Federal Tax Update - Aug. 18, 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:

TAXPAYERS PARTICIPATING IN STATE GAMBLING TREATMENT PROGRAM WHERE ANY FUTURE WINNINGS ARE FORFEITED TO THE STATE NOT TAXABLE ON WINNINGS FORFEITED (CCA 201433015, 8/15/14) The interaction of a state run gambling addiction treatment program and federal tax on reporting and taxation of gambling winnings created the need for a Chief Counsel Advice outlining the National Office’s view of the proper resolution of the matter, found in Chief Counsel Advice 201433015 (http://www.irs.gov/pub/irs-wd/201433015.pdf).

The state in which a casino was located ran a program (the Voluntary Exclusion Program or VEP) that individuals who have gambling problems may enter. Such individuals agree, via a contract with the State, that they will both not enter a state casino (they agree they can be arrested for trespassing if found in one) and, as well, if they do enter a state casino they will forfeit any winnings.

Casinos are given information regarding VEP program participants and are required to consult the list of such participants whenever they are paying out jackpots. If a VEP participant’s payout is confiscated, it is sent to the State for use in its gambling addiction treatment programs.

The question arose about what should a casino do if a VEP participant has winnings that would generally require the casino to issue a Form 1099G? As well, would the gambler be taxable on his/her winnings under the assignment of income doctrine in this event?

The IRS first concludes that no information return is required so long as the casino recognizes the person as a VEP participant and redirects the payment to the state. The IRS determined that the information reporting is triggered only upon a payment to an individual and, in this case, no payment is made. However, if the casino does end up failing to recognize the winner as a VEP participant and pays the winnings to that person, then the Form W2-G is required to be issued.

The IRS also concluded that this program does not run afoul of the assignment of income doctrine. The VEP participant has made an election prior to participating in the gambling activity that any winnings are going to be forfeited. The ruling finds this is a case where the taxpayer has waived all rights to the income and does not direct or retain the ability to direct the disposition of the income after it is earned and payable.

EQUITABLE OWNERSHIP NOT DEMONSTRATED, TAXPAYER DENIED DEDUCTIONS RELATED TO PROPERTY TITLED IN HER SISTER'S NAME (LUCIANO-SALAS V. COMMISSIONER, TC SUMMARY OPINION 2014-76, 8/11/14) Taxpayer who have an equitable interest in a personal residence and who make the mortgage payments, even though not listed on the title or the mortgage itself, may still qualify to claim the mortgage interest deduction under IRC §163.

The problem, however, is that a taxpayer claiming equitable ownership has to do more than simply announce this fact—they must show the equitable ownership would be recognized under state law. In the case of W, http://ustaxcourt.gov/InOpHistoric/Luciano-SalasSummary.Guy.SUM.WPD.pdf, the taxpayer fell short of this standard for a number of reasons.

Dolorosa claimed that the property she lived in (a duplex) was purchased by her sister (whom she claimed lived with her husband in a bordering state) and titled in her sister’s name because of Dolorosa’s poor credit history. That argument is one that has been seen before in equitable ownership cases where the taxpayer had prevailed.

But Dolorosa faced some issues with her claim that successful taxpayers did not have. First, she only paid the mortgage payments sporadically. While she claimed to have paid various expenses related to the property, she offered no evidence of the same.

Most importantly, Dolorosa did not produce any written agreement between herself and her sister to show that she was the equitable owner, nor did she have her sister testify at trial.

In fact, her sister had claimed the property has her residence during her own Chapter 13 bankruptcy proceeding. Her sister was also awarded damages by the bankruptcy court when a lender attempted to foreclose the property while the bankruptcy proceeding was in effect. Obviously, if her sister wasn’t the true owner of the property there seems to be some issue with her sister’s filings with the bankruptcy court.

The Tax Court decided that Dolorosa failed to show that she was truly the equitable owner of the property.

What could have changed the result here? The best way to document equitable ownership is to have written confirmation of such an arrangement. It’s also important that the parties (both the taxpayer’s and that of the person listed on the title) be consistent with the taxpayer being the “real” owner of the property.

"DISREGARDED" LLC MUST BE CONSIDERED WHEN VALUING CHARITABLE CONTRIBUTION (RERI HOLDINGS V. COMMISSIONER, 143 TC NO. 3, 8/11/14) How and when a “disregarded” entity is not disregarded can be a tricky issue for tax purposes. Reg.§301.7701-2(c)(2)(i) provides that, generally, an LLC with only a single member is treated as an entity to be disregarded from its owner for federal tax purposes.

