Parker's Federal Tax Bulletin - Issue 84 - March 13, 2015

IRS Releases Detailed FAQ Explaining Repair Regulations

Last week, the IRS released a clear and detailed FAQ explaining key aspects of the new tangible property regulations (a.k.a., the "repair regulations"). IRS FAQ - Tangible Property Regulations (3/5/15).

Although the IRS's question-and-answer style guidance covers quite a bit of ground, most falls into four categories:

• De minimis safe harbor election
• Rules for the treatment of materials and supplies costs
• Distinguishing capital improvements from deductible repairs
• When and how to apply the new regulations

The following are lightly paraphrased excerpts from the IRS FAQ. As is typical for IRS guidance of this type, the FAQ omits citations to the regulations. As a convenience to subscribers who wish to dig deeper into the rules, we've provided cites as well as links to relevant Parker analysis sections and practice aids. For completeness, we've included Parker observations and cautionary warnings where appropriate.

De Minimis Safe Harbor Election

Under the final tangible property regulations, taxpayers may elect to apply a de minimis safe harbor to amounts paid to acquire or produce tangible property to the extent such amounts are deducted for financial accounting purposes or in keeping books and records. If a taxpayer has an applicable financial statement (AFS), he or she may use this safe harbor to deduct amounts paid for tangible property up to $5,000 per invoice or item. If a taxpayer does not have an AFS, he or she may use the safe harbor to deduct amounts up to $500 per invoice or item.

Parker Observation: Under the prior regulations, there was no de minimis safe harbor exception to capitalization; taxpayers were required to determine whether each expenditure for tangible property, regardless of amount, was required to be capitalized.

These limitations are for purposes of determining whether particular expenses qualify under the safe harbor; they aren't intended as a ceiling on the amount a taxpayer can deduct as business expenses. Read more...

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Eight Circuit Rejects Like-Kind-Exchanges Structured to Avoid Related Party Restrictions

The Eighth Circuit found that a construction equipment seller entered into like-kind-exchanges involving unnecessary intermediaries to avoid related party restrictions. The court upheld a district court determination disallowing nonrecognition treatment. North Central Rental & Leasing, LLC v. U.S., 2015 PTC 67 (8th Cir. 2015)

Background

Butler Machinery Company ("Butler Machinery") sells agricultural, mining, and construction equipment for manufacturers, primarily Caterpillar, Inc. ("Caterpillar"). In 2002, Butler Machinery formed subsidiary North Central Rental & Leasing, LLC ("North Central") to take over rental and leasing operations. Although considered separate entities, Butler Machinery and North Central are closely related and are ultimately controlled by Daniel Butler and his family.

Less than two months after formation, North Central instituted a like-kind-exchange (LKE) program. Under that program, North Central sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary, Accruit, LLC ("Accruit"). Accruit forwarded the sales proceeds to Butler Machinery, and the proceeds went into Butler Machinery's main bank account. At about the same time, Butler Machinery purchased new Caterpillar equipment for North Central and then transferred the equipment to North Central via Accruit. Butler Machinery charged North Central the same amount that it paid for the equipment. The LKE program allowed North Central to trade used equipment for new equipment and, in the process, defer tax recognition of any gains or losses from the transactions.

Butler Machinery's use of LKE transactions facilitated favorable financing terms under which Butler Machinery was given up to six months from the date of the invoice to pay Caterpillar for North Central's new equipment, essentially giving Butler Machinery an interest-free loan for up to six months.

From 2004 to 2007 North Central claimed nonrecognition treatment of gains from 398 LKE transactions pursuant to Code Sec. 1031. These transactions frequently resulted in significant sales proceeds which would be placed in Butler Machinery's accounts, giving it unfettered access to the funds until the payments to Caterpillar became due.

The IRS determined that North Central structured the transactions to avoid the related-party exchange restrictions under Code Sec. 1031(f), and disallowed nonrecognition treatment. In response, North Central brought suit in the District Court of North Dakota, alleging the LKE transactions were entitled to nonrecognition treatment. After the district court sided with the IRS, North Central appealed to the Eighth Circuit Court.

Analysis

Under Code Sec. 1031(a), no gain or loss is recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment ("like-kind exchange"). However, Code Sec. 1031(f) generally prohibits this nonrecognition treatment where a taxpayer exchanges like-kind property with a related person, and either party disposes of the exchanged property within two years of the exchange. In addition, Code Sec. 1031(f)(4) broadly prohibits nonrecognition treatment for any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of Code Sec. 1031(f).

