income from a trade or business (with the exception of certain commodities trading income) is exempt from the net investment income tax.

As previously mentioned, taxpayers not in a trade or business are not required to file Form 1099s. Whether a taxpayer is considered to be in a trade or business has become a hot topic because of the net investment income tax. As a result, taxpayers may be claiming that their activity is not subject to the net investment income tax because it rises to the level of a trade or business without considering the impact that will have on their Form 1099 filing requirements and the associated penalties if such forms are not filed.

Conclusion

Practitioners should advise their clients to have non-employee workers or contractors complete a Form W-9 if they believe payments to any individual might add up to $600 or more for the year. To the extent anyone is paid more than $600, a Form 1099-MISC should then be issued at the end of the year. Practitioners should also document in their files that they've had this discussion with clients and may want to consider revising their engagement letter to reflect the documentation a client will need to take certain deductions on the return. Similarly, practitioners may want to warn their clients about the trade-offs for claiming they are in a trade or business in an effort to escape the net investment income tax and their responsibility for filing Form 1099s when they are in a trade or business.

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IRS Releases Guidance on Tax Preparer Best Practices for Determining ACA Penalties

In December, the IRS quietly released "Return Preparer Best Practices" for tax professionals seeking to determine whether clients are subject to penalties in 2014 under the Affordable Care Act's individual mandate (aka, the Code Sec. 5000A penalty).

The two-page IRS Section 5000A Best Practices guide's stated goal is to present best practices for practitioners to gather necessary information to demonstrate a client's compliance with the individual healthcare mandate. It starts by noting that, for practitioners, "[t]here are no special or specific due diligence requirements related to Affordable Care Act (ACA) issues."

Practice Aid: The IRS Section 5000A Best Practices guide PDF is available for downloading on the Parker Tax Pro Library website.

The IRS suggests a fairly conventional three-step process for determining if a client is subject to a Code Sec. 5000A penalty: (1) review the client's documentation to determine if the client and all of his or her family members had qualifying health care coverage in place for the entire tax year, (2) for any month coverage was not in place, determine if the client received an Exemption Certificate Number (ECN) from a healthcare Exchange, and (3) to the extent necessary, determine if the client qualified for one of the ACA's exemptions.

In discussing documentation that practitioners should review, the guide starts with the obvious: Forms 1095 and W-2. Next, the IRS provides four specific examples of alternate documentation that may substantiate coverage (implicitly acknowledging that many taxpayers will not receive Forms 1095 for the 2014 tax year). The examples include:

• Medical bills showing that during the tax year an amount due was paid by a health insurance company (indicating coverage)
• Documentation/statement from an employer indicating health insurance coverage
• Medicare card
• Record of advance payments of the premium tax credit

The guide goes on to provide a summary of eight of the exemptions available to taxpayers who did not have health coverage in place for all or part of 2014: (1) short coverage gaps of less than three consecutive months, (2) income below filing threshold, (3) certain hardship situations, (4) citizen living abroad or in a U.S. territory, (5) not lawfully present in U.S., (6) member of a Federally-recognized Indian tribe, (7) member of a Health Care Sharing Ministry, (8) incarceration.

The IRS also reminds preparers that while they are not subject to specific due diligence requirements for ACA issues, they are expected to resolve conflicting or contradictory statements from their clients, as they would with any issue during the return preparation process.

For a discussion of the individual healthcare mandate and penalties, see Parker ¶190,100.

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Third Circuit Denies Capital Gain Treatment of Oil and Gas Lease Bonus Payments

The Third Circuit affirmed the Tax Court's determination that a bonus payment made under an oil and gas agreement was taxable as ordinary income because the agreement was a lease and not a sale of taxpayers' rights in their land. Dudek v. Comm'r, 2014 PTC 603 (3rd Cir. 2014).

Background

Michael Dudek, a CPA and attorney licensed to practice in Pennsylvania, and his wife, Brenda, purchased acreage that was subject to oil and gas leases with Ohio Lease Development Co. between 1996 and 1998. The Dudeks entered into an oil and gas lease agreement with EOG Resources, Inc. in 2008, under which EOG could develop the couple's acreage and drill for, extract, and sell any gas and oil discovered on the property, and the couple would receive royalty payments equal to 16 percent of the net profits of any oil and gas extracted.

Pursuant to the terms of the agreement, the Dudeks received a bonus payment of $883,250.00 in 2008, which they reported as a long-term capital gain on their 2008 tax return. The payment was not dependent on any extraction or production of oil or gas. In 2013, the IRS issued a notice of deficiency, claiming the bonus payment should be treated as ordinary income. Michael and Brenda argued that the agreement was not a lease; rather, it was, in substance, a sale of their rights to any oil and gas on the property that generated capital gains, and filed a suit in the Tax Court.