Since §7701 provides for definitions that apply throughout the entire Internal Revenue Code, it might seem that this “disregarded” rule would apply for any tax issue. But it’s not quite that simple. In the 2009 case of Pierre v. Commissioner, 113 TC 24 the

Tax Court held that, for purposes of determining a valuation for estate and gift tax purposes, the existence of a single member LLC, even though treated as a disregarded entity by the taxpayer prior to the gift, would not be ignored when determining the value of the interest transferred.

A slightly different question confronted the court in the case of RERI Holdings v. Commissioner, 143 TC No. 3, (http://ustaxcourt.gov/InOpHistoric/RERIHoldingsI,LLCDiv.Halpern.TC.WPD.pdf). In this case the issue involved valuation of a remainder interest in an asset for purposes of a charitable contribution deduction under IRC §170.

This particular case involved an IRS motion for summary judgment on issues in the case, a motion that was denied as the Court found there were still issues of fact to be decided.

The item contributed was real property held in an LLC 100% of the interests of which were held by the taxpayer. Quite often real is placed into an LLC “wrapper” to help insulate owners from potential liabilities related to the property.

The taxpayer had granted a remainder interest in the property to a charity and obtained an appraisal of the real property and then used the tables provided for by §7520 to value the remainder interest.

The IRS protested that the wrong asset had been valued—the charity was given the interest in the LLC rather than in the real estate, and thus the interest in the LLC should have been valued. The IRS also argued that the transferred interest was not of a type for which the discount tables found in §7520 can be used.

The Court agreed with the IRS that, in fact, the LLC had to be respected for valuation purposes despite being “disregarded” for federal income tax purposes generally under Reg.§301.7701-2. The Court noted:

            We were faced in Pierre, as we are faced here, with identifying the appropriate property against which to apply the customary willing seller and willing buyer standard (here, as a first step in applying the section 7520 tables). The customary willing seller and willing buyer standard is described in substantially identical language both for valuing charitable contributions of property for income tax purposes and for valuing gifts of property for gift tax purposes. Compare sec. 1.170A-1(c)(2), Income Tax Regs., with sec. 25.2512-1, Gift Tax Regs. See sec. 20.2031-1(b), Estate Tax Regs. (same definition for estate tax valuations). And it is only on account of a charitable contribution deduction provided for in the gift tax statute that gifts to charity are not included in the amount of taxable gifts. See sec. 2522. We see no reason to identify the property to be valued for income tax purposes (and subject to a charitable contribution deduction) differently from the property to be valued for gift tax purposes (and subject to a charitable deduction).

The Court did agree with the taxpayer that it is possible there would be no material in value between the value of the LLC and the underlying real estate. If so, the Court indicated that it would be willing to apply a “no harm, no foul” test on the appraisal—but the Court noted that, due to certain provisions in the various documents, the issue of whether this was a “no harm, no foul” situation was not appropriate to be decided in this proceeding.

Similarly, while the Court agreed with the IRS that it is possible that various issues related to this transaction might make the use of the §7520 tables inappropriate, the Court also found that these were issues to be decided in later proceedings.

The key take away from this case is that advisers need to make sure that qualified appraisals of donations of property held in a SMLLC take note of the existence of the LLC and appraise that asset as the asset donated. While the court left open the door to argue a “no harm, no foul” approach, prudence suggests that it would be best to avoid having to make that argument remember that the taxpayer in this case still has to go to court and prove that the value of the LLC and the underlying real estate are truly the same or the taxpayer will lose the deduction due to not having a qualified appraisal to back up the deduction.

IRS ISSUES LAST SET OF FINAL REGULATIONS FROM TANGIBLE PROPERTY PROJECT RELATED TO GROUP ASSET ACCOUNTS (TD 9689, 8/18/14)

The IRS has issued the last portion of the “repair” regulations, finalizing the rules for general asset accounts under §168(i) in TD 9689 (https://s3.amazonaws.com/public- inspection.federalregister.gov/2014-19403.pdf).

The final regulations generally follow the provisions found in the 2013 proposed regulations issued at the same time as all other final regulations that were part of the tangible asset/repairs project (TD 9636, 9/19/13).

Only minor changes were made to the proposed regulations issued in 2013. One set of changes related to dispositions involving demolition of structures governed by IRC §280B. The preamble describes these changes as follows: In the case of a loss sustained on account of the demolition of a structure to which section 280B and §1.280B-1 apply, however, the loss is capitalized to the land on which the demolished structure was located, and no gain or loss is reported at the time of demolition. Nevertheless, a taxpayer generally will report a depreciation deduction for the demolished structure for the taxable year in which the demolition occurs.

