Federal Tax Update - July 14, 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:

PROPERTY WAS NO LONGER (IF EVER) A RENTAL TRADE OR BUSINESS, INTEREST ONLY POTENTIALLY DEDUCTIBLE AS HOME MORTGAGE INTEREST

Hume and Dilana v. Commissioner, TC Memo 2014-135, 7/7/14

In the case of Hume and Dilana v. Commissioner, TC Memo 2014-135, http://www.ustaxcourt.gov/InOpHistoric/HumeMemo.Wherry.TCM.WPD.pdf, the key question was whether the taxpayers had a rental activity in the years in question which could enable them to claim a deduction for mortgages related to a particular property.

The taxpayers purchased a property in San Clemente, California of minor historic significance (the property had been constructed for Oscar nominated actress Ann Harding in 1926) with a view towards renting out the property for weekly vacations and events. The property had tenants living in it in 2005 at low rent, and the couple evicted them.

However they quickly discovered the property had a number of problems and issues. As well their marriage began to go downhill and in 2006 Mr. Hume moved out of their home and the parties eventually divorced in 2008.

In the years before the court Mr. Hume had lived in the property when he was not traveling, having moved out of the family’s main home.

The Court had to decide if the operation was a trade or business of renting the property. In doing so the court outlined three criteria that would need to be met to find that they had a business: · Did they undertake the activity with the intention of making a profit? The court found that they satisfied this criteria, as there was no evidence they entered it for any reason other as a money making activity. · Was the taxpayer regularly and actively involved in the activity? The Court granted that it was plausible that this criteria was met. · Has the taxpayer’s activity actually commenced? This was where the Court found the taxpayers fell short of the standard (and likely why the court was not concerned about delving too deeply into the question of whether the “regularly and active” test was met.

The problem, the court found, was that it was clear by the years in question (2008 and 2009) that the taxpayer was living in the home, actions that were no longer consistent with the view that a rental activity was underway. In essence, if one had been started in earlier years, by 2008 it had been abandoned.

FAILURE TO ESTABLISH A BONA FIDE DEBT FATAL TO TAXPAYER'S CLAIMED BUSINESS BAD DEBT DEDUCTION

Dickinson v. Commissioner, TC Memo 2014 136, 7/10/14

For a taxpayer to claim a bad deduction, the taxpayer must be able to establish that an actual debt existed. In the case of Dickinson v. Commissioner, TC Memo 2014-136, http://www.ustaxcourt.gov/InOpHistoric/DickinsonMemo.Chiechi.TCM.WPD.pdf, the taxpayer was unable to establish the facts to allow for a bad debt deduction for a loan he claimed to have made to a business partner.

Mr. Dickinson was a self-employed consultant. In 1998 he decided to retain the services of an individual who had previously worked for him. At the time he hired this person, Mr. Dickinson was aware that the individual owed money to his former spouse and children and had a number of financial problems arising from that situation.

Nevertheless, he advanced money to this person in spite of his financial difficulties. He also did not execute a promissory note or any other evidence of the obligation aside from a note he wrote to the individual, stating “I agree to loan you money to get settled in over here, and help you out financially as long as I see our new company is working, and you are going to work as hard as you did for me the last time we worked together.” He never charged the individual interest nor was any repayment schedule.

It turns out that the funds in question were not quite enough—so the employee took funds he was not authorized to withdraw from bank accounts over which Mr. Dickinson had signature authority over.

Eventually the parties went their separate ways and Mr. Dickinson now began to look for ways to get money back, filing suit against the employee. In response the employee claimed that the amounts in question were not loans. The lawsuit was still pending at the end of 2007 and in 2009 the court dismissed the lawsuit.

Mr. Dickinson claimed a business bad debt loss on his 2007 Schedule C for the amounts advanced to the employee. The IRS disallowed the deduction, setting up the case decided by the Tax Court.

The first question the Court looked at was whether or not there was a bona fide debt, since only a bona fide debt can qualify for a bad deduction. Mr. Dickinson claimed it was his usual practice to make such loans in his business and that he did not require written documents.