Before the Tax Court, the Dudeks argued that if the court determined that the bonus payment was ordinary income, then they were entitled to a percentage depletion deduction of approximately $130,000. The Tax Court disagreed, and held that the agreement between the Dudeks and EOG was a lease and the bonus payment to the couple was taxable as ordinary income. Additionally, the Tax Court held the bonus payment was not eligible for percentage depletion because the payment did not relate to the extraction or production of oil and gas.

Appeal and Analysis

On appeal, the Dudeks continued to assert the agreement was a sale, not a lease, and therefore the bonus payment should be treated as a long-term capital gain. The IRS maintained the agreement was a lease and therefore the bonus payment was ordinary income.

Where the owner of land retains an economic interest in oil and gas deposits, the transaction is regarded as a lease and the proceeds are taxable as ordinary income (Laudenslager v. Comm'r, 305 F.2d 686 (3d Cir. 1962). A lessor has an economic interest if, by virtue of the leasing transaction, he has retained a right to share in the oil produced (Palmer v. Bender, 287 U.S. 551 (1933)).

The Circuit Court affirmed the Tax Court decision, ruling that the bonus payment was ordinary income. Adopting the Tax Court's reasoning, the Circuit Court relied on Laudenslager, which held that bonus payments for mineral deposits obtained where the owner retained an economic interest in the mineral deposits was regarded as a lease, and the proceeds were taxable as ordinary income. Under the oil and gas agreement, the Dudeks were entitled to royalty payments equal to a percentage of the net profits of any oil or gas extracted from the property. The court stated this royalty interest was an economic interest, because the Dudeks retained the right to share in the proceeds of any oil or gas extracted from the property.

The court noted the agreement could not be a sale as it did not provide for a determinable quantity of oil and gas to be transferred to the lessee, thus failing to reflect the economic realities of a sale. The court also dryly noted that the Supreme Court long ago had held in Burnet v. Harmel, 287 U.S. 103 (1932) that bonus payments made as part of an oil and gas lease are ordinary income, not capital gains.

Consequently, the court concluded the Dudek's received the bonus payment as part of a lease and therefore the payment was ordinary income.

For more on determining whether a natural resource transaction is a sale or a lease, see Parker Tax ¶ 117,545.

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Ex-CPA Tax Protester Slammed With Fraud Penalty and $25,000 Sanction

A well-known tax protestor's failure to file his tax returns was deemed fraudulent, resulting in a 75 percent civil fraud penalty under Code Sec. 6651(f). An additional $25,000 penalty under Code Sec. 6673 was assessed as a sanction for his persistent frivolous contentions before the Tax Court. Banister v. Comm'r, T.C. Memo 2015-10.

Background

It's tough to tell whether Joe Banister's star is rising or falling. On the one hand, he's been losing professional certifications and piling up six-figure tax assessments at a frightening pace. On the other, he's becoming something of an icon in the tax protester community, garnering coverage in the New York Times and other national publications.

Banister had an impressive early career as an accountant. He became licensed in California as a CPA in 1991, worked as an auditor for KPMG for three years, and was an IRS special agent in the Criminal Investigation Division from 1993 to 1999.

In 1999, Banister authored a book entitled "Investigating the Federal Income Tax: A Preliminary Report" in which he espoused tax protestor beliefs, including arguments that the payment of Federal income tax is voluntary, the Sixteenth Amendment was not legally ratified, and Government financing operations are unconstitutional. He ultimately resigned from the IRS and rose to fame as a champion of the tax protestor movement, providing tax consultation services, speaking at conventions throughout the country, operating Web sites, and selling books, CDs, and DVDs setting forth his views on income tax and the Internal Revenue Code.

In December 2003, Banister was disbarred from practice before the IRS after findings that he advised taxpayers to rely on frivolous positions, similar to those advanced in his book, and a determination that his advice constituted disreputable conduct. The same conduct that led to his disbarment also led the California Board of Accountancy to revoke Banister's CPA license in 2007. Banister filed unsuccessful challenges to that decision with the California Court of Appeals, the California Supreme Court, and even the U.S. Supreme Court.

