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Federal Tax Update - July 28, 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:
TAX UPDATE JULY 28, 2014
FACT MOTHER NAMED CUSTODIAL PARENT IN DIVORCE DECREE NOT RELEVANT TO DEPENDENCY EXEMPTION WHEN CHILD SPENT MORE NIGHTS WITH FATHER Davis v. Commissioner, TC Memo 2014 147, 7/24/14
In the case of Davis v. Commissioner, TC Memo 2014-147, http://www.ustaxcourt.gov/InOpHistoric/DavisMemo.Thornton.TCM.WPD.pdf, the IRS mistakenly believed the fact that a divorce decreed named the other parent as the custodial parent meant that Patrick Davis could not claim his daughter as a qualifying child and obtain an earned income credit based on having her as a dependent.
Mr. Davis was divorced from Sandra Johnson Davis in 1997, and in 2000 a court gave custody of their two children to Sandra. One child, Ashley, turned 20 in 2010 and was a full-time student. In 2010 she lived with Patrick Davis’s mother (her paternal grandmother). Mr. Davis also resided with his mother.
The IRS challenged Mr. Davis for claiming Ashley as a dependent. However, regardless of what a state court decree may say, federal law determines dependency status. Mr. Davis had claimed Ashley was a qualifying child. As the court pointed out:
Generally, a “qualifying child” must: (1) bear a specified relationship to the taxpayer; (2) have the same principal place of abode as the taxpayer for more than one-half of the taxable year; (3) meet certain age requirements; (4) not have provided over one-half of his or her own support for the year in question; and (5) not have filed a joint return (other than a claim for refund) with a spouse. Sec. 152(c)(1).
The IRS contended that while Patrick Davis met the first and last requirement, he failed to meet the other three requirements and thus Ashley was not his qualifying child.
The Court addressed the question of meeting the tests by noting the IRS was mistaken in its assumptions here. As the Court held: The Louisiana court judgment named Ashley’s mother as her custodial parent. Apparently for that reason, respondent contends that petitioner was a noncustodial parent in 2010 and so cannot claim Ashley as his qualifying child because he did not attach to his 2010 return a written declaration from Ashley’s mother waiving her right to claim Ashley as her dependent, as respondent contends section 152(e) required. Respondent is mistaken. The special rule of section 152(e) is inapplicable because, if for no other reason, in 2010 petitioner was in fact Ashley’s custodial parent within the meaning of the statute. A custodial parent is defined as “the parent having custody for the greater portion of the calendar year.” See sec. 152(e)(4)(A).
The regulations simply “count the nights” to determine a custodial parent status, and don’t look to who was awarded such status if, in fact, the child did not reside with that person. [Reg. §1.152-4(d)(1)]
Even though Ashely did not reside at a residence owned or rented by Mr. Davis, the Court noted: According to the regulations, a child is treated as residing with a parent for a night if: (1) the child sleeps at the residence of the parent or (2) if the child sleeps in the company of the parent when the child does not sleep at a parent’s residence. Sec. 1.152-4(d)(1)(i) and (ii), Income Tax Regs. Because Ashley resided with petitioner at her grandmother’s house more than half of 2010, petitioner was the custodial parent and was not required to attach a written declaration to his return.
The opinion goes to note that the evidence shows that Ashley received over ½ of her support from the family members and, by virtue of being a full-time student, met the age requirements even though she was age 20.
The Court did note one potentially significant issue that was not raised—that is, given Ashley’s age, could she really have a custodial parent. In a footnote the court noted that it seemed very possible that since Ashley was over age 18, she would be emancipated under state law and thus not technically in the custody of either parent. But the Court noted that the parties hadn’t raised this issue and so the Court did not consider its impact.
ORGANIZATION OFFERING QUALIFIED PLANS TO ATTORNEYS ONLY NOT A TAX EXEMPT BUSINESS LEAGUE
ABA Retirement Funds v. United States, CA7, 114 AFTR 2d ¶2014 5081, 7/26/14
The ABA Retirement Funds filed a refund claim with the IRS, arguing the entity should qualify as a business league under IRC §501(c)(6). However, the Seventh Circuit disagreed with this view (ABA Retirement Funds v. United States, CA7, 114 AFTR 2d ¶2014-5081, http://caselaw.findlaw.com/us-7th-circuit/1673437.html).