The Eighth Circuit drew attention to the comparative complexity of the transactions, noting that prior cases in both the Eleventh Circuit and the Ninth Circuit had determined that LKEs were structured to avoid the purposes of Code Sec. 1031(f) in part because of their unnecessary complexity and unnecessary parties involved in the transaction. Each of the transactions involved an intricate interplay between at least five parties: North Central, Accruit, Butler Machinery, Caterpillar, and the third party who bought North Central's used equipment. Although North Central, Caterpillar, and the third-party customer were indisputably necessary for the sales and purchase transactions to occur, the court believed Butler Machinery and Accruit were not.

The court questioned why Butler Machinery was involved in the transactions at all as North Central had acknowledged that Butler Machinery functioned as a passthrough for both the cash and the property. North Central proffered several alternative reasons for Butler Machinery's involvement, including that it made the transactions administratively easier and more efficient.

However, the court dismissed those arguments, noting that North Central could have placed the orders with Caterpillar directly; injecting Butler Machinery into the transactions added unnecessary inefficiencies and complexities, including additional transfers of payment and property. Instead, the court believed the more plausible explanation for Butler Machinery's involvement was that it financially benefitted from what amounted to six-month, interest-free loans under the financing terms.

The court found Butler Machinery was not necessary to the transactions yet possessed significant, unearmarked cash proceeds as a result of the transactions.

The court found that Accruit was also an unnecessary party as Butler Machinery and North Central could have exchanged property directly with each other. This unnecessary layer of complexity supported finding that the exchanges were structured to sidestep Code Sec. 1031(f), because if Butler Machinery and North Central exchanged the property directly with each other, they, as related parties, would have to hold the exchanged-for property for two years before the exchanges could qualify for nonrecognition treatment.

Because North Central could have achieved the same property dispositions via a much simpler method, the Circuit Court believed the transactions took their peculiar structure for no purpose other than to avoid Code Sec. 1031(f) and upheld the district court's determination, denying like- kind-exchange treatment for the transactions.

For a discussion of like-kind-exchanges, see Parker Tax ¶113,100.

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Bartender's Meticulous Records Defeat IRS's Claim of Unreported Tip Income

The Tax Court held that a Las Vegas bartender, audited after he stopped participating in an IRS tip compliance program, had fully reported his tip income. The court concluded that the taxpayer's records reflected his income earned from tips more accurately than the IRS's reconstruction formula did. Sabolic v. Comm'r, T.C. Memo. 2015-32.

Background

Alan Sabolic, a bartender with over 20 years of experience, worked at the Zuri Lounge at the MGM Grand Hotel and Casino (MGM Grand). During 2009 to 2011, Sabolic chose not to participate in the IRS's Gaming Industry Tip Compliance Agreement Program (GITCA Program). GITCA sets an automatic tip rate for participating employees used to calculate taxable tip income. Sabolic had participated in the GITCA Program for over 20 years, but opted out of the program citing concerns that the automatic tip rate was too high and did not reflect the poor economic conditions.

Since Sabolic opted out of the program, he was required to self-report his cash tips to MGM Grand and keep personal records of how much he received in tips. At the end of each shift, he would add together his tips and enter the total into the MGM Grand's system, tip-out the barbacks, and give the cashiers the loose change he would receive with cash tips. He also kept a daily personal tip log, recording the total on a slip of paper. Sabolic reported income from tips of $18,110, $23,941, and $21,926 for tax years 2009 to 2011, respectively, and also claimed deductions for the tip outs.

The IRS contended Sabolic's logs were inadequate and determined deficiencies for 2009 to 2011. In calculating the amount owed, the IRS reconstructed Sabolic's tips based on sales records, reduced by 10 percent to account for the tip outs to the barbacks. The IRS determined that Sabolic had underreported his tip income by $19,729, $19,000, and $20,284 for 2009 to 2011.

Sabolic challenged that determination, arguing the IRS's reconstruction did not accurately reflect his tip income and petitioned the Tax Court.

Analysis

Tips constitute compensation for services and are includable in gross income (Reg. Sec. 1.61-2(a)(1)). When a taxpayer receives tips daily, he or she is required to keep an accurate and contemporaneous record of such income (Reg. Sec. 31.6053-4(a)(1)). When a taxpayer's records are inadequate or incomplete, the IRS can reconstruct the employee's tip income in any manner that clearly reflects income. The IRS has great latitude in choosing the method of reconstruction, and the method chosen need only be reasonable in light of all of the surrounding facts and circumstances (Schroeder v. Comm'r, 40 T.C. 30 (1963)).