From 2003 through 2006, Banister capitalized on his fame as a tax protester, earning income from his tax consultation services, speeches, book sales, and other business activities promulgating his views of the Federal income tax system. In keeping with his beliefs, Banister failed to file returns for those years and failed to submit to examination on audit. In response, the IRS prepared substitute returns using the bank deposit method after examining six bank accounts. The IRS determined that taxable deposits of $143,607, $177,402, $130,502, and $87,389 had been made for 2003, 2004, 2005, and 2006, respectively. Those amounts were used in the statutory notice sent to Banister, who challenged the determinations before the Tax Court.

Analysis

Banister claimed the statutory notice the IRS sent him was invalid because it was not signed by an authorized person and as a result, the court lacked jurisdiction over his case. The court quickly rejected that argument, relying on the fact courts have consistently held that a signature is not required on a notice of deficiency. The court then turned to the issue of whether Banister's failure to file returns for 2003 through 2006 was fraudulent and subject to the penalty under Code Sec. 6651(f).

Banister argued that his U.S. income was not subject to tax and that he had no obligation to file tax returns, repeating or restating the arguments that had led to his disqualification to practice before the IRS and the loss of his CPA license.

Code Sec. 6651(f) provides for a civil penalty of 75 percent of the amount required to be shown as tax on unfiled returns if the failure to file the returns is fraudulent. Code Sec. 6673 provides for a penalty up to $25,000 if the taxpayer makes frivolous arguments in U.S. Tax Court. Fraud may be proved by circumstantial evidence, and the taxpayer's entire course of conduct may establish the requisite fraudulent intent. Circumstantial evidence includes "badges of fraud" such a longtime pattern of failure to file returns, failure to report substantial amounts of income, failure to maintain adequate records, failure to cooperate with taxing authorities in determining the taxpayer's correct liability, and implausible or inconsistent explanations of behavior (Bradford v. Commissioner, 796 F.2d 303 (9th Cir. 1986)).

The Tax Court concluded that the IRS properly assessed deficiencies and a 75 percent penalty under Code Sec. 6651(f) on amounts due for Banisters fraudulent failure to file. The court reasoned that Banister failed to provide a plausible nonfraudulent explanation for his behavior, as he refused to testify. The court also pointed to his persistence in advancing continuously discredited arguments as negating any good faith defense to the inference of fraudulent intent.

Further, the court determined that the additions to tax penalty under Code Sec. 6673 were proper given Banister's persistent frivolous contentions and the fact he failed to present evidence or arguments showing a reasonable dispute as to the income, tax, penalties, or additions to tax determined in the statutory notice. The court acknowledged that adding the $25,000 penalty to Banister's existing substantial tax debt may fail to dissuade him personally, but underscored the secondary value such sanctions can play in warning other taxpayers to avoid similar tactics.

For a discussion on penalties relating to frivolous tax submissions, see Parker Tax ¶262,145.

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IRS Releases Employer Guidance on Retroactive Increase in Excludable Transit Benefits

To address employers' questions regarding the retroactive application of the increased transit benefits exclusion for 2014 pursuant to TIPA, the IRS clarified how the increase applies and provided a special administrative procedure for employers to use in filing their fourth quarter Form 941, and Forms W-2. Notice 2015-2.

Background

Under Code Sec. 132(a)(5), the value of the qualified transportation benefits provided by an employer to an employee is excludable from the employee's gross income to the extent that value does not exceed certain dollar amounts. Excludable qualified transportation benefits include:

• transportation in a commuter highway vehicle between home and work;
• transit passes;
• qualified parking; and
• qualified bicycle commuting reimbursements.

Prior to the enactment of the Tax Increase Prevention Act of 2014 (TIPA), the maximum monthly amount excludable for 2014 for transportation in a commuter highway vehicle and/or any transit pass ("transit benefits") was $130 per participating employee and the maximum monthly amount excludable for qualified parking was $250. TIPA increased the $130 maximum monthly excludable amount for transit benefits to equal the $250 maximum monthly excludable amount for qualified parking. The increase is effective retroactively, beginning on January 1, 2014 and extends through December 31, 2014.

Pursuant to the change made by TIPA, transit benefits provided during 2014 by an employer to an employee in excess of $130 (the former maximum monthly excludable amount) up to $250 (the amended maximum monthly excludable amount) ("excess transit benefits") are excluded from the employee's gross income and wages. Neither Code Sec. 132, nor the change made by TIPA, mandate that employers provide additional transit benefits to their employees for 2014, and employees may not retroactively increase their compensation reduction for 2014 to take advantage of the increase in the excludable amount for transit benefits in 2014.

Employers who originally reported excess transit benefits as includible in gross income and wages and withheld income taxes and FICA taxes would normally be required to file Form 941-X for each quarter to make corrections accounting for the increase in excludable transit benefits.

