Federal Tax Update - Aug. 11, 2014

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Ed Zollars from Nichols Patrick CPE delivers the weekly podcast on federal tax issues.  For all of your CPE needs, please go to www.ficpa.org/cpe.  This week's podcast covers the following topics:

OFFICE IN HOME RULES APPLIED TO RV, NO DEDUCTION ALLOWED DESPITE SHOWING OF BUSINESS USE
Jackson v. Commissioner, TC Memo 2014-160, 8/7/14

There were two issues raised by the IRS in the case of Jackson v. Commissioner, TC Memo 2014-160, http://www.ustaxcourt.gov/InOpHistoric/JacksonMemo.Wherry.TCM.WPD.pdf. The taxpayers prevailed on the first IRS objection to their deductions, but unfortunately the IRS was able to use the "office in home" rules of §280A to still prevail in denying the taxpayer a deduction – even though this home had wheels.

The issue involved expenses incurred by the taxpayer for a recreational vehicle (RV) that they claimed they were using to sell insurance. Mr. Jackson sold various forms of insurance, but his interest in RVs caused him to discover what he felt was an opportunity for him.

He noted that traditional car insurance did not really "fit" with higher end RVs. He noted this because he had been a member of RV clubs since 1995 and regularly attended RV rallies put on these organizations. At the rallies, held about once a month on a weekend, RV owners would gather with their RVs for a general social event and also had time for information sessions related to RV topics such as maintenance.

In 2004 Mr. Jackson decided that he could use his attendance at these rallies not just for the social purposes he had previously used them for, but also to sell specialized RV insurance policies. He began marketing his insurance at the rallies and, in fact, at least one person who had attended the rallies called Mr. Jackson, frankly, a nuisance regarding insurance.

Mr. Jackson claimed expenses related to his RV as part of his insurance business beginning in 2004.

The IRS objected first that these were primarily social events and that Mr. Jackson did not show a significant enough relationship to his business to allow for a deduction. The Tax Court, looking at the facts of the case rejected this view.

The Court noted that it is perfectly possible to convert what had been a personal, social activity into a business activity if the facts supported that view – and the Court found they did here. The Court found that a significant portion of the expenses incurred had a reasonable relationship to Mr. Jackson's business and, therefore, in general would have been deductible under §162.

But the Court agreed with the IRS that there was a second problem that blocked the deduction – the office in home rules of §280A.

IRC §280A(c) provides generally that: Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.

An exception to that rule is found at IRC §280A(b)(c)(1) which allows: Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis— (B) as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business, ...

First the Court noted that an RV has been held under the law to be a qualified dwelling unit – the fact that has wheels and can move on its own doesn't change the fact that it is a self-contained "residence" of sorts.

Being a dwelling unit no deduction will be allowed, even if clearly used for business purposes, if the rules of §280A are not met.

In this case the court found the taxpayer did regularly meet with clients in the RV – but there was no portion of the RV exclusively used for that purpose. For that reason, no deduction was allowed.

APPLICATION OF SECTION 382 OWNERSHIP CHANGE RULES TO INITIAL CAPITALIZATION TRANSACTION EXPLAINED
Chief Counsel Advice 201432015, 8/8/14

The IRS discussed initial capitalization issues and the loss trafficking limitation rules of IRC §382 in Chief Counsel Advice 201432015 (http://www.irs.gov/pub/irswd/ 201432015.pdf ).

Generally, IRC §382 is meant to restrict the ability to "sell" a net operating loss by transferring ownership of a corporation with a net operating loss to outsiders. Absent §382, such individuals could buy a corporation that had incurred large losses and use that corporate shell as entity from which to start a new business or transfer in an existing one.

The memo outlines what events would trigger the application of IRC §382's limits: The pivotal event that triggers the operation of section 382 is an "ownership change," which occurs under section 382(g) whenever, immediately after (i) an owner shift involving a 5 percent shareholder or (ii) any equity structure shift, the percentage of stock of the loss corporation owned by one or more 5 percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock of the loss corporation (or any predecessor corporation) owned by such shareholders at any time during the testing period. Under section 382(k)(6)(A), preferred stock which is convertible into another class is considered stock for purposed of section 382. As provided in section 382(k)(6)(C), determinations of the percentage of stock held by any person is made on the basis of value. Under section 382(i), the testing period is generally the three-year period ending on the day of any owner shift involving a 5 percent shareholder or equity structure shift.