The IRS asserted multiple arguments designed to establish that Sabolic's logs were inadequate.

First, the IRS pointed to the fact that the logs were recorded in whole numbers, arguing that Sabolic was not tipped in exact dollar amounts. The court did not believe this made the records inadequate, noting Sabolic's explanation that the whole numbers reflected the fact he gave change he received to cashiers.

Second, the IRS argued that the daily tip logs were inadequate because Sabolic did not keep track of how much he actually tipped out the barbacks at the end of each shift. The court found that, while ideally Sabolic should have kept track of the exact amounts he tipped the barbacks, his testimony that he always tipped them between 10 percent and 20 percent and the fact the IRS allowed Sabolic a 10 percent reduction for tip outs defeated the IRS's assertion.

Third, the IRS claimed the logs were inadequate because they appeared to be missing days. The court, however, found that vacations, flexible work days, and frequent system outages adequately explained why the records appeared to be incomplete.

Finally, the IRS contended that the logs were inadequate because they did not precisely match up with the information on Sabolic's Forms W-2. The court disagreed, reasoning that while the information did not precisely match, timing differences in the pay period and malfunctions in the MGM Grand System that tracked tips likely accounted for the discrepancies.

The court noted that while in general the IRS's method of reconstructing taxpayers' tip income was reasonable, there was no evidence of a discrepancy in Sabolic's records that would result in the unreported income reflected in the IRS's calculations. Thus, in this case, the IRS's method was not an accurate reflection of Sabolic's income.

Because the court concluded the IRS's method did not reflect Sabolic's income as accurately as Sabolic's own daily records, the court ruled Sabolic was in compliance with the requirements of Reg. Sec. 31.6053-4(a)(1) and found Sabolic fully reported his tip income on his 2009 to 2011 tax returns.

For a discussion of employee tip recordkeeping and reporting requirements, see Parker Tax ¶124,105.

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IRS Issues Proposed Rules on Winnings from Electronic Slot Machines

The IRS has issued updated guidance, in a proposed revenue procedure and proposed regulations, on how taxpayers calculate their wagering gains or losses from electronic slot machines and the thresholds for when gambling establishments must report winnings from electronic slot machines. Notice 2015-21; REG-132253-11 (3/4/15).

Determining Gains and Losses from Electronic Slots

In recent years, controversy between taxpayers and the IRS over determining wagering gains or losses from slot machine play has been complicated by changes in gambling technology. The increased use of electronic gambling, with the development of player's cards and tickets, has curtailed the redemption of tokens by slot machine players, normally the preferred method of tracking gains or losses. To reduce the burden on taxpayers, the proposed revenue procedure in Notice 2015-21 provides an optional safe harbor method for determining what constitutes a "session of play" for purposes of calculating wagering gains or losses from electronically tracked slot machine play.

In general, gains from wagering transactions are included in gross income (Rev. Rul. 54-339), and gains from a slot machine wagering transaction are determined on a session-by-session basis (Shollenberger v. Comm'r, T.C. Memo. 2009-306). Under Code Sec. 165(d), losses from wagering transactions are allowed only to the extent of the gains from such transactions.

Under the proposed safe harbor, a "session of play" begins when a patron places the first wager and ends when the same patron completes his or her last wager before the end of the same day. A taxpayer recognizes a wagering gain if, at the end of a single session of play, the total dollar amount of payouts from electronically tracked slot machine play during that session exceeds the total dollar amount of wagers placed by the taxpayer on electronically tracked slot machine play during that session. Conversely, a taxpayer recognizes a wagering loss if wagers exceed payouts at the end of a session of play.

A taxpayer must use the same session of play if the taxpayer stops and then resumes electronically tracked slot machine play within a single gaming establishment during the same calendar day. However, a separate session of play will begin if the taxpayer moves to a different establishment, or if the taxpayer uses a non-electronic slot machine. Additionally, if a continuous session extends from one day to the next (i.e. begins before midnight and ends after midnight), a separate session of play will begin at midnight.