However, because of the year-end passage of TIPA, and the fast-approaching due dates for fourth quarter Forms 941 and Forms W-2, the IRS has provided a special administrative procedure for employers who treated excess transit benefits as wages and that have not yet filed their fourth quarter Form 941 for 2014. Employers who choose to use this special administrative procedure must repay or reimburse their employees for the overcollected FICA tax on the excess transit benefits for all four quarters of 2014 on or before filing the fourth quarter Form 941.

Observation: Employers must act quickly in order to take advantage of this special procedure as the fourth quarter Form 941 is due on February 2, 2015.

Special Administrative Procedure

The procedure allows the employer, in reporting amounts on its fourth quarter Form 941, to reduce the fourth quarter wages reported on lines 2, 5a, 5c, and 5d by the excess transit benefits for all four quarters of 2014. By electing this special administrative procedure, employers will avoid having to file Forms 941-X, and will also avoid having to file Forms W-2c. Additionally, employers using this special procedure do not need to obtain written statements from their employees confirming the employee did not, and will not, make a claim for a refund of FICA tax. This procedure can only be used to the extent that employers have repaid or reimbursed their employees for the employee share of FICA tax attributable to the excess transit benefits.

Practice Tip: Employers who have already filed the fourth quarter Form 941 must use Form 941-X and follow normal procedures to make an adjustment or claim a refund for any quarter in 2014 with regard to the overpayment of tax relating to excess transit benefits.

Employers who paid excess transit benefits and have not furnished 2014 Forms W-2 to their employees must take into account the increased exclusion for transit benefits in calculating the amount of wages reported. Employers who have repaid or reimbursed their employees for the overcollected FICA taxes prior to furnishing Form W-2 (whether they utilized the special administrative procedure or the normal procedures) must reduce the amounts of withheld tax reported. In all cases, employers must report the amount of income tax actually withheld during 2014. The additional income tax withholding will be applied against the taxes shown on the employee's individual income tax return.

Employers who repaid or reimbursed their employees for the overcollected FICA taxes after furnishing Forms W-2 to their employees, but before filing Forms W-2 with the Social Security Administration (SSA), must check the "Void" box at the top of each incorrect Form W-2 (Copy A). The employer must prepare new Forms W-2 with the correct information, and send those new Forms W-2 (Copy A) to the SSA. Employers who have already filed 2014 Forms W-2 with SSA must file Forms W-2c, Corrected Wage and Tax Statement, to take into account the increased exclusion for transit benefits and to reflect any repayments or reimbursements of the withheld FICA tax and must furnish copies of Form W-2c to the employees.

For a discussion of transit benefits excluded from income, see Parker Tax ¶123,140.

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Tax Court Clips Attorney-Pilot's Wings, Disallows Nearly 80 Percent of Flight Expenses

An attorney-pilot was denied the majority of claimed deductions relating to his use of an airplane in his law practice, as most of his flights were to locations within 100 miles of his home, and only a small number involved travel to court appearances, witness interviews, or other activities directly related to his practice. Peterson v. Comm'r, T.C. Memo. 2015-1.

Background

Tulane M. Peterson is an avid aviator and general practice attorney specializing in personal injury cases. In June 2005, he purchased a Cessna Turbo Skylane airplane for $332,000, ostensibly for transportation needs related to his law practice. Peterson kept a flight log, recording flight activities and categorizing the flights as either "training", "maintenance", or "business." Many of these flights were to airports within 100 miles of his home, but he maintained that flying made business sense because it enabled him to avoid Los Angeles traffic.

Peterson claimed that 100 percent of his flights, including those he had categorized as training and maintenance, entailed business expenses of his law practice. A relatively small percentage of these flights involved travel to court appearances, witness interviews, or depositions in litigation in which he was actually engaged. The remainder of his flights involved travel for personal or family reasons.

On his 2006 Schedule C, Peterson reported depreciation and Code Sec. 179 expenses relating to his airplane of $74,368, and other airplane-related expenses of $41,252. On audit, the examining agent determined that Peterson had substantiated $14,277 of airplane-related expenses; however, at the conclusion of the audit, the agent disallowed the entirety of the depreciation expense, the Code Sec. 179 election, and the remaining airplane-related expenses on the ground that none of those costs were ordinary and necessary for Peterson's trade or business.