If such an ownership change is triggered, the amount of loss that can be used in the future is restricted based on the value of the loss corporation and a rate of return tied to the long term federal rate in effect when the ownership change occurs. Since 1995 that rate has never risen above 6% and recently has been in the low 3% range.

In the transaction in question a new corporation was being formed. During the period being looked at that gave rise to the inquiry to the National Office there were five separate issuances of stock. Just mechanically testing the five transactions, the fifth transaction would be treated as a §382 ownership change.

However the taxpayers have argued that the first three transactions were actually simply the original plan to provide initial capitalization of the entity. Thus, the organization argues, only the last two transactions are involved in the testing, with the owners at the end of the third transaction being treated as the original owner. Specially, if the third transaction is part of the initial issuance of stock and not itself a transfer of ownership, then the fifth transaction would no longer mechanically trigger an ownership change under §382.

The memorandum does not come to a conclusion about the validity of that position with the facts in question, but does hold that it is possible that the taxpayer's assertion with regard to the proper treatment is correct.

The memorandum notes: For example, assume stock of a start-up was issued on two different dates two months apart by a loss corporation where both issuances of stock were part of the initial capitalization of the loss corporation, and they both occurred before business activity had started. These facts do not present the abuse of trafficking in net operating loss carryovers, that section 382 was designed to prevent. Congress was concerned with situations where the shareholders who bore the economic burden of NOLs no longer hold a controlling interest in the corporation. H. Rept. 99-426, at 256 (1985), 1986-3 C.B. (Vol. 2) 1, 256. In this example, the shareholders who purchased stock on the two different dates were both the initial investors under the taxpayer's plan for the corporation's initial capitalization and both equally bore the economic burden of the NOLs arising after business activity commenced. The purpose of the statute would not have been served by treating the second acquisition as a testing date within the testing period of a subsequent testing date.

The analysis in the memorandum can be helpful in planning related to such original capitalization. For instance, getting all of the initial stock issued before business operations begins clearly is very useful in pushing all initial transactions outside the ownership shift testing period.

DESPITE ADMISSION OF ADVISER OF GIVING BAD ADVICE, IRS DENIES LATE ROLLOVER RELIEF
PLR 201432032, 8/8/14

In many of the IRS rulings granting taxpayers the right to rollover amounts after the 60 day period from IRAs, a financial adviser's admission of having given mistaken advice has proven a key factor in the IRS grant of such relief. However that admission also means that if the IRS does not grant relief, the adviser now has an admission on the record of responsibility for a bad tax result – an admission that will likely prove costing when (not really if) the client seeks economic redress.

In PLR 201432032 (http://www.irs.gov/pub/irs-wd/201432032.pdf) we have just such a case that takes place – the adviser admits to having misinformed the client (and it's very clear that is the case) but the IRS concludes that it would not be proper to grant relief.

In this case a taxpayer wanted to make an investment in a partnership but the custodians of his IRA would not consent to holding the investment. The taxpayer sought advice from his CPA about what could be done in this case.

The CPA did himself have experience in this manner, so the CPA consulted with the compliance department of the wealth advisory firm which employed the CPA and a national accounting firm the was associated with his employer. Following these consultations the CPA told the taxpayer that even though the custodian would not accept an investment in the partnership, he could simply title the investment in the name of the IRA and all would be well.

Unfortunately that's pretty much the same situation a taxpayer encountered in the case of Dabney v. Commissioner, TC Memo 2014-108, though in that case the taxpayer did his own research. The Tax Court informed that taxpayer that if the custodian doesn't agree to take on the asset, merely titling it in the name of the IRA is not going to be effective to put the asset in the IRA.