The IRS also clarified rules related to determination of the unadjusted basis when disposing of a portion of a group asset. These rules interact with the revised treatment of buildings under the capitalization regulations for §280(a) by allowing taxpayers to write off, for instance, a structural component of a building (such as a roof) when that component is replaced and required to be capitalized under Reg.§1.263(a)-2.

The preamble notes: The final regulations generally retain the rules in the 2013 proposed regulations on determining the unadjusted depreciable basis of an asset for which general asset account treatment is terminated. Because the general asset account is the asset, the final regulations provide that a taxpayer may use any reasonable method that is consistently applied to all assets in the same general asset account to determine the unadjusted depreciable basis of a disposed asset in that account if it is impracticable from the taxpayer's records to determine the unadjusted depreciable basis of that asset. This rule also applies when the partial disposition rule applies to a disposition of a portion of an asset included in a general asset account. The IRS and the Treasury Department expect that reasonable methods are available that use information readily available or known to the taxpayer and do not necessitate undertaking an expensive study.

These final regulations also provide nonexclusive examples of reasonable methods. These examples are the same examples in the 2013 proposed regulations, except the final regulations do not include the Consumer Price Index as an example of a reasonable method for the reason previously discussed in II.E. Similar to the rules for determining the unadjusted depreciable basis of a disposed asset under §1.168(i)-8, the final regulations clarify that, when discounting the cost of the replacement asset, using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand) is a reasonable method. The examples in the final regulations include the following: (1) discounting the cost of the replacement asset to its placed-in service year cost using the Producer Price Index for Finished Goods (or its successor, the Producer Price Index for Final Demand, or any other index designated by guidance in the Internal Revenue Bulletin (see §601.601(d)(2) of the chapter) only if the replacement asset is a restoration under §1.263(a)-3(k) and is not a betterment under §1.263(a)-3(j) or is not an adaptation to a new or different use under §1.263(a)-3(l); (2) a pro rata allocation of the unadjusted depreciable basis of the general asset account based on the replacement cost of the disposed asset and the replacement cost of all of the assets in the general asset account; and (3) a study allocating the cost of the asset to its individual components.

QSUB INCOME NOT ALLOCATED ON PER DAY BASIS WHEN PARENT REVOKES SELECTION, DESPITE PARENT NOT ELECTING TO CLOSE THE BOOKS (CCA 201433014, 8/15/14) If an S election is revoked by a corporation, absent an election to the contrary, the corporation’s income is split between the portion of the year it was an S corporation and the portion of the year it was a C corporation by allocating items based on the ratio of C to S days in the full year, pursuant to IRC §1362(e)(2).

Reg. §1.1361-5(a) provides that if a QSUB ceases to be a QSUB, it is treated as if the parent contributed assets to a new corporation immediately before the termination, with stock received in exchange.

The question posed in Chief Counsel Advice 201433014 (http://www.irs.gov/pub/irs- wd/201433014.pdf ) is whether the “per day” allocation applies to the QSUB, or whether the “new corporation” rule applies when a QSUB is held by a parent that revokes its S election.

In the case before the IRS, the subsidiary had significant losses following the revocation of the parent’s S status. If the “per day” rule applied, the shareholders of the parent would end up benefitting from those losses. deemed formation of a new corporation. Thus, while income f rom the parent is allocated on a per day basis absent an election otherwise, the subsidiary’s income through the date of the revocation passes on to the S return, while results following that date become part of the new corporation’s return, in this case flowing onto a consolidated C corporation return for the parent.

CORPORATION INCLUDED SUBSIDIARY IN CONSOLIDATED GROUP PREMATURELY, SINCE PARENT DID NOT HAVE RIGHT TO VOTE STOCK (CCA 201414015 AND CCA 201433013, 4/4/14 AND 8/15/14) In Chief Counsel Advice 201414015 (http://www.irs.gov/pub//irs-wd/1414ced015.pdf) the IRS concluded that a corporation had included a new subsidiary prematurely in its consolidated tax return.

In the case in question the taxpayer had agreed to acquire 100% of the stock of a corporation over the course of several purchases. In the first year the parent acquired less than 80% of the stock. The agreement provided that the seller would put all remaining shares into an escrow account, to be released when the buyer at the time the shares were purchased.