Peterson reported similar expenses on his on his 2007 Schedule C. A different agent examined his 2007 return and determined he had substantiated all of the reported expenses. Relying on Peterson's flight logs, the agent determined that 27 percent of his flight hours were directly related to his law practice because they involved flights to court appearances, depositions, or litigation-related witness interviews and allowed a deduction for 27 percent of the airplane-related expenses. The agent also determined that Peterson was not eligible to make an election under section 179 because his airplane constituted "listed property" that was not predominantly used in his trade or business, but did allow a deduction equal to 27 percent of that amount.

The IRS sent Peterson separate notices of deficiency for 2006 and 2007 based on the reports of the examining agents. Peterson timely petitioned the Tax Court for redetermination of his tax liabilities.

Analysis

Taxpayers are allowed to deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business" (Code. Sec. 162(a)). An ordinary expense is one that is normal, usual, or customary in the taxpayer's industry (Deputy v. du Pont, 308 U.S. 488 (1940)). A necessary expense is one that is appropriate and helpful for the development of the taxpayer's business (Welch v. Helvering, 290 U.S. 111 (1933)). Strict substantiation is required for expenses relating to travel and "listed property," which includes airplanes (Code Sec. 274).

Taxpayers are also allowed to take depreciation deductions for certain tangible property used in the taxpayer's trade or business (Code Sec. 167). Where a taxpayer can demonstrate that the business use exceeds 50 percent, a taxpayer can elect to deduct the cost of certain property acquired and used in a trade or business and placed in service during the year (Code Sec. 179).

In examining the airplane expenses, the court questioned whether aeronautical expenses were ordinary and necessary given Peterson was a solo practitioner conducting business travel close to his home. The court noted a powerful argument could be made that none of the expenses should be regarded as "ordinary and necessary." The cost of owning and operating a private airplane did not appear to be "normal, usual, and customary" for an attorney in solo practice, especially one who made approximately 65 percent of his flights to destinations within 100 miles of his home. Nor, the court opined, would it seem "reasonable," at the cost of $236 to $433 per flight hour, to fly to destinations that could be reached by car in less than an hour.

However, by allowing Peterson to deduct 27 percent of his airplane-related costs for 2007, the IRS had conceded those costs were "ordinary and necessary" to the extent they were genuinely business related. The court stressed that the IRS is not required for any given year to allow a tax benefit that was permitted for a previous or subsequent year, but given the unique nature of the case, the court found it appropriate to treat Peterson's airplane-related expenses for 2006 and 2007 as "ordinary and necessary" to the extent they were business related.

The court then used the methodology for determining business use employed by the 2007 examining agent to determine that 18 percent of his 2006 flight hours were for business purposes, and allowed deductions for 18 percent of the substantiated business expenses. The court concluded that Peterson failed to establish a business purpose for the other airplane-related expenses and failed to substantiate certain 2006 expenses under the rigorous Code Sec. 274 requirements imposed for "listed property, denying the associated deductions. The court noted that receipts or invoices for maintenance of or repairs to the aircraft were conspicuously absent from Peterson's 2006 records.

In examining the airplane-related depreciation, the court found that Peterson was ineligible for the Code Sec. 179 deduction, as he failed to meet the "over 50 percent business use" requirement for both 2006 and 2007. However, as the IRS had conceded Peterson was allowed a depreciation deduction under Code Sec. 167 for 2007, the court allowed a "comparable" depreciation deduction for 2006 determined by reference to 18 percent deemed business use of the airplane.

For a discussion of trade and business expenses, see Parker Tax ¶90,100.

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Fifth Circuit Upholds Constructive Receipt of Stock Redemption Proceeds

The Fifth Circuit upheld a district court decision finding that a shareholder constructively received redemption proceeds from the surrender of her stock certificates in the year the company made the redemption funds available to her, and not in the year the stocks were actually surrendered. The income was properly attributed to the year the funds were made available and not when the proceeds were actually received. Santangelo v. U.S., 2014 PTC 609 (5th Cir. 2014).

Background

Natalie Santangelo owned 21,534 shares of common stock in HCA, Inc., divided into two certificates, which she kept rather than turning them over to a broker or bank. In 2006, HCA merged with another company, and as part of the merger agreement, all common stock holders would have their stock canceled and receive $51 per share. Santangelo was eligible to receive over $1 million when HCA deposited the required funds with a paying agent in November.

Although the funds were available in November 2006, to collect the funds, Santangelo was required to surrender the physical stock certificates. She did not take any steps to obtain the proceeds before her death in March 2007. Her estate redeemed the shares from one certificate and received a payment in January 2008. The second certificate was never found, but a second payment was received in October 2009 after the estate followed procedures for lost certificates.