Now let's return to the situation in the PLR at hand: after nearly two years had passed, the CPA discovered that, in fact, merely titling the asset in the name of the IRA was not effective as a rollover. The CPA contacted the taxpayer, advised the taxpayer of the error and suggesting seeking late rollover relief.

In this case the IRS refused to grant relief. The ruling held that the taxpayer "chose to use proceeds from IRA B to fund a business venture rather than attempt to roll the proceeds over into an IRA account for retirement purposes."

While it's not clear what triggered the denial, the IRS's comments on using the funds to start a business venture suggests that it's possible what we have is blown attempt to use IRA funds to start a business.

It's possible (though again we don't know from the limited facts) that the problem was that the taxpayer wanted to keep the funds invested somewhere the IRS did not approve of by using a new custodian. The IRS has been active in challenging attempts by taxpayers to use IRA funds to fund new business start-ups by using the prohibited transaction rules at §4975 against such IRAs, resulting in a deemed distribution of the balance of the account. (See Ellis v. Commissioner, TC Memo 2013-245 and Peek v. Commissioner, 140 TC No. 12)

If, in fact, the taxpayer proposed not to move the funds in question into "traditional" investments but rather to simply find a "cooperative" custodian to take over holding the partnership interest, then it's not surprising the IRS would refuse to grant relief. In such a case the IRS would likely immediately look for (and under the standards given by the Tax Court in the Ellis and Peek decisions cited above likely fund) grounds to claim the IRA violated the prohibited transaction rules.

If this is not the case, the ruling would be very troubling since previously the IRS has shown itself willing to grant relief regularly where the taxpayer relied on bad advice that the adviser admits giving.

FINANCIAL INSTITUTION UNDER NO OBLIGATION TO INFORM CUSTOMER OF 60 DAY ROLLOVER RULES WHEN TAKING A DISTRIBUTION
PLR 201432030, 8/8/14

A taxpayer's claimed belief that the institution in which she held the IRA from which she took funds to rollover had an obligation to inform her of the rollover rules was not found sufficient grounds to grant late rollover relief in PLR 201432030 (http://www.irs.gov/pub/irs-wd/201432030.pdf).

The taxpayer took a distribution of IRA funds from a financial institution on Sept. 22, 2012. She deposited them in IRAs with another institution in January of 2013 – well after the end of the 60 day period.

The taxpayer claims that the institution from which she took the distribution was her adviser and, as such, had an obligation to tell her about the 60 day rule. However, she did not provide any documentation showing that the institution had taken on the obligation to be her financial adviser.

The IRS held that there was no evidence that the institution had taken the roll of adviser for the taxpayer. And, regardless, an IRA custodian does not have an obligation imposed on it by the IRC to inform customers of the rollover rules when they take a distribution. So unless the institution voluntarily took on that obligation, something that was not shown by the taxpayer, there was simply no error on the part of the financial institution.

AIRCRAFT WAS SEPARATE ACTIVITY FROM BUSINESS, TAXPAYER FAILED TO SHOW MATERIAL PARTICIPATION
Williams v. Commissioner, TC Memo 2014-158, 8/5/14

Under the "passive activity" provisions of §469, it is important to first properly determine what constitutes an activity and then determine if the taxpayer can show material participation in that activity. The taxpayer in the case of Williams v. Commissioner, TC Memo 2014-158, http://ustaxcourt.gov/InOpHistoric/WilliamsMemo.Buch.TCM.WPD.pdf failed in his arguements relating to both counts.

What constitutes an "activity" is determined by definitions found in Reg. §1.469-4(c) which looks at what constitutes an appropriate economic unit. Factors listed in that regulation, which were noted by the Court, include:

  • Similarities and differences in types of trades or businesses;
  • The extent of common control;
  • The extent of common ownership;
  • Geographical location; and
  • Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Mr. Williams had a business giving telephone training seminars. Originally he had worked for his father in the business and had persuaded his father that he, being a licensed pilot, should be able to charter planes to fly to the seminar locations to avoid the hassles of commercial flights. However, this proved costly and it was abandoned.