Under the agreement, the buyer could acquire shares during the first quarter of year 2 for a price set on the value of the selling corporation immediately before the beginning of year 2. The taxpayer bought shares at that price (which pushed the buyer over the 80% threshold). Both the buyer and seller recorded the sale as taking place on the first day of year 2 and reported the transaction that way in their GAAP financial statements.

The escrow agent delivered the shares to the buyer upon payment, which took place in the first quarter (but not on the first day) of year 2.

The buyer then included the new subsidiary in its consolidated return as of the first day of year 2, and did not file any short year return for the subsidiary since it had acquired it as of the first day of both company’s tax years.

The taxpayer argued that it was under an unconditional obligation to acquire shares sufficient to push it over 80% at a price fixed immediately before the beginning of the tax year. Thus the benefits and burdens of ownership had passed even if legal title transfer and actual possession of the shares did not take place until later.

The memorandum did not agree. It noted that the purchase agreement provided that the sellers maintained voting rights and rights to all distributions up until payment was made and the shares released from escrow.

Thus, the ruling notes, the buyer did not have 80% voting control as of the first day of the tax year. Those voting rights (which are required in order to consolidate the subsidiary) did not pass until payment was made.

The ruling held that the case law on the transfer of benefits and burdens cited by the taxpayer was not relevant with regard to the specific technical requirements of IRC §1504.

The taxpayer was not happy with this ruling and submitted additional information and arguments. The National Office responded with CCA 201433013 (http://www.irs.gov/irs -wd/201433013.pdf) where the same position was taken and the taxpayer’s objections were addressed. The taxpayer presented two arguments:

  • Once the Buyer had over 50% control, the Buyers effectively divested the Sellers of

any useful right to Vote the shares or the right to receive liquidating distributions or dividends, as the Buyer completely controlled the corporation and the entity could not pay a dividend or liquidate unless the Buyer decided it would.

  • The prior ruling failed to take into account the true benefits and burdens of

ownership, and thus is at odds with earlier rulings in the area of §1504.

On the first issue the IRS cites the cases of Handy & Harman v. Burnet, 284 U.S. 136 (1931) and Ice Service Co. v. Commissioner, 9 B.T.A. 386 (1927); affd., 30 F.2d 230 (2nd Cir. 1929) for the position that practical control of a corporation does not provide affiliation.

As well, the ruling notes that even if the voting power theory was accepted (which the IRS does not accept) it is clear that they did not have 80% of the value as of that date, a requirement under §1504(a)(2)(B). The IRS does not accept the view that since the Buyer had to consent to any liquidation or dividend the value had effectively been transferred to the Buyer.

The IRS also did not agree that the Buyers had the benefits and burdens of ownership. The CCA notes that the taxpayer had cited a 2012 Chief Counsel memorandum which provided

  • Which party has the opportunity to share in gain from an appreciation in value of the

stock and bears the risk of loss from a decline in value of the same;

  • Which party has legal title to, and the ability to dispose of, the stock;
  • Which party has the right to vote the stock; and
  • Which party has possession of the stock

Courts have also focused upon the right to receive dividends.

”In this case only the first factor is resolved in favor of the Buyer, as the purchase price was fixed. The memo notes that the Seller retained legal title on the stock, the Buyer had no ability to dispose of the Seller’s stock, the Seller retained the right to vote the stock (albeit, a vote that may not stop anything), an escrow agent had possession of the stock and the Seller retained the right to receive dividends (again, recognizing that the Buyer may very well control whether any such dividends would be paid).

Thus, the memo concludes the same as before the subsidiary may not be consolidated until the 80% control trigger is passed.

FACT THAT TMP WAS UNDER CRIMINAL INVESTIGATION DID NOT INVALIDATE FPAA MCELROY V. COMMISSIONER, TC MEMO 2014-163, 8/12/14

A number of complications arose from the taxpayers’ investments in partnerships that claimed tax benefits that sounded “too good to be true” in the case of McElroy v. Commissioner, TC Memo 2014-163, http://ustaxcourt.gov/InOpHistoric/McElroyMemo.Nega.TCM.WPD.pdf.

The partnerships in question were marked to individuals as a way to obtain tax benefits well in excess of the amounts invested. Specifically Mr. McElroy invested $37,500 in each of three of these partnerships and expected to obtain $50,000 in reduced taxes from each of the investments, though he’d never see his money again.

The partnerships claimed to work this magic by acquiring cemetery sites, hold the sites for over one year, and then contribute the sites to charities.