Example: Taxpayer engages in electronically tracked slot machine play at Lucky Casino from 3:00 pm to 6:00 pm, and then moves to a different establishment, Happy Casino, to play slots from 7:00 pm to 9:00 pm before returning to Lucky Casino for more electronic slot play from 10:00 pm to 2:00 am the next day. Taxpayer will have three distinct sessions of play: one session encompassing his time at Lucky Casino from 3:00 pm to 6:00 pm and 10:00 pm to 11:59 pm, a second session at Lucky Casino for 12:00 am to 2:00 am, and a session encompassing his time at Happy Casino from 7:00 pm to 9:00 pm.

A taxpayer must calculate his or her wagering gains or losses separately for each session of play, and may not net the sessions together.

Taxpayers may not rely on the safe harbor in the proposed revenue procedure until it is finalized.

Reporting Winnings from Electronic Slots

On the other end of the spectrum, and in conjunction with Notice 2015-21, the IRS issued proposed regulations in REG-132253-11updating and simplifying badly outdated reporting requirements to account for how gambling establishments report payouts from electronically tracked slot machines. The updated requirements are proposed to be set forth in new Reg. Sec. 1.6041-10, which would replace the current regulations in Sec. 7.6041-1 of the Temporary Income Tax Regulations under the Tax Reform Act of 1976.

The current regulations governing information reporting of winnings from bingo, keno, and slot machine play were published in 1977. There have been significant advances in gaming industry technology since then, such as electronic slot machines and other mechanisms that permit electronic tracking of wagers and/or winnings. The proposed regulations will be effective when finalized.

The proposed regulations contain the same reporting threshold requirements for winnings from bingo, keno and non-electronically tracked slot machine play. However, the proposed regulations include new rules for determining the reporting threshold for electronically tracked slot machine play. The changes are intended in part to facilitate reporting that more closely reflects the gross income that will be reported by payees on their individual income tax returns, pursuant to Notice 2015-21.

Under these new rules, gambling winnings for electronically tracked slot machine play must be reported when two criteria are met: (1) the total amount of winnings earned from electronically tracked slot machine play during a single session netted against the total amount of wagers placed on electronically tracked slot machines during the same session is $1,200 or more; and (2) at least one single win during the session (without regard to the amount wagered) equals or exceeds $1,200. The first criterion helps to implement the safe harbor for computing gross income attributable to electronically tracked slot machine play described in Notice 2015-21. The second criterion is intended to be consistent with the casino industry's current practice of gathering payee information when a player wins a single jackpot that satisfies the reporting threshold.

Under this rule, reporting with respect to electronically tracked slot machine play is not required if no single win (without reduction for the amount of the wager) meets the $1,200 reporting threshold or if the net amount of winnings reduced by the amount of all wagers is less than $1,200. However, if the $1,200 reporting threshold for a single win is satisfied and all winnings from electronically tracked slot machine play during a session netted against all wagers during that session are $1,200 or more, gambling winnings for the session must be reported on a Form W-2G.

For a discussion of income from gambling, see Parker Tax ¶85,120.25. For a client letter explaining the reporting of gaming income, see ¶320,770.

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Abandonment of Securities Not an Abandonment of Contractual Rights; Fifth Circuit Allows a Nearly $100 Million Ordinary Loss

The Fifth Circuit reversed the Tax Court, finding that Code Sec. 1234A only applies to the abandonment of contractual rights, as opposed to rights inherent in assets like securities. By allowing a $98.6 million ordinary loss, the court validated the taxpayer's decision to decline a $20 million purchase offer in favor of a $30 million tax savings. Pilgrim's Pride v. Comm'r, 2015 PTC 61 (5th Cir. 2015).

Background

Pilgrim's Pride Corporation is the successor-in-interest to Gold Kist, Inc., an association taxed as a nonexempt cooperative. In the late 1990's, Gold Kist was contractually obligated to purchase, and did purchase, securities from Southern States Cooperative, Inc., and Southern States Capital Trust I (Southern States). The purchase price was $98.6 million. The securities were capital assets of Gold Kist.

In 2004, Southern States offered to redeem the securities for $20 million. Instead of accepting the offer, Gold Kist's board of directors decided to surrender the securities to Southern States for no consideration, reasoning a $98.6 million ordinary loss would produce greater tax savings than the $20 million offered by Southern States. On its 2004 federal income tax return, Gold Kist reported a $98.6 million ordinary abandonment loss deduction under Code Sec. 165(a) and Reg. Sec. 1.165-2(a).