After his father passed away Mr. Williams did additional research and determined that he could purchase a plane and lease it to flight schools in order to help offset the costs. For the year in question the plane was leased out to flight schools that had the right to use the plane, with Mr. Williams being able to use it for his business only if the school did not have it already booked.

Mr. Williams argued the phone training seminar business and the aircraft operations were one activity. However, the Tax Court, applying the tests noted above, found they had little to do with each other – rather, the rental of the plane was a separate economic activity from the seminar business.

The next key problem is showing material participation under the rules for passive activities. Mr. Williams had argued that he met the 500 hour test when treating the seminar and aircraft activities as one, but since the Court rejected that rule he next fell back on two other possibilities provided to demonstrate material participation under the regulations:

      He spent more than 100 hours in the activity and no person spent more time or
      He met the "facts and circumstances" test (which also requires a minimum of 100 hours of participation)

The first test, in particular, was one Mr. Williams had uncovered in his research on leasing planes to flight schools. In fact, his agreement with the schools specified that the schools were aware Mr. Williams wanted to show material participation and thus each school agreed no employee would perform more than 100 hours related to the plane.

Unfortunately Mr. Williams had very little to show what hours he had spent on the activity. The largest block of time for which he could provide support involved his claimed daily activity of arguing about maintenance bills. However, Reg §1.469-5T(f)(2)(ii)(A) provides that work as an investor does not count towards material participation – and this "studying the bills" approach is exactly, in the Court's view, the sort of activity an investor would conduct.

His other time was based solely on his after the fact estimates, which the Court ignored as it normally does. Thus, the Court found that Mr.Williams failed to show that he had 100 hours of participation and thus, he could not meet either test he argued he should meet.

ESTATE'S ORIGINAL VALUE, AND NOT THOSE IRS AND ESTATE EACH ARGUED FOR AT TRIAL, WAS THE PROPER VALUE FOR ESTATE TAX PURPOSES
Estate of Adell v. Commissioner, TC Memo 2014-155, 8/4/14

In the case of Estate of Adell v. Commissioner, TC Memo 2014-155, http://www.ustaxcourt.gov/InOpHistoric/EstateofAdellMemo.Paris.TCM.WPD.pdf, both the estate and the IRS agreed that the value of a closely held corporation reported on the decedent's return of $9.3 million was in error. However, what they disagreed about was whether it was worth $4.6 million (as the estate now claimed) or $26.3 million (as the IRS was now claiming).

In fact, this was a significant narrowing of the amount of disagreement, since the estate took the position on a second amended Form 706 that the company was worthless while the IRS had claimed a value of $92.3 million.

The entity in question (STN.com) provided satellite uplink services to a religious television station located in Michigan. The station was a §501(c)(3) tax-exempt organization who paid STN.com to send its signal via satellite to cable television and satellite providers.

Franklin Adell, the decedent, owned STN.com, but his son (Kevin) had been deeply involved in coming up the idea for providing such services. The television station was one that Mr. Adell had acquired and which initially broadcast infomercials. When a competitor lost its affiliation with a local channel, the Adell's channel was able to acquire all of the original programming originally broadcast on that channel.

Kevin had familiarity with religious programming, so he decided to create a 24-hour station broadcasting urban religious ministries and gospel music, meeting with religious leaders who agreed to help him launch the station. He also went to Los Angeles and, with the religious leaders, met with the president of DirecTV to see about having the satellite company carry the programming, which eventually took place.

To utilize the available broadcast space the station had to be a nonprofit entity, so the organization was formed that way and entered into an agreement with STN.com. The agreement provided that the religious stations would pay STN.com the lesser of 95% of its net programming revenue or STN's "actual costs" each month for STN.com's services.

In fact, STN.com was always paid 95% of the net revenue of the station, which consisted primarily of fees paid to the station by ministers, clergy and other religious leaders with local programs who wished them broadcast nationally on the station. Both Mr. Franklin Adell and his son were paid a minor amount of compensation by the station and a much more significant amount of compensation from STN.com. As well, both were provided with luxury automobiles and provided other significant non-cash compensation (including paying a $6 million judgment against Kevin from Mr. Franklin Adell's salary).