Under IRC §501, one of the allowed tax exempt organization is described at §501(c)(6) as: (6) Business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.
As the Court of Appeals noted, that doesn’t provide a lot of details. So the IRS filled in details at Reg. §1.501(c)(6)-1. That regulation provides: A business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. It is an organization of the same general class as a chamber of commerce or board of trade. Thus, its activities should be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons. An organization whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self-sustaining, is not a business league. An association engaged in furnishing information to prospective investors, to enable them to make sound investments, is not a business league, since its activities do not further any common business interest, even though all of its income is devoted to the purpose stated. A stock or commodity exchange is not a business league, a chamber of commerce, or a board of trade within the meaning of section 501(c)(6) and is not exempt from tax. Organizations otherwise exempt from tax under this section are taxable upon their unrelated business taxable income. See part II (section 511 and following), subchapter F, chapter 1 of the Code, and the regulations thereunder.
In this case ABA Retirement Funds marketed retirement programs to attorneys. In doing so, it received a fee based on a percentage of assets under management by the Plan. The organization also took on the role of creating and maintaining an IRSapproved master tax-qualified retirement plan and took on the role of plan fiduciary. By doing so, the organization relieved employers who adopted their program from being forced to undertake those roles for compliance with ERISA.
As the Court noted, this arrangement competed with other plans in the market—plans run by entities that were subject to income tax on their net earnings.
However, ABA Retirement Funds claimed that they should qualify for §501(c)(6) treatment as their goal was to improve business conditions for the legal profession by insuring attorneys had the peace of mind of knowing they had a plan in place for their retirement.
While the Court of Appeals agreed that it’s probably a good thing for attorneys to look after their retirement, that’s really no different than for any other group. As well, the principal benefit accrued to the individual attorneys rather than to the legal profession as a whole. The court noted that while a business league could offer a service like this part of its service to the industry, in such a case the item must be incidental to the overall purpose of the organization. However, if such activities become substantial then tax exempt status is not warranted—and, in this case, such activities were the only activity of the organization.
As well, the Court noted this sole activity was one regularly carried on for profit by nonexempt organizations. The Retirement Fund pointed out that one of the requirements for the IRS to grant approval to their retirement was that the organization be “similar to” a business league. Thus, the Retirement Fund argued, the IRS had conceded they were a business league due to having approved the plan.
The Court addressed this by discussing art and baking, of all things. It noted that one might argue a cucumber has characteristics “similar to” a zucchini—that is, it is green and shaped similarly to a zucchini, so that it might, the court argued, to stand in for a zucchini in an impressionist still life.
But similar to doesn’t mean that it is a zucchini—and that while its similarity is fine for the still life, it doesn’t mean it could then be substituted as an ingredient when looking to bake a loaf of zucchini bread.
Similarly, while the organization was “similar to” a business league for qualified plan purposes, that doesn’t mean it is a business league for purposes of being treated as a tax-exempt organization.
FINAL REGULATIONS CLARIFY THAT PARTNERSHIP MAY NOT WRITE OFF UNAMORTIZED START-UP COSTS OR PARTNERSHIP ORGANIZATION COSTS DUE TO A TECHNICAL TERMINATION. TD 9681, 7/23/14
The IRS issued final regulations (TD 9681, http://www.gpo.gov/fdsys/pkg/FR-2014-07- 23/pdf/2014-17335.pdf) regarding technical terminations of a partnership to clarify that a technical termination under IRC §708(b)(1)(B) does not entitle a partnership to deduct unamortized start-up expenses under IRC §195 or partnership organizational expenses under IRC §709.
Some partnerships had taken the position that when a technical termination takes place that the partnership may write off any unamortized start-up costs under IRC §195 and partnership organization expenses under IRC §709.
The regulations make revisions to Regs. §1.195-2, §1.708-1 and §1.709-1.
The rules are effective for a technical termination occurring on or after December 9, 2013.