Five years later, while Pilgrim's Pride was in bankruptcy, the IRS issued a deficiency notice to Pilgrim's Pride with respect to Gold Kist's 2004 tax year asserting that Gold Kist's loss from the abandonment of the Securities was a capital loss, rather than an ordinary loss, creating a tax deficiency of nearly $30 million. The IRS argued that Code Sec. 1234A(1) applied and rendered the abandonment a deemed sale or exchange of capital assets subject to capital loss treatment.

The Tax Court agreed with the IRS, holding that the securities were intangible property comprising rights that Gold Kist had in the management, profits, and assets of Southern States which terminated when Gold Kist surrendered the securities. Pilgrim's Pride appealed to the Fifth Circuit, challenging the IRS' determination that Gold Kist's abandonment generated a capital loss and arguing that Code Sec. 1234A was inapplicable.

Analysis

Under Code Sec. 165(a) and Reg. Sec. 1.165-2(a), an abandonment loss deduction can be taken for a loss incurred and arising from the sudden termination of the usefulness in a business or transaction of nondepreciable property. The loss is allowable where a business or transaction is discontinued or where such property is permanently discarded from use. The loss is taken as a deduction for the tax year in which the loss is actually sustained. However, under Reg. Sec. 1.165-2(b), an abandonment loss cannot be claimed on a sale or exchange of property. Under Code Sec. 165(f), losses from sales or exchanges of capital assets are subject to the limitations on capital losses. Further, Code Sec. 1234A(1) requires gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right with respect to property that is (or on acquisition would be) a capital asset in the hands of a taxpayer to be treated as gain or loss from the sale of a capital asset.

The Fifth Circuit noted that, by its plain terms, Code Sec. 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets), not to the termination of ownership of the capital asset itself.

The IRS asserted that Code Sec. 1234A(1) also indirectly applies to the abandonment of a capital asset because such abandonment involves the termination of certain rights and obligations inherent in those assets. Thus, the IRS claimed, when Pilgrim's Pride abandoned the securities it abandoned the rights in the securities, meaning it should be treated as a capital loss pursuant to Code Sec. 1234A(1).

The court disagreed, stating that the IRS's position was essentially that Congress, rather than simply stating that the abandonment of a capital asset results in capital loss, chose to legislate that result by reference to the termination of rights and obligations "inherent in" capital assets. The court assumed that the ordinary meaning of Code Sec. 1234A accurately expressed its legislative purpose, noting that interpreting the section as the IRS argued would render Code Sec. 1234A(2) superfluous. Thus, the court found Pilgrim's Pride had abandoned the securities themselves, not a right or obligation with respect to the securities within the meaning of Code Sec. 1234A(1).

As an alternative argument, the IRS claimed that Code Sec. 165(g) required the abandonment of securities to be treated as a capital loss resulting from worthless securities. Although the securities were worth at least $20 million when Pilgrim's Pride abandoned them, the IRS argued that they were "worthless" because they were useless to Pilgrim's Pride.

The court found that this argument conflicted with prior precedent, as the Fifth Circuit had previously held in Echols v. Comm'r, 950 F.2d 209 (5th Cir. 1991) that property cannot be treated as worthless for tax loss purposes if it objectively has substantial value. Since the abandoned securities had a value of at least $20 million, they were not objectively worthless, and thus the court held Code Sec. 165(g) did not apply.

Because the court determined Code Sec. 1234A(1) only applies to the termination of contractual or derivative rights, and not to the abandonment of capital assets, the Fifth Circuit reversed the judgment of the Tax Court and allowed Pilgrim's Pride to claim a $96.8 million ordinary loss.

Caution: While the holding in this case may seem like a windfall for taxpayers looking to abandon securities to generate an ordinary tax loss, the regulations under Code Sec. 165(g) were amended in 2008 to provide that abandonment of securities generate capital losses (Reg. Sec. 1.165-5(i)).

For a discussion of abandonment losses, see Parker Tax ¶114,510.

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Dude Ranch Shareholders Liable for Unpaid Corporate Taxes after Liquidation Scheme Collapses

The Seventh Circuit affirmed a Tax Court decision holding former dude ranch shareholders liable as transferees for unpaid taxes left over from participation in an intricate tax-avoidance scheme pitched to them as an alternative to a standard liquidation. Feldman v. Comm'r, 2015 PTC 58 (7th Cir. 2015).