However, the Court indicated that the only evidence presented on that point was Mr. Dickinson’s own self-serving testimony. While the Court did not expand on this view, it seems reasonable to assume that the Court would have wanted to have heard from individuals to whom Mr. Dickinson had made such loans, both to confirm it was his practice and, likely of even more interest, whether he ever actually looked for repayment of such obligations.

The Court then noted the lack of a number of objective factors that would serve to indicate an actual debt, such as a signed promissory note, collection of interest on the notes, a repayment schedule for the loans, any collateral pledged for such notes and actual repayment on the note.

As well, the Court did not believe, given the employee’s significant financial difficulties at the time the loan was made, that Mr. Dickinson could have had any reasonable expectation of repayment.

While the Court did not comment on the issue, the facts suggest that Mr. Dickinson would have faced another problem even if he had shown it was a bona fide note—the fact that, as of the end of 2007, he was still pursuing collection of the debt in Court. A taxpayer need to establish the fact that there is no longer a reasonable expectation of collecting the balance of the debt and it seems likely with a claim before the Court for repayment in excess of the bad debt claimed that Mr. Dickinson would have failed this test as well.

IRS OFFICIALLY WITHDRAWS PROPOSED REGULATIONS AT ODDS WITH COURT RULING IN THE BOBROW IRA CASE

Bobrow v. Commissioner, TC Memo 2014-21, 1/28/14, Announcement 2014-15, 3/20/14, REG-209459-78, 7/10/14

In the case of Bobrow v. Commissioner, TC Memo 2014-21 (http://ustaxcourt.gov/InOpHistoric/BobrowMemo.Nega.TCM.WPD.pdf) the taxpayers made two errors with regard to attempted rollovers of IRA distributions.

The first error may have been one of documentation. A deposit that was intended to be a completion of the rollover of an IRA of the wife was deposited into the new IRA account on the 61st day following the distribution, one day late. As well, the amount deposited into the IRA was $25,064 less than the amount of the original distribution.

The taxpayers claimed they had instructed the financial institution to transfer the entire amount of the original distribution to the IRA account prior to end of the 60 day period. The failure to make any transfer by the 60th day or to transfer the entire amount were actually financial institution errors, and the taxpayers had actually made an effective transfer prior to that date.

The Court found, however, that the taxpayers presented no evidence to support this earlier directive. There was neither an admission from the financial institution of the error, nor any documentation provided by the taxpayers of their directive to the financial institution aside from their claim they had done so. Thus the Court found no amount had been properly rolled from the wife’s distribution and thus the entire amount was taxable.

The husband’s rollovers posed a different problem. On April 14, 2008 the husband requested and received a distribution from his “regular” IRA account with the financial institution in the amount of $65,064. On June 6, 2008 the taxpayer requested and received a distribution from a “rollover” IRA account he held with the same institution in an identical amount to the April 14 distribution.

On June 10, 2008 the taxpayer placed $65,064 into a traditional IRA. On August 4, 2008 the taxpayer placed $65,064 into another IRA.

The IRS disputed the contention that there was a proper rollover of the June 6 distribution. The problem was not that it was past 60 days—it wasn’t. Rather, the IRS pointed to IRC §408(d)(3)(B) which provides that a distribution does not qualify for rollover if the taxpayer had received any funds from an IRA account during the one year period prior to the distribution that had been excluded from income under the rollover rules.

In this case, once the taxpayer completed the rollover of the April 14 distribution the taxpayer was not eligible to rollover the June 6 distribution.

The taxpayer attempted to argue that this limitation should apply on an account by account basis. However, the Court noted that the language of the statute does not provide for any such “account by account” test and that the language rather clearly implies that a rollover from any IRA account will taint the beneficiary for a full year.

How a taxpayer come to the conclusion that each IRA is tested separately for this purpose? Although not mentioned as a factor in the taxpayer’s decision in this case, in fact Publication 590 (2013 edition) said that such a transaction was just fine. Or, at least, the example given after an explanation that implied the taxpayer could do this does exactly what Mr. Bobrow did.