There were a couple of issues with how this worked in practice. First, the partnerships purchased the properties for $95,639, $169,167, and $252,373 respectively, but then claimed deductions of $1,864,850, $2,936,700, and $5,282,050 for the properties —a growth in value that seemed suspicious. But let us assume it’s possible the promoter was simply that good at finding undervalued cemetery sites —a bigger problem was that the promoter apparently wasn’t very patient. In each case the contributions were made to the charity before a year was up. So regardless of the value of the properties, the partnership’s deductions would have been capped at the partnership’s (rather low) basis in the properties in question.

The IRS began a partnership level examination of the entity under the TEFRA partnership provisions. Later, in January 1999, the IRS Criminal Investigation Division began a criminal investigation into the promoter. In November of 1999 the IRS mailed a request to extend the statute to the promoter, who was also the tax matter partner. The promoter, citing the criminal investigation underway, declined to extend the statute.

The IRS issued an FPAA at that time and mailed it to the promoter, who filed a petition in Tax Court, with the case being continued under a number of motions. In 2005 the promoter was indicted for activities related to the partnership’s tax issues and in 2007 he pled guilty to a portion of the indictment.

In June of 2008 the McElroy’s petitioned the Tax Court to remove the promoter (who was incarcerated at that time) as TMP and appoint them to take over as TMP for the partnership case. The taxpayers continued to serve in that capacity until they were removed due to their own bankruptcy case.

In 2013 the Tax Court issued decisions on the partnership proceedings denying the deductions. The IRS then issued notices to the taxpayer s for 1996, 1997, 1998 and 1999 related to the partnership adjustments.

The taxpayers argued that these adjustments had been issued well after the three year statute of limitations under §6501(a) and the IRS was simply too late. However, generally IRC §6229 extends that statute with regard to partnership items if an FPAA is mailed to a tax matters partner for the partnership on a timely basis.

The taxpayers in this case argued that the promoter, being under criminal investigation at the time, was barred from serving as the TMP and, therefore, no valid FPAA was issued in a timely manner. The Court first held that this issue was one that should have been raised at the partnership level proceeding and since it wasn’t raised there, generally the taxpayers are barred from raising the issue in their personal proceedings.

But the Court found that even if that was not the case and the issue could be raised at this level, the taxpayers would not prevail. The Court notes:

Under the second scenario, we assume without deciding that petitioners' challenge to the validity of the petitions filed in the partnership level proceedings, and petitioners' challenge to the conduct of those proceedings, are proper subjects of this proceeding. Contrary to petitioners' assertion, Mr. Johnston's filing of the petitions as to the FPAAs in his stated capacity as the partnerships' TMP suspended the periods of limitations as to the partnership items underlying the FPAAs until at least one year after our decisions in the partnership level proceedings became final. This is so regardless of the validity of the underlying petitions. See sec. 6229(d) (requiring only that a petition be filed under section 6226 in order to suspend the period of limitations, with no mention to whether the petition must be valid); H.R. Conf. Rept. No. 105 -220, at 679-680 (1997), 1997-4 C.B. (Vol. 2) 1457, 2149-2150 (specifically stating that the period of limitations is suspended notwithstanding whether a petition filed under section 6226 is valid or timely); see also O'Neill v. United States, 44 F.3d 803 (9th Cir. 1995). Not to mention that even if Mr. Johnston failed to qualify to act as the partnerships' TMP (which we need not and do not decide), he was at least a notice partner in that his name, address, and status as a partner were included in each of [*17] the subject Form 1065. See secs. 6223(a), (b), and (c)(1), 6231(a)(8) (providing with respect to partnerships with no more than 100 partners that the term "notice partner" generally includes any partner whose name and address appear on the relevant partnership returns); see also Barbados #6 Ltd. v. Commissioner, 85 T.C. 900 (1985) (holding that the term "notice partner" generally includes any partner whose name and address appear on the relevant partnership returns). Mr. Johnston, as a notice partner, could file the petitions to the extent he could not file the petitions as the TMP.11 See Barbados #6 Ltd. v. Commissioner, 85 T.C. 900.

Thus the disallowance of the charitable deduction for the years in question and assessment of tax could move forward.

The taxpayers then argued they should at least be able to deduct the $37,500 they paid to acquire the partnership interests each year as a loss under IRC §165. The Tax Court ruled against that view. A plan to “make charitable contributions” is not a transaction entered into for profit as required by §165(c)(2). The claimed tax benefits do not provide a “profit motive” for entry into the transactions.

LAST UPDATED 8/18/2014