Background

William Feldman founded Woodside Ranch in the 1920s and over time the ranch came to offer a wide array of outdoor recreational activities. The ranch was incorporated in 1952 as Woodside Ranch Resort, Inc. ("Woodside") and was owned and operated by the descendants of the founder until its sale in 2002.

By the late 1990s, the ranch was facing a number of challenges to its ongoing viability as due to competition from nearby casinos and water parks. The ten shareholders, all descendants of the founder, decided to sell the ranch to a third party who they hoped would continue to operate the ranch. Although the shareholders proposed a stock sale, the buyer insisted on an asset sale and the shareholders acquiesced. The asset sale netted the shareholders $2.3 million, resulting in a taxable capital gain of $1.8 million (on a basis of $510,000) and triggering tax liabilities of approximately $750,000.

While the asset sale was pending, Woodside's accountant and financial advisor introduced the shareholders to Honora Shapiro, a 50 percent owner of Midcoast Acquisition Corp. ("Midcoast"), a firm specializing in tax shelters. The shareholders jumped at the opportunity to reduce their tax liability, and in June of 2002 Midcoast sent a letter of intent offering to buy Woodside's stock for its liquidation value (about $1.4 million) plus a premium of about $225,000.

The closing involved a number of steps in quick succession, taking place in a single day in July of 2002. First, Woodside redeemed 20 percent of its stock directly from the shareholders, leaving it with $1.83 million in cash, and the still-unpaid tax liabilities. The parties then executed the share purchase agreement and the funds were then wired into and out of a trust account. At 12:09 p.m., Woodside's cash reserves of $1.83 million were transferred into the trust account. Then, at 1:34 p.m., Shapiro transferred $1.4 million into the trust account, purportedly as a loan to Midcoast to fund the transaction, although there was no promissory note or other writing evidencing a loan. At 3:35 p.m., $1,344,451 was wired to Woodsedge LLC, an entity set up to receive the proceeds of the stock sale, as payment to the shareholders. One minute later, at 3:36 p.m., $1.4 million was returned to Shapiro, repaying the undocumented "loan."

After the stock sale, Woodside had $452,729 cash on hand along with the tax liabilities from the initial asset sale. A few days later, Woodsedge LLC, which was holding the proceeds of the redemption and stock sale, disbursed approximately $1.2 million to the shareholders. Woodside never paid federal taxes on the capital gain from the asset sale; its 2003 tax return claimed a net operating loss carried back to 2002, reducing Woodside's 2002 federal tax liability to zero.

In 2008 the IRS sent notices to the former shareholders assessing transferee liability for Woodside's unpaid taxes and penalties under Code Sec. 6901.

At trial before the tax court, the shareholders conceded that the tax shelter was illegal, but contested transferee liability. In a comprehensive opinion, the tax court ruled in the IRS's favor, holding that the stock sale was in substance a liquidation with no purpose other than tax avoidance, making the shareholders liable for the unpaid tax debt as transferees of Woodside under Code Sec. 6901 and Wisconsin law. The shareholders then appealed to the Seventh Circuit.

Analysis

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must first establish that the target for collection is a "transferee" of the delinquent taxpayer within the meaning of Code Sec. 6901; next, the IRS must show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

The Circuit Court reviewed the Tax Court's decision for error. The tax court had found that the stock sale was structured to avoid the tax consequences of Woodside's asset sale, which the shareholders would have had to absorb had they pursued a standard liquidation. Formally, the shareholders sold their Woodside stock to Midcoast, which purported to fund the transaction via a loan from Honora Shapiro.

The tax court looked past these formalities to the substance of the transaction, recasting it as a liquidation, and found that Midcoast did not actually pay the shareholders for their stock; instead, each shareholder received a pro rata distribution of Woodside's cash on hand (which came from the proceeds of the asset sale) making them "transferees" under Code Sec. 6901(h). The circuit court found nothing wrong with this recharacterization by the tax court, noting it has long been established that courts may look past the form of a transaction to its substance to determine how the transaction should be treated for tax purposes.

Accordingly, the circuit court agreed with the tax court's conclusion that the transaction was a de facto liquidation. Woodside carried on no business activity, its only asset was cash from the initial asset sale, and the shareholders had planned to liquidate. The circuit court reasoned that the $1.4 million loan from Shapiro was a sham, because if it was removed from the transaction, nothing of consequence would change. What remained after disregarding the sham loan was a transfer of cash from Woodside to the trust account and then to an LLC owned by the shareholders established for the sole purpose of receiving the proceeds of the transaction. The circuit court noted that, in reality, the only money that changed hands was Woodside's cash reserves. On those facts the circuit court found it was entirely reasonable for the tax court to conclude that this was a liquidation cloaked in the trappings of a stock sale.