Originally when Mr. Adell died the estate's valuation expert came up with a value of $9.3 million for STN.com's stock. The expert used a discounted cash flow analysis after adjusting officer's compensation to reasonable level. However, since Kevin had no employment agreement with the organization, a charge was made against income for the value of the personal goodwill held by Kevin.

Kevin had negotiated the various deals, and the parties in question deal with Kevin. In fact, many were unaware that there was a corporation involved that they were dealing with indirectly. Since Kevin had no employment or non-compete agreement with the corporation, he effectively could pick up and take the business with him.

Following Mr. Adell's death, disputes arose within the family and Kevin's sisters brought suit against him. In reaction to the dispute, the station terminated its agreement with STN.com and signed a new deal with a corporation that Kevin formed – and which ended up employing the employees of STN.com.

Following this change of course, the estate filed an amended return on which it claimed that STN.com had no value whatsoever. The IRS, examining the estate, proposed the $92.3 million value.

When the parties ended up before the Court their positions had modified somewhat, with the estate now believing the true value was $4.3 million while the IRS was now set for a $26.3 million value.

The estate's value came from its original expert and another expert who worked with the same firm, but who had prepared an independent valuation. The major reason for the difference in value is that the original expert claimed that he become aware of the "cost" limit in the contract with the station, and that based on that the entity could never truly show a profit. Effectively, he argued that Franklin Adell and Kevin Adell had taken salary and compensation well beyond a reasonable level and once salaries were adjusted to a reasonable level there would be no future cash flow to buy. Thus the entity was most properly valued at its liquidation level.

The Tax Court did not accept this modification. The Court noted that since the estate had been the original source of the $9.3 million valuation, it had to show that the prior valuation was erroneous before it would be allowed to argue for a lower valuation.

The Court noted that the Company clearly had been profitable for years before Franklin died, and that it continued to be profitable up until the family litigation came in. The financial statements prepared for the Company referred only to the 95% revenue agreement and the station had never attempted to enforce the cost provision. The Court concluded that a buyer who ended up in the same position as the Adells would expect to receive the same treatment, thus the discounted cash flow method was the proper valuation.

The IRS's expert agreed with the idea that discounted cash flow was the proper approach, but took a different route to deal with Kevin's personal goodwill. The IRS expert determined that a buyer could retain Kevin's goodwill by paying him a fixed percentage of revenue that resulted in a much lower charge.

The Tax Court did not accept this view – it found that Kevin's goodwill was far more valuable than what the IRS expert was giving credit for, and that there was no reason to believe Kevin would accept a salary of $1.3 million when he had stepped into the shoes of his father who had earned between $2 million and $7 million in each of the five years prior to his death.

Thus the Tax Court found the original $9.3 million valuation to be the most credible value, and decided to make use of that number in arriving at a value to be included in the decedent's estate.

FINAL WHISTLEBLOWER REGULATIONS ISSUED BY IRS
TD 9687, 8/12/14

The IRS has issued final regulations related to whistleblower awards under IRC §7623 in TD 9687 (https://s3.amazonaws.com/public-inspection.federalregister.gov/2014-18858.pdf). The regulation issued are:

  • Reg. § 301.6103(h)(4)-1
  • Reg. § 301.7623-1
  • Reg. § 301.7623-2
  • Reg. § 301.7623-3
  • Reg. § 301.7623-4

Generally the final regulations adopt guidance previously found in Notice 2008-4 and portions of the Internal Revenue Manual.

Some changes that were made in the regulations when the IRS moved from the proposed regulations to final regulations include:

  • Removing State and local government employees and members of a Federal or State body or commission from the list of ineligible individuals
  • The IRS will monitor future tax filings to determine if future payments are increased by changes made due to the information (for instance if the information reduced a net operating loss carryforward).

Generally the regulations are effective for claims filed or information provided on or after Aug. 12, 2014.

LAST UPDATED 8/11/2014