HCA issued a Form 1099 to Santangelo , indicating that she received taxable proceeds in the full amount in 2006. Santangelo's estate filed her 2006 tax return and claimed as income the full amount reflected on the Form 1099. Subsequently, the estate filed suit in the district court for a refund, on the ground that the income should not have been claimed in 2006 since it was not actually received in 2006. The district court held that the stock proceeds were constructively received by Santangelo in 2006 and were properly reported on her 2006 tax return. The estate appealed this decision to the Fifth Circuit, challenging the determination that the stock proceeds were constructively received.

Analysis

Santangelo's estate argued that substantial obstacles prevented her access to the funds and the three-year delay in obtaining the funds negated the constructive receipt theory. The IRS contended that the income was properly claimed on the 2006 return because it was constructively received, and thus no refund was due.

Code Sec. 451 states that generally income is taxable when the funds are received. In addition, Reg. Sec. 1.451-2(a) provides for the reporting of income that is actually or constructively received during the tax year. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

The district court cited Oliver v. U.S., 193 F.Supp. 93 (1961), finding income which is unqualifiedly and without substantial limitation available to the taxpayer is considered to be constructively received even though it is not actually received. It was undisputed that HCA immediately deposited the funds in November 2006 and that the funds were available to Santangelo, a cash basis taxpayer, as of that date. Santangelo also made no attempt to obtain the funds when they were first available. Moreover, the delay in redeeming the shares was a self-imposed event to the extent the stock certificates were lost. The court did not believe the process for a lost certificate was a substantial limitation or restriction on obtaining the funds.

The district court concluded that since the funds were unqualifiedly and without substantial limitation available to Santangelo in 2006, her failure to actually receive the funds was due to her own volition, and the income should be considered as having been constructively received in 2006, and was thus properly included in her 2006 tax return.

The Circuit Court considered the party's briefs, the record on appeal, and all relevant law, and concluded unanimously that the district court's judgment should be affirmed for the reasons articulated by the district court.

For a discussion of constructive receipt of income, see Parker Tax ¶241,515.

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No Refund Available for FICA Taxes on Compensation Deferred but Never Received

A retired airline pilot was denied a refund for FICA taxes paid on deferred compensation he never received, as the statute allowing taxes on deferred compensation did not provide for such a refund. Balestra v. U.S., 2014 PTC 610 (Ct. Fed. Cl. 2014).

Louis Balestra, Jr. was a pilot for United Airlines (United) from January 1979, until his retirement in October 2004. Balestra had a vested right in deferred compensation under a retirement benefits plan through United, the full present value of which was included in the FICA tax base in the year of his retirement. United entered bankruptcy proceedings in 2002, two years before Balestra's retirement, and as a result, United's obligation to pay the deferred compensation was discharged, with the majority of the benefits never having been paid.

United made the final payments required under its bankruptcy reorganization plan and consequently Balestra will not receive any additional benefits from this retirement plan. Because United withheld FICA tax from Balestra based on a present value calculation of his retirement benefits at the time of his retirement, Balestra effectively paid tax on wages he will never receive. In total, Balestra paid tax on $289,601 worth of nonqualified deferred compensation, of which he only received $63,032. He paid $4,199 of FICA tax on these benefits, which reflects the tax rate applied to the $289,601 present value of the benefits.

Dissatisfied with this tax result, Balestra pursued a suit in the Court of Federal Claims for a refund of $3,285, an amount reflecting the FICA tax attributable to the portion of the deferred compensation he did not receive.

The IRS argued the FICA "special timing rule" was properly applied to Balestra's benefits, and, as neither the statutes nor the regulations provide for a refund for FICA taxes imposed on wages that are never received, the court should rule in the IRS's favor. Balestra, by contrast, argued he was entitled to the refund because the regulations enacted under Code Sec. 3121(v)(2) were arbitrary and irrational in not providing for a "true-up" (i.e., refund) in the event of plan-failure, nor allowing the risk of nonpayment to be included in the calculation of the present value of deferred compensation subject to tax under the special timing rule.

Under the general timing rule, FICA taxes are imposed on wages in the year that they are actually or constructively paid by employers to employees (Code Sec. 3101). Under the special timing rule, any amount deferred under a nonqualified deferred compensation plan is taken into account at the later of

(1) when the services are performed, or  

(2) when there is no substantial risk of forfeiture (as defined under Code Sec. 83) of the rights to such amount (Code Sec. 3121(v)(2)(A)).  

The rights of a person in property are subject to a substantial risk of forfeiture if such person's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual (Code Sec. 83(c)(1)).