Having received Woodside's cash in a de facto liquidation, the circuit court agreed with the tax court, holding the shareholders were transferees under Code Sec. 6901. In addition, the circuit court found the shareholders were liable for Woodside's tax debts under Wisconsin state law, and sustained the tax court's determination of transferee liability under Code Sec. 6901.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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Portions of Refundable State Tax "Credits" Were Includable in Federal Income

[The Tax Court held that taxpayers had to include in income portions of refundable state tax "credits" received from participating in a New York economic development program. The court found that, contrary to the state's characterization, the refundable credits were effectively taxable subsidies. Maines v. Comm'r, 144 T.C. No. 8 (3/11/15)

Background

The New York Empire Zones Program (EZ Program) provides incentives for businesses to stimulate private investment and business development, and tries to create jobs in impoverished areas in New York State. David and Tami Maines received these incentive payments from their participation in the EZ Program between 2005 and 2007 through their two passthrough entities, Endicott Interconnect Technologies, Inc., and Huron Real Estate Associates.

New York calls these payments "credits" and treats them as refunds for "overpayments" of state tax. All the credits required the Maines to make some amount of business expenditure or investment in targeted areas within the state. One of the credits, the QEZE Real Property Tax Credit, is limited to the amount of past real property tax actually paid. The other two credits, the EZ Investment Credit and the EZ Wage Credit, are not limited to past tax actually paid. All the credits first reduce a taxpayer's state income-tax liability; any excess credits may be carried forward to future years or partially refunded.

For 2005 to 2007, the Maines eliminated their state income-tax liability primarily through the use of other nonrefundable state credits. Because the Maines had little to no state income-tax liability in these years for the credits to offset, the refundable credits under the EZ program led to large "refund" payments from New York, which the Maines did not include on their federal income tax returns.

The IRS assessed deficiencies for 2005 to 2007, arguing that the refundable credits were, in substance, cash subsidies constituting taxable income, and the Maines challenged this determination in the Tax Court.

Analysis

State tax refunds are not income unless the taxpayer claimed a deduction for them, for example, by itemizing for the previous year (Tempel v. Comm'r, 136 T.C. 341 (2011)). Likewise, under the tax-benefit rule, a taxpayer is allowed to exclude a refund from his income only if he never got the benefit of a corresponding deduction for an earlier year (Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370 (1983)).

The Maines claimed they took no deduction on their federal income-tax returns for 2005 to 2007 for state income tax paid in the preceding years, arguing their refunds should not be included in their income under the tax benefit rule. They pointed out that their credits under the EZ Program were defined by New York state law to be "overpayments" of state income tax.

However, the Tax Court noted that the state-law label of the credits as "overpayments" of past tax was not controlling for Federal tax purposes; if that were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. The court quoted Abraham Lincoln, reasoning that under the Maines' logic, "if New York called a tail a leg, we'd have to conclude that a dog has five legs in New York as a matter of federal law." Instead, the court looked to the nature of the credits to determine whether they were non-taxable refunds of overpaid state taxes.

The court observed that to qualify for the EZ Investment Credit and the EZ Wage Credit, taxpayers must own a business with property in a designated Empire Zone and have full-time employees receiving qualified EZ wages. Neither of the credits depended on a refund of previously paid state taxes deducted under federal law and instead were essentially cash subsidies from the state to incentivize taxpayers.

The court held that the portions of the EZ Investment Credits and the EZ Wage Credits that actually reduced the Maines' state-tax liabilities were not taxable income. However, any excess portions of the credits that were refundable were taxable income.

In contrast, the court noted that taxpayers receive a QEZE Real Property Tax Credit only if their business pays eligible real-property taxes, and the amount of the credit cannot exceed the amount of those taxes actually paid. Thus the refundable portion of the credit could be treated like a refund of past overpayments.

The court held the portions of the QEZE credit payments that only reduced the Maines' state-tax liabilities were not taxable income. However, the refundable portions of the credit were includible in the Maines' gross income under the tax-benefit rule to the extent that they had taken previous deductions for property-tax payments.

For a discussion on the recovery of tax benefit items, including state tax credits, see Parker ¶76,900.