While the IRS may very well change the wording of Publication 590 following this case (especially since RIA pointed out this issue in their reporting of the case), the 2013 Publication 590 provision is reproduced below:

Even more interestingly, the IRS in 1981 had published proposed regulations (though they never became final) that implemented the same “IRA by IRA” test. Proposed Reg. §1.408-4(b)(4)(ii) also clearly supported what Mr. Bobrow had done.

While it may seem that it is “unfair” for the IRS to take an inconsistent position in court, the reality is that the law and not the publications control outcomes, and the Courts have ruled that the IRS is not bound by either the publications or instructions. And this case is not the first where the IRS has won a case taking a position contrary to a publication.

Similarly the Court effectively ruled that the Code itself denied the option for an IRA by IRA treatment. So the regulation, not only being merely proposed, arguably is at odds with the unambiguous language of the law.

The publications may only be used to establish reasonable cause by a taxpayer seeking to escape penalties—but not the actual tax assessment. However, as a practical matter the publications often will cause an agent to stop pursuing an issue if the text in the publication is pointed out to the agent and clearly applies to the matter at hand.

It may not be coincidental that this “contrary to publications” and “contrary to proposed regulations” ruling does not mention the publication or proposed regulations—it may simply be that neither the taxpayer nor the IRS Counsel ever looked in either place. That appears to have been the case in some prior cases where a “contrary to publications” result has been obtained.

In fact, following the issuance of the decision the taxpayers asked the Tax Court to reconsider its ruling. The American College of Tax Counsel filed an amicus brief supporting the taxpayer's request. In its order, dated appropriately April 15, 2014 (https://www.ustaxcourt.gov/InternetOrders/DocumentViewer.aspx?IndexSearchableOr dersID=131933), the Tax Court denied the request.

The Court first noted that the matter had not been raised by the taxpayer at trial and the taxpayer admitted that it should have been raised prior to the decision. However, the Court went on to explain:

The Court was aware of the position taken in Publication 590 prior to the issuance of the opinion in this case. Since neither party discussed Publication 590 in their briefs, the Court did not address it in its holding. Regardless, respondent's published guidance is not binding precedent. See Johnson v. Commissioner, 620 F.2d 153 (7th Cir. 1980), affg, T.C. Memo. 1978-426; Carpenter v. United States, 495 F.2d 175 (5th Cir. 1974); Adler v. Commissioner, 330 F.2d 91, 93 (9th Cir. 1964), affg, T.C. Memo. 1963-196. Additionally, taxpayers rely on IRS guidance at their own peril. Miller v. Commissioner, 114 T.C. 184, 194-195 (2000), affd sub nom. Lovejoy v. Commissioner, 293 F.3d 1208 (10th Cir. 2002). Thus, had petitioners argued reliance on Publication 590 in their briefs, such an argument would not have served as substantial authority for the position taken on their tax returns.

Note that the Court also denied penalty relief in this case, holding that such a reliance would not have constituted "substantial authority" (the trigger for relief from the substantial understatement penalty). All may not lost on penalties, though. Since the parties never mentioned the issue, the Court did not address whether (as seems likely) such reliance would have been reasonable cause that could have granted alternative relief from the penalty. However, since no one claimed to have relied upon this publication, the publication did not serve to mislead the taxpayers (at least not directly-- it is still not clear how the taxpayer truly originally arrived at the belief that this worked).

However, following the case the IRS found a bit of an uproar taking place, as financial institutions complained that they had relied upon the publication’s statements and their systems were not programmed to reject rollovers in cases where a rollover had been made from another account within the year and their disclosure documents also contained the incorrect (though in line with the IRS Publication) statements regarding allowed rollovers.

In Announcement 2014-15 (http://www.irs.gov/pub/irs-drop/a-14-15.pdf) the IRS announced that it would not apply the Bobrow interpretation that imposed an aggregate limitation on any distribution taking place before January 1, 2015. However, the IRS does indicate in the announcement that it expects to issue regulations that will provide for such an aggregate limit, though not having an effective date before the January 1, 2015 date.

In July the IRS also finally got around to “cleaning up” the hanging proposed regulations. In REG- 209459-78 the IRS officially the withdrew the 1981 proposed regulations.