Nonqualified deferred compensation benefits may be taxed before they are paid, and such benefits taxed under the special timing rule are taxed at their "present value," which is calculated with reference to actuarial projections concerning life expectancy and a discount rate is applied to account for the time value of money (Reg. Sec. 31.3121(v)(2)-1). However, the present value of retirement benefits cannot be discounted for the probability that payments will not be made (or will be reduced) because of the risk that the employer will be unwilling or unable to pay (Reg. Sec. 31.3121(v)(2)-1(c)(2)(ii)).

The court disagreed with Balestra's principal argument that the use of the words "income of every individual" means that FICA taxes are a type of income tax computed with reference to "wages received," and that "wages" are a subset of "income," and thus if an item is not "income" it must, by definition, also not be "wages" subject to tax under FICA. The court reasoned that under the plain language of the Code, remuneration for employment can be "wages" for FICA purposes although not "income" for income tax purposes. Additionally, the court reasoned that the plain meaning of Code Sec. 3121(v)(2) treats certain benefits as taxable FICA wages before they have become part of an employee's income, and that section must impose taxes on wages before they are considered income, otherwise it would be meaningless.

Balestra's also argued that Congress, by imposing a portion of FICA taxes on a non-cash basis, must have intended to employ an accrual accounting basis and that while the provision would allow benefits to be taxed prior to receipt, it must implicitly require that some sort of deduction or adjustment to be made when it can be determined that the benefits will never be received. However, the court pointed out that while it was true that Congress accelerated the taxation of deferred benefits such as those promised Balestra, the "substantial risk of forfeiture" trigger it selected essentially means the employee has satisfied all of the requirements under his employment contract to earn the right to the deferred compensation, which does not concern any risk of nonpayment. Moreover, the court determined there was no reason to believe that by taxing deferred compensation under a provision that references "income," Congress intended to silently incorporate the features of accrual accounting, as it would have done so by explicit reference if it had desired. The court mentioned it may have been wiser to select a different trigger, but that was a matter for law makers to address, not judges.

Finally, Balestra argued it was unreasonable for the Treasury to forbid a bankrupt employer from discounting its unsecured promises for the risk of non-payment when calculating the present value of those promises, explaining that courts generally treat the concept of present value as including both a credit risk discount and a time value of money adjustment. The court disagreed, noting that Code Sec. 3121(v)(2)(A) says nothing about how any "amount deferred" is to be calculated, and with no guidance from Congress on how to calculate present value, no rule is violated by the Treasury's choice of a present value method. Absent evidence of any uniform practice regarding present value that the Treasury typically employs contrary to the regulations under Code Sec. 3121(v)(2), and considering the clear, contemporaneous explanation of the rationale for the valuation method (minimizing administrative costs and complexities), the Court could not say the choice of method was irrational.

Finding Balestra's arguments unpersuasive, the Court of Federal Claims ruled that he was not entitled to a refund for the FICA taxes paid on compensation he never received.

For a discussion of the imposition of FICA taxes, see Parker Tax. ¶213,135.

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Money Services Business Not Considered a Bank; Write Off of Bad Securities Denied

A money services business was not permitted to write off worthless asset-backed securities and incurred long-term capital gains after the Tax Court ruled the business failed to qualify as a "bank" under Code Sec. 581, and therefore was not entitled to deduct such securities as bad debts against ordinary income. MoneyGram Int'l, Inc. v. Comm'r, 144 T.C. No. 1 (2015).

Background

MoneyGram International Inc., (MoneyGram) is a global payment services company that provides consumers and financial institutions with payment services. The services provided by MoneyGram involve the movement of money through money transfers, payment processing services, and money orders. MoneyGram is registered with the Department of the Treasury as a "money services business," which includes money transmitters, check cashing services, issuers and sellers of money orders, and issuers and sellers of travelers checks.

Prior to the 2008 financial crash, MoneyGram held a large amount of high-value asset-backed securities. Due to the precipitous decline in value of these securities, MoneyGram fell out of compliance with state law requirements regarding "permissible assets" and minimum net worth and consequently undertook a recapitalization to satisfy State regulators' demands. The recapitalization included writing down or writing off a substantial volume of partially or wholly worthless asset-backed securities

The IRS challenged MoneyGram's treatment of the asset-backed securities as incurring ordinary losses, not capital losses, and sent a notice of deficiency disallowing the claimed deductions. MoneyGram then petitioned the Tax Court, claiming it was entitled to deductions because it met the definition of a "bank" under Code Sec. 581.