IRS FINALIZES REGULATIONS REGARDING "BONA FIDE" DEBT RULES FOR S CORPORATIONS TD 9682, 7/23/14
In TD 9682 (https://s3.amazonaws.com/public-inspection.federalregister.gov/2014- 17336.pdf) the IRS issued final regulations applying a “bona fide” debt standard to debts that are to be allowed to be used in providing basis in S corporations.
The regulations are meant to replace the “actual economic outlay” standard used by courts in S corporation basis cases. Under the new regulations, the S corporation shareholder will get basis if the debt is “bona fide” debt, as determined under general Federal tax principles and depends on all facts and circumstances. [Reg. §1.1366-2(a)(2)(i)]
The regulation also continues to require that a shareholder will only get to increase basis for guaranteeing an S corporation when and if the shareholder actually makes a payment on the debt. [Reg. §1.1366-2(a)(ii)]
The IRS includes four examples with the regulations, but each example simply comes to the conclusion that if the debt in the various circumstances (original shareholder loan, back to back loan, loan distributed to shareholder from another entity and payment on a guarantee) is a bona fide debt under general Federal tax principles, then the shareholder will be given credit for additional basis.
The “general Federal tax principles” are those that have been established in cases decided under other provisions of the IRC (such as debt vs. equity cases in corporate settings, the reality of debt when a bad debt is claimed, etc.). Similarly, the rule would make less relevant prior S corporation cases looking at whether debt “counts” for basis purposes.
The rules apply on and after July 23, 2014. Taxpayer may elect to apply these rules to earlier periods.
IRS NOT PROHIBITED FROM ISSUING NOTICE OF INTENT TO LEVY DURING PENDENCY OF INSTALLMENT AGREEMENT Eichler v. Commissioner, 143 TC No. 2, 7/23/14
In the case of Eichler v. Commissioner, 143 TC No. 2, http://www.ustaxcourt.gov/InOpHistoric/EichlerDiv.Thornton.TC.WPD.pdf, the issue was what, exactly, IRC §6331(k)(2) prohibits the IRS from doing. Nichols Patrick Tax Update 7 July 21, 2014
The parts of that provision in question provide: (2) Installment agreements No levy may be made under subsection (a) on the property or rights to property of any person with respect to any unpaid tax -
(A) during the period that an offer by such person for an installment agreement under section 6159 for payment of such unpaid tax is pending with the Secretary;
(B) if such offer is rejected by the Secretary, during the 30 days thereafter (and, if an appeal of such rejection is filed within such 30 days, during the period that such appeal is pending);
The taxpayer’s representative submitted a proposed installment agreement in April 2011. In early May the IRS issued a Letter CP 90, Final Notice—Notice of Intent to Levy and Notice of Your Right to a Hearing.
The taxpayer’s representative filed a request for a hearing timely and, argued with the request that the Letter CP 90 had been prematurely issued, as the taxpayer had an installment agreement proposal pending when the letter was issued.
It turns out that, for whatever reason, the IRS did not actually enter the status of the installment agreement request into their computer system until June. As well, IRM 188.8.131.52.2.8 directs the IRS Collections Division to rescind notices of intent to levy in various circumstances, including one where the taxpayer has an installment request pending and the taxpayer timely requests an Appeals hearing.
However, the settlement officer determined that, in fact, the letter should not be rescinded. She did determine that she would accept an installment agreement, but only if the taxpayer made a down payment of $8,520.
The taxpayer argued two issues before the court: The original letter CP 90 was barred from being issued at the time it was issued and The settlement officer abused her discretion by demanding the down payment as a condition for the installment agreement given the financial data provided to her.
The Court concluded that, in fact, all that IRC §6331(k)(2) prohibited was an actual levy by the IRS—and that the IRS had not done that. Rather they had issued the Notice of Intent only.
The Court went on to note that the IRM is not binding on the IRS. As well, the provision in question was directed at the Collections Division and not appeals. As the settlement officer is an appeals officer, she would look towards those provisions in the IRM directed towards appeals. IRM 184.108.40.206.2.2(5) directs Appeals should not rescind a notice of intent to levy while an installment agreement is pending, even if an actual levy is blocked by the statute.