Many clients have read about the ability to “borrow” from an IRA. In fact, this case appears to be just such a case of a client attempting to use IRA funds for such purposes. However, like this taxpayer, few have ever heard of the “one year” limitation on such rollovers. And, as this taxpayer discovered, ignorance of the provision can prove very costly.

USE OF §121 GAIN EXCLUSION DOES NOT BLOCK TREATMENT OF SALE AS FULLY TAXABLE DISPOSITION FOR PASSIVE LOSS PURPOSES

Chief Counsel Advice 201428008, 7/11/14

If a taxpayer sells a rental property formerly used as the taxpayer’s principal residence that has been used as a rental, there is the possibility that §121 may be available to be used to exclude gain from the sale of the rental. But if the rental activity has unused passive losses, does invoking §121’s gain exclusion prevent the ability to release the excess losses under IRC §469(g)(1)’s special rule for dispositions?

Generally, IRC §121 allows for exclusion of up to $250,000 of gain ($500,000 for a married couple filing a joint return) from the sale of property that was owned and used by the taxpayers as their principal residence for two of the five years immediately before the sale.

IRC §469(g)(1) provides: (1) Fully taxable transaction. (A) In general. If all gain or loss realized on such disposition is recognized, the excess of— (i) any loss from such activity for such taxable year (determined after the application of subsection (b) ), over (ii) any net income or gain for such taxable year from all other passive activities (determined after the application of subsection (b)), shall be treated as a loss which is not from a passive activity.

Chief Counsel Advice 201428008, http://www.irs.gov/pub/irs-wd/201428008.pdf, deals with that situation.

The ruling concludes that the use of §121 does not serve to create a transaction that is not a “fully taxable transaction” under IRC §469(g)(1)(A). The ruling finds that: Section 121 is not a nonrecognition provision for property exchanges. Nonrecognition Code sections generally provide "no gain or loss shall be recognized." The sale of a principal residence is not an exchange of reciprocal property in which particular differences exist between the property parted with, and the property acquired, but such differences are more formal than substantial. Rather a sale of a principal residence is a transfer of property for money consideration and, as such, gain realized on the sale is recognized in the year of the sale. Section 121 is simply an exclusion provision for gain that is realized and recognized in the year of sale.

The memo notes that §121 simply says the gain shall not be included in gross income if the election is made. It is, as noted above, nevertheless recognized in the view of the memo.

The memo does conclude, though, that the excluded gain is not an item of passive income and thus cannot be used to “free up” losses from other passive activities.

IRS CAN NOTIFY WITHHOLDING AGENT IT CAN NO LONGER RELY ON W-8ECI IF FOREIGN TAXPAYER FAILS TO FILE U.S. TAX RETURN

Chief Counsel Advice 201428007, 7/11/14

In Chief Counsel Advice 201428007, http://www.irs.gov/pub/irs-wd/201428007.pdf, the IRS Chief Counsel’s office advised that the IRS may notify a withholding agent that a beneficial owner’s claim of exemption from withholding for effectively connected income is in error due to the failure of that owner to file a U.S. income tax return.

Generally, as the memo notes, IRC §§1441 and 1442 require a withholding agent to withhold 30 percent any U.S. fixed or determinable, annual or periodic income made to a foreign person subject to withholding. However, IRC §1441(c)(1) provides an exception to mandatory withholding for any item of income effectively connected with the conduct of a U.S. trade or business which is included by the owner in gross income under §871(b)(2).

Generally a withholding agent may rely upon a claim of exemption unless the withholding agent has reason to know that the claim is invalid. [Reg. §1.1441-4(a)(2)] As well, if the agent receives notification from the IRS that the claim of exemption is invalid, the agent must begin withholding within 30 days after receiving the notice. [Reg. §1.1441-7(b)(1)]

The memo concludes that since the foreign taxpayer (referred to as the “beneficial owner, or BO, in the memo) had signed a Form W-8ECI that contains language indicating that the BO must file an annual U.S. tax return to claim this status, the IRS, having established that such returns are not being filed, has evidence the claim of exemption is invalid and can notify the withholding agent.

The agent then has 30 days from receipt of that notice to begin withholding. If the agent fails to do so, it may be subject to liability for any tax due under IRC §1461.