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IRS Proposes "Next Day Rule" for Changes in Consolidated Group Membership

The IRS has issued proposed amendments to the consolidated return regulations, revising the rules for reporting certain items of income and deduction that are reportable on the day a corporation joins or leaves a consolidated group. The proposed regulations would affect these corporations and the consolidated groups that they join or leave. REG-100400-14 (3/6/15).

Background

The proposed regulations provide guidance under Reg. Sec. 1.1502-76, which prescribes rules for determining when items of income, gain, deduction, loss, and credit (tax items) of a corporation that joins in filing a consolidated return are included. Reg. Sec. 1.1502-76(b) provides, in part, that if a corporation becomes or ceases to be a member of a consolidated group during a consolidated return year, that corporation must include in the consolidated return its tax items for the period during which it is a member. The corporation also must file a separate return (including a consolidated return of another group) that includes its items for the period during which it is not a member.

Under the end of the day rule of Reg. Sec. 1.1502-76(b)(1)(ii)(A)(1) in the current regulations, a corporation is treated as becoming or ceasing to be a member of a consolidated group at the end of the day of the corporation's change in status, and the corporation's tax items that are reportable on that day generally are included in the tax return for the tax year that ends as a result of the corporation's change in status.

There are two exceptions to the current end of the day rule. The first exception, in Reg. Sec. 1.1502-76(b)(1)(ii)(A)(2) (S corporation exception), provides that if a corporation is an S corporation immediately before becoming a member of a consolidated group, the corporation becomes a member of the group at the beginning of the day the termination of its S corporation election is effective, and its tax year ends for all federal income tax purposes at the end of the preceding day.

The second exception, in Reg. Sec. 1.1502-76(b)(1)(ii)(B) (current next day rule), provides that if a transaction occurs on the day of the corporation's change in status that is properly allocable to the portion of the corporation's day after the event resulting in the change, the corporation and certain related persons must treat the transaction as occurring at the beginning of the following day for all federal income tax purposes.

Proposed Next Day Rule

The IRS has determined that changes should be made to Reg. Sec. 1.1502-76(b) due to uncertainty regarding the appropriate application of the current next day rule. To provide certainty, the proposed regulations clarify the period in which a corporation must report certain tax items by replacing the current next day rule with a new exception to the end of the day rule (proposed next day rule) that is more narrowly tailored to clearly reflect taxable income and prevent certain post-closing actions from adversely impacting the corporation's tax return. The proposed next day rule applies only to "extraordinary items" (as defined in Prop. Reg. Sec. 1.1502-76(b)(2)(ii)(C)) that result from transactions occurring on the day of the corporation's change in status, but after the event causing the change, and that would be taken into account by the corporation on that day.

The proposed next day rule requires those extraordinary items to be allocated to the corporation's tax return for the period beginning the next day. The proposed next day rule is expressly inapplicable to any extraordinary item that arises simultaneously with the event that causes the corporation's change in status.

The proposed regulations further clarify that fees for services rendered in connection with a corporation's change in status are an extraordinary item if they constitute a "compensation-related deduction." The proposed regulations also clarify that the anti-avoidance rule in Reg. Sec. 1.1502-76(b)(3) may apply to situations in which a person modifies an existing contract or other agreement in anticipation of a corporation's change in status.

The proposed regulations also add a rule (previous day rule) to clarify the application of the S-corporation exception. In addition, the proposed regulations limit the scope of the end of the day rule, the next day rule, the S corporation exception, and the previous day rule to determining the period in which a corporation must report certain tax items and determining the treatment of an asset or a tax item for purposes of Code Secs. 382(h) and 1374.

Additionally, the proposed regulations provide that short taxable years resulting from intercompany transactions to which Code Sec. 381(a) applies are not taken into account in determining the carryover period for a tax item of the distributor or transferor member in the intercompany Code Sec. 381 transaction or for purposes of Code Sec. 481(a). Furthermore, the proposed regulations provide that the due date for filing a corporation's separate return for the taxable year that ends as a result of the corporation becoming a member is not accelerated if the corporation ceases to exist in the same consolidated return year.

The proposed regulations make several other conforming and non-substantive changes to the current regulations, along with adding several examples to illustrate the proposed rules. The IRS notes that neither the current regulations nor the proposed regulations are intended to supersede general rules in the Code and regulations concerning whether an item is otherwise includible or deductible.

The proposed regulations are not effective until finalized.

For a discussion of consolidated income tax returns for corporations, see Parker Tax ¶42,120.