The Court found that the record of the Appeals hearing did not provide enough information to determine if the special financial condition of the taxpayers had been considered, the Court remanded the case to Appeals for an explanation from the settlement officer about the reasons why she found the down payment reasonable given the concerns raised at the hearings with regard to the taxpayer’s age and financial condition.
TAXPAYER WHO GAVE CONTRACTOR RESTRICTIVELY ENDORSE CHECK IN PAYMENT OF DISPUTED DEBT FOUND LIABLE FOR ISSUING FRAUDULENT 1099 Shiner v. Turnoy, 114 AFTR 2d 2014-5179, USDC ED IL, 7/11/14
The case of Shiner v. Turnoy, 114 AFTR 2d 2014-5179, http://www.gpo.gov/fdsys/pkg/USCOURTS-ilnd-1_13-cv-05867/pdf/USCOURTS-ilnd- 1_13-cv-05867-1.pdf, illustrates a number of interesting factors in the area of taxes, though it arises out of a business dispute between the parties. In the end, though, David Shiner found himself stuck with liability due to fraudulently filing a Form 1099.
David Shiner had agreed to divide certain insurance commissions evenly with Bernard Turnoy. At the end of 2012 David told Bernard that he had received $298,000 in total in commissions. Bernard protested that the actual amount was much higher.
David ignored Bernard’s complaints and rather decided to try to put the matter to rest by issuing Bernard a check for $149,000 with a note on the reverse side, where the check would be endorsed, that endorsing the check would constitute a full and absolute release of any additional claims against David by Bernard. He also informed Bernard that the $149,000 would be reported on a Form 1099 to be issued to Bernard.
Bernard did not cash the check but rather filed suit the following day. While Bernard did not immediately return the check, he did not cash it and in August of 2013 eventually returned it.
David in January met with his CPA and told him he had paid Bernard $149,000 for his share of the commissions. He did not inform the CPA about either the dispute or the restrictive endorsement note he had placed on the check. His CPA advised him that he was required to file a Form 1099 for the payment to Bernard for 2012 and David filed the Form 1099.
The Court noted that the general rule is that a creditor cannot escape having constructive receipt of income (and therefore become taxable on it if reporting on the cash basis) by failing to cash a check. The mere receipt of the check is generally considered constructive receipt.
However, the Court found that this is different, presenting the same issue the Tax Court had dealt with in the case of Bones v. Commissioner, 4 TC 415 (1944). Where there is a legitimate dispute over the amount of the debt, the placing of a restrictive endorsement on the check gives the creditor the right to reject the payment and, therefore, not be subject to tax based on the receipt of the check.
In this case it was clear that the point of the endorsement was to force Bernard to put his position regarding the right to additional compensation at risk, being sent along with the implied threat that “you’ll need to pay tax on this anyway” so that he risked owing tax but not having cash if he did not cave in on the matter. The Court, not surprising, decided this looked like a bad faith issuance of a Form 1099 and found David liable under IRC §7434(a) for damages for having willfully filed a fraudulent Form 1099.
But David protested that his CPA had told him he had to file the form, so he was just following professional advice. The Court noted that while reliance on a professional might serve as a defense in the proper circumstance, this wasn’t it.
The key problem was that David failed to disclose facts to the CPA (specifically the dispute over the amount of the fees and the existence of the restrictive endorsement) when seeking the CPA’s advice. Failing to turn over information the individuals either knows or should have known was relevant is fatal to a claim of reasonable reliance on professional advice.
The case illustrates the risks that a taxpayer undertakes when they decide to use a Form 1099 to threaten or punish another party, something that all too often clients who get into disputes want to do. A CPA should be sure to advise a client about the risks under §7434(a) if a Form 1099 is found to be issued in “bad faith” and generally should suggest clients limit the use of such forms to cases where they are required if the taxpayer wishes to avoid having additional (and likely expensive) additional litigation, as well as the risk of owing penalties to the party that they wanted to see “punished” for some bad act.
LAST UPDATED 7/28/2014