If the foreign taxpayer eventually does file a tax return for a year when tax is withheld, it will be able to claim credit for the tax withheld.

ERRONEOUS ADVICE SERVED OBTAINED FROM TWO CPAS DEEMED TO ALLOW TAXPAYER TO ESCAPE SUBSTANTIAL UNDERSTATEMENT PENALTY

English v. Commissioner, TC Summary Opinion 2014-66, 7/11/14

Reasonable reliance on a tax professional can serve to get taxpayers out of the accuracy related penalty of IRC §6662. In the case of English v. Commissioner, TC Summary Opinion 2014-66, http://www.ustaxcourt.gov/InOpHistoric/EnglishSummary.Gerber.SUM.WPD.pdf, the taxpayers were able to use what turned out be erroneous advice to escape the penalty (albeit, not the tax) on an assessment.

Cheryl English had been receiving disability payments from Hartford Insurance after she became disabled in 2007 and could no longer work. The policy provided that her benefits would be reduced if she qualified for Social Security disability benefits. While she applied for such benefits in 2007, she did not receive any in 2007, 2008 or 2009.

In 2010 she was finally awarded Social Security benefits of $49,610 for her prior years and thus had to repay Hartford Insurance $48,144. Since the Hartford benefits had been excluded from Cheryl’s income when paid as disability benefits, she wondered if she might be able to exclude the Social Security benefits that she had to require to pay back to Hartford Insurance.

To answer that question she consulted two CPAs and they generally advised her that the benefits would not be taxable. The return for the couple was prepared by a CPA who did not include the benefits as taxable income, though the Court did not indicate if this was one of the two CPAs from whom they initially sought advice.

The IRS disagreed with that view, seeing the payment as being simply Social Security benefits and the Tax Court concurred. The Court noted: Section 86 provides that a taxpayer's gross income includes up to 85% of Social Security benefits, including disability benefits, received during the taxable year. However, for purposes of that section, taxpayers may reduce Social Security benefits by repayments of other Social Security benefits previously received. Sec. 86(d)(2)(A). A Social Security benefit is defined as "any amount received by the taxpayer by reason of entitlement to--(A) a monthly benefit under title II of the Social Security Act, or (B) a tier 1 railroad retirement benefit." Benefits received from private insurers, such as Hartford, do not satisfy this definition.

As the understatement of tax exceeded 10% of the amount required to be shown on the return and was also greater than $5,000, the threshold for the substantial understatement accuracy related penalty under IRC §6662(b)(2) and (d)(1) was initially triggered.

However, the penalty is not applicable if the taxpayer can show she acted with reasonable cause and in good faith. [IRC §6664(c)(1)]

In this case, the Court noted that the underlying is “curious” stating: Congress saw fit to make a certain percentage of Social Security benefits taxable, even if the payments are for a disability. Congress also provided that in circumstances where Social Security benefits had to be repaid, the initial receipt of the benefits would not be taxable. The disparate treatment of private and public disability benefits for tax purposes is curious and somewhat confusing.

Noting that Cheryl looked to two CPAs for advice on the situation and was told the Social Security was not taxable to the extend it was used to repay the tax free disability benefits, the Court had to decide if that was acting in reasonable cause and with good faith. The Court found that it did.

Note that even though the advice was in error, the taxpayer still escaped the penalty due to reliance on the work of a professional. Generally such reliance is deemed to create reasonable cause if the taxpayer can show: · The taxpayer sought out the advice of a professional whom they reasonably determined (based on the taxpayer’s own knowledge and sophistication) was competent to give such advice; · The taxpayer provided the adviser will all information they believed to be relevant, as well as any information the adviser requested and · The advisor was not a promoter of the transaction in question (and whose advice therefore cannot be reasonably assumed to be unbiased).

Advisers should be aware that due to the existence of this defense, the director of the Office of Professional Responsibility has commented multiple times that an adviser who prepared the return and then represents the client before the IRS must consider whether an impermissible conflict of interest exists in representing the client if the adviser’s own work becomes an issue.

LAST UPDATED 7/14/2014