Analysis

Generally, a loss is allowed as a deduction for the tax year in which the loss is sustained (Code Sec. 165(a)). If a security that is a capital asset becomes worthless during the tax year, the resulting loss is treated as a capital loss (Code Sec. 165(g)(1)). Additionally, debts that becomes wholly worthless or recoverable only in part during the taxable year ("bad debts"), are deductible (Code Secs. 166(a)(1) and (2)). Debts that are evidenced by a security as defined in Code Sec. 165(g)(2)(C), such as asset-backed securities, are excluded from the relief provided by the bad debts deduction (Code Sec. 166(e)).

However, banks are entitled to an exception under Code Sec. 582(a), and are permitted to deduct bad debts even when the debts are evidenced by a security. To qualify as a "bank" under this exception, the institution must

(1) be a bank or trust company incorporated and doing business under Federal or State law,

(2), a substantial part of the institution's business must consist of receiving deposits and making loans and discounts, and

(3), the institution must be subject to supervision and examination by authorities having supervision over banking institutions under Federal or State law (Code Sec. 581).

The Tax Court held that MoneyGram did not qualify as a bank within the meaning of Code Sec. 581 because it lacked the essential characteristics of a bank and a substantial part of its business did not consist of receiving bank deposits or making bank loans. Consequently, the court concluded MoneyGram was ineligible to claim ordinary loss deductions on account of the partial or complete worthlessness of its asset-backed securities under Code Sec. 582 during the years in question.

MoneyGram first argued the initial requirement of Code Sec. 581 that the institution possesses the essential characteristics of a bank didn't exist and instead argued Code Sec. 581 only requires that an institution accept deposits, make loans, and be regulated by a banking authority in order to be considered a "bank." The court dismissed this argument, noting that, as a matter of statutory construction, such an argument would render the principal clause of the first sentence of Code Sec. 581 meaningless. In determining whether MoneyGram possessed the essential characteristics of a bank under this requirement, the court relied heavily on Staunton Indus. Loan Corp. v. Comm'r, 120 F.2d 930 (4th Cir. 1941). Staunton held an entity can be a "bank" for Federal tax purposes, even though it is not chartered as a bank under State law, where the entity manifests three basic features: (1) the receipt of deposits from the general public, repayable to the depositors on demand or at a fixed time; (2) the use of deposit funds for secured loans; and (3) the relationship of debtor and creditor between the bank and depositor.

The court ruled that MoneyGram failed to meet "the bare requisites" enumerated in Staunton for status as a bank; based on its operations and characteristics MoneyGram was not a bank, nor was it regulated as a bank, and therefore MoneyGram was not a "bank" for purposes of Code Sec. 582. The court concluded MoneyGram also failed the second requirement of Code Sec. 581: that a substantial part of the institution's business must consist of receiving deposits and making loans and discounts. The court determined that MoneyGram did not receive "deposits" because MoneyGram's accounts were short-term holding tanks for funds in transit and further concluded that MoneyGram's accounts receivable did not constitute "loans."

MoneyGram also put forth a policy argument, claiming Code Sec. 582 recognizes that certain institutions hold securities because of government regulations and as part of their ordinary course of doing business. Because MoneyGram was required to hold these securities and incurred losses in the ordinary course of its business, it argued ordinary loss deductions should follow. However, the court disagreed and relied upon legislative history to conclude that Congress acted deliberately in limiting the benefits of section 582 to "banks" as opposed to other financial institutions and that Congress never intended an institution such as MoneyGram to qualify as a "bank" within the meaning of Code Sec. 581.

For a discussion on bad debt deductions, see Parker Tax ¶98,400.

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Late-Filed 1040s are Not "Returns" Under Bankruptcy Discharge Exception

In a case of first impression, the Tenth Circuit affirmed a district court ruling that late individual tax returns filed by a debtor couple, after the IRS assessed tax liabilities and issued notices of deficiency, were not returns within the meaning of the Bankruptcy Code. The couple's tax liabilities were thus not dischargeable. Mallo v. U.S., 2014 PTC 606 (10th Cir. 2014).

Background

Edson and Liana Mallo did not file their Form 1040, Individual Income Tax Return, on time for 2000 and 2001. As a result, in 2006, the IRS made assessments against the couple and issued deficiency notices. After the couple failed to pay the assessed income taxes, the IRS started collection efforts by issuing a Notice of Intent to Levy. In 2007, the couple jointly filed their 2000 and 2001 Form 1040s. In 2010, the couple filed a Chapter 13 bankruptcy petition and, at the time of filing, owed tax liabilities from 2000 through 2009. Read more...